II. Comparing 19th c. and Modern Money Market Assets
This is Part II of a lengthy critique of the paper, Bagehot was a Shadow Banker. First, this Part explains a few of the means by which modern banks address the funding risk inherent in the shadow banking system by providing services that are very similar to acceptances. Then, the maturity of the assets funded on 19th c. and modern markets is discussed along with the consequences of the fact that capital assets are financed on modern markets, creating market risk, in addition to funding risk. Finally, the likelihood that the credit quality of 19th c. money market assets was significantly greater than that of modern assets is explored.
A. Modern equivalents of 19th c. acceptances are common in the modern shadow banking system
The paper correctly explains that an “acceptance,” or the guarantee of payment by a London firm whose acceptance made the bill eligible for discount at the Bank or England, was what made a bill liquid or tradable on London money markets. (Note, however, that it was not unusual for bills to circulate locally without a London acceptance.) The paper makes the rather odd claim, however, that “the closest thing we have to the institution of ‘acceptance’ is the credit default swap” (at 6). On the contrary, the modern shadow banking system is replete with a wide variety of bank guarantees that make otherwise illiquid assets liquid.
The commercial paper market, a cornerstone of the shadow banking system, has always relied on “backup lines of credit” or “liquidity facilities” provided by banks to make it possible for non-financial issuers – and asset-backed commercial paper conduits – to market their commercial paper. These facilities mean that, even if a firm (or conduit) is facing liquidity difficulties when the commercial paper matures, the bank guarantees that the commercial paper will be retired at maturity. In theory, these facilities were designed to address only liquidity problems and did not enhance the credit quality of commercial paper issues; however, regulatory capital requirements made the provision of credit facilities much more costly for banks than the provision of liquidity facilities and, as a result, liquidity facilities were structured to provide credit enhancement along with a liquidity backstop. Just as an acceptance made 19th c. bills marketable in London, so the backup facilities provided by banks to commercial paper conduits make commercial paper marketable in modern markets.
The other cornerstone of the shadow banking system is the repurchase agreement, or repo, market. The most important repo market is the tri-party repo market and this too is anchored by bank guarantees of liquidity. 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 (to give the borrowers access to their assets during the day), the two tri-party clearing banks, J.P. Morgan Chase and Bank of New York Mellon, 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. 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. Here, we find that the liquidity of a key shadow banking market is created by bank guarantees, similar to the reliance of the 19th c. London money market on acceptances.
In short, both the commercial paper and repo markets derive their liquidity from bank guarantees. These guarantees seem to be the closest analogs to the acceptances issued by 19th c. London banks. Let us evaluate, however, the claim that a credit default swap is also an analog of an acceptance.
The most important difference between a credit default swap (CDS) and an acceptance is that combining a CDS on mortgage backed securities with mortgage backed securities, for example manufacturing a collateralized debt obligation or CDO, does not produce a liquid asset. (This is true of the backup facilities provided to commercial paper issuers too.) The additional protection may have made the aggregate product marketable, in the sense that the product could be placed once with an investor, but it did not make it liquid in the sense that it created an asset that was traded actively on a market or circulated from hand to hand as a form currency.
Another important difference is basis risk. Unlike acceptances and the guarantees provided to commercial paper issues or to tri-party repo unwinds, a CDS is not related to a particular debt obligation. As the authors of Bagehot was a Shadow Banker note, because a CDS does not guarantee payment of a particular debt, the payment received on a CDS will not necessarily be sufficient to compensate for the amount lost on the unpaid debt. This is basis risk: the risk that the hedging instrument is not a good match for the hedged instrument.
As I understand it, however, when comparing a CDS to an acceptance the authors’ principle claim is that an acceptance converted a non-prime asset, the bill, to a prime asset, the accepted bill, just as a CDS (together with an interest rate swap (IRS) and foreign exchange swap, if needed) converts a risky long-term asset into a “risk-free” prime bill or short-term asset. Thus, the point is that both an acceptance and a CDS (plus IRS) can be used to convert non-prime assets into prime short-term assets. (In my view, bank backup facilities provided to commercial paper and repo markets can play the same role as acceptances in converting non-prime credit risks into prime credit risks, but that was addressed above.)
The nature of the non-prime, risky assets being funded on the money markets in the 19th c. and in modern markets differs in two important respects. First, the risky non-prime assets in modern markets are long-term assets, and as such carry very different risks than the short-term assets funded in the 19th c. Second, the credit quality of the non-prime assets in the two markets is not necessarily comparable.
