Sizing the European Shadow Banking System: A New Methodology

One of the critical unanswered questions relating to the shadow-banking system has been to quantify its scale in an industry where entities, by design, are opaque and often outside of regulated and publically shared frameworks. However almost all shadow banking entities, including hedge funds, private equity funds and special purpose vehicles ("SPVs"), interact with the financial markets via regulated investment banks. For example, many SPVs are in fact originated as part of investment banking business and hedge funds typically transact in financial markets exclusively via the "prime brokerage" division of investment banks. This interface with the regulated banking environment combines with the typical practise by investment banks of equalizing compensation (Including bonus) ratios to revenues globally which then allows identification of the implied difference in revenues and hence assets that represents the shadow banking system. The paper will present for critique the results of this methodology to estimate the UK shadow banking system including European business managed from the UK. The estimate will imply a larger scale of shadow banking than previous estimates at £548 billion which, when combined with hedge fund assets of £360 billion (FSA, 2011) gives total shadow banking assets of over £900 billion. It is proposed that the large gap between the estimates of this paper and other estimates reflects the huge, and previously unknown, scale of offshore activities of UK investment banks.