Latest update: October 2, 2012
In recent months economists and other experts have published a torrent of reports on repo and shadow banking, noting their importance and their dangers and urging reform.
Following are 74 of the reports, arranged chronologically with the most recent report first.
“Key Mechanics of the U.S. Tri-Party Repo Market“ by Adam Copeland, Antoine Martin, and Susan McLaughlin at the New York Fed and Darrell Duffie at Stanford University, October 1:
During the 2007-09 financial crisis, it became apparent that weaknesses existed in the design of the U.S. tri-party repo market that could rapidly elevate and propagate systemic risk. This article describes key mechanics of the market, focusing on two that have contributed to its weaknesses and impacted market reform efforts: the collateral allocation and “unwind” processes.
The authors explain that collateral allocation in the tri-party repo market involves considerable dealer intervention, which can slow settlement processing. The length of time required to allocate collateral has in fact been a significant obstacle to market reform.
Another impediment to reform is the unwind process, or the settlement of expiring and continuing repos that occurs before new ones can be settled and continuing ones can be “rewound.” The intraday funding required as a result of the unwind process creates potentially perverse dynamics that increase market fragility and financial system risk. Indeed, a reengineering of the tri-party repo settlement process to be much less reliant on intraday credit is a main goal of current market reform.
The authors argue that streamlining the collateral allocation process and eliminating the time gap associated with the unwind could minimize market risk and assist in the reform efforts.
“Restoring Confidence and Progressing on Reforms,” by the International Monetary Fund, Global Financial Stability Report, September 25:
A host of regulatory reforms are under way to make the financial system safer, and the reforms are aimed in the right direction: to make markets and institutions more transparent, less complex, and less leveraged. …
Most reforms are in the banking sector and impose higher costs to encourage banks to internalize the costs of certain risky activities. Basel III requirements for more and better-quality capital and liquidity buffers should enable institutions to better withstand distress.
Banks will likely adjust to the new costs in various ways, some of which may not have been intended. The new banking standards may encourage certain activities to move to the nonbank sector, where those standards do not apply. Alternatively, big banking groups with advantages of scale may be better able to absorb the costs of the regulations; as a result, they may become even more prominent in certain markets, making these markets more concentrated. …
The data suggest that financial systems are still overly complex, banking assets are concentrated, with strong domestic interbank linkages, and the too-important-to-fail issues are unresolved. Innovative products are already being developed to circumvent some new regulations. …
Despite much progress on the reform agenda, reforms in some areas still need to be further refined by policymakers. These areas include a global-level discussion on the pros and cons for direct restrictions on business models; monitoring, and a set of prudential standards if needed, for nonbank financial institutions posing systemic risks within the so-called shadow banking sector; careful thought on how to encourage the use of simpler products and simpler organizational structures; and further progress on recovery and resolution planning for large institutions, including cross-border resolution to help secure the benefits of financial globalization.
“Fitch: money market funds focus on repo counterparty credit” by Fitch ratings, September 24:
Money market funds’ (MMF) proportion of secured exposure in the form of repurchase agreements (repos) has been on a secular rise for almost a decade. Fitch Ratings attributes this trend to a number of factors, including a shift in demand for secured assets, broadening collateral practices, and the general evolution of the credit markets. In addition, amended rule 2a-7 has contributed to demand for repos by requiring taxable MMFs to hold at least 10% of their assets in daily liquid instruments (such as overnight repos).
MMFs are focused on the counterparty credit quality first and foremost as the primary source of repayment. We believe regulatory requirements to maintain high quality short duration portfolios make it problematic for MMFs to take a possession of the long-term collateral securities in the event of dealer insolvency.
For example, a great majority of repos are collateralized by instruments with remaining maturities of greater than one year. If the fund were required to accept the collateral underlying the repo, these instruments would have to be taken into account in calculating the fund’s weighted average maturity (WAM). The fund would then have to dispose of the collateral as soon as possible if the instruments constituting the collateral caused WAM to exceed 60 days or did not satisfy other regulatory and rating agency criteria.
“The Odd Behavior of Repo Haircuts during the Financial Crisis ” by Adam Copeland and Antoine Martin, Liberty Street Economics, Federal Reserve Bank of New York, September 17:
Since the financial crisis began, there’s been substantial debate on the role of haircuts in U.S. repo markets. (The haircut is the value of the collateral in excess of the value of the cash exchanged in the repo; see our blog post for more on repo markets.) In an influential paper, Gorton and Metrick show that haircuts increased rapidly during the crisis, a phenomenon they characterize as a general “run on repo.” Consequently, some policymakers and academics have considered whether regulating haircuts might help stabilize the repo markets, for example, by setting a minimum level so that haircuts can never be too low, as discussed in another paper by Gorton and Metrick. In this post, we discuss recent findings showing that the rise in haircuts wasn’t a general phenomenon after all—haircuts didn’t rise in every repo market. We also discuss why the divergence across markets is odd, and the implications for policymakers.
Josh Galper and Jonathan Cooper at Securities Finance Monitor say they can explain the haircut anomaly. See “Liberty Street Economics Blog on bilateral and tri-party repo haircut differences: they can’t explain it. We can,” September 18.
ForEx Pros also says there’s “Nothing ‘Puzzling’ About Higher Haircuts In Bilateral Repo Markets,” September 19.
“‘Puts’ in the Shadow” by Manmohan Singh, International Monetary Fund, September 14:
In the aftermath of the Lehman crisis, payouts (i.e., taxpayer bailouts) in various forms were provided by governments to a variety of financial institutions and markets that were outside the regulatory perimeter — the “shadow” banking system. Although recent regulatory proposals attempt to reduce these “puts”, we provide examples from non-banking activities within a bank, money market funds, Triparty repo, OTC derivatives market, collateral with central banks, and issuance of floating rate notes etc., that these risks remain. We suggest that a regulatory environment where puts are not ambiguous will likely lower the cost of bail-outs after a crisis….
… the tri-party repo market, a primary source of funding for banks in the U.S., was about $1.8 trillion (July 2012, New York Fed). It provides cash on a secured basis, with the collateral being posted to lenders through one of two clearing banks, Bank of New York—Mellon (BoNY) and JP Morgan. … the systemic importance of this market may preclude an unwinding of BoNY and JP Morgan … which together account for the whole of the $1.8 trillion tri-party repo market (which was almost $3 trillion in 2008). Owing to the magnitude of the exposures, a small decline in the market price of the collateral posted with a clearer could significantly undermine its capital in the absence of overcollateralization.
The Fed‘s involvement with the two clearers also allows substantial use of their systems for its operations to the extent it could not tolerate their failure. … the Fed needs to keep tri-party repo clearers in business to meet the needs of its own operations, particularly in light of the large liquidity draining operations that will eventually be needed when monetary policy is again tightened. The dealers are used to the subsidy and do not want to change the status quo. Not surprisingly, the recent whitepaper of the Fed did little to change the existing tri-party repo system.
“Why cutting IOER could be suicidal” by Izabella Kaminska, Financial Times Alphaville, September 14:
By Jove! Someone’s finally got it.
Cutting interest on excess reserve is a hugely risky option for the Fed, and could do more damage than good (leading even to major systemic issues). We’ve said as much, and now RBC Capital markets makes the same argument too. But much more eloquently (dare we say).
The main reason, of course, is that cutting IOER could wreak untold havoc in the money and repo markets.
“Securitization Shouldn’t Be the Government’s Business” by Amar Bhide, Bloomberg View, September 9:
As we should have learned from the 2008 financial crisis, the mass production of securitized credit enables reckless borrowing, shortchanges productive businesses and destabilizes banks. It has been nourished by regulation, not its inherent economic advantages. Yet officials in Washington continue to favor this top-down misdirection of credit….
