Illustration by Bloomberg View
Illustration by Bloomberg View

Five years after a crisis that almost took down the world economy, regulators are still groping for a way to address one of the global financial system’s most obvious weaknesses: the trillions of dollars in banking activity that happens outside traditional banks.

Here’s a suggestion. If it acts like a bank, regulate it like a bank.

The business of banking is inherently perilous. It turns short-term savings (such as customer deposits) into long-term investments (such as mortgages and corporate loans). This is risky: If too many savers want their money back at once, the bank can’t pay. It must either liquidate its assets or freeze its accounts, either of which can trigger a broader panic.

That’s why governments insure bank deposits and central banks stand ready to make emergency loans. In return for the insurance, banks are asked to follow certain rules. They face limits, for example, on how much they can lend for each dollar of equity their shareholders invest. The bigger the equity cushion, the less likely it is that taxpayers will have to bear losses.

Regulating ordinary banks well is proving difficult enough, but there’s a constellation of other financial intermediaries that gamble in much the same way -- converting short-term liabilities into long-term assets -- with no explicit government backstop. This so-called shadow-banking industry is enormous. Its global assets are estimated to have been more than $60 trillion at the end of 2011, making it about half the size of the traditional banking sector.

In this shadow realm, other forms of short-term borrowing such as shares in money-market mutual funds play the role of deposits. Securities dealers, hedge funds and other financial firms buy longer-term assets such as bonds backed by mortgages or corporate loans. They employ the assets as collateral against further loans, which they get from money-market funds, banks and one another. The collateral gives creditors a guarantee they’ll be repaid.

The shadow banks’ leverage is limited mainly by the amount of money they can borrow against a given amount of collateral. Before the crisis, they could borrow $97 against each $100 in mortgage-backed securities -- a “haircut” of 3 percent, the equivalent of putting just $3,000 down on a $100,000 home loan. Such high leverage amplifies risk: If the price of the security falls just 3 percent, the creditor’s margin of safety is wiped out.

The 2008 crisis demonstrated just how fragile the shadow-banking system can be. Worries about mortgage bonds caused prices to plunge, rendering all kinds of leveraged investors -- including investment banks such as Bear Stearns Cos. and Lehman Brothers Holdings Inc. -- insolvent or unable to finance their investments. The Lehman bankruptcy, in turn, triggered a run on money-market funds, further draining the system of the liquidity it needed to function.

How can this system be made more resilient? Mark Carney, the new governor of the Bank of England, offered a sense of what regulators are thinking in a speech last week: Give shadow banks the same access to emergency central-bank loans that traditional banks enjoy. This is a dangerous idea, with the potential to produce the kind of speculative boom that would end very badly. Imagine the risks investors would be willing to take if they knew the central bank would always provide cash if private lenders balked.

Granted, Carney noted that this expansion of public insurance would have to be accompanied by expanded regulation, but he was vague about it. What he should have said is this: If an entity engages in banking activity, and hence is vulnerable to runs with potentially systemic consequences, it must register as a bank, with all the backstops and capital requirements that entails.

Money-market mutual funds, for example, could become special-purpose “narrow” banks, as proposed in a 2010 paper by Yale University economists Gary Gorton and Andrew Metrick. The same goes for entities that borrow short-term to invest in asset-backed securities -- the so-called structured investment vehicles and conduits that were the first to suffer runs in the last crisis.

As for hedge funds and other institutions that would remain in the shadows, minimum requirements for haircuts -- combined with proper capital rules for the regulated banks that often lend to them -- should suffice to keep leverage from getting out of control. The Financial Stability Board, an international group of regulators, has proposed a set of global minimum haircuts that individual countries would do well to build upon. There’s ample evidence that extreme leverage presents a threat to markets and the economy -- and zero evidence that it provides any benefits.

“Shadow banking” is really a misnomer. Regulators know what’s going on and understand the threat it poses. They ought to stop discussing the problem and start acting to solve it.

To contact the Bloomberg View editorial board: view@bloomberg.net.