liquidity

Is Money View Ready to Be on Trial for its Assumptions about the Payment System?

Published by Anonymous (not verified) on Wed, 19/02/2020 - 2:47am in

A Review of Perry Mehrling’s Paper on the Law of Reflux

By Elham Saeidinezhad | Perry Mehrling’s new paper, “Payment vs. Funding: The Law of Reflux for Today,” is a seminal contribution to the “Money View” literature. This approach, which is put forward by Mehrling himself, highlights the importance of today’s cash flow for the survival of financial participants. Using Money View, this paper examines the implications of Fullarton’s 1844 “Law of Reflux” for today’s monetary system. Mehrling uses balance sheets to show that at the heart of the discrepancy between John Maynard Keynes’ and James Tobin’s view of money creation is their attention to two separate equilibrium conditions. The former focuses on the economy when the initial payment takes place while the latter is concerned about the adjustments in the interest rates and asset prices when the funding is finalized. To provide such insights into several controversies about the limits of money finance, Mehrling’s analysis relies deeply on one of the structural premises of the Money View; the notion that the payment system that enables the cash flow to transfer from a deficit agent to the surplus agent is essentially a credit system. However, when we investigate the future that the Money View faces, this sentiment is likely to be threatened by a few factors that are revolutionizing financial markets. These elements include but are not limited to the Fed’s Tapering and post-crisis financial regulations and constrain banks’ ability to expand credit. These restrictions force the payment system to rely less on credit and more on reserves. Hence, the future of Money View will hinge on its ability to function under new circumstances where the payment system is no longer a credit system. This puzzle should be investigated by those of us who consider ourselves as students of this View. 

Mehrling, in his influential paper, puts on his historical and monetary hats
to clarify a long-standing debate amongst Keynesian economists on the money
creation process. In understanding the effect of money on the economy, “old”
Keynesians’ primary focus has been on the market interest rate and asset
prices when the initial payment is taking place. In other
words, their chief concern is how asset prices change to make the new payment
position an equilibrium. To answer this question, they use the “liquidity
preference framework
” and argue that asset prices are set as a markup over
the money rate of interest. The idea is that once the new purchasing power is
created, the final funding can happen without changing asset
prices or interest rates. The reason is that the initial increase in the money
supply remains entirely in circulation by creating a new demand for liquid
balances for various reasons. Put it differently, although the new money will
not disappear on the final settlement date, the excess supply of money will be
eliminated by the growing demand for money. In this situation, there is no reflux
of the new purchasing power.

In contrast, the new Keynesian orthodoxy, established by James Tobin,
examines the effects of money creation on the economy by focusing on the final
position
rather than the initial payment. At this equilibrium, the
interest rate and asset prices will be adjusted to ensure the final settlement,
otherwise known as funding. In the process, they create discipline in the
monetary system. Using “Liquidity Preference Framework”, these
economists argue that the new purchasing power will be used to purchase
long-term securities such as bonds. In other words, the newly created money
will be absorbed by portfolio rebalancing which leads to a new portfolio
equilibrium. In this new equilibrium, the interbank credit will be replaced by
a long-term asset and the initial payment is funded by new long-term lending, all
outside the traditional banking system
. Tobin’s version of Keynesianism
extracted from both the flux of bank credit expansion and the reflux of
subsequent contraction by only focusing on the final funding equilibrium. It
also shifts between one funding equilibrium and another since he is only
interested in final positions. In the new view, bank checkable deposits are
just one funding liability, among others, and their survival in the monetary
system entirely depends on the portfolio preferences of asset managers.

The problem is that both views abstract from the cash flows that enable a continuous
payment system. These cash flows are key to a successful transition
from one equilibrium to another. Money View labels these cash flows as “liquidity
and puts it at the center of its analysis. Liquidity enables the economy to
seamlessly transfer from initial equilibrium, when the payment takes place, to
the final equilibrium, when the final funding happens, by ensuring the
continuity of the payment system. In the initial equilibrium, payment takes
place since banks expand their balance sheets and create new money. In this
case, the deficit bank can borrow from the surplus bank in the interbank
lending market. To clear the final settlement, the banks can take advantage of
their access to the central bank’s balance sheet if they still have short
positions in reserve. Mehrling uses these balance sheets operations to show
that it is credit, rather than currency or reserves, that creates a
continuous payment system. In other words, a credit-based payment system lets
the financial transactions go through even when the buyers do not have means of
payment today. These transactions, that depend on agents’ access to liquidity,
move the economy from the initial equilibrium to the ultimate funding
equilibrium. 

The notion that the “payment system is a credit system” is a
defining characteristic of Money View. However, a few developments in the
financial market
, generated by post-crisis interventions, are threatening
the robustness of this critical assumption. The issue is that the Fed’s
Tapering operations have reduced the level of reserves in the banking system.
In the meantime, post-crisis financial regulations have produced a balance
sheet constrained for the banking system, including surplus banks. These
macroprudential requirements demand banks to keep a certain level of
High-Quality Liquid Assets (HQLA) such as reserves. At the same time, the
Global Financial Crisis has only worsened the stigma attached to using the
discount loan. Banks have therefore become reluctant to borrow from the Fed to
avoid sending wrong signals to the regulators regarding their liquidity status.
These factors constrained banks’ ability to expand their balance sheets to make
new loans to the deficit agents by making this activity more expensive. As a
result, banks, who are the main providers of the payment system, have been
relying less on credit and more on reserves to finance this financial service.

Most recently, Zoltan Pozsar, a prominent scholar of the Money View, has warned
us
that if these trends continue, the payment system will not be a credit
system anymore. Those of us who study Money View realize that the assumption
that a payment system is a credit system is the cornerstone of the Money View
approach. Yet, the current developments in the financial ecosystem are
fundamentally remodeling the very microstructure that has initially given birth
to this conjecture. It is our job, therefore, as Money View scholars, to
prepare this framework for a future that is going to put its premises on
trial. 

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post Is Money View Ready to Be on Trial for its Assumptions about the Payment System? appeared first on Economic Questions .

