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Shadow Banking

2012 Financial Markets Conference

April 2012

An interview with Paul McCulley, chairman for the Society of Fellows of the Global Interdependence Center and former managing director at PIMCO

Mark Jensen: So we have Paul McCulley here with us. He's the former managing director of PIMCO and now the current chairman of the Society of Fellows of the Global Interdependence Center. He's here with regards to the shadow banking session. Paul is notorious for having coined the term "shadow banking," and he credits that to the start of the money market mutual funds. So, there's a lot of proposed regulation with regards to money market mutual funds. What steps do you think have to be taken by regulators in order to ensure the safety of the money market mutual funds and also to kind of reduce the overall systemic risk associated with them?

Paul McCulley: Lots of questions there in that one question… clearly, the money market mutual fund, that 2a-7 fund as it's known here in the United States, is the bedrock of the shadow banking system. And particularly, the institution-only money market mutual funds. When money market mutual funds first came in, way back in the 1970s, they were an arbitrage around Regulation Q for the retail investor. Regulation Q capped the amount that individuals could get on their deposits or their savings accounts at banks. So therefore, the retail investor, the retail bank customer, wanted to have something just as good as an FDIC [Federal Deposit Insurance Corporation] or FSLIC [Federal Savings and Loan Insurance Corporation], a savings and loan insured deposit, but wanted to have a market rate. So originally, there was the arbitrage around Regulation Q, which is really what the shadow banking system is about, is arbitraging around some regulation. Over time, money market mutual funds morphed into where they are now and predominately money market mutual funds are driven by wholesale investors now who want to have an asset that is diversified against a portfolio of collateral held by a money market mutual fund, because, as we know, FDIC insurance is only up to $250,000.

The money market mutual fund industry is a huge industry and poses massive systemic risk to the system because it's subject to runs, because it's not just as good as an FDIC bank deposit. We found out that in spades in 2008 and ultimately, Secretary of Treasury Hank Paulson had to use the foreign exchange stabilization fund to create a FDIC-like insurance wrapper to put around money market mutual funds to stop the run. And to me, that was proof positive that money market mutual funds should not exist in their current form. They should not exist in their current form.

We've seen tightening of guidelines for what money market mutual funds can do on the asset side of their balance sheet, but for me they are a sitting duck for a run in a crisis. Now I know money market mutual funds will tell you that crises don't happen very often. They provide a wonderful service to the large-scale investor who doesn't want to be undiversified in uninsured deposits. So I understand all of the arguments of the money market mutual fund industry. But the bottom line is they pose severe systemic risk in a crisis and the fact of the matter is, is in the last severe crisis, the Treasury had to step up and provide them deposit insurance.

Now as a practical matter, it didn't last very long, and defenders of the current system will say, "And the Treasury made money on it," but to me that does not cut the mustard. The fact that, in extremis, the Treasury secretary had to use the foreign exchange stabilization fund to put a full faith and credit wrapper around the money market mutual funds, tells me they should not exist in current form. Most importantly, they should not be allowed to have at-the-buck pricing, which comes about through accrual accounting or book value accounting, because as long as they have the reputation in the marketplace—Gary Gorton has written beautiful stuff about this—as long as they are marketed as just as good as a bank deposit then, effectively, ex post the government will have to treat them like a bank deposit. And if you're going to be treated in good times like a bank deposit and not pay deposit insurance, but get deposit insurance in bad times, then it's a bad system.

So I think that we should have fundamental change, including, most importantly, having floating net asset values [NAVs]. Now many will say that will not stop a run if you get into a crisis, and actually I think there's an element of truth to that. That in a crisis there's a run on everything except dollar bills and canned green peas. However, the fact of the matter is, that if you're going to get ex post protection from we the taxpayers, then you should ex anti pay a fee for it. And if you're not going to, you should have floating NAVs, which will reduce the size of the footings in the industry. It will be reintermediated back into other products. So I actually am not warm and fuzzy, as you can tell, about the money market mutual fund industry as it currently exists and given the fact that I'm retired, I now have the privilege of saying that publicly.

Jensen: Well, thank you. You mentioned that it was Reg Q that really was what the money market mutual funds were trying to get around. When we look at the shadow banking industry, the proposal is to have more regulations. That's been the response to the financial crisis. More regulations, as a result, cause kind of pushing things into the shadow. Do you agree that more stringent regulation is going to create a larger, more hidden shadow banking market? And if yes, how do you overcome that?

