Banks - Shadow Banking System

Many Financial Institutions that act like Banks are not supervised like Banks.  If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck - or so the saying goes. But what about an institution that looks like a Bank and acts like a Bank ?  Often it is not a Bank -  it  is  a  Shadow  Bank  !

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The  Shadow  Banking  System

The 2008 financial crisis was triggered by a run on short term bank debt, illiquidity in the commercial paper market and a sudden lack of confidence in the money market mutual fund industry. All three of these financial products are part and parcel of what is called the “Shadow Banking System,” which cannot depend on the safety net of either a lender of last resort like the Fed or regulatory agencies that can intervene to deal with the volatility of a run. 
As Yale economist Gary Gorton put it in his book, Misunderstanding Financial Crises : Why We Don’t See Them Coming, only a late bold move by the Fed and Treasury to guarantee the commercial paper market, to guarantee bank deposits up to $250,00, and inject the banks with tens of billions, saved the day. We learned that banks cannot survive without the substantial injection of short term funds from a sudden panicky withdrawal in the Repo Market, the Money Market, Mutual Funds or Commercial Paper.
A chart in the Financial Crisis Inquiry Commission Report underscored the significance of “ Shadow Banking” by showing it as a larger dollar amount than traditional banking from 2004 until 2008. “ The new Shadow Banks,” blares the report, issued in early 2011,” had few constraints on raising and investing money.” There was no regulation then and the situation has not been rectified. It is the reason Gorton predicts we will be blindsided again by the next financial crisis.
Curious, isn’t it, that until very recently the financial media has had very little focus on the “Shadow Banking System,” as distinct from the regular banking system represented by giant institutions like J.P. Morgan Chase, Citigroup and Bank of America. In point of fact, former Treasury Secretary and current Harvard economist Larry Summers underscored for me his anxiety over the continuing lack of regulation in the “Shadow Banking System,” suggesting that it could again by the locus of instability.  In other words, it’s definitely time for “ Shadow Banking ” to come out of the shadows.

Lately, we have had a cover story from the Economist called “Shadow and Substance,” which raises the question of whether the world of finance is safer now that “Shadow Banks are taking on a growing share of their business” away from traditional banks. The Financial Times has published a series of pieces on the “Shadow Banking” phenomenon including a column by Paul Tucker, former deputy governor of the Bank of England, who wrote recently that “tightening banking regulation is not sufficient to prevent excessive liquidity risk and leverage among so-called ‘shadow banks’ brewing another crisis down the road. That is a strong lesson from the US experience during the 2007-09 crisis, when myriad varieties of shadow banking collapsed in a heap, spreading panic and distress through the world economy.”
The danger is that policy makers and regulators have had their hands tied by parts of the Dodd-Frank bill. No longer is the Treasury Secretary allowed to independently decide in a crisis to guarantee the money market mutual funds. The FDIC cannot simply guarantee bank debt. I’m not sure what the process would be to guarantee the commercial paper market, where major corporations raise their short term working capital. Is it pie in the sky for Tucker, a senior fellow at Harvard University, to call for “a clearer framework for the regulation of markets, articulated as a coherent whole and based on clear economic and policy principles addressed to real-world vulnerabilities.”
Yes, I doubt this goal can be achieved by the Financial Stability Oversight Commission, which is made up of the bosses of every single regulatory agency, from the Fed to the Treasury, to the SEC, the CFTC, the FDIC, the Comptroller of the Currency. You get the idea. If the coming out of the shadows “shadow banking system” is taking a large share of business from the traditional banking system, then we better be making it an issue of current policy here in the U.S. We would not want to see a worse repeat of 2008, when the run on money market funds and short term repo agreements, the heart of short term banking finance, were subject to instant panic and money fleeing.