Chapter 2. US Shadow Banks Unleashed

Tamim Bayoumi
Published Date:
October 2017
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The rapid expansion in shadow banks that performed bank-like activities such as taking deposits and holding loans but remained outside of the perimeter of bank regulation transformed US banking between 1980 and 2002. These lightly regulated firms, which held much lower capital buffers against financial shocks than the regulated banks, were the main US institutions that ran into trouble over the crisis.

Reflecting US culture, the transformation of the US banking system was both less structured and more entrepreneurial than in Europe. It involved a series of small steps rather than a few major decisions. It started when the competitiveness of the regulated banks—those with deposit insurance and access to Federal Reserve emergency funding—eroded as the rise in inflation in the 1970s interacted with outdated caps on interest rates on deposits and loans. In response, large depositors managing so-called “wholesale” money drifted away from the insured deposits offered by regulated banks to uninsured but higher paying deposits offered by shadow banks. As their funding base narrowed, the regulated banks increasingly bundled safer and more routine loans such as mortgages into securities and sold them to the shadow banks. The shadow banking system expanded to fill a vacuum created by loss in the competitiveness of regulated banks.

This migration of activity from the regulated to the shadow banking system has often been portrayed as a result of excessively speedy financial deregulation driven by self-interested lobbyists.1 While such lobbying played a role in the years immediately preceding the 2008 crisis, the origins of the shadow banking system came from the opposite dynamic, namely the slow response of regulators to strains in the banks. The major components of the shadow banking system all emerged between 1980 and 2002, including mortgage-backed securities, investment banks, money market mutual funds (all of which increased by ten-fold compared to the size of the US economy over this period), and repurchase agreements (which quadrupled).

A dual banking system was already in place by 2002. On one side were the relatively stolid, soundly regulated banks such as Bank of America and Wells Fargo. On the other were the much more dynamic, lightly regulated shadow banks such as Goldman Sachs and Morgan Stanley that (confusingly given that they were called investment banks) were not subject to bank regulations. The regulated and shadow banks were increasingly linked through mortgage-backed securities issued by the two main housing government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, whose assets quadrupled compared to the economy over the 1990s.

These markets and institutions all played major roles in the North Atlantic financial crisis. The prices of mortgage-backed securities plummeted after US house prices started to crumble in 2007. The investment bank groups included Bear Stearns and Lehman Brothers, the two major shadow banks that collapsed in 2008. The market for repurchase agreements froze after Lehman Brothers went bankrupt, depriving the North Atlantic banking system of a major source of cash, while Fannie Mae and Freddie Mac were put into receivership as the crisis unfolded.

The overall outcome was the same as in Europe, with increasing amounts of banking migrating to undercapitalized institutions that could not withstand the shock of the North Atlantic crisis. However, the process by which this change occurred was completely different. To explain how this happened it is useful to understand quite how constrained the US regulated banks were in 1980.

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Inflation and the Rise of a Dual Banking System

The US banking system in 1980 was even more fractured than in Europe. Banks were only allowed to operate within a single state, so that there were effectively fifty separate banking systems. Indeed, in many states banks were limited to operating out of a single branch. In addition, there were upper limits on interest rates banks could charge—deposits rates were limited by national regulations while charges on loans were constrained by individual state usury laws. Finally, the Glass–Steagall Act of 1933 separated these banks from investment banks that operated outside of the federal safety net. The outcome was a large but highly splintered regulated banking sector as well as a small nationwide investment banking industry which handled other peoples’ money but had minimal assets of its own.

This structure reflected the lasting impact of the Great Depression. In popular memory, the national banks of the time had transferred financial instability to the heartland by pulling back from loans to local banks as a result of losses in risky investment banking activities. To avoid a repeat of this experience, regulated banks were kept small, local, and safe, including by being prohibited from engaging in investment banking. The focus was on creating a system that was unlikely to collapse, rather than one that was efficient.

As memories of the Great Depression waned, however, the winds of change started to blow. The rise of inflation in the 1970s initiated a process that undermined the competitiveness of the regulated banks and transformed the banking sector through three interrelated dynamics. Higher inflation and limits on deposit rates reduced the attractiveness of depositing money with regulated banks, and sophisticated investors with large funds increasingly switched their deposits to shadow banks. In addition, limits on lending rates further undermined the profitability of regulated banks, resulting in costly banking crises that led to a hike in capital buffers so as to preserve their financial safety. This further encouraged the expansion of the shadow banks those thinner capital buffers gave them a cost advantage. Finally, these competitive pressures encouraged regulators to dismantle prohibitions on regulated banks engaging in interstate and investment banking, allowing the creation of diversified national banks such as Citi and JP Morgan. Each of these trends had their own dynamics.

The Diversion of Bank Deposits and the Rise in Securitizations

Regulation Q of the Federal Reserve Board, which dated from 1933, limited interest rates that could be offered by banks on deposits. It prohibited paying interest on checking accounts and set upper limits on the rates offered on other types of accounts such as savings and time deposits. The logic of such caps was to discourage banks from exploiting the security provided by federal deposit insurance to offer high rates on deposits and use the resulting cash to make risky investments. The concern was that if these investments did not pan out then the bank would flounder and taxpayers would be saddled with the cost of bailing out the depositors. However, limits on deposit interest rates assumed that inflation remained low and stable. When inflation rose in the 1970s banks were unable to raise their deposit rates to compensate for the faster increase in prices.

The regulators reacted slowly to this loss in competitiveness of bank deposits. It was not until 1980 that Congress amended Regulation Q as part of the Depository Institutions Deregulation and Monetary Control Act, and even this legislation took five years to phase out the caps on deposit rates (checking account rates continued to be frozen at zero). By this time the genie was out of the bottle. Frustrated by the low returns offered on the insured deposits at regulated banks, investors increasingly turned to uninsured deposits offered by the investment banks whose returns were not capped as they were not subject to regulation Q. Ironically, the interest caps that had been introduced with the intention of restricting competition in deposit rates out of fear that that such competition could lead banks to take excessive risks ended up promulgating the growth of the less regulated and riskier shadow banks.

