PIMCO's McCulley Discusses The Ticking $3 Trillion Shadow Banking Time Bomb, Defends The Fed As Head Regulator
Pimco's McCulley does a rather good dissection of the shadow banking system, and aside for the conclusion that the Fed should be the ultimate controller of everything, we believe it is a worthwhile read. We obviously disagree with McCulley on his view of the Fed - the Chairman is simply far too political, incompetent (don't make us take out all the clips of Bernanke rehashing the Moody's model and claiming housing was going up in perpetuity) secretive and in the big banks' pocket, which explains why Pimco of course is a fan, with its $1 trillion + dollars in AUM. A systemic change in which the precarious financial balance is toppled would simply wipe it off the face of Fashion Island overnight. That said, McCulley's other points are worth reading as he does the shadow banking system justice, specifically explaining how it is a $3 trillion Frankensteinian time bomb construct of the Keynesian religion that it is just awaiting to go off and wipe out the bulk of US deposits in one fell swoop.
State of the U.S. and World Economies
April 15, 2010
you very much. It is an absolute pleasure and honor to be here. I gave
the keynote a couple years ago and it was my first time to be at the
Minsky Conference. I feel that I’m part of a church, and it’s a good
church in that we’re on the right side of history. And it’s absolutely
wonderful to be attending services with you again.
I want to open up with a little story that should
make everybody in the room feel particularly good, and then we’ll get
into discussing economics. Harry Markowitz has been a friend of mine
for about a decade. I became friends with Harry through two channels.
Number one, Rob Arnott of Research Affiliates has an Advisory Panel of
famous academics, such as Harry and Jack Treynor, that he gets together
every year. I’m frequently invited to speak. We spend two or three days
over a weekend together. I’ve also gotten to know Harry because he and
the late great Peter Bernstein were very close friends. Peter and I
were also very close friends.
I’ve been preaching the Minsky Framework at Rob’s
event for a number of years. And Harry’s always been very, very polite.
I spoke again just this past Sunday morning. After I finished, we had a
nice Q&A. And Harry said, “Paul, if I had to read one book by
Minsky, which one would it be?” And I said, “Harry, please, tell me
that you’ve read at least one book by Minsky.” And he says, “No, I
haven’t, but I think I would like to, and I think I’m probably old
I promised Harry that I would send him one
personally. And I’m quite sure that if I don’t follow up on that,
somebody at the Levy Institute would gladly follow up. So, the bottom
line is that one of the fathers of the Efficient Market Hypothesis has
finally decided to attend services at the Church of Minsky. I think
that is a glorious, glorious moment. Don’t you? Harry is an absolutely
From the standpoint of what I want to talk about
tonight, a great deal of it has already been discussed today. I feel a
little bit like St. Louis Federal Reserve President Jim Bullard did at
lunch when he said that Paul Krugman, who spoke just before Jim, had
already given 90% of his speech. That’s basically true for me as well.
Paul’s speech was superb, laying out six possible culprits in the
I want to focus on Paul’s Number 3, the Shadow
Banking System. Paul was drawing a lot of his comments today from the
work of Professor Gary Gorton of Yale, which is absolutely fantastic
material. Have a lot of you read Gary’s essay, “Slapped in the Face by
the Invisible Hand”?2 I see a lot of nods here. That’s where
the phrase that Paul used, “Quiet Period,” came from. Gary coined it.
He’d be a great person to have here next year at the Minsky Conference.
And one of the fascinating things that he details is
the nature of banking. That’s where I want to start tonight. Let’s
start with first principles. If we do, then I think we can understand
why we shouldn’t look at the conventional banking system and the Shadow
Banking System as separate beasts, but intertwined beasts.
The essence, or the genius of banking, not just now,
the last century or the century before that, but since time immemorial,
is that the public’s ex-ante demand for assets that trade on demand at par is greater than the public’s ex-post demand for these types of assets. Let me repeat this, because this is a first principle: The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore, we can have banking systems because they can meet the ex-ante demand, but never have to pony up ex-post.
