Arnold Kling  

The Shadow Banking System

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Perry Mehrling says,


The idea of the shadow banking system was in some way, not only tolerated by regulators, but encouraged by regulators. They thought, "Let's get some of these risks off the balance sheet of the traditional banking system. Let's get interest rate risk off the balance sheet of the traditional banking system. Let's get credit risk off the balance sheet of the traditional banking system." They thought that would be a good thing. The traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. It was avoiding the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system.

The first sentence is important. If you read through the papers coming out of the regulatory community from 2000 through 2006, I will bet that you find many more references to "better dispersal of risk" or "innovative risk management tools" than to concerns about shadow banking. The fact is, we had regulators looking at the issue of systemic risk, and most of them were saying it was all ok.

An interesting tidbit:


UBS started to say if AIG isn't going to sell us insurance at this cheap rate, we are going to make a plan to buy just 2% insurance and then make a plan to do "dynamic hedging" ourselves, which is a problem. That means when the price goes down, we sell, assuming that there would be a buyer on the other side.

Merhling's solution is for the government to be a risk insurer of last resort. That sounds to me like Freddie Mac and Fannie Mae, which did not work well at all. But Merhling says,

the important thing for government intervention here is to get that price closer to a reasonable rate...

Thus, the insurer of last resort has to charge a very high premium.

With all due respect to Professor Mehrling, I think that this is unworkable. The market will figure out a way to make the insurer of last resort take much more risk than it thinks it is taking. That is what the market did to AIG, as Merhling points out. I see no reason to expect that the government insurer will always be able to outsmart the market.

UPDATE: More on the Mehrling diagnosis and the Mehrling prescription.


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COMMENTS (5 to date)
Niccolo writes:

So what exactly is a "reasonable rate" for Mehling? What arbitrary number is he going to throw out there?

Vichy F. writes:

"I see no reason to expect that the government insurer will always be able to outsmart the market."
Edit:
"I see no reason to expect that the government insurer will ever be able to outsmart the market."
Especially since it's not clear how we can imagine what 'outsmarting the market' would even imply. Prices and monetary costs don't exist until people have actually arrived at an exchange. There is just no logical point of reference to compare an imposed situation to the catallactic one which could never come to pass.
There is no such thing as 'price' information outside of the market, and the government basically has a constant institutional demand that almost forces it to think back-assward.

Karl Smith writes:

Arnold

Isn't the government the insurer of last resort anyway? In case of systemic risk it falls to the government to prop the system up or risk economic collapse.

Wouldn't there be a benefit to making this explicit, in that the government could at least collect premiums?

q writes:

i don't know whether it is worth the time to bother criticizing this sort of thing as it is completely unworkable politically. but to point out the obvious and indisputable:

-- there would be no way to estimate the premium for this insurance, and near a crisis any estimate of the premium would be so dear that it would become prohibitively expensive leading to a breakdown in market liquidity, which is exactly what it tries to address. the only way it works is if the insurance stays uneconomically cheap during a crisis, which begs the question: why not wait until a crisis occurs to offer it? well, we did, and we are, in a way.

-- most financial crises stem from currency rate problems (ie borrow estonian, pay back euro) and the fed can only print dollars

-- money paid to the fed from banks and holding companies as premium would be destroyed or used to fund federal operations -- because the fed is charged with maintaining monetary levels it would want to create that money elsewhere in the system to keep growth where they want it. so it couldn't be seen as as 'savings' to be applied during a disaster.

-- payouts during a crisis would depend on political conditions anyway. this is analogous to the social security 'trust fund'.

-- the real problem is that this would cause the government / financial system to decide on its crisis actions long in advance of an actual crisis and without knowing the nature of the crisis or prevailing politics at the time of the crisis. in the present crisis, losses in US banks are going to be about $1-$1.5T -- what if the losses were going to be $10T? in that case you might just let the system crash and deal with the wreckage later.

etc.

Zz's writes:

Karl,

"Wouldn't there be a benefit to making this explicit, in that the government could at least collect premiums?"

The government already collects premiums. Unfortunately, there is no negotiation on price and without a drastic relocation there are no other providers of this type of insurances. :)

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