The switch in deposits was particularly focused on large “wholesale” funds that typically deposited sums well above the upper limit on federal deposit insurance. The shadow banks offered two main forms of deposits. Money market mutual funds, where the client bought shares in a mutual fund that invested in safe short-term assets such as government bills and paid interest in a similar manner to traditional deposits. Investors were protected because, if the mutual fund failed to pay interest, they could take possession of the underlying assets. The more complex and popular option for sophisticated investors with wholesale funds was a repurchase agreement, in which assets such as Treasury bonds were sold to the depositor with an agreement to buy back (repurchase) the treasuries at a fixed price at a later time, with the difference between the two prices representing an effective rate of interest. In this case, protection came from the fact that if the shadow bank was unable to repurchase the treasury, then the depositor got to keep it. A discount on the initial selling price of the treasury (called a haircut) provided added security that the depositor would not lose money by making it more likely that the value of the treasury would exceed the value of the cash that had been loaned. The freezing of the repo market after the bankruptcy of Bear Stearns was a crucial driver in the North Atlantic crisis.

The migration of deposits into uninsured deposits led to a massive expansion in the size of investment banks, the institutions at the heart of the shadow banking system, while limiting the size of the regulated banking sector. The regulated banks responded by selling increasing amounts of the loans that they made to their clients to shadow banks rather than keeping them on their books. This was the other half of the dual banking system. Increasingly, the core functions of banking—attracting deposits and using the money to hold loans—were being farmed out to the shadow banks. The trade worked for both sides because the shadow banks held lower amounts of (expensive) capital against these loans, which had the effect of diluting the capital buffers held by the dual banking system against loans.

The regulated banks used securitized assets to sell loans to the shadow banks. In a securitization, the bank took a bundle of loans such as mortgages and sold them to investors in return for cash. The buyers bought the rights to the loans and hence to the associated repayments. In this “originate to distribute” model, the regulated bank acted as a go-between, using their knowledge of clients to originate loans and collect the associated fees but then bundling the loans and selling them to shadow banks. Securitization was supported by the development of ways of tracking the credit-worthiness of borrowers, in particular standardized credit scores. Credit scores allowed the riskiness of loans to consumers—mortgages, car loans, and credit cards balances—to be independently checked. By contrast, securitization was never used to bundle loans to firms, where much greater knowledge of the client was needed to assess viability.

Securitization occurred in two waves. The first was driven by federal housing policy as promulgated through the main government-sponsored enterprises (GSEs). It was aimed at lowering the cost of mortgages by creating a liquid secondary market where such loans could be bought and sold by investors, just as a stock market lowers the cost of raising money by issuing shares in a company by allowing investors to buy and sell shares easily. Such securitizations were relatively safe as the GSEs provided investors with a guarantee against defaults by home owners. Understanding how this came about requires some knowledge of the GSEs.

Safe Government-Sponsored Securitizations

The GSEs originated during the Great Depression as a way to provide relief to homeowners and banks by buying up troubled mortgages.2 As the depression gave way to the more stable and prosperous postwar period, their mission switched from providing immediate relief to the housing market to supporting home ownership more generally. By the 1970s, the housing GSEs were dominated by two corporations. The larger, Fannie Mae, took on its pre-crisis form in 1968 when the Housing and Urban Development Act made it into a for-profit shareholding company under the regulation of the Department of Housing and Urban Development. In addition to supporting home ownership in general, Fannie Mae was required as part of its public mission to devote a reasonable proportion of its mortgage purchases to low- and moderate-income housing. It’s smaller sister organization, Freddie Mac, was created in 1970 by the Emergency Home Finance Act with the mission of helping specialized mortgage lenders, called Savings and Loans, manage the challenges caused by rising inflation and interest rates. Higher interest rates were particularly problematic for the Savings and Loans as almost all of their loans were thirty-year mortgages with fixed interest rates. As inflation drove short-term interest rates upwards, the costs of attracting deposits rose while the income from the typical thirty-year fixed-rate mortgage remained unchanged.

In the 1970s and 1980s, Fannie Mae and Freddie Mac pursued different business strategies. Fannie Mae kept the mortgages it bought on its balance sheet. As a result, its profits got squeezed by higher deposit rates just like the banks that it served. By contrast, given its mandate to help Savings and Loans avoid interest rate risk, Freddie Mac bundled its mortgages into mortgage-backed securitizations that it then sold to investors with a guarantee that the underlying borrowers would maintain payments. In the jargon of the business, Freddie Mac offered a “wrap”—insurance against defaults by home owners. Because it no longer held the underlying mortgages on its books, Freddie Mac was unaffected by higher interest rates and remained profitable.

In the light of these obvious benefits, in the 1990s Fannie Mae switched to the Freddie Mac model of buying mortgages from banks and then selling them to investors with a guarantee on the quality of the underlying loans. Both of the major GSEs became financial intermediaries, buying loans, bundling them, and selling them to investors with insurance. This business model worked because, even though Fannie and Freddie were theoretically private institutions, their close relationship with the federal government led markets to assume that they had implicit government support (an accurate prediction over the 2008 crisis). A thin capital base and favorable borrowing costs gave Fannie and Freddie the competitive edge needed to support the housing market by creating a successful secondary market in mortgages.

The business model also worked because Fannie and Freddie only accepted relatively safe mortgages that conformed to their rules. For example, they put limits on the size of the loan, the minimum downpayment, and on the credit score of the borrower. This made “conforming” mortgages safer and hence easier for the GSEs to insure. The GSEs also insisted that there were no charges for early repayment of loans, so that consumers were not locked into a loan if a more favorable one became available. Since the typical US mortgage was issued over a thirty-year term at a fixed rate, when long-term interest rates fell some borrowers took out a new mortgage and used it to repay the old one—a one-sided risk as higher rates did not induce the opposite behavior. Investors offset this “duration” risk using derivative markets on interest rates, in which (for example) an investor received a payout if bond yields fell below a certain level. This example illustrates how securitization created demand for other complex derivative markets to offset risks.

