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Shadow banking is a topic I haven't heard discussed much, if at all, by Objectivists. Maybe I don't read enough Objectivist blogs or forums or listen to enough Objectivist podcasts. Anyway, I used the search function on this site and entered "shadow banking" but got no results.

In a nutshell, there supposedly exists a vast "shadow banking system" that is mostly untouched by regulators. Investopedia defines it as follows:

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A shadow banking system refers to 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, while examples of unregulated activities by regulated institutions include credit default swaps.

(http://www.investopedia.com/terms/s/shadow-banking-system.asp)

Then there's this from Investing Answers:

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Shadow banking institutions generally serve as intermediaries between investors and borrowers, providing credit and capital for investors, institutional investors, and corporations, and profiting from fees and/or from the arbitrage in interest rates.

Because shadow banking institutions don't receive traditional deposits like a depository bank, they have escaped most regulatory limits and laws imposed on the traditional banking system. Members are able to operate without being subject to regulatory oversight for unregulated activities. An example of an unregulated activity is a credit default swap (CDS).

And it goes on like this wherever you search on the subject. Every supposedly legitimate source treats this so-called "shadow banking system" that is allegedly shielded from regulations as a reality. Economist Paul McCulley is credited with coining the term in 2007, but supposedly this system has existed for decades without being threatened by lawmakers in any meaningful way. As the story goes, the shadow banking system played an important part in causing, or least exacerbating, the 2008 financial crisis. Wikipedia puts it thus:

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The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions - but it has been common practice for investment banks to conduct many of their transactions in ways that do not show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors.[10] For example, prior to the 2007-2012 financial crisis, investment banks financed mortgages through off-balance sheet (OBS) securitizations (e.g. asset-backed commercial paper programs) and hedged risk through off-balance sheet credit default swaps.[10] Prior to the 2008 financial crisis, major investment banks were subject to considerably less stringent regulation than depository banks. In 2008, investment banks Morgan Stanley and Goldman Sachs became bank holding companies, Merrill Lynch and Bear Stearns were acquired by bank holding companies, and Lehman Brothers declared bankruptcy, essentially bringing the largest investment banks into the regulated depository sphere.

(https://en.wikipedia.org/wiki/Shadow_banking_system)

And:

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Hervé Hannoun, Deputy General Manager of the Bank for International Settlements described the structure of this shadow banking system at the annual South East Asian Central Banks (SEACEN) conference.(Hannoun 2008)[7]

"With the development of the originate-to-distribute model, banks and other lenders are able to extend loans to borrowers and then to package those loans into ABSs, CDOs, asset-backed commercial paper (ABCP) and structured investment vehicles (SIVs). These packaged securities are then sliced into various tranches, with the highly rated tranches going to the more risk-averse investors and the subordinate tranches going to the more adventurous investors."

— Hannoun, 2008

Variations on this narrative have been repeated by politicians, regulators and news analysts ever since the crisis, but it wasn't until a few years ago that the term "shadow banking" started to become mainstream (at least, that has been my observation). The term connotes a sinister conspiracy, and yet analysts and politicians in the know have apparently been well aware of these practices for a long time, going back to well before the subprime crisis. Leftist politicians like Bernie Sanders decry the SBS, but they don't actually do anything to regulate it in any meaningful way. Supposedly even Dodd-Frank did very little to address SBS practices.

I have heard Objectivists argue that it's ridiculous to say the financial crisis was caused by lack of regulations, after all there were a ton of banking regulations in effect and basically it was the government's fault for creating a moral hazard after decades of repeated bank bailouts that only encouraged more risky lending. While these are reasonable arguments, they don't directly address the allegations that investment banks, at least prior to the meltdown, were not as heavily regulated as traditional depository banks, and so they were able to conceal their activities in the SBS until everything imploded (this is a deliberate oversimplification of the allegations, I am not heavily versed in lending jargon). Now, I'm sure that politicians and the media have exaggerated at least some facts about SBS practices, and probably have exaggerated the size and scope of the SBS, all in order to make the public scared of a rogue banking system that could easily run wild and cause a repeat of 2008. Nevertheless, I'm very interested to know just exactly how true their claims are. Is all of it B.S., or just some of it?

