Fixing the shadow banking system requires letting in the sunlight

Since the beginning of the credit crisis the shadow banking system has been rapidly contracting.  In particular, we have seen multi-trillion dollar decreases in asset backed structured finance securities and repurchase funding.

Why?

Opacity.

In the case of asset-backed structured finance securities, think residential mortgage backed securities, there is a buyers' strike that was brought on by the lack of disclosure.

As symbolized by the Abacus deal, Wall Street was happy to sell investors securities where the investors could not possibly assess the risk and therefore properly price the security.

Buyers learned from this experience and are now demanding current performance data on the assets underlying each structured finance security.  This is the data they need if they are going to eliminate Wall Street's information advantage and be able to independently assess the risk and price the securities.  In the absence of this data, buyers are on strike.

For its part, the Wall Street Opacity Protection Team is fighting to maintain the status quo when it comes to disclosure.

A prime example of this is the ECB's ABS data warehouse.  It is being built to provide performance data once per month.  This is the same frequency as the opaque, toxic sub-prime mortgage backed securities provide disclosure.

Clearly, the Opacity Protection Team would rather protect the opaque status quo than let in sunlight, end the buyers' strike and give banks a way to generate credit for the economy without increasing their balance sheets.

In the case of the repurchase funding market, there is a freeze going on.  This run on the repo in the form of higher haircuts is the natural result of opacity.  This occurs when lenders cannot assess the solvency of the borrower.

The inability to assess the solvency of the borrower is particularly true of banks which are essentially 'black boxes'.  Potential lenders know the banks have exposures to sovereign debt, commercial real estate loans, and toxic structured finance securities.  What potential lenders don't have is the ability to assess these exposures.

Financial institutions know that they have to let sunlight into their black boxes if they are going to restore their access to funding.  This blog has documented several institutions that have turned to much greater levels of disclosure to restore their access to funding -- for example Soc Gen, BNP Paribas and Jeffries.

The only question is whether market participants have to drag ultra transparency out of the banks by cutting off their access to funds or regulators are going to require it.

The bottom line is that fixing the shadow banking system requires letting in the sunlight.