Pondering the Collapse of the Entire Shadow Banking System


What's behind the ever-increasing need for emergency repos? A couple of correspondents have an eye on shadow banking.

Shadow Banking

  • The shadow banking system consists of lenders, brokers, and other credit intermediaries who fall outside the realm of traditional regulated banking.
  • It is generally unregulated and not subject to the same kinds of risk, liquidity, and capital restrictions as traditional banks are.
  • The shadow banking system played a major role in the expansion of housing credit in the run up to the 2008 financial crisis, but has grown in size and largely escaped government oversight since then.

The above from Investopedia.

Image courtesy of my friend Chris Temple.

Hey It's Not QE, Not Even Monetary

Yesterday, I commented Fed to Increase Emergency Repos to $120 Billion, But Hey, It's Not Monetary.

Let's recap before reviewing excellent comments from a couple of valued sources.

The Fed keeps increasing the size and duration of "overnight" funding. It's now up $120 billion a day, every day, extended for weeks. That is on top of new additions.

Three Fed Statements

  1. Emergency repos were needed for "end-of-quarter funding".
  2. Balance sheet expansion is "not QE". Rather, it's "organic growth".
  3. This is "not monetary policy".

Three Mish Comments

  1. Hmm. A quick check of my calendar says the quarter ended on September 30 and today is October 23.
  2. Hmm. Historically "organic" growth was about $2 to $3 billion.
  3. Hmm. Somehow it takes an emergency (but let's no longer call it that), $120 billion "at least" in repetitive "overnight" repos to control interest rates, but that does not constitute "monetary policy"

I made this statement: I claim these "non-emergency", "non-QE", "non-monetary policy" operations suggest we may already be at the effective lower bound for the Fed's current balance sheet holding.

Shadow Banking Suggestion by David Collum

Pater Tenebrarum at the Acting Man blog pinged me with these comments on my article, emphasis mine.

While there is too much collateral and not enough reserves to fund it, we don't know anything about the distribution [or quality] of this collateral. It could well be that some market participants do not have sufficient high quality collateral and were told to bugger off when they tried to repo it in the private markets.

Such market participants would become unable to fund their leveraged positions in CLOs or whatever else they hold.

Mind, I'm not saying that's the case, but the entire shadow banking system is opaque and we usually only find out what's what when someone keels over or is forced to report a huge loss.

Reader Comments

  1. Axiom7: Euro banks are starving for dollar funding and if there is a hard Brexit both UK and German banks are in big trouble. I wonder if this implies that the EU will crack in negotiations knowing that a DB fail is too-big-to-bail?
  2. Cheesie: How do you do repos with a negative interest rate?
  3. Harry-Ireland: [sarcastically], Of course, it's not QE. How can it be, it's the greatest economy ever and there's absolutely nobody over-leveraged and the system is as healthy as can be!
  4. Ian: Taking bad collateral to keep banks solvent is not QE.

In regards to point number four, I commented:

This is not TARP 2009. [The Fed is not swapping money for dodgy collateral] Someone or someones is caught in some sort of borrow-short lend-long scheme and the Fed is giving them reserves for nothing in return. Where's the collateral?

Pater Tenebrarum partially agrees.

Yes, this is not "TARP" - the Fed is not taking shoddy collateral, only treasury and agency bonds are accepted. The primary dealers hold a huge inventory of treasuries that needs to be funded every day in order to provide them with the cash needed for day-to-day operations - they are one of the main sources of the "collateral surplus".

Guessing Game

We are all guessing here, so I am submitting possible ideas for discussion.


I am not convinced the Fed isn't bailing out a US major bank, foreign bank, or some other financial institution by taking rehypothecated, essentially non-existent, as collateral.

Rehypothecation is the practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients.

In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades.

Current Primary Dealers

  1. Amherst Pierpont Securities LLC
  2. Bank of Nova Scotia, New York Agency
  3. BMO Capital Markets Corp.
  4. BNP Paribas Securities Corp.
  5. Barclays Capital Inc.
  6. Cantor Fitzgerald & Co.
  7. Citigroup Global Markets Inc.
  8. Credit Suisse AG, New York Branch
  9. Daiwa Capital Markets America Inc.
  10. Deutsche Bank Securities Inc.
  11. Goldman Sachs & Co. LLC
  12. HSBC Securities (USA) Inc.
  13. Jefferies LLC
  14. J.P. Morgan Securities LLC
  15. Merrill Lynch, Pierce, Fenner & Smith Incorporated
  16. Mizuho Securities USA LLC
  17. Morgan Stanley & Co. LLC
  18. NatWest Markets Securities Inc.
  19. Nomura Securities International, Inc.
  20. RBC Capital Markets, LLC
  21. Societe Generale, New York Branch
  22. TD Securities (USA) LLC
  23. UBS Securities LLC.
  24. Wells Fargo Securities LLC.

