Did QE and Bank Regulations create the “Capital Flight” from Traditional Banks to Shadow Banks?

1. Blog Entry: Capital Flying into the Shadows
Author: Deitric Muhammad
Date Completed: 29 May 2015
I have a burning question that needs to be answered. After some diligent research I
found myself asking:
Did QE and Bank Regulations create the “Capital Flight” from Traditional Banks
to Shadow Banks?

2. It appears so. According to a report titled “More permanent role seen for Fed's
repurchase program” it reads, and I'm quoting:
“Years of monetary stimulus and new capital requirements has left the
overnight federal funds market for banks a quarter of its pre-crisis size. Non-bank
lending, meanwhile, has risen above pre-crisis levels, and comprises 40 percent of
U.S. credit.”
In other words, the flushing of cash into the market by consistent monthly
purchases of long-term Treasury bonds at a rate of 10s of billions of dollars at a
time and bank regulators forcing banks to hold a minimum level of cash while
limiting their investment exposure to shadow banks (with a maximum investment
of 3% in hedge funds, investment banks, etc.) where they are able to make higher
returns, albeit at high risk levels. All while interest rates are at near-zero levels.
The federal funds market for banks is much smaller (75% smaller to be exact) than
its pre-crisis size.
Of course it is! Duh! The Federal Reserve have trillions of dollars in non-liquid
assets with its cash flooding the markets. What can it lend? Its liquidity is pretty
much dried out. Secondly, these banks are receiving liquidity from T-bond
purchases and mortgage-backed bond (MBS) purchases. Why would they need to
borrow from the overnight window? At 0% to 0.25%, where is the incentive to
lend?
Non-bank lenders filled a void caused by QE. So it is only natural that it grew
above its pre-crisis levels. According to my report “Understanding the Fed's Latest
Moves”, I stated that the purpose of T-bond purchases was to add liquidity to the
markets—creating inflationary pressure. The purpose of MBS purchases is to
provide banks with liquidity in order to keep interest rates between 0%-0.25%.
Seriously, no banks would want to lend money if they can't make any money from
their loans.
If you look at the FOMC statements on 19 June 2013, it clearly states that
lending conditions were “eased” for commercial and industrial borrowers. This is
great. However, there is still a high demand for credit. Businesses that received
loans,or capital, from banks did not use that capital to grow their businesses as
expected. They used that capital to acquire assets, to acquire other companies, and
invest in other assets that can yield a good return under the conditions created by
QE. This helps explain why companies generated great profits while employment
levels remained relatively stable with little growth. The demand for capital is still
high, so many businesses received credit from shadow banks to purchase assets and

3. other companies.
Now let's look at regulations—specifically the Volcker Rule.
It says in Section 619 of the 2010 Dodd-Frank Act, the Volcker Rule prohibits an
insured depository institution and its affiliates from:
Engaging in “proprietary trading”;
Acquiring or retaining any equity, partnership, or other ownership interest in a hedge
fund or private equity fund; and
Sponsoring a hedge fund or a private equity fund
Now I want take a quote from a report written by Sol Steinberg of OTC Partners.
In the report he states:
“Partly as a result of the confusion, banks may decide to avoid the multiple risks and
liabilities associated with the conflictive nature of hedge accounting and the Volcker
Rule altogether. And banks could be discouraged to take on traditional market-
making activity due to further regulatory scrutiny and potential fines. Frustrated with
this new legislative regime, proprietary traders may seek employment at buy-side firms
in an effort to continue exploiting their skills. (The financial industry has already
cited that traders who worked at G16 banks have begun departing for hedge funds
and other investment pools outside of bank holding companies.) Ultimately,
proprietary trading may transfer to shadow banking, an area that is outside financial
regulatory jurisprudence.
More important, banks have become reluctant to take on inventory positions due to
the Volcker Rule’s hindrance on market making activities. Without inventory, markets
for securities such as corporate bonds will lose substantial liquidity. The Volcker Rule
is intended to limit bank trading desks primarily to transactions where they can match
a buyer and a seller. By restricting banks from trading while using their proprietary
capital, the Volcker Rule will eliminate a significant source of liquidity for bond
market participants.”
It appears that QE, along with the Dodd-Frank Act and other regulations have
practically produced a literal “capital flight” from traditional banking to shadow
banking institutions.
This is why it is no surprise that today in 2015 shadow banking , or non-bank
lending, “comprise of about 40% of US credit”.
If you want to see a much more in-depth analysis of this subject, you can go to my
latest blog at www.mge19.com/blog/Feds-WTH.pdf.

4. Deitric Muhammad is Chief Economist of MGE19's Economic Research & Structural Models and
Economist for American Business Television. He is also the host of the widely-popular TV show, “The
Supply Side”--an American Business TV Original!
Deitric Muhammad can be reached at deitric@americanbusinesstv.net