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Shadow Banking

by MIKE WHITNEY

Regulators are worried about the explosive growth of shadow banking, and they should be. Shadow banks were at the heart of the last financial crisis and they’ll be at the heart of the next financial crisis as well. There’s no doubt about it. It’s simply impossible to maintain a system where unregulated, non-bank financial institutions are able to create their own money (credit) without oversight or supervision. The money they create–via off-balance sheets operations, securitization, repo or other unmonitored mega-leveraging activities–feeds into the economy, creates artificial demand, lowers unemployment, and fuels growth. But when the cycle slams into reverse (and debts are no longer serviced on time), then thinly-capitalised shadow banks begin to default one-by-one, creating a daisy-chain of counterparty bankruptcies that push stocks into a nosedive while the economy slips into a long-term slump.

Sound familiar?

The reason the global economy is still in a shambles a full 5 years after Lehman Brothers collapsed, is because this deeply-flawed system –which had previously generated 40 percent of the credit in the US economy–was still in rebuilding-mode. But now, according to a new report by the Financial Stability Board, shadow banking has made a comeback and is bigger than ever. The FSB found that assets held by shadow banks have swollen to $67 trillion, a sum that’s nearly as large as global GDP ($69.97 trillion) and greater than the $62 trillion that was in the system prior to the Crash of ’08. The more shadow banking grows, the greater the probability of another financial crisis.

So what is shadow banking and how does it work?

Here’s how Investopedia defines the term:

“The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments. Examples of unregulated activities by regulated institutions include credit default swaps.

The shadow banking system has escaped regulation primarily because it did not accept traditional bank deposits. As a result, many of the institutions and instruments were able to employ higher market, credit and liquidity risks, and did not have capital requirements commensurate with those risks. Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.” (Investopedia)

Shadow banking may have “come under increasing scrutiny”, but not a damn thing has been done to fix the problems. The banks and their lobbyists have beaten back all the sensible reforms that would have made the system safer. Instead, we’re back at Square 1, where credit is expanding in leaps and bounds by–what Pimco’s Paul McCulley called–“a whole alphabet soup of levered up non-bank investment conduits, vehicles and structures”. What we are seeing, in essence, is the privatizing of money creation. Privately-owned financial institutions of every stripe are increasing the amount of credit in the system even though the underlying collateral they’re using may be dodgy and even though they may not have sufficient capital to honor claims if there’s a run on the system.

Let’s explain: When a bank issues a mortgage, it is required to hold a certain amount of capital against the loan in case of default. But if the bank securitizes the mortgage, that is, it chops the mortgage up into tranches, pools it with other mortgages, and sells it as a bond (mortgage backed security), then the bank is no longer required to hold capital against the asset. In other words, the bank has created money (credit) out of thin air. This is the ultimate goal of banking, to maximize profits off zilch capital.

So how is this different than counterfeiting?

There’s no difference at all. The banks are creating “near money” or what Marx called “fictitious capital” without sufficient resources, without supervision, and without any regard for the damage they may inflict on the real economy when their ponzi-scam blows up. What matters is profits, everything else is secondary.

We live in an economy where the Central Bank no longer controls the money supply. Interest rates only play small part in this new paradigm where risk-oriented speculators can boost broad money by many orders of magnitude by merely increasing their debt levels. This new phenom has intensified systemic instability and caused incalculable harm to the real economy. Keep in mind, that ground zero in the financial crisis was a shadow bank called The Reserve Primary Fund. That’s where the trouble really began.

In 2008, the Reserve Primary Fund (which had lent Lehman $785 million and received short-term notes called commercial paper) was unable to keep up with the withdrawals of clients who were concerned about the fund’s financial health. The sudden erosion of trust triggered a run on the money markets which sent equities plunging. Here’s how Bloomberg sums it up:

“On Tuesday, Sept. 16, the run on Reserve Primary continued. Between the time of Lehman’s Chapter 11 announcement and 3 p.m. on Tuesday, investors asked for $39.9 billion, more than half of the fund’s assets, according to Crane Data.

“Reserve’s trustees instructed employees to sell the Lehman debt, according to the SEC.

“They couldn’t find a buyer.

