If it walks like a bank, it should be regulated like a bank

Financial institutions that borrow short-term loans and use that money to lend long-term loans – that is, they borrow short and lend long – should be regulated like FDIC-insured banks.

That’s the essence of a new paper by Morgan Ricks, a visiting assistant professor at Harvard Law School and, until June 2010, a senior policy advisor and financial restructuring expert at the U.S. Treasury Department.

Ricks’ proposal is one way to reform repo, because much of the short-term borrowing is done on the repurchase market.

In brief, Ricks would apply bank-type regulations to broker-dealers, money market funds, off-the-books trusts and any other businesses that want to borrow short and lend long.

He fears that The Dodd-Frank Act alone will not prevent – and could make it harder for regulators to deal with – another 2008-style financial crisis.

Some background:

A primary function of FDIC-insured banks is to borrow short, from depositors, and lend long, to companies and people who need credit. In financial jargon, this is called maturity transformation. It’s risky, because the bank might have to pay its depositors before it gets repaid by its borrowers. If that happens a lot, like when all depositors run on the bank and demand their money back, a bank can become insolvent quickly – which is a key reason FDIC-insured banks operate under lots of government rules.

In the past two decades, companies that are not FDIC-insured banks began borrowing short and lending long. This activity has become known as shadow banking, securitized banking, market-based banking, or parallel banking.

Key shadow banking companies are broker-dealers, money market funds, investment banks, hedge funds, parts of commercial banks, and off-the-books trusts, also called conduits. These companies became a lightly regulated and profitable alternative to traditional banking.

Key ways for shadow banking companies to get short-term money are to sell repurchase agreements, ABCPaper (asset-backed commercial paper), unsecured commercial paper, and money market fund shares.

These were the transactions that collapsed in the financial panic of 2007-2008. Ricks argues they need to be brought under the umbrella of banking regulation.

From Ricks’ paper, “Regulating Money Creation After The Crisis”:

It would mean establishing criteria of admission to the money market and disallowing access to moneyclaim funding by firms whose business models do not meet those criteria — just as we prohibit non-banks from issuing deposit liabilities. Among other things, this would probably mean that both the modern broker-dealer business model and the money market mutual fund industry would have to change in fundamental ways. Given that these two species of financial institution were at the epicenter of the recent financial crisis, perhaps this should not be very troubling.

Although it’s widely known that shadow banking was at the heart of the 2007-2008 financial crisis, it has not been reformed, Ricks writes:

Over the past several years, a number of scholars, market participants, and policymakers have noted that the existence of maturity transformation outside the regulated depository sector raises serious policy concerns. The firms engaged in this activity—the issuers of the vast majority of outstanding money market instruments—have even come to be known by a distinctive name: the “shadow banking system.”

Moreover, it is increasingly recognized that this giant system was at the center of the recent financial crisis. Indeed, as we will see, very nearly the entire emergency policy response to the crisis was directed at stabilizing this system.

But there has yet to emerge a consensus as to how the shadow banking system should be regulated, if at all, to reduce the likelihood of future crises. Nor is there any consensus as to how the government ought to respond in the event of a future panic in the money market.

Securitization – that is, pooling loans and selling securities called ABS (asset-backed securities) backed by those pools – is an important part of shadow banking. Ricks offers this description:

Various components of the shadow banking system arose over the course of several decades. However, only in the most recent decade did that system achieve full bloom. In shadow banking, pools of long-term financial assets are financed with money market liabilities through a variety of channels.

Various types of consumer and business loans are warehoused in conduits after origination, where they are financed with asset-backed commercial paper (ABCPaper) with typical maturities of four weeks or less. After warehousing, these loans are packaged into asset-backed securities (ABS), including mortgage-backed securities. Along with other types of financial assets, many of these ABS are funded on broker-dealer balance sheets through short-term repurchase agreements (repos), which usually mature the next business day.

To generate additional high-quality collateral, ABS tranches are often combined and  re-securitized into complex structured credit instruments. Senior tranches of structured credit are often funded on dealer balance sheets through short-term repo or held by structured investment vehicles (SIVs), highly leveraged credit hedge funds, or similar entities that finance themselves in the short-term markets.

Major broker-dealers and finance companies also commonly issue garden-variety commercial paper, a long-established form of unsecured short-term credit, as an important source of funding. Many of these short-term instruments (commercial paper, ABCP, and repo) make their way to money market mutual funds. Here, in a final step of maturity transformation, they serve as the basis for the creation of demandable money for retail and institutional customers. Money market fund “shares” are fixed in value and redeemable at will. As such, they are functionally indistinguishable from interest-bearing demand deposits. These funds often serve as the final step in the chain of shadow banking: the transformation of long-term assets into demandable obligations, redeemable at any time at the holder’s option.

The shadow banking system was huge prior to the crisis, and it remains so. As of 2007, the aggregate known short-term liabilities of this system were about $6.2 trillion, far exceeding outstanding FDIC-insured deposits of $4.3 trillion.

(Editor’s note: The $6.2 trillion includes only about half of the repurchase agreements, according to RepoWatch’s estimate, none of the securities lending, and none of the hedge fund deposits with investment banks.)

This $6.2 trillion figure is conservative; it excludes significant categories of instruments for which no reliable figures are available. The precise mechanics of these instruments are not important for present purposes. What is important is that they all represent short-term claims on private entities that invest in longer-term financial assets.

The shadow banking system has existed outside the explicit banking safety net and, in most cases, with minimal regulatory constraints. Naturally this freedom has been conducive to high returns. But this system has also proved fragile. The crisis that began in 2007 eventually tore through the entire shadow banking sector. ABCPaper conduits (including SIVs), dealer repo markets, commercial paper markets, “liquidity put” bonds, money market mutual funds, repo-financed credit hedge funds, and uninsured bank deposits all experienced modern-day bank runs.

The role of the shadow banking system in the crisis is fairly widely acknowledged. The term “shadow banking” was coined in 2007 by Paul McCulley of PIMCO, the giant bond fund manager. Since then, the concept has achieved wide currency.

– Timothy Geithner used the term “parallel financial system” to describe the same phenomenon in a June 2008 speech, when he was still President of the Federal Reserve Bank of New York.

– Economist Paul Krugman has argued that shadow banking was central to the recent crisis.

– Paul Tucker of the Bank of England has given an influential and perceptive speech on shadow banking.

– Within the academic literature, economists Gary Gorton and Andrew Metrick have studied the policy implications of shadow banking.

Gorton in particular has insisted that the distinction between shadow banking and depository banking is in many ways an artificial one. In Gorton’s words, “the ‘shadow banking system’ is, in fact, real banking.”