The Shadow Banking Sector
Executive Summary
- Shadow banking is even more corrupt than normal megabank banking and it is a major risk to the banking system.
Introduction
The lack of coverage of shadow banking is a serious issue with understanding private banking. More and more banking is moving away from transparent companies and into the opaque world of shadow banking.
This is explained in the following quotation.
“Today, the commercial lending business has largely migrated to unregulated intermediaries belonging to the shadow banking system, a sector that includes mutual funds, private equity funds, hedge funds, and the Asset Management Division of insurance companies and banks. By 2013 in the shadow banking sector controlled about $53 trillion in assets, up 60% since 2008, and nine financial crisis, time firms each individually control over 1 trillion, with BlackRock the largest managing $4.1 trillion in assets. By 2018, BlackRock was up to $6 trillion under management making it larger than the world’s largest conventional bank, which is in China. Yet BlackRock escaped the regulations imposed on traditional banks under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.” – Banking on the People
Source: Banking on the People
https://www.amazon.com/Banking-People-Democratizing-Money-Digital-ebook/dp/B07R3F6ZX7/
The Federal Reserve Supports Shadow Banking
What is interesting is to see the Fed write articles in support of shadow banking. The following quote is one example of this.
The first of these arrangements uses repo, or repurchase, transactions, whereby firms with surplus cash buy securities for cash only and then resell them back after a short term. Effectively, this repo transaction is a short-term cash loan to the seller of the security, with the security acting as collateral on the loan. Repo transactions can be open-ended and rolled over on a daily basis, making them analogous to deposits at a traditional bank that are withdrawable on demand. However, unlike demand deposits, which derive their safety from deposit insurance, repo transactions derive their safety from the underlying security that is the collateral on the loan. In the event of default on the loan, the lender retains the right to sell the security in the open market and collect the proceeds. – St. Louis Fed
Source: St Louis Fed
What the St. Louis Fed Leaves Out About Repos
(Note on definition. A repo is an overnight repurchase agreement.)
What is curious about this quotation, is that this explanation leaves out entirely that the repo market is unregulated. This fits into a pattern of the Fed supporting unregulated area. Which should not be surprising. The Fed is nothing but private bankers who masquerade and being a government agency with a public service function. Naturally, the Fed supports less and less regulate banking. Because the repo market is unregulated (much like Alan Greenspan fought Brookley Bourne on regulating the over-the-counter derivatives), the Fed supports repos. And all the while the Fed is arguing for regulation to be reduced, it is increasing the number of different items that it insures. As a private entity, it does not need the approval of congress to increase its mandate. The private banks want every derivative they create insured by the government to prevent (systemic risk). This allows private banking entities to book all profits from derivatives, and then to have the Fed come by to gobble up their bad derivatives. This would be like having an entity with the government’s checkbook, managed by professional gamblers, that insured any losses of these same gamblers. Everytime the gambler would win, the gambler would take home the profits. And every time the gambler loses, they would simply drop the losses off on the government.
From Originate and Hold to Originate to Distribute (i.e. get rid of)
The St Louis Fed continues.
Financial intermediation has moved from an originate-to-hold model of traditional banking to an originate-to-distribute model of modern securitized banking.
The first part of the quote means that the banks or banking entity does not hold loans. It gets rid of the loans. One common mechanism is securitization. This was the exact problem with the subprime mortgage crisis. When the banks did not hold the loans, they did not care much about loan quality.
Traditional Banking Not Profitable
The St Louis Fed continues..
Economist Gary Gorton argued in a book last year that deregulation and increased competition in banking rendered the traditional model of banking unprofitable.
How the traditional model of banking could be unprofitable is difficult to fathom. Banks create money out of nothing which is an obligation to the borrower, and they then collect interest. There is no other business where you can create the product from nothing. One example might be digital media, but digital media requires an initial investment for production costs. The item is only created from nothing through copying after the item has been produced. Loans aren’t like that. They require no investment and are created from a ledger entry.
What is more accurate is to say that traditional banking is less profitable than shadow banking.
And this extends into another area that increasingly banks are not interested in providing basic banking services to the population when they can lend larger amounts to say a hedge fund. This is the banks stripping away their public service function, which is something they have in return for the government granted a concession of the ability to create credit. However, whenever banks want a bailout, they begin anew their talk of how they are critical for the public. However, if banks are increasingly providing fewer and fewer services to the people, shunning small business loans and increase lending to hedge funds, why should banks continue to keep their charters?
Securitization
The St Louis Fed continues..