Much Ado About Nothing

Published by Anonymous (not verified) on Tue, 18/02/2020 - 12:01am in

The Fed's interventions in the repo market are attracting considerable comment. A lot of people seem to think the Fed has embarked on another QE program without Congressional approval. And the usual suspects are complaining that the Fed is pumping up stock prices and debasing the dollar.  Stocks are indeed heading for the moon - though so is the dollar, which rather undermines those who think it is being debauched. But the Fed's interventions in the repo markets have nothing to do with stock prices. They are all about banks.

Last September, sudden spikes in the Fed Funds Rate (FFR) and its repo market equivalent, the Secured Overnight Funding Rate (SOFR), caught the Fed off guard. It  acted quickly, injecting copious quantities of reserves to bring the rates down. But this was by any standards a seat-of-the-pants operation. The Fed simply hadn't expected banks to run out of reserves. After all, despite the Fed's balance sheet reduction, total reserves were still far more than banks needed to meet reserve requirements. There should have been ample reserves in the system for banks to draw on when settling sudden large payments. But for some reason, there weren't.

"Excess" reserves used to mean any reserves the banks held over and above their reserve requirement. But since the introduction of Basel III liquidity rules and Fed "living wills", that has changed. Banks need to keep far more liquid assets than their reserve requirements suggest. Admittedly, Basel III requirements don't force them to keep these in the form of reserves. But "living wills" do. Additionally, the big banks now have to pre-fund their expected liquidity requirements for the following day, rather than relying on intraday overdrafts at the Fed. So they tend to hold much larger quantities of reserves than they used to. For example, Jamie Dimon estimated that JP Morgan had to hold at least $60bn of reserves to meet its expected intraday liquidity requirements. That is one heck of a lot of reserves withheld from the market.

"Excess reserves" has thus acquired a different meaning. It now means whatever reserves the banks are willing to unload, either by lending them to each other or by lending cash in the repo market (which triggers a reserve movement). But when banks are facing enormous payment demands, they won't do anything that reduces their reserves. So when corporations started making their quarterly tax payments, banks simply stopped lending excess reserves to each other. And because cash lending to non-banks causes reserve outflows, they stopped that too.

But quarterly tax payments happen, er, every quarter. Why was September different? Well, it wasn't. The Fed made an error of judgement. It assumed that the big banks would continue to act as dealers of last resort in the repo market even when the reserves on which they depend for liquidity were being drained by Fed balance sheet run-off, overnight reverse repos, and Treasury debt issuance to finance the growing US budget deficit. But banks' primary duty is to their customers and shareholders, not to the Fed. If market liquidity becomes stressed, banks will protect themselves. Rather than lending more cash to maintain market liquidity, they will stop lending and hoard reserves, thus making the market liquidity problem worse. So the SOFR and FFR spikes had two causes. Firstly, a sudden drain of market liquidity, mainly due to quarterly tax payments and Treasury debt issuance; and secondly, reserve hoarding by big banks.

After the September spikes, the Fed continued to inject liquidity into the repo market by means of intermittent asset purchases. In December, Zoltan Poszar at Credit Suisse predicted that the Fed would have to start QE to prevent the repo market freezing at year end. This was incendiary. When the Fed made substantial liquidity injections over the year end, thus preventing serious market disruption, lots of people decided Poszar was right. The Fed had started QE again, and it was pumping up stock and bond prices.

But the Fed's liquidity injections are not like QE. They are more like the open market operations (OMOs) that the Fed used to do before the financial crisis, though on a much larger scale, because the repo market is much larger than the pre-crisis Fed Funds market and not restricted to banks.

Like OMOs, the Fed's liquidity injections put downwards pressure on short rates, thus keeping the FFR within its target range and the SOFR within a few basis points of the FFR. And by relieving funding pressures, they enable the big banks to supply liquidity to the repo market, preventing it from freezing as it did in 2008. Keeping the repo market liquid prevents stock and bond prices from crashing due to fire sales by distressed non-banks.

But preventing a disastrous stock market collapse due to liquidity failure is emphatically not the same as "pumping up" asset prices with QE. And the Fed's asset purchases this time are fundamentally different from QE purchases. In QE, the Fed bought government bonds and agency MBS of varying maturities, thus flattening the yield curve. The idea was to encourage investors to diversify into higher-yielding corporate bonds and equities. But this time, the Fed is buying Treasury bills and TIPS - short-term government bonds of similar liquidity to reserves. The effect is to change the composition of repo market liquidity, reducing the quantity of liquid collateral in circulation and increasing the cash and reserves held by banks. Reducing the quantity of liquid collateral depresses short-term interest rates, leaning against any tendency of the yield curve to invert (note that this is the opposite of QE's effect). And increasing the cash and reserves held by banks should encourage them to lend. As repo market lending is entirely short-term, none of this should have any effect on longer-term rates.

So the Fed's asset purchases aren't QE, and they aren't pumping up stock and bond prices. They are a purely technical operation to enable the Fed to control short-term interest rates as it has done for decades. If the Fed were intervening in the Fed Funds market in this way, no-one would say a word.

But why is the Fed intervening in the repo market instead of the Fed Funds market? The reason is that in this strange post-crisis world, the Fed Funds market is fast becoming an anachronism. Banks now prefer the safety of collateralised lending, even to other banks. The interbank market has embedded itself in the repo market, and the repo market has effectively replaced the Fed Funds market as the primary vehicle through which the Fed must transmit monetary policy. The Fed wanted to restrict its interventions to the Fed Funds market and rely on the big banks to transmit policy to the repo market. But the big banks wouldn't play the game. So the Fed now has to backstop the repo market itself in order to keep control of interest rates.

However, the Fed's backstop is problematic. Firstly, as I noted before, it means that the Fed is now implicitly guaranteeing dollar liquidity to non-banks and foreign banks as well as US regulated banks. Admittedly, foreign banks already enjoy an effective guarantee of dollar liquidity via their own central banks because of Fed swap lines. But guaranteeing dollar liquidity to non-banks is a different matter. The last time the Fed did that was in the financial crisis, and it was severely criticised for it. Firms that know the Fed will dampen interest rate volatility are much more likely to take excessive risks. If Elizabeth Warren finds out what is going on there will be hell to pay.