GSE securitizations transformed the mortgage market. In 1980, most home mortgages issued by banks were retained on their balance sheets. By 2002, they were typically sold to investors via Fannie and Freddie, a change that led to the creation of a national mortgage market and hence housing market. In the late 1980s, New England experienced a regional housing crash in which house prices fell by one-third in real terms after the local economy was hit by a decline in defense spending and greater competition in the information technology sector, causing major distress to regional banks. As securitization led to an increasingly national mortgage market during the 1990s, however, changes in regional house prices became more coherent, a switch that later created the national housing bubble of the 2000s.

To ensure that the market for mortgage-backed securities stayed liquid, Fannie and Freddie had always kept some of their own securities on the books. Over time, however, they increasingly used their ability to borrow money at favorable rates to buy and hold mortgage-backed securities issued by banks.3 Since their understanding of the mortgage market allowed them to hedge the resulting interest rate and duration risks, they were able to make money for their private investors. Over the financial crisis, however, it was the losses from defaults on their holdings of higher paying but riskier “private label” securitizations that forced the thinly capitalized Fannie and Freddie into receivership. It is to this market that we now turn.

Risky Private Label Securitizations

After the GSEs successfully developed markets for securitized assets, a second wave of securitization occurred involving regulated banks selling loans directly to investors. Private label securitizations were the second major trend to come from the erosion in competitiveness of regulated banks. In addition to the caps on deposit rates discussed earlier, bank profitability was also hampered by widespread state-specific usury laws. These laws were designed to protect consumers from predatory lending and to ensure that banks did not take excessive risks that could lead to bankruptcy. As inflation rose, however, these caps eroded profitability of lending and led to a wave of bank failures in the early 1980s.4

The largest and most spectacular of these failures was the 1984 bankruptcy of Continental Illinois National Bank and Trust Company, which was the largest US corporate bankruptcy to that date.5 Despite Chicago’s role as a money center, Illinois was a state that limited banks to one branch. Out of its single branch in Chicago, Continental Illinois managed to become the seventh largest bank in the country and the largest US commercial and industrial lender by attracting large deposits (two-thirds of its deposits were above the insurance limit) and lending the proceeds aggressively to risky borrowers such as energy companies and the Mexican government. Controversially, after Continental Illinois filed for bankruptcy regulators decided to fully recompense deposits above the federal insurance cap (including the 179 banks that had deposits worth more than half of their equity capital) and also bondholders, rather than let them absorb the losses. The bailout of these uninsured lenders caused outrage and popularized the phrase “too big to fail”.

The outrage was compounded by the even larger and costlier Savings and Loans crisis.6 Savings and Loans were a specialized sector that lent for home mortgages using savings deposits. Their deposits were popular with investors because under Regulation Q they could offer slightly higher deposit rates than regulated banks. Savings and Loans failures rose rapidly during the 1970s and early 1980s, however, because their business model was particularly susceptible to rising inflation. Their funding came from short-term deposits while almost all of their loans were in thirty-year fixed-rate mortgages. With bankruptcies rapidly depleting the funds available to support failed banks, the dedicated regulator of the Savings and Loans decided to let the industry grow its way out of its problems by expanding into new types of lending beyond their traditional mortgage business. Unfortunately, just as in the case of Continental Illinois, many of the resulting highly speculative loans did not pan out. The result was a prolonged crisis across the industry. Between 1986 and 1995 almost one-third of the Savings and Loans had to be closed, at the cost of some $160 billion (2 percent of 1995 GDP) including $120 billion in taxpayer money.

The political furor over the cost to taxpayers of the failure of Continental Illinois and the Savings and Loans crisis led to a major tightening of US rules on capital buffers for regulated banks that went over and above existing Basel Committee rules.7 To reduce the potential for costly regulatory forbearance of the type seen in the case of Continental Illinois, a “prompt corrective action” framework was introduced by the Federal Deposit Insurance Corporation Improvement Act of 1991 that required automatic interventions if a bank’s capital fell below certain ratios.8 To be well capitalized and avoid intervention, a regulated bank needed to have core capital that was at least 6 percent of risk-weighted assets (2 percent above the minimum defined by the Basel Committee in 1988) and total capital that was at least a 10 percent of risk-weighted assets (again 2 percent above the Basel minimum).

In an even more important deviation from the Basel approach, prompt corrective action also required regulated banks to hold core capital that was at least 5 percent of total assets. The unintended side-effect was that it created major incentives for regulated banks to bundle safe loans and sell them to shadow banks using “private label” securitized assets. This was because the regulated banks were under the simple leverage ratio which meant that if they kept a relatively safe loan such as a mortgage on their books, they still had to hold 5 cents of capital. By contrast, the investment banks that funded the shadow banking system were subject to a different capital rule that involved much lower buffers on safe loans such as mortgages. Because it was much cheaper for an investment/shadow bank to hold a mortgage on its books than for a regulated bank to do so, there were clear incentives to transfer such loans through private mortgage-backed securities. Indeed, the same dynamic occurred between US regulated banks and their European counterparts after the 1996 market risk amendment allowed the large European banks to use their internal risk models to calculate capital buffers on investment banking. This divergence in capital standards was the genesis of the massive inflows of northern European banks into the US markets over the financial boom of the 2000s.

The wedge in capital buffers between the regulated and shadow banks explains why the regulated banking sector remained roughly constant as a proportion of the economy even as shadow banks boomed. Regulated banks were creating more loans for customers but, rather than keeping them on the books, they sold them to shadow banks. In this “originate to distribute” business model, regulated banks used their superior knowledge of clients to originate loans, but then distributed them to shadow banks. These transactions had no real social value. Rather, they simply exploited differences in capital buffers between regulated and shadow banks. Ironically, prompt corrective action helped to lower capital buffers against bank loans as the tough capital standards for regulated banks were circumvented as they sold loans to lightly capitalized shadow banks. At the same time, the regulated banking sector was going through its own transformation.

