January 4, 2014
Federal Reserve Governor Jeremy Stein recently spoke to economists at an American Economic Association (AEA) conference on the subject of the “shadow banking sector” (SBS) that has created to temperament for a run on the banks.
Stein said this SBS was integral to the crash in 2007 that has cost the US a stable economy.
The central banker said: “Shadow banking money is much more run prone than bank money.”
Stein explained: “A stable deposit franchise gives a bank the ability to ride out transitory valuation changes of the sort that might come from noise-trader shocks or fire sales, without being forced to liquidate assets at temporarily depressed prices.”
Indeed Stein asserted that “banks have government insurance for the deposits they hold and are relatively well capitalized compared to other financial institutions thanks to the regulation that comes along with that insurance. It’s other financial institutions, generally called shadow banks, that are much more prone to runs.”
Government handouts, deposit insurance and a reliance on digital transactions have developed the pathway we are on now.
This shadow banking has taken alternative forms such as:
• Advanced check cashing stores
• Crowd-funding websites
• Money-market funds
• Repurchase agreements
Stein pointed toward the unregulated nature of the SBS culture.
Stein said that “part of the reason for this instability is that non-bank financial institutions often give investors the option to seize collateral in a transaction at a moment’s notice.”
During a run on the bank, investors pull their money out of non-traditional banks as a reaction to a perceived economic downturn looms in the distance.
Stein commented: “Compared with shadow banks, traditional banks pay more to have a stabler funding structure” in the form of insured deposits. That stability allows them to invest in assets such as long-term fixed-income securities and hold onto them during bad times, rather than selling them at fire sale prices.”
SBS cause the element of negative consequences to the market. Stein is comparing how the Volcker Rule can work out this kink in the system.
Stein posed the question: “Does the private sector allocation kind of get it right in terms of the mix between the shadow banking and banking system or do you want to have regulation or policy kind of pushing one way or the other?”
Experts say that the Volcker Rule glosses over the fact that it was “trading mishaps” that were the “root cause of the financial crisis.”
Because of this, “the rule doesn’t go far enough . . . prohibition [will] draw a line, making it clear that banks’ business is about lending not investing.”
Protections against customers running on the banks may come in the form of federal legislation derived from a related crisis.