Unfair Advantages of the Shadow Banking System

We’ve written for some time about the unfair advantages the shadow banking system (notably money market funds and investment banks) enjoys as it competes with the real banking system. The shadow system operates with essentially no regulation, pays no deposit-insurance fees, and isn’t saddled with mandated social missions imposed by legislation such as the Community Reinvestment Act.

The result? Shadow banks weaken the actual banking system by using their advantages to skim off the financial services industry’s most profitable business. Money market funds in particular can offer premium returns to bank deposits and promise bank-like safety--without the cost or safety of the FDIC insurance system

This is no idle objection I’m making. As the past two years have shown to anyone who might still harbor doubts, the health of U.S. banks is critical of the health of the economy as a whole. Competition from the shadow banking system only added to the banking system’s problems during the credit crunch, and has hampered the industry’s slow recovery as the crunch finally eases. It is as unfair to the banks as it is unsafe for the financial system.

It turns out that I’m not the only one with this complaint. Now comes former Fed chairman Paul Volcker to offer the same view:

Paul Volcker, the former Federal Reserve chairman who is an adviser to President Barack Obama, said money-market mutual funds undermine the strength of the U.S. financial system and should be regulated more like banks.

“Banks remain the functioning heart of the financial system, and they are protected and regulated,” Volcker said in a telephone interview last week from his New York office. “To the extent they have competitors that have different ground rules, kind of free-riders in my view, weakens the financial system.”

Amen to that! Volcker sensibly argues that MMFs should be forced to operate under bank-like regulation. “In my vision of the new financial system, you obviously want to protect banks and have strong banks, and I don’t think they should be put at a competitive disadvantage vis-a-vis money-market funds,” he tells Bloomberg.

Defenders of MMFs also argue that the funds provide crucial support for the commercial paper market. So what? All the CP market is is another part of the shadow banking system; it allows big corporations to borrow outside the regulated banking system--at the expense of the economy in general, and especially small business in particular.

The shadow banking system simply skims deposits and loans from the real banking system, to the detriment of the financial system and the economy overall.

If it looks like a duck, walks like a duck, and quacks like a duck, isn’t it a duck?

Of course it is. Money market funds accept deposits, make loans, and provide liquidity.

Is that not the definition of a bank?

If the administration wants to reform the financial system, it should start by reforming shadow banking system.

Comments

[User241885/...:]

The laws are clear that if you are a depositor at a commercial bank and trust company, your money market fund, like any other deposit, is insured up to certain limits. If you bought a money market fund from a brokerage, mutual fund, investment bank or any other SEC 34 Act Company, the laws are also clear that you are an investor who has no insurance against the risk of the MMF share breaking a buck.

If the idea is to legislate consumer protection that insures every money market fund (MMF) will never break the buck, then it probably makes sense to put all money market funds under the regulatory umbrella of the commercial bank and trust industry. It is only fair that if your deposits are going to be insured that you, the MMF issuing bank, pay the premium, just as all the other MMF issuing commercial banks do.

It goes without saying, however, the consumer is also paying for that insurance. What if he or she prefers to self-insure? Shouldn't the consumer be given the choice as to whether they want a fixed or floating share value? There is no shortage of regulation that distinsguishes whether you want to be a "depositor" at a commerical bank and trust company or an "investor" at a brokerage/ investment bank. SA recently reported that DB has a floating price share MMF in registration. That makes sense and certainly complies with the appropriate regulatory framework.

Let's talk about that for a moment. The entire purpose of Glass Steagal was to separate commercial banking (and its insured deposits) from investment banking (and its unisured or self-insured risk).

Some aspects of Glass Steagal have been repealed, most noteably in regards to security underwriting and distribution, which should be noted favored commercial banks, not investment banks. But the chief aspect of Glass Steagal is the qualitative distinction based upon enjoying deposit insurance versus accepting investment risk, which is still very much with us. It is the fundamental distinction between the two financial intermediaries.

