Richard Smith: Did We Wind Up With Any Reform of the Shadow Banking System?

By Richard Smith, a London-based capital markets IT consultant

In my last post, “Tracking the Rabbit through the Anaconda” , I mocked Geithner a bit and promised you all a spot of moaning about what’s missing from the financial reform bill.

Well, the anaconda has now had the time it needed to produce its offering. As an outsider considering the 20 hour orgy of bill consolidation and last-minute horsetrading that rounded off the whole process, I must say I find the US legislative process combines frivolity, pomp and ineptitude in a way that – reminds me of dear old England. Perhaps you are all very proud.

Shadow banking reform is the subject this post, since it is terribly important, much more compact than the rest of the reform, and the outcome is very very depressing. That leaves consumer finance, derivatives, and consumer finance for later. And let us see what FASB deliver in accounting changes, if anything.

This is how it all looked to me four weeks ago:

“The shadow banking stuff now looks appropriately targeted, by and large. They have sort of got it. Doubtless there will be nits to pick, down in the detail…

…To be honest, at this level of description the proposals don’t look quite as horrific as they might have done (after TARP et al, one’s expectations were modest indeed). So should one hold out for more, or quite a lot more? Is perhaps this – all holes and no cheese – still the right take on what will emerge?”

With respect to shadow banking, it seems, alas, that I was still far too optimistic; the short answer to the last question above is a resounding YES, and here is why.

Thoughtful NC regular RueTheDay has returned to blogging, and saved me some re-exposition with this crisp recap on the shadow banking system and its role in the Great Financial Crisis. To add: US shadow banking assets at the peak were $8-10Trn. That depends on what you include; the NYFRB’s relatively inclusive figure for market-based credit puts the figure at $16Trn (see Fig 1 here ), comfortably larger than the traditional deposit-based banking sector’s $10Trn.

Whatever the bonus-enhancing attractions of near-infinite ROC, you really wouldn’t want a run on that little set-up, and naturally, in September ’08, we got one. Trouble was, there wasn’t much equity in those shadow banks, and no liquidity buffers at all. Shadow banking “equity” – the capital that is there to absorb losses and promote investor confidence in the bad times – is something of a nebulous concept. Instead of ordinary equity you have various kinds of guarantee, for instance:

for SIVs: ‘liquidity puts’ (vide CitiGroup SIVs)

for money market funds: informal guarantees that the buck will not be broken, extended by the fund’s parent, but not credible in a crisis (vide Reserve Fund Sept ’08 and the ensuing shadow banking seize up)

for repo: haircuts for repo collateral, that increase dramatically in a crisis, and thus, precipitate runs

for in house hedge funds: you sometimes have an honour system, whereby the parent informally undertakes to indemnify hedge fund investors against losses (following through on that promise killed Bear Stearns)

for financial insurers: you might have a huge well-capitalized parent (though AIG and the monolines turned out to be not quite well capitalized enough)

Roughly speaking, it would be safe to say that the amount of equity in shadow banks turned out to be negligible.

Now suppose you decided: “Well, shadow banking is just a form of banking. Let’s just ignore the liquidity issue for the moment, and ignore the variety of business models of the various kinds of shadow bank, and require the shadow banks to put up a not very demanding 5% capital cushion and regulate to that, somehow.” Assume, for simplicity, that we want to keep all that lovely shadow banking activity going and that shadow banks’ assets are identical in size to their liabilities; that 5% capital cushion would then be 5% of $8-16Trn. That’s between $400Bn and $800Bn of capital to raise.

Or, perhaps more likely, our shadow banks take 50% losses on 15% of their loans that they never never want to do again (the CDO bonanza, etc), and then need 5% equity on the rest. That way our shadow banks would need $925-$1,850 billion in equity. Which is impressive, but fair enough: the traditional banking system has about $1.3Trn of equity, and we know the shadow banking system is the same size, or somewhat bigger, and more prone to runs. Why, pray, should it not at least be capitalized to the same level, either by new capital, or by shrinkage?

