The Lure of, and Luring Shadow Banking

The post-2008 rise of shadow banking continues to generate a dustup between those who view its nebulous activity as a bulwark against both illiquidity and inefficiencies in the distribution of capital, versus those who hold it as a perennial threat to global stability. The most recent Economist includes a special report on shadow banking, in which declamations of the system’s potential to vitiate regulated, on-balance sheet activity is cast aside in favor of a more fecund discussion: the increasingly acknowledged potential for use as a viable form of risk securitization and lending.

Before one enters into discussion regarding the nebulous system, a proper definition is seemingly necessary. Shadow banking, however, is difficult to define, and for obvious semantic reasons (i.e. the signifier “shadow’). The following is taken from The Economist report:

“The definition of shadow banking is itself shadowy. The term was coined in 2007 by Paul McCulley, a senior executive at PIMCO, a big asset manager, to describe the legal structures used by big Western banks before the financial crisis to keep opaque and complicated securitised loans off their balance-sheets, but it is now generally used much more broadly. The Financial Stability Board, an international watchdog set up to guard against financial crises, defines shadow banking as ‘credit intermediation involving entities and activities outside the regular banking system’—in other words, lending by anything other than a bank […] Some of these competitors are simply banks by another name, trying to boost profits by cutting regulatory corners, which is a worry. But most are genuinely different creatures, able to absorb losses more easily than banks. They are a buttress rather than a threat to financial stability.”

Thus, shadow banking isn’t really just a system of recalcitrant competitors belying financial stability. Rather, as the report states, it has become a non-entrained system with all the plenum of traditional finance, now comprising a quarter of the global financial system, with assets reportedly reaching $71 trillion in 2013 –signaling a growth of $26 trillion in the last decade alone.

As I’ve argued before, it’s quite likely we can more readily account for the growth of shadow banking than the system itself, by beginning to think, or rather examine, its attractors as (Deleuzian) singularities. Why? Simply put, unlike the system itself, its basins of attraction are in fact not new at all. Just take, for instance, The Economist’s anecdote of Hall & Woodhouse, an English brewery founded in 1777. Until this year, H&W’s financial activity was a tableau of a “traditional” business that borrowed money in the form of bank loans, and then proceeded to gradually pay back the interest and principal, thus generating revenue, a steady income, a low level of debt, and a “pristine credit record”. Hall & Woodhouse, however, encountered some trouble in 2010 following the financial crisis, when their traditional lender, the Royal Bank of Scotland, informed the business it would only renew their line of credit for three years, instead of the usual five –and notably, now at a higher interest rate. Rather than conceding to this new, more expensive line of traditional credit, Hall & Woodhouse turned to shadow banking.

The Economist reports:

“They decided they needed more reliable long-term creditors, so they reduced their bank borrowing and turned instead to a shadow bank—a financial firm that is not regulated as a bank but performs many of the same functions (see article). The one they picked was M&G (the asset-management arm of Prudential, a big insurance firm), which offered them £20m over ten years.”

The Economist’s narrative here is that shadow banking offered H&W what traditional banks no longer could, or would, thus filling the void. However, this new trajectory, at least in Hall & Woodhouse’s case, is driven by much older, perennial business practices: securitization against risk via cost-effective loans. The attractors for businesses such as Hall & Woodhouse, then, haven’t changed. Shadow banking has been increasingly replacing traditional banks, which are now bogged down by post-crisis regulations and putative risk-minimizing measures. As The Economist puts it, “[t]his retreat of the banks has allowed the shadow banking system to fill the ensuing void.” But are we truly witnessing a meaningful exodus from tradition? The structure of shadow banking paradoxically mimes that of traditional lending, albeit in a more elliptical and unregulated dimension. So increasingly we see the discourse shifting away from oversimplified declamations against shadow banking, towards arguments that borrowers are drawn towards shadow banking because it offers what traditional banks can’t, as these banks are now “beset by heavier regulation, higher capital requirements, endless legal troubles and swingeing fines.” If we examine such activities in finance as Deleuze, and after him Manuel Delanda, conceive dynamical systems –namely, as comprised of trajectories whose basin of attraction are singularities, and wherein shocks or various critical stimuli help account for the creation of a bifurcated systems like shadow banking– this “draw” to the shadows, which accounts for the system’s subsequent growth, increasingly seems obvious.

Today regulators are apparently seeking ways to promulgate the upside of the shadow banking system, their intention being the attenuation of activities potentially leading to future crises, while simultaneously utilizing the system “for good”. Much of their focus, The Economist reports, is on leverage.

