Shadow Banking 2.0

(… I still owe you an in-depth analysis of this graph referring to our country:

presented here , but at least I told you where to find the algebra that relates net debt to net foreign position:

that is, in equation (3) of this paper by Obstfeld, which interests us for other reasons as well, namely because it is a competent refutation of the thinking of Trump's economists. The trend of the stock of net foreign assets does not coincide with the cumulative trade balance because, as some of you have highlighted, it is also necessary to take into account capital gains, that is, variations in the prices of both assets and liabilities.

All correct and all interesting, but now, in our vain attempt to anticipate Murphy's law and its corollaries, I wanted to comment on a passage of today's report by Savona in the meeting with the markets at Piazza Affari …)

Speaking on June 20th at the traditional meeting with the markets, the president of CONSOB, known and dear to you, Prof. Paolo Savona, said, among other things, that:

"the analogy that is being established with the roots of the 2008 financial crisis due to the spread of complex derivatives that contained credits that were difficult to repay ( subprime ) cannot be ignored…"

In my opinion, however, it escapes most people, and it could also escape us here, because we have never discussed it in detail. It is time to do so, because this analogy belongs to the group of things that are best dealt with, before they deal with us!

Another is certainly the decoupling between private debt and "productive" investments (gross fixed capital formation) highlighted in the latest OECD report on debt:

but this phenomenon does not surprise us that much, because it is the direct practical consequence of a theoretical model that we analyzed here .

On the other hand, we have dealt less with "virtual" finance, even if in Goofynomics, the liber scriptus in quo totum continetur , it was discussed anyway. In this regard, it was the report of one of you, Davide Sarti , that made me aware of an article ( DeFi: Shadow Banking 2.0 , by HJ Allen) that I then used to prepare this speech:

The search for financial innovations that allow one to escape the constraints and costs of financial regulation (at the cost, however, of exposing those who adopt them to a certain risk) are the basis of shadow banking , which Allen defines as the set of financial activities or transactions that are functionally equivalent to those conducted on regulated banking markets but which (thanks to innovation) escape banking regulation.

A common feature of these activities is their complexity, which, as you may have understood, is also typical of DeFi (in fact, I'm not sure you survived my explanation, just as I'm not sure I understood it)!

Complexity, Allen notes, is in and of itself a destabilizing factor.

It can in fact make the structure of certain financial products and their interactions with the financial system not fully intelligible, thus increasing the probability that the risk related to these products is not perceived. But even if the risk is somehow anticipated, complexity means that it can be underestimated when things are going well (causing bubbles), and overestimated when they are going badly (causing panics).

Allen provides three examples of financial innovation that can be classified as shadow banking, highlighting the regulatory constraints they were intended to circumvent, the risks they caused, and the destabilizing potential (which in all three cases manifested itself in the 2008 crisis).

MMF

The Pecora report explains on page 28 that among the various measures taken to contain the role of banks in the excessive use of financial leverage (intended as the purchase of financial assets financed with debt, in particular towards banks) was the ban on remunerating demand deposits:

The purpose of this ban, known as Regulation Q , was to discourage banks from attracting funds by competing with each other on passive interest rates (those paid to depositors), flattening the spread between active and passive interest, and thus encouraging the use of the funds raised in high-risk activities (in search of high returns). We can also conceptualize this vicious circle in another way: the prospect of making high profits by lending money to speculators in a phase of growing markets pushed banks to attract deposits by offering customers ever higher interest rates, but this mechanism forced them to look for speculative uses downstream, that is, it crowded out productive investments, which could not pay interest rates on loans high enough to remunerate the collection. In any case, the vicious circle could be broken by controlling the price of collection.

(… how many of you knew that the autopsy of the '29 crisis had been commissioned to a magistrate born in Nicosia, Ferdinand Pecora ?…)

Regulation Q also capped the rates on time deposits and savings accounts (and also on savings & loans , but I'll tell you about that later). For some time, this cap was higher than the market rate (the story is here ):

but since the early 1970s, with the effects of the oil shock, which increased inflation and interest rates, the limit became increasingly anachronistic:

Thus an alternative market developed, that of money market mutual funds.   MMMFs are funds whose shares are generally worth one dollar and can be redeemed at any time (the fund is open-end ). The sums collected are invested by managers in money market assets (short-term government bonds, in Italy they would be BOT, or other short-term liquid assets), and the returns obtained are distributed to members in the form of dividends. In this way, a functional equivalent of the demand deposit was created (I put the money in when I want, I take it out when I want), which circumvented the interest cap (since this cap obviously did not concern dividends), but which of course, in addition to not having the limits of banking regulation (not being a deposit), did not even have the guarantees of a bank deposit (which today in the US reach 250,000 dollars per deposit).

