By Bob Needham
Michigan Law
Policymakers and academics have long been concerned about the danger posed by “shadow banks”—financial institutions that function like banks but are not subject to banking regulations, such as money market mutual funds or stablecoin issuers.
That lack of safeguards leaves shadow banks susceptible to instability that can quickly spread throughout the financial system. Typical approaches to addressing this risk have focused on changing banking laws.
Yet a conversation between Professors Gabriel Rauterberg and Jeffery Zhang during a stroll around the Law Quad led to a new idea: using securities law instead.
Rauterberg and Zhang took the idea from that initial conversation and developed it into a new paper, forthcoming in the Stanford Law Review.
They argue that securities regulators—who already exercise some authority over shadow banks—can and should do more, even if it might not be the first-best solution.
They recently answered five questions about the issue:
1. How does the shadow banking sector contribute to problems of insecurity in the broader economy?
Rauterberg: Businesses need both long-term and short-term funding. They get a lot of their short-term funding from the shadow banking sector. So when there are mass withdrawals of financing from the shadow banking sector, it destabilizes the shadow banks themselves. Then it also dries up funding for businesses just when we’re in a moment of financial instability or panic. The broader economy depends on financial institutions for funding, and it turns out they’re kind of fragile.
Zhang: If the shadow banking market was tiny, it probably wouldn’t matter. But shadow banking in the last few decades of US financial history has grown into a multi-trillion-dollar industry. When you have an industry that large, that is so interconnected with the rest of the US economy—and that is also subject to the dynamics of bank runs, but without the safeguards that banks have—you get problems in the real economy.
—————
2. Efforts to address this vulnerability have largely focused on banking law, but your paper suggests approaching the issue through securities law. How did you develop this idea?
Zhang: It started in 2022, when a banking law scholar (Zhang) was walking with a securities law scholar (Rauterberg) around the Law Quad. We’d both noticed how banking scholars and securities scholars don’t really talk to each other.
We talked about how these economic phenomena are well known, but everyone has their own tools and their own perspectives. When you have entrenched views, it’s hard to think about the problem from the other side. So we asked ourselves, what would be another approach, even if it’s not perfect?
Rauterberg: We began with an observation that turned out to be massively more complicated than we thought it would be—that securities law provides securities regulators with a lot of jurisdiction over aspects of shadow banking. And as a result, there was this ambiguous relationship that seemed worth exploring between the two bodies of law. That started us thinking about whether that meant that securities regulators could play a more important role.
—————
3. You mentioned that securities regulators already have some authority over shadow banking. What’s an example of that?
Rauterberg: One entire body of law that securities law usually doesn’t think of as relating to shadow banking, but it could, is broker dealer regulation. Broker dealers play a huge role in the financial sector. They can influence financial stability, but broker dealer regulation is designed only with customer protection goals in mind, not broader systemic issues.
For another example, money market fund regulation is at the heart of shadow banking. The Securities and Exchange Commission (SEC) knows that it’s important to financial stability, but has taken only modest action. The paper wrestles with this because it’s an ambiguous proposition, but the SEC could probably do more on that front.
—————
4. What’s an example of the bigger reforms you advocate?
Zhang: To stick with money market funds—they are like banks. We force banks to hold capital for safety and soundness purposes; why not have money market funds do the same? The SEC could do this.
Of course, the counter argument is that this is really aggressive. In fact, this idea has been floated before, and the SEC has not taken it up. The industry certainly balks at it every single time, but that doesn’t mean that, logically, it isn’t a proper solution.
—————
5. The paper discusses how finding political will for these changes could be an issue. Does that become even harder with a new presidential administration?
Rauterberg: Like a lot of the things about the incoming administration, it’s uncertain. The SEC in the first Trump administration was widely regarded as a perfectly reasonable SEC making competent if contestable judgment calls.
Overall, though, I think the change makes it less likely the SEC will adopt these proposals.
Most of the people who study shadow banking think that this is such a big problem, we need to plan for whatever moment gives an opening for regulatory reform. That opening might be in six years or in two years. Some of these reforms could be doable as a staff-initiated set of changes. But the presidential administration will shape things.
Zhang: If you focus on the standard talking points, a Republican administration might mean less regulation. But what we are really addressing here is financial crises, system-wide failures. When that happens, everybody loses. Nobody wants that.
This should be thought of as the beginning of an undertaking, of a true synthesis of securities law and banking law. This first collaboration is planting a seed; we’re just going to let it grow, and we think it’s going to grow quite well.
