Home > Uncategorized > Out of the shadows

Out of the shadows

from David Ruccio

The latest bank to admit criminal fraud is Wells-Fargo. The largest U.S. mortgage lender and third-largest U.S. bank by assets, Wells-Fargo deceived the U.S. government into insuring thousands of risky mortgages, and formally reached a record $1.2 billion settlement of a U.S. Department of Justice lawsuit. Several lenders, including Bank of America Corp, Citigroup Inc, Deutsche Bank AG, and JPMorgan Chase & Co, previously settled similar federal lawsuits.

To read Paul Krugman (who’s “been doing a lot of shovel work for the Hillary Clinton campaign lately”), the real problem in the run-up to the spectacular crash of 2007-08 was not Too Big to Fail banks like Wells-Fargo, but the so-called shadow-banking system. But, as Matt Taibi [ht: db] explains, “Krugman is just wrong about this.”

The root problem of the ’08 crisis lay in a broad criminal fraud scheme in the mortgage markets. Real-estate agents fanned out into middle- and low-income neighborhoods in huge numbers and coaxed as many people as possible into loans, whether they could afford them or not.

Those loans in turn were bought up by giant financial companies on Wall Street, who chopped them up into a kind of mortgage hamburger. Out of this hamburger, they made securities. These securities were then sold to institutional investors like pension funds, unions, insurance companies and hedge funds.

shadow-traditional

source (pdf)

There’s no doubt shadow-banking activities surpassed those of the traditional banking system in the years leading up to the crash. But—and this is crucial—they weren’t two separate systems or sets of institutions; they were just two different sets of activities by a wide variety of firms within the financial system. And so-called traditional banks were heavily involved in the shadow-banking activities.

The two economically most important shadow banking activities are securitization and collateral intermediation. According to Stijn Claessens, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh,

The first key shadow banking function, securitisation, is a process that repackages cash flows from loans to create assets that are perceived by market participants as almost fully safe and liquid. The repackaging occurs in steps, and takes the form of risk transfer. First, risky long-term loans are ‘tranched’ into safe and complementary (‘equity’ and ‘mezzanine’ respectively) tranches. Then the safe tranche is funded in short-term money markets, with additional protection provided by liquidity lines from banks. The resulting assets, such as Asset-Backed Commercial Papers (ABCPs), were regarded prior to the crisis by market participants as safe, liquid, and short-term, i.e. almost money-like, but with returns exceeding those on short-term government debt. . .

Another key function of shadow banking is supporting collateral-based operations within the financial system. Such operations include secured funding (of bank and, especially, nonbank investors), securities lending, and hedging (including with OTC derivatives). Collateral helps deal with counterpart risks and more generally greases financial intermediation. One of the main challenges in using collateral is its scarcity. The shadow banking system deals with the scarcity through an intensive re-use of collateral, so that it can support as large as possible a volume of financial transactions. The multiplier of the volume of transactions to the volume of collateral (the ‘velocity’ of collateral) was recently about 2.5 to 3.

The key is that traditional banks (such as Goldman Sachs, Morgan Stanley, JP Morgan, Bank of America-Merrill Lynch, and Citibank in the United States, in addition to Barclays, BNP Paribas, Crédit Suisse, Deutsche Bank, HSBC, Royal Bank of Scotland, Société Générale, Nomura, and UBS elsewhere—all of them classified as “strategically important financial institutions”) both financed and directly participated in shadow-banking activities. The traditional banks made record profits from those activities and served both to expand shadow banking and to increase the degree of risk, instability, and contagion.

In other words, traditional banks played a key role in creating the financial house of cards that came crashing down in 2007-08.

So, it’s simply wrong to assert that Too Big to Fail or Jail banks were peripheral in creating the conditions that caused the global financial crisis—or, for that matter, that continue to plague the financial system today.

What this means is that regulating and transforming the financial system—by taxing financial transactions, breaking up the now-Too Bigger to Fail banks, and creating new forms of financial intermediation (such as various forms of public and community banking)—are still on the agenda.

It’s time, then, to bring both the financial system and arguments by mainstream economists that attempt to shield traditional banks and their favorite political candidates out of the shadows.

  1. April 11, 2016 at 7:12 pm

    Thank you. I read the latest Krugman/Clinton message as an assignment.

    I wonder what percent of illicit profit that record 1.2 billion dollar settlement represents?

    • Ctesias62
      April 13, 2016 at 6:13 pm

      Mr Rogoff & Ms Reinhardt can set you up a nice spreadsheet for that!

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