May 31, 2012
What is shadow banking?
"Shadow banking is a market-funded, credit intermediation system involving maturity and/or liquidity transformation through securitization and secured-funding mechanisms. It exists at least partly outside of the traditional banking system and does not have government guarantees in the form of insurance or access to the central bank."
As the Deloitte study makes clear, this definition is fairly narrow—it doesn't, for example, include hedge funds. Though Deloitte puts the size of the shadow banking sector at $10 trillion in 2010, other well-known measures range from $15 trillion to $24 trillion. (One of those alternative estimates comes from an important study by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky from the New York Fed.)
What definition of shadow banking you prefer probably depends on the questions you are trying to answer. Since the interest in shadow banking today is clearly motivated by the financial crisis and its regulatory aftermath, a definition that focuses on systemically risky institutions has a lot of appeal. And not all entities that might be reasonably put in the shadow banking bucket fall into the systemically risky category. Former PIMCO Senior Partner Paul McCulley offered this perspective at the Atlanta Fed's recent annual Financial Markets Conference (video link here):
"...clearly, the money market mutual fund, that 2a-7 fund as it's known here in the United States, is the bedrock of the shadow banking system...
"The money market mutual fund industry is a huge industry and poses massive systemic risk to the system because it's subject to runs, because it's not just as good as an FDIC bank deposit. We found out that in spades in 2008...
"In fact, I can come up with an example of shadow banking that really didn't have a deleterious effect in 2008, and that was hedge funds with very long lockups on their liability. So hedge funds are shadow banks that are levered up intermediaries, but by having long lockups on their liabilities, then they weren't part and parcel of a run because they were locked up."
The more narrow Deloitte definition is thus very much in the spirit of the systemic risk definition. But even though this measure does not cover all the shadow banking activities with which policymakers might be concerned, other measures of the trend in the size of the sector look pretty much like the one below, which is from the Deloitte report:
The Deloitte report makes this sensible observation regarding the decline in the size of the shadow banking sector:
"Does this mean that the significance of the shadow banking system is overrated? No. The growth of shadow banking was fueled historically by financial innovation. A new activity not previously created could be categorized as shadow banking and could creep back into the system quickly. That new innovation might be but a distant notion at best in someone's mind today, but could pose a systemic risk concern in the future."
Ed Kane, another participant in our recent conference, went one step further with a familiar theme of his: new shadows are guaranteed to emerge, as part of the "regulatory dialectic"—an endless cycle of regulation and market innovation.
In getting to the essence of what the future of shadow banking will (or should) be, I think it is instructive to consider a set of questions that were posed at the conference by Washington University professor Phil Dybvig. I'm highlighting three of his five questions here:
"1. Is creation of liquidity by banks surplus liquidity in the economy or does it serve a useful economic purpose?
"2. How about creation of liquidity by the shadow banking sector? Was it surplus? Did it represent liquidity banks could have provided?...
"5. If there was too much liquidity in the economy, why? Some people have argued that it was because of too much stimulus and the government kept interest rates too low (and perhaps the Chinese government had a role as well as the US government). I don't want to take a side on these claims, but it is an important empirical question whether the explosion of the huge shadow banking sector was a distortion that was an unintended side effect of policy or whether it is an essential feature of a healthy economy."
Virtually all regulatory reforms will entail costs (some of them unintended), as well as benefits. Sensible people may come to quite different conclusions about how the scales tip in this regard. A good example is provided by the debate from another session at our conference on reform of money market mutual funds between Eric Rosengren, president of the Boston Fed, and Karen Dunn Kelley of Invesco. And we could see proposals by the Securities and Exchange Commission in the future to enact further reforms to the money market mutual fund industry. But whether any of these efforts are durable solutions to the systemic risk profile of the shadow banking sector must surely depend on the answers to Phil Dybvig's important questions.