“One focus is leverage, the amount an institution has borrowed relative to the amount of loss-absorbing equity its owners have put into it. Most investment funds (with the notable but small exception of hedge funds) have minimal leverage or none at all, so if they run into trouble there is little risk that other lenders will suffer as a result. Alas, such contamination was a much bigger problem for the shadowy vehicles that issued asset-backed securities before the crisis.”

Much of the post-2008 discourse initially painted shadow banking as a principal contributor to the financial meltdown, partly due to the difficulty of evaluating off-balance sheet transactions, which proved so insidious, albeit only after the fact. That being said, we now better understand the cognitive response to post-crisis risk aversion (e.g., Hall & Woodhouse); consequently, we better understand the draw to shadow banking, and we better understand, to some extent, the risks associated with it. As The Economist report observes, “[t]he sooner the regime spells out which assets are protected, the sooner investors will take more care about risk. Shadow banking can make finance safer, but only if it is clear whose money is on the line.” So perhaps the important question here is a Deleuzian inquiry into the potential utilization of this new, bifurcated system of finance, which in turn will require that we move beyond traditional approaches to the topic, and now towards an understanding of the more fungible, even topological form of trading, lending, and securitization that is shadow banking. Indeed, shadow banking has already seemingly proved itself as a viable lending and borrowing tool par excellence in a post-crisis world, comprised of comparatively fewer, if any, nascent, state-violenced regulatory structures. Therefore, the question here is, how do we really wish to utilize such a system that holds the potential for disaster, but, conversely, the potential “for good” –and of course, as always, by what do we mean “good”? Mark Carney of the Financial Stability Board recently described shadow banking as the greatest danger to the world economy. The Economist report, however, is obviously more optimistic (The report celebrates shadow banking, while still betraying some anxiety: “Shadow banking certainly has the credentials to be a global bogeyman. It is huge, fast-growing in certain forms and little understood—a powerful tool for good but, if carelessly managed, potentially explosive.”)

We know shadow banking is inherently elliptical and difficult to map. But viewed through the analytical prism of the Deleuzian ontology, perhaps we will become more capable of mapping its growth, but subsequently must also be willing to then seek out concrete ways for its positive, alternative, even radical utilizations. Most of the discourse surrounding shadow banking articulates a deep and no doubt warranted concern over inadvertently instigating another liquidity crisis-turned-solvency crisis-turned-systemic-crisis. But is it enough for political economy to always concern itself with preempting a repeat of the same mistakes of the past? Is this to be our only vocation? Shadow Banking is indeed, in actuality, relatively new. So far as we seek to draw upon a metricized balance sheet to account for, understand, and regulate the correlative risks represented therein, there does seem to be a common, perhaps warranted, but at any rate apprehension that this system is too vague, nebulous, and potentially threating to system-stability. More proactive, however, may be to continue to prepare our imagination for our financial system’s alternative potential uses in ways that eschew habit and tradition (à laNietzsche). Only then can we thus elude the perpetual, surreptitious introjection of crippling anxiety over ongoing psychological, emotional, and cognitive attachments to traditional practices that vitiate our ability to actualize the virtual potential of finance, which is so necessary for rejecting the trope of insulating security against risk: for perhaps today our true task is to favor expanding universal risk against its perpetual threats by individuated insecurity.

            — by Alex Montero



Cited web versions of The Economist report:





Topology & Fiscal Federalism in the EU

In his analogous coda on the perennial search for the phase singularities of cardiac arrhythmias (i.e., the arrhythmia’s temporospacial raison d’être), biologist Arthur Winfree draws on an industrial consultant’s inability to compile a complete set of answers for his/her final report. As is the nature of a human’s cerebral difficulty in approaching the intensive properties of dynamical systems, which are not only often unpredictable, but simultaneously function within a highly topological temporospacial scale (thus, rendering it almost entirely impossible to create any sort of cerebral tableau), the consultant concludes that his/her report has not, in fact, acted as a true coda, but simply created further confusion and further questions, which have naturally arisen out of the attempt to circumscribe some preliminary answers. But for Winfree, the lack of concrete answers ought not to predicate a state of delirum. Rather, the confusion is now superior a posteriori, as in it has elevated the questions to a “higher level,” (i.e. the consultant and the affected parties are now questioning which key fits in which lock, rather than deliriously questioning what the rudimentary purpose of the lock mechanism even is).