B. Maturity of assets funded on the money market
The authors of Bagehot was a Shadow Banker define shadow banking as “money market funding of capital market lending” and describe it as “the centrally important channel of credit for our times” (at 2). Capital market lending generally refers to lending with a maturity in excess of one year, and contrasts with lending on money markets for terms of one year or less. (They also describe shadow banking at great length as a “market based credit system.” The question of whether a market based credit system has ever existed will be discussed in Part IV.) The authors do not attempt to show that money market funding of capital market lending took place on a significant scale in Bagehot’s time.
Instead the authors claim that the bill brokers of Bagehot’s day were comparable to money market dealers of the modern era, acknowledging that the market at issue in the 19th c. was a market in short-term private debt (at 4-5). In one sense, I agree with the authors: as argued in Part I, bill brokers were the shadow banks of mid-19th c. England. But it is important to note that the bill brokers’ activities do not meet the authors’ definition of shadow banking, because the funding of capital market lending was a not a legitimate focus of their activities. The business of the bill brokers and of the bankers was the funding of money market instruments that were issued by businesses throughout Britain and functioned as a form of working capital. These money market instruments were short-term and did not involve lending on capital markets.
In contrast, the fact that long-term assets are funded short term by the modern shadow banking system means that modern shadow banking is not “a bill funding market, not so different from Bagehot’s,” but a capital asset funding market. It is for this reason that “mere guarantee of eventual par payment at maturity doesn’t do much good” since “so many promised payments lie in the distant future” and the only option for a lender in a liquidity crisis is to sell the asset or use it as collateral to borrow. Thus, the need for market liquidity is generated by the fact that long-term assets are being funded.
Although the authors imply that market liquidity and funding liquidity – or guarantees of payment in the event of default such as acceptances, backup credit lines, and tri-party clearing bank guarantees – are substitutes (at 7), in fact, modern markets require market liquidity in addition to funding liquidity. In short, the reason that modern markets require a different form of support from 19th c. markets is that by funding long term assets they have characteristics that mean that they are very different from – and much less safe than – 19th c. markets.
Funding long-term assets with short-term liabilities creates funding risk, that is, the risk that you can’t pay the maturing paper by rolling it over into new short-term debt, and relies on bank guarantees in the form of liquidity facilities or tri-party clearing bank guarantees to address this risk. Funding long-term assets with short-term liabilities also creates market risk, the danger that the value of the assets drops significantly below the value of the short-term liabilities before they are refinanced. CDS and IRS are designed to address market risk, but cannot address funding risk. The latter is addressed by the liquidity guarantees provided by banks that are common in the shadow banking system.
Where there is market risk, that risk can be exacerbated when a borrower whose assets have fallen in value is forced to sell assets to get the cash to make up the difference between the value of the collateral and the debt. The sale of assets can drive the price of the assets down further worsening the borrower’s position and forcing additional sales. This has been termed a “liquidity spiral” (though I prefer Richard Bookstaber’s phrase “riding the leverage cycle to hell”).
The authors argue that in order to prevent such liquidity spirals the central bank should act as a “dealer of last resort.” This role requires two changes to the traditional lender of last resort role: first, the central bank should purchase prime securities outright, and, second, it should accept as collateral non-prime securities in order “to put a floor on their price in times of crisis” (at 9). While it is trivially true that an omniscient central bank which knows the “true” value of the assets and the swaps could indeed put a floor on prices in times of crisis, the real question is whether a less-informed real-world central bank can effectively play the role of dealer of last resort.
C. The credit quality of 19th c. assets as compared to modern assets
Another important characteristic almost certainly differentiates 19th c. money market assets from those of modern markets: the personal liability of the issuers and the guarantors. The authors of Bagehot was a Shadow Banker note that “sloppy, or even fraudulent, underwriting” contributed to the severity of the 2008 crisis (at 13 n.3). By contrast in 19th c. Britain, issuers and bankers faced unlimited liability – or capital calls if they were stockholders – on their obligations. Because of the personal stake that the bankers and the owners of banks had in the success of their business, the general credit quality of both assets and acceptances in 19th c. Britain was almost certainly higher than that of the underlying assets or CDS of modern markets. After careful analysis of the data economic historians have concluded: “The Bank of England operated in an almost perfectly risk-free market, whereby losses were entirely transferred to market participants.”
