Shadow Banking

The term “shadow banking” conveys a sense of darkness and illegality. However, that is not an accurate description of what is 21st century market-based banking. “Shadow banking” has become a popular description for credit intermediation outside the regulated banking system but, in many ways, it is highly misleading. Since the GFC, regulators are keenly watching what is going on in this sector of finance – the shadows that we know about, pretty much always on the right side of the law, have powerful spotlights pointing at them. The trick, however, is knowing where to point the spotlight and being able to figure out the significance of what is revealed.

In session 10 we shall examine the essence of market-based banking which combines both securitisation and collateral management. Conceptually, we already know how to “securitise” cash flows – we did that back in Session 4 by applying PDV/DCF techniques to, for example, regular mortgage payments. Now we look at actual examples and track the history of mortgage-backed securities (MBS) since the 1970s. Specifically, we look at the rise of Fannie Mae and Freddie Mac. Together with Ginnie Mae, these government-backed agencies dominate US housing finance and comprise at least 60% of US shadow banking.

Although Fannie and Freddie got into trouble, requiring both to be formally “adopted” by the Government (the official term is conservatorship), the main problem area in the GFC swirled around so-called private-label MBS. These were securities generated by loans that did not meet the relatively high standards of Fannie and Freddie. Such loans feeding into the private sector machine were either large, lacked key documentation or were dependent on borrowers with poor credit history (the infamous sub-prime sector). Another problem was the excess complexity of structured mortgage-backed securities. These were securities that involved slicing and dicing; apparently creating AAA credits out of mish-mashes of cash flows. Blinded by poor science and tainted by misaligned incentives, it was not long before the alchemy was caught out.

Policymakers have clearly been chastened by the GFC but the enthusiasm for securitisation and shadow banking remains intact. Rightly so, such activities have the potential to improve access to finance – encouraging growth and better living standards. But there is still an enormous amount of work to do to acquire information and understanding of what is going on in a rapidly evolving sector. Even on relatively narrow definitions, shadow banking is probably already larger than it was at the time of the GFC. Regulators are trying hard to keep pace but they are always going to be hard pressed to identify where the problem areas are. Back in the early 2000s, asset-backed commercial paper was the darling of the shadow funding sector. But that form of private sector money has long fallen out of fashion. Do we know where to look now? China’s huge shadow banking sector, Facebook, Google, Amazon, private equity, leveraged loans, maybe insurance companies, CCPs?

The problem in pinning down future financial risk arguably has parallels in international military conflicts. When former US Secretary of Defense, Donald Rumsfeld, was briefing journalists in 2002 on the flaky evidence linking Iraq to weapons of mass destruction he provided this epic quote:

…as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones

6 Nov 2019

Capital Punishment

We learnt in Session 7 that banks – for all their power and swagger – are not that profitable, especially on RoA measures.

Now combine that with a key message from Session 5 – high returns are unlikely if you are not prepared to take risk. Low risk, low returns. No pain, no gain.

But here’s a paradox. Banks give us low returns but they are decidedly not “safe”. In bad times, they are risk on steroids, as was evident in the GFC.  So how do they get away with it?

Of course the answer was addressed in Session 1. Money and banking are society’s beating heart and breathing lungs. The modern world cannot function without finance. Love it or hate it, we have to live with it.

Little wonder, then, that State involvement in, and support for, finance is huge. Partly that is to temper any abuse of monopoly power. It also acknowledges that a well functioning finance system delivers essential social benefits. We do not expect governments to make huge profits out of policing and national defence. Why should we expect banks to do any better in delivering utility money, credit and payments services?

Session 7 revealed another twist. Well meaning safety nets for the banks can generate moral hazard – making banks riskier than warranted. As citizens we want protection from financial catastrophes. But do our efforts, through all those explicit (and implicit) public subsidies make catastrophes more likely? This dilemma is nothing new. Roosevelt was well aware of the problem when deposit guarantees were introduced in the 1930s. The trick is getting the right balance through smart social contract design.

So what shall we focus on next? Our review of commercial banking has frequently underlined the critical importance of liquidity and capital. Do not default, do not go bust. In the upcoming session we shall not say much more about liquidity (the Bear Stearns episode spoke volumes about the havoc that illiquidity can wreak and we have space later on in the course to talk more on improving liquidity positions). Rather, for now, our attention will focus on capital risk.

