The Shadow Banking System

by Russ Roberts on January 22, 2009

in Financial Markets

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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{ 29 comments }

Adam January 22, 2009 at 8:48 am

Yes, your exactly right with the idea of two interdependent banking systems. The shadow feeds on the moral hazard created by the insured system. It seems that the shadow system inevitably amplifies bubbles, that due to the insured system, seem secure until they overwhelm both systems. The Rx is, as you say, to get the risk out in the open by eliminating govt insurance.

piperTom January 22, 2009 at 9:28 am

Thanks for reading Krugman, Russ. Now I don't have to ;-)

I have to take issue with this: "But the attempt to create a stable global system via regulation may be an illusion." May be? Regulation is based on political whims and whoever is the lobbyist at the moment. "Stable" is the last thing it could be.

Happily, in this fast paced internet world, regular people can out run the regulators.

Ike January 22, 2009 at 9:47 am

I like the use of the double-edged sword — why assume that MORE regulation is the way to address the imbalance?

When you have more regulation, you create a "shadow regulation system" where key congressmen and their staffers are targets for campaign cash and influence-seekers.

Eliminate the unnecessary regulation that creates the need for a Shadow Market, and there will never be a need for a Keating to pamper his Five, or for Fannie and Freddie to play Santa Claus for the Dodds and Franks.

muirgeo January 22, 2009 at 10:16 am

Again,the Glass Steagall Act seemed to set up a regulatory firewall between commercial and investment banks. I say bring it back.

Let there be a banking system that is totally unregulated and let there be one that is regulated. People can then decide KNOWINGLY where they want to put their money.

Repealing of the GSA simple allowed speculators into our retireent accounts.

The fact is the unregulated market couldn't get the returns it wanted without access to government backed securities. That's why they attempted 8 or 9 times to repeal the Glass Steagall. The fact that they needed to do so is in itself evidence that the free market cannot compete with a well regulated one.

Randy January 22, 2009 at 11:35 am

"I say bring it back."

No need. Caution has set in, and caution is a far better regulator than any bureaucracy could possibly be.

pk January 22, 2009 at 11:59 am

"The puzzle is why that shadow system took on so much risk that it imploded." The key to understanding this is thinking about the shadow system (and each individual company) not as entities, but as collections of individuals, just as you do with "the government".

When you look at risk from the perspective of the employees, it makes comlete sense. Bankers and traders are given bonuses and judged based on their relative performance in the short term. In the short term, it pays to take on more risk, juicing performance and providing the opportunity to stay around for another year. Imagine being a trader, and having to explain to your boss that your performance is poor because you were trying to avoid a blowup that is likely to happen once every 50 years.

I highly doubt that individual traders and managers were weighing the odds of an implicit government bailout. The problem stems from a misalignment of interests between employees and shareholders – employees get upside but are not exposed to downside.

Greg Ransom January 22, 2009 at 12:01 pm

And has been since 1914 …

"But the attempt to create a stable global system via regulation may be an illusion."

The Fed gave us the Great Depression … and now the Fed & bad Fed regulations have give us the crash of 2008.

A remarkable record ..

Matt January 22, 2009 at 12:13 pm

What is a "well regulated" market?

The S&L crisis occurred under GSA. Fannie and Freddie were heavily regulated, although not in practice.

Investors might have been frightened away from these more traditional "regulated" markets in favor of something they perceived to be more secure where people weren't operating under an implicit guarantee, even though that's what happened in the end.

A lot of people made out like bandits in the unregulated market, the suckers/losers should have known better. When you have millions to invest, the government shouldn't be there to hold your hand. When you're investing other people's money, now that might be a different story, but prospectuses usually do a good job of explaining risk. The alternative is to stick it in a savings account. Might take you longer, but it will still be there after all the crazy imprudent money disappears.

Kevin January 22, 2009 at 12:28 pm

Russ I think you, Nocera, and Taleb are all correct. You are correct in that everyone knew it was safe to take AIG (and Fannie, and Freddie, and Citi, etc.) risk because even in the worst case the politicians would step in. That explains the endless extension of credit of all kinds to these names, and the creditors' read of the situation actually proved correct.

Nocera and Taleb are correct that hubris and arrogance on the part of management inspired a belief that they faced known risks rather than unknowable risks. The firms acted on this belief and lost most/all their equity value.

Biomed Tim January 22, 2009 at 12:47 pm

I don't think that critique of Geithner is written by Charles Wheelan. It was posted by Yves Smith.

Current January 22, 2009 at 2:06 pm

Those who advocate reinstating the Glass Stengall act have a point.

A Federal Reserve bank is give *government priveleges* by the Fed. It can borrow from them, they are it's lender-of-last-resort. And it is protected by FDIC. In such a situation there must be regulation preventing these priveleges from being conferred on other groups allied to the bank.

The GSA was partly for this purpose and the Gramm-Biley-Leech act that followed it aimed to do the same thing while also allowing the formation of combined financial services institutions. It could be argued that the GBL act was not successful.

