On The Verge Of A Historic Inversion In Shadow Banking

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?


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.