The problem with the shadow banking system

The discussion over at the Atlantic has evolved so now the argument is that regulators knew about the “shadow banking system” and, thus, its failures are the regulators fault.  Of course, there’s some truth to this view — but it also implies that the shadow banking system should be regulated.

When I hear the term “shadow banking system” I don’t think of “shadow” as meaning “in the shadows” or “hiding”, I think of it as a term like “shadow government” in the UK.  In other words, the “shadow banking system” is just a parallel banking system.  It’s public; everybody who cares to know knows about it, but the average person pays it no attention because it doesn’t appear to have any effect on their lives.

The problem with the shadow banking system is that it’s every bit as unstable as a traditional banking system, without any of the safeguards in terms of capital requirements and a lender of last resort.

In other words, the problem with the shadow banking system is that it wasn’t regulated as a banking system.  It’s certainly fair to argue that the fact that it’s not regulated as a banking system is the fault of the regulators, but to argue that it doesn’t need to be regulated strikes me as daft.

The shadow banking system was an important cause of the crisis

There’s an amusing debate going on over at the Atlantic over whether the shadow banking system “caused” the crisis.

A timeline of events will help:

March to July 2007:  deteriorating subprime culminates in Bear Stearns hedge fund blowups

August 2007 to December 2007:  The financial crisis starts with the collapse of asset backed commercial paper (ABCP) markets (which had some exposure to subprime, but mostly relied on companies like Bear Stearns to do quality underwriting).  The Fed then released banks to discount ABCP issues that they guarantee themselves and within months the market stabilized after falling by $0.4 Trillion.  The Fed’s Term Auction Facility may have contributed to the stabilization (i.e. banks can now dump their ABCP at the Fed).

NOTE:  Asset backed commercial paper is a cornerstone of the shadow banking system.  ABCP  is how securitizations get financed by money market funds which play the same role as bank deposits in the traditional sector.

March 2008:  Bear Stearns collapses largely because 50% of its balance sheet (see page 25 in link) was financed on an ultrashort term basis in repo markets.  Bear experienced a banker’s bank run that took it down in a matter of days.

NOTE:  Whether repo markets are technically a part of the shadow banking system depends on your definitions.  They are, however, unquestionably part of the unregulated financial sector that two years ago our regulators were claiming banks could manage on their own.  They supported the process by which securitized assets got financed by money market funds, because they allowed investment banks to treat assets in the process of being securitized (i.e. warehoused product) as liquid assets.

UPDATED 6-17-09:   Upon reflection I realized that of course repos are part of the shadow banking system, because money market funds invest heavily in them.  Data is available in the Investment Company Institute Factbook.  While the data doesn’t go back to the late 70s, I suspect that repo markets and money market funds grew up together.  In particular, government money market funds have a long history of being major repo investors — usually investing one-third of their assets in repos.  Non government money market funds invested only 5% of funds in repos in 1992 increasing to 9% in 2004 (during which period funds quadrupled).  2005 through 2007 saw 11-12% of funds invested in repos.  At the end of 2007 more than $600 billion was invested in repos via money market funds.  Of that approximately $380 billion was invested by government funds (and therefore presumably backed by Treasuries and Agencies).

Summer 2008:  Fannie Mae and Freddie Mac stabilized only after government takeover.

NOTE:  This is definitely a case of failure in the regulated sector.

September 2008:  Lehman failure disrupts money markets.   AIG bailed out.  Goldman Sachs, Morgan Stanley rescued by Fed granting them special treatment due to emergency conditions (see p.3 in both docs).  Merrill Lynch, Washington Mutual and Wachovia sold to commercial banks.

NOTE:  Lehman was a barely regulated investment bank.  It demonstrated that banks had so mismanaged the shadow banking system that the banks themselves could fail because of it — resulting in a generalized flight from commercial paper.  Every single one of the lightly regulated investment banks had to be rescued.   Highly regulated commercial banks (JP Morgan, Wells Fargo, Bank of America) assisted the regulators in the rescues.  Some of largest  commercial banks (e.g. JPM, WFC) had spent the last few years foregoing bubble driven profits in order to profit from the coming collapse.  None of the investment banks were able to do so without an extraordinary assist from the Fed, which in theory had no business helping them (since the SEC was their primary regulator).

