How to Back Up the Shadow Banking System

Mike from Rortybomb has an interview with Perry Mehrling on the shadow banking system. I was going to try to put this in some context, but Mark Thoma (who played an important role in this saga) beat me to it.

Merhling’s takeaway point is that there needs to be a “credit insurer of last resort,” who will insure any asset against a fall in value – for a sufficiently high premium. This would make it possible for financial institutions to unload the risk of their asset portfolios in a crisis, if they are willing to pay enough to do so. The only institution that would have the credibility to play this role in a real crisis would be the federal government; as we saw, AIG – the world’s largest insurance company, remember – was not up to the task. Still, though, I’m not sure this would do the trick. If I’m a large bank with a balance sheet full of toxic assets, and I don’t want to pay the premium that the insurer of last resort is charging, then I go to the government, say the price is too high, and ask for a bailout. The credit insurer of last resort would need to be coupled with a commitment not to provide an alternative form of government support, or we would end up where we are today.

By James Kwak

22 thoughts on “How to Back Up the Shadow Banking System

  1. But your point in the past has been that a lot of this market activity was not necessary in the first place and was merely the product of bad incentives, correct? I’m not sure why we would need an institution to fulfill such a role if banking became boring again, as has been suggested.

  2. James,

    Given that the best and brightest at the fed so terribly misjudged this crisis, and that the bailout has been thoroughly politicized at this point, what gives you faith that The One Credit Insurer To Rule Them All will be competent enough to set appropriate rates and will avoid both regulatory capture and politicization?

    My solution remains largely the same:

    * Tight, hard restrictions on leverage on all financial companies (undo the accounting shenanigans of the last three decades.)
    * Let institutions fail hard
    * The Govt. provides direct social services and return-of-capital in cases of fraud (which should be more aggressively prosecuted)

    It would nuke the highly-leveraged financial sector, which sounds about right to me at this point, is simple to administer and restricts governments role to what it is moderately competent at: social services and legal work.

    I can’t see how further centralization of power, without checks and balances, is a solution to the problem that our financial system is too centralized and interdependent.


  3. I agree with Carson on this. I don’t understand how a higher premium on credit insurance would correct the flaws of our system. Who sets the price? The feds, whose regulators seemed to overlook significant regulatory gaps? The businesses who viewed exceptionally dangerous risk as a nice new instrument for profit?

    And correct me if I’m wrong – hasn’t the government become the de facto insurer of last resort – thanks to TARP? Hasn’t a precedent been set that the feds will step in to prop up all failed financial firms that have been destroyed by gambling with systemic risk (except Lehman)?

    When will the rest of the nation begin to see the benefits of the bailout? With Goldman having its best year ever (and plans for record bonuses) and AIG looking to get the feds to payout millions in bonuses, it seems like our energies have been devoted to maximizing the payout to financial executives, not really salvaging the economy. At least an economy with steadily rising unemployment rate seems very far from recovery.

    And can someone explain how a firm (GS) caught within the net of all this systemic risk can have such a great year? Something seems so very wrong about such phenomenal success on the heels of such terrifying systemic failure….

  4. “If I’m a large bank with a balance sheet full of toxic assets, and I don’t want to pay the premium that the insurer of last resort is charging, then I go to the government, say the price is too high, and ask for a bailout.”

    Umm, what do you think the Fed’s discount window is? Or any central bank lender-of-last resort function, for that matter? It’s technically a “bailout” too, but it’s a bailout we long ago established is beneficial to both taxpayers and banks (see e.g., Great Depression).

    The fact that a lender-of-last-resort for all financial firms would deviate from perfect free market efficiency in the short-run isn’t a serious argument against such a lender-of-last-resort, because I’ve got news for you: the financial markets haven’t even remotely resembled “free markets” in over 75 years. Quick comparisons to the Econ 101 model of financial markets don’t count as real analysis of proposed policies. The real world is complex, and requires that you actually put meaningful time into thinking about proposed financial regulations before you can have an informed opinion.

  5. If the government had that commitment it could have avoided all of the problems of the bailout. It is precisely the awkward fact that the government was more eager to save the companies than the companies were to save themselves that gave the government such a weak hand in negotiating its various interventions.

    More broadly, there IS a credit insurer of last resort: the bankruptcy court. AIG could have essentially sold its assets to its creditors by simply filing for bankruptcy (recognizing that creditor priority would have been affected by likely government seizures of various consumer businesses). The decision to use a more convoluted mechanism has nothing to do with the time constraints or other criticisms of the bankruptcy court and everything to do with its openness; the very tunnels that were so imperative for Goldman and SocGen would not have operated in the light of a Chapter 11/7 process.

    Throughout this crisis we have heard that some or another new rule or regulation is needed. Many might be helpful. But if anything has been demonstrated by the various forms of government intervention – buying common, buying preferred, buying warrants, insuring debt, buying debt, redefining the 363 process to let a subordinated claimant jump a senior claimant, telling Ken Lewis he and his board would be fired, etc – it is that no procedural or even regulatory barrier gets in the way of government when it wants to act.

