Rising price of money through the demise of ‘shadow’ banking system

February 14th, 2008

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Recently, as we all know, Commonwealth Bank was censured for raising mortgage rates independently of the Reserve Bank of Australia (RBA) and raising them for more than the RBA’s rise of 0.25 percent in cash rate. The reason given was that credit conditions had ‘tightened’ and thus, raising its cost of funding. In another instance, we saw this mainstream media article, Business confidence hits 6-year low: NAB:

Australian business confidence slumped to a six-year low in January, hurt by sharp falls in global equity markets and tightening credit conditions, even as actual sales and employment remained healthy in the month.

As we can see, there is a trend of money getting more expensive. This trend affects both business and consumer confidence because Australia (along with the rest of the English-speaking nations) as a whole, is mired in huge amount of debt. Worse still, why is money getting more expensive than what was officially ‘set’ by the RBA?

To understand this question, we have to understand what the ‘shadow’ banking system is. Traditionally, the purpose of the banking system is to act as an intermediary between those with surplus capital and those who needs capital- one saves, bank lends, the other borrow. But as we said before in Collateral Debt Obligation?turning rotten meat into delicious beef steak, thanks to the ascent of securitisation,

… the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan. As the loan travels down the chain from the lender to the ultimate owner, intermediaries along the way collect fees and charges. Thus, lenders make profits the moment they make a loan. After that, they pass the risk of bad debt down the chain like a hot potato.

Securitisation has grown to the point of having a life of its own outside the banking system, thus becoming a ‘shadow’ banking system. It has become like this: one ‘invest,’ complex web of intermediaries take cuts and mash and re-mash the ‘invested’ money, and finally the other borrows. Such a scheme of arrangement was so lucrative that even banks began to join in the racket by sourcing their money from the ‘shadow’ banking system (see What is SIV?). Thus, the global banking system, in conjunction with the ‘shadow’ banking system becomes a colossal credit machine, spewing out vast amount of money to be lent. Eventually, the global economy becomes accustomed to such cheap money in the same way drug addicts are accustomed to cheap drugs. Obviously, huge amount of bad debts will accrue if too much money becomes too cheap for too long.

One faithful day, the world awakens to the sub-prime problem. Suddenly, money is not that cheap any more. The ‘shadow’ banking system turned out to be the emperor with no clothes. Banks that source their money from the ‘shadow’ banking system suddenly find that they face big losses. They eyed each other suspiciously, wondering whether who among their peers have more hidden losses to confess. The world has awakened to the fact that that much amount of money should not be that cheap for that long.

What can central bankers do? They do not control the ‘shadow’ banking system, for their sphere of influence lies in the banking system. That is how Australia’s RAMS get into trouble. Their source of funds came from the discredited ‘shadow’ banking system.

What will happen next? Imagine a gambler who won big initially through a string of good luck. With his newfound wealth, he became careless with his money. One day, he made one big losing bet and lost most of his wealth. Suddenly, he has to live life very frugally- more frugal than when before he became a gambler. If the credit crisis continues to gnaw and bite at the global financial system, then money will be forced to become more expensive in the same way the gambler was forced to be more frugal.

The danger is, this can develop into a vicious cycle. As money becomes more expensive, individuals and businesses that are addicted to cheap money find themselves in trouble. Bad debts accumulate in the financial system. That makes money more expensive. Then more find themselves in trouble.

How does this affect Australia? As we can see, Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia’s debts are sourced from overseas. With the demise of the global ‘shadow’ banking system, the price of money in Australia has to rise too.