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Awhile back there was some controversy over the role of the shadow banking
system in the financial crisis. Resetting the stage:
Much Ado About the Shadow Banking System, The Hearing: Occasionally, a blog
post will flower into a wide-ranging debate in what is usually called the
"economics blogosphere." Last Friday's
guest post on regulation by Mark Thoma triggered just such a debate. I'll
quote the controversial passage at some length:
Deregulation beginning with the Reagan
administration combined with financial innovation and digital technology led to
the emergence of what is known as the shadow banking system. These are financial
institutions that, for all intents and purposes, function just like banks but
are not subject to the same rules and regulations and, in some cases, are hardly
regulated at all.
The development of the shadow banking system is
important because the troubles we are seeing today are not the result of
problems in the traditional, regulated sector of the financial industry. The
problems began in the unregulated shadow banking system.
We need to bring the shadow banking system –
essentially any institution that takes deposits and makes loans either directly
or indirectly – under the same regulatory umbrella as the traditional banking
Dr. Manhattan, an anonymous blogger at The
Atlantic, focused on that middle paragraph in a post called "Sentences
That Don't Compute," arguing that the crisis was due to problems at
regulated financial institutions, such as AIG, not the shadow banking system.
defended Thoma, drawing the line between commercial deposit-taking banks
(heavily regulated) and other institutions (lightly regulated).
Thoma also responded on
his own blog, pointing to the fact that AIG's problems, for example, were
caused by the unregulated part if its business – the Financial Products
Arnold Kling (who usually blogs
here) responded to DeLong at
Atlantic, saying that failures of regulation of commercial banks were also a
Rortybomb has a careful review of the issues, showing how different people
mean different things by "shadow banking system." Ultimately he sides with Thoma
on this point: money shifted into a sector of the financial system where there
was no backstop against a liquidity crisis – unlike the regulated operations of
the commercial banks, where deposit insurance plays that role. This is a problem
that needs to be fixed.
Mike Rorty follows up today in The Atlantic's business blog with an interview with Perry Mehrling on shadow
banking and its role in the crisis. Mehrling's bottom line for regulators is a "new
Bagehot Rule" for modern markets: Insure freely but at a high premium.
Here's part of the interview:
Shadow Banking: What It Is, How it Broke, and How to Fix It, by Mike Rorty:
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:] 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. … 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. …
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.
The way this played out is the following. Once
there is any concern about the value of the collateral you are putting up in an
overnight borrowing situation, the first thing the lender does is to alter the
deal, to say "Ok, we'll continue to lend. But just to be on the safe side,
instead of giving you 99 cents on the dollar we'll give you 95 cents on the
dollar." That immediately creates a problem for the shadow bank that is
borrowing. Where are they going to get that other 4%? The way that plays out is
that … collateral value was marked down. You couldn't borrow as much as
you used to in order to carry the underlying security. This became a
self-fulfilling prophesy on the way down, something I refer to as a
"liquidity-solvency downward spiral."
I've told my students for a decade that this new
system would inevitably get tested by a crisis. And when it got tested it was
inevitable that it was going to break. We didn't know where it was going to
break, and the important thing now is to identify where it broke and to fix it
so it doesn't break there again. …
So what can the Federal Reserve do going forward
to try and regulate this shadow banking system?
I use the term "Credit Insurer of Last Resort." And
here's the idea: The
Bagehot Rule – lend freely, at a high rate, in a crisis – dates from 1873.
That was a good enough rule for the 19th century British economy, an economy
that ran on short term commercial bills of exchange, 90-day paper. You can see
for the new capital markets banking system we have a problem. We have 30-year
mortgages that are the underlying asset that are being turned into 90-day paper
through asset-backed commercial paper, or a
agreement, or repo, but the underlying asset is still a 30-year mortgage.
That is where the system broke, because those mortgages serve as collateral for
the short term borrowing.
Floating the system with money market liquidity,
which is what the Fed did, didn't solve the problem, because it wasn't getting
to the capital markets. That's why we need a credit insurer of last resort, to
put a floor on the value of the best collateral in the system. I say the new
Bagehot Rule should be: Insure freely but at a high premium.
Why a high premium? If you insure an earthquake,
you are not making earthquakes more likely. The insurance contract is a purely
derivative contract, it isn't influencing earthquakes. That is not true of
insurance of financial risk. When AIG is selling you systemic risk insurance for
15 basis points, that price is too low. People said: "If I can get rid of the
whole tail risk that cheaply, I should load up. I should take more systemic
risk." So the prices were wrong. So the important thing for government
intervention here is to get that price closer to a reasonable rate to prevent
people from creating earthquakes.
Mehrling has a fantastic paper,
The Global Credit Crisis, and Policy Response, about the shadow banks and
their role in the current crisis. It’s very accessible to a general reader with
an interest in the subject matter and just a bit of background knowledge and by
far the best explanation of this part of the crisis; I highly encourage you to
read it before or after tackling the interview. He also has
a video of him presenting the paper, as well as a webpage full
of relevant papers and editorials. Check it out.
Update: Arnold Kling disagrees based upon the idea that the market will always be one step ahead:
Merhling's solution is for the government to be a risk insurer of last resort.
That sounds to me like Freddie Mac and Fannie Mae, which did not work well at
all. But Merhling says,
the important thing for government intervention here is to get that price closer
to a reasonable rate…
Thus, the insurer of last resort has to charge a very high premium.
With all due respect to Professor Mehrling, I think that this is unworkable.
The market will figure out a way to make the insurer of last resort take much
more risk than it thinks it is taking. That is what the market did to AIG, as
Merhling points out. I see no reason to expect that the government insurer will
always be able to outsmart the market.
Whether that's true or not, to me it says nothing about whether we should add regulation to
close the holes we already know exist – we should – though I suppose
one could counter with an unintended consequences argument. And we
should also close any holes we are able to anticipate. We won't always
stay one step ahead, that's true, but at least we won't fall further
Update: James Kwak adds:
Merhling’s takeaway point is that there needs to be a “credit insurer
of last resort,” who will insure any asset against a fall in value –
for a sufficiently high premium. This would make it possible for
financial institutions to unload the risk of their asset portfolios in
a crisis, if they are willing to pay enough to do so. The only
institution that would have the credibility to play this role in a real
crisis would be the federal government; as we saw, AIG – the world’s
largest insurance company, remember – was not up to the task. Still,
though, I’m not sure this would do the trick. If I’m a large bank with
a balance sheet full of toxic assets, and I don’t want to pay the
premium that the insurer of last resort is charging, then I go to the
government, say the price is too high, and ask for a bailout. The
credit insurer of last resort would need to be coupled with a
commitment not to provide an alternative form of government support, or
we would end up where we are today.
Update: More from Mike Rorty, Ezra Klein, and Free Exchange.