As the thing called finance evolves, the political economist, the financial consultant, fall more and more in line with Winfree’s allegory. This is currently the case in the European Union, which is facing, amongst other things, post-crisis financial fragility, which the International Monetary Fund confabulated on in a report[1] prepared for last weekend’s G20 Summit in Australia. A posteriori the IMF has now begun raising pertinent questions regarding the future security of and in finance in the Eurozone. The report states that intensive international financial regulations in the EU have the potential to boost the global economy’s size by over $2 trillion in the face of the current state of fragile, post-crisis recovery in Europe. While global economic and financial activity has picked up amongst advanced international economies, the IMF report states that substantial exogenous and endogenous risks continues to plague emerging economies (e.g. Brazil, Indonesia, Turkey, South Africa), which have recently experienced volatility in equity markets, rising balance-sheet spreads, and currency depreciation. Among the proposed measures, the IMF has called for product and labor market reforms and increased cooperative, international policy measures, which if implemented, and correctly, will supposedly both raise economic growth by 0.5 percentage points annually, and reduce the risk of future shocks to the global financial system.

The IMF report—which builds upon recent discussions throughout the EU to implement a more dynamic EU-wide paradigm of financial regulations and implementation—has brought a topological approach to post-crisis financial questions. Before the implementation of the Euro in 2001, the EU struggled, some may even say failed,[2] in its implementation of a single European currency. Subsequently, its Growth and Stability Pact[3] faltered in the face of credulity due to “purely mathematical parameters without any discretionary powers or political instruments to enforce it.”[4]

As of late, discussions throughout the EU have pointed toward a system of so-called fiscal federalism, whereby the deployment of EU-wide Euro Bonds could act as a form of risk-averting securitization in which the pooling (i.e. de-differentiating) of Euro bonds would result in the tranching (i.e. re-differentiating) of said bonds in order to create a nomadic form of debt oscillation between EU member states—essentially, the move toward a more defined EU-wide financial system, similar to the U.S.’s federal/state relationship. From a topological (and Deleuzian) standpoint, the proposed idea of fiscal federalism roots itself within dynamical systems theory, along with a form of Nietzschean genealogy, in which Euclidian lock-and-key tests are eschewed in replacement of an empirical, constitutive approach to the inherently international dynamism of financial markets and their interconnected relationship with different systems, such as political relationships and regulations. The IMF reports a perennial state of post-crisis fragility existing within the EU, which requires, according to the IMF, the aforementioned topological approach (i.e. as of now, advanced economies appear to be ascending; however, we know future external shocks or perturbations will inevitably disrupt the oscillation of debt within the not-so-financially-unified EU). The presumption behind fiscal federalism is a type of Deleuze-cum-Rawls ideology, in which the difference principle is applied to states within a union—granting the premise that economic inequality is inevitable amongst states: therefore, the better-off states buoy-up the struggling states via a dynamic, but centralized system of pooling and tranching with so-called Eurobonds (a sort of distributive-financial justice).

Here’s Winfree on dynamical systems’ susceptibility to lethal stimuli with regards to the circadian rhythms of mosquitos: “The focus is on the organization in time that we sense in circadian rhythms and its susceptibility to shattering by a flash of light near midnight; and on the quicker rhythms of the mammalian heartbeat, their electrical signatures, and the susceptibility of the rhythm to lethal disruption by an unfortunately timed stimulus.”[5]

Compare Winfree’s work with the critique in last week’s IMF report, which states, “[a] new risk stems from very low inflation in the euro area, where long-term inflation expectations might drift down, raising deflation risks in the event of a serious adverse shock to activity…Vulnerabilities related to built-up positions, including a substantial increase in foreign holdings of domestic sovereign bonds and higher leverage, both in the form of more direct FX borrowing by corporations and a rapid increase in domestic credit, could amplify the impact of shocks.”[6]

As advanced economies continue to grow, a number of insidious progressions within the world of finance have the potential to “amplify the impact of a shock,” such as foreign holdings of domestic sovereign bonds and assets (e.g. Goldman Sach’s recent purchase of Denmark’s previously-public DONG Energy). However, the IMF report approaches the potentiality of shocks from a topological viewpoint, taking in mind domestic, foreign, money and capital markets with regards to international finance and macroeconomics, while additionally drawing upon bifurcated systems such as China’s shadow banking sector and the effects of international corporate funding.

