Why Do We Need Shadow Banking?

by: Kevin Wilson


Economist and former PIMCO fund manager Paul McCulley famously coined the phrase "shadow banking" in 2007 in order to describe the activities of non-bank financial intermediaries.

Although we avoided a bank run in 2008, we in effect had a run on the shadow banks; not much has been done to restrict shadow banking activities since 2008.

Over 85% of total corporate borrowing is now attributable non-bank (shadow) lenders; meanwhile, the TBTF mega-banks run huge derivatives books and yet are being turned into regulated utilities.

The economy needs the shadow banking system for innovation and risk-taking, but it needs a regulatory regime to give us early warning of the next meltdown; avoiding crises is unlikely.

I would not hold big banks like JPM, BAC, WFC, C, GS, DB, CS, etc. I would hold USMV, SPLV, OTCRX, QLENX, AQMNX, BXMX, TLT, BIV, BOND, and TOTL.

Paul McCulley

Source: Bloomberg.com

Economist and former PIMCO fund manager Paul McCulley famously coined the phrase "shadow banking" in 2007 in order to describe the activities of non-bank financial intermediaries. These included risky off-balance sheet Structured Investment Vehicles ("SIVs"), Asset-Backed Commercial Paper ("ABCP") conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies. Arguably, hedge funds, private equity funds, credit insurance providers, and other securitization markets involving Residential Mortgage-Backed Securities ("RMBS") and Collateralized Debt Obligations ("CDOs") are also part of the shadow banking system (Chart 1). Much has been written in the years since 2008 about the damage done in the Great Financial Crisis by shadow banks and the non-bank activities of commercial banks (e.g., M. Farhi & M.A.M. Cintra, 2009; The Financial Crisis and the Global Shadow Banking System; Barry Ritholtz, 2009, Bailout Nation, John Wiley & Sons, New York, 332p). Many have pointed out that although we avoided an old-style bank run in 2008, we in effect had a run on the shadow banks, and that is a big part of what caused the crisis. Not much has been done to restrict shadow banking activities since 2008, and the risk of another major financial crisis emanating from the shadow banks is growing. Why do we tolerate this? Why don't we just eliminate them and avoid a potential repeat of 2008?

Chart 1: Diagram of the Traditional and Shadow Banking Systems

Source: rooseveltinstitute.org

The financial collapse in 2007-2009 greatly diminished some types of shadow banking activities, at least temporarily (Chart 2). However, government-backed securitizations of shadow banking vehicles by GSEs have continued at nearly their pre-crisis levels, and are still at around $8.0 trillion in value, according to the Money and Banking blog (Chart 3). Amazingly, the value of government-backed securitizations now exceeds the amount of insured bank deposits covered by the FDIC (Chart 4), with the latter estimated at only about $6.1 trillion in 2014. Overall shadow banking also declined sharply after 2007, falling below its long-term growth trend (Chart 5). Total shadow banking assets (net) were around $20 trillion in 2008, exceeding those of the traditional banking sector, but fell by around $8 trillion or 40% in the aftermath of the crisis.

Chart 2: Collapse of Certain Shadow Banking Activities in 2007-2009

Source: commons.wikimedia.org

Chart 3: Government-Backed Securitizations

Source: moneyandbanking.com

Chart 4: Share of Bank Deposits Insured by FDIC, 2014

Source: moneyandbanking.com

Chart 5: Shadow Banking's Rise to 2007 and Decline Thereafter

Source: Federal Reserve; unaigaztelumendi.com

The antecedents of the shadow banking crisis go way back. For instance, analyst John Tamny has written about the fact that as far back as 1913, 70% of corporate borrowing took place outside the traditional banking system, and in 2008 over 80% of that borrowing was outside the traditional banking system (John Tamny, 2016; Who Needs the Fed?, Encounter Books, New York, 202p). Now (2014), the level of non-bank lending to corporate America has grown to about 85% of the total. Shadow banking began its great expansion in the early 1980s, and at its peak in 2008 represented about 50% of total credit market assets and 150% of the market share held by conventional banks (Chart 6). Tamny maintains that because the traditional banking system has generally abhorred innovation and also (of course) risk, it has long been essential to the economy that non-bank sources of credit be developed. Non-bank lenders like USAA, Lending Club (NYSE:LC), Sam's Club, and Quicken have been providing much-needed services to millions of people. One of the more interesting points made by Tamny is that despite the financial meltdown in 2008, what we need is more shadow banking. It is the existence of conventional banks that Tamny thinks ought to be questioned! Now that is an intriguing idea, and it turns my question as posed in the title of the present article completely on its head.

