Readers are well aware, that when it comes to big picture economic topics, one of our favorite themes is the gradual disintegration of Shadow Banking (discussed previously in detail here and here). The main reason for this is that the shadow banking system, while materially larger than traditional bank liabilities ($17 vs $13 trillion), is collapsing at a whopping $4 trillion a year annualized rate. What this implies for credit money, and for the Fed's limited reaction arsenal is hopefully all too clear. Yet as we have a habit of jumping into slightly advanced topics, here is an informative introductory post written by Dave Friedman of Wall St. Cheat Sheet (the first of three) covering some of the fundamentals of this arguably most critical for the great deflation/hyperinflation debate topic.
Here’s Why We MUST Care About Shadow Banking
by Dave Friedman of Wall St. Cheat Sheet
Given the complex nature of the topic, this blog post will be the
first in a series of three posts examining the various issues the paper
raises. This blog post will focus on what the shadow banking system is
and how it came to be, the second blog post will focus on why we should
care about the shadow banking system, and the third will focus on
proposed regulatory reforms.
The paper is written by two Yale School of Management professors, Gary Gorton and Andrew Metrick.
Its principal claim is that there are certain features of the shadow
banking system which caused problems in the financial markets over the
past three years, but which have not been addressed by any current
legislation, and therefore need attention. They write:
In its broadest definition, shadow banking includes
familiar institutions [such] as investment banks, money-market mutual
funds, and mortgage brokers; rather old contracts, such as sale and
repurchase agreements (“repo”); and more esoteric instruments such as
asset-backed securities (ABS), collateralized-debt obligations (CDOs),
and asset-backed commercial paper (ABCP).
They further explain the reasons for the rise in shadow banking:
One force came from the supply side, where a series of
innovations and regulatory changes eroded the competitive advantages of
banks and bank deposits. A second force came from the demand side,
where demands for collateral for financial transactions gave impetus to
the development of securitization and the use of repo as a money-like
instrument. Both of these forces were aided by court decisions and
regulatory rules that allows securitization and repo special treatment
under the bankruptcy code.
So, there are three main components of the shadow banking system,
which I will briefly review below: money market mutual funds (MMMFs),
securitization, and the repo market.
Money market mutual funds provide short-term liquidity to financial
intermediaries, but are not regulated in the same way as banks are
regulated. Money market mutual funds seek to maintain a net asset value of $1.00 per share; prior to September 2008, no money market mutual fund, save one, “broke the buck.”
Gorton and Metrick note that “MMMFs were a response to interest-rate
ceilings on demand deposits (Regulation Q).” More information on
Regulation Q, which has since been repealed, can be found here.
In short, since banks were prohibited by law from paying interest
rates above a certain ceiling, the private market developed alternative
vehicles for large investors to manage short-term liquidity needs,
namely, money market mutual funds, and so these vehicles operated
outside the regulatory purview of the FDIC and other banking regulators.
Further, the government’s response in the midst of the crisis was to
guarantee these unregulated investment vehicles:
the government made good on the implicit promise [of
MMMFs maintaining their $1.000 per share value] by explicitly
guaranteeing MMMFs, and it may not be credible for the government to
commit to any other strategy in the future. As long as MMMFs have
implicit and free government backing, they will have a cost advantage
over other insured deposits.
The paper defines securitization as:
the process by which traditionally illiquid loans are
sold into the capital markets. This is accomplished by selling large
portfolios of loans to special purpose vehicles (SPVs), legal entities
that issue rated securities in the capital markets, securities that are
linked to the loan portfolios.
An originating firm lends money to a number of borrowers….[Then] a
portfolio of loans is selected for the purpose of securitization. This
step is the “pooling” of the loans into a portfolio. The portfolio is
then sold to an SPV….The SPV finances the purchases of these loans by
selling rated securities in the capital markets. These securities,
called tranches, are ranked by seniority and have ratings reflecting
that. The whole process takes the loans that traditionally would have
been held on-balance sheet by the originating firm and creates
marketable securities that can be sold and traded via the off-balance
As with MMMFs, securitization is a process that occurs outside of the
regulatory purview of the banks’ regulators, yet is essentially a
banking function, in that it provides a source of liquidity to the
entity which previously had the loans (assets) on its balance sheet.
Finally, repurchase agreements, colloquially called “repo” are
agreements which allow borrowers to use a financial security as
collateral in order to get a loan at a fixed rate; it is another source
of liquidity and is, again, outside the purview of banking regulators.
The paper notes that the repo market grew because of
the rapid growth of money under management by
institutional investors, pension funds, mutual funds, state and
municipalities, and nonfinancial firms. These entities hold cash for
various reasons, but would like to have a safe investment, which earns
interest, while retaining the flexibility to use the cash, in short, a
demand deposit-like product. In the last thirty years these entities
have grown in size and become an important feature of the financial
In short, these three products–money market mutual funds, securitized
investment vehicles, and repurchase agreements–have become sources of
liquidity for holders of large amounts of cash and they occur outside of
the “normal” banking system, and so are more or less unregulated by
traditional banking regulators. The amount of leverage used and the
opacity of the various transactions have been implicated in the
The next blog post in this series will investigate why regulators,
and, more pertinently, individual investors, should care about the
shadow banking system. Finally, the third and last post will examine
proposed regulatory reforms.