That being said, the IMF report is not without criticism. Robin Harding of the Financial Times has referred to the recommended regulations as “politically difficult,” stating, “[i]t is not clear whether coordinating reforms at the G20 will make individual countries more likely to carry them out.”[7] Following the release of previously-secret documents last Friday regarding the Fed’s expansion of hundreds of billions of dollars in aid to foreign countries in 2008, discussions appear to be moving more toward the international interconnectivity of finance. “To the rest of the world, I don’t think these transcripts are going to be very reassuring,” Eswar S. Prasad, a Cornell economist and author of ‘The Dollar Trap,’” was quoted in Tuesday’s New York Times. “What they show is that the U.S. policymakers are very narrowly focused on U.S. interests, and their actions are not so much determined by any moral obligation to save the world economy, but rather a clear self-interest in preserving U.S. economic interests.”[8] Thus, the EU may predicate further financial decisions on alleviating what some see as a potentially detrimental relationship with the U.S via topological regulations. That being said, the IMF report, while not entirely comprehensive, approaches the U.S.-E.U. relationship from a topological stance, calling for specified regulations regarding international financial relationships rather than instituting a series of credulous, codified regulations aimed at alleviating ostensibly pernicious behavior (i.e. the Fed’s recent consideration to subject U.S. arms of foreign banks to annual stress tests).[9] Regardless, the IMF report and the movement toward fiscal federalism appears to be moving towards a more dynamical and topological approach, or at least—as with Winfree’s industrial consultant—increasingly asking the right questions.

[1] International Monetary Fund, Global Prospects and Policy Challenges. Feb. 22-23, 2014.

[2] Romano Prodi, “A big step toward fiscal federalism in Europe,” The Financial Times. 20 May, 2010. Web. – axzz2uFsW6ZHD

[3] An EU financial “regulation,” which attempted to avert risk within member states (i.e., a given nation’s debt could not exceed 60 percent of its GDP)

[4] Note 3 [supra]

[5] Arthur Winfree, When Time Breaks Down: The Three-Dimensional Dynamics of Electrochemical Waves and Cardiac Arrhythmias, (New Jersey: Princeton University Press, 1987), 6.

[6] Note 2 [supra]

[7] Robin Harding, “IMF says Reforms Could Add $2.25tn to Global Economy,” Financial Times, 19 Feb. 2014. Web. – axzz2tqmgxD1p

[8] Neil Irwin. “Fed Extended Rescue Effort Globally in 08’ Crisis,” International New York Times. 25 Feb. 2014. Print.

[9] Banks are selling assets or considering moving business into legal structures outside the purview of U.S. regulators…Bank executives say the steps they are considering are legitimate ways of adhering to increasingly onerous regulations, while minimizing costs to shareholders…The new rules are likely to force European banks to add billions of dollars to loss-absorbing capital to their U.S. units.” Max Colchester and David Enrich. “Banks Parry U.S. Rules,” from The Wall Street Journal. 11 Feb. 2014. (a) To avert this regulation, U.S. companies can sell so-called convertible bonds to their parent companies to build equity in order to fall above this $50 million threshold. Analysts worry of the bonds’ potential to harm the system by quantitatively increasing the substratum of funding debt. So-called convertible bonds are another example of shocks resulting in the bifurcation of trajectories. I.e., in Deleuzian terms this utilization of lock-and-key mechanisms w/r/t regulations continues to ignore the substratum of attraction w/r/t banks and financial institutions following consistent singularities (e.g., risk management, building capital and increasing equity.) However, these “onerous” regulations are meant to better tests banks’ potential risks and strengths in the face of future perturbations, which the tests will attempt to track. Thus, there is a slight paradox of Deleuzian ideologue at play within the Fed’s actions. The intent of the stress tests seemingly revolve around the need to map the actualization of future (i.e., virtual) financial shocks and perturbations (i.e., a sort of Winfree-esque test to track the affects of perturbations on a given system. Here, the light is simply replaced with the Fed’s stress test, while the mosquitos mime the foreign arms of U.S. banks). However, ironically, the tests are simply an off-shoot of a larger regulation, which, like the Volcker Rule, seemingly eschews a contextual view of financial intermediaries; thus, surrendering itself to exactly what the WSJ states: banks are seeking to continue on their longstanding trajectories toward attractors by simply bifurcating their trading schema into different areas (convertible bonds).

