Young versus mature small firms seeking credit

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June 28, 2012

Young versus mature small firms seeking credit

The ongoing tug of war between credit supply and demand issues facing small businesses is captured in this piece in the American Prospect by Merrill Goozner. Goozner asks whether small businesses are facing a tougher borrowing environment than is warranted by current economic conditions. One of the potential factors identified in the article is the relative decline in the number of community banks'down some 1,124 (or 13 percent of all banks from 2007). Community banks have traditionally been viewed as an important source of local financing for businesses and are often thought to be better able to serve the needs of small businesses than large national banks because of their more intimate knowledge of the business and the local community.

The Atlanta Fed's poll of small business can shed some light on this issue. In April we reached out to small businesses across the Sixth Federal Reserve District to ask about financing applications, how satisfied firms were that their financing needs were being met, and general business conditions. About one third of the 419 survey participants applied for credit in the first quarter of 2012, submitting between two and three applications for credit on average. As we've seen in past surveys (the last survey was in October 2011), the most common place to apply for credit was at a bank.

For the April 2012 survey, the table below shows the average success of firms applying to various financing sources (on a scale of 1 to 4, with 1 meaning none of the amount requested in the application was obtained, and 4 meaning that the firm received the full amount applied for). The table also shows the median age of businesses applying for each type of financing.

The results in the table show that for credit applications, Small Business Administration loan requests and applications for loans/lines of credit from large national banks tended to be the least successful, whereas applications for vendor trade credit and commercial loans/line-of-credit from community banks had the highest average success rating.

Notably, firms applying for credit at large national banks were typically much younger than firms applying at regional or community banks. If younger firms generally have more difficulty in getting credit regardless of where they apply, it could explain why we saw less success, on average, among firms applying at larger banks.

To investigate this issue, we compared the average application success among young firms (less than six years old) that applied at both regional or community banks and at large national banks, pooling the responses from the last few years of our survey. The credit quality of borrowers is controlled for by looking only at firms that applied at both types of institutions. What we found was no significant difference in the average borrowing success of young firms applying for credit across bank type'it just does seem to be tougher to get your credit needs met at a bank if you're running a young business. Interestingly, we also found that more mature firms were significantly more successful when applying at regional or community banks than at large national banks'it seems to be relatively easier for an established small business to obtain requested credit from a small bank.

While this analysis did not control for other factors that could also affect the likelihood of borrowing success, the results do suggest that Goozner's question about the impact of declining community bank numbers on small business lending is relevant. If small businesses are generally more successful when seeking credit from a small bank, will an ongoing reduction in the number of community banks substantially affect the ability of (mature) small businesses to get credit? More detailed insights from the April 2012 Small Business Credit Survey will be available soon on our Small Business Focus website, and we will provide an update when they are posted.

By John Robertson, vice president and senior economist,

 

and

Ellyn Terry, senior economic research analyst, both of the Atlanta Fed's research department

June 28, 2012 in Banking, Economic Growth and Development, Saving, Capital, and Investment | Permalink

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Do falling commodity prices imply disinflation ahead?

« Employment growth and the FOMC Summary of Economic Projections | Main

June 25, 2012

Do falling commodity prices imply disinflation ahead?

Cost pressures at the manufacturing level appear to be easing'at least, so say the manufacturers in our Business Inflation Expectations survey. In June, manufacturers reported that unit costs were up only 1.3 percent over the last 12 months, a full percentage point below their assessment at the end of last year. Retailers, on the other hand, report unit cost increases of 2.1 percent, down a bit from May, but 0.3 percentage points higher than in December.

We put a special question to our panel in June that may shed a little light on these patterns. When we asked firms to tell us what has been driving their unit costs over the past 12 months, manufacturers saw considerably less pressure coming from their cost of materials compared with other firms. Perhaps this discovery isn't very surprising. After all, commodity prices have been falling pretty sharply of late, and these costs are especially influential to manufacturers' assessment of the cost environment. (Indeed, in response to a special question we asked our panel in March, manufacturers ranked materials costs as the number-one influence on their pricing decisions.)

Does the fall in commodity prices mean we can expect a pass-through of these lower costs to consumers?

