The (Official) World Still Has A Ways To Go

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by: Jeffrey Snider

Before Mario Draghi took over the ECB, he was head of the Bank of Italy. In between, Draghi was also Chairman of something called the Financial Stability Forum (FSF). This latter organization was created in 1999 "to promote international financial stability through enhanced information exchange and international cooperation in financial supervision and surveillance." Draghi was appointed to lead the effort in April 2006.

Given that mission, the FSF was surely out front of the global financial crisis, warning about the extreme dangers posed by global monetary structures hidden way out of sight of regulators and central bankers? Of course not. In a statement put out on April 14, 2007, Chairman Draghi reassured us:

The FSF reviewed the turbulence in global equity, credit and foreign exchange markets in late February and early March. As is typical in such episodes, a broad range of markets moved sharply in concert, and there was some evidence of positive feedback effects amplifying price movements. Markets generally functioned well amidst large volume increases and remained liquid during the episode. Counterparties met margin calls without causing further market disruptions.

They were far more preoccupied with hedge funds at that moment. Hedge funds. The main report given at their regular meeting the month before had focused on the presumed dangers of those particular investment vehicles. Nothing was said about repo markets, MBS collateral, and not a peep about eurodollars and global monetary contagion (or, why it was important to really understand how a European money market fund would all of sudden stop calculating its NAV because of its holdings of US$ ABS commercial paper it bought perceiving prime MBS collateral as a perfectly nondescript way to beat Eonia and Euribor benchmarks).

The big report delivered the prior fall in September 2006 said nothing about the massive global credit bubble and how it was being funded, worried instead about several things including first, "Significant risks and related financial stability challenges over the medium to long run may originate from demographic trends and ageing populations." The Financial Stability Forum was caught just as off-guard by gross financial instability as all the rest.

So, despite its mission which was meant to help prevent something like 2008 happening, when 2008 happened anyway what did the FSF do? They became the FSB. It was renamed by the G20 London Summit held in April 2009, right about the worst of it, rebranded as now the Financial Stability Board. Mario Draghi, of course, later failed upward to lead the ECB into multiple QEs and the like.

Despite my obvious intent to negatively bias your opinion of the FSB, they have in the years since put out some decent material, often with some purpose toward honest inquiry. A rarity these days.

One of these has become what's now known as the Global Shadow Banking Monitoring Report (GSBMR). Taking great care to try and detail as much of the hidden global reach of credit institutions, the FSB's researchers have put together a substantial volume of material on the subject.

It is marginally useful.

The reason is largely the same bureaucratic blindness that obscured the real problems a decade ago from official reach. Officials are obsessed with mapping out the players inside the shadow system rather than more fruitfully focusing on what it is these players are doing, and with whom.

It is largely wasted effort, in my view. Open up the Federal Reserve's Financial Accounts of the United States (Z1), or what used to be called the Flow of Funds. In it, you will find all sorts of bank and non-bank entries with seemingly endless detail about how and what each segment does. There are depository institutions, credit unions, and central banks, but also exotic sounding things like Issuers of Asset-backed Securities, Funding Corporations, and Security Dealers.

Taking even complete notes of the size of each one and what each one has on its books gives us precious little insight into how the system actually operates. We can make some limited observations about the effects of what's going on inside, but we don't really know much about the inside. It's simply not enough to know how big one part is or how that has changed in comparison to how big it was last year, we need to know why it is that big and how it got that way.

The reason for this token view is quite simple; they want to focus on credit, not money. All the FSB has done is take the same US Z1 and add to it the Z1's (or equivalent data set) from eighteen other countries plus the euro area. It's a global focus on credit with very little focus on the money that makes it all go - balance sheet capacity.

I'll give you an example of what I mean. The GSBMR has come up with what the FSB calls a "narrow measure" of shadow banking worldwide. They start with $160.4 trillion in global assets that can be identified, subtract off $104 trillion that are determined to be "not shadow banking" by their definitions, remove another $10 trillion as consolidations and rounding, and what's left is global exposure of $45.2 trillion in this "narrow measure."

They can further tell you all sorts of things about this $45.2 trillion. The report even breaks it down by "economic function" in order to try and sort out the various risks associated with all this obscured financial activity.

The first is EF1, defined as collective investment vehicles. It is the majority share of the narrow measure, about 72%. We want to know something about them because they are associated "with features that make them susceptible to runs." Straightforward enough.

EF2 are maturity transformations of the non-bank type, those that lend but funded almost totally by wholesale rather than deposit means. EF3 are the same except securities businesses rather than lending.

Further down the list, EF4, are those entities that are almost indescribable. They do things that facilitate credit growth, but even the FSB isn't really sure how and has no idea how much. These are the AIG's of the world, the default swap writers of the housing mania. For the narrow measure, EF4's are tiny just $175 billion out of that $45 trillion. But not all is what it appears.

The size of this EF and its importance relative to the other EFs may be significantly understated due to the difficulty of adequately capturing off-balance sheet exposures. This is largely because the balance sheet assets of credit insurers, which are typically classified into this EF, are often modest due to the nature of their business, while they can still facilitate substantial volumes of credit extended by bank or non-bank financial entities.

This is the dark leverage that I often write about, the derivatives dealers whose activities just cannot be expressed let alone described by traditional accounting methods. Yet, they are absolutely crucial to modern credit creation and maintenance. It is money in every way. They write not just CDS (nobody does that anymore) but all kinds of liabilities that are designed for one thing - balance sheet control and capacity. This stuff mattered more as to the propagation of panic in 2007-09 than anything else, and it still matters today for the same damn reasons.

What does the narrow measure have to say about it?

More jurisdictions reported at least some risk data compared to the 2016 monitoring exercise. However, due to the small size of EF4 (jurisdictions do not need to report risk metrics if an entity type's aggregate size is below 1% of their jurisdiction's total financial assets), the relatively sparse risk data provided by jurisdictions and the unique nature of EF4, it is difficult to infer broad conclusions about the risks posed by EF4 to the financial system.

After all this time, that's all they can come up with regarding the most important piece of the shadow money picture. That's (largely) because they don't really care as much about shadow money as shadow credit, their original bureaucratic mandate that survives from 1999 when economists believed there was nothing interesting about the details of the monetary system. They didn't much care before 2008 about shadow credit, either, but at least they've come to realize that was a mistake. How much time until they figure out just that they need to figure out the former, too?

It's a major weakness that renders so much potentially useful inquiry as misdirected exertion. The GSBMR is the right idea carried out by the same wrong people.