How to evaluate “central banking for all” proposals

The first question to ask regarding proposals to expand the role of the central bank in the monetary system is the payroll question: How is the payroll of a new small business that grows, for example, greenhouse crops that have an 8 week life cycle handled in this environment? For this example let’s assume the owner had enough capital to get the all the infrastructure of the business set up, but not enough to make a payroll of say $10,000 to keep the greenhouse in operation before any product can be sold.

Currently the opening of a small business account by a proprietor with a solid credit record will typically generate a solicitation to open an overdraft related to the account. Thus, it will in many cases be an easy matter for the small business to get the $10,000 loan to go into operation. Assuming the business is a success and produces regular revenues, it is also likely to be easy to get bank loans to fund slow expansion. (Note the business owner will most likely have to take personal liability for the loans.)

Thus, the first thing to ask about any of these policy proposals is: when a bank makes this sort of a loan how can it be funded?

In the most extreme proposals, the bank has to have raised funds in the form of equity or long-term debt before it can lend at all. This is such a dramatic change to our system that it’s hard to believe that the same level of credit that is available now to small business will be available in the new system.

Several proposals (including Ricks et al. – full disclosure: I have not read the paper) get around this problem by allowing banks to fund their lending by borrowing from the central bank. This immediately raises two questions:

(i) How is eligibility to borrow at the central bank determined? If it’s the same set of banks that are eligible to earn interest on reserves now, isn’t this just a transfer of the benefits of banking to a different locus. As long as the policy is not one of “central bank loans for all,” the proposal is clearly still one of two-tier access to the central bank.

(ii) What are the criteria for lending by the central bank? Notice that this necessarily involves much more “hands on” lending than we have in the current system, precisely because the central bank funds these loans itself. In the current system (or more precisely in the system pre-2008 when reserves were scarce), the central bank provides an appropriate (and adjustable) supply of reserves and allows the banks to lend to each other on the Federal Funds market. Thus, in this system the central bank outsources the actual lending decisions to the private sector, allowing market forces to play a role in lending decisions.

Overall, proposals in which the central bank will be lending directly to banks to fund their loans create a situation where monetary policy is being implemented by what used to be called “qualitative policy.” After all if the central bank simply offers unlimited, unsecured loans at a given interest rate to eligible borrowers, such a policy seems certain to be abused by somebody. So the central bank is either going to have to define eligible collateral, eligible (and demonstrable) uses of the funds, or some other explicit criteria for what type of loans are funded. This is a much more interventionist central bank policy than we are used to, and it is far from clear that central banks have the skills to do this well. (Indeed, Gabor & Ban (2015) argue that the ECB post-crisis set up a catastrophically bad collateral framework.)

Now if I understand the Ricks et al. proposal properly (which again I have not read), their solution to this criticism is to say, well, we don’t need to go immediately to full-bore central banking for all, we can simply offer central bank accounts as a public option and let the market decide.

This is what I think will happen in the hybrid system. Just as the growth of MMMFs in the 80s led to growth of financial commercial paper and repos to finance bank lending, so this public option will force the central bank to actively operate its lending window to finance bank loans. Now we have two competing systems, one is the old system of retail and wholesale banking funding, the other is the central bank lending policy.

The question then is: Do federal regulators have the skillset to get the rules right, so that destabilizing forces don’t build up in this system? I would analogize to the last time we set up a system of alternative funding for banks (the MMMF system) and expect regulators to set up something that is temporarily stable and capable of operating for a decade or two, before a fundamental regulatory flaw is exposed and it all comes apart in a terrifying crash. The last time we were lucky, as regulatory ingenuity and legal duct tape held the system together. In this new scenario, the central bank, instead of sitting somewhat above the fray will sit at the dead center of the crisis and may have a harder time garnering support to save the system.

And then, of course, all “let the market decide” arguments are a form of the “competition is good” fallacy. In my view, before claiming that “competition is good,” one must make a prior demonstration that the regulatory structure is such that competition will not lead to a race to the bottom. Given our current circumstances where, for example, the regulator created by the Dodd-Frank Act to deal with fraud and near-fraud is currently being hamstrung, there is abundant reason to believe that the regulatory structure of the financial system is inadequate. Thus, appeals to a public option as a form of healthy competition in the financial system as it is currently regulated are not convincing.

