It’s a parallel universe where conventional physics don’t apply and the rules of law are suspended.
Recessed from public view and largely from public scrutiny is the shadow banking system. In many ways it resembles Sicily’s Cosa Nostra – the covert society that long stood in as the government behind the government.
The shadow banking system has it own conventions and Omerta – code of silence. Similar to the Mafia, only a select minion is permitted among its ranks. Despite this clandestine reality, however, its power and importance in our financial system are unmatched.
In recent decades, this “alternative” banking organism sprang up in the American economic scene as a novel way for the finance industry to perform its traditional role of linking savers with borrowers. This system was at the heart of the financial crisis — and, according to a new paper prepared by the New York Fed, bigger than our traditional banking system.
According to the best figures compiled by the Fed, there's still $16 trillion associated with the shadow-banking system, more than the entire gross domestic product of the U.S. The U.S. GDP was only about $13.2 trillion in 2009. Shadow banking comprises the esoteric material that came to define the recent financial crisis. These include securitized loans, CDOs and the repo market. But the shadow system also encompasses the money-market mutual funds that have long been familiar to ordinary investors, and that provide much of the cash that keeps the system flowing.
Timing Was Way Off
Although conventional wisdom cites the housing bust as the engine that drove the economy into the ground, the most acute phase of the crisis was defined by a run on the shadow banking system; all of the savers/lenders wanted their money back at the same time.
As we learned from the Great Depression, banks can't survive when runs are uncontrolled — particularly if the banks are heavily dependent on short-term loans. This is why the FDIC (Federal Deposit Insurance Corporation) was created.
Lehman Brothers collapsed and Bear Stearns both were forced out of business by unchecked runs on the shadow banks.
The transformation of high-risk, 30-year mortgages into AAA-rated securities held by money market funds involved multiple transactions along an interconnected chain. As detailed in the recently released report from the New York Fed, “over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term securities”
Fed researchers acknowledged that the shadow banking system also helped to finance a significant part of the U.S. current account deficit by creating trillions of dollars of top-rated securities that were purchased by foreign investors.
They Are Looking More Alike
The gap between the shadow banks and conventional banking has narrowed. Back in 2008 as the crisis began to swallow the economy, the shadow banking system accounted for $20 trillion in obligations compared to just $11 trillion for conventional regulated banks.
To stave off a full-blown depression, the U.S. government lent, spent or guaranteed $11.6 trillion to bolster the financial markets and to pull the economy out of the deepest recession in 70 years. This aid included agreeing to backstop obligations such as asset-backed commercial paper, collateralized debt obligations and money market funds that helped finance home mortgages, credit card borrowing and auto loans.
Profits from the shadow banking world are the bread and butter of financial powerhouses like Goldman Sachs, JP Morgan Chase, Citigroup and AIG. Although these surreptitious banking practices are now under greater public scrutiny, this should not be mistaken for increased public oversight or control over their activities. Unfortunately, the recent passage of the biggest financial overhaul since the Great Depression will do very little to change this.
Recently, after much ballyhoo, the Securities and Exchange Commission sued Goldman Sachs over one of its shadow banking vehicles known as Abacus. The government claimed that it had caught Goldman red-handed in a web of lies, deceit and fraud. This suit was touted as the tip of the spear – a real step in bringing these murky machinations into the light of day.
I wrote then that the SEC might as well have brought suit against the wind. Even though, Goldman has now settled the Abacus suit for $550 million – the largest civil settlement ever obtained by the SEC – the government was unable to make the charges stick, and Goldman has not been compelled to admit any real wrongdoing. As to the half-billion dollar fine, it represents only about nine days’ profit for the banking behemoth.
The newly passed financial oversight laws merely tinker at the edges of the problem. They will not force real changes in the shadowy doings that nearly toppled our entire financial system. While the bill sets up a commission to monitor these unregulated practices in the hope that it can nip the next crisis in the bud, few economists believe this will abate the risks of “too big to fail” financial institutions. Most agree that the six largest banks will continue to enjoy the enormous implicit subsidy that results from the expectation that the federal government will bail them out in the event of a crisis.
Like the Cosa Nostra, politicians of every ilk have vowed to put an end to the grip shadow banking holds over our financial system. Yet despite their best efforts and intentions, the Mafia remains, and the shadow banking system is as potent a force in our economy as it has ever been.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
