GW Law Faculty Publications & Other Works

Document Type

Article

Publication Date

2024

Status

Accepted

Abstract

Patrick Corrigan’s recent article highlights the abuses of securitization by universal banks during the subprime lending boom that led to the Global Financial Crisis of 2007–09 (GFC). Professor Corrigan’s article focuses on what Zoltan Pozsar and other researchers have called “internal” shadow banking—namely, the origination and securitization of hazardous loans by universal banks through nonbank affiliates, including broker-dealer subsidiaries and off-balance- sheet securitization vehicles. I agree with Professor Corrigan that the enormous credit risks generated by universal banks and their “internal” shadow banking affiliates played a major role in precipitating the GFC.

Professor Corrigan’s article gives less attention to what Pozsar and other researchers have called “external” shadow banking—namely, the origination and securitization of risky loans by nonbank financial intermediaries that are not controlled by banks. “External” shadow banks, including finance companies, hedge funds, and private equity firms, obtain much of their funding by issuing “shadow deposits” (short-term financial instruments that are functional substitutes for bank deposits), such as money market mutual funds, commercial paper, and securities repurchase agreements (repos). Shadow deposits pose grave risks to financial and economic stability and should be regulated in the same way as traditional bank deposits.

The dangers created by universal banks (including their “internal” shadow banking affiliates) and “external” shadow banks have intensified since 2009. A toxic symbiosis has developed between the syndication and underwriting of risky loans and debt securities by universal banks and the origination of speculative private credit by “external” shadow banks. That noxious partnership has helped to produce unprecedented levels of risky consumer and corporate debts.

Unsustainable debts promoted by universal banks and shadow banks have created dangerously unstable financial markets that depend on frequent bailouts from central banks and other government agencies. Four serious financial disruptions since the GFC have triggered significant government interventions and bailouts—the repo crisis of 2019, the pandemic financial crisis of 2020–21, the failures of three U.S. regional banks in 2023, and the collapse of Credit Suisse. Those episodes demonstrate that universal banks and shadow banks pose massive and unacceptable threats to our financial system, economy, and society.

Professor Corrigan proposes two reforms to limit the risks of shadow banks. His reforms are incremental in nature, and their effectiveness would depend on strong implementation and enforcement by federal regulators. Unfortunately, the checkered track record of those agencies over the past four decades raises significant doubts about the efficacy of such reforms.

A new Glass-Steagall Act would provide the most direct and effective way to remove the threats posed by universal banks (including their “internal” shadow banking affiliates) and “external” shadow banks. A new Glass-Steagall Act would break up universal banks by forcing banks to divest their capital markets activities. It would greatly reduce the dangers of “external” shadow banks by prohibiting nonbanks from issuing short-term financial claims that are functional substitutes for bank deposits.

A new Glass-Steagall Act would restore strong structural buffers designed to stop crises from spreading across financial sectors. Federal authorities would no longer be required to bail out the entire financial system to prevent large banks from suffering crippling losses related to their capital market operations. Nonbank financial institutions would be more stable and resilient because they would be compelled to fund their operations with equity and longer-term debt securities instead of short-term runnable liabilities.

A new Glass-Steagall Act would ensure that our political, regulatory, and monetary policies are no longer held hostage by giant financial conglomerates. It would create a more decentralized and competitive financial system by breaking up universal banks. Capital markets would once again become true markets because they would no longer be bailed out to protect universal banks and “external” shadow banks. Financial institutions and financial markets would return to their proper roles as servants—not masters—of commerce, industry, and society.

GW Paper Series

2024-27

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