The Shadow Banking System.

I've been watching Quantum of Solace on a calm night off, drinking some beers, lounging on my couch doing absolutely nothing (except responding to RS' absurdity of absurdities on the previous post...which explains the 30 odd comments), and even though it's midnight and I have a 9 am call tomorrow morning and my mind is not functioning optimally at all from the beerage, I thought maybe I'd take a stab at the Shadow Banking System. I have to say, as a term, it is an awesome one. (And Quantum of Solace appears to mark a very quick descent for the previously good Daniel Craig bond movie into schlocky, overwrought, over directed and over choreographed action nonsense. But, as usual, the bond girl was smokin.)

As always, subject to the usual caveats, I have the distinct idea that what I'm about to write is going to sound very pompous and bizarre in tone, but I find it easier to write this way, so go fuck yourself with a big rubber dick and then call your mother to report on it, because, for a fact, I know she likes being fucked with a big rubber dick and would love to hear some family input on the matter. Yes, I'm talking to you. Even if you are my brother.

So to understand the shadow banking system, the normal banking system needs a quick review. (Pardon me if this is too elementary, but I still barely understand this myself.) Let's start with the concept of money and the money supply. So there's about 900 billion dollars of physical US currency in circulation right now, yet US GDP is somehow over 13 trillion. How is this possible? What is money, if not currency? How do you "print" money if you're not actually printing money? What the fuck is money? Yes, let's start there.

Well, we'll start there after this. The control of the US money supply is crucial to maintaining stability in the economy. If the US government "prints" too much money, that is, if the Federal Reserve lends out too much money at super low interest rates, then money because less valuable. That's inflation. This is what has happened in Zimbabwe, where the government printed SO much money that inflation was last reported at 231 million percent. Yes. I typed that correctly.

So why did i put "prints" in quotations? Because when the US "prints" money, that has absolutely nothing to do with printing currency. "Printing" money merely means increasing the money supply. What the fuck does THAT mean? (They now call this "Quantitative Easing" in the press, if you ever wondered wtf that means.)

Starting with the simplest banking system. Imagine you have 100 dollars of value, whatever that means. Lets just say that is 100 dollars of hard currency, let's say Gold. You take that 100 dollars and you put it in a bank. The bank says "cool doucher" and then promptly turns around and lends that money to RS, doucher extraordinaire. Now the bank cannot lend out all 100 dollars. It has to have SOME money in the bank if you decide to come back and get your money. So it holds a "capital cushion" or a "reserve." Roughly speaking, this is usually 4% to 8% of that 100 dollars. Anyway, so the bank takes 100 from you and lends 92 dollars to RS, doucher extraordinaire. RS, doucher extraordinaire, then goes to another bank and deposits those 92 dollars in another bank, which we will call Boucher Bank. So then Doucher Bank (not to be mistaken with Deutsche Bank), lends out like 86 of those dollars to me. I then take those 86 dollars and deposit them in my bank, Awesome Bank, which lends the money out after holding some cushion of its own. By now you get the picture. From those 100 dollars of original currency, the banking system, through its loans, has effectively "printed" 100 + 92 + 86 + ad nauseam dollars. And ALL of that, every entry on the books, is real money. At any time, each of us could go to our respective banks and should be able to pull our money out. And it has value. (Of course, underlying all of this is the stability of the banking system and the confidence that not everyone will run to get their money out of the banks at once. As NPR aptly put it, money is trust. And this is why.)

So the Federal Reserve's job, generally speaking, is to set the amount that banks have to hold in reserve, and thus control how much is being lent out at each iteration, and thus controlling how much money is in the system. So if the Fed were to require banks to hold 20 dollars for every 100 dollars it takes in, only 80 could be lent out the next time, and so on and so forth, leading to MUCH less money in the system compared to a situation where banks only had to hold 4 dollars for every 100. In addition, the Federal Reserve also operates as a bank. It lends out money at interest rates it sets (Federal Funds Rate), and by lending at high or low rates, it also controls the general interest rate in the economy. By setting these capital reserve requirements and interest rates, the Fed controls the amount of currency that exists in the system. If it looks like there's going to be massive inflation and money will start to lose its value, the Fed will ramp up the capital cushions and ramp up interest rates, thus restricting the amount of lending and thus shrinking the money supply. This is also why Alan Greenspan is getting F'd in the A over his time at the Fed. He kept the interest rates super low when he should have reined them in...leading to a massively inflated asset bubble. Nevermind.

Anyway, there you have it. The money supply. Banks have to hold certain reserves at the Federal Reserve's dictates and that constitutes the primary means that the government has to control inflation, the money supply, and in some sense, economic growth. And it generally worked.

So what the holy fuck is the shadow banking system?

The shadow banking system is where lending and borrowing takes place outside of this oversight and supervision. This is where derivatives and mortgage-backed securities and other such nonsense come into play. So imagine a bank, instead of taking in deposits and lending out those deposits, or lending money for a mortgage and taking the house as collateral, decides to engage in a brand new endeavor. Instead, this bank decides that it will not keep any of the loans on its books. So it will loan out lots and lots of money for people to buy their houses. And then it will take the houses as collateral. So far, just like a normal mortgage.

But now, instead of holding the houses and loans on their books, and holding the capital cushion, they will drop all of the loans and houses into a giant pool, slice them into securities and sell them to Wall Street investors. So Wall Street will get the 6% interest rates being paid on those mortgages, the home owners will get funding to buy their houses from the Wall Street funding, and the bank no longer holds either while taking a cut off the top. If you dig in to this structure, you notice that there is lending. You notice there is borrowing. You notice that everything operates the way it normally would in a banking system. It IS a fucking banking system. Money is borrowed and lent by banks.

EXCEPT, because the banks are not taking in and lending out that original 100 dollars, they are not required to hold 8 dollars on their books anymore. So you still have that same 100 dollars, and instead of that 100 dollars become 92 dollars, and then becoming 88 dollars, and so on....you have the 100 dollars and no restrictions on lending.

Thus, instead of the Fed controlling the money supply by carefully controlling and calibrating the "reserve ratio" or "capital cushion," you have unfettered loans by all of these banks without any regard to capital requirements. In essence, these banks are "printing" more and more money with each of these lending structures, and it is completely out of the control of the regulators. Banks begin to loan more and more and more through these structures, and the money supply is no longer able to be controlled by the Federal Reserve. And if you look at it from a bigger picture, all this lending and all this borrowing is happening, it's just been restructured outside the formal banking system. Hence, the shadow banking system.

And the consequence? The level of consumer and household debt dramatically increases. And what we perceive to be "Growth" because there's more money, is actually an increase in the money supply and an increase in debt. And then a bubble inflates. And inflates. And inflates. And then pops. And here we are.

Anyhow, I'm not even going to bother re-reading that. I'm slightly tipsy and I'm not even sure if that made any sense. But I thought I'd share it, incomprehensible or not. Because it interests me. And I remember how I used to find everything financial and everything economic entirely incomprehensible until I somehow found a way to understand it. And hopefully, I am helping SOMEONE in that process.

Did anyone make it this far? Peace out bitches.