    It just needs the will to do so.

  6. “credit insurer of last resort,”

    There is more utter and complete nonsense.

    Don’t lend to people who can’t pay the debt off.
    Don’t lend to people with the idea of taking their asset/assets.

    What is the point of a “credit insurer of last resort” and “a lender of last resort (like the fed)”?

    Would it be to allow the spoiled and the rich and the banks to get the lower and middle class too far into debt knowing that they will be bailed out leaving the lower and middle class with a lower standard of living?

  7. Taunter said: “More broadly, there IS a credit insurer of last resort: the bankruptcy court.”

    Would this “new” credit insurer of last resort make sure the spoiled and rich bond holders in china, the oil exporting countries, and even in the USA get 100% of their money back so that they keep investing their excess currency printing into financial assets here in the USA to keep their currency pegs?

  8. If a company reveals a “black hole” after the fact the government’s negotiating position is effectively zero as long as the too big to fail policy survives.

    Also regarding to Bond Girl’s comment – I don’t see that anybody really wants to see global banking (esp shadow banking) become boring. Policy makers may pay lip service to the notion of prudential macro regulation when a camera is pointed at them, but they know that jurisdictional arbitrage will keep the boffins in work
    and if it’s not in New York or London, plenty of offshore havens will welcome them with open arms.

    I read that property prices are booming in Monaco and parts of Switzerland.

  9. Having an “insurer of last resort” makes no sense.

    Look, the reason why the New Deal made sense to economists and politicians of the time was that a lot of people who had nothing to do with the risks that were taken on by the financial sector and their customers were suffering through no fault of their own. The TARP program and AIG bailout were sold on the basis that innocents would suffer just as they had during the Great Depression, if nothing were done. We know better now.

    The fact that anybody is raising an “insurer of last resort” smacks of hubris on the part of the financial industry, who have gotten away with their blatant looting thus far.

    This merry-go-round has to stop. Soon. Please make it stop.

  10. We do not need a “credit insurer of last resort”.

    We do need a “lender of last resort” (e.g., the Fed) because banking is inherently unstable due to the maturity mismatch involved in banking operations. If you’re going to have a fractional reserve banking system, deposit insurance and a lender of last resort are essential to keep it from blowing up. Doing away with fractional reserve banking is not, IMO, in any way a workable option. So we’re left with building firewalls around it to isolate it and prevent it from destabilizing the rest of the economy (which was the function of Glass-Steagall) and stabilizing it to the extent possible (deposit insurance, lender of last resort, strict regs on the amount of risk and leverage that can be taken).

    The problem is that, somewhere along the line, we forgot about the inherent instability of banking and its ability to destabilize everything it touches. So we allowed a shadow banking system to arise. This system, which consisted largely of the money market mutual funds and the commercial paper market, operated like a bank, had all the inherent instability of a bank, yet had none of the failsafes and safeguards that, through experience, we learned had to be imposed on banks.

    The answer is not a “credit insurer of last resort”. The answer is to recognize that the shadow banking system IS a banking system and must be regulated as such. It needs to be brought under the same umbrella as the primary banking system, with the same failsafes, safeguards, and restrictions. Of course, this would likely mean the end of the shadow banking system, since it’s entire purpose seems to be to offer slightly higher rates of return and dramatically increased risks by avoiding traditional banking regulations. So be it.

  11. Isn’t the fed “lender of last resort” today, thanks to stepping in and bailing out free market entities whose risky activities we’re now propping up and rewarding?

    Who will set the higher premium price? The feds, whose regulatory arm can at best be considered a failure in multiple areas? The “best and brightest” in the free market, whose narrow-minded focus on profit compromises their ability to set such a price?

    The idea that the feds would operate in the long-term as the clean-up guy for the unregulated shadow banking system is a frightening concept – an “solution” that would further institutionalize the socialization of loss and privatization of profit.

  12. This wouldn’t change anything. TBTF means the government pays at the end of the day. Period.

  13. The offloading of risk in a crisis should not be allowed. What happened was banks, real and shadow, denied they had any risk on their books. Remember Cassano’s famous we won’t lose more than a dollar on subprime? Banks were accumulating risk like it was going out of style, but denying there was any risk.

    Had mortgage default risk been properly priced, you would have had higher overall rates, no teaser interest rates or pick-a-payment, and you would have had geographically dependent rates – bubbly markets get higher rates due to collateral risk. We got the opposite. If you got a 90% loan in 2005, you could have turned it into a 80% loan in 2006, with a higher balance! Is that reducing risk?