Secondly, leveraged trading is a feature of the repo market, unlike the Fed Funds market which is a pure cash market. Leveraged trading inevitably amplifies rate movements. Transmitting monetary policy via such a market means that the Fed must constantly intervene to dampen rate movements. But the Fed is talking about ending liquidity injections in April. Colour me sceptical. Unless it can persuade the big banks to take over as lenders of last resort to this market, it will have to provide funds forever.

What would the Fed have to do to persuade the banks to take back responsibility for providing liquidity to the repo market? Well, it would have to guarantee them unlimited liquidity. You would think they already have such a guarantee, especially since the consequences of central banks failing to provide adequate liquidity to banks were so catastrophically exposed in the financial crisis. But you would be wrong. They don't - at least, they do, sort of, but they are systematically discouraged from using the facility that is supposed to provide them with liquidity at need. I refer, of course, to the Fed's broken "discount window", which is a fine example of how perfectly sensible institutions can be rendered useless by ridiculous beliefs.

Non-banks such as hedge funds, pension funds and shadow banks are the customers of regulated banks, which act as their gateways to the payments network. Non-banks are also prone to runs. When non-banks are run on, the money flows through regulated banks can be far more than the banks hold in reserves: during the systemic runs on shadow banks in 2008, trillions of dollars flowed through the big banks. The Fed must provide unlimited liquidity to banks to enable those flows to happen. If it doesn't, then disturbances in the non-bank (shadow bank) sphere can cause regulated banks to fail, with potentially disastrous consequences for the real economy.

The discount window is intended to enable banks to obtain liquidity at need, thus eliminating the risk that a bank will fail due to exceptionally large outflows of customer funds - whether because of a run on the bank itself or runs on its customers. But the discount window is expensive, and - more importantly - stigmatised. Banks are very unwilling to use it, because it signals to the market that they are in distress, making their funding problems even more acute and raising the risk of failure. An emergency lending facility that no-one will use because using it makes matters worse is surely worse than useless.

David Andolfatto of the St. Louis Federal Reserve has proposed that the Fed should create a "standing repo" facility (SRF) which would enable banks to help themselves to new reserves from the Fed whenever they need them, provided they have adequate collateral. A bank that meets its Basel III requirements for high-quality liquid assets (HQLA) would be unlikely to lack collateral. So a SRF would effectively eliminate funding stress for banks.

The quid pro quo for this arrangement would be that the Fed would no longer backstop the repo market as it has since September. The Fed would guarantee liquidity for solvent regulated banks, and the banks would be expected to guarantee liquidity for creditworthy non-banks.  Monetary policy would be transmitted through the banks, not through enormous open market operations in an international money market populated by foreign banks and non-banks. In short, normal service would be resumed, despite the imminent demise of the Fed Funds market.

However, not everyone agrees that a SRF is the solution. The Fed's Randal Quarles agrees that banks need to be provided with unlimited liquidity, but thinks that fixing the discount window would be sufficient. The discount window could be extended to provide intraday liquidity against HQLA collateral, and the interest rate could be reduced to a few basis points above SOFR, which would keep a lid on SOFR and (by extension) FFR.

But the problem is the discount window stigma. Stigmas are notoriously difficult to remove. The Fed can signal that using the discount window is now to be considered "normal", but it has no way of ensuring that markets will see it that way. I fear that improving the discount window's facilities won't be sufficient for banks to want to use it. And if banks won't use it, then the Fed will be unable to stop intervening directly in the repo market.

Rather than attempting to persuade banks that the Fed now wants them to use a facility that it has spent decades trying to stop them using, it would probably be simpler to create a new facility. As Claire Jones at FT Alphaville says, "It would be neater to start afresh with a standing repo facility designed with the specific purpose of exchanging treasuries for reserves, rather than trying to use a discount window long seen as a last resort (complete with the stigma one would expect)." I concur. The discount window is beyond repair. Time to replace it.

And it is also time to stop worrying about the repo market. The Fed's backstop is effective. Interest rates are under control, and no-one is suffering serious liquidity shortages. The liquidity injections are not creating a dangerous bubble in stocks and bonds. And the moral hazard that the backstop creates will eventually be eliminated when the Fed replaces its market liquidity injections with unlimited funding for banks, whether that is via a reformed discount window or a new SRF. There is nothing to look at here. Time to move on.

Related reading:

The blind Federal Reserve 
More "money" Treasuries would calm repo markets - FT Alphaville
Anatomy of a Bank Run
Liquidity Matters

Image from David Strine,CC0, via Wikimedia Blog

Where Does Profit Come from in the Payments Industry?

Published by Anonymous (not verified) on Thu, 13/02/2020 - 2:25am in

“Don’t be seduced into thinking that that which does not make a profit is without value.”

Arthur Miller

The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment systems during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.

Traditionally, the banking system provides payment services by being
prepared to trade currency for deposits and vice versa, at a fixed price par.
However, when we try to understand the economics of banks’ function as
providers of payment systems, we quickly face a puzzle. The question is how
banks manage to make markets in currency and deposits at a fixed price and a
zero spread. In other words, what incentivizes banks to provide this crucial
service. Typically, what enables the banks to offer payment systems, despite
its negligible earnings, is their complementary and profitable role of being
dealers in liquidity. Banks are in additional business, the business of bearing
liquidity risk by issuing demand liabilities and investing the funds at term,
and this business is highly profitable. They cannot change the price of
deposits in terms of currency. Still, they can expand and contract the number
of deposits because deposits are their own liability, and they can expand and
contract the quantity of currency because of their access to the discount
window at the Fed. 

