After the so-called Wall Street reform and the new Basel II rules has been approved, one might think that we have some kind of framework in place that’ll give us more transparency into the global financial activity, and hopefully a possibility to put the brakes on if any of the major banks should try to run wild again. But that’s certainly not the case. A few major US and European banks still keep about USD 25 trillion – of their total interbank market of USD 55 trillion – in the shadow banking system – with no oversight, no rules and no control.
“The first change that is required is what I have called a true “quantum leap” in the rules that regulate how countries make their national economic policies.”
Map of the most central nodes in the web of financial connections.
The shadow banking system or the shadow financial system consists of non-depository banks and other financial entities – investment banks, hedge funds, and money market funds – that grew dramatically in size after the year 2000 is still playing a critical role in lending between banks and businesses. It is also a key element in explaining the financial crisis. But little has changed over the last couple of years.
Shadow banking institutions are typically intermediaries between investors and borrowers. For example, an institutional investor like a pension fund may be willing to lend money, while a corporation may be searching for funds to borrow.
The shadow banking institution will channel funds from the investors to the corporation, profiting either from fees or from the difference in interest rates between what it pays the investors and what it receives from the borrower.
Many shadow-bank-like institutions and vehicles emerged in both the American and the European markets between 2000 and 2008, and have come to play an important role in providing credit across the global financial system.
In June 2008, US Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, described the growing importance of the shadow banking system, saying:
“In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.”
In other words, lending through the shadow banking system seemed to exceed lending via the traditional banking system based on outstanding balances.
The equivalent of a bank run occurred within the shadow banking system during 2007 – 2008, when investors stopped providing funds to (or through) many entities in the system. Disruption in the shadow banking system is a key component of the ongoing financial crisis that started with the US subprime mortgage crisis.
But in spite of all the new regulations, both legislated and proposed, the shadow banking market seems to keep on growing.
According to the latest estimates from the IMF (illustrated above) the shadow interbank market of the major US and European banks is estimated to about USD 25 trillion, compared to the “official” banking system with an estimated value of USD 30 trillion.
I assume there’s no (or little) data on the Chinese shadow banking market. And if you take all banks in the world into account, you’ll end up with a global financial shadow system of stunningly USD 450 trillion!
Estimated notional value of the global shadow banking system.
Now – compare this to the total value of the global economy.
Or – to the total size of the US economy.
(NOTE: This is the notional value rather than market value, but in uncertain times market values and notional values can converge.)
In short, it’s the massive pile of derivatives accumulated over the past decades.
It’s also tightly coupled and extremely complex, and worse, not fully understood.
It isn’t regulated, nor is it liquid enough to price, which is why global banks are still able to “act” like they are solvent.
Lloyd Blankfein, Kenneth Chenault, Kenneth D. Lewis, Edward Yingling.
You can also view the shadow banking system is as a financial amplification system.
A byproduct of its operation is that it can take small financial events and convert them into financial nuclear weapons that explode with a spectacular display and devastating effect.
I would not be surprised if we were to see more financial nuclear explosions as the shadow banking system may amplify an increasing number of small and unexpected events into a full-blown disasters.
Trichet’s Desperate Call
“The first change that is required is what I have called a true “quantum leap” in the rules that regulate how countries make their national economic policies. Countries need clear rules and procedures to guide policy-making and sanctions if they stray from a sustainable path,” Jean-Claude Trichet said in a speech on February 11.
Trichet pointed out that this means a strengthening of the European Stability and Growth Pact, (the framework first negotiated by the German finance minister Theo Waigel to prevent countries accumulating excessive public debts and deficits).
“The period between 1999 and 2008 was generally acknowledged as a period of economic fair weather. Yet in this period, hardly any euro area country put their fiscal house in order, attaining what might be called a safe budgetary position. What is more, governments decided to weaken the Pact in 2004 and 2005. This initiative was led by the euro area’s largest economies.”
“The ECB voiced its grave concerns at the time. I now see that many acknowledge that the weakening of the Pact was a serious misjudgment.”
