10 Shadow Banking
The sole purpose of shadow banks is to circumvent regulation
Gabor
The last four decades have witnessed a transformation of the global financial landscape. Whereas most saving and borrowing once took place through traditional banks — institutions that issue loans and deposits on their books — today, those functions are migrating toward a set of markets collectively known as “shadow banking.” The 2008 crisis was, above all, the first systemic crisis of this new financial landscape.
In place of ordinary loans and deposits, shadow banks use securities transactions of various kinds. In this world, traditional bank loans are sliced up into more liquid securities for sale to institutional investors, a process known as securitization. And instead of financing their activities using retail deposits, shadow banking institutions turn to a vast yet arcane part of the money market known as repurchase agreements, or repo.
The shadow banking revolution has been fostered and sustained by the visible hand of the state, which is now angling to extend it to every corner of the developing world. With its vast potential for instability and profiteering, shadow banking is an obstacle to any progressive economic policy, yet it has entrenched itself deeply in the day-to-day workings of the economy.
The global financial crisis now seems a blip in the unstoppable rise of finance. Shadow banking is far larger than it was ten years ago, even though everyone after Lehman Brothers’ collapse believed that shadow banking needed to be properly regulated. Policymakers are again portraying finance as the solution to pressing social and economic problems.
The World Bank’s new Maximizing Finance for Development (MFD) agenda recasts shadow banking as the solution to developmental challenges.
The resurgence of shadow banking should be understood through the lens of financial capitalism, or financial globalization. This involves the continuous search for new tradable asset classes, created through shadow or traditional banking, and the preservation of their value to facilitate financial profits. Financial capitalism increasingly orients the (shadow) banker toward profits made from daily changes in the price of securities and commodities, whether held directly or via derivatives or exchange-traded funds, and all typically financed through wholesale money markets.
That shadow banking is back with a vengeance is the result of three related processes: a sensationalized narrative of the global financial crisis that downplays its structural roots in financial capitalism; a politics of austerity driven by central banks’ dislike of the institutional changes necessary to stabilize financial capitalism; and deliberate strategies to reengineer financial systems in developing countries to avoid the political struggles necessary to reverse the rise of financial capitalism.
Securitization and repos (repurchase agreements) are the two markets that lie at the core of shadow banking.
Lehman aggressively pursed profits with a business model rooted in shadow banking: packaging and securitizing mortgages to issue tradable securities, storing these on its balance sheet as a bet on rising house prices, and then borrowing money in repo markets by using those same illiquid securities as collateral.
The rise of shadow banking was not a post–Bretton Woods accident, but a structural shift towards financial systems increasingly organized around securities, derivatives, and repo markets, underpinned by growing levels of household debt, all in the shadow of the dollar. Authorities in high-income countries actively encouraged this shift.
Regulators first embraced shadow banking as the necessary infrastructure of the new, anti-Keynesian macroeconomic order of the 1980s and ’90s, in which governments had to finance themselves through securities markets, rather than subservient central banks, while competing with each other for investors.
Shadow banking offered individuals market-based protection via pension funds, insurance companies, or securitizable housing, and it offered elites vehicles to invest their wealth. It also churned out safe assets that global institutional investors — pension funds, insurance companies, money market funds, or multinational corporations — were required to hold, plus the risky assets demanded by European banks hungering for yield, as well as leveraged funds often acting on behalf of institutional investors.
When the United States failed to keep up with the demand for safe US government debt, the Federal Reserve reacted quickly. It spearheaded initiatives to make it easier for investment banks like Lehman to raise finance using mortgage-backed securities, as an alternative to US Treasuries, in repo markets. If the Treasury would not provide “safe” assets, then Lehman would produce them, with a little help from the Fed. Central banks’ support for financial capitalism had been unscathed by the earlier collapse, in 1998, of the hedge fund Long-Term Capital Management (LTCM). Its largest lenders agreed to finance the firm’s orderly unwinding, worried that a disordered collapse of LTCM would trigger fire-sales of collateral securities that would, in turn, affect their own repo financing. This private bailout created a false sense of confidence for both financiers and central banks. Central banks agreed that self-imposed market discipline and more sovereign bonds to act as safe collateral assets would be enough. It is one of the paradoxes of financial capitalism that central banks call for less public debt when talking about monetary policy, and for more public debt when considering financial stability.
The new, postcrisis Basel III rules on liquidity and leverage targeted global banks’ systemic footprints in shadow markets. The newly created, international Financial Stability Board focused on shadow banks and shadow markets (securitization and repo markets). The European Commission, prompted by Germany and France, proposed a financial transaction tax (FTT), that is, a “Tobin tax” for financial capitalism that directly targeted intra-financial securities trading and financing via repos and derivative markets.
There is a powerful contradiction at the core of the macroeconomic architecture underpinning financial capitalism: neither central banks nor elected politicians have institutional incentives to pursue the structural change that would reverse the rise of shadow banking.
Public debt is “vital to the functioning of the financial system, analogous to the function of money in the real economy,” stressed the ECB’s Benoît Cœuré in a 2016 speech on safe assets. But if sovereign debt represents money for the (securities) market-based financial system, that means the safe assets issued by treasuries (government bonds) are as important for financial capitalism as the safe assets issued by central banks.