The Federal Reserve has bought hundreds of billions of dollars of mortgage securities under its “credit easing” policy, and its staff economists have proposed a permanent insurance program to cover every form of securitized credit. Mortgages securitized by Fannie and Freddie account for a higher proportion of home lending than ever before. The risk- retention rules in the Dodd-Frank regulatory overhaul aim to reassure buyers of mortgage-backed securities.
To fundamentally reform the financial system, we need to end state sponsorship of securitization….
We needn’t debate whether a securities-based financial system is better than a bank-based one. A healthy economy needs both loans and securities — but no one can know the right, oft- changing mix. For that, we need unrigged competition.
“Regulators must shine a light on ‘shadow banking‘” by Lord Turner, executive chairman of the Financial Services Authority, The Telegraph, September 8:
In 2008, the developed world’s banking system suffered a huge crisis and only bank bail-outs prevented financial meltdown. Despite these rescues, a “Great Recession” has followed.
In response, the world’s regulators and central banks, led by the Financial Stability Board, have focused on building a more stable banking system – less leveraged, more liquid and with all banks resolvable without taxpayers’ support. The implementation of that bank-focused regulatory agenda is unfinished, but significant progress has been made.
Looking back to 2007-08, however, it is striking that the crisis did not at first look like a traditional banking crisis, but was linked to a new phenomenon – shadow banking….
Our regulatory response must therefore cover “shadow banking” as well as banks. The Financial Stability Board has committed to delivering a reform package by the end of this year. That is being developed by the Financial Stability Board’s Committee on Supervisory and Regulatory Co-operation, which I chair….
Shadow banking has become smaller, but that has contributed to a harmful credit crunch. At some time credit supply will need to grow again, and when it does we must ensure that risks are contained. And when credit demand does recover, there will be strong incentives to innovate new forms of non-bank credit intermediation, precisely because we have increased capital and liquidity requirements on the formal banking sector. Such non-bank credit intermediation may be welcome, but only if it avoids the bank-like risks created by pre-crisis shadow banking.
An integrated programme of reform to address the risks revealed by pre-crisis shadow banking is therefore essential. Three categories of risk deserve particular attention – poor credit risk assessment; non-transparent maturity transformation and the risk of increased volatility in credit supply and asset prices. … the FSB is considering five categories of further reforms focused specifically on shadow banking risks.
See Securities Finance Monitor’s take on Lord Turner’s piece, “Lord Turner and the FSA on Shadow Banking: Its Not Pretty.”
“Redistributive Monetary Policy” by Markus K. Brunnermeier and Yuliy Sannikov, Princeton University, September 1:
We group financial firms into commercial banks, bank holding companies together with investment banks, shadow banking institutions, government agencies, insurance companies, and pension funds …
Bank Holding Companies and investment banks have net repo liabilities to the nonfinancial business sector and the household sector. Corporations use the repo market like a checking account to hold short-term funds. They also invest along with households in money market funds and other bond funds.
Money market funds are part of the (less regulated) shadow banking system. Money market funds invest in various other shadow banking institutions and structured vehicles, such as securitized mortgage pools, auto loans, and credit card receivables. While many obligations (including repos) net out within the shadow banking sector, shadow banking institutions also hold long-term debt of Bank HOlding Companies and investment banks. Prior to the Great Recession, Bank Holding Companies obtained cheap secured funding since they could re-hypothecate their customers’ collateral at favorable haircuts. Their securities lending activity is part of this activity….
The general trend is a steady and fast rise in shadow banking, partly at the expense of the traditional banking system from the 1980s onwards. During that period, the following events occurred: 1) Basel I created incentives for securitization, and 2) interest rate regulation favored money market funds. At the same time, IT innovations made collateral management for repo markets easier. …
During the S&L crisis in the 1980s and early 1990s, the burgeoning shadow banking sector only partly compensated for the slowdown in traditional banking activity. However, financial sector liabilities grew at only a moderate pace prior to the S&L crisis.
This result is in stark contrast to the beginning of the current financial crisis, where we observed a sharp drop in shadow banking activity in the second half of 2007. The initial drop occurred as asset-backed security issuance and the asset-bcked commercial paper market froze up.
Interestingly, this drop was more than offset by an expansion in activity by the government-sponsored enterprises and Federal Home Loan Bank. A closer look at Figure 3 also highlights the role that government-sonsored enterprises played in the early part of the crisis. In July 2008, the debt of government agencies became explicit government debt and it seems that the government-sponsored enterprises lost their moderating role. The real collapse of the shadow banking system followed the demise of Lehman. At that point, investors fled to FDIC-insured demand deposits, leading to an increase in the liabilities of traditional banks at that time.
“Some Reflections on the Recent Financial Crisis” by Gary B. Gorton, Yale School of Management, September:
Economic growth involves metamorphosis of the financial system. Forms of banks and bank money change. These changes, if not addressed, leave the banking system vulnerable to crisis. There is no greater challenge in economics than to understand and prevent financial crises. The financial crisis of 2007-2008 provides the opportunity to reassess our understanding of crises. All financial crises are at root bank runs, because bank debt—of all forms—is vulnerable to sudden exit by bank debt holders. The current crisis raises issues for crisis theory. And, empirically, studying crises is challenging because of small samples and incomplete data.
“Combatting the Dangers – Lurking in the Shadows: The Macroprudential Regulation of Shadow Banking” by David Longworth, C.D. Howe Institute, September:
In many ways, the recent global financial crisis was similar to earlier ones. … The crisis, however, also had many differences from previous ones. Chief among these was a run on the shadow banking system, which consists of finance companies, commercial paper issuance, money market funds, the securitization process, and repurchase (“repo”) markets for the short-term financing of securities. This system, which has risen in importance over the past 20 years, had expanded rapidly, with much of it providing maturity transformation – the short-term financing of long-term assets. Many of the system’s short-term liabilities were seen as nearly risk-free (“AAA”) assets, but some proved not to be so. Not only did the shadow banking system contract considerably during the financial crisis in both the United States and Canada, but so did the system’s provision of financing to regulated banks, which exacerbated their liquidity difficulties and worsened the crisis….
Unless the federal and provincial governments give priority to the development of strong domestic and international macroprudential regulation of the shadow banking sector while memories of the financial crisis are fresh, dangers will continue to lurk in the shadows and show themselves only in times of extreme stress.
“Interest on Excess Reserves: An Illustrated Investigation” by Yichuan Wang, Synthenomics, August 26:
The Federal Reserve’s policy response to the latest financial crisis can be summed up in one word: unconventional. Between interest on excess reserves (IOER), quantitative easing (QE), and purchases of mortgage backed securities (MBS), the Fed has deployed a wide range of instruments to avoid deflation while preserving financial stability. However, although it is clear the Fed has acted in many ways, what is still unclear is how these policies impact the financial sector and the economy at large. Is interest on excess reserves expansionary or contractionary? Are large scale asset purchases expansionary or contractionary? A rapidly growing and evolving shadow banking sector has only worsened this confusion, and this post is an attempt to make some sense of these arguments in an illustrated form.
“Securities Finance: half year review” by Will Duff Gordon, Data Explorers, August 23:
We are over halfway through the year so it is a good time to review some mega trends. …
Some investment banks are aiming to be Basel III compliant by the end of the year and this means wrestling with the issue of the Liquidity Coverage Ratio. By rights this should lead to more term trades being booked in the securities lending market as banks try to secure fixed funding to match their liabilities – and for longer periods.