We touched on this topic before in Session 6, noting that broken promises are not the only means by which vital capital is eroded. To fix ideas, we shall consider three major sources of capital risk:

  • operational risk … especially cyber risk but also covering litigation costs, rogue traders, etc
  • credit risk … the chances of defaults and poor recovery rates and what can be done in the way of protection
  • market risk … the problems arising from interest rate and currency volatility when balance sheets are not “properly” balanced. This leads us into gap & duration analysis and the wonderful world of derivatives, hedging and speculation.

With so many risks to capital it is easy to lose sight of the big picture. This is where Value at Risk (VaR) models, stress tests and market-based metrics such as SRISK come in useful. Then again, with any modelling exercises, you need to avoid the danger of “garbage in, garbage out”. So we take the opportunity to unpick some accounting methods and assumptions that could lead us astray (contingencies, netting and marking-to-market).

Tracking back to credit risk, we already know that it poses major headaches for banks. Tackling credit risk requires lots of information-gathering efforts, smart contract design and, above all, ample capital buffers. So, you might be wondering, why don’t banks do what the rest of world does when faced with risk (falling ill, house burning down, smartphone screen cracking)? Specifically, why don’t banks just get insured?

Good idea… and one that several banks came up with in the 1990s. However, only one persevered with the concept, JP Morgan, who developed the so-called Credit Default Swap in 1994 – primarily as a tool for controlling risk, so persuading regulators that less capital buffers would be required.

The full story has been expertly written up by Gillian Tett in Fool’s Gold. The book provides an excellent perspective on the Great Financial Crisis and touches on a number of themes we are covering in our course:

  • Europe’s significant participation in the development of credit derivatives and associated issuing vehicles
  • how the Greenspan Fed was persuaded by the powerful Wall Street lobbying machine to view credit derivatives as a rationale for light-touch regulation in the new millennium (an approach also backed by New Labour, under PM Tony Blair)
  • the transformation of credit default swaps into a means of speculation, so lifting global systemic risk to dizzying heights
  • how stodgy, risk averse, institutions (AIG, Deutsche Bank) got infected by the hype; hubris and nemesis following in quick succession

Tett notes that, by 2006, as US house prices turned and underlying sub-prime problems burst into view, some (but not all) Wall Street players and regulators were getting cold feet. But, by then, the genie was out of the bottle; bulls and bears were battling it out, adding to the trading frenzy. The CDO (collateralised debt obligation) machine was in full gear and speculators pounced on the new “doom” indices that could be tracked and traded in huge amounts.

Complex derivatives combined with misaligned incentives, a toxic mix: the rest is GFC history.

23 Oct 2019

Many Unhappy Returns

Banks have always operated in dangerous conditions. As we discovered in Session 5, risk is all around us. And toughest of all, we face radical uncertainty. You don’t know what you don’t know. The Medicis in Renaissance Italy knew a thing or two about risk as well as the symbiotic links between money, banking and power. Certainly they understood that being small was not beautiful. For diversification reasons alone, you need to spread your wings, and spread them far.

But even the savvy of the Medicis did not prevent their demise as the 16th century approached. Italy’s domination of European finance ended, showing that even financial behemoths can come badly unstuck. It was a lesson echoed many times in the centuries that followed, not least our own.

Through the 20th century, megatrends such as globalisation, deregulation and financial innovation contributed to a huge expansion of banking activity, traditional and “shadow”. Financial knowhow accelerated with the help of rocket science and whizzy new derivative products. All-powerful, all-knowing Masters (and Mistresses) of the Universe were strutting the streets of London and New York.

After the dotcom “blip” Wall Street attention moved to the most important tangible asset on the planet, property. Surely, with all that sophistication and mathiness the world of finance could do a great rebuilding job for Joe Public. The democratisation of capital reaching out to impoverished borrowers. Sub-primers who, hitherto, could only dream of ever buying their own home. The politicians salivated, the money wheels turned. This was Nirvana.

Of course, with the benefit of hindsight it was a horrible example of pride before a fall; hubris followed by nemesis. As the GFC dust settled, serious failures of judgement – business and ethical – came to light.

