Shadow Banking and Liquidity Risks

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Shadow Banking and Liquidity Risks

Last night I attended an economic forecast event for investors at the invitation of Tim Curley, a financial advisor at UBS. Two of BlackRock’s top investment heads gave their economic outlook and views on the investment climate. It wasn’t positive and optimistic but it wasn’t exactly negative or pessimistic either.

What caught my attention the most was Curtis Arledge, managing director and co-head of U.S. Fixed Income Portfolio Management Group, talking about the origins of last year’s financial meltdown in the “shadow banking” system. Despite the work I do in banking and treasury management, I had not heard the term or known how it worked.

To Arledge, the financial crisis had its origins in the shadow banking system, which provided abundance and inexpensive credit until it melted down. Then the Federal Reserve essentially created a new banking system to keep the economy from disaster.

Before 1980, virtually all loans to businesses came from banks—he likened it to a single engine plane. In the 1980s, banks and other organizations began to both protect and leverage their assets through securitization, which, in a highly simplistic explanation, means that individual loans were pooled and sold as a single investment security. “The idea was to make credit cheaper for the ultimate borrower and more available, but also to separate the credit system from the payment system,” noted Professor Perry Mehrling, economist at Barnard College, in an interview in The Atlantic last July.

Lending was now like a twin engine plane, as Arledge put it. “That was the lending that fed the economy with credit.”

Last fall, however, the second engine blew out. In a now well-documented series of events, the Federal Reserve made up the difference by lending through TALF and other programs. It effectively amounted to a third banking system, at least in terms of a source of credit; a third engine to replace the blown-out second.

Credit dried up not so much because banks stopped lending but because the source of inexpensive credit for home and other loans stopped as the poor quality of the underlying loans became apparent. “It’s not banks that shut down lending but the shadow banking system,” Arledge said.

Nouriel Roubini, chairman of Roubini Global Economics, announced the demise of the shadow banking system on 21 September 2008 in an article in the Financial Times.  Maybe. Even so, the effects are still with us and likely will be for some time.

Although some indicators from the last week suggest that the economy is improving, it still has a lot of debt to work out. CFOs and treasurers are still wary. After initially hording cash, they are watching for risks to liquidity because, as Arledge said, there are companies that will not be able to refinance their debt, as they could in years past, and won’t have the cash flow to make payments. As the last year shows, debt may be created in the shadows, but it doesn’t stay there forever.

Note:

From a Google perspective, “shadow banking” isn’t a highly known term, if search stats are any indication. It shows up on its Google Trends chart only toward the end of the third quarter of 2008, as expected given its relationship to the crisis. Google also reports no news articles on the term, though the links above show otherwise.