Liquidity and Leverage

Transcription

1 Tobias Adrian Federal Reserve Bank of New York Hyun Song Shin Princeton University European Central Bank, November 29, 2007 The views expressed in this presentation are those of the authors and do not necessarily represent those of the Federal Reserve Bank of New York or the Federal Reserve System.

2 Objectives of This Talk Document evidence on the behavior of nancial intermediaries { Leverage is strongly pro-cyclical { Margin of adjustment is in collateralized borrowing/lending (repos and reverse repos) Show that such behavior has aggregate consequences for risk appetite { Balance sheet changes forecast shifts in risk appetite (VIX index) Shed light on \liquidity" as change in aggregate balance sheets Link to monetary policy 1

3 Shedding Light on \Liquidity" Asset price booms often linked to \liquidity" in nancial system Suggestive metaphors, such as { \Awash with liquidity", The Economist, February 3 rd { \Liquidity sloshing around", Reuters, July 26 th We propose a denition of liquidity in this context in terms of balance sheets of nancial intermediaries. 2

4 Basic Balance Sheet Arithmetic: Passive Investor Household balance sheet Assets Liabilities House, 100 Equity, 10 Mortgage, 90 Leverage = Assets Equity = 10 Assume that the market value of debt is constant at 90. L = A A 90 3

5 Leverage is inversely related to total assets: 4

6 Balance Sheet Size and Leverage: Households 5

7 Non-Financial, Non-Farm Corporations 6

8 Financial Institutions Financial institutions actively manage balance sheets so as to meet value at risk or economic capital targets to meet performance measures such as return on equity (ROE). to hit desired credit ratings meet regulatory requirements What are the consequences? 7

9 Commercial Banks 8

10 Security Dealers and Brokers 9

11 Targeting Constant Leverage Initial balance sheet Assets Liabilities Securities, 100 Equity, 10 Debt, 90 Assume price of debt approximately constant. increases by 1% to 101. Suppose the security price Assets Liabilities Securities, 101 Equity, 11 Debt, 90 10

12 Leverage falls to = 9:18 If bank targets constant leverage, it must take on additional debt of D to purchase D worth of securities on the asset side so that assets equity = D 11 = 10 The solution is D = 9. In other words, the bank takes on additional debt worth 9, and with this money purchases securities worth 9. The demand curve is upward-sloping. 11

13 The new balance sheet looks like this. Assets Liabilities Securities, 110 Equity, 11 Debt, 99 The leverage is now back up to 10. The mechanism works in reverse, too. security price so that Suppose there is shock to the Assets Liabilities Securities, 109 Equity, 10 Debt, 99 Leverage is too high (109=10 = 10:9). 12

14 Sell securities worth 9, paydown debt of 9. Assets Liabilities Securities, 100 Equity, 10 Debt, 90 Back to leverage of 10. Supply curve is downward-sloping. What is the aggregate impact of perverse demand and supply curves? 13

15 Aggregate Impact If leverage is procyclical, then amplifying eect is that much larger. 14

16 Wall Street Investment Banks Why investment banks? Their balance sheet is very close to the ideal of being continuously marked to market. { Stylized balance sheet of an investment bank: Assets Trading assets Reverse repos Other assets Liabilities Short positions Repos Long term debt Shareholder equity They are a signicant part of nancial system, both in quantities and impact through prices 15

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18 Sample Name Bear Stearns Goldman Sachs Lehman Brothers Merrill Lynch Morgan Stanley Sample 1997 Q1 { 2007 Q Q2 { 2007 Q Q2 { 2007 Q Q1 { 2007 Q Q2 { 2007 Q3 These banks are \pure play" stand alone investment banks, not part of larger commercial banking group. Panel regressions use these ve banks. Citi Global Markets for comparison 17

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21 Margin of Adjustment Total assets and leverage move together. What is the margin of adjustment? We will see that repos are the margin of adjustment. Repos are the cheapest form of taking on debt (and hence leverage). 20

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24 Reverse Repos Repos are securitized short term debt of the investment banks. Reverse Repos are the securitized short term debt of the buy side. We would expect the expansion of investment banks' balance sheets to be accompanied by the expansion of the buy side' balance sheets. 23

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26 Explaining Leverage Leverage is procyclical: it increases with the total size of the balance sheet. But we would expect it to mean-revert: in contractions or nancial crisis, nancial intermediaries typically de-lever. This summer have been a prime example of delevering. Consider GSAM's letter to investors (from the WSJ, Sep 19, 2007): The letter (to investors) said the fund would constrain its borrowing in the future, one of the factors that led to the problems last month, and consider the level of borrowing as a separate risk factor. 25

27 Value at Risk Economic capital K is proportional to Value-at-Risk: K = V ar The proportionality is potentially time varying. Hence, leverage L satises: L = A K = 1 A V ar Procyclical leverage arise from counter-cyclical nature of value at risk. Measured risk is low during booms and high during busts. 26

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29 Aggregate Impact on Risk Appetite Weekly data on primary dealers with the Federal Reserve, published every Thursday VIX index: options weighted average of implied volatilities of S&P 500 index Volatility risk premium: VIX index realized volatility of S&P Averages over the week (Wednesday - Wednesday) 28

30 Figure 1: 29

31 Forecasting Risk Appetite 30

32 Completing the Circle 31

33 Aggregate Liquidity Liquidity is the rate of growth of aggregate balance sheets. Strong balance sheets ) surplus marked-to-market capital ) \surplus capacity" in banking system For surplus capacity to be utilized, intermediaries expand their balance sheets. { On the liabilities side, take on more short-term debt. { On the asset side, search for potential borrowers How hard do nancial intermediaries search for borrowers? { Sub-prime mortgage market { Debt nancing of private equity / LBOs 32

34 Liquidity and Monetary Policy What is the link between liquidity and monetary policy? Broad money is liability of deposit-taking banks. In nancial systems dominated by deposit-taking banks, money stock tracks aggregate balance sheets. { 19th and early 20th centuries, developing countries today { but poor indicator of aggregate liquidity for market-oriented nancial system Focus on the right analogies for classical notion of money. { Repos are the rightful successors of "money" 33

35 Liquidity and Monetary Policy Taylor rule: Fed Funds Target= 1:3 + 0:8 Output Gap + 1:3 Ination Rate {z } Rule based Monetary Policy + Taylor Rule Residual {z } Discretionary Monetary Policy The R 2 is 75%, i.e. one quarter of monetary policy is discretionary. 34

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38 Summary Leverage of nancial intermediaries is pro-cyclical. Pro-cyclcical leverage is a natural outcome of delegated nancial intermediation: maximize return on equity subject to a VaR or credit rating constraint. In equilibrium, this behavior of nancial intermediaries has eect on prices: we show that the constraction of balance sheets (via repos) forecasts innovations in market volatility. 37