In modern banking, origination of loans is done mostly with a view to convert the loan into securities—a practice called securitization, whereby the transaction, processing and servicing fees are the intermediaries’ principal source of revenue.
To enhance the safety of the transactions, repos are overcollateralized—that is, the loan amount is typically less than the face value of the securities used as collateral.
The safety of investments in MMMFs comes from the fact that the securities they invest in are regulated to be of high quality and short maturity, such as Treasury bills and highest-grade commercial paper.
This ignores the fact that as with the subprime mortgage crisis, these entities do not know what is in the security. In the case of the 2008 crisis, rating agencies were paid to upgrade the security into a rating it did not deserve. As this is not a regulated market, what is there to stop this from happening again?
Secondly, the Fed leaves out that some securities have been used to obtain multiple loans on the same security. None of the problems with securitization are mentioned at all by the St. Louis Fed.
Major Benefits to the Shadow Banking System?
The St. Louis Fed continues..
While some analysts have asserted that the shadow banking system is redundant and inefficient, it is not difficult to see the benefits of securitized banking.
Benefits to who? To private banking interests or to the public. This is an unregulated market, an which the Fed has decided to insure against loses. And now normal banks have been sucked into the shadow banking sector. And banks are providing large loans to shadow banks, which means the banks now have to do much less work, because they can minimize their loaning to individuals and small businessses and focus it on shadow banks/hedge funds/private equity, etc.. How does this not overpower the hedge funds and private capital firms? It allows them to acquire small businesses, and puts the public within the control of the hedge funds and private equity firms. This is a problem in housing where shadow banking is purchasing houses, and becoming absentee landlords. The common feature is that hedge funds and equity firms have a rentier’s perspective on managing business and takes very short timeline perspectives on their businesses.
Shadow Banking for Exploiting Scale and Scope?
The St. Louis Fed continues.
In addition, it exploits benefits of both scale and scope in segmenting the different activities of credit intermediation, thereby reducing costs.
Yes it is concentrating private banking power, and it may lower costs — but does it decrease the price? Because the cost of borrowing outside of the 30 year mortgage has increased. There has been a rich history in the US of people like Thomas Jefferson, John Adams, Louis McFadden and countless others declaring their concern for concentration of private banking interests. “Scale and scope” is not a good thing in finance, as it is then translated into oligarchic control. The six major US banks have scale and scope, and they also control the US political system and cannot be regulated.
Getting Out of the St Louis Fed’s Propaganda on Shadow Banking
Lets use a more reliable source on repos and shadow banking to verify the claims by the Fed.
Let us first address the issues with unregulated banking.
Experiences With Wildcat Banking
In the 19th century, unregulated banks were called Wildcat banks in the 21st century they are called shadow banks, Shadow banks or financial companies are borrow short term and lend long term outside the safety nets of the FDIC insurance and the Federal Reserve discount window. They include money market funds, securities broker deals, investment, and commercial banks, and their holding companies, finance companies, and mortgage brokers issue wares of asset-backed securities and asset-backed commercial paper derivative product companies. Hedge Funds are off the books business is variously known as trusts, special purpose entities, variable interest entities, conduits, and structured investment vehicles. Commercial Banks also conduct much of their business in the shadow banking system, although most are not classed as shadow banks themselves.
Source: Banking on the People
https://www.amazon.com/Banking-People-Democratizing-Money-Digital-ebook/dp/B07R3F6ZX7/
Why does the Fed not point to the history of unregulated banking such as wildcat banks? It is as if the St Louis Fed is proposing there is no history of unregulated banking to look at.
Let us now see how differently Ellen Brown descibes repos than what the St Louis Fed did in the previous quotes.
Rehypothecation or Repo
The shadow banking system is a black hole of invisible landmines largely due to a practice called rehypothecation. The real lending of collateral for multiple loans. The problem is that the shadow banking system actually needs to counterfeit collateral, just as the conventional banking system needs to counterfeit banknotes in the fractional reserve system collateral is the gold of the shadow banks and there was not enough of it to go around.
Let us stop the quote there for a moment. Banks are allowed to create money from nothing. That is what a banking charter allows. However, shadow banking does not have this power. Therefore, they have to create a loan based upon a security. However, how many securities are there to serve as collateral versus the demand? The St. Louis Fed is silent on this issue, but it is a hugely important issue.
Now as discussed earlier banks are providing loans to shadow banking. So it is not the case that repos are the only source of funds. If repos had the “liquidity” that shadow banks needed, they would not have to go to normal banks to borrow money.
