Decoding the NY Fed on Shadow Banking

Back to this thing to try to work out what it’s driving at. Yves wrote:

I have serious trouble with its bottom line:

We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance.

This extract ought to be a joke, but I fear this is deadly serious. By some estimates (we’ll see what the Fed comes up with), the shadow banking system came to $8 trillion dollars (repo alone was $10 trillion, but that is often double-counted, and many shadow banking assets were used as repo collateral). This $8 trillion had close to zippo equity behind it, and quite a few of those assets, starting with ABS CDOs. were greatly overvalued. But the Fed seems constitutionally incapable of seeing the financial crisis as a solvency crisis, and keeps insisting it was a liquidity crisis. That view, by the way, may not be that of all the staffers whose names appeared on this work.

Indeed, a couple of pages in to the Fed’s piece, the solvency issue does peep out, rather shyly:

However, once private sector put providers’ solvency was questioned, even if solvency in some cases was perfectly satisfactory, confidence in the liquidity and credit puts that underpinned the stability of the shadow banking system vanished, triggering a run. Ultimately, a wholesale substitution of private liquidity and credit puts with official liquidity and credit puts became necessary to stop the run, but not before large portions of the shadow banking system were already gone.

And again, via this oblique allusion to the dodgy collateral that crept into the system:

Securitization-based credit intermediation also creates agency problems which do not exist when these activities are conducted within a bank, as illustrated by Ashcraft and Schuermann (2007). If these agency problems are not adequately mitigated with effective mechanisms, the financial system has weaker defenses against the supply of poorly underwritten loans and structured securities, and the end result could potentially be more severe than the failure of a single institution or even a group of institutions, since, as the financial crisis of 2007-2009 would demonstrate, it may involve the collapse of entire markets.

Whatever one makes of the paper’s slight conflictedness about ‘liquidity’, perhaps just a needed genuflection to the boss, or to the old boss, it has plenty of good things, too. Some cherrypicking: a handy definition of shadow banks first:

We define shadow credit intermediation to include all credit intermediation activities that are (1) implicitly enhanced, (2) indirectly enhanced or (3) unenhanced by official guarantees. Financial entities that engage exclusively in shadow credit intermediation are shadow banks.

The not very original handle, “credit intermediation” leads to exactly the right smackdown for the financial reforms that have just chugged through Congress:

The recent financial reform legislation imposes restrictions on the proprietary trading activities of banks and directs banks to put swaps activity in to a non-bank subsidiary, but largely ignores credit intermediation activities that take place outside the traditional banking system. In the end, the principle that should connect each theme of the regulatory reform debate is the identification of all forms of activities that facilitate credit intermediation (whether they are conducted from inside or outside of banks) that should take place with the benefit of public-sector liquidity and credit enhancement, and what (if anything) should take place in the shadows.

The paper’s disaggregation of traditional banks’ credit intermediation into credit transformation, maturity transformation, and liquidity transformation is a handy conceptual framework, rather overwhelmingly illustrated by examples of how shadow banks pick and choose which activities to engage in. That leads straight to the idea of regulating by function (according to which of the above transformations is performed by a given entity), rather than form (banking is banking; it doesn’t matter if the company that engages in it is called a bank, or a hedge fund or an insurer). Heh, it sounds as if the Fed is discovering the “rules vs principles” distinction. We will see, eventually, if this “regulation by function” actually manages to turn into something practical and useful. For the moment, it is just a promising idea.

On Money Market funds (my emphasis) the Fed do actually agree with Yves above:

On the eve of the financial crisis, the volume of cash under management by regulated and unregulated money market intermediaries and direct money market investors was $2.5 trillion, $1.5 trillion and over $3 trillion, respectively (see Exhibits 22 and 23). This compares to bank deposits (as measured by the sum of checkable deposits, savings deposits and time deposits) of $6.2 trillion. These cash pools can effectively be interpreted as “shadow bank deposits”, as similar to banks’ deposits they were expected to be available on-demand and at par. In other words, these cash pools have an implicit “par” put option embedded in them. Yet, their promise of redemption at par and on-demand is not supported by any amount of capital or official enhancement whatsoever.

