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So far the reformers of finance have neglected the shadow system

The parallel “shadow” banking system needs fixing: that should mean painful choices for money-market funds

Mar 25th 2010 | From The Economist

IF THEY were to film “It’s a Wonderful Life” today, the hero would probably not be a banker—and not just because of the optimistic title. The shape of finance has changed radically in the past few decades. For every traditional bank clerk there are several sorts of financial intermediators. The character of George Bailey would today be as likely to manage a money-market fund as take in humble bank deposits. Or he might work at Fannie Mae and Freddie Mac, America’s housing-finance giants, buying home loans from banks and packaging them into mortgage-backed securities.

This “shadow” banking system is huge, particularly in America—too big for the banks to be able to replace it. In the summer of 2007 assets funded through the capital markets were larger than those held by America’s banks. Only one-third of the country’s home mortgages were on banks’ balance-sheets. The bank bail-outs hog attention, but many of the government’s crisis measures were designed to prop up the shadow system. Even so, many bits of it, especially private mortgage-backed securities, remain moribund (see article).

That is a bad thing. The intellectual case for securitisation, the process of pooling lots of different loans and selling the cashflows to investors, remains strong. Done properly, it should enable banks and investors to diversify their exposures. In Europe, where bank lending is more important, it offers a useful, alternative source of financing. But the shadow system has to become far more stable. Great chunks of the crisis happened outside the banks. The rot started in the market for securitised subprime mortgages. Bear Stearns and Lehman Brothers were non-banks that were crippled by a silent run among panicky overnight “repo” lenders, many of them money-market funds uncertain about the quality of securitised collateral they were holding. Mass redemptions from these funds after Lehman’s failure froze short-term funding for big firms.

Towards a penumbral banking system

So far the reformers of finance have neglected the shadow system. Some changes are on the way—new liquidity rules for money-market funds, for instance. But uncertainty about the long-term prospects of Fannie and Freddie has been a brake on the revival of securitisation. Congress started hearings on their future this week, but the White House has yet to put forward detailed thoughts of its own. Fiddlier issues require more clarity, too. Investors want assurance that securitised assets will be ring-fenced from claims if a lender fails, for instance.

So more attention is needed. But what should be done? Two things stand out. The first is the need to project some light into the shadows. The pre-crisis securitisation markets were deeply murky. Efforts to get banks to retain more of the risk associated with securitised loans are well-intentioned, but the danger is that investors will regard this as a comfort blanket (as they previously saw gold-plated credit ratings) and skimp on due diligence. Investors need to have up-to-date information on the quality of the loans inside securities: central banks can help by mandating disclosure requirements for collateral that they accept at the discount window. And regulators need better data on obscure areas like triparty repo and stock lending.

The other imperative is to make sure that the bits of the shadow system that act just like banks are regulated accordingly. That shift in thinking has already happened for investment banks, but needs to go further. Money-market funds are an obvious example. Investors in these funds expect to get their money back on demand, just like depositors in a bank. The post-Lehman run started after one fund “broke the buck”; it stopped when the government said it would guarantee investors against losses. So these funds should be forced to make a choice: keep the commitment to pay up and set aside capital and insurance funds (like banks have to do); or drop the commitment and put the burden of losses on investors.!~~~

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See also at Riski:

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From Simon Johnson

“>~~~ ” …Why exactly do you think big banks, such as JP Morgan Chase and Goldman Sachs, have been so outspoken in support of a resolution authority? They know it would allow them to continue not just at their current size – but actually to get bigger. Nothing could be better for them than this kind of regulatory smokescreen. This is exactly the kind of game that they have played well over the past 20 years – in fact, it’s from the same playbook that brought them great power and us great danger in the run-up to 2008.

When a major bank fails, in the years after the Dodd bill passes, we will face the exact same potential chaos as after the collapse of Lehman. And we know what our policy elite will do in such a situation – because Messrs. Paulson, Geithner, Bernanke, and Summers swear up and down there was no alternative, and people like them will always be in power. If you must choose between collapse and rescue, US policymakers will choose rescue every time – and probably they feel compelled again to concede most generous terms “to limit the ultimate cost to the taxpayer” (or words to that effect).

The banks know all this and will act accordingly. You do the math.

Once you understand that the resolution authority is an illusion, you begin to understand that the Dodd legislation would achieve nothing on the systemic risk and too big to fail front.”~~~

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