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«2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 593 IT’S ALL SHADOW BANKING, ACTUALLY JONATHAN MACEY* Introduction “Shadow banking” is a great term. ...»

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In addition to acquiring and utilizing information about borrowers to reduce the incidence of losses on their investments, a second way that bankers of all types respond to the pressure to improve their reported financial results is simply to increase the distance on the yield curve between their low-return short liabilities and their high-return long assets. This mismatch creates risk for two reasons. First, interest rates change. Holding the slope of the yield curve constant, if short-term interest rates go up, as they inevitably do during times of financial stress or crisis, then the financial institution will have to pay more for its short-term funds. The rates it receives, however, on long-term projects that were financed at the old, lower rates remain the same because these borrowers will not want to refinance at higher rates.34 Second, borrowing short-term and lending long-term creates risk because the slope of the yield curve is not constant. It is not unusual for yield curves to become inverted, i.e., for long-term rates to dip below short-term rates. When this occurs, financial institutions both shadow and otherwise, earn negative spreads.35


See Macey, supra note 27, at 696 n.28 (“A yield curve is the general term for a graph that measures yield to maturity of a particular issuer's securities on the vertical (Y) axis and length of time to maturity of those securities on the horizontal (X) axis.”).

Id. at 696.

See Macey & Miller, supra note 19, at 3 (“Banks become unprofitable whenever short-term interest rates rise above the rates they receive on the long-term loans they hold in inventory.”).

Yield curves typically become inverted in times of economic stress.

Arturo Estrella & Mary R. Trubin, The Yield Curve as a Leading Indicator:

Some Practical Issues, 12 CURRENT ISSUES ECON. & FIN. 1, 3 (2006). For example, the yield curve for U.S. Treasury securities recently became inverted because of low expectations about future growth and future inflation. Furthermore, significant concerns about the future effects of the 606 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   Third, banks and shadow banks also create profit by borrowing short and investing long through the provision of liquidity. Holding all else equal, liquid assets are more valuable than illiquid assets. In addition to moving out further on the yield curve, banks make money by obtaining cash for investment by issuing highly liquid liabilities, such as deposits, swaps and commercial paper, and then investing that money in assets that are not only longer in maturity, but also far less liquid.

Fourth, banks generate profit by acquiring high-return risky assets with cheap, low-return liabilities that have received some form of credit enhancement. That is, if banks and shadow banks can persuade depositors or repo market lenders that providing them with credit is not very risky, than they will be able to obtain credit more cheaply because depositors will not demand much, if any, return on their deposits, and purchasers of securities from shadow banks in the repo market will not charge very high rates. Here, regulation plays an important role for both shadow banks and other banks.

For traditional banks, the federal government guarantees the repayment of banks’ borrowed funds through the sale of deposit insurance by the Federal Deposit Insurance Corporation (“FDIC”), which helps enable banks to borrow money at low rates to make risky loans and acquire risky, high return assets. Financial institutions doing business in the shadow banking system do not qualify for FDIC insurance on their short-term debts, both because such debt is not in the form of insurable deposits and because the companies doing business as shadow banks are not officially chartered as banks. This keeps many institutions out of the shadow banking market entirely. Other institutions, however, have the functional equivalent of deposit insurance because they are deemed to be “too-big-to-fail” as a result of their size or, as it is called, their purported “systemic importance.” The Financial Stability Board (“FSB”) was established in 1999 to “coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies.”36 The FSB “brings together national authorities responsible for financial stability in


U.S. budget deficit have a much stronger negative pull on long-term interest rates than on short-term rates.

Overview, FIN. STABILITY BOARD, http://www.financialstabilityboard.

org/about/overview.htm (last visited Apr. 7, 2012).

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 607 significant international financial centres, international financial institutions, sector-specific international groupings of regulators and supervisors and committees of central bank experts.”37 It is an organization whose membership is comprised of the central bankers of every major economy, together with every major international financial regulatory organization, including the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, the Organisation for Economic Co-operation and Development, the World Bank, the Basel Committee on Banking Supervision, the Committee on Payment and Settlement Systems, the International Accounting Standards Board and the International Organization of Securities Commissions.38 In late 2011, the FSB embraced the view that risk to the global financial system was posed by what are known as “global systemically important financial institutions,” or G-SIFIs. G-SIFIs are defined as those financial institutions “whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity. To avoid this outcome, authorities have all too frequently had no choice but to forestall the failure of such institutions through public solvency support.”39 Twenty-nine banks are designated as G-SIFIs.40 Of these twentynine, eight are U.S. banks.41 The G-SIFIs are subject to “[m]ore intensive and effective supervision.”42 Banks that are not lucky enough to be designated as G-SIFIs will experience not only less supervision, but less “effective” supervision. The more intensive and effective regulation enjoyed by G-SIFIs includes higher capital requirements, requirements for resolvability assessments, recovery and resolution plans, institution-specific cross-border cooperation



Links to FSB Members, FIN. STABILITY BOARD, http://www.

financialstabilityboard.org/members/links.htm (last visited Apr. 7, 2012) (providing links to all current member central banks and international institutions).


IMPORTANT FINANCIAL INSTITUTIONS 1(2011), available at http://www.





