An economy of debt...  

I have been struggling to get my mind around the working of the shadow banking system. 

It's not easy for me.

The shadow banking system is the collection of financial entities, infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and structured investment vehicles. Investment banks may conduct much of their business in the shadow banking system (SBS), but they are not SBS institutions themselves.
The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions - but it has been common practice for investment banks to conduct many of their transactions in ways that don't show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors.^[1] For example, prior to the financial crisis, investment banks financed mortgages through off-balance sheet securitizations and hedged risk through off-balance sheet credit default swaps.^[1]
The volume of transactions in the shadow banking system grew dramatically after the year 2000. By late 2007 the size of the SBS in the U.S. exceeded $10 trillion. By late 2009 the United States SBS had shrunk to under $6 trillion due to increased regulation, changes in business practice, and pressure from investors who in some cases no longer wanted their funds to be used in the shadow banking system. Globally, a study of the 11 largest national shadow banking systems found that they totalled to $50,000bn in 2007, fell to $47,000bn in 2008 but by late 2011 had climbed to $51,000bn, just over its estimated size before the crisis. Overall, the world wide SBS totalled to about $60 trillion as of late 2011.  [More] 

These complex, interwoven financial contracts are essentially a function of debt of various kinds - mortgages, bonds, commercial paper, and other assorted and newly arrived instruments. As the shadow banking system grows relative the the regular banking system, (avoiding regulation and offering bigger profits) demand for debt grows.



The idea of demand for debt is exactly the opposite of what most of us are conditioned to expect. Our moralistic teachings from the Depression Generation has left us confused about how debt could have any redeeming aspects whatsoever.


But the effect of what happens in the SBS immediately is felt in the money supply which in turn impacts economic growth in a big way.

The blurring, or even absence, of the line between fiscal policy and monetary policy in the shadow banking system is often ignored.
It’s no longer enough to understand traditional monetary policy transmission mechanisms (money multipliers, federal funds rates, reserves); it is also necessary to understand how the shadow banking system (collateral supply, rehypothecation) affects monetary policy, and vice versa.
And this also seems like the source of the many challenges in working out how to regulate the sector.
Because one thing that’s clear from the note is that the shadow banking system represents a lot of money, and more specifically a lot of credit flowing through the economy. Regulating it won’t be as easy as saying bring it all on balance sheet or higher capital standards (though the latter is probably still a good thing).
How to define, for instance, the appropriate coordination between the central bank and fiscal policymakers when the outstanding Treasury stock affects monetary policy in this way? Or how to go about discovering the right balance between government readiness to respond (as it did in this case) vs the moral hazard it would bring?

… and summary from Credit Suisse:

Crucially, this chart and the shadow money perspective allows one to see that there has been
(1) a huge and necessary change in the composition of the effective money stock,
(2) a big reduction in the velocity of circulation of liquid collateral,
(3) a sharp reduction in the value of illiquid collateral (houses),
(4) an increase in the “haircuts” on illiquid collateral (higher LTV ratios), and
(5) a big increase in the precautionary demand for money by both firms and households.
The net result cannot be reasonably characterized as posing a major inflationary threat – at least until such time as financial system deleveraging is more complete, collateral values, especially house prices have recovered substantially, and overall private sector credit demand is growing strongly…
The public sector is still doing King Collateral’s work. How long it acts as Regent may be the central question for financial markets in the next decade.

[More]

This is pretty obscure I know. But when we argue about the size of our federal debt, it is a powerful complicating factor.  The SBS needs an immense supply of US Treasury securities, regardless of whether we think it is a good idea or not to run deficits. This is one reason why despite now-decade long predictions of interest rate increases, it hasn't happened, and doesn't appear likely in the near future.


In order for the massive financial sector which has grown to about 1/3 of our economy - and its outsized rewards to those employed there - to continue, a steady supply of debt/currency is needed to substantiate deals as acceptable collateral. 


Our financial system has evolved from supplying limited capital to enormous demand for investment loans, to chasing limited investment opportunities with wads of cleverly contrived debt-based capital.


I don't see - nor do any economists I read - any way to reverse this trend. The investments the world needs are to a significant degree public investments - infrastructure is a great example - and the political winds are blowing us away from those ideas. Absent massive government spending on roads, schools, locks and dams, etc. we only have industrial production to fund. That's not enough to absorb both public (like China) and private pools of capital.


As a result the financial sector makes money by betting on itself. This produces little other than big winners and losers, and frantic action, to my eye. To make it more complex, it will take us a long time, I think to grasp the idea of a world where free capital is plentiful and places to put it or not.


Strangely enough, we have been in a similar position before: the Middle Ages, after the Great Plague.
Demand had collapsed and the tiny number of nobles with money had nearly zero investment choices. This is one of the reasons they chose to plow money into their afterlife by building cathedrals - it was simply one thing to do with their accumulating wealth.


It is almost impossible for many of us to comprehend debt as an asset, but it has to be for the counterparty, by any accounting system. The stronger we make our guarantees for both public and private debt the more we enable the SBS to spin off derivatives of them to trade in various manners. Aided by new technologies that slice time into tiny segments to extract value, the possibilities seem nearly endless, but I can envision an upper bound to this profit source, as it simply becomes more common.


The demand for high-quality debt, however, may never abate. In other words, it may be a long time before interest rates reach anything like what many of us consider normal.  Bad news for savers and investors, good news for those who can deploy capital profitably.