“At 4 p.m., the trustees determined that the $785 million investment was worth nothing. With all the withdrawals from the fund, the value of a single share dipped to 97 cents.

“Legg Mason, Janus Capital Group Inc., Northern Trust Corp., Evergreen and Bank of America Corp.’s Columbia Management investment unit were all able to inject cash into their funds to shore up losses or buy assets from them. Putnam closed its Prime Money Market Fund on Sept. 18 and later sold its assets to Pittsburgh-based Federated Investors.

“At least 20 money fund managers were forced to seek financial support or sell holdings to maintain their $1 net asset value, according to documents on the SEC Web Site.” (“Sleep-At-Night-Money Lost in Lehman Lesson Missing $63 Billion”, Bloomberg)

The news that Primary Reserve had “broken the buck” sparked a panic that quickly spread to markets across the world sending stocks into freefall. Primary Reserve was the proximate cause of the financial crisis and the global crash, not subprime mortgages and not Lehman Brothers. This fact is obfuscated by the media to conceal the inherent dangers of the shadow system, a system that is just as rickety and crisis-prone today as it was in September 2008.

Although there are ways to make shadow banking safer, the banks and their lobbyists have resisted any change to the current system. Recently, the banks delivered a stunning defeat to Securities and Exchange Commission chairwoman Mary Schapiro who had been pushing for minor changes to money market accounts that would have made this critical area of the shadow system safer and less susceptible to bank runs. Schapiro’s drubbing at the hands of an all-powerful financial services industry sent shockwaves through Washington where even diehard friends of Wall Street –like Ben Bernanke and Treasury Secretary Timothy Geithner–sat up and took notice. They have since joined the fight to implement modest regulations on an out-of-control money market system which threatens to crash the financial system for the second time in less than a decade.

Keep in mind, that the changes Geithner, Bernanke and Schapiro seek are meager by any standard. They would involve “a floating net asset value, or share price, instead of their current fixed price,” or more capital to back up the investments in the money market fund (just 3 percent) in case there’s a panic and investors want to withdraw their money quickly. That sounds reasonable, doesn’t it? Even so, the banks have rejected any change at all. They believe they have the right to decieve investors about the risks involved in keeping their money in uninsured money market accounts. They don’t think they should have to keep enough capital on hand to cover withdrawals in the event of a bank run. They’ve decided that profits outweigh social responsibility or systemic stability.

So far, Wall Street has fended off all attempts at regulatory reform. The banks and their allies in Congress have made mincemeat of Dodd Frank, the reform bill that was supposed to prevent another financial crisis. Here’s how Matt Taibbi summed it up in a recent article in Rolling Stone:

“At 2,300 pages, the new law ostensibly rewrote the rules for Wall Street. It was going to put an end to predatory lending in the mortgage markets, crack down on hidden fees and penalties in credit contracts, and create a powerful new Consumer Financial Protection Bureau to safeguard ordinary consumers. Big banks would be banned from gambling with taxpayer money, and a new set of rules would limit speculators from making the kind of crazy-ass bets that cause wild spikes in the price of food and energy. There would be no more AIGs, and the world would never again face a financial apocalypse when a bank like Lehman Brothers went bankrupt.

Most importantly, even if any of that fiendish crap ever did happen again, Dodd-Frank guaranteed we wouldn’t be expected to pay for it. “The American people will never again be asked to foot the bill for Wall Street’s mistakes,” Obama promised. “There will be no more taxpayer-funded bailouts. Period.”

Two years later, Dodd-Frank is groaning on its deathbed. The giant reform bill turned out to be like the fish reeled in by Hemingway’s Old Man – no sooner caught than set upon by sharks that strip it to nothing long before it ever reaches the shore.” (“How Wall Street Killed Financial Reform”, Matt Taibbi, Rolling Stone)

Congress, the White House and the SEC are all responsible for fragile state of the financial system and for the fact that shadow banking has not been brought under regulatory oversight. This mess should have been cleaned up a long time ago, instead, shadow banking is experiencing a growth-spurt, adding trillions to money supply and pushing the system closer to disaster. It’s shocking.

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at fergiewhitney@msn.com.

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at fergiewhitney@msn.com.

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