Shadow banking is a feature of the modern financial system that has started modestly some time in the 70s or 80s and which has grown immensely since then. It is estimated that in 2007-2008 shadow banking in the US accounted for more than 40% of financing of the ‘real economy’. Shadow banking’s importance thus grew significantly without however, being subject to much regulation and most importantly without being provided with access to a Federal Reserve backstop in case of crisis. It is not surprising then that the global financial crisis in 2008 originated in the shadow banking. Specifically, a chain of events, which otherwise could have led to a relatively benign downturn, set in motion a precipitous drop in asset prices that freezed the money markets and the financial system. Afoot was a run on the shadow banks.

First of all what are shadow banks? The term is used loosely to encompass a wide variety of non-bank financial entities but in this post we will designate as shadow banks mostly the ‘investment vehicles’ created by investment banks as a lending intermediaries between the money markets and market for packaged mortgages. Shadow banks borrowed short term from the Money Market Mutual Funds (MMMF) and lent long term on the capital market by buying residential mortgage-backed securities (RMBS), i.e. packaged mortgages. The particular variety of RMBSs used were called collateralised debt obligations (CDOs), relatively complex instruments, a feature often highlighted by commentators as the reason for the crisis. For the purposes of this narrative, though, that is not a crucial factor, except that their complexity rendered CDOs highly illiquid: they are opaque and not publicly traded.

The ‘shadow’ in the term shadow banks stands for their being off-balance sheet entities of the banks (called Structured Investment Vehicles or SIVs). In other words there is nothing inherently ‘shadowy’ or fishy about shadow banking, they are just not banks strictly speaking.

The ‘bank’ in the term shadow banks stands for short-term borrowing and long-term lending. This is what every bank is doing. Deposits in banks are liability of the banks, i.e. they borrow from their depositors. Depositors are said to be lending short-term to the banks because they can withdraw their deposits at any time. On the other side, banks are lending out to businesses or consumers for a fixed period of time, which is long-term (or at least certainly longer than deposits). In other words the maturities of banks’ borrowing and lending are not aligned in time. Banks are thus exposed to runs: depositors can claim their money back at any moment while the bank cannot claim repayment of the loans which have fixed periods (i.e. long-term by definition as compared to deposits). This business model is therefore inherently risky and can be potentially ‘deadly’ for the banks.

The shadow banks in 2008 did not have depositors. But they were financed by short-term borrowing form the MMMFs, typically three to six months loans which were rolled over (i.e. the loans are renewed/extended). However, the MMMFs had the possibility to claim their money back at maturity and refuse to roll over. The RMBSs on the other hand were 20-30 years mortgages. In other words the maturities of the borrowing and the lending of the shadow banks were not aligned in time. That is what made the ‘shadow banks’, banks.

What precipitated the crisis was initially a small drop in the value of the RMBSs, a drop of around 2%. That was sufficient to make the MMMFs nervous and decide to not roll over the financing of the shadow banks/SIVs. The losses were initially absorbed by the SIVs’ sponsors, the investment banks who created them, but the chain of events that was triggered by the initial drop proved to be unstoppable. As the shadow banks were in difficulty they started selling their RMBSs.

As already said, RMBSs were not very liquid, it was hard to find buyers. So SIVs started selling RMBSs at fire sale prices, i.e. at a steep discount. That in turn made the MMMFs even more nervous and they withdrew further their financing which in its turn prompted further selling of assets. This is a classic situation of a run on the banks that triggers a death spiral.

In the past runs on the banks were ordinary events. As is known, even if the trigger of the run is trivial and based on rumours or downright false information, once the run is afoot the only rational way to behave for depositors is to run as fast as possible and try to get their funds back before other depositors do so and deplete the bank’s reserves.

Nowadays runs on the banks are a rarity. This is partly due to the deposit insurance schemes but more importantly due to the central banks’ function of lenders of last resort. In times of crisis central banks ‘lend freely at a high interest rate against good collateral’. Central banks thus have the power to backstop a run, by simply expanding their balance sheets (this creates money out of the thin air). That is why nowadays runs rarely start and do not lead to bank bankruptcies if the troubled banks have sufficient assets to use as collateral.

It took centuries to figure out that banks need a central bank backstop. How much time will it take us to extend that to sound shadow banks and thus make them mainstream and safe feature of our financial system?

(to be continued)