    Take out those mispriced risk variables in the prior paragraph and what happens to the housing bubble? What the risk-taker of last-resort will breed is more of this eyes closed mindless risk taking. Risk is mitigated through underwriting standards. How crappy were underwriting standards from 03-07? For so many of the loans, had the risk been acknowledged, the rate would have been high enough that the borrower said – not a good idea. Pick a payment, 2/28’s didn’t lower risk, they transferred it to the future. You had a continual shifting of risk time-wise until it could not continue to be rolled over. There is no way to eliminate risk, it just gets shifted either from one party to another (eventually to the govt) or it gets shifted temporally.

    The whole irrational fear of risk is weird to me. Stupid people without adequate planning and research should not blindly walk into risk jungles. Companies spend millions developing risky project – but they put huge effort into making sure the projects work. They don’t always, but risks are acknowledged and effort is taken to understand the risks and change the design to reduce them. If banks don’t want risks – don’t lend money! Their whole function is offering no risk return on insured deposits and making semi-risky loans at rates greater than the no-risk return they offer. Why shoudl they get no-risk returns higher than an individual depositor?

    Increasing risk increases returns, until it doesn’t.

  14. I am seeking a definition in “plain English” for shadow banking system.

    Would this be correct?

    The shadow banking system represents a financial system that operated (operates?) totally outside regulation (national and international). In this system AAA-bond rated financial products were sold to mainly pension funds and mutual funds.

    Thanks James for this timely post. All replies welcome.

  15. “Doing away with fractional reserve banking is not, IMO, in any way a workable option.”

    Why not?

  16. Possible shadow banking system defintion:

    An attmept by geekspeak (greenspan) to create a near 0% or 0% capital requirement banking system.

    Does that help in creating UNLIMITED debt?

    Are going off the gold standard; suppressing jobs and wages with outsourcing, legal immigration, and illegal immigration; a 0% reserve requirement; and a 0% capital requirement needed to produce unlimited debt on the lower and middle class?

    Is the last thing needed no bankruptcy allowed?

  17. Our goal should be to shrink the shadow banking system by removing the cost penalties imposed on regulated commercial banks. We put commercial banks in a costly straight jacket for very good reasons. Shadow banking exists because this activity is not burdened by regulatory costs. It is in the public interest to tilt the playing field in the opposite direction and to incentivize regulated banks to dramatically de-leverage.

    Insurer of last resort is a cute idea but it seems to be completely impractical.

  18. How would you get there from here?

    1. ALL current bank loans would have to be called in, as they represent deposits that were created without full reserve backing.

    2. The process of increasing the reserve requirement to 100% would mean a massive decrease in the money supply. The gov’t would have to counter this with a massive reflation of currency. But since currency, demand deposits, and time deposits do not turn over at the same velocity, how much new currency should be issued? There’s no way to know.

  19. I agree with James’ skepticism, that natural political tendencies would make any broad-based credit insurance program ultimately unsustainable. It’s incredibly difficult for governments to resist the pressure to help out large corporate interests. An example of this can be seen up here in Ontario, where I live.

    Ontario’s government introduced a mandatory pension insurance fund a few decades ago. In the 1990s they increased premiums to improve the fund’s finances, but after lobbying from a few large employers who would face significant premium hikes, they cut a side deal to exempt those employers in return for commitments to improve their respective pensions’ solvency. The companies, of course, didn’t hold up their end, assuming that the 90s economic boom would go on forever and their pension funds would be fine on their own. And, when some of them later ran into trouble and declared bankruptcy the insurance fund was far too small to cover the pension shortfalls. In (I believe) each case, the government ended up deciding to make large payments to help out anyway.

    This was all before my time, but I’ve been told that predictions of that exact outcome were made when the exemptions were given. It’s the most basic example of the problems with politics and governance – the politicians in charge when the deal was made had something to gain, and were then long gone by the time the problems eventually arose and presumbly didn’t care much at that point. The lack of a meaningful chain of accountability will almost always lead to short-term compromises when powerful interests are involved.

  20. How about doing away with fractional reserve banking over time, not immediately?

  21. I’m not putting down Perry Mehrling or “Mike Rortybomb” (by the way it’s killing me to know who the heck “Mike Rortybomb” is). Both of them are better educated and much sharper than me. It’s always good to toss around ideas, brainstorm, and trot down obscure roads and see where it leads to. But if such private insurance was workable it would have ALREADY been offered.

    If you believe in Efficient Markets Hypothesis (I don’t in a strict sense) then the unworkability of a “credit insurer of last resort” is obvious on the face of it. It’s even hard for me to type “credit insurer of last resort” without cracking up in laughter. It’s nice to toss around the idea, but the only entity large enough to provide insurance for the behemoth known as banks could only be provided by Uncle Sam. Love it or hate it, that is a fact. Professor Mehrling deserves a tip of the hat for trying, but no chart, graph, or equation Professor Mehrling writes will change that.
    Try making credit default swaps illegal, and go from there. I know that will never happen because it’s just to damned simple.

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