The above Primary Dealer List from Wikipedia as of May 6, 2019.

Anyone spot any candidates?

My gosh, how many are foreign entities?

It's important to note those are not "shadow banking" institutions, while also noting that derivative messes within those banks would be considered "shadow banking".

Tenebrarum Reply

In this case the problem is specifically that the primary dealers are holding huge inventories of treasuries and bank reserves are apparently not sufficient to both pre-fund the daily liquidity requirements of banks and leave them with enough leeway to lend reserves to repo market participants.

The Fed itself does not accept anything except treasuries and agency MBS in its repo operations, and only organizations authorized to access the federal funds market can participate by offering collateral in exchange for Fed liquidity (mainly the primary dealers, banks, money market funds,...).

Since most of the repo lending is overnight - i.e., is reversed within a 24 hour period (except for term repos) - I don't think re-hypothecated securities play a big role in this.

But private repo markets are broader and have far more participants, so possibly there is a problem elsewhere that is propagating into the slice of the market the Fed is connected with. Note though, since the Treasury is borrowing like crazy and is at the same time rebuilding its deposits with the Fed (which lowers bank reserves, ceteris paribus), there is a several-pronged push underway that is making short term funding of treasury collateral more difficult at the moment.

So I'm not sure a case can really be made that there is anything going on beyond what meets the eye - which is already bad enough if you ask me.

Preparation for End of LIBOR

What about all the LIBOR-based derivatives with the end of LIBOR coming up?

The Wall Street Journal reports U.S. Companies Advised to Prepare for Multiple Benchmark Rates in Transition from Libor

Libor is a scandal-plagued benchmark that is used to set the price of trillions of dollars of loans and derivatives globally. A group of banks and regulators in 2017 settled on a replacement created by the Federal Reserve known as the secured overnight financing rate, or SOFR. Companies must move away from Libor by the end of 2021, when banks will no longer be required to publish rates used to calculate it.

“We don’t expect that 100% of the Libor-based positions today will migrate 100% to SOFR,” Jeff Vitali, a partner at Ernst & Young, said this week during a panel at an Association for Financial Professionals conference in Boston. “It is going to be a scenario where entities are going to have to prepare and be flexible and build flexibility into their systems and models and processes that can handle multiple pricing environments in the same jurisdiction.”

Repro Quake

​I invite readers to consider Tenebrarum's "Repro Quake - A Primer" but caution that it is complicated.

He informs me "a credit analyst at the largest bank in my neck of the woods sent me a mail to tell me this was by far the best article on the topic he has come across".

Note: That was supposed to be a private comment to me. I placed it in as an endorsement.

Tenebrarum live in Europe. Here are his conclusions.

What Else is the Fed Missing?

  • Contrary to similar spikes in repo rates in 2008, it was probably not fear of counterparty risk that led to the recent repo quake. What’s more, the Federal Reserve without a doubt knew that something like this was coming. We say this because even we knew it – it was not a secret. A number of analysts have warned of just such a situation for months.
  • It is astonishing that the Fed somehow seemed unprepared and quite surprised by the extent of the liquidity shortage. We would submit that this fact alone is a good reason for markets to be concerned. If the Fed is not even able to properly gauge such a “technical problem” in advance, what else is there it does not know?

Effective Lower Bound

Finally, Tenebrarum commented: "I agree on your effective lower bound comment, since obviously, the 'dearth' of excess reserves was pushing up all overnight rates, including the FF rate."

For discussion of why the effective lower bound of interest rates may be much higher than zero, please see In Search of the Effective Lower Bound.

Mike "Mish" Shedlock

Comments (48)
No. 1-20

Anyone remember the events as described in the movie 'Too Big To Fail'? I re-watched that recently and it comes to mind. Remember how the US taxpayer got forced into accepting the 700 billion (and then some) bailout? Well, in todays political climate, they can't get away with that. Or if they could, it would be political suicide. Especially with Trump 2020 in mind. Maybe the Democratic socialists could be persuaded, since they're planning on giving money away to any swinging dick out there anyway. (no offence) As for the list of banks, my guess is Deutsche Bank and of course some unmentioned Spanish and Italian banks. And isn't it a total coincidence that the Bundesbank has recently purchased additional gold and repatriated substantial goldreserves which was stored outside Germany, back into the country. Russia, China, India are all stockpiling gold. And then the Dutch DNB talking about gold being necessary to rebuild after 'a collapse'....nah, total coincidence. I'd better follow suit and stack some extra bars.


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I have a hard time believing that the Fed can't pinpoint where the problem lies. They are entering into Repo contracts daily, so they should understand or at least be investigating who is having problems, starting with those looking for a free handout.

