Search Results

I show how to use data from the Financial Accounts of the United States to estimate how much funding of nonfinancial businesses, households, and governments is provided by the domestic shadow banking system. I define the shadow banking system as the set of entities and activities that provide short-term funding outside of the traditional commercial banking system, but I do not equate all nonbank funding with shadow banking. My results suggest that at the end of 2008, domestic shadow-bank funding of the nonfinancial sector was an important, but fairly modest source of funding relative to that provided by more traditional funding sources such as commercial banks, insurance companies, and pension funds. However, my results suggest that domestic shadow banking played a large role in the increase of nonfinancial-sector debt in the two years before 2008:Q4 and was, at least in an arithmetic sense, the entire reason for the slowdown in nonfinancial-sector debt growth after 2008. Domestic shadow-bank funding of the nonfinancial sector has increased since 2010, but remains well below the level seen right in late 2008.

This chapter examines the unique characteristics of banks that make them heavily regulated and subject to public intervention. It first explains the roots of fragility, contagion, and systemic risk in the banking sector before discussing as an example of fragility the development and crisis of shadow banking in the 2007–2009 crisis. It then considers the regulatory response to banking fragility with the establishment of prudential regulation and the safety net, the side effects of regulation, and the reasons behind the regulatory failure in the 2007–2009 crisis, along with the main measures of the regulatory reform that followed, including the emphasis on macroprudential measures. The chapter concludes with an assessment of regulation in emerging and developing economies and the contrast with developed economies.

In 2009, the U.S. and other G20 nations agreed on reforms designed to improve the regulation of systemically important financial institutions and markets. However, those reforms did not change the fundamental structure of the financial system, which continues to be dominated by universal banks and large shadow banks. Those giant institutions are too big, too complex, and too opaque to be effectively managed by their executives or adequately disciplined by market participants and regulators. In addition, government officials have failed to hold top executives accountable for widespread misconduct at financial giants during and after the financial crisis. The extensive networks linking capital markets, universal banks, and shadow banks create a strong probability that serious problems arising in one financial sector will spill over into other sectors and trigger a systemic crisis. Consequently, governments face enormous pressures to rescue universal banks and large shadow banks whenever a financial disruption occurs. There are serious doubts whether many governments and central banks will possess the necessary resources in the future to provide comprehensive bailouts similar to those arranged during the last crisis. Accordingly, the next systemic financial crisis might not be contained and could potentially lead to a second Great Depression.

A new Glass-Steagall Act would break up universal banks and end the conflicts of interest that prevent universal banks from acting as objective lenders and impartial investment advisers. It would produce a more stable and resilient financial system by reestablishing structural buffers to prevent contagion between the banking system and other financial sectors. It would improve market discipline by preventing banks from transferring their safety net subsidies to affiliates engaged in capital markets activities. It would shrink the shadow banking system by prohibiting nonbanks from issuing short-term financial claims that function as deposit substitutes. It would remove the dangerous influence that large financial conglomerates exercise over our political and regulatory systems. It would end the current situation in which our financial system and our economy are held hostage to the survival of universal banks and large shadow banks. It would restore our banking system and financial markets to their proper roles as servants—not masters—of nonfinancial business firms and consumers.

What was shadow banking, why did it collapse, why did the Fed intervene, why did their intervention work, and what does it all mean? This chapter places the global financial crisis of 2007–9 in the larger context of the globalization of finance and the shift from a bank-based credit system to a capital market-based credit system, both of which seem to be ongoing facts of our time. Put simply, shadow banking is in our future as well as our past. The central argument of the chapter is that global funding banks and derivative dealers are the two central financial intermediaries of our day, and must therefore be the central concern of policy.

The Introduction frames the problem of monetary system design and lays out the book’s central themes and arguments. The shadow banking system—basically, the system of private money creation—serves as an entry point. The chapter offers a brief overview of this system and the central role it played in the recent financial crisis. It then explains what it means to say that shadow banking is a monetary phenomenon. Armed with this recognition, we can see that asking “what should be done about shadow banking” is tantamount to asking “how should our monetary system be designed.” Next, the chapter sketches the book’s blueprint for a revamped system of money and banking. The approach would confine the issuance of monetary instruments (functionally defined) to a designated class of chartered entities, and it would make the money supply sovereign and nondefaultable. The chapter concludes that, before embarking on a vast array of costly and speculative interventions in the financial system, we might be well served by trying to get money right. It might then turn out that many of the supposed problems of finance are not as big as we thought.

