As part of our series of blogs examining the relationship between Modern Monetary Theory and Positive Money’s proposals, this guest post by Spencer Veale examines the shadow banking sector in the context of that relationship.
Shadow banking, while exceedingly complex and notoriously difficult to grasp, has become central to the global financial system, as demonstrated by its role in the 2008 crisis. The infamous mortgage backed securities and credit default swaps which played starring roles in the crisis are very much creatures of the shadow banking sector. The crisis itself has often been characterized as a run on the market in ‘repurchase agreements’ (‘repos’), a key aspect of shadow banking.
To reform the monetary system, it is crucial to understand shadow banking. A critique of proposals for a Sovereign Money System, made by supporters of Modern Monetary Theory and others, has been that suppressing bank money creation would merely push this activity into the shadow banking system.
While MMTers have criticized the Sovereign Money proposal as inadequate in its approach to shadow banking, MMT does not dismiss the viability, nor the usefulness for the purposes of advancing the public interest, of curtailing private credit creation, both in the traditional banking sector and the shadow banking sector. This is a key area of rough alignment between Positive Money and MMT, yet has not yet received much attention in the comparisons of the two perspectives. It is therefore well worth exploring.
What is shadow banking?
Shadow banking creates instruments that are so similar to bank money that advocates of a Sovereign Money-type reform cannot ignore them. To appreciate this, we need to acknowledge a continuum of “moneyness”. The more liquid, safe, and widely accepted in transactions a financial asset is, the further along this continuum it is. However, even private credit contracts low in moneyness create private purchasing power, and do so with the help of public supports such as the enforcement of contracts and the rule of law. For instance, a department store credit card balance may be neither liquid, nor safe. Nonetheless, the card allows the customer to make purchases they otherwise might not have been able to.
This continuum is highly relevant for the purposes of reforming the monetary system. Bank money creation promotes a harmful build up of private debt. It also reduces the amount of public spending that can be undertaken without causing unacceptable levels of inflation. Importantly, much bank money creation contributes to inflationary pressures while providing little public benefit. Each of these criticisms of bank money creation can be more or less equally leveled against shadow money creation. Therefore, our efforts to suppress bank money creation should extend to highly money-like shadow monies (and perhaps also other less money-like forms of credit) as well, in order to be effective.
To understand shadow banking we must recognize the ways in which shadow monies mimic, capture, and benefit from the same public supports extended to bank deposits. This grants shadow bank institutions the ability to create virtually unlimited amounts of shadow money. To illustrate this, we will trace the steps in the shadow money creation process. Not all instruments considered shadow monies will go through each of the following steps; the following is just an example.
Step 1: Loan origination. These loans may be for mortgages, or credit cards or any form of lending to the “real economy”. They might be made by a commercial bank through bank credit creation, or they might be made by a shadow bank lender which raises the money to fund its lending by issuing bonds. In the former case, the loans will then be sold off to a shadow bank institution which raises the money to fund its purchase by issuing bonds as well.
Step 2: Securitization. Here the shadow bank institution warehousing the loans bundles them into securities. The resulting securities entitle their owners to a stream of loan and interest payments from an array of loans. This step provides a claim to diversification. Yes, there will be some defaults, but by diversifying your exposure by purchasing the rights to various streams of payments, it becomes less likely the securities will suffer significant losses.
Step 3: Risk-stripping. Actually consisting of several convoluted stages, in essence this step attaches insurance policies against various risks to the securities produced in step 2. This step is best thought of as a private mimic of deposit insurance. Yes, your securities may suffer some losses, but you are insured against them. And what’s the chance that the financial institution underwriting your insurance contract will default? Can’t be big. That would take a systemic crisis.
Step 4: Repurchase agreement. Now we use this security as collateral to borrow. We sell the collateral to a money market mutual fund and agree to repurchase it at some later date at a higher price. Repurchase agreements (repos) are basically collateralized loans. The higher repurchase price serves as the interest charge.
In the meantime, our counterparty, the money market mutual fund, has the right to do a margin call in the event that our collateral loses value. This means they can demand we post cash of equal value to that lost on our collateral. This reassures our counterparty that the repo they hold is highly safe. After all, not only do they have collateral, but this collateral is diversified, insured, and allows recourse to margin calls. This means that not only is the money that our counterparty lends us money, but the repo that our counterparty holds is perceived to be about as good as money itself.
