INTRO to ECONOPHYSICS
The shadow banking system is vastly bigger than regulators thought / September 17, 2013
In most parts of the world, the banking system is closely regulated and monitored by central banks and other government agencies. That’s just as it should be, you might think. But banks have a way round this kind of regulation. For the last decade or so, it has become common practice for banks to do business in ways that don’t show up on conventional balance sheets. Before the 2008 financial crisis, for example, many investment banks financed mortgages in this way. To all intents and purposes, these transactions are invisible to regulators. This so-called shadow banking system is huge and important. Indeed, many economists blame activities that took place in the shadow banking system for the 2008 crash. But the size of the system is hard to measure because of its hidden and impenetrable nature. But today, Davide Fiaschi , an economist at the University of Pisa in Italy, and a couple of pals reveal a powerful and simple way of determining the size of the shadow banking system. Their conclusions are revealing. They say that the shadow banking system is vastly bigger than anyone had imagined before. And although its size dropped dramatically after the financial crisis in 2008, it has since grown dramatically and is today significantly bigger than it was even then. Perhaps the biggest problem with measuring the shadow banking system is that nobody quite knows how to define it. Economists say it includes activities such as hedge funds, private equity funds credit insurance providers and so on. But there is significant debate over where to draw the line.
The de facto arbiter of this question is the Financial Stability Board set up in 1999 by the Group of Seven developed nations. It estimates the size of the shadow banking system each year by adding up all the transactions that fall outside mainstream regulation, or at least as much of this as it can see. The Board estimated the size of the shadow banking system to be just over $60 trillion in 2007, the year before the great financial crash. This figure dropped a little in 2008 but rose again to $67 trillion in 2011. That’s more than the total GDP of the 25 countries from which the figures are obtained. Now Fiaschi and co say the Financial Stability Board has severely underestimated the total. These guys have developed an entirely different way of calculating its size using the emerging discipline of econophysics. These guys begin with empirical observation that when economists plot the distribution of companies by size, the result is a power law. In other words, there are vastly many more small companies then there are large ones and the difference is measured in powers of 10. So not 2 or 3 or 4 times as many but 100 (10^2), 1000 (10^3) or 10,000 (10^4) times as many. These kinds of power laws are ubiquitous in the real world. They describe everything from the size distribution of cities, websites and even casualties in war. That’s not really surprising. A power law is always the result when things grow according to a process known as preferential attachment, or in common parlance, the rich-get-richer effect. In economic terms, big businesses grow faster than smaller ones, perhaps because people are more likely to work with big established companies. Whatever the reason, it is a well observed effect. Except in the financial sector. Fiaschi and co say that this power law accurately governs the distribution of small and medium-sized companies in the financial world. But when it comes to the largest financial companies, the law breaks down. For example, the UK’s Royal Bank Of Scotland is the 12th largest firm on the planet with assets of $2.13 trillion. If the size of these firms followed a power law, the largest would be ten times bigger than the 10th on the list. But that isn’t the case. But world’s largest, Fannie Mae, has assets worth $3.2 trillion, just 50% larger than the Royal Bank of Scotland. Why the discrepancy? Fiaschi and co hypothesise that the difference is equal to the size of the shadow banking system, which is not captured in the balance sheets of the largest financial firms. And if that’s the case, it’s straightforward to calculate its size. The value of the shadow banking system is simply the difference between the value of the largest financial firms and their projected size according to the power law. By this measure, the shadow banking system is significantly bigger than previously thought. Fiaschi and co estimate that in 2007, the year before the financial crisis, it was worth around $90 trillion. This fell to about $70 trillion in 2008 but has since risen sharply to be worth around $100 trillion in 2012.
This new Shadow Banking Index has significant advantages over conventional ways of calculating its size. “This index is based on simple and robust statistical features, that are expected to characterize the collective behavior of an economy,” says Fiaschi and co. That’s useful because the growing complexity of the financial markets makes them hard to measure directly. Fiaschi and co point out that any detailed description and classification of financial activity is unlikely to keep pace with the rate of innovation in the financial industry. So the new Shadow Banking Index looks to be an important step towards the proper and meaningful oversight of an industry that is hugely valuable and important and yet increasingly complex and renegade. Of course, there is an 800lb gorilla in the room. That’s how these financial companies come to be so huge in the first place. The global economy is dominated by financial firms. On the Forbes Global 2000 list of the world’s largest companies, the first non-financial firm is General Electric, which ranks 44th. How can that be? If it isn’t evidence that something is rotten in the state of Denmark, then it’s hard to imagine what would constitute such proof. The size and impenetrability of the shadow banking system is clearly part of the problem so an index that can measure it quickly and easily is a useful step in the right direction.
