Shadow Banking

KH sent a link to an article he read about shadow banking. Blame him for this big thing you’ve got to read ;-)>

I wouldn’t generally cover this topic in ECON 3020. In principles, I go broad and shallow, and I do touch on shadow banking for about 10 minutes. In ECON 3020, I go into much more in depth about the really big ideas: how individual well-being relates to measured aggregate performance, what the time series tells us about what’s knowable about aggregate performance, and how growth theory can explain that.

But … shadow banking is a buzz phrase that’s in the news. As a macroeconomist I’m not sure that makes me happy: why don’t people get the message that it’s all about growth, you know?

Anyway, politicians feel that they are masters of the universe, and the legacy media are sycophants who confirm this. And shadow banking is something they’re concerned about, so I should at least give you a primer.

The parallel you need to draw is between banking and shadow banking. A shadow bank is like a bank, but it isn’t one. So what is it?

First, think about what it means to be a bank. Your liabilities are primarily your depositors deposits. Your assets are primarily (loans that are) invested in less liquid assets. You act as an intermediary between lenders and borrowers (or equivalently between more liquidity and less liquidity), and take a cut for your services. You generally have more depositors than borrowers, and the depositors are smaller. Your liabilities are more liquid than your assets, so you always run the risk that the depositors will want their money back on short notice.

Compare this to other institutions: if they have many liquid investors and many illiquid investments, they’re going to behave a lot like a bank. In particular, they might have runs like banks do.

The [shadow banking] sector, which includes mutual funds, exchange-traded funds, hedge funds and other institutional investors, has ballooned …

A lot of people (again, this is often politicians, bureaucrats, and the media) blame the financial sector, including the banking and shadow banking sectors, for the global financial crisis of 2007-9.

In any financial crisis, it’s hard to differentiate between liquidity and solvency problems. Liquidity problems go away if treated. Solvency problems usually can’t be treated effectively. The message of the last 10 years should be that the financial system had liquidity problems (because it’s more or less recovered and paid off its infusions of liquidity), while other sectors like construction, real estate, and the public sector had solvency crises (which are mostly still unresolved).

The distinctions of the last two paragraphs are important. It’s not clear if politicians and bureaucrats are going after the financial sector as a diversion, or because they need to show they can do something and haven’t figured out how to effectively address the more serious problems in the insolvent sectors.

The particular article forwarded by KH, entitled “IMF Warns (Again) of Growing Shadow-Banking Risks” from the April 8 issue of The Wall Street Journal discusses how the IMF wants to get involved in regulating shadow banking.

This should frighten you. On the other hand, keep in mind that the IMF has got its own set of primary problems, and if they feel that shadow banking is a secondary problem that makes their primary problem worse, then their position is somewhat reasonable. It’s a matter of degree though.

The IMF is a little bit scary, as far as bureaucracies go. It was created (as part of the Bretton Woods system) as an independent international organization to help countries maintain fixed exchange rates with each other by offering financial aid when some countries got into short term exchange rate trouble. It was sort of like a credit union for countries: everyone contributed money all the time, and out of those pooled funds big loans were made occasionally to those countries that were in need.

And when the Bretton Woods system started to break down in the 1970’s, the IMF lost its reason for existence, and withered away. NOT!

So the IMF is definitely a bureaucracy that has evolved to find new roles for itself. That’s just great: bureaucrats who don’t really report to anyone, in search of problems to address. Having said that, the IMF is staffed by bright people, tends to be a fairly low corruption organization, and has tried to be helpful. This is why they’re involved with the Greek financial crisis: they have expertise, some money of their own, and they aren’t seen as a bigger country bullying a smaller one.

But now they’re worried about shadow banking. Why is that so?

Well, why is anyone interested in putting their money into a shadow bank in the first place? Probably because they offer a better risk for return tradeoff, or a risk for return tradeoff that they can’t get from banks.

Gee … d’ya think that’s because they aren’t regulated like banks? Or maybe that bank customers are the “dumb” money, and shadow bank customers are the “smart” money?

Now I start to get worried a little bit. I worry because the regulators regulate banks, and if they call something that isn’t a bank a bank, it’s because they want to regulate it too. And then they put the modifier “shadow” on the front of it. That’s not exactly a positive adjective in most cases. If they called them super-terrific-happy-banks, and then wanted to regulate them, I wouldn’t be so suspicious.

I also wonder if this is productive in the long-run. If my supposition is correct — that people are doing shadow banking instead of banking because their investments do better — then regulation that pushes shadow banks to behave more like banks will just lead to the creation of a shadow-shadow banking system that perpetuates the problem. This is what I’ve referred to elsewhere in this blog (and in class) as the water balloon problem: you squeeze one end and it bulges at the other.

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OK. But maybe the IMF has other problems. In particular, the mobility of capital is creating problems for the maintenance of exchange rates at reasonable levels. This is a problem both for depreciating currencies, like the Euro, and for appreciating currencies — like the (American) dollar, and the Swiss Franc. The reason for this instability is primarily the inability of some countries to practice reasonable fiscal policy, but secondary to that is the ease with which smart money can move out of the bad places and towards the better places. To play the devil’s advocate, the IMF has to make a cost-benefit analysis of dealing with future financial crises vs. discouraging shadow banking, and reasonable people may view the latter as the better option.