So Charles Davi, I have a question for you:  In the absence of the $1.2 Trillion asset backed commercial paper market that made it possible for money market fund investors to finance securitization and in the absence of the multi-trillion dollar repo market, do you honestly believe that we would have had a financial panic in August 2007 and seen the failure of Bear Stearns in 2008 — in other words, do you honestly believe that this crisis would have taken place anyhow?

Why wasn’t a resolution authority an integral part of TARP?

Remember that the TARP proposal was made after the first rescue of AIG.  It was clear at this time that the real problem in the economy was the fact that regulators did not have the authority to manage a controlled resolution of firms like AIG (i.e. of non-bank financial institutions).  I can understand that regulators would need a big line of cash to aid them in resolving the AIGs of this world, but I can’t understand how the cash is useful – even today – without the legal authority to perform the resolution.

Some might say that the reason that a resolution authority wasn’t included in TARP was that nobody thought it would be necessary before AIG and things were simply happening too fast to create a proposal of that magnitude on the fly.  There’s a huge problem with this argument:  Bear Stearns.  After Bear Stearns’ sudden collapse in March, one of the first priorities should have been to draft a resolution authority for taking over a firm in a similar situation.

Thus, the question remains:  Why didn’t Hank Paulson insist that Congress create an authority to resolve insolvent non-bank financial institutions in September 2008?

Also of note Tim Ryan, CEO of SIFMA, in a FT commentary titled “Wall Street is a willing partner in financial reform” carefully omits support for the one tool that would make it possible for the government to get the too big to fail problem under control.  The message the financial industry seems to be broadcasting loud and clear is this:  we’ll submit to more regulation, but we really, really don’t want to ever have to face the consequences of competing in a real free market environment.

19th v 21st c. banking: What has changed …

There’s one last quote from Lombard Street that I want to record. In reference to the Bank of England’s lender of last resort activities, Bagehot writes:

No advances indeed need to made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimal small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.

Is anybody else wondering whether it’s still true that: “the amount of bad business in commercial countries is an infinitesimal small fraction of the whole”?

(cross posted here)

Why Bagehot wrote Lombard Street

A recent exchange made me think for the first time about the events preceding the publication of Lombard Street. The financial crisis of 1866 had rocked the financial system dramatically without really destabilizing it. But Bagehot saw in that crisis the possibility of total financial collapse. (A detailed description of financial collapse takes up much of Chapter 7, part II of Lombard Street.) For this reason he thought it was important to explain what made it possible for the British economy to survive such brutal storms — and thus to make it clear to politicians and to the Governors of the Bank of England what their obligations were in a crisis.

After 1844 politicians played an important role in the Bank of England’s lender of last resort activities. The Banking Act of 1844 (Peel’s Act) restricted the issue of Bank Notes. It was, however, written with an escape clause, allowing the law to be suspended by executive order (i.e. bypassing Parliament). And in every subsequent crisis 1847, 1857, 1866, the law had to be suspended in order for the Bank of England to act as lender of last resort to the banking system. That is, without suspension of the law the Bank would have run out of Bank Notes.

Peel’s Act was so controversial that Bagehot states: “Two hosts of eager disputants on this subject ask of every new writer the one question — Are you with us or against us? and they care for little else.” For this reason Bagehot chooses not to take sides in the debate, but instead to explain clearly (without condemning the law itself) why Peel’s Act had to be suspended in 1847, 1857 and 1866.

Bagehot’s main concern in Lombard Street is to put an end to any controversy over:
(i) the importance of suspending Peel’s Act in a financial crisis
(ii) the importance of copious lending by the Bank of England in a crisis.
Chapter 7 is dedicated to explaining that public uncertainty about either of these two actions in a crisis is dangerous. He concludes:

The best palliative to a panic is a confidence in the adequate amount of the Bank reserve, and in the efficient use of that reserve. And until we have on this point a clear understanding with the Bank of England, both our liability to crises and our terror at crises will always be greater than they would otherwise be.