The Emergence of National Banks

The final trend coming from the loss of competitiveness of the regulated banking system after the inflation of the 1970s was the gradual creation of large regulated banks as constraints on theie activities were gradually lifted. This culminated in the emergence of a small number of national US banks, including two that expanded into a universal banking model that was more typical of the European mega-banks.

Small banks had remained a dominant presence in US regulated banking sector through the 1970s partly as a result of laws that restricted banks to operate in only one state. These restrictions were initially driven by the revenues that states obtained from selling bank charters. However, the importance of these revenues had dwindled and by the 1970s state banking rules were effectively simply a protection for small banks. By reducing the cost of communication and transportation, however, information technology reduced the benefits from local banking. For example, the introduction of automatic teller machines in the 1970s allowed larger banks to widen their presence without the need to set up branches.9 Political support for state banking restrictions eroded along with the competitive position of small banks. Maine was the first state to allow reciprocal interstate banking in 1978 (out-of-state banks could purchase local banks as long as local banks had the same privilege). The change was initially only symbolic as no other states followed suit, but in 1982 Alaska and (much more importantly given its larger size) New York passed similar laws. A decade later all states except Hawaii allowed interstate banking, and in 1997 the rules were made nationally consistent under the Reigal–Neal Interstate Banking and Branching Efficiency Act. A similar process occurred with intrastate branching. In 1970, only twelve states allowed unrestricted branch banking. By 1994, thirty-eight states had removed such restrictions.

Over the same period, the strongly pro-deregulation Federal Reserve gradually reduced the restrictions on US regulated banks being involved in investment banking. These rules were initially motivated by concerns that banks could have inside information that could undermine the integrity of market transactions. They dated from the 1933 Glass–Steagall Act and had been reinforced in the Bank Holding Company Act of 1956 and its amendment in 1970.10 The relaxation of these rules started in 1987 when the Federal Reserve determined that “Section 20” subsidiaries of three bank holding companies could underwrite some previously prohibited securities as long as the revenue from such activities did not exceed 5 percent of total revenue. In early 1989 this rule was expanded to a wider range of banks and products. The revenue limit was then gradually raised to 10 percent later in 1989 and 25 percent in 1996. At the same time, the Office of the Comptroller of the Currency loosened restrictions on banks’ activities in insurance. By the time Congress formally repealed the Glass–Steagall Act through the Graham–Leach–Bliley Act of 1999 it was largely a symbolic gesture.

The US regulated banking industry thus entered the 2000s unencumbered by limits on interest rates, constraints on location, or prohibitions on engaging in investment banking. The gradual loosening of geographic rules led to steadily larger banks, including three truly national banks, JP Morgan, Bank of America, and Citi.11 These banks grew through a convoluted burst of acquisitions over the 1990s, as restrictions on bank size crumbled. For example, one strand of the origins of JP Morgan Chase involved the merger of Chemical Bank and Manufactures Hanover in 1991, then with Chase Manhattan Bank in 1996, and then with JP Morgan and Company in 2000. Bank of America went through a similar process, acquiring its California rival Security Pacific Corporation in 1992, Continental Illinois Bank and Trust Company in 1994, and then being taken over by NationsBank, another rapidly expanding “super-regional” bank, in 1999 (the group decided to retain the name Bank of America, which was better known). Finally, Citigroup was formed by the 1998 merger of Citicorp and the Travelers Group, a much more diversified financial institution, to form the first US universal bank and spell the effective end of the Glass–Steagall prohibition on mixing commercial and investment banking.

The Dual Banking System

By the early 2000s bank deregulation had shifted the US regulated banking industry from a mass of small banks to a hodge-podge of large and small ones. However, the expansion of market activities that occurred mainly within the universal mega-banks in Europe took place largely in the shadow banking sector, especially the independent investment banks that were already lightly regulated and remained highly competitive. Only two regulated banks moved to a universal banking model by expanding into investment banking, Citi and JP Morgan, and their operations remained relatively limited by comparison to the major independent investment banks. The remaining regulated banks used the new-found flexibility to expand and make their commercial banking operations more efficient. Rather than diversifying into investment banking, they sold increasing amounts of loans to shadow banks.

The repeal of the Glass–Steagall Act in 1999 has often been seen as a key moment in a deregulatory process that led to banking excesses and the housing crisis.12 However, by then the important transformation of the US banking system had already taken place, as the relatively heavily capitalized US regulated banks sold standardized loans such as mortgages to the less capitalized investment banks and other parts of the shadow banking system, thereby undermining the capital buffers behind bank loans. The parallel change on the deposit side was that many large depositors switched to investment banks that offered better returns but without federal insurance. Before discussing the expansion of the investment banks, it is useful to first understand why the US financial regulators did not respond more vigorously to the undermining of capital buffers by the shadow banks.

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Bank Regulators Looking Under the Wrong Lamppost

In stark contrast to the dynamic changes occurring within the banking industry, the structure of financial regulation stayed basically unchanged between 1980 and the 2008 crisis. The regulatory system in the United States was much more complex and splintered than in other major countries.13 This reflected the wider range of institutions involved in the US financial system compared to the bank-centric systems typical in the rest of the world. It also reflected the Roosevelt Administration’s predilection for creating complex institutional set-ups with overlapping powers during the “New Deal” of the 1930s that created most of the regulatory structure.14 Several regulators were responsible for overseeing regulated banks, while the rest (the “nonbanks”) were overseen by different agencies that focused on compliance with rules on behavior rather than financial safety. This sharp split between those who regulated the banks and the nonbanks was what allowed the shadow banking system to mushroom.

Bank financial safety was (and still is) primarily overseen by three regulators.15 The Office of the Comptroller of the Currency is the main supervisor of federally chartered banks while the Federal Reserve primarily oversees the holding companies of the larger and more complex banks that often include nonbank subsidiaries (such as the “Section 20” operations discussed earlier) as well as consumer protection for mortgages. The main job of the Federal Deposit Insurance Corporation (FDIC) is to oversee the deposit insurance system and resolve insolvent banks. The roles of the Fed and the Comptroller are similar—to supervise banks’ capital buffers—albeit for different types of banks (small individual banks versus large bank holding companies). The FDIC has a different focus, namely on the risks and costs of bank failures.

