One of the great regulatory failures of the recent financial crisis was the inability to recognize the role, growth and size of the shadow banking system. That system includes intermediation activities performed by unregulated nonbanks. The crisis was caused by a traditional banking run in the shadow system. The run was triggered — not caused — by subprime losses. These losses, although significant at several hundred billion, were too small relative to the multitrillion-dollar financial system to have caused such widespread damages.
The continued inability to recognize the problem is reflected in current regulatory reform efforts, including the Dodd-Frank Act and Basel III, which continue to round up the unusual suspects.
The danger of an unregulated and uninsured shadow banking system remains. It is based on the vulnerability of shadow banking liabilities resulting from their mismatch to the assets being funded.
Depression-era deposit insurance was designed to address this problem. In exchange, banks became heavily regulated. The shadow banking system lacks deposit insurance protection.
Thus, it is vulnerable to a run, which started in 2007 when questions concerning subprime collateral values became too large to ignore. The run involved nonbank financial institutions such as Bear Stearns and investors like Fidelity instead of depositors and regulated banks.
The first shadow banks were the government-sponsored entities Fannie Mae and Freddie Mac. They created information-insensitive claims like bank demand deposits by backing their claims with high-quality collateral. The system grew rapidly since the 1980s to rival traditional banking in size. The growth reflected, in part, the absence of regulatory capital requirements. It relied upon a secured form of short-term lending known as a repo.
A key feature of the repo is the assets are excluded from the borrower's bankruptcy estate.
Securitization vehicles like asset-backed commercial paper conduits used bankruptcy remote structures to achieve similar investor protection from issuer bankruptcy. The lender can liquidate the securities if the borrower fails to repurchase them at par.
The collateral used shifted from low-risk Treasuries to higher-risk triple-A-rated structured products over time. The triple-A rating served as a substitute for demand-deposit-related FDIC insurance.
The key to the shadow system is the stability of repo collateral values. Once subprime losses occurred from falling housing prices in 2007, belief in those values evaporated, leading to a run.
It reached crisis proportions in the third quarter of 2008 as banks and nonbanks were forced to sell assets at large losses to satisfy liquidity needs. The opaque nature of triple-A structured products relying on subprime collateral complicated identifying who held the assets.
Consequently, counterparty risk concerns increased once the ratings facade of structured products collapsed.
This caused the repo haircut or discount to increase from essentially zero in precrisis 2007 to over 50% for triple-A structured debt in late 2008.
This constituted a massive reduction in the effective money supply with spillover effects into the real economy.
The Federal Reserve's monetary policy has tried to offset this contraction by increasing banking system liquidity, albeit only with partial success.
Addressing the shadow banking issue involves two considerations. The first is regulatory collateral control by establishing minimum repo haircuts for structural products. Also, a cap on the level of investment grade-rated structured products created from a pool of underlying assets is needed.
These actions would enhance the system's stability by reducing leverage levels.
A more expansive consideration would extend the banking system safety net of deposit insurance to shadow banks. This requires extending banking system regulatory controls as well.
Understanding what happened is critical to developing effective remedies. Unfortunately, existing financial reforms continue to ignore the shadow banking system. Thus, we will undoubtedly experience another crisis in the not too distant future.