And yet, despite all that risk – exogenous and endogenous, we learn in Session 7 that the returns offered to investors (both before and after adjusting for leverage) appear pathetically low. In looking at measures of profitability we need some more tools: RoE, RoA, NIM. We discover that RoE is a particularly popular metric but very misleading for the unwary. A key takeaway is that business performance, especially in banking, is not simply about returns. The risks taken to achieve those returns are critical. For that reason we shall also look at asset quality metrics such as non-performing loan ratios, charge-off rates and the so-called Texas Ratio. Equity market signals also provide useful insights – we pay special regard to price-book ratios as a way of tracking market confidence in banks’ business models.

On a more optimistic note, efforts have been made since the GFC to improve some of the key fundamentals – notably more liquidity and more (and better) capital. However, it is worth maintaining a broad historical perspective. For sure, banks are doing a better job than they were 10 years ago. But, in comparison with the liquidity and capital reserves held 50-150 years ago, the record looks far less impressive.

In the UK, for example, the liquid assets ratio was around 10 times larger in the 1960s than it is now. Also median leverage ratios were much higher.

As for the US, a similar pattern emerges. For example, the FDIC’s Thomas Hoenig webpage contains information on the US leverage ratio since the 1860s (the chart below). In a later session, we assess the adequacy of the current global reform program (Basel III). That program seeks a few percentage points more on capital ratios, amongst many other reforms.

Brave new world? Or just lamentably unambitious? When critics like Admati & Hellwig and the Minneapolis Fed chief are calling out for far higher leverage ratios, in the 20-30% range, you can hopefully now appreciate where they are coming from.

16 Oct 2019

US leverage ratio

Liquidity & Capital Watch

Session 6 will reiterate the now familiar twin mantras: do not default, do not go bust. And we repeat a banker’s to-do list that involves gathering more information, diversifying, smart contract design, keen risk pricing together with plenty of capital and liquidity buffers.

Around a decade ago, the global financial system went into meltdown. What seemed so shocking at the time was that, despite the apparent sophistication and smartness of modern banking, the financial system proved tragically fragile and vulnerable.  In 2011 a senior Chinese central banker reportedly said to Lord King (former governor of the Bank of England)

“We in China have learnt a great deal from the West about how competition and a market economy support industrialisation and create higher living standards. We want to emulate that… But I don’t think you’ve quite got the hang of money and banking yet.”

The GFC was partly bad luck but, in finance, as in many walks of life, you make your own luck. Risk is typically endogenous not exogenous.

We shall learn that the property reversal from 2005 onwards was the GFC trigger, but the problems went much deeper

  • excessive leverage
  • poor liquidity management
  • reduced lending standards
  • misinformation & misaligned incentives
  • flawed rocket science
  • regulatory weaknesses
  • limited legal powers to resolve failing banks
  • contagious networks
  • doom loops (positive feedback mechanisms)

If you have not done so already, I recommend dipping into The Economist’s survey of past financial crises or the wonderful book by Rogoff & Reinhart, This Time Is Different: Eight Centuries of Financial Follies. As the FT’s Martin Wolf has commented, “This Time Is Different” are the four most dangerous words in finance.

You will notice that many of the GFC problems we list are common features in many past crises. The narratives vary but the underlying themes are remarkably similar.  So why do we keep making the same mistakes, over and over? Human foibles – greed and fear – play their part. Certainly, the ancient Greeks warned about hubris and nemesis, and yet many centuries later, the trap is still catching the unwary.

On the theme of human irrationality, the 2017 winner of the Nobel Prize in Economics, Richard Thaler has broadened our understanding. He makes a brief appearance in the following Big Short clip, with Selena Gomez, to describe one particular GFC folly (the synthetic CDO). Enjoy – and don’t skip the awesome interplay with the CDO manager; believe me, these sort of people really do exist!

9 Oct 2019

Risk Is All Around Us

We now take a big step forward in our money and banking journey. “Safe” is in short supply; even if attained, “safe” can disappoint.

Debt instruments, even if issued by top quality credits such as the US government, can suddenly lose value if the interest rate environment goes sour (the Fed unexpectedly tightens by raising the fed funds target, for instance). And if you have to liquidate that asset sooner than planned, then that loss will have to be crystallised, maybe a large amount if you are sitting on long-dated bonds. It’s one manifestation of what we call market risk (there are other types we review later on in the course).

