Shadow banking refers to money market funding of capital market lending. We essentially need to extend the money view for the money market to the capital market, to the prices of risk. Traditionally, to most people, the bank’s balance sheet is like this. In the balance sheet, Capital is the FDIC solvency backstop, Reserves is the FRB liquidity backstop.
| Traditional banks Assets | Liabilities |
| Loans Reserves | Deposits Capital Liquidity put |
This is increasingly not the world is. Now the world is much like this one, where:
- RMBS is Residential Mortgage Backed Securities
- IR Swap is Interest Rate Swap
- CD Swap is Credit Defaults Swap
- RP is Repo
- ABCP is Assets-Backed Commercial Paper
- MMMF is Money Market Mutual Fund
| Securitization Assets | Liabilities | Shadow bank Assets | Liabilities | MMMF Assets | Liabilities |
| RMBS | Hi tranche Mid tranche Low tranche | Hi tranche IR swap CD swap Liquidity put | RP ABCP | RP ABCP Liquidity put | “Deposits” |
The link between the shadow banking system and the Federal Reserve Bank, are those Liquidity put. That’s how the shadow banking system got onto the balance sheets of the traditional banking system and the Fed.
Separation of Money Markets and Capital Markets
Money market and capital market, traditionally were separated from each other. There was a sort of intellectual disjuncture there.
| Capital markets | The province of finance |
| Money markets | The province of banking and economics |
With shadow banking, this intellectual separation is not in line with the real world, in which these things are intertwined. The reason why these things are separated has a historical origin.
In the past, banking worked as discounting short-term bills, which were issued by firms to finance goods on their way toward final sale. Banks discounted these bills, and would hold a portfolio of them that matured at various dates. The liquidity of a bank was ensured by the maturation of these bills, when they came due there would be a cash inflow.
| Business Assets | Liabilities | Bank Assets | Liabilities | Household Assets | Liabilities |
| Bills Bonds Equity | Bills | Deposits | Deposits Bonds Equity |
The bank is working as an intermediation. This is what we called indirect finance in the money market in the past.
However in the past, there was also capital market. Government issued bonds without any maturity, corporations issued bonds to finance various kinds of large scale projects. Bonds and equity (as a form of wealth) are held by rich people. There were called direct finance in the capital market, since there is no intermediary bank in between.
Integration of Money Markets and Capital Markets
American banks were quite different from those of England. The U.S. was a developing country, as a consequence, there were needs for long term finance to build the railroads, buildings, factories, and homes. Banks in the U.S. acceded to that, they didn’t confine themselves to short-term discounts, the way the British banks did. The banks made long term loans.
The American banking system before there was a central bank. They can not go to the central bank when they need extra reserves, they have to rely on each other. When the deficit bank needs to pay the surplus bank, it either paying in cash, or paying in bankers balances, or paying through REPO (using bonds as collateral for inter-bank borrowing from other banks).
| American Bank A (deficit) Assets | Liabilities | American Bank B (surplus) Assets | Liabilities |
| Bonds Loans Cash reserves Bankers balances – Cash – Bankers balances | Deposits + Repo | Bonds Loans Cash reserves + Cash + Repo | Deposits Bankers balances – Bankers balances |
The capital market and the money market are completely intertwined here. This is sort of the 19 century shadow banking before the Fed.
So in the American system the concept of liquidity was very different than that in the British system:
British system: liquidity is about having these cash inflows that are guaranteed.
American system: liquidity of a bank has to do with having bonds that are pledgeable or shiftable to some other person. Shiftability, often called market liquidity, is the ability to buy or sell an asset quickly without moving the price very much. The Fed needs to be backstopping shiftability. The Fed did wind up doing that, not for all assets, but for treasury bills. The Fed buy and sell treasury bills, that is where open market operations came from. It was supporting market liquidity in the capital market by buying and selling treasury bills.
Banking is important for economic development. It’s really important to have banks that are willing to expand its balance sheet. This is exactly “money market funding of capital market lending”. This is creating new money to give to entrepreneurs so that they can then go, without having to save money, without having to get somebody who has saved money to give it to them. The money is created from nothing.
| Bank Assets | Liabilities |
| Long term development loans | Deposits |
Intermediaries: Banks, Pension Funds and Insurance Company
Payment system is a credit system. It exists to make sure that whenever there’s a mutually agreeable trade of real goods, there’s no real problem in fund making the trade happen.
Suppose a business took some loan from a bank, and want to use the deposit to buy some machine. These are the the balance sheets in a money market payment system:
| Business Assets | Liabilities | Bank Assets | Liabilities | Society Assets | Liabilities |
| Deposit -Deposit +Mahine | Loan | Loan | Deposit | -Machine +Deposit |
As long as the society wants to hold that deposit as part of its portfolio financial assets, it will be fine since the deposit funds both the loan and the machine. If society is unwilling to fund this machine by holding the money balances, then the business has to fund it some other way, say a bond. These are the balance sheets in a capital market funding system:
| Business Assets | Liabilities | Bank Assets | Liabilities | Society Assets | Liabilities |
| Deposit -Deposit +Mahine | Loan +Bond -Loan | Loan -Loan | Deposit -Deposit | -Machine +Deposit -Deposit +Bond |
In essence, the money market, is intermediary, is temporary. It got the ball rolling, and then once the machine is there. The issue of bond is to get some permanent funding. We have separate capital market, and money market, but now they’re starting to get intertwined.
Besides banks, there are the 2 most significant intermediaries:
- Pension funds, whose liabilities are pension benefit promises. They tend to hedge the liabilities using equity.
- Insurance companies whose liabilities are contingent insurance policies. They tend to hold bonds as their assets.
| Pension funds Assets | Liabilities | Insurance companies Assets | Liabilities |
| Equities | Pension benefit | Bonds | Insurance policies |
Both of pension funds and insurance company are intermediaries between businesses and households. They are very big in funding the economic development, even more than banks. The problem that these institutions are solving is that the kinds of assets that household want to hold is different than the kind of liabilities that businesses want to issue. This indirect finance is key for economic development, because otherwise, this disjuncture between the desires of households and the desires of businesses, could get in the way.
The evolution of intermediation in the United States since 1916 has been to a hollowing-out of this sort of indirect finance, and has been to a much more direct finance through mutual funds.
Intermediaries: Mutual Funds
We have stock or bond mutual funds, which hold equities or bonds, but instead of promising particular payments, they just give you shares. You are bearing the risk directly. This is like direct finance. There’s no actual risk shifting. The risk is just passing right through.
| Stock Mutual Funds Assets | Liabilities | Bond Mutual Funds Assets | Liabilities |
| Equities | Shares | Bonds | Shares |
Bond funds have replaced the saving component of whole life insurance policies, and also bank time deposits, as fixed income saving instruments. Stock funds have replaced defined benefit plans as retirement income savings instruments. The mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by price changes rather than by traditional intermediation.
The rise of finance has been about the replacement of indirect finance (that , so) with direct finance (that promise the same thing to both sides).
| Indirect finance | Promise different things to different people. Solve mismatches with quantities. |
| Direct finance | Promise the same thing to both sides. Solve mismatches with prices. |
This is a big evolution from where it started, from indirect finance to direct finance. Today all the risks are counted for, all the risks are priced in markets. And there’s complete integration of the money market and the capital market.
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