The Three "Financial Structure" Paradigms Of Modern Finance

In a prior post, we discussed the implications of the global shadow banking system having risen to the unprecedented level of roughly 100% of global GDP. By now it should be quite obvious to even the most jaded optimists, that the reason why traditional leverage conduits are no longer applicable (and the only real source of bank credit creation is the Fed via the hopeless blocked up excess reserve pathway), and why credit money (and hence in a Keynesian world "growth") has to come via deposit-free, unregulated "shadow" venues, is that there are no longer enough good money good assets for conventional secured credit creation, and viable levered projected cash flows for conventional unsecured credit creation. Yet not the entire world has gone all in on this gambit, which together with the Fed's money printing, is truly the last bastion of "money' creation. In fact, as the FRB demonstrated, there are three distinct paradigms when it comes to source of credit creation or as it puts it, "financial structure": the US "massive shadow banking system" way, the German "conventional bank deposits funds loan creation" way, and the Saudi Arabian, and soon everyone else, "central planning to the max" way. In a nutshell, these are the three credit system structure extremes, with everything else currently inbetween. These can be visualized as follows:

Follows the FRB's commentary on these three financial system "paradigms"

Three main groups of jurisdictions emerge when analysing the structure of financial systems based on the share of banks, insurance companies and pension funds, other NBFIs/OFIs, public financial institutions and central banks in the total (see Annex 2 and Exhibit 3-1):

  • A first group includes advanced economies characterised by a dominant share of banks combined with a limited share of OFIs that does not exceed 20%. Jurisdictions such as Australia, Canada, France, Germany, Japan, Spain fall in this category.
  • A second group includes economies where the share of OFIs is above 20% of the total financial system and relatively similar, or higher, to that of banks. For instance, the Netherlands, the UK, the US, fall in this category.
  • A third group includes emerging market and developing economies where the share of public financial institutions or the central bank is significant, often on account of high foreign exchange reserves or sovereign wealth funds, and where the share of OFIs is relatively low. This group includes jurisdictions such as Argentina, China, Indonesia, Russia and Saudi Arabia.

The chart above, incidentally, explains much if not all, the tension in modern finance.

On one hand, Germany and some of the other more stable financial systems in the world such as Canada, have traditionally relied on deposits (a bank liability) to fund bank assets (loans, secured mostly and to a less extent unsecured), represented in this case by the Green line (traditional banks) being so far higher than the Red line (Shadow banks). This system had a direct linearity between cause (deposit dollar) and effect (loan dollar), magnified simply by the legacy structures of fractional reserve banking.

It is this chart which explains why Germany is so scared of hyperinflation: should the massive "deposit" liability tranche of its banks start to withdraw over fears of rising price, and start chasing hard assets, not only would this start an epic bank run, not only will banks be promptly undercapitalized (recall that Deutsche's Bank's Tangible Capital is in the ~2% neighborhood, meaning the bank can withstand just 2% of deposits flowing out due to an inflation risk scare or otherwise, before it has to start selling assets to keep its equity buffer in place).

Ironically, it is the fact that Germany played along the rules of the conventional game that has put it in the current predicament: had Germany followed in the footsteps of many others, such as the US, and had "Other Financial Institutions" (OFIs) represent the bulk of assets, the Bundesbank and German politicians could care one bit what the ECB does to spark inflation fears. After all shadow banking is deposit free, and there is no fear of deposit outflows leading to an undercapitalized position. Sadly, that is the price to pay for preserving some semblance of a traditional banking system.

Which takes us to the US (and UK and Holland) three jurisdictions, where Shadow Banks (or OFIs) represent the bulk of assets. It is here that deposit levels are largely irrelevant as the financial system has over the past 2 decades primarily used shadow liabilities as funding conduits, which in turn means that central planning authorities have far greater degrees of freedom to intervene and monetize assets in the system, to preserve overall systemic leverage. It is also this tension between non-German Europe (willing to load up with Shadow liabilities) and Germany (not quite so willing), that has defined the European crisis for the past 3 years. It also implies that going forward central bank intervention will be determined to a big extent how dominant the Banking Sector is, whether Shadow Banking liabilities are rising (non-German Europe mostly) or falling (the US), and the relative position of central banks within the financial sector).

Which finally takes us to the third paradigm, that os Saudi Arabia, and China, and Russia, and Argentina, and Indonesia, and Switzerland and slowly but surely virtually every other place in the world, as the coordinated central bank cartel becomes the one and only source of money. And not just any money, but the definition of "Gresham Law" money, as creeping central planning and ubiquitous monetization, means very soon only central banks will be the source of any incremental leverage, while all "good credit" is slowly but surely driven out of the system (courtesy of perpa-ZIRP and fears of what happens when central banks finally lose control).

It is this third paradigm that is the preamble to the final collapse, because just before the endgame, it will be every central bank against everyone else, and against itself, whereby the only way to get ahead is to destroy your own currency of exchange as fast as possible, at first on a relative basis, by devaluing against all other currencies in a closed loop, then on an absolute, by devaluing against hard assets (see Executive Order 6102 and PM confiscations/redenominations).

It is this endspiel that the entire developed world is rapidly rushing toward. And it is this endspiel that only the hopelessly clueless central bankers and Economist PhDs that are responsible for bringing the world to the edge of collapse, are confident can be safely navigated. Everyone else is quietly tiptoeing toward the exits...