Over two years ago, in March of 2012, when it was taboo to even suggest the Fed may be forced to admit failure once again with its then “final” monetary intervention Operation Twist (following similar failures with QE1 and QE2), we explained clearly “Why The Fed Will Have To Do At Least Another $3.6 Trillion In Quantitative Easing.” The premise was simple: while the Fed had succeeded in raising the notional amount of traditional bank liabilities, primarily deposits (through a matched reserve expansion) courtesy of unsterilized QE, it was failing to expand the universe of money-equivalent collateral in the shadow banking system. In fact, as the following chart shows, the deleveraging in shadow banking has continued, and aside for a tiny bounce in Q4 2012, resumed its downward path in Q1 2013, recording 19 of 20 consecutive quarterly drops (primarily on the back of nearly $3 trillion in ABS deleveraging and $1.2 trillion in repos).
Regardless, we were right, and as of last Friday, the Fed’s balance sheet was $750 billion higher, and rising at $85 billion each month, confirming that the true underlying economy is now worse than ever before, and to all those claiming the US is recovering we have a simply thought experiment (because it will never become an actuality) – have the Fed halt and undo its monetary interventions. Yeah… That’s what we thought.
More importantly, the balance sheet will continue rising for a long time, because in terms of the big picture, adding across traditional and shadow liabilities (or collateral) the consolidated all important number has been flat at ~$30 trillion despite the surge in the stock market which is one reason why broad inflation has been relatively tame: the Fed’s reserves have been parked in various repo pathways almost exclusively in the world’s risk assets. So while the Fed needs to slow QE modestly due to the slower rate of Treasury issuance due to a momentary contraction in deficit funding needs it can’t possibly halt it, at least not until the private sector picks up “leveraging” where the Fed leaves off. This would likely entail an even more epic housing bubble than in 2006 to restart the RMBS and HELOC monetary conduits.
As we have discussed in the past, financial liability creation has been entirely on the back of the public sector, and yet there is a limit to how much collateral the Fed can absorb before terminally distorting the Treasury bond market (as shown earlier), and unless a handoff of collateral creation to the private sector, primarily housing collateral, is successful in the next 2 to 3 years, the Fed may as well pack up. This was the key point of the TBAC’s most recent quarterly refunding presentation, and specifically the slide showing Policy Conclusion 2 discussing the need for private sector generation of moneylike collateral.
The whole point of this preamble was to repeat what we have been saying since 2009 – shadow banking is important. Perhaps the most important component of the Fed’s decision making process, far more so than any conventional, and flawed, understanding of its “reaction function.”
Which brings us to today’s post: a charming and whimsical essay by James Sweeney of Credit Suisse (whose recent essay When Collateral Is King is recommended to anyone still unfamiliar with shadow banking – that and Matt King’s “Are the Brokers Broken” of course). In it he makes a peculiar statement: modern shadow banking, as misunderstood as it may be, is merely a complex extension of the world Walter Bagehot described in “Lombard Street: A Description of the [London] Money Market” and may well be the reason why Bernanke recently has not only been increasingly referring to Bagehot in his public appearances, but also why both he and Draghi are gradually shifting away from a role of injecting flow and liquidity – since traditional cash flow is increasingly become less relevant in a world in which outright creation of collateral serves as a “cash flow” proxy in itself, if only in terms of promises of future (re)payment – to providing an explicit backstop of not only US but global shadow liabilities.
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Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance (pdf)
The modern shadow banking system, at its core, bears a surprising resemblance to the 19th century world that Walter Bagehot helped us to understand in his magisterial book Lombard Street: A Description of the [London] Money Market (1873). At the heart of both worlds is the wholesale money market, and operating as crucial liquidity backstop in both worlds is the central bank. At the time Bagehot was writing, this backstop function was not yet fully understood, much less accepted; much the same could be said of the central bank’s backstop of the shadow banking system today (Capie 2012). We are living today in a Bagehot moment, when the outlines of the new are just emerging from the ashes of the old.
During crisis, the central banks of Bagehot’s time and our own both dutifully employed their own balance sheets to stem the downturn. In both cases they did so without any prior overarching theory of why it worked, much less any thought about possible implications for their role in more normal times. The time for all of that would come later, after the crisis had died down. Bagehot’s book started the process of necessary rethinking for his own time by bringing out into the open how the Bank of England had acted during previous crises. We start our own process of necessary rethinking, for our own time, by using Bagehot as an entry point into understanding the modern shadow banking system, and the global financial crisis of our own time.
