Shadow Banking

Short article for this chapter, and mainly some links. Shadow banking arises when people find a need for credit and cannot get it from a licenced bank. At least that’s the basic story.

Overview

Synopsis:

(a) There is no essential need for shadow banks.

(b) Shadow banks nevertheless pop up because government licencers fail to adequately provision the private banks.

(c) The basic provision needed is not cash, but full 100% deposit insurance. The proper place for discipline on private banks is on their asset side, not their liabilities.

The last policy is critical. On a floating exchange rate the monopoly currency issuer (aka. government) is not financially constrained, so (i) can always provide full deposit insurance, and (ii) does not risk a currency depreciation nor hyperinflation when doing so. On a fixed exchange rate there would be such risk, but they are entirely inapplicable to the USA economy today, and to most nations operating a fiat currency monopoly.

Below I will reference a recent insightful interview Nathan Tankus gave, from it we have a new technical term in chartered banking lexicon in USA context: the “ComeOn2Big2FailBank”.

It’s a good term to use. Most people might think that even though FDIC insurance only covers you up to $$250$K in the USA if you deposit at one of the ComeOnIts2Big2FailBanks or one of the NoReallyComeOnIts2Big2FailBanks then you are effectively fully insured to any deposit amount. Tankus points out the harsh reality that this cannot be used in a court of law, it is not a legal term you can literally “take to the bank.”

The recent failure of SVB Bank is an interesting example. It was not too big to fail, but the FDIC made depositors whole anyway. However, this was a bit arbitrary and extra-legal. There was never any legal guarantee for depositors, and that is why they withdrew their deposits causing the run on SVB. They knew taking the term ComeOnITs2Big2Fail to court would not cut the mustard.

Excess Credit Risk

The argument from free market and neoclassical ideologues is that if the government insures deposits the “tax payer” is stiffed with holding the bill.

MMT lens correction: This is completely inapplicable for a government running a floating exchange rate policy for a non-convertible currency (aka. the tax credits).

The other argument is that private banks that are not heavily regulated need market discipline.

MMT lens correction: The market cannot adequately discipline bank credit, no one, not even the new AI systems, knows what the true risk of depositing at any particular bank might be. The government should just remove all such risk. The discipline on banks should then be strict credit assessment and prudential requirements, these can be made very simple: tell bankers only what they can do. They are not allowed to do anything else. If banking is narrow in this sense, with the list of activities banks “can do” made very narrow (basically clear payments and assess credit worthiness) then the regulatory bureaucratic burden is minimised, and fits with the public purpose.

The last point answers critics of MMT who claim MMT is a sort of hyper-government approach. It is not. MMT allows us to have as small a government as we desire. The point of regulation should be as simple as needed, but no simpler. Banks can be easily well-regulated with simple regulations telling banks the “can” and forget about listing the “cannots”. Needless to say, all such regulations should be enforceable, and can be drafted to require minimal bureaucracy.

If you are a critic of private commercial banking and have not yet read Warren Mosler, this is all you need to know for starters. This goes the same if you are a critic of public banking too, or a critic of any banking system.

There is little point to going through parliamentary motions to pass regulatory legislation that cannot be enforced. It is a waste of time of policy makers. Only in some rare exceptions are regulations useful in serving a symbolic purpose.

For example, a nation might wish to retain a “death penalty” for certain heinous crimes, but choose to never enforce it, as a symbolic gesture. Such symbolic policy might be practical if, for instance, such crime rates were non-existent.

A lot of banking regulations could be automatically enforced by licenced open source software.

I am all for making politicians lives easier so that can become as lazy as possible. The more time they spend on the golf course the better, in a lot of cases. Especially the narcissistic politicians. The sincere socially motivated politicians probably cannot be drawn out onto the golf course, but if we minimize their workload that cannot hurt the poor. Lifting up the poor and oppressed benefits everyone in society in the long run, and fits with the public purpose, provided this is accomplished let those socialistic politicians enjoy their lunch hours, make them 3 hour long lunches in an 6 hour work day.

“As small or as big a government as we desire”"

My colleague Douglas the MMT Macro Trader gave us a (I think original) metaphor.

We can have super big government that is also non-invasive in the private market, and as liberal as the culture desires. He proposed the wide and flat versus tall and skinny axis concept.

You can incorporate this into the old 2D political landscape map, where,

• Forward = total anarchist
• Backwards = totalitarian government
• Left = so liberal you can walk around naked
• Right = so conservative you cannot bare your knuckles.

