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Elham's Money View Blog Hot Spots and Hedges

Banks as Alternative Investment Funds?

By Elham Saeidinezhad

This piece is published initially in Phenomenal World Publications.

Executive Summary

In this piece, I examine SVB’s business model as a model of modern commercial banking. SVB has failed, but its business model will be reincarnated as modern banking. So, what would be modern commercial banking?

Liability Management

– The nature of depositors in large commercial banks shifts from uninformed to informed, such as fund managers.

– Bank’s behavior makes deposit-taking activity into a Ponzi scheme than traditional banking.

Asset Management

– Traditional bank loans to businesses will die. Instead, the banks lend to alternative investment managers themselves through financial engineering methods such as “subscription lines.” This makes banks an investor in the PE world rather than a creditor.

– This business is not that lucrative unless the fund managers default and bankers become the de-facto investors.

– Nonetheless, the loan directly to fund managers and the resulting relationship with them brings a stream of large deposits to such banks, hence the Ponzi.

– Banks invest heavily in fixed-income securities. Nonetheless, the investment strategy is not based on holding safe assets but on following hedge funds’ trading strategies, such as “fixed-income arbitrage.”

-In other words, banks’ investment in fixed-income and hedging strategies will be a bet on the arbitrage opportunities implied in the interest rate term structure. In doing so, they become excessively exposed to interest rate risk.

Vulnerabilities/Structural Shifts

– Lots of unknown ones.

– It will be the death of “Held-to-Maturity” accounting and the birth of “marked-to-market” ones.

-Informed investors keep mark to market banks’ assets and become ultrasensitive to interest rate risks and unrealized losses.

-In other words, banks will become a mixture of investment funds, such as hedge funds and PE funds, but with public support.

Introduction

Silicon Valley Bank’s (SVB) short lifespan—from October 17, 1983 to March 10, 2023—has been witness to crucial transformations in the world of modern banking. The bank’s collapse has sparked wide ranging reflections on the roots of the crisis, the utility of government bailouts, and appropriate responses. I identify two crucial shifts in the banking system exemplified by the Bank’s fall. On the liability side of SVB’s balance sheets, the shift from uninformed to informed depositors renders hedging against interest rate risk more critical. On the asset side, a strategy of “fixed income arbitrage” means that regional banks fell into similar difficulties as hedge funds—one in which low profits rendered betting on the shape of the yield curve too expensive to maintain. 

From uninformed to informed investor

Among a number of channels, the crisis has been interpreted according to the classic Diamond-Dybvig Model. This model assumes that depositors in a particular bank are uninformed: as long as they do not reach the $250,000 threshold, they do not distinguish between depositing money in a bank and buying treasuries, given that both investments are backed by the government. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. Driven by “animal spirit” rather than the details of financial statements, they are capable of generating a run on the bank based on “any” worries, imaginary or real. The surest way to stop a bank run, the model thus argues, is through deposit insurance, which stabilizes investor confidence. 

However, recent events deviated significantly from these expectations. Rather than being motivated by a herd driven shift in “animal spirits,” the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks were informed.  Even prior to the run, they were known to extensively tweet about each detail and footnote in the financial statements of their bankers. In the case of SVB, for instance, they examined the bank’s balance sheet and “marked to market” its assets, revealing its exposure to interest rate risk. When the bank reported virtually no interest rate hedges on its massive bond portfolio, investors depositors instigated a bank run. 

This distinction between traditional, uninformed depositors and modern, informed ones reflects a revolution in the structure of contemporary banking. In the first phase of this structural change, which took place during the 1950s, “retail” depositors were replaced by “institutional” ones such as pension funds. Though institutional investors injected far greater amounts of cash, they ultimately remained uninformed. They cared little about the financial condition and balance sheets of the banks that received their  deposits, and instead prioritized the rate available on an FDIC-insured deposit. So long as they did not breach the $250,000 limit, putting money in a bank appeared as safe as buying Treasuries—particularly given that both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, were flooded with money so long as they posted attractive rates.

With the strengthening of liquidity ratios in the aftermath of 2008, systemically important financial institutions like JPMorgan Chase, Credit Suisse, and Bank of America increasingly transformed into market makers in wholesale money markets,  buying and selling securities for their own accounts and thereby minimizing their deposit-taking activity. Liquidity requirements like liquidity coverage ratio (LCR) required banks to have enough high-quality liquid assets to survive thirty days of deposit outflows in a stress scenario. In doing so, they rendered short-term deposits, and the illiquid assets they fund, less appealing. 

Big banks coped with these liquidity requirements by reducing deposit-taking activities, leaving medium-sized and large regional banks to pick up the slack. These banks sought to compensate for greater deposit-taking through other financial pursuits. In particular, they were betting on higher returns and attracting new deposits from a piece of financial engineering known as “fund subscriptionlines.” These credit facilities were different from a traditional business loan on three main fronts. First, a subscription line is a loan to venture capitalists (VC) and private equity fund managers themselves rather than the actual businesses. Second, unlike traditional corporate loans that use the firms’ assets as collaterals, subscription lines are secured against unfounded capital commitments by private equity investors. Finally, banks anticipate returns not through interest accrual but capital gains once the investment is finalized. In other words, subscription lines transformed regional banks into private equity investors rather than creditors. 

Subscription lines appealed to venture capital and private equity because they enabled them to manage their cash flows and increase the internal rate of returns on their investments without issuing a capital call to their investors. As such, they increasingly constituted the primary clientele for subscription lines. While big banks fundamentally altered the market-making business, large regional banks’ changed the banking and deposit-taking world. On the liability side, the current banking era started with the “death of the retail deposits.” On the asset side, the trend continued with the death of traditional loans. Instead, VCs and startup depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities. In this environment, regional banks, such as SVB, used Ponzi-like schemes, such as the fund subscription lines, to maintain the steady stream of deposits and become a stakeholder in the alternative investment world. 

Marcy Stigum called this the “death of loans” in the late 1970s. This shift transformed banks’ asset management beyond their embrace of subscription lines. SVB and other specialized banks that served informed depositors practically eliminated their loan-giving activity. Lacking fixed assets or recurring cash flows, startups, and crypto investors were less reliable corporate borrowers. But more importantly, these customers did not need loans—equity investors provided them with a constant supply of cash. Consequently, banks shift their operations from issuing loans to purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

The shifts in the nature of depositors, from uninformed to informed, and the assets-liabilities management of banks contributed to the current banking mania. As a result of the large-scale addition of long-term bonds backed by the US government to banks’ portfolios, these specialized banks are unusually exposed to “interest-rate risk.” While most banks earn a higher interest on their loans during interest rate hikes, banks like SVB and Signature are stuck with long-duration bonds whose value goes down as rates go up. Every bank borrows short to lend long, but many banks ultimately strike a balance. Moreover, informed depositors continuously pay attention to the financial statements and footnotes of the banks in which they deposit. As a result, they constantly “mark to market” the banks’ financial assets and penalize them whenever the fair value of their assets is at a loss.

A brief example demonstrates the systemic importance of this point. Let us assume that a bank has $100 worth of deposits as its liabilities. On the asset side, the bank uses cash to purchase a government bond worth $100. In the meantime, the Fed announces a rate hike from 0 percent to 2 percent. A traditional depositor would account for the bank’s assets “at cost,” using the price the bank paid to purchase those bonds, in this case, $100. This is especially true if the bank has announced that these assets are intended to be “held to maturity.” An informed depositor, by contrast, continuously “marks to market” the value of the bank’s assets. In this case, they account for the value of the bonds at their fair market value. When interest rates go up, this value falls: if a bond is issued with a 5 percent coupon and the market rate rises to 8 percent, demand for the 5 percent bond declines. Consequently, its price must fall until its expected return matches the competitive return of 8 percent. Informed depositors know this—if the bank has a bond with a face value of $100, they will check the market price for that bond when the Fed announces its interest rate policy. If, for instance, it is $97, then the bank’s asset is only worth $97 on its balance sheet. The other $3 is gone, and the bank is considered insolvent. Informed depositors notice—they write long tweet threads, initiating a bank run. In doing so, they heighten the bank’s exposure to interest rate risks, particularly if the bank is invested in fixed-income securities, such as government bonds. 

Fortunately, this shift also opens up new directions for bank run management: interest rate hedges. Often in the form of swaps, this financial instrument effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. Once available for sale, the value of outstanding bonds can be protected if combined with interest rate hedges like swaps. Swaps transform the nature of an asset by converting a fixed-income investment into a floating-rate one and vice versa.

Consider SVB in our earlier example. A proper swap could transform SVB’s bonds earning a fixed interest rate into an asset earning a floating interest rate. Suppose SVB owned $100 million in bonds that will provide 3.2 percent for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup, and enters into a swap where it pays the fixed rate (3.2 percent) and receives floating plus 0.1 percent. Its position would then have three sets of cash flows: it receives 3.2 percent from the bonds, and the floating rate under the terms of the swap, and pays 3.2 percent under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1 percent percent (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2 percent into assets earning the floating rate plus 10 basis points. 

The real question underpinning the current crisis then, is why SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. On the contrary, its year-end financial report notes that it terminated or let expire rate hedges on more than $14 billion of securities throughout the year. The US government’s offer of unlimited deposit insurance has failed to calm markets, in part because it assumes the uninformed depositor behavior characteristic of the Diamond-Dybvig Model. But in reality, the banking world has changed: well-informed depositors treat their deposits as an investment vehicle. In this new financial reality, bank runs may be better dealt with using a proper hedging strategy.  Strangely, the crisis teaches us that the current regional banking market structure may be better served by a private risk-management solution, available through the derivative markets. 