Collateral and Monetary Policy: A Puzzle

A stylized fact about post-crisis economies is that asset markets have become segmented with “safe assets” trading differently from assets more generally. I have argued elsewhere that the collateralization of financial sector liabilities has played an important role in this segmentation of markets.

I believe that this creates a puzzle for the implementation of monetary policy that provides at least a partial explanation for why we are stuck at the zero lower bound. Consider the consequences of an increase in the policy rate by 25 bps. This has the effect of lowering the price of ultra-short-term Treasury debt, and particularly when combined with a general policy of raising the policy rate over a period of months or years this policy should have the effect of lowering the price of longer term Treasuries as well (due to the fact that long-term yields can be arbitraged by rolling over short-term debt).

A decline in the price of long-term Treasuries will have the effect of reducing the dollar value of the stock of outstanding Treasuries (as long as the Treasury does not have a policy of responding to the price effects of monetary policy by issuing more Treasuries). But now consider what happens in the –segmented — market for Treasury debt. Assuming that demand for Treasuries is downward sloping, then the fact that contractionary monetary policy tends to shrink the stock of Treasuries itself puts upward pressure on the price of Treasuries that, particularly when demand for Treasuries is inelastic, will tend to offset and may even entirely counteract the tendency for the yield on long-term Treasuries to rise. (Presumably in a world where markets aren’t segmented demand for Treasuries is fairly elastic and shifts into other financial assets quash this effect.)

In short, a world where safe assets trade in segmented markets may be one where implementing monetary policy using the interest rate as a policy tool is particularly difficult. Can short-term and long-term safe assets become segmented markets as well? Given arbitrage, it’s hard to imagine how this is possible.

These thoughts are, of course, motivated by the behavior of Treasury yields following the Federal Reserves 25 bp rate hike in December 2015.fredgraph

 

Lenders of Last Resort have duties in normal times too

I have a paper forthcoming in the Financial History Review that studies the role played by the Bank of England in the London money market at the turn of the 20th century. The Bank of England in this period is, of course, the archetype of a lender of last resort, so its activities shed light on what precisely it is that a lender of last resort does.

The most important implication of my study is that the standard understanding of what a lender of last resort does gets the Bank’s role precisely backwards. It is often claimed that the way that a lender of last resort functions is to make assets safe by standing ready to lend against them.

My study of the Bank of England makes it clear, however, that the duties of a lender of last resort go far beyond simply lending against assets to make them safe. What the Bank of England was doing was monitoring the whole of the money market, including the balance sheets of the principal banks that guaranteed the value of money market assets, to ensure that the assets that the Bank was engaged to support were of such high quality that it would be a good business decision for the Bank to support them.

In short, a lender of last resort does not just function in a crisis. A lender of last resort plays a crucial role in normal times of ensuring that the quality of assets that are eligible for last resort lending have an extremely low risk of default. This function of the central bank was known as “qualitative control” (although of course quantitative measures were used to predict when quality was in decline).

Overall, if we take the Bank of England as our model of a lender of last resort, then we must recognize that that the duty of such a lender is not just to lend, but also to constantly monitor the money market and limit the assets that trade on the money market to those that are of such high quality that when they are brought to the central bank in a crisis, it will be a good business decision for the bank to support them.

A central bank that fails to exercise this kind of control over the money market, can expect in a crisis to be forced, as the Fed was in 2008, to support the value of all kinds of assets that it does not have the capacity to value itself.

Note: the forthcoming paper is a new and much improved version of this paper.

Do “net financial assets” matter?

I’ve just read Steve Waldman’s post on “net financial assets” and am connecting it up with Michael Pettis’ excellent discussion. (See also Cullen Roche’s comment on the issue.)

Steve discusses the decomposition of financial positions on which MMT is based. He points out that the term “net financial assets” is used for the “private sector domestic financial position” which refers exclusively to the aggregate netted financial position of both households and firms and explicitly excludes “real” savings such as any housing stock that is fully paid up. By definition, if the “private sector domestic financial position” is positive, then it must be the case that on net the private sector holds claims on either the government or on foreign entities. Of course, the value of such claims depends entirely on the credibility of the underlying promises — this is the essential characteristic that distinguishes a claim to a financial asset from a claim to a real asset.

