We have received many questions on what shadow banking really is. Here is one of the easiest explanations, courtesy Azizonomics.
Meet James. James bought a house. It cost him $150,000, of which $30,000 had come from his own savings, leaving him with a $120,000 30-year fixed-rate mortgage from the WTF Bank, with a final cost (after 30 years of interest) of $200,000. Now, up until the ’80s, a mortgage was just a mortgage. Banks would lend the funds and profit from interest as the mortgage is paid back.
Not so today. James’s $200,000 mortgage was packaged up with 1,000 other mortgages into a £180 million MBS, (mortgage backed security), and sold for an immediate gain by WTF Bank to Privet Asset Management, a hedge fund. Privet then placed this MBS with Sacks of Gold, an investment bank, in return for a $18 billion short-term collateralised (“hypothecated”) loan. Two days later Sacks of Gold faced a margin call, and so re-hypothecated this collateral for another short-term collateralised $18 billion loan with J.P. Morecocaine, another investment bank. Three weeks later, a huge stock market crash resulted in a liquidity panic, resulting in more margin calls, more forced selling, which left Privet Asset Management — who had already lost a lot of money betting stocks would go up — completely insolvent.
You should be. This is of course a fictitious story. But the really freaky thing is that this kind of scenario — the packaging up of fairly ordinary debt into exotic financial products, which are then traded by hundreds or even thousands of different parties, has occurred millions and millions of times. And it is extremely dangerous. When everybody is in debt to everybody else through a complex web of debt one small shock could break the entire system. The $18 billion debt that Privet owed to Sacks of Gold could be the difference between Sacks of Gold having enough money to survive, or not survive. And if they didn’t survive, then all the money that they owed to other parties, like J.P. Morecocaine, would go unpaid, thus threatening those parties with insolvency, and so on. This is called systemic risk, and shadow banking has done for systemic risk what did the Beatles did for rock & roll: blow it up, and spread it everywhere.
The banking system has blown up multiple times in history, when depositors have panicked and withdrawn funds en masse in what is known as a bank run. So traditional banks have become party to a lot of regulations. For example, banks must keep on hand 10% of deposits as a reserve. This reserve is a buffer, so that if depositors choose to withdraw their money they can do so without the bank having to call in loans. Of course, banks can still suffer from a liquidity panic if a large proportion of their depositors choose to withdraw their money. Under those circumstances, traditional banks have access to central bank liquidity — short term loans from the central bank to guarantee that they can pay depositors.
Shadow banking arose out of bankers’ desire to not be bound by these restrictions, and so to create more and more and more financial products, and debt, without the interference or oversight of regulators. Of course, this meant that they did not have access to central bank liquidity, either.
Essentially, shadow banking is still banking. It is a funnel through which money travels, from those who have an excess of it and wish to deposit it and receive interest payments, to those who want to borrow money.
Shadow banking institutions are intermediaries between investors and borrowers. They can have many names: hedge funds, special investment vehicles, money market funds, pension funds. Sometimes investment banks, retail banks and even central banks. The difference is that in the new galaxy of shadow banking, these chains of intermediation are often extremely complex, the shadow bank does not have to keep reserves on hand, and shadow banking institutions raise money through securitisation, rather than through accepting deposits.
With securitisation, the financial industry creates the products which populate the shadow banking ecosystem, and act as collateral. Rather than accepting deposits (and thus accepting regulation as traditional banks) shadow banking gets access to money through borrowing against assets. These assets could be anything — mortgages, credit card debt, commodities, car loans. These kinds of products are packaged up into shares, sold and traded. There are various forms: collateralised debt obligations, collateralised fund obligations, asset-backed securities, mortgage-backed securities, asset back commercial paper, tender option bonds, variable rate demand obligations, re-hypothecation, and hundreds more exotic variants. (Hypothecation is where the borrower pledges collateral to secure a debt – i.e. a mortgage, and re-hypothecation is where that collateral is passed on and someone else borrows against it, even though it remains in the original debtors hands). The function of these assets are essentially the same; securitisation is a way of creating products with an exchange value, and bringing money into the shadow banking system; so much money that the shadow banking system in 2008 was much larger than the traditional banking system:
Read more: Shadow Banking 101 |