Last Friday, Mark Thoma wrote a guest post for The Hearing arguing that the “shadow banking system” was a significant contributor to the financial crisis and needed to be regulated. This prompted a series of posts either attacking or defending his position; for a rundown, see today’s Hearing post.
For now, I just want to highlight the analysis by Mike at Rortybomb (hat tip Mark Thoma). (Those who have read Gary Gorton’s new paper can probably skip this post.) Mike points out that people mean at least three different things by “shadow banking system:”
1) Subprime lenders, who were not subject to the same regulatory burden as depository institutions.
2) A market that trades “informationally insensitive” debt as the result of the repo market and securitized debt as collateral. Where depositors are corporations and money market funds and where lenders are financial firms.
3) Traditional firms who took big bets in the investment markets while their regulators were not present or asleep at the wheel.
For Mike, #2 is the the one that matters. Here’s his explanation:
A bank is, in abstract, an institution that borrowers short and lends long.
Your local bank borrows short deposits and lends long investments. If it needs liquidity it can always go to the central bank’s discount window. The central bank’s discount window is the market maker of last resort for this banking system. [Regulated banks can always borrow money from the Fed at a pre-set interest rate, so they always have access to cash.] This prevents bank runs. In exchange it is regulated by the government.
Your local shadow bank took in money in the repo market as deposits, and used senior tranches of debt as the collateral. Now what happens when it needs liquidity? There is no market maker of last resort who the system as a whole could turn to. Repeat that again. It exists in the shadows, there is nowhere to turn to for emergency liquidity. There is no regulation/liquidity tradeoff here. This is what is meant by being unregulated – not that there weren’t any government agents in sight.
I’ll take that last paragraph a little slower. A repo, or repurchase agreement, is a transaction where one party (the “shadow bank”) sells some securities to another party (the “depositor”) in exchange for cash and simultaneously agrees to buy those securities back at a predetermined (higher) price at some date in the (near) future (like tomorrow). In effect, the depositor is lending cash to the shadow bank, and holding the securities as collateral; the difference in the two prices is the interest. It wants the collateral because nothing else is guaranteeing its loan to the shadow bank (as opposed to ordinary FDIC-insured deposits). The collateral is generally worth at least as much as the amount of the loan, to minimize the risk to the depositor; but the remaining risk is that the shadow bank won’t make good on the repo and the collateral will fall in value.
Why would this happen? The depositors do it because they get higher interest rates than they can get in an ordinary deposit account at a commercial bank. Why would the shadow bank offer higher interest rates? It wants to attract the cash so it can lend it out at a yet higher interest rate (“lend” here could mean buying up subprime mortgages to package into securities that are then used as the collateral for more repurchase agreements to start the cycle again); it doesn’t want to become a commercial bank because commercial banks were traditionally more highly regulated. For example, the major commercial banks were significantly less leveraged than the investment banks during the boom.
The problem that Mike highlights is that there was no liquidity backstop for the shadow banking system. So when the “depositors” got nervous about investment banks like Bear Stearns, they refused to roll over their repo agreements (that is, when the shadow bank closed a repo by buying back the securities, the depositor refused to lend new cash via a new repo), or they imposed a larger “haircut” – they lent less cash for the same amount of collateral. The result is a bank run – only this time the run is on the shadow bank. (Gorton focuses on a slightly different problem, which is that when the same collateral doesn’t bring in as much cash, you have to shrink your balance sheet by dumping assets.)
Mike’s analysis draws heavily on Gorton’s paper, which is helpfully summarized by Ezra Klein. The basic conclusion of both Mike and Gorton is that banking systems need to be reliable, the shadow banking system is a banking system, and hence the shadow banking system must be regulated to some degree. Robert Lucas, quoted in Mike’s post, puts it well:
The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.
But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.
