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Finance Must Escape the Shadows

August 1, 2012
Financial Times


There are two ways finance can inflict disaster upon us. The first involves the collapse of a large, systemic institution: the Knickerbocker Trust at the start of the last century, Lehman Brothers at the start of this one. The second involves a convulsion in a particular market: tulips in 1637, various forms of "shadow banking" in 2008. The past three years have brought much debate and modest progress on regulating the megabanks, and the Libor scandal has added fresh impetus to these efforts. But shadow-bank reform has remained, well, shadowy. This is because nobody wants to grapple with the basic question of what money really is.

To understand the stakes, start with one pillar of the shadow banking world: asset-backed securities. Because these IOUs seemed safe before the crisis, they were treated effectively as money: for example, traders used them to make downpayments on derivatives positions and settle up if they made a wrong bet. Many asset-backed securities were sold to money market mutual funds, which enhanced their cash-equivalence further. The money market funds never lost value and you could write cheques against them. Or consider the enormous "repo" market. Anybody who owned securities – government bonds, corporate bonds or the aforementioned asset-backed ones – could use this market to swap them for cash. Indeed, in the run-up to the crisis, even synthetic collateralised debt obligations, consisting of nothing more substantial than a bunch of Wall Street promises, could be turned into money with few questions asked. Financiers were conjuring money out of nothing. By no means was this the exclusive province of central banks.

Of course, private money is an old phenomenon. Banks used to issue private banknotes; and even the humble current account is based on the audacious notion that a $100 entry on a statement from your friendly bank manager is as real and reliable as $100 worth of wheat or gold. But, however pedigreed, private money is susceptible to panics. And so, over the years, uncertain private promises have given way to solid public ones. Starting in 1863, the Feds replaced private banknotes with greenbacks. In 1934 they panic-proofed bank accounts by instituting deposit insurance.

The big question about shadow banking is whether the authorities should perform this alchemy again. To a certain extent, they have already, as Federal Reserve governor Daniel Tarullo described in a recent speech. In the heat of the crisis there was a run from money market funds, which lost a tenth of their deposits in a two-day period; meanwhile, the repo market threatened to collapse. To prevent catastrophe, the Feds rushed to the rescue. As in 1863 and 1934, flimsy private promises were fortified by government.

Now that the crisis has receded, what next? On both sides of the Atlantic there is an earnest push to fix the plumbing of the shadow banking system: regulators want money market funds to hold capital buffers; they aim to reduce the repo market's precarious reliance on vast financing from clearing banks. But, though these initiatives are valuable, policy makers are not grappling with the core dilemma. Should asset-backed securities, money market funds and repo be viewed as a private system? Or should they be entitled to expect more rescues in the future – rescues that depend ultimately on emergency lending from the central bank?

The right judgment on these questions must depend on another one: if governments formalised the backstop, whom would they serve? One answer is savers. Particularly in the US, the explosion in securitisation was partly a response to a global craving for safe assets. In the four years leading up to the crisis, foreign official purchasers bought roughly 80 per cent of all new Treasury and semi-government agency bonds that were created. The US was not issuing enough official reserve assets to satiate investors so unofficial reserve assets multiplied to fill the gap. A second answer is that backstopping the shadow banks would promote the efficiency of finance. Before securitisation, banks made loans and held them; investors who bought bank shares got an opaque bundle of exposures. Now, thanks to securitisation, investors can cherry-pick the risks that suit them. Better risk-management options for investors means cheaper capital for borrowers. To preserve that advantage, the Fed should be as willing to rescue shadow banks as normal banks.

How persuasive are these answers? Both invite robust retorts. Savers may crave safe assets, but nowhere is it written that Uncle Sam must provide them in unlimited amounts. Indeed, Wall Street's promiscuous creation of seemingly safe securities pulled excess capital into the country, fuelling an overvaluation in the dollar and a current account deficit that policy makers should not want to underwrite.

Likewise, the claim of shadow bank efficiency should be treated with caution. Banks securitise assets partly to transfer them to unregulated funds that don't have capital cushions; the driver is regulatory arbitrage, not efficiency. Similarly, the complex shadow bank lending chains that link banks to money market funds to hedge funds may theoretically be productive: they shift capital around the system to the players that deploy it best. But serpentine lending chains involve a risk of breakage. Must taxpayers be on the hook for that?

Wherever you come down on these questions, what is really striking is their absence from the public square. It has been politically easier to chase bankers and their bonuses than to reckon with these fundamental problems: is quasi-money real money? If so, under what conditions? Yet until we resolve these issues, large swaths of finance will exist in limbo. There will be implicit guarantees but not explicit ones. There will be moral hazard but no honest recognition that its consequences must be managed. Whatever your preferred understanding of money, this intellectual muddle promises the worst of both worlds.

The writer is a senior fellow at the Council on Foreign Relations and a Financial Times contributing editor


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