The Shadow Banking System That Operated In Broad Daylight: Part I

Mark Thoma and Brad Delong are completely entrenched into the position that this crisis was brought on by the nefarious “shadow banking system.” In fairness to Thoma, he is trying quite sincerely to argue his point, and I think my disagreement with him stems mostly from my objection to labeling particular aspects of the financial system as “shadow banking.” That said, I do take issue with a few of his substantive points. Rortybomb does a fine job summarizing the recent history of this debate, highlights some of the strengths of Thoma’s position, and also clarifies the debate by providing a reasonable framework for what it is that people are referring to when they talk about the “shadow banking system.”

As for Delong, his argument takes the form of an excursion through unmitigated nonsense, as he boasts his deep knowledge of comic books, and little else. As such, in this post, I’ll begin with Delong’s argument, since it is completely unfounded. In the next post, I’ll take on Thoma’s position, as it warrants more attention and represents an opinion held by a lot of intelligent people. I just happen to disagree. So here goes Delong:

[C]ommercial banks–with their massive retail savings deposits–have for the most part come through this all right. In fact, the possession of lots of inertial commercial savings and checking deposits that they did not have to worry might flee provided JPMorgan (with the retail banking assets of Chase) and the bank formerly known as NationsBank (with the retail banking assets of Bank of America) with competitive advantages that allowed them to pick up the assets of Bear Stearns and Merrill Lynch at what they thought were bargain prices.

Wow, those are some seriously important-sounding terms there. We’ve got “massive retail savings deposits,” “competitive advantages,” and don’t forget those “inertial commercial savings and checking deposits.” How could deposit taking banks fail with all that going for them?  Surely, deposit taking banks are doing swell! And, they are, with the noted exception of the seemingly endless list of failures that have occurred at deposit taking banks over the last 2 years. But there are even more inconvenient aspects of the observable universe that Delong must tackle before we can accept his deposits-cure-all theory of banking. For example, U.S. banks and bank holding companies are currently receiving all kinds of direct and indirect support from the U.S. government through the alphabet soup of liquidity and guarantee programs that have been set up since the crisis got underway. Also, it is my understanding that European banks, while more leveraged than their U.S. counterparts, rely much more on deposits than U.S. banks do. Yet, the European banking system is suffering a crisis that rivals our own by several measures.

Delong’s position seems to be just another manifestation of the idea that, somehow, good old fashioned banking is the answer. Deposits and lending, and that’s it. None of this fancy stuff. That has a nice ring to it. It’s sentimental, makes us think that our parents are smarter than us, and it has an almost sanctimonious aspect to it, in that it suggests that if we part with some of the more luxurious aspects of finance, we can have some more stability. However, history has a few counterexamples to this position, one being the Great Depression.

While others chalk this crisis up to SIVs, CDOs, and a bunch of other acronyms they really don’t understand, I see it in much simpler terms: banks, and others in the financial system, all made the same bad bet based on unsustainable assumptions. Sure, some of them made this bet using sophisticated means, and that itself is a topic worth exploring. But the root cause of all of this, in my opinion, is underestimating risk. This underestimating had heavy assistance from some very regulated entities and markets. As such, I reject the argument that the “shadow banking system” caused this crisis for two reasons: first, everyone that mattered and could do something about what was going on knew full well what was going on. So how is it productive to ascribe such a mysterious sounding name to something that people were fully aware of? And second, the root cause of this crisis is, in my opinion, much easier to grasp once we reduce all of the complexities to simpler constructs, and think in terms of what risks entities and markets were exposed to, and for that limited purpose, ignore the means by which they were exposed to those risks.

Originally published at Derivative Dribble and reproduced here with the author’s permission.

5 Responses to "The Shadow Banking System That Operated In Broad Daylight: Part I"

  1. Ernesto Munoz   June 23, 2009 at 2:04 pm

    Mr Davi brings as back to the experience of the Great Depression. Precisely! Because of that, Commercial Banks were restricted to do short term commercial loans as payoff for having their deposits guaranteed. Higher risk bonds, stocks and mortgages were outside their turf. Mr Davi points out to the simple fact that “all made the same bad bet based on unsustainable assumptions”. Agreed. Commercial Banks took excessive risks because the repeal of the Glass-Steagall act in 1999, allowed them to do so. It is time them to go back to old fashioned banking and restore some updated form of Glass-Steagall, which proved effective for 66 years. If Mr. Davi is of a different opinion I challenge him to show how many, of his endless list of banks, have failed because of excessive lending in their commercial division.

  2. old gringo   June 26, 2009 at 2:32 am

    Excellent 12 page article on “Goldman Saks” in the July issue of “Rolling Stone”.

  3. Guest   June 26, 2009 at 9:32 am

    Ernesto Munoz has hit the nail on the head. The banking industry could not have made these bad bets if they had remained in a form that did not allow betting. Mr. Davi’s attempt to rationalize the destruction of a rather large portion of the entire world’s wealth cannot change that fact. The author has helped us understand both why we need entirely new leadership in the banking industry, and why this article was originally published in something called “derivative dribble.”

  4. Derivative Dribble   June 26, 2009 at 2:16 pm

    Guest,”The banking industry could not have made these bad bets if they had remained in a form that did not allow betting.”They made these bets by LENDING. That’s what banks do. They happened to make bad loans. That’s my point.

  5. Anonymous   June 29, 2009 at 10:06 am

    Derivative Dribble,They would not have made bad loans had they not been able to foist them off onto someone else – securitize them.