Perhaps. There's certainly a strong intuitive appeal to the "pipeline" theory of inflation. Here's the idea as described by the Bank of England (BOE):

"Consumer prices'can be thought of as the end of a 'pipeline' of costs and prices. The final price will be made up of many different components of cost as well as the retailer's profit or margin' Prices at one stage of the pipeline become costs for the next stage'"

But economists who have looked down the inflation pipeline haven't found flows, but rather trickles. Years ago, Todd Clark of the Cleveland Fed put it this way while he was at the Kansas City Fed: "the empirical evidence' shows the production chain only weakly links consumer prices to producer prices."

So the "inflation pipeline" theory isn't that simple, as the BOE goes on to explain:

"The [pipeline] idea is a simplification' Prices are determined by the interaction of supply and demand. If the cost of raw materials rises, for example, producers or retailers might accept lower profit margins rather than raise their prices. They are more likely to do this if demand is weak or because of competition. The degree of competition in markets can affect how much cost increases are passed on to consumers."

Investigations into what might be obstructing the flows through the inflation pipeline have taken several approaches, including the one suggested by the BOE above: Firms may vary their markups (or margins) to damp the influence of costs on prices as they pass from one stage of production to the next. This idea has become a cause célèbre in macroeconomics and a key element of something called the New Keynesian Phillips Curve.

And so we've been keeping our eyes on how our panel assesses their margins, and we note something pretty striking. That is, margins are rising, but primarily for retailers. Indeed, as our panel sees it, retail margins are getting pretty close to returning to normal. Manufacturers, however, still see their margins as well below normal.

Expanding margins, then, may slow the flow of falling commodity prices through the inflation pipeline. Manufacturers may take the fall in commodity prices as an opportunity to improve their woeful margins. And if they do pass these cost savings on down the production chain, it still might not hit consumers' wallets if retailers continue to increase their margins. (Based on our survey, that's what seems to have been going on lately, anyhow.)

For other insights from the June Business Inflation Expectation survey, see the Inflation Project on our website.

By Mike Bryan, vice president and senior economist,

Laurel Graefe, economic policy analysis specialist, and

Nicholas Parker, economic research analyst, all with the Atlanta Fed

June 25, 2012 in Inflation, Pricing | Permalink

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Employment growth and the FOMC Summary of Economic Projections

« The armchair Fed historian | Main

June 22, 2012

Employment growth and the FOMC Summary of Economic Projections

Here at macroblog we are always keen for an excuse to play with the Atlanta Fed's Jobs Calculator, and Wednesday's release of the Summary of Economic Projections (SEP) from the most recent meeting of the Federal Open Market Committee (FOMC) provides the perfect opportunity. The SEP, as you know, offers up three-year (and longer-run) projections of growth in gross domestic product (GDP), inflation measured by the personal consumption expenditure index (both headline and core), and the unemployment rate.

The SEP does not directly provide information on employment growth, and each of the 19 FOMC participants among the seven governors and 12 Federal Reserve Bank presidents will have their own views about how all the dots connect between GDP growth, unemployment, and job creation. I don't presume to speak for any of them, but with a few assumptions we can get a ballpark sense of how the range of unemployment rate projections might map into payroll job changes.

Assume, for example, that the labor force participation rate'the share of the working population that is either employed or actively seeking work'remains at its May level of 63.8 percent through 2014. In this case, the "central tendency" range of unemployment rate projections implies the following:

As a frame of reference, here is the recent employment record in the United States:

Overall, the hypothetical job growth based on SEP projections looks reasonably consistent with the employment experience of the last year and a half or so. If you yourself are inclined to think that the 2011 experience or the 12-month trend represent the most likely pace for the job growth going forward, you would probably find yourself in agreement with the lower unemployment numbers in the SEP. If you are convinced that the past three months represent a persistent downshift in the pace of job creation, you probably align with the higher end of the projections.

All of these calculations depend on my assumption about the labor force participation rate, and we along with many others have been warning that a constant participation rate may not be in the cards. Interested readers can go to the calculator and plug in their own participation rate assumptions and see how the resulting jobs numbers change. Our sense is that the participation rate is most likely to rise, which would count as a risk that the calculations above understate the job growth needed to hit the indicated ranges for the unemployment rate. On the other hand, some have argued that the expiration of extended unemployment benefits will actually lower the participation rate, as some people will simply drop out of the labor force. Declines in the participation rate would lower the job creation needed to support the unemployment rate projections in the SEP.