For Steve, there is a tradeoff between holding financial claims and holding real claims, and a principal reason for holding financial claims is to offset the risk of the real claims. Thus, Steve goes on to claim that to the degree that such a positive private sector financial position is due to claims on government, the government is using its credibility to provide a kind of insurance against real economy risk.

This is where I think Steve both gets what happened in 2008 right, and gets the big picture of the relationship between the financial and the real, and between the private sector and the public sector wrong. Steve is completely correct that in 2008 the issue of public sector liabilities played a huge insurance and stabilization role.  But Steve extends his argument to the claim that: “The domestic private sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the state.”

The key point I want to make in this post is this: the financial and the real are so interdependent that they cannot actually be divorced. The same is true of the private and the public sectors. Financial activity and real activity, public sector activity and private sector activity are all just windows into a single, highly-integrated economy. Thus, I would argue that it is equally correct to state that: “The domestic public sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the private sector.”

That financial activity and real activity are two sides of the same coin is most obvious when one considers that the credibility of private sector financial liabilities depends fundamentally on the performance of the real economy. But it is equally true that the credibility of public sector liabilities (when measured in real terms) depends fundamentally on the robustness of the real economy as well. Those countries that have very highly rated debt did not achieve this status ex nihilo, but because of the historical performance of their economies and the robustness of their private sectors.

Thus, it is entirely correct that the public sector can temporarily step in to provide insurance for the private sector when it is struggling, but the view that it is the public sector that is the primary provider of insurance fails to capture the genuine interdependence that lies at the heart of a modern economy.

Indeed, Steve recognizes the danger of framing the financial and the real and the public and the private in this way in his last paragraph, where he acknowledges that this publicly-issued insurance is in fact provided in real terms at the expense of a segment of the private sector — the segment that does not hold the claims on government.

Michael Pettis on Creating Money out of Thin Air

Now let’s turn to Michael Pettis (whom I’ve never met, so I’ll call him by his last name). Pettis has long stood out as an economist with a uniquely strong understanding of the relationship between the financial and the real. He argues that “When banks or governments create demand, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other, equally easily specified, cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand out of thin air, as many analysts seem to think, because doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.”

His two cases are a full employment economy (without growth) and an economy with an output gap. He argues that it is only in the latter case that the funding provided by banks (or government) can have an effect on output. In a comment to Pettis’ post I observed that his first case fails to take into account Schumpeter’s theory of growth. An economy is at full employment only for a given technology. Once there is a technical innovation, the full employment level of output will increase. Schumpeter’s theory was that the role of banking in the economy was to fund such innovation. Thus, there is a third case in which bank finance in a full employment economy does not just transfer resources to a different activity, but transfers them to an innovative activity that fundamentally alters the full employment level of output. Thus, it is not only when the economy is performing below potential that bank funding can create the production that makes savings equal to investment. When banks fund fundamental technological innovation, it is “as if” the original economy were functioning below potential (which of course if we hold technology constant at the higher level, was in fact the case — but this deprives the concept of “potential GDP” of its meaning entirely.)

Schumpeter was well aware that the same bank funding mechanisms that finance fundamental technological innovation, also finance technological failures and a vast amount of other business activity. Indeed, he argued that even though the banking system was needed to finance innovation and growth, the consequences of the decision making process by which banks performed this role included both business cycles and — when banking system performed badly — depressions.

In short, there is very good reason to believe that even in a “full-employment” economy when banks create debt, some fraction of that process creates additional demand. The problem is that the fraction in question depends entirely on the institutional structure of the banking system and its ability to direct financing into genuine innovation. It’s far from clear that this fraction will exhibit any stability over time.

How Did We Get Here: The Fault Lies in Our Models

So why do economists fall into the trap of treating the financial and the real as separable phenomena? Why do macroeconomists of all persuasion look for solutions in the so-called public sector?

