Shadow banking system and runs on commercial paper –

Paul McCulley, managing director of Pimco, said there was a “run on the shadow banking system”.

Financial Times columnist Tony Jackson commented in a column on August 27, 2007 "[t]he originators of risk - hedge funds, private equity, investment and commercial banks - are not in the business of holding [risk]. That job falls to investors who are prepared for the long haul."

The concept of a bank run is an effective analogy for the current problems in money markets. The securitization market has become the surrogate banking system because banks have turned into “merchants of debt”. Holding loans locks in a spread with risks for a set time. There is more money in the fee business of packaging loans which turns over bank capital than holding loans. Packaging is a more efficient use of capital, but to perpetuate the fees, the banking system has to find others who take on the role of banks. This could be money funds, hedge funds, or other banks. This accessing of new funds outside the banking system created a lending bubble which carried along housing. It is not the other way around.

The assets on the balance sheet of these shadow or surrogate banks are at best illiquid or at worse worthless, yet the funding source is still highly liquid. They have short maturities which have to be rolled. Money market funding is not like sticky deposits. When the “ shadow bank” misunderstands the concept of liquidity and take for granted that short-term funding can be rolled, there is a potential for crisis. This potential is realized if the funding source decides that the underlying collateral is worth less.

We are seeing the results of a run with the decline in CP outstanding, but it seems as though this is being funneled back onto the bank balance sheet. The banks are playing the critical role of the “lender of last resort”. Unfortunately, there ability to play this role is limited by their capital. Yet, there has not been a significant decline in spreads. New funds cannot be attracted to fund the shadow system fast enough to lower spreads. This financial intermediation is to some degree outside the realm of the Fed, and this will be the number one policy issue for banking. How can there be placed better structure around this shadow banking system.