The Shadow Banking System | Wreaking Havoc on the Economy

Paul McCulley parents his 20-year-old son with this principle: “If you want access to the ‘Bank of Dad,’ then you must comply with the rules of the ‘Bank of Dad.’ ”

McCulley claims that Wall Street abandoned a similar rule in the 2008 credit crisis and now that core principle needs to be restored before another crisis occurs.

McCulley, a managing director of the international bond firm PIMCO, asserts, “Regulatory reform is going to happen. This crisis will not be wasted.”

He demonstrated that over the last 40 years, a segment of the investment industry, the “shadow banking system,” evolved in such a way as to avoid conventional banking regulations. Banks took in short-term, low-quality deposits from individuals and said those liabilities could be claimed by the depositors at any time at the price they were issued, at par or $1,000 a unit. By doing so, the banks extended the maturity of those deposits, decreased their liquidity, and reduced their quality.

Banks have made handsome profits for providing this service, based on the prevailing interest margin—the difference between the interest rate they pay depositors and the rate at which they can invest their capital.

For their business to be stable, banks issuing deposits must have access to two public assets: deposit insurance and a lender of last resort. The latter is necessary to provide liquidity and to avoid potential runs on the bank.

Both of those assets mean conventional banking today amounts to a joint venture between the private and public sectors. When those elements are lacking, as was the case during the 19th century, the banking system is subject to panics. That’s what happens when the public’s demand for liquidity exceeds the banks’ cash on hand.

The last banking panic occurred in 1907 when J.P. Morgan himself acted as the lender of last resort. That panic led to the creation of the Federal Reserve in 1913.

From the Great Depression of the 1930s to 2007, the banking system, except for the savings and loan crisis of 1990-91, was without systemic runs, thanks to the fact that the joint venture between government and private bankers was an accepted principle. If bankers did stupid things, the regulators shut them down.

Bankers, however, eventually sought higher profits without the constraints of regulation. The shadow banking system, McCulley said, came about as a means to that end.

The first shadow banking innovation was the invention of money market mutual funds in the 1970s. Their shares always traded at par, unlike a conventional mutual fund whose net asset values (NAVs) fluctuate. Money market funds lacked capital. Share values were equal to asset values. There was no buffer to absorb losses from bad assets. However, the public generally believed the shares they owned were just as safe as a bank deposit.

Money market mutual funds bought commercial paper (CP) and repurchase transactions (repos) to offer higher returns to investors. These instruments in turn became a source of funding for investment banks before those banks became commercial bank holding companies.

Therefore, McCulley said, the assets of money market mutual funds were the liabilities of the investment banks and also of the structured investment vehicles (SIVs).

SIVs were highly leveraged entities that were off balance sheets created by investment banks as mechanisms to create collateralized debt obligations (CDOs) and other instruments that were among the worst toxic debt.

The shadow banking system was regulated, McCulley said, by the rating agencies, Moody’s Standard & Poor’s, and Fitch. To create CDOs, the banks needed the rating agencies to provide AAA ratings. The fees for the ratings agencies were five times the fees they could earn for rating corporate bonds, McCulley said.

So, during 2003-7, the shadow bankers held the equivalent—in McCulley’s analogy—of an underage drinking party with rating agencies passing out fake IDs.

Eventually, the assets proved to be illiquid. In the ensuing months, $500 billion of asset-backed securities could not be rolled over, which ultimately led to the failures of Bear Stearns and Lehman Brothers.

The shadow banking system did not abide by the rules of the “Bank of Dad,” McCulley said. When Bear Stearns had to be bailed out, it was as if a gun was put to Dad’s head with the bankers demanding more money.

The federal government, acting as the “Bank of Dad,” provided sufficient liquidity to avoid a recurrence of the Great Depression, McCulley said, but it did not do so from a position of authority. Let’s hope the new laws take care of that.

Joe Brisben is a financial advisor at BDF Investments, a division of Broker Dealer Financial Services, member of FINRA and SIPC. Hear his commentaries at 11:50 a.m. weekdays on KCCK, 88.3 FM.

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