The problem though is deeper, and stems from the Fed itself. The Fed protect the banks this is what allows them to be reckless. Without this protection evolutionary winnowing would long ago have made them careful. (It has in places with no such protection, such as some tax havens.)

The solution is Von Mises' solution – 100% reserves by law and no Fed. In this situation there is no strong need for a lender of last resort. Similarly there is no need for anything like the GSA.

Lee Kelly January 22, 2009 at 2:34 pm

*bangs head against wall*

That which is earned but not consumed is available to invest, that is, savings.

Since the savings rate in the U.S. is almost zero, where did so many people get the money to invest in the housing bubble?

There should hardly have been any savings to invest, and so interest rates ought to have been sky high. Most of these people who contributed to the bubble should not have been able to get loans, because there were hardly any savings to invest with!

The problem is that the Fed and Banking system paper over the difference. They hand out claims to savings which do not exist. Willingness to invest must match willingness to save, otherwise you get a credit shortage–a boom and bust.

These kind of bubbles should peter out in a hurry, since savings are wasted on malinvestments, interest rates rise and people cannot keep getting ever larger loans. But U.S. monetary policy does not allow that to happen.

Charlie January 22, 2009 at 2:53 pm

Russ,

The fault I find with your analysis is that you make way too much out of the implict guarantee.

Fannie Mae and AIG equity holders have lost 95% of their investment in the last 6 months. Bear Stearns and Lehman have lost even more. The puzzle is why the owners, the equity holders, took on so much risk. If unregulated financial systems worked, the owners should be protecting themselves.

You talk as if all the financials have gotten off scott-free or thought they would, but that doesn't match the evidence.

Also, there is the time-consistency problem. We may say that we will not bail-out, but a firm can get big, fail and hold the financial system hostage. Will we take ourselves down with it? No, if a bailout is better ex-post, we will bailout, so we need rules ex-ante that are compatible with that.

Charlie

Charlie January 22, 2009 at 2:56 pm

Lee: "Since the savings rate in the U.S. is almost zero, where did so many people get the money to invest in the housing bubble?"

ROW – rest of world.

Oil Shock January 22, 2009 at 3:15 pm

Have you ever posted a comment on delong's or krugman's blog. I will guarantee you that the post is unlikely to see the light. I tried posting comments on delong's blog 4-5 times. I have never used foul language, never called names, and never was disrespectful to the host. Each time, my message was deleted within minutes or hours. Here we have a bunch of regular liberals, constantly bitching about everything, and yet they fail to see the openness and magnanimity of the hosts of this blog.

I know it is off topic, but I had to say it.

Lee Kelly January 22, 2009 at 3:34 pm

Charlie,

Perhaps some, yes, but not all.

george from VA January 22, 2009 at 4:02 pm

Hey Tim,

When you say:

"The solution is Von Mises' solution – 100% reserves by law and no Fed. In this situation there is no strong need for a lender of last resort. Similarly there is no need for anything like the GSA."

How does the bank $ on deposits?
I'm not against it I just don't understand how that works as a business (would a bank then have to earn off service fees)?

george from VA January 22, 2009 at 4:03 pm

ahhh crap I did it again I ment Current not Tim

dg lesvic January 22, 2009 at 6:18 pm

I have barely skimmed through this analysis of the different banking systems. And how many of the hundred million or so of American voters do you think would do any more? And why should we? Why must we be experts on the banking industry any more than on the auto industry, any more on the ins and outs of high finance than on carburetors and wheel bases? Why couldn't we do the same with banks as with cars, just buy the best end result without worrying about how it got that way?

Isn't that the ultimate question of political economy?

Do any of you great minds have the answer to it?

I do, but, first, I'd like to see if you.

Russ Roberts January 22, 2009 at 6:24 pm

Biomed Tim,

Thanks for the correction on Yves Smith. I have changed the post.

Kevin January 22, 2009 at 9:01 pm

dg, it's because people expect ongoing performance from the bank. You don't have to know anything about companies to whose performance you're not exposed.

Incidentally, although I'm not sure this is true, I don't think new cars are actually a very good example because of the performance obligations of warranties. But it could be that those are actually third party obligations – I don't buy new cars so I'm not familiar with the structure. Anyway the point is if you sign up with a company to perform for you tomorrow you should probably have some cause to believe it will be able to do so.

dg lesvic January 22, 2009 at 10:36 pm

Kevin,

Do you mean that every one who buys a car must know as much about it as the people who designed it, and be able to convince others that it was the best choice in cars before being permitted to buy it?

Vic January 23, 2009 at 12:20 am

The obvious reason is that fractional reserve lending is inherently a confidence scam, and while the banking system is built on top of it – either regulated or shadow – it's going to eventually lead to panics. The only way we can get around this is to recognize the fraud and prohibit it. That is, money cannot be paper promises, but made by 100% backed by the commodity money represented by the bailment.