“But the crisis has given us an opportunity. It has made plain the flaws in the Pact that allowed countries’ fiscal policies to become a problem, not just for themselves, but for everyone else within the monetary union. We now have an obligation to fix the flaws.”
First and foremost, this means creating stronger and more binding rules for fiscal policy, backed up by reinforced sanctions or mechanisms to ensure compliance with the rules, Trichet said.
Second, a new framework is needed to monitor competitiveness and to ensure that measures are taken to control them.
“We need to put in place binding rules that guide policies towards sustainable and balanced growth. Such a reform package is currently before the European Parliament. The ECB very much counts on the Parliament to call for very clear and strong governance rules, including automatically in triggering procedures and sanctions, which will be to the long-term benefit of Europe’s citizens. In a union with a single monetary policy and 17 different fiscal and economic policies, a “quantum leap” in economic governance is necessary to ensure that the degree of economic union is fully commensurate to the already achieved monetary union.”
(Here’s a transcript of the speech.)
Exactly How Serious?
“Grave concerns,” a “serious misjudgment,” and need for a “quantum leap” in surveillance and regulation of the banking system – sounds pretty serious to me….
But finding out exactly how serious, is not an easy task.
However, the International Monetary Fund, IMF, have done some research on the topic. Recent published documents and working papers contains some statements, calculations and illustrations that gives some clarity of the problem.
In a working paper on cross-border capital flows from November 2010, the IMF researchers write:
“Thus, with international asset positions now dwarfing output, global portfolio allocations and reallocations have profound effects on the world economy, as demonstrated by recent boom-bust episodes of both global reach and regional significance (in Asia, Latin America, and Central and Eastern Europe). Such cycles and reversals in cross-border capital flows should not be surprising, given that these flows—more so than domestic ones—imply crossing informational barriers, currency and macroeconomic risks, and regulatory regimes.”
“In contrast to trade in goods and services, there are no widely accepted “rules of the game” for international capital flows—this despite being the principal conduit for the transmission of global shocks.”
“Cross-border capital flows take place without global “rules of the game.” At the Fund [IMF], and in contrast to the obligation to liberalize payments and transfers for current international transactions, the Articles of Agreement explicitly grant members the right to “exercise such controls as are necessary to regulate international capital movements.” Since the failure to amend this provision of the Articles in 1997, the Fund’s work in this area has focused on analytical and conceptual issues, with policy advice not always offered consistently.”
While the consensus amongst professional economist seems to be that the cross-border activity mostly have positive effects on economic growth and financial stability, there is a few studies that points at the following:
- There is no consensus on the appropriate speed of liberalization. Overly hasty loosening appears to have contributed to financial instability in a number of cases. While gradualism allows agents to adjust, interest groups may use delays to try to frustrate reform.
- Weak regulation, especially of banks, is associated with financial crises following liberalization and suggests a more measured pace of liberalization, with regulatory reform running in parallel. Specific risk exposures of financial institutions should also be considered.
- Weaknesses in fiscal or external conditions, or questions on debt sustainability, could result in premature capital account liberalization resulting in a rapid build-up in imbalances or an increase in vulnerability to large reversals in capital flows.
At a systemic level, the size and nature of cross-border financial liabilities between major financial centers implied that unprecedented international coordination is required to mobilize resources sufficient enough to stem the impact of the liquidity shock.
“Given that usage of the US Federal Reserve swap lines rose to US$600 billion during the crisis, it is pertinent to ask how future crises might be tackled should capital flows, and the attendant balance sheet exposures, resume their former growth trends,” the IMF researchers writes.
They also give a few hints on the current trends:
“Strong, structural, economic reasons underpin much cross-border investment: ageing populations in advanced economies, sustained differential in growth potential between emerging markets and advanced economies, steadily improving access to information and declining home bias in investment all suggest capital flows will keep increasing, albeit not necessarily in a steady fashion.”
“The global nature of capital flow cycles suggests that cross-border flows may be driven by common factors such as global liquidity conditions or overall increases in risk appetite.”
