Shadow Banking and its Implications for monetary reform John N. Howell 2/7/2020 What are Shadow Banks? Shadow banks are financial entities which do things much like banks do. Under a variety of names, they borrow and they lend. The difference is that banks take in “deposits.” In particular, banks take in “demand deposits” from their customers, who can demand cash by withdrawing their deposits at any time. This makes banks depository institutions. Shadow banks are not. An example of an entity engaged in shadow banking is one that offers money market mutual funds (MMFs). These funds do not take in deposits. Money goes into MMFs through the purchase of shares, which pay dividends, not interest. MMFs in turn invest the money they receive when people, or institutions, buy their shares. The investments are typically in short term securities of various kinds. Other examples of entities in the shadow banking system are investment banks, mortgage lenders, insurance companies, hedge funds, private equity funds and payday lenders. They all borrow and lend, but because they are not depository institutions they are not regulated as banks are. What do shadow banks do? Among other things, shadow banks extend credit. This is the essential feature of shadow banking that is related to the money system and to monetary reform. Banks use shadow banks to support their liquidity. As banks lend, liquid assets (cash) decrease on their balance sheets and the value of illiquid assets (loans) increases. In order to continue to lend, banks must replenish their supply of liquid assets. They do this by borrowing. One form of this borrowing is to take in additional deposits made by bank customers. Another form of borrowing is from other banks, either other commercial banks or the central bank (the Federal Reserve banks in the US). In addition, it turns out that banks support their liquidity (and maintain reserve requirements) by borrowing from shadow banks, like MMFs (McMillan, The End of Banking, 2014). Do shadow banks create money? It is now clear that lending by banks creates new money (McCleay, M. et al., https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy.) Authorities disagree, however, about money creation by shadow banks. McMillan, in The End of Banking (2014), argues that shadow banks do create money. The book describes a process by which money originated by banks during lending goes into shadow banks, such as MMFs, and is then lent back to banks to increase their liquidity to enable further bank lending. It goes like this. Someone buys shares in an MMF. The MMF can lend that money to a bank. The process is arcane. The MMF will make a loan to a bank in the form of a “repo.” A repo is a loan which is very short term, but can be rolled over serially, making it into a longer-term loan. Repo lenders typically require the borrowing bank to put up collateral, in case the bank becomes unable to repay the loan. As collateral some kind of security is offered. It could be a US Treasury bond, but what can also be used is an “asset backed security” (ABS). ABSs are created by banks out of loans they have made. That means that the asset is backed by those loans, which are presumably being faithfully repaid according to their own loan terms. With the loans now converted to securities on the asset side of the bank’s balance sheet, those securities can be offered as collateral for the loan the bank wants to get from the MMF. Money “deposited” in an MMF (through buying shares) is as fully liquid as money deposited in a bank checking account, and it is claimed as money. That is, it is included in M2. So, when the MMF lends, it is creating money as well as creating credit and debt, as McMillan argues. According to McMillan, this repo lending manipulates the balance sheets of banks while increasing the money supply - by actually creating new money. Richard Werner, on the other hands, argues that only banks create money and that shadow banks do not. In 2014 Werner published a paper entitled “How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking” (International Review of Financial AnalysisVolume 36, December 2014, Pages 71-77). In it he presents tables of balance sheets of banks, non-bank financial institutions, and a non-financial corporation. These figures show different accounting systems used by banks compared to other firms with regard to lending. Lending by banks is shown to create money, through the creation of new deposits by the bank for the use of the borrower, just as McMillan illustrates. Werner, however, shows a different system for non-banks. When non-bank firms, including non-bank financial institutions, make a loan, the loan is shown as an asset on the asset side of the balance sheet, just as in the case of banks, but when the loan leaves the firm, a new deposit is not created. Rather a negative entry goes into the asset side. Werner is explicit in saying that this analysis applies to shadow bank firms, firms that are not banks. Another way to understand this is that when a nonbank disburses a loan, its bank account drops by the amount of the loan, meaning that the money supply does not rise. When a bank makes a loan, no one’s bank account decreases in value; no balance statement shows a decrease to offset