Guest Post: Why the Fed Can't Stop Fueling The Shadow Bank Kiting Machine

Tyler Durden's picture

Submitted by Bill Frezza via Menckenism blog,

Fractional reserve banking is unlike most other businesses. It's not just because its product is money. It's because banks can manufacture their product out of thin air. Traditional commercial banks essentially create money through a well understood and time honored pyramiding of loans. Depositors who understand that their deposits are thereby placed at risk choose their banks accordingly.

Under the bygone rules of free market capitalism, only one thing kept banks from creating an infinite amount of money, and that was fear of failure. Failure occurs when depositors come to believe that their bank has lent out too much manufactured money to too many dodgy borrowers and may not be able to cover depositors’ withdrawals. When this happens, depositors rush to reclaim their money while there is still some left, leading to the bank’s collapse.

Under free market capitalism, banks compete along a spectrum of risk and reward. Conservative banks offer a higher degree of safety by maintaining larger reserves, thereby manufacturing and lending out less money. Through word and deed they let depositors know that they lend to only the most creditworthy borrowers, who generally must post valuable collateral. These banks remain profitable because they successfully attract prudent depositors willing to accept lower rates of interest.

Banks of a more speculative bent offer a lower degree of safety, maintaining smaller reserves to create and lend out more money. Seeking higher returns, they often lend to less creditworthy borrowers who may put up poor quality collateral or none at all. These banks attract risk-taking depositors looking for a higher rate of interest. They can be very profitable during periods of economic expansion but often fall into distress during economic downturns.

Periodic bank failures remind depositors of the connection between risk and reward. When caveat emptor rules, smart depositors who pay attention make money and dumb depositors who don't lose theirs.

Because the latter outcome is intolerable in a democracy, we have government-provided deposit insurance and other taxpayer-financed backstops that shield most depositors from the risk of loss. In theory banks pay premiums to fund this insurance. In practice these premiums are not risk-based. Banks are not penalized for making riskier loans, in turn often leaving the premiums too low to finance payouts. This creates a huge moral hazard, as it frees depositors to seek the highest return without regard for safety.

Worse, it removes conservative banks’ competitive advantage. Under a government-guaranteed deposit insurance regime, conservative bankers who want to stay in business must take on more risk in order to pay the higher interest rates necessary to attract depositors. This often sets off a race to the bottom, which results in periodic banking crises.

After each of these crises, politicians promise taxpayers that it will never happen again. And each time it does, the government creates a new set of labyrinthine regulations that attempt to mimic the business judgment of conservative bankers. Minimum reserve requirements are established, which normally become the maximum as there is little advantage in exceeding them. And both depositors and the bankers themselves become complacent about the banks’ investments because it is so easy to privatize gains and socialize losses.

Banks also learn that competitive advantage can be obtained by either gaming the regulations or having cronies write them. As regulations get more intrusive and complex, politicians discover that they can be used to advance social policies, such as increasing home ownership among voters with poor credit, thereby increasing the risk on banks’ loan books.

This mixed economic system is the one that replaced free market capitalism in hopes that it would prevent bank failures. Despite, and some even say because of, a regulatory regime that discouraged conservative banking and rewarded reckless mortgage lending, the banking system crashed - again - in 2007-2008.

What is not widely appreciated is that the ensuing government bailouts allowed an underlying shadow banking system to not only survive but grow even larger. It is called the shadow banking system because it operates outside most government-regulated banking laws. This is primarily because regulations and accounting standards haven’t caught up with the practices of these banks, which are relatively new and poorly understood.

It was the seizing up of the commercial paper and repo markets that funds the shadow banking system that abruptly halted the flow of liquidity that kept the mortgage bubble propped up. This revealed the underlying insolvency of Fannie Mae, Freddie Mac, and many commercial banks stuffed with subprime mortgage securities accumulated under the mixed economic system described above.

Powered by an exclusive club of primary reserve dealers, a group that once included high flyers like Lehman Brothers, MF Global, and Countrywide Securities, these shadow banks work hand in glove with the Federal Reserve to manufacture money by pyramiding loans atop the base money deposits held in their Federal Reserve accounts.

