Is it correct to say that the shadow banking system affects money supply?

Hi,
I saw this comment recently and I wanted to fact-check it. I look forward to your feedback
davidmich

“The factors that affect money supply are the required reserves for bank rates. Money is mostly created by loans, therefore the shadow banking system is the one that creates the loans. The federal banking system does not control the shadow banking system, so therefore there are no reserve requirements.”
http://en.wikipedia.org/wiki/Shadow_banking_system

"The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks. Former Federal Reserve Chair Ben Bernanke provided a definition in April 2012: “Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies.”

Look again at your definition of shadow banking.

Now look at the definition of the M3 money supply.

So yes, many parts of the “shadow banking” system are included in the M3 stock of money. By definition.

Now the next question – the much more important question: how useful is this particular definition of money that includes parts of the shadow banking system? We can define money in countless different ways. M0, MB, M1, M2, MZM, M3. How many of these definitions are actually helpful in letting us understand what’s going on? We can look back at the previous definition link for a little exploration of this.

As they say, the Fed no longer keeps track of the M3. You can see that for yourself at their own site. They don’t think this particular monetary aggregate gives them any use. Obviously the shadow banking system played its dismal role in the crisis, but arguably not because of its role in the M3 stock of money. That number is too broad and imprecise to wrap the whole thing in a neat bow. I don’t think that definition of money really gets us anywhere.

Whether or not M3 is the “money supply” or another measure is, and whether or not the assets/credit involved in shadow banking are included in whatever you want to call the money supply. It is almost certainly true that shadow banking affects the money supply even if not directly.

Shadow banking certainly was a big component in starting the 2008 recession and that certainly affected the money supply.

It’s an incoherent aggregation of mostly incorrect statements.

  1. “The factors that affect money supply are the required reserves for bank rates.”

Reserve requirements are one factor affecting money supply, but by no means the most important. As explained in this Bank of England publication, http://www.bankofengland.co.uk/publications/documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf, whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. Although the amount of bank lending may be affected by reserve requirements, it usually is more affected by other considerations that more directly relate to bank profitability, such as interest rates and the availability of creditworthy customers. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.

  1. “Money is mostly created by loans.”

As just explained, this is correct.

  1. “Therefore the shadow banking system is the one that creates the loans.”

No, most loans that increase the money supply are made by commercial banks, although there are some shadow banking transactions that may increase the money supply, depending in part on the definition of “money supply.”

  1. “The federal banking system does not control the shadow banking system.”

Contrary to what you might think, quite a bit of the shadow banking system is controlled by the federal banking system. For example, most repurchase agreements (repos) are tri-party repos involving a federally regulated bank. However, it’s true that shadow banking transactions generally are not subject to bank reserve requirements.

  1. “Therefore there are no reserve requirements.”

Even though bank reserve requirements may not apply, there often are equivalent or stronger requirements. For example, money market funds have leverage limits that are much more stringent than bank reserve requirements.

More to the point, since most money creation is through commercial bank lending, reserve requirements are indeed applicable, although as noted above they tend not to be the most important consideration in determining money creation.

Thanks jbaker. Very helpful.
davidmich