“Financial institutions will typically not consider the systemic vulnerabilities their actions engender, and single-country regulation can simply push financial activity elsewhere, without reducing systemic risk. Within economic cycles, banks may generate an externality by taking on too much risk as asset prices rise and the economy expands, without taking into account the consequences to the broader economy when the cycle turns down. This implies small shifts in assets within the institution can generate large capital flows for the debtor countries, and that neither the financial institution nor their home regulators will attach much weight to risks taken in these economies.”
Liberalization, maintenance, or re-imposition of capital controls has responded to domestic policy priorities, and has had often far-reaching consequences for domestic stability.
These policies have also had implications for partners, peer countries and, collectively, the IMS as a whole. Over the past decades, there has been a trend toward capital account liberalization.
“This trend has declined in recent years, with emerging markets tightening controls on inflows at the margin, although this has not yet made an appreciable difference overall. More generally, for many emerging markets the process of integration with international capital markets has been “stop and go”, with periods of liberalization and growing capital inflows punctuated by reversals, and a less linear approach to liberalization, with some reversals in policy and a more frequent use of capital controls or prudential policies with a similar ultimate effect. The liberalization process has also varied across types of financial instruments, with a larger share of countries maintaining controls on debt creating capital inflows.”
And this is where the money seems to be heading:
Trends in capital flows.
The common roots and potential solutions for risks associated with capital flows arise in the context of an absence of any universal frameworks for addressing them, according to IMF.
In contrast to trade and related payments, for example, there is no universal framework that governs or otherwise oversees international capital movements. In turn, this might lead to the following:
Prolonged maintenance of controls: Could effectively protect the financial sector from competition, and act as a tool of financial repression. Long-run efficiency costs could be high. This idea lies behind the intellectual and policy trend toward liberalization.
Poorly sequenced or “too rapid” liberalization: Financial stability can be compromised by rapid liberalization in contexts of weak supervision or regulation, or unbalanced macroeconomic conditions. Some examples of crises where liberalization and its consequences played a role could include Chile in the early 1980’s and the Nordic crisis of the early 1990’s. Liberalization in accordance with EU accession requirements contributed to several emerging economies in Europe experiencing strong inflows and subsequent reversals in recent years.
Crisis controls: Once such a crisis arrives, controls on capital outflows may be necessary in circumstances where the potential level of outflows exceeds both the member’s adjustment capacity
and the financing available from the official sector.
Externalities from controls: To the extent capital flows to emerging markets are determined by “push factors”, their overall magnitude may be relatively invariant to conditions in individual markets. Imposition of capital controls may simply displace flows to other economies with similar attributes. Policymakers have raised this concern in recent weeks, though it may be difficult to show empirically.
How much is $10 trillion?
Imagine a pile of $100 bills. (US banknotes are about 1/10 millimetres thick):
$10,000,000,000,000 / 100 = 100 billion x $100 banknotes
/10 = 10 billion millimetres
/1000 = 10 million metres
/1000 = 10,000 km (+/- 6,200 miles)
Can you imagine a pile of $100 bills 6.200 miles high – or, if laid flat – stretching all the way from Los Angeles across the USA, over the Atlantic, through Europe, and on to 100 miles past Moscow?
(And 450 trillion?!…)
IMF: World Economic Outlook Update. January 25. 2011.
Deutsche Bundesbank – Financial Stability Review 2010
Gertrude Tumpel-Gugerell, Member of the Executive Board of the European Central Bank, “The euro area’s economic outlook.” 11232010.
New Journal of Physics. “Worldwide spreading of economic crisis”. 11262010.
President of Bundesbank, Axel A Weber: “Global imbalances – causes and challenges” October 2010.
Economist Intelligence Unit. 2011 Forecast: The Euro Zone Breaks Up
Economist Intelligence Unit. 2011 Forecast: New Asset Bubbles Burst, Creating Renewed Financial Turbulence
BIS Working Papers. “Banking crises and the international monetary system in the Great Depression and now.”