Chart 6: The Rise of Shadow Banking After 1945

Source: scalar.usc.edu

Tamny notes that asset concentration in the five biggest banks (all deemed "too-big-to-fail" by the Dodd/Frank reform act) has continued to grow post-crisis (Chart 7), and is now bigger than ever. We know that these banks (JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp. (NYSE:BAC), Wells Fargo & Co. (NYSE:WFC), Citigroup Inc. (NYSE:C), and Goldman Sachs Group (NYSE:GS)) are a direct risk to the financial system because of their huge size and enormous complexity, and because some of them suffered terrifying collapses in 2008. Their risks are considered to be much lower now than they were then due to new regulations, and restrictions on activities and leverage. However, they are still huge players in the global derivatives markets, which are estimated to involve a gross exposure of about $1,200 trillion, according to J.B. Maverick at Investopedia.com; this market is still opaque and the risks on net exposures, which are a small fraction of the gross level, are still poorly understood, but potentially quite large.

Chart 7: Continued Asset Concentration in the Five Biggest US Banks

Source: St. Louis Fed; en.wikipedia.org

The federal reforms put in place after 2008 have basically reduced the conventional banking sector to utility status, and global NIRP is driving a stake through the heart of many global banks. This has been driving more business towards the shadow banking sector over time, according to Jeff Cox at CNBC.com. Tamny has simply accepted that at face value and rightly questioned why we even need such toothless old dinosaurs. Since many large commercial banks and investment banks were bailed out in 2008, moral hazard has been made a permanent part of the banking landscape, so the notion that regulators can make a difference in a future crisis seems absurd. Regulators closed some conventional banks and let some shadow banks fail in 2008, but they also bailed out some of the worst offenders in both groups, in direct contradiction of Bagehot's Rule and other common sense maxims of the banking business that have stood the test of time.

John Tamny maintains that the markets would have taken these poorly run institutions out if left to their own devices, and I strongly agree with him on that. So what we appear to have on the one hand is over-regulated conventional banks that are TBTF and therefore a risk to all of us, with little hope (based on history) that regulators would be able to prevent another crisis; and on the other hand, we have shadow banks that are completely unregulated or nearly so, with no system for protecting us from their next big mistake. The FDIC is more or less permanently underfunded now, so another systemic crisis would quickly run through the assets it has on hand to cover the deposits of conventional banks, leaving the taxpayer on the hook yet again. Shadow banks are supposedly hedged, but we can't really look inside them and see if that's true. Declining liquidity buffers are increasing the vulnerability of the system, according to a report for the ECB by Nicola Doyle et al. (2016). It would be much more straightforward to simply set up mandated commercial insurance programs for hedging away the risk in both the shadow banking and conventional banking sectors, as John Tamny suggests. Then if the insurers detect increasing risk in a bank, they can increase the cost of insurance; the bank's directors and investors would get a direct indication of risk to guide them, and the public would at least be given a signal that something is wrong there, in contrast with the current system.

Federal Reserve Vice Chair Stanley Fischer (Chart 8) believes that we need to put in place some bank-like regulations for the shadow banking system. Perhaps he is right in terms of politics, but I see no reason a priori to think that this would necessarily work effectively to cut our risk exposure. Banks were allowed by the Feds to circumvent the system at will prior to 2008, and they will always have an incentive to do so again (Chart 9). Indeed, that is part of the point behind why conventional banks have set up off-balance sheet shadow banking operations in the first place. Of course, more things have to be shown on the balance sheet now, according to The Economist, but new work-arounds will be found, as they always are. Even the huge fines (estimated at $224 billion for just the largest banks) that the banking sector has paid over the last few years (Chart 10) haven't had much impact, except perhaps short term in the markets, because they are dwarfed by cumulative quarterly profits (Chart 11).

