Hyun Song Shin delivered the Mundell-Fleming lecture at the IMF Annual Research Conference earlier this month. This very interesting lecture argues that European banks essentially constitute the US shadow banking system.
While there has been much discussion of how the US has been relying on capital flows from Asia, there is little mention of Europe as a financing source. This is because Europe is not a significant source of net capital flow for the US – after all, Europe has a roughly balanced current account, and is not therefore a source of capital. The picture changes when one looks at gross capital flows instead of net capital flows. This is because European banks borrow dollars in the US and lend the dollars back in the US. This too is well known because it was a major source of distortions in the dollar Libor market and in the currency swap market (see for example, my blog post from April 2008 on this issue).
What makes Shin’s paper important is his demonstration that the sheer scale of this gross flow is much bigger than most people imagined. At least, it is an order of magnitude larger than what I thought it was. In fact, he shows that for a brief period in 2007 and early 2008, the total dollar assets of non US (largely European) banks exceeded the total assets of US commercial banks.
As a result, European banks while not being important sources of net capital, were hugely important sources of liquidity and credit transformation in the US financial system. They created liquid and apparently safe assets out of illiquid and risky loans to US borrowers, and they did this mostly through the shadow banking system (securitization and repos). As Shin points out, this is hugely important in the context of the European crisis. The ongoing deleveraging by European banks could be painful for the US financial system even if none of the big European banks fail.
I am tempted to think of the US as a giant CDO (collateralized debt obligation). China (and the rest of Asia) own the super-senior and senior pieces (Treasury and Agency paper) while Europe holds the equity piece. Much of the complacency about the US financial position is based on the idea that Asia cannot find another home for its money and so the super-senior piece will continue to find buyers. When all else fails, the US Federal Reserve has also provided buying support for this piece through its QE (quantitative easing) programmes. However, the real challenge in selling the CDO is in selling the equity piece because this piece has no natural buyer, and the only buyer in town might be delevering itself out of existence.