The Macroeconomics of Shadow Banking

Abstract

We propose a simple short-run Post-Keynesian model in which the key aspects of shadow banking, namely securitization and the production of structured finance instruments, are explicitly formalized. To the best of our knowledge, this is the first attempt to broaden purely real-side Post-Keynesian models and their traditional focus on shareholder-value orientation, the financialization of non-financial firms, and the profit-led vs. wage-led dichotomy. We rather put emphasis on the role of financial institutions and rentier-friendly environment in determining the predominance of specific growth and distribution regimes. First, we illustrate the macroeconomic rationale of shadow banking practices. We show how, before the 2007–08 crisis, securitization and shadow banking allowed for an increase in profitability for the whole financial sector, while apparently keeping leverage under control. Second, we define a variety of shadow-banking-led regimes in terms of economic activity, productive capital accumulation, and income distribution.

The Financial Innovation Hypothesis: Schumpeter, Minsky and the sub-prime mortgage crisis

“…In the case of financial firms, as we saw securitized mortgages (MBSs) are used as inputs for the production of collateralized debt obligation (CDOs), a structured financial product that pools and repackage cash-flow generating assets (the collateral). In a similar way to what explains the appetite of entrepreneurs to innovate, the key driver for a financial innovation like securitization has been the opportunity for an increase in profitability for the whole financial sector (Botta et al, 2018). In brief, the "business of banking is a trade-off between the appeal of profits and fear of losses.…”

“…In our reading, financial institutions embodied the novel 'entrepreneur', with the traditional banking sector (on their same side) as the provider of credit. Even though most of the financing through repo agreements 23 (more on this below) took place within the investment banks sector, at the aggregate level commercial banks represented the main external source of funds (see Caverzasi et al, 2018). The weakening and then the demise of the Glass-Steagall Act made the distinction between 'financial entrepreneurs' and 'credit providers' purely conceptual, resulting in the presence of almost fictitious counterparts.…”

“…33 Also, the financing of financial activities became much easier. A measure of this can be found in the chain of repledgement of collaterals in the repo market, which Singh (2011Singh ( , 2012 shows to have peaked before the crisis, and in the sky-rocketing increase in the amount of repo deals by investment banks (see Caverzasi et al, 2018). The boom in production of financial assets is well described by the words of Mike Francis, executive director at Morgan Stanley saying: "We almost couldn't produce enough to keep the appetite of our investors happy.…”

“…38 In addition, another feature securitization that is similar to what happened for previous innovations has been its impact on the relative cost structure, which further promoted the rise of this new 'paradigm'. In fact, going back to the discussion about financial innovation (Section 3.2), and again borrowing the terminology from Perez (2009), this new input a) provided relatively cheap credit, b) was unlimited in the foreseeable future, and was c) all-pervasive in its applications (on these three points see also Botta et al, 2018).…”

Securitization and business cycle: an agent-based perspective

“…A stockflow consistent model that includes securitisation process is developed also by Nikolaidi (2015), pointing out that the combination of risky financial practices with wage stagnation can increase the likelihood of financial instability in a macro system. Moreover Botta et al (2016), following a post-keynesian stock-flow consistent approach (Lavoie and Godley (2012) and Caverzasi and Godin (2015)), provide a model of shadow banking system analysing its impact on the whole economy from a macroeconomic perspective, showing how banks, before the crisis, were able to increase the issuance of mortgages while apparently keeping their financial position stable, leading to an increase in the financial instability and that securitisation process makes legislations on capital requirement not only ineffective, but also potentially counterproductive.…”