Note the subtle reference to Peel’s Act in the first sentence. Bagehot avoids controversy, but makes his point clear. In the second sentence he calls on the Bank to publicly acknowledge its role as lender of last resort to the financial system.

One thing needs to be emphasized: Bagehot is concerned about uncertainty — but that uncertainty references explicitly whether or not a lender of last resort exists and will step in to provide liquidity in a crisis. Thus Bagehot wants the Bank of England to reduce uncertainty in the financial system, but only by promising to lend copiously against high quality assets.

He is entirely at ease with the fact that the Bank of England allowed Overends Gurney, a systemically important bill broker, to fail despite the fact that the failure rocked the financial system with uncertainty, as illustrated by the following two quotes:

In 1866 undoubtedly a panic occurred, but I do not think that the Bank of England can be blamed for it. They had in their till an exceedingly good reserve according to the estimate of that time—a sufficient reserve, in all probability, to have coped with the crises of 1847 and 1857. The suspension of Overend and Gurney—the most trusted private firm in England—caused an alarm, in suddenness and magnitude, without example.

… no cause is more capable of producing a panic, perhaps none is so capable, as the failure of a first-rate joint stock bank in London. Such an event would have something like the effect of the failure of Overend, Gurney and Co.; scarcely any other event would have an equal effect.

Thus, Bagehot does not argue that the lender of last resort should act to eliminate general uncertainty, he argues only that a lender of last resort should eliminate uncertainty about the actions it will take in the midst of a financial panic.

(cross posted here)

Learning from the Crises of 1857 and 1866

I’ve been rereading Lombard Street, this time reading it as a history of the money market in mid-nineteenth century England. There are some very, very interesting parallels to the current crisis.

In particular, the period (after the passing of the Bank Charter of 1844) was one of remarkable financial innovation. On the one hand, banks that had initially issued circulating notes adapted to the new environment by converting to deposit banks and eventually offering checking accounts. On the other hand, new bank like financial intermediaries were developing. Bagehot calls these financial intermediaries bill brokers, and elsewhere they are called discount houses. In any case, as Bagehot makes clear bill brokers, that in the past were pure brokers matching savers with credit-worthy borrowers, had become intermediaries who guaranteed the bills that they placed in large quantities with banks. This was a tight margin business where the “brokers” borrowed most of their capital from these same banks and thus they were essentially earning money on spreads and the value of their highly specialized knowledge of the quality of commercial bills. Aggressive competition meant that it was not profitable for these brokers to maintain reserves (i.e. capital) to back up their guarantees. Instead the bill brokers relied on the Bank of England’s discount policy: Even in the worst of crises the Bank was expected to discount good bills at Bank rate.

In the crisis of 1857, the Bank of England advanced more than £9 million to the bill brokers and only £8 million to bankers. After the crisis, the Bank stated a new policy which restricted the Bank tranactions of the bill brokers to advances which were only offered on a quarterly basis. Should the brokers need discounts at any other time, they would have to ask for an exception to the Bank’s policy. The stated goal of the policy was to make the brokers “keep their own reserve.”

Needless to say, the bill brokers were unhappy with the new policy. Gurneys, which controlled more than half of the commercial bill market and was in many ways a competitor of the Bank of England, apparently tried to start a run on the Bank in April of 1860 by withdrawing from its deposit account an outrageous sum of money all at once. (While Bagehot claims the sum was £3 million, other sources cite a figure of £1.65 million.) This action was roundly condemned in the press.

In the meanwhile Gurneys was being poorly run by a second generation of the family. As badly underwritten bills went into default, the company advanced money on mortgages and even ended up running a fleet of steamships — also unsuccessfully. By matching short term obligations with long term assets, Gurneys violated one of the most fundamental principles of 19th century banking. This explains the strong words Bagehot uses to describe the company:

The case of Overend, Gurney and Co., the model instance of all evil in business, is a most alarming example of [the] evil [of a hereditary business of great magnitude]. No cleverer men of business probably … could well be found than the founders and first managers of that house. But in a very few years the rule in it passed to a generation whose folly surpassed the usual limit of imaginable incapacity. In a short time they substituted ruin for prosperity and changed opulence into insolvency.