Regional banks as the new hedge funds

The hedge fund crisis of 1998 offers a blueprint for understanding regional banks’ asset-liability management today. At the time, funds like Long Term Capital Management (LTCM) relied on a very popular, and very painful, strategy known as “fixed-income arbitrage.” This strategy uses the model of the term structure of interest rate (yield curve) to identify and exploit “mispricing” among fixed-income securities.

For instance, let us assume that the firm’s reading of the Fed is that the central bank pivots toward cutting rates sooner than the market expects. In this case, the firm’s models show a yield curve below the market yield curve. The difference between these two is the so-called “mispricing.” In this environment, when rates are expected to fall, the fixed-income securities gain in value, justifying the purchase of government-backed securities like Treasuries and mortgage-backed securities. Nonetheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund enters an interest rate swap (IRS) and becomes a fixed-payer and floating-receiver. If the hedge fund’s prediction is correct, the IRS will generate slight cash outflows for the fund. In this case, the floating rate (determining the value of the fund’s cash inflow) would fall while the fixed rate (setting the cash outflow value) would remain unchanged. Most importantly, the fixed-income securities’ capital gain would compensate for the slight fall in the value of the IRS. Alternatively, if the hedge fund’s bet was wrong and rates increased instead, the IRS value would rise and neutralize the loss in the fixed-income securities’ fair value. Fixed-income arbitrage has its roots in the fixed-income trading desks of most brokerage houses and investment banks.

As LTCM’s failure showed, the strategy contains critical vulnerabilities. First, profits generated through fixed-income arbitrage transactions are often so small that managers have to use substantial leverage to generate significant levels of return for the fund. As a result, even a slight movement in the interest rate in the wrong direction could make hedging too expensive to be maintained. With small profit margins and greater exposure to interest rate movement, fixed-income arbitrage has been described as “picking up nickels in front of a steamroller.”

There are many reasons to think SVB’s business model has come to resemble that of hedge funds. Unlike the traditional model of deposit taking, SVB invested most deposits in fixed-income securities. Of its $190 billion in deposits, it had invested $120 billion into Treasury and agency mortgage-backed securities. Conscious of the limitations of fixed-income arbitrage, SVB’s managers suddenly dropped the interest rate hedges without providing reasonable economic justifications in mid-2022. But attributing this decision to poor risk management can be misleading. SVB’s decision to liquidate the swap positions coincided with a shift in the market consensus on the Fed—towards the perspective that the Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. The shift made it too expensive to bet on the fall in interest rates.

But this strategy becomes even more dangerous in the hands of a bank. Whereas a hedge fund can lock up liquidity and ensure investors do not run, banks can only pressure government insurance schemes or threaten the stability of the financial system. While hedge funds can impose momentary lock-up periods, bank restrictions on deposits access generate a broader banking crisis. Finally, hedge funds can employ redemption notices which require investors to give weeks or months of notice before redeeming funds, thereby enabling investment in illiquid, high-return assets.

The transformation of banks into hedge funds thus bears enormous implications for financial stability. Their investment strategies are yet to be identified by regulators—so long as deposits flow into the regional bank, it can maintain its hedges. But unlike hedge funds, which are expected to periodically disappear, banks are meant to serve a public function, have a government backstop, and occupy a vital role in the financial system. For the sake of financial stability, they should not be engaging in a short-term, high risk, and high profit business model. 

Through the shift to informed investors, and the utilization of hedge fund investment practices, the SVB crisis holds significant consequences for the structure of contemporary banking, and the tools available to prevent future collapse. 

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Hot Spots and Hedges #4: SVB offered “Fund Subscription Facilities” to Private Equities. Was It Bad for Banking and Business?

“Not all private equity people are evil. Only some.”— Paul Krugman

One of SVB’s financial indicators that were considered a missing red flag was its superior return before its collapse. SVB’s return exceeded that of large banks such as JPMorgan Chase. The returns were more in the caliber of those alternative investment funds such as Private Equities (PEs) than banks. The similarity, however, does not end here. In fact, a close examination of SVB’s business model reveals a practice at the heart of the firm that has yet to be known even after its collapse. SVB extensively used a piece of financial engineering known as “fund subscription lines (SL).” Technically speaking, SL is a form of bank credit. However, they are distinct from traditional commercial loans. Banks become a fund’s creditor by issuing bank loans. On the other hand, SL, in practice, transforms banking from being a fund’s creditor to one of the PE shareholders. In addition, the SL establishes a tight relationship between the bank and private equity managers themselves. This relationship with these fund managers attracts a growing stream of deposits. These deposits, in return, became the bank’s primary funding source. However, the implied role of SL in bringing new deposits from VC and PE funds to the SVB converted the bank’s deposit-taking activity into a Ponzi game.

The subscription lines were one of the SVB’s primary businesses. However, it turned out that they were not a lucrative business. Unlike traditional commercial loans, SL does not fund companies and “operating businesses.” Instead, it subsidizes the venture capitalists and PE managers themselves. As a result, the loans generated very low returns, even compared to commercial loans, which yielded little due to the low-interest-rate environment. Nonetheless, the subscription lines brought new clients and deposits to the bank. In return, these deposits became the bank’s primary source of funding. In other words, the SVB’s deposit-taking business was more like a Ponzi scheme than a banking service to highly specialized businesses. 

To understand SL, and the changing world of corporate loans, we should start the business model of the clients that SVB served and replicated. Over the last 40 years, the PE industry has grown from a relatively small niche for skilled bankers to an across-the-board area of modern finance. Importantly, buyout (BO) funds became the largest subsegment of PE. The primary business model of BO funds is to purchase a business through borrowed money using the business’s assets as collateral. Eventually, the PE would sell levered stakes of companies to generate profits. To finance their acquisitions, almost all BO funds are structured as closed-end vehicles in which a PE firm serves as the general partner (GP) and various (institutional) investors provide capital as limited partners (LPs). 

PE fund managers receive lucrative compensations for their services. These financiers typically receive a fixed management fee of 2% of the committed or invested capital. However, they are mainly compensated by variable carried interest equal to 20% of the fund’s profit. However, before the fund managers are paid any carried interest, the PE investors should be compensated based on their contribution with a preferred interest of 8%. From a PE’s economic perspective, the relevance of SL mainly is the ability of this facility to artificially boost the internal rate of return (IRR) of the investment. 

Fund managers’ compensation primarily depends on the IRR they achieve. The IRR, in return, has an inverse relationship with the amount of capital that the PE general investors would inject into the investment. Traditionally, such funds would call the investors to inject more capital, known as a “capital call,” as soon as the fund needs additional funding. However, in modern days, funds employ credit facilities. This is because IRR, the key assessment metric for PE fund managers’ performance, depends on when an LP’s capital is put to work. SL reduces the ultimate cash flow to investors because they pay the fees and interest on the bank loans. However, it helps the managers to delay the date when client money enters the fund and goose the fund’s internal rate of return. 

SL transforms banking into alternative investment through at least two fronts. First, it makes deposit-taking into a Ponzi scheme. Second, SL makes banks, such as SVB, a private equity managers in disguise. Let us start to understand the latter effect. From a banker’s perspective, in SL, the bank funds limited partners themselves. However, in doing so, instead of becoming entitled to the businesses’ assets in case of default, the bank receives a “power of attorney” (POA) and “steps into the shoes” of the general partner or the investment manager. POA is a written agreement wherein the PE manager provides advance authority to the bank to make certain decisions or to act on the principal’s behalf, generally or in certain circumstances. 

In the case of PE managers’ default to make payments in a timely manner, the bank could take any necessary actions without the requirement to provide prior written notice or obtain written or other consent from the PE managers and investors. Most importantly, banks can utilize POA to issue capital call notices or become a PE general partner. In the latter case, the bank becomes a private equity investor and will be compensated based on the fund’s return. In other words, if managers clear the loans promptly, banks receive the principal and interest payments on the loan. This is not a very lucrative business. However, if managers default, the bank becomes a private equity investor itself and receives a share of the return on investment. 

In addition, the SL establishes a tight relationship between the bank and private equity managers themselves. This relationship with these fund managers attracts a growing stream of deposits. At the heart of SVB’s growth were the deals with thousands of venture capitalists and private equity firms that invested in everything from experimental medicines to artificial intelligence, with checks ranging from $5 million to more than $30 million. These financiers deposited their money with the SVB. These deposits, in return, became the bank’s primary funding source. However, the implied role of SL in bringing new deposits from VC and PE funds to the SVB converted the bank’s deposit-taking activity into a Ponzi game. In this scheme, the SVB relied on SL as a backchannel to bring more institutional deposits and used the same deposits to fund this hidden activity. 

The systemic risks of subscription lines are under-appreciated by both investors and regulators. Nonetheless, this technique has already become part of banking DNA. Many PE managers are using subscription lines more aggressively than a decade ago. The SVB crisis revealed that such dirty practices put a ticking bomb at the heart of the commercial banks’ balance sheets. It also destabilizes the alternative investment world by creating a more oversized interconnectedness between the banking system and such funds. After the SVB’s failure, banks recalled the subscription lines, forcing private equity managers to ask investors to deliver vast sums of cash immediately. This could create a downward spiral if investors are forced to sell assets into a falling market to meet their existing promises to private equity managers. SVB was not just a banker to alternative investment funds. It also transformed traditional banking to become a form of alternative investment. This creates a new threat to the stability of global financial markets.

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Hot Spots and Hedges #3: Have Regional Banks Become New Hedge Funds with A “Fixed-Income Arbitrage” Strategy?

