The banking industry in its organized format is not very old. A century ago banks operated in a system with very limited regulation and little backing from the government. It was a system characterized by bank runs. The depression saw the introduction of the federal deposit insurance, which helped reduce bank runs and gave banking some credibility. Early on Banks have used short term liabilities to fund long term assets, which often led to bank runs. Bank failures can have huge negative impacts on the economy. To counter this American Governments helped them counter the risk of short term lending by giving them greater liquidity through deposit insurance. These put options, are difficult to price and this keeps the options for risk-taking very high. This can be kept in check only by greater regulation and limits.
In 2007 the Lehman brothers fell to such engagement of credit and risk taking. The crisis that followed was brought to check by the Feds intervention by introducing greater liquidity in the system. This helped the system to get ‘oiled’. The FDIC’s Temporary Liquidity Guarantee Program (TLGP) of financial institutions’ senior unsecured debt and corporate transaction accounts, and the U.S. Treasury’s temporary guarantee program of money market funds, are the modern-day equivalents of deposit insurance. The period 2007-09 saw the investment banks and other intermediaries play with asset based mortgages, derivatives, etc. The impression was that these assets were considered to be risk free and highly liquid.
The G20 is deliberating on how to regulate the shadow banking system, which is de facto a parallel financial system to the traditional, government-backed one. Consumer finance companies, pawn brokers, securities traders all come under the ambit of shadow banking. In view of the current financial crisis it includes asset backed commercial paper issuers and companies who develop and market highly complex derivative products.
Shadow banking uses asset backed securities to mop up short term credit from the repo market or money market funds. It then uses these funds for other lending purposes. They then lent this monies to corporates or in buying long term assets. When the realty market came crashing down, these assets quickly became `toxic’. Most of this was ‘off balance sheet’. Many banks bundled these toxic assets and sold them to bigger banks. Bigger banks in turn sold them to investors as mortgage backed securities with monthly EMI’s as payouts to investors. The shadow banking‘s liabilities stands at about $16 trillion as against $13 trillion liabilities of traditional banking (2011 1st quarter) according to New York Fed. This being a fairly unregulated market, the government can do little in terms of either monitoring it or containing should a ‘run’ occur.
According to Timothy Geithner, United States Secretary of the Treasury “The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system… In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.”
“In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.”