Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, November 21, 2012

Shadow Banking

The Arrow-Debreu model provides the foundation for modern macroeconomic theory and the theory of finance. This is probably as it should be. But like most foundations, it is just a place to start. As John Geanakoplos explains here, the AD model is "relentlessly neoclassical." And what this means, among other things, is that the basic AD model offers no explanation for phenomena related to money, liquidity, banking, and corporate finance (just to offer a partial list). 
To make sense of phenomena like money, liquidity, and collateral, we need to model the "frictions" that make intertemporal trade difficult. Frictions like private information, limited commitment, and limited communication. Absent such frictions, debtors could spend their promises easily. Creditors would not not have to worry about promises being broken. Such a world is not likely be free of the business cycle. But business cycles would likely be muted (small shocks would not be magnified as much, or propagated throughout the economy to the same extent). 
Of course, economists throughout the ages have thought about these sort of frictions. And there is a substantial body of modern macroeconomic theory that attempts to formalize these notions. A heretofore neglected area of research, however, is what economists have come to call the "shadow banking" sector (see here, here and here). Some recent theoretical work can be found here: 

A Model of Shadow Banking, Gennaioli, Shleifer, Vishny
Shadow Banks and Macroeconomic Instability, Meeks, Nelson, Allesandri

The shadow banking sector is still very large--take a look at this recent news story: Shadow Banking Still Thrives. According to Gary Gorton (Shadow Banking Must not be Left in the Shadows) the shadow banking sector needs to be regulated...somehow. It seems like we're still not exactly sure how this should be done or, indeed, if it is even feasible. 
What I mean about "feasibility" is the observation that private agents, particularly those in the financial industry, seem to be extremely good at innovating their way around existing bank legislation. Shedding light on one dark place in the room just causes the little critters to find other shadows. Who knows, maybe that's even a good thing. But I haven't really seen any theoretical papers on the subject (please send if you have). 

Here is Ken Rogoff on the subject: Ending the Financial Arms Race. Here is an excerpt:
Legislative complexity is growing exponentially in parallel. In the United States, the Glass-Steagall Act of 1933 was just 37 pages and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages, and requires regulatory agencies to produce several hundred additional documents giving even more detailed rules. Combined, the legislation appears on track to run 30,000 pages. 
As Haldane notes, even the celebrated “Volcker rule,” intended to build a better wall between more mundane commercial banking and riskier proprietary bank trading, has been hugely watered down as it grinds through the legislative process. The former Federal Reserve chairman’s simple idea has been co-opted and diluted through hundreds of pages of legalese. 
The problem, at least, is simple: As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.


  1. Glass-Steagall Act of 1933 was just 37 pages

    Those of us who have practiced banking law from Glass-Steagall until today would argue that there are no new products, except for the ATM and that the length of statutes and regulations has increased geometrically since the conservative assault began on the Warren Court. Courts, today, for example, require every term (even those of the most common everyday meaning) to be defined.

    Just think of the hue and cry that would come from the throat of Scalia if Congress made it a federal felony to fail to operate an investment bank in a save and sound manner or to fail to use due care in the management of a commercial bank.

    The regulatory expansion you see is entirely the result of conservative courts that refuse to enforce plain, simple rules.

    1. Can you give us an example of what you claim in your last sentence? And also, explain why this is the case (that is, what motivates courts not to enforce plain simple rules?)

    2. The best single example I can give is how the Courts have treated the mail and bankfraud statutes

      18 USC 1341 starts, "Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises etc."

      If you read the early cases the courts said that everyone knew was a scheme to defraud was.

      Further, the routine jury instruction was a scheme to defraud was a departure from fundamental honesty, moral uprightness, or fair play and candid dealings in the general life of the community

      Now, the right wing pro business judges attack such a vague. United States v. Leahy, 445 F.3d 634, 646 (3d Cir. 2006) is a good example. Here are passages from the opinion.

      Focusing on the emphasized sentence above, the Defendants contend that the jury instruction defining fraud as a deviation from moral uprightness or fairness was erroneous. In particular, the Defendants contend that the instruction was too vague, permitting conduct to be criminalized without sufficient specificity, and failing to ensure that "ordinary people can understand what conduct is prohibited and in a manner that does not encourage arbitrary and discriminatory enforcement."

      We have, in the past, defined fraud with reference to the elastic concepts of morality and fairness when discussing the reach of the federal fraud statutes.