The footnote to the above is another smackdown for current regulatory reform efforts:

Strikingly, regulatory reform efforts are completely ignoring cash intermediation activities outside of 2(a)-7 MMMFs.

I think “strikingly” must translate as “major cockup alert”. The Fed is drawing the right conclusion from its history of the rise of shadow banking:

This erosion [of traditional banks’ “specialness”] occurred due to the entry and growth of an army of specialist non-banks since the late-1970s into the businesses of (1) credit intermediation (for example, finance companies) and (2) retail and institutional cash management (for example, money market mutual funds)… Combined with the high costs and restrictions imposed by regulators on banks, growing competition from specialist non-banks put increasing pressure on banks’ profit margins… Eventually, what was regulated, restricted and “innovated” out of the banks found its way back into them…

Those lessons are: if MMMFs continue to have this particular kind of competitive advantage over banks (they have no equity but get backstopped anyway in a crisis), there will continue to be pressure on banks to match MMMFs’ RoE by taking larger and larger risks. MMMFs are just another arb. So MMMFs will keep blowing up, and banks that try to compete with them will, too. And the same applies to other Shadow Banking actors, by the promise-shifting mechanism depicted by OECD, P13.

Given the above, the Fed is right to warn that the tighter regulation expected from Basel III could boost the Shadow Banking system some more:

Over the last thirty years, market forces have pushed a number of activities outside of banks and into the parallel banking system. Interestingly, the reality of significant increases in traditional banks’ capital and liquidity requirements could make the “parallel” banking system even more prominent and competitive going forward.

That is a displeasingly perverse possibility, echoed by the OECD, P13 again. Basel III could make instability worse, just like Basel II did.

The Fed kinda leave this one hanging:

However, a related deep question is whether or not the “parallel” banking system will ever be stable through credit cycles in the absence of official credit and liquidity puts. If the answer is no, then there are questions about whether or not such puts and the associated prudential controls should be extended to parallel banks, or, alternatively, whether or not parallel banking activity should be severely restricted.

“Deep” is unencouraging. Does it just mean “unlikely to be answered”? Perhaps it just a hedge for when they come up with a set of reforms that doesn’t reduce the incidence of shadow banking runs? Alternatively, if they are saying that the Shadow Banking system really can’t be stabilised, then they had better step up and propose some ways to restrict its size. Otherwise it will certainly just be crashes and bailouts for ever. But this is a matter for ‘policymakers’:

…given the still significant size of the shadow banking system and its inherent fragility due to exposure to runs by wholesale funding providers, it is imperative for policymakers to assess whether shadow banks should have access to official backstops permanently, or be regulated out of existence.

I think “pay a fair rate for a backstop, or be regulated out existence” sounds like a nice pitch. If we hadn’t all seen the post-crisis indications of government/regulatory capture, we might even believe it would become policy sometime…

Looking at the contents page, the next few iterations of this Fed paper will add tons more detail to the description of how the Shadow Banking system works, and attack the question of how big it really is. Reform proposals and any structural changes in banking (one can dream) will be downstream of that. Still some way off.

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  1. RueTheDay

    I have a fairly detailed post on shadow banking up on my blog:

    I intend to do an even more detailed followup in the near future.

    With regard to “pay a fair rate for a backstop, or be regulated out existence”, this is what it all really comes down to. How anyone can argue that a MMMF that takes deposits (and lets depositors write checks against their deposits) and then loans the funds to firms via purchases of commercial paper is anything other than a bank is just beyond me. Declare them banks and then regulate them as such or put them out of business. Those are the only two options. Tinkering around the edges is absurd.

  2. Richard Smith Post author

    Looking forward to your next, RTD.

    This FED stuff is the *only* official engagement with Shadow Banking that I can find anywhere. Would like some evidence that BoE at least is thinking about it.