The Introduction frames the problem of monetary system design and lays out the book’s central themes and arguments. The shadow banking system—basically, the system of private money creation—serves as an entry point. The chapter offers a brief overview of this system and the central role it played in the recent financial crisis. It then explains what it means to say that shadow banking is a monetary phenomenon. Armed with this recognition, we can see that asking “what should be done about shadow banking” is tantamount to asking “how should our monetary system be designed.” Next, the chapter sketches the book’s blueprint for a revamped system of money and banking. The approach would confine the issuance of monetary instruments (functionally defined) to a designated class of chartered entities, and it would make the money supply sovereign and nondefaultable. The chapter concludes that, before embarking on a vast array of costly and speculative interventions in the financial system, we might be well served by trying to get money right. It might then turn out that many of the supposed problems of finance are not as big as we thought.

This chapter looks at the imbalance between financial-market power in branding states and state power in taming financial markets. It examines collective-action problems in the face of the various channels and instruments of financial-market power, including regulatory and tax arbitrage and regulatory capture. The Basel agreements are used as case studies of these problems. The chapter addresses the question of why creditors originate problems for states. It examines the impacts of digitalization, globalization, and the de-synchronization of state and market time. Particular attention is paid to the distinctive character of financial markets, including the compound of fear and greed that plays such a vital part in their ‘animal spirits’. The chapter analyses in depth the distinctive configuration of power in sovereign-bond markets, focusing on the role of the Primary Dealer investment banks. Finally, the chapter examines the cultural, social, and political consequences of financial-market power.

This chapter reviews the modern theoretical literature on banking and bank runs. In particular, it examines the three leading modern theories of banking in the academic literature, and it identifies problems with each of them. One of these theories, sometimes called the “risk sharing” theory, receives special attention because it forms the basis for the canonical model of bank runs: the famous Diamond-Dybvig model. The chapter offers a critique of this model on the basis of its underlying theory of banking, which is essentially nonmonetary. Next, the chapter argues that financing structure “matters” for banks in a way that it does not for other firms—a proposition that has recently been challenged by prominent financial economists. The chapter concludes with a fairly detailed account of the shadow banking panics of 2007 and 2008. It shows how the analysis of the first three chapters provides a framework for understanding these events.

The Glass-Steagall Act created a decentralized financial system composed of three separate and independent financial sectors—commercial banking, securities markets, and insurance. The Bank Holding Company Act of 1956 reinforced Glass-Steagall’s policy of structural separation by prohibiting bank holding companies from engaging in any activities that were not “closely related to banking.” Glass-Steagall’s structural barriers prevented the occurrence of systemic financial crises for more than four decades. During that period, federal regulators could deal with problems arising in one financial sector without need to rescue the entire financial system. Despite Glass-Steagall’s success, federal agencies and courts undermined its prudential buffers during the 1980s and 1990s by opening loopholes. Those loopholes allowed banks to convert their loans into asset-backed securities and to offer derivatives that functioned as synthetic substitutes for securities and insurance products. Regulators and courts also allowed money market mutual funds and other nonbanks to issue short-term financial claims that served as deposit substitutes, despite Glass-Steagall’s prohibition against deposit-taking by nonbanks.

This chapter reviews the modern theoretical literature on banking and bank runs. In particular, it examines the three leading modern theories of banking in the academic literature, and it identifies problems with each of them. One of these theories, sometimes called the “risk sharing” theory, receives special attention because it forms the basis for the canonical model of bank runs: the famous Diamond-Dybvig model. The chapter offers a critique of this model on the basis of its underlying theory of banking, which is essentially nonmonetary. Next, the chapter argues that financing structure “matters” for banks in a way that it does not for other firms—a proposition that has recently been challenged by prominent financial economists. The chapter concludes with a fairly detailed account of the shadow banking panics of 2007 and 2008. It shows how the analysis of the first three chapters provides a framework for understanding these events.

Large banks and their political allies waged a twenty-year campaign to secure legislation that would remove the structural buffers established by the Glass-Steagall and Bank Holding Company Acts. That campaign triumphed in 1999, when Congress passed the Gramm-Leach-Bliley Act (GLBA). GLBA authorized the creation of financial holding companies that owned banks, securities firms, and insurance companies. In 2000, Congress passed the Commodity Futures Modernization Act (CFMA), which exempted over-the-counter derivatives from substantive regulation by the federal government or the states. GLBA and CFMA enabled large U.S. banks to become universal banks for the first time since the 1930s. Large U.S. securities firms responded by becoming shadow banks (and de facto universal banks) through their issuance of deposit substitutes (shadow deposits). Similar patterns of deregulation encouraged the growth of large universal banks in the U.K. and Europe. A group of seventeen U.S., U.K., and European financial conglomerates dominated global financial markets by 2000.