So – do you want a big capital raise, or a massive credit contraction (that would in turn impact OTC derivatives activity), or another crash? Not an enticing choice, and perhaps unsurprisingly Geithner’s 6th May marketing statement doesn’t have anything to say about capital and liquidity in shadow banks. So I suppose “another crash” is the preferred option, by default.

Though actually, when you do delve into the bill, you find, with one exception (the Collins amendment, which is a departure from Treasury’s script) that there isn’t much nitpickable detail at all. It just doesn’t have much to say about shadow banking. In May the US Treasury Secretary identified four shadow-banking related reforms. Here they are, with summaries of their form. Since there is no more detail now than there was in the May puff piece, I quote from it again; what detail there is ain’t encouraging.

Comprehensive Constraints on Risk Taking

“Chairman Ben S. Bernanke will have a seat on a newly created Financial Stability Oversight Council. That board will deputize the Fed to set tougher standards for disclosure, capital and liquidity. The rules will apply to banks as well as non-bank financial companies, such as insurers, that pose risks to the financial system.”

Repo Markets

“These reforms [FSOC, above]will give the Federal Reserve the authority to build a more stable funding system, take action to address the unstable aspects of the short-term repo markets, and ensure that these markets are used much more conservatively in the future. ” Well I hope this infrastructure paper isn’t the sneak preview – the paper itself acknowledges, in a strangled kind of way (p 4, para 2), that infrastructure isn’t the key issue.

Higher Standards for Money Market Mutual Funds

“The President’s Working Group on Financial Markets is preparing a report setting forth options to reduce the susceptibility of money funds to runs.”

Ratings Agencies:

Bloomberg have an update , needed because Geithner’s proposals have (did you guess?) been watered down: “The overhaul legislation requires the SEC to conduct a two-year study on whether to create a board to decide who rates asset-backed securities. That curbed a Senate proposal to establish the board with SEC oversight. After the study, the board would be established only if regulators can’t come up with a better alternative.

Congress also softened a proposed liability provision, making it harder for investors to sue ratings agencies than it would have been under language approved by the House in December.”

Or perhaps you would prefer the short version:

Comprehensive Constraints on Risk Taking:

TBC, by a committee called the Financial Stability Oversight Council.

Repo Markets:


Higher Standards for Money Market Mutual Funds:

Options for standards are TBC, by a committee called The President’s Working Group on Financial Markets. The actual standards will then be selected – by yet another committee perhaps, or maybe the same one.

(I can’t find anything in the sneak preview that addresses csissoko’s more fundamental gripes here and here )

Ratings Agencies:

TBC. First a two year study by an SEC committee on whether a) to create a committee to approve ratings agencies (perhaps they should pick a resonant name for it first), or b) do something else. After that, do whatever the SEC decides to do, assuming they reach a conclusion; otherwise, create a committee to approve ratings agencies…

It seems to have been drafted by the Monty Python crew when you put it like that, but I don’t think it’s a terribly unfair caricature. Not to downplay the importance of other reforms, but a page or to create the committees to save the world, some Fed initiatives that were already in hand before the legislative process started, and then 1,495 pages of other stuff? It seems out of balance.

Still, there is the Collins amendment. It is pretty sensible: bank holding companies will have to be capitalized to the same level as their subsidiaries. You’d think that will force more capital behind some shadow banking activities at least: repo for instance? With due deference to the creativity of accountants, perhaps it will put pressure on some kinds of OBS vehicle too? Here’s hoping…

Collins does have a smart move on capital quality, specifically TruPS, which no longer count as capital. Though not just yet – if you are a big bank, you have 5 years to replace TruPS with proper capital; if you are a small bank, up to 20 years. TruPS were a feature of the crisis, especially once repackaged into (you guessed it) CDOs . The whole idea that holdings in other banks’ debt should count as bank capital is batshit insane, and not even in hindsight; cross holdings have been known to be major contagion vectors since the investment trust fiasco of 1929 (see JK Galbraith “The Great Crash”; UK readers may also remember the Split Capital Investment Trust disaster of 2002, our very pale British imitation of the Wall Street Crash). And in something between 5 and 20 years, that TruPS coupling will be gone, perhaps after another crash. The pace of reform is not dizzying.

