The rise of the shadow bank – a kind of credit intermediary that lies outside the range of much banking regulation – carries a subtler corollary. It has created a kind of money that is likewise beyond reach of central bankers’ traditional instruments of oversight and control. Rightly, the US Federal Reserve is responding by forging new tools.
Money created by governments comes in two forms. There is currency, the notes and coin you carry in your wallet; and there are reserves, balances held at the central bank by deposit-taking institutions. These liabilities always trade at par; a retail bank can reduce its reserves by $1m in return for receiving the same value in notes and coin from the central bank, just as you can exchange a dollar bill for four quarters.
But money also comes in private forms. Deposits in retail banks are one example. Balances in money market funds are another. (These institutions are similar to banks, except that they raise funds in the money markets instead of taking it from private depositors; and they use the proceeds to buy bonds instead of extending loans.) This “private” money usually trades at par, too. You can exchange $20 in bank deposits for a $20 bill as quickly as you can reach a cash machine.
As long as people expect this situation to continue, the system works well. But if confidence disappears, panic ensues, as happened time and again in the 1900s. Then came the creation of the Fed, which could lend to besieged institutions as a last resort to stop a run. Deposit insurance also prevented fears about the solvency of a bank from becoming self-fulfilling.
Such backstops were needed to give the public confidence that banks would always be able to deliver on their promise to exchange deposits for cash. They turned banking into a public-private partnership. But they applied only to the formal banking sector. There were no similar protections for shadow banks.
For most people, money is currency and insured deposits. These are the kinds of money included in the M2 monetary aggregate, which is closely followed by policy makers. But for asset managers and corporations, money begins where M2 ends. These economic actors must hold billions of dollars worth of liquid assets – far too much to keep in physical currency, and far larger than the maximum bank balance covered by government guarantees.
Such behemoths must resort to other forms of money. Uninsured bank deposits are one option – but not an especially attractive one, since they are just unsecured and undiversified claims on banks. A better alternative is “shadow” money: either balances in money market funds; or repurchase agreements, also known as “repos”, in which a borrower sells a security and promises to buy it back at a predetermined price and time. What is under-appreciated is that those who hold such shadow money do so not out of choice but because they lack access to better alternatives.
When this informal financial system seized up during the crisis, the response was to extend public backstops – this time to shadow banks, as well as hitherto uninsured deposits in regular ones. But these were temporary measures. Now the Fed has begun extending to shadow banks many of the same protections and controls that have been used to stabilise the formal banking sector for more than a century.
The Fed’s new “reverse repo” (RRP) facility in effect gives shadow banks an account at the Fed, similar to the reserve accounts that deposit-taking institutions keep there. It conceptually gives the Fed with a way to prevent excessive credit creation in the shadow banking sector. Regular banks are required to hold minimum levels of capital, placing a limit on the expansion of their loan books. The Fed could achieve a similar effect in the shadow banking sector by setting minimum “haircuts” – limits on the amount market participants can raise against safe assets such as Treasuries. This could give it a degree of macroprudential control it lacked pre-crisis, when haircuts became perfunctory. Similarly, just as regular banks are required to hold a certain level of reserves, so shadow banks could be forced to maintain minimum balances in the RRP.
The facility could also enable the Fed to become a “dealer of last resort”, just as it is a lender of last resort to regular banks. This would ensure a troubled shadow bank could always find a counterparty in the market. The Fed ended up playing this role in 2008 but only hesitantly – for counterparties whose books it did not intimately know and for whom it did not maintain reserve accounts. The RRP will formalise both the oversight mechanism and the rescue procedure.
The crisis of last decade was a reminder of the instability inherent in private money. The Fed is taking vital steps towards turning shadow banking – and the shadow money it creates – into a public-private partnership, much as was done with regular banking 100 years ago. This is wise. Individuals and small businesses are not alone in needing a safe form of private money.
The writer is chief economist at Pimco. This piece was co-written by Zoltan Pozsar