To the frustration of Keynesians, and despite an unprecedented Quantitative Easing (QE) by the Federal Reserve, conventional commercial banks have broken with custom and have amassed almost $2 trillion in excess reserves they are reluctant to lend as they scramble to digest all the bad loans still on their books. So most of the money manufactured today is actually being created by the shadow banks. But shadow banks do not generally make commercial loans. Rather, they use the money they manufacture to fund proprietary trading operations in repos and derivatives.

Where does the pyramiding come from if shadow banks aren’t making loans that get redeposited to fuel the cycle? Securities held as collateral by counterparties in a repo contract can be rehypothecated by the lender to obtain additional loans. (So can securities held in customer accounts, unless their brokerage agreements expressly prohibit it. This was an unwelcome discovery by MF Global’s hapless clients, who saw their assets whooshed off to London where different brokerage rules allow such hypothecation.) Loans made against securities held as collateral can then be used to either buy more securities, which can be fed back into the repo market, or trade a bewildering array of complex synthetic derivatives.

If this sounds like circular check kiting that’s because it is, especially when you add in the issuance of commercial paper required to grease the wheels. The biggest difference is that an embezzler kiting checks does not have the support of a central bank providing steady injections of liquidity, beefing up balance sheets that create confidence in their debt instruments.

How much of the original high quality collateral must shadow banks hold in reserve should some of their derivatives implode, as many did during the last crisis? Zero. By repeatedly spinning the wheel, the top 25 U.S. banks have piled up over $200 trillion  in leveraged bets atop a thinning wedge of collateral, claims to which are spread across an opaque and complex chain of counterparties residing in multiple legal jurisdictions. These collateral claims are co-mingled with an estimated $400 trillion to $1.3 quadrillion in notional outstanding derivatives made by other banks around the world, altogether amounting to more than 20 times global GDP.

Due to the fact that accounting standards have not kept up with these innovative practices, banks are not required to report the gross notional value of the outstanding derivative contracts on their books, only their net asset positions. These theoretical Value at Risk positions, which would only be netted out if all the contracts were unwound in an orderly manner—as one might unwind a check kiting scheme before getting caught—can only be realized in a liquidity crisis if the counterparty chains across which these contracts are hedged hold up.

These counterparty chains froze in spectacular fashion during the last financial crisis. After the collapse of Lehman Brothers and with the insolvency of AIG looming, a chorus of politicians, bankers, and bureaucrats browbeat the government into delivering a system-wide bailout. As a result, many reckless banks and bankers that should have been driven out of the market are back doing business as usual.

The largest banks learned that they need not worry about the possibility of bankruptcy. When the next crisis hits, all they have to do is shout “systemic collapse” and another bailout will appear. Being Too Big To Fail, they can maximize profits without having to hold reserves against the risk of counterparty failure, knowing that the taxpayer will always be there to make them whole.

The solution is not more regulations, which will never keep up with the financial wizards whose lobbyists end up writing these rules anyway. In addition, trades can be made anywhere in the world, so to be effective the regulations would have to be global. As long as governments continue to prop up failing banks, regulation will always be inadequate to mitigate the moral hazard that accompanies bailouts. And, ironically, the added costs of regulatory compliance will make it harder still for smaller and more prudent banks to compete.

True to form, Congress has not solved the TBTF problem but has actually made it worse, loading ever more regulations on commercial banks through Dodd-Frank. Meanwhile, taxpayer exposure to the banking system has grown even larger.

Optimists believe that as long as everyone remains calm and keeps believing everything is fine, then everything will be. Central planning advocates hope that the kiting scheme can be unwound by extending banking regulations to cover the shadow banks while the Fed somehow weans them off of Quantitative Easing. Cynics believe that asking Washington to get the situation under control is a hopeless quest, especially since few Congressmen have a clue what is really going on.

Meanwhile uncertainty hangs over the system since bankruptcy laws, which differ from country to country, have not kept up with hyper-hypothecation. Moreover, the government’s handling of the auto bailout shows that investors cannot rely on existing bankruptcy law even when it speaks clearly on an issue. Therefore, no one really knows who will have first dibs on the collateral when the music stops. And just what are those high quality assets? Sovereign bonds and mortgage CDOs, which are themselves subject to precipitous losses.

