On The Verge Of A Historic Inversion In Shadow Banking

Tyler Durden's picture

While everyone's attention was focused on details surrounding the household sector in the recently released Q1 Flow of Funds report (ours included), something much more important happened in the US economy from a flow perspective, something which, in fact, has not happened since December of 1995, when liabilities in the deposit-free US Shadow Banking system for the first time ever became larger than liabilities held by traditional financial institutions, or those whose funding comes primarily from deposits. As a reminder, Zero Hedge has been covering the topic of Shadow Banking for over two years, as it is our contention that this massive, and virtually undiscussed component of the US real economy (that which is never covered by hobby economists' three letter economic theories used to validate socialism, or even any version of (neo-)Keynesianism as shadow banking in its proper, virulent form did not exist until the late 1990s and yet is the same size as total US GDP!), is, on the margin, the most important one: in fact one that defines, or at least should, monetary policy more than most imagine, and also explains why despite trillions in new money having been created out of thin air, the flow through into the general economy has been negligible.

Before we get into the nuances, here, courtesy of Zoltan Pozsar is a reminder of the nebulous entity under discussion which is the definition of "baffle them with bullshit." We recommend only Intel chip technicians try to make any sense of this schematic.

As another reminder, US Shadow Banking liabilities - a combination of Money Market funds, GSE and Agency paper, Asset-Backed paper, Funding Corporations, Open market paper and of course, Repos - hit a gargantuan $21 trillion in March 2008. They have tumbled ever since, printing at just under $15 trillion at the end of March 2012, the lowest number since March 2005 when shadow banking liabilities were soaring. This is an epic $6 trillion in flow being taken out of credit-money circulation, with a $143 billion drop in Q1 alone! (blue line on the chart below).


In fact over the past 16 quarters there has not been a single increase in the total notional contained within shadow liabilities.The chart below shows perfectly just where the credit bubble popped: a bubble which has affected shadow banking far more than normal credit transformational conduits.


It is precisely this ongoing contraction that the Fed does all it can, via traditional financial means, to plug as continued declines in Shadow Banking notionals lead to precisely where we are now - a sideways "Austrian" market, in which no new credit-money money comes in or leaves.

In fact, as the chart below shows, while the collapse in shadow banking has been somewhat offset by increasing liabilities at traditional banks solely courtesy of the Fed, the reality is that for two years in a row, consolidated US financial liabilities amount to just shy of $30 trillion and have barely budged. As long as this number is not increasing (or decreasing) substantially, the US stock market has virtually no chance of moving higher (or lower) materially.

What is worse is that even when accounting for offsetting traditional bank liabilities, on a consolidated basis, the US total financial sector is still an epic $3.8 trillion below its all time highs, just above $33 trillion. Unless and until this $3.8 trillion hole is plugged, one thing is certain: risk is not going anywhere (also notable is that consolidated liabilities in Q1 declined by $86.2 billion at a time when the Fed was engaged in Twist but that is for Ben Bernanke to worry about, not us).

So what is this "historic inversion" referenced in the title?

As some may have noticed looking at Chart 1, as shadow banking continues to collapse, it has to be offset by increasing conventional bank liabilities: for the most part real cash (technically electronic) deposits. And as of March 31, the spread between Shadow Banking and traditional financial liabilities has collapsed to just $206 billion, after hitting a record $8.7 trillion in March 2008. It is also important because the last time shadow banking as notional overtook the conventional banking system was back in December of 1995. Next time we update this chart, the blue line will be below the red one for the first time in 17 years.

Here it is again in chart format:

(At this point it may be worth noting that the only reason why we are so close to this critical inflection point is because this past quarter the Fed shifted $2 trillion in liabilities away from the household sector and dumped them in the US depository sector; for the time being this reclassification is not relevant but may require some clarification down the line).

Why is any of this relevant?

Simple.

What shadow banking has been for America is nothing short of an inflation buffer. Recall what the primary characteristic of shadow banking is: it performs all the traditional credit intermediation transformations that conventional banking entities do: Maturity, Credit and Liquidity.

However, unlike traditional banks, shadow banking has one huge deficiency: it has no deposits! In other words, the entire rickety shadow banking system is based simply on the good faith and credit that rehypothecated assets, converted into liabilities, and so on (think repos and reverse repos) courtesy of fractional reserve credit formation (recall rehypothecation), are valid and credible sources of liquidity. While that may be the case in a leveraging environment, i.e., in the expansionary phase of the ponzi, it no longer works when systematically deleveraging, i.e., where we are now.

