It’s a useful piece for explaining, as he did at Jackson Hole, why the problem isn’t remedied by interest rate cuts. Even if you can shore up the system on a short-term basis, the underlying structure is unsound (although Hamilton would never use such a dramatic term). Hamilton believes that stronger supervision and regulatory reform are needed.
What I find striking is that it seems that Hamilton has had to go over his argument more than once with fellow top level economists, many of whom are policy makers or influencers. It’s a worrying sign that they may be having trouble getting their minds around the Brave New World of finance, and as a result may not take the best course of action.
What has happened over the last decade is that a variety of new institutions have evolved that play a similar role to that of traditional banks, but that are outside the existing regulatory structure. Rather than acquire funds from depositors, these new financial intermediaries may get their funds by issuing commercial paper. And instead of lending directly, these institutions may be buying assets such as mortgage-backed securities, which pay the holder a certain subset of the receipts on a larger collection of mortgages that are held by the issuer. Although the names and the players have changed, it is still the same old business of financial intermediation, namely, borrowing short and lending long.
There are a variety of new players involved. The principals could be hedge funds or foreign or domestic investment banks. Others could be conduits or structured investment vehicles, artificial entities created by banks, perhaps on behalf of clients. The conduit issues commercial paper and uses the proceeds to purchase other securities. The conduit generates some profits for the bank but is technically not owned by the bank itself and therefore is off of the bank’s regular balance sheet.
This system has seen an explosion in recent years, with the Wall Street Journal reporting that conduits have issued nearly $1.5 trillion in commercial paper. Their thirst for investment assets may have been a big factor driving the recklessness in mortgage lending standards, as a result of which much of the assets backing that commercial paper have experienced significant losses.
Without an adequate cushion of net equity for these new financial intermediaries, and with tremendous uncertainty about the quality of the assets they are holding, the result is that those who formerly bought the commercial paper are now very reluctant to renew those loans, a phenomenon that PIMCO’s Paul McCulley described at the Fed Jackson Hole conference as a “run on the shadow banking system.” I heard others at the conference claim that there might be as much as $1.3 trillion in commercial paper that will be up for renewal in the next few weeks, with great nervousness about what this will entail.
In some cases, these intermediaries have lines of credit with conventional investment banks on which they will be drawing heavily, which will cause these off-balance-sheet entities to quickly become on-balance-sheet problems. Their losses may severely erode the net equity of the institution extending the line of credit. How big a mess will this be? I don’t think anybody really knows for sure.
In my remarks at Jackson Hole, I basically suggested that we should be thinking about both the causes and potential solutions to the current problem not just in terms of choosing an “optimal” level for the fed funds target interest rate, but also in terms of seeking regulatory and supervisory reforms, the ultimate goal of which would be to ensure that any financial institution whose failure would exert significant negative externalities on the rest of us should be subject to net equity requirements, so that most of the money the players in this game are risking is their own.
I also recommended that we need reforms to make the whole system more transparent. I think the accounting profession has let us down, in that it is very difficult to look at the annual reports of some of the institutions involved and determine what exactly the exposures are. In theory, competitive market pressures are supposed to result in incentives for private auditors to ensure accurate and informative reports. But I think there is a networking equilibrium issue here in which it is very hard for one auditor to try to change the rules if nobody else does, even if getting everybody to change at once would unambiguously improve social welfare. I recommended that the Federal Reserve could itself be a catalyst for such a change by revisiting the reporting requirements on its member institutions.