We are seeing more term trades and they are being booked for longer. …
This ties in with highlights from ICMA’s recent repo survey who report: “The latest survey confirmed the trend of a significant lengthening of the maturity profile of European repo in anticipation of stricter regulatory liquidity requirements, with transactions with more than a year to maturity expanding to 13.3 percent of the survey.” …
Finally, in their Shadow Banking report released last week, it is worth noting that the European Parliament hold similar views to the Financial Stability Board on what should be done about securities lending and repo. The ECON committee: “Takes note of the importance of the repo and security lending market; invites the Commission to adopt measures by beginning of 2013 to increase transparency as well as to allow regulators to impose minimum haircuts or margin levels for the collateralised financing markets.”
“Money fund and repo reform: fix both for the price of one” by High Line Advisors, August 23:
While the SEC concerns itself with reform of money market funds and the Federal Reserve calls for reform of the tri-party repo market, let us recognize the link between the two and the potential to address both concerns with a single solution: cleared repo.
Three Commissioners, constituting a majority of the Commission, have informed me that they will not support a staff proposal to reform the structure of money market funds. The proposed structural reforms were intended to reduce their susceptibility to runs, protect retail investors and lessen the need for future taxpayer bailouts….
The declaration by the three Commissioners that they will not vote to propose reform now provides the needed clarity for other policymakers as they consider ways to address the systemic risks posed by money market funds. I urge them to act with the same determination that the staff of the SEC has displayed over the past two years.
As we consider money market funds’ susceptibility to runs, we must remember the lessons of the financial crisis and the history of money market funds. And, we must be cognizant that the tools that were used to stop the run on money market funds in 2008 no longer exist. That is, there is no “back-up plan” in place if we experience another run on money market funds because money market funds effectively are operating without a net.
One of the most critical lessons from the financial crisis is that, when regulators identify a potential systemic risk – or an industry or institution that potentially could require a taxpayer bailout – we must speak up. It is our duty to foster a public debate and to pursue appropriate reforms. I believe that is why financial regulators both past and present, both Democrats and Republicans, have spoken out in favor of structural reform of money market funds. I also believe that is why independent observers, such as academics and the financial press — from a variety of philosophical ideologies — have supported structural reform of money market funds, as well.
The issue is too important to investors, to our economy and to taxpayers to put our head in the sand and wish it away. Money market funds’ susceptibility to runs needs to be addressed. Other policymakers now have clarity that the SEC will not act to issue a money market fund reform proposal and can take this into account in deciding what steps should be taken to address this issue.
“The Fed’s Emergency Liquidity Facilities during the Financial Crisis: The PDCF” by Tobias Adrian and Ernst Schaumburg, New York Fed, August 22:
During the height of the 2007-09 financial crisis, intermediation activities across the financial sector collapsed. In response, the Federal Reserve invoked section 13(3) of the Federal Reserve Act, citing “unusual and exigent circumstances,” to authorize the creation of a series of emergency lending facilities. These liquidity facilities provided last-resort-lending options to qualified borrowers in several strained markets in order to prevent the distress on Wall Street from spilling over onto Main Street. In an earlier post, we discussed the commercial paper funding facility. In this post, we review the Primary Dealer Credit Facility (PDCF), a program that represents the Fed’s first lending facility to nondepository financial institutions since the Great Depression….
PDCF funding was provided through short-term collateralized loans known as repurchase agreements, or repos. … Over several decades, repo contracts had become increasingly important instruments for the short-term financing of securities, in part because of their collateralized nature and preferential treatment under the U.S. bankruptcy code, which assures lenders that repo collateral is bankruptcy remote. Financing in the repo market peaked at $4.5 trillion, in March 2008, and continues to be a large source of financing for primary dealers.
“Spooked by Glass-Steagall’s Ghost?” by Mark Roe, Harvard Law School, August 21:
CAMBRIDGE – America’s long-controversial Glass-Steagall Act of 1933, which separated deposit-taking commercial banks from securities-trading investment banks in the United States, is back in the news. …
The first question is whether Glass-Steagall’s repeal strongly contributed to the financial crisis in the US. If it did, Glass-Steagall’s repeal should be revisited, and quickly. If it did not contribute much to the crisis, keeping risky trading away from commercial banks’ deposit base may still be desirable, but not something that the financial crisis “proved” is necessary.
Those who say that the financial recent crisis tells us to re-enact Glass-Steagall overlook what failed and what did not: the largest failures in the 2008 crisis – Lehman Brothers, AIG, and the Reserve Primary Fund – were not deposit-taking commercial banks on which Glass-Steagall’s repeal had a major impact. …
True, major commercial banks, like Citibank and Bank of America, tottered, but they were not at risk because of their securities underwriting for corporate clients or their securities-trading divisions, but because of how they (mis)handled mortgage securities. Mortgage lending, however, is a long-standing activity for commercial and savings banks, mostly unaffected by Glass-Steagall or its repeal….
The so-called “Volcker Rule,” proposed by Paul Volcker, the former US Federal Reserve chairman, is a mini-Glass-Steagall, aiming to bar deposit-taking commercial banks from derivatives trading – now seen to be a dangerous activity for them. But, again, although derivatives trading played an important role in the crisis (AIG’s inability, without a government bailout, to honor its risky credit-default swaps is the best example), Glass-Steagall’s repeal did not unleash the riskiest trades in the institutions that failed. ….
If the financial crisis reveals a structural problem in banking, it is more likely to come from insufficient capital to cushion a bank’s fall, or from too many financial institutions having become too big to fail….
If big banks have become too complex to regulate, then a workable Volcker Rule is the best way to start simplifying them. And, if the problem is systemically risky derivatives trading in banks and elsewhere, then the priority given to derivatives traders over nearly every creditor ought to be curtailed.
“The Evolution of Banks and Financial Intermediation” by the Federal Reserve Bank of New York, August 21:
The Research and Statistics Group recently published the results of a broad investigation into the transformation of banks and financial intermediation over the last several decades. In a special issue of the Economic Policy Review and a seven-part companion series on the Liberty Street Economics blog, our economists look at the causes and consequences of the industry-changing shift in the way banks operate—from a deposit-funded, hold-to-maturity lending model to the more complex credit intermediation chain associated with securitization.
A key question driving the two series is the extent to which traditional banks and bank holding companies (BHCs) may have been eclipsed by the newer “shadow banks,” which appear to be playing an increasingly important role in a securitization-based market.
“For Stability’s Sake, Reform Money Funds” by William C. Dudley, president Federal Reserve Bank of New York, Bloomberg View, August 14:
The crisis in the euro area is a reminder that threats to financial stability are never far away. …
A glaring vulnerability exists with money-market mutual funds. I believe changes along the lines proposed by Mary Schapiro, the chairman of the U.S. Securities and Exchange Commission, are essential. In particular, money funds should have capital buffers and modest limits on investor withdrawals. Such reforms are necessary to protect the economy from financial instability in the future.
Let me explain why. In our modern financial system, most of the credit to consumers, businesses and governments is supplied through the capital markets. This supply of credit depends on activities that are financed with short-term IOUs issued to money funds and other institutional investors.
For example, the ability of a car buyer to obtain an auto loan on good terms rests on the ability of the dealer’s financing arm to issue commercial paper to fund its inventory of loans. Likewise, corporations and the government can issue debt at a reasonable price because of the willingness of securities dealers to make markets in notes and bonds, and the dealers in turn rely on their ability to issue short-term debt to finance their holdings.