the money supply increase when the loan gets deposited in another bank. In a paper with the promising title of “Do shadow banks create money? Financialisation and the monetary circuit” 2016 (https://www.onlinelibrary.wiley.com/doi/full/10.1111/meca.12149) Jo Mitchell seems to lean toward Werner’s view with the following statement. “…the accumulation of claims in the shadow banking sector logically relies on the prior creation of money claims by the ‘traditional’ banking sector (Page 33).” The author goes on to say, “In gaining access to a ‘warehousing’ facility for debt claims, the monetary circuit is able to escape the confines of production and serves to both accommodate and reinforce rising income inequality, increasing concentration of wealth, and inflation of asset prices,” good reasons for thinking about reform. Implications for monetary reform. Monetary reform seeks to transfer money creation from the private sector, banks, to the public sector, government. The basic argument is that 1) with government creation of money, new money could be directed to projects which increase the production of goods and services necessary for our time, such as efforts to address climate change, healthcare, infrastructure and education, and 2) government creation of money would decrease debt, both public and private, and eliminate the component of inflation resulting from the extraction of money from the real economy into the financial sector through interest payments arising from the creation of money as debt. One approach to monetary reform is illustrated by the National Emergency Employment Defense Act, introduced into Congress in 2011. It ends money creation by banks; it ends government borrowing and sets up a mechanism within the Treasury Department for determining the appropriate rate which Congress can spend beyond its revenue from taxes by using newly created money. Another approach, that of McMillan (2014), is to make an accounting rule change that would apply to both banks and non-banks. This change would end money creation throughout the private sector. The new accounting rule would be that no firm could have financial assets (loans outstanding) in excess of its equity. It would effectively eliminate leveraging, that is, borrowing in order to relend at higher interest rates. McMillan argues that the NEED Act approach is well intended, but, because it applies only to banks, it will not stop private money creation in the shadow banking sector. Proponents of both of these proposals argue that radical change, which both of these proposals represent, is necessary to prevent breakdown of the current economic system and to permit the direction of resources so as to address the challenges of the 21 st century. There are other proposals currently receiving some attention, such as Modern Monetary Theory (MMT). MMT focuses on government creation of money, but fails to address ending the private creation of money. This raises questions about the potential consequences of these two proposals. In The End of Banking McMillan avoids any discussion of how his recommended accounting system change might be imposed. Nor is there any discussion of the consequences of elimination of shadow banking or of how transition might occur. The NEED Act, as a bill already vetted and submitted to Congress, does provide a mechanism of implementation, namely Congressional approval of the bill, and addresses the transition from privately created to publicly created money. What can be said in response to McMillan’s criticism that the NEED Act would not solve the problem of private creation of money because it applies only to banks, and not to the shadow banking system? This is what McMillan refers to as the “boundary problem.” This question needs more analysis and research. The NEED Act is bound to have an effect on bank lending, including lending to and by other financial firms, such as shadow banks. Would it be enough to address the boundary problem? A major effect of the NEED Act would be to end government bailouts of banks. It is argued that under the NEED Act, failure of a bank of any size would no longer threaten the payments system. Payments will be done out of transaction accounts which are held in bailment by banks but no longer appear on bank balance sheets. The deposits held in bailment would not belong to the bank and would be backed up by the government. If one bank fails, the transaction accounts which it is managing are simply transferred to another bank. This is equivalent to have one’s checking account in a government-owned central bank, a proposal now being considered in Sweden and elsewhere in Europe under that name, “Central Bank Digital Currency.” The current guarantee of bailouts for banks presents a moral hazard. Banks can engage in high risk lending because the government ultimately assumes the risk. This will end under the NEED Act. Banks and their investors will bear fully the risks of their lending. How will that change lending behavior? Will the NEED Act end the securitization of loans and their packaging as ABSs and collateralized debt obligations (CDOs)? Securitization is a way banks currently use to pass the risk of their lending on investors who buy securities which banks create out of the loans they