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The Federal Reserve Board
originally led us to believe that it was necessary to expand money supply
through quantitative easing to offset the contraction of bank credit. Bank
credit is no longer contracting, and indeed was already expanding when QE3
was introduced. This objective is now being satisfied as illustrated in the
chart below:
Perhaps helping to drive this
trend is a fall in the general level of charge-off and delinquency rates to
less than 1.5% of all loans and leases, down from the crisis levels of twice
that. According to an article
at Bloomberg dated
August 6, “…. households have cut debt since the 2008-09 crisis, while banks have increased liquidity and bolstered
capital buffers”. So the up-coming fiscal cliff permitting, conditions
are in place for a further expansion of bank credit and we can put the past
behind us.
Well, not quite.
As well as conventional bank
lending, there is also shadow banking to consider. The Global Shadow Banking
Monitoring Report 2012 tells us that at $23 trillion for the US alone, it dwarfs reported
bank lending. According to Exhibit 3-3, before the banking crisis, shadow
banking in the US was growing at a compounded annual rate of over 10%, and
subsequently has contracted slightly. But this probably masks a more recent
pick-up in the growth rate in line with on-balance sheet bank lending, and we
must also take into account the far greater growth in shadow banking in
non-US financial centres, particularly in the UK,
Hong Kong, Singapore and Switzerland, where restrictions on re-hypothecation
are often less onerous.
The problem with this
elephant-in-the-room is that shadow banking requires no bank capital to back
it, because it works on collateral pledged by non-bank institutions and the
general public. It is comprised principally of securitised
consumer property loans and mortgages, as well as sovereign debt. And because
the global financial system is fully integrated, the $22 trillion equivalent
that is the eurozone’s exposure to shadow
banking must also be seen as a significant risk: no wonder the European
Central Bank has signalled it will save the eurozone in its entirety, at all costs. This is also
interest rate sensitive stuff, and with no capital buffers to absorb losses
it will not take much of a rise in rates to trigger a crisis, even without an
external shock.
Now consider what happens if
interest rates are forced upwards by the economic recovery, clearly signalled by the bank lending statistics in the chart
above. The value of this collateral will fall, and anything more than a
modest interest rate increase will risk collapsing the entire financial
system. The Fed, along with the other central banks is effectively trapped:
it can no longer manage the money supply in accordance with its mandated
objectives. It is now the Fed’s primary function to worry about shadow
banking, over which it has no direct control, other than to make sure sufficient
collateral of good quality continues to be available.
There is a worrying complacency
in financial circles about this problem, which suggests that financial assets
are not discounting the serious risk of systemic failure. This
problem demands serious attention.
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