YOUR INVESTMENT: Rise of the 'shadow banks'

IRRATIONAL exuberance became the defining term of the dot.com age in the late 1990s.
Now a new phrase has been coined, which I believe will become the defining term of the 2010s: "The shadow banking system."
Devised by United States economist Paul Krugman, the term refers to entities that have taken on banking tasks such as creating credit but are not subject to banking regulations.
These unregulated entities are most likely to have caused the credit crisis.
He comes to this conclusion after reviewing the six most common reasons provided for the credit crisis. These are:
Size: Some financial institutions became too big to fail.
Shadows: Institutions that fulfilled banking functions evaded regulation.
Opacity: There were too many complex financial instruments that most people didn't understand.
Predation: Financial firms deliberately misled consumers and investors.
Government intervention: Governments encouraged lenders to make bad loans, especially to the poor.
Monetary mismanagement: The Federal Reserve kept interest rates too low for too long.
Looking at the issue of size, Krugman notes there was a huge increase in financial concentration, with a few, true gigantic banks emerging.
Deregulation allowed various entities to engage in core banking activities while escaping banking regulations.
However, such institutions were equally vulnerable to a "run on the bank".
There was the emergence of securities and contracts with obscure, hidden risks. And Krugman finds it no coincidence that the most complex, confusing loans were offered to those least able to understand them.
There was probably also a substantial amount of deliberate selling of mortgage-backed securities to investors who didn't grasp the risks.
Having identified shadow banking as the main culprit, Krugman looks at how effective proposed reforms will be.
One suggestion is to reduce government intervention and rely on market discipline. However, this may not work. In 1930, the US let banks fail and the result was the Great Depression.
A second version of reform calls for increased regulation, including a return to the post-Depression enforced separation of deposit and investment banking.
Krugman doesn't think this is realistic. "Shadow banking isn't going away. Like it or not, short-term debts now play a role in our economy comparable to that of bank deposits," he says.
The third option is to extend regulation to shadow banks. If a regulator had the capacity to seize shadow banks like it can with depository institutions, that might help the problem.
However, regardless of what actions are taken, Krugman admits he is "not wildly optimistic" that any form of regulation can prevent another crisis.
David McEwen is chief investment officer of Investment Research Group. A disclosure statement is available free on request. View: www.irg.co.nz.