I always find it odd that free-market economists miss the ponzi nature of fractional reserve banking. You should read Guido Hulsmann's writing on this stuff. He's fantastic

Jacob Oost January 23, 2009 at 5:00 am

Sorry, but I contend that Krugman is a charlatan, and all economists should shun such a dishonest person. In fact, I find it extremely difficult to take any social democrat economist seriously in this day and age, but at least most of them don't resort to lying like Krugman. There was a time when they had an excuse, their ideas on the welfare state and government management of the markets hadn't been 100% debunked. Now they are, and it doesn't matter how many people still cling to them. Wrong is wrong, science has to jettison the crap and move on.

Current January 23, 2009 at 5:59 am

"How does the bank $ on deposits?
I'm not against it I just don't understand how that works as a business (would a bank then have to earn off service fees)? "

Yes, banks would have to charge fees as they did in earlier times of the gold standard.

That said current accounts don't really cost them much to run. They run them mainly a sweetener to get people to use their other services.

Mesa Econoguy January 23, 2009 at 7:54 pm

Thanks for posting this, Russ, I haven’t had time to read (busy with financial mkt meltdown), but fits my expectation. Krugman the economist is thoughtful, though often wrong (which got him fired from CEA), but it’s when he delves into political economy he gets downright bizarre, conflating cause, effect, and ripple effects.

It’s like there’s a shadow Krugman, too.

Krugman understands (mostly) the banking system, but as we’re seeing currently with his cohorts, he doesn’t understand the securities markets aspect, which is why this stimulus has failed to date.

Anyway, I wish I had time to post all the thoughts here, but you’ve hit upon most of them. My response as a participant/observer in this mess is that incentives have everything to do with this mess. If you follow the money, understand (mis)regulation, and understand financial market incentives and investor behavior, you can get a pretty good feel for how we got here. It has very little to do with what the financial (and all other press) has told you.

John Lehman January 23, 2009 at 9:33 pm

"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."

I suspect that Krugman is getting at the right answer when he points to – or at least gestures toward – liquidity as the problem. But the claim that participants missed the liquidity risk associated with the assets they were holding because liquidity had always held up before is foolish. I'm not even sure how you would test that hypothesis. It is undeniable, however, that the mortgage-backed obligations that have gotten most of the attention traded in a market whose liquidity was provided by Fannie and Freddie as a part of their promise to support residential mortgage markets.

High default rates will cause the value of CMO's to fall, but that doesn't make them "toxic". Falling interest rates would increase the early payout of pools of residential mortgages as well, but that wouldn't drive their market value to zero either. I mean, WPPS bonds continued to trade reasonably actively well after default, on the off-chance that a court someplace would force the government to ultimately make some sort of payment against the obligation. So why were mortgage-backed instruments hit so hard that their mark-to-market value could plausibly be said to be zero?

It seems to me pretty obvious that these instruments fell as far as they did because the market makers; that is, the providers of liquidity for that market, failed. When Fannie and Freddie were allowed to fail investors were caught holding mortage-backed securities with notional values in the trillions with no one left standing to provide the market a meaningful bid. No bids, trillions in offers – price zero.

Fannie and Freddie ran silly debt ratios, and the market continued to buy their debt because they were implicitly backed by the U.S. government. The very fact that the government allowed their creations; their instruments of policy, to operate with such thin equity while spurring them on to greater and greater involvement in the markets could reasonably have been understood as a sign that they would back-up F&F should things get tough. And institutions that held securities in which Fannie and Freddie made markets were running the related risk in liquidity. The market didn't believe that the U.S. government would let Fannie and Freddie fail.

Of course, now we know that they were allowed to fail, but that fact doesn't mean that the assessment of risk was "wrong" any more than you can be said to be "wrong" to assign a 50% chance to my getting a 'head' in a coin toss that turns out to be tails.

And to say that the market believed the liquidity would hold up just because it had in the past is to miss the really big story. The market believed the liquidity would hold up because it didn't expect the U.S. government to fail to honor its 'promise' to support the liquidity of the secondary mortage markets. Not exactly mindless stupidity, and certainly not a failure from deregulation. Nor is it a reasonable justification for greater involvement of the same government in financial markets.

Mesa Econoguy January 23, 2009 at 9:42 pm

It is undeniable, however, that the mortgage-backed obligations that have gotten most of the attention traded in a market whose liquidity was provided by Fannie and Freddie as a part of their promise to support residential mortgage markets.
Posted by: John Lehman

Absolutely, John, and that is one of the (government-induced) drivers in this mess.

And institutions that held securities in which Fannie and Freddie made markets were running the related risk in liquidity. The market didn't believe that the U.S. government would let Fannie and Freddie fail.

And that is exactly the moral hazard endgame problem we have now, caused by government.

Very well said, sir.

Mesa Econoguy January 23, 2009 at 9:50 pm

''These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,'' said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ''The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.''

New Agency Proposed to Oversee Freddie Mac and Fannie Mae

Senator, please proceed directly to jail.

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