Money-market mutual funds are the biggest source of this type of finance, which economists call short-term wholesale funding. Money funds finance about 40 percent of the $480 billion financial-sector commercial paper market and about one- third of the $1.8 trillion tri-party repo market, in which financial firms borrow against their inventories of securities.
But we discovered in 2007 and 2008 that this type of funding is highly unreliable in a crisis. We saw that, when there is stress, money funds and other providers of short-term wholesale funds are prone to “run,” or to pull back on financing.
“A Transactional Genealogy of Scandal: from Michael Milken to Enron to Goldman Sachs” by William W. Bratton, University of Pennsyvlania Law School, and Adam J. Levitin, Georgetown University Law Center, August 13:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together—a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, an approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
“Why does repo exist?” by Worthwhile Canadian Initiative, August 7:
Today’s dumb question from the back of the Finance class. (But I would guess some other students might not know the answer either, and some maybe hadn’t even thought of the question).
[Update: just to be explicit, I am not asking why lenders want security for loans. I am asking why I don't sell my watch instead of pawning my watch.]
I want to borrow $80 for one month. I have a watch worth $100. I go to the pawnbroker, hand over my watch as security, and borrow $80. I promise to repay the $80 plus interest next month, and the pawnbroker promises to give me back my watch if I do this.
That’s like a “repo”, which is short for “sale and repurchase agreement”. It is as if I had sold my watch for $80, and the pawnbroker had promised to sell it back to me, and I had promised to buy it back from him, for $80 plus agreed-on interest next month. If I borrow $80 on a watch worth $100 there’s a 20% “haircut”. (The difference is that in a repo I get to keep wearing the watch for the month (I get the coupons on the bond) even though the pawnbroker legally owns it.)
Why don’t I just sell my watch instead, then wait till next month before deciding whether to buy it back?
“Repos: A Deep Dive in the Collateral Pool” by Martin Hansen, Robert Grossman, Kevin D’Albert, and Viktoria Baklanova, Fitch Ratings, August 1:
Repurchase agreements (repos), a core part of the “shadow banking” system, are increasingly in the spotlight, given both their importance as a funding mechanism and their role in past episodes of market distress. This study updates Fitch Ratings’ earlier report, “Repo Emerges from the ‘Shadow,’” dated Feb. 3, 2012, which highlighted the postfinancial crisis resurgence in the use of structured finance collateral within triparty repo markets.
As revealed through Fitch’s analysis of the 10 largest U.S. prime money market funds’ disclosures, structured finance repos are typically collateralized by pools of securities that are of lower credit quality (e.g. ‘CCC’ and below), deeply discounted, and small in size. Additionally, while Treasurys and agencies represent a significant majority of collateral, repos are also used to finance corporate debt, gold, and equity securities. Funding relatively less liquid, more volatile assets through repos (which are effectively short-term loans) creates potential liquidity risks for both repo borrowers and the underlying assets.
“Ultra Easy Monetary Policy and the Law of Unintended Consequences” by William R. White, Federal Reserve Bank of Dallas, August:
In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. …
Similar to the way that easy money in successive cycles encouraged imprudent borrowing, it also encouraged imprudent lending. There are a number of dangers associated with this. The first of these would be that lenders suffer losses severe enough to cause an eventual and marked tightening of credit conditions….
A second concern would be that easy monetary conditions, in association with regulatory and technical developments, would encourage over time the development of a “shadow banking sector” based less on traditional banking relationships and more on collateralized lending.
Again, there is clear evidence of such an expansion in recent years. Since this kind of lending seems to be even more procyclical than traditional bank lending, and subject to other risks as well, this would have to be thought of as another unintended consequence of easy monetary conditions. …
The essence of shadow banking is to make loans, securitize them, sell the securities and insure them, and actively trade all the financial assets involved. In effect, traditional relationship banking is replaced by a collateralized market system with the repo market at its heart. Banks thus get risky assets off the balance sheet, reducing the constraints just noted, while providing a rich source of fees and further profits from market making and proprietary trading. However, while seemingly convenient to the financial institutions involved, shadow banking activities have significant externalities (or systemic risks) for the financial system as a whole.
“Measuring Systemic Risk-Adjusted Liquidity, A Model Approach ” by Andreas A. Jobst, International Monetary Fund, August:
A defining characteristic of the recent financial crisis was the simultaneous and widespread dislocation in funding markets, which can adversely affect financial stability in absence of suitable liquidity risk management and policy responses. In particular, banks’ common asset exposures and their increased reliance on short-term wholesale funding in tandem with high leverage levels helped propagate rising counterparty risk due to greater interdependence within the financial system. The implications from liquidity risk management decisions made by some institutions spilled over to other markets and other institutions, contributing to others’ losses, amplifying solvency concerns, and exacerbating overall liquidity stress as a result of these negative dynamics. …
Under the post-crisis revisions of the existing Basel Accord, known as Basel III, the Basel Committee on Banking Supervision has proposed two quantitative liquidity standards to be applied at a global level and published a qualitative guidance to strengthen liquidity risk management practices in banks. Under this proposal, individual banks are expected to maintain a stable funding structure, reduce maturity transformation, and hold a sufficient stock of assets that should be available to meet its funding needs in times of stress – as measured by two standardized ratios: (Liquidity Coverage Ratio and Net Stable Funding Ratio) …
Larger liquidity buffers at each bank should lower the risk that multiple institutions will simultaneously face liquidity shortfalls, which would ensure that central banks are asked to perform only as lenders of last resort—and not as lenders of first resort. However, this rationale underpinning the Basel liquidity standards ignores the impact of the interconnectedness of various institutions and their diverse funding structures across a host of financial markets and jurisdictions on the probability of such simultaneous shortfalls. …
In this paper, we propose a structural approach – the systemic risk-adjusted liquidity (SRL) model – for the structural assessment and stress testing of systemic liquidity risk.
“Assessing the possible sources of systemic risk from hedge funds” by the Financial Services Authority, August:
Hedge funds did not play a major role in the financial crisis, but they have the potential to pose systemic risks to financial stability if they are individually very large or leveraged. …
We consider two channels through which financial stability may be affected by hedge funds: the ‘market’ channel where market dislocations disrupt liquidity and pricing, and the ‘credit’ channel where failure of a hedge fund (or a group of hedge funds) leads to losses by banking, brokerage and other counterparties….
In general, surveyed hedge funds reported improved conditions for the six-month period between October 2011 and March 2012. …
It is important to assess the amount and sources of hedge fund borrowing because of the potential impact on financial stability through ‘market’ and ‘credit’ channels. …
The latest results show that hedge funds continued to rely heavily on borrowing via repo in aggregate, with 47% coming from this source. This represents a decline from 57% recorded in the September 2011 survey, with hedge funds increasing their borrowing via prime brokerage as well as their synthetic borrowing. ….
If the provision of finance is withdrawn rapidly, hedge funds may be forced to liquidate their portfolios quickly. This may in turn result in a disorderly fire sale of assets. While hedge funds have a small footprint in most markets, forced selling could still affect market liquidity and efficient pricing if it occurs during periods of heightened market stress or where hedge funds make up a significant proportion of market liquidity. Repo borrowing may be a particular risk as it has to be continually rolled, and this may be difficult for hedge funds to achieve during stressed market conditions.
Another element of credit counterparty risk is the rehypothecation of hedge fund assets by prime brokers. … Results for the March 2012 survey state that 89% of surveyed funds have legal agreements with a brokerage counterparty that permits rehypothecation, title transfer or other similar arrangements for transferring ownership of collateral posted or assets placed in custody. On average, these funds permit rehypothecation up to 119% of net indebtedness.