By Dave Altig, executive vice president and research director at the Atlanta Fed
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April 13, 2011
How has the financial system changed? (And what to do about it)
The subject of this post's title was, in essence, the centerpiece of the most recent edition of the Atlanta Fed's annual Financial Markets Conference, convened this year in Stone Mountain, Ga. (just outside Atlanta). In terms of formal papers, the conference was bookended by work that came to very similar conclusions but from very different angles. From the vantage point of recent developments in micro banking structure, Arnoud Boot offered this diagnosis:
"A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability."
Taking the very long view, Moritz Schularick presented (from a paper co-authored with Alan Taylor) pretty compelling evidence that the ongoing shift from relationship banking to transactions-based banking has fundamentally altered the nature of financial developments on real activity in modern economies:
"We first document and discuss our newly assembled dataset on money and credit, aligned with various macroeconomic indicators, covering 14 developed countries and the years from 1870 to 2008. This new dataset allows us to establish a number of important stylized facts about what we shall refer to as the 'two eras of finance capitalism.' The first financial era runs from 1870 to 1939. In this era, money and credit were volatile but over the long run they maintained a roughly stable relationship to each other, and to the size of the economy measured by GDP. The only exception to this rule was the Great Depression period: in the 1930s money and credit aggregates collapsed. In this first era, the one studied by Friedman and Schwartz, the 'money view' of the world looks entirely plausible. However, the second financial era, starting in 1945, looks very different. With the banking sector progressively more leveraged in the second financial era, particularly towards the end, the divergence between credit supply and money supply offers prima facie support for the credit view as against a pure money view; we have entered an age of unprecedented financial risk and leverage, a new global stylized fact that is not fully appreciated."
If there was agreement on increasing threats to financial stability, what to do about it (unsurprisingly) was somewhat more controversial. On the microprudential front, several conference participants—Viral Acharya, for example—looked to greater capital buffers as a key to greater financial stability. Others—George Kaufman commenting on Boot's paper, for instance—were more inclined to rely on market solutions. Boot, for his part, was highly skeptical of the self-correcting market forces and, while sympathetic to greater reliance on bank capital, believes much more is required:
"What we have also argued is that market discipline might be rather ineffective. We described this as a paradox. When particular strategies have momentum in financial markets, the market as a whole may underestimate the risks that these entail. How then can we expect market discipline to work? It appears to us that market discipline might not be present when banks follow financial market inspired strategies. Things are even worse because these strategies will lead to a high correlation in actual exposures between financial institutions because all see the same opportunities and hence herding occurs. Systemic risk would then be considerable and not checked by market discipline."
Earlier in the paper, Boot puts forward:
"We believe that heavy handed intervention in the structure of the banking industry—building on the Volcker Rule—might ultimately be an inevitable part of the restructuring of the industry. It could address complexity but also help in containing market forces that might run orthogonal to what prudential concerns would dictate (as the insights on market discipline in section 6 suggest). For now, the structural interventions in the banking industry are rather tentative. Other measures such as higher capital and liquidity requirements are clearly needed. But these primarily focus on individual institutions while a more system-orientation is crucial to identify externalities and interlinkages (Goodhart, 2009; and Calomiris, 2009). Anti-cyclical capital surcharges and other measures and surcharges depending on the degree of interconnectedness are needed as well to add some further comfort. We tend to subscribe to John Kay's (2009) notion of redundancy: having comfort in the stability of the financial sector dictates building redundancy into the regulatory and supervisory structures of banking."
With respect to "system-oriented" signals, Schularick was clear where he and his co-author think their research leads:
"These new results from long-run data, if they pass scrutiny, inform the current controversy over macroeconomic policy practices in developed countries. Specifically, the pre-2008 consensus argued that monetary policy should follow a 'rule' based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst."
Credit and bank capital—along with sound fiscal policy and a little good luck—do appear to have been key to how well different economies fared during the recent financial crisis. At least that is the conclusion reached in a study by Stephen Cecchetti and his co-authors from the Bank of International Settlements:
"The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part."
