The Shadow Banking System

Posted in Financial Markets, Politics and Policy at 9:24 pm

What we saw from mid-2007 through early-2009 was a run on the shadow banking system.

There were two primary channels by which the shadow banking system operated: the Money Market/Commercial Paper Channel and the Repo Channel.  Note that I am deliberately avoiding a discussion of SIVs, Conduits, and other SPEs which at one point made up a substantial part of the shadow banking system, because they were generally sponsored by banks as off balance sheet entities, and the sponsoring banks generally had to bring them back on balance sheet during the crisis, so they are presently of limited concern.

The Money Market/Commercial Paper Channel worked as follows:  Individuals and firms, seeking higher yields on cash accounts than offered by banks, deposited money in money market mutual fund (MMMF) accounts.  These MMMFs, in turn, used the deposits to purchase, among other things, commercial paper.  In some cases, they bought commercial paper of non-financial firms directly; in most cases they bought commercial paper issued by financial firms (broker-dealers) who in turn bought commercial paper from non-financial firms.  Commercial paper represents a short term (30-270 day), generally unsecured, largely unregulated, debt security that often substitues for bank loans.  In fact, during the few years before the crisis, commercial paper did displace bank lending as a source of short term industrial funding to a large degree.  So here we have largely unregulated entities (MMMFs) taking deposits (largely withdrawable on demand and usually checkable) and making the equivalent of loans, in other words, acting as banks.  Except that the MMMFs were not subject to much in the way of prudential regulation beyond some broad parameters that dictated what investments they could buy, did not have access to FDIC deposit insurance, and did not have lender of last resort access to the Fed’s discount window.  They were a disaster waiting to happen.

The Repo channel was a little less direct.  A repo (repurchase agreement) is a transaction where a seller agrees to sell a security to a buyer and agrees to then buy it back at a specificed point in the near future.  The seller is in effect borrowing money from the buyer at an interest rate represented by the difference in price of the security on the two dates that is agreed upon up front, with the security serving as collateral.  Thus a repo is really just a short term, collateralized loan.  Repos also became a very popular mechanism for raising funds in the pre-crisis days, with MMMFs becoming large buyers of repos (lenders) and the broker dealers becoming both buyers and sellers (borrowers and lenders).  An added wrinkle is that in many cases the collateral pledged for a repo could be “rehypothecated” or used by the buyer (lender) as collateral to sell another repo (borrow) and so on down the chain.  There are obvious paralells here to the expansion of deposits in a traditional commercial banking system.

What went wrong during the crisis, in both channels, was that longer term assets (commercial paper bought by MMMf in the first case and investments by broker dealers in the second case) were funded by shorter term liabilities (MMMF deposits and repos).  This is the classic maturity mismatch situation faced by commercial banks in general (where loans are funded by deposits that may be withdrawn on demmand) that exposes them to bank runs.  Commercial banks, however, have deposit insurance and access to the Fed discount window, designed to protect them against this possibility.  In the case of the shadow banking system, concerns about the quality of commercial paper held (triggered by the collapse of Lehman who had issued a signficant amount of commercial paper) led MMMMF investors to attempt to withdraw their funds en masse, just as concerns about the value of securities pledged as collateral in repos led to additional collateral calls by repo buyers (lenders) along with a general fall in their willingness to engage in repo transactions, which made it difficult for repo sellers (borrowers) to roll over the funding needed to support their longer term asset holdings.  Without the traditional protection of deposit insurance and lender of last resort financing by the Fed, it turned into a full blown panic in late 2009.

The Fed and FDIC took a number of steps, once the panic started, to try and alleviate the stress.  This included extending deposit insurance to MMMF depositors and the expansion of liquidity facilities to make both short term funding and “safe” Treasuries more available to market participants.  However, most of the emergency measures were temporary by design.

Any meaningful financial reform must bring the shadow banking system out of the shadows.  It must be treated as banking, and its institutions regulated as banks.  That means prudential regulation and capital adequacy standards in exchange for the protections traditionally afforded to commercial banks.  Perhaps the shadow banking system was only profitable because it was able to externalize risks in the absence of banking regulation and the extension of regulation to it will make it unprofitable and drive its activities back to the traditional banks.  Perhaps not.  What’s not acceptable or sustainable, however, is maintenance of the status quo.


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