Too-big-to-fail banks are generating plenty of anger from the public, but former Secretary of State Hillary Clinton says the real risks to the financial system lie in the vast, lightly regulated corners of the economy called shadow banks.
Under fire for her ties to Wall Street, Clinton increasingly has talked about the need to crack down on the hedge funds, private equity firms, money market funds and derivatives traders that perform many of the same functions as banks without being regulated the same way.
While shadow banks like these are more heavily regulated than they were before the 2008 financial crisis, the International Monetary Fund warned in October 2014 that their unchecked growth "could compromise global financial stability."
Clinton's opponent, Vermont Sen. Bernie Sanders, has emphasized shadow banking less, but maintains that his overall platform is much tougher on Wall Street than Clinton's.
Coined by former PIMCO economist Paul McCulley, the term "shadow banks" usually refers to institutions, such as money market funds, which take in trillions of dollars in assets from customers and then lend much of it out, by buying short-term debt or purchasing bonds, for example.
Unlike commercial banks, the holdings in such entities aren't insured by the federal government, which means that in a crisis, they may be susceptible to runs. They also don't have access to a key source of liquidity for banks, the Federal Reserve's discount window, according to a report from the Federal Reserve Bank of New York.
"They're sold and marketed as incredibly stable funds where you put in a dollar, you get a dollar out. But there's no guarantee of that, and there's no deposit insurance of that, as there is in a regulated bank," says Dennis Kelleher, president and CEO of Better Markets, a nonprofit group that advocates for reform in the financial sector.
In 2008, the Treasury Department was forced to insure the holdings of publicly offered money market funds, after a fund that had been caught up in the Lehman Brothers disaster "broke the buck" by paying back only 97 cents on the dollar.
Hedge funds represent a similar risk, says Lawrence White, professor of economics at New York University's Stern School of Business.
"The money you put into a hedge fund is not guaranteed at all by anybody, and if you're worried that your hedge fund is going to start losing money, you may start pulling that money out," White says.
While hedge funds and money market funds are usually too small to cause systemic problems for the economy, large bank holding companies are another story: Many of them engage in shadow banking through their less-regulated subsidiaries.
In the aftermath of the financial crisis, traditional banks tightened credit, and shadow banks increasingly filled the void, shifting the "locus of risks" to less-regulated parts of the industry. That shift could "compromise global financial security," the IMF warned in 2014.
Clinton has warned that focusing too much on breaking up the big banks — something she suggests Sanders does — obscures the bigger threat posed by these shadow banks.
"There were a lot of bad actors" behind the 2008 financial crisis, Clinton said at a Feb. 3 town hall meeting New Hampshire, "and if all you do is look over here, I'm telling you, they're going to be over there in the shadow banking sector just cooking up all kinds of ways to once again put our economy at risk."
She has proposed a number of steps to curb shadow bank activities, such as enhancing reporting requirements for hedge funds and private equity firms and imposing stricter collateral requirements on repurchase agreements, a risky form of short-term debt.
NYU's White says Clinton has a point when she talks about the continuing threat posed by shadow banking, in areas such as money market funds. Even so, he notes, "That shouldn't blind us to the fact that the regulatory system is much tougher and robust today than it was eight years ago. No question in my mind about that."
Global and U.S. regulators have imposed many changes on the banking system, making banks better capitalized and more closely scrutinized than they used to be, White says.
Anat Admati, professor of finance and economics at Stanford's Graduate School of Business, says many regulations are already in place to accomplish the reforms Clinton advocates, but regulators don't always want to enforce them.
"Yes, we know that there are all these risks, but we also have some tools to deal with them right now. So what is she saying to the fact that the regulators are not doing them right now?" said Admati, author of The Bankers' New Clothes: What's Wrong With Banking And What To Do About It.
Clinton campaign officials say she believes some regulations can be strengthened, such as those that apply to the Financial Stability Oversight Council, which is supposed to monitor excessive risk-taking by financial institutions.
