Capital Markets Based Money System
Lately there has been much criticism of MMT (Modern Monetary Theory) and other heterodox schools of macro for failing to account for the role of this new “shadow banking” financial economy in creating money (and leverage and instability and risk) above and beyond the regular banking system. See for example a recent Zero Hedge article. A more scholarly article was published recently by Manmohan Singh and Peter Stella, “What economists need to know about the modern money creation process”.
But ultimately all of this derivatives industry money is just froth on the foam of the bubble money that is originated in the “real” banking sector. To come home to roost where it can actually access the real economy to buy yachts and mansions and islands for its “participants”, the money must ultimately return to the real banking system. This was laid out by Perry Mehrling in his definitive 30 May 2009 analysis “The Global Credit Crisis, and Policy Response”. He described the move away from a banking-based money system (regulated by national governments who license and supervise banks) toward a capital markets-based money system (beyond the reach of any regulation).
He opened by observing, “This thing has a lot of moving parts.” Indeed, Rube Goldberg would be impressed. Here is how Mehrling summarizes what has been happening over recent decades:
“Over the last thirty years, we have been moving from a bank credit system to a capital markets credit system, but our regulatory apparatus has not kept up. As we made this historic shift, some argued that the new capital markets credit system would not need any regulatory apparatus, but such arguments are harder to credit today. Today we see more clearly that the new system was not so much an independent alternative to the existing system as it was symbiotic with it, intertwined at multiple levels including the level of regulatory support through the Fed and the FDIC.
Under the old “legacy” banking system, banks made loans and funded those loans with deposit liabilities. The liquidity risk involved in this operation was handled by a system of interbank lending (Fed Funds market), subject to ultimate government backstop through the discount window. The solvency risk was handled by a system of capital buffers (Basel Accord), subject to ultimate government backstop through deposit insurance (FDIC).
In the new “shadow banking” system, by contrast, loans were transformed into securities, and investors in those securities funded their positions in the wholesale money market using asset-backed commercial paper, repurchase agreements, or simply unsecured short term borrowing (Eurodollars). Liquidity risk was handled by designing the securities so that they would be eligible collateral for such money market borrowing, but the ultimate liquidity backstop proved to be lines of credit with the legacy banking system. Solvency risk was handled by credit enhancement using interest rate swaps and credit default swaps, so the ultimate solvency backstop was the capital buffer on the balance sheet of swap counterparties.”
Welcome to Moral Hazard Country
Mehrling’s conclusion is that securitization can be, and perhaps should be, resurrected. But he feels it can only work if government agrees to act as insurer of last resort. I say, “Welcome to Moral Hazard County” if we go that route, which would permanently privatize gains and socialize losses in the thoroughly out-of-control too big to regulate financial casino economy.
The ‘money line’ in Mehrling’s intro is:
“Liquidity risk was handled by designing the securities so that they would be eligible collateral for such money market borrowing, but the ultimate liquidity backstop proved to be lines of credit with the legacy banking system.”
In other words, the “real” banking system is still the ultimate originator of the “money” that underpins and backstops the entire securitization, rehypothecation and derivatives based capital markets financial system. And the “capital buffer on the balance sheet of swap counterparties” is also real money from the real banking system. The capital markets house of cards is built upon the real banking system house of dominos, so MMT is correct in focusing on the operations of the real system and advocating solutions in the primary system rather than in the dependent system.
Derivatives and Securitization
The whole “derivatives” industry all began with “securitization” in the 1970s. Instead of holding their mortgages and other loans on their own balance sheets, banks would sell those “assets” to investment banks who would package them up as “mortgage backed securities” (MBS) then sell them into global financial markets. For example, a teachers’ pension fund in Norway might buy a ‘Made on Wall Street MBS’ because it paid slightly higher interest than other investments that were available to earn interest on their savings.
Securitization is attractive to banks for a number of reasons, but fundamentally because bank leverage is “capital constrained” under the various Basel (I, II, III) global banking protocols, and securitization frees up capital to create new leverage against it. The process is highly profitable to banks who collect upfront fees (and thus collect upfront bonuses) for originating and servicing loans, and then collect fees again for selling the packaged products. In the meantime it frees up the banks capital to go right back and do the same thing all over again. The banks’ own capital and balance sheets are not at risk because they kept selling off those loans to other parties. The risk devolved to the teachers in Norway and other securitized debt buyers.
