A Roadmap of the Shadow Banks, plus targeting the Volcker Rule

I just found a short, must-read presentation on the shadow banks. But first:

I think the Volcker Rule is a good first step that I am excited about as it starts to get at the problem of shadow banks, but I am incredibly unhappy with the both the follow-through on it, and how it isn’t getting at the actual problems with overlapping business models creating ‘shadow banks’ subject to bank runs.

If you follow the finance blogs but aren’t necessarily in the deep end, you may not know what people are getting at when they say that the real problem is with how lending is done in the capital markets. Yves Smith gets it, and as bond girl pointed out “the old classifications used to mean something because banks were the locus of credit intermediation. Now that this function has largely shifted to the credit markets, through repos and securitization, for example, they are less relevant.”

Trying to get a working definition and a coherent explanation for journalists and laypeople of shadow banks and overlapping business models is something I’ve been trying to do for a while. It’s important because you need to see that relationship in order to get what works and what doesn’t with the Volcker Rule, and how it needs to be expanded. With the way Volcker and the administration are selling the reform, it looks like their mental model of the financial markets stopped in the 1970s – and it’s incredibly important, for a narrative of what broke and how to fix it, to see the way financial markets and lending have changed over the past 30 years.

Luckily, someone just sent me this guide, Through the Looking Glass (Steagall): Banks, Broker Dealers, and the Volcker Rule, by Raj Date and from the recently opened Cambridge Winter Center for Financial Institutions Policy. This guy gets it. And this guide has my new favorite illustration of the financial markets – a roadmap to the shadow banks:

(Why didn’t I think to draw it out in overlapping circles!?) In red, you can see that there is a mismatch between the assets and the funding in the intersection between commercial banking and investment banking. From the short presentation:

Like the Glass-Steagall regulatory framework, the Volcker Rule focuses on the intersections between commercial banking, investment banking, and proprietary activities. Notably, each of those business models — in their “pure” forms — has a funding model that suits its asset risk profile. Commercial banks make relatively illiquid loans, but they have privileged access to relatively resilient core deposit funding. Investment banks hold inventories of relatively liquid securities, which enables them to use extremely efficient, short-term, low-cost funding (like the overnight “repo” markets).

Many of the credit bubbleʼs excesses can be traced to the “shadow banking” sector, which is essentially the
intersection between commercial banking and investment banking business models: shadow banks take
illiquid credit and interest rate risk (like commercial banks), but fund themselves principally through the
wholesale markets (like investment banks). Because of long-recognized regulatory loopholes, shadow banks
were also frequently able to operate with significantly lower capital requirements than commercial bank
competitors. With both capital and funding advantages in hand, shadow banks grew to some 60% of the U.S. credit system.

To many investors and policy-makers during the bubble, shadow banking vehicles (like “SIVs”) appeared to
perform precisely the same functions as commercial banks, but were more efficient. Unfortunately, shadow
banks proved to be extraordinarily fragile; both the asset and liability components of their business models
suffered as the credit cycle turned. Unwilling to risk a shutdown in the short-term funding markets, central
banks and governments stepped in to prop up the shadow banking system.

And as such, the Volcker Rule is poorly targeted. Also from the presentation:

See that?

I rarely say this, but for anyone interested in financial markets this presentation is a must-read. The graphical approach works perfectly. Read it twice, then go back and read the interview I did with Perry Mehrling about shadow banks, or Ezra Klein’s write-ups (One and Two) of how a bank run in that overlapping space works, using that map as a guide.

Also, for fun, here’s why the financial system looked so efficient during the naughts, efficient in a way that made regulators want to sit back and let it work its wonders: