On “How the world economy shifted”

This is a commentary on Chapter 5 of Martin Wolf’s book, The Shifts and the Shocks.

Martin Wolf’s explanation of the euro zone crisis, and of the problems created for the currency union by countries that are determined to run a surplus is clear and convincing. (Indeed, if my memory serves me correctly, his reasoning echoes the initial rationale for the IMF, with its deliberate penalties for countries that run a surplus.)

The discussion of the savings glut is however less effective. The problem is that there are two aspects to this story: first the policies of emerging market countries that undervalue their currencies and make it easy for them to run current account surpluses and, second, the uncharacteristic movement of the U.S. business sector into surplus around the same time period.

Wolf makes it clear that the latter played an important role in the savings glut. The problem faced by Wolf and other advocates of the savings glut view is, however, that there is a coherent explanation for the surplus only in the case of the emerging market countries. Not surprisingly the text focuses on the explainable aspects of the glut and restricts its discussion of the U.S. business sector surplus mostly to remarks on the significance of its size.

This omission is extremely important, because Wolf makes it clear that an important factor in the crisis was the dysfunctional manner in which U.S. markets responded to both the savings glut and the subsequent reduction in the federal reserve’s policy rate which was designed to stimulate the U.S. economy and offset the adverse effects on U.S. employment of the combination of a huge trade imbalance and a deficit of business borrowing. U.S. financial markets responded to these two phenomena by creating unsustainable leverage and balance sheet deterioration in the household sector.

My concern is with the causality that Wolf assumes. Let me propose an alternative interpretation of the facts. We know that when a bubble pops there is a transfer of resources away from those who purchased at the peak and to those who buy at the nadir. One function of the massive extension of credit to households was to ensure that there was a lot of underinformed, “dumb” money buying into the peak of the bubble. To the degree that corporate decision-makers have access to investment funds where knowledgeable financiers either can navigate the bubble successfully or are just successful at convincing the decision-makers that they can do so, a profit maximizing corporate decision maker may prefer to invest in financial assets than to risk money on the production of products that need to be marketed to the already over-extended household sector. In short, the possibility that (i) the U.S. business sector was the important factor in the savings glut “at the margin,” and that (ii) the causality for the U.S. business sector’s participation in the savings glut runs from the overindebtedness of the U.S. household sector and a general tendency of the modern financial sector to misallocate resources to the financialization of the U.S. business sector’s use of funds, at least needs to be entertained and evaluated.

In short, I am uncomfortable with the assumption of causality implied by sentences like the following: “What the market demanded the innovative financial sector duly supplied . . . By creating instruments so opaque that they were perfectly designed to conceal (credit) risk.” (at 172). Given how difficult it is to establish causality, should we not be asking whether financial innovation, and in particular the ability of the financial sector to create assets that one side of the transaction did not understand, drove a demand to take the other side of transactions with such “dumb” money (of course, giving a substantial cut of the returns to the innovators and originators of these assets)?

Thus, while Wolf argues that household leverage and balance sheet deterioration were necessary to offset the massive demand deficiency created by the savings, he doesn’t really address the problem that a big chunk of this demand deficiency was endogenously created by the business sector itself. Blaming the crisis on foreign lenders who were only interested in riskless assets is too easy. Any genuine explanation of what was going on needs to include an explanation of the behavior of the U.S. business sector, and Martin Wolf does not offer such an explanation.

Overall, this chapter does a very good job of describing the trends that fed into the financial crisis. This careful description, however, is what made this reader see a gap in the explanation that made me question the causal story as it was presented. On the other hand, Wolf also draws the conclusion that a financial system capable of such extraordinary dysfunction is in need of serious reform. So perhaps my criticism of this chapter will turn out to be only a quibble with the full book. I’ll let you know.

A question for Martin Wolf: Was the crisis “unprecedented”?

In the acknowledgements to The Shifts and the Shocks (which I am currently reading) Martin Wolf has stated that friends like Mervyn King encouraged him to be more radical than initially intended, and I suspect, as I read Chapter 4, “How Finance Became Fragile,” that this was one of the chapters that was affected by such comments. In particular, I see a contradiction between the initial framing of financial fragility which focuses on Minsky-like inherent fragility, and the discussion of regulation. Was this a crisis like that in the U.K. in 1866 or in the U.S. in the 1930s, or was this an “unprecedented” crisis that was aggravated by the elimination of legal and regulatory infrastructure that limited the reach of the crisis in 1866 and the 1930s? I am troubled by Wolf’s failure to take a clear position on this question.

Because Martin Wolf understands that the government intervention due to the crisis was “unprecedented” (at 15), I had always assumed that he understood that the nature of the 2007-08 crisis was also unprecedented. He appears, however, to be of the opinion that this crisis was not of unprecedented severity. Martin Wolf really surprised me here by taking the position that: “The system is always fragile. From time to time it becomes extremely fragile. That is what happened this time.” And by continuing to treat the crisis as comparable to the 1930s in the U.S. or 1866 in the U.K. (at 123-24).

His treatment of how regulation played into the crisis could be more thorough. He concludes that “the role of regulation was principally one of omissions: policymakers assumed the system was far more stable, responsible, indeed honest, than it was. Moreover, it was because this assumption was so widely shared that so many countries were affected.” (at 141). Wolf is undoubtedly aware of the many changes to the legal framework that protected the U.K. financial system in 1866 and the U.S. financial system in the 1930s that were adopted at the behest of the financial industry in both the U.S. and the U.K. (Such changes include the exemption of derivatives from gambling laws, granting repurchase agreements and OTC derivatives special privileges in bankruptcy, and the functional separation of commercial banking from capital markets.) Is the argument that these changes were not important? or that these changes fall in the category of omission by regulators? Given the preceding section of this chapter, it would appear that he believes these changes were not important, but given the conclusion of the chapter, I am not so sure.

In the conclusion, Wolf takes a somewhat more aggressive stance than he does in the body of the chapter: “The crisis became so severe largely because so many people thought it impossible.” (at 147). So maybe the crisis is unprecedented compared to 1866 and the 1930s. (In 1866 at least the possibility of financial collapse seems to have been recognized.) He also adds two more points to the conclusion that I didn’t see in the body of the chapter: the origins of the crisis include “the ability of the financial industry to use its money and lobbying clout to obtain the lax regulations it wanted (and wants)” and the fact that “regulators will never keep up with” the ability of the financial industry to erode regulation (at 147).

Thus, once I reached the conclusion of the chapter, it was no longer clear that Wolf views this crisis as primarily an example of inherent fragility. He has laid out the argument for how the financial industry successfully removed the legal and regulatory protections that were in place in 1866 and the 1930s. So this is my question for Mr. Wolf: Was the crisis itself “unprecedented” in the course of the last two centuries of Anglo-American financial history, or was this just a Minsky moment like many that have come before?

REITs are not the largest borrowers on the repo market

I have a nit to pick with Tracy Alloway’s recent reporting on the repo market. She writes:

What remains of the $4.2tn market is increasingly being taken up by non-bank entities such as real estate investment trusts (Reits), mutual funds and hedge funds . . . The growing use of repo has been particularly marked among Reits, which have overtaken banks and broker-dealers as the largest borrowers in the market, according to Federal Reserve data. To purchase long-term mortgage assets, Reits have increased their repo borrowings to $281bn, up from $90.4bn in 2009. Closed-end funds, which invest in assets ranging from corporate bonds to municipal debt, also have increased their borrowing in the repo market, from $2.74bn at the end of 2007 to almost $8bn now, according to Fitch Ratings data.

