Guest Post: Shadow Banking Part II - Why You Must Care
A week ago we posted Dave Friedman's insightful piece on "Why We Must Care About Shadow Banking" as shadow banking, whose shadow liabilities comprises the bulk of the unreported M3, represents a critical component of the credit system. Today, we present the second part in this three part series for all who wish to get up to speed with some of the key issues in this most critical topic.
Submitted by Dave Friedman of Wall St. Cheat Sheet
Shadow Banking Part II: Why You MUST Care
I recently blogged
about the origins of the shadow banking system. This is the second
blog post in that series, which discusses in more detail why the average
investor should care about shadow banking. The third post in this
series will discuss proposed regulatory reforms that address shadow
In short, shadow banking is the largely unregulated component of the
banking sector. The shadow banking system is a source of funding and
liquidity for non-bank financial institutions. What is a non-bank
financial institution? Well, it can be any large institution (a
corporation, a pension fund, a very wealthy individual, etc.) that has a
large cash balance. These institutions have a large asset, cash,
sitting on their balance sheet. It is both a source of liquidity for
the institution, and a source of return, assuming that the cash can be
invested safely. So, for example, say Microsoft is sitting on $10
billion in cash. It can deposit the cash with a financial intermediary,
such as the now-defunct Bear Stearns, in exchange for collateral of
short-term debt instruments, and so earn a return on its liquid asset.
At its heart, this is the shadow banking system: it is a funding and
liquidity source provided by non-banks, and it arose because entities
with large piles of cash needed to manage that asset in some manner that
generated a return.
So, going back to the paper from the previous post,
why should we care about the shadow banking system at this juncture?
After all, a reasonable person would point out that the Dodd-Frank bill
contains many regulatory reforms. But, as the authors point out,
“[t]hree important gaps [in the Dodd-Frank bill] are in money-market
mutual funds (MMMFs), securitization, and repurchase transactions
(‘repo’).” These are the three parts of the shadow banking system.
Recall from the previous post that money market funds were created when
“cash-rich non-financial companies did not have easy access to safe,
interest-earning, short-term investments.”
So, we have a situation in which companies and other institutions
laden with cash needed a way to earn money on those stockpiles, but they
didn’t want to do so by depositing the cash with a traditional bank.
Traditional bank deposits are insured only to $100,000 (though this has since been changed to $250,000),
which is far too small a balance for institutions with hundreds of
millions, or even billions, of dollars of cash on their balance sheet.
Since the regulated market did not provide a solution, the private
market did, in the form of money market mutual funds, off-balance-sheet
securitizations, and the repo market.
But, because no bank could afford to serve as a backstop to the
shadow banking system, in the midst of the crisis, the US government,
and other sovereign governments, had to step into the breech and act as a
de facto backstop to this unregulated system of liquidity and
funding. But, once governments accepted this role, they provided an
implicit, if not explicit, guarantee of the shadow banking system. In
the short term, this was likely necessary, in order for non-financial
entities to continue to operate, be able to pay their employees, etc.
But in the longer term, the implications of making an implicit guarantee
on an un-regulated banking system are unclear. The third and final
post in this series will explore one regulatory proposal, called narrow-funding banks, to deal with this mess in the future.