“Prophesy as much as you like, but always hedge. – Oliver Wendell Holmes, 1861” 

Hedge fund trading strategies provide a blueprint for understanding regional banks’ Asset-Liability Management (ALM), such as SVB’s. During the hedge-fund crisis of 1998, market participants were given a glimpse into the trading strategies used by large hedge funds, such as Long Term Capital Management (LTCM). Few of these strategies were as popular or painful as “fixed-income arbitrage.” As a highly leveraged strategy, fixed-income arbitrage effectively bets on the shape of the yield curve. Despite its big role in the LTCM’s fall, the regulators have not internalized this strategy, and its dangers, well enough. In fact, the so-called puzzling facts about the SVB’s business model would make sense once examined as a hedge fund with a “fixed-income arbitrage” strategy. For instance, unlike the traditional model of deposit taking, SVB invested most of the deposits in fixed-income securities. In addition, SVB was unusually exposed to interest rate risks when failed. These characteristics could be explained through the mechanics of fixed-income arbitrage trading. Indeed, the small margins and the massive exposure to interest rate movement are why this strategy is known as “picking up nickels in front of a steamroller.” The problem with becoming a hedge fund for a bank is that a hedge fund can lock up liquidity and ensure investors do not run. Banks do not have such an option, and when they face the run, they either put pressure on the government’s insurance schemes or the stability of the financial system, or both.

An anomaly in the business model of the SVB is that, for a bank, it had a lot of safe fixed-income securities. SVB had about $190 billion of deposits and invested nearly $120 billion of that money in Treasury and agency mortgage-backed securities (MBS). However, this mystery would be resolved once we consider SVB a hedge fund. Hedge funds, including the doomed LTCM, function based on different strategies, including “fixed-income arbitrage” trading. This strategy uses the model of the term structure of interest rate (yield curve) to identify and exploit mispricing among fixed-income securities. For instance, let us assume that the firm’s reading of the Fed is that the central bank pivots toward cutting rates sooner than the market expects. In this case, the firm’s models show a yield curve below the market yield curve. The difference between these two is the so-called “mispricing.”

In this environment, when rates are expected to fall, the fixed-income securities would gain in value, which justifies purchasing government-backed securities such as Treasuries and MBS. Nontheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund would enter an IRS and become a fixed-payer and floating-receiver. If the hedge fund’s prediction is correct, the IRS will generate slight cash outflows for the fund. In this case, the floating rate (determining the value of the fund’s cash inflow) would fall while the fixed rate (setting the cash outflow value) would remain unchanged. Nonetheless, and most importantly, the fixed-income securities’ capital gain would compensate for such a slight fall in the value of the IRS. Alternatively, if the hedge fund’s bet was wrong and rates increased instead, the IRS value would rise and neutralize the loss in the fixed-income securities’ fair value. Fixed-income arbitrage has its roots in the fixed-income trading desks of most brokerage houses and investment banks.

However, as LTCM’s failure showed, two critical vulnerabilities are implied in such an apparent risk-less strategy. First, profits generated through fixed-income arbitrage transactions are often so small that managers have to use substantial leverage to generate significant levels of return for the fund. As a result, even a slight movement in the interest rate in the wrong direction could make hedging too expensive to be maintained. This aspect, known to the hedge fund watchers, could explain the behavior of the SVB’s managers to drop the interest rate hedges. In mid-2022, the managers suddenly dropped the interest rate hedges without providing reasonable economic justifications. However, labeling this decision as mere poor risk management can be misleading. The mechanics of the fixed-income strategy explain this behavior more accurately. SVB’s decision to liquidate the swap positions coincided with when the market consensus on the Fed shifted. Fed watchers started to believe a more hawkish tone of the central bank. Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. In this environment, it becomes too expensive for the fund that has bet on the fall in interest rate to maintain the hedging aspect of the portfolio.

To understand this point, let us go through an example together. Let us assume that a hedge fund manager takes a long position in 1000 2-year Treasuries for $200. His unhedged position is worth 1,000 × $200 = $200,000. The bond’s annual payout is 6% or 3% semiannually. The bond Duration is 2 years, so the fund would expect to receive the principal after 2 years. After the first year, the amount earned, assuming reinvestment of the interest in a different asset, will be: $200,000 × .06 = $12,000. After two years, the fund’s earnings are $12,000 × 2= $24,000. However, the risks in the above transaction include: (a) not being paid back the face value of the municipal bond and (b) not receiving the promised interest. To hedge this Duration risk, the manager must short a 2-year IRS with a notional value of $200,000. The fund negotiates so that the fixed rate in the IRS is less than the 6% in annual interest, let us say %5.9.


The final hedged position results in the following short cash position for the first year: $200,000 × .059 = $11,800, and for the two years, the fund will pay a total of $11,800 × 2 = $23,600. In this example, if the manager has to pay out a total of $23,600 to hedge his duration risk, we must subtract this amount from the anticipated interest made on the bond: $24,000 −$23,600 = $400. Thus $400 is the net profit made on this transaction. Profits generated through fixed-income arbitrage transactions are often so small that managers drop the hedge when the interest rates move in the wrong direction for a relatively consistent period. This explains the use and the drop of the IRS by the SVB.

An essential problem with fixed-income arbitrage is that maintaining the hedges can be unsustainable for firms adopting this strategy. In addition, empirical evidence shows that the so-called arbitrage opportunity might not be riskless. In fact, the deep losses, and extra returns, might be less due to the high leverage and more a reflection of more profound risks, such as market risks, inherent in the nature of such strategies. Fixed income arbitrage is assumed to be a riskless, market-neutral investment strategy. This strategy is considered market-neutral as it consists of a short position in a swap and an offsetting long position in a Treasury bond with the same maturity (or vice versa). In actuality, however, this strategy is subject to the risk of a significant widening in the fixed (swap rate)-floating (SOFR rate) spread. Suppose this spread is correlated with market factors, which in most cases, it is. In that case, the excess returns may represent compensation for this strategy’s underlying market risk. In other words, this fixed-income arbitrage strategy has little or no riskless arbitrage component.

In addition, this strategy has exposure to a wide array of price risks. In particular, the strategy has exposure to the stock market, the banking industry, the Treasury bond market, and the corporate bond market. In particular, the researchers have shown that the excess returns for these fixed-income arbitrage strategies are related to excess returns for the stock market, excess returns for bank stocks, and excess returns for Treasury and corporate bonds. This suggests that the risk of a significant financial event or crisis is a risk that is priced throughout many financial markets. Thus, the financial-event risk may be a critical source of the widely-documented commonalities in risk premia across different asset classes. These results are consistent with the view that the financial players, including the market-makers and their balance sheet positions, play a central role in asset pricing.

One practice that connects the regional banks’ business model with hedge funds is the Ponzi aspect of their businesses. Both types of firms rely on the continuity of short funding to finance their assets. For hedge funds, the cash inflow is in the form of capital from the investors, while in the case of the banks, it is depositors’ money. Nonetheless, there is one more similarity between these two that is even more fundamental yet is more obscured. At first glance, it might look like regional banks’ holding of fixed-income securities was an attempt to invest in safe assets. However, after examining the SVB’s business models and their managers’ narratives, these investments start to look more and more like the “fixed-income arbitrage” strategy of hedge funds and less like their investing in safe assets. This strategy tries to exploit mispricing amongst fixed-income securities. It is based on the firms’ understanding and modeling of the term structure of interest rate. In doing so, it creates excessively high exposure to interest rate risk. This is because if the fund is betting on the shape of the yield curve, it becomes at the mercy of its financial model’s predictions. If these models are incorrect, interest rate movements will crush their profits. Unfortunately, this is what happened with SVB.

When the dust settles, SVB might be more like a hedge fund than a bank. However, banks becoming hedge funds have implications for financial stability. For example, their business model could be concealed from the untrained eyes of the regulators as long as deposits flow into the regional bank. However, once the profit margin collapsed, the bank had to drop the strategy of acting like a hedge fund as it was no longer hedged. Nonetheless, the difference between a hedge fund and a bank is that hedge funds are designed to earn lots of money and disappear. Therefore, no one misses them once they disappear. However, banks serve a public function, have a government backstop, and occupy a vital role in the financial system. As a result, adopting such a short-term, high-risk-high-profit business model for such an important institution is dangerous for financial stability.

Most importantly, banks, if they decide to restrict people’s access to their deposits, they generate a banking crisis. On the other hand, hedge funds often impose lock-up periods, such as several years in which investments cannot be withdrawn. Many also employ redemption notices requiring investors to provide notice weeks or months before their desire to redeem funds. These restrictions limit investors’ liquidity but, in turn, enable the funds to invest in illiquid assets where returns may be higher without worrying about meeting unanticipated demands for redemptions. The events leading to the banking disruption of March 2023 suggest that market participants or regulators needed to adequately internalize essential lessons from the 1998 hedge fund crisis case. If they did, they could recognize the fixed-income strategy at the heart of the SVB’s business model.

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Hot Spots and Hedges #2: Has March 2023 Banking Crisis Exposed Interest Rate Risk as the New Liquidity Risk?

“Street Speaks in Swap Land” — Marcy Stigum

The collapse of Silicon Valley Bank (SVB), and its aftermaths, in March 2023, showed a structural change in the business model and the risk structure of deposit-taking institutions. In 2008, Great Financial Crisis (GFC) revealed that the banking system’s balance sheets are ingrained with liquidity risk. Bankers borrowed in the short-term, liquid money markets to invest in long-term illiquid assets with high yields. In contrast, the March 2023 crisis showed that deposit-taking institutions had shifted their gear towards investing in liquid assets such as government bonds. In doing so, they have become hedge funds in disguise. Nonetheless, instead of noticing such changes in banking structure, regulators assessed commercial banks based on the lessons of the GFC. They were considered safe as long as they had healthy liquidity and leverage ratios and were funded by deposits. By over-relying on the lessons of the GFC, the regulators and bankers’ risk managers alike disregarded a risk that every hedge fund manager and fixed-income investor is alerted by: interest rate risk.