      However, as a tool for construing the scope of the federal fraud statutes, the formulation of fraud as a departure from moral uprightness and fairness has come under increasing criticism. In particular, the ambiguity inherent in concepts such as morality and fairness has been thought to provide constitutionally inadequate notice of what conduct is criminal, involve judges in the creation of common law crimes, and place excessive discretion in federal prosecutors. See United States v. Panarella, 277 F.3d 678, 698 (3d Cir.2002) (noting that such formulations of fraud "do little to allay fears that the federal fraud statutes give inadequate notice of criminality and delegate to the judiciary impermissible broad authority to delineate the contours of criminal liability")

      Defendants correctly note that courts, including this one, have typically used the morality and fairness formulation of fraud only as a statement of statutory intent or as a means of defining the scope of the federal fraud statutes; we have not, however, examined the proprietary of using such language in jury instructions. We admit that the concerns we expressed in Panarella, as well as by other courts, are magnified in the context of jury instructions, as it is probable that the jury will be swayed by elastic formulations of morality and fairness in the absence of sufficient context and guidance from the court.

      Now, people who write regulations know that the Courts will listen to silly attacks such as that made by the Defendant in Leahy so, anticipating such, they define, define, and define, anticipating the argument and the judicial bias to its favor.

      If you read advance sheets everyday like I do this would be routine knowledge. Right wing judges endless harp that this term or that phrase is not defined in the statute or regulation. It is constant and unending. To try to anticipate the vagueness argument, millions of words are added to statutes and regulations.

      Examples abound. Look at OSHA. The regs have to detail how high a guard rail because the argument will be made, if you just say, the employer shall furnish a safe place to work, that "I didn't have notice that such meant I had to have guard rails on stairs."

      This is an example of academic silos. Every lawyer knows about what I am writing. Few economists.

    3. David

      Courts don't enforce simple rules because they work.

      Look at the hue cry is Dodd Frank read.

      1. No one who accepts money on deposit or who lends money shall engage in an unsafe or unsound practice.

      2. The Secretary of the Treasury may impose a monetary penalty of not less than $1,000 and not more than $100,000,000 upon any person who personally participates in an unsafe or unsound practice or who actively participates in such unsafe or unsound practice or who furthers such by cooperation or request or who lends aid or abets or encourages the unsafe or unsound practice under facts and circumstances where a person, exercising the highest degree of care, would have known that such cooperation or request or aiding or abetting encouraging would have assisted or resulted in such unsafe or unsound practice.

      The simpler the rule the more power one gives to the government. It is that simple, as my two sentences show

    4. Here is a link discussing this kinds of legal issues, as such applies to the what is unfair in the eyes of the Federal Trade Commission

    5. So really time consuming work is done to answer your question, time spent going through thousands of opinions to find one (United States v. Leahy) where the judges even write that the vagueness attack is a recent one ("come under increasing criticism")(corresponding the the increasing right wing nature of the federal judiciary) and the reply? Nothing, not a peep, not a word of thanks.

      The need for Dodd-Frank to be 848 pages long has nothing to do with the merits of the law and everything to do with judiciary intent to interfering in every possible way with its enforcement.

    6. For the interested reader, yesterday, the 2nd Circuit freed two accountants convicted of tax fraud. United States v. Coplan

      If one wants to understand why Dodd Frank is so long and why there have been indictments of all the crooks on Wall Street, read United States v. Coplan

      You will quickly see from the tone and result of the opinion, holding the gov't had proved a case, why there were no prosecutions and why Dodd Frank is so long and detailed.

    7. For the interested reader, and this is my last comment, as I am stopping all commenting on economic blogs for I believe such blogs no longer serve a useful function, it is important to point out how the Hayekian pov on the rule of law plays into this discussion. For starters, this POV didn't start with Hayek (he was just a ringer who stole ideas of others). The argument is made that the "rule of law" requires detailed advanced notice. That there is no rule of law if the law permits discretion. The wise reader will not that the premise of this proposition is that the government knows the future and what it holds well enough to know what detailed rules are needed. This is the fundamental duplicity of Hayek. If a government were that smart, well it could plan centrally, which he argues isn't possible.

      George Soros has given the best answer and he did such at a televised event at CATO, which is easily found for anyone who wants to look.

      As to why no more comments. The election has been won and Modernity has prevailed for another two years. The public has shown it has learned the wisdom of Mark Twain (there are lies, damn lies, and then economics, especially economic bloggers).

      There is simply no future point in commenting about matters which are not science. Until economics reaches a point that it is sufficiently scientific that all the false profiteers (Taylor, Cochrane, Williamson, etc) are thrown out, the best approach to the subject going forward is the Twain attack (lies, damn, lies, and economics).

      Look at this blog. Look how hard it was for David to write against the utter silliness of the gold bugs. Gold bugs do nothing but erode confidence, playing upon the fears, doubts, and uncertainties of the public. The linkage that should be attacked are those between the advertisers for Rush, Beck, and Forbes and the silliness of gold.

