Minsky Was a Shadow Banker

Daniela Gabor, Yannis Dafermos, Jo Michell

How did shadow banking contribute to the global financial crisis? Is a stable shadow banking system possible? And why have shadow banks become so important?

Although a decade has passed since the crisis, answers to these questions remain incomplete. Macroeconomics has made some progress in modelling the mechanisms by which shadow banks generate instability. But we lack an understanding of the dynamic processes by which shadow banking emerged and continues to grow, promoted under the guise of market-based finance.

The prevention of future instability requires a deeper understanding of the co-evolution of shadow banking activities with institutional development, at the national and global level. Shadow banking is not simply the result of unequal access to information, regulatory arbitrage or behavioural biases. It is the outcome of an evolutionary process in which finance interacts with global macroeconomic and political forces.

This research project draws on Hyman Minsky’s insights about institutional development to develop a new approach to thinking about shadow banking.

Minsky is best known for his argument that modern financially advanced economies are inherently unstable. But he also emphasised that instability rarely spirals out of control because of what he called thwarting mechanisms: customs, institutions and policies that limit instability.

These can be divided into two types. First, growth-enhancing thwarting mechanisms aim to ensure a minimum level of economic activity, preventing deep recessions. Second, repressive mechanisms aim to prevent economic activity expanding to the point where it causes fragility. Growth-enhancing mechanisms include counter-cyclical fiscal and monetary policy, and institutions that ensure real wage growth – and thus spending power – keeps up with productivity. Repressive mechanisms include measures to constrain inflation, financial regulation, and restrictions on cross-border financial flows.

These mechanisms are not fixed, but are subject to long-run evolutionary processes of development and erosion that Palley refers to as supercycles. In the upturn of the supercycle, new thwarting mechanisms emerge, ensuring a period of relative stability. But profit-seeking agents adapt to the new environment, learning and innovating in ways that gradually reduce the effectiveness of these mechanisms. Over longer periods, thwarting mechanisms may also create new sources of vulnerability. For example, expansion of private debt may stabilise economic activity in the short run but lead to fragility in the long run.

The erosion and transformation of thwarting mechanisms eventually leads to the downturn of the supercycle: a period of deep instability during which the thwarting mechanisms of the next supercycle begin to emerge.

Shadow banking emerged as a response to the new set of thwarting mechanisms that was established during the 1970s, at the start of what we call the “post-Bretton Woods financial globalisation supercycle.” This supercycle is characterised by the generation and preservation of financial wealth across a global system organised on the interconnected balance sheets of banks and shadow banks.

The new architecture was guided by the pursuit of price stability and the redistribution of power from labour to finance. For example, inflation targeting by independent central banks became the dominant monetary policy strategy; asset-based welfare (through pension funds and insurance companies) made up for the shrinking welfare state; restrictions on cross border finance were lifted; labour market flexibility was imposed; and the growth-enhancing role of fiscal policy was replaced by increasing reliance on the accumulation of private debt.

Shadow banking developed in this new institutional and macroeconomic environment. Securitisation, repo markets and institutions such as special purpose vehicles and hedge funds fuelled leverage, maintaining financial profits and economic growth in the absence of other sources of demand. Securitisation also enabled shadow banks to create “safe” financial assets that could be used as collateral for borrowing, ensuring the availability of liquidity even in the absence of sufficient volumes of public debt securities.

Central bank provision of liquidity in times of crisis – the lender of last resort– took on a more central role in this period. This function changed as central banks shifted to lending against securities that were marked to market. This introduced new forms of instability, transforming what was previously a stabilising mechanism into a potential new source of fragility.

Shadow banking activities therefore played an important role in the erosion of repressive thwarting mechanisms and the transformation of growth-enhancing mechanisms into new sources of fragility.

This project, supported by Rebuilding Macroeconomics, will analyse the development of shadow banking over recent decades, exploring how finance has interacted with macroeconomic policy and institutional and regulatory development. A detailed understanding of these processes is an essential prerequisite to the design and implementation of policy that can effectively tame financial instability over the long run.