Mark Thoma and Brad Delong are completely entrenched into the position that this crisis was brought on by the nefarious "shadow banking system." In fairness to Thoma, he is trying quite sincerely to argue his point, and I think my disagreement with him stems mostly from my objection to labeling particular aspects of the financial system as "shadow banking." That said, I do take issue with a few of his substantive points. Rortybomb does a fine job summarizing the recent history of this debate, highlights some of the strengths of Thoma's position, and also clarifies the debate by providing a reasonable framework for what it is that people are referring to when they talk about the "shadow banking system."
As for Delong, his argument takes the form of an excursion through unmitigated nonsense, as he boasts his deep knowledge of comic books, and little else. As such, in this post, I'll begin with Delong's argument, since it is completely unfounded. In the next post, I'll take on Thoma's position, as it warrants more attention and represents an opinion held by a lot of intelligent people. I just happen to disagree.
So here goes Delong:
[C]ommercial banks--with their massive retail savings deposits--have for the most part come through this all right. In fact, the possession of lots of inertial commercial savings and checking deposits that they did not have to worry might flee provided JPMorgan (with the retail banking assets of Chase) and the bank formerly known as NationsBank (with the retail banking assets of Bank of America) with competitive advantages that allowed them to pick up the assets of Bear Stearns and Merrill Lynch at what they thought were bargain prices.
Wow, those are some seriously important-sounding terms there. We've got "massive retail savings deposits," "competitive advantages," and don't forget those "inertial commercial savings and checking deposits." How could deposit taking banks fail with all that going for them? Surely, deposit taking banks are doing swell! And, they are, with the noted exception of the seemingly endless list of failures that have occurred at deposit taking banks over the last 2 years. But there are even more inconvenient aspects of the observable universe that Delong must tackle before we can accept his deposits-cure-all theory of banking. For example, U.S. banks and bank holding companies are currently receiving all kinds of direct and indirect support from the U.S. government through the alphabet soup of liquidity and guarantee programs that have been set up since the crisis got underway. Also, it is my understanding that European banks, while more leveraged than their U.S. counterparts, rely much more on deposits than U.S. banks do. Yet, the European banking system is suffering a crisis that rivals our own by several measures.
Delong's position seems to be just another manifestation of the idea that, somehow, good old fashioned banking is the answer. Deposits and lending, and that's it. None of this fancy stuff. That has a nice ring to it. It's sentimental, makes us think that our parents are smarter than us, and it has an almost sanctimonious aspect to it, in that it suggests that if we part with some of the more luxurious aspects of finance, we can have some more stability. However, history has a few counterexamples to this position, one being the Great Depression.
While others chalk this crisis up to SIVs, CDOs, and a bunch of other acronyms they really don't understand, I see it in much simpler terms: banks, and others in the financial system, all made the same bad bet based on unsustainable assumptions. Sure, some of them made this bet using sophisticated means, and that itself is a topic worth exploring. But the root cause of all of this, in my opinion, is underestimating risk. This underestimating had heavy assistance from some very regulated entities and markets. As such, I reject the argument that the "shadow banking system" caused this crisis for two reasons: first, everyone that mattered and could do something about what was going on knew full well what was going on. So how is it productive to ascribe such a mysterious sounding name to something that people were fully aware of? And second, the root cause of this crisis is, in my opinion, much easier to grasp once we reduce all of the complexities to simpler constructs, and think in terms of what risks entities and markets were exposed to, and for that limited purpose, ignore the means by which they were exposed to those risks.
From the Editors: In the last few days, Atlantic Biz has taken on the issue of the shadow banking system and its role in the financial crisis, and created something of a fracas! The debate begins with Prof. Mark Thoma's Washington Post op-ed (here), which argued that the financial crisis began in the shadow banking system. Our Dr. Manhattan takes issue with that conclusion here. Prof. Thoma responds in the comments to say it did too begin in shadow banking system (and takes the fight back to his home blog here). Prof. Brad DeLong tags in for Thoma and pulls no punches when he announces that "the Atlantic Monthly crashes and burns" here. Charles Davi emerges from the flames here to state unequivocally that the shadow banking system did not cause the financial crisis. Arnold Kling blasts DeLong again here. And now you're caught up! For now.