McCulley: I don't think more regulation necessarily leads to a more shadowy shadow banking system. Actually, I think we need to have more regulation. But I think fundamentally we need to have an understanding of the nature of the system, which is that the shadow banking system will always exist unless we have unlimited bank deposit insurance, and now we've moved up from $100,000 to $250,000. As long as we don't have unlimited deposit insurance at banks, we will have a shadow banking system.

However, we should have sufficient regulation so that the shadow banking system can't control the outcome in a crisis. Meaning, we need to have regulation that prevents a repeat of 2008 where the shadow banking system has access ex post to the full faith and credit of Uncle Sam because systemic risk is so severe that there is no other choice. And, actually, I'm reasonably optimistic that we will not face another 2008 for an extended period. We don't tend to repeat the same mistakes quickly in our system. We tend to repeat the same mistakes, but it takes time to build up the excesses that lead to the crises such as 2008.

So I don't worry about an immediate crisis of growth in the shadow banking system, which I think is a perfect time to put the clamps down on the separation between conventional banking and shadow banking, because you can do it now without creating tremendous adverse effects on the overall system. You can't reregulate in a crisis. You have to reregulate post the crisis and try to batten down the boundaries between what is and isn't protected by Uncle Sam. So at our conference here, I have shared some of the pessimism, but also I have probably a greater than average a sense of optimism that we will go for an extended period, I think, without another crisis because we just had one.

I think crises are a function of the longevity of regulatory arbitrage, and regulatory arbitrage is human nature. Any parent with teenage children knows that they will be "arbed" against. So, to rule out regulatory arbitrage would be to rule out human nature, but you don't tend to get mean, nasty, nefarious outcomes right after a crisis. You need to have time since the last crisis for memories to fade, and, in fact, that was the essence of Hyman Minsky's financial instability hypothesis, in that stability, time ultimately breeds instability because the further time you are away from your last crisis the less that last crisis is vivid in the memory, and more risk seeking financial agents and economic agents become. And I think Hyman was right, and 2008 proved him demonstrably right. That stability does beget instability in the fullness of time because it begets ever more risky data arrangements. But it takes time, so actually time is on our side, I think, right now.

Jensen: So initially with the shadow banking industry, people felt that that provided cheaper credit. You know, better access to credit. Do you see the successor to the shadow banking of the past being able to provide the credit that the economy needs to be able to continue to grow, or is shadow banking just something we should always be mindful of in a negative sense?

McCulley: I don't think we should necessarily be mindful of shadow banking always in a negative sense. Shadow banking is where regulatory arbitrage comes about, but regulatory arbitrage itself requires a fair degree of innovative thinking. I think innovation has a role in our system, so I don't have a blanket viewpoint that shadow banking is at all times everywhere a nasty thing.

In fact, I can come up with an example of shadow banking that really didn't have a deleterious effect in 2008, and that was hedge funds with very long lockups on their liability. So hedge funds are shadow banks that are levered up intermediaries, but by having long lockups on their liabilities, then they weren't part and parcel of a run because they were locked up. Now, in some situations they got caught in nasty situations and did fire sales of assets, and so forth, but at least they weren't subject to runs in the way that a money market mutual fund would be. So I don't think that shadow banks at all times are bad. Where they're bad is when they get close enough to bank deposits that, in extremis, the government has to treat them like bank depositors. So therefore, they get to free ride on the safety net in bad times and not pay for it in good times. And that's the real negative, I think, of shadow banking.

Through your direct question about cheap credit, cheap credit is not at all times and all places a good thing. I'm a big believer in the democratization of credit so it's not just rich people that can get credit. At the same time, I'm also a believer in the notion that there are some people born to be renters, not homeowners. Effectively, what we did as a country, not just with the shadow banking system, but as a country with Freddie and Fannie, and so forth, is to turn everybody into a homeowner. And some of our citizens were destined to be renters for their life and if you force them into a home and they should be renters and ultimately it comes a cropper. Is it their fault for having taking the loan for a house they couldn't afford, or is it we as a society saying you should be a homeowner or else you're not a full standing citizen? So I think it's a bigger question. Is I think, that affordable credit on a fair basis to society does make sense, but cheap credit to every human being that carries an American passport is not necessarily a god-given or a constitutional given right that we can have some discernment, if you will, in the notion of democratization of credit.

Jensen: Well, thank you, Paul, we appreciate your time and your attendance at this year's conference.

McCulley: My pleasure.

Jensen: Thanks.