MMMFs are a typical example of shadow banking : an activity functionally equivalent to that conducted by banking intermediaries that manages to escape the clutches of banking regulation thanks to financial innovation (the creation of a particular type of fund).

The first fund of this type, the Reserve Fund , was founded in 1970 and was liquidated in 2008 after "breaking the buck ". What does this mean? MMMF shares do not fluctuate, but are maintained at the value of one dollar (which is the value at which they can be redeemed), because dividends are recorded daily for an amount equal to the returns obtained, and because the assets are valued at amortized cost rather than at fair value , i.e. at market value (details here ). It is precisely the stability of the share that makes the MMMF a functional equivalent of a bank deposit, because having (fund) shares that are worth exactly one dollar is like having a dollar deposited in a bank account. However, if things go wrong (it rarely happens, but it does happen), the assets purchased with the sums raised can lose value. This is not so much about short-term government bonds, but about commercial paper , which is a kind of promissory note issued at a discount by large companies to finance working capital. If the issuing company goes into serious trouble, in principle it is unlikely that it will return all the money and it is certainly impossible to get rid of its commercial paper at the purchase price (no one would buy it), so the market value of the fund (the fair value ) obviously falls. If the fair value deviates by more than half a cent below the amortized cost, the fund is said to have "broken the dollar" (because it becomes difficult to imagine that it can return a dollar for each share).

The end of the Reserve Fund is told by Allen and contains several useful lessons. The Reserve Fund had started buying commercial paper in 2006. Before that, it had considered it an unnecessarily risky investment. Two years later, in 2008, 56% of its portfolio was made up of commercial paper , part of which was issued by Lehman Brothers. You already understand how it went (cit.) . When Lehman declared bankruptcy on September 15, 2008, the Reserve Fund 's clients, knowing of the exposure to Lehman, asked to redeem their shares. This triggered a banking-type run : 25% asked to redeem their shares on the same day and another half the following day. Unlike bank deposits, in fact, fund shares are not guaranteed, and it was therefore rational for the "depositors" to hurry up and get their sums back before the fund had sold its best assets (safer and more liquid). Of course, on the fund's side, the need to respond to such pressing requests meant that financial assets had to be sold urgently (the fund did not keep cash aside but invested it, otherwise it would not have been able to pay a dividend higher than the ceiling set by Regulation Q ), that is, it caused fire sales , which as you know depress the price and therefore the proceeds (in the urgency to sell, you sell at a discount). The realized value thus diverged further from the balance sheet value. The fund was forced to declare that a share was no longer worth one dollar, but 97 cents (despite holding only 1.2% of Lehman commercial paper ).

The dollar was broken.

This event caused quite a bit of panic, causing contagion: even the clients of other funds began to not be satisfied with the (well-remunerated) promise of having real dollars back, and instead demanded to have unproductive but reassuring liquidity in their pockets. The contagion could have had disastrous effects: in fact, as a first effect it would have brought about a credit crunch towards those companies to which the MMMFs lent money (by purchasing their commercial paper ), but imagine for yourselves the spiral into which we would have been caught: unable to finance their working capital, the companies would have had difficulty repaying the commercial paper issued, sending other funds into difficulty, etc. At this point the Treasury Department intervened, guaranteeing that the MMMF shares would maintain the value of one dollar, and the FED opened emergency credit lines to support the funds in difficulty. The guarantee that did not exist by law was created in fact to avoid the worst, but the Reserve Fund was liquidated anyway. The sector was somewhat reformed, but this did not prevent, and indeed, according to some authors exacerbated , the subsequent crisis episode at the beginning of the pandemic, which was also contained by providing liquidity in emergency conditions, and therefore definitely created a problem of moral hazard : if those who manage a fund know that when things go badly the State will intervene, the incentive to manage well (at the cost of sacrificing some profits) obviously decreases.

The lesson from this episode is simple: when there is a product that promises to give you back a dollar on demand, as soon as this promise seems difficult to keep, people run to demand the dollar. Those who know how stablecoins work have already understood where I want to get to (or rather: where Allen wants to get to!), the others will be accompanied by me later.

ABS

…not the one of machines (Anti-lock Bracking System), but the financial one: asset backed securities , that is, securities guaranteed by (financial) assets. Allen includes some of these instruments, in particular MBS ( mortgage backed securities), among the practices that can be defined as shadow banking . Let me clarify the concept first: the "guarantee" does not come from the fact that a mortgage is taken out on a bond! The mortgage has as its object a real asset, therefore the guarantee here is indirect. An MBS is constructed like this: the bank transfers to a specialized intermediary a package of bank real estate credits (each secured by a mortgage on the relevant property), and in exchange collects (at a discount) the value of the credit. The specialized intermediary finds the money to buy the package (the "sausage") of credits by issuing MBS, which technically are a securitization operation of a package of real estate credits secured by a mortgage. The credit recovery is managed by the intermediary who, with the flow of payments received from the debtor (owner of the mortgaged property), returns the capital and interest related to the MBS and makes a profit. Therefore: mortgages are on houses, and the fact that the credits transferred by the banks are supported by such a strong real guarantee makes the MBS a relatively safe form of investment, because it is essentially a pass-through between the owner of the property and the investor who buys the MBS.