Michigan Law
Policymakers and academics have long been concerned about the danger posed by “shadow banks”—financial institutions that function like banks but are not subject to banking regulations, such as money market mutual funds or stablecoin issuers.
That lack of safeguards leaves shadow banks susceptible to instability that can quickly spread throughout the financial system. Typical approaches to addressing this risk have focused on changing banking laws.
Yet a conversation between Professors Gabriel Rauterberg and Jeffery Zhang during a stroll around the Law Quad led to a new idea: using securities law instead.
Rauterberg and Zhang took the idea from that initial conversation and developed it into a new paper, forthcoming in the Stanford Law Review.
They argue that securities regulators—who already exercise some authority over shadow banks—can and should do more, even if it might not be the first-best solution.
They recently answered five questions about the issue:
1. How does the shadow banking sector contribute to problems of insecurity in the broader economy?
Rauterberg: Businesses need both long-term and short-term funding. They get a lot of their short-term funding from the shadow banking sector. So when there are mass withdrawals of financing from the shadow banking sector, it destabilizes the shadow banks themselves. Then it also dries up funding for businesses just when we’re in a moment of financial instability or panic. The broader economy depends on financial institutions for funding, and it turns out they’re kind of fragile.
Zhang: If the shadow banking market was tiny, it probably wouldn’t matter. But shadow banking in the last few decades of US financial history has grown into a multi-trillion-dollar industry. When you have an industry that large, that is so interconnected with the rest of the US economy—and that is also subject to the dynamics of bank runs, but without the safeguards that banks have—you get problems in the real economy.
—————
2. Efforts to address this vulnerability have largely focused on banking law, but your paper suggests approaching the issue through securities law. How did you develop this idea?
Zhang: It started in 2022, when a banking law scholar (Zhang) was walking with a securities law scholar (Rauterberg) around the Law Quad. We’d both noticed how banking scholars and securities scholars don’t really talk to each other.
We talked about how these economic phenomena are well known, but everyone has their own tools and their own perspectives. When you have entrenched views, it’s hard to think about the problem from the other side. So we asked ourselves, what would be another approach, even if it’s not perfect?
Rauterberg: We began with an observation that turned out to be massively more complicated than we thought it would be—that securities law provides securities regulators with a lot of jurisdiction over aspects of shadow banking. And as a result, there was this ambiguous relationship that seemed worth exploring between the two bodies of law. That started us thinking about whether that meant that securities regulators could play a more important role.
—————
3. You mentioned that securities regulators already have some authority over shadow banking. What’s an example of that?
Rauterberg: One entire body of law that securities law usually doesn’t think of as relating to shadow banking, but it could, is broker dealer regulation. Broker dealers play a huge role in the financial sector. They can influence financial stability, but broker dealer regulation is designed only with customer protection goals in mind, not broader systemic issues.
For another example, money market fund regulation is at the heart of shadow banking. The Securities and Exchange Commission (SEC) knows that it’s important to financial stability, but has taken only modest action. The paper wrestles with this because it’s an ambiguous proposition, but the SEC could probably do more on that front.
—————
4. What’s an example of the bigger reforms you advocate?
Zhang: To stick with money market funds—they are like banks. We force banks to hold capital for safety and soundness purposes; why not have money market funds do the same? The SEC could do this.
Of course, the counter argument is that this is really aggressive. In fact, this idea has been floated before, and the SEC has not taken it up. The industry certainly balks at it every single time, but that doesn’t mean that, logically, it isn’t a proper solution.
—————
5. The paper discusses how finding political will for these changes could be an issue. Does that become even harder with a new presidential administration?
Rauterberg: Like a lot of the things about the incoming administration, it’s uncertain. The SEC in the first Trump administration was widely regarded as a perfectly reasonable SEC making competent if contestable judgment calls.
Overall, though, I think the change makes it less likely the SEC will adopt these proposals.
Most of the people who study shadow banking think that this is such a big problem, we need to plan for whatever moment gives an opening for regulatory reform. That opening might be in six years or in two years. Some of these reforms could be doable as a staff-initiated set of changes. But the presidential administration will shape things.
Zhang: If you focus on the standard talking points, a Republican administration might mean less regulation. But what we are really addressing here is financial crises, system-wide failures. When that happens, everybody loses. Nobody wants that.
This should be thought of as the beginning of an undertaking, of a true synthesis of securities law and banking law. This first collaboration is planting a seed; we’re just going to let it grow, and we think it’s going to grow quite well.
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