Her data is apparently derived from the flow of funds data, which states that in Dec 2013 REITS has $281 bn in repo borrowings and broker dealers had $135 bn in *net* repo borrowing.

If REITs had indeed “overtaken” banks and broker-dealers as the largest borrowers in the market with a share of $281 bn, it would be very hard to explain how the market could possibly be a $4.2 tn market. In fact, of course, the broker-dealers are using their own (government supported) creditworthiness to intermediate access to the repo market for their customers, who don’t have the credit to borrow directly on the tri-party repo market. For this reason, it is almost certain that broker-dealers remain the largest borrowers on the market. In fact on page 170 of JPM’s 2013 10-K we find that this one bank had $156 bn of borrowings in the repo market. GS 10-K has $165 bn in such borrowings (p 173).  In short, the fact that the broker-dealers are intermediating access to credit should not be used to obfuscate the fact that they are the largest borrowers on the repo market.

 

Banking is what makes the neo-classical model work

Paul Krugman writes: “while banks are indeed more complicated creatures than the mechanical lenders of deposits we like to portray in Econ 101, this doesn’t mean either that they have unlimited ability to create money or that they are somehow outside the usual rules of economics”

I want to propose a very different view of banking than the one Krugman embraces. Banking is what makes the “usual rules of economics” conceivable. Remember that Adam Smith wrote the Wealth of Nations in 1770′s Scotland, which was one of the birthplaces of modern banking — and banking was having an extraordinary effect on the economy that Smith acknowledged. (Book II, Chapter 2, paras. 40-41 )

If one discards the neo-classical framework and conceives as the economy as an environment where the average person’s life is defined by liquidity constraints that preclude profitable investment, then one can understand banking as the crucial innovation that allows the average person to overcome liquidity constraints and, thus, that makes the neo-classical framework a meaningful model of economic behavior.

Of course, banks have never had “unlimited ability to create money” — even though the statement that banks “create money at the stroke of a pen” is a shorthand description that can be misread if taken out of context. Banking functions to alleviate liquidity constraints because of the institutional constraints on banks’ ability to create money — just as debt can alleviate liquidity constraints only if institutional constraints make it enforceable.

It is true that banks “create money at the stroke of a pen,” but it is also true that they are liable for the deposits that they create when doing so — just as they are liable for liquidity puts that make the issue of asset-backed commercial paper possible. It is the institutional structure in which banks operate which controls the money supply.

In my view, when there is an institutional infrastructure that makes it possible for banks to issue safe private sector assets abundantly, the economy performs well — because the new-classical framework becomes a not-unreasonable approximation of the economy. By contrast, when this institutional infrastructure starts to break down as it has in recent years, we begin to inhabit an economy where liquidity constraints are one of the most important forces in the average individual’s life and vast amounts of profitable investment never see the light of day.

A paper that expresses my view and its implications for shadow banking in detail is here. Some related posts are herehere, here and here.

Other blogposts and articles related to this topic are:
Atif Mian & Amir Sufi, 100% Reserve Banking — The History
Paul Krugman, Is a Banking Ban the Answer
Martin Wolf, Strip Private Banks of Their Power to Create Money
John Cochrane, Toward a Run-Free Financial System
Isabella Kaminsky, Martin Wolf on Funny Money Creation, On the Elimination of Privately Issued Money
S
tephen Cecchetti & Kim Schoenholtz, Narrow Banks Won’t Stop Bank Runs

How Shadow Banking Provides Less Support for the Real Economy than Traditional Banking Did

I’ve finally organized the thoughts about banking that poured onto the pages of this blog in January. Unfortunately, the argument does not lend itself to convincing exposition in a blog post. So anybody who’s interested is going to have to trundle over to SSRN and download the paper, Shadow Banking: Why Modern Money Markets are Less Stable than 19th c. Money Markets but Shouldn’t Be Stabilized by a ‘Dealer of Last Resort’. I’ll warn you upfront, it’s tl;dr with a vengeance. On the other hand, I’m a pretty concise writer, so you’ll find I cover an awful lot of ground, if you give me an hour or two of your time.

Some highlights:

  • I start with Shadow Banking is an Unstable Funding System for Banks, Not Assets (so if you’re already familiar with the blogpost, you can skip that part).
  • I continue with my interpretation of why the industrial revolution took off in Britain: the banking system, of course — and it’s ability to create money. To make the point, I very briefly explain the nature of early modern financial markets, and how they gave birth to fiat money.
  • I then explain the components of the system that allowed 19th c. bankers to create risk-free private sector assets. Next I explain how these components fit in with a theoretic model of banking, and distinguish this model from Gorton and Ordonez model of “informationally insensitive” bank debt.  (Don’t worry, no math.)
  • Then I argue that the 19th c. lender of last resort, as it was understood by Bagehot, did not only serve as a source of liquidity, when panics threatened a crisis of confidence in the (fundamentally sound) banking system, but also actively managed moral hazard by explicitly withdrawing support from institutions that were undermining the quality of the money supply.
  • At last I come back to modern shadow banking, explaining how the modern perversion of the “lender of last resort” into “too big to fail” has led to the growth of extraordinarily unstable forms of funding, including financial commercial paper and repo. Collateralized money markets in particular maximize the value of the central bank put, by draining liquidity when it’s most needed.
  • I explain why a “dealer of last resort” cannot support asset market prices in general, but can only protect asset markets from forced sales by the specific dealers who are granted access to the central bank.
  • Finally, I distinguish the tight connection that exists between traditional commercial banking and the real economy from the much more ambiguous relationship between traditional dealer banks and the real economy. After all, traditional dealer banks don’t hold assets on their balance sheets over the long term and are far more focused on their short-run ability to sell off an asset, than in the asset’s performance over the long run.
  • It is because of the important role that commercial banks play in the real economy that they have privileged access to the lender of last resort facilities of the central bank. Dealer banks don’t play the same role and don’t deserve similar support. As for shadow banking, repo markets, to the degree that they fund private sector assets at all, fund market-traded assets and don’t support unsecured lending to smaller businesses, whereas asset backed commercial paper markets are steadily shrinking now that avenues of regulatory arbitrage are being closed.

 

Did Gold Standard Ideology or Cost-Avoidance Strategies Aggravate the Great Depression?

I had the good fortune to attend the INET 2014 conference this past weekend, to hear speak a variety of luminaries whose work I have been reading for years, and to meet bloggers with whom I have debated arcane points that none of my non-internet-based friends care about. I had a conversation there that I think sheds light on the causes of the Great Depression.

The thesis of Golden Fetters, Barry Eichengreen’s magnum opus, is this:

The gold standard is conventionally portrayed as synonymous with financial stability. … A central message of this book is that precisely the opposite was true. Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.

More recently Eichengreen and Peter Temin conclude that a gold standard ideology played an important role in worsening the Depression. They quote in their conclusion an author who wrote in 1932:

What is astonishing is the extraordinary hold which what is called the gold mentality has obtained, especially among the high authorities of the world’s Central Banks. The gold standard has become a religion …

Certainly in retrospect it seems likely, that had Britain gone off gold in 1924 — before the accrual of seven years of credit imbalances built on a disequilibrium exchange rate — the world economy’s adjustment to that event would have been less traumatic than the events that took place after 1931.  The question then is why there was such a strong commitment on the part of the world’s central bankers to supporting Britain in the maintenance of the gold standard.

I had a conversation at INET in which the following question was discussed:  Why are the central bankers committed to coordinating with the ECB on protecting the Eurozone when there is a significant possibility that the politicians will fail to make the necessary adjustments, that the Eurozone will break apart, and that in retrospect their actions will appear ill-advised?  The conclusion was this: from the point of view of the central bankers the immediate costs of failing to support the Eurozone are so high, that the central bankers have no choice but to have faith that the politicians will play the role they need to play.