This chapter begins with a micro-history of the Great Crash of 2007–8. It describes the instruments, transactions, size, and growth of the shadow banking system in the years before the crash. Heralded with widespread affirmation by public decision makers and intellectuals, the new financial architecture received only occasional criticism from within. The chapter describes the construction of the financial system—both the history of its development and how the networks and connections looked on the eve of the crisis. Despite the dangerous warning signs offered by a series of regional crises on the periphery, advocates plowed ahead with certainty that the market could not be wrong. When the crash came, many experts broke briefly with orthodoxy, but most have returned rapidly to their faith in financial markets. A more technical appendix, “The Realm of Shadow Finance: How and How Much” details the shadow banking system.

This chapter examines how the deregulation of financial markets allowed the dramatic growth of a shadow financial system of special investment vehicles, highly leveraged hedge funds, and private equity. The nonbank financial firms and the products they buy and sell are widely seen as a second banking system that grew up apart from, but not unconnected to, the older financial system. The shadow banking system includes hedge funds, private equity groups, insurance companies, money market funds, and pension funds, among others, and features funding sources involving the use and reuse of collateral posted with banks and others to finance transactions that show up as non-balance-sheet funding. This chapter argues that any analytic separation of a regulated banking system from a shadow system should be entertained with caution, suggesting that the commercial and investment banks, owing to their heavy use of the overnight repurchase market, were in the most serious trouble when their lenders refused to roll over short-term loans.

China’s surging debt levels and an overheated property market have led many to believe that the country is headed for an economic collapse. Yet the argument that China is facing a financial crisis is overstated. China’s debt problem is largely confined to the state sector; its property market is not about to implode; and there is little evidence of widespread insolvency. The risks of shadow banking are also not as serious as many have argued. While the government has the discretionary resources to manage the situation, a set of SOEs does face serious financial problems and the country’s financing modalities are creating risks. Most observers see the banking system as the source of these problems, but the solution begins with reforming China’s fiscal system and restructuring management of SOEs. Addressing these issues would lead to a more financially sustainable growth path over the coming decade.

The 2008 global financial crisis thus was not just a garden-variety, white swan, business cycle event. It was a long time coming, and prospects for a repetition depend on whether underlying structural disequilibria, including political indiscipline, are redressed. Factors that either triggered the 2008 financial crisis or that reinforced its severity could be listed as follows: (1) an evolving deregulatory consensus, especially concerning financial institutions; (2) the notion that government insurance guarantees, off-budget unfunded obligations such as social security, and mandated preferences to savings and loan banks were innocuous, despite the savings and loan debacle of the late 1980–1990s; (3) an indulgent attitude toward destructive financial innovation apparent in the 1987 “program trading” and 2000–2002 “dot-com bubble” stock market crashes,5 as well as the 1998 Long-Term Capital Management hedge fund collapse6; (8) a permissive approach to financial auditing, including mark to face valuation for illiquid securities; (4) the creation of a one-way-street, too-big-to-fail mentality that transformed prudent business activity into a venal speculative game on Wall Street, main street, and in Washington; (5) the emergence of “institutional” bank runs, where financial and nonfinancial companies flee repurchase (repo) agreements; and more. The Chapter surveys the creation of the credit bubble and its sudden burst.

Chapter 2 tells the story of the crash as it unfolded. At that moment much of the public discovered a previously hidden world of obscure financial instruments and deals. Prior to the crash, the public might get only occasional glimpses of high finance when one of its components failed. In 2007, almost the entire system came crashing down. The complexity and tight coupling of the shadow banking system had created the possibility of a chain reaction and in 2007 and 2008 the chain was yanked tight. These events shocked the general public, most economists and most of the shadow bankers themselves.

This chapter examines an alternative view on the development of Chinese banking over the past fifteen years. In this view, the banking transformation initiated by Zhu Rongji stalled: Chinese banks today look modern, but they rest on fragile foundations and will encounter severe difficulties. A constant critical barrage from media and assorted pundits who lack understanding of how the Chinese system works lead to a negative consensus on Chinese banks. Chinese economy and its banks do face real issues and challenges: high debt levels, shadow banking, real estate overbuilding, local government debt, and the challenge of transitioning to the “New Normal.” In addition, the change in the banking industry poses new threats to banks: lack of private sector lending experience, disintermediation from development of non-bank alternative funding channels, and digital disintermediation.

The chapter argues that market-based financial systems will experience episodes of booms and bust, even if regulation can reduce their likelihood and severity. It sees significant risk in the shadow banking world, which has grown rapidly in recent years and yet is still not well understood. The chapter calls for greater efforts toward cataloguing the asset classes, organizations and activities involved in shadow banking, and toward developing the right set of regulatory tools.