Regulating the shadow banking system

by on September 17, 2010 at 1:46 am in Current Affairs, Economics | Permalink

There is a new paper by Gary Gorton and Andrew Metrick, and (part of) the abstract reads as follows:

We first document the rise of shadow banking over the last three decades, helped by regulatory and legal changes that gave advantages to the main institutions of shadow banking: money-market mutual funds to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (“repo”) that facilitated the use of securitized bonds in financial transactions as a form of money. All of these features rely on an evolution of the bankruptcy code that allows securitized bonds to be used as a form of privately created money in large financial transactions, a usage that can have significant efficiency gains and would be costly to eliminate. History has demonstrated two successful methods for the regulation of privately created money: strict guidelines on collateral (used to stabilize national bank notes in the 19th century), and government-guaranteed insurance (used to stabilize demand deposits in the 20th century). We propose the use of strict rules on collateral for both securitization and repo as the best approach for shadow banking, with compliance required in order to enjoy the safe-harbor from bankruptcy.

I liked this paper very much.  It has excellent detail on how the shadow banking system works, excellent conceptual analysis comparing shadow banking to America's earlier "free banking era," and the central point that we don't have enough safe collateral for repo (should the Fed issue a special form of such collateral?).  It uses the word "rehypothecation" and ends with an excellent (and to me somewhat scary) few sentences:

It seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money…This means that open market operations are exchanging one kind of money for another, rather than exchanging money for "bonds."  "Quantitative easing" may well be the monetary policy of the future.

Addendum: Arnold Kling comments.

1 Alex September 17, 2010 at 2:14 am

Noob question: Why exactly are those sentences scary?

2 Andrew September 17, 2010 at 7:55 am

I think this is a scary sentence:

“This note is legal tender for all debts, public and private.”

3 jack September 17, 2010 at 9:33 am

Is this really a “shadow banking system”? Or is it just a shadow expansion of the current system, or maybe a shadow asset class?

I don’t have an answer and will read the links. I just think the the term shadow banking system is so ominous that if we are going to use it, it should be accurate.

4 jack September 17, 2010 at 10:02 am

Wikipedia says this:

“The shadow banking system or the shadow financial system consists of non-bank financial institutions that play an increasingly[when?] critical role in lending businesses the money necessary to operate.”

But that sounds like the inevitable outcome of disintermediation.

5 JamieNYC September 17, 2010 at 1:51 pm

Tyler, I don’t have time to read the whole paper, but I don’t think that the following comment of yours is true (in reality. May be that is what the authors really mean.): “the central point that we don’t have enough safe collateral for repo”.

If you repo Treasurys, you get 98 cents on the dollar (say, for an overnight repo); if you try to repo sub-prime mortgages that are trading at 30 c on the dollar, you may get 15 cents for them, overnight. The ‘haircut’ takes care of the safety issue.

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