Shadow Banking: The Money View Arvind Krishnamurthy IMF/Chicago Fed International Banking Conference November 7, 2013
Liquidity Creation by Financial Sector Assets Illiquid Long-term Loans Treasury bonds, cash Liabilities Equity + Long-term Debt Short-term debt Financial sector transforms illiquid assets into liquid assets Liquid asset = promise of cash redemption Profit = liquidity premium Shadow liabilities Assets Liabilities Contingent credit lines Derivatives liquidity call
Liquidity Mismatch 2002-2013 From Bai, Krishnamurthy and Weymuller (2013)
Liquidity Creation: 1914-2012 From Krishnamurthy and Vissing-Jorgensen (2013)
Outline Why was there so much liquidity creation 2002-2007? Theory: The money view Gorton, and others Evidence for the money view historically Interpreting 2002-2007 movements in the money view
Model and Notation Liquidity demanders (money-market investors, nonfinancial corporates, households, foreign investors): max U(L) - P L L = L private + L public P = Price of liquidity Private liquidity supply (banks + shadow banks): max P L private - F(L private ) F(L) is private cost of running a liquidity mismatch Government supplied liquidity: L public. 6
Private supply of liquidity Liquidity demanders: Liquidity supply: max U(L) - P L L = L private + L public P = Price of liquidity max P L private - F(L private ) F(L) is private cost of running a liquidity mismatch Equilibrium: Government supplied liquidity: L public U (L private + L public ) = P = F (L private ). demand supply
graphically F -1 (P) + L public P U -1 (P) F -1 (P) + L public B A L public P and L private L private + L public
Liquidity premium and public supply Aaa-Treasury is proxy for P The graph measures liquidity demand, U (L private + L public ) = P Based on variation in L public = Debt/GDP From Krishnamurthy and Vissing-Jorgensen (2012)
.2.4.6.8 1 Private and public supply of liquidity 1915 1916 1914 1917 2007 2006 2005 2004 2003 2002 2001 20001987 1988 1974 1979 1980 1975 1973 1978 19811982 1977 1972 1976 1983 1984 19851986 1999 1989 1990 1998 1997 19911992 1996 1994 1995 1993 1971 1970 1969 1967 1968 1966 1965 1929 1930 1928 1927 1964 1926 1931 1925 1933 1924 1923 1932 1922 1963 1934 1918 1962 19191961 1920 1921 1960 1935 1959 1958 1936 1957 1937 1956 1938 1955 1954 1940 1939 1941 1953 1952 1951 1942 1950 19491948 1947 1946 1943 1944 1945.2.4.6.8 1 1.2 Govt supply/gdp From Krishnamurthy and Vissing-Jorgensen (2013) L private = Short-term Debt Banks + Shadow banks (broker/dealers,securiti zation, repo, MMFs) After netting inter-bank and shadow bank sector claims Graph measures variation in L private based on variation in L public
.75.8.85 OIS-Tbill 0.5 1 1.5.9.95 Crisis Build-up: 2002-2007 Spread between 3M OIS and T-Bills measures liquidity premium (P) Short-Debt rises by $5.4 trillion from 2002Q2 to 2007Q2 01jan2002 01jan2004 01jan2006 01jan2008 time Short-Debt/GDP OIS-Tbill
Money Demand Shock P U -1 (P) U -1 (P) F -1 (P) + L public A B U -1 (P) P and L private Demand shock: Foreign demand for US safe assets Caballero and Krishnamurthy (2008) L private + L public
Demand Shock (B) + Supply Shift (C) P U -1 (P) U -1 (P) F -1 (P) + L public A B C Supply shift: Financial innovation, regulatory arbitrage, implicit bailout promises, TBTF L private + L public
Decomposition 1: Structural Approach Based on data from 1920-2001, we can estimate the slope of F -1 (P): 1 We find: Per 10 basis point increase in P, financial sector supplies 0.026 more short-term debt/gdp From first-half 2002 to first-half 2007, average P increases by 32 basis points Pure demand shift explains 0.08 = (3.2 X 0.026) increase in short-term debt/gdp Actual increase is 0.19 Supply factors responsible for 0.11 1 This comes from regressing Short-term Debt/GDP on the spread between CP and T-Bills, instrumented by Debt/GDP and (Debt/GDP) 2
.7.75.8.85.9.95 Decomposition 2: Reduced Form Approach 2002 2003 2004 2005 2006 2007 Fitted values Net short-term debt/gdp Regress short-term debt on L public and Foreign Holdings of US Treasury bonds (as proxy for demand factors) Fitted values increase by 0.10
Summary: Money and Bank Growth Banks and Shadow Banks run a liquidity mismatch This mismatch grew substantially from 2002 to 2007 Two factors: 1. Money demand shock Foreign demand for safe/liquid assets rose 2. Money supply shock Banking sector found it cheaper to run a liquidity mismatched book Roughly equal contribution to growth of liquidity mismatch
References 1. Financial Fragility and Global Imbalances, Caballero and Krishnamurthy (2008), American Economic Review 2. Aggregate Demand for Treasury Debt Krishnamurthy and Vissing-Jorgensen (2012), Journal of Political Economy 3. Short-term Debt and Financial Crises: What we can learn from Treasury Supply Krishnamurthy and Vissing-Jorgensen (2013), working paper 4. Measuring Liquidity Mismatch in the Banking Sector Bai, Krishnamurthy and Weymuller (2013), working paper 5. Liquidity Mismatch Measurement Brunnermeier, Gorton and Krishnamurthy (2013), Risk Topography: Systemic Risk and Macro Modeling, NBER Volume