Shadow Banking Blueprint: thoughts on regulation/minsky

This morning's FT comes with a very interesting article. The article itself recoils in horror at the graphic of the structure of the modern banking system, comparing to a "motherboard". It also references a paper by the NYFed which is the origin of the diagram. The paper is a lot more interesting (click to enlarge, and you still won't see anything :))

I have skimmed the 80 odd pages article. It is really a factual description of the "blueprint" of the shadown banking system. There is a little bit of analysis and that has captured my attention. Page 72, article 9:

(9) Regulation by function is a more potent style of regulation than regulation by institutional form. Regulation by function could have ““caught”” shadow banks earlier:

I find this statement both very interesting and somewhat immature. Basically what this says is that the standard regulation framework that of balance sheet of depositor banks, failed to effectively regulate liquidity levels. Why? because the risk is effectively spread over the whole motherboard and not just the balance sheet of the banks, which would be just one chip. In fact the existence of the shadow banking system was to a degree an arbitrage of existing regulation. By using off-balance sheet instruments, banks were avoiding balance sheet restrictions, in a almost tautological way. The bank "chip" was just a pass-through mechanism, it didn't accumulate debt. it therefore escaped regulation.

So an example of regulation by institution is "lets regulate the balance sheets of the banks". Modern Basel 3 is still based on this framework. And it is therefore insufficient.

The "functions" that this board describes are the classic functions of banking. a/Debt b/maturity transformation c/liquidity transformation. I like to think of "total level of debt" in the system. This system's raison d'etre is to finance the real economy needs.

As a side note, Glass Steagal did regulation by institution but because all of the risk in the system was accounted for in the banks, it effectively was functional regulation as well. The moment derivatives came in, institutional regulation was in effect separated from functional regulation and rendered void. Regulatory arbitrage was a big part of it.


Minsky Cycles

Why is that function of liquidity important? very simply put debt begets more debt as long as returns are positive. in fact returns increase with more debt until new debt is only chasing asset price appreciation. This is the last stage (ponzi in nature) of the minsky cycle. In layman terms "I buy housing, on a lot of debt with no capital down, because housing always increases". That simple NINJA narrative describes the essence of a minsky bubble.

Assuming one CAN regulate these cycles, it would require measuring the total levels of debt in the system and detecting "bubbling stage" which is of course complicated. At least this blueprint tells you where the "measuring" points are in the system so you could reconstruct a complete picture of the liquidity levels. Since some of this is in "the shadows" putting the exchange on public platforms would go a long way towards regulation.

There is also the question of whether we CAN regulate them. Minsky cycles, monetary cycles, take 20-30-40 years to unfold. Meaning you will run up during 20 years and then crash. With a press corp that by necessity, tries to make news out of the daily volatility of asset prices, 20 year trends do not feel like "trends" but like "facts of life". No company, with a 3 mo horizon, will stand up against this. Few politicians with a 4 year horizon, will stand up to this, and only the most committed regulators will stand up to movements that may not see a downturn during the professional careers. It is just professional suicide to do so. I have written about this in a tongue in cheek manner here.


Monetary creation and the private sector

Finally there are a couple of aspects of the blueprint that dominate the money creation process. These are the focus of regulation, they are also difficult to regulate.

1- Reserve requirements work in reverse. As many MMT'ers will tell you (Modern Monetary Theory), banks first issue loans and then go get reserves. So essentially the level of liquidity is never controlled by Basel type regulation.

2- The derivatives to the shadow essentially created infinite liquidity. Loans would recycle to cash and then to loans etc. The balance sheet of the banks never changed. Banks were just a passthrough of debt creation and thus the total level of risk in the system increased without checks. Again a failure of the Basel type regulation by institution.

3- Naked CDS. My pet-peeve. It is described under the "synthetic" section of the blue-print. The interesting part of this one is that it created future liquidity in the worse possible cases of meltdown. And it did so at a multiple of the face value of the principal of debt. In other words: bad debt was multiplied at the worst possible moment and realized in cash. I have written more extensively here on this topic.

All of this points to the fact that

A/ Macro-monetary levels play a direct role in minsky cycles

B/ Macro-monetary levels are under the control of the private sector

C/ Macro-monetary levels are going to be difficult to recapture