Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.
Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a selffulfilling and destructive run on its liquid liabilities.
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.
A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire
SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.
The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.
The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.
http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html"The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers"
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