— by Alex Montero

Deleuze on the Volcker Rule

The Deleuzian dynamical model of our financial system, theoretically synonymous with the view of “the plumbing behind the walls,” as Perry Mehrling calls it, provides not only a multidimensional, topological map of interlocking markets, banks, hedge funds and the Fed to name a few, but an empirical, constitutive understanding of the ripple effect of certain regulations, especially in regards to the shadow banking sector, which Mehrling correctly notes “relied symbiotically—some might say parasitically—on ties with [the traditional banking system][1]. As we now understand, a posteriori, there were a few driving forces behind the growth of the shadow banking system, to which a recently approved regulation has the symbiotic potential to contribute.

Explained simplistically, within the traditional system, or Jimmy Stewart banking, banks used deposits to make loans to other community households and faced four general risks—repetitions, or singularities, in the morphogenetic process—solvency risk, interest rate risk, liquidity risk and credit risk.[2] As a semi-bifurcated system, shadow banking arose as these trajectories continuously attempted to meet the aforementioned singularities to alleviate risks through the purchase of credit default swaps and the utilization of securitized loans as collateral for borrowing asset-backed commercial paper and repos in the wholesale money market.[3] As the name entails, trading within the shadow banking system predominantly exists off banks’ balance sheets, often in the unregulated territory of Cayman Island hedge funds. However, from the traditional perspective, as a pseudo-entrained[4] system, Mehrling notes that a traditionalist perspective backed the acceptance of shadow banking, which for all intents and purposes was, and to an extent still is, the Ghost of Jimmy Stewart’s Past.

So in 2013 what has the rise, fall and subsequent post-crisis rise of shadow banking taught the political economist?  On Dec. 10, 2013, five regulatory agencies approved the long-awaited Volcker rule, which seeks to set a ban on propriety trading.[5] As the history of shadow banking has shown us, and as some critics[6] have rightfully pointed out, a simple regulatory ban on propriety trading does not take in mind the multidimensional potentialities of financial instruments, which, as intensive properties of a hyper-fungible dynamical system, hold the potential to bifurcate into a new system (i.e. shadow banking) when faced with an external perturbation (i.e. the Volcker Rule).

Herein lies, to the most recent and literal extent, what a Deleuzian approach to financial case studies (or with the Volcker Rule, a lack-thereof) ought to provide the spectrum of heterodox political economy. When we understand the multidimensional nature of the dynamical system that is finance—i.e the symbiotic relationship between shadow banking and propriety trading, which further coincides with liquidity in both money and capital markets—we, by proxy, understand the virtual potentiality of the paradoxical Volcker Rule, a regulation that in its roughly 1,000 pages, makes only one mention of its potential to “drive risk-taking to the shadow banking system”[7] and, thus, increase the very trading it sought to deplete.

With every move toward risk-averting singularities, the shadow banking system has become differentiated and bifurcated from on-balance sheet proprietary trading. As these singularities act as a substratum of repetition, the singularity of proprietary trading will continue to act as an attractor. But now, with the institution of the Volcker rule, these trajectories hold the potential to pass into the continuously expanding bifurcated multiplicity that is shadow banking. Because, as we now know, what is shadow banking but the actualized potential of intermediaries attempting to consistently meet the singularity of risk alleviation through the shadows of off-balance sheet proprietary trading?

Arthur Winfree’s work on the seemingly untraceable phase singularities of cardiac arrhythmias may offer the best coda in regards to what a Deleuzian approach provides the political economist when observing the potentiality of regulatory attempts to change the trajectory of risk securitization:

“What does any of this mean? Perhaps not much. Our situation is like that of the anonymous industrial consultant whose final report concludes; ‘We have not succeeded in answering all your problems. The answers that we have found only serve to raise a whole new set of questions. In some ways we feel we are as confused as ever, but we believe we are confused on a higher level and about more important things.”[8]

by Alex Montero

[1] Mehrling, Perry The New Lombard Street pg. 116

[2] Mehrling, Perry The New Lombard Street pg 117. While, Mehrling only lists solvency and liquidity as the prominent risks faced by traditional banks, Saunders and Allen introduce interest rate risk (as interest rates rise, long term loans become unprofitable) and credit risk, and leave out solvency risk in their empirical study of the crisis. However, it appears that the banking system’s consistent exposure to all four as repeated driving forces, or singularities to some extent, played a part in the creation and growth of the shadow banking sector.

[3] Mehrling, Perry The New Lombard Street pg. 118

[4] I say pseudo-entrained since, while shadow banking ostensibly appeared as an unregulated–and unsecure–independent reincarnation of traditional banking, the crisis proved its symbiotic relationship with money market liquidity, which in turn affected capital market liquidity.

[8] Winfree, Arthur. When Time Breaks Down page 29.