The consumer still gets to decide whether they want the protections of being a depositor at a commercial bank or whether he or she assumes the risk of being an investor at the the brokerage/mutual fund/ investment bank. The SEC Act of 1934 made the prospectus the tool of full and fair disclosure for determining whether the consumer wishes to be a depositor or an investor. That body of regulation is also still very much with us.

With all due respect to Chairman Voclker, the idea that all money market funds should be soley under the jurisdiction of the banks sounds like more heavy handed lobbying by big corporate and big government self interests (sorry I can't narrow it down to one only but I can't tell the two apart anymore). Furthermore, the idea that commercial paper should never have been made available by investment banks really oversteps the bounds of how our financial markets work.

The consumers of those products know well in advance whether they bought an insured product or not simply by virtue of who they bought it from. If the risks is realized at the commercial bank, the insured depositor enjoys the benefit of his bargain: protection. When the brokerage/mutual fund realizes the risk, since neither paid for the insurance, neither the investment bank does nor the customer gets any protection.

The only thing unfortunate about this system is not the lack of regulation but the lack of enforcement of the regulation. Both the republican and democrat administrations failed to observe and uphold those laws. It is not the shadow banking system that failed, but the polticians who interferred with it.


FAMCO

Sep 09 11:33 AM

[BRUCE E. W.:]

www.larouchepub.com/ot...

www.informationclearin...

www.informationclearin...

OFFSHORE: THE DARK SIDE OF THE GLOBAL ECONOMY 2005 by William Brittain-Catlin from Farrar, Straus and Giroux 19 Union Square West, NY 10003 fsgbooks.com

Everyone seems to have forgotten about the shadow economy and the "shadow banking" system is certainly only the initial face of this network. The truth is that there are shades of gray that go all the way to complete darkness. The "dark" side of finance is underwriting every conceivable corruption on the face of this earth.
This is not a real revelation or discovery but it is frequently minimized in pursuit of a less offensive field of "fast" money and venture capital in flightful escapades of chance and questionable accountability. The truth is that more and more big finance takes place offshore and in remote areas of the world to simply evade truthful responsibility and scrutiny. Keep this in mind: There is no coordinated evil deed or power on the planet that is not sustained by some kind of financing. Offshore "republics" have been spawned and globally sprawling as centers of pseudo-sovereign power that are not just detracting from the foundations of open book economy; but are in direct competition with it and may well be ultimately seeking to dominate it. Unfortunately economic competition from these sources make it nearly impossible for large corporate entities to operate without following the same course of hidden agendas. So when you begin to open the doors to the "shadow banking" transaction questions, one needs to realize that there are deeper incentives to keep this area disagreeably "UNTOUCHABLE" and left as a marginalized denial.

Sep 09 01:09 PM

[User241885/...:]

Having just read the post above, I want to withdraw my earlier post.

Vernon Hill made excellent observations in his blog. As a result, I expected that the responses would include intelligent rebuttals written by well-informed contributors.

Apparently I was mistaken.

Sep 09 02:27 PM

[flow5:]

You couldn't be more wrong (it was Keynes' fault).

The source of all time/savings deposits within the commercial banking system, are demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts.

Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.

The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And also, why should the banks pay for something they already have? I.e., interest on time deposits.

Sep 09 04:34 PM

[flow5:]

Paul Volcker is the worst FED Chairman ever (worse than Greenspan). In fact he is vacuous. Monetarism has never been tried.

"In a letter of March 15, 1981, Willis Alexander of the American Bankers Association claims that: 'Depository Institutions have lost an estimated $100b in potential consumer deposits alone to the unregulated money market mutual funds.' As any unbiased banker should know, all the money taken in by the money funds goes right back into the banks, in the form of CDs or bankers acceptances or other money market instruments; there is no net loss of deposits to the banking system. Complete deregulation of interest rates would simply allow a further escalation of rates by the banks, all of which compete against each other for the same total of deposits."

Biographical note: Written by Louis Stone whom the movie "Wall Street" was dedicated to - former Vice President Shearson/American Express

Sep 10 01:00 PM