The different regulators makes it cumbersome to change the regulation of US banks, a process that had both disadvantages and advantages over the pre-crisis boom. On the negative side, the sluggish response to the challenges to bank competitiveness as a result of higher inflation supported the expansion of the shadow banking sector and the “originate to distribute” model that failed over the 2008 crisis. On the other hand, the slow response to change was the main reason that the US regulated banks remained relatively sound in the face of international rules on internal risk models that eroded capital buffers elsewhere, especially in the Euro area.

The nonbank half of the regulatory system comprised the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission. These agencies were primarily tasked with overseeing rules on market behavior, such as ensuring that information in a firm’s prospectus is accurately and fairly provided to market participants. Until the crisis, the SEC was also in charge of supervising the investment (non)banks, the institutions at the center of the shadow banking system. This involved enforcing the Net Capital Rule for broker-dealers, the core institutions at the center of the US investment banking groups. The Net Capital Rule required broker-dealers to maintain capital that depended on the perceived riskiness of their assets. Despite the inclusion of the word “capital” and the use of risk-weighted assets, the Net Capital Rule was primarily aimed at ensuring that customers were able to recover their money in the event of a bankruptcy rather than protecting broker-dealers from going broke. Since the rule was not aimed at preserving the broker-dealers from bankruptcy, the SEC did not have the authority that the bank regulators had to conduct examinations or to intervene to ensure that a bankruptcy did not disrupt the payments system. This was a critical difference that became apparent over the North Atlantic crisis after the immediate cessation of trading caused by the bankruptcy of the investment bank Lehman Brothers led to the collapse in many financial market segments.

This splintered regulatory system explains the relatively lax regulation of the investment bank groups. A major weakness of the system was that as the investment banks became increasingly large and influential they continued to be supervised by the SEC when such regulation would have more naturally fallen under the purview of the Federal Reserve, which already oversaw bank holding companies and their associated nonbank subsidiaries. Such a change would have been a major break with the distinction between commercial and investment banking that was hardwired into the US regulatory system via the Glass–Steagall Act. However, this distinction was already blurring in reality as the Federal Reserve allowed bank holding companies more and more freedom to perform investment banking.

The main reason the investment banks continued to be supervised by the SEC was that the Federal Reserve was not interested in the job. The Fed took the strong view that investors were the most effective monitors of the risks taken by investment banks. They saw private monitoring of risk by investors and government monitoring through regulation as alternatives rather than complements. In particular, they were concerned that stronger government oversight of investment banks could be potentially counterproductive as it might reduce the incentives of investors to monitor risk-taking. As Alan Greenspan stated in a speech in 1996:

On the other hand, if central banks or governments effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could be costly to society as well. Leverage could escalate to the outer edge of prudence, if not beyond. Lenders to banks (as well as their owners or managers) would learn to anticipate central bank or government intervention and would become less responsible, perhaps reckless, in their practices.16

In the Fed’s view, regulation (to the extent it was at all valuable) was a cost imposed on regulated banks in return for access to government support through deposit insurance and access to emergency Federal Reserve funds, both of which reduced the incentives for depositors to monitor the underlying health of the institution. Since neither applied to the investment banks, they were left outside of bank regulation.

An alternative view argues that Alan Greenspan and the Federal Reserve understood the risks posed by the financial system, but would have been unable to stop the underlying forces behind deregulation.17 Certainly, Greenspan’s 1998 warnings about “irrational exuberance” in markets suggests he was aware of potential financial risks. However, in the end the view that Greenspan understood the risks to the financial system is not convincing. The Federal Reserve promulgated market discipline as an alternative to government regulation in many fora. Crucially, this included the Basel Committee on Banking Supervision where the Federal Reserve’s firm support for internal risk models was crucial to the disastrous decision to adopt the 1996 market risk amendment. As discussed in the last chapter, European regulators were skeptical about risk models, having agreed to a completely different framework in 1993, building off the existing “bucket” approach to credit risk. It was the Federal Reserve that pushed internal risk models over the finishing line.

The commitment of the highest echelons of the Fed to internal risks models is illustrated by the following passage from a speech to international bank supervisors made by Chair Greenspan in July 1996, soon after the market risk amendment had been released:

The decision to craft bank’s capital requirements for trading activities around accepted and verifiable internal risk measures was an important step in the supervision and regulation of large, internationally active, banks. … Within the United States, the Federal Reserve and other bank supervisors are placing growing important on a bank’s risk management process … We are also working to develop supervisory tools and techniques that help supervisors perform their duties with less disruption to banks.18

Another result of the complex and fractured US regulatory arrangements was that before the crisis no institution was charged with overseeing the entire dual banking system. In particular, there was a split between those who oversaw regulated banks and those who oversaw conduct in securities markets, including the rapidly expanding shadow banks. Fundamentally, as a result of the Fed’s rejection of regulation of investment banks, the US regulatory system failed to modernize as the investment banks moved from bit players holding other people’s money to major cogs in the financial system. Inattention to the risks posed by investment banks helped drive the 2008 crisis. It is to these entities that we now turn.

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Investment Bankers Become Masters of the Universe

Investment banking is a general term used for firms that support financial markets.19 Typical services include the placement of initial equity and debt issues, including assessing the appropriate price and providing a backstop should the issue flop. They also play an important role in creating secondary markets that allow assets to be traded across investors, including providing advice on investment strategies, executing transactions, and assisting in negotiating the terms of mergers and acquisitions.

The essence of investment banking is summed up by the term “broker-dealer”, the legal description of the entities at the center of investment banking groups. The broker side of the equation involves accepting money from investors and placing that money on their behalf in the market. The dealer half of the equation initiates these trades. Together, brokers and dealers take money from individuals and invest it. This is very different from a commercial bank, which accepts deposits at a fixed rate of interest and uses the money to make loans to people or firms.