If the central bank is mandated to defend financial stability, then the rise of shadow banking structurally requires that mandate to include defending the safe-asset status of government debt — that is, protecting governments from volatility in sovereign bond markets, even if it means printing money to do so. This is an unpalatable conclusion. It questions the theoretical basis for central-bank independence, as well as the entire edifice of modern macroeconomics, which views fiscal policy as an obstacle to optimal monetary policy and economic stability in general.
Central banks are outposts of private finance in the state. As outposts of shadow banking in the state, central banks can now discretionarily inject liquidity into private securities markets to arrest their fall in price, thus protecting (shadow) banks’ profits and access to secured financing. Arguably more important, central banks have instituted a discretionary regime for intervening in sovereign bond markets (qe, the ECB’s Outright Monetary Transactions, and market-maker-of-last-resort operations) that tacitly recognizes the fundamental role these markets play as safe havens for fragile finance.
By burying these measures in a sea of acronyms removed from public debate, central banks effectively protected the powerful position that financial capitalism has conferred on them through the discourse of central-bank independence.
In abandoning efforts to reverse shadow banking, states took the global finance space from a handful of global banks and handed it to a handful of global asset managers. This new systemic breed of shadow banks has grown rapidly, from $60 trillion in 2007 to $85 trillion in 2016, with around 80 percent held on the accounts of institutional and retail investors in Europe and North America. China’s rapidly growing asset-management sector will accelerate this trend, without challenging the dominance of the Big Three (BlackRock, Vanguard, and State Street), which own corporate America on behalf of retail and institutional investors. Their next target: poor and middle-income countries. Poor countries should aim for the trillions institutional investors and asset managers have available for “impact investment.” For poor countries to access global institutional investors, they would need to reengineer their financial systems around securities markets on the terms of those investors, a Trojan horse for shadow banking and financial globalization. On its 2017 launch, the World Bank euphemistically termed this strategy “Maximizing Finance for Development” (MFD). Everything can become an asset class, as development is recast as an exercise in the privatization of public services to generate returns for global finance.
The World Bank explains the process — formally termed the Cascade Approach — for turning everything into an asset class. The Cascade Approach offers a sequence of steps to diagnose why global investors are reluctant to finance development projects: first, identify reforms (regulatory or other policies) that improve the risk-return profile; if reforms are insufficient, then identify subsidies and guarantees to de-risk the project; if reforms, subsidies, and guarantees are still not enough, then opt for a fully public solution. This is a blueprint for promoting shadow markets in which bankable projects can be transformed into liquid securities ready for global institutional investors. The MFD agenda envisages creating three new markets where they are currently missing: derivative, repo, and securitization markets.
Gabor (2018) Why Shadow Banking Is Bigger Than Ever
Tankus
there are a wide set of institutions which manage literally trillions of dollars of assets. Just like you or I do, these institutions have to hold a certain amount of their funds in “cash”, in order to manage their investments and meet outflows. Deposit insurance caps are a problem for this wider network of institutions, because these caps are sized relative to most household “cash balance needs”. By contrast, they are almost laughably tiny compared to the monetary needs of these institutions. This “mismatch” is a gigantic problem. What the financial services part of the financial system ecosystem did ( and does) is create new financial products in an attempt to solve these problems- for a fee. In short, they invented new types of “money”.
Zoltan’s paper zooms in on this phenomenon. Before Zoltan’s work there were large discussions of the “shadow banking system”, but they tended to focus on the incentives that financial institutions had to create “shadow money” in order to hold (seemingly) high yielding assets. Pozsar’s work flips this perspective. Instead he asks, why is there such a large and deep customer base for shadow money? The answer he provides is- deposit insurance caps. It’s worth quoting Pozsar at length here:
As the limits of slicing and spreading growing institutional cash pools in fixed, insured increments across a shrinking number of banks and against binding unsecured exposure limits were reached, institutional cash pools faced two alternatives:holding uninsured deposits and becoming uninsured, unsecured creditors to banks, or
investing in insured deposit alternatives—that is, safe, short-term and liquid instruments—such as short-term
(ii/a) government guaranteed instruments or
(ii/b) a range of privately guaranteed instruments (secured instruments and money funds) issued by the so-called “shadow” banking system.