It also explains why with collapsing shadow banking system it is purely up to traditional banks to grow if not to create additional credit-money instruments, then simply to plug the hole that is created every quarter with the expiration of more shadow liabilities. Because, once again, these are not of the Federal Reserve note variety, but credit instruments themselves, which in time maturity, and effectively take money out of the system all else equal.

Most importantly, it also explains why Goldman IS right, and the Fed has no choice but to shift to a "flow" reserve creation format, at least until such time as the balance of shadow liabilities is offset by generic liabilities: i.e., deposits.

However, there is a rub. As we noted previously, shadow banking is simply an inflation buffer: since there are no deposits, there is little risk of the "money" contained in the banking system from furiously vacating and be used to spur purchases of everything from 1,000x P/E/ stocks, to overvalued housing, to just being packed away safely in a mattress. In other words, the Shadow Banking system is circular as the money contained therein is self-contained.

Not so for deposits. Just ask any banker, central or otherwise, especially in Europe, who has had to deal with the threat of bank runs.

The biggest paradox is that as the US financial system takes more and more steps back, and reverts to a more conventional system (look at Europe as a paradigm of what is coming), the risk that incremental money creation by the Fed will eventually spur inflation rises exponentially, as more and more "money" ends up residing within conventional bank deposit accounts.

That currently there are just shy of $10 trillion give or take in consolidated deposits across the US financial system, on total liabilities of $30 trillion, is the only reason why the Fed has still be unable to spawn the kind of "virtuous" inflation that Bernanke dreams about every night but is unable to create.

Said inflation buffer, however, is getting smaller and smaller every quarter, and at this rate, shadow banking as a transformational conduit will completely disappear in a few short years, at which point everything will be in the hands of fickle depositors.

It is then, that America will finally figure out why Germany and the Bundesbank, are so leery of runaway printing. Because while the US still has the benefit of shadow liabilities, Europe does not. And Schauble, Merkel, and Weidmann, not to mention the German population (at least subconsciously) all know this.

In a few years, when traditional bank liabilities have soared by another $10 trillion (think doubling of the current depositor base), and when shadow banking is essentially non-existent, and when the stock market is still where it is, then, and only then, will all those three-letter economic theories, which on purpose ignore the impact of shadow banking, be finally put to the test. We can only hope that by then the market still has some discounting capacity left in it, and can prevent the kind of final outcome that tens of trillions in deposits shifting from Point A to Point B on a whim will certainly create. Alas, with encroaching central planning having made discounting virtually meaningless and impossible, we wouldn't be surprised if once again the "capital markets" don't understand what has just happened before it is too late.

 

Appendix A:

Historical components of shadow liabilities.

Sequential change in the historical components of shadow liabilities.

Source of all the data used in this article: Fed's Flow of Funds, which for some reason no other financial analyst, let alone journalist, wants to touch with a ten foot pole.

Finally, anyone who wishes to learn some more, here is some additional info from Deloitte (generically correct perspective, but incomplete).

Finally, those who wish to learn the details of logic behind this analysis can do so courtesy of Zoltan Pozsar's latest report on Shadow Banking.

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Ahmeexnal's picture

War and Pain.

In the smoke of combat...no gods give you the guts.
http://www.youtube.com/watch?v=_64PBTgKUSE

Silver Bug's picture

Just hurry up and collapse, so we can get on with rebuilding a real sustainable system.

 

http://silverliberationarmy.blogspot.ca/

sunaJ's picture

Time to come up with a new and exclusive banking system to cover shadow.  Any suggestions on a name?  Since shadow didn't work, maybe we can call it "screaming phoenix" or something.

groundedkiwi's picture

Cloud sounds good to me.

Pinto Currency's picture

 

A good article but it continues the misperception that money has to come out of the bank accounts and "chase" goods to cause price inflation.  Similarly we continually hear analysts say that "inflation is low because monetary velocity is low". 

The Austrian School has repeatedly shown that monetary velocity has nothing to do with the purchasing power of money.  Prices are set simply by market forces of what market participants are willing to pay for various items.  As such, purchasing power is directly related to the stock of money in the system and these measures have increased dangerously over the last two decades.

The question remains whether attacking prices of real good through the futures market can contain prices while the money stock is increased - and the answer to that question is k"no"wn.

http://mises.org/daily/918

http://mises.org/daily/2916

steve from virginia's picture

 

 It is precisely this ongoing contraction that the Fed does all it can, via traditional financial means, to plug as continued declines in Shadow Banking notionals lead to precisely where we are now - a sideways "Austrian" market, in which no new credit-money money comes in or leaves.