They operated in Broad 8==Daylight. Have they no shame!?!
To reduce this to a simpler construct:
Traditional banks are those that take deposits and lend according to their deposit capacity, creating the "spread(s)" with which to finance operations. Their security portfolio's consist mainly of interest income generating securities that are highly stable (US bonds, etc.) as another revenue stream.
Tradtional banks also lend within their community and market, rarely going outside their lending areas (because of the risks of lending to "unknown" borrowers). So typically the loan that traditional banks make for interest income purposes are to known entities.
To sum it up: A traditional bank is well aware of how it derives income and the revenue streams are from simple and straight forward products.
Commercial banks on the other hand are more complicated.
Let's use Goldman Sach's as an example.
Goldman's deposit base are strictly with people and institutions that conduct securities trading with them. Thus Goldman's deposit (depending on the leverage of the individual customers) are "accounted" for.
Likewise, given the multitude of, not just consumer trading, but balance sheet trading and hedging that a commercial bank like Goldman conducts, their income streams are varied by product and the potential hedges.
Again, to simply: Traditional banks take deposit from known entities and lend them to known entities, commercial banks do not. Commercial banks have revenue streams from various entities and products.
Traditional banks get a paychecks from their bosses - their customers. Commercial banks are salesman, getting varied income from varied sources at varied time.
Thus the "thought" that traditional banking is safe and commercial banking is not.
When you cut the Glass-Stegall act and merge the two entities, you create a schizophrenic relationship betwenn the steady and the unsteady - and you get the Recession.
Dan
I kinda get what you're trying to say, but that's a ridiculous comment, seriously, local banks loan to "know" entities? Gimme a break! Geographical proximity to borrowers does not "knowledge" guarantee.
When I say local, I mean community bank. When I say traditional, I mean only retail banks with less than $1 Billion in Assets.
But yes, your "local" banker from the community bank to the local branch of the BoA feels more comfortable lending you money, if the person knows you (character, capacity to repay, etc.).
Where your confusion may lie is the fact that "large" banks apply these risk models (based on credit score, DTI, etc.) across the board. That's not the lending that I'm speaking of as local and traditional banking.
Ok, "if" is the key word though, I don't know my community banker(s) and they sure as hell don't know me. I know my father has a relationship with one or two local banks from working with them for the past 20-30 years, I guess that's what you mean by "know?"
Regardless, the huge conglomerate bank can "know" you then just as well as the local bank. I don't get your point, but I'm not even sure what the point is by now...
Well if you read the comment you'd see that the community banker "knows" the borrower and can make exceptions to lending policies.
The conglomerate banker doesn't know you, doesn't care, because you're a number on a sheet.
That's the difference in community banking and commercial banking.
Hi Charles,
When I hear the term “shadow banking system” I don’t think of “shadow” as meaning “in the shadows” or “hiding”, I think of it as a term like “shadow government” in the UK. In other words, the “shadow banking system” is just a parallel banking system. It’s public; everybody who cares to know knows about it, but the average person pays it no attention because it doesn’t appear to have any effect on their lives. The problem with the parallel banking system is that it’s every bit as unstable as a traditional banking system, without any of the safeguards in terms of asset supervision, capital requirements and a lender of last resort.
Would you be happier with the discussion if we called it the "alternative banking system" or the "parallel banking system"?
ACC,
Honestly, yes, I would. It would frame the debate in more reasonable terms.
Sorry bad link to Brender and Pisani's monograph (HT: Setser) where they use the term "alternative banking system": http://www.dexia-am.com/globalisedfinance/
"Banks, and others in the financial system, all made the same bad bet based on unsustainable assumptions. Sure, some of them made this bet using sophisticated means, and that itself is a topic worth exploring. But the root cause of all of this, in my opinion, is underestimating risk."