Knowing that in advance means that, before buying, investors will want higher yields the longer the maturity of the US government’s debt (both to cover for likely Fed tightening and for the anguish of living with such risks). Indeed, the US Treasury yield curve typically slopes upwards, unless there are recessionary rumours brewing.

Market risk is also present in the equity market. Recall that with equity there are no promises in the first place and that, with a high probability, prices will display roller-coaster features at times (specific, maybe even market, risk on steroids).

With debt, there are legally-binding promises but that does not mean that the borrower always delivers. Bonds can be unnervingly surprising at times! It’s what we call credit risk. We shall look at a number of examples by examining yield spreads against “gold-plated” US and German government paper. Banks, companies, even governments themselves can wobble – in terms of perception if not reality.

Managing risk is an important task, not just for banking professionals, but in our own daily lives. So we shall introduce concepts such as diversification (including hedging), together with supporting quantitative tools, notably covariances and correlations. We put theory into practice with a portfolio visualizer site. Other (free) tools you might find interesting include Fin Wiz and Sector SPDRs.

1 Oct 2019

Shadow Money

We have already learnt that money can take on many shapes and sizes. At any one time several monies can happily co-exist, even within a single jurisdiction. For most advanced economies, especially the US, top-quality money – the best that money can buy – is issued by the State (either coins, typically minted by the Government or bills and electronic deposits issued by the central bank). Such money is ultra-safe since it is directly supported by the promise of the State. If you can’t trust that promise then what hope is there?

However, we have also discovered that top-quality money is in relatively short supply. Most money, even as conventionally defined, is issued by the private sector – in the form of commercial bank deposits. These deposits are not quite as safe as high-powered money (aka the monetary base) especially if balances exceed the FDIC guarantee limit. However, for the many retail customers who are under the $250k limit, bank deposits are effectively a State promise and so, rationally, can be considered safe.

But for wholesale customers, such as cash-rich companies, there are risks in holding large pools of commercial bank deposits for which there is little compensation. US Treasury bills and bonds offer safe havens but, again, supply is insufficient to match demand and the yields on offer are skimpy.

This is the primary reason why shadow money – and the banking apparatus that supports it – is, and always has been, so large. The private creation of money-like instruments to supplement commercial bank deposits and government debt is legal, useful and huge. Across the three main sectors we focus on – commercial paper, money market mutual funds (MMMFs) and repos (repurchase agreements) – we shall find thriving multi-trillion dollar industries. Of course, the GFC dented shadow business, but it was not a killer blow.

Needless to say, private shadow money is not as safe as the monetary base. When the economy is in good shape shadow money is regarded as good as conventional money, arguably better since it offers higher interest rates. However, as brutally demonstrated during the GFC, the presumption of safety can be shattered in bad times leaving a sad pile of broken promises. Little wonder then that huge chunks of financial activity – built on “safe” quicksand – quickly tumbled into crisis.

In our introduction to shadow money we spend extra time talking about repurchase agreements (aka repos). One angle we shall probably not have time for is how, against the spirit – if not the letter – of accounting law, repos can be used to “window-dress” balance sheets; to make them look less leveraged than they really are.

Needless to say, Lehman Brothers provides a great example of what repos should NOT be used for – to mislead regulators, trading counterparties and investors. But they were used for that purpose, and Lehman’s sleight of hand was roundly condemned when the post-mortem took place. You can read the story here and here. This “loophole” was reportedly closed although suspicions often resurface about new forms of chicanery.

Our session on shadow money will also cover bonds – longer-term promises. Strictly speaking, bonds are not money – you cannot buy your weekly groceries with bonds. But a few agile moments with a smartphone could readily turn bonds into “cash” (market liquidity) or act as collateral for borrowing “cash” (funding liquidity). Bonds can reasonably be viewed as quasi-money and certainly play a leading role in the shadow money and banking world.