As the debate drags on and global economic conditions worsen, the growing pyramid is being kept afloat by the easy money policies of central banks too frightened to withdraw their support lest a stock market correction trigger a cascade of margin calls that brings down the whole system—much like last time.

All this money creation has not yet generated much visible consumer price inflation. This is partly because official inflation measures are suspect but mostly because the bulk of the new money being created is flowing into financial assets and not the consumer economy. This has inflated asset bubbles to levels impossible to justify based on underlying economic conditions, in particular the stock market where investors have fled in search of yield. No one knows when the bubble will pop, but when it does a donnybrook is going to break out over that thin wedge of collateral whose ownership is spread across counterparties around the world, each looking for relief from their own judges, politicians, bureaucrats, and taxpayers.

When that happens and the clamor for regulation, nationalization, confiscation, and demonization arises there is only one thing we can be sure of. The disaster will once again be blamed on a free market capitalism that has not existed in this country for over 100 years.

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flacon's picture

"Under the bygone rules of free market capitalism" --> Fractional reserve capitalism is the same as a virgin HOOKER. 

espirit's picture

Keynesian Economics my ass, this is full blown Kenyensian Economics.

Jreb's picture

I logged in just to up arrow that comment.... well done. I am going to use it elsewhere... shoulda trade marked it.

neidermeyer's picture

I can see why we can't leave fractional reserve banking ,, the problem is that the reserves/assets are not accounted for properly ... The favorite scam back in the S&L crisis was for S&L "A" to trade worthless stock certs to S&L "B" and "B" to sell worthless certificates to "A" and both of them would book the asset at a huge valuation ... we have that same problem today ...


I have a SIMPLE solution ... get the watchdogs to DO THEIR JOB... AUDITS every year at a minimum ... what do they think .. we pay them to cruise or something?

Rakshas's picture

I have never understood the valuation of fiction or in this case confidence, but i really miss the days when a Confidence (person) was reviled rather than revered - how did it all come to this.........

At least Jesus got to boot fuck the money changers out of the temple, now western society just drops to thier knees and ....... fuck it I'm moving to thailand with farber

DaddyO's picture

Raj, is that you?


New_Meat's picture

"hat do they think .. we pay them to cruise or something?"

Why, that is an easy one: "YES"

Melin's picture

"...get the watchdogs to do their job..."

At some point you'll realize the "watchdogs" are doing their job, as "watchdogging" is merely a works program.  What will you then screech for?  Oh, I know.  You'll cry out for another layer of tax payer funded watchdoggery, right? 


New World Chaos's picture

Yes, more watchdogs are a mental can kick to help DailyKos types maintain their faith in the system. 

"We are, yet again, just one more regulatory agency short of bureaucratic-collectivist Nirvana!"

"We just need to get the right people (i.e. our people) in there, and they will be incorruptible!"

"Give the new agencies time!  Obama is a great being of Light, and he is playing 11-dimensional chess.  Listen to his speeches.  He obviously cares!"

Watchdogs are also there to watch the little people and punish them if they compete with the big corporations that buy the laws.  Even if the big guys didn't end up running the watchdogs they would still want more, because competitors who can't afford legal compliance departments will be driven out of business.

August's picture

Truly, he IS a great being of Light. 

If Heaven smiles upon our nation, Obama will be our leader for many, many years to come, as is the ancient custom among our African ancestors. Kumbaya.

kchrisc's picture

Off topic, but check this out:

Illinois is so broke, "how broke are they?!" (Couldn't resist) Roseland Community Hospital is threatening to stop taking new patients on Wednesday unless the state pays up money the hospital says it’s owed. ($6 million)

Gov. Pat Quinn’s office said the state has advanced all of this year’s payments to the Far South Side hospital and has tried working with Roseland to create a viability plan, a spokeswoman said.

Illinois is so broke that they sound like a debtor talking to a collector. LOL

Ness.'s picture

This isn't going to help.

Fitch Downgrades Illinois, Drowing in Pensions

Fitch said that the state’s long-term liabilities are very high. As of the June 30, 2012 actuarial valuation, the unfunded actuarial accrued liability was reported at $94.6 billion and that generated a 40.4% reported funded ratio

kchrisc's picture

I have been following the pension thing with amusement.

