In market-based banking, asset side of a bank’s balance sheet is securitized and liabilities are based on wholesale borrowing such that the simple assets (loans, bonds, reserves) -liabilities (deposits, capital) balance of regular banking is scaled up into a chain of complex interconnected balance sheets of multiple intermediate entities which are outside the regulatory framework that governs banks, i.e. in the ‘shadows’. Before the crisis, banks would offload the loans to Special Purpose Vehicles (SPV) which securitized them as Asset-backed Securities (ABS) which combined with Credit Default Swaps (CDS) from insurance companies became Collateralized Debt Obligations (CDO). These CDOs, stamped dubiously by credit ratings agencies, were coupled with interest rate swaps (IRS) and liquidity puts by the owning bank.

The product were issued as short-term Asset-backed Commercial Paper (ABCP) by a Structured Investment Vehicle (SIV) or used as a source of funding in the repo market. Finally, the investment in ABCPs and repo came from money market mutual funds (MMMF) which were saddled with savings. However, the SPVs and SIVs were not state-regulated entities which allowed a toxic, subprime securities to grow at a “grotesque scale” while the complicated engineering of securitization which allowed banks to earn more through fees. In regular banking, this commodification of both the assets and liabilities side of the bank’s balance sheet wasn’t possible.

Regular banks have diverse sources of short-term borrowing in the form of depositors. While they are fragile because they borrow short and lend long, the market-shadow banking is much more fragile. This is because the primary source of funding from ABCP or repo was MMMFs, as Tooze write, “Lehman got its funding wholesale by tapping the cash pools and so too would the new mortgage lenders, including Lehman. This was the truly lethal mechanism at the heart of the crisis. Funds from money market cash pools were channeled into financing the holding of large balance sheets of MBS.” If this funding stopped, the system would crash as it did.

Moreover, in regular banking, all bad loans would sit on bank’s balance sheet as illiquid assets but couldn’t have taken down the financial system. In shadow banking, the securitizers held their own product, albeit off-balance sheet. This meant that risks were concentrated on a few large, unregulated balance sheets. As Tooze write, “contrary to the professed logic of securitization, hundreds of billions of private label MBS were not spread outside the banking system, but were stockpiled on the balance sheets of the mortgage originators and securitizers themselves.”

At the same time, to issue such risky loans in a regular banking system would have required the bank to adequate capital provisioning to account for risk. But the institutional setup of incentives in the shadow banking led to hardly any allocation of capital. In fact, as Tooze writes, “under the bank regulations prevailing until the early 2000s, assets parked off balance sheet in the SIV could be backed by a fraction of the capital that would be required if they were on balance sheet.” This would turn out to be one of the straws that broke the camel’s back and lead to a collapse of shadow banking.

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019

“In a way,” one European central banker remarked, “we became the thirteenth Federal Reserve district.”

CRASHED: HOW A DECADE OF FINANCIAL CRISES CHANGED THE WORLD, ADAM TOOZE (2018)

The policy measure being talked about here is the currency swap lines from the Fed which gave major national central banks like European Central Bank (ECB), Bank of England (BoE), Bank of Japan (BoJ), Swiss National Bank (SNB) etc. unlimited access to the precious dollars, which they could then lend to their megabanks, who “faced very substantial dollar funding needs”, at ‘one remove’. The way this worked was, as Tooze writes: “The Fed and the central banks it was supporting agreed on an exchange rate. The European central bank needing the dollars deposited the required amount of local currency in an account in the name of the Fed. The Fed credited the European central bank with the equivalent amount in dollars. The two sides agreed to reverse the trade at a future date at the agreed exchange rate.”

At the same time as it was fighting to get congressional approval for Troubled Asset Relief Program (TARP), the Fed acted as the global lender of last resort without any political mandate in the US national interest. The European megabanks had borrowed over $ 1 trillion from the money market mutual funds (MMMFs) but the ECB could not provide dollar funding to the off-shore dollar banking system where the European banks were functionally Structured Investment Vehicles (SIVs – shadow banks) for transatlantic financial system. As the funding in wholesale funding market became stressed, the ECB, BoE and the European states were helpless, as the Euro couldn’t alleviate this dollar-liquidity crisis, and the International Monetary Fund (IMF) far too small. If the US stood passively, the European Banks would have created a fire-sale of US assets, which would have plunged the barely recovering American economy into a recession again. As Tooze writes, “That it did not result in a spectacular transatlantic crisis was decided not in Europe but in the United States, where the Fed, acting in the enlightened self-interest of the US financial system, acknowledged the compelling force of financial interconnectedness and acted on it.”

The 2008 financial crisis clearly showed the dependence of European banks on the United States. When Bernanke remarked that “Europe would be under a great deal of stress and was not going to be decoupled from the United States”, what he did not explicitly state was that the ‘decoupling’ could be disastrous for the US too, which was precisely the ‘enlightened self-interest’ which they Fed and Treasury were acting. They couldn’t just restrict their role to the American banks which were under their political mandate, extending their actions, as Paul Volcker put it, “to the very edge of its lawful and implied powers.” As Tooze writes, “The Fed’s programs were decisive because they assured the key players in the global system—both central banks and large multinational banks—that if private funding were to become unexpectedly difficult, there was one actor in the system that would cover marginal imbalances with an unlimited supply of dollar liquidity. That precisely was the role of the global lender of last resort.

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019