Runnable Debt: This is effectively “money”. It is created normally by banks through demand deposits. Through some complicated ways, they were created by Shadow Banking System, in run up to the crisis.


What is the Shadow Banking System?

First let’s see how banks create safe debt.

So, depositors give money to banks. Banks in turn, loans the money to borrowers. The banks take the loans onto their balance sheet (which is an asset to them) and gives the depositor an account which is insured by the government upto first 100,000 dollars.

So, what’s the problem?

Yep, the insurance is limited (Don’t feel sad if you couldn’t figure it out, happens to the best of us). Now obviously insurance can’t be ulimited. That would mean the government insuring the whole banking system. That’ll be terrible.

So what should fund managers with loads of money do?

Hence the need for Shadow Banking system.

So let’s say you are an institutional investor who gets money from retail investors. Now you won’t give the pool of money directly to a bank unless you are sure that you are going to be paid back. So what we achieve through Shadow Banking System is a way to figure out how this money is safe.

The following can be achieved in two ways:

  1. The banks now don’t keep the mortgages on their balance sheet as assets. They convert them into securities through securitization. Now the banks ask the you to buy a slice of this security. So you don’t need to keep a eye on banks but rather on the assets. Also, what the banks do is they take the first slice of risk from the assets and hence what you are getting are last and safest piece of those assests. So instead of just giving money to banks, you buy assets from the banks and this acts as collateral for them.

  2. Second way of achieving security is by giving the money to banks and asking for collateral(including securitised bonds) so that you feel safe. So the government will be protecting you for the first part of the money and you’ll get additional collateral from the bank making you feel extra safe. This is useful as collateral can be quickly sold in the market (during normal times) getting all the money back. But during panic times, you may not be able to unload your collateral. The process described above is called a repurchase agreement.