Modern shadow banking system

Paul McCulley is a managing director at PIMCO. He is particularly influenced by Hyman Minsky, and coined phrases like the shadow banking system and the Minsky moment. Here is an extract from his May 2009 speech. I particularly liked reading this speech because it clearly explains how the financial crisis came about within the modern financial banking system:

"The conventional banking system is based on what is known as the fractional-reserve banking system. Customers deposit funds at a bank to store savings in the form of a demand claims on the bank. Holders of the demand deposits can withdraw all of their funds at any time. Banks use most of these short-term funds to invest in longer-term interest bearing loans and securities. This is called borrowing short to invest long. The assets being longer term (and riskier) have higher yields than the short-term liabilities. This is how the banks make their profits.

However, this also causes a cash-flow insolvency. If all the depositors showed up at the same time, it can cause a bank run and cause the bank to collapse. In the absence of crisis that cause a bank run, fractional-reserve banking functions well because only a few depositors will make cash withdrawals compared to the total amount of deposit (liabilities are sticky), and a cash reserve is maintained to meet the demands of depositors seeking withdrawals.

A key reason that the depositors can sleep well at nights not worrying about bank runs is the fact that since 1913 here in the United States, banks have access to the Federal Reserve as a lender of last resort. This is known as having access to the Federal Reserve's discount window, where banks can post assets for loans to redeem flighty depositors. A second government sleep-well safety net was introduced, post the great depression, in 1933. Taxpayer-backed deposit- insurance (FDIC), in which the federal government insures that deposits up to a limit will not lose value, no matter how foolish the bankers may have been. Obviously, deposit banks don't just get this for nothing - they have to submit to strict regulatory standards in exchange for such a government safety-net.

The financial crisis did not originate within the confines of the highly regulated fractional-reserve banking system. Instead, it originated within the shadow banking system which operated legally, yet almost completely outside the realms of the regulatory system. The rise of this system drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crisis we have ever seen.

Unlike the conventional regulated banks described above, unregulated shadow banks fund themselves with uninsured short-term funding. They do so by raising funding in the non-deposit markets, unsecured debt through commercial paper, and secured borrowing such as reverse repo and asset-backed commercial paper. Since they fly below the radar of traditional bank regulation, these leveraged financial institutions operate in the shadows without backstopping from the Fed's discount window or access to FDIC deposit insurance. Examples of such shadow banks are investment banks (Bear Stearns and Lehman Brothers), conduits, SIVs (at Citi), money market funds, monoline insurers (Ambac and MBIA) and hedge funds (Bear Stearns High-Grade Structured Credit Fund).

Structured to not have access to the government safety-nets, the shadow banks essentially avoided regulation, notably on the amount of leverage, the size of their liquidity buffers and the type of lending and investing they could do.

In the absence of the government backstopping, the shadow banks needed some seal of approval, so that the providers of short-dated funding could convince themselves that their claims were just as good as the deposits at the regulated banks. Conveniently the friendly faces at the ratings agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval. Moody's and S&P would put an A-1/P-1 rating on the commercial paper, which in turn would be bought by the money market funds. Of course, its inherently an unstable structure. The ratings agencies face an in-built problem of putting ratings on new innovations, because they haven't had a chance to observe a historical track record - to see their performance over a full cycle.

Over the last three decades or so, the growth of the "banking" outside formal, regulated banking has exploded, and it was a great gig so long as the public bought the notion that such funding instruments were 'just as good' as bank deposits. Keynes provides the essential - and existential - explanation as to why the shadow banking system became so large. It was a belief in a convention, backed by the length of time that belief held: shadow bank liabilities were 'just as good' as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by the government-blessed rating agencies. Until, of course, the convention was turned on its head, starting with a run on the asset-based commercial paper market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization Fannie Mae and Freddie Mac in July 2008, and the actual death of Lehman Brothers in September 2008 (all being examples of banks runs on the shadow banking system.) Maybe, just maybe, there is something special about a real bank, as opposed to a shadow bank! And indeed that is ambiguously the case, as evidenced by the ongoing partial re-intermediation of the shadow banking system back into the government supported conventional banking system, as well as the mad scramble by the remaining shadow banks to convert themselves into conventional banks, so as to eat at the same government-subsidized capital and liquidity cafeteria as their former stody breathen."