In dealing with money market instruments and bonds we need some technical expertise in calculating interest rates and yields. Along the way we learn about

  • the inverse relationship between asset prices and yields
  • the heightened price sensitivity of assets as duration (maturity, length of borrowing) increases
  • that a safe asset (the promise is kept) is not necessarily a risk-free asset; market risk can be especially painful for holders of long-term promises;

We shall use discounted cash flow (present value) methods to price credible promises. A key insight here is that a promised cash flow can be viewed as an income earning asset. That promise could start off as an OTC loan but it could also readily spawn the creation of an exchange-traded security. Mortgages provide an excellent example.

This, and our following session on risk, are amongst the most technical of the course. However, while some of the material is tricky, please persevere with it. The lessons learnt will be invaluable – not just for this course but for navigating your personal financial future!

25 Sep 2019

Money, Banking & Alchemy

In our preliminary discussions about banks and balance sheets we shall learn something new about money. Trust remains central, not least our trust, as bank customers, that electronic deposits are safe. And yet you may well feel that something fishy is going on. Banks appear to create money out of nothing. In a sense, because balance sheets balance, deposits (money) – liabilities of a commercial bank – are backed by assets, notably the loans that commercial banks make. But then those loans can be risky and banks are often locked into contracts that mean they cannot necessarily call in those loans at a moment’s notice. In contrast depositors can shift or withdraw their deposits very quickly. Deposits are meant to be safe and liquid. Loans are typically much less safe and illiquid. It makes money and banking seem like a form of medieval alchemy: a magical transformation of base metals into gold.

Well, you are right to feel uncomfortable. Money and banking is a form of alchemy except textbooks like to give it more “scientific” descriptions such as risk and maturity transformation. In fact, the former Governor of the Bank of England, Mervyn King, has written a book on the issue called “The End of Alchemy: Money, Banking and the Future of the Global Economy“. It is an excellent book and I highly recommend it. Your textbook authors, Cecchetti and Schoenholtz, also give the book high praise in their blog article, Making Banking Safe.

18 Sep 2019

Money Matters

Our introductory session on money highlights a number of points, including

  • money as symbolic of civilisation: the dominance of voluntary, commercial exchange over violence; the emergence of respect for the rule of law and property rights
  • the State (democratic or autocratic) has always played a huge role in supporting the “moneyness” of money
  • money is typically an IOU (though there are exceptions) and so fundamentally depends on trust

By way of illustration, a little-known ceremony in London – dating back to the 13th century – takes place each year. So, in addition to taking a look at the above video, check out the following references if you’re still not convinced that money is steeped in history and politics.

History of the Trial of the Pyx Royal Mint website
Have you ever seen a £1,000 coin? BBC News, 1 Feb 2017

Needless to say, the lecture will cover more contemporary examples of how the State uses money and its supporting infrastructure not just to achieve core objectives such as financial and monetary stability but also to help enforce the law and pursue foreign policy.

Money comes in many shapes and sizes: physical or digital, privately or publicly issued; widely or narrowly available; and with transfer systems that can be centralised (“traceable” bank deposits) or decentralised (“anonymous” peer-to-peer bitcoins). Textbooks generally focus on money that is an asset for the holder with a corresponding liability somewhere else in the system (a central bank if it is dollar bills or a commercial bank if it is an electronic bank deposit).

However, popular interest – but not participation – is currently engaged by new, disruptive, quasi-money. Bitcoins, like many of their cryptocurrency rivals and other commodity-style moneys, are not the liability of anyone else. It can all get rather confusing. As such, I highly recommend you read a recently published article from the BIS (Bank for International Settlements) which contains some illuminating “flower” visualisations.

Money Flower: Taxonomy
Money Flower: Taxonomy
Money Flower: Examples
Money Flower: Examples

The article also discusses

  • issues that central banks need to consider, should they decide to introduce their own cryptocurrencies
  • some key technical drawbacks with the blockchain system (which is just one type of distributed ledger technology)


Like any product, money has its price. Indeed we shall unveil four prices to choose from. One is the exchange rate and we shall take the opportunity to review currency markets and how not to get confused by foreign exchange quotations. As we look at the grand historical sweep of global currencies over millennia we shall see once more that power, politics and money are inextricably linked.

8 Sep 2019


Welcome to London – still a top global financial centre, despite Brexit uncertainties. I look forward to meeting you all soon.

The world of Money & Banking remains as controversial, disruptive and surprising as ever. We are just over ten years on from the Lehman Bros bankruptcy; a defining moment in a defining period of 21st century history – the so-called Great Financial Crisis (GFC for short). As we shall discover, the impact on day-to-day finance is still very much with us and there are plausible concerns that another major shock could be around the corner.