By James Kwak
The Baseline Scenario 
At the risk of disagreeing with a Nobel laureate (Lucas), we don’t need something “new”. We need what we had back around 1998 before Glass-Steagall was repealed. We need retail banks separated from investment banks so fat cat SPECULATORS cannot speculate with OUR money. If the fat cat SPECULATORS want to gamble and play roulette with credit default swaps, packaged securities stuffed with garbage, etc.—let fat cats borrow from fat cats—not from main street taxpayers that work hard for their money.
The post touches on some key points, but leaves out others.
For example: “Where depositors are corporations and money market funds and where lenders are financial firms.”
This is only partially true. Shadow bank depositors are also individuals/corporations who park their money in money market funds. From that standpoint, money market fund purchases of commercial paper represents shadow bank lending. Money market funds thus represent the clearest example of a shadow bank. They were also the epicenter of the shadow bank run – as Bernanke and Paulson testified to Congress about the attempted withdrawal of trillions of dollars from MMMF in mid-September, prompting the extension of FDIC insurance to the money funds.
The other point to consider is the link between the shadow banking system and the regular banking system by way of SIVs/conduits. SIVs worked somewhat to the reverse of MMMF in that they issued CP to raise funds and used the proceeds to buy ABS/MBS. Thus, they complemented MMMF. The standby lines of credit they obtained from their sponsoring banks meant the regular banking system had a huge off-BS liability in the event the CP market seized up. Which is exactly what happened.
The SIVs have pretty much disappeared at this point, and any discussion on what to do about the shadow banking system has to center on MMMF and the CP market.
James,
I think a useful addition to the “for beginners” series would be something about carrying assets “off balance sheet.” Just how is this sort of thing done, and what is the rationale offered for allowing a practice that, on its face, sounds like nothing less than rank fraud.
Keep up the good work.
And all of this was done with other people’s money. Other people’s savings, sometimes their life savings. Money that was supposed to be reinvested to make the economy grow & thus make the savings grow. But was invested instead to make fat bonuses for those who had been given custody of innocent people’s money to protect. Indeed the bonuses were taken from & are still taken out of other people’s accounts.
Can someone explain to me why we should care that on any given night, a MMF might be unable to roll over its debt?
Breaking the Buck? Who cares; the investors have been enjoying outsized returns and are just paying them back.
Businesses unable to meet current obligations? Any CFO who puts immediately needed CAs in speculative MMFs (or in less than several different MMFs) is a greedy fool.
Banks experience losses on the collateral they took from the MMFs? Too bad; take more collateral. Anyhoo, that’s how the world works.
Regulate the CFOs and the loan officers, not the MMFs?
Because it can blow-up the world:
http://blogs.cfr.org/setser/2009/03/08/the-shadow-financial-system-–-as-illustrated-in-three-new-papers-that-cut-through-london’s-fog/
A quote:
“It turns out that Lehman (and no doubt other investment banks) and European banks both borrowed heavily from the US money markets. In effect, they shared a common creditor – “prime” money market funds – and when Lehman’s default led the reserve primary fund to break the buck and massive withdrawals from “prime” money market funds – European banks lost access to dollar financing. Baba, McCauley and Ramaswamy write: “the run on US dollar money market funds after the Lehman failure stressed global interbank markets because the funds bulked so large as suppliers of US dollars to non-US banks.”
Correction —
“Indeed the bonuses were taken from & are still taken out of other people’s accounts.”
Indeed the fat cat’s bonuses ultimately came from & still ultimately come out of other people’s accounts.
It appears Gorton collapses two payment risks into one. Separating the risks, changes the analysis and maybe the conclusion.
We all probably at some time have bounced a check due to insufficient funds in our checking account, or have dipped into a overdraft privilege or credit line to allow an overdrawn check to be paid.
A holder of a check (a payee) has two concerns. One is that the check writer has sufficient funds in the account so payment is received at time of cashing the check, and two, that the bank (as opposed to the check writer) will have sufficient funds to make good on the funds in the check writer’s account. These are two different risks. Government insurance does not apply to the account holder’s sufficient funds risk. It only applies to the bank’s liquidity, bank run risks and the bank’s ability to cash the check. Insurance makes a check holder insensitive to liquidity risks, but not to insufficient funds risk.
