Understanding Shadow Banking

We’ve all heard about the shadow banking system in recent years, but do you really understand what it is? Don’t worry, it’s really not as dark and mysterious as some people make it sound and it’s really not as complex as it sounds, but it’s very important to understand given its size and scope.  So I’ve gone ahead and compiled a list of good papers that explain the basics of the shadow banking system and why it matter.

Here are some basic primers on shadow banking for future reference. I hope you find it helpful and please feel free to add more resources in the comments:

Understanding Shadow Banking:

 

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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    • I find this distracting as well as it makes me question the credibility of the rest of the paper. The author states “Maturity transformation refers to the use of short-term deposits to fund long-term loans, which creates liquidity for the saver but exposes the intermediary to rollover and duration risks.” Isn’t it the opposite. The creation of long-term loan assets, through double entry bank book-keeping marking up electronic ledger accounts, also creates a short term deposit liability somewhere else in the banking system, but not necessarily at the same bank. It’s kind of convoluted, as you could argue that through transfer of reserves (the most liquid asset) to the bank receiving the liability could be seen as funding this loan per se. Anyway, if the author gets this part wrong, is it worth devoting the time to the rest of the paper, presuming they get Shadow Banking right?

    • The chicago fed disagrees: http://www.rayservers.com/images/ModernMoneyMechanics.pdf

      See the table and caption on the page marked “11″ in the pdf:
      “Thus through stage after stage of expansion, “money” can grow to a total of 10 times the new reserves supplied to the banking system as the new deposits created by loans at each stage are added to those created at all earlier stages and those supplied by the initial reserve-creating action.”

      • The entries are correct, but they get causation wrong. The banks don’t lend reserves to borrowers. They create deposits as the entries show. Most of the time they use deposits to fund these loans, but reserve maintenance to cover deposit outflows can be done without the Fed first creating new reserves. Yes, lending could be constrained if the Fed stopped creating reserves, but then the Fed would lose the ability to maintain a functioning payments system and target interest rates.

        This is what should be posted at the Chicago Fed in my opinion:
        http://monetaryrealism.com/loans-create-deposits-in-context/

  1. Video: it splits the shadow banking system from the banking system, but this is not true – the banks were major (if not the biggest players) in the shadow banking system and they were the systemically important entities which needed to be saved because of the implosion of the shadow banking system, as they held a lot of risky tranches of their own securitizations, so this and not the consumer turned the authorities attention to shadow banking.

    • I was just going to say that.

      If the only difference is that the loans are securitized and sold, removing them from the balance sheet…well then that can happen inside or outside the banking system.

    • I am getting divorced and need some cash to tide me over. What shall I do so that the attorneys for my spouse do not find out about me selling my gold chain, boat, and collectable german daggers?

      I Am CEO for Circuit City, Best Buy is kicking my companies ASS and I need to come up with 100 Million to send to the BANK OF KOREA to settle a loan to LG…………

      Come on Folks it’s not that hard to figure out what “Shadow banking”

  2. But isn’t QE impairing (may be even destabilizing) the shadow banking system by reducing the amount of good colletaral ? Is it an unavoidable side effect or is it deliberate ?

    • No. The only generally-accepted liabilities are banks under the bank act. Shadow banks are part of the problem in that banks create money/loans, then spins them off into securities which are bought by Shadow banks. So Shadow banks create the liquidity which permits the banks to take temporary risks through creating crap credit (and the banks love this because after they flip the loans to the Shadow banks, they carry no risk AND also earn a fee!).

      • Is that right? A margin account in a brokerage account is technically a form of shadow banking and that results in the creation of money to purchase new securities. Isn’t this basically what shadow banking is all about? Using existing securities as collateral to extend credit so people can buy other things?

        I think the only major difference between shadow banking and real banking is that there’s no insurance on the loans being made.

      • Right, shadow banks don’t create money directly, but it seems they DO create demand for money, which is ultimately supplied by regular banks out of thin air. So shadow banks can indirectly cause the creation of new money by regular banks.

        Not sure if that’s correct. Just thinking out loud.

        • I don’t know that the shadow bank creates the demand for money, but I agree with the rest of your comment. And banks like the shadow system because they can move risk off their balance sheet and reduce operating costs.

        • I think shadow banks do create money. A brokerage firm is basically a shadow bank and creates new money by using securities as collateral so clients can purchase new securities on margin.

          • Hey GLG,

            Go Leafs Go. Where is the brokerage firm obtaining the money that it loans to clients? I think it ultimately comes from banks.

            • I’m not positive actually. I am just assuming that they’re making the equivalent of a loan. Anyone got any insights there? Cullen?

              • You can make a loan w/o creating a deposit. Non-banks do that when they loan to one another. Regular banks do this also when they lend reserves to one another: they exchange reserves for the loan agreement. However, when they lend to non-banks, it’s a different story: then a deposit is created out of thin air. Geoff, when you mention “money” do you ultimately mean a bank deposit?

                • “You can make a loan w/o creating a deposit. Non-banks do that when they loan to one another. Regular banks do this also when they lend reserves to one another: they exchange reserves for the loan agreement. ”

                  Good point Tom

                  I think its this “loan without a deposit” view that many people mistake for what happens when a bank extends credit to a non bank.

                  The scenario you describe there is perfectly zero sum and does not result in credit crashes like we had in 2007.

            • Right, the brokerage firmcan credit your brokerage account, but when you actually purchase securities on margin, it’s bank deposits that are used to settle. And those deposits came from a bank loan.

              • Joe, you write: “And banks like the shadow system because they can move risk off their balance sheet and reduce operating costs.”

                Can you give a simple example of that?

                • A commercial real estate loan has a higher risk weighting than a bank investing in a AAA rated senior tranche of CMBS. If a bank can just purchase ABS or have a structured finance team to set up deals and sell them in the open market, you don’t need a sales staff or a servicing staff to originate loans or service them.

                  • Joe, thanks, I get some of that, but am struggling a bit still. So let’s say our bank has just created a risky commercial real estate loan and wants to use the shadow banking system to “move risk off their balance sheet and reduce operating costs.” I think I get your point about “reduce operating costs.” … but I’m struggling to see how anything goes “off their balance sheet” … unless you mean the risk goes “off BS” … not necessarily that total amount of assets: i.e. they’re effectively trading riskier assets for safer ones, but they’re all still on their BS.

                • Read WFC’s recent reports on their mortgage business. They spin off most of the mortgages and get a very nice fee …. not bad if they can unload that mortgage in 1 quarter … very good use of capital.

          • In private credit card companies, liabilities are created in the bank holding division, and sometimes they are spun out in ABS. Check out e.g. Discover Financial and read their annual reports. Maybe if you read the ETrade financials they will tell you how brokerages are structured.

            • Thanks. So real bank lending is still the heart of the monetary system and shadow banking is just an extension of this core piece? Is that pretty accurate?

              • The core of a sound private money system is productive creation of money. Historically, the bank is the guardian for “productiveness” by keeping the loan on their balance sheet … they have skin in the game. If you split out these functions via the shadow bank then you split the two functions, so both become core, i.e. a loan/money origination piece and a “guardian” piece. What caused the GFC was dumb Shadow banks or dumb investors in Shadow banks, or both.

    • I think they do through the rehypothecation of collateral. The City (UK) has no legal limits on rehypothecation.