In doing so, we are conscious of taking a different approach to the subject than does most of the existing literature. For most authors, the important thing about shadow banking is the “shadow”, the distinct whiff of illegitimacy that comes from regulatory evasion in good times combined with unauthorized access to the public purse in bad times. From this starting point, it is natural to frame the question of appropriate oversight and regulation of shadow banking as a matter of how best to extend the existing system of oversight and regulation as it is applied to traditional banking. See for example the much-cited paper of Gorton and Metrick (2010), as well as the recent overviews by Adrian and Ashcraft (2012) and the Financial Stability Board (2012).
Starting from Bagehot, by contrast, we are able to see the rise of shadow banking as part of a larger process of financial globalization, our own century’s version of the process that Bagehot was grappling with for his own century. For our purposes, shadow banking system is not some troubling excrescence on the healthy body of traditional banking. Rather it is simply “money market funding of capital market lending”, sometimes on the balance sheets of entities called banks and sometimes on other balance sheets. The phenomenon is global because the world funding market is global, i.e. the global dollar money market. In short, shadow banking is nothing more than the characteristic institutional form of the present stage of financial development. From this vantage point, the question of appropriate oversight and regulation requires us to abstract from traditional banking, and to start instead from a world in which shadow banking is the only banking system.
The defining role of markets, both money and capital markets, for the shadow banking system directs attention to the central importance of prices, and also to the central importance of market-making institutions both for price discovery and for continuing secondary market liquidity. These institutions, relatively unimportant from the perspective of traditional bank loan-based credit, are both central and essential for modern capital market-based credit. When they are working well, the whole system works well; and when they stumble, the whole system stumbles. Accordingly, in what follows, we place them at the very center of analytical attention.
Figure 1 shows an idealized picture of the shadow banking system, which we might more neutrally call the “market-based credit system”. The “capital funding bank” is engaged in money market funding of capital market lending, specifically of residential mortgage backed securities (RMBS). We imagine the price risk in these securities being hedged in various swap markets—generically credit default swaps, interest rate swaps, and foreign exchange swaps—so that the combined CFB asset position is essentially riskfree. We further imagine this asset position being used as security for the money market funding.
The “asset manager” is the mirror image of the capital funding bank, holding its capital in (secured) money form and enhancing the return on that capital by selective risk exposure in various swap markets—again generically credit default swaps, interest rate swaps, and foreign exchange swaps. Standing in between the asset manager and the capital funding bank are two types of market-makers, one the “global money dealer” whose dealing activities establish the price of funding, and the other the “derivative dealer” whose dealing activities establish the price of risk. These dealers will be the central focus of our analysis.
In this stylized model, there is no counterparty risk because all funding is secured, and because all derivative positions are matched either by offsetting natural positions (RMBS for the CFB) or by reserves sufficient to make good even in the worst case scenario (“deposits” for the AM). Our dealers are matched-book dealers, with no net exposure to price risk, and thus have no need of capital reserves. Because their cash and collateral inflows and outflows are exactly matched, they have no need of liquidity reserves either. The only capital in the system, and the only deposit holding as well, are both is on the balance sheet of the asset manager, which is as it should be since the asset manager is the only agent facing any risk. (We will be relaxing these strong assumptions when we consider boom-bust dynamics in Section II.)
The stylized character of this model means that it cannot be expected to line up exactly with the institutional arrangements of current financial markets. Indeed, most large investment banks probably contain elements of all four functions. The value of the model is in helping us to make conceptual distinctions between these functions, both within given institutions and across institutions. Just so, for example, capital funding bank structures can be found on the balance sheets of most European universal banks, but also in off-balance sheet conduits of various kinds. Money market mutual funds might be considered global money dealers, but they are not the only ones. Pension funds might be considered asset managers, but also non-financial corporate treasurers and even synthetic Exchange-Traded Funds. Central counterparty clearinghouses might be considered derivative dealers, but so is anyone running a bespoke swap book.
The main purpose of the model is to provide an overarching framework to make conceptual sense of the many moving parts of the market-based credit system. Most important, by conceptualizing shadow banking as money market funding of capital market lending, the model reveals the central importance of the dealers who make prices in money and capital markets. In doing so, we uncover a link to the older Bagehot-era literature since, in effect, Bagehot’s bill brokers were last century’s version of the model’s Global Money Dealers (Wood 2000). At the core of the modern-world credit system lies a bill funding apparatus quite analogous to one Bagehot and his contemporaries were trying to understand, and to manage. For understanding and managing our own system, we start with Bagehot.