What is the root cause of underestimating the risk? Isn't that the key question?
Felix Salmon has an interesting article that explains how the guys creating the derivatives based on sub prime mortgages estimated risk:
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Did this erroneous way of calculating risk spread through the industry? Isn't it true that the vast majority of the people in the lending industry didn't have a clue about the risk mathematics?
Yes. It is the Value at Risk (VaR)model.
It was used by funds managers to manage the total trades for a day and they began using the formula to measure the risks of total business units.
And no, people in the lending industry are salespeople, personalities no preciensce abounds.
DeLong - as usual - is wrong
IndYMac was a depository
WAMU was a depository
there are probably 200 more "community banks" yet to be shut down but the FDIC is too busy trying to build up Shelia Bair
If DeLong is implying that the real systemic risk was created by non-depositories, he should be clearer. He would still be wrong.
Look to Europe, where stolid banks (yes, deposit-taking banks) have driven the economies off the cliff. When I lived in NY I would see European banks all over dubious projects and deals. Not that they didn't waste enough money in their home countries.
Banks (depositories) in east asia created the financial crises there in the late 90s as well. always aided and abetted by government of course...
it helps to define terms if you want to argue these points effectively. like financial crisis. the subprime market started blowing up in late 2006 and really picked up steam in 2007. remember the implode-o-meter? most of the mortgage bankers - certainly charter members of the credit creating shadow banking system, were dead and buried long before Lehman blew up. New Century, the 2nd largest subprime lender, went bankrupt in March, 2007.
but the meltdown of this market did not immediately trigger the full blown financial crisis.
the assets created by these companies were well on their way to melting down by the fall of 2007, and mark to market became a household phrase (at least in my household) by that time, as investors started taking big write downs on formerly AAA MBS and CDO bonds.
stan o'neill and chuck prince were fired in the fall of 2007.
Yet still no financial crisis.
even after mortgage specialist banker, bear stearns went belly up, the crisis didn't hit, though things were certainly ugly.
it wasn't until it became clear that the traditional banks were at risk on a scale much larger than they had admitted before, that the rough patch in the market became a full blown financial crisis.
i have been amazed at the vehemence with which big league bankers and investment bankers (many of them now unemployed, yet still fiercely in denial) deny that they were the cause of the real crisis.
in my view, much time has been spent dissecting the supply side of the issue - thus the focus on the "shadow banking system" that made these many bad loans.
but this market was clearly one that was demand driven, as well. like it or not traders, bankers and company, but the demand for these horrible securities came from your companies. you bought them up, put them in CDOs and, rather them sell them off the increasingly skeptical third party investors, you kept them all to your selves, for your ABCP, SIVs, proprietary trading books, etc.
true traditional cash investors did not have big enough balance sheets to make this a financial crisis. it took the top minds of the banks and wall street, their unquenchable demand to squeeze a few basis points of yield out of a tapped out market, and their massive, highly regulated balance sheets to push the supply high enough to cause the implosion of the fall of 2008.
the mortgage market and the shadow banking system functioned well for decades, and suffered periodic set backs and blow ups (including the 1998 issues, the bankruptcy of Conseco, the recession of 2001, etc.) many times without it triggering a global panic. it wasn't until the big banks started committing huge piles of cash to a market they had always sneered at and assigned third rate status to, that pricing became extreme and irrational, and origination volume exceeded levels that the market could tolerate.
with out the big banks buying billions and billions of dollars worth of this stuff, and all of the related consequences of such buying, the subprime explosion would have been an isolated event, serious but on a much smaller scale. it would have been event that the market learned from and avoided, on its own, again in the future.
when bear, and lehman, and citi, and goldman, and DB, and merrill, and morgan, and b of a, and chase (all of the big commercial banks had huge ABCP programs and all of the european banks had big SIV programs and all of the investment banks had big prop desks and hedge fund groups) stopped being salesmen for the MBS bonds and started being buyers of those same bonds, that's when the trigger for the financial crisis was cocked. and it was only a matter of time before it was tripped.