Wednesday, July 14, 2010

Another Excuse: Shadow Banks

“One important reason” for the magnitude of the recent crisis, Federal Reserve Chairman Ben Bernanke told a Dallas audience on April 7, was “that the subprime mortgage market was closely linked to a broader framework for credit provision that came to be known as the shadow banking system…. The innovation underlying the shadow banking system was that it helped provide a wide range of borrowers indirect access to global credit markets” (my italics).

On May 6, Treasury Secretary Timothy Geithner told a commission investigating causes of the crisis that “Failure to give regulators enough legal power and the growth of a shadow banking system were behind the eruption of the financial crisis…. [L]oosely-regulated non-bank financial firms had grown to a size nearly equal to the traditional banking system.”

Who are these shadowy lenders outside the control of regulators and therefore able to bring the system down? So far as I can tell from the discussions of Bernanke, Geithner, and others, they are simply the nonbank financial intermediaries that have always been with us, and, as in other developing economies, have tended to grow faster than commercial banks. The figure shows the percentage of commercial bank assets relative to those of all financial intermediaries (including banks, savings and loans, credit unions, and insurance) in the U.S. since 1900, based on data in the references below (Goldsmith, Boyd and Gertler, and Mishkin). Geithner’s belated recognition of the “problem” is an understatement. Textbooks on “money and banking” have long considered, and often been titled, “money, banking, and financial markets,” with extensive treatments of nonbank financial intermediaries (NFIs). An example, is, Ritter and Silber, dating from the 1970s and now in its 12th edition.

So if the shadow banking system (NFIs) is not new, what’s their point? It’s apparent that they are using shadow banks as an excuse for policy failure – not for the first time. In the 1960s and 1970s, NFIs were cited as a reason for the impotence of monetary policy, inspired by Goldsmith’s data (see the figure) that showed the considerable relative decline of commercial banks since 1900. If most of the credit system is outside the Fed’s control, monetary policy must be irrelevant, argued proponents of the New View of banking and credit, who also denied the special characteristics of commercial banks. “The distinction between commercial banks and other financial intermediaries has been too sharply drawn,” James Tobin (1963) wrote. “The differences are of degree, not of kind [and] have little intrinsically to do with the monetary nature of bank liabilities.”

That leaves fiscal policy the Keynesians said. Keynes’s (1936) definition of money had been loose, applying to short-term assets in general rather than to the medium of exchange, and therefore, his followers alleged, could not be controlled. Anyway, they said, prices were due to the wage- and cost-push of unions and monopolists rather than money. These views coincided with the Great Inflation that lasted from the effective end of the gold standard in the early 1930s to the early 1980s, during which the U.S. price level rose eightfold.

The turnaround of monetary policy in the 1980s followed the rejection of Keynesianism, including the New View. Critics of the New View pointed out that the monetary nature of their liabilities gave banks unique leverage over total credit since all transactions, including financial transactions, are carried on through money (Guttentag and Lindsay 1968; Wood 1970). Money is important, Milton Friedman and Anna Schwartz (1963) argued. That inflation is a monetary phenomenon, which the Fed can control, was accepted in the 1980s and successfully applied throughout the developed world. It was again agreed that price and financial stability follow from stable monetary policy.

NBIs are not unimportant, but the vital roles of money and commercial banks have not changed. And neither has the principal cause of financial crises – bad bank loans.


John Boyd and Mark Gertler. “Are banks dead or are the reports greatly exaggerated?” Federal Reserve Bank of Minneapolis Quarterly Rev., Summer 1994.

Milton Friedman and Anna Schwartz. A History of Monetary Policy in the U.S., 1867-1960. Univ. of Princeton Press. 1963.

Raymond Goldsmith. Financial Intermediaries in the American Economy since 1900. Princeton Univ. Press. 1958.

Jack Guttentag and Robert Lindsay. “The uniqueness of commercial banks,” J. Political Economy, Oct. 1968.

J.M. Keynes. The General Theory of Employment, Interest and Money. Macmillan. 1936.

Frederic Mishkin. The Economics of Money, Banking, and Financial Markets. 7th ed. update. Pearson Addison Wesley. 2006.

Lawrence Ritter, William Silber, and Gregory Udell. Principles of Money, Banking, and Financial Markets, 12th ed. Prentice Hall. 2009.

James Tobin. “Commercial banks as creators of ‘money’,” in D. Carson, ed., Banking and Monetary Studies. Irwin. 1963.

John Wood. “Two notes on the uniqueness of commercial banks,” J. Finance, March 1970.