While local banks are held in check by the new banking czars in Basel, Wall Street’s “shadow banking system” has hardly been curbed by regulators at all; and it is here that the 2008 credit crisis was actually precipitated.  The banking system’s credit machine is systemically flawed and needs a radical overhaul.

On September 13, the Bank for International Settlements issued heightened capital requirements that will make lending even more difficult for local banks, which do most of the consumer and small business lending today.  The new rules are ostensibly designed to prevent a repeat of the 2008 credit collapse, but they fail to address its real cause, which involves a “shadow” banking system that has largely escaped regulation.

What went wrong in September 2008 was not that the existing Basel II capital requirements were too low but that banks found a way around the rules.  The Basel II rules base a bank’s capital requirement on how risky its loan book is, and banks can make their books look less risky by buying unregulated “insurance contracts” known as credit default swaps (CDS).  This insurance, however, proved to be a fraud, when insurer AIG went bankrupt on September 15, 2008.  The credit collapse that followed has normally been blamed on the collapse of the subprime housing market.  But according to Yale economist Gary Gorton (whose views were recently embraced by Fed Chairman Ben Bernanke), the subprime problem was not itself sufficient to trigger a global credit freeze.  What it did trigger was an old-fashioned bank run, in the not-so-familiar market known as the shadow banking system.

Bank runs don’t generally occur in the traditional banking system anymore, because (a) depositors are now protected by FDIC insurance, and (b) banks that run out of reserves can borrow from the Federal Reserve, which is empowered to create money ex nihilo (out of nothing).  But FDIC insurance covers only $250,000 in deposits, and there is a massive and growing demand for banking by large institutional investors – pension funds, mutual funds, hedge funds, sovereign wealth funds – which have millions of dollars to park somewhere between investments.  They want an investment that is secure, that provides them with a little interest, and is liquid like a traditional deposit account, allowing quick withdrawal. 

The shadow banking system evolved in response to this need, operating largely through the repo market.  “Repos” are sales and repurchases of highly liquid collateral, typically Treasury debt or mortgage-backed securities.  The collateral is bought by a “special purpose vehicle” (SPV), which acts as the shadow bank.  The investors put their money in the SPV and keep the securities, which substitute for FDIC insurance in a traditional bank.  (If the SPV fails to pay up, the investors can foreclose on the securities.)  To satisfy the demand for liquidity, the repos are one-day or short-term deals, continually rolled over until the money is withdrawn.  This money is used by the banks for other lending, investing or speculating.  But that puts the banks in the perilous position of Jimmy Stewart in “It’s a Wonderful Life,” funding long-term loans with short-term borrowings.  When the investors get spooked for some reason and all pull their money out at once, the banks can no longer make loans and credit freezes.  

In September 2008, investors were spooked when the mortgage-backed securities backing their repo “deposits” proved not to be “triple A” as represented.  But the next time it might be something else, and Basel III has not fixed this systemic weakness.  Arguably, the weakness cannot be fixed under the current scheme of private banking and credit.  As noted in an article on Seeking Alpha by The Business Insider:   

“Our financial system remains vulnerable to another credit crunch, with many of the same exact features as the last. All it needs is someone to strike the match of panic.”

The question is how to eliminate this systemic risk:

“Regulate shadow banking more tightly, and you probably have to also provide government backstops. Shudder. Try to shut the thing down or restrict it and you suck credit out of the system, credit which much of the non-financial 'real' economy uses and needs.”

The real economy needs credit, and choking it off by over-regulating the banks will kill the real economy.  Indeed, according to Gary Gorton, the shadow banking system evolved because banks were already so over-regulated that they could not turn a profit.  He writes:

“Holding loans on the balance sheets of banks is not profitable. . . . This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners exit the industry by not investing; they invest elsewhere.  Regulators can make banks do things, like hold more capital, but they cannot prevent exit if banking is not profitable. ‘Exit’ means that the regulated banking sector shrinks, as bank equity holders refuse to invest more equity.”