With only a limited appetite for direct, unsecured exposures to banks through uninsured deposits, however, institutional cash pools opted for the second set of alternatives. Relative to the aggregate volume of institutional cash pools, however, there was an insufficient supply of short-term government-guaranteed instruments to serve as insured deposit alternatives […[ With a shortage of short-term government-guaranteed instruments, institutional cash pools next gravitated—almost by default—toward the other alternative of privately guaranteed instruments
I will return to the issue of “insufficient supply of short-term government-guaranteed instruments” in another piece. For today, what matters is that the key element of uninsured deposits is that they are “unsecured” i.e. not collateralized. This has two issues. 1) you’re less protected against loss because you’re exposed to all of a bank’s potential losses, rather than simply the value of one asset (the collateral). 2) Worse, you have the threat of illiquidity. Even if you will ultimately be paid back, the time it takes the FDIC to fully dispose of the bank’s assets can potentially be quite long. In the meantime, you have a “receivership certificate” which, to say the least, is not an attractive asset to hold. The attractive feature of secured claims- that is collateralized IOUs- is that in case of default you can sell the collateral- and typically quite quickly. Even the extreme case of taking the exact same loss with shadow money that you would have with uninsured deposits favors shadow money because you realize the loss quickly and have liquid funds on hand rather than an illiquid claim that will take- at the very least- months to resolve itself. At least, in theory
Which leads to the negative consequences part. This search for collateralized shadow monies to replace uncollateralized uninsured deposits is not some harmless, costless process. Indeed the very term shadow banking was coined by Paul McCulley in 2007 to describe a set of “non-bank” financial institutions which ultimately themselves experienced a run… A “shadow bank run”, if you will. Recall that the thing that makes today’s shadow money valuable is that “even” in the case of default, and you can sell the underlying collateral quickly and easily. In other words, the collateral is safe and liquid. Just as losses (whether unrealized or realized) can cause a run by uninsured depositors, potential losses can cause a run by shadow money holders. Remember 2007 and 2008? Remember a little instrument called a Mortgage-Backed Security? It should not surprise you to learn that these were one of the key forms of safe collateral which “collateralized” shadow money. Oops!
That there was a “shadow” bank run is one of the less discussed elements of the financial crisis in popular culture but to those of us obsessed with the structure of the financial system, it’s a key element of the whole episode. It’s also important to understand that while loss fears triggered these runs, the key deadly element was the collapse of liquidity. Ultimately, the highest rated private mortgage backed securities (AAA) were the principal taken-as-safe collateral for these shadow monies. AAA MBS securities ultimately took only a couple percentage points of losses on average. Remember that, as I explained at length in 2020, Collateralized Debt Obligations (CDOs) are a different instrument entirely.
The point is that ultimately, even the extreme and fraudulent activities which emerged during the 2000s housing boom were not enough to create losses in the safest portion (or tranche) of Mortgage Backed Securities. In this sense, the financial engineering actually worked. The problem was all the financial byproducts (the lower- especially the lowest- tranches) and the inappropriate further use of these financial engineering tools.
Where the financial engineering completely failed is in creating an asset that truly had the liquidity of government securities. The losses may have ultimately been small, but there was no way to know that in the moment. That fear made these assets illiquid.
You might even remember the terminology that emerged at the time to describe this: toxic assets. What the public did not understand at the time is that while fear of losses may have made them toxic, the real issue of toxicity was “liquidity”. The shadow banking system had collapsed as a result of runs which meant the multi-trillion dollar system which financed them no longer existed. The only possible solution was the chartered banking system directly financing the holding of AAA mortgage-backed securities (which it was in no position to do) or else the government stepping in. The money creation process which generated liquidity in these securities markets collapsed and only government balance sheets- i.e. government money creation- could fill the void.
The larger issue Zoltan Pozsar is highlighting in this paper is that when you look beyond narrow measures of “the money supply”, deposit insurance is providing less and less protection as these financial net worth pools grow and grow. He says this outright in the paper:
Indeed, if institutional cash pools continue to rely on banks as their credit and liquidity put providers of last resort, the secular rise of uninsured institutional cash pools relative to the size of insured deposits is going to make the U.S. financial system increasingly run-prone, not unlike it used to be prior to the creation of the Federal Reserve and the FDIC. Put another way, the secular rise of cash pools reduces the effectiveness of deposit insurance in promoting system-stability, if depository institutions are wired to serve as insurers of last resort for the world’s uninsured dollar liquidity
In some fundamental sense, institutional investors want collateral because they don’t want to do careful credit monitoring.
The dream of “market discipline” crashes against a wave of financial engineering in the real world.
Leaning completely on collateral is the opposite of careful monitoring of balance sheets.
The latest innovation in shadow money- “cash sweep” programs. These programs, which I discussed two weeks ago, use financial technology to take your large uninsured deposit and break it up into literally hundreds of insured deposits at various banks. If every uninsured depositor used cash sweep type programs, then there would be no “market discipline” i.e. uninsured depositors monitoring bank balance sheets. This would be functionally the same as uncapped deposit insurance, except formally uninsured depositors would pay a fee for that service upfront.
These “brokered deposits” products essentially transform uninsured deposits into shadow monies. These shadow monies simply have the unique feature that they emerge from within the banking subsidiary, and the collateral is insured deposits themselves.
This is a kind of reductio ad absurdum of shadow money which shows that shying away from eliminating deposit insurance won’t provide “liability side discipline”, it will just generate more shadow banking system instability. At best, these “cash sweep” innovations (and other similar devices) will effectively create a consumer unfriendly version of unlimited deposit insurance. The difference will be that the pressure for corresponding asset side regulation will dissipate in a fog of complexity. Rip the bandaid off, eliminate the cap on deposit insurance and let’s have the real policy debate.