Broker-dealers are at the center of financial markets as much of their business depended on their smooth functioning. Deep and liquid markets encourage firms to raise money by issuing securities, lower the costs of mergers and acquisitions, and make investment advice more predictable. It also explains why investment banks are interested in creating new products as they would benefit from the resulting transaction fees. No other financial institution has such an incentive to make sure that markets function smoothly. Indeed, choppy and illiquid markets provide opportunities for firms that focus only on making profits from trading, such as hedge funds, as price volatility increases the potential to make money. At the same time, before the crisis the investment banks were largely outside of the rules on safety, soundness, and deposit insurance that had been developed for the regulated banks. This is why they became the center of the largely unregulated shadow banking system.20

The information technology revolution gradually transformed the markets investment banks served. Settlement of trade moved from a cumbersome process involving people and paperwork to lightning-fast deals based on electronic matching of offers, and increasing algorithmic trading dictated by computer programs rather than human dealers. Lower costs of information also ushered in a wider variety of assets, including complex derivatives, and gradually changed the nature and size of investment banking. As costs of trades fell and transactions rose, the potential profits from trading increased. The importance (and pay) of dealers rose while the status of brokers fell. Increasingly, the modestly boring business of looking after other people’s money was transformed into a highly paid and high-stakes business centered around trading their own money. As the balance sheets of investment banks expanded, they became one of the preferred destinations for graduates from top business schools. In addition, as trading became increasingly complicated, the business attracted mathematicians and statisticians or, as popular imagination put it, “rocket scientists” who used advanced mathematic techniques to maximize returns compared to risk. Investment bankers became the “masters of the universe” and were increasingly lauded (or derided) in books and movies.21 This expansion was also aided by the permissive regulatory environment in which (for example) financial derivatives were exempted from federal oversight since markets were assumed to be able to police themselves. In many ways, the markets became a financial wild west.

Lower costs of trading and lax regulations also created the hedge fund industry. 22 Hedge funds were trading firms that used advanced strategies to achieve high returns (and charged fees to match). Since they only used money from high-value individuals who were assumed to understand and be able to handle the risks involved, hedge funds were largely exempt from the laws governing entities that were available to less savvy investors, such as mutual funds. The name, which came from the 1960s, was something of a misnomer as “hedge” funds did not hedge (i.e. reduce) risks. On the contrary, hedge funds generally took significant risks and as a result had a relatively high attrition rate.

Hedge funds were useful to investment banks for two reasons. The first was that as firms that specialized in market trading, they made markets more liquid, thereby making investment banking easier. In addition, hedge funds created much of the demand for new products that investment banks created. The rocket scientists in the investment banks not only invented new trading strategies, they also dreamed up new assets to accomplish such trades. Given this symbiotic relationship, the investment banks increasingly provided hedge funds with cash to supplement their investor equity and finance larger trades.

Not all went smoothly. In particular, in 1998 Long-Term Capital Management (LTCM) had to be rescued.23 LTCM was a high-profile hedge fund whose general partners included a former head of bond trading at Salmon Brothers (John Merriweather), a former vice-chair of the Federal Reserve (David Mullins), and two Nobel laureates in finance (Myron Schoales and Robert Merton). It also returned high profits for the first three years after its formation in 1994. However, by early 1998 LTCM was using huge amounts of borrowed money to bet that emerging market risk-spreads, which had spiked over the Asia crisis, would fall. This did not happen. Rather, they rose after the Russian government declared a moratorium on payments of part of its government debt in August 1998. In early September, LTCM advised the Federal Reserve Bank of New York of its financial difficulties, which led to a rescue financed by its creditors. Tellingly, these were major domestic- or foreign-owned broker-dealers, including Goldman Sachs, Merrill Lynch, Morgan Stanley, JP Morgan, Barclays, and Credit Suisse First Boston. In an interesting plot twist, the only major investment bank to not participate in this rescue was Lehman Brothers, thereby creating a certain amount of animus that may have contributed to the reluctance to rescue it over the 2008 crisis.

Despite this setback, the hedge fund industry continued to prosper. Increasingly, investment banks became go-betweens, borrowing funds from institutions with large pools of cash looking for a safe place to put their money and lending to risky hedge funds and similar institutions. Cash was provided to hedge funds using repurchase agreements (repos) in return for relatively safe assets. These safe assets were then reused to raise cash from wholesale investors through money market mutual funds or new repos. Through most of the period repos were the most important source of investment bank funding. However, this started to change in the late 1990s due to limited collateral for repo deals, which the SEC limited to a small number of safe assets such as treasury assets. As the market expanded the amount of collateral available for repos became a constraint. As discussed in the next chapter, the desire for wider collateral for repos was to be a crucial driver of the crisis.

The business of creating derivative assets that rebundled existing assets in attractive new ways also gradually changed the relationship between the investment banks and the ratings agencies whose job it was to assess the riskiness of bonds. When the vast majority of debt instruments were plain vanilla assets such as corporate bonds, the business of the rating agencies was to look at the characteristics of the underlying firm and the seniority of the debt and provide an assessment of the safety of the bond. As assets became increasingly complex pools of loans, with characteristics determined by their creators, this inevitably generated a closer relationship between the investment banks and the rating agencies because the investment banks needed to understand the ratings models in order to design their products.

This inversion of the relationship between issuers of bonds and the ratings agencies tended to increase market risk for a given rating. As bonds began to be designed with the rating in mind, the investment banks aimed to achieve the maximum possible returns for a given rating by creating products that exploited weaknesses in the links between the rating agency models and the risk as assessed by market prices. In particular, they took advantage of the focus of some rating agencies on the likelihood of default rather than the losses to investors associated with a default. They did this by creating securitized assets as well as more complex derivatives such as collateralized debt obligations (CDOs) in ways that lowered the likelihood of default but increased the losses should default occur (called “waterfall” structures since if you fell, you fell a long way).24 The relatively favorable ratings on such structures allowed investment banks to sell risky loans on the cheap but had little or no social value as they simply reflected deficiencies in the rating system. That being said, this activity can be seen as a consequence of the natural to and fro between investment bankers creating new instruments and the ratings agencies. This contrasts with the typical narrative portrayed in popular accounts of the crisis that views the generous ratings of CDOs as part of a plot between the investment banks and rating agencies to exploit the general public.