Not only has this repo transaction essentially created money, but once we borrow through the repo, we can use that money to buy another financial asset which we can again post as collateral in another repo. This process can repeat as long as there is an incentive to do so, such as an interest rate spread between the rate at which we borrow through the repo and the rate at which we lend by purchasing another financial asset.
Step 5: Re-hypothecation. On top of our ability to create money as described above, our repo counterparty is in a similar situation. The counterparty can itself do a repo using our collateral. So both parties can engage in countless rounds of shadow money creation if there is an incentive to do so.
Step 6: Money market mutual fund shares. Where does the money market mutual fund get the money it lends through the repo? These are largely deposits from institutional investors like pension funds and insurance companies. They have bank deposits in excess of the amount insured by public deposit insurance and so they need a safe place to park their cash that will earn a modest yield. The shares that the money market mutual fund offers investors (like various other shadow money instruments) are often thought to be so safe as to be a substitute for treasuries, the quintessential safe asset.
Step 7: Hijacking public validation of the illusion of security. Shadow monies, secure as they may seem, are a tenuous daisy chain, a house of cards that can come crashing down at the slightest panic.
If the value of repo collateral declines enough for any number of reasons, this triggers margin calls from the holders of the collateral. If the amount that the repo borrower owes on their margin call is in excess of their cash on hand, this will trigger distress selling of their assets. This can put downward pressure on those assets as well. All of a sudden repo collateral across the financial markets is declining, triggering even more margin calls. This can quickly lead to a contemporary version of the bank runs that regularly sent economies into collapse until the advent of deposit insurance. Once this process is set in motion, the authorities are faced with a decision: they can let the house of cards come crashing down and hope they can contain the fallout, or they can extend the public supports that these shadow monies supposedly did not need.
When the central bank jumps into action as dealer of last resort to buy up distressed securities, it effectively puts a floor under how low the value of those securities can fall. If a security was initially valued at $100 and the central bank offers to buy it at $80, then this means that the holder of the security really only ever bore 20% of the risk associated with their position. The other 80% was borne by the public. If the government bails out the insurance underwriter (like with AIG) then the private mimic of deposit insurance becomes in effect public deposit insurance.
By privately creating the illusion of safety, the shadow banking sector lures enough “hostages” into the scheme so that when the illusion comes under stress, the government has little choice but to validate it. The pretense of shadow money being private was all along a fig leaf concealing the essentially public nature of the money created. Indeed, even shadow monies which do not receive such financial insurance from the government still benefit from other public supports, as mentioned earlier.
(To speak of “hostages” is not to claim that those involved are necessarily unwitting victims. They may or may not be, and often are not. This said, once there are systemic implications, we all become hostages.)
Shadow money and monetary reform
In light of this, a few things become clear. First, that shadow monies, given the expansion of purchasing power and build up of private debt their creation entails, are problematic in the same ways that bank money creation is. Second, that there is a strong public interest argument for cracking down on this alternative way of hijacking the public function of money creation for private uses. Third, limiting bank allocation of public money to public interest uses without also regulating the shadow banking sector would indeed merely push private money creation into the shadow banking sector where it could continue unabated. To effectively curtail private credit creation, we need a carefully designed approach to prevent the financial sector from circumventing our restrictions via the shadow banking sector.
Positive Money has long argued that private credit creation comes with very real and significant downsides. To implement a policy regime based on this insight we must distinguish when those downsides outweigh the benefits of allowing private credit creation and when they don’t. Then we must design viable enforcement mechanisms. It is essential that we further explore and weigh these tradeoffs and the possibilities for enforcement if we want to deliver on the promise of the Sovereign Money proposal. This is necessary to answer concerns expressed by proponents of MMT, and would be an important step towards achieving greater consensus on viable policy proposals among heterodox schools of thought.
Last, it is often argued that such measures would likely be futile, as the financial sector will always find a way around regulation. While the difficulty of designing enforceable measures should be taken seriously, we do not see the field of medicine as futile because it will never definitively eradicate disease. Private money creation for non-public interest uses is ultimately a financial rentier problem. Our job then must be to erect and maintain as robust an immune system as possible against this drain on public, democratic power and general prosperity.