The Shadow Banking System Will Not Die

Many of the problems that have afflicted the financial system over the past two years can be traced directly to abuses in the wild-west world of the (largely unregulated) shadow banking system. Subprime mortgage CDO securitizations, credit defaults swaps, you name it. They all fall outside the purview of state and federal banking regulators. Which is a key reason why those products were able to mutate so quickly into financial versions of IEDs that nearly blew up the entire economy.

People often forget that the mother’s milk that finances a big chunk of the shadow banking system is that vast, unregulated pot of money known as money market funds.

In a very real way, money market funds are the foundation of Wall Street’s worst excesses. They compete directly for bank deposits, yet MMF issuers don’t have to pay for deposit insurance or labor under regulatory severe restrictions. Nor do they have to carry out any crazy social missions, such as Community Reinvestment Act, mandated by Congress.

So MMF issuers are free-riding cowboys. Still, when the current crisis began, the first thing the government did was unconditionally guarantee these funds in order to protect the Morgan Stanleys and Merrill Lynches of the world—the very same unfair competitors that were the source of so much systemic upheaval in the first place!

Now the S.E.C. proposes, in the name of “safety,” several reporting and operating rules for MMFs, all of which figure to be toothless and have little effect on how issuers do business. It’s just another example of Wall Street protecting itself.

There is only one solution: if the money market funds want to offer themselves as an alternative to bank deposits, they need to operate under the same rules that banks do. That means:

• Paying for deposit insurance.
• Accepting the social burdens borne by banks.
• Providing financial transparency similar to banks’.

Financial regulation that doesn’t include oversight of the shadow banking system cannot be effective. Money market funds look like bank deposits, walk like bank deposits--and must be regulated like bank deposits. You bankers that continually whine about unfair competition, this is your chance!

Comments

[Clive Corcoran:]

A very good piece that has very little to do with the title.

Jun 28 05:35 AM

[CLH:]

We need two markets. One regulated and guaranteed for the people who are easily frightened. And the so called "shadow banks" for rest of us. Of course the govt. was wrong to guarantee the shadow market but it would be even more wrong to regulate it. (but they probably will). Take away risk and you take away all innovation.

Jun 28 11:23 AM

[4Annie:]

I've had about enough "innovation" in the financial markets to last a lifetime. All the crazy products, leverage & shenagins has brought us close to collapse and cost Joe six-pack, Joe average investor, and Joe saver too much.

Jun 28 12:23 PM

[lazzybum:]

The shadow banks also print money, more so than Fed. Why do people worry about Fed and not the shadow banks. Let's regulate those shadow banks to the best of our knowledge.

Jun 28 02:18 PM

[Drew Horn:]

Let the shadow banks and the rest of those who offer high risk investments go ahead and do their best to make money. The fundamental change that is needed is to find a way to separate the unregulated investments from the regulated part of the investment community. A regulated "bank" should not be allowed to offer unregulated investments. Regulated brokers should not be allowed to offer unregulated MM funds. The purpose here is to simply prevent those who make investments in higher risk vehicles from too easily assuming they are putting their money in a regulated and a "safe" place to invest. Banks should only participate in regulated investments. Companies that are hybrids can easily prey on those who don't understand the differences.

Jun 28 05:33 PM

[everyotherc...:]

Outstanding article, Mr. Brown!

It makes no sense whatsoever banks and insurance companies should be able to conduct risk transactions opaquely in their holding companies or off-balance sheet.

And Brown is absolutely correct that money market funds are analogous to bank deposits and should be regulated accordingly. Also a no brainer.

To say these areas of regulation stifle innovation is incorrect. Plenty of responsible, functional products have been engineered by the financial services industry. The issue is to regulate them in a way which will fairly protect the saving and investing public.

Now to the elephant in the room---the question of regulation of the investment banking sector.....

Jun 28 07:07 PM

[ArtfulDodger:]

CLH:

This makes perfect sense, but I fear the Obamas are going to regulate everything that moves. If it doesn't move, they'll regulate it for not moving.

It's contrarian true, but a good comment to motivate thought and debate.


On Jun 28 11:23 AM CLH wrote:

> We need two markets. One regulated and guaranteed for the people
> who are easily frightened. And the so called "shadow banks" for rest
> of us. Of course the govt. was wrong to guarantee the shadow market
> but it would be even more wrong to regulate it. (but they probably
> will). Take away risk and you take away all innovation.

Jun 29 01:14 AM