[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in 2021.]
Although it conjures up scary imagery, shadow banking is simply a term for banking operations that occur through financial intermediaries that are not traditional commercial banks. The term was coined in 2007 by economist Paul McCulley and is related to the fact that standard banking regulations often do not apply to nonbank institutions (such as hedge funds and private equity lenders), which are hence operating “in the shadows.” According to estimates of nonbank credit intermediation made by the Financial Stability Board, “the global shadow system peaked at $62 trillion in 2007, declined to $59 trillion during the crisis, and rebounded to $92 trillion by the end of 2015.”
The existence of a shadow banking system thus limits the ability of governments to regulate the credit markets if they merely restrict attention to traditional banks. To understand the mechanics of today’s monetary system, it is therefore important to recognize that the nexus between savers and borrowers doesn’t necessarily flow through a commercial bank, the way economics textbooks often imply.
Similarly, American textbook treatments often provide a USA-specific viewpoint, even though in reality there is a global market for US dollars. In this chapter we will provide an overview of these complications to give a more accurate description of money and banking practices.
Mises and Hayek on Regulation versus Economic Reality
Although they didn’t use the term “shadow banking,” the Austrian economists Ludwig von Mises and Friedrich von Hayek made observations consistent with the theme of this chapter. Mises argued that Peel’s Act of 1844 failed in its attempt to mitigate the business cycle because it limited the ability of banks to issue paper banknotes unbacked by gold but didn’t limit banks’ ability to issue customer checkbook deposits. This inconsistent regulation—which ignored the economic equivalence between banknotes and “checkbook money”—ended up discrediting the Currency school, which (in Mises’s view) correctly perceived unbacked bank credit as the source of business instability. See chapter 9 for more on Mises’s theory of the boom-bust cycle, and see this chapter’s endnotes for an academic paper extending Misesian business cycle theory in light of shadow banking.
For his part, Hayek in a 1931 lecture gave a very modern statement of the issues involved with shadow banking, though he did not use the term:
[I]t is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economize money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required. The criterion by which we may distinguish these circulating credits from other forms of credit which do not act as substitutes for money is that they give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else. This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods. It applies also to a number of other forms of commercial credit, as, for example, when book credit is simultaneously introduced in a number of successive stages of production in the place of cash payments, and so on. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided. (bold added)
These brief references illustrate that economists have been aware of the issues surrounding shadow banking for a century. The specific market structures may be new, but the issue is not.
Shadow Banking during the Housing Boom
The nature and potential problems with the shadow banking system became apparent during the housing boom of the 2000s. To illustrate, we can consider a typical example: suppose in 2006, during the height of the boom, a couple in Phoenix applies for a traditional mortgage at their local bank. The bank approves the application and lends the money to the couple, who then buy the house, which serves as the collateral on the loan. However, rather than holding the mortgage for thirty years as an asset on its own books, the commercial bank in Phoenix turns around and sells it to a major investment bank in New York.
The Wall Street–based investment bank then takes the mortgage tied to the home in Phoenix and packages it with hundreds of other mortgages tied to houses across the United States, in order to create a “mortgage-backed security” (MBS). Every month, the incoming mortgage payments from the homebuyers across the country flow into the bucket represented by the MBS. The investment bank then sells “tranches” of the MBS to other investors, and these tranches have different risk characteristics. For example, the safest claims represent the lowest “slice” of the bucket being filled each month, whereas the riskiest claims point to the highest “slice” of the bucket. If, in a given month, some of the homebuyers fall behind on their mortgage payments, then the top slices of the bucket do not get filled, and the investors holding those particular tranches don’t get paid. This relative risk was reflected in the original (lower) price for these tranches, however; there was a chance to make a higher rate of return if things went well, but it came with a higher risk of loss.
In contrast, those investors who purchased the safest tranches of the MBS thought they were being quite prudent—and indeed, the credit ratings agencies (such as Moody’s, Fitch, and S&P) agreed with them, giving these complex derivative assets triple-A ratings. Because the pool of mortgages was spread across the country, and because people believed “real estate was local,” it seemed very unlikely that homebuyers would fall behind in their mortgages for the whole bucket. Even though the credit agencies’ computer models recognized that, say, the Phoenix real estate market could suddenly crash 20%, that same outcome happening in Miami or San Francisco was treated as an independent statistical event. In retrospect, what actually happened—namely, all of the major US real estate markets crashed simultaneously—had been modeled as a once-in-a-thousand-years scenario.
