All Hail Shadow Banking

Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities.

Murray Rothbard, The Mystery of Banking, Chapter VII: Deposit Banking

I begin with this cite of Rothbard.  He points out one of the key destabilizing features of modern banking – the mismatch of the time structure of the banks’ assets and its liabilities.  This mismatch has been allowed to exist and expand due to the monopoly nature of money and credit and the backing of central banks and governments.

Bank liabilities are made up in good measure of short-term instruments – instantly demandable deposits being the shortest-term of all.  Its assets are often of a longer duration – various types of loans and loan commitments of several years’ duration.

The Economist (mouthpiece of mouthpieces) offers an extensive article on this topic, “Shadow and substance” (HT Ed Steer).

As banks retreat in the wake of the financial crisis, “shadow banks” are taking on a growing share of their business, says Edward McBride. Will that make finance safer?

As long as they stay reasonably and relatively unregulated and unbacked by the state, I offer a resounding YES, YES, and YES in reply.

What is meant by the term “shadow bank”?

Shadow banks are easier to define by what they are not than by what they are…. The Financial Stability Board, an international watchdog set up to guard against financial crises, defines shadow banking as “credit intermediation involving entities and activities outside the regular banking system”—in other words, lending by anything other than a bank.

Why am I all gaga about shadow banks?  What does this have to do with Rothbard’s quote?  The tale is told through the experience of a brewery, Hall & Woodhouse brewery, founded in 1777.  In the past, whenever outside capital was required, they turned to a bank for a loan.  The financial calamity of a few years’ back changed all that:

…bank lending to businesses in America is still 6% below its 2008 high. In the euro zone, where it peaked in 2009, it has declined by 11%.  In Britain it has plummeted by almost 30%.

So the brewery went looking for other sources:

They decided they needed more reliable long-term creditors, so they reduced their bank borrowing and turned instead to a shadow bank—a financial firm that is not regulated as a bank but performs many of the same functions (see box overleaf). The one they picked was M&G (the asset-management arm of Prudential, a big insurance firm), which offered them £20m over ten years.

Do you think Prudential, “a big insurance firm,” has liabilities that align better with this loan than might a typical bank?

M&G…is not considered a bank, nor regulated as such. The money it has doled out to Hall & Woodhouse comes directly from institutional investors, including Prudential and various pension funds, which have given M&G £500m to lend to mid-sized British businesses. All the proceeds from the loans go to the investors, who must also bear any losses…

As long as the central banks do not come to their rescue, this seems like an ideal marriage – perhaps one for which Rothbard might even officiate!

There are other avenues:

…private debt is only one form of lending that takes place outside banks. Bond markets—by far the biggest source of non-bank financing—continue to grow even as bank lending shrinks.

Peer-to-peer (P2P) lenders—websites that match savers with borrowers—are also growing like topsy, albeit from a tiny base.

We aren’t talking small potatoes:

The Financial Stability Board (FSB), a global financial watchdog, reckons that shadow lending in all its forms accounts for roughly a quarter of all financial assets, compared with about half in the banking system. But it excludes insurance and pension funds from its calculations; add those in, and shadow banking is almost on a par with the better-lit sort.

The report in The Economist goes on to identify the relative shrinking of banks’ presence in payment systems and trading.  Who knows?  Eventually we might even return to a world where banking is split into two distinct businesses: deposit banking and loan banking, with all the other miscellaneous functions performed by more specialized firms (thank you, internet).  The market might achieve what is necessary, despite the roadblocks put up by the regulators (and without crony legislation such as the often called-for re-enactment of Glass-Steagall).  

As always, something can go wrong – and the potential problem will not come from the market:

Shadow banking can reduce risk, but only if failure is an option….

Failure is an option in the free-market.  It is only when government steps in to save people from their own failures where failure is not an option.  And this is the rub…

Bankers…talk about shadow banking in a much more sweeping way, to refer to any financial institutions that banks see encroaching on their business.

Will the banks just stand aside?  Will the states that back them do so?  Will they have a choice? 

Sooner or later, the market will win.  There is no human force on earth that can stop it.  I don’t suggest absolutely free-markets in all places everywhere; merely that what is uneconomical cannot continue forever. 

Good for you, Murray!