    The US Financial Reform just ignored Shadow Banking (perhaps preempted by Treasury/Geithner, perhaps just clueless).

    Basel III ignores it too, as far as I can see (see the OECD paper linked to twice above, vaguely mulling a post sometime on that and what it means for Basel).

    If FinReg and Basel III were boats, they’d have elaborate superstructures, and great big holes in their hulls, below the waterline.

    So there is a lot hanging on what the Fed decides to do with Shadow Banking. Even though I like their redefinition of what banking is, the thought that it’s all up to the Fed doesn’t put a spring in my step.

  3. flow5

    This goes back to Keynes. Commercial banks create new money in the lending & investing process, they do not loan out existing deposits or savings. Financial intermediaires (the non-banks) on the other hand, loan existing money that has been saved, and all of these savings originate outside the intermediaries.

    A commercial bank: Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, via negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    “Regulating by function” describes the old regulatory regimes before the DICMCA. This Act created the legal framework for the addition of 38,000 more commercial banks to the 14,000 we already had, and in the process, the abolition of 38,000 intermediary financial institutions.

    Economic theory propounds that commercial banks are financial interemediaries (intermediaries between savers and borrowers). It is the single biggest error in all of the literature. It is one facet of the Shadow Banking System’s problems. Another facet was the deregulation that encouraged the proliferation of new financial inovations.

    The old days by John Mason “So Long to the S&L Association”: “The original Savings and Loan Association was created to help Americans own their own homes. The S&Ls deposits were time and savings accounts, no transaction accounts, and the assets of an association were mortgages. An S&L could hold 80% of its assets in mortgages…not mortgage-backed securities or any other type of synthetic concoction of mortgage instruments or derivatives”.

    The collapse of the Shadow Banking System resulted from the weaknesses in the dominat economic theories. I.e., money flowing to the intermediaries are not transferred out of the commercial banking system, only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: THE INTERMEDIARIES SHRINK IN SIZE, BUT THE SIZE OF THE COMMERCIAL BANKS REMAINS THE SAME. THIS IS AT THE HEART OF THE GREAT RECESSION.

    The financial intermediaries are not in competition with the commercial banks. Essentially, you cannot take money out of the CB system. So IORs have created massive disintermediation of the non-banks and bank credit within the CB system.

    This proves they don’t understand the salient differences: Since Mutual Savings Bank’s (MSB) inception, their account balances in the Member Commercial Banks (MCB)were designated as inter-bank demand deposits (IBDD’s –balances maintained by customer banks in correspondent banks), presumably because MSBs were called banks (with the exception of 6 MSB banks that had MCB regulations) and were insured by the Federal Deposit Insurance Corporation (FDIC) and not the Federal Savings & Loan Insurance Corporation (FSLIC), and not counted in M1.

    At the same time S&L’s deposits were insured by the FSLIC and their balances in the MCBs were not designated as IBDDs (were counted in M1); neither institution had the right to hold deposits transferable on demand, without notice, and without income penalty (the legal basis for becoming a MCB), prior to the Depository Institutions Deregulation & Monetary Control Act (DIDMCA); both were the customers of the MCBs; and neither had Regulation Q restrictions prior to 1965.

    Everything today is mud pie.

  4. gerold k. b. weber

    I have to applaud Richard Kline for delving deeper into the interesting NY Fed research paper, and commenting brightly on some noteworthy sections.

    On another aspect the paper shows that many financial institutions, being in the sun or in the shadow, are dancing around the same indivudal and subsequently packaged basic loans, as well as their corresponding data items stored in heterogenous systems.

    Chains of automatic processing of this data are extended across participants, complexity increases, dependencies are created where there have been none in the past. Information is stored repeatedly, often in different semantics, and regularly gets lost along the process chain.

    The wonders of the ever increasing capitalist specialization of work tie us all together in one great universe of contagion and systemic risk.

    1. gerold k. b. weber

      Sorry, Richard Smith, for associating your excellent work wrongly with Richard Kline, whom I also hold in high esteem. Gerold

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