“Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.
Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-fulfilling and destructive run on its liquid liabilities.
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.
A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent.
The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency …
The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.
The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors …
The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. …
…
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.
The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies. …”
Nouriel Roubini, “The shadow banking system is unraveling”, Financial Times (21 September 2008).
http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html
Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at the Stern School of Business, New York University. The “shadow banking system” discussed by Professor Roubini consists of non-bank financial institutions such as structured investment vehicles, money market funds, investment banks, hedge funds and other financial institutions that are not subject to normal commercial banking regulations. They are often affiliated with, but not kept on the books of, the major banks that make up the commercial banking system regulated by the Fed and given access to its lender-of-last-resort function.
Roubini may well be right about a coming crash. High oil and food prices have sapped consumer purchasing power while a collapse of the housing market and financial sector turmoil has undermined consumer and business confidence. Industrial production is beginning to decline, shipments are slowing and more and more people are being laid off. Firms and consumers cannot gain access to credit. Add to this, American exports have been the only source of growth this year but forecasts for European and Asia growth are being revised downward and some of these countries are clearly headed for a recession. Stock markets abroad are in worse shape than those at home. It is not just the U.S. economy that is headed down, and headed down for an extended period, it is the world economy. A worldwide crash seems inevitable.
It will not be easy to recover and re-establish a stable path of growth. Restoring financial stability and economic growth at home will mean eliminating the extensive national budget and international trade deficits that have characterized the U.S. economy for decades. We have been living beyond our means and finally the bills have come due. We must eliminate these imbalances by restructuring our economy in terms of its spending and saving patterns and in terms of its production and trade patterns. Needless to say, restructuring any economy for growth is difficult but it is doubly difficult at a time when ageing populations, rapid technological advance and changing patterns of international trade are incessantly reshaping the world economic landscape. It is triply difficult when the adjustment must begin during a period of recession. We have as large a challenge before us as at any time since the end of the Second World War when military demobilization and a devastated world economy threatened our economic future.
Today, failure to make significant adjustments of our patterns of expenditures and output and failure to implement a substantial restructuring of our financial markets will threaten not just the future of the U.S. economy but the entire world economy. The U.S. is not simply the world’s largest economy. It is the economy to which the rest of the world links their production and their prosperity. If we fail to meet the challenge of revitalizing our economy, the unprecedented expansion in production and trade the world has enjoyed since the end of the Second World War will come to an end, perhaps never to return.
No comments:
Post a Comment