I’ve finally organized the thoughts about banking that poured onto the pages of this blog in January. Unfortunately, the argument does not lend itself to convincing exposition in a blog post. So anybody who’s interested is going to have to trundle over to SSRN and download the paper, Shadow Banking: Why Modern Money Markets are Less Stable than 19th c. Money Markets but Shouldn’t Be Stabilized by a ‘Dealer of Last Resort’. I’ll warn you upfront, it’s tl;dr with a vengeance. On the other hand, I’m a pretty concise writer, so you’ll find I cover an awful lot of ground, if you give me an hour or two of your time.
- I start with Shadow Banking is an Unstable Funding System for Banks, Not Assets (so if you’re already familiar with the blogpost, you can skip that part).
- I continue with my interpretation of why the industrial revolution took off in Britain: the banking system, of course — and it’s ability to create money. To make the point, I very briefly explain the nature of early modern financial markets, and how they gave birth to fiat money.
- I then explain the components of the system that allowed 19th c. bankers to create risk-free private sector assets. Next I explain how these components fit in with a theoretic model of banking, and distinguish this model from Gorton and Ordonez model of “informationally insensitive” bank debt. (Don’t worry, no math.)
- Then I argue that the 19th c. lender of last resort, as it was understood by Bagehot, did not only serve as a source of liquidity, when panics threatened a crisis of confidence in the (fundamentally sound) banking system, but also actively managed moral hazard by explicitly withdrawing support from institutions that were undermining the quality of the money supply.
- At last I come back to modern shadow banking, explaining how the modern perversion of the “lender of last resort” into “too big to fail” has led to the growth of extraordinarily unstable forms of funding, including financial commercial paper and repo. Collateralized money markets in particular maximize the value of the central bank put, by draining liquidity when it’s most needed.
- I explain why a “dealer of last resort” cannot support asset market prices in general, but can only protect asset markets from forced sales by the specific dealers who are granted access to the central bank.
- Finally, I distinguish the tight connection that exists between traditional commercial banking and the real economy from the much more ambiguous relationship between traditional dealer banks and the real economy. After all, traditional dealer banks don’t hold assets on their balance sheets over the long term and are far more focused on their short-run ability to sell off an asset, than in the asset’s performance over the long run.
- It is because of the important role that commercial banks play in the real economy that they have privileged access to the lender of last resort facilities of the central bank. Dealer banks don’t play the same role and don’t deserve similar support. As for shadow banking, repo markets, to the degree that they fund private sector assets at all, fund market-traded assets and don’t support unsecured lending to smaller businesses, whereas asset backed commercial paper markets are steadily shrinking now that avenues of regulatory arbitrage are being closed.