Forget SEC registration. Forget the AIFMD. Forget the Short Selling Directive. The regulatory steps that could do more to change the hedge fund industry than any others have only just reached the bottom the legislative agenda. They are the measures now being contemplated by the G20 to tackle what has become known as “shadow banking.” This is a slippery concept, and a moving target to boot, but almost any definition of “shadow banking” will include the ways in which investment banks fund themselves and then use that funding to finance their hedge fund clients.

A Financial Stability Board (FSB) paper published in April this year, entitled Shadow Baking: Scoping the Issues, noted that “there is as yet no commonly agreed definition.” Its own attempt at a useable definition for regulators, which consumes half the ten page document, might be summarised as any forms of lending (or promises to lend) by any organisation outside the regulated banking sector that creates systemic risk or opportunities for regulatory arbitrage, particularly if long term assets are being funded by short term liabilities, and those assets are securitised and/or re-hypothecated.

That sounds a lot like a system in which investment banks fund themselves in the overnight tri-party repo markets, in large part by using the securities and cash deposited with them by hedge funds, which the extraordinary structure of the US tri-party repo market in particular ensured they could play with throughout the working day. One reason investment banks got into trouble in 2008 was because they had come to rely on prime brokerage assets to fund themselves in the repo market at the end of the working day, and to get their cash back at the beginning of the working day when the repos were unwound. When hedge fund investors demanded that hedge fund managers shift cash and securities from the prime brokers, the investment banks lost access to collateral they needed to fund themselves. It was in March 2008, when Bear Stearns could no longer fund itself in the overnight tri-party repo market that funded all of the broker-dealers and investment banks of America, that the Federal Reserve was forced for the first time in its history to give non-banks direct access to central bank money via the Primary Dealer Credit Facility (PDCF). Daily use of the PDCF facility peaked at $150 billion. The central bank also had to lend its users general collateral in exchange for other assets that could no longer be financed, through a separate Term Securities Lending Facility (TSLF). Daily use of the TSLF peaked at $200 billion.

Though they should not have come as a surprise – the Federal Reserve bailed out the repo market on a previous occasion, when Drysdale Securities defaulted in 1982, by lending Treasury securities to broker-dealers so they had enough eligible collateral to fund themselves - exposures of $150 or $200 billion a day were certainly big enough to shock the Federal Reserve. It was shaken by the disappearance of the $2 trillion US tri-party market, where broker-dealers borrowed short term cash from money market funds and banks. It was even more shocked to discover that, because the American tri-party market starts afresh every morning, just two clearing banks (BNY Mellon and J.P. Morgan) bore the whole of the intra-day credit risk of the broker-dealing industry.

The disappearance of the tri-party market in 2008 is one reason Morgan Stanley and Goldman Sachs needed little encouragement to become banks. That is a decision the two investment banks are occasionally tempted to re-visit, as they contemplate the tighter regulatory and capital constraints of being a bank, including the obligation to shed proprietary trading activities. That reluctance, coupled with memories of investment banks finding only the Fed would fund them in the spring and autumn of 2008, makes unusually interesting the definition of “shadow banking” advanced by Federal Reserve EVP Sandra Krieger in a speech on 8 March this year. Shadow banks, she argued, were those that “do not have direct and explicit access to official liquidity.”

Krieger went on to say that defining characteristic was “violated” during the crisis, when the central bank lent to shadow banks. She warned that such extraordinary measures, though justifiable in the context of the time, risked creating “wrong incentives” for prime brokers and their satellites to take on excessive risk and illiquid collateral in the knowledge that they would always be rescued. Quite how that moral hazard can be undone is not clear. Not only did the “credit enhancements” designed in the boom prove largely value-less in the bust – equity collateral is an honourable exception here – the official alternatives manifestly did work when put to the ultimate test.

Indeed, moral hazard has if anything increased since 2008. It is now widely agreed, for example, that letting Lehman fail was a bigger mistake even than rescuing General Motors. But Krieger proposed two measures to undermine this widespread belief that central banks have made all forms of financial intermediation effectively immortal. The first is to make it more expensive for regulated banks to act as bankers to “shadow banks.” The tighter liquidity and capital ratios set by Basel III were designed with this in mind. The second is to force “shadow banks” to find other ways of persuading counterparties to take the risk of dealing with them than a credit line from a regulated bank. How this can be done has yet to be decided, but it will also increase the price of money.