We'll see, but barring the participation complication, the unemployment rate projections on their face look pretty consistent with the same sort of progress on the job creation front that we have seen over the past couple of years. For better and worse.

By Dave Altig, executive vice president and research director at the Atlanta Fed

June 22, 2012 in Employment | Permalink

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The armchair Fed historian

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June 13, 2012

The armchair Fed historian

I enjoy researching economic history'some of my work with Steve Quinn on early central banking is here, here, and here.

The only problem with historical research, though, is that it tends to involve some real work'long hours spent with dusty archival volumes, consumption of lots of coffee and antihistamines, and a steady hand on the digital camera.

Just recently'and somewhat belatedly'I became aware of a Google application (thanks to Benjamin Guilbert's blog) that lets would-be economic historians breeze over the rough stuff and do some interesting research from their own computer keyboards. The application is called Ngrams, and here's how it works.

Basically, Ngrams counts occurrences of words in books that have been scanned by Google into its Google Books database. It then plots out the frequencies of these words as annual time series. These plots can then be used to measure how interest in a topic varies over time'to construct "cultural histories."

There are some limitations to this technique, mostly related to unavoidable issues in Google's database. For example, the dataset I chose to work with covers only English-language publications and stops in mid-2009. (See the Ngrams website for more detailed information.)

The six charts below represent a first attempt to use Ngrams to delve into the cultural history of the Federal Reserve.

Question 1: How popular is the Federal Reserve as a discussion topic compared with other central banks?

• Search terms: Bank of England, Federal Reserve, Reichsbank, Bundesbank, Bank of Japan
• Time period: 1900'2008

• My interpretation: almost from its beginning in 1913, the Federal Reserve has been the primary focus of English-language writing on central banks.

Question: 2 The Fed was founded as a means to counteract banking panics. What has been the impact of the Fed on the discussion of panics?

• Search term: bank panic
• Time period: 1866'2008

• My interpretation: that bank panics were widely discussed in the wake of three National Banking Era panics in 1873, 1893, and 1907, no surprise. Interest in bank panics peaked following the widespread bank failures of the early 1930s. This topic became less popular after World War II, but interest reawakened with the numerous savings and loan failures of the 1980s and early 1990s.

Question 3: One of the early policy goals of the Fed was to improve the efficiency of the check payment system. When did use of checks become the norm for ordinary Americans?

• Search terms: pay envelope, pay check, paycheck
• Time period: 1900'2008

• My interpretation: in 1920, most people did not have checking accounts and were paid in envelopes stuffed with cash. By 1960, most households had checking accounts and were paid by "pay check," later contracted to "paycheck."

Question 4. What has been the impact of the Fed on people's concerns about inflation and unemployment?

• Search terms: unemployment, inflation
• Time period: 1900'2008

• My interpretation: interest in unemployment shot up during the Great Depression, fell back in the postwar years, but resurged in the 1970s. Discussion of unemployment then falls steadily to the end of the sample in 2008. Inflation was rarely discussed until the United States left the gold standard in 1933. Interest in inflation remained below unemployment until inflation began to accelerate in the 1970s. Since about 1980, interest in these two topics has been almost identical.

Question 5: In the mind of the public, which policy goal should the Fed be most concerned with: price stability, financial stability, or employment?

• Search terms: price stability, financial stability, Phillips curve (as an imperfect proxy for "employment"; note that the original article by William Phillips appeared in 1958)
• Time period: 1900'2008

• My interpretation: financial stability was paramount until after the 1951 Treasury-Fed Accord. Price stability then takes center stage until the turn of the 21st century but by 2008 had converged with financial stability. Interest in the Phillips curve seems to have peaked in the early 1980s.

Question 6: What has been the impact of two "big ideas" on monetary policy, proposed by Robert E. Lucas (1976) and John B. Taylor (1993)?