This two-tier monetary system, with the central bank serving as the banker to commercial banks, is the essence of the account-based payment system and creates flexibility for the banks. This flexibility enables banks to provide payment systems despite the fact the price is fixed, and their profit from this function is negligible. It also differentiates banks, who are dealers in the money market, from other kinds of dealers such as security dealers. Security dealers’ ability to establish very long positions in securities and cash is limited due to their restricted access to funding liquidity. The profit that these dealers earn comes from setting an asking price that is higher than the bid price. This profit is called inside spread. Banks, on the other hand, make an inside spread that is equal to zero when providing payment since currency and deposits trade at par. However, they are not constrained by the number of deposits or currency they can create. In other words, although they have less flexibility in price, they have more flexibility in quantity. This flexibility comes from banks’ direct access to the central banks’ liquidity facilities. Their exclusive access to the central banks’ liquidity facilities also ensures the finality of payments, where payment is deemed to be final and irrevocable so that individuals and businesses can make payments in full confidence.

The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve). 

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post Where Does Profit Come from in the Payments Industry? appeared first on Economic Questions .

Is the Recent Buyback Spree Creating Liquidity Problems for the Dealers?

Published by Anonymous (not verified) on Wed, 05/02/2020 - 4:12am in

Tags 

liquidity

“You are a side effect,” Van Houten continued, “of an evolutionary process that cares little for individual lives. You are a failed experiment in mutation.”

― John Green, The Fault in Our Stars

By Elham Saeidinezhad | The anxieties about large financial corporations’ debt-funded payouts—aka “stock buybacks”—are reemerging a decade after the financial crisis. Companies on the S&P 500 have poured more than $5.3 trillion into repurchasing their own shares since 2010. The root cause of most concerns is that stock buybacks do not contribute to the productive capacities of the firm. Indeed, these distributions to stockholders disrupt the growth dynamic that links the productivity and pay of the labor force. Besides, these payments that come on top of dividends could weaken the firms’ credit quality.

These analyses, however, fail to appreciate the cascade effect that will hurt the dealers’ liquidity positions due to higher stock prices. Understanding this side effect has become even more significant as the share of major financial corporations, including JPMorgan, is trading at records, and are getting very expensive. That high-class problem should concern dealers who are providing market liquidity for these stocks and establishing short positions in the process. Dealers charge a fee to handle trades between the buyers and sellers of securities. Higher stock prices make it more expensive for short selling dealers to settle the positions by repurchasing securities on the open market. If stocks become too high-priced, it might reduce dealers’ ability and willingness to provide market liquidity to the system. This chain of events that threatens the state of market liquidity is missing from the standard analysis of share buybacks.

At the very heart of the discussion about share buybacks lay the question of how companies should use their cash. In a buyback, a company uses its cash to buy its own existing shares and becomes the biggest demander of its own stock. Firms usually repurchase their own stocks when they have surplus cash flow or earnings, which exceed those needed to finance positive net present value investment opportunities. The primary beneficiaries of these operations are shareholders who receive extra cash payments on top of dividends. The critical feature of stock buybacks is that it can be a self-fulfilling prophecy for the stock price. Since each remaining share gets a more significant piece of the profit and value, the companies bid up the share values and boost their own stock prices. The artificially high stock prices can create liquidity and settlement problems for the dealers who are creating a market for the stocks and have established short positions in the process.

Short selling is used by market makers to provide market liquidity in response to unanticipated demand or to hedge the risk of a long position in the same security or a related security. On the settlement date, when the contract expires, the dealer must closeout—or settle—the position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market. If the prices become too high, they will not have enough capital to secure their short sales. At this point, whoever clears their trade will force them to liquidate. If they continue losing money, dealers face severe liquidity problems, and they may go bankrupt. The result would be an illiquid market. To sum up, in recent years, buybacks by public firms have become an essential technique for distributing earnings to shareholders. Not surprisingly, this trend has started a heated debate amongst the critiques. The problem, however, is that most analyses have failed to capture the effect of these operations on dealers’ market-making capacity, and the state of market liquidity when share prices become too high. 

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory


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How Does Information Affect Liquidity in Over-the-Counter Markets?

Published by Anonymous (not verified) on Mon, 13/01/2020 - 11:00pm in

Tags 

liquidity

Michael Lee and Antoine Martin

How Does Information Affect Liquidity in Over-the-Counter Markets?

A large volume of financial transactions occur in decentralized markets that commonly depend on a network of dealers. Dealers face two impediments to providing liquidity in these markets. First, dealers may face informed traders. Second, they may face costs associated with maintaining large balance sheets, either due to inventory or liquidity costs. In a recent paper, we study a model of over-the-counter (OTC) markets in which liquidity is endogenously determined by dealers who must contend with both asymmetric information and liquidity costs. This post provides an intuitive explanation of our model and the dynamics of interdealer liquidity.

A Stylized Model of Interdealer Markets

We consider a stylized representation of interdealer markets. First, each dealer makes markets for its clients, who may be interested in buying or selling an asset. Dealers offer a bid-ask spread at which they are willing to execute trades. Next, dealers can trade among themselves. This interdealer market helps dealers manage liquidity. A dealer who purchased an asset from a client would like to sell that asset to rebalance its inventory. Conversely, a dealer who sold an asset to a client will want to purchase the asset in the interdealer market. Dealers have an incentive to trade with each other because they suffer a cost if their inventory is “unbalanced.”

The value of the asset being traded is uncertain to dealers. For simplicity, we assume that the value of the asset can be either high or low. The dealers know the expected value of the asset, but they don’t know the true value. Traders have private asset valuations that are distributed symmetrically around the true value of the asset, which dealers care about. A trader’s private valuation could differ from an asset’s true value—for example, because a trader is liquidity constrained and is desperate to sell the asset to obtain cash.

The next exhibit represents the two possible values of an asset and the distribution of traders’ associated valuations. The top line represents the case where the true value of the asset is low. The traders’ valuations are represented by the blue line, which is centered on the value of the asset. The lower line represents the case where the true value of the asset is high. Again, the traders’ valuations are represented by the blue line. The expected value of the asset is represented by the dotted vertical line.

How Does Information Affect Liquidity in Over-the-Counter Markets?