It is so bad that none of the current pols and crats want to actually do anything about the pension mess that might have their name become associated with it.

That's bad.

My bet is that Illinois will be the first state to "go under," de facto and otherwise.

ebworthen's picture

Anyone showing up in the emergency room will be treated.

Illegal, bankrupt, no assets get the best deal.


SafelyGraze's picture

what they need is an affordable care act



disabledvet's picture (sounds pretty good on computer speakers actually. normally these things are total shit.)

disabledvet's picture

here's the visual... quality bongo's going on there too.

disabledvet's picture

and here's another perfectly good kid pissing off dad again. Billy's what kids do. it's not your fault. it's just kids.

disabledvet's picture

just tell her "no helicopter. no private planes."

New_Meat's picture

dude, u b talkin' to u-sef.  u can do the "edit" thingie, until some little piglet comes along and breaks the chain.


- Ned

SafelyGraze's picture

SEC/DOJ entrance examination:

question 1: read the examples on the check kiting page

what evidence of fraud do you find?

(correct answer: "none, if the entity is a financial institution")

question 2: deficit spending = checks from the UST based on the expectation of future funds from income tax receipts to cover the payments

explain how this is different from check kiting

Colonel Klink's picture

Wow I read the T in kiting as a K.  I've been reading too much criminal ponzi stuff.

machineh's picture

... or maybe reading the US attendee list at the Bilderberg meeting.


LetThemEatRand's picture

"When caveat emptor rules, smart depositors who pay attention make money and dumb depositors who don't lose theirs."

The problem with this hypothesis is that in a true free market, "smart depositors" in this scenario will generally include mostly those with influence and access to insider information.   They know which banks have the best investment portfolio because they have access the average person does not.  The average person with no insider connections who wants to put her $75K life savings into a "safe" savings account has no way to determine if bank A, B, or C has a better porfolio of risk.  So if she picks wrong through no fault of her own, she loses everything.    The better solution is not to dismantle all regulations and government protections. It is to get rid of the rampant crony capitalism and replace it with a balanced system of free market with meaningful but minimal regulations and protections.

Oldwood's picture

You feeling OK? I always took you as more of a couped chicken than the free range variety such as myself.

fonzannoon's picture

LTER we are so far past the point of reasoned debate it's not even funny. Other things have to happen first. Most of them unpleasant.

smlbizman's picture

has anyone seen francis_ lately? would really be bothersome if he was suicided...lets face it, there is absolutely nothing that comes close to being on the up and up.....which brings us to 0 hedge....i like to trick myself into believing that we are in fightclub, but i know better....however i do expect a higher level of integrity....and if you are man enough to be here, than you are man enough to tolerate any and all comments.....if anyone here "reports" comments, than you need to go....if its the hands on the machine that decide   the "francis_ 's are not welcome....than that means the hedge for all of the good it does is no different than any other untrustworthy source......if they feel the need to exspell someone than i think i want an explanation of why, at that point at least i can decide if the hedge had a point...

fonzannoon's picture

I saw him on here several times today.

dick cheneys ghost's picture

the ZH comment section sucks without ~francis_saywer~


daxtonbrown's picture

So even a dumb Grandma should be smart enough to spread the risk over a few banks. A few failures and everyone would know this.

andrewp111's picture

Or to use Treasury Direct. then there is no risk of loss at all.

Nue's picture

The average depostiors has been losing their money for 90 years now through REAL Inflation and loss of purchasing power. The Smart money all own hedgefunds and High Frequency Trading computers.

FreeMktFisherMN's picture

Yes, that person actually does have means to verify the trustworthiness of the institution: it's called reputation, and this can be made known through friends' experiences or the inevitable ratings agencies/Yelp-like entities. Nobody would put up with the fraud. Mattresses would be the default unless an institution is truly proven worthy, has insurance to cover losses, etc.

Free markets are always providing alternatives. 