I. Bagehot and Beyond
Reading Bagehot, we enter a world where government securities are not yet the focal point of trading and prices, as they would come to be in the 20th century. Instead, the focus of attention is the private bill market, which domestic manufacturers tap as a source of working capital, and which traders worldwide tap to finance the movement of tradable goods. It is a market in short-term private debt, typically collateralized by tradable goods, quite different from our 20th century market in long-term public debt.
Supplying funds to the bill market were, among others, banks that purchased bills at discount from face value using their own deposit liabilities, typically planning to hold to maturity and redeem at par. The institution of “acceptance”, by which a bank or some other party guaranteed payment of a bill at maturity, was the way non-prime bills became prime. Backstopping the whole thing was the Bank of England, whose posted “Bank Rate” in effect put a floor on the price of prime bills; bank rate was usually somewhat higher than the market rate of discount. Banks whose immediate cash outflow (from deposit withdrawals) outran their immediate cash inflow (from maturing bills) could take their prime bill assets to the Bank of England for rediscount, and get cash for them. Normally, though, they were able to get a somewhat higher price by tapping the lively secondary market in bills to find a private buyer. In normal times, the central bank backstop operated to support the market; only in crisis times did the central bank backstop become the market.
What has come down to us as the Bagehot Rule for stemming financial crisis—lend freely but at a high rate of interest—was originally about the Bank of England buying bills freely but at a low price. But the Bank also did make loans (“advances”) against collateral, and the Bank’s generous collateral valuations provided further support for market prices. Bagehot famously urged the Bank to accept as collateral “what in ordinary times is reckoned a good security” rather than attending to current market valuation. The point of all these measures was to prevent troubled banks from being forced to liquidate fundamentally sound assets at fire sale prices.
Figure 2 shows a stylized picture of how the discount system worked in Bagehot’s day. We show the Bank of England as the ultimate backstop for the system, rediscounting prime bills by using its own liabilities as a source of funds. Note well that the Bank of England takes in as assets both the underlying bill and the acceptance which guarantees par payment at maturity. The Bank of England’s risk exposure is thus about when it will be paid, not about whether it will be paid, thus liquidity risk not solvency risk.
What would Bagehot make of modern shadow banking?
On the surface, the modern system looks quite different. The closest thing we have to the institution of “acceptance” is the credit default swap (Mehrling 2010), but that does not so much guarantee eventual par payment as current market value. Just so, according to standard financial theory, price of “risk free” security = price of risky security + price of risk insurance. Further, the modern system is fundamentally a world of long term debt, which connects to the world of short term bills through the institution of the interest rate swap. Again, in standard financial theory, price of short term security = price of long term security + price of interest rate swap. As well, the gold standard of Bagehot’s day is long gone, with the consequence that securities contain currency risk, which risk can be stripped out using the institution of the FX swap. Price of dollar security = price of foreign currency security + price of FX swap.
These differences from the world of Bagehot are significant but should not distract us from seeing that at the heart of both worlds is the money market, and operating as crucial backstop in both worlds is the central bank. Indeed, it could be said that the whole point of the various swaps is to manufacture prime bills from diverse raw materials. Putting together all the equations in the previous paragraph, we can distinguish the various stages of manufacture:
Price of “risk-free” prime bills = price of risky security
+ price of risk insurance
+ price of interest rate swap
+ price of FX swap.
At its core, modern shadow banking is nothing but a bill funding market, not so different from Bagehot’s. The crucial difference between his world and ours is the fact that Bagehot’s world was organized as a network of promises to pay in the event that someone else doesn’t pay (i.e. “acceptances”), whereas our own world is organized as a network of promises to buy in the event that someone else doesn’t buy.
What accounts for the shift from his time to ours?
The key reason is that in today’s world so many promised payments lie in the distant future, or in another currency. As a consequence, mere guarantee of eventual par payment at maturity doesn’t do much good. On any given day, only a very small fraction of outstanding primary debt is coming due, and in a crisis the need for current cash can easily exceed it. In such a circumstance, the only way to get cash is to sell an asset, or to use the asset as collateral for borrowing. In the private market, the amount of cash you can get for an asset depends on that asset’s current market value. By buying a guarantee of the market value of your assets, in effect you are guaranteeing your access to cash as needed; if no one else will give you cash for them, the guarantor will.