Acquiring Information through Trade

Dealers can learn about the true value of an asset through trading. This is illustrated in the next exhibit, where the bid-ask spread is represented by dashed vertical lines. If a trader values the asset at less than the ask price of the dealer with whom she is matched, she will sell her asset to the dealer. This is represented by the shaded region to the left of the dashed line representing the dealer’s ask price. Conversely, if a trader places a value on the asset that is greater than the bid price of the dealer with whom she is matched, she will purchase the asset from the dealer. This is represented by the shaded region to the right of the dashed line representing the dealer’s bid price.

How Does Information Affect Liquidity in Over-the-Counter Markets?

As can be seen from the exhibit above, a dealer is more likely to sell his asset when the value of the asset is low and buy the asset when the value of the asset is high. Hence, conditional on trading, the dealer gains some information on the true value of the asset.

What happens if a dealer chooses a wider bid-ask spread? The exhibit below shows that the dealer learns more about the true value of the asset, conditional on a trade. Indeed, if the dealer sells the asset, for example, it is now much more likely that the true value of the asset is low. This can be seen by the fact that the shaded area to the left of the ask price when the value of the asset is low is much greater than the shaded area to the left of the ask price when the value of the asset is high.

How Does Information Affect Liquidity in Over-the-Counter Markets?

It is possible for a dealer to widen a bid-ask spread to the point that no trader would ever be willing to buy an asset, if its value is low, and no trader would ever be willing to sell an asset, if its value is high. In this extreme case, the dealer would learn the true value of the asset, conditional on trading. It is important to also note that with a wider bid-ask spread, the dealer is less likely to trade. This can be seen by the fact that the shaded areas become smaller as the bid-ask spread widens.

How Is Interdealer Market Liquidity Determined?

Any information acquired by dealers at the market-making stage is useful when dealers expect to trade in the interdealer market. A dealer who is better informed about the true value of an asset could, for example, reject an offer from another dealer if it’s not attractive enough, even though the dealer would have accepted the offer absent the additional information.

At the same time, the informational advantage that a dealer can achieve through its market-making activities diminishes interdealer liquidity. This is because interdealer liquidity is greatest when more dealers with offsetting positions trade. When the bid-ask spread is wider, fewer dealers trade in the market-making stage, reducing trading opportunities in the interdealer market. Fundamentally, there is a conflict between private incentives to obtain an informational edge and the socially efficient provision of liquidity in the market-making stage.

Endogenous Interdealer Trades and Fragility

A key insight from our model is that interdealer liquidity depends on dealers’ market-making activities. Tighter bid-ask spreads, which correspond to greater liquidity provided by dealers to their clients as they make markets, lead to more liquidity in the interdealer market. Wider bid-ask spreads have the opposite effect, reducing liquidity in both markets.

In the extreme case that dealers expect no interdealer trades to occur, their optimal response is to exploit their market power over their customers and offer them wide bid-ask spreads. When that happens, markets become segmented, with dealers making markets for their local markets but not engaging in interdealer trades to offset imbalances between local markets. In other words, illiquidity begets illiquidity.

This problem of expectations substantiating and rationalizing a breakdown in coordination is a form of financial fragility, reminiscent of runs in the context of banking or wholesale money markets. In particular, we show that, under certain circumstances, dealers’ beliefs are an important determinant of interdealer liquidity. For intermediate levels of fundamental uncertainty, dealers’ expectations about other dealers’ market-making practices can rationalize either active interdealer trading or no trading at all. Because spreads dramatically widen in the event of a cessation of interdealer trading, markets could quickly dry up if dealers’ beliefs change abruptly. For example, interdealer trading, which accounts for 61 percent of all trades in sterling OTC markets, fell to 2 percent during the sterling flash crash in October 2016. In a report on the episode, the Financial Conduct Authority cited the sharp withdrawal of dealers from interdealer markets as one of the key catalysts of the crash.

Post-Trade Information Acquisition

If dealers can learn something about the true value of an asset through trading, then they can gather a lot more information by observing many trades. Hypothetically, observing all trades by dealers would reveal the true value of the asset with perfect accuracy. In many financial markets, post-trade processing entities that perform clearing and settlement are naturally positioned to acquire information about executed trades. Trade reporting engines, such as TRACE, are another mechanism through which information about trades can be shared with market participants.

What happens when all dealers know that they will be informed of the true value of the asset before they enter the interdealer market? We find that liquidity improves because dealers no longer have an incentive to learn about the true value of the asset by widening the bid-ask spread. As a result, all dealers set tighter bid-ask spreads, so more trades take place. Since there are more trading opportunities in the interdealer market, it is also easier for dealers to rebalance their inventories and they don’t have to worry about being less informed or being taken advantage of in that market.

When all dealers can become informed, they have fewer incentives to acquire information by setting wide bid-ask spreads, improving liquidity. However, given substantial heterogeneity between dealers, and the profit-maximizing objectives of platforms and exchanges, it is unclear whether rules and practices regarding disclosure will be implemented consistently and effectively. We will explore this issue in a future blog post.

Michael Lee
Michael Lee is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

Antoine Martin
Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

How to cite this post:

Michael Lee and Antoine Martin, “How Does Information Affect Liquidity in Over-the-Counter Markets?,” Federal Reserve Bank of New York Liberty Street Economics, January 13, 2020, https://libertystreeteconomics.newyorkfed.org/2020/01/how-does-informati....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

The Evolving Market for U.S. Sovereign Credit Risk

Published by Anonymous (not verified) on Mon, 06/01/2020 - 11:00pm in

Tags 

liquidity

Nina Boyarchenko and Or Shachar

The Evolving Market for U.S. Sovereign Credit Risk

How should we measure market expectations of the U.S. government failing to meet its debt obligations and thereby defaulting? A natural candidate would be to use the spreads on U.S. sovereign single-name credit default swaps (CDS): since a CDS provides insurance to the buyer for the possibility of default, an increase in the CDS spread would indicate an increase in the market-perceived probability of a credit event occurring. In this post, we argue that aggregate measures of activity in U.S. sovereign CDS mask a decrease in risk-forming transactions after 2014. That is, quoted CDS spreads in this market are based on few, if any, market transactions and thus may be a misleading indicator of market expectations.

