Banks has been in business for hundreds of years. But how have they changed over the years in their function and role?

Banks have traditionally been the intermediary between households and businesses, channeling savings via loans into investments. The balance sheets of entities might change to look something like this:

This is the picture of the old-fashioned banking where most of what banks did was accept deposits and issue loans with a view to match its cash inflows from loan repayments and cash commitments to depositors.

However, over time loans became unattractive for the businesses as the interest rates weren’t very low. Similarly for rich entities, bank deposits were not a compelling deal as rates offered were low. So, a parallel system emerged with finance companies and money market mutual funds (MMMFs).

In this new system, the rich cash pools deposited their savings in MMMFs which looks and feels like a bank as it gives them access to a ‘deposit account’ from which they can withdraw shares whose Net Asset Value (NAV) is promised to be at par i.e. 1. Moreover, this pays much better rates than a normal bank deposit account pays. On the other side, finance companies cropped up that issue loans at better rates than bank loans. The finance companies interact with the MMMFs via commercial paper (CP) i.e. finance companies issue CP which are held by MMMFs as assets in exchange for funding.

So, the balance sheets now look somewhat like this:

This is a system totally outside the purview of the conventional retail banking. We can see that finance companies do not have reserves and the MMMFs do not have deposit insurance of banks. So, here intermediation is going on via non-banks – a parallel system outside the purview of regulation of the Treasury and Central Banks.

However, this system evolved further with the onset of large-scale securitization, standardization and tranching of loans into securities with tranches of risk, which could then be sold to other intermediaries as per their preferences. In this new system, the households do not deposit as much as they borrow, e.g. for housing. The borrowing happens via shadow banks which have several entities that tranch the loans into quasi-AAA residential mortgages backed securities (RMBSs). The funding again comes from MMMFs via asset backed commercial paper (ABCP) or biparty repo funding – both of which are money market instruments.

The balance sheets now look somewhat like this:

In this system, that emerged in early 2000s, there was no intermediation through banks anywhere. The shadow banks and MMMFs didn’t have access to Fed funding or deposit insurance. Moreover, much of these transactions were offshore and outside the purview of regulatory agencies.

So, the emergent shadow banking system was a capital markets based credit system with assets in the bond markets and funding in money market. This was not a bank loan based system that was earlier there. The retail banking ballooned into something entirely different.

References:

1. Mehrling, P.; Course: ‘Money and Banking’ at Barnard College – See 
   http://www.perrymehrling.com/
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019