Interest rate risk was disregarded in the narrative of financial stability. Moreover, GFC was partially to blame. GFC exposed the extent of liquidity risk in the banking system. The liquidity mismatch between the banks’ assets (long-term illiquid assets) and liabilities (short-term money market instruments) became known as the hot spot of banking. The liquidity mismatch would cause a solvency problem if the bank, for instance, needed to sell some of its assets quickly to manage its daily survival constraints and cash flows. In this case, illiquid assets would go through a fire sale process not because they had lost their potential income or become less attractive but simply because they did not have a liquid market. Such circumstances led to Bagehot’s dictum that to avert panic, central banks should lend early and freely (i.e., without limit), to solvent firms, against good collateral, and at “high rates.” In this context, it should not be surprising that the Fed and FDIC provided extensive liquidity provisions, including offering blanket deposit insurance, after the March 2023 banking crisis started. 

Nevertheless, such facilities have yet to calm the market. The failure of liquidity provision to stabilize the market in the March 2023 banking crisis is partially generated by the intellectual mismatch between the root of the banks’ vulnerability (interest rate risk) and the proposed remedies (liquidity backstops). The reason is the change in the banks’ business model. Commercial banks started to hold excessively safe assets, such as government bonds, to prevent a GFC-like crisis and escape regulatory pressure. Government bonds may not have default risk. They are also liquid. However, their market value goes down when rates rise. In addition, rising interest rates generally force banks to raise deposit rates or lose funds to alternatives such as money-market funds. For banks, that was only an issue if the bonds were not adequately hedged and had to be sold to redeem deposits, which is exactly what happened to SVB. The signature relied more on loans, but it also experienced a run on its uninsured deposits. 

Regional banks’ business model exposes them to unusually high interest rate risks. Regional banks’ liabilities are mostly deposits from modern corporates such as Venture Capitals (VCs), Startups, and Crypto firms. These corporate depositors do not need a bank loan. Instead, they can raise cheap funding through equity, IPOs, and other capital market techniques. As a result, banks use their cash to purchase a very high level of interest-sensitive fixed-income assets such as bonds. The classic problem with holding a large portfolio of fixed-income assets is that when rates go up, they fall in value, as with SVB’s assets. At the same time, as deposits pay competitive rates, higher rates increase the value of banks’ liabilities. This is called “interest rate risk.” All types of deposit-taking activities involve a certain level of interest rate exposure. However, commercial banks’ portfolios used to be more diversified as they also made floating-rate corporate loans. As a result, their balance sheets were less sensitive to interest rate changes in the past.

The heightened sensitivity of banks’ assets to interest rate risks could stay unrecognized by more traditional depositors who treat checkable deposits as safe as government liability. However, like equity investors, corporate clients use all the available information to continuously mark-to-market bank assets. When interest rate is volatile, as was the case in the past few years as a result of the Fed’s policies, bond prices change dramatically. If these assets are marked to market, their fair value sometimes falls below their book value. More informed and rational depositors are impatient and reactive to such developments. As was the case for the SVB, they could hugely penalize the banks by collectively withdrawing their funds and creating a run on a bank. The SVB-derived banking crisis showed that compared to other depositors in history, these new and individually rational types of corporate depositors could collectively create a more unstable banking system.

As a result, regulators are deciding how to secure this segment of the banking system that is unusually exposed to interest rate risk. Nonetheless, regulators should consider more innovative risk management approaches instead of returning to the standard regulatory toolkits, such as stress tests. For example, they could require the banks with such a business model to use interest rate swaps (IRS). First, from a risk management perspective, IRS can provide interest rate hedges. As corporate depositors continuously mark-to-market banks’ financial positions, neutralization could help calm their nerves when interest rates are highly volatile. IRS could also act as a cash management tool. The parallel loan structure of the IRS synthetically transforms the banks’ fixed-income assets into floating-rate- assets to match deposits’ cash flows.

From a classic risk-management perspective, swaps would neutralize the interest rate risks. To understand this point, let us go through an example. Suppose a regional bank tends to issue a $ 1 million deposit at a floating rate. The bank uses this fund to purchase a fixed-income bond. However, additional liability (deposit) at the variable rate will undermine compliance between interest rate-sensitive assets and liabilities. In the event of rising interest rates in the market, banks’ cash outflows and cash inflows increase. The cash outflow increases as the banks make higher interest payments to the depositors. The value of the cash inflow increases too. Even though the bonds generate fixed cash flows, these payments will be reinvested at a higher interest rate and earn a higher income. However, let us assume that the value of the liabilities will be greater than the increase in the income value by one million dollars. The result is a decline in the net interest margin and bankers’ profitability. 

To avoid this risk, the banker can convert $ 1 million of liabilities with variable interest rates in the $ 1 million liability insensitive to interest rate movements, tiding interest-sensitive assets to interest-sensitive liabilities. Entering into an interest rate swap will enable her this. Therefore, the banker will contract an interest rate swap under which she will be required to pay at a fixed rate and receives at a variable rate. Variable income from the swap will equal the losses from the additional variable liability, and the net result will be a fixed obligation from the swap. In other words, profit/loss in swap would neutralize variable income from bonds, and the net result will be an interest-insensitive asset and liability because of the swap. 

Another way to think of the swap is as a tool that matches cash inflows and outflows synthetically. The mechanics of the swaps can allow the banks to convert their bond holding (that earns fixed income) into repo lending (that earns a floating rate), albeit synthetically. Buying an IRS (being a fixed-payer, floating-receiver) by the bank is like borrowing in the bond market to lend the proceeds in the short-term money market. Banking is the equivalent of borrowing short and lending long. In contrast, IRS is equivalent to borrowing long and lending short. In this scenario, the swap position increases in value when the floating interest rate rises and generates the cash flows required to neutralize the cash flow mismatch between the banks’ assets and liabilities. 

Historically, risk managers and regulators have often tried treating such risk as an “accounting” problem. As a result, positions were converted into risk equivalents and added together. For example, in fixed-income markets, participants have, for many years, scaled their positions into units of a common duration. Each position is converted into a basis—for example, a number of “10-year duration equivalents”—which should have equal sensitivity to the main source of fixed income risk, a parallel movement in interest rates. In this case, risk managers and regulators use indicators such as the delta (the net interest rate sensitivity), the vega (the net volatility sensitivity), and the gamma (change in delta concerning a one bp change in interest rates).

While these bits of information are essential to understanding and managing the position, they do not provide an adequate basis for risk management. Over the past several years, the accounting approach to risk management has been largely supplanted by using “stress” tests. Stress tests are the output of an exercise in which positions are revalued in scenarios where the market risk factors sustain significant moves. No doubt, using stress tests improves a situation of not knowing what might happen in such circumstances. However, significant limitations in stress testing need to be recognized.

What are their important limitations? First, it is sometimes unclear which dimensions of risk need to be considered. Also, stress tests do not reveal the relative probabilities of different events. For example, a position with negative gamma that loses money in significant moves in either direction will look bad in extreme scenarios but generally look very attractive when only local moves are considered. In any case, the shrewd banker can tailor his positions to look attractive relative to any particular set of scenarios or, given the opportunity, can find a set of scenarios for which a particular set of positions looks attractive. Moreover, in complex portfolios, there are many scenarios to look at; in fact, it may be virtually impossible to know which risk factors need to be considered. Furthermore, even if an exhaustive set of scenarios is considered, how does the trader or risk manager know how to consider the risk reduction resulting from the diversification of the risk factors? Thus, while stress testing is useful, it often leaves large gaps in understanding risk.

The ongoing banking crisis shows that while we mistakenly disregarded liquidity risk as an anomaly before the GFC, we made the same mistake regarding the interest rate exposure until the collapse of the SVB. As long as banks held safe, liquid assets, the interest rate mismatch between assets and liabilities was considered systemically unimportant. It is true that in modern finance, liquidity kills banks quickly, and liquidity facilities save lives. Nonetheless, the SVB crisis shows that we are also moving towards a parallel world, where interest rate risk evaporates a whole banking ecosystem. In this environment, looking at other instruments, such as swaps, and other players, such as swap dealers, that can neutralize the interest rate risk would be more logical. The neutralization aspect of the IRS can provide a robust financial stability tool to hedge against systemically critical hot spots.

Nonetheless, at least two critical issues should be extensively discussed to better understand swaps’ potential as a tool to strengthen financial stability. First, the economic benefit of the interest rate swaps results from the principle of comparative advantage. Interest rate swaps are voluntary market transactions by two parties. Nonetheless, this comparative advantage is generated by market imperfections such as differential information and institutional restrictions. The idea is that significant factors contribute to the differences in transaction costs in both the fixed-rate and the floating-rate markets across national boundaries, which, in turn, provide economic incentives to engage in an interest-rate swap, is true “a market failure.” Second, any systemic usage of swaps would engage swap dealers and require expanding the Fed’s formal relationship with such dealers. 

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Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #1: Have SVB’s Informed Depositors Created a Derivative-Based Solution to Bank Runs?

“[Interest Rate Swap] is a perfect example of the gains that can be realized from specialization along the lines of comparative advantage. Triple-A and single-B can together reduce their joint costs of borrowing by each borrowing in the market in which they get the best terms; then, using a swap, they can divvy up the savings they have realized, and each ends up with the type of liability they wanted in the first place.” Says Marcia Stigum (1978)

Silicon Valley Bank (SVB) was born on October 17, 1983. It was announced dead by the FDIC and other government agencies on March 1o, 2023. Nonetheless, SVB’s failure began an intriguing postmortem debate on bank runs. Many discussions have been conducted on essential issues such as the roots of the crisis, the nature of government bailouts, and recrafting bank regulation (such as making liquidity measures such as liquidity coverage ratio (LCR) time-sensitive). However, one of the standard narratives indicates that the SVB’s doomed fate is determined by the classic type of depositors who follow herd behavior and are primarily driven by human psychology and panic. 

