By Elham Saeidinezhad
“A person often meets his destiny on the road he took to avoid it.” Jean De La Fontaine
The shift in the provision of financial intermediation away from traditional banks towards the shadow banking system highlights the evolving structure of the financial market. The recent disorder in the short-term repo market has created new openings for money managers. Money managers, such as money market funds and investment funds, are hoarding unusually large amounts of cash in anticipation of the excessive demand for liquidity on December 31st. In doing so, they are planning to serve both as the primary cash providers and the lender of near last resort in the repo market. Traditionally, the latter is the role that the large banks are inclined to have in the repo market. This shift in market structure from banking to shadow banking system seems to be the unintended consequence of the Fed’s tapering and regulatory requirements. It is also no accident that the change in the investment strategy of money managers coincides with the unwillingness of the large banks to borrow from the discount window of the Fed. This reluctance by banks cost the financial system the recent turmoil in the overnight lending market in September. The repo market experiment at the end of December, where money managers are preparing to take over the banks’ role, will be a real-world stress test of this new system.
In this piece, we focus on three factors that derive these changes in the market structure. These forces include Basel III regulatory requirements, Fed’s tapering, and the reluctance of banks to use the discount window to prevent the run on them. Post-crisis macroprudential requirements demand banks to keep a certain level of High-Quality Liquid Assets (HQLA) such as reserves. For example, JPMorgan Chase keeps about $120 billion in reserves at the Fed and will not let it dip below $60 billion on any given day. These requirements reduced banks’ ability to be intermediaries between the Fed and other players. Further, the Fed’s tapering that involved the reduction of the Fed asset purchases reduced the amounts of reserves in the banking system. These factors constrained banks’ ability to provide cash in the repo market during September turbulences. Meanwhile, although the amounts of reserves in the system have shrunk, banks are reluctant to use the Fed’s credit facilities, including the discount window. The Global Financial Crisis has only worsened the stigma attached to using the discount loan for at least two reasons: first, the Dodd-Frank requires the name of the banks that borrow from the discount window to be released. Second, banks are worried that borrowing money from the Fed spur a run on these institutions.
Soon, the resilience of the most critical market for short-term borrowing will be tested when stress hits the system under a new condition. In this unique situation, when there is excessive demand for the cash, both the primary provider of funding liquidity and the lender of near last resort will be shadow banking system, who does not have the Fed’s backstop, rather than the large banks, who do. Perry Mehrling defines shadow banking as the money market funding of capital market lending. In this system, money market funds are primary providers of the funding liquidity. These funds are plotting to seize the new opportunity of becoming the lender of near last resort in December mostly because the large banks did not intervene when the repo rates hiked in September. The main question that remains to be answered is whether this new system will survive extensive pressure. After all, the bolstered role of shadow banking in the repo market is an unintended, rather than planned, consequences of post-crisis macroeconomic and regulatory changes.
Discussion Questions:
- Which regulatory requirements have constrained the ability of the banks to lend to the repo market?
- What does the lender of near last resort mean?
- Who are the main players in the shadow banking system?