• Search terms: Lucas critique, Taylor rule
• Time period: 1970'2008

• My interpretation: in his 1976 paper, Lucas argued that there were limits on the usefulness of statistical relationships (the Phillips curve in particular) in monetary policymaking. Partly in response to the Lucas critique, Taylor in 1993 proposed that central banks follow a simple rule in setting short-term interest rates. Interestingly, discussion of the Lucas critique peaked around the time of the publication of Taylor's paper. Interest in the Taylor rule was still growing at the end of the sample in 2008.

You may or may not agree with the choice of search terms or the interpretations of the search results, but you are welcome to conduct your own historical research with the same application'all from the comfort of your armchair, no digital camera required. We'll have more of these cultural histories to share in later posts.

By Will Roberds, research economist and senior policy adviser at the Atlanta Fed

June 13, 2012 in Employment, Federal Reserve and Monetary Policy, Inflation, Monetary Policy | Permalink

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Fed purchases of government debt: Flow-share versus stock-share

« The skills gap: Still trying to separate myth from fact | Main

June 11, 2012

Fed purchases of government debt: Flow-share versus stock-share

In last Friday's entry to his Economics One blog, Stanford Professor John Taylor reiterated an observation he made a week earlier in a June 1 Wall Street Journal op-ed: In fiscal year 2011, the Federal Reserve, largely as a result if its second large scale asset purchase program (or "QE2"), purchased a quantity of Treasury debt equivalent to 77 percent of all the debt issued to the public by the federal government. In his blog post Taylor refers to this as an "amazing percentage" and in the Wall Street Journal piece lumps it in with a collection of other policies that he views as problematic:

"... the discretionary stimulus packages and exploding debt, the regulatory unpredictability associated with ObamaCare and Dodd-Frank, which includes hundreds of rules still waiting to be written, and the unprecedented quantitative easing through which the Federal Reserve bought 77% of new federal debt in 2011."

The 2011 figures cited by Taylor do reflect, in dollar terms, a large increase in the Fed's Treasury purchases. As he notes, the 77 percent represents an increase of $853 billion in Fed holdings over a $1,109 billion expansion in publicly held government debt. Prior to last year, the largest dollar increase in Federal Reserve holdings of Treasury securities over a single year was $278 billion, in fiscal year 2009 (equivalent to 16 percent of the record increase in publicly held debt of $1,741 billion). The next three largest increases were $70 billion (32 percent), $52 billion (14 percent), and $44 billion (12 percent) in fiscal years 2002'04 (in that order).

So, in historical terms and absolute dollar terms, the 2011 share of the debt flow was quite large. But does it represent a significant change in economic terms? In their review of the evidence regarding the effects of earlier central bank asset purchase programs in the United States and elsewhere, Sharon Kozicki and her Bank of Canada colleagues make this observation (emphasis added):

"The effectiveness of unconventional monetary policy measures depends on several factors. Measures appear to have been effective (i) when targeted to address a specific market failure, focusing on market segments that were important to the overall economy; (ii) when they were large in terms of total stock purchased relative to the size of the target market; and (iii) when enhanced by clear communication regarding the objectives of the facility."

Professor Taylor's calculation focuses on the flow of debt issuance and who purchased it, and we wouldn't completely discount the proposition that flows of purchases can be important. But the accumulated evidence suggests to us that we should be really thinking in terms of something like the stock or accumulated total of Fed purchases relative to the size of publicly held Treasury debt, as the passage from Kozicki and coauthors indicates. That calculation produces a Federal Reserve share of about 16 percent of publicly held Treasury securities for fiscal year 2011, which is up sharply from the 8'10 percent levels seen during the 2008'10 period but very similar to the share of Treasury securities held by the Federal Reserve during the years 2000 through 2007.

We obviously would not conclude from this that monetary policy was less accommodative in the past several years than it was prior to the crisis. In 2009 and 2010 asset purchases were dominated by the accumulation of agency-issued mortgage-backed securities. We would want to measure the stance of monetary policy with reference to the Fed's share of a broader set of assets, an idea that was introduced in a previous macroblog post.

But whether one prefers to think in terms of stock-share or flow-share, thinking in terms of ratios does highlight an important part of the policy environment of the moment. Harvard professor and former Treasury Secretary Lawrence Summers has, for example, suggested that the federal government issue more longer-term debt in order to support government spending at a low cost. Because both QE2 and the more recent maturity extension program were targeted at reducing the holdings of longer-dated Treasury securities that would otherwise be held by private investors, the effectiveness of the Fed's actions is sensitive to the type of debt management actions advocated by Summers (as this paper nicely explains).