The Treasury Secretary’s angle on the very reasonable Collins amendment makes me unsure whether these avowals about shadow banking reform were totally sincere:

The lesson of this crisis, and of the parallel financial system, is that we cannot make the economy safe by taking functions central to the business of banking, functions necessary to help raise capital for businesses and help businesses hedge risk, and move them outside banks, and outside the reach of strong regulation.

But compare Geithner’s ringing words with Geithner joining hands with the banks versus the Collins amendment. The attempt to unpick the Collins amendment looks suspiciously like the familiar “divide and conquer” approach to banking regulation, but led, it seems, by the US Treasury. The steps would be: try to dilute the US regs now, then, in due course, dilute the Basel III provisions on leverage (presumably Geithner is actually the US official said to be opposing the Basel III tightening of capital rules), then, exploit the international dimension to excuse porous regulations. And then you are back to business as usual.

Still, Collins’ amendment has survived; that is a little victory for Collins, or more accurately, I suspect, Sheila Bair and FDIC – see more here (though you should take the stuff about Eurobank leverage with a grain of salt).

So where does that leave us with our shadow banking reforms? Well, we have a modest tweak to bank capital requirements, of unknown efficacy (Collins) and a bunch of new committees, mostly in the Fed. The mountain has laboured, and brought forth a mouse.

Or you might prefer to pursue the anaconda/rabbit imagery to a physiologically realistic conclusion.

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  1. RueTheDay

    I just wrote an 8 part series dissecting the textual summary (published over the weekend by the WSJ) of the Financial Reform Bill:

    One of my conclusions is that there is almost nothing in the bill about the shadow banking system, which most agree was at the heart of the collapse in September 2008.

  2. i on the ball patriot

    The movie you watch is made by a hijacked production company.

    The movie production company has illegally been bought and sold more times than Bayer has produced an aspirin.

    The hijacked production company only makes movies that glorify, aid, and abet the exploitation and oppression of others, of and by those who bought and own the production company.

    The hijacked production company is now a monopoly that prevents other movies from being made.

    The movie is therefore illegal, immoral and corruptly produced.

    When you watch the movie you validate it, legitimize it, make it moral and empower it.

    When you watch the movie so intensely you give up your own power to make your own movie.

    The movie is only real when you watch it.

    The movie loses its power when you walk out of the theater.

    What is it about the movie that keeps the movie patrons so enthralled and makes them such obeisant movie empowering dumb shits?

    No balls! No brains! No freedom!

    Deception is the strongest political force on the planet.

  3. Dwight Baker

    WHAT is the CURE?
    By Dwight Baker
    June 29, 2010


    Larry Fink, BlackRock’s founder and CEO, had joined Blackstone in 1988 as a partner, along with Ralph Schlosstein, former White House aide under the Carter administration, and Robert Kapito and Sue Wagner. Before joining Blackstone, Fink was a managing director at First Boston, where he pioneered the mortgage-backed securities market in the United States. In 1992 Fink, Schlosstein and Co separated from the Blackstone Group under the name BlackRock and aggressively re-invented it as an independent asset-management company. In 1995, PNC Financial Services Group purchased BlackRock and in 1999, assets under management had grown to $165 billion and the firm decided to go public.
    Much of BlackRock’s recent growth has been through its acquisitions. On January 28, 2005, BlackRock purchased State Street Research Management, a mutual-fund business that had previously been owned by MetLife. This acquisition added a sizable equity business to BlackRock’s funds, which had previously comprised mostly fixed-income securities. On September 29, 2006, BlackRock completed its merger with Merrill Lynch Investment Managers (MLIM), halving PNC’s ownership and giving Merrill Lynch a 49.5-percent stake in the company. On October 1, 2007, BlackRock acquired the fund-of-funds business of Quellos Capital Management.[6] On April 30, 2009, BlackRock hired 43 employees from R3 Capital Management, LLC and took control of the $1.5 billion fund.