In turn, the essence or the genius of banking is maturity, liquidity
and quality transformation: holding assets that are longer, less liquid
and of lower quality than the funding liabilities.
A second principle: A banking system is solvent only
if it is believed by the public to be a going concern. By definition,
if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante
demand, a banking system is insolvent because a banking system ends up,
at its core, promising something it cannot deliver. Everyone following
Professor Gorton, in his paper, goes through how
that promise was dealt with during the 19th century, before the New
Deal Era. There were panics all the time, otherwise known as runs,
because we didn’t have a lender of last resort and we didn’t have
deposit insurance. During the 19th century, the system dealt with its
reoccurring panics in lots of novel ways, including clearing houses
which would de facto be a central bank, and suspension of
convertibility of deposits into cash. So the problems we’ve been
dealing with in the last couple of years are not new. They go back to
the origin of banking.
The Quiet Period, from the New Deal Era until the
Panic of 2007, was actually unique in history. And the Quiet Period
came about, I think, for a lot of the reasons that were articulated
earlier today in that banks, conventional banks, after the Great
Depression, were considered to be special. And, in fact, banks are
special. If you think that the banking system can be guided to
stability as if by an invisible hand, then you are deluding yourself.
But, that is, in fact, what happened with the explosive growth of the
Shadow Banking System.
Banking is a really profitable business. In its most
simple form, think in terms of a bank issuing demand deposits, which
are guaranteed to trade at par because they’ve got FDIC insurance
around them and also because the issuing bank can rediscount its assets
at the Fed in order to redeem deposits in old-fashioned money, also
known as currency.
In fact, let’s take a look at the $1 bill I am
holding in my hand. It says right at the very top, “Federal Reserve
Note.” It also says right down here, “This note is legal tender for all
debts, public and private.” This is what the public ex-ante
wants: the knowledge that they can turn their deposits into these
Federal Reserve Notes. And if the public knows they can turn them into
these notes, they don’t. With me here? If I know I can, I don’t.
Now, this is a unique note. This is a Federal
Reserve liability. And, actually, it’s really cool. It’s missing two
things. It doesn’t have a maturity date on it. So, it’s perpetual. And
it doesn’t have an interest rate on it. I would love to be able to
issue these things. It would make me very, very happy to issue these
things. But it would be against the law! But, in fact, that’s what
banks did in the 19th century. They issued currency. After the creation
of the Federal Reserve, it was given monopoly power to create currency,
which I think was a pretty bright idea. But demand deposits issued by
banks are just one step away from a Federal Reserve Note.
Conceptually, demand deposits have a one-day
maturity. I can write a check on it, and it goes out at par tomorrow,
if not today. Demand deposits, conceptually, have a one-day maturity.
But in aggregate, they have a perpetual maturity. So, therefore,
banking can engage in maturity, liquidity and quality transformation: a
very profitable business. Banks can issue, essentially, perpetual
liabilities – call them demand deposits – and invest them in longer
dated, illiquid loans and securities, earning a net interest margin.
It’s a really, really sweet business.
In the early years of the Quiet Period, we regulated
that really sweet business. I think that was a really bright idea. In
order for that business not to be prone to panics and, therefore,
financial crises, you needed to have deposit insurance. Deposit
insurance, by definition, cannot come about as if by the invisible
hand. Deposit insurance cannot be, cannot be a private sector activity.
It is a public good. The deposit insurer must be a subsidiary of the
fiscal authority. And in extremis, the monetary authority can
monetize the liabilities of the fiscal authority. I’m not saying that
pejoratively. I’m not being pejorative at all. Just descriptive. Bottom
line: Deposit insurance is inherently a public good.