Because the major ratings agencies gave their highest seal of approval to (certain types of) derivative assets tied to mortgages, pension funds and other institutional investors—including foreign ones—were allowed to gain exposure to the “hot” real estate market but apparently without taking on the usual risk. Because the commercial bank in Phoenix was not intending to hold the original mortgage, it had less incentive to vet the application provided by the couple, to make sure they had steady incomes and could afford the house. The entire process helps to explain why the usual credit safeguards were abandoned, and how buyers could continue to push up home prices as the bubble grew.
Depending on their world views and political orientations, analysts had vastly different reactions to the housing boom and bust. Some blamed “deregulation” and pointed to the shadow banking system as proof that more government oversight was needed to plug the holes. Others argued that government would never be able to keep up with evolving markets, and that it was government housing subsidies and central banks with their easy-credit policies that were to blame. Either way, it is important to understand the role of shadow banking to make sense of the financial crisis that erupted in the fall of 2008.
LIBOR and the Eurodollar
LIBOR stands for London inter-bank offered rate, and is a survey average of the interest rate that leading banks in London estimate they would be charged for loans from other banks. Thomson Reuters had traditionally calculated LIBOR for five different currencies (US dollar, euro, pound sterling, yen, and Swiss franc), and seven borrowing periods (ranging from an overnight loan to a maturity length of one year). For decades, the relevant measure of LIBOR served as a benchmark against which other interest rates and derivative assets were calibrated. However, in the wake of criminal settlements due to allegations of “price-fixing” by major banks and other evolving factors in global finance, LIBOR is scheduled to be discontinued by the end of 2021.
The term Eurodollar actually refers to any US dollar-denominated deposit held at a financial institution outside of the United States, or even a USD deposit held by a foreign bank within the US. It thus has nothing to do with the euro currency, and is not restricted to dollars held in Europe; they are dollar deposits that are not subject to the same regulations as US dollars held by American banks, nor are they guaranteed by FDIC (Federal Deposit Insurance Corporation) protection (and hence they tend to earn a higher rate of return). As the CME Group explains on its website:
After World War II when recovering economies gradually began to accumulate onto U.S. dollars, some countries preferred not to repatriate U.S. dollars through U.S. banks, but instead held them “off-shore”, primarily in London-based banks out of the reach of the United States government.
Over time, a bank lending market grew up around this pool of funds.
British bankers began referring to the lending rates in this market as the London Inter-Bank Offer Rate, also known as ICE LIBOR.
By its nature, the Eurodollar market is harder to quantify than the more conventional US-based market. However, one study estimated that at its peak before the 2008 financial crisis, the size of the Eurodollar market was 87 percent of the US banking system.
The BIS and the Basel Accords
The Bank for International Settlements (BIS) was established in 1930 and is headquartered in Basel, Switzerland. According to the BIS website, its mission is “to support central banks’ pursuit of monetary and financial stability through international cooperation, and to act as a bank for central banks.” Its website (as of summer 2021) also explains that “the BIS is owned by 63 central banks, representing countries from around the world that together account for about 95% of world GDP.”
After the final collapse of the Bretton Woods system in 1971 (which we briefly discussed in chapter 3), the central bankers of the major powers wanted a new framework for regulating global finance. Consequently the BIS formed what is now called the Basel Committee on Bank Supervision (BCBS) in 1974, with the stated aim of enhancing “financial stability by improving supervisory knowhow and the quality of banking supervision worldwide.”
Over the years, the BCBS has provided three major updates on its guidance for central banks and governments. The first Basel Accord (or Basel I) was formally issued in 1988. Among other provisions, it recommended that banks operating internationally must maintain a capital-to-risk-weighted-assets ratio of at least 8 percent. Basel I also defined the types of “tier 1” and “tier 2” capital, designating the different sources of funding for the bank that could be used to satisfy this requirement. Tier 1 capital includes common shareholder equity, and is the most reliable source of funding, as it can’t be “called” or withdrawn by the original contributors in the event of a market downturn. Tier 2 capital includes hybrid instruments, some of which—such as subordinated debt—mix characteristics of equity and debt.
