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The Political Economy of Shadow Banking

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The Political Economy of Shadow Banking The Political Economy of Shadow Banking Eloy Fisher PhD Candidate at The New School October 7, 2013 Abstract This paper presents a theoretical overview of the political econ- omy behind shadow banking. Neither new or original, what is modern in shadow banking are its broader institutional implications and how it bore witness to the dramatic changes experienced by global capi- talism in the last century. Intimately tied to the political economy of capitalist dynamics, shadow banking is nested in the discontinu- ous distributive tension between workers and firms. These politics are a wedge in the operation of the shadow financial system, as govern- ment policy internalizes, guides and participates in dealings mediated by financial intermediaries. This government agency (especially in spending and borrowing) is itself a result of endogenous, differential pressures between workers' desires to push for re-distributive stabi- lization and firms’ tolerance of increased worker bargaining power. We present a broad theoretical overview to motivate a formal politi- cal economy model of the shadow banking sector (stylized around the operation of money market mutual funds, or MMMFs) using insights from Mehrling, Pozsar, Sweeney and Neilson's model. Our simula- tions suggest the leading push of distributive dynamics that nest the operation of shadow banking. JEL Codes: E12, E62, E63, H5, H6, P16. 1 Keywords: Political Cycles, Debt and Public Finance, Shadow Bank- ing, The Political Economy of Finance, Kaleckian Macrodynamics, Political Macroeconomic Models. 2 1 Introduction. Shadow banking (a term used interchangeably with shadow financial system) is \money market funding of capital market lending" [19] which generally takes place outside the regular banking system [3]. This definition high- lights the activities of financial intermediaries that use short-term money market funding, sourced on global dollar markets, to fund long-term invest- ment projects - namely capital loans. Both banks and other types of insti- tutions (a broad array of financial agents allowed to take client deposits to invest in different types of projects) engage in these activities. Estimates differ on the size of the shadow banking sector - some pin a figure around 65 trillion dollars worldwide as of 2011, from a \mere" 26 trillion in 2002 [5]. This eye-staggering growth was direct consequence of advances in securitization (which sought to minimize risk by packaging and pooling assets in structured products), a favorable regulatory climate and a macroeconomic environment of low interest rates. With the above in mind, this document describes the operation of the shadow financial system through an approach which not only underscores the inter-linkages between the sources and the target of this funding, but also the political economy of profits and wages that lies behind the dense web of financial intermediaries who participate as dealers, investment banks or special purpose vehicles (or SPVs, for short) to price funding and risk, depending on the assets and liabilities they hold on their balance sheets. However, these assets and liabilities originate in the relationships between firms and workers, and the rolling clout of special circumstances around government action and policy. With this in mind, we will argue that the financial operation of the shadow financial system is not a mere mechanical outgrowth of advances in securitization and risk management, but the natural result of tensions at the core of capitalist political development. Indeed, the 2008 financial crisis and other, perhaps less momentous events (like the 2011 debt ceiling crisis) turned sour the earlier enthusiasm with regards to shadow banks, managed money as Hyman Minsky would put it - the lot of hedge funds, mutual funds and the much-maligned investment 3 banks, whose top performers became extinct in the immediate aftermath of the crisis when they shed their skin to become bank holding companies. However, perhaps the important link in shadow banking is the operation of money manager mutual funds (or MMMFs, for short), who came to dominate an ever-growing share of financial flows after the elimination of interest rate ceilings on demand deposits in 1982. According to the Investment Company Institute (or ICI, for short), MMMFs comprise 17% of total assets held in mutual funds worldwide, behind equity and bond mutual funds. Unlike the latter two funds, MMMFs are deemed very safe and liquid investments: MMMFs sell shares to investors, and lend those funds (via repurchase agreements, or repos) to banks or dealers who demand liquidity for overnight operations. At a general level, MMMFs deposit their cash on investment banks or broker accounts, who in turn provide MMMFs with collateral - usually, high quality debt, whether commercial or sovereign in nature. The collateral provided is worth more than the deposit - the difference between the par value of the collateral provided and cash deposit is commonly known as the haircut. Under the terms of the repo, the bank