Offshore City of London puffed up shadow banking

Published on Tax Justice Network, by blog owners, July 27, 2010.

The IMF has produced a curious new working paper with the exciting title of The (sizable) Role of Rehypothecation in the Shadow Banking System, with a particular look at the role that the United Kingdom has played in this vast, dangerous unregulated market.

Please forgive the slightly wonkish nature of this, but rehypothecation is the practice that allows collateral posted by, say, a hedge fund to its prime broker (the investment banks or securities firms that provide lending and a bunch of other services to hedge funds) to be used again as collateral by that prime broker for its own funding.

Rehypothecation is a form of expanding the off-balance sheet part of the financial system, by letting prime brokers use collateral that isn’t really theirs to use, allowing further expansion of their balance sheets and injecting greater riskiness into the financial system as a whole. Off balance sheet financing was an essential ingredient in the conditions that brought the world to the edge of financial calamity recently.

Now all sorts of angles are interesting in this area. Two things they say are worth pointing out from the outset.

there has been very little research in this area.”

and, as a result of the studies by the authors Manmohan Singh (no, not the Indian Prime Minister but an IMF senior economist) and James Aitken:

we show that the shadow banking system was at least 50 percent bigger than documented so far.”

In other words, this matters a lot, and nobody has noticed.

But it’s another angle we want to concentrate on here. It is this:

In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets while in the United States rehypothecation is capped.”

… (full text).

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