The answer to the first question is almost certainly the heavy reliance of the economics profession on “market-clearing” based models. In models with market-clearing everybody buys and sells at the same time and liquidity frictions are eliminated by assumption. Of course, one of the most important economic roles played by financial assets is to address the problem of liquidity frictions. As a result, economists are generally trained to be blind to the connections between the financial and the real. People like Michael Pettis and proponents of MMT are trying to remove the blindfold. They are, however, attempting to do so without the benefit of formal models of liquidity frictions. This is a mistake, because the economics profession now has models of liquidity frictions. The future lies in the marriage of Schumpeter and Minsky’s intuition with New Monetarist models.

The answer to the second question is that we have a whole generation of macroeconomic policy-makers who think that the principal macroeconomic economic debate lies between Keynesians and Monetarists, when in fact both of these schools assume that the government is the insurer of last resort. The only distinction between these schools is whether the insurance is provided by fiscal or by monetary means. (To understand why our economies are struggling right now one need only understand how the assumption that the government is the fundamental source of liquidity has completely undermined the quality of our financial regulation.)

The concept of liquidity as a fundamentally private sector phenomenon that both drives the process of growth and periodically requires a little support from the government (e.g. giving the private sector time to weather a financial panic without the government actually bearing a penny of the losses) has been entirely lost. Only the future can tell us the price of this intellectual amnesia.

A question for our times: the role of the central bank

Peter Conti-Brown and Philip Wallach are having a debate that cuts right to the heart of what appears to me to be the most important economic question of the current era: what is the proper role of the central bank?

Conti-Brown takes what I think is a fairly mainstream view of the central bank’s role as lender of last resort: In a crisis, the central bank should intervene to rescue a troubled bank as long as, given Fed support, the bank can over time be restored to solvency. He writes:

in a systemic crisis, the problem of determining whether a specific asset class is sufficiently valuable to justify its temporary exchange for cash isn’t just “murky,” it can be impossible to determine. This is true for two reasons: first, the reason the systemic crisis exists at all is because the line between illiquidity and insolvency has become a mirage. And second, whatever line is left is endogenously determined: what the central bank does in response to the crisis has immediate consequences on both liquidity and solvency. There is essentially no way, in the depth of a crisis, to draw the line meaningfully between solvency and illiquidity. After Lehman, the Fed recognized this and extended loans through 13(3) so quickly on so many different kinds of collateral that we saw an explosion in its 13(3) lending.

The clear implication here is that if there is doubt as to whether a firm is illiquid or insolvent, the Fed should err on the side of supporting the firm.

Wallach responds that if one follows this logic to its end, there appear to be no limits to the Fed’s powers:

If I’m understanding him correctly here, Peter means to put in the Fed’s mouth some version of an infamous 2004 pronouncement of a Bush administration aide: “when we act, we create our own reality.” Amidst the chaos of crisis, it is for the Fed to decide which firms are solvent and which kinds of assets are really valuable as collateral and, whatever they decide, the markets will follow, allowing the central bank to benefit its own balance sheet and the larger financial system through self-fulfilling optimistic prophecy. As they forge this new reality, making the security on loans satisfactory to themselves will be the least of their miracles.

Teasing aside, I think that’s far from crazy, but one can get carried away. It can’t be the case that the Fed is capable of rescuing any institution through this kind of heroic thinking: if a firm is in a downward spiral, and the only collateral it has is rotten, then the Fed does not have the legal authority to funnel money into it.

I think that there are actually three question raised by this exchange: First, what are the Fed’s potential powers; that is, what is it feasible for the Fed to do? Second, what were the Fed’s powers in 2008; or alternatively, what was both legal and feasible for the Fed to do? And, third, what should the Fed have legal authority to do? Conti-Brown and Wallach are debating the second question, but I think it’s important to explore the first question regarding what the Fed can do, before moving on to the second and third questions regarding what the Fed is legally authorized to do.

A little history on the concept of the lender of last resort is useful in exploring the first question. A previous post makes the point that the term lender of “last resort” was initially coined, because the central made the self-fulfilling determination of whether or not a bank was solvent and worthy of support. The fact that the central bank has the alternative of saving a bank, but chooses not to is what defines the power of a lender of “last resort.” From the earlier post:

The term “lender of last resort” has its origins in Francis Baring’s Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.