Moreover, why is the Fed having to bail out the party or parties. With Long Term Capital, Greenspan brokered a deal with the large investment banks and basically said, this is a problem that you facilitated, everybody pitch in.

In the back of my head, I'm wondering if this isn't a ruse to create an excuse to reload the QE program and stoke the equity market - notice the rally since the Oct. 8th announcement of NOT QE. I know, I must be getting paranoid in my old age, but really nothing would surprise me anymore.



@Roger_Ramjet They do know where the problem is but they can never say as it would cause an immediate run on that bank or institution.

So yes, this is a stealth bailout IMO.

As Tenebrarum pointed out however, the Fed was completely caught off guard by the sizer of the problem.


Either there are excessive reserves of ~$1.5T or there are not. If they are there, why is nobody willing to get the pickup over IOER to fund the GC repo? And if they are a fiction, why is the reporting sham allowed to continue?


Axiom7's hypothesis is a likely scenario. Foreign investors of every ilk, but especially EU and Japanese banks are starved of yield in their own currency. They have no source of dollar funding to buy higher yield USD assets. This has been a very meaningful investment flow. I can see why the US banks would need help with USD funding for this pool of investments at reasonable levels and why accommodating these investors is in the national interest. If the collateral is treasuries and agencies, overnight repo is not especially risky. US Treasury would also not want to see repo discounts blowing out as this creates market nervousness.


I believe that I expounded on the probability of a "re-hypothecation" problem in a comment several days ago. We are apparently in an era of "Fractional Reserve of Everything" Banking.

And this also speaks, yet again, to the Fed's horrific record as regulator of the largest Nationally Chartered Commercial Banks - otherwise known as "TBTF".


I second Douche Bank as the likely culprit.


Speaking of collapse, so the USA is heading FAST towards negative interestrates, the EU is already there and it's probably not hiking for the next few years with the arrival of Princess Lagarde and Japan...well, need I really comment on that... How exactly is the bankingsector going to survive? It's already proving to be lethal for German banks and others. And what about pensionfunds? What about depositor withdrawals when negative rates get passed on to savers? Or will the banks divert those costs by simply making transactions and accountfees higher, just as I've noticed in Holland and Ireland? So many questions and not a single politician who's willing to fight against this insanity.



LIBOR is not likely the explanation but it could be.

There is pressure on institutions to unwind those contracts - NOW. If the new repricing or margin requirements are even slightly different, it could be a part of the problem.

There can be many parts to this problem, and probably are given how the Fed was caught totally off guard.

Lots of small problems = one big problem.

Tony Bennett
Tony Bennett

As noted, it could be anything ... or multiple anythings.

BUT I still lean to (or one of) FASB 157 related. Major banks were given wide discretion to price (mark to model) illiquid assets. Think banks are reticent to lend to other banks (or just certain others) due opaque balance sheets. Came about now to business cycle ending and players know defaults Dead Ahead.


Golly gee my confidence in our monetary system is skyrocketing! What a load of horse****.


Mish, I don't believe that SOFR can replace LIBOR because of the basis risk between the two rates. SOFR is a rate only relevant to US banking system dollars whereas LIBOR is the rate relevant to "Eurodollar" funding which comprises all shadow banking and most bank derivatives books (which are off-balance sheet except for the mark-to-market). If derivatives were forced to reference SOFR that would add a lot of basis risk. Hence the resistance. See Jeffrey Snider @ Alhambra's blog for details.


There must be something I don't get about these markets:

How can the repo rate shoot up to 10%? -- in theory other intermediaries could use excess reserves, borrow unsecured money in the federal funds market or in the inter-bank lending market and swap it for Treasuries at a big profit. You never expect the rate for swapping GC/Treasuries overnight to be higher than unsecured lending rates: they're supposed to be the most liquid risk-free collateral in existence. In addition, there are larger markets (than just repo-ing GC) for secured borrowing where you can raise cash for a better rate.

In principle somebody should be able to make money arbitraging this.

What am I missing here ???


I'm a very simple person, and all of this makes my head spin reading about all of the speciation and theories.

Does anyone know what the term is of the collateral is that's used in the repo market? Is it typically short or long, or is it a mixed bag?


I thought someone suggested that the repo need came from Chase Bank?


FWIW, in London in 2009, Gilts were considered better collateral than cash.


Mish, What are your thoughts on the whole WeWork situation. They have $50 billion in leases which is a huge amount. It is curious that Softbank would agree to back stop them and I was wondering if instead they were getting some money from other sources to keep WeWork from crashing commercial real estate.


The overall problem is that the non-banks are largely absent from the funding market.


"What Else is the Fed Missing?"

What else is the FED hiding?

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