I hate to say I told you so but here on ZeroHedge and elsewhere I have been insisting that the Fed (and other central banks) cannot 'print money', they are balance sheet constrained.

As the Fed's balance sheet expands, the private sector balances contract. There is no new credit-money, it is impossible. What takes place is credit recycling.

Central banks lend against collateral that are in general loans previously made. Loans are made at face-price or less. It is the precious private sector that extends loans without collateral or upon the re-pledged/rehypothecated variety. Any inflation comes from the private sector, not the central banks.

The central bank cannot lend in excess of pledged collateral, it cannot leverage, it cannot offer unsecured loans. To do so means there is no central bank.

Central banks that extend unsecured credit are no different from the banks they intend to 'bail out'. These are banks that are insolvent because they have extended unsecured loans that have become non-performing. With no solvent bank there is no lender of last resort, the consequence is bank runs (as are underway in Europe right now).

The term 'bank' includes any lending finance institution.

The reason for the bank runs is the perception there is no lender of last resort, the perception that all the banks are insolvent, because the central banks at all levels are perceived to have made unsecured loans, just like 'Brand X' European banks.

You can go back to sleep now.

Pinto Currency's picture

 

That is silly Steve.

The Fed creates digital money from nothing and buys previously created bonds or other assets and inject money into the economy.

And it does a very good job of this: http://research.stlouisfed.org/fred2/series/M2NS

JimBowie1958's picture

The total notional value of the shadow banking system is contracting, but is there any evidenc that it is going into the M2 money supply instead of other M3 type investments that still pretty much keep it out of regular circulation?

Why are commodity prices for most commodities going down if all this is inflationary?

I am no economist, but am just asking some questions to try and understand this better.

Thank you to whomever answers my question.

Pinto Currency's picture

 

In 2002 the CCI commodity index was 200.

Today it is 520.

Short term trend is down. 

Long tem trend is up.

http://www.mrci.com/client/crb.php

 

 

slewie the pi-rat's picture

i was just thinking:  isn't this just like 1995?

...hard to believe, i know...

Ignatius's picture

This is one of the more important articles of late here at ZH.

francis_sawyer's picture

Robot Trader isn't going to be very happy to see this...

Matt's picture

Did anybody else find the diagram unreadable, not due to complexity, but simply due to the resolution being so poor, that all the labels are illegible?

Ghordius's picture

oh, the diagram is utterly irrelevant, Tyler's take is what counts. Fantastic article, my compliments. The momentum that is building up in the decrease of the shadow banking system would then go on in the conventional banking system, like a racecar that has already built top speed at the start of a race... < shudders > 

Long live King Dollar, long live King Dollar, long live...

Ghordius's picture

LOL - meanwhile Mish's takes this article as deflationist proof that shows "...

why hyperinflationists are in an alternate universe and why proponents of "huge inflation but not hyperinflation" are on Mars"
Vesuvius's picture

You can find a very high resolution pic of the diadram here, if you dare go here:

http://www.ny.frb.org/research/staff_reports/sr458.pdf

New_Meat's picture

the real RT, or the current fantasm?

all of your plus-upz have no clue

don't cha' know.

- Ned

illyia's picture

Yes, one of the more important, indeed...

MarsInScorpio's picture

While it could be argued that nearly every article on ZH is important, it is this type of deep, highly technical article that sets ZH above the crowd and gives it the credibility those who run the ponzi wish it didn't have.

 

Congratulation Tyler and company.

-30-

Reese Bobby's picture

I feel like the kid in The King with No Clothes.  I find the basic assumptions in this MMT man-love piece odd.

“What shadow banking has been for America is nothing short of an inflation buffer.”  Really?  Well perhaps the explosion in the size of the shadow banking system caused the debasement of fiat currency and led to the global currency war that ends with no winners.

It is some kind of tragedy if money is taken out of the system?  Well most people are not beneficiaries of artificially inflated financial assets.  Credit is tight anyway.  Pop the bubble already.  Let liabilities AND assets find their intrinsic levels.  The back-end of dislocation will be better than the current shell game.

IMO

Tyler Durden's picture

What the hell are you rambling about? Read and reread as many times as is necessary to actually grasp what is being said.

  • What is being said is that $23 trillion in deposit-free liabilities have been an exquisite buffer to inflation, and have allowed Bernanke to print with impunity without seeing results.
  • What is being said is that with every dollar in shadow banking evaporating, the moment when we will see not only inflation but hyperinflation, is rapidly approaching.
  • What is being said is that it is a tragedy that the same "solutions" are being applied over and over, when the solution is merely shifting from one from of credit transformation to another. Since you have some problems with comprehension, this means you can't fix debt with more debt.