What Might a U.S. Sovereign Default Look Like?

As with corporations, a credit event for a sovereign may take one of several forms, including “fundamental” default, with the government unable to repay its debt obligations in total, and “technical” default, with the government temporarily postponing payments on the debt. In the case of the United States, a credit event would most likely be a technical default—for example, if borrowing were to reach the debt ceiling legislated by Congress. Under such a scenario, the U.S. Treasury might be forced to postpone one or more coupon payments or security redemptions until the ceiling were suspended or increased. The U.S. sovereign CDS spread is thus more likely to reflect the probability of a technical, rather than a fundamental, default.

Aggregate Activity in the U.S. Sovereign CDS Market

The market for U.S. sovereign credit risk has been shrinking since June 2014, as shown in the chart below, with 128 contracts outstanding as of June 11, 2019, less than one-tenth the peak of 1,538 contracts outstanding on September 16, 2011. At the same time, the gross notional value of outstanding positions in the market has also shrunk, to $3.7 billion, from its peak of $32.3 billion on August 26, 2011.

The Evolving Market for U.S. Sovereign Credit Risk

Transactions in the U.S. Sovereign CDS Market

To understand what has driven the decrease in activity in the U.S. sovereign CDS market, we use proprietary transaction-level data from the CDS trade repository maintained by the Depository Trust and Clearing Corporation to track the types of transactions in U.S. sovereign CDS over time. We focus on “risk-forming” transactions, which change market participants’ risk exposures. Risk-forming transactions can be separated into trades, which create new exposures in the financial system; terminations, which remove exposures from the financial system; and assignments, which transfer exposures among market participants.

The chart below shows that, between January 2010 and June 2019, a total of 433 “risk-forming” transactions took place involving a U.S. supervised institution, with the majority of these transactions occurring prior to January 2016. Moreover, out of the 433 total transactions, only 124 are new trades, and these occur almost exclusively prior to January 2014. Starting in January 2014, the majority of transactions are instead assignments, redistributing exposure to U.S. sovereign credit risk within the financial system. Terminations are particularly rare in our sample, with the majority of the 55 terminations taking place in 2010. Thus, the overall decrease in gross notional volume outstanding that we discussed above has likely been driven by a decreased willingness of market participants to create new exposures by initiating trades. As the existing contracts mature, the gross notional volume declines commensurately.

The Evolving Market for U.S. Sovereign Credit Risk

The chart above also shows that during the 2011-2014 period, trades primarily occurred ahead of debt ceiling suspensions, with market participants speculating on whether the debt ceiling would be breached, causing the United States to enter into a technical default. However, the more recent debt ceiling suspensions and subsequent debt ceiling increases seem not to have generated the same type of trading activity.

Who Trades with Whom?

We now turn to studying which institutions were buying and selling protection in the U.S. sovereign CDS market. The chart below shows that, prior to 2015, the majority of transactions involved U.S.-based institutions buying protection from institutions based in advanced European economies. Post 2015, when the majority of transactions were assignments, U.S.-based institutions were assigning their positions to institutions based in advanced European economies. Thus, the market for U.S. sovereign credit risk involves little wrong-way risk: buyers of protection in the U.S. sovereign CDS market are not facing U.S. counterparties.

The Evolving Market for U.S. Sovereign Credit Risk

What about the Observed Spreads?

So, are the quoted U.S. sovereign CDS spreads a useful measure of market participants’ expectations of U.S. sovereign credit risk? The chart below shows that this is unlikely to be the case. First, starting in 2014, not enough trades in the benchmark five-year maturity occur to compute a traded spread on U.S. sovereign CDS: quoted CDS spreads in this market are based on few, if any, transactions. Second, even prior to 2014, the difference between the quoted and the traded spreads was frequently as large as 10 percent of the spread.

The Evolving Market for U.S. Sovereign Credit Risk

Conclusion

The spread on U.S. sovereign CDS has received increased academic scrutiny in recent years, with proposed drivers including the probability of endogenous fiscal default and compensation for inflation risk. Our post suggests that such fundamental factors are unlikely to be the source of variation in quoted spreads because the quoted spreads in recent years are backed by few to no transactions.

Nina BoyarchenkoNina Boyarchenko is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.

Or ShacharOr Shachar is an economist in the Bank’s Research and Statistics Group.

How to cite this post:

Nina Boyarchenko and Or Shachar, “The Evolving Market for U.S. Sovereign Credit Risk,” Federal Reserve Bank of New York Liberty Street Economics, January 6, 2020, https://libertystreeteconomics.newyorkfed.org/2020/01/the-evolving-marke....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Banking System Vulnerability: Annual Update

Published by Anonymous (not verified) on Wed, 18/12/2019 - 11:00pm in

Tags 

banks, liquidity

Kristian Blickle, Fernando Duarte, Thomas Eisenbach, and Anna Kovner

 Annual Update

A key part of understanding the stability of the U.S. financial system is to monitor leverage and funding risks in the financial sector and the way in which these vulnerabilities interact to amplify negative shocks. In this post, we provide an update of four analytical models, introduced in a Liberty Street Economics post last year, that aim to capture different aspects of banking system vulnerability. Since their introduction, vulnerabilities as indicated by these models have increased moderately, continuing the slow but steady upward trend that started around 2016. Despite the recent increase, the overall level of vulnerabilities according to this analysis remains subdued and is still significantly smaller than before the financial crisis of 2008-09.

Vulnerability Measures

We consider the following measures that are based on models developed by New York Fed staff or adapted from academic research.