Such rice-rising measures are already taking effect. Banks have had to put conduits which they support with credit lines on to their balance sheets, making them subject to the tighter capital and liquidity ratios now being set by Basel III. The Volcker Rule is forcing investment banks to get out of the proprietary trading business. Over the last two years, a Fed-sponsored Tri-Party Repo Infrastructure Reform Task Force has worked to eliminate the massive intra-day risk of the “daily unwind,” through automated collateral substitution and a switch to term repo. Money market funds are now required to hold a higher proportion of their assets in higher quality, more liquid securities.

The results of these measures must include an increased cost of funds. Banks and money market funds that provide cash to prime brokers will demand higher returns and better quality collateral, and exit the market if they cannot secure them. Prime brokers will face further constraints on their ability to re-hypothecate client assets. All prime brokers, but especially those unsubsidised by large volumes of retail deposits gathered by a universal banking parent, will face a further increase in their cost of funding. Those higher costs will be passed on to hedge funds, in the form of less attractive prices and terms for financing.

The problems created for the hedge fund industry by the gathering regulatory assault on “shadow banking” are becoming clear. Central bankers and regulators have identified direct links between the funding of investment banks and hedge funds in the repo markets and those other fast-growing phenomena of the pre-crisis years: securitisation and money market funds. They believe investment banks, with the connivance of ratings agencies and insurance companies, manufactured highly rated securitised collateral out of low quality auto, credit card, student and mortgage loans. These were then “warehoused” by their own proprietary trading arms, their hedge fund clients, and a variety of in-house and third party SIVs and conduits, because such long term assets could be financed at a positive spread in the short term repo and commercial paper markets by cash-rich banks and money market funds.

The clarity of this interpretation by regulators and central bankers of how “shadow banking” worked in practice before the crisis is a relatively new force in the ever-changing regulatory environment. The earliest official reference that I can find to “shadow banking” appears in the Turner Review, the report into the crisis commissioned by British Prime Minister Gordon Brown in October 2008, and published in March 2009. It identified a “shadow banking” sector made up of SIVs and conduits, overnight repos, and a vaguely defined set of “mutual funds” that “held long-term credit assets against liabilities to investors which promise immediate redemption.”

The term “shadow banking” did not appear in A New Foundation, the June 2009 US Treasury Department report on the financial crisis that led to SEC registration and most other parts of Dodd-Frank, though that document did express dismay that investment banks operated with insufficient regulatory oversight and hedge funds with none at all. In a widely reported speech he gave in June 2008, when still President of the Federal Reserve, Timothy Geithner had referred to a “parallel” banking system in which investment banks and hedge funds financed securities on a short term basis in the repo markets, with much of the cash being put up by money market funds. But he did not use the term “shadow banking.”

The January 2011 Financial Crisis Inquiry Report prepared by the National Commission on the Causes of the Financial and Economic Crisis in the United States, on the other hand, effectively opens with an 11 page exposition of “shadow banking” that blames yield-hungry money market funds for fuelling the growth of the repo, commercial paper, stock loan and asset-backed securities markets. By adding up the outstandings of the repo, commercial paper, securities lending, ABS and money market fund industries – surely case of double counting, if ever there was one – the report alleges that by 2007 the “shadow banking” industry was larger than the traditional banking industry.

“Over the past 30-plus years, we have permitted the growth of a shadow banking system – opaque, and laden with short term debt – that rivaled the size of the traditional banking system,” reads the report. “Key components of the market – for example, the multi-trillion dollar repo market, off-balance sheet entities, and the use of over-the-counter derivatives - were hidden from view, without the protections we had constructed to prevent financial meltdowns.”