The reasons for using these tools are twofold.

On the one hand, securitizations served to attract funds to the real estate market at a time when institutions traditionally dedicated to real estate lending ( savings & loans , intermediaries specialized in collecting deposits and issuing mortgage-backed real estate loans) were unable to raise capital on the market because of Regulation Q which made their deposits unattractive (by the way: do you see how much trouble happens in a market economy when a price is frozen? Now you can begin to appreciate the situation we have been in since we decided here in the Eurozone to freeze the most important price, that of national currencies).

The other reason was to circumvent a regulatory constraint, the one that requires banks to set aside reserves for loans issued, even if guaranteed by mortgages. The Basel rules require that in order to absorb any losses on credit, banks set aside a certain amount of capital, in proportion to their risk -weighted assets. For a bank, a loan is an asset (the promise to receive money from someone, i.e. to receive repayment of the loan), just as for pension funds, pension credits are assets (the promise – implicit – of the insured to pay the contributions not yet paid), but both these asset classes are subject to the "procedural" risk (of the Marchese del Grillo): "I don't put out the money and you don't take it!" (it's called credit risk ). The wise (…) Basel regulator therefore requires that the bank put something aside to cover this risk. But of course the capital set aside as a reserve cannot be used for other investments (it cannot be lent, you cannot buy profitable financial assets with it…), and therefore it represents a burden for the bank. Hence the simple and effective idea: sell the credits to third parties after having granted them! In this way the bank replaces an asset that immobilizes its capital (a loan) with cash (which, as you will remember, is king ), freeing up capital and being able to grant other loans to be sold, and so on. The assignee (the one who buys the credits) finances himself by issuing MBS (the mechanism seen above) and everyone lives happily ever after: the bank's customers buy houses, the bank cleans up the balance sheets, the specialized operator makes profits.

Isn't it beautiful? After all, Pangloss had told us: "everything goes to the best in the best possible worlds". But then Murphy had advanced the hypothesis that: "anything that can go wrong will go wrong".

What could go wrong in this case? At least a couple of things. Since the banks know that they are not keeping the credits (because they contract them to then sell them), they will obviously be less scrupulous in granting them (since if the debtor does not pay, the problem is not theirs but the assignee's, i.e. the issuer of the MBS), and they console themselves with the idea that the sale and the inclusion in complex vehicles creates diversification and therefore a mitigation of risk. The probability that "garbage" ( junk , subprime ) ends up in an MBS therefore obviously increases. On the other hand, since between Pangloss and Murphy the latter wins, things often go wrong, and if the debtor gets stuck for some reason, it is one thing if the credit is in the bank's charge, which knows about it and can evaluate the opportunity to manage this sticking point with some flexibility, for example by offering a restructuring of the maturities; but if the debtor has been assigned, then automatic mechanisms are triggered that generally provide for the immediate enforcement of the guarantee (real estate seizure). Let's be clear: it is absolutely understandable and rational that a complex financial product, in which dozens or hundreds of positions converge, should provide for simple and automatic rules for the management of these situations (of the type: "You don't pay? I'll seize you!"). It would be inconceivable for the issuer of an MBS to enter into the merits of situations that he does not know (because he did not originate them, because they involve subjects unknown to him, etc.) trying to find the best composition of interests on a case-by-case basis. On the other hand, if it is true that the rigidity of the rules implicit in these "Frankenstein contracts" (as Gelpern and Levitin call them) can favor compliance with commitments in times of prosperity, it is also true that it can turn out to be a suicide pact in times of crisis. In 2007, the rigidity of MBS, the explicit prohibition to modify in any way the structure of the underlying (to restructure the flow of payments of the debtor) unleashed an unprecedented wave of judicial auctions, which in some ways fed itself, because naturally the supply of a high number of properties on the market led to a collapse in prices, with the consequence that a high number of mortgages found themselves " under water ".

I would like to draw the conclusions of this example: on the one hand, we have a case of shadow banking , because a regulatory requirement (that of setting aside capital against loans) is circumvented with a financial innovation (MBS), allowing for a greater number of loans to be granted that are inevitably of worse quality. On the other hand, the main problem of this innovation is that it prescribes automatisms in real estate foreclosures that equally inevitably cause contagion and amplification of the crisis.