If the same dynamic was at play historically, perhaps the golden fetters that chained central bankers in the 1920s and 30s were not ideological at all. But simply the fact that given a choice between causing an immediate crisis and leaving open the possibility, even if small, that the crisis can be avoided by political action, they could not bring themselves to take the pessimistic-realistic view. Maybe the central bankers in the 1920s and 30s felt that they had no choice but to place their faith in politicians, who were not worthy of that faith.

Liquidity provision and total informational “efficiency” are incompatible goals

Matt Levine writes:

Prices very quickly reflect information, specifically the information that there are big informed buyers in the market.

That’s good! That’s good. It’s good for markets to be efficient. It’s good for prices to reflect information.

Let’s take this argument to the limit. Every order contains some small amount of information. Therefore every order should move the market (as they do in building block models of market microstructure)– and of course big orders should move the market even more than small orders. Matt Levine is claiming that this is the definition of efficiency.

But wait: What is the purpose of markets? Do we want them to be informationally efficient about the fundamental value of the assets, or do we want them to be informationally efficient about who needs/wants to buy and sell in the market? These are conflicting goals. When a hedge fund is forced to liquidate by margin calls, those sales contain no information about the fundamental value of the asset. Should prices reflect the market phenomena or should they reflect fundamental value? According to Matt Levine they should reflect the market not the fundamentals.

Matt Levine supports his view by referencing an academic paper that assumes on p. 3 that all orders contain some information about fundamental value — and thus assumes away the problem that some market information has nothing to do with fundamental value. With only a few exceptions the theory supporting the view that trade makes markets informationally efficient in the academic literature assumes (i) that  informed traders trade on the basis of fundamental information about the value of the asset and (ii) that the informed traders have no opportunity to use their information strategically by delaying its deployment. Almost nobody models the issue of intermediaries trading on the basis of market information.  And the whole literature by definition has nothing to say about efficiency in the sense of welfare (i.e. the Pareto criterion) because it assumes that liquidity traders are made strictly worse off by participating in markets.

It has long been recognized that liquidity is one of, if not, the most important service provided by secondary markets. Liquidity is the ability to buy or sell an asset in sizable amounts with little or no effect on the price.

Matt Levine’s version of informational efficiency presumes that there is no value to liquidity in markets. Every single order should move the market because there is some probability that it contains information.

I thought the reason that financial markets attract vast amounts of money from the uninformed was because they were carefully structured to provide liquidity and to ensure that the uninformed could get a fair price. Now it’s true that U.S. markets were never designed to be fair — and were undoubtedly described in extremely deprecating terms by London brokers and dealers for decades — at least prior to 1986. But there’s a big difference between arguing that markets don’t provide liquidity as well as they should, and arguing, as Matt Levine does, that the provision of liquidity should be sacrificed at the altar of some poorly defined concept of informational efficiency.

If Matt Levine is expressing the views of a large chunk of the financial world, then I guess we were all wrong about the purpose of financial markets: as far as the intermediaries are concerned the purpose of financial markets is to improve the welfare of the intermediaries because they’re the ones with access to information about the market.  Good luck with that over the long run.

Time priority is the key to fair trading

A true national market system would have the following property. There are clearly defined points of entry to the system: that is, when an order is placed on specific exchanges, ECNs or ATSs, they will count as part of the system. These orders are time-stamped by a perfectly synchronized process. In other words, it doesn’t matter where your point of entry is, the time-stamp on your order will put it in the correct order relative to every other part of the system.

Order matching engines are, then, required to take the time to check that time-priority is respected across the national market system as a whole.

This structure would eliminate many of the nefarious aspects of speedy trading, while at the same time allowing high-speed traders to provide liquidity within the constraints of a strictly time priority system. Speedy orders couldn’t step in front of existing orders, because time-priority would be violated. Cancellations couldn’t be executed until after the matching engine had swept the market to look for an order preceding the cancellation that required a fill. In short, speedy traders would be forced to take the actual risk of market making, by always being at risk of having their limit orders matched before they can be cancelled.

Overall, it seems to me that the error the SEC made was in creating a so-called “national market system” without a time-priority rule.

Note: this post was probably influenced by @rajivatbarnard ‘s tweets about this same topic today.

Update: Clark Gaebel explains very clearly that we don’t have anything remotely resembling a “national market system.” We have a plethora of independent trading venues and your trade execution is highly dependent on your routing decisions.

The Shadow Banking System is an Unstable Funding System for Banks, Not Assets

There are many definitions of shadow banking. A New York Federal Reserve Bank monograph effectively equates shadow banking to securitization, or the process by which individual loans are packaged into bundles, used to issue a wide variety of collateralized assets, and sold to investors. The New York Fed monograph is often used to demonstrate how complicated and virtually incomprehensible the shadow banking system is – it includes a “map” of the shadow banking system that, for legibility, the authors recommend printing as a 36” by 48” poster.[1]

More commonly, however, the term shadow banking refers to the use of money market instruments to provide short-term finance to long-term assets,[2] and thus focuses attention on bank runs and on the fact that shadow banks can face such runs, just as traditional banks do. For this reason securitization should not be equated with shadow banking, because a significant portion of private sector securitized assets were financed on a long-term rather than on a short-term basis.[3] This post will limit its focus – as does most of the literature on shadow banking – to the role played by money markets in longer-term finance.

This post finds that our current money markets play only a very small role in the direct finance of private sector long-term assets and for the most part are used as a financing system for investment banks. In short, the “market-based” credit system that some equate with the shadow banking system,[4] is very small – and relies heavily on commercial bank guarantees. To the degree that a substantial shadow banking system continues to exist, it does not fund long-term assets directly, but instead provides wholesale funding for investment banks, and to a lesser degree commercial banks.

To be clear, the focus here is on finance of private sector banks and assets. Thus, although Fannie Mae and Freddie Mac played a very important historical role in the development of the shadow banking system, by pioneering the practice of financing long-term mortgage debt on money markets through the issue and roll over of short-term debt that was at least nominally a private-sector obligation,[5] they now officially have government support, and, for the purposes of this paper their debt is treated not as part of the shadow banking system, but as a government obligation.

This post provides a simple framework for understanding the shadow banking system that is organized around  the two instruments, commercial paper and repurchase agreements, that play an important role in money markets and that are, very roughly, comparable to deposits. Studying how these instruments are used not only allows a distinction to be drawn between the direct finance of assets and the finance of assets that sit on bank balance sheets, but also makes clear why the shadow banking system is unstable.

This analysis finds that the money market instruments have in the past played three roles: they have funded banks and non-financial firms directly, they have funded assets that lie off bank balance sheets, and in order to play these roles, they have created a need for commercial bank guarantees that induce lenders to lend off-balance-sheet or  in the case of tri-party repo to investment banks. In practice, the direct funding of assets now takes place only on a very small scale.

Because the two money market instruments, commercial paper and repurchase agreements (repos), are both short-term, it is easy for those who invest in them to “run,” or to decide that they no longer wish to invest their funds with a specific issuer or, indeed, in privately issued money market assets at all. Because these investors can always choose to put their money in Treasury bills or bank deposits, runs in the money markets are associated with unmanageably sudden shifts in investor preferences across short-term assets. In short, a fundamental attribute of the shadow banking system is that the decisions of money market investors can destabilize the money markets.

