The collision of global markets and social mood

Wednesday, December 26, 2012

Shadow Banking: Hiding In Plain Sight

I just read a recent IMF staff discussion note on shadow banking. It was chilling.

Sometimes the scariest things are hiding in plain sight. This IMF note is freely available for all to read.

"In its collateral intermediation function, shadow banking serves the demand of agents
for safety by reducing counterparty risk. Collateral underpins a wide range of financial
transactions: secured funding (mostly by nonbank investors), securities lending, and hedging
(including with over-the-counter (OTC) derivatives). As collateral is scarce, a key shadow 
banking function is to re-use collateral to support a large volume of transactions . . . ."

Notice the scary contradiction? In order to seemingly reduce counter party risk, shadow banking simply re-uses collateral until it supports a large volume of transactions. If it's scarce, it should be protected. Instead, it is prostituted until it functions just like fractional reserve banking, which means there is essentially no collateral at all. This works until it doesn't.

"The first key shadow banking function, securitization, is a process that, through tranching,
repackages cash flows from underlying loans and creates assets that are perceived by market participants as fully safe . . . ."

Perception is reality until perception creates a new reality. The only thing supporting the current "reality" is confidence. When fear creeps in, as it did in 2007-2008, the same contraction will occur in the shadow banking system because nothing at all has changed.

"Another key function of shadow banking is supporting collateral-based operations within the
financial system. This involves the intensive re-use of scarce collateral, so that it supports as large as possible a volume of financial transactions. A small number of dealer banks, all SIFIs, are central in this process, which leads to systemic risks . . . ."

Again, intensive re-use of already scarce collateral simply weakens it.

"Altogether, the shadow banking system is complex, with a multitude of nonbank agents, and
many links to traditional banks and dealer banks. In part due to its complexity, its exact size
is not even well known . . . ."

No one knows its size, therefore no one can quantify the risks.

"Unless the systemic risks in shadow banking are addressed, these contingent liabilities will remain in place, with perhaps larger actual costs in future crises . . . ."

It's not a threat; it's a promise.

"Conclusion: Addressing the shadow banking system is a work in progress for regulators and policymakers, and research is yet to catch up fully with the issues. Since not all components of the response are yet clear, more policy-oriented research is needed."

The safety of the entire financial system is a work-in-progress. The prescription is more research. The inmates are running the asylum.

Time to take matters into our own hands.

Each day we're asked innocent "hiding in plain sight" questions. Maria says (or is told to say) "do you know where your money is?" while Capital One asks "what's in YOUR wallet?"

Such cute questions, asked with nauseating repetition, are an insidious form of truth telling. The money we deposit into "our" bank accounts becomes the scarce collateral that is lent and re-lent and intensively re-used to enable a multitude of further transactions, the vast percentage of which are supported not by actual collateral itself, but confidence. Shake that confidence and you shake the system -- the house of cards -- to its core.

So, do you know where your money is? Not exactly.

What's in YOUR wallet? Maybe a few Federal Reserve Notes and some plastic cards to access bits of electronic credits attached to your name.

More that that, we don't really know. And it sounds like no one else does either. Which makes it a great time to go long that which is so scarce: actual cash in your hand.

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