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Not what you're asking (I can't really answer your actual question), but, just in case there's any confusion about this: Objectivism is opposed to regulation, but it is in favor of contract enforcement and the protection of individual rights in general. More importantly, it is in favor of a market ruled by objective laws.

This market, like all black markets, doesn't just lack regulation, it also lacks the other things (for the most part...I guess off shore jurisdictions can in theory provide them...they just don't always do so reliably). Black markets are also under threat from powerful nation states, so they tend to attract unscrupulous, incompetent, and even violent participants.

So black markets are not capitalist, free markets. They are not the kind of markets Objectivism, or most free market advocates, call for. Far from it. That's probably why you don't see notable Objectivists try and defend them.

P.S. The shadow banking system also serves to hide the wealth of dictators, corrupt politicians and oligarchs, and organized crime syndicates. In fact, it probably caters more to that category of clients than the western private sector.

 

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10 hours ago, NewbieOist said:

Nevertheless, I'm very interested to know just exactly how true their claims are.

Since you say you don't have much of a background on the topic, let's start with a really trivial example: you, as an individual could lend money to another individual, and you would not be regulated as a bank. If the borrower does not pay you back, you will suffer a loss. If a lot of people lend money this way, and the economy turns down, many borrowers may not be able to pay back their loans, and a lot of such lenders will suffer losses. 

Lending: Now, one small step up: imagine you do not know anyone worth lending to, but you have a friend who has a lot of family/friends,  who run some type of businesses (gas stations, corner stores, restaurants, etc.). You -- and many like you who trust him -- lend him money, and he figures out whom he trusts and how much, and he lends the money to them. When they pay interest or return the principal, ... that's when he returns it to you. Once again, if a higher than average number of borrowers turn out to be duds, then the lenders ultimately suffer. 

Next, imagine the middleman is personally wealthy. So, he tells you that he will pay you from his pocket, if the actual borrowers don't. This provides some degree of buffer. Now, to make it more realistic, imagine a billion-dollar company that borrows money for various investors and lends it to borrowers. 

None of these examples are quite completely "banking" in the sense meant by McCulley; rather, they're "lending".  Lending has its own regulations, but they're not banking regulations. Folk like McCulley would not include any of the above as being shadow banking.

 Banking: Now, imagine the middle man says that you do not have to wait for the original borrowers to repay their loans. If you suddenly need your cash, he will pay you back out of his own money, because he's confident that others will be depositing more money anyway, and he also has other ways of getting additional cash. This is where things become "banking" in the sense meant by the term "shadow banking". This is where some new benefits and risks come in. 

The key difference in such a system is that the original borrower has been given a certain amount of time to pay, but the original lender has been told he can have his funds back sooner. This is called a "duration mismatch". The middleman keeps a reserve of money from which he pays folk who want to withdraw. As they withdraw, others make deposits. If people withdraw from one bank and deposit in another, one bank can then borrow back the funds from the other bank. The system works pretty well most of the time. This system is called a "Fractional Reserve System" since the bank does not keep all the cash on hand that depositors may theoretically withdraw; it only keeps enough to meet the normal range of activities. 

The danger arises if lots of depositors demand their money back because they fear they will not get it if they leave it in. The bank does not have the money and isn't going to get it quickly. That's the "run on the bank". It becomes particularly problematic if there is a run not just on one or two banks, but on banks as such. That's when it becomes a banking panic. [Aside: Some libertarians say that it should be illegal for bankers to promise to pay out "on demand" if they do not hold 100% of the possible cash that might be withdrawn.]

Panics and response: There have been repeated panics across history. Over decades, people (aka the market) figured out various ways to address the issue of duration-mismatch and thus bank-runs. But, a full and robust solution had not yet evolved. In parallel, the government also started to build systems that would take on some of the risk. When the government takes on risk, the market sees no need to plan for that risk. So, this undercut the private systems that were evolving. Also, when the government takes on risk, it cannot do so willy-nilly. It has to specify rules that the lenders should follow, in order to get government protection. 