In 1865 before all of Gurney’s problems were public knowledge, the partners took the firm public, creating Overend, Gurney and Co. While this action required the Gurney family to guarantee the new firm against losses on the business of the old, presumably it was hoped that new capital would save the firm. Unfortunately the losses were so great that the Gurneys had to liquidate their personal property and news of this event caused a run on the Company. Those who had bought shares in 1865 ended up losing £2.9 million. (Because they had only paid 30% of the face value of their shares, they had the misfortune to face a capital call in order to satisfy obligations to creditors — who were paid in full.) The lawsuit that followed this failure found the Gurneys’ actions to be incompetent rather than fraudulent and they were acquitted. (Ackrill and Hannah, 2001, Barclays: The Business of Banking, 1690-1996, p. 46-7)

Because many London banks were exposed to Gurneys, there was a run on the London banks and many solvent banks, such as the Bank of London, failed. Wikipedia claims that in the crisis that followed there were a total of 200 bank and commercial failures. By any standard the crisis was severe. In particular because London held large foreign deposits that were slow to return after the run, the Bank of England was forced to keep the Bank Rate elevated for a full three months — which undoubtedly aggravated the domestic consequences of the crisis.

It was, however, a watershed because for the first time the Governor of the Bank of England publicly acknowledged “a duty … of supporting the banking community”, that is, he acknowledged that the bank was the lender of last resort to the banking system. (While the Bank had been playing this role for almost a century, it often did so with reluctance and heretofore had never publicly recognized the role as an obligation.)

For this reason, Bagehot repeatedly treats the Bank of England’s actions in 1866 as the model for a lender of last resort. A few points are worth mentioning:

(i) In Bagehot’s time, it was exceptional for lender of last resort activities to last more than a few weeks. Frequently the simple fact that they were available (e.g. a lifting of government restrictions) was enough to end the panic.

(ii) A lender of last resort is not expected to prevent the failure of a systemically important bank. On the contrary, Overend, Gurney and Co. was systemically important, but it was also so badly managed that the Bank of England could not be expected to discount its paper.

(iii) A successful lender of last resort action will leave the bulk of the financial system standing (i.e. at least say 75% to 90% of the banks). Bank failures — even large numbers of bank failures — are part of a typical lender of last resort activity.

(iv) The government should never support a bad bank; such action could only serve to prevent the development of good banks.

So long as the security of the Money Market is not entirely to be relied on, the Goverment of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

Now let’s address the parallels between 1857/66 and today. First of all note that in 1857 Gurneys was a huge player in the money market and thus in 1857 when the Bank of England lent £9 million to the bill brokers, you can expect that at least £2 million and possibly as much as £4 million went to Gurneys.

In other words the Bank of England probably saw evidence that in a crisis the line of credit it was giving to an individual firm was becoming unreasonably large. Even if all the bills discounted at the Bank by Gurneys were good quality bills at this particular time, the Bank was opening itself to a future problem where reliance on the careful management of Gurneys allowed low quality bills to be discounted at the Bank and thus exposed the Bank to significant credit losses. As the Bank was a private institution, it had an obvious interest in limiting it’s exposure to the credit risk of a single firm or to the credit judgment of a single underwriter of commercial bills.

In fact, it was precisely the ultra-conservative management of the Bank of England that created the trust necessary for the Bank to be relied on as a lender of last resort:

The great respectability of the directors, and the steady attention many of them have always given the business of the Bank, have kept it entirely free from anything dishonorable and discreditable. Steady merchants collected in council are an admirable judge of bills and securities. They always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions; and no sophistry will persuade the best of them out of their good instincts. You could not have made the directors of the Bank of England do the sort of business which ‘Overends’ at last did, except by a moral miracle—except by changing their nature. And the fatal career of the Bank of the United States would, under their management, have been equally impossible. Of the ultimate solvency of the Bank of England, or of the eventual safety of its vast capital, even at the worst periods of its history, there has not been the least doubt.

Thus, in 1858 the Bank put in place a policy that only allowed bill brokers access to emergency credit by exception. The purpose of the policy was to force bill brokers to keep their own reserve, or in other words to be prepared to act as their own lenders of last resort.