    MY TAKE —- What is the shadow about those facts? Larry Fink, created mortage back securites now the USA has hired his firm to get to the bottom of all the corruption in Fannie Maye and Freddie Mack. The wolf is in charge of our hen house.

    Try to figure that one out!!!

    I am a sovereign American Citizen I will not bow down to the G-8 and G-20 Banksters, none of those crookmasters were elected. CNN called that bunch lawmakers ??????

    With all the many reasons for folks to protest contest and dissent, no wonder we even have a nation half fit —– half-wit people to do so.

    But the simple truth of the matters about all our problems is in the CURE if we will do so.

    Meaning get off the GRID. Refuse to play the game that the tyrants have set out to make us play.

    How hard can that be? Drain your bank accounts dry —- convert to spend able gold. Then set back, trim the sales, take a break, look around, lose all the un-necessary baggage, tear up the credit cards, drive less, spend less, eat right eat at home, tell the kids NO more often, put all on a strict budget.

    Buy a cheap pre-paid credit card to buy stuff on the web. Get away totally from the crooked banks.

    Take your mainframe computer and un- plug from the web.

    Never plug it in again then tell all who might want to know “ got destroyed in a fire”.

    By a cheap computer to keep at home —– put in on the web for nothing at all except to read etc. never take your private notebook with all your private stuff out.

    Now do your best to be sane while your ride out this storm?

    Last thought The Banksters G-8 and G-20 are shaking in their boots—- why else would they spend one billion for security?
    They only RULE because we allow them too.

    Get off the D—mn Grid.

    1. LeeAnne

      a little additional from the NYT here

      “No single institution has more money riding on BP than BlackRock, the money management firm that is BP’s largest shareholder. On behalf of clients, BlackRock funds held more than 1.1 billion shares, or 6 percent of the shares, as of the end of last year.

      Along with Barclays Global Investors, which BlackRock owns, the combined stock was worth $14.57 billion on April 20. But as of Wednesday, those shares were worth about $7.5 billion.”

      1. ubu

        Blackrock is the brainchild of billionaire Pete Peterson, the mastermind behind the Peterson institute and the international billionaire banking cartel. Peterson always gets his way.

  4. Mickey Marzick in Akron, Ohio

    Did you really expect more? Did anyone? Why?

    Isn’t it a bit of a paradox that after 30 years of less government and less regulation that suddenly “WE” now look to the federal government to deliver US from our own folly? Then when the “feds” seem unable to deliver – Katrina, “wars” in Iraq and Afghanistan, financial reform, and now BP in the Gulf – it only confirms our suspicions that the federal government is both incompetent and corrupt, lacking the fundamental expertise to do anything. It simply isn’t there, a mere shadow relegated to the sidelines by conscious design.

    Government is the problem, not the solution. Anyone old enough to remember that line? Anyone still believe it?

    Isn’t this what less government and less regulation mean when taken to their logical conclusion? “Starving the beast” isn’t just about tax revenue but a systematic approach to dismantling the federal government and reducing it to the role of a “night watchman” – and one not even paid “minimum wage”. So is it really a surprise when he’s found sleeping on the job or partying with the burglars giving them the keys to the building? Perhaps even more naïve is the belief that many of the same “parties” responsible for this particular financial debacle are somehow going to “reform” the shadow banking system in a way that precludes it from cratering the system first time around. Is this the way a limited government with competing factions amidst a separation of powers and checks and balances functions, especially after 30 years of less government and less government that facilitated the emergence and growth of the shadow banking system?

    A nation locked in “free market” groupthink wakes up to the consequences of the latter but has no memory of how it got here. Please wave your magic wand, Mr. Obama, and deliver us from our sins – INTERVENE and fix it! Because come this November I’m going to vote for less government and less regulation again…

    1. NOTaREALmerican

      Re: Isn’t it a bit of a paradox that after 30 years of less government and less regulation that suddenly “WE” now look to the federal government to deliver US from our own folly?

      We’ve had 30 years of less government?

      If you mean we have 30 years of bigger but less efficient government, then I’d agree.