Shadow banking: Finance is pretty sophisticated these days, with some very complex instruments available. Companies that are not banks can buy and sell combinations of instruments that leave them with huge "duration risk". Yet, when they do not do so in the normal way of having deposit accounts etc. they don't have to follow the rules that apply there. That's shadow banking.

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So there is "duration mismatch" and "duration risk".

A "duration balance" would be where the borrower and the lender have a contractual agreement and the lender rides out the duration of the terms of the loan, where the lender's only risk is default, and the borrower is bound by the original agreement penalties.

A "duration mismatch" is where the borrower and the lender have a contractual agreement, and the lender "sells" out the duration of the terms of the loan to a third party. In essence, the "duration risk" is sold to a third party for an agreed upon, or contractual agreement transferring the "default risk" of the lender to a third party.

If this is being assessed correctly, shadow banking amounts to little more than peddling  the "duration risk", a.k.a. "default risk", while potentially transferring the onus of responsibility for the repayment of the original loan (and consequences of default) from the original borrower to one of the intermediate "risk takers",

In a slightly different scenario, an apartment is subleased. The original lease holder, is still responsible for any damages that may arise on the property. In subleasing the property, the "responsibility" of the rent and/or damage liability is passed on to the sub-leaser.

If I am reading this cogently,

In the case of an apartment, if damage is done by a sub-lessor of the property, the manager's recourse is limited to the original lessor.

In the case of a loan, the default risk is passed on via any "agreed upon price" for the remainder of the loan. The original borrower is still bound the the terms of the original contract.

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7 hours ago, softwareNerd said:

Panics and response: There have been repeated panics across history. Over decades, people (aka the market) figured out various ways to address the issue of duration-mismatch and thus bank-runs. But, a full and robust solution had not yet evolved. In parallel, the government also started to build systems that would take on some of the risk. When the government takes on risk, the market sees no need to plan for that risk. So, this undercut the private systems that were evolving. Also, when the government takes on risk, it cannot do so willy-nilly. It has to specify rules that the lenders should follow, in order to get government protection.

I'm trying to connect this with the idea of shadow banking. So the government takes on the risk of lenders, including non-bank lenders. The non-bank lenders are still subject to lending regulations when they make loans, but what about when they buy and sell loans? Treating loans as financial instruments, that's shadow banking, right? So that's not subject to banking regulations, but is it subject to any regulations? Isn't the whole idea of shadow banking to keep all these trillions of dollars in transactions off the books and away from the eyes of regulators? So when the sh*t hit the fan in the shadow banking system in 2008 and all these "banks" had to be bailed out, the government was essentially caught off-guard and had no idea how deep a hole these companies had dug themselves into.

Proponents of more regulations would then argue that there needs to be stricter oversight of financial transactions, effectively doing away with shadow banking and off-the-books transactions. In this hypothetical revamped financial system, the government would be able to see when too much risk has been accumulated and step in before a crisis can happen. Now obviously the question of how the government would be able to know everything the companies are doing all the time without morphing into an Orwellian (or Kafka-esque) bureaucracy is conveniently sidestepped by regulations proponents. Nor will they listen to the argument that what we need to do is outlaw bailouts altogether so that we don't create moral hazards in the system. They dismiss that as being "too idealistic" and "impractical". "We don't need to go to extremes," they say. "We're never going back to the days when companies were completely on their own, so we must accept a compromise that allows bailouts but at the same time enables the government to contain risk."

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Isn't a financial institution that makes risky loans that is subject to loss and failure being "regulated" in a sense?

Does it make sense that when a company is insulted from responsibility for its own actions that this is called "regulated" whereas one that is held accountable is "unregulated"?

Unless you clarify what you mean by regulation, this isn't helpful. What ultimately matters is what kind of regulation should prevail and what are its effects.

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