Official: Shadow Banking is Too Big To Fail

It remains to be seen if the dodgy mechanics inside the financial system have in any way been properly reengineered to protect the economy from further systemic shocks. I happen to think that too little has yet been done to address core issues, from the trading of off-exchange instruments, the structure and interoperability of banking institutions and the question of adequate regulation at both a local and international level. Politicians appear to prefer to stay in their comfort zone which largely consists of hammering "bankers bonus's"; that's it boys, look at the symptoms, not the cause.

Guest writer Bankvigilante examines the recent NY Fed report on shadow banking and concludes that not much has changed.

Just in case you hadn't seen it, this report is one of the most important ones for banking I've seen for a while, and from one of the most, (if not the most), important institutions for banks. The report shows that the ultimate "Lender Of Last Resort" (LOLR) is playing with fire, probably knows it, and accepts that risk. But it doesn't make it the right thing to do.

The NY Federal Reserve's report on Shadow Banking is actually quite a good and easy read despite the fearsome-looking charts. The main chart on page three is recommended to be printed as a poster 48 inches x 36 inches, such is the complexity of the system. The report identifies traditional, high street, banking as less than 50% of total US banking liabilities, and the shadow banking system as having the lion's share, although down from its bubble peak. The authors then describe three types of "cash" shadow banking: officially sponsored,  (by the US government agencies and privatised-now-renationalised agencies like Fannie and Freddie); the internal one (whereby banks push out risk to their more or less off-balance sheet entities); the external one, (whereby "parallel banks" disintermediate the banks in some straightforward ways but also in creating structures similar to the banks but even more leveraged). There is also a, would you believe it, "synthetic shadow banking" sector too.

The trouble for the NY Fed is that they, and all other regulators, were just not up to speed on this shadow banking world, and did not realise until it was too late what danger it presented to the economy. The sector was performing the usual credit, maturity and liquidity transformations that the NY Fed sees as acceptable for banks - although I am not so sure, being a bit of a 100% reserve man rather than a fractional reserve supporter. We all  now know that the shadow banking system grew too large was too leveraged, and engaged in some very extreme forms of transformation.

Was it unregulated? Market failure proponents and the NY Fed would say it was unregulated, yet when the run on the system started the banks stepped in to rescue their creations, and when they too got infected the NY Fed stepped in to rescue the banks and the shadow banks. Although they were not formally regulated the market assumed they were underwritten by the banks, and that the banks were underwritten by the NY Fed (via the Greenspan "put" as a first line of defence and by real support as the last line). Who was right, the market or the market failure experts in the regulatory establishment? The crisis is really one giant unintended consequence of regulation. Regulation to discourage risk, actually encourages it, as those regulated and those dealing with them as counterparties belief that regulated, authorised banks are officially blessed and part of the TBTF complex

The authors of the report argue now, scarily, argue that the shadow banking system is too big to be shrunk and is therefore too big to fail. What it needs is regulation, perhaps not by form (banking vs shadow banking) but by function (credit vs maturity vs liqudity transformation). They are mad to attempt this feat and should stop now, and abolish themselves entirely.


In my view, if there are not good enough rules, and probably there can never really be enough good rules to control so many people so determined to get around them, then the policy is really just "Leave It To The Regulators" (or "LITTR" for short). And this policy won't work in the long run as those regulators will always end up being captured by those they regulate ... according to standard Public Choice economics which I agree with.

Public Choice economics doesn't get a lot of airtime because the vast majority of academic economists work for the government, which tends not to pay people to too closely analyse where they go wrong, they prefer economists to focus on so-called "market failure" which needs more and bigger government to "regulate". What the "market failure" advocates always miss is that some "failure" is an essential feature of the market, without it there would be no success.

The "banks are different" line peddled by the banks (of course) and their friends is precisely what leads to threat of systemic failure. The knowledge that the banks will be bailed out leads to the irresponsible behaviour that leads to the seemingly systemic risk, and the need for bailouts.

It is a  very sad conclusion that the "shadow banking" system is also To Big To Fail, and so (inevitably) needs to be regulated, by ever more, ever smarter regulators (like the ones who wrote the report).

Plus ca change.