Shadow Banking: What It Is, How it Broke, and How to Fix It

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We hear a lot of chatter about the shadow banking system and its crucial role in the financial crisis. But rarely do we find time to step back and ask the basic questions: What is shadow banking, where did it come from, how did it operate, what role did it play in this crisis and how do we deal with it going forward?

I hope this Q&A with a very smart professor and economist at Barnard College Professor Perry Mehrling provides answers to each of those questions.


Mike Rorty: Let's start by talking about what a traditional bank does, how it takes money and the special kinds of risks it faces.

Perry Mehrling: You are talking about the Jimmy Stewart bank. There are two sides to it, the liability side which looks to the depositor. The other side is lending, for consumer loans and other loans. The regulatory support and backstop for that system was devised over many years to deal with two fundamental problems facing that kind of structure.

One risk is liquidity risk, which is the risk that people on the deposit side might want to take their money out and, since the money is locked up in houses and long term loans, it can't happen. So there has to be a lender of last resort. There's a second problem, a solvency problem, which is maybe all those loans go bad, and we want to make sure that the depositors aren't all wiped out. That's where the Federal Desposit Insurance Corporation (FDIC) comes into the picture, making sure that if the bank is insolvent that the depositors are covered to a certain limit.

I referred to the lender of last resort, and that's the role of the Federal Reserve in this story. If a bank does not have liquid funds to pay depositors who want to withdraw their money, the Fed can lend a bank the funds it needs in order to make the payment system work. It isn't then a problem for the depositor, but instead a problem between the bank and the Fed.

That's traditional banking. One thing to understand is that the regulatory support structure of the government is designed for that kind of banking.

Before we start talking about shadow banks I want to go to this quote I found from your presentation. It's Fischer Black in 1970:

"Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral."
- Fischer Black, "Fundamentals of Liquidity" (1970)

It's amazing in how accurate that quote is, as a motivating factor for what the capital market would become, 20 plus years before credit default swap contracts.

He's thinking about corporate bonds, and splitting off interest rate risk and selling it separately and splitting off the credit risk and selling it separately. The instruments he is imagining back then are what we know today as interest rate swaps and credit default swaps.

Why do this? The idea is to make the corporate bond market a more complete market. So by being able to trade interest rate risk and credit risk those risks will move to the people most able to bear them, thus lowering the price of that risk and lowering the price of corporate credit.

So let's talk about shadow banks. What are they, where did they come from, and how did they operate?

We have to appreciate that we are writing history as it is being made so these are provisional theories. I'm really hoping that there will be a big congressional inquiry and we'll find out the facts of the matter, if only for future historians.

The shadow banking system was built up alongside the traditional banking system, using some of these tools of modern finance we were just talking about like interest rate swaps and credit default swaps. The idea was to make credit cheaper for the ultimate borrower and more available, but also to separate the credit system from the payment system. A lot of the regulation we have on the traditional banking system is there to protect the payment system, to make sure that when you write a check on your deposit account, that money actually gets transferred.

The idea of the shadow banking system was in some way, not only tolerated by regulators, but encouraged by regulators. They thought, "Let's get some of these risks off the balance sheet of the traditional banking system. Let's get interest rate risk off the balance sheet of the traditional banking system. Let's get credit risk off the balance sheet of the traditional banking system." They thought that would be a good thing. The traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. It was avoiding the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system.

But of course it had the same risks. You aren't actually getting rid of liquidity risk or getting rid of solvency risk; you are just moving them into a different place.

Let's look at a specific example of how a shadow bank would use a prime AAA collateralized debt obligation (CDO) tranche -- that is, the highest rated portion of the security.

Because these things were rated AAA, or if they weren't they got AIG to insure them and make them AAA, they were able to borrow almost 100% of the value of the CDO tranche in the overnight repo market at low overnight rates and were able to make money on the difference. They were trying to do the funding piece of Fischer's idea, and get rid of all the other risks by selling them off. They were taking advantage of what they understood to be their access to low-cost funds and leveraging them up.

So that explains how the shadow banks evolved. Now where did the weaknesses start to show up?

There's some controversy about this. It is certainly true that problems in subprime started to create some anxiety as to whether or not these assets were really AAA or not. But I don't think that this can be sustained, the notion that this was just a housing bubble that collapsed. Because if it was, we'd be done already. As many people said at the beginning of the crash, "oh [the problem is] just subprime, there's only, say, $400 billion of that stuff out there, it is not big enough to undermine the entire financial system." The fact that crisis continues shows that it isn't just a crisis of subprime, but a crisis of the whole securitization structure, that everything came into question.

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Mike Konczal is a fellow at the Roosevelt Institute.

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