As we seek to shore up our financial timber to avoid a repeat of recent history, it is appropriate to remember that, while it is good to be lucky, fortune is probably not arbitrary in choosing where it will shine.
By Dave Altig
senior vice president and research director at the Atlanta Fed
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April 01, 2009
Snapping ropes and breaking bricks
James Hamilton of Econbrowser is concerned about the current state of monetary policy. On the blog, Jim writes:
"I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.
"The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward."
After I looked up "pullulating," I found much to agree with in Professor Hamilton's description—or at least I did up to that last sentence. I certainly share his discomfort with a presumption that "Fed officials are better able to make… decisions than private investors," but that doesn't quite capture my view—and I emphasize my view—of how nontraditional policy is supposed to work. My own description of what the "fundamental transformation" of central bank policy is all about appears, hot off of the virtual press, in the first quarter issue of EconSouth, the Atlanta Fed's regional economics publication:
"I have a simple way of thinking about how monetary policy works. Imagine a long rope. At one of end of the rope are short-term, relatively riskless interest rates. Farther along the rope are yields on longer-term but still relatively safe assets. Off at the other end of the rope are multiple tethers representing mortgage rates, corporate bond rates, and auto loan rates—the sorts of interest rates that drive decisions by businesses and consumers. In the textbook version of central banking, the monetary authority grabs the short end of this allegorical rope, where the federal funds rate resides, and gives it a snap. The motion ripples down and hopefully reaches longer-term U.S. Treasury rates, which then relay the action to other market interest rates, where the changes reverberate throughout the economy at large.
"That's the story in normal times, and over the past year and a half the Federal Open Market Committee (FOMC) has done a fair bit of rope-snapping. In August 2007 the FOMC set the federal funds rate target—the overnight rate on loans made between banks—at 5.25 percent. As of December 2008, the rate target was lowered to a very low range of 0–0.25 percent. As the committee noted then (and reiterated in January), 'weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.'
"These FOMC statements held another extremely important message: 'The focus of policy going forward will be to support the functioning of financial markets and stimulate the economy.' In a speech to the National Press Club on Feb. 18, Federal Reserve Chairman Ben Bernanke elaborated:"
'Extraordinary times call for extraordinary measures. Responding to the very difficult economic and financial challenges we face, the Federal Reserve has gone beyond traditional monetary policy making to develop new policy tools to address the dysfunctions in the nation's credit markets.'
"One way to view the effects of those credit market dysfunctions is to imagine that someone had placed a series of bricks at strategic points along the segment of rope connecting short-term interest rates to broader market rates. With these bricks in place, it is simply not enough for a central bank to keep snapping short-term interest rates: The bricks—dysfunctions in the markets—will keep the impulse from being transmitted to the interest rates that are directly connected to market outcomes. Thus, a new set of policy instruments is needed, instruments that allow the monetary authority to circumvent blockages in the monetary transmission mechanism."
The "policy instruments" I have in mind, of course, are the pullulating new facilities that have Jim Hamilton worried. But it is worth emphasizing that many of these facilities are motivated by "unusual and exigent circumstances," a point emphasized in the recent Treasury-Federal Reserve statement (which is discussed in some detail by Tim Duy):
"As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system."
How long will those conditions persist? Returning to my EconSouth commentary:
"No set timetable exists, but one would presume that as long as the bricks of market dysfunction are lying around, the tools will be necessary. Eventually, of course, markets will heal, the bricks will crumble, and the stage will be set to a return to business as usual in monetary policy and the economy. The sooner the better, but in the meantime it's helpful to have the tools in hand to start cracking the bricks."
That's my story, and I'm sticking to it.
By David Altig, senior vice president and research director of the Atlanta Fed
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September 30, 2008
On rescues and bailouts
I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:
I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.
I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.
It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.
I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?
Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.
Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?
UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.
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» The "House on Fire" Hypothetical from At These Levels
Dave Altig of the Atlanta Fed explains the rescues-and-bailouts dilemma:Ive been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have [Read More]
Tracked on Sep 30, 2008 8:52:26 PM