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October 6, 2008
Policy for the parallel banking system
Tom Palley has offered what I think is one of the clearest explanations of why we need to craft a new regulatory policy for the so-called shadow banking system (which he calls the parallel system). The essay ("Why Federal Reserve Policy Is Failing") is available on the Financial Times or Palley's website. Core of his argument is the different situations facing the traditional banking and the parallel system:
First, traditional banks are significantly funded by customer deposits. Ironically, such deposits can be withdrawn on demand and are in principle even more insecure than short term roll-over funding. However, they stay in place because of federally provided deposit insurance.
Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans. These loans are therefore priced by auditors on a mark-to-realization basis. However, if they were securitized their market value would be significantly lower owing to current disruptive market conditions.
The bottom line is that the banking system is in better shape not because of its virtues, but because of policy. Deposit funding is safe because of deposit insurance. Banks are spared mark-to market losses because of different accounting rules. And the Federal Reserve is providing banks with massive liquidity infusions through its discount window and its various emergency auction facilities.
Policy has therefore ring-fenced traditional banks. But in the meantime it has left the parallel system in the cold, leaving a gaping hole in the policy dyke.
This policy stance reflects the Fed’s continuing attachment to an antiquated view of the system whereby it takes responsibility for traditional banks and nothing else. Such a policy makes no sense and will fail. The Fed encouraged development of the parallel system, and that system undertakes many of the same activities as traditional banks. Meanwhile, failure of the parallel banking system will continue putting downward pressure on asset prices and lender confidence.
The Treasury’s proposed $700bn asset purchase program will help put a needed floor under asset prices. However, it does nothing to tackle the parallel banking system’s roll-over funding crisis that is crimping lending and pushing firms into bankruptcy. That is causing distress to spread far beyond the mortgage market, undermining the ability of any asset purchase program to put a floor under asset prices.
The urgent implication is the Fed (and other central banks) must extend its safety network to include the parallel banking system. Just as the traditional banking system needs liquidity assistance, so too does the parallel system. That assistance can be provided through such vehicles as the discount window and Federal Reserve auction facilities, and it should be allocated to qualified firms able to post appropriate collateral.
I'm not sure Palley's recommendations go far enough. But they do underscore the fact that the current situation is a result of policy failure as well as market failure. Similar to the S&L Crisis, policy changes did not keep up with market changes and in part drove market behavior. To cope with the current situation, we will need a more comprehensive re-look at the financial system -- not just the regulatory process.
Unfortunately, history shows that we are not very good at such comprehensive undertakings. We tend to muddle through, putting out fires as we go. That would lead me to predict more fires -- big and small -- as we go forward, rather than a large scale fire prevention program.
Let us hope I am wrong.
Posted by Ken Jarboe at October 6, 2008 10:16 AM
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