US regulators released some signal financial numbers last week. As the Financial Times reported, “The US financial sector's losses on large loans exploded in 2009, exceeding the combined losses since 2001, with hedge funds and other members of the ‘shadow banking system’ hit the hardest.” These non-bank institutions “held 47 per cent of problem loans in spite of accounting for only 21.2 per cent of the total loan pool.” Shadow banks, which generated such handsome returns in good times, today, in bad times, are on the floor.
Shadow banking. The invidious edge in the term is not, in my mind, unjust. There is definitely a shadowy aspect to this; but it is not so much, as liberals would have it, in the fact that the shadow banks were nefariously unregulated, real free radicals of capitalism betting like gamblers; it is in the fact that, off at the end, public capital would have to be substituted for the private capital that once drove their business.
To those who would answer that public capital should never have been committed, I must say there are certain considerable difficulties that confront you. (a) Virtually all the participants, from both government and industry, did truly believe that, whether we knew it or not, we all faced in that moment the possibility of irremediable calamity; the very crack of doom yawned before us. (b) Even if that judgment is wrong, there is still the fact of the actual statutory obligations of, say, a Fed Chairman. Does Bernanke even have the authority to adopt a policy of studious neglect of the unraveling of the financial system? It seems to me that his office entails an allegiance to stability which precludes running the experiment of an advanced capitalist economy operating with no banking system.
What is a shadow bank? As I understand it, a shadow bank is a financial institution operating outside the heavy regulation of the traditional banking sector, but basically doing the same thing that banks do: borrowing short and lending long — only its activities are notably more aggressive. A huge chunk of those long-term loans, we now know, were into fields of really speculative investment, above all in US housing. And now the short-term borrowing from the private sector has dried up. The securitization markets lies in ruins (though we have seen some uptick recently). Realistically, the primary demand driver is government capital.
Reasoning, then, from what this reveals, I propose that moral hazard was woven into the very fabric of shadow banking as such. In other words, the industry actually depended in a decisive way upon the expectation that, off at the end, its key players would be rescued from ruin by government capital.
The only remedy to this would have been a sacred and unbending public pledge, almost constitutional in significance, never to wager a dollar of public money to rescue a non-bank bank, a shadow bank.
To even state such a remedy is to demonstrate its practical folly. Not merely the idea of a kind of second Philadelphia Convention, called to proclaim to all the wide world that shadow banks are on their own; but indeed consider that it was precisely an attempt (however reluctant) to deliver this statement — I mean the ultimately laissez faire treatment of Lehman Brothers at its extremity as a going concern — that triggered the near-calamity.
In brief, the principle that would remove moral hazard from shadow banking is not conceivable in practice, given the state of affairs, our statutory commitments, and indeed our recent history as a commercial republic.