However, the March 2023 banking crisis revealed that modern depositors’ behavior, including their decision to run on a bank, is less driven by the animal spirit and more by the actual information in banks’ financial statements. In other words, modern depositors’ behavior has shifted from being uninformed and displaying herd behavior to becoming individually informed and information-derived. This distinction between traditional, uninformed depositors and modern, informed ones has essential implications for the measures to stop the bank run. Given the nature of the modern depositors, banks’ usage, and reporting of hedges, including interest rate futures and swaps, would be a better option to stop a run on a bank and a banking crisis in general than other classic solutions such as deposit insurance. In addition, accounting for the structural change in the type of depositors, from uninformed to informed, could open new avenues, such as using derivatives, to improve financial stability in the future.

Most standard narratives of the March 2023 bank run are based mainly on classic models such as the Diamond-Dybvig Model of bank runs. In this model, the assumption is that the depositors are uninformed. To such depositors, as long as they did not reach the $250,000 threshold, putting money in a bank appeared as safe as buying Treasuries. Both investments had full government backing. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. As their behavior is driven by “animal spirit” rather than a particular detail in banks’ financial statements, “any” worries, imaginary or real, about the viability of such insurance, if believed by enough people, could lead to a run on a bank. In this environment, the model suggests that even though some banks tend to stop the convertibility of checkable deposits to currency, the best option to stop a bank run would be “deposit insurance.” 

In contrast to the assumption of such models, the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks are characterized as informed, finance-savvy, well-informed, and informed. They are known to use all the available information and extensively tweet about every detail and footnote in the financial statements of their bankers. For instance, in the case of SVB, they examined the bank’s balance sheet, “marked to market” its assets, and noticed its exposure to interest rate risk. Moreover, they initiated the run on the bank once the bank reported virtually no interest rate hedges on its massive bond portfolio. In other words, the run on the SVB revealed that modern depositors’ behavior is less driven by the animal spirit and psychology and is indeed informed. 

This distinction between traditional, uninformed depositors and modern, rational ones has essential implications for the measures to stop the bank run. It opens the door for derivatives to be considered as a private-risk management tool that enhances financial stability. One of the most significant risks to SVB’s business model was catering to a rational group of investors who treated bank deposits as a form of investment vehicle and continuously checked the bank’s balance sheet. This change from uninformed to rational (well-informed) depositors is a continuation of the existing evolution in banking. In the first phase of this structural change, “retail” depositors were replaced by “institutional” ones such as pension funds. The main difference between these two was the amount of cash they would inject into the banking system.

Nonetheless, both were uninformed. They cared not about the banks’ financial condition and balance sheets to which they gave their money. Instead, they just wanted the top rate available on an FDIC-insured deposit. To this depositor, as long as she did not breach the $250,000 mark, putting money in a bank appeared as safe as buying Treasuries. Moreover, both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, found they were flooded with money if they posted attractive rates. This is a pretty good picture of things in the fifties.

After the Great Financial Crisis (GFC), and the strengthening of the liquidity and capital ratios, systemically important banks, such as JPMorgan Chase, Credit Suisse, and Bank of America, restructured their business models to become market makers in wholesale money markets. They minimized their deposit-taking activity. As a result, medium-sized and large regional banks changed their business model to pick up the slack. For these banks, retail deposits were a dead end. Nontheless, attracting large deposits per se was not the only goal when it came to institutional deposits. Instead, they sought “well-informed” clients such as tech, crypto, venture capitalists (VCs), and startups. Therefore, banks such as SVB, Signature, and Silvergate preferred serving highly specialized, local, and finance-savvy depositors. These regional banks structured their business models to become the Bank of Crypto, VCs, or Startups.

If the change in systemically important banks’ business model transformed the market-making business, large, regional banks’ restructuring changed the banking and deposit-taking world. On the liability side, the modern banking era started with the “death of the retail deposits.” This evolution was revealed in the balance sheet of the SVB. On the liability side, much of the recent SVB’s deposit growth was driven by VCs and startup businesses. These depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities. 

On the asset side, SVB and other specialized banks that served rational depositors were outside the business of making loans. Indeed, startups and crypto customers do not have good collaterals like fixed assets or recurring cash flows. As a result, they are less-reliable corporate borrowers. Nonetheless, the most important reason was that these customers did not need loans. Instead, equity investors provided them with a constant supply of cash. Marcy Stigum, in the late 1970s, called this a “death of loans.” The idea is that top corporate customers have access to public and private market credit, where they can borrow more cheaply than banks. Banks have adjusted to the loss of this business by instead purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

This change from uninformed to rational depositors and the corresponding assets-liabilities strategies contributed to the ongoing banking mania in at least two hybrid ways. On the one hand, serving rational depositors who do not need loans implies the large-scale addition of long-term bonds backed by the US government to the banks’ portfolios. The result is that these specialized banks are unusually exposed to “interest-rate risk.” When interest rates go up, most banks have to pay more interest on deposits but get paid more interest on their loans and end up profiting from rising interest rates. On the other hand, banks such as SVB and Signature own a lot of long-duration bonds. These bonds’ market value goes down as rates go up. Every bank has some mix of this — every bank borrows short to lend long; that is what banking is — but many banks end up more balanced. At the same time, rational depositors, unlike traditional ones, continuously pay attention to the financial statements of the banks and the footnotes. As a result, they constantly “mark to market” the banks’ financial assets and extremely penalize the banks whenever the fair value of their assets is at a loss. 

Let us use an example to understand this point and its systemic importance. Let us assume that a bank has $100 worth of deposits as its liabilities. On the asset side, the bank uses cash to purchase a government bond worth $100. In the meantime, the Fed announced a rate hike from 0% to 2%. A traditional depositor would account for the bank’s assets “at cost,” using the price the bank paid to purchase those bonds, in this case, $100. A rational depositor, in contrast, continuously marks to market the value of the bank’s assets. In this case, they account for the value of the bonds at their fair market value. If the bank has a bond with a face value of $100, this type of depositor will check the market price for that bond when the Fed announces its interest rate policy. If, for instance, it is $97, then the bank’s asset is only worth $97 on its balance sheet. The other $3 is gone, and the bank is considered insolvent. Rational people notice, tweet, and write long threads. Then, they start a bank run. This characterization explains the behavior of SVB’s depositors, mainly from the tech and VC industries. As rates went up fast, SVB’s depositors, who were all on Twitter a lot, read the footnotes on the notices on the financial statements of the SVB and started to write long threads on the topic that SVB was insolvent. As a result, they all pulled their money out at once. 

Rational depositors, not unlike traders and capital market investors, use all the available information and continuously mark to market the balance sheet of financial institutions. Unfortunately, in doing so, they heightened the bank’s exposure to interest rate risks, especially for the banks that invest in fixed-income securities, such as government bonds. However, this opens up an opportunity for using interest rate hedges to stop the run on the banks. Interest rate hedges are often in the form of swaps, a financial instrument that effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. These can be important for banks like SVB because many of their investments are tied to fixed-income bonds like mortgages or Treasuries. 

When rates go up, fixed-income bonds fall in value, as with SVB. Why do bond prices respond to interest rate fluctuations? Remember that in a competitive market, all securities offer investors fair expected rates of return. If a bond is issued with a 5% coupon when competitive yields are 5%, then it sells at par value. If the market rate raises to 8%, however, who would be willing to pay a par value for a bond that only offers a 5% coupon bond? The bond price must fall until its expected return increases to the competitive return of 8%. In this environment, the fair value of the bonds will fall. Even if the investors are intended to hold these assets until maturity, which indicates they would still earn the par value, a mark-to-market method reduces the fair value of these investors’ assets. 

However, once these available-for-sale, outstanding bonds are combined with interest rate hedges, such as swaps, their value can be protected against interest rate movements. One of the swaps’ functions is to transform the nature of an asset. Consider SVB in our example. A proper swap could transform SVB’s bonds earning a fixed interest rate into an asset earning a floating interest rate. Suppose SVB owned $100 million in bonds that will provide 3.2% for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup. We assume it agrees to enter into a swap where it pays the fixed rate (3.2%) and receives floating plus 0.1%. Its position would then have three sets of cash flows. First, it earns 3.2% from the bonds. Second, it receives floating under the terms of the swap. And third, it pays 3.2% under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1% (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2% into assets earning the floating rate plus 10 basis points. In the real world, however, SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. Instead, it terminated or let expire rate hedges on more than $14 billion of securities throughout the year, the company said in its year-end financial report. Being unhedged was SVB’s fatal sin that its depositors did not forgive.

In this piece, I shed light on a corner of the crisis that has made this run on the bank different from the classic ones. In the current banking crisis, the collective behavior of the depositors to withdraw their cash from these banks, more than being driven by pure speculation and panic, is driven by depositors’ careful examination of the banks’ financial statements. In other words, in this crisis, we are dealing with rational depositors rather than uninformed ones. Although small, this detail would change the best approach towards stopping the run on the banks, away from deposit insurance towards using derivatives. The influential Diamond-Dybvig Model posits that deposit insurance is the best way to deal with bank runs. Accordingly, in March 2023, after the SVB’s failure, the government introduced extraordinary measures to extend the deposit insurance “to all the deposits” and disregard the $250,000 threshold. Nonetheless, despite the government’s all-in approach to providing deposit insurance, such a state-backed promise did not stop the run on the other banks. 

The US government’s failure to calm the market, despite offering full-blown deposit insurance, calls for a new framework beyond the classic Diamond-Dybvig Model, where the depositors choose to remain uninformed about the financial health of their bankers. The SVB’s tragedy revealed a modern financial system made by modern, well-informed depositors. These depositors treat their deposits as a form of investment vehicle. In this new financial reality, what stops the run on a bank is a proper hedging strategy that is reported in the bank’s financial statement instead of government-backed insurance. In a strange twist, the March 2023 banking crisis teaches us that the regional banking market structure has moved in the direction that a private risk-management solution, available through the derivative markets, would be a superior resolution than the government-backed insurance for financial stability. Every cloud, even if it includes a cascade of bank runs, seems to have a silver lining. 