Basel II was issued in 2004, and refined the definitions of various regulatory concepts used in Basel I, using the credit rating of certain assets to determine their risk weighting. It also introduced the notion of tier 3 capital, which is less reliable than tier 1 or tier 2. Basel III was published in 2010, and introduced further “stress test” requirements for bank strength in the wake of the financial crisis. It eliminated the use of the weakest (tier 3) capital for satisfying regulatory requirements and highlighted the danger of financial institutions that were “too big to fail.”
It should be stressed that strictly speaking, the Basel Accords are merely recommendations or guidelines, portions of which the various governments and central banks around the world may adopt for their own domestic regulation of the financial sector. For example, although Basel III was published in late 2010, the Federal Reserve waited until late 2011 to announce that it would adopt most of the new guidelines, and even then, they would be phased in over the course of years.
Bank Reserves versus Bank Capital
As we explained in the previous section, one of the key takeaways from the Basel Accords was a strengthening of capital requirements for banks (and other important financial institutions). These are different from reserve requirements, which are covered in standard textbooks about money and banking. In this final section of the chapter we will illustrate this distinction through a simplified example.
Let us consider the hypothetical case of Acme Commercial Bank. When Acme is first formed legally, it takes in $5 million from investors who want to be shareholders of the new bank. It then opens its doors for business and accepts $95 million from customers who deposit those funds into their brand-new Acme checking accounts. Further suppose that all of the money transferred into Acme’s possession comes in the form of checks written on preexisting checking accounts at other banks. When Acme submits these checks for processing, what ultimately happens is that the Federal Reserve debits the amount held by other banks (such as Bank of America, Citibank, etc.) in their accounts with the Federal Reserve and credits the corresponding amount to the account held by Acme.
At this point, the managers running Acme have $100 million in assets, which are in the form of electronic deposits reflected in Acme’s account with the Federal Reserve. But Acme needs to have some of this money in the form of actual currency in its vaults (and ATMs), in case its customers want to withdraw some of their checking account balances. Therefore Acme requests $6 million in actual currency, which reduces its electronic balance with the Fed to $94 million. Of this, Acme then lends out $90 million to new homebuyers who request mortgages from Acme. When the dust settles from these operations, this is what Acme’s balance sheet looks like:
Hypothetical Acme Bank’s Balance Sheet
LIABILITIES AND SHAREHOLDER EQUITY
|$6 million in vault cash||$95 million in customer checking account balances|
|$4 million electronic deposits with Fed||
$5 million in shareholder equity (Acme’s capital)
|$90 million in residential mortgages (held by Acme Bank)|
|TOTAL: $100 million||TOTAL: $100 million|
In this simple example, Acme Bank would satisfy a 10 percent reserve requirement. Specifically, Acme’s customers collectively have $95 million on deposit in Acme checking accounts. The traditional 10% reserve requirement—which in the United States was discontinued in 2020, as we explain in chapter 8—means that Acme must hold at least $9.5 million in the form of reserves, which include both currency in the vault and electronic deposits held at the Fed. As the balance sheet indicates, Acme actually holds $10 million in reserves ($6 million in vault cash and $4 million on deposit with the Fed). It thus satisfies the traditional reserve requirements, and even has $500,000 in excess reserves, which Acme would be allowed to lend out to new borrowers.
However, when we calculate the ratio of Acme’s capital to total assets, we see that it is only 5 percent ($5 million / $100 million = 5%). If Acme is subject to a regulatory regime requiring at least an 8 percent capital ratio, then it falls short. Even though Acme satisfies its reserve requirements, regulators could still say that Acme is “overleveraged” or “undercapitalized,” because its portfolio of assets relies too heavily on money it obtained from depositors, rather than from investors. Consider: if real estate took an unexpectedly bad turn and the market value of Acme’s mortgages fell a mere 5 percent (i.e., $4.5 million), then Acme’s capital—defined as assets minus liabilities—would be almost completely wiped out. This is why, other things equal, the more capital a financial institution has, the better it can handle a plunge in asset values.