Shadow Banking and The Golden Pyramid

Yesterday in our article about gold’s price going down we discussed gold and the shadow banking system. Today we’ll explain how it all fits together and what it means for the markets and your investments.

The world today is so inter-connected that if you try to explain things in isolation it becomes meaningless. You have to look at everything to see how the pieces fit together.

US banks fund European banks and vice versa. And both of these banking systems help fund the assets of the Aussie banks. Which is why APRA, Australia’s banking regulator, has asked the banks to do their own stress test – modelling a sharp rise in unemployment and collapse in the Aussie property market.

The problem with self-stress testing is that the results are always too hopeful. It’s easy enough to assume a certain fall in property prices or a few percentage points rise in the unemployment rate. But the banks stress test in isolation. What about counterparty risk?

Prior to the collapse of the US property market, the US banks all thought they would pull through OK. They didn’t take into account the collapse of a counterparty.

This is a crucial point to consider. We reckon counterparty risk could well be in for the phrase of the year in 2012.

What does it mean?

Here’s an example. In the US, banks that had excessive exposure to residential mortgages hedged this risk by buying insurance with AIG. In their stress tests, they thought they were safe. They thought AIG would cover their losses if the housing market went south. AIG went bankrupt.

We’re pretty sure that scenario wasn’t modelled. AIG was a counterparty to the banks. There is always a risk the counterparty won’t pay out on the insurance claim. That’s what counterparty risk means.

The point is you can’t really conduct an accurate stress test in such an interconnected world. You cannot accurately model counterparty risk. These stress tests are an attempt to build confidence in an inherently fragile industry. Confidence is the backbone of the banking system. It’s a con game.

How Shadow Banking Works

An examination of the shadow banking system shows you just how fragile banking is. Weekend DR editor Nick Hubble sent this IMF working paper through yesterday. It explains how the shadow banking system works. If you have the time and inclination, it makes for fascinating – and scary – reading.

We’ll sum up the best points here. Firstly, the IMF paper points out the role of traditional banking/finance is to transform the short-term savings of households into longer-term assets. The banks do this via lending the money for mortgages. Or it is done via you investing with an asset manager to buy bonds or shares. Either way, your cash is ‘transformed’ into a longer-term security.

The IMF paper then points out the role of shadow banks. (Which include hedge funds, exchange traded funds, sovereign wealth funds, central banks, pension funds, insurance companies and managed funds.) And that role is to transform these longer-term assets back into shorter-term liquid investments.

The mechanics of this process are complex. But in effect, the shadow banking system simply monetises long-term securities. This creates liquidity, which creates more demand for longer-term securities like shares and bonds.

The Beginning of the End for Shadow Banking

This system worked ‘brilliantly’ for all involved for many years. Through a combination of ignorance and blind confidence, the system kept expanding. But the US housing bust was the beginning of the end.

The shadow banking system had effectively monetised the stock of US housing – a long term, illiquid asset. Once everyone realised the stupidity of this ‘system’ it was game over. The shadow banking market has been deflating ever since.

With the recent revelations surrounding MF Global’s abuse of the shadow banking system, you can bet it will continue to deflate in the years to come.

Why Gold Can Be Your Safeguard Asset in a Shadow Banking Environment

Once you grasp the basics you can see why money printing is the only way out for the monetary authorities. You can also see how the credit boom got out of control, how it affects your wealth and, as you’ll see in a moment, why gold will benefit in the end.

This system deflation will continue to have major implications for liquidity creation. You’re already seeing the effects of this in Europe. The European banks are struggling to get funding from the shadow banks. Less liquidity means a higher cost of remaining liquid funds. That’s why Aussie banks are struggling with higher funding costs despite the RBA lowering rates. The shadow banks fund Australia’s banks too.

This is why global central banks will step in and start monetising debt soon. To ensure against a violent deflationary downdraft, central banks will replace the liquidity that the shadow banks are no longer creating.

Because if they don’t, you’ll soon see bank failures. That will have a domino effect around the world. Ben Bernanke knows this and will use the printing press to prop up the system. He’s trying to act cool now, but he has no choice.

The ECB, to its credit, is trying to put the value of the euro ahead of the interest of the banks and their desire for money printing. But doing so while trying to maintain the structure of the Eurozone will prove an impossible task. Something will have to give. Either the ECB relents and prints, or the Eurozone breaks up and the peripheral countries turn to the printing press as an easy route to improved competitiveness.

Once all this transpires the gold price will soar. If you think of the financial markets as an inverted pyramid, gold sits at the bottom. On top of this sits physical paper currency. Stacked on top are more ephemeral forms of ‘money’ – such as government bonds, commercial paper and asset backed securities – created by modern finance and the shadow banks in search of a free lunch.

But the credit bubble bust in 2007 has made the question ‘what is money’ more and more important. With each round of central bank money printing, the market will collectively think harder about the answer to that question.

It will come to the conclusion that money is not something central banks can create on a whim. As the pyramid of ‘money’ implodes, the world’s wealth will cascade down into the golden tip.

At that point, we think gold, priced in paper currency, will be worth many times its current value. In the short term, it may have further to fall. But in the long term, gold will always remain as a protector of wealth. After all, there is no counterparty risk with physical gold. It’s your asset, but no one else’s liability.
Greg Canavan

for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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2 Comments on "Shadow Banking and The Golden Pyramid"

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Almost any default anywhere has become a systemic risk, even if they were to stop creating new smoke collateral that too is systemic risk. With smoke for collateral at the heart of every corner of asset prices, if something doesn’t keep tread water or the corner leg is knocked out of the smallest chair, it blows ….

Gold gold gold. All fair and well but if it does start to zoom into the stratosphere wont it be perceived by governments as taking away money that they rightly deserve? It doesn’t make sense to me that they will just sit there and take it and say “oh well” throwing their hands in the air. They have the weapon of legislation and by golly I reckon they will definitely be using it to stop gold in its tracks. It has been done before and I am sure a crisis which causes gold’s value to zoom up will not be… Read more »
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