In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain [where the concept of lender of last resort was developed].

There is a long list of banks that were deliberately allowed by the Bank of England to fail in Britain, including the Ayr Bank in 1772, and Overend, Gurney, & Co. in 1866. The latter was, second to the Bank of England, the largest bank-like intermediary in England at the time, and its failure triggered a Lehman-like financial crisis — that was, however, followed by only a short, sharp recession of unexceptional depth. Bagehot made it very clear in Lombard Street that he did not believe that the Bank of England had mishandled Overend Gurney. He argued, on the contrary, that it was always a mistake to support a “bad bank.”

In short, just as it is in some cases the job of a court of last appeal to uphold the law in the form of a death sentence, so it is in some cases the job of a central bank to pronounce a death sentence on a bank in order to promote healthy incentives in financial markets. The fact that the bank would still be alive in the absence of the death sentence is as obvious and irrelevant in the case of the lender of last resort as it is in the case of the court of last appeal.

So let’s go back to the original question: What are the potential powers of the Fed? Can it in fact determine “which firms are solvent and which kinds of assets are really valuable as collateral” and expect markets to follow that determination? We have a partial answer to this question: from past experience we know that a central bank can choose not to support a bank in a crisis in which case it is almost certain the bank will fail, or that a central bank can choose to support a bank and with equal certainty carry it through a crisis of limited duration. We also know that sometimes a bank that was saved fails a few years or a decade after it was saved (e.g. City of Glasgow Bank). The British history also indicates that it is possible for a central bank to have a similar effect on assets (see here).

Thus, the fact that ex post the Fed did not lose money on any of the Maiden Lane conduits — or more generally on the bailout — is not evidence that the Fed exercised its lender of last resort role effectively. Instead this fact is simply testimony to powers of a central bank that have been recognized from the earliest days of central banking.

What we don’t know are the limits of a central bank’s ability to “create it own reality.” Can a central bank continue to support banks and assets for a prolonged period of time and still be successful in leading markets? At what point, if ever, does the central bank’s intervention stop being a brilliant act of successful alchemy, and end up looking like fraud?

What makes a lot of people in the financial industry nervous about the current state of central bank intervention (see for example here, here or here) is that they are not sure that the central banks will be able to exit their current policies without causing a crash in financial markets of the sort that none of us has ever seen before. Of course, we are sailing uncharted waters and literally nobody knows the answer. Let’s just hope that Janet Yellen and Mario Draghi are brilliant and creative helmsmen. (Should that be helmspeople?)

In summary, the term lender of “last resort” itself makes it clear that a fundamental aspect of a central bank’s duties is to refuse to support firms such as Lehman. Thus, in my view Conti-Brown, even though he gives a description of a lender of last resort that many modern scholars would agree with, envisions a lender of last resort that is very different from that of Bagehot and 19th century bankers. Whereas Conti-Brown appears to argue that, because the line between solvency and insolvency is so murky in a crisis, if a bank can be saved, it should be saved, Bagehot clearly understood that even though Overend Gurney could have been saved (ch X, ¶ 11), it was correct for the Bank of England to choose not to save it.

This very traditional view of the central bank, as the entity that determines which banks are managed in such a way that they have the right to continue operating, indicates that the Fed’s error in 2008 was not the decision to let Lehman fail, but the failure to prepare the market for that decision beforehand. The Bank of England announced its policy of not supporting bill-brokers such as Overend, Gurney & Co. in 1858, fully eight years before it allowed Overend to fail. This failure was followed by a full century of financial stability. The Federal Reserve, by contrast, never clearly stated what the limits of its lender of last resort policy would be in the decades preceding the 2007-08 crisis. Indeed, the Fed was busy through those decades expanding the expectations that financial institutions had of support from the Fed. Thus, the post-Lehman crisis was decades in the making, and was further aggravated by the inadequate warning signs provided to markets subsequent to the Bear Stearns bailout.

The definition of the proper role of the central bank is probably the most important economic question of our times. We are learning through real-time experimentation what are the consequences of extensive central bank support of the financial system — and whether financial stability is better promoted by a 19th century lender of last resort that very deliberately allows mismanaged banks to fail or by a 21st century lender of last resort that provides much more extensive support to the financial system.

