The Credit Meltdown and Wall Street's Shadow Banking System

[What_Goes_Up]

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The Credit Meltdown and Wall Street’s Shadow Banking System - What Basel III Missed
Global Research, September 25, 2010
by Ellen Brown

*While local banks are held in check by the new banking czars in Basel, Wall Street’s “shadow banking system” has hardly been curbed by regulators at all; and it is here that the 2008 credit crisis was actually precipitated. *

The banking system’s credit machine is systemically flawed and needs a radical overhaul.

On September 13, the Bank for International Settlements issued heightened capital requirements that will make lending even more difficult for local banks, which do most of the consumer and small business lending today. The new rules are ostensibly designed to prevent a repeat of the 2008 credit collapse, but they fail to address its real cause, which involves a “shadow” banking system that has largely escaped regulation.

What went wrong in September 2008 was not that the existing Basel II capital requirements were too low but that banks found a way around the rules. The Basel II rules base a bank’s capital requirement on how risky its loan book is, and banks can make their books look less risky by buying unregulated “insurance contracts” known as credit default swaps (CDS). This insurance, however, proved to be a fraud, when insurer AIG went bankrupt on September 15, 2008. The credit collapse that followed has normally been blamed on the collapse of the subprime housing market. But according to Yale economist Gary Gorton (whose views were recently embraced by Fed Chairman Ben Bernanke), the subprime problem was not itself sufficient to trigger a global credit freeze. What it did trigger was an old-fashioned bank run, in the not-so-familiar market known as the shadow banking system.

Bank runs don’t generally occur in the traditional banking system anymore, because (a) depositors are now protected by FDIC insurance, and (b) banks that run out of reserves can borrow from the Federal Reserve, which is empowered to create money ex nihilo (out of nothing). But FDIC insurance covers only $250,000 in deposits, and there is a massive and growing demand for banking by large institutional investors – pension funds, mutual funds, hedge funds, sovereign wealth funds – which have millions of dollars to park somewhere between investments. They want an investment that is secure, that provides them with a little interest, and is liquid like a traditional deposit account, allowing quick withdrawal.

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