Money market mutual funds  and enhanced cash funds (that promise liquidity, but are less regulated than money market funds) are the most obvious money market investors, but the buy-side of the money market is composed of a huge array of institutional investment funds, corporations, and government bodies that have funds they wish to keep in liquid form. All of these entities can be part of a run in the shadow banking system. In addition, as will be explained in detail below, in the repo market it is possible for the recipients of funds, such as prime brokerage clients and banks in the interdealer market, to run.

Now that the basic instability of the money markets has been established, the next step in understanding the shadow banking system is to understand the different ways in which commercial paper and repo-based instruments are used; this is discussed in sub-part A. The following sub-parts evaluate what shadow banking does, and discuss why it is more unstable than traditional banking.

A.  Shadow Banking Instruments

1.  Commercial Paper

a.  Unsecured

Commercial paper is traditionally an unsecured obligation to make a payment that has a maturity of one year or less. It is analogous to the commercial bills that were used to finance economic activity in 19th c. Britain, and indeed has existed in one form or another for centuries.

i.  Issued by financial institutions

A little over half the commercial paper issued in the United States, or approximately $550 billion, is issued directly by financial institutions.[6] Because this market-based funding source is much less stable as a funding source than retail deposits, it is categorized along with other bank funding sources that are prone to runs as wholesale funding. The case of Lehman Bros. illustrates the instability of this form of funding. When Lehman declared bankruptcy, its commercial paper went into default, and set off a run by investors who feared money market mutual fund losses on money funds that invested in commercial paper; as a result the commercial paper market itself faced a run.

ii.  Issued by non-financial corporations

Approximately one quarter of commercial paper is unsecured and issued by non-financial corporations. Because non-financial corporations have less access to liquidity than banks, there is a risk that when their commercial paper is due they will be unable to roll it over into a new issue and will be unable to honor their commercial paper obligations due to this liquidity risk. For this reason, almost all non-financial commercial paper is protected by a liquidity facility provided by a bank, which promises to retire the commercial paper if the issuer is unable to do so. Observe that when Lehman failed, the run on commercial paper was not carefully targeted to financial commercial paper, and as a result non-financial commercial paper was subject to a run as well.

b.  Collateralized: Asset Backed Commercial Paper

In recent decades, sponsoring banks have moved assets that they originated into financing vehicles that are “bankruptcy-remote,” or not available to the sponsor’s creditors in the event that the sponsor declares bankruptcy. In addition, in theory any support that would be provided by the sponsor to the vehicle was defined in a contract, so the sponsor had contractually limited exposure to the vehicle’s liabilities.[7] Thus, these vehicles were designed as a means of removing assets from the sponsoring bank’s balance sheet.

The ABCP market was one of the key markets that collapsed in the early days of the financial crisis – from $1.2 trillion outstanding in early August 2007 to $905 billion three months later. Since then the market has continued to decline slowly, and it now hovers around $250 billion.

Because these vehicles finance long-term assets they face the same liquidity risk as non-financial issuers when issuing commercial paper. In addition these vehicles face credit risk in the event that the value of the assets falls below the value of the commercial paper, and the vehicle is no longer fully collateralized. Both liquidity and credit risk must be addressed before the vehicle can receive a credit rating that is high enough for it to issue asset-backed commercial paper (ABCP) that is secured by the assets in the vehicle. The three principal means by which liquidity and credit risk were resolved are discussed below.

i.  Bank supported ABCP:  Conduits

Prior to the financial crisis most ABCP was issued by ABCP conduits that were sponsored by banks. The banks typically provided both a liquidity facility, which guaranteed that the commercial paper would be retired even if it could not be rolled over, and a credit facility, which promised to honor some fraction of the commercial paper in the event that the value of the collateral fell too low to cover the costs of repaying the commercial paper.

In August 2007 when the crisis started there was a sudden loss in confidence in the ABCP market and many conduits could not roll over their commercial paper. The banks had to step in and honor the liquidity guarantees that had been made – and in order to do so they had to seek regulatory exemptions that are documented by the Federal Reserve.[8]

ii.  Liability structure supported ABCP: SIVs, LPFCs, etc.

Some ABCP-issuing vehicles guaranteed the payment of ABCP by funding the assets with a combination of bonds, medium-term notes and ABCP. These vehicles took many forms; the most common were called  structured investment vehicles (SIVs).

The concept behind these vehicles was that, in the event that the commercial paper could not be rolled over or the value of the assets fell below a trigger point, assets would have to be sold to pay off the ABCP and any losses would fall to the longer term debt holders. In 2007 most SIVs hit their triggers and were unwound. Because of the losses that were incurred by both longer-term and commercial paper investors (after lawsuits determined the allocation of proceeds), they are no longer a popular investment product.

iii.  Repo Conduits – discussed below

2.  Repurchase Agreements

A repurchase agreement (repo) is a simultaneous agreement to sell an asset today and to repurchase it a specific date and time in the future. It has the same economic effect as a collateralized loan. Typically the amount lent is less than the value of the collateral;[9] the percentage difference is called a haircut.

There are two repo markets: the bilateral repo market and the tri-party repo market. In the bilateral repo market the lender must have the capacity to receive and manage the collateral, whereas in the tri-party repo market the tri-party clearing banks, JP Morgan Chase and Bank of New York Mellon, provide collateral management services for the lenders. Money market investors like mutual funds lend only on the tri-party repo market where the principal borrowers are the dealer banks (although a few hedge funds and private institutions are credit-worthy enough to be accepted as counterparties on this market).[10]

The clearing banks also provide bank guarantees of liquidity to the tri-party repo market. Because it is the broker-dealers that borrow heavily on this market and because every trade in the market is unwound at the start of each trading day giving the borrowers access to their assets during the day, the two tri-party clearing banks extend credit to the borrowers during the day until the trades are rewound in the late afternoon. Thus the tri-party clearing banks provide a guarantee to the market and bear the risk of a broker-dealer failure during the day.[11] While reform of the tri-party repo market has been high on the Federal Reserve’s agenda, five years after the financial crisis 70% of the market is still being financed by the clearing banks on an intraday basis.[12]

On the bilateral market, where the lender must manage the collateral, the dealer banks are the lenders. The borrowers are prime brokerage clients, such as hedge funds, and other dealers.

As a result of this structure, funding generally enters the repo market via tri-party repo and the dealer banks, then, distribute this funding more broadly to their prime brokerage clients on the bilateral repo market. Thus, when a hedge fund buys an asset on margin, it borrows a significant fraction of the purchase price from the dealer bank that is its broker and posts the asset as collateral for the loan in a repo transaction. The dealer bank can then repo the asset on the tri-party repo market so that the dealer bank is effectively intermediating lending from the tri-party market to its client and earning an interest rate spread for the intermediation services. When the asset is of a type that cannot be used as collateral in the tri-party repo market, the dealer may choose to use the asset to raise funds on the inter-dealer segment of the bilateral repo market.

The dealer banks also hold collateral that is posted against derivatives contracts by other dealers and by prime brokerage clients. Whereas the inter-dealer derivatives contracts may have symmetrical collateral posting requirements, prime brokerage clients have typically been required to post collateral without having the right to require that dealer bank follow the same rule when the balance on the derivatives contracts is in the brokerage client’s favor. As a result a dealer bank is almost certain to receive collateral from its prime brokerage services when its client accounts are aggregated. The collateral posted by prime brokerage clients can then be used by the dealer to borrow in the tri-party repo market. As a result of this structure collateral posting by prime brokerage clients on their derivatives liabilities is also a form of financing for the dealer banks.

Thus, dealers often finance their own inventories, their prime brokerage clients’ assets, and any collateral that is posted against derivatives liabilities by other dealers or prime brokerage clients on the tri-party repo market.

