The market-based Evolution of the US Financial System

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2 Bernanke and Blinder (1989) explicitly describe the importance of commercial banks behaviors to transmit the effects of monetary policy decisions to the economic system: - Standard money channel - Credit channel: commercial banks may decide to switch from bonds holdings to loans to their clients (firms and households). Changing reserves conditions (i.e. changes in monetary policy) will influence such allocation decision, hence interest rates (i and ρ) and economic activity. - Firms and households (loans) - Government (bonds holding) Central Bank may intervene through open-market operations: it buys bonds held by banks and release liquidity. Interest rate i decreases and banks reserves R increase. Banks may start to expand credit to clients

3 Is the above representation of financial intermediation appropriate to get the functioning and features of nowadays financial systems? New financial operators, new financial instruments and financial practices have emerged since the beginning of the 80s and spread in the first decade of the 2000s challenging the central role of commercial banks. As a reaction of money tightening (Volcker s monetary experiments at the beginning of the 80s!), the traditional banking products became less appealing and less profitable than before (Regulation Q limited the competitiveness of traditional banks by setting limits to interest rates on deposits and on loans three-six-three business model no more profitable). 1) Banks disintermediation and Money-market Mutual Funds 2) Securitization and originate and distribute practice 3) Repos

4 1) Disintermediation and market- based 2inancial institutions: According to Wray (2007), commercial banks share on total =inancial assets passed from around 50% in the 50s to around 25% in the 90s. A static perspective A dynamic perspective

5 1) Disintermediation and market-based financial institutions: In the most recent periods, new financial institutions have emerged as providers of loans

6 1) Disintermediation and market-based financial institutions Implications for the economic theory and crisis interpretations: Commercial banks are not the unique providers of funds Deposits do not collapsed when the crisis erupted Commercial banks may find resources other than deposits, this way bypassing reserve requirments: monetary policy less effective?

7 3) Securitization: the process through which some assets are grasped in a pool and moved out of the balance sheet of the institutions originating them. Acquisition of the asset pool is financed by issuing asset-backed securities, i.e. securities whose promise of payments are based on the proceedings of the asset pool.

8 2) Securitization: The diffusion

9 2) Securitization: why? Reduction of the bankcrupcy tax: off-balance-sheet financing (through SPVs and issuances of ABS) reduces the cost of financing with respect to on-balance-sheet financing (through corporate bonds issuances) because subscribers of ABS are less exposed to borrower s bankcrupcy risk and financing costs are lower. Higher transparency and reduced moral hazard: due to limits posed to SPVs operations (they simply have to handle the pool of asset). No need to check for the behavior of managers. Lower regulation: operations on ABS are not subjected to minimum capital standard as usually imposed on commercial banks recollecting deposits. Flexible management of the balance sheet: (when market is functioning properly) financial operators may easily sell securitized obligations to meet capital requirements, obtain liquid resources from the market and give rise to higher volume of transactions (hence profits).

10 A representation of current market-based financial systems Repos

11 3) Repos: what is this? Sale and repurchase agreement according to which a part sales an asset (whose market value is X) in exchange of a given amount of money Y (with X > Y) and with the obligation to buy it back at a given future time at a given price Z (with Z > Y). - Repo rate : (Z-Y)/Y Interest rate implicitly paid by the institution taking on the repo position. - Haircut : (X-Y)/X implicit remuneration that the institution taking on the reverse repo position will gain in case of insolvency of the counterpart. - Rehypothetized collaterals: collaterals may be used in other transactions giving rise to a high velocity of circulation of collaterals

12 3) Repos: Why? - Repos allow to enormously increase the volume of transactions and therefore profits. - Repos help to manage the balance sheet with more flexibility, perhaps to accomplish liquidity requirements. - Repos allow to take on short speculative positions: I temporarily buy an asset and I immediately sell it on the market. When the repo agreement must be closed, I have to rebuy such an asset on the market and give it back to the original seller. Obviously I bet that the price of such an asset will decrease compared to its current face value.

13 3) Repos: the diffusion as an operation to create liquidity (in figure below we see the amount of repos as a percentage of M2 money stock) Lehman Brothers backrupcy