We know the Financial Stability Board’s theme song now that we’ve read the latest on shadow-bank regulation. It’s, “If You Can’t Regulate the One You Want, Regulate the One You’re With.” Yesterday, global regulators announced that they plan to noodle on for another year or so about just how to define the $15 trillion shadow sector. Even so, they’ve proposed a way to choke it off. How? By tightening the garrote around global banks, in part through yet another surcharge. This is, we think, a grand rhetorical flourish that will do little but strengthen shadow firms as banks sink deeper into a quagmire of even more punitive regulation.

Why? First, let’s examine one of the main concepts on which the FSB apparently agreed: the afore-mentioned surcharge for banks that lurk in the shadows along with their non-bank customers. This comes atop all the other Basel capital increases – the basic Basel III rules, the new market-risk rules, the outstanding operational-risk capital requirements, the counter-party-credit-risk charge, the conservation buffer, the counter-cyclical buffer built atop the first buffer and, now, the proposed G-SIB surcharge. Each of these is supposed to capture the risk of doing business, including with non-banks through a host of new risk weightings, correlation factors, added capital for some of the customers and business lines cited by the FSB, and on and on. Why isn’t this enough to curb bank appetite for shadowy counterparties? Banks surely think it will, so why not the FSB? No word in the release, which like a lot of other recent pronouncements is propounded as if none of the other rules was on the table.

But, even if all these capital charges made sense, which bank is going to be able to handle them? The IMF has reportedly concluded that EU banks need another $200 billion to hold their heads above water. EU policy-makers vociferously object to this, but it’s at the least clear that current capitalization is weak, Basel III compliance will be costly, the G-SIB surcharge adds to the pain and yet another surcharge doesn’t exactly help. The biggest U.S. banks for the most part aren’t in as dire a capital circumstance, but one might well argue that they should be using the capital they’ve got to support economic recovery, not to build Fort Knox.

But, there’s an even more fundamental flaw in the FSB’s one-sided shadow-bank regulatory regime. Sticking it just to banks leaves that $15 trillion or so shadow market on the loose. Regulators counter that shackling banks hobbles non-banks because banks are the pipeline that empowers the unregulated sectors. At best, though, this is an untested proposition. Did banks promote the shadow securitization market, as the FSB believes? Or was it non-banks like subprime issuers, investment banks that got big into this game and – let us not forget — the GSEs. Fannie and Freddie at one point bought more than a third of the private-label MBS on offer. If they hadn’t, the non-bank shadow originators and securitizers would have been dead in their tracks, no matter how much the big banks wanted to help out.

Do banks pull the strings on money-market funds – another shadow sector that worries the FSB? Or, rather, is it the longstanding fact that MMFs have themselves been exempt from meaningful liquidity and prudential rules that puts banks at risk? Telling banks they can’t take funds from MMFs any more might forestall one risk, but the MMFs will quickly find other more-than-willing takers for their dollars.

Thus, the FSB has recognized the importance of shadow-bank systemic risk and, then, ducked it by postponing all the hard decisions needed to do something about it. This means that banks will be even harder pressed to meet all the rules imposed on them because the FSB’s shadow ones add to the already formidable, costly pile. Even worse, it leaves the financial system at still greater risk because unregulated firms are free not just to keep doing what they want, but also to pick up all the leavings banks will have to shed.

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