Shadow Banks and the Economic Cliff of an Iran War
*The original post can be seen here, on lobelog.
Shadow banks may control about 25 to 30 percent of the world’s financial system. They may be about 50 percent of all banking assets in the world. I say may in both of those sentences because it is hard to measure the size of this financial sector. Shadow banking exists outside of state-sanctioned monitoring and regulation and includes hedge funds, money market funds and structure investment vehicles, amongst other rather exotic investment devices. The United States may make up about 40 to 50 percent of all shadow banking. However, shadow banking is spread throughout the world.
Shadow banks are not as regulated as regular banks and they gather capital for lending in a different way than regular banks. They often securitize assets such as commercial and residential mortgages, corporate bonds, consumer loan packages, student loans and the like. Shadow banks also find other assets and derivatives of those assets to back up their securitized debt instruments. Many use US Treasury bills and other sovereign debt to act as risk mitigation and collateral in the “loan” making process.
Shadow banks also rely on something called the repurchase (repo) markets to liquefy debt and other assets in the short run – even though many of the underlying assets are long run ones, like mortgages and long term bonds. Simply put, repos are a way to quickly pay off short term debts and also to get some debt off the books of the shadow banks either overnight or even for longer periods.
Ok, this is all very complicated. Frankly, this complexity has protected the shadow banks over the years. It has also led to some very big crashes because the people who should have understood what was going on did not. That includes many governments and even some of the leadership of the shadow banks themselves.
So what we have is a massive part of the world financial system basing its capital on sliced and diced assets with sometimes questionable risk calculations and even sometimes questionable valuations of the assets. How much might it be? How does $40 trillion dollars sound?
The valuation of the assets could be a real problem if there is a war with Iran that leads to significant damage to oil and gas fields and facilities in the Gulf. If energy prices spike again for the short run, the market could bear that. If the oil and gas prices spike and stay way up in many markets then we have a much bigger problem.
One of the mechanisms of asset destruction in the shadow banking system can be a huge increase in energy prices followed by recessions or worse in many places, including in the already fragile EU, China and the US. Other commodity and goods prices will be affected as well. Many shadow banks, and especially hedge funds are hoarding some commodities, such as aluminum. This could make the volatility and losses of a protracted war much greater.
Many shadow bank assets are heavily leveraged. Does this sound familiar? Leveraged shadow bank assets took down the US and part of the world economy when the housing market went bust in 2007-2008.
Many shadow banks are heavily into derivatives and even derivatives of derivatives. If the underlying assets of the derivatives collapse due to falling economies then the derivatives collapse along with them. This derivatives market could be in the range of hundreds of trillions of dollars.
It is quite possible that under some war and conflict scenarios that include energy price spikes, the economic impacts of a protracted and damaging war with Iran could be magnified well beyond the normal expectation.
Shadow banking is huge. It needs to be considered in calculations regarding military conflict. The damage to the financial markets and the many other markets connected to financial markets could be gigantic.
Some shadow banks could benefit from war if their executives preemptively set up derivatives and options as hedges betting on a war. They cash in if the war happens. In this scenario, those in the shadow banks could win or lose, but the regular folks could only lose.
A war with Iran now would be very different than if it happened in 1979 - when the shadow banking system was tiny and derivative markets were also much smaller. The leverage and risk inherent in sliced and diced assets in the tens of trillions, and other associated risks, were simply not there.
My recommendation - the world should take care and do its homework on the real risks within the world economy before stepping off the cliff toward a potentially very costly war.