Clinton lurks in shadows when sparring with Sanders on banks

Hillary Clinton says that she, too, would break up banks. If necessary.

"But I go further," she said at a Democratic debate in April, "because I want the law to extend to those that are part of the shadow-banking industry." This has been her consistent answer as Bernie Sanders defines his campaign in opposition to the largest banks. An institution's size, she's saying, is not necessarily the problem.

Shadow banking is an issue only a wonk could love, ideal for the Clinton campaign's preference for bulleted policy briefs. But it's more than just a way to avoid talking about banks.

Clinton and Sanders stand on two sides of an argument among regulators and academics over what caused the last financial crisis, and how to avoid the next one. Sanders is focused on how financial institutions are structured. Clinton is looking at how they are funded.

There is no universal definition for "shadow bank." At its broadest, it's any institution that borrows money and invests in financial assets, but is neither a bank, nor regulated like one. This can include insurance companies, hedge funds, private equity firms, and government-sponsored entities such as Fannie Mae and Freddie Mac. In debates, Clinton brings up hedge funds and insurance companies. But her published plan hints at a more precise definition: if it's runnable, it's a shadow bank.

A research note last year from economists at the the Federal Reserve Board in Washington describes "runnables" -- short-term funds at financial institutions that can evaporate in a panic. Bank deposits over $250,000 are uninsured, and therefore runnable. So are shares in money-market mutual funds; they should be considered investments, but in practice are not expected to lose principal. Repurchase agreements, also on the list, allow a borrower to sell a stock or bond, along with a promise to buy it back, often in a day or two. Short-term corporate debt, called "paper," is similarly runnable.

According to the Fed economists' research, until the mid-1990s, the sum of runnable liabilities was steady at about 40 percent of U.S. gross domestic product. That number peaked in early 2008 at 80 percent, but remains above historical levels, at about 60 percent of GDP. The definitions differ slightly, but this is consistent with patterns measured by Morgan Ricks, an associate professor at the Vanderbilt University Law School in Nashville, Tennessee, and by the the Financial Stability Oversight Council, a group of representatives from several regulators. Runnables, said Ricks, are the "central unsolved problem of financial reform."

Ricks, who was a senior policy adviser at the Treasury Department in 2009 and 2010, takes a historical view of financial runs. Before the U.S. government began insuring bank deposits in 1933, bank runs happened about once a decade. Since then, even during the financial crisis, they've been rare. But the risk moved outside the banks.

Paul McCulley coined the term "shadow bank" during the Kansas City Fed's 2007 Jackson Hole conference on economic policy. Then the chief economist of the Pacific Investment Management Co., McCulley laid out the systemic danger hidden in bank-like firms that relied on uninsured short-term funding.

By the end of the next year, Bear Stearns, Lehman Brothers, and Merrill Lynch all collapsed. None of these were banks, but all had seen runs on short-term funding. "These are all species of the same genus," said Ricks.

"If there is one lesson to be drawn from the financial crisis," said Federal Reserve Governor Daniel Tarullo in a speech last year, "it is that the rapid withdrawal of funding by short-term credit providers can lead to systemic problems." Like Ricks, Tarullo compares the Depression-era runs on bank deposits to the crisis-era runs on short-term debt. In his speech, he pointed out that post-crisis reforms such as the Dodd-Frank law had focused on banks, and that there was more work to be done on institutions beyond bank regulators' reach -- shadow banks.

Clinton's top-line recommendation for Wall Street calls for a "risk fee" for banks with more than $50 billion in assets. But her plan looks at funding, too; the charge would be higher for firms with more short-term debt.

The campaign also dedicated several bullet points to what it calls "risky forms of short-term borrowing," in particular repurchase agreements. She wants to raise margin and collateral requirements on them, so long as other financial centers do as well. It would make them both safer and more expensive. It would also require coordination not only with Congress, but with other nations.

She also wants to "review regulatory changes to the money market fund industry," essentially putting a stamp on work by the Securities and Exchange Commission that will come into force in October of this year. Clinton's turn toward shadow banking mirrors work already underway in several federal agencies. There's movement among Democrats in Congress, too; on May 23, Ohio Senator Sherrod Brown wrote a letter to Treasury Secretary Jack Lew, seeking answers about shadow banks.

The Clinton campaign provided a version of its policy brief with footnotes, but did not respond to requests for comment.

Sanders has built his campaign in part on a proposed law, introduced in the Senate by Elizabeth Warren, that would separate investment banks from what he calls "boring" banks - the ones that take insured deposits. This would address shadow banks, he says, by severing their institutional ties to conventional banks.

"This business of risky derivatives, betting on the price of oil, whether interest rates will go up or down," said Warren Gunnels, Sanders' policy director, "that's the type of non-productive banking activities we want to eliminate."

What Gunnels named are all assets. They sit on the opposite side of the balance sheet from the runnable liabilities that Clinton is worried about. Gunnels doesn't see this as a significant distinction. A Sanders administration, he says, will offer a new law, and newly energized regulators.

Viral Acharya, who works on financial stability at New York University's Stern School of Business, said that while he's much more worried about an economic collapse in China than he is about shadow banks, regulators aren't yet focused on the issue. Risks -- such as short-term funding -- will always move from closely watched areas into the shadows. "This has been the real problem of regulation," he said. "It's always fighting the last war."