Thus, faced with financial innovation and the growth of an extremely large, highly leveraged firm closely intertwined with the banking system, the Bank of England immediately made it clear that it did not support the growth of this firm. It set a policy: if financial innovation was going to allow huge firms to develop, then those firms should be prepared to support themselves through a crisis.

One obvious consequence of this policy is to push the bill brokers to reduce their leverage ratios and thus reduce the likelihood that they will (i) need the services of a lender of last resort and (ii) cause a financial crisis by failing. In short, even though the Bank of England had no regulatory authority whatsoever over the financial system, the fact that it was the lender of last resort meant that its policy decisions affected the stability of the financial system by affecting the leverage in the financial system.

Contrast the behavior of the Bank of England in 1857-8 with the behavior of authorities in the US after the 1987 investment banking crisis. In 1987 the stock market crash could have led to the complete collapse of the investment banking industry were it not for the actions of the New York Federal Reserve President (who basically told the commercial banks to give the investment banks unsecured loans). Notice that at the moment of the 1857 and the 1987 crises both central banks took aggressive action. The difference is in their behavior after the crisis was over. The Bank of England immediately acted in a manner that would push the firms that were endangering the financial system to reduce their leverage ratios and be less reliant on the Bank of England in the future. By contrast, the Federal Reserve stood by without objection when Congress extended it’s authority to permit it to lend directly to the investment banks in the 1991 FDICIA law.

In other words the two Banks took diametrically opposed actions: that of the Bank of England would tend over the long run to decrease the leverage of financial institutions and thus decrease the risk of financial instability, whereas that of the Fed tended to increase leverage and increase instability over the long run. Observe, however, that the short run effects of these different policies were precisely the opposite of their long run effects.

The willingness of the Bank of England to let a bill broker fail was tested within a decade. Overend and Gurneys actually made the decision easier by being the subject of rumors (which turned out to be well founded) for over a year before they finally turned to the Bank of England for aid in 1866. (The Economist wrote at the time “the failure of Overend, Gurney and Co. Ltd. has given rise to a panic more suitable to their historical than to their recent reputation.” Victor Morgan, 1943) Despite their size, the Bank of England did indeed refuse to discount their bills — and the result was a financial crisis that matched the worst in living memory.

On the other hand, no further failures threatened to rock the market until 1890, when Barings’ exposure to South American loans could have resulted in failure and a major crisis. The potential losses were so great that the Bank of England refused to intervene directly, but it did broker a joint support from the other large banking houses. Overall, however, England’s financial system was remarkably stable from 1866 up through 1914 (the year which marked the beginning of the end of the gold standard).

By contrast the Federal Reserve’s policy of bringing the investment banks under their wing forced the Fed in 1998 to extend the safety net even further. When the Fed brokered a bailout, it was not a bailout of a systemically important bank, it was the bailout of a hedge fund. In hindsight it’s extremely easy to see that the fact that a hedge fund had grown large enough to be systemically important was a clear sign that the financial system was dangerously overleveraged.

If the Fed had been a private bank like the Bank of England in 1857, at this juncture it would have made it clear to all members of the financial system that its balance sheet could not support the liabilities that were growing. It would have told them that they needed to start paying attention to their own reserves by dramatically reducing their leverage ratios.

Instead, the calming effects of an endless sequence of government bailouts of the banking system (Continental Illinois in 1984, Brady Bonds in 1989, low interest rates to ease the burden of bad debts in the early 90s, the late 90s and early noughts) left the Fed with the illusion that financial instability was no longer a problem that needed to be addressed, while at the same time fostering an accumulation of dead wood in the financial system that ensured that the resulting conflagration would be beyond all imagination.

In short, while the Bank of England in 1858 was willing to precipitate a crisis in order to foster stability, the Fed in the 1980s and 90s fostered the illusion of stability, while at the same time creating an environment where crisis was inevitable. Thus, just as the forest manager is better off allowing small fires to flare up regularly, so a central banker is better off precipitating small crises to avoid a disastrous and uncontrolled burn.

(cross-posted here and here)