Tuesday, December 18, 2007

The Derivative House of Cards: The “Shadow Banking” System falters

Traditionally banking was collecting cash, making loans, and selling low-risk bonds. The old-world apparently was run over by the freight train of modern derivative banking. The brave new world of banking is focused on derivative structures, generating fees, and passing risk down the chain. However the recent credit crisis has proven that eventually someone will be left holding the bag as the house of cards crumbles.

The new modern banking system has operated in “the shadows” according to many. The recent credit crisis has exposed the monstrosity as a multi-headed dreaded hydra. Is it time to properly apply regulatory structure to tame this beast?

A recent article in the Financial Times discusses the system of opaque institutions, non-existent regulation, and derivative vehicles which has led to the credit market turmoil.

Out of the shadows: How banking's secret system broke down

"What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending [that is] so hard to understand," Bill Gross, head of Pimco asset management group recently wrote. "Colleagues call it the 'shadow banking system' because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain."