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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
banking.
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.
(As a side note, there are a number of very good posts on the shadow banking system at Zero Hedge. See here, here, here, and here.)
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.
David Friedman is the Editor of our new Wall St. Watchdog platform. Click here to follow Wall St. Watchdog on Twitter or Facebook.
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And because the government replaced the Shadow Banking system we haven't seen the deflationary collapse we would otherwise have seen.
Either that government gap-filling measure works or it doesn't, in which case you really don't want to hold any asset class.
Still and all, gold will go to $1700.
Investing in "Shadow Gold" right now!
Time has not healed. Mark to fantasy was supposed to allow a pause that refreshes followed by resumption of former trajectories. But this hasn't happened. THat's the reason why you hear Ben and Co sweat and fret that we need to "return to more normal levels of inflation". In shadow banking that means underwater deals need to be re-strucutred and unwound to conform to new valuations and expectations. Which all reinforces deflation. So the gamble will be to create inflation through other means. It's why we're starting to see biflation.
Tyler nice play today on Rush Limbaugh
While I recognize that RL has an extremely wide audience, of which I once was a part (when he was very fresh and new on the East coast), it should be understood that the man understands himself foremost as an entertainer. He is very good at entertaining, but he is terrible at finance and economics.
So, perhaps I am not so cheered by Rush's hat tip today; and perhaps the ZH community needs to be a bit wary. Because this man is intimately connected now, and has been for a very long time, with the neocon wing of the Republican Party, and guess who they are connected to? Longtime readers know the answer to this one, but let me spell it out: Council on Foreign Relations, Bilderberg Group, and all the other Rockefeller Foundation pawns, etc., etc.
I rather doubt that ZH readers really want to be associated with the Beast.
glad i opened up the shadow bank of velobabe. i am diversified now, just got some coin.
Nice touch.
Learn something every day!
:)
I'm forecasting that large holders of Gold and Silver will become the de-facto banks in the future.
The shortcomings of regulation were similarly exposed. The shadow banking system was not supported, regulated, or monitored in the same fashion as the conventional banking system, despite the fact they were of equal size on the eve of the crisis.6
There were also major flaws in the regulation and supervision of banks themselves. Basel II fed procyclicalities, underestimated risks, and permitted excess leverage. Gallingly, on the day before each went under, every bank that failed (or was saved by the state) reported capital that exceeded the Basel II standard by a wide margin.
Most fundamentally, the global financial crisis revealed the fallacy of composition that strong individual financial institutions collectively ensure the safety and soundness of the system as a whole. Even the most vigilant, microprudential regulatory regime can be overwhelmed by systemic risks. As a consequence, policy-makers now recognise that systemic risk is the product of the resiliency of financial institutions, the robustness of systemically important markets, and the interconnectedness between institutions and markets. ---- Governor, Bank of Canada
More here on what international bankers intend to do about it:
http://www.bankofcanada.ca/en/speeches/2010/sp140910.html
The shortcomings of regulation were similarly exposed. The shadow banking system was not supported, regulated, or monitored in the same fashion as the conventional banking system, despite the fact they were of equal size on the eve of the crisis.6
There were also major flaws in the regulation and supervision of banks themselves. Basel II fed procyclicalities, underestimated risks, and permitted excess leverage. Gallingly, on the day before each went under, every bank that failed (or was saved by the state) reported capital that exceeded the Basel II standard by a wide margin.
Most fundamentally, the global financial crisis revealed the fallacy of composition that strong individual financial institutions collectively ensure the safety and soundness of the system as a whole. Even the most vigilant, microprudential regulatory regime can be overwhelmed by systemic risks. As a consequence, policy-makers now recognise that systemic risk is the product of the resiliency of financial institutions, the robustness of systemically important markets, and the interconnectedness between institutions and markets. ---- Governor, Bank of Canada
More here on what international bankers intend to do about it:
http://www.bankofcanada.ca/en/speeches/2010/sp140910.html
People do need the truth about the precarious foundations upon which everything social rests. But frankly, what you speak of is very big and the potential impact very chilling.