Footnote: While writing this piece, I am visiting my family in Iran. My access to the internet is nonexistent. However, a student of mine sent me all the articles through text messages. Like always, my students are my main drivers and backers in my intellectual journey.

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Elham's Money View Blog Primary Source Columns

Inside the Blackbox of Market Structure: A Financial Stability Framework Based on Systemic Fluidity

*This is the first draft of the Primary Source column #1. The final version will be published at Jain Family Institute’s Phemomonal World Publications.

The Primary Source’s Raison D’être: Financial Stability Across the Market Structure

Jain Family Institute has launched a project called Primary Source, which provides a “forward-looking” and “structural” approach toward financial stability. This project uses “systemic fluidity” and the quality of “market structure” as the foundations of financial stability. In contrast to systemic risk, systemic fluidity refers to the flow of four market attributes across an invisible spectrum: collateral, risk, liquidity, and payments. It is a characteristic of a resilient market microstructure. Classical financial stability theories concentrate on the ex-post systemic risk, the type that drives system-wide breakdown, or ex-ante preventive liquidity and volatility indicators. In these models, systemic risks occur, and financial indicators fluctuate in a “black box.” This program departs from this classical approach and looks inside the black box. 

Specifically, the quality of market structure determines systemic fluidity, captured by four essential flows. First, the collateral flow depends on the quality of the firms’ industrial organization. Collaterals move between different types of entities and for various purposes. Therefore, firms’ business models determine the shiftability of collaterals across the system. The second nexus of systemic fluidity is the flow of risk. Risk flow depends on the derivative markets’ institutional and engineering qualities. Derivative markets are the structure underlying the distribution of risk. The third element of systemic fluidity is the flow of funds. The flow of funds across the system depends on the quality of the liquidity in circulation. This quality is determined by the structure of the market for financial intermediation.

Finally, the flow of payments depends on the tendency of two systemically important market structures to hoard junk liquidity and siphon off high-quality claims. Our central insight is that the financial system continually transforms public claims into private claims, both secured collateralized and unsecured ones, through two different structures: the payment processing system and the firms’ liquidity and payment solutions. First, the payment processing mechanism has two stages: payment and settlement. Nonetheless, the type of claim in the former is usually of a lower quality than in the latter. Second, firms’ liquidity and payment solutions continually involve their balance sheets’ liquidity and maturity transformations. As a result, both structures tend to hoard bogus liquidity and siphon off public liquidity. Nevertheless, the system’s quality depends on the trust that relatively safe and secured monetary liabilities exist at every layer. These claims are from collateral-taking private entities or the government’s presence as a lender of last resort. 

The four nexus of the market structure are collateral, risk, funding, and payments. These topics, usually in isolation from each other, have been a focal point in four strands of theoretical literature: (1) macroeconomic theories of financial intermediation, (2) microeconomic models of industrial organization, (3) empirical finance literature on market microstructure and (4) theoretical finance models of asset pricing and capital valuation. This project connects these pieces of literature, as they closely coexist in the real world, to examine the quality of the market structure. The program’s ultimate objective is to build a forward-looking financial stability framework founded on systemic fluidity and the quality of the market structure rather than systemic risk and the strength of certain activities or entities. 

The project’s primary source is the financial institutions’ research papers and narratives. Our vision is to let the market speak in real time. At the same time, we use academic frameworks to cut through the many noises of such market-generated narratives and categorize the changes in the quality of market structure as structural, cyclical, and event-driven. The preliminary results will be published in monthly columns called “Primary Source” in the Phenomenal World Publication.

Figure 1: The Four Key Elements of Systemic Fluidity

  1. The Flow of Collateral: Financial System is A Web of Interconnected Balance Sheets

Every trade involves financial assets, also called securities. The flow of such securities is a nexus of system-wide fluidity. Traditional financial stability models use market liquidity as an indicator of securities market strength. However, while market liquidity is significant in this framework, it is not the only element of such resilience. Market liquidity is provided by a specific type of financial intermediaries, market makers, who use their balance sheets to make the market in securities. However, the collaterals flow between a wide range of institutions with different business models. These institutions include capital and cash providers (such as institutional investors and money market mutual funds), financial intermediaries (such as exchanges, brokers, cash and security dealers, and alternative trading systems), and users of capital (such as asset managers and securities firms). These players operate differently. Nonetheless, they are all part of the supply chain of collateral. The economic structures and balance sheet decisions of all these entities determine the financial ecosystem’s flow of collateral.

The flow of collateral, in this framework, depends on a feature of the market microstructure called the firm’s industrial organization. Industrial organization (IO) links firms’ strategic choices with significant market attributes, such as competition within an industry, systemic balance sheet positions, and the overall resilience of the market structure. The development of IO theory during the 1970s has narrowed the gap between the fields of business management and finance. As a result, the IO provides powerful insights into the relationship between different aspects of the security market, including market liquidity and firm-level decisions. Moreover, these firms include all the entities along the supply chain and not only financial intermediaries. Therefore, understanding firms’ industrial organization is essential for understanding the collateral flows that run through the pipes of the financial system.

Collaterals flow for different purposes, including secured funding, investment, short-selling, margin requirements, and lending by securities owners. Financial firms sometimes adjust their business strategies, such as Collateral Management and Assets and Liabilities Management (ALM). In doing so, they sculpt the market microstructure required for the collateral flow. On a firm level, these strategies can help these entities maximize their utility function, achieve higher investment returns, and reduce counterparty risks. They do so by strategically matching their assets and liabilities or adjusting the type of collaterals they accept from the counterparties. Such counterparties include various financial entities such as banks, broker-dealers, insurance companies, hedge funds, pension funds, asset managers, and large corporations.

From a more systemic and industry-level perspective, such adjustments imply changing the types of lending and investment activities they engage in. It also affects the kinds of liabilities they issue and the assets they acquire. As a result, firms’ business management practices can affect the industry. Indeed, the increase in securities lending post-2000, the secular decline in market-making post-2008 Great Financial Crisis, and the sell-off of the U.S Treasury securities in March 2020 are examples of the systemic impacts of such firm-level strategies.

Financial institutions with different motivations and industrial organizations move collateral across the system. Nonetheless, these firms continuously change their business management strategies. By viewing the different firms’ balance sheets holistically as a pipeline of collateral flows, we can uncover hidden vulnerabilities that result from interconnections and interdependence between these firms. Furthermore, we can better understand how shocks are transmitted and amplified between different markets and entities. Thus, combining the overlooked industrial organization of the non-intermediaries with that of the more well-known financial intermediaries helps pave the way to a new framework describing the structure of the financial system. This shows that while financial intermediaries are at the center of such flow, they are not the only entities. In this framework, we also investigate the dependencies between these central activities in the financial system and how they lead to new forms of risks and vulnerabilities in the new era of collateral flow. 

  1. The Flow of Risk: Derivatives Make Collaterals Flow. At the Same Time, They Create Hidden Risks.

The flow of risk is a nexus of systemic fluidity. Derivative markets are the market-based structure for the distribution of risk across the system. These markets’ performance depends on various structures, such as dealing mechanisms, underlying assets, and the engineering of the traded securities. Traditionally, derivative strategies are considered essential for firm-level risk management and hedging purposes. For financial stability, however, derivatives are considered “toxic” instruments that must be centrally cleared. This is because derivatives have zero initial value, and the position taker does not have anything to put on the balance sheet. Therefore, they are off-balance sheets. The trader has simply taken a position with a derivative contract rather than “buying” or “selling” something tangible. The off-balance sheet aspect of the derivatives is the central and sole focus of the traditional financial stability frameworks.

However, derivatives’ net impact on systemic fluidity also depends on their role in stripping the risks from financial assets. In doing so, they become the parallel track required for shifting hedged collaterals across the financial industry. Derivatives separate the flow of risks (foreign exchange, interest rate, and credit risks) from the flow of collateral. In doing so, they have become the key to transforming collaterals into funding. Collaterals are the foundation of secured funding, just as access to funding is the basis for market-makers capacity to trade collaterals and provide market liquidity. Buying and selling assets move collateral across the system. At the same time, it creates financial risks that derivative transactions may hedge. Derivative markets provide a market-based structure to manage the risks and determine the value of collaterals. 

Derivatives positions, therefore, determine the fluidity of collaterals as they reduce counterparty credit concerns and protect against different types of exposures. A financial instrument, including U.S. Treasury bonds, can be traded as at least three separate instruments. The asset can be used as collateral to obtain short-term funding and make payments. The other instruments are derivatives, including interest rate swaps (IRS) and credit default swaps (CDS). IRS is an essential vehicle of risk distribution. It shifts the interest rate risk. Similarly, CDS distributes the default risk from the issuer to the derivative holder. A robust institutional foundation in the derivative market that ensures the simultaneous distribution of risks and collateral is essential for maintaining system-wide fluidity. This aspect, which is relegated to the background in most financial stability frameworks, will be a critical parameter of our approach when assessing the systemic impacts of derivatives.

Derivatives are the parallel structures that make the flow of collateral and their usage as the backbone of secured funding possible. In addition, derivatives are also the ongoing swap of IOUs, mainly in the form of cash. This parallel loan construction creates a web of hidden short-term debts. As most of these liabilities are in the form of daily cash commitments, they can put the traditional bank-based payment system under pressure both within and across borders. For instance, investors continually swap fixed interest payments with floating ones for a fixed period in an interest rate swap. Similarly, in a credit-default swap, the derivatives issuer promises to make periodic payments to its counterparty as a kind of insurance premium. Their payments happen parallel to the debt issuers’ periodic interest or coupon payments, making the time pattern of the derivatives holders’ payments the mirror image of the issuers of debt securities.