  • Capital vulnerability. This index measures how well capitalized banks are projected to be after a severe macroeconomic shock. The measure is constructed using the CLASS model, a top-down stress testing model developed by New York Fed staff. Using the CLASS model, we project the regulatory capital ratio of each large banking organization under a macroeconomic scenario equivalent to the 2008 financial crisis. The vulnerability index measures the aggregate amount of capital (in dollars) that would be needed under that scenario to bring each banking firm’s capital ratio up to at least 10 percent.
  • Fire sale vulnerability. This index measures the magnitude of systemic spillover losses among banks caused by asset fire sales under hypothetical stress scenarios, and is expressed as a fraction of system capital. In this New York Fed staff report, “Fire-Sale Spillovers and Systemic Risk,” we show that an individual bank’s contribution to the index predicts its contribution to systemic risk five years in advance.
  • Liquidity stress ratio. This ratio captures the liquidity mismatch between a bank’s assets and liabilities during a liquidity stress scenario. It is defined as the ratio of expected cash outflows in times of stress to the size of the bank’s portfolio of liquid assets. If the ratio is high, it means that there may be insufficient liquid assets to meet expected outflows in stressful conditions.
  • Run vulnerability. This measure gauges a bank’s vulnerability to runs, taking into account both liquidity and solvency. It combines a theoretical framework with projections of stress deterioration in bank capital from the CLASS model. An individual bank’s run vulnerability is the critical fraction of unstable funding that the bank needs to retain to prevent insolvency.

Trends in Vulnerability

The chart below shows how the different aspects of vulnerability have evolved since 2002, according to the four measures.

 Annual Update

Next, we discuss developments of the individual measures in more detail.

Capital Vulnerability

The capital vulnerability index has increased over the past year, continuing a trend of sideways or upward movement since 2016.

Movements in the capital gap reflect the combination of changes in the starting level of capital, as well as changes in the fall in capital under an adverse macroeconomic realization forecast by the model. Starting capital ratios have increased in the past year, but have not yet returned to prior levels after the fall related to the Tax Cut and Job Act in the second quarter of 2017 (see the blue line on the left panel of the chart below). The fall in capital—the difference between the starting point of the common equity tier 1 (CET1) ratio and that at the end of the crisis redux scenarios—has also increased over the past year (see the right panel of the chart below).

 Annual Update

The evolution of the fall in capital is a way of understanding how, subject to the same scenario, bank capital is vulnerable. Although the capital fall is variable from quarter to quarter, the fall has increased in the past year (by 32 basis points), continuing an overall trend since 2014 of increasing risk should a scenario similar to that of the crisis be realized. This increase in the fall in capital arises primarily from weaker profitability relative to a year ago.

Fire-Sale Vulnerability

The fire-sale vulnerability index has been increasing slowly but steadily in the last three years, with a cumulative growth of 18 percent. Despite this recent climb, the level of the index remains low compared to its pre-2014 levels.

 Annual Update

To shed some light on the reasons why the index evolves the way it does, the chart above decomposes the index into the overall size of the banking system (total assets), its leverage, and its “connectedness.” The increasing trend since 2016 can be attributed in equal parts to increases in leverage and connectedness, while the size component has remained essentially flat.

Another way to understand the index is by studying the contribution of individual asset classes to the index. The five asset classes that contribute the most as of the second quarter of 2019 are agency MBS, fed funds and repo loans, commercial and industrial loans, residential real estate loans, and consumer loans. Compared to the pre-crisis period, when residential real estate loans were considerably more systemic than all other asset classes, the model suggests no asset class stands out as particularly systemic in the recent past.

Liquidity Vulnerability

The aggregate liquidity stress ratio (LSR) has remained near all-time historical lows over the past few years. Looking at the decomposition of the LSR in the chart below, we see that liquidity-adjusted assets have risen slightly. This was accompanied by an inching down of liquidity-adjusted liabilities and off-balance-sheet items.

 Annual Update

The LSR saw a peak in the third quarter of 2007 that was driven, to some extent, by the collapse in securitization and asset backed commercial paper markets. The LSR was improved, in part, by the Federal Reserve’s monetary stimulus programs, which drastically increased the amount of reserves in the banking system. Reserves and cash constitute a large component of liquid assets for some banks.

In part thanks to liquidity regulation, such as the liquidity coverage ratio, the largest U.S. banks are in a much stronger liquidity position, on aggregate, than at any point before or during the 2008 crisis. This is perhaps best exemplified by the fact that the LSR has remained stable, despite the removal of reserves of more than 1 trillion U.S. dollars from the banking system since 2014. While cash, of which reserves can be a large part, has fallen slightly in the most recent year, its decrease was not commensurate with the aggregate drop in reserves. Moreover, decreases in cash were countered by an increase in securities held by banks.

Run Vulnerability

After remaining mostly flat between 2016 and 2018, the run vulnerability index has been slowly increasing over the past year. Considering the underlying components in the chart below, we see that the increase in the index was mainly due to small increases in stress leverage and illiquid assets. Stress leverage has been continuing an upward trend that started in 2015 (see the “Capital Vulnerability” discussion). The other two components, the shares of illiquid assets and unstable funding, have changed less over the past several years.

 Annual Update

To understand better these two characteristics of the assets side and liabilities side, respectively, we consider their comprising parts in more detail. Illiquid assets are defined as the complement to liquid assets—which are composed of cash—Treasury securities and fed funds lending. In the post-crisis period, most of the variation in the liquid asset share is due to the variation in banks’ cash holdings, which mirror the level of aggregate reserves (see the “Liquidity Vulnerability” discussion). Since the beginning of the Fed’s tapering in 2014, however, the liquid asset share has stopped increasing and there has been a corresponding shift in banks’ liquid assets from cash toward Treasuries. Over the past year, the shift from cash to Treasuries has accelerated and the overall liquid asset share has started to decline slowly.

Unstable funding in this analysis is composed of commercial paper, trading liabilities, fed funds borrowing, repos, and unstable deposits, that is all deposits except for money market deposit accounts and other savings accounts as well as time deposits of less than $250k ($100k before October 2008). The decline in the unstable funding share since 2013 was not accompanied by large changes in the composition of unstable funding. While unstable funding increased in absolute terms, it was outpaced by a concurrent increase in stable funding, leading to a decline in the unstable funding share. Over the past year, this decline has slowed and it seems like the unstable funding share may have bottomed out.