Those who know how smart contracts work have already understood where I want to get to, I will lead the others by the hand after a third and final example.

CDS

Better known as credit default swaps . Before explaining what they are, Allen reminds us of the concept of leverage : the use of debt to purchase financial assets. We mentioned one example above: that of the credit that banks granted to speculators before the 1929 crisis to allow them to acquire larger positions in risky financial assets. Obviously, if things go well for the speculator, there is something for everyone, but if things go badly, there is nothing for anyone, and above all there is nothing for the bank, which experiences considerable difficulty in getting the money back (because the speculator, by selling the assets he has bought, may not obtain enough liquidity to pay off the debt). As Allen notes, "leverage can multiply profits, but if an investor uses only a small portion of his or her own funds to buy an asset and borrows the rest, the down payment can be wiped out by even a small decline in the price of the asset," in which case the investor is forced to quickly sell the asset to repay the loan. This creates " fire sales externalities ": sales by one investor drive down the prices of similar assets, causing problems for other leveraged agents, with contagion effects, etc. (stuff we also saw above). Since excessive leverage weakens the financial system, banking intermediaries have been limited (in Europe the situation is described here ).

But of course (by now you have understood) once the law is made, find the loophole! To increase one's exposure in a manner substantially similar to that allowed by financial leverage, a type of contract known as credit default swap has become widespread since the 1990s, which works like this: the buyer ( protection buyer ) pays a premium on a periodic basis, generally expressed as a percentage of a notional capital, to the issuer ( protection seller ), who, in exchange, offers him insurance protection against a credit event relating to a certain security. If the security defaults , the protection seller (the issuer of the swap ) reimburses the protection buyer in place of the issuer of the security (who cannot reimburse it because it has defaulted ). Detail: the buyer can also insure against the default of securities that he does not own, and therefore, obviously, several subjects can insure themselves with the same protection seller against the failure of the same security that none of them owns . Obviously in this case the situation becomes complicated and to understand what payment will actually be granted to the buyers , an auction is held . The point that Allen insists on, however, is that since the buyer of the CDS does not have to physically own the security, the CDS allows him to acquire a speculative position, even a significant one, with a minimal use of his own capital.

Now, CDSs create leverage by multiplying the number of times someone can buy exposure to a given underlying. But in the cryptocurrency world, something essentially similar happens: there are no particular limits on the quality of the tokens taken as collateral for the loans granted, and there are tokens built to function like CDSs, creating a synthetic exposure to actual financial assets.

In conclusion: shadow banking 2.0?

I won't go too far: you have all the sources to go deeper. Allen's argument, which explains Savona's concerns, is that DeFi:

1) through the token structure it risks creating the excess leverage that has characterized the use of CDS;

2) through the use of stablecoins (cryptocurrencies anchored to an underlying asset such as the dollar) it risks causing runs like those that characterized the MMMF (with the aggravating factor that the rules through which the holders of stablecoins could get back the coveted real dollar are a bit opaque and who should or can enforce them is very unclear);

3) through the use of smart contracts introduces rigidities similar to those that caused the destabilizing contagion effects observed with MBS.

The actual risk at this time is relatively low because these tools are currently niche: they can harm a few people. But if their use were to spread, it would be essential to regulate these "virtual" situations, which in fact create a shadow banking 2.0 , possibly taking inspiration from what the less than brilliant results of shadow banking 1.0 have taught us (painfully).

This is what Savona has been asking for since he became head of CONSOB, and this is what he asked for last Friday in a passage that probably had less of an impact than many others.

Now we have US bombers in the air, the concerns are different, I understand (in particular, that of a further shock on the supply side). In fact, these are not very distant concerns: you will have noticed for example that the story that led to the creation of the MMMF began when the Yom Kippur War first and the Iranian Revolution later made inflation "skyrocket" (as the information operators say) (raising rates, making it necessary to circumvent Regulation Q , etc.).

The worries are always different, after all.

When this blog was opened, the concern was to reduce the debt/GDP ratio by cutting GDP, remember? Our concern was different. While we worry about something else, something that is nothing other than the more complex, therefore less readable, and less regulated, therefore more lethal, re-edition of what led us to the 2008 crisis is growing, taking hold, and step by step becoming a candidate for having systemic effects.

The worries are different, until those that were not worries take the place of the others…

(… good night! Tomorrow I will speak in the Chamber on the Iranian issue, if you have any observations on this too feel free to express them …)

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This is a machine translation of a post (in Italian) written by Alberto Bagnai and published on Goofynomics at the URL https://goofynomics.blogspot.com/2025/06/shadow-banking-20.html on Sun, 22 Jun 2025 21:10:00 +0000. Some rights reserved under CC BY-NC-ND 3.0 license.