Institute for Financial Transparency

Shining a light on the opaque corners of finance


PhD Economist Derp: Shadow Banking is a Creature of the Night

Since the acute phase of the Great Financial Crisis began in September 2008, there has been an explosion of articles by PhD Economists on the “shadow banking” sector.  These articles all share the fundamentally flawed assumption shadow banking is a “creature of the night” (h/t Daniela Gabor).

A creature of the night implies there was no driving force behind the creation of shadow banking.  It is as if shadow banking emerged from the primordial ooze.  In fact, there was a driving force behind the creation of shadow banking:  Wall Street.

Consider for a moment the name of this financial sector: shadow banking.  Focus on the first word: shadow.  This sector is appropriately named as Wall Street designed it to be opaque.

Why would Wall Street want opacity?  Its profit margins are dramatically higher selling opaque securities than transparent securities.

Of course, Wall Street and its incentives don’t appear in the PhD Economists’ articles on shadow banking.  Here is the abstract for a typical article on shadow banking:

Shadow banking in developing and emerging countries (DECs) oscillates between two semantic poles. One definition is typically deployed by scholars for the narrow analysis of non-bank financial intermediation as a viable alternative to banking. The other, more recent, definition circulates in the policy world to capture a new agenda of engineering (securities) market-based finance. This article argues that this second definition captures the essential but neglected aspect of shadow banking in DECs. The ‘shadow banking into market-based finance’ narrative reaffirms the celebratory tone of the financial globalization cum liberalization thesis dominant before the global financial crisis.  It seeks to depoliticize contentious debates about capital flows and the constraints that financialized globalization poses to development, instead asking DECs to encourage portfolio flows, relax the regulatory grip on shadow funding markets and tap into the growing global demand for securities that marks the new age of asset management

These two semantic poles hide the elephant in the room.  Market-based finance is Wall Street’s cover story for selling opaque securities.

It is true non-bank financial intermediation is a viable alternative to banking.  It is also true bundling assets like mortgages and auto loans into securities is a viable alternative to banks holding these loans on their balance sheets with the added benefit of increasing the safety, soundness and stability of the banking and financial system.

So what is there not to like about shadow banking?

China illustrates this argument well. In joining the global push for market-based finance with the ambition to further its RMB internationalization agenda, China underestimates the (Minsky-type) fragilities involved.

The author recognizes market-based finance as it is currently practiced creates fragilities in the financial system.  However, other than the growth in market-based finance, the author has no causal mechanism for why the financial system becomes more fragile.

In fact, market-based finance doesn’t have to make financial systems more fragile.  Market-based finance securities could be designed to increase the safety, soundness and stability of both the banking and financial system.

The author’s assertion market-based finance makes the financial system more fragile is pure PhD Economist derp.

The Information Matrix has many uses.

Information Matrix

                                      Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying? Yes No
Yes Perfect Information Antique Dealer Problem
No Lemon Problem Blind Betting

One of its uses is showing which quadrant an investment security belongs in.

By design, Wall Street’s market-based finance securities are currently always in the Blind Betting quadrant.  These securities are valued based on a story Wall Street tells.  A story the investors can trust, but cannot verify.  As a result, investors in these securities are likely to engage in “bank run” behavior as soon as the valuation story is called into doubt.

It is the “bank run” behavior to get out of Blind Betting quadrant securities that triggers a financial crisis (what the author refers to as Minsky-type fragilities).

Aside from Wall Street’s profit motive, there is no reason all shadow banking securities couldn’t be in the Perfect Information.

If all the market-based finance securities were in the Perfect Information quadrant, there would be no reason to think these securities would make the financial system more fragile.  In fact, the opposite would be true and the financial system would be dramatically more stable and less fragile.