Nobody knows exactly how this surf will break.
If another prime dealer goes under, there will be huge cascade of shocks.
1) Either accept another round of multi-trillion system backstops to save today. This means employment will not vaporize and life will go on with a lit fuse under it. The time-bomb is an impossibly large debt service burden that will explode in some way in the future.
2) There will be a shock so large that it will persist and absorb all other shocks into it. This means there will be no printing press (es) large or fast enough to fill the hole. This mean employment will vaporize and life will radically change. See: http://www.zerohedge.com/article/guest-post-notional-irs-cds-and-printing-press-irrelevance-jm-february
3) If the current playbook holds things together, a side effect is that ZIRP will kill MMMFs and ultimately the shadow banking system will “dehydrate”. Death will be slow enough that society can adjust to the implied changes.
Nice framing of the options. Many don't realize that ZIRP contains its own time bombs, not least of which is a flattening yield curve and death of all long term financing. This whole chimpanzee act is getting stranger by the week.
What happens to Fannie/Freddie if they are forced to keep making loans (they will be) when they can't possibly lay off the liability? Death spiral is a real possibility.
I don't disagree with you about death spirals, but I probably do have a differetn thought on outcomes.
If the lender of last resort to pretty much the world (the Fed) shows any semblance of restraint or sanity, like cutting loose the political piles shit now called Freddie and Fannie, or anything else, then the dollar will explode upward and everything else will collapse.
I think gold being at highs is a good indicator to the Fed that policy is working how they want it to. Keeping the dollar down is what they consider the imperative. It may work too well.
No one person knows just how large the CDS bomb truly is! I'm thinking megatons.
Nice introductory article. I would take exception with this statement, though:
"... 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"
With all due respect, the US government did not have to step in. They may have felt that they had to. But it wasn't required. And yes, the subsequent meltdown would've been enormous. However, two years later, we'd be in the process of coming out of this mess, instead of simply starting the process of going through it on an extended time schedule.
The Feds absoultely didn't have to step in at all. And over the long term, we'd have been better off if they hadn't.
How much of AIG's 100 trillion in derivatives exposure has been unwound? How many other black holes are out there? That's what we need to know. Good luck on getting any info out of Obama's goon squad.
Federal "Goons" showed just how "competent" they truly are with their responses to Hurricane Katrina and the BP oil disaster! What would make you think that they've suddenly gained knowledge and wisdom?
"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."
Question 1: "had to step in", why? To make me the taxpayer bailout the bad investments of these firms "liquid funds". These firms had a choice to sit on cash or make risky investments, except they don't want to accept the risk, but force me to accept their risk.
Question(s)2: Is it "unregulated" when they got a bailout...it seems like the taxpayer backstop regulation was very much in play. Isn't "regultion" one of these meaningless words like "reform" which have no specific meaning but speciously tries to imply accountability?
Ok, let us carefully examine this wonderous "regulated" market versus the "unregulated" shadow market:
http://bankimplode.com/
"Since early 2007 361 banks have imploded"
Wow, I am so convinced the "regulation" is the missing ingredient that is keeping us from utopia.
Question 3: Now that the shadow market got the bailouts how has this improved our condition? What, we took some financial pepto bismol and asprin to alleive the financial "food poisoning" so we can have a long slow enjoyable death?
What started as a simple way to make money for big investors has grown into an uncontrollable, underground monster. This monster will consume everything in its path when the game final comes to an end. The road to hell is paved with good intentions.
So, when the 2X4 hits me aside the head I'll know who was wielding it.
It will still hurt just as much. There is some comfort in knowing who the SOB was.
From Bill Bonner:
Love Bill.
yeah i use to read him, and enjoyed his outlook and spin. but i am very loyal to ZH and all the tyler's now. don't know why.
i love zerohedge policy cheap hosting