More generally, if the Fed's share of publicly held debt is a key element in determining the degree of monetary policy accommodation, changes in the level and composition of outstanding government (or agency) debt may amplify or mitigate the effects of central bank asset purchases. In normal times we wouldn't think too much about this impact because explicit changes in the funds rate would swamp any effects of asset share, which in any event would only evolve gradually. But with the funds rate at the zero bound, asset share and composition take on more importance.

In the shorter term, changes in the magnitude of federal government may not have too large of an independent impact on the stance of monetary policy, although it is noteworthy that current projections indicate the Treasury will sell about $1,450 billion of debt to the public in fiscal year 2012, and $1,060 billion in 2013. In addition there is this, from today's edition of The Wall Street Journal's Real Time Economics:

"The U.S. Treasury intends to continue to gradually extend the average maturity of the securities it issues'a tactic that locks in borrowing costs but potentially dilutes the impact of a Federal Reserve policy intended to boost the economy."

In such an environment, it is probably good to remember that standing pat with central bank asset purchases does not necessarily mean standing still with monetary policy.

By Dave Altig, executive vice president and research director at the Atlanta Fed, and

John Robertson, vice president and senior economist in the Atlanta Fed's research department

June 11, 2012 in Federal Reserve and Monetary Policy | Permalink

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The skills gap: Still trying to separate myth from fact

« Will labor force participation continue to rise? | Main

June 07, 2012

The skills gap: Still trying to separate myth from fact

Peter Capelli has looked at the skills gap explanation for labor market weakness and sees more myth than fact:

"Indeed, some of the most puzzling stories to come out of the Great Recession are the many claims by employers that they cannot find qualified applicants to fill their jobs, despite the millions of unemployed who are seeking work. Beyond the anecdotes themselves is survey evidence, most recently from Manpower, which finds roughly half of employers reporting trouble filling their vacancies.

"The first thing that makes me wonder about the supposed 'skill gap' is that, when pressed for more evidence, roughly 10% of employers admit that the problem is really that the candidates they want won't accept the positions at the wage level being offered. That's not a skill shortage, it's simply being unwilling to pay the going price."

To some extent, the issue is semantic:

"But the heart of the real story about employer difficulties in hiring can be seen in the Manpower data showing that only 15% of employers who say they see a skill shortage say that the issue is a lack of candidate knowledge, which is what we'd normally think of as skill. Instead, by far the most important shortfall they see in candidates is a lack of experience doing similar jobs. Employers are not looking to hire entry-level applicants right out of school. They want experienced candidates who can contribute immediately with no training or start-up time..."

In the language of economists, Capelli is defining skill as the possession of generalized human capital, while businesses are defining skill as the possession of firm- or job-specific human capital. In more familiar language, Capelli appears to be focused on innate skill levels and education, while businesses are looking for the types of skills that would be attained through past on-the-job training. In even more colloquial language, Capelli wants businesses to appreciate book-learning, and businesses prefer those who have already survived the school of hard knocks.

We have recently completed our own version of the Manpower survey Capelli references. Our results are based on the responses of about 100 businesses in the Sixth Federal Reserve District represented by the Atlanta Fed, and we do not claim that they are conclusive. But we do think they are instructive.

Of those firms that said they experienced an increase in hiring difficulty over the last year, our poll respondents confirm the notion that businesses are looking for candidates with specific skills:

The lack of technical skills is the only factor that really jumps out as an issue that businesses have with the pool of job applicants. We often hear anecdotal complaints about job seekers' lack of "soft skills," or the difficulty in finding applicants who can pass required background checks. But only 14 percent of all selections indicated too few applicants with required interpersonal skills, and only 7 percent indicated a problem with applicants passing screening requirements like drug-use or credit checks.

On the other hand, our poll found scant support for Capelli's claim that businesses are "unwilling to pay the going price." Only 9 percent of respondents reported that too few applicants would accept the offered compensation package.

