Yves here. This post is one way of pointing out that the rush of self-congratulatory articles of the “Ten years since Bear Steans, crises are a thing of the past,” sounds an awful lot like the confidence about the unsinkability of the Titanic.
And while so many people have warned of a coming credit crunch in China, the fact that China has managed to hold its financial system together through various interventions does not mean the underlying risks are not real and even growing.
Recall that Steve Keen, one of the few economists who predicted the 2008 meltdown, put China at the top of his list of potential credit crisis countries due to its rapid growth of private debt in an economy that already has a high debt burden. His model shows that merely having debt growth stop will lead to an implosion.
I hope to have more on this general topic in due course.
By Daniela Gabor, Associate Professor, University of the West of England, Bristol .Originally published at the Institute for New Economic Thinking website
Unregulated, speculative lending markets nearly brought down the global financial system 10 years ago. Now, Western banks are exporting this failed model to the developing world.
‘What a difference a decade makes’, mused Mark Carney, the head of the Financial Stability Board (FSB), in a recent speech. Carney was measuring, and applauding, regulatory progress since shadow banking brought Bear Stearns down in March 2008 and Lehman Brothers six months later, and since 2013, when he warned that shadow banking in developing and emerging countries (DECs) was the threat to global financial stability. A lot has changed since.
Shadow banking is no longer used pejoratively. The IMF recently noted that DEC shadow banking ‘might yield greater efficiencies and risk sharing capacity’. In scholarly and policy literature, DEC shadow banking is portrayed as an activity confined by national borders, connected closely to banks that move activities in the shadows, circumventing regulation or financial repression, complementary to traditional banks that underserve (SME) entrepreneurs, be it because of market imperfections or the priorities of the developmental state (China). Another C is relevant for China: constructed by the Chinese state as a quasi-fiscal lever. After Lehman, China’s fiscal stimulus involved encouraging local governments to tap shadow credit, often from large state-owned banks, through Local Government Financing Vehicles. Yet systemic risks pale in comparison to those that gave us the Bear Sterns and Lehman moments, since (a) complex securitization and wholesale funding markets are (still) absent and (b) DECs have preserved autonomy to design regulatory regimes proportional to the risks posed by shadow banks important to economic development. At worst, DECs may have to backstop shadow credit creation, just like high-income countries did after Lehman’s collapse.
The ‘viable alternative’ story has one shortcoming. It stops short of theorizing shadow banking as a phenomenon intricately linked to financial globalization. In so doing, it misses out a recent development. The global agenda of reforming shadow banking has morphed into a project of constructing resilient market-based finance that seeks to organize DEC financial systems around securities markets. The project re-invigorates a pre-crisis plan designed by G8 countries—led by Germany’s central bank, the Bundesbank—together with the World Bank and the IMF, to promote local currency bond markets, a plan that G20 countries endorsed in 2011. As one Bundesbank official put it then: “more developed domestic bond markets enhance national and global financial stability. Therefore, it is not surprising that this is a topic which generates an exceptional high international consensus and interest even beyond the G20.”
Deeper local securities markets, it is argued, would (a) reduce DEC dependency on short-term foreign currency debt by (b) tapping into growing demand from foreign institutional investors and their asset managers while (c) expanding the investor base to domestic institutional investors that could act as a buffer, increasing DEC’s capacity to absorb large capital inflows without capital controls; and (d) reduce global imbalances, since large DECs (for example, China and other Asian countries) would no longer need to recycle savings in U.S. financial markets. Everyone wins if DECs develop missing (securities) markets.
Despite paying lip service to the potential fragility of capital flows into DEC securities markets, this is a project of policy-engineered financial globalization. The key to understanding this is in the plumbing. Plumbing, for building and securities markets, holds little to excite the imagination. Until it goes wrong.
The plumbing of securities markets refers to the money markets where securities can be financed. According to the International Monetary Fund (IMF) and the World Bank: “the money market is the starting point to developing… fixed income (i.e. securities) markets.” The institutions refer to a special segment, known as the repo market. Repo is the “plumbing” that circulates securities between asset managers, institutional investors, market-making banks and leveraged investors, “greasing” securities’ liquidity (ease of trading). It allows financial institutions to borrow against securities collateral and to lend securities to those betting on a change in price. This is why international institutions, from the FSB to the IMF and World Bank, have insisted that DECs seeking to build resilient market-based finance need to (re)model their repo plumbing according to a ‘Western’ blueprint. The official policy advice coincides with the view of securities markets’ lobbies, as expressed, for instance, by the Asia Securities Industry and Financial Markets Association, in the 2013 India Bond Market Roadmap and the 2017 China’s Capital Markets: Navigating the Road Ahead.
