Risk Management, PRMIA

The term "shadow banking system" has no sinister connotations. Banks lend money to each other all the time via what is known as the repo market. Basically what happens in this market is as follows: Bank A buys a $100 bond (usually the numbers are of course much larger) but does not have the cash for it. What it does instead is go to Bank B and gets into a short-term repurchase agreement (or repo) to get the cash. Essentially Bank A sells the bond to Bank B immediately for $100, and at the same time agrees to buy the bond back from Bank B the next day for a slightly higher amount (say $100.10). The 10 cents difference that is made by Bank B is the interest rate for what amounts to a 1-day loan. The net effect is of Bank B lending $100 to Bank A with collateral for safety. Bank B is said to engage in a Reverse Repo. This sort of lending is usually considered very safe. First, if Bank A were to go bankrupt in the evening, Bank B is not left holding the bag - it has $100 of collateral that it can liquidate to ensure that it has no losses. Second, the loan is for a very short term (usually 1-day or at most a few days long) to minimize the chances of the borrower failing during that time. Third, banks resort to a mechanism called haircuts - rather than give Bank A $100 for the bond, Bank B may haircut the bond by $5 and lend only $95. This would ensure that even if Bank A went bankrupt and Bank B was forced to sell the bond in a distressed market, there was a safety cushion.

The perceived safety of this market had an explosive effect on its growth. Continuing the above example, if Bank A started off with $100 of cash, it could use successive rounds of repo financing to hold up to $2000 of bonds in this way, or establish a leverage of 20. This limit is established due to the 5% haircut. What if the haircut were made smaller, or entirely eliminated? Bank A would essentially have the potential for unlimited leverage. The foundation of this market, as in any other, is trust. Banks trust one another to be solid, upstanding organizations. Even if that line of defense fails, banks trust that the collateral can be liquidated for a price that is close to that which the repo was contracted at. The violation of this trust was at the heart of crisis in mid-September. The prices of mortgage-backed collateral rated "Super-Senior" (i.e. supposedly safer than the very safe AAA-bonds), started plummeting for a variety of reasons. This combined with the perception of weakness among various players in the wholesale market ensured a panic where lenders did not know which borrower was good for the loan, and decided to figuratively stuff their mattresses instead.

So, according to Gorton, the last-ditch firewall is to prevent the panic at all costs. The key notion here is to make debt like deposits or reverse-repos "informationally-insensitive", i.e. there is no value in knowing information about the debtor's credit-worthiness. In the retail deposit market in the US this has been effectively done by insuring deposits via the Federal Deposit Insurance Corporation (FDIC). He suggests a similar approach in the institutional market. Just like retail depositors don't need to think twice about which bank they deposit savings into, institutional investors will likewise not have to hoard cash if they had a federal guarantee.

The paradoxical aspect of this is, of course, that the informational insensitivity - that is the state where creditors do not care about information about their counter-party - can only come about with extreme amounts of information being provided. The only way the FDIC can avoid losing money in the aggregate is to closely monitor bank performance and take strong, rapid steps to address any issues that may come up. This is evidenced by the large number of banks that have been taken over by the FDIC in the past 2 years. Clearly, real informational insensitivity can only come by increasing the information sensitivity of a particular, credible entity. Credibility is critical. This mechanism would not work if the FDIC were not backed by a reserve fund that was properly managed. Indeed, where the fund has dropped to dangerous levels the FDIC has had to take steps to boost funding.

However, one could well ask if simple transparency into the information is enough. In other words, without the punitive power of the FDIC to shut down banks, would the informational insensitivity work simply by ensuring that information about the repo market is available? Clearly this would not be sufficient - for the mechanism to work it's essential for an organization like the FDIC to be keenly interested in continuously analyzing the information. The current financial reform bill, that was signed into law on 21,July 2010 provides such a mechanism for this market. While imperfect in many ways (see here for a contrary opinion), it does provide the mechanism and the intent for closer and more flexible monitoring of the largest financial players, especially those considered systemically important. Add to this the concept of deep data collection and analysis through the Office of Financial Research, also provided for in the bill, and we have the makings of a system that can bring trust to the shadow banking system. While the extreme aspects Gorton's proposal - with the Federal government actually guaranteeing deposits in this system - have not taken root, the underlying premise will surely have a salutary effect on the health and strength of the system.