There’s a lot talk from Fed governors, including the Fed Chairman Ben Bernanke, about the reforming the Repo market. One critique is that Repo funding is generally unstable, that is, cash Repo investors quickly flee a teetering bank leaving it insolvent. Then once a bank collapses, the assets are inherently illiquid and the Repo cash investors have a liquidation risk in a “fire-sale.” Strangely, by substituting the word “deposits” for “Repo” and “loans” for “assets,” we’d be talking about the traditional banking system 100 years ago. Since the explosion of securitization and the development of the Repo market in the 1980s, there have been two parallel banking systems: The traditional banking system with existing stability mechanisms that developed over the years, and the Shadow Banking system which is still in the process of developing.
Traditional Banking System
The traditional banking system, in a general sense, is the business of a Savings And Loan (S&L) – they take deposits and make loans. As the saying goes, it used to be a “3-6-3″ business: borrow money at 3.00%, make loans at 6.00% and be on the golf course at 3:00 pm. Not that there’s anything wrong with that kind of business, but there’s a fundamental a problem with it – the loans are long-term and the deposits are short-term, which meant that a bank can easily become insolvent if depositors suddenly withdrew their funds.
In short, the term “Shadow Banking” refers to non-banks which perform banking functions. It’s a relatively new term attributed to Paul McCulley who first used it at the Jackson Hole, Wyoming economic conference in 2007 to describe “the whole alphabet soup of leveraged up non-bank investment conduits, vehicles and structures.” Instead of making loans, a Shadow Bank purchases long-term assets in the form of securitized loans: mortgage-backed and asset-backed securities. The “deposits” for a Shadow Bank come from Repo financing, so it’s the Repo market that provides all the short-term funding. In essence, the business of a Shadow Bank is the same as a traditional bank, except the Shadow Banking industry has securitized financial instruments. What’s more, where traditional savings and loan assets are estimated to be $14 trillion, Shadow Banking assets are estimated at $20 trillion. The Shadow Banking industry has overtaken the banking industry!
Instability In The Banking System
Since the beginning of banking, banks have been faced with that common problem: assets are long-term while deposits are short-term. During normal times, the business model works well, there is historically a good spread between long-term and short-term interest rates. Years ago, major problems arose when there was trouble at a bank – depositors lined up outside the doors to withdraw their funds, because at the time, when a bank went bust a depositor would lose everything. During a crisis, the public would take their deposits out of many banks, not knowing which ones were necessarily in trouble, and that made the entire banking system inherently unstable. Luckily, solutions developed over the years.
The first step was the establishment of the Central Clearing Counterparty (CCP), which was not Fixed Income Clearing Corp (FICC) or LCH.Clearnet. The first bank clearinghouse was organized in 1853 to clear checks and become the era’s “bank examiners,” but most importantly, the clearinghouse served as a mutual support mechanism for its members in times of crisis or bank panic, which were numerous in the 19th century.
In 1913, Congress established the Federal Reserve System which provided back-up funding facilities for traditional banks and took over the CCP function from the clearinghouses. Ironically, the back-up funding facilities the Fed created was the Repo market, by allowing banks to temporarily finance Banker’s Acceptances with the Fed in 1919. The traditional banking system was then further stabilized with the Banking Act of 1933 which created FDIC insurance for depositors and allowed the FDIC to unwind failed banks. With the Federal Reserve, FDIC insurance and a mechanism to unwind failed banks, all the pieces were in place for a stable banking system for the next 70 years.
Evolution of The Shadow Banking System
With the creation of money market funds and securitization in the 1970s, then the development of the Repo market in the 1980s, Shadow Banking grew in parallel with traditional banking. It should be no surprise that Shadow Banks would have the same historical problems as a traditional bank – in a crisis, the deposits (Repo funding), can be pulled and banks become insolvent.
So far, support for the Shadow Banking industry has developed along the same lines as that for traditional banks. The first CCP for the Repo market, Government Securities Clearing Corp (which later became FICC), was created in the late 1980s and initially only compared trades – making sure the Street booked their trades correctly. In the mid-1990s, trade netting emerged and GSCC became the counterparty in between banks. At the time, the Fed was providing some liquidity in the Repo market for Primary Dealers, but support was minimal until after the Banking Crisis in 2008.
Current State of Shadow Banking
The Fed is now worried that the over-reliance of short-term funding in the Repo market is inherently unstable, which was the original issue in the traditional banking system. The development of the Shadow Banking system is now, historically, somewhere between the establishment of CCPs and the establishment of the Fed and FDIC for the traditional banking system.
So that’s where we are now. Much of the insolvency and liquidity problems for traditional banks were initially solved through CCPs, then through the creation of the Fed, then with FDIC insurance and liquidation. The Shadow Banking system is still developing and the traditional banking system can be a model. If this really is the path of the evolution, then the next step for Shadow Banking is a form of FDIC insurance and/or a mechanism to wind-down a failed institution. That’s exactly what the Fed is talking about now, since the Fed is pushing the Repo market to develop a liquidation facility which is to be maintained by the industry.
For all the talk about the need for a liquidation facility, still no one is sure what it should look like. Should there be a Repo Deposit Insurance Corporation (RDIC) and buy up failed Shadow Banks? I doubt it. Can you imagine Fed officials explaining that the Wall Street Repo market would be back-stopped by the government and ultimately taxpayers? Could the Repo liquidation facility be an extension of FICC and LCH.Clearnet, the CCPs? Maybe. But one thing has been made clear, if the market doesn’t come up with a solution, the Fed will mandate it through regulation.