The Banking-Securities Interface
Regulating “shadow banks” via securities law is a worthwhile second-best option
Financial activities that function like banks, but exist outside the scope of banking regulation—aptly termed “shadow banking”—were at the heart of the 2007-2008 Global Financial Crisis and most episodes of serious financial stress since then. While applying banking law to shadow banks might be the optimal regulatory strategy, progress along that path has stalled. We therefore explore the uneasy case for increasing the regulation of shadow banking through the SEC and securities law.
What’s the problem? Shadow banking results in financial turmoil
The International Monetary Fund wrote of the 2007-2008 Global Financial Crisis (GFC) that “economic activity declined in half of all countries in the world” and “the crisis may have had lasting effects on potential growth.” In the aftermath of the crisis, more than 15 million Americans were unemployed. Almost 500 U.S. banks failed over the next four years, and $245 billion was used by the federal government to stabilize hundreds more. From peak to trough, stock prices plummeted by roughly 50 percent. Millions of families suffered the foreclosure of their homes, and $17 trillion in household wealth was lost. Shadow banking played a central role in causing the crisis.
Shadow banks are financial institutions that function like banks but operate outside the scope of banking law. Well-known examples include money market funds, repo, stablecoin issuers, and new forms of cryptocurrency platforms. Shadow banking has been the defining problem of financial regulation since the GFC. Indeed, a leading scholar of banking aptly called the growth of shadow banking “the money problem.” It is a problem that remains of vast scale, as the financial system repeatedly reminds us. Since 2008, the United States has been rocked by periodic episodes of financial instability or near-panic by entities outside of the banking sector: “repo madness” in 2019, runs on money market funds in 2020, and, most recently, the collapse of major “algorithmic stablecoins” and cryptocurrency lenders in 2022 and 2023. Shadow banking is distinctively unstable because it is prone to the same fundamental problem of “runs” as banks but is not subject to the complex regulatory environment designed to prevent and contain bank runs.
For the most part, leading economists and legal scholars who study financial regulation have converged on a favored approach: the solution to shadow banking is to apply banking regulation in part or in whole to non-bank issuers of money-like claims. In this view, the optimal response is that shadow banking should be encompassed within the regulation of traditional banking (“the bank regulatory perimeter”). We do not disagree that this is the first-best approach. U.S. banking regulators, and the Federal Reserve in particular, possess a powerful set of tools to address the risks of shadow banking. The problem, of course, is that they do not possess clear legal authority over the shadow banking sector. And, in the fifteen years since the GFC, regulators and politicians have made little headway in expanding the bank regulatory perimeter.
Let’s look at this problem from a different perspective: securities law
We begin with where shadow banking ends up, legally speaking. While shadow banks operate outside of the bank regulatory perimeter and are sometimes said to be unregulated, almost all domestic shadow banking markets in fact already lie under the jurisdiction of securities regulators.
This pattern—where financial activities designed to evade banking law end up qualifying as securities—is not a simple accident of history. It has deep roots in the architecture of U.S. financial regulation and in market participants’ desire to avoid banking regulation. Famously, banking law adopts a narrow and formalistic definition of banking. Securities law does no such thing. Instead, it defines its foundational categories, like “security,” “investment company,” or “dealer” in extraordinarily capacious, open-ended, and functional terms. The securities laws define “security” not only by way of a laundry list of familiar financial instruments, but also include “investment contracts” and “any note.” The result largely captures Congress’s intent to “enact a definition of ‘security’ sufficiently broad to encompass virtually any instrument that might be sold as an investment.” Perhaps even more importantly to our analysis, the securities law define the category of “investment company”—what is usually termed investment funds—with similar breadth to include not only any entity whose primary business is investing in securities, but also a business that invests in securities and whose assets consist in significant part (40 percent or more) of securities.
As a result, securities law categories like “security” and “investment company” encompass almost any major financial activity, unless there is an explicit carveout. To wit, a bank account, without preemption by banking law, would be a security; and a bank, without preemption by banking law, would be an investment company subject to securities law.
What could the SEC do? In short, the core of our policy recommendation is that securities regulators should make more extensive use of their existing statutory authority to address core risks of shadow banking. Broadly speaking, there are two distinct routes for pursuing this general proposal. The first is an incremental complementarity approach that favors reforms within the traditional institutional expertise of the SEC, with modest ambition, and which would aim to complement any reforms adopted by banking regulators (e.g., repo haircuts). The second is a structural convergent approach that favors ambitious reforms requiring the SEC to develop new competencies and which would more closely parallel reforms advocated in banking regulation (e.g., capital requirements). We offer concrete institutional proposals for improving the efficacy of the SEC in these regards.
Don’t let perfect be the enemy of the good
To be sure, there are shortcomings to this proposal—and we carefully address a number of weighty concerns and objections—including the SEC’s institutional competence and willpower. One objection asks whether we should expect the SEC to regulate effectively if it did act. A second asks why we should expect the SEC to regulate shadow banking aggressively when banking regulators have failed to do so for decades.
In brief, our response to the question of institutional competence is that the SEC already regulates many forms of private money and shadow banks. Indeed, as we have argued, they appear to be securities. We are arguing for the SEC to dial up its regulatory stringency on these securities markets with an eye to financial stability. Moreover, this proposal has varying degrees of ambition, which correspond to varying degrees of institutional competence. Our response to the second issue of political will is that the SEC has broader statutory authorities than its banking agency counterparts and so it is less costly for the agency to act. The agency does not have to spend the same amount of political capital.
In sum, focusing on securities law to regulate shadow banking may seem counterintuitive, especially to readers accustomed to a debate centered on banking law. But given the reality of the situation—and the wide net and robust authority afforded by securities law—it appears that the SEC is going to remain the regulator of most shadow banks for the near future. Just counting money market funds and repo transactions alone, the SEC has existing jurisdiction over $9 trillion in private money creation. From the perspective of bank regulators, this vast amount of private money was created in the shadows outside their clear ambit. From the perspective of the SEC, this private money was created in their backyard. The SEC has the legal authority to do something about it, and they should do so, prudently.
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