      Under the best of circumstances, managing a modern system of finance and keeping public confidence is an immense task. People like Williamson, Taylor, and Cochrane are wrong for two reasons. First, they are wrong on the economics, but worse, they are wrong on the tone, manner, and means by which they launch their attacks. They destroy confidence, at no penalty to themselves.

      Probably everyone will say good riddance, but I am comfortable that, on reflection, someone is going to ask, why does someone who has the most moderate of views (it is not as simple as printing money) see so little in what I write?

    8. Again for the reader stuck in the economics silo and wants to understand why federal legislation must be so long and complex, the Harvard Law Review has as its Supreme Court Foreword, Democracy and Disdain

    9. Here is Alito, last term, driving statutes and regs toward complexity

      In this case, there are strong reasons for withholding the deference that Auer generally requires. Petitioners invoke the DOL's interpretation of ambiguous regulations to impose potentially massive liability on respondent for conduct that occurred well before that interpretation was announced. To defer to the agency's interpretation in this circumstance would seriously undermine the principle that agencies should provide regulated parties "fair warning of the conduct [a regulation] prohibits or requires." Gates & Fox Co. v. Occupational Safety and Health Review Comm'n, 790 F.2d 154, 156 (C.A.D.C.1986) (SCALIA, J.).[15] Indeed, it would result in precisely the kind of "unfair surprise" against which our cases have long warned. See Long Island Care at Home, Ltd. v. Coke, 551 U.S. 158, 170-171, 127 S.Ct. 2339, 168 L.Ed.2d 54 (2007) (deferring to new interpretation that "create[d] no unfair surprise" because agency had proceeded through notice-and-comment rulemaking); Martin v. Occupational Safety and Health Review Comm'n, 499 U.S. 144, 158, 111 S.Ct. 1171, 113 L.Ed.2d 117 (1991) (identifying "adequacy of notice to regulated parties" as one factor relevant to the reasonableness of the agency's interpretation); NLRB v. Bell Aerospace Co., 416 U.S. 267, 295, 94 S.Ct. 1757, 40 L.Ed.2d 134 (1974) (suggesting that an agency should not change an interpretation in an adjudicative proceeding where doing so would impose "new liability ... on individuals for past actions which were taken in good-faith reliance on [agency] pronouncements" or in a case involving "fines or damages").


  2. "Courts, today, for example, require every term (even those of the most common everyday meaning) to be defined. "

    There must be a limit somewhere. If nothing is taken as antecedently clear, there are no terms in which a definition can be given.

  3. Andrew Haldane had a paper about banking as creating pollution (systemic risk and a put on taxpayers). In the pollution literature, there are 2 approaches - taxation or regulation. So maybe the infeasibility of regulation shades us toward designing a tax structure for banking as a better method of controlling pollution ?

  4. David,
    The shadow banking sector exploded in size (relative to the traditional sector) after 2002. This is especially true if one looks at the non-GSE portion of shadow banking.

    Does financial innovation explain the post-2002 growth of the shadow banking sector? Unlikely. For instance, sub-prime lending and even option arm mortgages existed before then, as did CLO's (the cousin of CDO's).

    The purpose of shadow banking is primarily speculative maturity (and liquidity) transformation. What happened in 2002 to create more demand for that form of speculation? The Fed's dramatic shift to a (transparent) forward rate guidance regime, which made levered duration bets much safer.

    The Fed's communication strategy seeks to engage speculative shadow banking activity as the primary transmission for monetary policy. The problem is this creates a more homogeneous and therefore more fragile financial system. Regulation is an important check on shadow bank systemic risk, but as long as the Fed targets certain asset prices (i.e. long term bond yields) in a transparent manner, that risk will rise.

    1. It does not seem to me that our explanation is correct.

      Agents (corporate officers and directors) decided whether to enter the casino of shadow banking, especially gambling in its pure form like synthetic CDOs.

      The "explosion" in shadow banking came when we had Bush/Greenspan coupled with a federal legal system that through out all regulation of agents in Central Bank of Denver in 1995.

      AIG was an agency problem, having nothing to do with The Fed's dramatic shift to a forward rate guidance regime.

      When you have lawful gambling where agents can make hundreds of millions by gambling using other people's money, who can claim surprise that trillions are suddenly wagered?

    2. Shadow banking was not designed as a "casino". Firms placed giant levered duration bets using AA/AAA-rated assets. In other words, they sought to insulate themselves from credit risk while focusing on the information content of Fed communication: that rate volatility should drop and remain low.

      It was the six-sigma event of losses climbing up the waterfall of tranches to hit AA that finally broke AIG and the bond insurers (Ambac, MBIA). In other words, they too were playing a safe-asset "basis" trade that relied, in part, on low rate vol.

