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.
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
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.