Let pickup the quote.
When the rehypothecation of collateral is curtailed by regulation market liquidity dries up. Shadow banking comes in many forms where repos and derivatives are where the big money is today. Although the repo market is little known to most people, that is considered the main financing tool of the shadow banking system and a key player in the modern financial scheme. Repo in this case is short for repurchase in repo borrowing the bar or sells collateral to the lenders and promises to repurchase it the next day. repo operates on the pawnshop model, the borrower will get some money and the investor gets the collateral.
This is just a very odd description of something that is so popular and widely used. Why are repurchases performed with such rapidity? This describes a repurchase that happens on a day to day basis.
This is expressed in the following quotation.
Let us now look at another quote that supports the idea that repos are overscubscribed or have been committed and used as collateral on multiple repos.
For every US Treasury security outstanding, roughly three parties believe they own it. That’s right. Multiple parties report that they own the very same asset, when only one of them truly does. To wit, the IMF has estimated that the same collateral was reused 2.2 times in 2018, which means both the original owner plus 2.2 subsequent re-users believe they own the same collateral (often a US Treasury security).
This is why US Treasuries aren’t risk-free—they’re the most rehypothecated asset in financial markets, and the big banks know this. Auditors can’t catch this because GAAP accounting standards obfuscate it, as I’ll explain later. What it all means is that, while each bank’s financial statements show the bank is solvent, the financial system as a whole isn’t. And no one really knows how much double-, triple-, quadruple-, etc. counting of US Treasuries takes place. US Treasuries are the core asset used by every financial institution to satisfy its capital and liquidity requirements—which means that no one really knows how big the hole is at a system-wide level.
Source: Forbes
What this means is that the individual banks are not solvent. Each are showing collateral, but tha collateral has been committed to other banks also. If that loans or repo goes south, the collateral won’t be there for the other banks. Notice how different this is from how repos were described in the St. Louis Fed in the earlier quotations.
The quote from Forbes continues.
This is the real reason why the repo market periodically seizes up. It’s akin to musical chairs—no one knows how many players will be without a chair until the music stops. Every player knows there aren’t enough chairs. Everyone knows someone will eventually lose.
And why aren’t there enough musical chairs? Because the market is unregulated.
This is addressed in the following quotation.
Financial regulators can’t publicly admit to this, but big banks know it’s true—and that’s why they hunker down (and stop lending) when they sense one of their kin is in trouble. They recognize that what appears to be an 8% risk-free arbitrage is anything but risk-free.
Why won’t financial regulators publicy admit this? Are they captured by the private banking industry?
See this quote from Forbes.
The closest I’ve heard a financial regulator speak publicly of this is former CFTC Chairman Chris Giancarlo, to his credit, when he answered a question after a 2016 speech:
“At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another. Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”
This is why the FT’s interview with Williams was so extraordinary. It’s as close as a regulator will come to admitting the reality that the system doesn’t work the way most of us think it does and that the Fed may not even understand critical things about it.
So this means that nothing has changed since the 2008 financial crisis.
The Forbes article goes on to make another enormous claim.
Specifically, the Fed’s focus on the fed funds market is misplaced because the real action is in the much bigger, much more global repo market; the Fed shouldn’t have allowed America’s big banks to pay dividends or buy back stock when they’re so capital-constrained that they can’t even pick up an 8% “risk-free” arbitrage; the Fed’s proclamation that “the financial system remains resilient,” when it released the results of the most recent bank stress tests in June 2019, strains credulity; a staggering amount of US dollar liabilities have been issued offshore in recent decades and the Fed not only doesn’t control them but can’t measure them with any degree of accuracy; and banks’ financial statements don’t accurately reflect their financial health. No one really knows how solvent (insolvent?) the financial system is.
This means the system is now out of control. And banking has been even more privatized. With repos, the shadow banking industry can circumvent the banking credit lines. And it can oversubscribe securities that are collateral.
How is the Repo Market Secured?
The repo market is secured so the overnight purchase rate is often lower than the federal funds rate charged by other banks. A repo loan is typically rolled over when it comes due so a one day loan can last for months, and the lender can reuse securities as collateral for its own repo loan, getting its cash back in the meantime, through this lending of rehypothecation allocation of collateral for multiple loans, the shadow banking system can manufacture credit out of thin air, just as the traditional banking system does.
Source: Banking on the People
That is a curious quote, because banks have a charter and face regulation. This is a government granted right that comes with money creation. This makes it sound like shadow banks can create credit out of nothing, but they are not regulated.