The Interrupted Power Law And The Size Of Shadow Banking
Does the Federal Reserve really control the money supply?
by John Aziz / May 30, 2013
The Federal Reserve, which issues the United States’ monetary base (bank notes, coins, and bank reserves), has vastly increased its size since 2008 through quantitative easing programs — buying assets including Treasury bonds and mortgage-backed securities in open market operations with newly-created money:
(Federal Reserve Bank of St. Louis)
With such soaring quantities of new money resulting from quantitative easing, many economists including John Williams, Peter Schiff, and Marc Faber have predicted imminent high or hyper inflation. But by the broadest measures, like MIT’s Billion Prices Project, the predictions haven’t played out. Inflation hasn’t soared along with the monetary base. And the money supply, which is different from the monetary base (the actual currency), hasn’t really grown either. Bank notes and coins are the most tangible kind of dollars, but there are many more kinds of things called “dollars” that are used for exchange. Most obviously, credit. Banks create money through the fractional reserve banking system. Banks can lend — and thus create credit — up to 10 times their reserves on hand. This means that while the monetary base has tripled, the M2 money stock — which includes both checking and savings accounts as well as traveler’s checks, time deposits, and money market deposit accounts — has not increased nearly as much:
(Federal Reserve Bank of St. Louis)
But even M2 does not encompass the entirety of the money supply. There exists another banking system —the shadow banking system— where credit expansion also takes place. Shadow credit creation takes place via securitization, a process by which debt-based assets like mortgages, credit card debt, and auto debt are pooled together and sold, and via repo, through which assets are pawned to a lender as collateral for credit. One of the stories behind the 2008 crisis was the huge outgrowth of shadow credit creation that preceded it. Yet when the crisis hit, credit markets became spooked, shadow credit creation dried up, and the level of shadow assets began to deflate:
(Federal Reserve Bank of St. Louis)
So the hidden story behind the quantitative easing programs is that the new base money that the Fed has pushed into the financial system has been replacing shadow credit that dried up after 2008. The Fed does not control the money supply — most of the money supply has been created through credit. The Fed can only control one small part of the money supply. This is shown in this chart of M4 — the total money supply, including shadow money — created by Professor Steve Hanke of the Cato Institute, with the monetary base issued by the Fed in olive:
Even after all that quantitative easing, the money supply has still shrunk. In fact, quantitative easing may be choking off shadow credit creation. As the Fed buys more and more assets, there are less assets left in the market that can be used as collateral for credit creation. This so-called “safe-asset shortage” is one factor that has driven the price of Treasuries as well as corporate bonds and even junk debt to record highs. If choking off shadow credit creation and replacing shadow money with traditional money was the Fed’s implicit goal, then it is succeeding. But the money the Fed has issued since the crisis hasn’t even made up for the shrinkage.
Lars Schall: Dr. Hudes, let’s talk about the World Bank, which is often described as a “Bretton Woods organization,” since it was officially founded at the famous international conference in Bretton Woods, New Hampshire in 1944. However, the plan to establish this bank (and the International Monetary Fund) originated years before with the highly secretive “War and Peace Studies” that were conducted by the Council on Foreign Relations and the US State Department, while the money for the study came from the Rockefeller Foundation. (1) Given this background of being part of the “Grand Area” design and strategy for the post-war world order, isn’t the World Bank really a tool to exercise American hegemony?
Karen Hudes: I take issue with one part of that question – when you say, “American hegemony.” If you unbundle the political structure inside the United States, it’s not what you see is what you get. It’s not that the American citizens are the ones that are running the country. There is a very wealthy group that is secretly, through domination of the press, trying to keep the citizens in the United States in the dark. And so when you say a tool of “American hegemony,” the answer is it is a tool of hegemony but I would take the “American” out of the equation. What you saw in the last presidential election was massive amounts of foreign money coming in, in an attempt to influence voters. (2) That’s the group that I’m talking about and I would be very happy, as a sidebar at some point, to discuss who that group is, where they are, and what they’re doing. Because I didn’t know about that group when I started on my saga, but I found out about them later on. Now I try to tell them that they have to start behaving themselves. They are not above the law; they think they are, but they are subject to the law.
