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The Shadow Banking System

There was almost a parallel universe operating behind the scenes of the Wall Street banking system.  The main purpose of this shadow banking system was to hide from the public (and to a lesser extent regulators) the amount of risk that banks were assuming with their investments.  The problem was that this shadow banking system was not entirely a mirror universe.  It was not exactly like the one that operated in our realm.  This shadow banking system had no supports or “back stops” such as the Federal Reserve Bank (the Fed) to act as lender of last resort.  This problem affected us because this parallel universe was connected to our realm because of the common actors - the banks who operated in both universes.

Simply and Boring Banking

Banks borrow short-term and lend money long-term.  They make money on the difference between short-term interest paid and long-term interest earned.  In the old days, bank borrowing would consist mainly of bank deposits - saving accounts, checking, Certificates of Deposit.  They would take the money in the deposits and make loans with them.  The challenge was that banks could not predict when depositors would need their money so the Fed served as a “back stop” to provide short-term loans to banks to get through the short period where money outflows (from depositors) was greater than money inflows (from borrowers).  In exchange for this “back stop” the banks are monitored or regulated.  This system worked fine and banks made decent money but then something happened.

That something was de-regulation that allowed simple commercial banks to morph into huge financial conglomerates.  Huge financial conglomerates, in order to sustain their existence, needed high investment returns and huge amounts of capital investment.  This simple and boring banking structure was no longer enough for these financial conglomerates.

High Returns Mean High Risk

Size mattered for these financial conglomerates.  They needed huge amounts of capital and high returns to maintain their size.  Higher returns means higher risk.  But prudent regulations limited the amount of risk that financial conglomerates can assume.  So, the financial conglomerates had a problem: in order to sustain their size and get even bigger they needed to take more risks but couldn’t because of regulations limiting the amount of risk.  The financial conglomerates needed a solution.

Shadow Banking System

The solution was the this Shadow Banking System.  This Shadow Banking System had no regulations and it operated off the publicly disclosed balance sheets of the financial conglomerates and this is key to the whole system.  These “off balance sheet” investments were not transparent to investors and regulators.  This left the financial conglomerates free to take on as much risk as they thought the could handle which they obviously horribly misjudged.

This Shadow Banking System was not illegal.  In fact, it may have been encouraged by regulators.  Regulators knew about the existence of this Shadow Banking System - it was no secret.  What was secret was how deeply involved or invested were the financial conglomerates in the system.

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.

How It Operated

This system was complex and some argue it was so complex that the financial conglomerates didn’t even understand it.  Banks operated like they did in the regulated parts of the banking system.  The borrowed short and lend long.  In this case we are talking huge sums of money.  At some point the Shadow Banking System may have been bigger than the regulated traditional banking system. Banks would either issue (borrow) short-term debt known as commercial paper and turn around and lend money long-term through the purchase of mortgage-back securities.  Another method was to operate in the Repo Market where they accept huge deposits or loans from institutional investors sometimes just overnight.  These huge deposits/loans would be backed or collateralized by “AAA” Collateralized Debt Obligations (CDOs) tranche - which were perceived as a relatively safe investment.  This collateral acted like FDIC deposit insurance in our realm (regulated traditional banking side).  Banks would use this overnight loan to purchase more mortgage-backed securities and other investments in order to capture the spread (profit) between short-term rates and long-term rates.  There was one huge thing missing from this Shadow Banking System: lender of last resort.  There was no entity to turn to for liquidity in case of an emergency.

Banks were able to continually “re-finance” these short-term loans and continue to purchase mortgage-backed securities.  The system was working like a charm.  Until something happened that fooled the smartest people on Wall Street and the risk measuring computer models that they programmed. 

Everyone assumed that real estate prices would go up and all this crazy structured mortgages such “no downpayment” mortgages, interest only mortgages, “no documentation” mortgage loans would be fine because real estate prices always increase.  The Wall Street risk models never were programmed to assume real estate prices could go down.  They were terribly wrong. 

When real estate prices started to go down people/borrowers with these crazy mortgages were having a difficult time refinancing these loans.  People began defaulting on these mortgages.  This created a shock in the Shadow Banking System.  The prospects or expectations of more mortgage defaults caused the value of mortgage-backed securities to plummet.  This made it extremely difficult for financial conglomerates operating in the Shadow Banking System to “re-finance” their short-term debt at very low rates.  The “profit margin” or spread the banks tried to capture quickly disappeared.  A few financial conglomerates such as Lehman Brothers and Bear Stearns were heavily involved in this Shadow Banking System and were carrying a lot of short-term debt that they could not repay.  Bear Stearns was rescued by JP Morgan Chase and Lehman Brothers filed for bankruptcy.

This shock to the Shadow Banking System created huge problems that reverberated through the entire financial system.  Money Market (market for short-term debt securities) which is an important source of short-term liquidity for banks and businesses froze.  Confidence between participants in the system and the financial system itself crashed.

Questions

This Shadow Banking System serves to preserve the “too big to fail” financial conglomerates.  Proponents of the Shadow Banking System argue it is needed to provide more liquidity to the credit markets such as the mortgage market.  But do we need that much liquidity or credit provided by financial conglomerates through the Shadow Banking System?  Do we, as taxpayers, who bear the financial burden of supporting these “too big to fail” financial conglomerates, derive some public benefit from the financial conglomerates participation in the Shadow Banking System?  Answers: No and No.