Shadow Banking, Central Banking, and the Future of Global Finance
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1 Shadow Banking, Central Banking, and the Future of Global Finance Perry Mehrling Shadow Banking: A European Perspective City University London Feb 2, 2013
2 A Bagehot Moment
3 A Money View of Financial Globalization Global capital markets Global money funding system Central bank backstops and cooperation Bagehot was a shadow banker (2012) Global money markets Global foreign exchange system Central bank backstops and cooperation Essential hybridity (2013)
4 Shadow banking as characteristic institutional form Money market funding of Capital market lending Global funding of local lending Market pricing, both money and capital Key role of market-making institutions Key role of central bank as backstop
5 Collateral and Payment Flows Capital Funding Bank Global Money Dealer Asset Manager Assets Liabilities Assets Liabilities Assets Liabilities RMBS CDS IRS FXS MM funding MM funding deposits deposits Capital CDS IRS FXS Derivative Dealer Assets Credit Default Swaps Interest Rate Swaps FX Swaps Liabilities Credit Default Swaps Interest Rate Swaps FX Swaps
6 Idealization We abstract from Retail depositors, direct investors, traditional banks Securitization process (underwriting, legal basis) Liquidity reserves (Tbills and cash) Capital reserves (Haircuts) Proprietary dealing (price risk, leverage ) In order to focus on. System interlinkages and dynamics (boom-bust) Liquidity risk, not solvency risk Tail liquidity backstops funding liquidity and market liquidity
7 Other definitions Received views Gorton and Metrick (2011) Regulating the Shadow Banking System ; Adrian and Ashcraft (Oct 2012) Shadow Banking: A Review of the Literature ; FSB (Nov 2012) Strengthening Oversight and Regulation of Shadow Banking Emphasize shadow versus traditional banking Bank vs. non-bank Regulated vs. non-regulated (evasion) Direct government backstop vs. indirect (unauthorized) Versus our emphasis on banking evolution. Financial globalization: dollar funding, reserve currency holding Cf. Shin (2011) Global Banking Glut and Loan Risk Premium Financial revolution: derivatives, risk pricing markets Cf. Fischer Black and the Revolutionary Idea of Finance (2005) Imagine a world of ONLY shadow banking
8 Financial Stability Board (WS5) Securities lending and repo markets play crucial roles in supporting price discovery and secondary market liquidity for a variety of securities issued by both public and private agents.
9 Touching the Elephant
10 The Money View: Resources from the Past 1. Copeland (1952): A Moneyflow Economy 2. Minsky (1957): The Survival Constraint 3. Hawtrey (1919): Hierarchy of Money and Credit, Inherent Instability 4. Hicks (1989): Centrality of the Dealer Function 5. Bagehot (1873): Central Bank as Dealer of Last Resort
11 Solvency vs. Liquidity Equity Finance Bond Finance Money Finance Assets Liabilities Assets Liabilities Assets Liabilities PV(Future earnings) Bonds 10 Equity 90 PV(Future Earnings) Bonds 90 Equity 10 Leverage: Equity vs. Bond (Solvency) Modigliani-Miller Theorem Possible unpriced government safety net Liquidity: Bond vs. Money (Liquidity) Minsky: Hedge, Speculative, Ponzi Timing (mis)match of cash inflows/outflows Bonds 100 Deposits 90 Equity 10
12 Liquidity, Old and New Money Finance Shadow Bank Asset Manager Assets Liabilities Assets Liabilities Assets Liabilities Bonds 100 Deposits 90 Equity 10 Bonds 100 CDS 0 Survival Constraint, old and new Payment system clearing Collateral system clearing Secured lending Derivative settlement Deposits 100 Deposits 10 CDS 0 Equity 10
13 Money and Banking defined Money = transferable credit inside (credit) not outside (fiat) public and private hybrid Payment system as par credit clearing Banking = swap of IOUs On-balance sheet: loans create deposits Derivatives as natural banking business e.g. Interest Rate Swaps, CDS, FXS Banks as money dealers, market makers
14 Hierarchy of Money and Credit Asset Market Maker Price Gold Central Bank Exchange Rate Currency Banking System Par Deposits Security Dealers Interest Rate Securities
15 Making Markets, Money and Risk Capital Funding Bank Global Money Dealer Asset Manager Assets Liabilities Assets Liabilities Assets Liabilities RMBS CDS IRS FXS MM funding MM funding deposits deposits Capital CDS IRS FXS Derivative Dealer Assets Credit Default Swaps Interest Rate Swaps FX Swaps Liabilities Credit Default Swaps Interest Rate Swaps FX Swaps
16 Backstopping Market-making Global Money Dealer Derivative Dealer Central Bank (or C5) Assets MM funding Liquidity put (funding) Assets CDS IRS FXS Liquidity put (market) Assets Liabilities deposits Liabilities CDS IRS FXS Liabilities Liquidity put (funding) Liquidity put (market)
17 Transformation of the Fed
18 Fed Balance Sheet Transformed Dec 15, 2011 Dec 15, 2011 (restated) Assets Liabilities Assets Liabilities Treasuries $1.7 MBS/GSE.9 Other.3 Currency $1.0 Reserves 1.6 Other.3 [TBill $2.6 [Tbond 2.6 [Risky Secs.9 Other.3 Curr./Res. $2.6] Tbill 2.6] Tbond.9] Other.3 TOTAL 2.9 TOTAL 2.9 TOTAL 6.4? TOTAL 6.4? Fed as Dealer of Last Resort Global Money Dealer (OIS) [and FX swap] Global Derivative Dealer (IRS, CDS)
19 Dynamic Order Flow Boom and Bust, inherent instability of credit (Asset Manager) Demand > (Capital Funding Bank) Supply (Asset Manager) Demand < (Capital Funding Bank) Supply Dealer Balance sheet absorbs order flow imbalance (for a price) Dealer Balance sheet = Matched Book + Speculative Book Liquidity Risk + Price Risk Volcker Rule Matched Book Liquidity Backstop (Central Bank) Speculative Book Capital Backstop (Private)
20 Centrality of the Dealer Function Treynor, 1987
21 Boom Order Flow: Asset Manager > Capital Funding Bank
22 Bust Order Flow: Capital Funding Bank > Asset Manager
23 Bust Order Flow: Dealer Funding Stress
24 Making Markets, Money and Risk Capital Funding Bank Global Money Dealer Asset Manager Assets Liabilities Assets Liabilities Assets Liabilities RMBS CDS IRS FXS MM funding MM funding Reserves Liquidity put (funding) deposits Capital deposits Capital CDS IRS FXS Derivative Dealer Assets CDS IRS FXS Reserves Liabilities CDS IRS FXS Capital Liquidity put (market)
25 FX Issues Tapping global dollar funding markets, for domestic currency capital market lending FX risk National central bank as dollar liquidity backstop Payments and Collateral (private dealer backstop) Crisis (naked forward exposure) C5 (and IMF) as crisis backstop for NCB Liquidity swaps: BoJ, SNB, BoE, ECB, Fed IMF
26 Backstopping Global Funding Markets
27 Transformation of the Fed
28 Dollar funding and FX
29 Dollar funding and FX
30 EH and UIP anomalies
31 International Hierarchy of Money
32 International Hierarchy of Money
33 Touching the Elephant
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