“Finance must escape the shadows” by Sebastian Mallaby, Financial Times, July 31:
There are two ways finance can inflict disaster upon us. The first involves the collapse of a large, systemic institution: the Knickerbocker Trust at the start of the last century, Lehman Brothers at the start of this one. The second involves a convulsion in a particular market: tulips in 1637, various forms of “shadow banking” in 2008. The past three years have brought much debate and modest progress on regulating the megabanks, and the Libor scandal has added fresh impetus to these efforts. But shadow-bank reform has remained, well, shadowy.
“Fed Governor Speaks Out For Stronger Rules” by Simon Johnson, Baseline Scenario, July 28:
A powerful new voice for financial reform emerged this week – Sarah Bloom Raskin, a governor of the Federal Reserve System. In a speech on Tuesday, she laid out a clear and compelling vision for why the financial system should focus on providing old-fashioned but essential intermediation between savers and borrowers in the nonfinancial sector.
Sadly, she also explained that she is a dissenting voice within the Board of Governors on an essential piece of financial reform, the Volcker Rule. Her colleagues, according to Ms. Raskin, supported a proposed rule that is weaker, i.e., more favorable to the banks; she voted against it in October.
At least on this dimension, financial reform is not fully on track.
“A Principle for Forward-Looking Monitoring of Financial Intermediation: Follow the Banks!” by Nicola Cetorelli, New York Fed, July 23:
In the previous posts in this series on the evolution of banks and financial intermediaries, my colleagues and I considered the extent to which banks still play a central role in financial intermediation, given the rise of the shadow banking system. There’s no arguing that financial intermediation has grown in complexity. And there’s also little doubt that the balance sheet of banks is not as representative of financial intermediation activity, and the associated risks, as it once was. Yet as we’ve argued, regulated bank entities have remained very much involved in virtually every aspect of modern financial intermediation, either directly or indirectly providing support to other entities that themselves operate more in the regulatory shadow. I suggest in this post that the insights from the series can be relevant to the design of modern regulation as well.
“Income Evolution at BHCs: How Big BHCs Differ” by Adam Copeland, New York Fed, July 23:
As noted in the introduction to this series, over the past two decades financial intermediation has evolved from a traditional, bank-centered system to one where nonbanks play an increasing role. For my contribution to the series, I document how the sources of bank holding companies’ (BHC) income have evolved. I find that the largest BHCs have changed the most; they’ve shifted their mix of income toward providing new financial services and are earning an increasing share of income outside of their commercial bank subsidiaries. In this post, I summarize my study’s key findings.
“Register, Issue, Cap and Trade: A Proposal for Ending Current and Future Financial Crises” by Alistair Milne, School of Business and Economics, Loughborough University, July 20:
A fundamental cause of the global financial crisis was excessive creation of short-term money-like liabilities (‘quasi-money’), notably in shadow banking holdings of sub-prime MBS and other US dollar structured credit instruments and in cross-border flow of capital to the uncompetitive Euro area periphery. This paper proposes a registration system for: (i) controlling quasi-money and resulting economic externalities and systemic risks; and (ii) supporting public sector monetary issue to counter collapse of private sector credit in the aftermath of crises. This policy would trigger a profound but also economically beneficial change in the business models of both banks and long-term investors.
“Peeling the Onion: A Structural View of U.S. Bank Holding Companies” by Dafna Avraham, Patricia Selvaggi, and James Vickery, New York Fed, July 20:
RepoWatch editor’s note: Though not strictly about repos and shadow banking, this article describes the companies that do most of both.) When market observers talk about a “bank,” they are generally not referring to a single legal entity. Instead, large domestic banking organizations are almost always organized according to a bank holding company (BHC) structure, in which a U.S. parent holding company controls up to several thousand separate subsidiaries. This hierarchy of controlled entities generally includes domestic commercial banks primarily focused on lending and deposit-taking as well as a range of nonbanking and foreign firms engaged in a diverse set of business activities, such as securities dealing and underwriting, insurance, real estate, private equity, leasing and trust services, asset management, and so on. In this post, we present some results of our article and contribution to the special EPR banking volume, “A Structural View of U.S. Bank Holding Companies,” which uses public regulatory data to document trends and stylized facts about the size, organizational complexity, and scope of large U.S. BHCs.
“2012 Annual Report,” Office of Financial Research, July 19:
This inaugural Annual Report describes how the OFR is working to satisfy its statutory mandates and mission in four areas:
-To analyze threats to financial stability.
-To conduct research on financial stability.
-To address data gaps.
-To promote data standards.
“The Dominant Role of Banks in Asset Securitization” by Nicola Cetorelli and Stavros Peristiani, New York Fed, July 19:
As the previous posts have discussed, financial intermediation has evolved over the last few decades toward shadow banking. With that evolution, the traditional roles of banks as intermediaries between savers and borrowers are increasingly performed by more specialized entities involved in asset securitization. In this post, we summarize our published contribution to the series, in which we provide a comprehensive quantitative mapping of the primary roles in securitization. We document that banks were responsible for the majority of these activities. Their dominance indicates that the modern securitization-based system of financial intermediation is less “shadowy” than previously considered.
“2012 Annual Report,” The Financial Stability Oversight Council, July 18:
While member agencies of the Council are engaged in implementing the Dodd-Frank Act, much of the Council’s attention has also been on vulnerabilities that require additional focus beyond Dodd-Frank rulemaking. As emphasized in last year’s report, the instability of short-term wholesale funding markets is exacerbated by ongoing structural vulnerabilities in the tri-party repo market and in the money market fund industry. These vulnerabilities cannot be adequately addressed only at the firm level and must be tackled at the system level.
Consistent with the recommendation of the Council last year, the Federal Reserve has now taken a more direct supervisory approach to pursuing the necessary changes to the tri-party repo market. Similarly, the SEC continues to work through policy options for much needed reform of money market funds. Section 3 of this report sets out the Council’s 2012 recommendations in these and other areas.
“The Role of Bank Credit Enhancements in Securitization” by Benjamin H. Mandel, Donald Morgan, and Chenyang Wei, New York Fed, July 18:
As Nicola Cetorelli observes in his introductory post, securitization is a key element of the evolution from banking to shadow banking. Recognizing that raises the central question in this series: Does the rise of securitization (and shadow banking) signal the decline of traditional banking? Not necessarily, because banks can play a variety of background (or foreground) roles in the securitization process. In our published contribution to the series, we look at the role of banks in providing credit enhancements. Credit enhancements are protection in the form of financial support against losses on securitized assets in adverse circumstances. They’re the “magic elixir” that enables bankers to convert pools of possibly high-risk loans or mortgages into highly rated securities. This post highlights some findings from our article. One key finding: Banks are not being eclipsed by insurance companies (which are part of the shadow banking system) in the provision of credit enhancements.
“The Rise of the Originate-to-Distribute Model and the Role of Banks in Financial Intermediation” by João Santos, New York Fed, July 17:
In yesterday’s post, Nicola Cetorelli argued that while financial intermediation has changed dramatically over the last two decades, banks have adapted and remained key players in the process of channeling funds between lenders and borrowers. In today’s post, we focus on an important change in the way banks provide credit to corporations—the substitution of the so-called originate-to-distribute model for the originate-to-hold model. Historically, banks originated loans and kept them on their balance sheets until maturity. Over time, however, banks began increasingly to distribute the loans they originated. With this change, banks limited the growth of their balance sheets but maintained a key role in the origination of corporate loans, and in the process contributed to the growth of nonbank financial intermediaries.