      Anything big will be inefficient. All big piles of loot will eventually be owned by the smartest amoral scumbags.

      (Disclaimer: Work for a 2Big2Fail Zombie bank. I love big socialism. I just need another 5 years on this IT scam and I’m out-a-here! In the mean time, what we really need to do is get satellite phones for all “critical” IT people. You just never know when disaster might strike.)

      1. Mickey Marzick in Akron, Ohio


        Less efficient government? Compared to what? Is there a metric with which to substantiate your claims? Then why or how did this come about? Are you actually saying that the cumulative effect of deregulation and outsourcing of the federal government had no impact on this loss in efficiency/effectiveness? That the regulators’ ideological predispostions not to regulate had no impact on their behavior? What does “starving the beast” mean?

        I think you missed the whole point of my post. Blaming it merely on size is a bit of a generalization, particularly when that bank now deemed TBTF was laying golden eggs right and left three years ago. It wasn’t too big back then was it? Or is this just right wing drivel applicable to government only?

        When do you break a company up? And who determines how it is carved up? Do we leave it to the market and stockholders? Or is management responsible for this task? Toyota, Honda, Exxon-Mobil, Siemens, Phillips, Unilever… Reducing the size of government without a commensurate decrease in the other elephants – large corporations – in the room is the other road to serfdom. Do you trust profit-maximizing firms unconstrained by any constitutional constraints more than the government? Or are both equally damnable?

        How much KOOLAID have you drank?

    2. Atomist

      It’s called The Reaction Of Declining Expectations and in end the real victim won’t be Big Government but democracy itself.
      Which I suppose was the general idea in some quarters, such as those advocating doing away with popular vote for US Senator, etc..

  5. Siggy

    Under our contract for government we, presumely, are the government.

    What has occurred, it appears that there has been massive fraud concurrent with the malapportionment of capital and labor.

    In the face of massive financial fraud we have allowed our representatives and agents(think Fed) to forego the prosecution of the rampant fraud. This isn’t about more regulation this is about enforcing the regulation that is/was in hand, which if enforced would have severly limted the fraud we have experienced. This financial crisis is also about insolvency.

    At the root of our insolvency is the fallacy of a fiat currency and easy credit. Fiat currency balances heldin reserve at any level offer no protection whatsoever. Leverage is a lovely profit enhancer and a deadly destroyer when you can’t make the payment. Putting more money into the economy is akin to pouring water on a drowning man.

    Be very careful what you vote for or against. What has transpired has occurred more because our government has failed to enforce the laws extant than because we have too many laws.

    To say one favors ‘free’ markets is to missstate what is intended. Perhaps we could supplant free markets with fair markets.

    In 1946 when WWII ended the US stood a creditor nation with its manufacturing capacity intact. Demobiliztion led to a recession and the Congress then enacted the Full Employment Act. The GI bill flooded our universities and and we we went on a buying binge acquiring all those nice new belchfire behemoths that Detroit could produce. We even bought a lot of foreign made vehicles. The UAW was in the cat bird seat controling a scare resource, semi sjkilled labor. Then comes the Marshall plan and as the creditor nation of first resort we funded the reconstruction of Europe and Japan. China proved to be intractable because Chiang Kai Sheck (sp?) was utterly corrupt and there was this fellow Mao. This Mao fellow seemed to be communist so we backed the thief. Didn’t work. Mao prevailed because he led a population that was tired of being dirt poor. Irony that Mao called for a mass exudus from the cities to the farms. He also tried to control the birth rate. Anyone recall the population count, seems it was under a billion.

    Today China is a nation of 1.3 billion and its economy is on a trend to become larger than the US. The wage rate differential between China and much of the rest of the world is extreme. The differential is so large as to make Chinese goods lower priced than most western goods. So the successors to Mao have elected to employ mercantilist, beggar thy neighbor, economic policy to bring their population back from the farms into the cities.

  6. RueTheDay

    First of all, thanks for the kind words and link to my blog.