Now do you have any other witty "man-love" comments based on your complete lack of understanding (of not only this piece but of every other piece on shadow banking posted in the past two years) of what you pretend of have read and jumped straight into the comments?

Reese Bobby's picture

Actually all that was not said.  You are better off for having said it and I am glad my comment brought it out of you.  You are welcome and I forgive you for spitting venom at me.

Tyler Durden's picture

As was repeatedly said: reread.

What is worse is that even when accounting for offsetting traditional bank liabilities, on a consolidated basis, the US total financial sector is still an epic $3.8 trillion below its all time highs, just above $33 trillion. Unless and until this $3.8 trillion hole is plugged, one thing is certain: risk is not going anywhere (also notable is that consolidated liabilities in Q1 declined by $86.2 billion at a time when the Fed was engaged in Twist but that is for Ben Bernanke to worry about, not us).

 

It also explains why with collapsing shadow banking system it is purely up to traditional banks to grow if not to create additional credit-money instruments, then simply to plug the hole that is created every quarter with the expiration of more shadow liabilities. Because, once again, these are not of the Federal Reserve note variety, but credit instruments themselves, which in time maturity, and effectively take money out of the system all else equal.

 

Most importantly, it also explains why Goldman IS right, and the Fed has no choice but to shift to a "flow" reserve creation format, at least until such time as the balance of shadow liabilities is offset by generic liabilities: i.e., deposits.

 

However, there is a rub. As we noted previously, shadow banking is simply an inflation buffer: since there are no deposits, there is little risk of the "money" contained in the banking system from furiously vacating and be used to spur purchases of everything from 1,000x P/E/ stocks, to overvalued housing, to just being packed away safely in a mattress. In other words, the Shadow Banking system is circular as the money contained therein is self-contained.

 

Not so for deposits. Just ask any banker, central or otherwise, especially in Europe, who has had to deal with the threat of bank runs.

 

The biggest paradox is that as the US financial system takes more and more steps back, and reverts to a more conventional system (look at Europe as a paradigm of what is coming), the risk that incremental money creation by the Fed will eventually spur inflation rises exponentially, as more and more "money" ends up residing within conventional bank deposit accounts.

You are welcome.

Reese Bobby's picture

My main point of contention was:

"Most importantly, it also explains why Goldman IS right, and the Fed has no choice but to shift to a "flow" reserve creation format, at least until such time as the balance of shadow liabilities is offset by generic liabilities: i.e., deposits."

As you have now pointed out there is a choice; only one logical choice: stop trying to solve a debt problem with more debt.  I mistook your explanation of a stupid system/strategy as support of the stupid system/strategy.

Thank you.

Eireann go Brach's picture

Reese Bobby, please don't get upset and beat up your poodle dog named rainbow just because you got bitch slapped by Tyler!

Reese Bobby's picture

Tyler I can be polite to. Not so much an empty-headed, ass-kisser like yourself. Strive for an original thought kid. Get in the game.

doomandbloom's picture

I want to be bitch slapped by Tyler :(

Vesuvius's picture

Thanks for the excellent article! I would like future heads-up articles on the Total Shadow and Traditional Bank Liabilities Sequential Change.  The ZH 9/20/2011 article had a nice graph with the probably QE2 related upward $337 billion Sequential Change that coincided with the fall 2010 to spring 2011 inflation:

http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011...

The above pic is from this 9/20/2011 ZH article:

http://www.zerohedge.com/news/shadow-banking-system-imploded-q2-bernanke...

I am interested in when this current somewhat deflationary environment will change back to inflation.  According to a May 2012 reuters article, there is supposed to be a 35 percent CME margins increase in all commodities on August 5, 2012.  My guess is that this will bring temporary deflation on Monday August 6, 2012 as a selloff will occur so that the margin calls can be paid.  With increased margins CME will lose some of its power to affect change in prices, and inflation may take hold again.  I don't know if QE3 will be necessary for inflation, maybe this summer drought will have people move their monies into commodities again, or the treasuries bubble will burst, or something else.  

If inflation is 'up' in the liabilities graph, and QE2 increased the liabilities and produced inflation then I don't see why we would need to wait years for the shadow banking liabilities to go down before inflation can occur.  I would guess that if the shadow liabilities dropped in half, then another 600 billion QE3 could produce twice the inflationary pressure, but I don't see it necessary for a decrease in shadow banking liabilities before big inflation can occur.  Maybe the shadow banking liabilities will not go down anymore because there is not enough money to pay them and liabilities will go up and lead to inflation.  The liabilities could go up the stairs hyperbolically/exponentially and eventually the dollar could take the elevator down.  When? After the election?  Months or years from now?