“Introducing a Series on the Evolution of Banks and Financial Intermediation” by Nicola Cetorelli, New York Fed, July 16:
It used to be simple: Asked how to describe financial intermediation, you would just mention the word “bank.” Then things got complicated. As a result of innovation and legal and regulatory changes, financial intermediation has evolved in a way that invites us to question whether it revolves around banks anymore. The centerpiece of modern intermediation is the advent and growth of asset securitization: loans do not need to reside on the originator’s balance sheet until maturity any longer, but they can instead be packaged into securities and sold to investors. With securitization, banks’ balance sheets get replaced by a longer and more complex credit intermediation chain (Pozsar, Adrian, Ashcraft, and Boesky 2010). This evolution literally changes the picture of intermediation, as the figure below suggests. From a bank-centered system, we go to one where multiple entities interact with one another along the sequential steps of the chain, and concomitantly we hear increasingly of shadow banking, defined recently by the Financial Stability Board as a system of “credit intermediation involving entities and activities outside the regular banking system.”
“The Federal Reserve’s Term Asset-Backed Securities Loan Facility” by Adam Ashcraft, Allan Malz, and Zoltan Pozsar, Federal Reserve Bank of New York, July 10, 2012:
The securitization markets for consumer and business asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), which supply a substantial share of credit to consumers and small businesses, came to a near-complete halt in the fall of 2008, as investors responded to a drastic decline in funding liquidity by curtailing their participation in these markets. In response, the Federal Reserve introduced the TALF program, which extended term loans collateralized by securities to buyers of certain high-quality ABS and CMBS, as part of a broad array of emergency liquidity measures intended to avert lasting harm to the economy. This article describes the TALF program and operations in detail, explains how the terms and conditions of the TALF were intended to restore market liquidity while limiting the risk of loss to the public, and assesses the efficacy of the program. The authors find that, while it is hard to isolate the effect of the TALF, the facility is likely to have made a significant contribution to restoring liquidity in 2009 and 2010.
The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.
One of the financial system’s chief roles is to provide credit for worthy investments. Some very deep changes are happening to this system – changes that surprisingly few people are aware of. This column presents a quick sketch of the modern credit creation and then discusses the deep changes are that are affecting it – what we call the ‘other deleveraging’.
In the simple textbook view, savers deposit their money with banks and banks make loans to investors (Mankiw 2010). The textbook view, however, is no longer a sufficient description of the credit creation process. A great deal of credit is created through so-called ‘collateral chains’.
“Systemic risk due to retailisation?” by Oliver Burkart and Antoine Bouveret, European Systemic Risk Board, July:
Over the last few years “retailisation”, i.e. the marketing of complex products to retail investors by financial institutions, has reached very significant volumes and has emerged as a potential source of concern.
Retailisation has the potential to increase systemic risks through two main channels. The first is the household channel, whereby the exposure of retail investors to financial markets may result in losses that reduce their financial wealth and consumption, and so have an adverse impact on GDP. This effect could be amplified if the volumes of complex products – particularly those with a high risk profile which retail investors may not fully understand – were very significant and were spread over a broad base of investors.
The second is the banking channel, which is linked to the supply of complex products: financial institutions that rely heavily on complex products as a source of funding may be exposed to funding risk if the market experienced a sharp decline. Funding pressures could then lead to a reduction in the supply of credit to the real economy due to the deteriorating condition of financial institutions.
Risks arising through those two channels could be further aggravated by the increased interconnectedness between financial institutions resulting from the complexity of the products.
Unexpected low returns or losses which are broadly-based and large-scale might consequently trigger a loss of confidence in the financial system and could also have an impact on banks and other financial intermediaries.
This Commentary presents the results of work carried out on these issues …
“The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds” by Patrick E. McCabe, Marco Cipriani, Michael Holscher, and Antoine Martin, New York Fed, July:
This paper introduces a proposal for money market fund reform that could mitigate systemic risks arising from these funds by protecting shareholders, such as retail investors, who do not redeem quickly from distressed funds. Our proposal would require that a small fraction of each MMF investor’s recent balances, called the “minimum balance at risk,” be demarcated to absorb losses if the fund is liquidated. Most regular transactions in the fund would be unaffected, but redemptions of the minimum balance at risk would be delayed for thirty days. A key feature of the proposal is that large redemptions would subordinate a portion of an investor’s minimum balance at risk, creating a disincentive to redeem if the fund is likely to have losses. In normal times, when the risk of money market fund losses is remote, subordination would have little effect on incentives. We use empirical evidence, including new data on money market funds losses from the U.S. Treasury and the Securities and Exchange Commission, to calibrate a minimum balance at risk rule that would reduce the vulnerability of money market funds to runs and protect investors who do not redeem quickly in crises.
“Federal Reserve Liquidity Provision during the Financial Crisis of 2007-2009” by Michael J. Fleming, New York Fed, July:
This paper examines the Federal Reserve’s unprecedented liquidity provision during the financial crisis of 2007-2009. It first reviews how the Fed provides liquidity in normal times. It then explains how the Fed’s new and expanded liquidity facilities were intended to enable the central bank to fulfill its traditional lender-of-last-resort role during the crisis while mitigating stigma, broadening the set of institutions with access to liquidity, and increasing the flexibility with which institutions could tap such liquidity. The paper then assesses the growing empirical literature on the effectiveness of the facilities and provides insights as to where further research is warranted.
“Recovery and resolution of financial market infrastructures” by Bank for International Settlements and International Organization of Securities Commissions, July:
In November 2011, the G20 endorsed the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (henceforth, the Key Attributes). The Key Attributes set out the core elements that the Financial Stability Board considers necessary to establish a regime for resolving financial institutions without severe systemic disruption and without exposing taxpayers to loss. In the case of financial market infrastructures, the Key Attributes expressly require that resolution regimes be established in a manner appropriate to financial market infrastructures and their critical role in financial markets. …
The purpose of this report is therefore to outline the features of effective recovery and resolution regimes for financial market infrastructures in accordance with the Key Attributes and consistent with the principles of supervision and oversight that apply to them.
“Special Issue: The Evolution of Banks and Financial Intermediation,” Economic Policy Review, New York Fed, July:
The articles featured in this special issue are:
-“The Evolution of Banks and Financial Intermediation: Framing the Analysis” by Nicola Cetorelli, Benjamin H. Mandel, and Lindsay Mollineaux.
-“Regulation’s Role in Bank Changes” by Peter Olson.
-“The Rise of the Originate-to-Distribute Model and the Role of Banks in Financial Intermediation” by Vitaly M. Bord and João A. C. Santos.
-“The Role of Bank Credit Enhancements in Securitization” by Benjamin Mandel, Donald Morgan, and Chenyang Wei.
-“The Role of Banks in Asset Securitization” by Nicola Cetorelli and Stavros Peristiani.
-“A Structural View of U.S. Bank Holding Companies” by Dafna Avraham, Patricia Selvaggi, and James Vickery.
-“Evolution and Heterogeneity among Larger Bank Holding Companies: 1994 to 2010” by Adam Copeland.
“Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance” by Tiago Severo, International Monetary Fund, July:
I construct a systemic liquidity risk index (SLRI) from data on violations of arbitrage relationships across several asset classes between 2004 and 2010. Then I test whether the equity returns of 53 global banks were exposed to this liquidity risk factor. Results show that the level of bank returns is not directly affected by the SLRI, but their volatility increases when liquidity conditions deteriorate. I do not find a strong association between bank size and exposure to the SLRI—measured as the sensitivity of volatility to the index. Surprisingly, exposure to systemic liquidity risk is positively associated with the Net Stable Funding Ratio (NSFR). The link between equity volatility and the SLRI allows me to calculate the cost that would be borne by public authorities for providing liquidity support to the financial sector. I use this information to estimate a liquidity insurance premium that could be paid by individual banks in order to cover for that social cost.
