It is important to distinguish between leveraged and unleveraged non-bank lenders, both investors and both implicitly “shadow banks”.

Leveraged non-bank lenders are ultimately part of the regular banking system, not the shadow banking system. When a leveraged investor, such as a hedge fund, buys a loan directly or buys a bond (i.e. makes a loan), it funds the purchase of that loan in the banking system. Any recognized or unrecognized loss on that loan first hits the equity of investors in that fund. The bank lender to the fund continually ensures that the fund maintains adequate equity against the fund’s aggregate loan book, which means that investors in the fund take first loss. If interest rates rise and bond prices decline or if the fund loses money and investors redeem their capital, then the aggregate value of the fund’s portfolio should reflect the market value of the loans in the bank funding its positions (which in turn would hit the value of the bank’s assets). So, from a theoretical and practical perspective, non-bank lenders borrowing to make loans are simply conduit lenders of the banking system.

Alternatively, when an insurance company or mutual fund buys a bond it is a loan that is fully reserved. The unleveraged fund does not borrow to purchase the bond, as does a bank or leveraged investor. Any recognized or unrecognized loss on that loan must be immediately valued as a loss to, say, Pimco’s fully-funded fund and, in turn, to the investors in Pimco’s fund that wired cash to fund their investment. Thus, the loan Pimco made is fully-reserved and there is no risk to the banking system (albeit there is risk to investors and, if widespread enough, risk to the aggregate economy). This means that fully-funded investors disintermediate the banking system at their own risk, not at the risk of depositors or taxpayers (as is the case with “too big to fail” banks).

Last we looked, there was approximately $19.5 trillion in US bank assets (and almost $10 trillion in deposits) reserved by about $1.6 trillion. Globally, the ratio was about the same; approximately $95 trillion of bank assets reserved by about $7.5 trillion. Thus, banks are fractionally reserved at about 8%-9% of their loan books. Obviously, any losses in their loan books requires offsetting hits to their reserves. In the current environment it wouldn’t take much of a shift in bond values for system-wide bank insolvency. (Where is the risk again, in the shadow banking system?)

Finally, leveraged entities, either bank or non-bank, may borrow $1,000 from the Fed (directly or indirectly) at near 0% and purchase $10,000, $20,000, $50,000 US Treasury notes at 2%. Since the Fed has declared it has my back by targeting short rates near zero for at least through 2014, I have incentive to clip coupons and make 10%, 20%, 50% (almost an infinite return on capital). By the way, doing so funds Treasury…and Congress. It’s a win/win right? Banks and levered bond funds fund the government and their end-of-year bonuses are a lock.  (Pay no attention to the grossly false economic signal benchmark “risk-free” interest rates are sending to economists and tertiary bond and stock markets.) There’s no conspiracy here; only blatant incentives.

Lee Quaintance & Paul Brodsky
QB Asset Management Company, LLC
pbrodsky@qbamco.com

Category: Credit, Federal Reserve, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

2 Responses to “On shadow banking”

  1. Pacioli says:

    “By the way, doing so funds Treasury…and Congress. It’s a win/win right?”

    I almost fell out of my chair after reading this. Certainly someone at this level understands that Treasury bonds do not “fund” Congress’s spending. Right? You DO kn0w this, right? Then why prominently promulgate this false and harmful tripe to the detriment of those who may not fully understand?

    Shameful.

  2. Steve Hamlin says:

    QBAMCO wrote: “Globally, the ratio was about the same; approximately $95 trillion of bank assets reserved by about $7.5 trillion. Thus, banks are fractionally reserved at about 8%-9% of their loan books. Obviously, any losses in their loan books requires offsetting hits to their reserves.”

    I assume that “reserves” used here means “loan-loss & asset writedown accruals”, and not “bank reserves a/k/a reserves on deposit with Central Banks + vault cash”. And if so, throwing “fractionally reserved” in there just muddles the water even more.

    In which case QBAMCO is really talking about capital gearing (balance sheet leverage), and not really reserves as most people think when they hear “bank reserves.”

    If Broadsky actually meant “fractional reserve banking”, then he needs to acquaint himself with how the Fed describes its own monetary operations, how banks actually fund themselves in the real-world, and read a good MMT primer.