Who Knows What Secrets Lurk In the Hearts Of Bankers?

Mike Rorty (whom we’ve met before in the comments) has what I think is his first “post” at the Atlantic Monthly’s business blog, about the shadow banking system.

We hear a lot of chatter about the shadow banking system and its crucial role in the financial crisis. But rarely do we find time to step back and ask the basic questions: What is shadow banking, where did it come from, how did it operate, what role did it play in this crisis and how do we deal with it going forward?

So he interviews economist Perry Mehrling about the subject (which interview forms the substance of the post).

I agree with Mehrling’s core point:

Where I put my finger on this is that what AIG was doing when they were writing insurance on AAA CDO tranches was writing systematic risk insurance. This is insurance that they could never pay.

His solution to this problem is to create an “insurer of last resort” that would be analogous to the Fed as “lender of last resort” – a Federal entity that would provide systemic risk protection at appropriately high prices.

I feel like calling for such an insurer leaves out the most important question – namely: what’s the price for access? If you want your deposits insured by the FDIC and you want access to the Fed window, you submit to a variety of Federal banking regulations that, among other things are designed to limit the amount of leverage you can pile up. These regulations don’t work perfectly – anyone remember the S&L crisis? The Latin American debt crisis? – but they do work to a considerable to degree or nobody would have bothered creating the shadow banking system to get around them. So: what’s the price of access to the Federal reinsurer? Who would it regulate? How?

It seems to me that the problem of regulating entities that have access to such a reinsurer of last resort is not terribly different from determining the minimum capital you have to hold against a slice of exotic structured risk. Why, after all, should anybody be in the business of insuring specifically against systemic risks? They shouldn’t, right? Because nobody can afford to pay. Which means the goal is to prevent people from slicing out the systemic risk and leveraging it up. Which means imposing capital rules that make it uneconomical to try to do this. Which isn’t easy, but it seems to me that’s the real challenge, not figuring out how to get Fed liquidity into the right hands.

I agree with Mehrling that we don’t actually want to get rid of the shadow banking system – among other things, it would mean getting rid of things like money market funds that Americans have gotten very used to and generally think have added real value to their lives. But fixing it means getting the regulatory architecture right before talking about providing reinsurance of “last resort”.