“The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds” by Patrick E. McCabe, Marco Cipriani, Michael Holscher, and Antoine Martin, New York Fed, July:
This paper introduces a proposal for money market fund reform that could mitigate systemic risks arising from these funds by protecting shareholders, such as retail investors, who do not redeem quickly from distressed funds. Our proposal would require that a small fraction of each money market fund investor’s recent balances, called the “minimum balance at risk,” be demarcated to absorb losses if the fund is liquidated. Most regular transactions in the fund would be unaffected, but redemptions of the minimum balance at risk would be delayed for thirty days. A key feature of the proposal is that large redemptions would subordinate a portion of an investor’s minimum balance at risk, creating a disincentive to redeem if the fund is likely to have losses. In normal times, when the risk of money market fund losses is remote, subordination would have little effect on incentives. We use empirical evidence, including new data on money market funds losses from the U.S. Treasury and the Securities and Exchange Commission, to calibrate a minimum balance at risk rule that would reduce the vulnerability of money market funds to runs and protect investors who do not redeem quickly in crises.
“Mapping and Sizing the U.S. Repo Market” by Adam Copeland, Isaac Davis, Eric LeSueur, and Antoine Martin, New York Fed, June 25:
The U.S. repurchase agreement (repo) market is a large financial market where participants effectively provide collateralized loans to one another. This market played a central role in the recent financial crisis; for example, both Bear Stearns and Lehman Brothers experienced problems borrowing in this market in the period leading up to their collapse. Unfortunately, comprehensive and detailed data on this market are not available. Rather, data exist for certain segments of the repo market or for specific firms that operate in this market (see this recent New York Fed staff report). The spotty data make it difficult to understand the U.S. repo market as a whole and the relative importance of its different segments. In this post, we draw upon various data sources and market knowledge to provide a map of the U.S. repo market and to estimate its size. We argue that our estimate improves upon the $10 trillion estimate of Gorton and Metrick, which has received substantial press coverage.
“The roots of shadow banking” by Enrico Perotti, professor of International Finance, University of Amsterdam, June 21:
The ‘shadow banking’ sector is a loose title given to the financial sector that exists outside the regulatory perimeter. This column argues that despite its unpleasant sounding name, and its crucial role in the credit boom that preceded the global crisis, it does have its benefits – something that the regulators should be aware of.
“Shadow Banking After the Financial Crisis,” a speech by Federal Reserve Board Governor Daniel K. Tarullo, June 12:
The three decades preceding the financial crisis were characterized in the United States by the progressive integration of traditional lending and capital markets activities. This trend diminished the importance of deposits as a source of funding for credit extension in favor of capital market instruments sold to institutional investors. It also altered the structure of the financial services industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates. Although the structure of foreign banking systems was less noticeably changed, many foreign banks drew increasingly on the resulting wholesale funding markets and made significant investments in the mortgage-backed securities that had proliferated in the first decade of this century.
The financial crisis underscored the failure of the American regulatory system to keep pace with these developments and revealed the need for two reform agendas. One must be aimed specifically at the problem of too-big-to-fail institutions. The other must be directed at the so-called shadow banking system, which refers to credit intermediation involving leverage and maturity transformation that is partly or wholly outside the traditional banking system. As I have noted on other occasions, most reforms to date have concentrated on too-big-to-fail institutions, though many of these reforms have yet to be fully implemented. The shadow banking system, on the other hand, has been only obliquely addressed, despite the fact that the most acute phase of the crisis was precipitated by a run on that system. Indeed, as the oversight of regulated institutions is strengthened, opportunities for arbitrage in the shadow banking system may increase.
Today I want to focus on the development of a regulatory reform agenda for the shadow banking system.
“Why Rent When You Can Buy? A Theory of Securities Lending Repurchase Agreements” by Cyril Monnet, University of Bern and Study Center Gerzensee, and Borghan N. Narajabad, Rice University, June 6:
When asked why they rent securities, market participants usually answer that they need the security to settle a trade, to hedge, or to support their market-making activities. But this answers the question only partially: Most market participants have suﬃcient liquidity to buy some of the assets they need. But if they can buy the asset, why do they seemingly prefer to rent it?
“On the Existence and Fragility of Repo Markets ” by Hajime Tomura, Bank of Canada, June:
Repurchase agreements, or repos, are one of the primary instruments in the money market. In a repo, a cash investor buys bonds with a promise that the seller of the bonds, typically a bond dealer, will buy back the bonds at a later date. A question arises from this observation regarding why cash investors need repos when they can simply buy and resell bonds in a series of spot transactions. In this paper, I present a model to show that cash investors arrange repos with bond dealers because of an endogenous* bond-liquidation cost in an overthe-counter (OTC) bond market. This result is consistent with the fact that almost all bond markets are OTC markets in practice (Harris 2003). Furthermore, the bond-liquidation cost makes repos exist in tandem with a possibility of a repo-market collapse. This result provides an explanation as to why a repo market with safe repo collateral, such as the U.S. tri-party repo market, can collapse, as concerned during the recent ﬁnancial crisis.
*(RepoWatch add: “endogenous” means caused by the transaction itself.
“Leverage? What Leverage? – A Deep Dive into the U.S. Flow of Funds in Search of Clues to the Global Crisis” by Ashok Vir Bhatia and Tamim Bayoumi, International Monetary Fund, June:
This paper questions the view that leverage should have forewarned us of the global financial crisis of 2007–09, pointing to several gearing indicators that were neither useful portents of the onset of the crisis nor of its ferocity. Instead it shows, first, that the use of ill-suited collateral in the secured funding operations of U.S.-based investment banks was the fatal link between the collapse of structured finance and the global malfunction of funding markets that turbocharged the downdraft; and, second, that this insight (and others) can be decrypted from the Flow of Funds Accounts of the United States.
“Shadow banking”: a forward looking framework for effective policy” by the Institute of International Finance, June:
The IIF strongly supports the increased international focus on addressing risks from the non-bank financial system and in particular those activities that contribute to non-bank financial intermediation or “shadow banking”. We welcome in particular the work of the Financial Stability Board and European Commission on greater international coordination and consistency of policy across jurisdictions, and we are keen to contribute to this work.
Shadow banking may help drive the day-to-day financial system, but it is a concept looking for a hard-and-fast definition.Despite coming under intense scrutiny following the financial crisis, there have been disparate characterizations of what the shadow banking sector truly entails — with size estimates ranging from $10 to $60 trillion. At the same time, major regulatory efforts have either been enacted or are in the works to help reduce the size of this important sector, with no agreed-upon way to measure their effectiveness.The purpose of the Deloitte Shadow Banking Index is to define and quantify the sector over time, including its components. This ongoing effort is designed to more closely measure size, importance, effect of market, and impact of regulatory actions, as well as a way to assess the potential impact of shadow banking on regulated markets.
“Robust Capital Regulation” by Viral Acharya, Hamid Mehran, Til Schuermann, and Anjan Thakor, Current Issues in Economics and Finance, May 25:
Regulators and markets can find the balance sheets of large financial institutions difficult to penetrate, and they are mindful of how undercapitalization can create incentives to take on excessive risk. This study proposes a novel framework for capital regulation that addresses banks’ incentives to take on excessive risk and leverage. The framework consists of a special capital account in addition to a core capital requirement. The special account would accrue to a bank’s shareholders as long as the bank is solvent, but would pass to the bank’s regulators — rather than its creditors — if the bank fails. By design, this special account thus limits risk taking, but ensures that creditors’ disciplining incentives are preserved.