The repo market is very different from the ABCP market and from commercial paper markets in general, because a run in one of the latter markets can only be caused by end investors. In the repo market a run can be started either by end investors or by other dealers and/or prime brokerage clients. Darrell Duffie has explained the many channels by which funding can be withdrawn in a repo market. These include: brokerage clients can move their accounts – together with all the collateral they have posted – to another dealer; dealers or brokerage clients who are derivatives counterparties can seek a novation (i.e. transfer) of a derivatives contract in order to post collateral to or expect payment from a more creditworthy dealer; dealers or brokerage clients may seek to reduce new exposures by entering into derivatives contracts that will require a dealer to post collateral; or repo lenders may increase haircuts or stop lending entirely to the dealer.[13] In short, the repo market is subject to inter-dealer and brokerage client runs, as well as to runs by repo investors.

In 2008 it is very clear that both Bear Stearns and Lehman faced a withdrawal of funding from other dealers, from brokerage clients, and from end investors in the repo market.[14]

3.  Repo Conduits

A repo conduit is a bankruptcy remote financing vehicle. The vehicle issues commercial paper that is backed by a repo with a maturity that matches the commercial paper. Thus, a repo conduit is backed primarily by the credit of the repo counterparty. Only if the repo counterparty fails to pay, can the repo conduit foreclose on the repo collateral. Because the term of the repo matches the term of the commercial paper, rating agencies do not require that a repo conduit have a backup liquidity facility.

The credit rating of a repo conduit typically is based entirely on the credit of the repo counterparty.[15] For this reason, repo conduits can be used – by institutions with high credit ratings – to finance assets that would not be eligible for tri-party repo financing.

B.  What Does Shadow Banking Do?

1.  Shadow Banking is a Funding Mechanism for Banks

The most important role of the shadow banking system is to provide wholesale funding for banks. Unsecured wholesale funding is provided when a bank issues commercial paper. Secured wholesale funding is provided when a investment bank uses the tri-party repo market to finance inventories, the assets of brokerage clients, and any collateral posted by counterparties in derivatives transactions.

As of Dec. 31, 2013, financial institutions raised $550 billion unsecured on financial commercial paper markets and the dealer banks used the tri-party repo market to borrow on a secured basis close to $1.6 trillion. 80% of the collateral posted is Treasuries and Agencies. Only $330 billion of private sector assets are financed on this market.

2.  Shadow Banking is a Funding Mechanism for Assets

Before the crisis, the shadow banking system played an important role in funding assets with liabilities that were secured by assets that were held off of bank balance sheets in bankruptcy remote vehicles. When this secured asset funding relied on bank support, it was usually provided by ABCP conduits. When this secured asset funding was made possible by a tiered liability structure, it was provided by SIVs and similar vehicles. When this secured asset funding relied on a maturity-matched repo, it was provided by a repo conduit.

Before the crisis the ABCP market was the most important source of shadow bank funding of private sector assets. (Not only did the tri-party repo market fund private sector assets that were for the most part on dealer bank balance sheets, but it was dominated by Treasuries and Agencies and thus played a relatively small role in financing private sector assets even indirectly.[16]) In post-crisis markets vehicles like ABCP and repo conduits are financing far fewer assets than they did before the crisis. The ABCP market is continuing its slow but steady decline over time and now hovers in volume around $250 billion.

3.  Shadow Banking Allows Money Market Issuers to Rent Bank Credit and Allows Banks to Avoid Capital Requirements

When assets were directly financed by the shadow banking system, it was usually because financing vehicles paid a small fee to “rent” a commercial bank’s credit rating by purchasing a guarantee of the vehicle’s liabilities. Because these guarantees were off-balance sheet, the bank was able to avoid the capital requirements that would have been imposed if the bank had done the lending itself. The role played by the clearing banks in the tri-party repo market is similar: they provide intraday credit in order to give dealer banks access to their assets during the day, but face no capital charge for the credit. Thus, a key function played by shadow banking is the arbitrage of capital regulations.[17]

The liquidity and credit facilities provided by banks to ABCP conduits are examples of unsecured bank guarantees.[18] By contrast, the tri-party clearing banks provide secured guarantees. The intra-day credit that the clearing banks provide to the dealer banks is secured by the collateral that has been posted on the tri-party repo market. Banks may also issue guarantees in the form of swaps that offset the market risk of collateral; these guarantees may be secured or unsecured depending on the derivative contract.

The collapse of the ABCP market since regulators have become attuned to the problem of regulatory arbitrage of capital requirements is just another piece of evidence that the vast majority of financing on the ABCP market at its peak was not driven by economic efficiencies, but by regulatory arbitrage as banks used liquidity and credit facilities to take on credit risk, while avoiding capital requirements. Indeed, the industry reaction to the 2004 Final Regulation governing such liquidity facilities – which resulted in a “reinterpretation” of the regulation that effectively gutted it – is also evidence of the importance of regulatory arbitrage to this market.[19]

C.  Collateralized Money Markets Are More Unstable Than Traditional Banks

The use of collateral in repo markets makes them particularly unstable for two reasons: leverage and the fact that not just lenders, but borrowers, can start a run.

When the price of the collateral in a repo contract falls, the borrower is typically required to post more collateral within a day, and, in the event that the collateral call is not met, the collateral that was posted can be liquidated immediately. While this description shows how quickly market price changes can be reflected in the sale of collateral on repo markets, it does not take the leverage that is ubiquitous on repo markets into account. Because of leverage small changes in the market price of an assets can force the borrower to sell off a large fraction of the borrower’s holding of that asset.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[20] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

Not only does leverage make repo markets inherently unstable, but, in addition, a key characteristic distinguishing the repo market from unsecured credit markets generally is that not only the lenders, but also the borrowers, can start a run. The use of collateral in bilateral repo markets makes a borrower run possible, because the collateral can be rehypothecated, or posted as collateral in a subsequent loan by the recipient of the collateral. In short, the collateral posted by borrowers in the bilateral repo market is a source of liquidity for the lender.

When borrowers decide that they don’t want to be exposed to a troubled lender that may not be able to return the borrowers’ collateral in the event that it fails, the borrowers may seek to transfer their accounts to a lender who is not troubled. When the borrowers’ accounts are transferred, the collateral they have posted it transferred with the accounts, and the troubled lender loses the liquidity that was provided by that collateral.

As a result of this property of the repo market, the dealer bank failures of 2008 were characterized by “runs” by both prime brokerage clients and other dealers, none of whom wanted to be exposed to a failing bank. In fact, Krishnamurthy, Nagel, & Orlov conclude that the evidence supports the view that the 2008 crisis looks more like an inter-dealer credit crunch than a run by end investors on the two firms.[21] For these authors one factor distinguishing the two types of runs is the fact that the dealers are well-informed market participants, whereas end investors typically must decide whether to pull out of the market based on very limited information.[22] In short, it is possible that, far from being comparable to bank runs, the runs that took place in 2008 were runs that started with the most informed participants in financial markets.

Thus, there are two very important differences that make the repo market more unstable than unsecured funding markets. Not only does leverage mean that a small decline in price can easily force a large sale of asste, but in the bilateral repo market a run can be started not only by lenders, but also by borrowers.

In conclusion, it is misleading to describe the shadow banking system that exists today as “money market funding of capital market lending” and to focus on it as a means of financing assets,[23] because at present by far the most important use of shadow banking instruments is to provide wholesale funding for dealer banks and through them indirect financing of assets that sit on their balance sheets. Although the view that shadow banking finances assets directly may have held some truth prior to the crisis when $1.2 trillion of ABCP financed bankruptcy remote vehicles, today, to the degree that shadow banking disintermediates commercial banks, it does so by reintermediating investment banks – using a form of funding that is even more unstable than deposits.