FreeMktFisherMN's picture

I would't want an institution storing my gold speculating anyway. And I think you underestimate how, when it is caveat emptor, people really take seriously trustworthiness. In my great grandfather's house after he had passed on we found tons of cash literally in bricks in the wall and all throughout the house. He had had bad experience in the Depression. But as you can see people respond, and obviously guarding one's money is about as high a priority as anything, so people wouldn't be so careless. Unlike now where .gov FDIC means people don't care; it is abdication of personal responsibility, and all these 'safeguards' cost money, too you know, to pay for bureaucrats who implement them, and also considering how bad .gov is at managing anything. 

shovelhead's picture

They'll care when they find out there's no 'I' in FDIC

jimijon's picture

Socialocracy can address this spectacularly.

Oldwood's picture

So are you saying our economy and banking system are NOT sustainable? Does anyone else know?

fonzannoon's picture

Everyone knows. But the thing is that Adam guy on American idol said "I hate this country" last week so we need to deal with that first. Then Angelina's tits.

Oldwood's picture

He likely just had his little panties in a wad, but Angelina should at least publish some nude photos before she loses them, so the world can mentally fondle them in remembrance. But hell she will probably get new ones even better. As far as I can tell most women in the public eye are faking it one way or another. She's probably making a smart move for her health and her publicist.

Schmuck Raker's picture

Good article. Thanks.

dryam's picture

This article is absolutely spot on.

jmc8888's picture

Glass-Steagall separates the deposits from the derivatives, which then allows countries to let the worthless bets collapse under their own weight. 

If deposits aren't risked there is no reason for bailouts either. Afterall it's the fear of an FDIC payout that was the hostage Wall Street held over Washington like a sword of Damocles.

Now we're at the point where they want to (and in Cyprus and Spain already have) use deposits to bail-in the derivatives.

Dodd-Frank puts derivatives senior to everything else.   Bail-ins will be used to prop up the worthless derivatives bets.  All under the guise of market stabiliteeeeeee.


So yes, the answer is legislation. 

The same simple legislation that worked for about 66 years, and would stop the madness in its tracks.


No need for bailouts.

No need for bail-ins.

No need for QE to keep the faltering products from taking out a link in the counterparty chain.

Allow money for the physical economy, not loot and plunder everything for worthless derivatives.

It's always been about Glass-Steagall


Oldwood's picture

No, its always been about theft.

oddjob's picture

Sounds like somebody wants to give Fiat an umpteenth do over.

ebworthen's picture


Re-instate legislation that was enacted to address the wanton excesses of the 1929 crash?

Heresy!  You speak heresy!  The Ponzi must continue!  The spice must flow!  The heroin must be supplied to the "investment" banks!

Kirk2NCC1701's picture

Isn't it interesting how Texas keeps cropping up when topics like S&L Crisis, the repeal of the Glass Staegall Act (Phil Gramm, R-TX) come up?  Wasn't some 'penis sucker'* from TX also involved way back in 1913, to get the Fed established?  Col. Ed Mandell House**, if I recall correctly.

Deregulation and playing it fast & loose... "look, just 'trust' the big boys to do the right thing, bubba". /sarc

Or how Texas comes to mind in a word-association game, with names like Enron, death sentences, Bush, Daley Plaza, Koresh, Tom Delay, Waco, W, ...

What is it about that state?  Can't possibly be anything in its (business or political) culture.  Must be a big-state, power-state thing -- like CA or NY, no doubt.  Else Iowa, North Dakota or Oregon would have its share of infamy.  :-)

Is it "ok" to ask, or do you get shot down for that also? /s

* pejorative reference to someone who is prepared to do menial and unpleasant acts for someone in power?


BigJim's picture

Glass Steagal was better than nothing, but when our monetary system lost all link to gold - the only real restraining factor - it was off to the races. Look at a graphs of the money supply - Glass Steagal was repealed in 1999, but M2 and M3 starting accelerating after 1971 after Nixon ended Bretton Woods.

Even if Glass Steagal were reinstated, the existence of government-backed deposit insurance would ensure the kiting would continue. As the article points out, if all bets are covered by the government, it's business suicide not to take greater and greater risks with depositors' cash because your competitors will be doing it (knowng they'll get bailed out if it all goes to hell) and the higher interest they'll be offering will take away your depositors, who no longer have to take any notice of the risk their bank is taking.