When a bank fails, the FDIC has two options. The FDIC can allow another bank to acquire the deposits of the failed bank or the FDIC can make a direct payout to all depositors (an FDIC payoff) of the closed bank.
If there is a direct FDIC payout to depositors and a check is presented for payment, the FDIC states (“When a Bank Fails – Facts for Depositors, Creditors, and Borrowers”, http://www.fdic.gov/consumers/banking/facts/payment.html):
“In a payoff, however, any outstanding transactions or checks presented after the bank has closed cannot be paid or charged against the account. The FDIC needs to freeze all deposit accounts at the time the bank is closed to quickly pay the depositors for the insured deposit balances in their accounts. Any outstanding checks or payment requests presented after the bank failure will be returned unpaid and will be marked to indicate that the bank is closed. This does not reflect on your credit standing. However, it is your responsibility to make other funds available to creditors who receive checks that were returned and did not clear your deposit account because of the bank closing.”
The holder of a check will have a payment priority risk since checking accounts and general creditors are paid on a first come, first paid basis. Nonpayment and the return of the check, which forces the check holder to seek a new form of payment from the payor changes the timing priority of payment and changes the risk of payment. The risk is that at the time the check holder approaches the check writer or his new bank, the writer will no longer have sufficient funds to make good on the check.
Repo collateral needs to minimize and protect against both risks. To the extent that collateral loses value and no longer is sufficient to cover the repo amount, the excess amount due is a general claim against the firm’s non-legally obligated, non-restricted funds. It is a general creditor claim against the firm. Loss of collateral value is similar to having insufficient funds in a checking account.
Obviously, the creditor did not want to be a general creditor of the firm or the firm did not want to borrow without posting collateral. If the lender wanted to be an unsecured creditor, they would have lent to the firm without collateral. The borrower similarly wanted to post collateral most likely as a means to lower the cost of borrowing.
Assuming the lender is indifferent between lending unsecured at a higher rate or at lower rate with collateral, then it is borrower who makes the decision based on factors such as the lower interest rate. However, there is also the possibility that there is no reasonable rate at which the lender will lend funds to the borrower without collateral because the risk of default is already too high.
As the value of Bear Stearns and Lehman’s collateral declined, lenders faced both risks. The collateral, which is equivalent to the funds in a checking account, was no longer sufficient to repay the loan amount. Bear Stearns and Lehman became overdrawn and the lender became a general creditor for the excess amount. Lenders could have renegotiated for a higher interest rate as a general unsecured creditor, if they had deemed Bear and Lehman an acceptable risk. Lenders did not because they perceived the risk of default as too great (bankruptcy too likely, general creditor payout rate too low), or because Bear Stearns and Lehman refused because the apparent costs were too high. In the latter, obviously the firms did not believe they faced a high probability of bankruptcy or they would not have deemed the costs too great.
As Bear and Lehman faced putting up greater amounts of a limited supply of collateral, the market new they would eventually run out of available collateral. The two firms would face a funding crisis only if they could not borrow as an unsecured creditor.
The firms probably had open lines of unsecured credit. They either both drew these lines down and could not obtain more or lenders withdrew these lines due to heighten risk.
How did these firms’ funding staff (CFO, Treasurer, CEO) allow Bear to risk its funding sources by becoming highly concentrated in a single collateral asset class (residential mortgages) or allow it to be so dependent on short term, collateralized funding as opposed to general credit lines and longer term funding? Single asset funding classes have a history of surprising declines, e.g., LTCM, Amaranth, etc.
Bear and Lehman failed either because they were bad credit risks, because they misread their chances of bankruptcy or because they relied to heavily on short term funding. Insurance fixes neither of these problems. The firms failed because of mismanagement. Either they had an unprofitable business model (in a risk-adjusted sense) or their management did not understand the likelihood of failure and bankruptcy due to funding problems.
Relax, Patrick.