    As I was going through the WSJ summary of the newly negotiated legislation (which is by far the most detailed document released to date, post negotiation), I was shocked to see no mention at all of money market funds, the repo market, and off balance sheet bank vehicles. None. I read it and re-read it, and did a keyword search, because I just couldn’t believe that extending regualtion to the shadow banking system was completely left out of the bill.

    The only occurrence of the word “shadow” is this:

    “Fills Regulatory Gaps: Ends the “shadow” financial system by requiring hedge funds and private equity advisors to register with the SEC as investment advisers and provide information about their trades and portfolios necessary to assess systemic risk.”

    As if hedge funds are the only component of the shadow banking system, and the only change needed was requiring the largest ones to register with the SEC and report some aggregate information.

    Perhaps this was just an oversight on the part of the staffers who compiled the summary. If not, and shadow banking was completely left out of the new bill, I don’t know what to say, just WOW.

    1. Mickey Marzick in Akron, Ohio


      Could it be that “the shadow banking system” is so complex and interconnected as to defy reform the first time around? Or reform can only be accomplished at a supranational level [BIS] given its international scope and ramifications? Then as the shadow banking system is unwound and becomes more “transparent” to the “regulators” over time perhaps it will become more amenable to meaningful reform? Does anyone really understand this mess or comprehend it enough to enact measures to control it?

      I’m not trying to excuse the participants or the political machinations/influence of Wall Street in the results or lack thereof but am trying to eliminate the various explanations for why it didn’t happen this time around.

      1. RueTheDay

        I don’t buy that for a moment. Put aside the “complex” parts of the shadow banking system for the time being, and focus on Money Market Funds. It doesn’t get any simpler than this. What do MMF do? They take deposits (and allow checks to be written against those deposits) and then use the funds to buy securities (usually Treasuries) and to make loans to financial and non-financial firms via the commercial paper market. In other words, they do essentially the same exact thing as banks, and most people view them as a substitute for bank accounts. So why can’t we apply the same exact regulation that we apply to banks to money market funds? We went halfway down that path during the crisis when the FDIC extended deposit insurance to them. Why not make that permanent (and charge the same premium), and along with it extend the usual capital requirements and regulatory examinations as we do banks?

        Let’s not forget that this financial reform legislation has been in the works for around a year, with significant input from the Fed and Treasury, and scores of staffers comprised of lawyers, accountants, economists, and professional regulators working on it. It wasn’t written on the back of a napkin over cocktails. There’s no excuse for it to be missing the huge areas it’s missing.

    2. Richard Smith

      RTD – yes that is my take too, FWIW: there is nothing specifically about the shadow banking system in the bill. OTC derivatives, which *are* tackled in the bill, are a related area, to be sure.

      But apparently the key shadow banking reforms will all be sorted out by committees – the ones I mentioned above; plus the Basel Committee of course (eventually).

      That must be worth a raised eyebrow at least, even over here, in the Land Of Inhibition.

      It would be good to be hear the rationale for this approach, rather than have to guess at it.

  7. dcortex

    The markets are tanking…do you think the selloff is related to the news item that in the wake of Byrd’s death, 3 democrats refuse to pass FINREG bill?
    Is the bill so full of secret earmarks for banking that its lack of passage is bumming banks out?

    1. NOTaREALmerican

      Well, if you can believe what is said on Zero Hedge, there’s no “market” left. All prices are now set based on computer trading. So, any movement will be huge as volume is low and the humans that monitor the machines are all hovering over the red-panic button. The last sucker to sell loses the game.

      So, this could just be another wild end-of-tail swing, or (queue ominous music) it could be the black-swan-of-doom.

    2. LeeAnne

      I think you’re right. Without a coupla thousand pages of loopholes the free market might actually work and put these guys out of business. The social pressures should be getting to them about now in spite of Blankfein’s poster boy grin. Russ Feingold wasn’t going to vote for it and he can be trusted IMHO.

      Nothing is going to be done for the good of the American people until these guys are pushed back in their place, downsized and off the welfare system.

  8. Pluto

    Algo trading is based on the same principles any trader can use, the computers are just better at it.

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