What happened in the shadow banking market?

by on February 23, 2010 at 7:38 am in Economics | Permalink

Gary Gorton has a new and excellent paper on this question.  It is called "Questions and Answers About the Financial Crisis."  Here is one excerpt:

Q. Why doesn't the repo market just use Treasury bonds for collateral?

A. A problem with the new banking system is that it depends on collateral to guarantee the safety of the deposits.  But, there are many demands for such collateral.  Foreign governments and investors have significant demands for U.S. Treasury bonds, U.S. agency bonds, and corporate bonds (about 40 percent is held by foreigners).  Treasury and agency bonds are also needed to collateralize derivatives positions.  Further, they are needed to use as collateral for clearing and settlement of financial transactions.  There are few AAA corporate bonds.  Roughly speaking (which is the best that can be done, given the data available), the total amount of possible collateral in U.S. bond markets, minus the amount held by foreigners, is about $16 trillion.  The amount used to collateralize derivatives positions (according to ISDA) is about $4 trillion.  It is not known how much is needed for clearing and settlement.  Repo needs, say, $12 trillion.

…to get a sense of the magnitudes, suppose the repo market was $12 trillion and that repo haircuts rose from zero to an average of 20 percent.  Then the banking system would need to come up with $2 trillion, an impossible task.

One bottom line is this: the repo market funds the banks and there isn't enough "safety" to ensure the repo market is always working well.  We ended up using synthetic securities, including those backed by mortgages.  So every now and then we get a run on our banks.  Gorton predicts the crisis was not a one-off event and it could happen again.

One implication of this (my inference, not found in the paper) is that most (all?) major current proposals for banking reform don't get at the real problem.  You might wish to go back to "old banking" but according to Gorton that stopped being profitable during the 1980s.  There's always an uninsured place to put your money, regulation can't stop that, and such money can find its way back to help fund the banking system, right?  The systemic implications of that can prove scary.

I read all the same material that you do about "shrinking the banking system" or "decreasing leverage."  This paper makes you realize just how far we are from making those recommendations work.

Gorton's short paper is one of the best essays on the crisis so far.  Here are earlier posts on Gary Gorton and the crisis.

1 pireader February 23, 2010 at 8:06 am

You might wish to go back to “old banking” but according to Gorton that stopped being profitable during the 1980s.

It’s implausible that a much-desired low-cost service turned ‘unprofitable’ for an entire industry. The reality is that changes in technology and regulation left too many “old” banks competing in a given market in the 1980s. Since then, the industry has rationalized/ consolidated, and lots of retail banks earn perfectly adequate profits.

Also, Citi, Chase, etc. contain, as separate business units, traditional banks that earn perfectly adequate profits. But there’s additional money to be made by making lots of bets where ‘heads I win, tails the taxpayer loses’.

There’s always an uninsured place to put your money, regulation can’t stop that, and such money can find its way back to help fund the banking system, right?

No, actually. At the end of the day, there’s a pool of savings by households, businesses, etc. seeking a depositary home.

The regulators could define “deposit taking” broadly enough to embrace any service offering that would come close to meeting these depositors’ needs. (It would include money market mutiuual funds, sweep accounts, etc.) And they could regulate what those deposit takers did with the money.

They did for 50 years, before they deliberately started allowing loopholes to develop in the 1970s/1980s.

2 TA February 23, 2010 at 8:45 am

The problem I have, and have had with Gorton’s analysis is — where do these numbers come from? $12 trillion repo market? Really? Who are the borrowers? Who are the lenders? This doesn’t look anything like the FRB’s funds flow numbers.

3 George Colpitts February 23, 2010 at 8:59 am

Why is it so difficult to do a basic compare and contrast exercise with countries such as Canada that didn’t have a crisis and have a profitable banking industry? There are undoubtedly trade-offs but couldn’t we discuss those rather than ignore a counter-example?

4 Ginger Yellow February 23, 2010 at 9:16 am

I don’t have figures for the US, but the latest survey by the European Repo Council put the market’s size at just under Eu5bn, with around 80% of collateral comprising government bonds. On the other hand, government bonds are used much less frequently in tri-party repo, which I understand is more common in the US. Equity is commonly used in tri-party as it is liquid and (relatively) easy to value, and there’s plenty of that around.

5 zbicyclist February 23, 2010 at 10:07 am

Isn’t this rejecting of “old banking” a bit like saying: “My body’s cells aren’t growing fast enough. I need some cancer cells to boost growth?”