But it was the G20, meeting in Seoul in November last year, that formally identified “shadow banking” as unfinished business in the long re-regulation of the financial services industry. The FSB paper, published on 12 April this year, was the initial consequence of that work. It was published to coincide with the Washington meeting of the G20, whose communiqué noted that finance ministers had “welcomed the FSB work on the scope of shadow banking and look forward to the recommendations that the FSB will prepare for our next meeting on the regulation and oversight of the shadow banking system.”

The FSB is advising regulators to “cast the net wide” in their search for systemic risk and regulatory arbitrage opportunities created by the “shadow banking” sector – and in particular cases of short term funding of long term assets. Its ruminations are somewhat jumbled, and struggle to link repo, securitisation and money market funds, stock loan and cash collateral reinvestment in a recognisably coherent way, but Scoping the Issues definitely identifies a repo-funded prime brokerage industry as a classic instance of a systemically worrying mismatch between short term funding and long term assets.

After all, the whole reason investment banks took the enormous risk of reliance on overnight funding – and Bear Stearns was doing an average of $75 billion a day by 2007-08 – is the shape of a normal yield curve. In an upwardly sloping yield curve, in which the price of borrowing increases with duration, investment banks and broker-dealers can finance higher-yielding but longer-dated inventory with a positive cost of carry by borrowing at the short end of the money market. The conduits and SIVs that held portfolios of structured credit instruments were doing the same thing in the commercial paper markets.

Yet the term “shadow banking” still seems an unnecessarily tendentious description of this activity. It is “maturity transformation” of exactly the kind that the highly regulated traditional banks exist to provide. In other words, the “shadow banking” system does exactly the same thing as the traditional banking system, merely outside the purview of most of the regulators, most of the time. Even then, it would be wrong to say that “shadow banking” was unregulated. Regulation T, set by the Federal Reserve, prevents hedge funds borrowing from prime brokers more than 50 per cent of the value of the securities they are buying.

There was self-regulation too. As the report of the Tri-Party Repo Infrastructure Reform Task Force made clear, two thirds of the collateral posted in US repo transactions is US Treasury or Agency securities. In fact, the unwillingness of cash investors to finance the structured credit instruments being manufactured by investment banks was a constant source of chagrin to the repo desks of the major investment banks in the years immediately prior to the onset of the crisis in the summer of 2007. It was an equal source of puzzlement that cash-rich European banks preferred to lend unsecured in the inter-bank markets than on a secured basis in the repo market.

Nor were money market mutual funds unregulated. In the US, they are governed, like other mutual funds, by the 1940 Investment Company Act. Even in the regulatorily easygoing Europe, some money market funds were regulated under the UCITS rules (and US rules are now being transposed from across the Atlantic).

In 2007-08, albeit with considerable official assistance, only one US money market fund actually “broke the buck.” A large number of hedge funds did fail but, unlike the investment banks, not one sought the protection of the government or the support of taxpayers. None was large enough to create systemic risk either.

Whatever the realities, a case is being built for regulating investment banks either directly or indirectly (by restricting lending to them by commercial banks or by regulating particular activities, as the Volcker Rule has begun to do). Basel III will increase the capital cost to banks that offer credit lines to “shadow banking” entities, but greater disclosure is probably the first step toward direct regulation. The FSB is already engaged in a data collection exercise designed to estimate the size of the “shadow banking” industry, and recommend new reporting requirements for regulatory purposes.

The great irony, which may be lost on securities regulators but not on central bankers, is that the “shadow banking ” industry was in large part a creation of the previous regulatory and capital regimes. As the FSB paper points out, for example, banks substituted ABCP back-up lines for traditional credit lines because the capital charge on collateralised lending was lower. The same was true of repo.

It is entirely predictable that measures to stifle the “shadow banking” industry of the last financial crisis should sow the seeds of the next “shadow banking” crisis. Constriction of the banking industry will increase the incentives to create new forms of “shadow” financing. The attempt to exterminate “shadow banking” by regulation, like the attempts to eliminate drugs by attacking their production and banning their consumption, is likely only to drive up the profitability of the business.

It was not for nothing that Bob Sloan described prime brokerage, in Don’t Blame the Shorts, as the “largest, most unnoticed banking system in the world.” Unfortunately, it is unnoticed no longer.