Access to the Fed’s balance sheet is also inherently
a public good, because the Federal Reserve is the only entity that can
print currency. So essentially, banking has two public goods associated
with it. Therefore, naturally, it should be regulated.
That was the Quiet Period Model. And regulation took
the form of what you could do, how you could do it and how much
leverage you could use in doing it. And, as was mentioned by Paul
Volcker a number of times earlier this afternoon, the regulatory burden
that has historically come with being a conventional bank has been
actually quite high. During the early years of the Quiet Period,
however, banking was nonetheless a very profitable endeavor.
There was a quid pro quo, which actually led to the
old joke – which was actually said about the savings and loan industry
– that banking was a great job: Take in deposits at 3, lend them out at
6, and be on the golf course at 3. 3-6-3 banking was a pretty nice
franchise. So, therefore, bankers had a pretty strong incentive not to
mess it up. Essentially, there were oligopoly profits in the business.
I think Gary Gorton is actually right on that proposition.
The invisible hand, however, naturally wanted to get
the oligopoly profits associated with banking while reducing the impact
of some regulation. Thus, the Shadow Banking System came into
existence, where the net interest margin associated with maturity,
liquidity and quality transformation could be earned on a much smaller
And, in fact, that’s what happened starting
essentially in the mid-1970s, accelerating through the 1980s and 1990s,
and then exploding in the first decade of this century.
The birth of the Shadow Banking System required that
capitalists be able to come up with an asset – which actually for
shadow bankers is a liability – that was perceived by the public as
just as good as a bank deposit. Remember, the public has an ex-ante
demand for something that trades on demand at par. Therefore, shadow
bankers had to be able to persuade the public that its asset – which is
actually the shadow banker’s liability – was just as good as the real
thing. If they could do that, then they could have one whale of a good
That asset – which, again, is the bank’s liability –
needed, in Gary Gorton’s terms, to be characterized by “informational
insensitivity,” meaning that the holder didn’t need to do any due
diligence, just taking it on faith that this asset could be converted
at par on demand. And, in fact, money market mutual fund shares
achieved that status. With one small exception prior to the Reserve
Primary Fund breaking the buck, they always traded at par. And if there
was any danger they wouldn’t trade at par, the sponsor would step in
and buy out any dodgy asset at par. So, essentially, the money market
mutual fund industry was at the very core of the growth of the Shadow
It created a liability perceived as just as good as
a demand deposit wrapped with deposit insurance, issued by a bank with
access to the Fed. It was a great game. But in and of itself, that
didn’t lead to the explosive growth in the Shadow Banking System. There
needed to be another link in the chain. Yes, money market mutual funds
needed an asset that the public perceived as just as good as a bank
deposit. But they also had to put something on the other side of the
What went on the other side of the balance sheet?
Money market instruments such as repo and commercial paper (CP). And
under Rule 2a-7, they were allowed to use accrual accounting for their
assets. The assets didn’t have to be marked to market. So, therefore,
2a-7 funds could actually maintain the $1 share price, unless they did
something really dumb.
At their peak, money market mutual funds were about
$4 trillion. They are about $3 trillion now. They interacted with the
larger Shadow Banking System. And the largest shadow banks were the
vehicles of investment banks, funded heavily with repo and CP. So,
explosive growth of the Shadow Banking System was logically the result
of the invisible hand of the marketplace wanting to get the
profitability of the regulated banking system, but without the
regulation. Shadow banks created information-insensitive assets for the
public that were perceived as just as good as a demand deposit, and
then levered the daylights out of them into longer, less liquid,
lower-quality assets. And it all worked swimmingly well, for a while.
But then they embarked on the Forward Minsky Journey.3
Shadow banks were the predominant place where
securitizations of subprime mortgages were placed, as well as
securitizations of other types of assets. So the Shadow Banking System
was, essentially, mirroring the banking model, which had deposits and
Turn the deposit into asset-backed commercial paper.