That’s what the Fed’s currency-swaps with foreign central banks are there for.
Furriners as dumb as our own dumb, greedy CFOs should be regulated by their domestic central banks.
Quaere: Is there one MMF prospectus which doesn’t permit the fund to put up a gate when redemption requests become burdensome?
This, of course, was the antecedent problem with the subprime mortgage market. Mortgage brokers who were given “lines” to fill, originated mortgages to fill those lines. Initially, there were strict packaging and underwriting guidelines as to what loans could be included by the broker as submissions to the investors. But, as the market superheated, the guidelines were substantially relaxed because the security was considered to have unquestioned value (homes would never drop in price). The more relaxed rules permitted the mortgage brokers and mortgage companies to become more and more agressive in obtaining loans, no matter how questionable. Then, of course we had the widely reported and analyzed structuring of the investment portfolios. But the real bottom line was at the consumer level, because most mortgage companies and brokers took their profits immediately, and never retained an interest in the originated loans. They were completely desensitized to risk, unlike the larger investment houses (although, one could argue that they were, for horrible reasons, substantially desensitized).
It is easy to see how substantially unregulated “shadow banks” can destroy us.
Or maybe their lenders (Goldman Sachs?) held CDSs on them written by AIG Financial Products, and when Paulson and Bernanke told the lenders they’d make them money-good on all AIG products, the lenders pulled the lines of credit and cashed in on the CDSs.
The idea that this was caused by “shadow banking” is another red herring. The biggest cause of this mess was the Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act allowed the securities industry (speculation) to combine with commercial banks (checkings and savings) and become one . The Gramm-Leach-Bliley Act was shoved down our throats by Phil Gramm and the bank lobbies. In essence this created a new type of Insurance. SPECULATIVE investments are now covered by checking and savings account depositors. You can think of it as the new “MAIN STREET INSURANCE COMPANY”. The “MAIN STREET INSURANCE COMPANY” allows bankers to take any/all risks they like and if they lose the “MAIN STREET INSURANCE COMPANY” pays the bills. This is free insurance for all banking institutions. THE BANKS NEED NOT PAY ANY PREMIUMS FOR “MAIN STREET INSURANCE”. Just scream “Panic!!!” and “MAIN STREET INSURANCE COMPANY” pays all of a bank’s creditors, no questions asked. Thank you Phil Gram, Thank you Jim Leach, Thank you Thomas Bliley Jr.!!! The banking industry is forever grateful to you.
I don’t think you’ve explained why anyone should care whether a mortgage broker (or hundreds of mortgage brokers) gets its funding line pulled by its Wall Street enabler and winds up being shutdown.
What? You wanted more money going to those scallywags? You thought the bubble wasn’t big enough so you wanted to make it bigger?
Sorry, That’s Phil Gramm with to m’s in my comments above. I want to make sure Phil Gramm gets all the credit he deserves.
Bear Stearns, Lehman Brothers, and Merrill Lynch went under; none was a child of G-L-B.
BS and M-L were saved because the effects of their failure on their lenders — that is, the too-big-to-fail banks — were deemed unacceptable.
Was it not the case that before G-L-B commercial banks were permitted to loan to investment banks? And if they were, wouldn’t the failure have occurred with or without G-L-B?
Most mortgage brokers sell the loans they close to investors — or lately to MBS packagers.
It’s up to the buyer to look at the mortgage application and closing files to determine the price that buyer is willing to pay for the mortgage.
Note: A review of the supporting documentation would have shown that many of the 2005-7 loans coming out of the Sand States should have been priced at 20-30 cents on the dollar.
No one can save the lazy, stupid lender — caveat emptor.
The debate over at the Post seem to hinge on whether the regulated banks were a major impetus for the systemic breakdown. Thoma claims it was unregulated institutions, the “shadow banking system”, that fueled the crisis, while Dr. Manhattan believes that heavily regulated entities were responsible.