Our course will touch on many contemporary issues; placing them in historical and political context.  I make no apologies in revisiting medieval, even earlier, periods to illustrate core concepts that remain deeply relevant. Politics also figure largely since governments, autocratic and democratic, work hand-in-hand with finance to maintain order and preserve power. As both Lenin and Keynes preached, debauching the currency is the quickest route to social revolution.  While the media gets excited about Russian influence on election results, consider whether it matters compared with the power of the finance lobby.

Romance, popular culture and finance are similarly embraced.  Renaissance Italy’s Monte delle doti, Shakespeare, Hamilton and his hip-hop sidekick, Wizard of Oz ,the return of Mary Poppins,  plus numerous Hollywood renditions of the GFC; all Money & Banking at heart.

Of course, I would be remiss not to balance the Arts with the Sciences. So there will also be some maths, psychology, statistics, and other technical analysis to help unravel underlying themes.

Do not worry if you have limited academic experience of finance and associated disciplines. It is not required as the course begins with basic principles before gearing up. Like a rollercoaster ride, the trip starts slow… teasing you for the fun to follow. So just keep riding, hold on to your seats and, above all, enjoy!

We start our first session with administrative issues which should take about 30-40 minutes:

  • course overview and syllabus
  • textbook and online resources
  • attendance, registers & class etiquette
  • office hours
  • session formats & student presentations
  • assessment and grading

The remainder of Session 1 will focus on the Financial System and its three key components: Institutions, Instruments and Markets.

Finance offers indispensable contributions to society and the economy:

  1. running the payments system
  2. matching lenders and borrowers
  3. lifetime wealth management
  4. dealing with risk

For these reasons, money, other forms of debt, banks and financial markets have been essential building blocks of civilisation for millennia. Finance, including derivatives, go back to pre-Christian times and plays a central role in the wealth of nations and the rise in living standards. Financial revolutions generally preceded Europe’s industrial revolutions over two centuries ago. It was finance that built, and destroyed, great Empires. Just over a decade ago, a bank won the Nobel peace prize just before the global financial system started plunging into meltdown.

Finance is ingrained in human culture – art, drama, literature, old and new. Are we impressed that “A Lannister always pays his debts“? And what are your thoughts about Gordon Gekko, 1980s Hollywood villain, who infamously preached that greed is good?

Modern society needs finance; we cannot exist without it. But we have to take the rough with the smooth. Finance can go horribly wrong; history is littered with systemic crises. The GFC is just the latest, but surely not the last, example of catastrophic global underperformance.

The main conceptual learning objectives for this session are to flag several key themes that will be examined more deeply in future meetings:

  • Finance is a mirror of the human condition; joyful and productive moments tainted by cheats, irrationality, instability and illusions
  • Crises are irregular, tough to predict and, all too often, chaotic – displaying unnerving, amplifying doom loops
  • Risk is omnipresent and is aggravated by globalisation and innovation; it takes on many guises. Risk is generally disliked and, even if recognised, is not always properly managed
  • Wall Street is Main Street and vice versa;  the worlds of finance and the “real” economy are inseparable, especially when it comes to real estate
  • Finance is a force for both good and evil. Society needs finance but, too often, we overindulge and succumb to financialisation
  • Banks (and related financial companies) do not always add value; sometimes they just reshuffle existing assets and, in so doing, can actually destroy value
  • Modern finance reflects the Jeckyll & Hyde impacts of globalisation, regulatory overhauls and technological innovation; in our digital age, value is even harder to establish, exacerbating volatility and risk
  • Banks (and money) can take many different forms; simple or complex, transparent or “shadowy”
  • Finance, old and modern, involves a mutually beneficial public-private partnership that can sometimes backfire

No specific technical skills will be introduced at this stage although students will be expected to have a rough idea of so-called “safe” assets, the role of banks as producers (not simply intermediaries) and the nature of principal-agent problems.

For class prep, in addition to looking at the above video, I recommend this introduction from the Association for Financial Markets in Europe (AFME). Also take a look at this blog article about the connection between banks and nuclear reactors.

29 Aug 2019