Discount Markets, Liquidity, and Structural Reform

Bengt Holmstrom has a paper explaining the “diametrically opposite” foundations of money markets and capital markets.* This dichotomy is also a foundation of traditional banking theory, and of the traditional functional separation that was maintained in the U.S. and Britain between money and capital markets.

Holmstrom explains that “the purpose of money markets is to provide liquidity,” whereas price discovery is an important function of capital markets. In a paper I extend this view a step further: money markets don’t just provide liquidity but a special form of price stable liquidity that is founded on trade in safe short-term assets; by contrast capital markets provide market liquidity which promotes price discovery, not price stability.

A century ago in Britain privately issued money market assets were, like capital market assets, actively traded on secondary markets. The two types of assets traded, however, on completely different markets with completely different structures that reflected the fact that money market assets needed to be “safe.”

To understand why the markets had different structures consider this question: how does one ensure that the safety of the money market is not undermined by asymmetric information or more specifically by the possibility that when the owners of money market assets have information that the assets are likely to default they do not use the market to offload the assets, adversely affecting the safety of the market itself, and therefore its efficacy as a source of price stable liquidity? The answer is to structure the market as a discount market.

In a discount market, every seller offers a guarantee that the asset sold will pay in full. (You do this yourself when you endorse a check, signing its value over to a bank — while at the same time indemnifying the bank against the possibility that the check is returned unpaid.) This structure was one of the foundations upon which the safety of the London money market was built. The structure ensures that the owner of a dubious asset has no incentive to attempt to sell it, and in fact is very unlikely to sell it in order to hide from the public the fact that it is exposed to such assets.

From their earliest days it was well-understood that discount markets were designed to align the incentives of banks originating money market assets and to promote the safety of the assets on the money market. (See van der Wee in Cambridge Economic History of Europe 1977.) Any bank that originates or owns a money market asset can never eliminate its exposure to that asset until it is paid in full. For this reason a discount market is specifically designed to address problems of liquidity only. That is, a bank that is illiquid can get relief by selling its money market assets, but if it has originated so many bad assets that it is insolvent, the money market will do nothing to help.

Contrast the structure of a discount market with that of an open market. On an open market, the seller is able to eliminate its exposure to the risks of the asset. This has the effect of attracting sellers (and buyers) with asymmetric information and as a result both increasing the riskiness of the market and creating the incentives that make the prices of the risky assets that trade on open market informative. Thus, it is because price discovery is important to capital markets, that they are structured as open markets. Capital markets can only offer market liquidity — or liquidity with price discovery — rather than the price stable liquidity of the money market. On the other hand, an entity with asymmetric information about the assets that it holds can use the open market structure of capital markets to improve its solvency as well as its liquidity position.

Historically it appears that in order for a money market to have active secondary markets, it must be structured as a discount market. (Does anyone have counterexamples?) That is, it appears that when the only option for secondary trading of money market instruments is an open market, then secondary markets in such instruments will be moribund. This implies not only that the absence of incentives to exploit asymmetric information plays an important role in the liquidity available on money markets (cf. Holmstrom) — but also that price stable liquidity is an important benefit of the discount market structure.

Both discount markets and open markets can be adversely affected by extraordinary liquidity events. But only one of the two markets is premised on safe assets and price stable liquidity. Thus, the lender of last resort role of the central bank developed in Britain to support the money (discount) market only. (In fact, I would argue that the recognized need for a provider of liquidity support to the discount market explains why the Bank of England was structured as it was when it was founded, but that goes beyond the scope of this post. See Bowen, Bank of England during the Long 18th c.) One consequence of the fact that the central bank supported only assets that traded on a discount market is that it was able to support the liquidity of the banks, without also supporting their solvency.

Given the common claim that one hears today that it is unreasonable to ask a central bank to distinguish illiquidity from insolvency in a crisis, perhaps it is time to revisit the discount market as a useful market structure, since acting through such a market makes it easier for a central bank to provide liquidity support without providing solvency support.