The key question that regulators have yet to answer is whether this collateralized wholesale funding market is a valuable addition to the financial system or whether the risk of instability that accompanies it is so great that lending on this wholesale market should be curtailed.


[1] Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, & Hayley Boesky, Author’s Note in Shadow Banking, NYFRB Staff Rep. No. 458 (July 2010).

[2] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker (Nov. 2013).

[3] For example, although only $35 billion of private label residential mortgage-backed securities have been issued since 2008, at the end of 2013 more than $1 trillion of such securities remained outstanding. Data from SIFMA: http://www.sifma.org/uploadedFiles/Research/Statistics/StatisticsFiles/SF-US-Mortgage-Related-SIFMA.xls?n=47986.

[4] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker 2 (Nov. 2013).

[5] See Frank Fabozzi & Michael Fleming, U.S. Treasury and Agency Securities 11 (April 2004), available at http://www.newyorkfed.org/cfcbsweb/Treasuries_and_agencies.pdf.

[6] Federal Reserve Commercial Paper Release, Outstanding

[7] In practice, banks sometimes supported these vehicles even in the absence of a contractual obligation to do so, and sometimes did not.

[8] See the letters granting JPMorgan Chase & Co., Citigroup Inc., and Bank of America Corp. Regulation W exemptions that are dated August 20, 2007, available at the Federal Reserve website: http://www.federalreserve.gov/boarddocs/legalint/FederalReserveAct/2007/.

[9] Note that in securities lending, where institutional investors provide high-quality, high-demand collateral like Treasuries to the market, haircuts frequently go in the reverse direction. That is, more money must be lent than the value of the collateral in order to induce the securities lenders to lend.

[10] Tobias Adrian, Brian Begalle , Adam Copeland , Antoine Martin, Repo and Securities Lending, Federal Res. Bank of NY Staff Report No. 529, Feb. 2013 at 5-6.

[11] Adam Copeland, Darrell Duffie, Antoine Martin, and Susan McLaughlin, Key Mechanics of The U.S. Tri-Party Repo Market, 18 FRBNY Economic Policy Review 17, 22, 24 (2012).

[12] William C. Dudley, speech, Introductory Remarks at Workshop on “Fire Sales” as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets, Oct. 4, 2013.

[13] Darrell Duffie, How Big Banks Fail 23 – 42 (2011). See also William Dudley, More Lessons From the Crisis, Remarks at the Ctr. for Econ. Policy Studies Symposium, (Nov. 13, 2009), available at http://www.newyorkfed.org/newsevents/speeches/2009/dud091113.html; Adam Copeland, Antoine Martin & Michael Walker, The Tri-Party Repo Market before the 2010 Reforms 56-58 (Fed. Res. Bank of N.Y. Staff Rep. No. 477, 2010).
Duffie observes that when there is a repo market run, the coup de grace is almost always given by a clearing bank when it responds to concerns about a firm’s financial position by exercising its right to offset aggressively, by for example demanding collateral for intraday exposures or refusing to give access to deposits. Duffie, supra note 9, at 41¬-42.  See also Tobias Adrian & Adam Ashcraft, Shadow Banking Regulation 17 (Fed. Res. Bank of N.Y. Staff Report No. 559, 2012).

[14] Duffie, at 23-42.

[15] Moody’s Revises Approach To Counterparty Rating Actions In Repo ABCP Conduits, Oct. 21, 2009, available at http://www.cranedata.com/archives/all-articles/2541/

[16] Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo 22 (NBER Working Paper No. w17768, 2012).

[17] Carolyn Sissoko, Note, Is financial regulation structurally biased to favor deregulation, 86 Southern California Law Review 365 (2013). Sissoko also has a discussion of the broader literature on the role of regulatory arbitrage in the ABCP market.

[18] See id. for details.

[19] See Sissoko, Deregulatory Bias at.

[20] Fitch Ratings, at 8.

[21] Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo 19,22 (NBER Working Paper No. w17768, 2012).

[22] Id. at 6.

[23] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker (Nov. 2013).

Critique Part IV: Should the Collateralized Money Market be Stabilized or Euthanized?

IV. Should the Collateralized Money Market be Stabilized or Euthanized? 

This is Part IV of a lengthy critique of Bagehot was a Shadow Banker by Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson. The authors of Bagehot was a Shadow Banker equate the shadow banking system with what they call the “market-based credit system” (at 2). To be clear, the authors focus specifically on a market-based short-term credit system or on money markets. In this Part I ask what does it mean to call a credit system “market-based” and whether such a system exists, then I discuss the consequences of moving from an unsecured money market to a collateralized money market, and finally I evaluate the likely effectiveness of the solution proposed by the authors of Bagehot was a Shadow Banker in stabilizing the collateralized money market.

A.  Does a “market-based” credit system exist?

The “market-based” credit system is often contrasted with the “bank-based” credit system to distinguish environments where firms raise funds by issuing securities on markets from those where firms raise funds by borrowing from banks.[1] This distinction is clear when we focus on long-term capital markets, such as bond markets where established companies can and do raise money on a regular basis.

When it comes to money markets, however, the line between market-based and bank-based systems cannot be clearly drawn, because the so-called market-based systems rely heavily on guarantees provided by the banking system. The principle instruments used to borrow short-term on markets are commercial paper (the short-term version of a bond) and repurchase agreements, in which the borrower simultaneously sells an asset and agrees to repurchase it at a fixed future date and price, effectively creating a collateralized loan. As was discussed in Part II, as a rule non-financial companies can only borrow on these markets if they have liquidity support from a bank: Because commercial paper typically needs to be rolled over at maturity, almost all non-financial issuers including asset-backed commercial paper conduits must have a liquidity facility, or a bank’s promise to retire the paper if the issuer is unable to do so. Similarly, the most important repo market is backstopped by guarantees provided by the tri-party clearing banks, which bear the credit risk of the borrowers during the day. In short, in the money markets the “market-based” credit system might as well be called the “bank-guaranteed” credit system.

Furthermore, because so-called “market-based” money market instruments require bank guarantees and those guarantees are most likely to be called upon in a crisis, the “market-based credit system” insulates banks from the credit risk of borrowers in normal times, but not in crises. Because such instruments are always designed in normal times when the likelihood that the bank will be obliged to make good on its contingent liability is deemed minimal, these instruments create a form of bank risk that typically carries lower capital requirements than alternatives. For these reasons, the “market-based” short-term credit system is best viewed as a form of bank lending that is designed to minimize capital requirements, and it should be categorized as lying within the “bank-based” credit system.

Another sense in which money market instruments are only nominally “market-based” is that these assets do not trade on secondary markets. Commercial paper is placed and almost never resold before maturity. Repo obligations, similarly, are not traded actively, but held until maturity.[2] By contrast, in 19th c. London, the archetype of a traditional bank-based credit system, there was an active secondary market in the bills that were the primary tool by which central bank policy was implemented.

Repurchase agreements and asset-backed commercial paper (but not commercial paper more generally or 19th c. bills) are both collateralized forms of “market-based” money market instruments. Such collateralized money market instruments can also be considered “market-based” in the sense that they are subject to market risk; that is, if the value of the collateral falls below the value of the debt, the borrower will have to post additional collateral. Market risk is a key concern of the authors of Bagehot was a Shadow Banker, and it is possible that when the authors use the term “market-based credit system” they mean only to refer to collateralized money market instruments that are subject to market risk; if this is the case, in my view, the term, collateralized money market is more clear.

