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Banking and Shadow Banking

Words… what do they really mean?  What is banking?  What does a bank do, or what is it that a bank is supposed to do?  I’m 53 and in my lifetime I’ve witnessed a complete change in the banking system in the U.S.  When I was younger there were many banks, and some were even called “Savings Banks,” or “Savings & Loan’s.”  Then, banks were smaller and localized.  As recently as 25 years ago the nation’s largest banks had total assets in the neighborhood of $100-200 billion.  Today that number hovers closer to $2 trillion.   Back then there were restrictions on interstate banking, which could only be done by a very few federally chartered banks, who themselves had state supervised limitations on their activities.  Then, banks made loans to people and to businesses and funded those loans on their balance sheets mostly with deposits taken in from their mostly local depositor clientele.

In the early 1980’s securitization began to proliferate.  For those of you unfamiliar with that term (which by now should only be those not yet in college), a simplified definition of securitization (for the purpose of this writing) is a process that transforms loans into bonds, which then can be rated by a rating agency and more easily sold to others, who are in business to invest in bonds and not loans because they are deemed to be easier to resell (are more “liquid”).  Securitization brought about a revolution in the field of finance.  All of a sudden a borrower, whether it was one aiming to buy a home or to buy a major company, didn’t need to call a bank to finance his aspirations.  Access to debt capital broadened immensely and this fostered a major economic boom as values of all sorts soared, including those for homes, companies, and most everything else that could now be financed with more abundant helpings of inexpensive debt.

Banks, and their old and now seemingly outdated business model of making loans and funding them to maturity on their balance sheets with short-term deposits, became dinosaurs virtually overnight.  The period between 1982-1996 were the golden years for the non-bank financial companies who grabbed the mantle of finance through their embracing of the securitization model.  Firms with the names Salomon Brothers, Lehman Brothers, Morgan Stanley, Drexel Burnham Lambert, Goldman Sachs, Bear Stearns, First Boston, Paine Webber, Merrill Lynch and Kidder Peabody transformed from advisory companies with very small balance sheets advisory into financing powerhouses with large balance sheets. Utilizing the securitization process, these companies led the way in providing credit to both corporations and consumers.  Banks seemed obsolete.  They couldn’t really participate in this new world because a law enacted in 1933 called Glass-Steagall prevented them from engaging in trading activities, which was an essential element of the securitization business as bond buyers wanted to buy bonds from firms that could make active secondary markets in the bonds sold, thus providing them with liquidity when/if they wished to sell bonds.

The foundation of the revolution rested on the simple fact that securitization was a system of finance that made more sense than the old portfolio lending model represented by the traditional banking business.  The securitization process allows for cash flows to be re-directed and partitioned such that cash flows from a pool of loans could create highly targeted securities, some with longer term or shorter term maturities or average lives, and some with more or less credit risk.  A pool of 30 year fixed rate mortgages could thus be converted, if you will, into many different sorts of securities, some with average lives of only one or two years and some with 30 year average lives; some with very little credit risk and some with a very magnified level.  The value of creating these targeted securities was that they appealed to bond buyers for whom the original loans were unattractive but who were seeking more specific and targeted investment goals. Thus, this form of creating bonds with targeted risk attracted massive amounts of new money to fund things like homes, cars, credit card debt, boats, and corporate debt, which until then had no interest or entry point into financing these different areas.  Securitization introduced more abundant, consistently available, and cheaper capital to the borrower community all of which has surely boosted asset values.    

As is often the case in a transformation there were winners and losers.  The winners were the aforementioned firms, who were called at the time “Investment Banks,” or “Wall Street Firms,” and the losers were called either “Banks,” or “Commercial Banks.” Losers never like to lose, and in 1999 Bank lobbying helped to persuade the Clinton Administration to overturn Glass-Steagall, thus enabling banks to enter into businesses that they had previously been denied.  The Investment Banks were no match for the Banks, who were armed with a subsidized inexpensive source of capital – federally insured deposits.  Also, the Banks had ready access to the Federal Reserve in the event of a liquidity crisis.  Investment Banks did not.  The rest, as they say is history.  Today there are no more Investment Banks.  They are all dead or, in the case of Goldman Sachs, Merrill Lynch, and Morgan Stanley, converted to becoming Banks.

In the intensive lobbying campaign to influence Congress and the White House to overturn Glass-Steagall, Bank lobbyists invented a new term to discredit all activities undertaken by the former Investment Banks.  These activities began to be referred to as “Shadow Banking Activities,” a label that intentionally conveyed a sense of nefariousness.  Today, that label is now still used as an idiotic slandering of any activity in finance not done by a Bank, even if a bank does the very same activity.  So, if a non-Bank makes loans, these are done as a part of the “Shadow Banking System.”  If a Bank makes the very same loans, those are not.  If a non-Bank securitizes loans and sells the resulting bonds, that is also done as a part of that terrible “Shadow Banking System.  Yet if a Bank does the very same thing it is not.

Anyone with a modicum of understanding of finance should understand that more capital being made available is generally a good thing, and characterizing any source of capital as being somehow bad, save perhaps loan sharks and the Mafia, is a pretty silly thing.  Perhaps the most ironic part of this all is that activities undertaken with taxpayer-guaranteed money (Bank deposits) are always more dangerous for our system than the same activities financed by private at-risk capital, even capital from loan sharks and the Mafia.  Words are powerful and their misuse can have long-term negative effects.  We all need to be more careful in both the language we use and tolerate, as well as how we allow ourselves to be manipulated by others’ abuse of language.  Anyone in D.C. reading this?

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