Turn the loan into a security. What you end up with is the same vehicle
as a bank from a functional standpoint, but you have it outside the
conventional bank regulatory structure. Actually, let me correct
myself. There was a de facto regulator in the Shadow Banking System. They are called the rating agencies.
In order to do the trick of creating a shadow bank,
you had to have the rating agencies declare that your senior
short-dated liabilities were just as good as bank deposits. In fact,
most money market mutual funds get themselves rated, and S&P,
Moody’s, and Fitch do have particular rules for giving a AAA rating to
a 2a-7 money market fund, mirroring SEC Rules. But, for the rest of the
Shadow Banking System, the rating agency rules evolved on the fly,
often under the guidance of shadow bankers themselves. It didn’t work
out very well, as the Shadow Banking System became the lead owner of
what was created in the originate-to-distribute model of mortgage
On August 9, 2007, game over. If you have
to pick a day for the Minsky Moment, it was August 9. And, actually, it
didn’t happen here in the United States. It happened in France, when
Paribas Bank (BNP) said that it could not value the toxic mortgage
assets in three of its off-balance sheet vehicles, and that, therefore,
the liability holders, who thought they could get out at any time, were
frozen. I remember the day like my son’s birthday. And that happens
every year. Because the unraveling started on that day. In fact, it was
later that month that I actually coined the term “Shadow Banking
System” at the Fed’s annual symposium in Jackson Hole.
It was only my second year there. And I was in awe,
and mainly listened for most of the three days. At the end, Marty
Feldstein always does the wrap-up. Everybody wanted to talk. And since
I was a newbie, I didn’t say anything until almost the very end. I
stood up and (paraphrasing) said, “What’s going on is really simple.
We’re having a run on the Shadow Banking System and the only question
is how intensely it will self-feed as its assets and liabilities are
put back onto the balance sheet of the conventional banking system.”
Now, I certainly didn’t anticipate that it was going
to lead to the debacle that eventually unfolded. In fact, while the run
commenced on August 9th of 2007, it was pretty much an orderly run up
until September 15, 2008. And it was orderly primarily because the Fed
– and here I give the Fed credit, not criticism – evoked Section 13-3
of the Federal Reserve Act in March of 2008 in order to facilitate the
merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed
opened its balance sheet to the biggest shadow banks of all, the
investment banks that were primary dealers, including most important,
the big five. It was called the Primary Dealer Credit Facility.
I’m sure that was an incredibly difficult decision
for the Federal Reserve Board to make – to open its balance sheet to
borrowers it didn’t regulate. But it was necessary, because runs are
self-feeding; you can’t stop them without the aid of somebody with the
ability to print legal tender. That’s the only way you can stop it,
because only the Fed can create an asset that will definitionally trade
at par in real time. During a run, that’s what the public wants. A run
turns upside down the genius of banking. A run is when the public’s ex-post demand for liquidity at par equals its ex-ante demand.
Post-Bear Stearns, financial life regained some
sense of normalcy. But then came the run on Lehman Brothers, and the
Fed didn’t have the legal power to implement a Bear-like rescue. And
then the Reserve Fund broke the buck. That week will be one that we
remember for the rest of our lives. It will also be one that we will
remember where the Fed was at its finest hour. The Fed created a whole
host of facilities to stop the run. In fact, they expanded the Primary
Dealer Credit Facility to what are known as Schedule 2 assets, which
meant that dealers could rediscount anything at the Fed that they could
borrow against in the tri-party repo market.
Concurrently, the FDIC stepped up to the plate,
doing two incredibly important things. Number one, they totally
uncapped deposit insurance on transaction accounts, which meant that
the notion of uninsured depositors in transaction accounts became an
oxymoron. If you were in a transaction account, there was no reason to
run. And then the FDIC effectively became a monoline insurer to nonbank
financials with its Temporary Liquidity Guarantee Program (TGLP)
allowing both banks and shadow banks to issue unsecured debt with the
full faith and credit of Uncle Sam for a 75 basis points fee. No
surprise some $300 billion was issued.
