policymakers demonstrate

Financial Regulation in Europe: Foundations and Challenges 493
long-term changes in the intermediation process and landscape of financial systems,
some of it has been the result of deliberate decisions of bank management
to maximize the use of existing capital and increase profitability.
To a large extent, other financial entities operating in financial markets, such
as mutual funds, hedge funds, and money-market funds, etc. have been left
unattended by financial-stability regulation. The idea was that they are different
from banks, as they do not have the peculiar structure of demand deposit
contracts and they do not have the system of vast connections among institutions,
so they do not put the system at risk. A common theme is that prices
should be allowed to fluctuate, people should be allowed to take risks, and institutions
should be allowed to fail as long as there is no severe externality that
they do not internalize, which might threaten the system. This line of thinking,
however, has proven to be incomplete.
Over the years, other financial institutions have started taking on bank-like
features. Perhaps the most striking example is the Long Term Capital Management
(LTCM) hedge fund which failed in 1998. LTCM exposed itself to huge
leverage in an attempt to enhance returns to shareholders. While doing that, it
also generated large risks, and indeed collapsed in 1998. Hence, the thinking
that deposit-type risk does not exist in such institutions was shown incorrect.
Moreover, after that, people realized that LTCM was also at the heart of a network
of vast connections to other institutions, so its failure put the system at
the risk of systemic failure. Indeed, it took considerable effort on the side of US
regulators to have all parties agree to a resolution to stabilize the system. The
failure of Lehmann Brothers in 2008, an investment bank outside the regulatory
perimeter of the Federal Reserve and FDIC, although different from LTCM in
many respects, carried some similar lessons.
More generally, the fact that banks have been so heavily regulated has limited
their ability to provide credit and liquidity leading to the emergence of
other institutions that had many features similar to banks, but were not treated
like banks or regulated like banks. The common name for such institutions is
‘shadow banking’, for which the definition is somewhat unclear. It probably
covers everything that is not a traditional bank. Indeed, one of the key lessons
from the last crisis is that shadow banking has to be looked at and that the regulation
of the financial system has to take an integrative approach and consider
the potential fragility of banks alongside shadow banks rather than banks in isolation.
The idea is that if you regulate only banks, other institutions will emerge
and take over their functions, thus it is important to prevent such a regulatory
arbitrage and regulate the system with a holistic view.
A case in point is the money-market mutual funds. These are funds that invest
in bonds, treasuries, and other such assets and have a liability structure that is
very similar to banks. Specifically, they promise investors the right to withdraw
a fixed amount. This is known as a fixed net asset value (NAV), whereby the net