“Money and Collateral” by Manmohan Singh and Peter Stella, International Monetary Fund, April:
Between 1980 and before the recent crisis, the ratio of financial market debt to liquid assets rose exponentially in the U.S. (and in other financial markets), reflecting in part the greater use of securitized assets to collateralize borrowing. The subsequent crisis has reduced the pool of assets considered acceptable as collateral, resulting in a liquidity shortage. When trying to address this, policy makers will need to consider concepts of liquidity besides the traditional metric of excess bank reserves and do more than merely substitute central bank money for collateral that currently remains highly liquid.
“Securities Lending and Repos: Market Overview and Financial Stability Issues” by the Financial Stability Board, April 27:
At the Cannes Summit in November 2011, the G20 Leaders agreed to strengthen the regulation and oversight of the shadow banking system, and endorsed the Financial Stability Board’s initial recommendations with a work plan to further develop them in the course of 2012. Five workstreams have been launched under the Financial Stability Board to develop policy recommendations to strengthen regulation of the shadow banking system, including securities lending and repos (repurchase agreements).
The Financial Stability Board Workstream on Securities Lending and Repos under the Financial Stability Board Shadow Banking Task Force is developing policy recommendations, where necessary, by the end of 2012 to strengthen regulation of securities lending and repos. …
This report documents the Workstream’s progress so far. Sections 1 and 2 provide an overview of securities lending and repos markets globally, including the main drivers of the markets. Section 3 places securities lending and repo markets in the wider context of the shadow banking system. Section 4 provides an overview of existing regulatory frameworks for securities lending and repos, and section 5 lists a number of financial stability issues posed by these markets. Additional detailed information on the market segments and a survey of relevant literature survey can be found in the annexes.
“Shadow banking: thoughts for a possible policy agenda,” a speech by Paul Tucker, Deputy Governor Financial Stability, Bank of England, April 27:
It is excellent that the EU Commission has published a consultative paper on shadow banking and is holding this conference today. The Commission’s paper fits well with the approach that the G20 Financial Stability Board is taking. The issues here are very important since, as the international community reregulates the banking industry, more activity is almost bound to be booked outside banking.
We need at some point to move on to policy. I am therefore going to use today’s occasion to put on the table some thoughts for a possible concrete policy agenda.
“Securitisation, Shadow Banking and the Value of Financial Innovation,” a speech by Adair Turner, chairman Financial Services Authority, April 19:
I aim to do two things – first, consider how and why the wave of financial innovation in the area of securitised credit ended in the financial crash of 2008. And second, consider what we know about the value of financial innovation in general – whether financial innovation has a systematic tendency to be less valuable than innovation in other sectors of the economy: and how we should attempt to assess the value of financial innovation.
“Strengthening the Oversight and Regulation of Shadow Banking,” a progress report to G20 Ministers and Governors by the Financial Stability Board, April 16:
At the Cannes Summit in November 2011, the G20 Leaders agreed to strengthen the oversight and regulation of the shadow banking system, and endorsed the Financial Stability Board’s initial recommendations with a work plan to further develop them in the course of 2012. The G20 Leaders also asked the Financial Stability Board to report its progress for review at the G20 Finance Ministers and Central Bank Governors meeting in April 2012. …
The Financial Stability Board issued initial recommendations in its report “Shadow Banking: Strengthening Oversight and Regulation” to address such risks posed by the shadow banking system. It has adopted a two-pronged approach.
First, the Financial Stability Board will enhance the monitoring framework through continuing its annual monitoring exercise to assess global trends and risks, with more jurisdictions participating in the exercise.
Second, the Financial Stability Board will develop recommendations to strengthen the regulation of the shadow banking system, where necessary, to mitigate the potential systemic risks with specific focus on five areas: (i) to mitigate the spill-over effect between the regular banking system and the shadow banking system; (ii) to reduce the susceptibility of money market funds to “runs”; (iii) to assess and mitigate systemic risks posed by other shadow banking entities; (iv) to assess and align the incentives associated with securitisation to prevent a repeat of the creation of excessive leverage in the financial system; and (v) to dampen risks and pro-cyclical incentives associated with secured financing contracts such as repos, and securities lending that may exacerbate funding strains in times of “runs”. The proposed policy recommendations in all five areas will be developed by the end of 2012.
The rest of this report details the Financial Stability Board’s progress to-date in response to the request from the G20.
“Shadow Banking Regulation” by Tobias Adrian and Adam B. Ashcraft, New York Fed, April:
Shadow banks conduct credit intermediation without direct, explicit access to public sources of liquidity and credit guarantees. Shadow banks contributed to the credit boom in the early 2000s and collapsed during the financial crisis of 2007-09. We review the rapidly growing literature on shadow banking and provide a conceptual framework for its regulation. Since the financial crisis, regulatory reform efforts have aimed at strengthening the stability of the shadow banking system. We review the implications of these reform efforts for shadow funding sources including asset-backed commercial paper, triparty repurchase agreements, money market mutual funds, and securitization. Despite significant efforts by lawmakers, regulators, and accountants, we find that progress in achieving a more stable shadow banking system has been uneven.
“A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncü, New York University Stern School of Business, March 23:
One of the several regulatory failures behind the ongoing global financial crisis that started in 2007 has been the regulatory focus on individual, rather than systemic, risk of financial institutions. Whether the recently proposed financial sector reforms can address the systemic risk associated with such systemically important markets as the sale and repurchase agreement market or such systemically important sectors of small institutions as the money market mutual funds remains debatable. Focusing on systemically important assets and liabilities rather than individual financial institutions, we propose a set of resolution mechanisms which is not only capable of addressing the issues of inducing market discipline and mitigating moral hazard, but also capable of addressing the systemic risk associated with the systemically important assets and liabilities. Furthermore, because of our focus on systemically important assets and liabilities, our proposed resolution mechanisms would be easier to implement at the global level compared to mechanisms that operate at the level of individual institutional forms. We, then, outline how our approach can be specialized to the repo market and propose a repo resolution authority for reforming this market.
“Green Paper – Shadow Banking” by the European Commission, March 3:
… the Commission considers it a priority to examine in detail the issues posed by shadow banking activities and entities. The objective is actively to respond and further contribute to the global debate; continue to increase the resilience of the Union’s financial system; and, ensure all financial activities are contributing to the economic growth.The purpose of this Green Paper is therefore to take stock of current development, and to present on-going reflections on the subject to allow for a wide-ranging consultation of stakeholders.
“The problem of collateral” by Carolyn Sissoko, Synthetic Assets, February 22:
As discussed in my previous post, the biggest problem with allowing Strategically Important Financial Institutions (SIFIs) to post collateral to one another is that it discourages them from restricting credit to banks that are poorly managed. By discouraging normal market forces from working to limit the growth and interconnectedness of bad banks with the rest of the financial system, a collateralized interbank lending regime places an enormous burden on regulators to both identify and shrink a bank that has deep connections with the rest of the financial system. Arguably collateralized interbank lending places an impossible burden on regulators.
The second major problem with shifting from a system of unsecured interbank lending to a collateralized banking system is that in the process of purging the money supply of unsecured debt, the money supply may well have to shrink to the size of the collateral base.
(RepoWatch editor’s note: Thanks to Felix Salmon for noting the Sissoko column.)