The advice ignores economist Hyman Minsky’s insights on fragile plumbing (and the lesson of the Bear Sterns and Lehman moments). Minsky was deeply interested in the plumbing of financial markets, where he looked for signs of evolutionary changes that would make monetary policy less effective while sowing the seeds of fragile finance. Fragility, he warned, arises where:
‘the viability of loans mainly made because of collateral, however, depends upon the expected market value of the assets that are pledged … . An emphasis by bankers on the collateral value and the expected values of assets is conducive to the emergence of a fragile financial structure’
Western or classic repo plumbing does precisely that. It orients (shadow) bankers towards the daily market value of collateral. For both borrower and lender, the daily market value of the security collateral is critical: the borrower does not want to leave more collateral with the lender than the cash it has borrowed, and vice-versa. This is why repo plumbing enables aggressive leverage during good times—when securities prices go up, the borrower gets cash/securities back, and can borrow more against them to buy more securities, drive their price up etc. Conversely, when securities prices fall, borrowers have to find, on a daily basis, more cash or more collateral.
Shadow bankers live with daily anxieties. One day, they may find that the repo supporting their securities portfolios is no longer there, as Bear Stearns did. Then they have to firesale collateral, driving securities’ prices down, creating more funding problems for other shadow bankers until they fold, as Lehman Brothers did. It was such destabilizing processes that prompted the FSB to identify repos as systemic shadow markets that need tight regulation in 2011. Since then, regulatory ambitions to make the plumbing more resilient have been watered down significantly, as the global policy community turned to the project of constructing market-based finance.
Paradoxically, when the Bundesbank advises DECs to make (shadow) bankers more sensitive to the daily dynamic of securities markets, it ignores its own history. Two decades ago, finance lobbies pressured the Bundesbank to relax its strong grip on German repo markets. The Bundesbank resisted because it believed only tight control would safeguard financial stability and monetary policy effectiveness. Eventually, the Bundesbank abandoned this Minsky-like stance because it worried other Euro-area securities would be more attractive for global investors.
Since the 1980s, the policy engineering of liquid securities markets has been a project of promoting shadow plumbing, first in Europe and the U.S., now in DECs. Take China. Since 2009, Chinese securities markets have grown rapidly to become the third largest in the world, behind the US and Japan. Such rapid growth reflects policies to re-organize Chinese shadow banking into market-based finance, driven by a broader renminbi (RMB, China’s currency) internationalization strategy that views deep local securities markets as a critical pillar. The repo plumbing of Chinese securities markets expanded equally fast, to around US$ 8 trillion by June 2017. Chinese plumbing is now roughly similar in volumes to European and US repo markets, when in 2010 it was only a fifth of those markets. Since then, Chinese (shadow) banks increased repo funding from 10% to 30% of total funding.
Yet China’s repo is fundamentally different. Legal and market practice there does not force the Chinese (shadow) banker to care about, or to make profit from, daily changes in securities prices. Without daily collateral valuation practices, the “archaic” regime makes for patient (shadow) bankers and more resilient plumbing. This is the case in most DEC countries.
The pressure is on China to open repo markets to foreign investors and to abandon “archaic” rules if it wants RMB internationalization. While China may be able to resist such pressures, it is difficult to see how other DECs will. The global push for market-based finance prepares the terrain for organizing international development interventions via securities markets, as suggested by the growing popularity of green bonds, bond markets for infrastructure, impact investment and digital financial inclusion approaches to poverty reduction. After all, the new mantra is “development’s future is finance, not foreign aid.”
In sum, the shadow-banking-into-resilient-market-based-finance agenda seeks to define the terms on which DEC countries join the global supply of securities. It silently threatens the monetary power of DEC countries to manage capital flows and the effects of global financial cycles, a hard-fought victory to weaken the political clout of what Jagdish Bhagwati termed the “Wall Street–Treasury complex” that successfully pressured DECs to open their capital accounts. This policy-engineered financial globalization seeks a clean break from “policy-engineered industrialization” that involved capital controls, bank credit guided by the priorities of industrial strategies and competitive exchange rate management. Instead, it seeks to accelerate the global diffusion of the architecture of U.S. securities markets and their plumbing, despite well-documented fragilities and contested social efficiency. Questions of sustainability, credit creation and growth should not be left to securities markets. Carefully designed developmental states, historical experience suggests, work better.
This is a short version of the article Goodbye (Chinese) shadow banking, hello market-based finance, published by Development and Change in a special issue on Financialisation and economic development, edited by Servaas Storm. The author thanks INET for generous funding under the grant Managing Shadow Money.
‘Shadow banking is no longer used pejoratively.‘
Indeed. As Mish Shedlock pointed out last week, shadow lenders now originate more than half of US mortgages.
Good luck buying or selling a house next time a credit crunch stresses collateral valuations. Seems like we saw this movie before. But that’s so ten years ago.
Yep, too long for AI times!
