SHADOW BANKS AND PENSION RISK

Shadow banks (unregulated bank-like financial entities like hedge funds and private equity funds) arose in the early 1980s when interest rates were high, but commercial banks could only offer low yields on depositor money because of Federal Reserve Reg Q.  In this environment, investment banks began to offer, through money market accounts, higher yields than banks were allowed to offer and therefore began direct competition with regulated financial institutions for depositor/investor money. This set up a 2-tier banking structure: regulated banks that were subject to regulatory compliance constraints, and unregulated (shadow) banks that were not. As noted above, unregulated shadow banks could always offer higher yields to investors (depositors) because of the lack of reserve requirements or other compliance requirements.

Nowadays, shadow banks are typically private equity or hedge funds, or special-purpose entities of large commercial banks. An enormous amount of money has moved from regulated banks to unregulated shadow banks in the 1990s and beyond. 

A common investing strategy of shadow banks is to borrow money in money markets (MMMF, repos, commercial paper) and use that short-term money to invest in long-term projects (such as real estate). As repayment obligations arise, the short-term loans are simply rolled over to another term. Using this strategy, shadow banks invest in long-duration assets without disclosing these investments to regulators, and without the reserve requirements and due diligence compliance obligations that commercial banks would be subject to when competing for the same project.

The “borrow short – invest long” strategies of shadow banks only work in stable or rising markets. In stable markets, investor-lenders are happy to roll money market payment obligations ad infinitum, such that repayment never becomes due unless and until a long-duration asset that serves as collateral for the short-duration loan is sold. At that point-and only that point-capital gains support repayment of the short-duration loan; a loan whose repayment obligations have been rolled over and over until the collateral can be sold for a capital gain.

But problems arise when markets become highly volatile or decline.  When this happens, interest rates rise and lender-investor typically require higher collateral requirements for short-duration loans.  If the shadow bank cannot make payments based on higher interest rates or increased collateral requirements, it faces liquidity risk.

A good example of this problem was the repo market melt-down that occurred on Sept. 16, 2019 when repo interest rates jumped from 2% to 10%–literally overnight.  All of the sudden, the repo loans taken by shadow banks were under water. Payment amounts and collateral requirements increased and money market loans were not rolled over by lenders. This caused the entire repo market to seize up, jeopardizing countless long-duration investments of shadow banks (private equity and hedge funds).

At this point, the Federal Reserve stepped in and bought all the bad collateral that had been posted by shadow banks, gradually relieving the liquidity failure that had occurred in the short-duration repo market.

Courtesy of shadow banks that control pension money (private equity and hedge funds) pension funds have become huge investors in money markets, including MMMF and repos. As such, pensions are at risk of melt down in money markets. In September 2019 – March 2020, this pension risk was averted by massive liquidity injections to the repo system by the Federal Reserve.  So, luckily, disaster was averted.

But had the Federal Reserve not come to the rescue of the shadow bank repo investors, all of the shadow bank investors (mostly pension funds) would have suffered catastrophic losses.

Investment managers (typically large banks managing collective investment trust structures) direct massive amounts of pension money to money markets–including the repo market. If and when we have another money market meltdown (as in 2008 and 2019), pension investors are entirely at the mercy of global central banks to (again) come to the rescue. Maybe they will…or maybe not. One issue to watch is preparation underway in the Bank of International Settlements (BIS) to implement a global digital currency.  In the next crisis, will BIS activate its digital currency? If so, how will that affect financial markets and asset investors like pension funds? No one knows answers to these questions.

Finally, what can be said for investment managers who continually ignore this risk of exceedingly high losses, while dumping pension money into risky money markets?

Our answer to that question is that such investment advisors are completely ignoring ERISA’s mandate to diversify so as to minimize the risk of large losses.