Sunday, 24 January 2010

What's to Become of Shadow Banking?

I listened to Obama's new, tougher stance on the banks (limit their size, eliminate proprietary trading) with a bit of skepticism. One, I don't quite trust him the way I did, say, three days after his election, when I thought that maybe -- just maybe -- the soaring rhetoric would be matched by an iron will and an incorruptible character. I'm no longer convinced he's on the side of the average American, though he displays a masterful populist oratory at times. Is he just a political elite who swaps in and out of roles, like a skillful actor?

In this case though, there's a bigger reason for my skepticism.

Obama is missing a huge part of the problem. To be blunt, what happens to shadow banking? It has revived in impressively scary fashion since seizing up completely in the aftermath of the Lehman bankruptcy. This is a world of repos (repurchase agreements), asset-backed securities, "haircuts" and off-balance sheet vehicles. This is a world that Washington needs to understand much, much better. The Fed (and other regulators) really need to think out a few things -- what implications does shadow banking activity have for effective money supply, for financial system leverage, for systemic fragility, for the efficacy of regulatory agencies. What does it mean to have a large, and thriving, shadow banking system that has no oversight and no liquidity backstop?

What good is it to remove proprietary trading from commercial banks, if we end up shoving volatile market activities into a dark corner, where they threaten again someday to haul down the entire financial system? What firewalls are we building between the regular banking system and the shadow one? What size do we want the shadow banking system to be? What role do we want it to have? What kinds of companies do we want operating in this "darkness"? What do we want them doing? Not want them doing?

I'm surprised that this subject isn't being more intensely debated. This is a biggie, folks.