Despite the fact that we see some evidence consistent with skill mismatch, it is far from clear that this issue is the smoking gun that explains the current anemic state of job growth. When asked if a dearth of skilled applicants is a persistent problem, our survey respondents overwhelmingly answer "yes." But when asked if they have had more difficulty hiring over the past 12 months, the overwhelming majority answered "no":

Even among the minority of businesses that report recent hiring difficulties, only half indicate that this difficulty is restraining growth:

We infer a couple of lessons from all of this information. First, it does appear that there is a long-term skill level problem in the U.S. economy. Adopting Capelli's definition of skill does not mean the existence of skill mismatch is a myth.

But turning to the short run, we've been pretty sympathetic to structural explanations for the slow pace of the recovery. Nonetheless, we have yet to find much evidence that problems with skill-mismatch are more important postrecession than they were prerecession. We'll keep looking, but'as our colleagues at the Chicago Fed conclude in their most recent Chicago Fed Letter'so far the facts just don't support skill gaps as the major source of our current labor market woes.

By Dave Altig, executive vice president and research director at the Atlanta Fed, and

John Robertson, vice president and senior economist in the Atlanta Fed's research department

June 7, 2012 in Employment, Labor Markets | Permalink

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Will labor force participation continue to rise?

« What is shadow banking? | Main

June 01, 2012

Will labor force participation continue to rise?

The labor force participation rate ticked up in May, as did the rate of unemployment. As we have noted in the past, the near-term trajectory of the unemployment rate depends critically on what happens to the participation rate. So the question is, can we expect further upward changes in the participation rate? The answer depends a lot on the labor market attachment of those that are currently out of the labor force.

A few weeks ago, my frequent coauthor, Julie Hotchkiss, wrote about what we can gain from detailed labor market data about the activities of people who have exited the labor force. In her posting, she discussed the overall increase in exits from the labor force, with a focus on 25'54 year olds. Her work concluded that while people identified "Household Care" as the dominant activity for those not in the labor force, there has been a significant upward shift since the recession in those indicating "School" or "Other" as their primary reason for not being in the labor force. A supposition is that at least those that indicated they were in school would reenter the labor force at some point, doing so with a higher level of skills or, at least, with skills that are better aligned with labor demand. However, because we know little about those in the Other category, the future labor market attachment for them is less clear.

This post explores data on transitions into the labor force, primarily for those in the Other category. As in the earlier blog, the focus is on individuals aged 25'54, as retirement dominates the activity of older individuals not in the labor force and schooling dominates the activity of younger individuals not in the labor force.

One indicator of whether those in the Other group are planning to reenter the labor force is whether the individuals in this group are classified as marginally attached to the labor force. A nonparticipant who is marginally attached indicates they want employment or are available for employment. Also, they indicate having looked for a job in the previous year but not actively looking for a job at present. Using monthly data from the Current Population Survey (CPS) that are matched year over year, we see that the marginally attached workers do transition back into the labor force at twice the rate of all individuals who are not in the labor force, as chart 1 illustrates. These rates are relatively stable over time.

As chart 2 shows, a much higher proportion of individuals in the Other category are marginally attached to the labor force, compared to other types of nonparticipants. Moreover, the percentage of these marginally attached nonparticipants has increased from around 20 percent to 30 percent over the last three years.

This higher probability of marginally attached workers returning to the labor force combined with the significantly increased share of marginally attached workers in the Other category suggests that we should expect to find a higher share of those in the Other group returning to the labor force than we've seen in the past. But it turns out that this expected development is not what has happened. The Other group also includes individuals who are not marginally attached to the labor market, and their transition rates into the labor market have declined. On net, while the transition rate to employment is highest for the Other category (reflecting the large of share of marginally attached), the transition rate into the labor force does not fully reflect the increased level of marginal attachment to the labor force.

The group with the next highest transition rate to employment is in the School category, which reflects the inherent transitory nature of that activity. However, it is noteworthy that the school transition rate is lower than it was before the recession. This development reflects an increase in the share of individuals continuing to indicate that school is their primary reason for not participating in the labor force from one year to the next. And it suggests that the lower opportunity cost of attending school is influencing the decision to remain in school longer.

While these trends suggest that we could expect to see higher rates of return to the labor force going forward, this potential development will likely require a much better showing of jobs numbers than were seen today before kicking in.

