Shadow Maturity Transformation and Systemic Risk. Sandra Krieger Executive Vice President and Chief Risk Officer, Federal Reserve Bank of New York

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1 Shadow Maturity Transformation and Systemic Risk Sandra Krieger Executive Vice President and Chief Risk Officer, Federal Reserve Bank of New York 8 March 2011

2 Overview of discussion What is shadow bank maturity transformation and why do we care about this? What role did this play leading up to and during the recent financial crisis? How will financial reform affect the shadow banking system? What more needs to be done? 2

3 What is credit intermediation? Maturity transformation: fund long-term assets with short-term liabilities Credit transformation: enhancement through use of priority or guarantees Liquidity transformation: illiquid assets funded by liquid liabilities 3

4 Topology of Credit Intermediation explicit and direct Credit put Liquidity put Official sector 4

5 Topology of Credit Intermediation implicit and indirect Credit put Liquidity put explicit and direct implicit and direct Credit put Liquidity put Official sector Credit put Liquidity put explicit and indirect Credit put Liquidity put unenhanced 5

6 Shadow Maturity Transformation Banksponsored MMMF Tri-Party Repo Banksponsored SIV ARS implicit and indirect Credit put Liquidity put explicit and direct implicit and direct Credit put Liquidity put Official sector Credit put Liquidity put GSE explicit and indirect Credit put Liquidity put unenhanced ABCP VRDO Independent MMMF Independent SIV 6

7 1985Q4 1986Q3 1987Q2 1988Q1 1988Q4 1989Q3 1990Q2 1991Q1 1991Q4 1992Q3 1993Q2 1994Q1 1994Q4 1995Q3 1996Q2 1997Q1 1997Q4 1998Q3 1999Q2 2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2 2006Q1 2006Q4 2007Q3 2008Q2 2009Q1 2009Q4 2010Q3 ($ millions) Shadow Banking Sector $25,000,000 $20,000,000 $15,000,000 $10,000,000 $5,000,000 $- Shadow Maturity Transformation Shadow Credit Transformation Bank Liabilities CP, Repo and Securities Lending, Money funds ABS, GSE debt, Agency MBS 7

8 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 ($ billions) TAF Established JPMC acquisition; PDCF/TSLF Lehman Bankruptcy /AIG Lending TALF announced FR releases Stress Test results Official Sector Support for Shadow Banking Activities September 2007 to March 3, ,200 1,000 Credit & Liquidity Programs 1 AMLF TSLF TALF CPFF 400 PDCF TAF Source: March 3, 2011 H.4.1 release. Differences in balances compared to other material in this presentation may be due to differences in timing or metrics 1. AMLF - Asset-Backed Commercial Paper Money Market Fund (ABCP MMMF) Liquidity Facility; TSLF- Term Securities Lending Facility; TALF - Term Asset- Backed Securities Loan Facility; CPFF -Commercial Paper Funding Facility; PDCF- Primary Dealer Credit Facility; and TAF - Term Auction Facility. 2. Assets of the portfolio are exhibited and not the loans. 8

9 ($ millions) Asset-backed commercial paper market (ABCP) $2,500, $2,000, $1,500, $1,000, $500, $- Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 ABCP Financial CP Nonfinancial CP 9

10 ($ millions) Tri party Repo $3,500,000 $10,000, $3,000,000 $9,000, $8,000, $2,500,000 $7,000, $2,000,000 $1,500,000 $6,000, $5,000, $4,000, ($ millions) $1,000,000 $3,000, $2,000, $500,000 $1,000, $0 $- Overnight Repo Financial CP M2 10

11 ($ billions) ($ billions) Money Market Mutual Funds 11

12 ABCP: Current regulatory changes FAS 166/167 and Basel capital rules may significantly increase liquidity and capital requirements for bank backup lines of credit for conduits Balance sheet consolidation for loans or securities of the conduit increased risk-based leverage ratio and capital requirements as well higher loan loss reserves Proposed liquidity requirements for banks could make backup lines more expensive liquid assets must be sufficient to meet its stress liquidity needs for a 30- day time horizon 12

13 The Future for ABCP The cumulative impact of these changes will likely include: More required capital and liquidity for bank-sponsored conduits, corresponding to higher-cost lines of credit to finance companies Likely end of programs which exist solely for off-balance sheet capital arbitrage Mitigating behavior by the industry might include: Shift in conduit sponsorship from US banks to non-banks or foreign banks with balance sheet capacity Re-structuring of conduits in order to avoid accounting consolidation (e.g. sale of first-loss tranche to transfer control to third-party) The ABCP market will be smaller and more expensive, sponsored by nonbanks and largely fund asset-backed loans originated by non- bank finance companies 13

14 Tri Party Repo Market: Current Regulator-Driven Changes Industry Tri-Party Task Force has suggested improvements in the following areas Operational Arrangements Dealer Liquidity Risk Management Margining Practices Contingency Planning Transparency Tri-Party Repo Infrastructure Reform White Paper by FRBNY Market reliance on intra-day credit from clearing banks Aggressive dealer liquidity management Cash investor and clearing bank risk management Cash contingency plans around large dealer default Taskforce Website: 14

15 The Future for Tri-Party Repo Impact on the market Reduced intra-day credit and daily unwind Higher margins, less cyclical margins, higher-quality collateral Future of broker-dealer model Broker-dealer model now has liquidity backstop, but will be subject to leverage requirements and prudential supervision instead of voluntary oversight Need tri-party solution to failure of major borrower to reduce systemic risk 15

16 MMMF Buffers Investor run event Ex ante buffers Ex ante buffers are costly but allow preservation of stable NAV Preferred option if investors care more about liquidity Example: Capital, liquidity, risk standards Ex post buffers Absorbing losses when they occur is less costly but is not consistent with stable NAV Preferred option if investors care more about yield Examples: variable NAV or hold back time Loss absorption buffers address the risk of credit losses but may not adequately reduce the risk of losses associated with sales of assets at fire sale prices Access to a source of non-official emergency liquidity could further reduce this risk 16

17 Conclusions The motivations for shadow banking have become even stronger with increases in capital and liquidity requirements on traditional institutions; The objective is to reduce the risks associated with maturity transformation through more appropriate, properly priced and transparent backstops credit and liquidity puts. Regulation has done some good, but more work needs to be done to prevent shadow credit intermediation from being a continued source of systemic concern. 17