 

*His focus is actually money markets and stock markets, but in my view he draws a distinction between debt and equity that is far less clear in practice than in theory. In a modern financial system unsecured long-term bonds are not meaningful claims on the assets of a firm, because as the firm approaches bankruptcy it is likely to take on more and more secured debt leaving a remnant of assets that is literally unknowable at the time that one buys an unsecured long-term bond.

New Monetarism and Narrow Banking: Take Two

The new monetarist framework makes it possible to draw a distinction between two types of liquidity: monetary liquidity and market liquidity. First, observe that market liquidity is the type of liquidity that is modeled in a competitive equilibrium framework. Or to be more precise, because models of competitive equilibrium are driven by market clearing which by assumption converts individual demand and supply into a price-based allocation, they give us information about the kind of liquidity that derives from the meeting of demand and supply. Not only do prices change in such market models, but it is an essential aspect of market liquidity that prices must change in response to fundamental changes in supply and demand.

Of course, money is not essential in competitive equilibrium models and the new monetarist framework grew out of the project of figuring out how to make money essential. The short version of the outcome of this project (discussed at somewhat greater length in my first post on New Monetarism and Narrow Banking) is that money is essential in models where agents buy and sell at different points in time.

As I have argued elsewhere, an implication of new monetarism is that the competitive equilibrium framework can be easily augmented to make money essential. All that is necessary is to divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability. (Note that the demand for micro-foundations meant that I was required to introduce the monetary friction in the form of assumptions regarding endowments and preferences — that as far I as am concerned simply muddy the model.)

An important advantage of introducing this simplest of monetary frictions into competitive equilibrium models is that all the implications that have ever been drawn from such models are still valid given one proviso: they must explicitly assume that the process of providing within period (or short-term) credit is perfect. In short, careful use of new monetarist methods can be used to illuminate the assumptions underlying the concepts of competitive equilibrium and market liquidity.

Monetary liquidity is then the process of addressing the within period frictions. It becomes immediately obvious in this framework that cash is an inadequate means of addressing the monetary friction, because an endogenous cash-in-advance constraint is generated. Any agent who is assigned to buy first and doesn’t hold enough cash will be liquidity constrained. In this framework, it is essential to have enforceable short-term debt contracts in order to eliminate the monetary friction and have perfect provision of monetary liquidity.

This last point is why narrow banking proposals are misguided. They misconceive of what is necessary to have perfect provision of monetary liquidity. Cash or sovereign/central bank solutions to the monetary problem generate a cash-in-advance constraint. Only a form of money that includes short-term debt can fully address the monetary friction.

A Counterproposal to “Shifts and Shocks”

Martin Wolf in Shifts and Shocks does a remarkable job of taking a comprehensive view of all the moving parts that have played a role in creating our current financial malaise and ongoing risks to financial stability. He also does a wonderful job of laying them out clearly for readers. Furthermore, I am entirely convinced by his diagnosis and prognoses of the Eurozone’s problems. When it comes to the question of the financial system more generally, however, even though I’m convinced that Wolf understands the symptoms, I don’t think he’s on target with either his diagnosis or his solutions. In fact, I think he too shows signs of being hampered by the problem of intellectual orthodoxy.

This post is therefore going to combine commentary on Shifts and Shocks with an introduction to my own views of how to understand the boondoggle that is the modern financial system. (I have nothing to say about the Eurozone’s grief except that you should read what Martin Wolf has to say about it.) For the long form of my views on the structural reform of the financial system, see here.

First, let me lay out the many things that Wolf gets right about the financial system.

  • The intellectual failures are accurately described:
    • orthodox economics failed to take into account the banking system’s role in creating credit, and thus failed to understand the instability that was building up in the system.
    • this has led to a dysfunctional and destabilizing relationship between the state and the private sector as suppliers of money
  • His basic conclusion is correct:
    • the system is designed to fail because banks finance long-term, risky and often illiquid assets with short-term, safe and highly liquid liabilities.
  • The inadequacy of the solutions currently being pursued is also made clear. Combining macro-prudential policy and “unlimited crisis intervention” with resolution authorities
    • just worsens the dysfunctional relationship between the state and the private sector
    • forces rulemaking that is designed to preserve a system that the regulators don’t trust and that is so complex it is “virtually inconceivable that it will work” (234)
  • His focus on the need for more government expenditure to support demand instead of attempts to induce the private sector to lever up yet again is correct.
  • The key takeaways from his conclusion are also entirely correct (349)
    • The insouciant position – that we should let the pre-crisis way of running the world economy and the financial system continue – is grotesquely dangerous.”
    • “leveraging up existing assets is just not a particularly valuable thing to do; it creates fragility, but little, if any, real new wealth.”

