Atlantic Business and the Shadow Banks

So Mark Thoma wrote a piece saying “The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.” The Atlantic Business Dr. Manhattan responded:

the systemic breakdowns we have been experiencing over the past 18 months have been caused by problems at the major banks (even the former investment-only banks which weren’t regulated by the Fed or FDIC cannot be called part of the “shadow banking system”), AIG (regulated by the state insurance commissioners, even if they’d rather you didn’t remember) and let’s not forget Fannie and Freddie, which had their own regulator.

Brad Delong declares it a “crash and burn” with some fun Watchmen allusions.

When people mention “The Unregulated Shadow Banking System” (TUSBS) they are often talking about different things and thus past each other, so let’s refocus. In general, I hear three things people invoke when they mention TUSBS.

1) Subprime lenders, who were not subject to the same regulatory burden as depository institutions.

2) A market that trades “informationally insensitive” debt as the result of the repo market and securitized debt as collateral. Where depositors are corporations and money market funds and where lenders are financial firms.

3) Traditional firms who took big bets in the investment markets while their regulators were not present or asleep at the wheel.

Mark Thoma is talking about #2. The Atlantic is referring to #3, and later to #1. Let’s work them backwards.

3) Arnold Kling is correct. Most of the firms doing crazy things with their portfolios had some sort of regulator. Fannie/Freddie had Congress, who were unwilling to regulate the firms. AIGFP had the OTS, who I believe were simply unable to regulate the firm. OTS may be good at some things, but they are not the SEC and they are not qualified to assess the credit risk of large out of the money puts on the market. If The Coast Guard and The League of Women Voters were put in charge of regulating AIGFP and their large concentrations of tail risk we could also say they were ‘regulated.’ But is that fair assessment?

Why was the OTS in charge of monitoring capital reserves on large portfolios of CDS contracts? As a result of deregulatory measures put in in the late 1990s, firms like this that could shove a thrift into their business could then pick-and-choose the weakest regulators. Maybe if we reform this finance sector, we might want to consolidate some of these regulatory agencies.

But the point stands. And Thoma made it too: “Today’s problems could have been eased or perhaps even avoided entirely if regulators would have simply enforced regulations already in place, or called for new ones when existing tools were inadequate.”

2) Ok, let’s do this carefully: A bank is, in abstract, an institution that borrowers short and lends long.

Your local bank borrowers short deposits and lends long investments. If it needs liquidity it can always go to the central bank’s discount window. The central bank’s discount window is the market maker of last resort for this banking system. This prevents bank runs. In exchange it is regulated by the government.

Your local shadow bank took in money in the repo market as deposits, and used senior tranches of debt as the collateral. Now what happens when it needs liquidity? There is no market maker of last resort who the system as a whole could turn to. Repeat that again. It exists in the shadows, there is nowhere to turn to for emergency liquidity. There is no regulation/liquidity tradeoff here. This is what is meant by being unregulated – not that there weren’t any government agents in sight.

As such it was only a matter of time before a bank run of epic proportions happened. Checkout this chart:

That’s what a 21st century bank run looks like. This narrative is influenced by Gary Gorton’s “Slapped in the Face by the Invisible Hand” (Ezra Klein is FTW with his writeup of it).

That this issue is newly broken and needs to be fixed is echoed by Robert Lucas:

The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.

When Robert Lucas and Brad Delong are both in agreement against your point, you may want to reconsider. I also want to point out this excellent Review of a Review of Tett’s Fool’s Gold by Anthropologist Anush Kapadia:

When the banks need liquidity, they go to the interbank market and borrow/lend at LIBOR. When they all run out, they go to the central bank’s discount window. As Tett points out, shadow banks had only one liquidity backstop: the absolutely vital “liquidity puts” with the banks themselves, (MacKenzie makes no mention of them at all. See Tett pg. 205-6). Insurance sellers on the ABX were also providing a kind of backstop, and those backing up AAA risks were in effect backing up systemic risk, really the only kind of risk that is expressed in that coveted rating. By making AAA insurance contracts liquid, insurance market makers were implicitly acting as systemic risk providers. Cheap liquidity led them to underprice systemic risk and help create an unsustainable credit boom. When this became clear and everyone ran for the doors, there was no market maker of last resort who the system as a whole could turn to. The system itself melted because the systemic watchdogs were private, profit-driven entities (AIG and the monolines) who, when it comes to systemic risk, are by definition under-capitalized. With the backstops blown out, even the safer-than-safe risks looked unsafe.

Read that again, it is fantastic. When Robert Lucas and an Anthropologist of Markets are both in agreement against your point, you may want to reconsider.

It may turn out that this narrative is bunk, or that it is a sideshow to a much more central narrative – but I don’t feel that Thoma’s critics are getting his point, much less providing a counter-narrative. Now granted, there were government agents hanging around all these firms. So correct me if I’m wrong, there were no mechanism to handle this liquidity-backstop-for-regulation prior to the crisis. And that’s a problem that we all need to deal with.