Chart 8: Stanley Fischer to the Rescue

Source: slideshare.net

Chart 9: Regulators Are Crushing Banks, Expanding Shadow Banks

Source: businessinsider.com; financialservicescommission.wordpress.com

Chart 10: Total Fines Paid by Largest Banks Since 2008

Source: Mary Beth Sullivan; linkedin.com

Chart 11: Quarterly Profits for US Banks

Source: wsj.com

A counter-argument to leaving shadow banks to the mercy of the markets is provided by Eugene Ludwig at the American Banker blog (2016). He suggests that since a collapse in the shadow banking sector cannot be contained to that sector, something must indeed be done. The Dodd-Frank Act of 2010 has mistakenly designated big banks as systemic risks, focusing more on an institution's size than on function. This has left the Financial Stability Oversight Council with "no latitude to determine what constitutes systemic risk," so their purpose has been thwarted from the start. Ludwig thinks that the right way to look at the risk from shadow banks is to apply a simple organizing principle: "like kind, like size, like regulation." This would end the strange practice of regulating one segment of a credit market while ignoring systemic risk that develops within their competitors in another segment.

Perry Mehrling of the Institute for New Economic Thinking (2016) has suggested that money dealing and risk dealing ought to be separated legally and institutionally, with separate regulations. Players would then be able to buy and sell term funding in the money markets, or buy and sell risk exposure, but not both. The market-making system for both of these sectors froze up in 2008, and the Fed resolved the problem by itself becoming the dealer (not just lender) of last resort. The development of central bank programs like QE, ZIRP, and NIRP has effectively made the central bankers the dealers of first resort. This clearly needs to change, as markets have become increasingly distorted as a result. As long as the global funding market remains the Eurodollar market, and the US dollar remains the pricing benchmark, the federal funds rate will remain ineffectual; however, Mehrling thinks that the Fed's new Overnight Bank Funding Rate ("OBFR") will resolve this problem over time.

The Foundation for Economic Education has written at the Value Walk blog (2016) that there is a knowledge problem in economics. That is, "no person or group of people can possibly have sufficient knowledge to make a pencil, much less plan the actions of millions of people." Indeed, Nobel Laureate F.A. Hayek has written extensively about the fact that it is impossible for a central authority to collect and use situational knowledge to engineer a better society. This is why we can never realistically expect central bankers or regulators to catch us in time to prevent a crisis. Yet ethically we must do something about the natural tendency of bankers of all types to blow up the system every once in a while.

In conclusion, I believe we should adopt some of the ideas of Tamny and Mehrling where possible, but we should also keep in mind the ideas of F.A. Hayek. The Financial Stability Board put out a thorough report on what might be done to regulate shadow banking (2011). They were concerned about regulatory arbitrage, and the lack of transparency in shadow banking. This is all good, but I would suggest that although we must probably go ahead and regulate shadow banks rather than adopting the pure capitalist ideal of John Tamny, it would be foolish to think that it will work in the end. We must therefore try to develop better monitoring systems so that at least we get enough warning to have a chance to do something. In answer to my question stated in this posting's title, I would just say that since shadow banking is now 85% of the total system, a better question might be: why do we think we need conventional banking, especially its TBTF mega-banks? Thus have my ideas evolved as I have gathered the research for this article. It is to be hoped that a debate on these issues will shed some light on what we should do going forward.

I would not hold the biggest banks in the world right now (e.g., JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co., Citigroup Inc., Goldman Sachs Group, Deutsche Bank AG (NYSE:DB), Credit Suisse Group (NYSE:CS), etc.); although as trades they might be fine in the short run, they are headed towards full utility status or in some cases ruin in the long run. And it is likely that interest rates are not going to go up enough to help them with their margins. Otherwise I would remain defensive, so it makes sense to hold some intermediate to long Treasuries: the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), the Vanguard Intermediate Term Bond ETF (NYSEARCA:BIV), the PIMCO Total Return ETF (NYSEARCA:BOND), and the SPDR DoubleLine Total Return Tactical ETF (NYSEARCA:TOTL); also defensive sector funds like the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA:SPLV), and the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV); also some liquid alternatives like the Otter Creek Long/Short Opportunity Fund (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), the AQR Managed Futures Strategy Fund (MUTF:AQMNX), and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Income Fund (NYSE:BXMX).

Disclosure: I am/we are long OTCRX, QLENX, AQMNX, BIV, BOND, TOTL, BXMX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.

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