Post-crisis bank regulations and financial market liquidity

Transcription

1 Post-crisis bank regulations and financial market liquidity Darrell Duffie GSB Stanford Belgian Research Financial Form National Bank of Belgium Brussels, June, 2018 Based in part on research with Leif Andersen, Antje Berndt, Yang Song, and Yichao Zhu Duffie Post-crisis bank regulations and financial market liquidity 1

2 A bank-intermediated over-the-counter market c 1 c 2 d 1 c 5 c 3 d 2 d 3 c 6 c 7 c 4 Duffie Post-crisis bank regulations and financial market liquidity 2

3 Implications of post-crisis regulations for market efficiency 1 More financial stability from higher bank capitalization and bail-in failure resolution. 2 Increased cost of access to bank balance sheets. The leverage-ratio rule has reduced incentives to intermediate safe assets. Bail-in failure resolution has significantly increased bank funding costs. 3 Market infrastructure and new competition rules lower the need for balance-sheet space. Duffie Post-crisis bank regulations and financial market liquidity 3

4 Dealer balance sheet assets debt equity Duffie Post-crisis bank regulations and financial market liquidity 4

5 More equity to fund more assets assets debt old assets debt equity equity new assets new equity Duffie Post-crisis bank regulations and financial market liquidity 5

6 Legacy shareholders have subsidized creditors assets debt old assets debt equity equity new assets new equity Higher capitalization implies a value transfer from legacy shareholders to creditors. Duffie Post-crisis bank regulations and financial market liquidity 6

7 Debt overhang assets debt old assets debt equity equity new assets new equity For shareholders to break even, the new assets must be purchased at a profit that exceeds the value transfer to creditors. (Myers, 1977) Duffie Post-crisis bank regulations and financial market liquidity 7

8 Leverage ratio rule is more binding than risk-based capital rules Results of the Fed s 2017 stress tests for the largest US dealer banks Excess capital ratio (%) CET1 (CCAR) CET1 (DFAST, adj.) SLR (CCAR) SLR (DFAST, adj.) JPM CITI BAML GS MS CCAR: stressed CET1 after assumed payouts, less 4.5%; stressed SLR less 3.0%. DFAST, adjusted: stressed CET1 (no payouts) less (4.5% + G-SIB surcharge); stressed SLR less the G-SIB minimum of 5%. Duffie Data source: Board of Governors of the Post-crisis Federal bank regulations Reserve, and financial market liquidity 8

9 European banks reduce their balance sheets at quarter ends Daily collateral outstanding in the tri-party repo market and the Federal Reserve s overnight reverse repo (ON RRP) facility Billions of dollars 600 U.S. banks European banks Other banks Fed (ON RRP) /2016 4/2016 7/ /2016 1/2017 4/2017 Figure Source: Egelhov, Martin, Zinsmeister, Federal Reserve Bank of New York, August, Notes: Banks headquartered in the euro area and Switzerland report leverage ratios as a snapshot of their value on the last day of each quarter, while their U.S. counterparts report quarterly averages. Totals only include trades backed by Fedwire-eligible securities that is, U.S. Treasury and agency securities. Duffie Post-crisis bank regulations and financial market liquidity 9

10 Impact of the leverage-ratio regulation on repo intermediation costs to legacy shareholders repo asset repo claim repo asset repo claim old assets old debt old assets old debt equity equity safe assets new equity Duffie Post-crisis bank regulations and financial market liquidity 10

11 Impact of SLR on UST repo market efficiency Decline in GCF net lending volume 25 GCF triparty rate spread (basis points) Q1 13 Q3 14 Q1 14 Q3 15 Q1 15 Q3 16 Q1 16 Q3 17 Q1 17 Q3 18 Q1 (a) bid-ask spreads up (b) inter-dealer positions down Figure: (a) Average within-quarter difference between overnight GCF and Tri-party repo rates. Data sources: Bloomberg and BNY-Mellon. (b) Figure source: Antoine Martin, FRBNY (2016). Duffie Post-crisis bank regulations and financial market liquidity 11

12 Cross-currency basis and bank funding costs Funding value adjustments now leave wider arbitrage bounds on the basis Five-Year Cross-Currency Basis: G10 Currencies Basis Points CDS rate US banks European banks AUD CAD CHF DKK EUR GBP JPY NOK NZD SEK (a) 5-year USD cross-currency basis. Source: Du, Tepper, and Verdelhan (2017) year (b) 5-year dealer credit spreads Duffie Post-crisis bank regulations and financial market liquidity 12

13 CIP arbitrage can be costly to dealer shareholders Debt overhang cost for funding synthetic dollar deposits EUR USD USD debt assets debt old assets old debt equity equity To benefit shareholders, the trade profit must exceed the funding value adjustment (FVA), a debt-overhang cost. Duffie Post-crisis bank regulations and financial market liquidity 13

14 Funding cost to shareholders EUR USD USD debt old assets old debt equity funding value adjustment (FVA) A debt-funded safe arbitrage is not valuable to bank shareholders unless it s excess yield is above the bank s credit spread. Source: Andersen, Duffie, Song (2018) Duffie Post-crisis bank regulations and financial market liquidity 14

15 Credit spreads: funding-cost wedge and arbitrage bounds one year IBOR OIS spread (basis points) EURIBOR OIS (Eonia) USD LIBOR OIS (Fed funds) year Figure: Spreads between one-year IBOR and OIS rates. Data source: Bloomberg. Duffie Post-crisis bank regulations and financial market liquidity 15

