If future credit needs will be met in part by shadow banking, as they were prior to the financial crisis, then we may need to bring repurchase agreements and money market funds, which provide much of the funding for the shadow banking system, into the public safety net that protects traditional banking.
That’s the view expressed by Perry G. Mehrling, professor of economics at Barnard College, Columbia University, in his The Money View blog June 5.
With these comments, Mehrling enters the debate among economists on how the repurchase market, which was the source of the systemic banking panic in 2007 and 2008, should be reformed.
Shadow banking is an umbrella phrase used to describe a Wall Street system where companies and off-the-books trusts make loans with money they have borrowed, instead of with FDIC-insured deposits. These companies borrow much of their money on the repurchase market, from money market funds. Shadow banking is less regulated than traditional banking because it doesn’t involve FDIC-insured deposits.
Mehrling’s comments were made in response to a May paper by Thomas M. Hoenig and Charles S. Morris, president and vice-president of the Federal Reserve Bank of Kansas City.
Hoenig and Morris argue that traditional banks are essential and should continue to be protected by the public safety net, and shadow banking is not essential and should be limited, by putting restrictions on repurchase agreements and money market funds.
Hoenig and Morris believe companies embraced shadow banking mainly to avoid the regulation that comes with traditional banking.
Specifically, they would let traditional banks provide payment and settlement services, make loans, accept deposits, underwrite securities, offer merger and acquisition advice, and provide trust and wealth and asset management services.
They would not let traditional banks or their affiliates conduct broker-dealer activities, make markets in derivatives or securities, trade securities or derivatives for either their own account or customers, or sponsor hedge or private equity funds.
The problem with the Hoenig and Wilson view, Mehrling said, is that it’s possible shadow banking has become essential. He calls it a capital market-centered credit system. This was the credit system that froze in 2007 and 2008. If it has become essential, it needs to be fixed, he said.
From Mehrling’s blog:
In the (Hoenig and Morris) version of the history, the rise of shadow banking is entirely about regulatory arbitrage; the shift in the last thirty years from a bank loan-centered credit system to a capital market-centered credit system is simply a mistake that we now have the opportunity to correct.
Maybe so, but maybe also there are other reasons for the shift to a market-centered credit system. The important point is that, to the extent the market-centered credit system is here to stay, the institutions that support the liquidity of that market system are also here to stay. Even more, to that extent we should view those institutions as essential to the operation of our credit system.
The problem is not, as (Hoenig and Wilson) would have it, how to keep those institutions out of the safety net but rather how to bring them in explicitly, along with a reformed system of regulation and supervision that ensures their safety and soundness.