The problem with Dodd-Frank, and with Basel III as well, is that they start with the banking system, not the shadow banking system.
Give credit where credit is due. Everyone (I hope) now appreciates that so-called “microprudential” safeguards are not enough, and this is so even if we extend the traditional focus on solvency (capital adequacy) to include also liquidity.
“Macroprudential” safeguards are needed also, to put bounds on the apparent instability of the system as a whole. Everyone says it, but what does it mean?
What it used to mean was control of financial aggregates, back when Hawtrey’s writing about the inherent instability of credit translated the trained instincts of practical bankers into the King’s English. If aggregate credit is expanding too fast, then watch out. If aggregate money is also expanding too fast, then take action immediately, since it will soon be too late.
This ancient central banker’s wisdom is resurfacing today, but mainly for lack of anything better. We heard it from Otmar Issing at the recent IMF conference. Here is Adair Turner’s version, from his 16 March speech at Cass Business School:
“It is therefore likely that one of the root causes of the crisis was that the aggregate maturity transformation performed by the financial system grew significantly in the pre-crisis years but that, fatally, we failed to spot this.”
What Turner means by growth of “maturity transformation” is expansion of aggregate credit financed by expansion of aggregate money. This return to Hawtreyan thinking is a huge step forward, comparatively, but it is only the first step. What we need is Hawtreyan thinking, but applied to modern shadow banking conditions.
Hawtrey’s idea, appropriate to the conditions of his own time, was that macroeconomic instability stemmed ultimately from excessive expansion of bank credit, meaning credit expansion financed by monetary expansion. But the modern credit system is not a bank-lending system, rather a capital market system. That is one reason we failed to spot the emerging problem.
My message is that, pace Turner, it is not going to be enough simply to extend the Hawtreyan analysis to include the assets (credit) and liabilities (money) of the shadow banking system on equal footing with the traditional banking system. Light on the shadows is a good thing, but not enough—what is happening in the shadows is not the same thing that was happening in the light.
Here is an example of what I mean. Think of an old-line asset manager, taking in client money and investing it in a portfolio of risky bonds. Now think of a new-line asset manager, offering exactly the same risk exposure to clients by buying credit default swaps and interest rate swaps, while investing the client money in a portfolio of short term riskfree money market assets.
One way to think about shadow banking is that it is just the mirror image of this new-line asset management strategy. Shadow banks bought risky bonds, but sold off the risk exposure using derivatives, and funded the portfolio in wholesale money markets. The key point is that the division of old-line asset management into new-line management on the one hand, and shadow banking on the other, showed up statistically as a simultaneous increase in the demand and supply of money.
If we simply extend the Hawtreyan analysis, then this institutional realignment looks like a case of credit expansion fuelled by money expansion, but that analysis misses the key role of the derivatives market. The derivatives exposure of the asset manager is just the mirror image of the derivatives hedging of the shadow bank. And standing in between them is an OTC derivatives dealer, making markets and making money on the bid-ask spread.
From this point of view, OTC derivatives reform is at the very center of any attempt seriously to engage with the problem of regulating the shadow banking system. We learned in the crisis that, under modern conditions, central banks serve as dealer of last resort, essentially backstopping the key market-making function of security dealers. But what about normal times?
The Federal Reserve Act of 1913 created the Fed as a democratically accountable analogue to the former private lender of last resort, J. P. Morgan, and his club of New York bankers. The issue of the current day is how to create a similarly accountable alternative to the club of New York dealers. This is the subtext of current debate about moving derivatives trading to central counterparty clearinghouses or exchanges.