So, 4-5 Moore Units? Thinking in terms of decades is so time-ist and human-ist! /s
Unfortunately shadow banking in the mortgage markets is bigger than just Fannie, Freddie, and Ginnie agencies. It’s also the FHLB’s.
‘The odds that the FHLBs will face a liquidity shock are quite low … this is unlikely except in the extreme case that FHLBs’ implicit public guarantee [is] called into question.’
Yeah right … after all, Fannie and Freddie’s implicit public guarantees were never called into question … oh, wait!
An FHLB investor presentation lauds their 5.11% capital ratio vs the required minimum of a skinny 4 percent (page 8):
That’s better than the ludicrous 1 to 2 percent capital ratios of Fannie and Freddie back in the high-rolling pre-conservatorship days of Daniel Mudd and Richard Syron, but well short of the Basel III minimum capital ratio of 8 percent for commercial banks.
Banks that fail to learn from history are doomed to repeat it, as Carlos Santana said [h/t rabid gandhi].
“I really didn’t say everything I said.”
The Real Engine of the Business Cycle
“A valuable lesson from the Great Recession is that credit-supply expansions play a key role in subsequent recessions. When lenders make credit more available or more affordable, households respond by taking on debt, which drives up aggregate demand – that is, until the music stops.”
https://www.project-syndicate.org/commentary/credit-supply-household-debt-drives-business-cycles-by-amir-sufi-and-atif-mian-2018-03
If we consider “market-based finance” as sugar it could be concluded that western countries are expanding diabetes to developing countries.
Bingo.
Hmmm… Wonder where HNA and the other $456 billion in securities where trading and price discovery have been halted by Chinese authorities for months fall in the matrix?
https://www.bloomberg.com/news/articles/2018-03-13/hna-s-big-freeze-a-31-billion-trading-halt-traps-investors
Not that price discovery in the West is being allowed, just different control mechanisms here IMO.
But all-in-all, maybe the policy options aren’t too terrific. It’s the pretense that I find particularly troubling.
It is equally telling that just a few weeks ago China announced a major ban on cryptocurrencies. At the time I read this as a simple act to stem outflows of cash but I now suspect that it may have as much to do with shadow lending. In China Shadow banking is in many ways the norms as few people trust Chinese banks and those that do borrow from them are often the most connected, with the least need to actually repay.
I’ve been a China bear for a long time, based on what I saw of what seemed highly speculative leveraged investment when I first visited in 1997, from regular visits and reading. At least twice in the last 12 years or so I’ve been quite convinced that a major financial crisis was going to hit China within a year, and I’ve been wrong every single time.
Partly, I think this is because China has gotten lucky with international cycles, and that mini-crises when they’ve happened have not proven systemic. But mostly I think because its because the broader leadership have proven to be very skilled at steering away from the rocks every time disaster has looked certain, mostly because the Chinese have been dedicated and perceptive students of economic history and so haven’t bought the sort of ideological cheerleading that has led other countries blindly over the cliff at regular intervals. The Chinese regulatory authorities have been very good at snuffing out bubbles and scams before they have gone out of control. They have particularly studied what happened to Japan very closely and are determined not to make the same mistakes.
But I do feel that they are increasingly in danger of running out of luck. The Chinese economy has become hugely more complex in just the last 5 years or so alone as financial markets have grown much more sophisticated (and I don’t mean ‘sophisticated’ in a good way). And the failure to deal with deeper structural imbalances (see Michael Pettis’s blog for details) ensures that the longer things go on, the bigger the problems will be. They are clearly now in the midst of a very determined effort to clamp down on the power of oligarchs and prevent individual banks and funds from running out of control. But in a situation like China, this is like chopping off a hydras heads, they just keep growing and popping up everywhere. I think eventually it will happen that they will run out of luck, and one bad egg will be so bad it will prove systemic.
Just one point on ‘shadow banking’. There is also what in China I’d call ‘shadow-shadow banking’ – a whole parallel system of informal loans between small companies and individuals, very often secured on the notional value of properties. As one friend put it to me ‘in my village, everyone owes money to everyone else’. I do wonder that if with all the regulatory attention to the ‘official’ shadow banking system, the real problems could rise in this unofficial one.
Do you think that the long run the Chinese have had avoiding the ‘crises’ is because the government owns so much? When a Company A (owned by the government) should go under and owes money to another company, Company B (owned by the government) the government can step in and decide what to do? Which may be to Company B not to try to collect from Company A?
