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Much Ado About the Shadow Banking System

Occasionally, a blog post will flower into a wide-ranging debate in what is usually called the "economics blogosphere." Last Friday's guest post on regulation by Mark Thoma triggered just such a debate.

I'll quote the controversial passage at some length:

Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.
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.
We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.

Dr. Manhattan, an anonymous blogger at The Atlantic, focused on that middle paragraph in a post called "Sentences That Don't Compute," arguing that the crisis was due to problems at regulated financial institutions, such as AIG, not the shadow banking system.

Brad DeLong defended Thoma, drawing the line between commercial deposit-taking banks (heavily regulated) and other institutions (lightly regulated).

Thoma also responded on his own blog, pointing to the fact that AIG's problems, for example, were caused by the unregulated part if its business - the Financial Products derivatives-trading business.

Arnold Kling (who usually blogs here) responded to DeLong at The Atlantic, saying that failures of regulation of commercial banks were also a problem.

Finally, Rortybomb has a careful review of the issues, showing how different people mean different things by "shadow banking system." Ultimately he sides with Thoma on this point: money shifted into a sector of the financial system where there was no backstop against a liquidity crisis - unlike the regulated operations of the commercial banks, where deposit insurance plays that role. This is a problem that needs to be fixed.

By James Kwak  |  June 19, 2009; 8:00 AM ET
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There's a missing link between shadow banking and commercial banking that does tie some culpability back to the regulators that is hard for the uninitiated to see.

"Shadow" banking arose partly out of the process of securitization. Securitization began in the commercial banks, and regulators saw it and generally approved of it, although with some concerns.

When the financial services industry saw how profitable "shadow" banking could be, they began to develop methods of structuring transactions in a way that would, at first, pass regulatory scrutiny, and later, avoid it as much as possible.

Regulators were somewhat aware of what was happening, but were not aware of the extent of it, and were also not aware of how the banks moved certain shadow activities off their books (e.g. SIVs).

Although I have no direct evidence, I'm confident that many mid-level regulators were becoming increasingly concerned about these things they were seeing (which we now call shadow banking); they would have reported that up thru the chain of command, and would have then received instructions to let it alone.

From that perspective, the new council might be able to compile such information and recognize the existence of a systemic risk (which I think is how Sheila Bair is thinking about it).

But without the political will, and support, to act on potential risks before they get too large, no amount of information or data will suffice.

Posted by: esdewey | June 19, 2009 2:01 PM | Report abuse

Some definitions:

A member commercial bank (depository institutions) only becomes a financial intermediary when there is a 100% reserve ratio applied to all its deposit liabilities. The weighed arithmetic average of reserve ratios applicable to deposit liabilities stood at 84%, and for demand deposits the ratio was 91, in 1942.

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, credit cards, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) & (every person), (except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs) -- somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free/gratis legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (10% on transaction accounts in excess of the low-reserve tranche), as fixed by the Board of Governors of the Federal Reserve System.

Posted by: flow5 | June 19, 2009 6:26 PM | Report abuse

That is, member commercial banks should be severly regulated in both their assets & liabilities. Thus, there is a big difference between a financial intermediary and a commercial bank (but it is not one that Keynes acknowledged

Posted by: flow5 | June 19, 2009 6:29 PM | Report abuse

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