[NYTr] Credit turmoil seen as a run pn the 'shadow' banking system

[All the News That Doesn't Fit]

Financial Times - Sep 3, 2007
http://www.ft.com/cms/s/0/d79548f2-5984-11dc-aef5-0000779fd2ac.html

Credit turmoil seen as a run in the 'shadow' banking system

By Krishna Guha

JACKSON HOLE, Wyoming -- The current turmoil in the financial markets
has all the characteristics of a classic banking crisis, but one
that is taking place outside the traditional banking sector, Axel
Weber, president of the Bundesbank, said at the weekend.

"What we are seeing is basically what we see underlying all banking
crises," said Mr Weber, one of the most influential members of the
governing council of the European Central Bank.

The comments mark the first time that a top central banker has
endorsed the notion that the non-bank financial system is seeing
an old-style bank run.

Some Federal Reserve policymakers also privately see comparisons
between the current distress in credit markets and the bank runs
of the 19th century, in which savers lost confidence in banks and
demanded their money back, creating a spiralling liquidity crisis
for institutions that had invested this money in longer-term assets.

That scenario ultimately led to the creation of the US Federal
Reserve and other central banks as lenders of last resort for the
banking system.

However, the tools that modern central banks possess to address
liquidity problems can only directly address such runs inside the
traditional banking sector, and do not directly touch the non-bank
financial sector, which has been hardest hit by the current credit
crisis.

Mr Weber's analysis highlights the dilemma facing central banks,
which cannot channel funds directly to the non-bank financial sector,
and may therefore have to resort to easing monetary policy instead.
The ECB is due to set its key interest rate on Thursday and the
Federal Reserve on September 18.

Mr Weber told fellow central bankers and economists at the Federal
Reserve's Jackson Hole symposium that the only difference between
a classic banking crisis and the turmoil under way in the markets
is that the institutions most affected at the moment are conduits
and investment vehicles raising funds in the commercial bond market,
rather than regulated banks.

These entities were inherently vulnerable to a sudden loss of
confidence on the part of their funders because "there is a maturity
mismatch" on the part of financial institutions that have invested
in long term mortgage-backed or asset-backed securities using
short-term finance.

"Most of the conduits are owned by the banks," he said. In many
cases, sponsoring banks are being forced to take risky assets back
onto their balance sheets, in turn causing banks to keep hold of
their own cash, putting pressure on short-term money markets, he
argued.

His comments came as Frederic Mishkin, a Fed governor, argued for
a rapid and aggressive monetary policy response to any fall in house
prices.

His diagnosis of the financial crisis was echoed by other experts.

James Hamilton, a professor at the University of California, warned
that -- as in old-fashioned bank runs -- sudden demand for liquidity
can lead to a firesale of assets that depresses their price, making
otherwise solvent institutions insolvent.

Paul McCulley, managing director of Pimco, said there was a "run
on the shadow banking system." He said the shadow banking system
held $1,300 billion of assets that now had to be put back onto the
balance sheets of the banks.

The issue, he said, is "how it is done and at what price."