I think Wolf makes a mistaking in diagnosing the problem, however. One can view our current financial system as simply exhibiting the instability inherent in all modern economies (a la Minsky), or as exhibiting an unprecedented measure of instability even taking Minsky into account, or something in between. Wolf takes the hybrid position that while the basic sources of instability have been present in financial systems since time immemorial, “given contemporary information and communication technologies, modern financial innovations and globalization, the capacity of the system to generate complexity and fragility, surpasses anything seen historically, in its scope, scale and speed.” (321) This, I believe, is where the argument goes wrong.

To those familiar with financial history the complete collapse of a banking system is not a particularly unusual phenomenon. The banking system collapsed in Antwerp in the mid-15th century, in Venice in the late 16th century, in France in the early 18th century, and in Holland in the late 18th century. What is remarkable about 19th and 20th century banking is not its instability, but its lack of total collapse.

Indeed, the remarkable stability of the British banking system was founded in part on the analysis of the reasons behind 18th century financial instability on the continent. (There is no important British banking theorist who does not mention John Law and his misadventures in France.)  In particular, a basic principle of banking used to be that money market assets — and bank liabilities — should not finance long-term assets; capital markets should have the limited liquidity that derives from buyers and sellers meeting in a market. Thus, when Wolf finds that our modern system is “designed to fail” because money market assets are financing risky long-term assets, and that market liquidity is a dangerous illusion that breeds overconfidence and is sure to disappear when it is most needed (344), he is simply rediscovering centuries-old principles of what banks should not do.

By arguing that the structural flaws of modern finance are as common to the past as to the present, Wolf embraces the modern intellectual orthodoxy and sets up his radical solution: that our only option for structural reform that stabilizes banking is to take away from banks the ability to lend to the private sector and require that all debt be equity-financed. Thus, Wolf obfuscates the fact that the 19th and 20th century solution to banking instability was to limit the types of lending to the private sector that banks were allowed to engage in. Britain had a long run of success with such policies, as did the U.S. from the mid-1930s to the 1980s. (Recall that the S&Ls were set up in no small part to insulate the commercial banks from the dangers of mortgage lending — as a result the S&L crisis was expensive, but did not destabilize the commercial banks, and was compared to 2007-08 a minor crisis.) Thus, there is another option for structural reform — to stop viewing debt as a single aggregate and start analyzing which types of bank lending are extremely destabilizing and which are not.

The real flaw, however, in Wolf’s analysis is that he doesn’t have a model for why banking lending is important to the economy. Thus, when he acknowledges that it is possible that the benefits of “economic dynamism” due to banking exceed the massive risks that it creates (212-13), he doesn’t have a good explanation for what those benefits are. As a result, Wolf too is intellectually constrained by the poverty of modern banking theory.

19th c. bankers were far less confused about the benefits of banking. When everybody is willing to hold bank liabilities, banks have the ability to eliminate the liquidity constraints that prevent economic activity from taking place. The merchant who doesn’t have enough capital to buy at point A everything he can sell at point B, just needs a line of credit from the bank to optimize his business activities. This problem is ubiquitous and short-term lending by banks can solve it. Furthermore, because they solve it by expanding the money supply, and not by sourcing funds from long-term lenders, the amount of money available to borrow can easily expand. Of course, there are problems with business cycles and the fact that the incentives faced by banks need to be constantly monitored and maintained, but these are minor issues compared with the asset price bubbles that are created when banks get into long-term lending and that destabilized the financial system in 2007-08.

Overall, banks can do a lot to improve economic efficiency without getting into the business of long-term lending. And a recipe for financial stability should focus on making sure that long-term lending, not all bank lending, is funded by equity.

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.

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).