The parallel loan structure of derivatives and their margin computation, or cash for margining, link them to the system-wide liquidity and funding conditions. A mark-to-market financial engineering technique makes derivatives’ actual cash flow commitments higher than their implied level. The disparity between the real and implied cash commitments can create system-wide liquidity risk. Mark-to-market means that the investors should pay for daily gains and losses, also called “margin calls,” when the market value of the underlying asset changes. Mark-to-market significantly alters the derivatives’ implied cash flow commitments. In doing so, it converts otherwise cash-rich institutions, such as pension funds, into vehicles of systemic liquidity risk. 

Cash-pool investors’ business model is at the heart of such transformation. These institutions, such as pension funds, generally have two opposing roles in the derivative markets. First, they use derivative strategies to hedge significant pension plan liabilities against interest rate risks. In the meantime, because they hold large cash pools, they use derivative techniques such as Liability-Driven Investment (LDI) to earn higher yields. They take significantly speculative risk in this second position. These institutional investors’ dual role in the derivative market exposes them to significant margin calls during large price swings. As a result, derivatives transform cash-rich investors into vehicles of systemic liquidity vulnerabilities. 

Finally, derivatives directly link the financialized commodity markets and the financial system. Commodities are one of the major asset classes that derive the values of derivative contracts. Any changes in commodity prices can generate excessive margin calls. Further, commodity traders’ financialized business model encourages them to establish speculative positions through derivatives. Derivatives allow them to use their information advantage as the market makers in an asset that underlies most derivative contracts. As non-financial corporations, however, they have considerable reliance on bank funding. As derivatives are mark-to-market, the large swings in commodity prices can expose them to significant and frequent margin calls. Commodity traders’ extensive usage of derivative strategies and over-reliance on bank funding can cause system-wide liquidity vulnerabilities.

Derivatives strip the risks from collateral and make them the backbone of secured funding. Nonetheless, the engineering of derivatives, especially their mark-to-market feature, makes them an essential linkage between markets for risk and markets for liquidity. Mark-to-market creates extra and unpredictable daily cash flows and can hide the true extent of liquidity risk in the system. And finally, derivatives can distribute risks between the commodity and financial markets. Derivatives link the flows of collateral, fund, risk, and commodities. Therefore, in this financial stability framework, we examine the “net” impact of derivatives on the quality of all these flows. Financial stability models that examine the role of derivatives without such a holistic view are limited in their effectiveness in monitoring systemic risks.

  1. The Flow of Fund: Financial Intermediation Is an Inherently Hierarchical Structure

The flow of funding across the system is a determinant of system-wide fluidity. The seamlessness of this flow depends on the quality of the monetary liabilities in circulation. This quality changes as the structures in the market for financial intermediation, such as the composition of players, activities, etc., evolve. The flow of funding is a layer of the flow of collateral, the backbone of secured lending. Nonetheless, it is based on somewhat different structures. The defining feature of collateral flows (and market liquidity) is that it is delivered in the long-term capital market. On the other hand, funding is provided in the short-term money market. At the same time, the flow of both funding and collateral depends on the quality of assets that underlie them. The shiftability of funding depends on the quality of monetary liabilities in circulation. Nonetheless, similar to the quality of different collaterals, monetary liabilities’ quality can vary widely. This framework focuses on the market microstructure that generates this inequality. 

The microstructure of the funding market is defined as how the different traders (both on the sell-side and buy-side) share their responsibilities and roles. In the financial ecosystem, short-term monetary liabilities are produced, traded, and priced in the market for financial intermediation. In this market, both sell-side (liquidity providers) and buy-side (liquidity takers) constitute the pipeline that moves funds across the system. The market for short-term funding, known as the market for financial intermediation in the literature, has two sides: the buy-side and the sell-side. The buy-side is made of buyers of financial intermediation and funding, such as asset managers. They are the liquidity takers.

In contrast, the sell-side, made of banks, dealers, and brokers, are the providers of financial intermediation. These firms provide liquidity and shed light on the market valuation of monetary instruments. Indeed, the business model of liquidity providers is so crucial for liquidity conditions that it has been the primary motivation behind practitioners’ monitoring of market microstructure evolutions. The resilience of the pipeline that moves funding depends on the dynamics of both the sell-side and buy-side. 

In the real world, not all the players on the sell-side provide the same quality of funding liquidity. The hierarchy of liquidity providers, ranked by their business model and the type of intermediation, is an essential characteristic of the financial intermediation industry. Some type of financial intermediation does not lead to a stable provision of traded liquidity. For instance, a traditional financial intermediary simply connects cash-rich to cash-deficit agents rather than making the market for funding. Similarly, the modern brokerage business only connects different counterparties and provides information about fair prices through financial analysis. These sell-side entities provide liquidity only by connecting traders with opposing needs. This type of intermediation provides conditional liquidity.

In contrast, market makers, including dealers, are the source of continuous liquidity. This is because they are uninformed (unbiased) liquidity providers and trade liquidity with any interested trader. When a dealer warehouses monetary instruments, it creates positions, a book, in those instruments. In this case, the dealer establishes long positions in certain assets and short in others. By running an inventory book, a dealer incurs certain risks. It does so to earn a reward- profits. As long as a monetary liability is in a dealer’s book, that liability creates some credit risk for the dealer. Whether the dealer sheds that credit risk when it trades out the claims depends on factors beyond the dealer’s control. Nonetheless, this is how they make the market. Market makers, such as dealers, use their balance sheets and absorb unwanted inventories for a reward. In doing so, they provide continuous liquidity, prices, and liquidity risk premia. This puts market-makers at the top of the sell-side hierarchy. Other intermediaries that provide conditional liquidity are at the lower layer.

Similarly, the buy-side’s access to funding is hierarchical for two reasons First, not all monetary liabilities in circulation have high quality. Second, high-quality funding is unequally distributed. The scale of access captures both dynamics. For example, some financial firms at the top of the hierarchy have access to highly convertible and liquid monetary instruments, including central bank reserves. Others, however, should pick mostly from a menu of shadow funds. Shadow funds are expensive and provided by low-rated and unstable liquidity providers. 

The frontier between access to high-quality liquidity and shadow funds is blurry during standard periods. In these times, the elasticity of credit and the high velocity of shadow funds (the frequency at which these funds are traded within a given period) makes the hierarchy non-binding and invisible. In contrast, during a crisis, the double hierarchies of the sell-side and buy-side bind simultaneously and to the fullest extent. In this period, not only does the separation of roles between the sell-side and buy-side become unmistakable, but the different qualities of liquidities in circulation also become evident. When this happens, the pipeline and infrastructure that circulates funding, in dynamics between the sell-side and buy-side, become the vessel for moving liquidity risk across the system. 

The linkage between the sell-side and buy-side, rather than the resilience of a few systematically important financial institutions, can aggravate an otherwise idiosyncratic funding problem in one layer into a system-wide liquidity crisis. Understanding the linkages between funding, collateral, and derivatives of the financial web is necessary for exploring the financial system as a dynamic process rather than a snapshot. To understand the financial ecosystem, we first must map and surveil interactions between different entities rather than the balance sheet of a few systemically essential firms in isolation and the transformation of collateral, derivatives, and funding to varying layers of the ecosystem. Our systemic fluidity framework shows the complex movements and shifts. In contrast, the financial industry typically focuses on cash and balance sheet items that do not capture the fluidity of these collective elements. 

  1. The Flow of Payment: Junk Liquidity Siphons Off Public Claims

The flow of payments is the last element of systemic fluidity. The payment system is the real-life stress test of the system-wide tendency to hoard junk liquidity and siphon off high-quality claims. The financial system continually transforms public claims into private claims. These private IOUs can be either safe and secured by collaterals or unsecured. Significantly, this transformation happens through two different channels: the payment processing system and the firms’ liquidity and payment solutions. First, the payment system has two layers: payment and settlement. In the meantime, the quality of claims in the first stage is usually lower than in the final stage. Second, firms’ liquidity and payment solutions continually transform their balance sheets’ liquidity and maturity. Both these channels and structures tend to hoard bogus liquidity and siphon off public liquidity. Nevertheless, the system’s quality and the flow of payments depend on the trust that relatively safe and secured monetary liabilities exist at every layer. These claims are from collateral-taking private entities or the government’s presence as a lender of last resort. 

The liquidity transformation that occurs in the system has two separate roots. The first component is the intrinsic feature of the payment system. Every payment starts and ends with liquidity. However, the quality of funding instruments required to settle each stage differs. Payments are processed in two phases. The first stage, known as the payment stage, is when the promise to make the final payment is made. These promises to pay are usually funded by exchanging collateral (secured funding) or short-term monetary liabilities (unsecured financing). At this stage, at each layer of the hierarchy, payments happen as a conversion of the lower-quality liabilities into higher-quality ones (issued by entities at the higher layer of the sell-side hierarchy). In the first stage, the hierarchical structure of funding instruments remains invisible. 

However, this hierarchy becomes binding in the final stage of payment. At this stage, the final settlement, all the net payments, should be settled and cleared. The final clearance happens only if the payment system can convert the remaining payments into the highest-quality form of money, such as the central bank’s reserve or cash. A systemic problem will happen if this convertibility is not economical. In this case, the conversion, if it happens, will be at a penalty or negotiable at prices lower than par and cause system-wide missed payments. The continuity of liquidity transformation in the first and last stages of payments determines the resilience of payment flows. The payment flows seamlessly only if there is a systemic trust that relatively safe and secured monetary liabilities exist at every layer.

The second channel reflects the corporates’ cash management strategies. Various types of financial and non-financial participants are involved in the payments ecosystem. Importantly, all these large firms use somewhat similar liquidity and payment solutions to meet their daily cash flow constraints. For instance, the two core and standard liquidity management techniques are netting and cash pooling. Netting aims to reduce funds transfer between subsidiaries or separate companies by settling the funds to a net amount. Cash pooling allows enterprises to combine positive and negative positions from various bank accounts into one account. This aims to reduce short-term borrowing costs and maximize returns on short-term cash. Corporate treasurers’ payment solutions, an often overlooked aspect of systemic risk, link the business models of otherwise wildly divergent firms with each other. As a result, the liquidity transformation that happens at the firm level can leave industry-level footprints on the payments system.