repurchases the collateral at a higher price - or the difference between the initial selling price and the repurchase price is the repo rate, or interest rate on the loan. If the borrower fails to pay the repurchase price, the lender gets to keep the collateral at par value. Given these terms, the shares of these MMMFs are backed by high quality debt, namely high quality commercial paper, Treasury bills and sovereign bonds. Their operation in the United States is closely regulated by the Investment Company Act of 1940 and subsequent amendments, legislation which describes what constitutes safe investment assets for these entities. Furthermore, unlike other types of mutual funds, these MMMFs keep a net asset value (or the value of its assets minus its abilities) greater than 1, as their assets are highly liquid and risk-free - at least in theory. Herein lies the caveat: these MMMFs are viable entities as long as mar- kets provision liquidity and are able to price risk adequately, an ability that market participants woefully overestimated in the run-up to the crisis. For 4 this reason, how markets are organized institutionally and they interests they represent are of utmost importance to the operation of the shadow financial sector in general, and particularly to MMMFs (who at the receiving end of government deficits, trade large amounts of sovereign United States debt). For this very reason, we need to know not only how these MMMFs operate within the wider net of the shadow financial sector, but are the drivers of debt capital markets and the conflicting interests behind government policy. These questions can be tackled from two analytical vantage points: for one, this shift towards shadow banking is neither new or original. After this introduction, the next section claims that shadow banking is steeped deep into the political economy dynamics of capitalism despite the ever-changing vagaries of the world economy - this has long being argued by heterodox writers of both Marxist and Post-Keynesian persuasion. Marx himself took interesting notes on the appearance of quasi-banking, highly leveraged fi- nancial institutions (namely, the \Cr´editMobilier" of the mid-XIX century, heir to John Law's General Private Bank a century before) whose operation was analogous to many shadow banks. His analytical innovation, however, stressed the political economy behind its operation. Marx highlighted not only the intimate political linkages of the \Cr´edit..."with the government of Napoleon III, but its overall function within French capitalism. Out of the Keynesian tradition, Hyman Minsky traced much later the development of what he coined money manager capitalism, a system \in which the proximate owners of a vast proportion of financial instruments are mutual and pension funds" [20]. In a later note, L. Randall Wray [28] updated Minsky's definition, as \capitalism characterized by highly leveraged funds seeking maximum total returns (income flows plus capital gains) in an environment that systematically under-prices risk". Their views stress the discontinuous changes in the institutional and political fabric of capitalism which provides for the rise of these institutions. In this section we also discuss how politics drives a wedge in the shadow financial system, as government policy provides needed guidance and col- lateral in dealings undertaken by financial intermediaries. We claim that government agency in deficit spending and borrowing is the result of endoge- 5 nous, differential pressures between workers' wages and firms’ profits. It is our view that this tug-of-war is of central importance to fully understand the role of shadow banking in modern capitalism. Out of both analytical approaches, the third section presents the stylized facts we use to build the political economy model of the shadow banking sector, using insights from Mehrling, Pozsar, Sweeney and Neilson's work on shadow banks [19] and data from the United States. Section four presents our mathematical model and a social-accounting matrix which fully describes our model. Section five presents our baseline results and alternative scenarios. Finally, Section six concludes. 6 2 Shadow banking in the political economy of capitalism. 2.1 Marx and Minsky: The role of shadow banks in capitalism. In journalistic undertakings and personal exchanges with Friedrich Engels, Karl Marx discussed the appearance of the Cr´editMobilier system in France. Sanctioned by the French government of Napoleon III and with direct involve- ment of cabinet members and influential personalities of the Second Empire, the Societ´eG´en´erale de Cr´editMobilier was founded by the P´ereire brothers, a resourceful duo who had in their earlier years toyed with Saint-Simonian ideas - to Marx's derision. Their company issued shares to select investors (later it was opened to the public) who wished to partake in long-term in- vestments in \mobile" property - namely, railways, industrial production (in contrast to real estate investments) or in stock market listings of these com- panies. Marx and other contemporary commentators described this venture as a \swindle" [26] given the obvious lack of safeguards.
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