Beyond this, I’d just be repeating pireader’s points.

6 mulp February 23, 2010 at 11:13 am

The biggest moral hazard created by the Bush administration was insuring the money market funds.

Every business and every individual with money in uninsured money market funds because they paid higher interest should have taken 5%, 10%, 50%, 99% haircuts or had their funds frozen for years.

If the money market funds hadn’t been bailed out, for at least the next 50 years FDIC insured banks would be the only place cash would be invested, no matter how low the interest rates. And that would provide more than enough insured collateral for banks selling bonds to the Fed.

I assume this moral hazard hasn’t been pointed out as the worst possible action by the Bush administration because the personal interests of readers and Tyler and Alan were best served by it.

After all, I’m sure free market economists put every penny into virtually unregulated banks out of principle and higher returns instead of socialized FDIC banks, but classically want the free lunch of a government bailout which socialized the risk that came with the higher returns.

7 Marc Roston February 23, 2010 at 11:40 am

To Tyler’s point about not addressing the real problem, I think the key requirement should be separation between cash management and transaction processing on the one hand, and risk taking and investing on the other.

Wiping out equity of the banks is a shareholder problem, not a systematic risk problem. The systematic risk problem results because depositors who thought they had riskless cash and transaction processing suddenly see they face risk, and currently have little alternative.

The unique opportunity presented by paying interest on excess reserves is that it would allow potentially more attractive (in terms of returns) fully reserved banks. I’ve suggested previously that if we did away with bank holding company restrictions, allowing anyone to own a bank that has 100% reserves, then new entrants would offer banking as services to existing customers, (e.g. Walmart.) (Here’s the idea: http://blog.riskrsquared.com/2010/01/financial-regulation-in-three-easy.html)

Of course that leaves “shadow banking” doing all the lending, with uninsured deposit-like instruments. However, the shadow bank “depositors” clearly know they have risk, while at the same time they have a riskless alternative. When shadow bank equity owners don’t have government subsidized deposits, they’ll be better risk managers too. And you can limit size organically, as I suggest, through ownership restrictions like law firms, addressing TBTF.

8 Nathan February 23, 2010 at 11:53 am

Somone should mention to the author that there are some typos in that paper that actually make it more difficult to follow in certain sections.

9 dlr February 23, 2010 at 2:54 pm

One thing Canada’s banks have going for them is that their property market hasn’t imploded. Yet. Their residential properties are now among the highest priced in the world, based on “rental price/cost to own”, and on “average income/cost to own”. Not as bad as China of course, but still something like double the historical average, and they haven’t even begun to deflate.

Australia and England are in the same boat too.

10 R. Richard Schweitzer February 23, 2010 at 6:07 pm

This paper is one of the few, perhaps only, that appear to describe the parameters of what is now the “system” that is the subject of “systemic” risk.

One can note that in all the babble about “systemic risk,” there is no given, nor accepted, defining of the system itself.

There are just a whole lot of assumptions that the “system” is understood by all involved in dealing with it politically.

11 Bernard Yomtov February 23, 2010 at 8:11 pm

Interesting paper. Thanks.

12 Buy Xanax February 24, 2010 at 6:29 am

Shadow institutions are not subject to the same safety and soundness regulations as depository banks, meaning they do not have to keep as much money in the proverbial vault relative to what they borrow and lend. In other words, they can have a very high level of financial leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage magnifies profits during boom periods and losses during downturns.

13 Jon February 25, 2010 at 2:27 am

And in late 2008 when “free banking” was going to demonstrate how it deals with the bank runs that loss of confidence with banking brings, the “free banks” asked for and got the moral hazard of insurance for the clear and present and damaging risk inherent in “free banking.”

All the money market funds had 100% assets backing their deposits; the only problem was the prices of the assets would have gone into free fall.

Of course to admit that money market funds are “free banking” which failed in 2008 and needed a government would be to admit you are wrong on “free banking” being the solution.

This narrative is shockingly wrong. The assets of money market funds did not go into a free fall. The ‘panic’ about money market funds arose because the Primary Reserve Fund had a reputation of being one of the most conservative. Thus the visceral reaction was that if they failed, everything must be horrible.

Wrong. It turns out that they had changed their investment strategy. They weren’t the conservative fund, they were deeply aggressive.

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