What We Don’t Talk About When We Talk About Shadow Banking – Real Time Economics

“There are no shadow banks,” Mr. Pozsar writes. “Just a shadow banking system.”
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Shadow banking–or financial activities outside the traditional banking system–is generally mentioned in the context of an uncertain future: Financial firms are providing new types of products and services in nontraditional ways, and academics and regulators are watching and worried about potential risks in a largely unregulated sector.

But some economists say we should focus on the past to understand why new forms of banking are emerging and why have they grown so fast.

One answer: Underfunded U.S. pension funds. According to a new draft paper from Zoltan Pozsar, a former senior advisor at the U.S. Treasury Department and now a director at Credit Suisse AG, the answers lies in fundamental changes in the economy, including the need for pension funds to earn enough money to pay retirees.

Mr. Pozsar, best known as the lead cartographer of a ridiculously complicated map of the shadow-banking system published by the New York Fed in 2010, this time paints a picture of shadow banking that doesn’t require a microscope to read. Rather than an exotic ecosystem created by money-hungry Wall Street types, Mr. Pozsar’s shadow banking system is fundamental to the way the U.S. financial system functions today. It is the result of structural changes in the economy, it’s not going anywhere, and in order to grapple with it, policy makers are going to have to deal with some tough policy questions, such as the age at which Americans retire.

Money in the traditional banking system comes from deposits. Mr. Pozsar describes three large sources of the shadow banking system’s cash: Reserves held for the purposes of exchanging and trading currencies, cash held at corporations, and cash held by asset managers (for instance, the cash held by mutual funds for buying stocks or bonds, for use as collateral when lending those securities, and for margin on derivatives). On any given day, there is $5 trillion or more sitting in these pools. That’s trillion with a “T.”

The owners of all those dollars have something in common: They want a safe place to store them, and they want to be able to withdraw them on demand. Bank accounts are only insured up to $250,000, so that won’t fit the bill. The safest investment in the world–U.S. Treasury bills–aren’t available in enough supply. The next-best remaining option for these firms is the shadow banking system. Using repurchase agreements or similar transactions, they can lend out their cash on a short-term basis, with Treasurys or other safe assets as collateral.

On the other side of the equation are bond portfolios held by pension funds and other investors, who are seeking low-volatility investments with better-than-average returns. These investors and their fund managers are happy to post some of their bonds as collateral in exchange for short-term cash loans, which they can reinvest at a small profit. This sort of “leverage” is fundamental to the way bond portfolios work today, Mr. Pozsar says. (The mutual fund industry says its leverage is limited.)

In the middle, broker-dealers, many of which are part of the largest U.S. banks, facilitate all these transactions. “There are no shadow banks,” Mr. Pozsar writes. “Just a shadow banking system.” On most days, the system works fine. But it is also prone to collapse, as occurred in 2008 when cash investors, spooked by broader market problems, suddenly became concerned about the security of short-term loans and pulled their money back.

That experience is one reason why regulators have been worried about the risks that shadow banking poses. But Mr. Pozsar suggests that unless policy makers acknowledge the causes of shadow banking–cash managers seeking safety and investors like pension funds seeking risk—it’s likely they’ll only be treating its symptoms.

Take the pension funds. U.S. regulators could take actions to reduce the amount of cash in the shadow banking system, but as long as pension managers have more liabilities to retirees than they do assets to pay them, they will still be looking to beat their benchmark returns and seek out that extra bump in “leverage.” If they can’t juice their returns via the current shadow banking system, they might be even more desperate as they look for other avenues to do so—outsides of the ones regulators restrict.

Related reading:

IMF: Shadow Banks ‘Could Compromise Global Financial Stability’

Regulators Are in the Dark on Shadow Banking, Says BOE’s Cunliffe

Fed Must Remain Vigilant For Financial Stability Risks: Paper

Fed’s Yellen Says Regulating Shadow Banks a ‘Huge Challenge’



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17 March 2015 | 1:57 pm – Source: blogs.wsj.com


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