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Secretary Geithner in his lecture talked about runnable debt as an important

precursor to crises.

Runnable debt is effectively money, and it comes in many forms.

In its simplest form, such debt is produced by banks,

in the form of demand deposits.

In the more complicated form that we started to see in

the run up to the crisis, it came in a wide variety of

forms created by what was called the Shadow Banking system.

Today I'm gonna talk about the Shadow Banking system and the various ways that

it can create runnable debt, money-like safe securities.

Start with a picture.

In this picture, we see the standard way that banks would create safe debt.

You would have a depositor, could just be a retail investor,

it could be a small business.

And the depositor would give dollars to the bank.

That's step A.

And that's the dollars that are flowing down from the depositor to the bank.

The bank then takes those dollars and loans them out to a borrower.

Let's say somebody who needs the money for a mortgage for a house.

The bank takes, onto their balance sheet, the arrow that coming up,

which is a loan, which is an obligation of the borrower and an asset to the bank.

What the bank gives back to the depositor is a savings account or

a checking account which is insured.

Which means in this case in the United States as of 2007,

$100,000 by the depositor could be put into the bank and

would be insured by the federal government.

Specifically by the FDIC.

So we have Step A where the depositor is giving money to the bank.

They can take that money out any time from their insured savings or checking account.

And then step B, the bank is handing that to a borrower.

It's a small business loan or a mortgage.

Now the borrower does not have to give that back any time the bank asks.

So the borrower may have a long term debt to the bank,

the bank has a short term debt back to the depositor.

From the perspective of the depositor, it's completely safe,

because the government has guaranteed that they will be paid back no matter what,

up to $100,000.

So this is the standard way that we would create money.

At least back until the civil war in the United States.

It was a very long history and as I talked about in the very first module,

we saw problems with this until we came up with the idea of insuring the savings.

The insurance function started nationally

just after the worst part of the Great Depression.

So now what's the problem?

Why can't we can't keep doing this forever?

Why can't we just have, everytime anybody needs safe debt, they just hand it to

a bank and it's insured by the government and we can go on completely safe forever?

The problem is, insurance is limited.

In the United States at this time, it was limited to $100,000.

If you make insurance unlimited,

that's effectively saying the government is ensuring the entire banking system,

no matter how rich you are and no matter how much risk the bank takes.

Nobody thinks that that's a good idea.

So, what do we do?

Suppose that I'm a depositor, a large depositor.

Maybe I'm a sovereign wealth fund, or a large money market mutual fund.

Or a large corporation like Apple, that has a $100 billion of cash.

Where can I put that cash and know that it's safe?

If I hand it to a bank, all I have is protection on the first $100,000.

So what do I do for the rest?

That's essentially where what we call the Shadow Banking system comes in.

And I'm gonna give you a relatively complex picture next.

But don't worry, we will start talking about it now, and

then we'll be talking about it at length throughout this module and

throughout many of the modules that come later in this course.

Okay, in this figure, we're gonna have the same exact function.

Again, we have an investor.

But now, we're going to be explicit and

say that this is an institutional investor.

This is some investor with a large amount of money, that needs to be put in place.

On the left are the investors who may be

giving money to that institutional investor.

That is, Retail Investors.

So a retail investor, that would be an ordinary consumer,

like me, or a small business.

They can give their money directly to a bank, but they also sometimes give it

directly to an institutional investor, like a money market mutual fund.

Sometimes institutional investors are there without taking the money from

anyone else.

That would be an example of a sovereign wealth fund or a large corporation.

Basically think of it as a big money pool.

And that's our key idea.

Now as we discussed, they can't give their money directly to a bank.

Instead, they're going to, even if they give it directly to a bank,

need some way of making sure they're getting paid back.

The bank in the middle of the figure is still doing what banks do.

It's handing money out to borrowers, maybe in the form of houses or

in the form of a small business loan.

But now the difference is,

some of the money that they've received isn't going to be insured.

So a lot of what goes on, in the so called Shadow Banking system

is a way to figure out just how can we make sure that this money is safe.

In this picture, there are two ways that you will see this happening.

One way is that instead of the bank giving a demand deposit back.

So instead of the bank taking the mortgages on its balance sheet and saying,

this keeps us safe, the mortgages on our balance sheet keep us safe, give us money,

and the first $100,000 of it will be insured.

The bank says hm, don't go through us, I'll tell you what we're gonna do,

we're gonna take the mortgages off our balance sheet.

We're gonna put them over here in this box.

This box, we're gonna call, Securitization.

And it's something that we're gonna talk a lot about.

So instead of saying my money goes to the bank, and the bank has managers and

people and branches, and it also has assets like mortgages.

We're gonna put it over here and

we're going to put it in a box that we call Securitization.

Take it off of the banks balance sheet and

say that you the investor are going to buy a slice of this directly.

So now, you don't have to worry so much about what the bank is doing.

All you have to worry about is what this slice of assets is doing.

Furthermore, what the bank will do, and this is something we'll talk about later.

What the bank will do is basically take the first

slice of risk out of those assets.

So all you're really getting is the last and safest piece of those assets.

So now instead of giving your money to the bank,

you just buy a slice of what used to be the bank's portfolio, the banks assets.

And you take that slice and that becomes your collateral,

that becomes the safe thing that is giving you protection.

A second way to do this is a little more indirect.

Instead of going and

just buying the securities by yourself, as the institutional investor.

You say to the bank, I will give you my $1 million or $10 million deposit.

But since you can only insure $100,000 of it, I would like you to give me some

additional collateral that I can hold to make sure that I am safe.

That's the arrow that we see here that

goes from the bank to the investor that says collateral.

The collateral makes the investor feel extra safe.

Just like you would feel extra safe if you gave somebody money and

not only did you know the government was protecting you for the first part of it.

But they handed you something you could hold to make sure if they didn't pay

you back, you would have that protection.

Collateral is useful, because in normal times

you can quickly sell it in the market and get all of the money back.

It's the best form of insurance that you can have, because of its speed.

In panic times you may not be able to sell collateral back in the market.

It's why in particular this system can start to breakdown if people are panicking

and thinking that they won't be able to unload their collateral.

The process by which the collateral insures an investor.

And the money goes from the investor to the bank, or to whatever financial

intermediary we have, is something called a Repurchase Agreement.

And once again that will play a central role in discussing what happened during

the crisis.

For now all you have to do is think about these things as other ways

an investor can feel safe when they give a demand deposit to a bank.

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Lecture: Shadow Banking

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