608 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   agreements and better supervision in the specific areas of risk management control functions, risk data aggregation capabilities, risk governance and internal controls.43 Interestingly and not coincidentally, of the eight U.S. banks on the list, two, Bank of NY-Mellon and State Street, made the list because of the roles they play in the global system of clearing, settlements and payments. The remaining six, Bank of America, Citigroup, Goldman Sachs & Co., J.P. Morgan Chase, Morgan Stanley and Wells Fargo, are major dealer banks.44 More significantly, these U.S. banks are responsible for virtually all of the over-the-counter derivatives business in the U.S.45 Professor Duffie described this group as the financial institutions “that, in addition to their securities and derivatives businesses, may operate traditional commercial banks or have significant activities in investment banking, asset management or prime brokerage.”46 The perfect overlap between the list of banks that are toobig-to-fail and the banks that are involved in shadow banking is significant. If I am correct in my view that shadow banking is no different as a functional matter than ordinary banking because both shadow banks and regular banks make money in the same very risky ways, then in order to explain the existence of this market we must understand why lenders and other counter-parties would be willing to lend, even on a short-term basis, to any financial institution that has such a structurally flawed, highly precarious balance sheet. The answer is that counter-parties will not extend credit to financial institutions unless they have actual de jure or de facto backing from the government. In other words, these banks are in the shadow banking sector because they are too-big-to-fail. This status gives the financial institutions the credit enhancement needed to attract cheap short-term funds from swaps and other derivatives that they then invest in illiquid, long-term, high-yield assets.

Unfortunately, the existence of this government-sponsored deposit insurance generates three costly by-products. The first is moral hazard. Unlike other banks, banks that enjoy government guarantees because they are too-big-to-fail will not be pressured or constrained to refrain from taking risks. At a minimum, their creditors will not constrain them from taking risks, and creditors are



DUFFIE, supra note 7, at 10.

Id. at 9.


2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 609 typically the parties that monitor borrowers and engage in costly, complex contracts with borrowers aimed at limiting excessive, unanticipated risk-taking by such borrowers.

A second costly by-product of our too-big-to-fail-culture is competitive inequality. Banks that are too-big-to-fail can enter into highly profitable lines of business, particularly shadow banking.

Other institutions are excluded from entering these lines of business precisely because these banks cannot find counter-parties, as counterparties only want to deal with the biggest institutions that are too-bigto-fail. In other words, our too-big-to-fail banking policies are the sine qua non for shadow banking. Without a too-big-to-fail policy firmly in place there would be no shadow banking industry, or at least no such industry of a size remotely approaching the size of the U.S. shadow banking sector prior to the financial crisis.

Finally, in addition to generating moral hazard and competitive inequality, the too-big-to-fail policy generates regulatory distortions, particularly capture. Regulators of the big banks that are too-big-to-fail inevitably generate a close—indeed, a symbiotic— relationship with the bankers who run such institutions.47 Both groups – the regulated and the regulators – have the same interests: to insure the continued health and viability, or at least the apparent health and viability, of these institutions. For the regulators this means, for example, protecting those that are considered too-big-tofail from the vagaries of competition from small institutions whose survival is not deemed critical. It also means acquiescing to the requests by the too-big-to-fail shadow banks for accounting rules that allow such banks to portray themselves as healthier than they actually are and by entering into new, risky but profitable lines of business, such as shadow banking, that require a “too-big-to-fail” status.

IV. Solving the Problems of Shadow Banks and Solving the Problems of Traditional Banks Both banks and shadow banks have the same limited array of options when they find themselves in financial distress. This point is


See Lawrence G. Baxter, Capture in Financial Regulation: Can We Channel It Toward the Common Good, 21 CORNELL J.L. & PUB. POL’Y 175, 181 (2011) (“There is ample evidence from various regulatory actions that the industry, particularly large financial organizations, have enjoyed surprising favor at the hands of the financial regulators.”).

610 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   important because, if true, it reinforces the basic proposition put forward in this paper that shadow banking and traditional banking are functionally equivalent.

As I have observed elsewhere, the difference between big banks and small banks is similar to the difference between rich people and poor people as articulated by Mary Colum to Ernest Hemingway: “I think you’ll find the only difference between the rich and other people is that the rich have more money.”48 There are more zeros on the balance sheets of big banks, but their basic issues are the same. Problems like banks’ lack of liquidity, the asymmetry between their long-term assets and short-term liabilities and their extreme leverage, all contribute to instability and vulnerability to bank runs.

For traditional banks, a bank run occurs when depositors collectively and simultaneously withdraw their money, draining the institution of cash and forcing it to liquidate long-term, illiquid assets at fire sale prices in order to meet their depositors’ demand on their deposits. For shadow banks, runs manifest themselves in the form of short-term creditors, e.g. purchasers of commercial paper or swap counterparties that refuse to roll over their investments, thereby depriving the shadow bank of liquidity and forcing them to liquidate their illiquid, highly volatile asset portfolio in a fire sale fashion. For both shadow banks and traditional banks, there often are no willing buyers for these assets at anything remotely resembling either the values at which such assets are recorded on the banks’ balance sheets, the real economic values that these assets actually have or the values that the banks hope – or fantastically believe – that they have.

Thus, not only do the biggest banks fail for the same reason that other banks fail, but the strategies for rescuing the biggest banks turn out to be the same not only for big banks and for small banks, but also for banks and other sorts of businesses. As Professor Duffie cogently observes, the same issues that prevent traditional banks from finding their own solutions to their problems also prevent shadow banks from availing themselves of “self-help” remedies when they are in trouble.49 These issues are: (1) “debt overhang”50 and the related problem of transaction and information cost obstacles


Eddy Dow, The Rich Are Different, N.Y. TIMES (Nov. 13, 1988), http://www.nytimes.com/1988/11/13/books/l-the-rich-are-differenthtml?src=pm.

See DUFFIE, supra note 7, at 45 (describing why it is difficult for a failing dealer bank to raise cash).

Id. at 43.

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