So, bottom line, you had the Fed step up and provide
its public good to the Shadow Banking System. You had the FDIC step up
and do the same thing with its public good. And as Paul Volcker was
noting this afternoon, you had the Treasury step up and provide a
similar public good for the money market mutual funds, using the
Foreign Exchange Stabilization Fund. It was a triple-thick milk shake
of socialism. And it was good. Again, I’m not being pejorative. I’m
Banking is inherently a joint venture between the
private sector and the public sector. Banking inherently cannot be a
solely capitalistic affair. I put that on the table as an article of
fact. And, in fact, speaking at a Minsky Conference, I know I’m
preaching to the converted. Big bank and big government are part of our
catechism. And, in fact, that’s exactly what came to the fore to save
us from Depression 2.0.
Let me draw to a few conclusions. How should we
re-regulate the financial landscape – as President Bullard was calling
it today – to make sure this doesn’t happen again? We must, because the
collateral damage to the global economy has been truly a tragedy.
And I think the first principle is that if what you’re doing is banking, de jure or de facto,
then you are in a joint venture with the public sector. Period. If
you’re issuing liabilities that are intended to be just as good as a
bank deposit, then you will be considered functionally a bank,
regardless of the name on your door. That’s the first principle.
Number two, if you engage in these types of
activities – call it banking, without making a big distinction here
between conventional banking and shadow banking, as Paul Krugman
intoned this morning – in such size that you pose systemic risk, you
will have higher mandated capital requirements and you will be
supervised by the Federal Reserve. Yes, I just told you who I think the
top-dog supervisor should be. You will have tighter leverage and
liquidity restrictions: You will have to live by civilized norms. In
fact, a great deal of what is on the regulatory reform table right now
proceeds precisely along those lines. If you’re going to act like a
bank, you’re going to be regulated like a bank. That simple. And maybe
you just might find the time to go back to working on your golf game at
3. That is the core principle.
There truly is a devil in the details, because it’s
quite natural that non-bank levered-up financial intermediaries don’t
want to be treated like banks. I wouldn’t either. But the truth of the
matter is if you’re going to have access to the public goods associated
with banking, then you’re going to be treated like a bank.
In fact, here is an example of this concept in my
own life, which I’m sure most of you have experienced who have older
children. When my son turned 18, he said, “Dad, I’m now the age of
majority and I can do whatever I want.” I said, “Son, that’s absolutely
true. However, I still control the Bank of Dad. And if you want to have
access to the Bank of Dad, there are going to be rules. If you don’t
want access to the Bank of Dad, that’s fine. But if you want access to
the Bank of Dad, there are going to be rules.”
The Federal Reserve and the FDIC and the Treasury,
together, are the Bank of Dad. And Mom. I expect regulation to be
similar to that which I have imposed on my son. It doesn’t mean I want
to stifle his innovation. That doesn’t mean I want to stifle his
creativity. I want him to be all he can be. But as long as he’s banking
at Bank of Dad, there are going to be rules.
So there’s my regulatory framework for you. Yes,
think in terms of the Federal Reserve and the FDIC and the Treasury as
all providing public goods to banking. But the Federal Reserve has got
to be at the top of the totem pole, because the Fed truly is the Bank
of Dad. The entity that can print money has got to be the lead
supervisor. To me, it’s unambiguously clear. And the fact that it’s
being debated actually befuddles me. I operate on the notion that
self-evident truths should be self-evident. But apparently Washington
doesn’t operate on that thesis.
I’ve talked too long. I promised you I wouldn’t do
this. I was going to talk short and then have a long Q&A, but I’m a
Baptist minister’s son, and we can’t help ourselves. Regardless of how
simple the sermon may be, it always goes on too long because the
minister always enjoys giving it more than the audience enjoys
Thank you very much.