16 At a given solvency level, big-bank credit spreads are higher Time fixed-effects in the relationship between CDS rates and distance to default CDS time fixed effect Big banks All other firms year Based on panel regression, from work in progress with Antje Berndt. Duffie Post-crisis bank regulations and financial market liquidity 16

17 GSIB 5-year credit spread at annual default probability of 0.5% Before adjusting for pre-crisis bailout protection CDS rate (basis points) Big banks year Based on panel regression, from work in progress with Antje Berndt. Duffie Post-crisis bank regulations and financial market liquidity 17

18 Sovereign support has been removed from GSIB ratings Refined rating Other firms GSIBs year Group medians of refined ratings. Data source: Moody s Investor Services. Duffie Post-crisis bank regulations and financial market liquidity 18

19 Average leverage of systemic banks and investment banks Leverage Dealers: GS MS LEH BSC MER Banks: C BAC JPM* WFC year Duffie Post-crisis bank regulations and financial market liquidity 19

20 Market-to-book equity ratios of systemic dealer banks Market to book equity ratio Dealers: GS MS LEH BSC MER Banks: C BAC JPM* WFC year Duffie Post-crisis bank regulations and financial market liquidity 20

21 Funding Costs to Dealer Shareholders From work with Andersen and Song: The marginal increase in the value of the dealer s equity per dollar of a debt-funded asset purchase is p π δ COV FVA, where p is the dealer s risk-neutral probability of survival to term. π is the trade profit (P&L). δ is the risk-free discount. COV is the risk-neutral covariance of the asset payoff and dealer default event. FVA is the funding value adjustment p δst, where S is the dealer s credit spread and T is the term. The extra marginal cost to dealer shareholders when a fraction α of the funding must be equity is α(1 p FVA), which annualizes to roughly αs (assuming a loss given default of 0.5). For safe assets, the shareholder breakeven arbitrage yield is thus the total annualized funding cost to shareholders of roughly (1 + α)s. Duffie Post-crisis bank regulations and financial market liquidity 21

22 When should a dealer arbitrage the USD-JPY CIP basis? /31/14 3/31/15 3/30/15 9/30/15 12/30/15 3/31/16 6/30/16 9/30/16 1w deviation 1m deviation 3m deviation Source: Du, Tepper, and Verdelhan (2016). 0 (a) Level of Yen CIP Deviations Duffie Post-crisis bank regulations and financial market liquidity 22

23 Central counterparties reduce need for balance-sheet space c 1 c 2 d 1 CCP c 5 c 3 d 2 d 3 c 6 c 7 c 4 Duffie Post-crisis bank regulations and financial market liquidity 23

24 Compression eliminates space used for redundant swaps 40 d 5 40 d 5 10 d d 2 10 d 1 60 d 4 d 1 20 d d 3 d 3 Figure: Counterparty exposures and initial margin are reduced without changing market exposures. Providers include TriOptima, which has eliminated over $1 quadrillion notional of swaps. Duffie Post-crisis bank regulations and financial market liquidity 24

25 A bank-intermediated bilateral OTC market c 1 c 2 d 1 c 5 c 3 d 2 d 3 c 6 c 7 c 4 Duffie Post-crisis bank regulations and financial market liquidity 25

26 Improving trade competition Objective: Migration of actively traded products to all-to-all trade platforms c 1 c 2 d 2 d 1 CLOB c 3 c 4 c 6 c 5 Duffie Post-crisis bank regulations and financial market liquidity 26

27 OTC competition after Dodd-Frank and MiFID Buy-side firms request quotes at multilateral trading platforms c 1 MTP d 1 d 2 Duffie Post-crisis bank regulations and financial market liquidity 27

28 Excessive fragmentation across platforms d 1 d 2 MTP 1 c 1 MTP 2 d 2 d 3 Duffie Post-crisis bank regulations and financial market liquidity 28

29 Reducing fragmentation improves competition c 1 MTP d 1 d 2 d 3 Duffie Post-crisis bank regulations and financial market liquidity 29

30 Source: Source: Hendershoc Hendershott and Madhavan (2014) and Madhavan (2016) Duffie Post-crisis bank regulations and financial market liquidity 30 At corporate bond platforms Dealer competition lowers buy-side trade costs 60 Investment Grade High Yield Cost in Basis Points Number of dealers responding

31 Now typical fragmented two-tiered OTC markets c 1 c 2 d 1 c 5 MTP 1 CLOB MTP 3 c 3 d 2 d 3 c 6 c 7 MTP 2 Duffie Post-crisis bank regulations and financial market liquidity 31

32 Appendix: How CIP arbitrage costs dealer shareholders Suppose the one-year USD risk-free rate is zero. Our bank has a one-year credit spread of 35 basis points. We borrow $100 with one-year USD commercial paper, promising $ We invest $100 in one-year EUR CP, swapped to USD, with the same all-in credit quality as that of our bank s CP, and uncorrelated. Suppose the EUR CP, swapped to dollars, promises $100.60, for a basis of 25bps. We have a new liability worth $100 and a new asset worth $100.65/ $100.25, for a trade profit of approximately $0.25. However, the marginal value of the trade to our shareholders is negative, because, conditional on dealer survival, the expected incremental payoff to equity is $ $ = $0.10. Conditional on default, equity gets nothing. Duffie Post-crisis bank regulations and financial market liquidity 32