Gordon Schücker

Shadows appear to me to be of supreme importance in perspective, because, without them opaque and solid bodies will be ill defined. Shadow is the means by which bodies display their form. The forms of bodies could not be understood in detail but for shadow.
– Leonardo da Vinci

Coming Wednesday I will once again hold a guest lecture at the FU Berlin on the topic of shadow banking. Rereading some of my favorite finance articles, I stumbled on a referenced research note I had previously missed that in my opinion gives a very good overview on how the current banking system works. It goes obviously a little further than the simplistic view of the world of traditional banking with only loans and deposits.

As an introduction, I always show this brief explanation video of the ’08 financial crisis. In case you haven’t seen it, I highly recommend it.

Following up, here are my highlighted parts from the Credit Suisse research note:

Long Shadows – Collateral Money, Asset Bubbles, and Inflation by J. Wilmot, J. Sweeney, M. Klein and C. Lantz

 

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There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.
Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.
– Friedrich Hayek, Prices and Production 1931 – 1935.

[…]

In this piece, we stress the importance of the shadow banking system and what might be called the shadow money stock for thinking about inflation and deflation. Shadow money is by no means a new concept or reality, but it can mean that conventional measures of the money stock are a (very) poor gauge of inflationary or deflationary pressure. So we also make a preliminary attempt to measure the “effective” money supply in the US, including the close substitutes for conventional money that are especially important in setting asset prices and financial system leverage.

[…]

Base Money, Bank Money, and Shadow Money

Shadow money and credit are arguably the Achilles heel of free market capitalism. But they are hard to regulate out of existence, especially once established, and most of the time serve a useful purpose rather than a destructive one.
Their existence – which makes conventional money stock measures incomplete or even downright misleading – helps to explain why, with the partial exception of the European Central Bank, nobody targets or forecasts inflation any more by looking at money demand and money supply.

[…]

The standard monetarist framework tells the inflation story via longer-term trends in money supply and money demand (as conventionally measured). Milton Friedman himself emphasised the “long and variable lags” between excess money growth and inflation. So did the Bundesbank tradition for that matter.The standard monetarist framework tells the inflation story via longer-term trends in money supply and money demand (as conventionally measured). Milton Friedman himself emphasised the “long and variable lags” between excess money growth and inflation. So did the Bundesbank tradition for that matter.

Of course, even conventional measures of money supply and demand can be highly volatile and unpredictable in the short run, so the key idea was that over long periods there was a reasonably stable and mean-reverting relationship between the money stock and nominal income. Persistent money growth above or below the underlying potential growth rate of the economy – set by the fundamental forces of “productivity and thrift” in Friedman’s language – would lead to either inflation or deflation.

For example, in the late 19th century, strong productivity and real income growth created strong trend money demand, but the classical gold standard and small commercial banking system did not create sufficient money to keep up with growth. The result was a trend deflation that became acute during periodic crises.

In most of the 20th century, by contrast, central banks could print money at their discretion and the public held more of their cash in banks, meaning it was easier for money supply to keep up with or even exceed money demand over time, generating positive inflation.If the amount of private and public shadow money follows a cyclical, but mean-reverting path (relative to GDP), then this simple framework might still be valid as a long-run story, but it would almost certainly fail to adequately account for the true transmission mechanism of policy, fatally underestimate the cyclical volatility of the economy, and give no explanation at all for repeated asset market bubbles and crashes. And if the economy is – like most other complex adaptive systems – importantly path dependent, the standard framework could in fact be seriously misleading.

To see this more clearly, we need to run quickly through the standard framework.The basic account of money supply starts with the monetary aggregates that by tradition matter most for CPI inflation: in the US case, cash balances in aggregates, such as M2 (roughly total deposits) or MZM (zero maturity money or cash plus bank claims and money market funds realizable as cash immediately). The available stock of money is determined by how much the central bank has printed (outside money) and how much the banking system has created by making loans (inside money). The inside money stock is much bigger than outside money because of the deposit multiplier.

Exhibit 4: shows that inside money (largely bank deposits) was nine times the size of the monetary base (outside money) before the recent crisis began.

Money demand, meanwhile, is the desired cash balances held by the public. Money
demand rises as the economy grows, via transactions demand, and falls as interest rates
rise, because zero-yielding cash becomes less attractive. From the perspective of the
equation of exchange, money demand is the inverse of the “velocity” of money. For
example if MV = PY (where M is the money stock, V is velocity and PY is nominal GDP),
then (1/V) = (M/PY), which is simply the level of the money stock relative to (nominal) GDP. For households, (1/V) can simply be thought of as desired money holdings as a share of nominal income. So for instance, if the average household decides it is prudent to increase their money holding to 9-months of income from 6-months, V would fall to 1.33 from 2.0.

This standard approach to money supply and demand captures some of the essentials but does not go far enough. Taking Hayek’s quote from the front page a little further, he goes on to say:

It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.The criterion by which we may distinguish these circulating credits from other forms which do not act as substitutes for money is that they give to somebody the means of purchasing goods [or securities] without at the same time diminishing the money spending power of somebody else. …
The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided (Emphasis added).

Hayek’s point is that the economy can create its own media of exchange in order to economize on the use of inside and outside money when there is significant demand for some type of money for use in purchasing assets. Of course, when assets can themselves serve as collateral, allowing for leveraged purchases, then they take on money-like properties. And when financial assets serve as collateral for borrowing to purchase yet more financial assets (buying on margin) this form of shadow money can become particularly potent in driving asset price overshoots and bubbles.

It starts with some genuine investment opportunity almost always related to a real improvement in technology or fundamentals. As strong price performance turns into a boom, optimistic investors desire to buy more on margin. They leverage up, usually using the buoyant asset itself as collateral. Lenders are all too willing to benefit by funding these purchases – after all, in the worst case, they will be holding valuable collateral. Borrowing terms such as haircuts, loan-to-value ratios, or margin requirements get easier. New money flows in, and associated financial assets begin to take on money-like attributes.

As buying on leverage accelerates, prices and credit conditions blow past what is warranted by fundamentals. There is a monetary expansion in the broad sense of shadow money, but when the bust comes this is quickly reversed. Lending conditions tighten, collateral prices plummet, and highly leveraged optimists are wiped out. Now cash is king; investors do not want houses, stocks, tulips or asset-backed commercial paper. To accommodate this demand for cash the government/central bank must quickly and forcefully expand the monetary base or else the increase in money demand can lead to a painful general deflation.

Meanwhile, the sudden disappearance of good collateral in the financial system has created a dangerous de-leveraging that could feed on itself. The government may respond by increasing its own debt, since public collateral in the forms of treasury bills and such do still have funding liquidity, and by flooding the market with government paper the leverage collapse can be better managed. In our stylized example effective money (meaning shadow money plus the conventional money stock) falls sharply, but it would have fallen much more without aggressive policy actions.

Exhibit 6 is a stylized version of a credit bubble where shadow money becomes important. In our opinion, the stylized facts of this cycle – and many others before it – can be summed up roughly as follows.

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Research note of course discovered via Zero Hedge, Chasing The Shadow Of Money. (Though I didn’t find that particular article that good).