It is not clear whether the authors of Bagehot was a Shadow Banker imagine a world in which so-called “market-based” money market instruments exist without the support of bank guarantees. If so, it should be noted that their solution is tailored to market risk, whereas the bank guarantees are needed to address funding risk. That is, even if there were no market risk and the collateral’s value could not fall, the possibility that the borrower would find itself illiquid and unable to retire or to roll over the debt (for reasons specific to the borrower or to the money market, not to the collateral) would almost certainly mean that funding guarantees were still necessary to support the market.

To summarize, because the finance of longer-term assets requires that these short-term instruments be rolled over, funding risk is always a concern in the so-called “market-based” short-term credit system, and this almost certainly means that this “market-based” credit system cannot exist except when it is backstopped by the banking system. Thus, what is commonly known as the “market based” short-term credit system – including most of the shadow banking system – should properly be understood to lie within the “bank-based” credit system.

The rest of this Part will assume that the authors use the term “market-based” credit system only for the purpose of focusing attention on the market risk inherent in the collateralized portions of the money market. Thus, I will focus on what I will call the collateralized money market.

B.  Is transforming credit risk into market risk a good idea?

In the collateralized money market, borrowing is collateralized in order to provide additional security to the lender, and market risk substitutes for a portion of the credit risk that lenders traditionally face. From the borrowers’ point of view less-creditworthy borrowers have access to credit, but this access comes at the expense of raising the costs of borrowing for borrowers, who now have to worry not only about having the resources to pay the debt at maturity, but also about maintaining sufficient collateral to back the loan throughout the life of the loan. Thus, borrowers will elect to use this system if they are not sufficiently creditworthy to borrow unsecured or they have easy access to collateral.

The authors of Bagehot was a Shadow Banker are correct to emphasize that the most important difference between 19th c. British money markets and modern money markets is the role that market risk plays in modern markets. 19th c. money markets focused on managing credit risk exclusively – so much so that Thornton viewed the “science” of credit as the great innovation of the British banking system and a driving force of the economy’s growth.[3] The careful management of credit risk in the 19th c. is illustrated both by the fact that every bill discounted by the Bank of England was guaranteed to be paid in full by at least three different parties, the issuer, the acceptor, and the discounter, and by the fact that the Bank had negligible losses on its discount portfolio, even after a crisis.[4]

The authors of Bagehot was a Shadow Banker treat the growth of market risk and collateralized money market assets as a demand-side phenomenon (at 12). They reference Pozsar’s work which emphasizes that the largest lenders in modern markets, asset managers such as mutual and pension funds, are reluctant to extend unsecured credit to the banks in the form of uninsured deposits and prefer to lend via repos or asset backed commercial paper.[5] (Note that this point should not be overemphasized, because banks are able to raise significant funds, unsecured, by issuing commercial paper.) The second demand-side explanation for the growth of the collateralized money market is the modern asset management practice of using derivatives markets to take on the risks of investing while holding invested funds in monetary assets. Presumably, supply-side effects may also have played a role in the growth of this market, as investment banks found the market both convenient for financing inventories, and possessed of the useful property that in normal times the market was not very sensitive to changes in the credit quality of the borrower.[6]

The authors view this transformation of the money market from one in which credit risk was carefully managed to one where market risk substitutes for credit risk as a benign, if not beneficial, development. There are, however, many concerns that this development should raise.

First are the implications the movement towards collateralized short-term lending may have for the credit quality of our financial institutions. It is possible that this movement reflects declining credit quality among financial institutions that makes it difficult for them to borrow on an unsecured basis. The fact that this change took place alongside the transformation of the investment banking industry from unlimited liability partnerships to limited liability corporations may be an indicator that declining credit quality is an important driving force behind this change. Another potential concern is that the movement to collateralized short-term lending aggravates declining credit quality among financial institutions. Research has shown that repo lending terms are principally determined by the quality of the collateral posted and do not tend to reflect incremental changes in the credit quality of the borrower.[7] For this reason, it is possible that the movement towards collateralized borrowing makes borrowers less concerned about whether or not they are viewed as good quality borrowers.

Second, as was discussed in Part I, early monetary theorists such as Henry Thornton believed that banking contributed to economic growth because it allowed the money supply to expand based on the needs of the economy and that the “science” of credit facilitated this expansion. Collateralized money markets, however, substitute market risk for credit risk, and as techniques for issuing unsecured money market instruments fall into disuse may have the effect of limiting the use of unsecured credit more than the principles of managing credit risk would require. If unsecured credit falls into disuse, the growth of the money supply, and arguably of the economy itself, may be limited by a deficit of collateral. In short, it is not clear that collateralized money market instruments can play the same role in expanding the money supply and in economic growth as that played by unsecured money market instruments.

Finally, repo markets are likely to be even less stable sources of funding for financial institutions than deposits, and thus even more prone to fire sales. Because the realization of market risk in collateralized lending markets can force immediate deleveraging, the availability of funding on repo markets can disappear just as quickly as deposits can be withdrawn – and even more quickly than credit based on unsecured term instruments which can only be withdrawn as the instruments mature. In addition, however, the fact that the collateral on repo markets is funded on a leveraged basis means that small changes in the market prices of assets can result in the need to sell off a large fraction of assets. Because of leverage, repo markets are probably less stable than deposit-based funding.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[8] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

C.  Should collateralized money markets be stabilized by protecting leveraged dealers from losses?

The authors of Bagehot was a Shadow Banker recognize that collateralized money market instruments are prone to fire sales and liquidity spirals, but they do not appear to realize that, due to the leverage that is used in repo markets, very small price declines can have very large effects. They argue that a dealer of last resort is all that is needed to stabilize these markets, and that the dealer can do this by putting a price floor on the assets used as collateral. Specifically they write:

just as in Bagehot’s day, the critical infrastructure is an interconnected system of dealers, backstopped by a central bank. Just as in Bagehot’s day, the required backstop may involve commitment to outright purchase of some well‐defined set of prime securities (such as Treasury securities). But it must also involve commitment to accept as collateral a significantly larger set of securities, in order indirectly to put a floor on their price in times of crisis. (at 9).

Two points should be emphasized with respect to this proposal. First, it is important to understand that despite the authors’ focus on the support of asset prices, the key innovation in the “dealer of last resort” proposal is the extension of central bank support to dealers. Secondly, because dealers are very different from banks, the extent of the support provided by the central bank to dealers is likely to be much greater than that provided to banks.

As for the first point, the Federal Reserve has had the ability to accept virtually any security as collateral since 1932 – as long as it was collateral for a loan to a commercial bank.[9] The problem in 2008 was not the nature of the collateral that could be used, but the fact that investment banks didn’t have access to the central bank. Thus, the key innovation of the “dealer of last resort” proposal is not the type of collateral that can be used for a loan, but the fact that dealers – or investment banks – are able to borrow from the central bank using that collateral.

For non-prime assets, the proposal is only that the central bank accept them as collateral, not that it buys them outright. One potential advantage of accepting assets as collateral, rather than buying them outright, is that the central bank may not need to determine their value, but can choose to rely on the valuation of the collateral given by the borrower, because the borrower will be liable for any shortfalls if the collateral is worth less than the loan. In this case, the purpose of accepting an asset as collateral is not to “put a floor” on its price, but to prevent the borrower from being forced to sell it in a fire sale. This is an important distinction to make, because the central bank is not, in fact, intervening in the market pricing mechanism in the way that the phrase “put a floor on the price” implies. Instead, the central bank is making it possible for the borrower to carry the asset at the valuation at which the borrower is willing to buy the asset back in the future. The level of the asset’s market price is affected, but not determined, by this policy.