* * *

Charting the Transforming US Financial System

The emergence of a dual banking system comprising of both regulated and shadow banks between 1980 and 2002 can be clearly seen in the data. In the early 1980s, the banking system was dominated by small, local regulated banks which kept most of their loans on their books. Securitized bonds and investment banks were bit-players in this landscape. By 2002, the regulated banking industry had been transformed in style if not in size by conglomeration, including the emergence of national banks, and by the widespread use of securitized assets to sell relatively standardized consumer loans to shadow banks while retaining riskier and more complex commercial loans. Securitization and the increasing diversion of deposits away from the regulated banking system (and the associated federal deposit insurance) had fed a massive increase in the size of the shadow banking system. This was epitomized by the growing size of the broker-dealers, the core institutions in the investment banking groups. And beyond the investment banks was an increasing penumbra of largely unregulated hedge funds and the like that focused on trading increasingly complex and largely unregulated instruments.

The size of the regulated banking industry was an area of relative stability within this dynamic environment (Figure 12). While changes in regulation resulted in the emergence of national banks, the balance sheets of private deposit institutions (a description that includes banks, Savings and Loans, and credit unions) as a ratio to US output fluctuated within a relatively narrow band (the size is measured as a ratio to output so as to abstract from the natural increase in the size of the sector as the economy expands due to more activity and higher prices). Although the debacle of the rapid expansion and subsequent contraction of the Savings and Loans industry in the late 1980s is visible, by the end of 2002 assets represented 75 percent of output, almost exactly the ratio at the start of 1980. Furthermore, the basic business model of attracting deposits (the light gray segment) and using them to make commercial loans (the medium gray segment) was largely unchanged. Deposits and loans made up around two-thirds of the balance sheet throughout the period.

Figure 12.Regulated banking did not grow from 1980–2002.

Source: US Flow of Funds.

This apparent stasis, however, masked a profound transformation in the banking system. Regulated banks were making more loans, but the additional loans were sold to shadow banks via mortgage-backed securities (Figure 13). The vast majority of this activity took place through the Fannie Mae and Freddie Mac, the two major GSEs. The amount of mortgage-backed securities that the GSEs issued and insured against defaults rose by almost a factor of ten compared to the size of the economy, from slightly over 3 percent of output in 1980 to almost 30 percent by the end of 2002. Private firms also started to issue mortgage-backed securities. Like the GSEs these private companies took pools of mortgages and sold them to investors, but without an insurance on creditworthiness of the underlying loans that was provided by the GSEs—a crucial difference over the 2008 crisis.

Figure 13.Securitization of mortgages boomed after 1980.

Source: US Flow of Funds.

Securitization transformed the market for residential mortgages (Figure 14). In 1980, banks retained about three-quarters of residential mortgages on their books (the dotted segment) and sold only about one-tenth of them to investors through GSE securitized assets (the black segment)—the remainder being mainly mortgages issued by the federal government through Federal Home Loan Banks. By 2002, banks were only retaining one-quarter of residential mortgages on their books and were selling well over half through GSE and private securitizations (the black and light gray segments). The originate-to-distribute model in which banks originated mortgages and then distributed them to investors that featured prominently in the financial crisis was already in place by 2002. In addition, private securitizations extended well beyond residential mortgages. Similar, if less spectacular, transformations occurred in the multifamily mortgage market (apartments and condos), where banks went from holding over 90 percent of all mortgages on the books in 1980 to holding under two-thirds by 2002, and in consumer loans, where securitization rose from nothing in 1980 to 20–30 percent of the market by 2002. In all, over one-third of bank loans were being securitized by 2002.

Figure 14.Banks sold most mortgages via securitizations by 2002.

Source: US Flow of Funds.

The counterpart to securitization was the diversion of deposits away from the regulated banks to shadow banks. Regulated bank deposits as a ratio to output peaked during the Savings and Loans boom, and then went into gradual decline. This was particularly true of large bank deposits that exceeded the insurance cap. In their place, there was a surge in deposits placed outside of the regulated banking system using money market mutual funds and repos. These uninsured deposits rose from under 10 percent of output in 1980 to over 40 percent by the end of 2002, by which point their size rivaled that of insured bank deposits.25

The major beneficiaries of the increase in nontraditional cash deposits were the investment banks (Figure 15). The assets of the core market operations of these groups, the broker-dealers and their holding companies (called funding corporations), exploded more than ten-fold as a ratio to output, from barely 2 percent in 1980 to well over 20 percent by 2002. The broker-dealers were central to markets. They sucked in large deposits of wholesale cash via repos and money market mutual funds (the medium gray and black areas) and used repos to lend this cash out to firms that traded such as hedge funds (the light gray area). This transfer of funds from holders of cash to traders comprised around two-thirds of assets and liabilities of the broker-dealers by 2002. This link was at the heart of the shadow banking system. The lightly regulated broker-dealers borrowed cash from investors and then lent it out to the even less regulated firms such as hedge funds, which bought and sold securitized assets and derivatives. Indeed, the expansion in the assets of broker-dealers closely mirrors the increase in securitized assets.

Figure 15.Balance sheets of broker-dealers, the core of investment banks, exploded.

Source: US Flow of Funds.

The Rise of National Banks

These shifts took place against a background in which the size of regulated banks expanded rapidly, creating massive institutions with a national reach (Figure 16). As in Europe, the regulated banking industry went through a period of mergers and acquisitions in the 1990s that created a small number of dominant institutions. By 2002, the three regulated banks, Citicorp, JP Morgan, and Bank of America, had aggregate assets of almost one quarter of the economy, well over twice the size they were in 1989 (dark gray segment). The average size of these banks rivaled those of the (more numerous) European mega-banks. By contrast, the ten or so other regulated banks that figured in the largest thirty US financial institutions remained at about the same size as a proportion of output.

