The Shadow Knows

From Annaly Capital Management

For those who missed it (and we had, until we were tipped by James Aitken, thank you very much), a vital paper was posted to the New York Fed’s website in the beginning of the month. “Shadow Banking,” a staff report authored by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft and Hayley Boesky, attempts to explain the so-called “shadow banking” system that developed over the last two decades. The shadow banking system is the financing system that developed in parallel to the traditional banking system, “interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo….The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.”

If you are a thinker about such things (and you should be), it is a paper of vast importance. To pick just three reasons why it is valuable: First of all, it puts a number on the size of the shadow banking system (about $20 trillion at its peak in March 2008, but now down to about $15 trillion) and compares it to the size of the traditional banking system (about $13 trillion). It is a market that would be missed if it disappeared. Second, the paper points out that this critical source of credit has no access to the usual governmental backstops like the discount window or federal deposit insurance, and the Fed had to resort to emergency facilities to prop them up. It begs the question of whether the Fed should make these emergency facilities a permanent feature. Third, it is terrifically reassuring that the Fed has the people and the resources dedicated to understanding this feature of the market.

But another question remains: What is the Fed doing with this information? To quote Mr. Aitken: “The shadow banking system has contracted by an estimated $5 trillion, and yet the Federal Reserve’s balance sheet has, so far, only increased by $1.2 trillion in response. It is any wonder we still have no credit traction.”