Under this interpretation of the proposal, the dealer of last resort should not be viewed as supporting the price of assets (as the authors claim in many places), but as supporting the dealer system. While this understanding is not consistent with “putting a floor” on asset prices, it is more consistent with the author’s claim that when the central bank intervenes, the price decline “is not so much halted or reversed as it is contained and allowed to proceed in a more orderly fashion” (at 14). After all, if the goal is to put a floor on the price of the assets, it doesn’t make much sense to claim that these prices will continue to decline in an “orderly fashion.”

Secondly, the function of dealers in supporting market liquidity is very different from the function of banks in honoring deposits and funding guarantees; as a result the nature of a central bank backstop, and indeed the degree of reliance on the central bank is likely to be very different for a dealer of last resort as compared to a lender of last resort. In order to address the problem of liquidity spirals, the authors of Bagehot was a Shadow Banker argue that:

what is clearly needed is some entity that is willing and able to use its own balance sheet to provide the necessary funding. … what we need is a dealer system that offers market liquidity by offering to buy whatever the market is selling. Only in crisis time does the central bank backstop become the market; in normal times, the central bank backstop merely operates to support the market. (at 9).

Because the primary work of a dealer is that of smoothing the market’s movement to a new price, and not of setting a floor on asset prices, it’s far from clear that dealers can ever be expected to the play the role that the authors of Bagehot was a Shadow Banker seem to expect them to play in supporting prices on markets. The traditional constraints on the behavior of a dealer are described by Jack Treynor, the source of the authors’ model of dealer pricing: “the dealer has very limited capital with which to absorb an adverse move in the value of the asset. Furthermore, the dealer’s spread is too modest to compensate him for getting bagged.”[10] Treynor contrasts the role played by a dealer with that of an investor who has the capital to hold positions over a longer term. Thus, a traditional dealer does not “use its own balance sheet to provide the necessary funding” except over very short time horizons. On the other hand, it is true that large-scale proprietary trading and the management of balance sheet exposure to related risks has become a core function of dealers in recent decades. (This is almost certainly related to the role played in the market by limited liability investment banks that have access to vast capital resources the use of which is monitored, not necessarily effectively, by boards of directors.)

Because the traditional function of a dealer is not to support asset prices, however, it seems likely that even dealers engaged in large-scale proprietary trading will let a liquidity spiral run before stepping in to buy in significant quantities – and then they may well allow the price to continue falling as they build up a significant stake in the assets. After all, if sellers want to sell at unreasonably low prices, this will only add to the dealers’ proprietary trading profits in the end.

Indeed, this is what we witnessed in 2008 when Bear Stearns and Lehman were failing: for the most part, the dealers instead of using their balance sheets to support prices on the market sought to avoid being caught holding assets that are falling in value. Thus, one would expect the burden of establishing a price floor for assets to fall heavily on the dealer of last resort or central bank, just as it fell heavily on the Federal Reserve which had to jerry rig facilities such as the Primary Dealer Credit Facility and the Term Securities Lending Facility in order to take on hundreds of billions of dollars of the asset risk of the investment banks in 2008.[11] At the start of October 2008, these two facilities accounted for 60% of the massive expansion of the Federal Reserve’s balance sheet as compared to the previous year. In short, because providing a price floor for assets is not the economic function of a dealer, a central bank that acts as a “dealer” of last resort must be prepared to purchase assets on this scale – and effectively to become the market – in every crisis.

These two points indicate that the value of the dealer of last resort policy is that a troubled dealer can use the assets as collateral to borrow from the central bank, and doesn’t need to sell them at all. The fact that the largest market participants are protected from ever finding themselves forced to sell their assets will undoubtedly be very effective in protecting asset prices from instability due to massive fire sales.

But the proposed policy would also introduces a very troubling asymmetry into our markets. Who has access to central bank’s discount window? Retail investors clearly do not, whereas “dealers,” however they end up being defined, do. The privileged dealers effectively have access to an unlimited balance sheet and can employ leverage without worrying about being forced into a fire sale – and no longer face the traditional constraints that govern dealers’ activities.[12] By contrast, those without this privilege are limited by their capital position in the degree to which they can increase their profits using leverage.[13]

In short, this policy is likely to have the effect of protecting the privileged dealers from losses due to market risk, while other market participants do not receive similar protection. By reducing the costs of leverage to the privileged dealers it is also likely to increase their use of leverage. If the central bank does not monitor the behavior of the privileged dealers vigilantly, it could end up making financial markets more risky, by making the largest financial market participants believe that it is “safe” for them to take on more risk.

These dangers are offset in part by the fact that the dealer of last resort’s actions in a crisis will forestall an immediate collapse and the economic repercussions of such a collapse. And this fact almost certainly justifies the Federal Reserve’s actions in 2008. It is less clear that this fact is enough to justify embracing the “dealer of last resort” proposal as a standing policy.

The reason that the lender of last resort is good policy, whereas the dealer of last resort probably is not good policy, is that banks are different. Their value lies in making possible money markets based on unsecured credit that is extended broadly across the business community and makes modern economic growth possible. The banking system merits the protection of a lender of last resort, because it provides such broad benefits to the community at large, and there is good reason to believe that without a lender of last resort a banking system will collapse entirely.

There is, by contrast, a long history of dealer systems that support trade on financial markets and are not at risk of collapse in the absence of a dealer of last resort. Furthermore, there is little or no evidence that collateralized money market instruments play the same role as uncollateralized money market instruments in economic growth, and thus little or no evidence that collateralized money markets are necessary to the community at large. In fact, the growth of collateralized money markets may undermine traditional unsecured money markets, where a financial institution’s ability to borrow depends on its credit quality, and thereby undermine the market forces that promote high credit quality in the financial industry. For this reason, the collateralized money markets may be destabilizing the financial industry. While the temporary support of these markets in 2008 was well justified, much more evidence of the value of collateralized money markets to the process of economic growth needs to be presented before dealers and investment banks are given privileges similar to those of commercial banks.

Introduction
Part I
Part II
Part III
Complete paper

[1] See, e.g., Michael Woodford, Financial Intermediation and Macroeconomic Analysis, 24 J. Econ. Perspectives 21, 21 (2010).

[2] The collateral posted against a repo can often be rehypothecated, but this is very different from the resale of the debtor’s obligation that takes place in secondary markets.

[3] Thornton, at 175-76.

[4] Vincent Bignon, Marc Flandreau, & Stefano Ugolini, Bagehot for beginners: the making of lender-of-last-resort operations in the mid-nineteenth century, 65 Econ. Hist. Rev. 580, 602 (2012).

[5] Zoltan Pozsar, Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System 10-11 (IMF Working Paper No. 11/190, Aug. 2011).

[6] Fitch Ratings, Repo Emerges from the “Shadow” 3 (Feb. 3, 2012).

[7] Id.

[8] Fitch Ratings, at 8.

[9] Critics complained that “any cat and dog” could be used as collateral at the Fed, after the Federal Reserve Act was amended in 1932. David McKinley, The Discount Rate and Rediscount Policy 97, quoted in David Small and James Clause, The Scope of Monetary Policy Actions Authorized Under the Federal Reserve Act 10 n.22 (FEDS Research Paper 2004-40, 2004).

[10] Jack Treynor, The Economics of the Dealer Function, 43 Fin. Analysts J. 27, 27 (1987).

[11] Federal Reserve Board of Governors, H.4.1 Release: Factors affecting reserve balances, Oct. 2, 2008.

[12] Treynor, at 27.

[13] For the role that capital constraints typically play in risk-taking, see Andrei Schleifer & Robert Vishny, The Limits of Arbitrage, 52 J. Fin. 35 (1997).

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