Yes China can MMT their way out of quite a bit. The trouble comes with the shadow banks that aren’t state owned.
https://www.adb.org/publications/monetary-and-fiscal-operations-peoples-republic-china-alternative-view-options-available
The strong control over the banking system is one reason why the Chinese have avoided problems so far. They’ve been able to bang heads together (and maybe put a bullet into one or two, pour encourages les autres, in a way other countries haven’t). But as Michael Pettis points out, a crucial issue is where all the debt is being invested. He argues that much of the ‘investment’ will never pay itself back – in effect, too many bridges to nowhere have been built. So the crunch will be one of malinvestment (i.e. a loss of productivity) as much as a liquidity or credit crunch.
PK, a solution for your village friend mentioned in your last paragraph?…
http://scienceblogs.com/evolutionblog/2009/06/15/an-amusing-brainteaser/
Indeed. But the problem comes when someone in that chain runs off to the Cayman Islands with that $100 bill and everyone finds that he used the same apartment for collateral to everyone.
Hmmmmm…
Yesterday’s Links contained an interesting article about repo and interbank ‘plumbing’. The article suggested that the use of repo, at least in the US, has declined substantially post-crisis. The authors attribute this largely to successful banking regulation and higher capital requirements in “developing and emerging countries.” (DEC)
https://www.moneyandbanking.com/commentary/2018/3/4/bank-financing-the-disappearance-of-interbank-lending
So, now the suits are proposing “local currency bond markets” as secure capital requirements . This market based ‘shadow plumbing’ would presumably increase the resilience of local capital markets through a kind of private quasi-repo. This is great until the suits all decide to get on the same plane to Frankfurt. Is this Thailand ’98 all over again?
This is all long form for how the metropolitans undermine the colonials control of their own currency.
Looks like Mr. Margin is getting ready to call DEC banks…
Pardon my dyslexia…
This should read…
…higher capital requirements-period.
and,
So, now the suits are proposing “local currency bond markets” as secure capital requirements in “developing and emerging countries.” (DEC)
sorry
Could Anbang be the Chinese Bear Stearns?
https://www.ft.com/content/92695cfa-8886-11e7-bf50-e1c239b45787
Hmmmmm…
Yesterday’s Links contained an interesting article about repo and interbank ‘plumbing’. The article suggested that the use of repo, at least in the US, has declined substantially post-crisis. The authors attribute this largely to successful banking regulation and higher capital requirements.
https://www.moneyandbanking.com/commentary/2018/3/4/bank-financing-the-disappearance-of-interbank-lending
So, now the suits are proposing “local currency bond markets” as secure capital requirements in “developing and emerging countries.” This market based ‘shadow plumbing’ would presumably increase the resilience of local capital markets through a kind of private quasi-repo. This great until the suits all decide to get on the same plane to Frankfurt. Is this Thailand ’98 all over again?
This is all long form for how the metropolitans undermine the colonials control of their own currency.
In re: “Shadow banking might be a more efficient way to raise funds!”
I recall that during the Japan, Inc. Era, the Keiretsu system of cross-shareholdings ( X owns 51% of Y, which owns 51% of Z, which owns 51% of X) was trumpeted as the most efficient way to raise capital known to date.
Of course, it’s really a way of selling watered stock, as anything that affects the capitalization or solvency of X, Y or Z will take down all of the other participants with it.
Steely Glint posted these excellent articles yesterday in water cooler. One on China and the other on monopoly;
Steely Glint
March 13, 2018 at 5:49 pm
Trade Policy: I found this article written by Barry C. Lynn in 2015 to be predictive & germane. For example, “As our biggest manufacturers and traders and investors succeed in China, they also come to depend on China for future profits — which brings them increasingly under the sway of a Chinese state that holds the power to cut those profits off. What if the master capitalists and corporate bosses who have so cowed us here at home are themselves being cowed in Beijing? What if the extreme economic interdependence between the United States and China is not actually carrying our values into a backward and benighted realm, but accomplishing precisely the opposite — granting the Chinese Politburo ever-increasing leverage over America’s economic and political life?”
https://harpers.org/archive/2015/11/the-new-china-syndrome/
Also, explaining modern day monopolies
https://harpers.org/blog/2017/10/killing-the-competition/
I greatly admire economists that are able to ground their views in a historical context.
Never. Wrong race and all. The Israelis will always be THE ONE to hold sway over Murica: https://www.themaven.net/mishtalk/economics/russia-meddling-think-israel-where-s-the-outrage-AHuZLbidIUazQraqBzHJqg
“Eventually, the Bundesbank abandoned this Minsky-like stance because it worried other Euro-area securities would be more attractive for global investors.”
So, is this the captial race to the bottom counterpart to cheap labor?
China might get lucky again. Supposedly a new round of tariffs specifically targeting China will come online soon.
At that point, the Chinese will have an excuse to devalue their currency.
The Art of the Deal?
A bit more than halfway through, I started thinking: why on earth do we put up with this? Let alone make it global, so everybody goes down together.
All just so the gamblers can play with BIG money – essentially, everybody’s money. Even Haygood doesn’t like it.