L.S.: Okay, then let us go straight down to the nitty-gritty: Can you name the individuals and institutions of that group?
K.H.: I’ll tell you what I can do; I can point you to a very good study that was done by three systems theorists at the Swiss Federal Institute of Technology in Zurich, ranked as the best university in continental Europe. What they did was examine the interlocking ownership of the world’s 43,000 transnational corporations using mathematical modeling tools. Are you familiar with that study?
L.S.: Yes, I am. I believe you are referring to a study which showed basically that a small group respectively “super-entity” of 147 financial institutions and multinational corporations is pretty much in control of the world economy. (3)
K.H.: Yes, that’s right. So, it’s whoever is behind that group which is in control of 1 percent of the investments but that 1 percent through corporate interlocking directorships is now in control of 40 percent of the assets and 60 percent of the revenues of this set of 43,060 transnational companies. That’s who that group is. Now, do I know who the individuals behind that group are? They’re very good at secretly hiding, so I’m not going to hazard a guess. But once we get the legal machinery in place, we will find out in great detail who these individuals are, and they will be playing by the rules along with everybody else on this planet.
The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives
by Ellen Brown / September 17, 2013
Five years after the financial collapse precipitated by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another full-blown financial panic is still looming large, despite the Dodd Frank legislation designed to contain it. As noted in a recent Reuters article, the risk has just moved into the shadows:
[B]anks are pulling back their balance sheets from the fringes of the credit markets, with more and more risk being driven to unregulated lenders that comprise the $60 trillion “shadow-banking” sector.
Increased regulation and low interest rates have made lending to homeowners and small businesses less attractive than before 2008. The easy subprime scams of yesteryear are no more. The void is being filled by the shadow banking system. Shadow banking comes in many forms, but the big money today is in repos and derivatives. The notional (or hypothetical) value of the derivatives market has been estimated to be as high as $1.2 quadrillion, or twenty times the GDP of all the countries of the world combined.
According to Hervé Hannoun, Deputy General Manager of the Bank for International Settlements, investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), although most are not generally classed as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.
The Hidden Government Guarantee that Props Up the Shadow Banking System
According to Dutch economist Enrico Perotti, banks are able to fund their loans much more cheaply than any other industry because they offer “liquidity on demand.” The promise that the depositor can get his money out at any time is made credible by government-backed deposit insurance and access to central bank funding. But what guarantee underwrites the shadow banks? Why would financial institutions feel confident lending cheaply in the shadow market, when it is not protected by deposit insurance or government bailouts? Perotti says that liquidity-on-demand is guaranteed in the SBS through another, lesser-known form of government guarantee: “safe harbor” status in bankruptcy. Repos and derivatives, the stock in trade of shadow banks, have “superpriority” over all other claims. Perotti writes:
Security pledging grants access to cheap funding thanks to the steady expansion in the EU and US of “safe harbor status”. Also called bankruptcy privileges, this ensures lenders secured on financial collateral immediate access to their pledged securities. . . . Safe harbor status grants the privilege of being excluded from mandatory stay, and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral. This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims. Critically, it ensures immediacy (liquidity) for their holders. Unfortunately, it does so by undermining orderly liquidation.
When orderly liquidation is undermined, there is a rush to get the collateral, which can actually propel the debtor into bankruptcy. The amendment to the Bankruptcy Reform Act of 2005 that created this favored status for repos and derivatives was pushed through by the banking lobby with few questions asked. In a December 2011 article titled “Plan B – How to Loot Nations and Their Banks Legally,” documentary film-maker David Malone wrote:
This amendment which was touted as necessary to reduce systemic risk in financial bankruptcies . . . allowed a whole range of far riskier assets to be used . . . . The size of the repo market hugely increased and riskier assets were gladly accepted as collateral because traders saw that if the person they had lent to went down they could get [their] money back before anyone else and no one could stop them.