Figure 16.Emerging national banks became increasingly important.

Source: SNL.

The large US regulated banks retained strong capital buffers throughout this period. All of the major regulated banks had equity buffers of over 5 percent of unweighted assets in 2002, in stark contrast to the experience of the Euro area mega-banks. This was because the simple leverage ratio that was part of prompt corrective action limited the ability of large US regulated banks to reduce capital buffers by manipulating risk weights from internal risk models. Within this group, capital buffers tended to be somewhat lower at the two emerging universal banks, Citi and JP Morgan, that followed the European model of combining commercial lending and investment banking under one roof, because prompt corrective action only applied to their commercial banking operations.

While the number of regulated banks was thinning, the booming US investment banking industry was attracting new entrants. The investment banking industry had always been more concentrated than the regulated banks, reflecting fewer regulatory constraints and the greater economies of scale that came with market trading as opposed to making loans to individual customers. The assets of the five main independent investment banks mushroomed five-fold from 1989 to 2002, rising to 20 percent of output. At the same time, however, the sector was becoming more diverse as US and European universal banks entered after the repeal of the Glass– Steagall prohibition on regulated banks owning investment banks.

Competition was putting pressure on the smaller independent investment banks. While Morgan Stanley and (at the time) Merrill Lynch were much larger than their rivals, the smaller independent investment banks (Goldman Sachs, Bear Stearns, and Lehman Brothers) were competing with the investment banking arms of the two major US universal banks and similar offshoots of several European universal banks (such as Deutsche Bank from Germany and Barclays from the United Kingdom, as well as Credit Suisse and UBS from Switzerland) that were backed by large commercial banking operations. It was the second tier of independent investment groups, which lacked the deep pockets of the market leaders or the more stable backing of the universal banks, that got into trouble over the financial crisis.

The two main GSEs, Fannie Mae and Freddie Mac, had also become major financial players by 2002. As they increasingly used their low capital buffers and favorable cost of borrowing to issue bonds and use the proceeds to buy securitized loans, their combined assets had risen to 15 percent of the economy in 2002, quintupling since 1989. This expansion was a distraction from their fundamental role in the financial system, which was to accept conforming mortgages, securitize them, and charge banks for providing insurance on the creditworthiness of the loans to investors.

The rapidly expanding investment banks and GSEs had much thinner capital buffers than the regulated banks (Figure 17). At 2 to 5 percent of assets, their equity cushion was similar to those exhibited by the major European universal banks (although different accounting rules muddy the comparison).

Figure 17.GSEs and investment banks had thin capital buffers in 2002.

Source: SNL.

* * *

The US Financial System in 2002

In 2002, the US financial industry had taken on most of the characteristics that were to be seen over the crisis but remained relatively sound (Figure 18). Securitization and uninsured deposits had led to a massive expansion in the shadow banking system centered around the investment banks. Increasing amounts of mortgages created by regulated banks were being securitized and sold to shadow banks, reflecting the incentives coming from differences in regulation. However, the market for home mortgages securitization (by far the largest part of the market) were dominated by the two main housing government-sponsored enterprises, Fannie Mae and Freddie Mac, who were limited to securitizing relatively safe “conforming” mortgages and who provided guarantees on the credit-worthiness of the underlying loans. While these two entities were increasingly exploiting their low funding costs by issuing debt and buying their own securitized assets, these products had many other willing buyers. The riskier private label part of the mortgage-backed securitization market, which lacked insurance on the creditworthiness of the underlying loans, was still only one-sixth of the size of the GSE pools, a proportion that had only crept up slowly since the early 1990s.

Figure 18.Structure of US banking in 2002.

Within the regulated banking sector, changes in rules had allowed the creation of three major national banks even as the aggregate size of the industry had remained relatively constant. While two of these mammoths had moved toward being universal banks, with part of their business in investment banking, the trend was not being followed by others and the industry as a whole remained focused on deposits and commercial loans. The market for deposits was also changing, with an increasing proportion bypassing federal insurance. New deposit instruments were generally most attractive to managers of wholesale funds whose deposits were typically above the limits to qualify for deposit insurance. However, since these had not been insured in the first place, there was limited reason to be concerned about the diversion to shadow banks.

Within this relatively benign picture, however, were three areas for concern. The first was the rapid expansion of the lightly regulated investment banks. While it was true that investment banks had never been regulated for safety and soundness, the explosion in the size of the sector boosted the potential risks to the financial system from a failure. Assets of the broker-dealers at the core of the investment banking groups had increased steadily from just 2 percent the economy in 1980 to 10 percent in 1990 and over 20 percent by the early 2000s. The risks to the investment banking industry posed through financing reckless market behavior were well illustrated by the rescue of Long-Term Capital Management, which had managed to amass over a trillion dollars in assets on a narrow capital base. When it collapsed, the investment banks had to band together for a rescue.

The second area for concern was the increasing participation of rapidly growing European universal banks in US markets. These firms further supported the expansion of investment banking and derivative markets and also provided a conduit to European banks to buy securitized assets with which they were less familiar. Between 1980 and 2002, foreign ownership of corporate bonds (which included securitized assets) doubled to one-tenth of the size of the US economy.

The final area of concern was the acceleration in house prices. After a long period of stable house prices in the early 1990s momentum in the housing market was gradually accelerating. By the end of 2002, house prices (as measured by the yet-to-be-invented Case Shiller index) were rising by almost 10 percent a year even as inflation remained quiescent and real house prices had already risen by one-third compared to their nadir in early 1993.

None of these trends made a crisis inevitable. Indeed, it is relatively easy to think of policies that could have prevented these trends from magnifying over the coming years. The failure to reign in these financial excesses reflected misguided regulatory decisions on both sides of the Atlantic, largely driven by a misplaced belief in the power of market discipline of investors to limit risk-taking by major banks. This dynamic is the topic of the next chapter.

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