      The GFC was not a crisis of risky lending, it was a crisis of perceived risk-less lending brought about largely by Fed-fueled duration bet strategies.

    3. Diego:

      Truth, like art, is in the eye of the beholder.

      You seem, to me, to make a Freudian slip [admission against interest] merely by the use of the word, "bet."

      Given the facts and circumstances, everyone knew the ratings were MAI and had no connection to reality. Were the agencies required to warranty their ratings? Opinions not backed up by one's bond have always been meaningless.

      Your problem is exposed incentive caused bias. It has to be the fault of the Fed because your bias is against the Fed.

      My POV is just based on the facts. Agents could make millions by gambling, with nothing to loose. Surprise they bet and won, leaving the later losses to shareholders and tax payers.

      Here is a little truth going forward. Poor management, not union intransigence, killed Hostess.

    4. I had hoped you had disappeared forever, John, but alas Santa Claus did not come this year. Get your nonsense to a less-knowledgeable crowd -- I hear anthropologists are a good audience for crackpot economics.

    5. The Fed's communication strategy seeks to engage speculative shadow banking activity as the primary transmission for monetary policy. The problem is this creates a more homogeneous and therefore more fragile financial system.

      Diego, how, in your view, should have monetary policy been conducted over that period to avoid the problem you highlight here?

  5. Interesting post. I am just now reviewing the FSB policy papers and you would be amazed by their regulatory ambitions (FSB oversight and regulation of shadow banking entities). It would Consultation Document: A policy Framework for strengthening seem that all maturity/liquidity transformation and leverage among non-bank financial institutions will be monitored and controlled/restricted. Interesting issue is who will retain any of the socially required maturity transformation once banks have abandonded long term investment to firms (is being replaced by more lucrative bond deals) and concentrate on real estate loans that they don't keep on the balance sheet (ref covered bonds)? And similar among shadow banks will be severely restricted. I guess central banks will be called upon once again to intervene when all this new market liquidity breaks down again. But, agree with first post that this is "old wine on new bottles", although the volumes are tremendously much higher now.

  6. Nice post David.

    I have recently, and unexpectedly, been placed squarely in the front lines of the shadow banking industry. My firm is now offering "direct lending" funds to our high net worth clientele. It seems startling to me that an elderly widow with a total net worth of say $2.5 million can relatively seemlessly lend to a relatively small, private recyling plant in rural Germany (about EUR 40M in annual EBITDA). Of course, total fees, which require Excel and several sensitivity tables to actually estimate, are in the 4-8% range, and some are not plainly disclosed. With both retail and institutional investors distorting yield-related product supply/damand fundamentals (I suppose more generally, distorting risk pricing), it seems only a matter of time until such products revert back to equillibrium. A bubble seems to be forming in high yield credit (perhaps all credit), and at least some of it seems to be the result of poor regulation. Some jurisdictions (ie BC) have toyed with a principles-based regulatory regime. To date, though, these models are still pipe dreams.

    1. Armchair,

      Can you tell me at what terms this elderly widow is lending to the German plant? Is it a short-term loan, expected to be rolled over indefinitely? Or is it a longer term loan (and if so, I wouldn't call this shadow banking)?

  7. I can't recall exactly, but the nature of the product is such that there is a long-term committment of capital requried by the client to the fund (much like a PE fund). The term on that particular loan, one of many that the fund will make, is something like 3 years.

    Could you please explain why the temporal distinction would matter? It seems to me that so-called "direct lending" is simply a means for depositors and borrowers to bypass the typical bank channel (or as the FSB says, "credit intermediation involving entities and activities outside the regular banking system").

    Direct lending also seems to skirt by market pricing mechanisms since the loans are generally just priced on a highly subjective comparative basis (i.e. private company x looks like public company y, whose debt trades at z, ergo the price of x's debt = z +/- various subjective adjustments). I would think that this subjective pricing mechanism should in and of itself be the subject of regulatory scrutiny.

    I should point out that this direct lending fund is sponsored by a bank-owned entity, and it may incorporate leverage.

    1. Armchair,

      My own definition of banking is an activity that transforms illiquid (typically longer term) assets into liquid (typically short term) liabilities. Demand deposit liabilities used to finance home loans, for example. Or in repo, overnight loans collateralized by MBS.

      The short term nature of the liabilities provides investors with flexibility and protection (they can get out quickly). But this type of finance structure may also be susceptible to rollover risk.

      This is why the temporal dimension matters, when talking about banking. Your elderly widow is just doing a conventional lending activity (long term liability supporting a long term capital project). Wouldn't call that "banking," but you may find the distinction just semantic.