(Article changed on September 18, 2013 at 21:20)
Increased
regulation and low interest rates are driving lending from the regulated
commercial banking system into the unregulated shadow banking system. The
shadow banks, although free of government regulation, are propped up by a hidden
government guarantee in the form of safe harbor status under the 2005 Bankruptcy
Reform Act pushed through by Wall Street. The result is to create perverse
incentives for the financial system to self-destruct.
Five years after the financial collapse precipitated
by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another
full-blown financial panic is still
looming large, despite the Dodd Frank legislation designed to contain it. As
noted in a recent Reuters article, the risk has just moved into the
shadows:
"[B]anks are
pulling back their balance sheets from the fringes of the credit markets, with
more and more risk being driven to unregulated lenders that comprise the $60
trillion "shadow-banking" sector."
Increased
regulation and low interest rates have made lending to homeowners and small
businesses less attractive than before 2008. The easy subprime scams of
yesteryear are no more. The void is being filled by the shadow banking system.
Shadow banking comes in many forms, but the big money today is in repos
and derivatives. The
notional (or hypothetical) value of the derivatives market has been
estimated to be as high as $1.2 quadrillion, or twenty times the GDP of all the
countries of the world combined.
According to Hervà © Hannoun,
Deputy General Manager of the Bank for International Settlements, investment
banks as well as commercial banks may conduct much of their business in the
shadow banking system (SBS), although most are not generally classed as SBS
institutions themselves. At least one
financial regulatory expert has said that regulated banking organizations
are the largest shadow banks.
The Hidden Government Guarantee that Props Up the
Shadow Banking System
According to
Dutch economist Enrico Perotti, banks are able to fund their loans much
more cheaply than any other industry because they offer "liquidity on demand."
The promise that the depositor can get his money out at any time is made
credible by government-backed deposit insurance and access to central bank
funding. But what guarantee underwrites
the shadow banks? Why would financial institutions
feel confident lending cheaply in the shadow market, when it is not protected
by deposit insurance or government bailouts?
Perotti says that liquidity-on-demand is guaranteed
in the SBS through another, lesser-known form of government guarantee: "safe
harbor" status in bankruptcy. Repos and derivatives, the stock in trade of
shadow banks, have
"superpriority" over all other claims. Perotti writes:
"Security pledging
grants access to cheap funding thanks to the steady expansion in the EU and US
of "safe harbor status". Also called bankruptcy privileges, this ensures lenders
secured on financial collateral immediate access to their pledged securities. .
. .
"Safe harbor status
grants the privilege of being excluded from mandatory stay, and basically all
other restrictions. Safe harbor lenders, which at present include repos and
derivative margins, can immediately repossess and resell pledged collateral.
"This
gives repos and derivatives extraordinary super-priority over all other claims,
including tax and wage claims, deposits, real secured credit and insurance
claims. Critically, it ensures immediacy (liquidity) for
their holders. Unfortunately, it does so by undermining orderly liquidation."
"This amendment which was touted as necessary to reduce
systemic risk in financial bankruptcies . . . allowed a whole range of far
riskier assets to be used . . . . The size of the repo market hugely increased
and riskier assets were gladly accepted as collateral because traders saw that
if the person they had lent to went down they could get [their] money back
before anyone else and no one could stop them."
Burning
Down the Barn to Get the Insurance
Safe harbor status creates the sort of perverse incentives
that make derivatives "financial weapons of mass destruction," as Warren
Buffett famously branded them. It is the equivalent of burning down the barn to
collect the insurance. Says Malone:
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