It seems that they’re both right, in a sense. Many of the big problems came from institutions that were regulated in the traditional markets in which they operated, but were not regulated while conducting off-balance-sheet trades. CDS trades, for example, were not subject to traditional capital requirement regulations, and many regulated banks were heavily engaged in these. So the ability of regulated banks to engage in activities which were not regulated was a huge problem.
Obviously, something should be done about derivatives, particularly the CDS’s. You can regulate traditional banking operations all you want, but if you are ignoring the potential for massive liquidity risk in unregulated trading, then you’re wasting your time, or, worse, creating a sense of false security.
But what can be done about derivatives? I do not believe that they can be made safe through regulatory oversight; they are simply too complex for regulators to properly value. And because of correlation issues, market participants are even less able to quantify liquidity risk because they do not have access to information regarding the overall positions of their counter-parties. (Presumably, the regulatory agency would have this information, but that is a big presumption.)
So, If they are not safe now, and they cannot be safely overseen, I think the answer is to ban them. I realize I’ve said this before in comments here, but I do not think this issue is getting enough attention.
Ellen, you take 3 firms that were ALREADY INVOLVED IN INVESTMENT BANKING before Gramm-Leach Bliley was passed (Bear Stearns, Lehman Brothers, and Merrill Lynch). You then argue that because these 3 firms ALREADY involved in investment banking BEFORE Gramm-Leach-Bliley was passed, failed, that Gramm-Leach-Bliley had no effect on systemic risk.
You ever heard of a little Insurance company called AIG?? Yes, well it USED to be an insurance company, before it got into credit default swaps, investment banking, and hedge operations. Before Gramm-Leach Bliley was passed that would have been illegal.
And after Gramm-Leach-Bliley Act was passed AIG got to cherry-pic which agency regulated them. That’s right–AIG got to choose who was their regulator. And guess who they chose??? The Office of Thrift Supervision, the smallest of the regulating agencies. Now the taxpayer owns 80% of AIG, and because we saved AIG, we indirectly bailed out Goldman Sachs also, because AIG owed 20 billion to Goldman Sachs.
Shall I go on?? Citigroup??? Bank of America???
For about 66 years under Glass-Steagall we had very few bank runs. 8 years after Gramm-Leach-Bliley was passed the ENTIRE system almost went down.
You do make 1 good point in that there was a lot of risk in the system anyway. Why? Because of credit default swaps. Credit default swaps were not regulated. Why were credit default swaps not regulated??? I’m so glad you asked…. Because the Commodity Futures And Modernization Act of 2000 exempts credit default swaps from regulation. It was also sponsored by Phil Gramm and friends. According to Wikipedia the bill WASN’T DEBATED in the House or the Senate.
Have no fear, Dark Pools are here!
…and opacity is the whole point!
Ellen – GLB was certainly a major factor in the crisis, but it was not the only one. The implosion of Bear/Merrill/Lehman can be attributed to the 2004 SEC rule change (net capital rule) that eliminated the 12:1 leverage cap for broker-dealers. Likewise, the AIG blowup was largely the result of the Commodity Futures Modernization Act of 2000 which exempted naked CDS from state gaming laws. Taken together, I’d say that the combination of GLB, the 2004 net capital rule change, and the CFMA account for 90%+ of the current crisis.
Robert Lucas: “The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.”
The Lucas quote is taken out of context, so it may not represent Lucas’s full view of the regulatory problem with shadow banking. However, the one way focus of the concluding statement, suggesting that the main point of regulation is to provide publicly funded insurance, can lead to moral hazard of the sort behind the S&L crisis and the current financial crisis. (Besides, what the public needs is another question.)
James Kwak; “But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks.”
Fortunately, the second statement is another non sequitur. If regulations are written for shadow banking per se, then the attempt to form a shadow bank would bring it into the regulatory fold. To bring up designer drugs again, Congress showed that it could legislate regulation for things that do not yet exist, but would come under regulation as soon as they are created. They can do the some for shadow banks.
by the way:
from what i understand, AIG lost north of 20 billion on securities lending. this had nothing to do with AIGFP.