Shadow banking system and macro-economic regulation
The World, and the US in particular, are facing a serious risk of deflation as individuals and corporations reduce their excessive debt/leverage all at the same time. Ben Bernanke, the Chairman of the Federal Reserve, explains why in this case, the central banks have to work with the treasuries to fight this risk. We also look at why the successive rate hikes have failed to curb the bubbling demand for credit: the answer is called shadow banking system.
Ben Bernanke, May 2003, about the different roles of a central bank in inflationary and deflationary times, taking the example of Japan:
"The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say "no" to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty"
Lack of regulation in the "Shadow Banking System" caused Fed rates hikes to become ineffective in reducing the demand for credit
Paul McCulley, Managing Director at PIMCO explains:
"Shadow Banks are levered-up intermediaries without access to either FDIC deposit insurance or the Fed's discount window to protect against runs or stop runs. But since they don't have access to those governmental safety nets, Shadow Banks do not have to operate under meaningful regulatory constraints, notably for leverage, only the friendly eyes of the ratings agencies.
The bottom line is that the Shadow Banking System created explosive growth in leverage and liquidity risk outside the purview of the Fed. Or, as I said here last time in November 2007, again playing the wonk, Shadow Banking both (1) shifted the IS Curve to the right and also (2) made it steeper, or less elastic, if you will. In such a world, Fed rate hikes had little tempering effect on the demand for credit, or if you prefer, little tightening effect on financial conditions.
And so it came to pass with the Fed hiking the nominal Fed funds rate to 5¼%, double that which I had forecast in May 2004, as financial conditions refused to tighten in sympathy with the Fed's desire. "
Similarly, the demand for credit didn't restart when the Fed reduced its rates to zero after the bubble has burst. One lesson we should learn from this crisis is that for regulation and monitary policy to be efficient, regulation has to apply to all the major players, not only the traditional ones.
Ben Bernanke, May 2003, about the different roles of a central bank in inflationary and deflationary times, taking the example of Japan:
"The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say "no" to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty"
Lack of regulation in the "Shadow Banking System" caused Fed rates hikes to become ineffective in reducing the demand for credit
Paul McCulley, Managing Director at PIMCO explains:
"Shadow Banks are levered-up intermediaries without access to either FDIC deposit insurance or the Fed's discount window to protect against runs or stop runs. But since they don't have access to those governmental safety nets, Shadow Banks do not have to operate under meaningful regulatory constraints, notably for leverage, only the friendly eyes of the ratings agencies.
The bottom line is that the Shadow Banking System created explosive growth in leverage and liquidity risk outside the purview of the Fed. Or, as I said here last time in November 2007, again playing the wonk, Shadow Banking both (1) shifted the IS Curve to the right and also (2) made it steeper, or less elastic, if you will. In such a world, Fed rate hikes had little tempering effect on the demand for credit, or if you prefer, little tightening effect on financial conditions.
And so it came to pass with the Fed hiking the nominal Fed funds rate to 5¼%, double that which I had forecast in May 2004, as financial conditions refused to tighten in sympathy with the Fed's desire. "
Similarly, the demand for credit didn't restart when the Fed reduced its rates to zero after the bubble has burst. One lesson we should learn from this crisis is that for regulation and monitary policy to be efficient, regulation has to apply to all the major players, not only the traditional ones.
Another regulatory issue to be addressed is the problem of "too big to fail" companies. Since they know they will be saved in case of trouble, they have an incentive to take more risks and have a competitive advantage compared to their smaller rivals. In order to balance this advantage, regulation should impose on them stricter rules of financing. Such a penality would also discourage them to become too big.