By Melinda Pitts, research economist and associate policy adviser

What is shadow banking?

« The relative expansion of central banks' balance sheets | Main

May 31, 2012

What is shadow banking?

What is shadow banking? Announcing a new index'hat tip to Ryan McCarthy'Deloitte offers its own definition:

"Shadow banking is a market-funded, credit intermediation system involving maturity and/or liquidity transformation through securitization and secured-funding mechanisms. It exists at least partly outside of the traditional banking system and does not have government guarantees in the form of insurance or access to the central bank."

As the Deloitte study makes clear, this definition is fairly narrow'it doesn't, for example, include hedge funds. Though Deloitte puts the size of the shadow banking sector at $10 trillion in 2010, other well-known measures range from $15 trillion to $24 trillion. (One of those alternative estimates comes from an important study by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky from the New York Fed.)

What definition of shadow banking you prefer probably depends on the questions you are trying to answer. Since the interest in shadow banking today is clearly motivated by the financial crisis and its regulatory aftermath, a definition that focuses on systemically risky institutions has a lot of appeal. And not all entities that might be reasonably put in the shadow banking bucket fall into the systemically risky category. Former PIMCO Senior Partner Paul McCulley offered this perspective at the Atlanta Fed's recent annual Financial Markets Conference (video link here):

"...clearly, the money market mutual fund, that 2a-7 fund as it's known here in the United States, is the bedrock of the shadow banking system...

"The money market mutual fund industry is a huge industry and poses massive systemic risk to the system because it's subject to runs, because it's not just as good as an FDIC bank deposit. We found out that in spades in 2008...

"In fact, I can come up with an example of shadow banking that really didn't have a deleterious effect in 2008, and that was hedge funds with very long lockups on their liability. So hedge funds are shadow banks that are levered up intermediaries, but by having long lockups on their liabilities, then they weren't part and parcel of a run because they were locked up."

The more narrow Deloitte definition is thus very much in the spirit of the systemic risk definition. But even though this measure does not cover all the shadow banking activities with which policymakers might be concerned, other measures of the trend in the size of the sector look pretty much like the one below, which is from the Deloitte report:

The Deloitte report makes this sensible observation regarding the decline in the size of the shadow banking sector:

"Does this mean that the significance of the shadow banking system is overrated? No. The growth of shadow banking was fueled historically by financial innovation. A new activity not previously created could be categorized as shadow banking and could creep back into the system quickly. That new innovation might be but a distant notion at best in someone's mind today, but could pose a systemic risk concern in the future."

Ed Kane, another participant in our recent conference, went one step further with a familiar theme of his: new shadows are guaranteed to emerge, as part of the "regulatory dialectic"'an endless cycle of regulation and market innovation.

In getting to the essence of what the future of shadow banking will (or should) be, I think it is instructive to consider a set of questions that were posed at the conference by Washington University professor Phil Dybvig. I'm highlighting three of his five questions here:

"1. Is creation of liquidity by banks surplus liquidity in the economy or does it serve a useful economic purpose?

"2. How about creation of liquidity by the shadow banking sector? Was it surplus? Did it represent liquidity banks could have provided?...

"5. If there was too much liquidity in the economy, why? Some people have argued that it was because of too much stimulus and the government kept interest rates too low (and perhaps the Chinese government had a role as well as the US government). I don't want to take a side on these claims, but it is an important empirical question whether the explosion of the huge shadow banking sector was a distortion that was an unintended side effect of policy or whether it is an essential feature of a healthy economy."

Virtually all regulatory reforms will entail costs (some of them unintended), as well as benefits. Sensible people may come to quite different conclusions about how the scales tip in this regard. A good example is provided by the debate from another session at our conference on reform of money market mutual funds between Eric Rosengren, president of the Boston Fed, and Karen Dunn Kelley of Invesco. And we could see proposals by the Securities and Exchange Commission in the future to enact further reforms to the money market mutual fund industry. But whether any of these efforts are durable solutions to the systemic risk profile of the shadow banking sector must surely depend on the answers to Phil Dybvig's important questions.

By Dave Altig, executive vice president and research director at the Atlanta Fed

May 31, 2012 in Banking, Financial System, Money Markets | Permalink

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