The Shadow Banking System

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I recently finished Krugman's The Return of Depression Economics and the Crisis of 2008. I learned a great deal from the book. It is full of interesting narrative about recent international crises (Asia, Mexico, Russia, and the current mess) and for the most part it is thoughtful and even-handed about what really happened.

Krugman takes a few cheap shots at free-market ideas but much of the time he is gives alternative viewpoints to his own and talks with nuance about how economists don't fully agree on what caused this problem or that one or what should be done in various crises.

When writing about the current mess, he makes the distinction between the banking system which is highly regulated and the parallel or shadow banking system which is much less so. He quotes approvingly this passage from a Geithner speech of June 2008:

The structure of the financial system changed fundamentally during

the boom, with dramatic growth in the share of assets outside the

traditional banking system. This non-bank financial system grew to be

very large, particularly in money and funding markets. In early 2007,

asset-backed commercial paper conduits, in structured investment

vehicles, in auction-rate preferred securities, tender option bonds and

variable rate demand notes, had a combined asset size of roughly $2.2

trillion. Assets financed overnight in triparty repo grew to $2.5

trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The

combined balance sheets of the then five major investment banks totaled

$4 trillion.

In comparison, the total assets of the top five bank holding

companies in the United States at that point were just over $6

trillion, and total assets of the entire banking system were about $10

trillion.

This parallel system financed some of these very assets on a

very short-term basis in the bilateral or triparty repo markets. As the

volume of activity in repo markets grew, the variety of assets financed

in this manner expanded beyond the most highly liquid securities to

include less liquid securities, as well. Nonetheless, these assets were

assumed to be readily sellable at fair values, in part because assets

with similar credit ratings had generally been tradable during past

periods of financial stress. And the liquidity supporting them was

assumed to be continuous and essentially frictionless, because it had

been so for a long time.

The scale of long-term risky and relatively illiquid assets

financed by very short-term liabilities made many of the vehicles and

institutions in this parallel financial system vulnerable to a classic

type of run, but without the protections such as deposit insurance that

the banking system has in place to reduce such risks.

Krugman describes the fall of Bear Stearns and others as a classic run–a loss of faith by "depositors" or in the case of Bear Stearns and others, counterparties, particularly the short-term borrowers and lenders.

So you have the "regular" bank system that is guaranteed by FDIC with strict requirements on capital ratios and you have the shadow system that is not guaranteed and with much looser capital requirements.

In such a world, it is not surprising that money tends to flow toward the higher yield shadow system.

The puzzle is why that shadow system took on so much risk that it imploded. One answer is Joe Nocera's (and Taleb's)–the people in the system didn't fully understand the risk they were taking. No doubt this is part of the problem.

But here is another way to think about financial markets. We have two banking systems–a "regular" system and a shadow system. The regular system is explicitly guaranteed with strict capital requirements. The shadow system is implicitly guaranteed with looser capital requirements. The implicit guarantee is that Bear Stearns and AIG and Merrill while not protected by FDIC, are protected by the political forces that say that some firms are too big to fail. Such a two-tiered system is inherently unstable–the shadow part is prone to take on too much risk and grows as investors look for ways to get higher yield relative to the safer, less-leveraged regular banks. The regular banks, in competition with their higher yield cousins, looks for ways to get around the capital requirements and boost their yields. So both parts are prone to instability.

So Krugman blames Greenspan and others for failing to put the umbrella of regulation over the entire banking system–for failing to recongnize that in the modern world, Bear Stearns is a bank even though it doesn't have depositors. (He fails to blame Geithner–see Charles Wheelan's Yves Smith's prescient critique from March 2007 where he correctly points out that Geithner is whistling in the dark in this speech.) [HT: Biomed Tim for the correction on who wrote the prescient critique]

So the obvious policy implication is that we need more regulation–bring the shadow banking system out of the shadows. In order to prevent "runs" on non-bank banks, we need to guarantee them to prevent a loss of confidence while regulating them to prevent excessive rsik-taking.

But maybe the lesson is that we need less regulation. The attempt to reduce risk to zero is an illusion. Maybe it is better to have the risk more out in the open where investors are much more cautious because the government is not the backstop.

In the highly regulated world, innovation takes place to find ways to achieve higher yield. Such higher yield is always prone to moral hazard because the government is always going to rescue you in some fashion, either implicitly or explicitly.

In a highly deregulated world, innovation would be different–innovators would be looking for ways to reassure investors that their money was safe.

Neither system is perfect. Both systems are prone to the human desire for a high yield, zero risk return. But the attempt to create a stable global system via regulation may be an illusion.

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