Douglas adds a third dimension, which is the policy space of government is completely recognized, and government is always “big” enough to issue enough currency for full employment, but the space is:

• Down = (government is short and very wide) big as in spending on fully public programs, as few as possible private markets. So private markets only for leisure goods and services, non-essentials.
• Middle = (robust government physique, neither tall and skinny, nor short and fat) big as in fully spending on all desired public services that hire all the unemployed the tax liability plus savings desires create, but no more. So this could be a system where the public sector might provide some public arts programs and the like, in addition to the social essentials.
• Up = (tall and skinny) big as in minimal tax liabilities only sufficient to drive the currency, no more. The culture desires otherwise no government services except tax system and legal system. The tall size of government here is in the tight regulatory control over taxation and legal contracts. It is akin to a form of totalitarianism, but highly non-invasive in peoples lives otherwise. Tall and narrow fits the picture I think.

Notice this Up–Down axis has nothing to do with cultural morés. It is purely about how big we desire our government to be to fit the democratic consensus on “what is the public purpose.” Which is mostly a currency monopoly set of operating parameters. The MMT axis, you might day.

I have to say though, that these political maps tend to ignore a critical aspect of a just economic system, which is distribution.

Economic distribution in a monetary economy is facilitated by the currency. If private markets dominate they have a long run tendency towards winner-take-all effects, or “the rich get richer, the poor get poorer” or a statistician might obscure by saying it is a Pareto distribution which is “natural.”

Well,… there is nothing natural about a Pareto distribution for economic output share, because under our present day MMT system the distribution of output is a government policy choice, since they are the currency monopolist.

No other macroeconomics school of thought recognizes this, not even the post- Keynesians or Marxists, and so there is no proper economic school of thought for facilitating macroeconomic justice (fair distribution of real output) than MMT.

VCP for Bank Capital Requirements

One of the issues for small banks is the regulatory need to have capital, to satisfy capital adequacy requirements, which do tend to be well enforced. (See the list of Mosler proposals below.)

Mosler suggests a work-around for banks which find themselves capital constrained and yet also have trustworthy credit-worthy customers they should be lending to — emphasis on should, since public purpose is not well served by artificially constraining credit. Non-fraudulent credit is Its own regulator through the need to repay the loan.

((Constraining fiat currency issue and bank credit issue artificially is like putting a plastic bag over the head of an elite athlete, the athlete is our real productive economy, not the predatory financial sector.))

The method Mosler recommends is the bank can issue VCP = variable convertible preferred stock.

What is VCP? Convertible preferred stock is a type of preferred share that pays a dividend and can be converted into common stock at a fixed conversion ratio after a specified time. The initial stock can be stocks in the bank. The customer then has an option to later sell this bank stock for common stock.

The method is that the bank should be permitted to offer their customer say 10% of the amount they desire to borrow as VCP. The customer can buy this stock. This adds to the bank balance sheet, and thus will automatically make the bank capitalised sufficient to make the loan, and then some, since most banks have about an 8% target capital ratio. Everyone is happy, the customer, the bank, the regulators.

Only the mainstream economists are unhappy, since their hair catches on fire with hyperinflation fear and panic, “Oh me oh my! Whatever can we do to impose austerity in bank credit now?” But they are not people.

Mosler elaborates:

The VCP functions as a ‘first loss piece’ for the bank as well. Terms of the VCP might include an interest rate equal to the loan rate, and a variable conversion ratio designed to give the borrower all her funds back if she doesn’t default.
      The VCP is non-dilutive to the holders of common shares. This VCP proposal can free up and create new balance sheet and raise capital as it services borrowing desires.
      Feel free to forward this to everyone you know in banking.

Some Links

• Nathan Tankus on the Blockworks podcast — on The “Pozsar Moment” In Shadow Banking
• Zoltan Pozsar and others — Federal Reserve Bank of New York Staff Reports, “Shadow Banking”
• Warren Mosler — Proposals for the Treasury, the Federal Reserve, the FDIC, and the Banking System
• Warren Mosler on small banks — Fixing the Small Banks
• Warren Mosler again — Financial Architecture Fundamentals

Caveats

I am still learning banking system nuances. So do not quote any of my writing on these issues. I write most of my Ōhanga Pai articles for general public education, but with no veridical guarantee, just honesty that I write what I know. It is up to readers to fact check matters for themselves, which I regard as a good thing. I am really just a scribe, not an expert, at least not yet. There are probably hundreds of MMT economists superior to myself in their expertise. I would consider myself an expert if I were in the top dozen, which I am nowhere near.

If you trust me too much you might fail to follow-through with your own research, which would be bad, or potentially bad for your quality of learning let’s say.