Periodically I read a speech by a Fed Governor that reveals how the economists at the Federal Reserve have absolutely no idea how our financial system works.  The most recent example was a speech on the shadow banking system given by Governor Tarullo, the man the WSJ calls the most powerful man in banking today.

He begins the speech by observing about shadow banking:

The very phrase evokes the sense of something hidden, furtive even–a sort of film noir backdrop for extending credit, in contrast to the well-lit setting of the local insured depository institution. In the pre-crisis years, there did indeed develop modes of financial intermediation in which certain features of a counterparty relationship were, if not quite obscured, then at least ambiguous, and thus “shadowy.”

He is right something is hidden in shadow banking.  However, he makes no connection between the idea something is hidden and there might be a problem because something is hidden.  Regular readers know what is hidden by opacity is risk the investors cannot assess.

He is also right this is in sharp contrast to the local (i.e. small community) banks.  As discussed previously, these banks are very transparent and will share with anyone who asks the information on all their non-performing loans.

Where he is not right is to contrast shadow banking with the Too Big to Fail banks.  These also happen to be the banks that are involved in shadow banking.  These banks are also opaque as shown by the simple fact that neither the banks nor the securities issued through shadow banking receive a Transparency Label Initiative label indicating they provide enough disclosure so an investor could know what they own or are thinking of buying.

Governor Tarullo then goes on to discuss what he sees as the contribution of shadow banking to the last financial crisis.

As has been frequently observed, the recent financial crisis began, like most banking crises, with a run on short-term liabilities by investors who had come to doubt the value of the assets they were funding through various kinds of financial intermediaries. The difference, of course, was that the run was not principally on depository institutions, as in the 1930s, but on asset-backed commercial paper programs, broker-dealers, money market funds, and other intermediaries that were heavily dependent on short-term wholesale funding [i.e., shadow banking].

After having observed that shadow banking was hiding something, he then observes shadow banking was front and center for a run on its funding during the crisis.  Why was there a run?  Because there was no logical stopping point in the downward valuation of the assets once investors came to doubt the value of these assets.  Why was there no logical valuation stopping point?  Because the opacity of shadow banking hid from investors the information they needed so they could know what they owned or were thinking of buying.

Let me repeat this: the necessary condition for a “bank-type run on funding” is opacity.  Opacity prevents investors from being able to value the investment and hence anything that shakes their belief in the value of the asset causes investors to run to get their money out.

Completely left out of Governor Tarullo’s speech is this fundamental characteristic of the global financial system.

Later in his speech, Governor Tarullo turns to “safe” assets.  A concept that has no place in any serious discussion of our global financial system.

An additional, important consideration here is that at least some of the short-term funding instruments implicated in this analysis respond not just to the desire of their creators for funding that is cheaper than equity or longer-term debt, but also to the demand of many entities–from other financial firms to pension funds to foreign sovereigns–for “safe” assets. As the term implies, these assets must be reliable stores of value that are readily available for use–features sometimes characterized as “money-like.”

Obvious forms of safe assets include currency itself (though that has its well-known limitations for large-value transacting), government-insured demand deposits, and obligations of highly creditworthy sovereigns such as U.S. Treasuries. But numerous commentators have observed that, for a variety of reasons, demand for safe assets in recent decades has been growing substantially faster than the supply of these most obvious and truly safe forms of government-backed assets. In these circumstances, they note, the demand for privately created safe assets has increased. One problem, of course, is that the privately created assets may be treated as safe in normal times but, as seen in 2008, not in periods of high stress. Hence the phenomenon of runs.

As regular readers of this blog know, there is no such thing as a “safe” asset.  Assets differ along two basic dimensions:  their risk and the ease with which their risk can be assessed.

Now to debunk the good Governor.  Mr. Tarullo says a “safe” asset has two characteristics: it doesn’t change in price and can be easily sold. Next, he offers up what he thinks are examples starting with currency and highly creditworthy sovereigns.

Is currency a “safe” asset under his definition?  If inflation is running at 10% per annum, currency loses 10% of its “value” each year.  How can something losing 10% of its value every year be considered safe?

Is a highly creditworthy sovereign a “safe” asset?  By definition, longer dated notes and bonds issued by any sovereign carry interest rate risk.  So we know these aren’t a store of value.  But what about short term government issued securities?  As shown by Emerging Market countries and highly rated countries in the EU, if the securities are issued in a currency the government doesn’t print, there is significant risk the securities won’t be paid at maturity.  So these aren’t a store of value either.  Oops.

Not content to stop after identifying assets as safe that don’t meet his own criteria, Governor Tarullo doubles down and offers up there is a growing demand for “safe” assets.  Hmmm…..  Is he sure the demand isn’t for low risk assets?