The horizon is not so far as we can see, but as far as we can imagine

Insuring Shadow Banks Without Proper Regulation Is Asking For Disaster

A correspondent suggested to me that what needs to happen is to create a system like the FDIC for the shadow banking system (largely unregulated financial institutions which act like banks without being regulated like them.) The argument is that this mitigates against hysterical herd behavior and that the shadow banking system is necessary because it’s where a lot of institutions put their money.  And no one is willing to insure this system but the government.

Shadow banking didn’t always exist at these levels, institutions found places to put their money.

As I understand this, it means insurance without equivalent regulation to ordinary banks—because if you used equivalent regulation you’d just make them into banks who have to follow the same rules as retail banks.  This means investors being insured who engage in extraordinarily risky behaviour in order to get returns which normal banks can’t and don’t provide.

I should note that, in fact, other people were willing to provide the insurance.  AIG did.  They just couldn’t pay up, because only the government could afford to pay up.

So therefore shadow banks, who can’t find anyone who could possibly afford to insure their risky business model, need governments to do it?

The question is if they are willing to charge the full price for the insurance?  I’ve worked in insurance, real insurance where we worry about having enough money to pay off when the loss event occurs, and here’s the way it works: it costs more than the value of the insurance.  If there’s going to be a crisis every X years because of these fools, then we need to charge enough money to not only cover the cost of their insurance every X years, but to cover the cost of things like the stimulus to clean up their messes, the unemployment insurance costs, and so on.  Or we could move to 90% taxation on all income over a million, which would only be fair, if we’re going to have to bail the rich out again and gain.

Either way, the high cost of real insurance would mean a lot lower profits.  It isn’t going to happen that way, the real cost is not something the shadow banking system is willing to pay.

And if they know they’re insured, without proper regulation, what they’ll do is drive over the cliff again.  Why not, if they know they’ll be bailed out, and in the good times they get to pay themselves massive bonuses and wages?  Moral hazard 101: heads they win, tails the taxpayer bails them out.

Maybe there are better solutions.  Like reinstituting Glass-Steagall, forcing everyone to 10:1 leverage ratios with nothing off the books, and shutting down the majority of shadow banking, which has shown that it costs the real economy more than it can possibly be worth.  What we don’t need is investors putting money into shadow banks in attempts to pursue 15%+ returns, thus ignoring putting money into the real economy.

As for hysterical herd behaviour, the real problem was the herd behaviour involved in CDOs, CDSs and the housing bubble.

Behaviour which should simply never have been allowed to occur.

If you don’t want bad behavior, don’t insure it, just outlaw it.


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  1. It’s hard to come up with a regulatory framework that resists subversion by thieving bankers because thieving bankers are so ingenious. Perhaps a bailout for imprisonment concept could be made to work: the government will bail out any systemically important institution that collapses, but in exchange, the CEO and board suffer complete asset forfeiture and spend the rest of their lives in prison.

    Managers will pay far more attention to risk management if they have a personal stake in long tail outcomes. Removing even the slightest component of limited liability will promote more good behavior with a minimum of leeway for bankers to misbehave by skirting the letter of regulation.

  2. I don’t even understand why there is a shadow banking system, much less whether people could be persuaded to live without it. Those are the questions that occur to me – is it feasible to make the people who used it do without. In a way, it’s like other illegal activities – there’s lots of money in it, so someone will probably be willing to provide it.

    I recognize that this could be a silly concern, but I also suspect someone will assert that this is true, and I’d like to think I knew the answer.

  3. John

    Maybe people such as drug dealers, arms dealers, kleptocratic rulers, etc. want a shadow banking system so that black money can be stored and moved around the planet without too much supervision.
    Where is all that Mexican drug cartel money going, likewise all the heroin money from Afghanistan?…
    A stiff financial transaction tax would also be a good thing as well as removing limited liability for corporate managers of the funds.

  4. Hungry for derivatives traders FEED ME

  5. David Kowalski

    Regulation may have worked for 40 or 50 years but post-Reagan it can’t work. We have too many regulators who are “philosophically opposed” to regulating and refuse to do their jobs. This not only applies to Republican administrations but has spilled over to Democratic ones as well.

    The century old argument between Theodore Roosevelt (bust up big companies and bad ones as well) and Woodrow Wilson (big isn’t bad; behavior is bad) has been settled on the side of TR. Shadow banks are both big and bad and in this environment are beyond effective regulation but not beyond rescue. We should not be the people cleaning up after the circus elephant because swindlers and con men/women can throw a lot of money around.

    Shut these bad boys down. Re-institute Glass-Steagall. Get back to a business model that works. The incentives are entirely on the side of risk. Call a few right and one is rich for life. That is unacceptable for the middle class. It is unacceptable for the poor. It is unacceptable for the rich who actually work for a living.

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