Burning Down the Barn to Get the Insurance
Safe harbor status creates the sort of perverse incentives that make derivatives “financial weapons of mass destruction,” as Warren Buffett famously branded them. It is the equivalent of burning down the barn to collect the insurance. Says Malone:
All other creditors – bond holders – risk losing some of their money in a bankruptcy. So they have a reason to want to avoid bankruptcy of a trading partner. Not so the repo and derivatives partners. They would now be best served by looting the company – perfectly legally – as soon as trouble seemed likely. In fact the repo and derivatives traders could push a bank that owed them money over into bankruptcy when it most suited them as creditors. When, for example, they might be in need of a bit of cash themselves to meet a few pressing creditors of their own.
The collapse of . . . Bear Stearns, Lehman Brothers and AIG were all directly because repo and derivatives partners of those institutions suddenly stopped trading and ‘looted’ them instead.
The global credit collapse was triggered, it seems, not by wild subprime lending but by the rush to grab collateral by players with congressionally-approved safe harbor status for their repos and derivatives. Bear Stearns and Lehman Brothers were strictly investment banks, but now we have giant depository banks gambling in derivatives as well; and with the repeal of the Glass-Steagall Act that separated depository and investment banking, they are allowed to commingle their deposits and investments. The risk to the depositors was made glaringly obvious when MF Global went bankrupt in October 2011. Malone wrote:
When MF Global went down it did so because its repo, derivative and hypothecation partners essentially foreclosed on it. And when they did so they then ‘looted’ the company. And because of the co-mingling of clients money in the hypothecation deals the ‘looters’ also seized clients money as well. . . JPMorgan allegedly has MF Global money while other people’s lawyers can only argue about it.
MF Global was followed by the Cyprus “bail-in” – the confiscation of depositor funds to recapitalize the country’s failed banks. This was followed by the coordinated appearance of bail-in templates worldwide, mandated by the Financial Stability Board, the global banking regulator in Switzerland.
The Auto-Destruct Trip Wire on the Banking System
Bail-in policies are being necessitated by the fact that governments are balking at further bank bailouts. In the US, the Dodd-Frank Act (Section 716) now bans taxpayer bailouts of most speculative derivative activities. That means the next time we have a Lehman-style event, the banking system could simply collapse into a black hole of derivative looting. Malone writes:
. . . The bankruptcy laws allow a mechanism for banks to disembowel each other. The strongest lend to the weaker and loot them when the moment of crisis approaches. The plan allows the biggest banks, those who happen to be burdened with massive holdings of dodgy euro area bonds, to leap out of the bond crisis and instead profit from a bankruptcy which might otherwise have killed them. All that is required is to know the import of the bankruptcy law and do as much repo, hypothecation and derivative trading with the weaker banks as you can. … I think this means that some of the biggest banks, themselves, have already constructed and greatly enlarged a now truly massive trip wired auto-destruct on the banking system.
The weaker banks may be the victims, but it is we the people who will wind up holding the bag. Malone observes:
For the last four years who has been putting money in to the banks? And who has become a massive bond holder in all the banks? We have. First via our national banks and now via the Fed, ECB and various tax payer funded bail out funds. We are the bond holders who would be shafted by the Plan B looting. We would be the people waiting in line for the money the banks would have already made off with. . . .
. . . [T]he banks have created a financial Armageddon looting machine. Their Plan B is a mechanism to loot not just the more vulnerable banks in weaker nations, but those nations themselves. And the looting will not take months, not even days. It could happen in hours if not minutes.
Crisis and Opportunity: Building a Better Mousetrap
There is no way to regulate away this sort of risk. If both the conventional banking system and the shadow banking system are being maintained by government guarantees, then we the people are bearing the risk. We should be directing where the credit goes and collecting the interest. Banking and the creation of money-as-credit need to be made public utilities, owned by the public and having a mandate to serve the public. Public banks do not engage in derivatives. Today, virtually the entire circulating money supply (M1, M2 and M3) consists of privately-created “bank credit” – money created on the books of banks in the form of loans. If this private credit system implodes, we will be without a money supply. One option would be to return to the system of government-issued money that was devised by the American colonists, revived by Abraham Lincoln during the Civil War, and used by other countries at various times and places around the world. Another option would be a system of publicly-owned state banks on the model of the Bank of North Dakota, leveraging the capital of the state backed by the revenues of the into public bank credit for the use of the local economy. Change happens historically in times of crisis, and we may be there again today.