That, in effect, is what all the swaps are doing, or at any rate what they are trying to do. Because the plain fact of the matter is that all the swaps in the world cannot turn a risky asset into a genuine Treasury bill. What works in standard finance theory works only approximately in actual
practice, and the devil is in the details of that approximation. The weird and wonderful world of derivatives at best creates what we might call quasi-Treasury bills, which may well trade nearly at par with genuine Treasury bills during ordinary times, only to gap wide during times of crisis.
Here we identify the fundamental problem of liquidity, from which standard theory abstracts, as well as the reason that central bank backstop is needed. Promises to buy are no good unless you have the wherewithal to make good on them; the weak link in the modern system is the primitive character of our network of promises to pay.
Just so, consider the situation of a shadow bank that holds both a risky asset and various swaps that reference that risky asset, and then finances the lot in the wholesale money market, as in Figure 1. In principle the combination of assets and swaps is risk-free (a quasi-Treasury bill), but the practical question is whether the shadow bank can finance the combination in the same way that it could if it were actually risk free (a genuine Treasury bill). Concretely, suppose that the market value of the asset falls a bit. Even supposing that the value of the swaps rises pari passu—which it may not, given liquidity issues-there still remains the issue how to use that change in market value to meet the funding gap on the asset itself.
If the terms of the swap contracts are mark-to-market with speedy cash collateral transfer, then the swap value gain produces immediate cash inflow that might possibly be used to fill the funding gap.
However, if the terms are otherwise so the funding gap cannot be filled, then the underlying risky asset position may have to be liquidated, so exacerbating downward price pressure as a liquidity spiral gets under way. And even if the swap terms are favorable there could still be a problem, since what is favorable to one party is unfavorable to its counterparty. Mark-to-market with speedy cash collateral transfer just means that the liquidity troubles of the shadow bank are shifted onto the shoulders of its swap counterparty which now faces a funding gap of its own. Even if the shadow bank is fine, its counterparty may be forced to liquidate and so spark a downward liquidity spiral on its own.
To stem these liquidity spirals, what is clearly needed is some entity that is willing and able to use its own balance sheet to provide the necessary funding. If the funding gap is at the shadow bank, we need an entity that can turn the increased value of swap positions into an actual cash flow. If the gap is at the swap counterparty, we need an entity that can turn whatever assets the counterparty might have into actual cash flow. Ultimately we need a central bank, but that is just the ultimate backstop. Even before this, what we need is a dealer system that offers market liquidity by offering to buy whatever the market is selling. Only in crisis time does the central bank backstop become the market; in normal times, the central bank backstop merely operates to support the market.
Just as in Bagehot’s day, the critical infrastructure is an interconnected system of dealers, backstopped by a central bank. Just as in Bagehot’s day, the required backstop may involve commitment to outright purchase of some well-defined set of prime securities (such as Treasury securities). But it must also involve commitment to accept as collateral a significantly larger set of securities, in order indirectly to put a floor on their price in times of crisis. In previous work, we have called this commitment “dealer of last resort” rather than “lender of last resort” in order to draw attention to the modern importance of market liquidity, and hence the importance of placing bounds on price fluctuation (Mehrling 2011).
The key issue for financial stability, now as in Bagehot’s day, is to ensure a lower bound on the price of prime bills. The difference is that today, unlike in Bagehot’s day, prime bills are manufactured by stripping price risks of various sorts out of risky long term securities. The consequence is that today, unlike in Bagehot’s day, a lower bound on the price of prime bills requires also some kind of liquidity backstop of the instruments that are used to create the prime bills from riskier raw material.
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We will let readers explore the rest of the essay on their own at the following link, but we will provide what we believe is the key punchline as the topic of abstract monetary philosophy becomes more and more pertinent in a day and age when virtually everyone is insolvent by conventional standards:
Even at the peak of the boom, government-issued Treasury bills and Fed-issued cash/reserve balances remained the ultimate collateral and ultimate money respectively. The point is that both became decreasingly important quantitatively given the growth of private capital markets and private money markets during time of expansion. At all times, ultimate collateral and ultimate money remain crucial reference points in modern financial markets, but the actual instruments are important only in times of crisis when promises to pay are cashed rather than offset with other promises to pay.
Stated simply: the modern monetary system based on “promises to pay” only works as long as nobody actually demands payment, and especially not all at the same time which is what happened in 2008. It also explains why the only way to mask the fundamental insolvency of the modern monetary experiment, is to keep creating money-equivalent credit at all times and costs.
In short: a system based on faith.
In even shorter: a religion.
Any stop to such “money creation” and the false idol of monetary voodoonomics falls.