make. Could this continue under the NEED Act? Could banks continue to make bets on securities by insuring securities through the purchase of credit default swaps (CDSs), again passing on the risk to firms willing to sell insurance? Could banks loan to shadow banks which would multiply that money through serial lending, and feed more bubbles, like those of mortgage lending prior to the 2007 crash or of the current stock market bubble? A feature of the NEED Act that raises this question is the provision of the Revolving Fund. The Revolving Fund gets funded by the payment of loans extended by banks prior to the imposition of the NEED Act. Under the current system, as loans are repaid, that money disappears, and the money supply is decreased. The money supply is currently maintained through the balance between money creation via lending and money disappearance through repayment of loans. Upon transition to the NEED Act all circulating money will be US money, subject neither to creation by bank lending nor to disappearance by repayment. Repayments of old loans, which will have become new, US money, will go into the Revolving Fund within the Treasury Department. The banks will still collect the interest on the loans, but loans repaid will no longer disappear and will not go the banks. They will go into the Revolving Fund. The NEED Act specifies that this Revolving Fund money can be made available as loans to government under emergency conditions and to banks to support their liquidity, if it is needed. The Revolving Fund is specified as under the control of the Secretary of Treasury. The terms of such loans are not specified. It is perhaps possible to imagine a Treasury Secretary very friendly to the banking industry who might make these loans available under conditions that would allow banks to lend into the shadow banking system. If that were to occur, the projected benefit of the NEED Act to reduce debt, at least private debt, may be impaired. Credit guidance. An approach to this problem is that of credit guidance. Credit guidance has been exerted in various ways by governments, typically to promote lending to business ventures and to limit other lending, such as mortgages for existing assets. Lending to businesses engaged in the production of goods and services stimulates the economy and contributes to increased standards of living. Lending for the purchase of existing assets, such as property, does not contribute to increased standards of living, but typically drives up asset prices, such as occurred the housing bubble that led to the 2007-8 crash. The history of credit guidance is reviewed in a 2018 paper by Bezemer, Ryan-Collins, van Lerven, and Zhang (https://www.ucl.ac.uk/bartlett/public-purpose/publications/2018/nov/credit-where-its-due), along with an analysis of the effects credit guidance has had on where bank loans have gone. They show that, historically, credit guidance has been used effectively to increase the share of credit going to business. They also show that, in the absence of credit guidance, banks favor lending for the purchase of existing assets. They do so because the risks are less. With existing assets there is typically good collateral. That may not be the case lending to business ventures. The types of credit guidance described by Bezemer at al. include a variety of mechanisms. They include requirements that certain sectors receive favored treatment in terms of amount of credit or interest rates. They also include overall limits on credit extension and the use of state banks to direct credit to publicly desired ends. Another approach to credit guidance is more specific rules. In a paper entitled, “Proposals for the banking system” (https://www.huffpost.com/entry/proposals-for-the-banking_b_432105) Warren Mosler proposed some very explicit bank regulations intended to stop lending from going into speculative ventures within the financial sector. His proposed regulations include requiring banks to keep loans on their own balance sheets rather than securitizing them, prohibiting banks from having subsidiaries, here again to prevent banks from holding assets off their own balance sheets, prohibiting the use of financial assets as collateral for loans as is done in the repo market, prohibition of lending off-shore, and prohibition of buying or selling credit default insurance. These would seem to be effective in ending the practices that led up to the 2007-8 crash. Critics of bank regulation are quick to point out that banks find ways around regulations. Such considerations lead to the kind of radical change in the banking system proposed either by the NEED Act and by McMillan. Conclusion: With regard to creation of money it appears certain that the shadow banking system contributes to the expansion of credit and debt, and that some components, such as MMFs, also create money. More analysis is required to know how the NEED Act would or would not affect shadow bank activity and whether additional credit guidance of some kind might be needed to achieve the desired effects of the Act. More analysis is also needed in predicting the consequences of a transition into the use of the accounting rule change proposed by McMillan

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