Monday, February 15, 2010

How the Volcker Rule Misses the Shadow Banking System

the timing of the announcement of the Volcker rule came suspiciously close after the Democratic loss of Kennedy’s seat, but linkage was denied, saying that the plan had been in the works for 6 months…to date, we havent seen much expansion of the detail, except for Volcker’s articles & interviews in several newspapers…besides, as yves smith saysdebating the merits of the Volcker Rule may be a tad academic, given the rousing opposition it is encountering from Congress (and you have to love the world of politics: the biggest obstacle is, basically, “We sorta have a deal, you can’t retrade it!” Funny how banks and AIG get to redo their deals on quick notice, but the poor chump public? Not a chance)”  nonetheless, she went on to post excerpts of a long article by Mike Konczal at New Deal 2.0 in her discussion of the rule…in turn, ive taken the end of Konczal’s article from his post at Rortybomb, below, if only because it graphically illustrates the problem…

Like the Glass-Steagall regulatory framework, the Volcker Rule focuses on the intersections between commercial banking, investment banking, and proprietary activities. Notably, each of those business models — in their “pure” forms — has a funding model that suits its asset risk profile. Commercial banks make relatively illiquid loans, but they have privileged access to relatively resilient core deposit funding. Investment banks hold inventories of relatively liquid securities, which enables them to use extremely efficient, short-term, low-cost funding (like the overnight “repo” markets).

Many of the credit bubbleʼs excesses can be traced to the “shadow banking” sector, which is essentially the intersection between commercial banking and investment banking business models: shadow banks take illiquid credit and interest rate risk (like commercial banks), but fund themselves principally through the wholesale markets (like investment banks). Because of long-recognized regulatory loopholes, shadow banks were also frequently able to operate with significantly lower capital requirements than commercial bank competitors. With both capital and funding advantages in hand, shadow banks grew to some 60% of the U.S. credit system.

To many investors and policy-makers during the bubble, shadow banking vehicles (like “SIVs”) appeared to perform precisely the same functions as commercial banks, but were more efficient. Unfortunately, shadow banks proved to be extraordinarily fragile; both the asset and liability components of their business models suffered as the credit cycle turned. Unwilling to risk a shutdown in the short-term funding markets, central banks and governments stepped in to prop up the shadow banking system.

And as such, the Volcker Rule is poorly targeted:

I rarely say this, but for anyone interested in financial markets this presentation is a must-read. The graphical approach works perfectly. Read it twice, then go back and read the interview I did with Perry Mehrling about shadow banks, or Ezra Klein’s write-ups (One and Two) of how a bank run in that overlapping space works, using that map as a guide.

Also, for fun, here’s why the financial system looked so efficient during the naughts, efficient in a way that made regulators want to sit back and let it work its wonders:

(click on images to expand to full window)

read Konczal’s post in it entirety

or see Yves’s take at naked capitalism

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