 

Sudden Debt's picture

If today is 1995 all over again.... ....
I CAN'T WAIT TO PARTY LIKE IT'S 19 99!!!!!!!

Skateboarder's picture

You have no idea how bad I want it to be the 90s all over again.

IndicaTive's picture

I'll pay extra for a window seat. Exit row only though. Thanks.

Son Of Juicyfruit's picture

@Silver Bug- Agreed! However, keep in mind that the longer they manage keep this up, the more profit can be made from gold/silver.

If right now there actually IS 1 oz for every 100 oz 'they' CLAIM to be out there, that's an immediate profit of 100x when they hit the proverbial 'reset' button- and that ratio could easily continue to rise in our favor as they try harder and harder to conceal and maintain this shadow banking scheme.

This could very well end with people being made to believe there is 500 or 1000 times more gold/silver out there than there really is.

I would also like to add a quick 'thank you' to all contributors (articles, comments, etc.). I'm a new member but have been diligently reading here for about a year- Excellent stuff. Although, as a 19 year old in college, I doubt citing any of the brilliance seen here would sit too well with my economics professors....Keep up the good work trying to educate the masses.

Precious's picture

Take out the GSE component, and the slide is about double.  The FED is responsible for supporting the GSE component, which is basically Freddie Mac and related zombies etc.

DanDaley's picture

Do those VOIVOD guys do weddings?  

falak pema's picture

funny money nirvana country, the stuff that lurid wet dreams of virtual kings are made off. Ask MAdoff. 

GeneMarchbanks's picture

The magic of hyper-hypothecation. The slow death of shadow banking is the cushion and the difference between Europe and US.

vast-dom's picture

well before shadow banking as conduit or otherwise will disappear, we will see a major market correction. at which point The Fed will print across several fronts and inflation will be achieved. this will happen well before the year is up.

Sweet Chicken's picture

So where does Gold correct to $5000? $10,000? $20,000?!?!?

LawsofPhysics's picture

Paper or physical?  The former will continue to be manipulated.  Physical PM's will be used in the black markets and central banks will continue to buy and probably encourage the governments they control to consider confiscation after imposing capital controls and price fixing.  This has been played out numerous times before.

resurger's picture

Only $'s accepted in blackmarkets... i hope they too wake up and convert their holdings to gold, this will be a true bitch

 

 

 

Sweet Chicken's picture

Physical of course. But even the market correction will need to be something like I listed correct?! Not sure how they go about confiscating the little there is out there? I was really hoping to pay off some of my debts with some of my physical when the prices really start correcting. Suggestions?!

ATM's picture

Pay off debts with physical? You are insane man! Y

The beauty of inflation is you pay off in the worthless paper and hold onto the physical asset. Hell it might be a good time to borrow more and buy physical.

Loan balances don't inflate. What you pay them back with does.

Sweet Chicken's picture

Well I think like you do but my wife is a totally different kind of nut. She doesn't believe like me that gold will be rising exponentially pretty soon. So whe is hoping that we can sell some of the physical to pay off the debt before they make it illegal to have it written down or worse and make it impossible for me to file a chapter 7.

ATM would you be will to do a little back and forth with me through email about my situation?

Western's picture

Once you are competent in the law you will realize that "chapter 7" and other corporate mish mash is all smoke and mirrors. If you are the general executor of your estate, nobody can touch any assets you own.

 

If you want to be more competent in the law, check out university.ucadia.info ; all the answers you seek are in there, somewhere.

spinone's picture

Think of the paper and the physical as two different worlds.  Firewall them.  Go BK in the paper world, but keep your physical.

OneTinSoldier66's picture

"So where does Gold correct to $5000? $10,000? $20,000?!?!?"

 

Only The Shadow knows

spinone's picture

There will be no dollar price for gold.  No one will accept dollars in exchange for physical gold.

spinone's picture

There will be no dollar price for gold.  No one will accept dollars in exchange for physical gold.

LawsofPhysics's picture

ZIRP is QE, and you are correct.  The Fed and all central banks have been "printing" in a coordinated effort.  The problem now is their efforts are becoming uncoordinated and the world, and the U.S.S.A. in particular will see that "free money" coming back in the damnest places.

There is a cost for creating capital, especially if you don't actually creat anything of real value.  ZIRP killed Japan and will now kill all those who have been using it.