A Sanders campaign official called "preposterous and absurd" any suggestion that Clinton's focus on shadow banks might make her a more effective opponent against Wall Street, noting her paid speeches to Goldman Sachs and other firms.
Warren Gunnels, policy director for the Sanders campaign, said Sanders' plans, which include a tax on all Wall Street financial transactions, would be much tougher on financial institutions, including shadow banks, than those proposed by Clinton.
"Bernie is committed to hiring the strongest regulators who will actually implement rules that would be stronger than Clinton's. And Bernie's regulators will actually enforce these rules," Gunnels said.
STEVE INSKEEP, HOST:
Let's listen to an effort to broaden the debate over banking. Presidential candidate Bernie Sanders says that if he is president, one of his first acts will be to break up big banks. His Democratic rival, Hillary Clinton, says big banks are just part of the problem. And she focuses a lot on what's called shadow banking. As NPR's Jim Zarroli reports, the shadow banking system contains trillions of dollars in assets, much of it held by financial firms like hedge funds, which are less regulated than traditional banks.
JIM ZARROLI, BYLINE: Hillary Clinton has faced plenty of criticism about her ties to the financial industry. And she has responded with a series of proposals that she says are meant to get tough on Wall Street. At a recent town hall in New Hampshire, Clinton said going after the big banks isn't enough to prevent the kinds of activities that sank the economy in 2008.
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HILLARY CLINTON: There were a lot of bad actors. And if all you do is look over here, I'm telling you, they're going to be over there in the shadow banking sector just cooking up all kinds of ways to once again put our economy at risk.
ZARROLI: Just what constitutes the shadow banking sector is open to some interpretation. But it's generally considered to consist of financial institutions that perform a lot of the same functions as banks without being regulated the same way. Dennis Kelleher, who heads the reform group Better Markets, says money market funds are one example.
DENNIS KELLEHER: They are sold and marketed as incredibly stable funds where you put in a dollar you get a dollar out. But there's no guarantee of that. And there's no deposit insurance of that as there is in a regulated bank.
ZARROLI: Like banks, money market funds take in money from customers and then lend it out again by buying bonds, for instance. But unlike commercial banks, their holdings aren't insured. The same is true of hedge funds and private equity firms. NYU economics professor Lawrence White says, in a crisis, of a lot of people could try to withdraw their money from these places at the same time.
LAWRENCE WHITE: If the holders of those short-term claims on these shadow banks start to become nervous, we can see runs. And that's exactly what happened in 2008.
ZARROLI: Some people say these shadow banks represent a big potential liability for the financial system and for the economy. And Clinton has proposed steps to regulate these shadow banks more tightly, such as requiring certain funds to hold more capital on hand. For his part, Bernie Sanders doesn't emphasize shadow banking as much. But he says his overall platform would be much tougher against Wall Street than Clinton's would be. Lawrence White says Clinton has a point. Shadow banking is still risky.
WHITE: But that shouldn't blind us to the fact that the regulatory system is much tougher and robust today than it was eight years ago - no question in my mind about that.
ZARROLI: White says, for example, the Dodd-Frank financial overhaul bill set up an oversight council that can actually shut down firms that pose a risk to the system. Even so, White says, the regulatory changes probably haven't gone far enough. Anat Admati, finance professor at Stanford, says Clinton overlooks the fact that there are already regulations on the books to address the risks of shadow banking. It's just that regulators don't always enforce them.
ANAT ADMATI: Yes, we know that there are all these risks, but we also have some tools to deal with them right now. So what is she saying to the fact that the regulators are not doing it right now?
ZARROLI: Admati also notes that shadow banking shouldn't be viewed as separate from the rest of the banking system. Many large bank holding companies own hedge funds and money market funds. So they're deeply involved in shadow banking, too. And the bigger those banks get, the riskier they are to the financial system. Jim Zarroli, NPR News, New York. Transcript provided by NPR, Copyright NPR.