You can head back to our homepage, or check out some great posts.Here I elaborate on the description of the nature of current problems in financial markets that I offered at the Fed’s Jackson Hole conference last week.A traditional bank is in the business of taking the funds it receives from its depositors and investing them in projects with higher rates of interest.If that was all that is involved, however, the system would be highly unstable, because it’s always possible that the bank could lose money on its long-term investments if interest rates rise or worsening economic conditions lead some of its borrowers to default.In such a situation, if the customers all decide they want their money back, there wouldn’t be enough to pay them all.The way this problem is solved is to have the capital that the bank lends come not just from its depositors but also in part from the owners of the bank.These owners should have invested some of their own money to start the bank and reinvested some of the profits of the bank to allow it to grow.

The capital that comes from the owners rather than depositors is known as the bank’s net equity.The idea is that if the bank takes a loss on its investments, that loss comes out of net equity, and there’s still money to pay off all the people who deposited money in the bank.And what if the losses are bigger than the net equity?Then we’re back to the unstable equilibrium, in which each depositor has an incentive to be the first one to get his or her money back, the situation for a classic bank run.bitcoin lawyer podcastDepositors may not be sure which banks have adequate net equity and which don’t, so some will be trying to get their money out of banks that are really in good shape.litecoin mining rig buyAs a result of the bank run, however, those previously solvent institutions will have to sell off their long-term assets, perhaps at a significant loss if they have to be unloaded at fire-sale prices in a panicked market.litecoin mining rig kaufen

The result of this may be that the bank panics themselves create new insolvencies, and the problem cascades into a worsening situation.Historical experience teaches us that this is a highly undesirable scenario, and can create significant economic hardship for people who are completely innocent bystanders.For this reason, we have developed institutions to regulate the banking system, one key goal of which is to ensure that banks always retain sufficient net equity to be able to weather such storms.bitcoin qr code iphoneWhat has happened over the last decade is that a variety of new institutions have evolved that play a similar role to that of traditional banks, but that are outside the existing regulatory structure.42 coin bitcointalkRather than acquire funds from depositors, these new financial intermediaries may get their funds by issuing commercial paper.5 gh/s bitcoin miner price

And instead of lending directly, these institutions may be buying assets such as mortgage-backed securities, which pay the holder a certain subset of the receipts on a larger collection of mortgages that are held by the issuer.Although the names and the players have changed, it is still the same old business of financial intermediation, namely, borrowing short and lending long.There are a variety of new players involved.The principals could be hedge funds or foreign or domestic investment banks.Others could be conduits or structured investment vehicles, artificial entities created by banks, perhaps on behalf of clients.The conduit issues commercial paper and uses the proceeds to purchase other securities.The conduit generates some profits for the bank but is technically not owned by the bank itself and therefore is off of the bank’s regular balance sheet.This system has seen an explosion in recent years, with the Wall Street Journal reporting that conduits have issued nearly $1.5 trillion in commercial paper.

Their thirst for investment assets may have been a big factor driving the recklessness in mortgage lending standards, as a result of which much of the assets backing that commercial paper have experienced significant losses.Without an adequate cushion of net equity for these new financial intermediaries, and with tremendous uncertainty about the quality of the assets they are holding, the result is that those who formerly bought the commercial paper are now very reluctant to renew those loans, a phenomenon that PIMCO’s Paul McCulley described at the Fed Jackson Hole conference as a “run on the shadow banking system.” I heard others at the conference claim that there might be as much as $1.3 trillion in commercial paper that will be up for renewal in the next few weeks, with great nervousness about what this will entail.In some cases, these intermediaries have lines of credit with conventional investment banks on which they will be drawing heavily, which will cause these off-balance-sheet entities to quickly become on-balance-sheet problems.

Their losses may severely erode the net equity of the institution extending the line of credit.How big a mess will this be?I don’t think anybody really knows for sure.In my remarks at Jackson Hole, I basically suggested that we should be thinking about both the causes and potential solutions to the current problem not just in terms of choosing an “optimal” level for the fed funds target interest rate, but also in terms of seeking regulatory and supervisory reforms, the ultimate goal of which would be to ensure that any financial institution whose failure would exert significant negative externalities on the rest of us should be subject to net equity requirements, so that most of the money the players in this game are risking is their own.I also recommended that we need reforms to make the whole system more transparent.I think the accounting profession has let us down, in that it is very difficult to look at the annual reports of some of the institutions involved and determine what exactly the exposures are.