Thus, another important distinction between a CDS and an acceptance is the fact that a CDS is issued by a modern corporation whereas an acceptance was issued by either an unincorporated firm or a 19th c. British joint stock firm. A debt incurred in the normal course of business by a modern corporation cannot result in a personal claim against a banker or bank shareholder even in bankruptcy. By contrast, an unpaid debt incurred by a 19th c. British joint stock bank was likely in bankruptcy to result in a capital call on the bank’s shareholders. Because joint stock investors in 19th c. Britain typically paid only a fraction of the par value of the shares, the corporation – or in the case of bankruptcy the liquidator – retained the right to call the remaining value of the shares until par was fully paid up. Thus, when Overend failed in 1866, the joint shareholders were required to pay to the liquidators 50% of par, more than their initial investment of 30%, and, as a result, the creditors were finally paid in full. Of course, for unincorporated banks, all bankers were personally liable for the debts of the bank.
Needless to say, in 19th c. Britain one of the reasons for confidence in the guarantees provided by the banking system was the visible personal wealth of the bankers themselves and the knowledge that this wealth was at stake.
Not only were the bank guarantees in 19th c. Britain of higher credit quality than those issued by modern corporations, but the underlying assets were most likely of higher credit quality too. While mortgages and other forms of consumer credit – often originated using faulty procedures – are an important raw material for modern shadow banking, in 19th c. Britain the credit issued was strictly commercial, and it was only put into general circulation when a local bank or London middleman guaranteed the debt through endorsement or acceptance, usually on the basis of personal knowledge of the issuer. As a result of this system, backed by multiple personal guarantees, the assets circulating in 19th c. British money markets were of extremely high credit quality.
Bagehot, when describing the optimal lender of last resort policy of discounting all good securities, describes the 19th c. credit environment: “No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.” In fact, because of Overend’s “bad business,” Bagehot clearly approved of the Bank of England’s decision not to support the bill broker, despite the fact that its failure caused a massive liquidity crisis. (Lombard Street VII.37, VIII.12, X.10-11).
Overall Bagehot was a Shadow Banker fails to recognize that funding risk is as important to modern markets as market risk. For this reason, bank guarantees of payment, the equivalent of acceptances, are relied on in the modern shadow banking system, just as they were in the 19th c. Modern money markets also face market risk because they finance capital, not just money market, assets. It is market risk that the “dealer of last resort” purports to address, by placing the burden on the central bank of determining the correct price floor for non-prime assets. This determination is likely to be complicated by the fact that flaws in modern origination processes together with a paucity of personal guarantees make it possible for low quality assets to end up backing the money supply.
 See, e.g., T.S. Ashton, The Bill of Exchange and Private Banks in Lancashire, 15 Econ. Hist. Rev. 25 (1945).
 Pu Shen, Why has the nonfinancial commercial paper market shrunk recently? Fed. Res. Bank of Kansas City Ecn. Rev. 55, 69 (1st Q 2003).
 Moody’s Investor Services, Understanding Structured Liquidity Facilities in Asset-Backed Commercial Paper Programs 4 (1997). For more details on the role played by bank guarantees in asset-backed commercial paper conduits, see Carolyn Sissoko, Is Financial Regulation Structurally Biased to Favor Deregulation? 86 Southern California Law Review 365 (2013).
 In addition to liquidity and credit facilities, letters of credit have long played a role in commercial paper markets. The standby letter of credit is a guarantee made by a bank to retire maturing debt if the issuer cannot. It has been used for decades to enable firms, whose stand-alone credit rating is not high enough for them to issue commercial paper, to “rent” the credit rating of the bank. Thomas Hahn, Commercial Paper, 79 Fed. Res. Bank of Richmond Econ. Quarterly 45, 58 (Spring 1993). In addition, the letter of credit is a traditional banking instrument, still in use today, that promises to honor any bill drawn in conformance with the letter of credit. Typically goods have been shipped to the party whose debt is guaranteed by the bank, and the shipper will be paid as long as evidence of the shipment and of the debt are appropriately documented. The letter of credit remains an important means of financing international trade.
 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).
 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.
 Indeed, Overend, Gurney and Co. failed in part because, instead of recognizing losses on bad bills, it converted them (due to inadequate management and less-than-honest employees) into long-term investments in, for example, steamships that ended up causing the losses that took the firm down, despite its robust bill-broking business. W.T.C. King, History of the London Discount Market 247-51 (1972).
 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).
 Bankers Magazine, Supplement, Overend, Gurney & Co. Trial 18 (January 1870); Ackrill and Hannah, Barclays: The Business of Banking, 1690-1996 at 46-7 (2001).
 A lyric for Gilbert & Sullivan’s Trial by Jury makes use of the phrase “rich as the Gurneys,” referring to cousins of the Gurneys who were involved in the Overend collapse.