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Tuesday, May 24, 2022

How I Learned To Stop Worrying And Love Shadow Banking...

I had an article planned and started, but I got caught up with events. Instead, I just wanted to make a few comments about the dreaded “shadow banking” sector — non-bank finance. I had seen a few articles complaining about lack of regulation and risks posed by shadow banks, which I think is just extrapolating the last financial crisis.

I had written a sequence of articles on banks (first one here), in which I emphasised that financial flows are circular. If the flows are not circular, things break, and you get a crisis. The issue is that shadow banking is outside the view of regulators, and hence things can blow up.

Although the regulators and investors dropped the ball heading into 2008, pinning the blame on regulators misses the point that the exuberance was consensus: even if the regulators had more power, they would not have used it. In fact, in places where the regulators had powers to slow down risk taking, they bought the financial sector’s story hook, line, and sinker (e.g., Canada’s CMHC).

Trying to contain problems to the formal banks because it is easier for the central bank to regulate (and bail out) banks misses the reasons why risk-taking moved to non-bank finance in the first place.

  • If everything is intermediated by formal banks, the only financial instruments in the economy is government debt (used as liquidity management by banks), bank liabilities, and equities. This is not a situation that makes pension funds happy, since a significant portion of their portfolio would end up directly exposed to a handful of banks (at least in countries with concentrated banking systems, less to the United States).

  • Banks do not want to make concentrated loans that result in a single default wiping out a significant portion of their capital. They also want to able to get riskier loans off their balance sheet to help the diversification of their assets.

It is not as if financial crises cannot be created by formal banks. Banking systems around the globe have blown themselves up multiple time by having all of them piling into the same dumb lending schemes (with residential mortgages being a repeat offender). Even if the banks can be bailed out, doing so is politically unpopular.

Finance is a pro-cyclical component of the business cycle. The increasing cash flows generated by loose lending validate those looser lending standards, and human nature is that pretty much everyone underestimates the risks involved. Condemning non-bank financing by itself does not explain what the existing system can be replaced with. For example, one might attempt reduce risk by forcing money market funds to only hold Treasury bills. However, this would just push people into “short duration credit funds,” and those funds would eventually blow up in exactly the same fashion as money market funds. Meanwhile, those credit funds will be far more annoying to deal with from a paperwork perspective (with a varying unit value, cost basis needs to be tracked for income tax purposes), and everyone involved would just get mad at whoever decided to enact that regulation.

Other Projects…

  • I decided to wait for some clarity on the inflation cycle before finishing my book. The current episode is too interesting to skip, but it really is hard to write about without an idea whether or not inflation rates roll over.

  • In the meantime, I am thinking about writing about banking, since that is the easiest primer to work on right now.

  • I have started to look again at my agent-based macro framework. I would like to have something to use with regards to recession modelling, and possibly even banks. As it has been some time since I worked on it, progress is a bit slow.

  • If I get enthusiastic about free-floating versus fixed currencies, I might try to create a new version of the international model within the SFC models framework.

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(c) Brian Romanchuk 2022

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