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