Kristian Blickle
Kristian Blickle
is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

Fernando DuartFernando Duarte is an economist in the Bank’s Research and Statistics Group.

Thomas Eisenbach
Thomas Eisenbach is a senior economist in the Bank’s Research and Statistics Group.

Anna Kovner
Anna Kovner is a Vice President and Policy Leader for Financial Stability in the Bank’s Research and Statistics Group.

How to cite this post:

Kristian Blickle, Fernando Duarte, Thomas Eisenbach, and Anna Kovner, “Banking System Vulnerability: Annual Update,” Federal Reserve Bank of New York Liberty Street Economics, December 18, 2019, https://libertystreeteconomics.newyorkfed.org/2019/12/banking-system-vul....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

The Side Effects of Shadow Banking on Liquidity Provision

Published by Anonymous (not verified) on Wed, 13/11/2019 - 11:00pm in

Tags 

banks, liquidity

Teodora Paligorova and João A.C. Santos

Correction: When this post was first published, line labels in the panel showing Tier 1 capital ratios were reversed; the labels have been corrected. (November 13, 10:40 a.m.)

The Side Effects of Shadow Banking on Liquidity Provision

Over the past two decades, the growth of shadow banking has transformed the way the U.S. banking system funds corporations. In this post, we describe how this growth has affected both the term loan and credit line businesses, and how the changes have resulted in a reduction in the liquidity insurance provided to firms.

The Syndicated Loan Market before and after the Mid-1990s

The chart below shows the contributions of banks, shadow banks, and “other nonbank investors” to the financing of syndicated loans taken out by U.S. corporations over the past three decades. Shadow banks include collateralized loan obligations (CLOs), loan funds, pension funds, and hedge funds, while “other nonbank investors” include insurance companies and finance companies. A syndicated loan is financing offered by a group of lenders—referred to as the loan syndicate—who work together under the direction of the lead arranger to provide funds for a borrower.

LSE_2019_shadow-banks_santos_ch1ab-c_art

Banks funded about 90 percent of outstanding term loans in the early 1990s, with the remaining 10 percent funded by nonbank institutional investors, as shown in the left panel of the chart. However, starting in the mid-nineties, the portion of term loans funded by banks began to decline steadily, leveling off at less than half by 2010. The exit of banks was entirely compensated by the growth of shadow banks. As a result, by 2010 shadow banks were as important as banks, with each responsible for funding 45 percent of outstanding term loans. The remaining 10 percent of loans were funded by “other nonbank investors,” which is unchanged since 1990.

In contrast to that of term loans, the funding structure of credit lines did not change over the past three decades, as shown in the right panel of the chart. Throughout this period, banks preserved their exclusive role in funding nearly all of the credit lines granted to corporations. In a term loan, the borrower accesses the entirety of the funding at the time of the loan origination. In contrast, in a credit line, borrowers earn the right to draw down their funds at their will. This uncertainty poses liquidity risk to providers of credit lines and explains why banks dominate this business. Their deposit funding base gives them a wedge to deal with that liquidity risk.

Shadow Banks’ Indirect Effect on Credit Lines

The absence of shadow banks from the credit line business, however, does not mean they had no effect on credit lines. As we document in this paper, the arrival of shadow banks in the term loan business had a negative impact on the liquidity insurance that credit lines provide to corporations.

Firms usually take out deals that comprise both term loans and credit lines. Historically, the set of banks that funded the term loan would also fund the credit line. With the growing presence of shadow banks in the term loan business, some banks, in particular the financially safer ones, exited term loans and in the process also exited the credit line. They may have exited term loans because of the additional competition from shadow banks, or because of the changes introduced in term loans to attract shadow banks. (Specifically, traditional term loans with linear amortization schedules were gradually replaced with “bullet loans” that amortize only at maturity. Bullet loans are more attractive to CLOs and funds because they do not require the lender to manage the stream of cash flow payments from amortization. However, bullet amortization makes loans riskier than traditional term loans and thus not as attractive to banks with lower risk appetite.)

After several years of decline in the concentration of credit line syndicates, since the late 1990s this trend has reversed and concentration has been increasing in parallel with the growth of shadow banks in the term loan business, as shown in the left panel of the chart below. The right panel, which plots the average tier 1 capital ratio in credit line syndicates, shows that credit line syndicates in deals with shadow banks have, on average, lower capital ratios compared to syndicates of credit lines in deals without shadow banks. Here, too, the difference emerges in the period of rapid growth of shadow banks in the term loan business.

LSE_2019_shadow-banks_santos_ch2ab-c_art

These changes in credit line syndicates are important because both the concentration and risk profile of syndicates are critical to the value of a credit line. Credit lines will meet borrowers' expectations solely to the extent that syndicate members are able to deliver on their credit commitments, because each syndicate member is only formally responsible for its share of the loan investment. In other words, when a syndicate member is unable to meet its loan commitment, the funds available to the borrower are reduced, unless another syndicate member steps in to fill the void left by the former member. Therefore, the more concentrated a credit line syndicate is and/or the riskier are its member banks, the lower the liquidity insurance the syndicate provides to borrowers.

Conclusion

Starting in the mid-nineties, shadow banks began to increase their presence in the term loan business, and by 2010 they were as important to that business as banks, with each being responsible for funding 45 percent of outstanding term loans taken out by U.S. corporations. Throughout this period, shadow banks remained virtually absent from the credit line business. However, their growing presence in the term loan business triggered the exit of some banks, in particular the financially safer ones, from both term loans and the credit lines in the deals containing those term loans. As a result, credit line syndicates became more concentrated and made up of financially riskier banks, thereby reducing the liquidity insurance they offer corporations.

Teodora Paligorova is a principal economist at the Board of Governors of the Federal Reserve System.

João A.C. Santos

João A.C. Santos is a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this post:

Teodora Paligorova and João A.C. Santos, “The Side Effects of Shadow Banking on Liquidity Provision,” Federal Reserve Bank of New York Liberty Street Economics, November 13, 2019, https://libertystreeteconomics.newyorkfed.org/2019/10/the-side-effects-o....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.