Corporate treasurers manage liquidity and payment costs by not leaving liquid assets uninvested for at least two reasons. First, the monetary instruments earn very low-interest rates. Second, the wholesale cash is uninsured and exposes the corporates to credit risk. If and when funding is required to ensure the payment accounts remain in a positive balance position, they convert these investments back to more cash-like instruments. As a result, they change the level of liquidity transformation daily and expose the system to systemic forecasting errors. 

In standard times, these strategies might not be consequential. Large corporates have access to short-term money market funding. In this system, money market dealers act as the ultimate corporate treasurers and correct their cash flow miscalculations. In doing so, money market dealers become the linkage between payment flows and short-term funding. In crisis times, however, this link might break. Under such circumstances, market makers usually exit the market. In this case, the full force of the liquidity mismatch embedded in the financial ecosystem becomes visible to everyone. Corporate treasures’ liquidity and payment strategies can expand the current level of liquidity transformation in the ecosystem and make its management unsustainable. In such circumstances, the payment system that inherently depends on the system-wide ability to manage such transformation will break down. 

  1. Conclusion 

Although invisible, market microstructure is the infrastructure underlying the financial system. In particular, its destabilizing dynamics can vividly disrupt the financial system’s fluidity captured by the (1) shiftability of collateral, (2)  the distribution of risk, (3) the transmission of liquidity, and (4) the payment flows. Although these four pillars of systemic fluidity can be examined separately and selectively, they are inseparable features of real-world market structure. At the same time, one of the byproducts of recent microstructure evolutions, and the consequent turmoils, is that it has demanded us to merge our academic and practical perspectives to uncover how the system works as a whole. 

Derivatives and collaterals are inseparable backbones of financial stability. In a complete market, market participants trade collaterals and hedge risk exposures by entering derivatives contracts. Therefore, systemic risk can be understood as the residual risk left in a portfolio when all the other risks have been hedged through all possible derivative strategies. In this environment, the financial stability models focus on the unhedged and uncovered risks in the balance sheets of a few systemically important entities. However, in our model, the derivatives’ role as systemic stabilizers goes beyond these micro, firm-specific unhedged positions. Instead, the stress is on the resilience of the market structure that enables the trading and engineering of such instruments in the first place. The idea is that these infrastructures facilitate or jeopardize the derivatives’ capacity to “shift” risk across the financial system. Further, institutional details, such as the trading mechanism and the dealing system, determine whether derivatives are the vehicles of risk distribution or the sources of systemic risks.

Systemic fluidity also depends on the flow of funds. This framework examines two inherent characteristics of the market structure that determine the ability of the system to shift funds. The first feature is the hierarchy of financial intermediation. The hierarchy captures the notion that not all intermediaries provide and move liquidity equally efficiently. The second premise is the hierarchy of access to liquidity- an idea that not all intermediaries have access to high-quality monetary claims. These hierarchies make liquidity risks and premiums vital features of the financial system. Liquidity risks arise when a financial institution cannot meet its obligations without incurring unacceptable losses. However, not all liquidity risks become systemic. Instead, they threaten the financial ecosystem when the transmission and flow of funds are structurally impaired. 

The financial system is inherently hierarchical. The dynamics of the hierarchies, whether they impose discipline or elasticity into the system, systemically affect liquidity distribution. Liquidity risk can tax firms’ daily cash flow management and lead to systemic missed payments. All payments have two stages which start and end with liquidity. In the first stage, payments are made by being postponed. In other words, institutions make their payments using credit instruments that can be convertible to more liquid assets. However, in the last stage, the financial system should settle and clear the remaining net payments. In this final settlement stage, only the best form of monetary claims can clear the payments. Therefore, the liquidity mismatch, and its dynamics, are the key to making or breaking the payment system.

To sum up, JFI’s Market Structure project introduces a financial stability framework based on the quality of the market structure, as apparent in the breadth of its fluidity. The program surveils this quality by examining the flows of collateral, risk, fund, and payments. Our forward-looking financial stability framework differs from other financial stability models with preventive rather than an after-the-fact compass. Market structure is the epicenter rather than an unwelcome complexity of our framework. This approach categorizes vulnerabilities as structural, cyclical, and event-driven. Therefore, instead of monitoring liquidity and volatility indicators, we look inside the black box of the market structure, where market participants and regulators’ tangible and pressing concerns are rooted.

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Elham's Money View Blog

The Fed is the Treasury’s Bank. Does it Matter for the Dollar’s Global Status?

By Elham Saeidinezhad

There is a consensus amongst the economist that the shadow banking system and the repurchase agreements (repos) have become the pinnacle of the dollar funding. In the repo market, access to liquidity depends on the firms’ idiosyncratic access to high-quality collateral, mainly U.S. Treasuries, as well as the systemic capacity to reuse collateral. Yet, the emergence of the repo market, which is considered an offshore credit system, and the expectations of higher inflation, have sparked debates about the demise of the dollar. The idea is that the repo market is becoming less attractive from an accounting and risk perspective for a small group of global banks, working as workhorses of the dollar funding network. The regulatory movement after the Great Financial Crisis (GFC), including leverage ratio requirements and liquidity buffers, depressed their ability to take counterparty risks, including that of the repo contracts. Instead, large banks are driven to reduce the costs of maintaining large balance sheets.

This note argues that the concerns about the future of the dollar might be excessive. The new monetary architecture does not structurally reduce the improtance of the U.S. government liabilities as the key to global funding. Instead, the traditional status of the dollar as the world’s reserve currency is replaced by the U.S. Treausies’ modern function as the world’s safest asset and the pinnacle of the repo market. Lastly, I put the interactions between the Fed’s roles as the manager of the government’s debt on the one hand and monetary policy architect on the other at the center of the analysis. Recognizing the interconnectedness could deepen our understanding of the Fed’s control over U.S. Treasuries.

As a result of the Bretton Woods Agreement, the dollar was officially crowned the world’s reserve currency. Instead of gold reserves, other countries accumulated reserves of dollars, the liability of the U.S. government. Till the mid-1980s, the dollar was at the top of the monetary hierarchy in both onshore and offshore financial systems. In the meantime, the dollar’s reserve status remained in an natural way. Outside the U.S., a few large global banks were supplying dollar funding to the rest of the world. This offshore bank-oriented system was called the Eurodollar market. In the U.S., the Federal Funds market, an interbank lending market, became the pinnacle of the onshore dollar funding system. The Fed conducted a simple monetary policy, detached from the capital market, and managed exclusively within the traditional banking system.

Ultimately, events never quite followed this smooth pattern, which in retrospect may not be regretted. The growth of shadow banking system meant that international investors reduced their reliance on bank loans in the Eurodollar markte. Instead, they turned to the repo market and the FX swaps market. In the U.S., the rise of the repo market implied that the U.S. monetary policy should slowly leak into capital market and directly targe the security dealers. At the heart of this structural break was the growing acceptance of the securities as collaterals.

Classical monetary economics proved to be handicapped in detecting this architectural development. According to theories, the supply of the dollar is determined in the market for the loanable funds where large banks act as financial intermediaries and stand between savers and borrowers. In the process, they set the price of the dollar funding. Regarding the global value of the dollar, as long as the Fed’s credibility in stabilizing prices exceeds its peers, and Treasury keeps its promises to pay, the global demand for the dollar will be significant. And the dollar will maintain its world reserve currency status. These models totally overlooked the role of market-makers, also called dealers, in providing short-term liquidity. However, the rise of the shadow banking system made such an abstraction a deadly flaw. In the new structure, the dealers became the de facto providers of the dollar funding.

Shadow banking created a system where the dealers in the money market funded the securities lending activities of the security dealers in the capital market. This switch from traditional banking to shadow banking unveiled an inherent duality in the nature of the Fed. The Fed is tasked to strike a balance between two rival roles: On the one hand, the Fed is the Treasury’s banker and partially manages U.S. debt. On the other hand, it is the bankers’ bank and designs monetary policy. After the financial crises of the 1980s and 1990s, the Fed tried to keep these roles divided as separate arms of macroeconomic policy. The idea was that the links between U.S. debt management and liquidity are weak, as the money market and capital market are not interconnected parts of the financial ecosystem. This weak link allowed for greater separation between monetary policy and national debt management.

The GFC shattered this judgment and exposed at least two features of shadow banking. First, in the new structure, the monetary condition is determined in the repo market rather than the banking system. The repo market is very large and the vast majority of which is backed by U.S. Treasuries. This market finances the financial market’s primary dealers’ large holdings of fixed-income securities. Second, in the new system, U.S. Treasuries replaced the dollar. The repo instruments are essentially short-term loans secured by liquid “collateral”. Although hedge funds and other types of institutional investors are important suppliers of collateral, the single most important issuer of high quality, liquid collateral, is the U.S. Treasury.

U.S. Treasury securities have become the new dollar. Hence, its velocity began to matter. The velocity of collateral, including U.S. Treasuries, is the ratio of the total pledged collateral received by the large banks (that is eligible to be reused), divided by the primary collateral (ie, sourced via reverse repos, securities borrowing, prime brokerage, and derivative margins). Before the GFC, the use (and reuse) of pledged collateral was comparable with the velocity of monetary aggregates like M2. The “reusability” of the collateral became instrumental to overcome the good collateral deficit.

After the GFC, the velocity of collateral shrank due to the Fed’s QE policies (involving purchases of bonds) and financial regulations that restricted good collateral availability. Nontheless, the availability of collateral surpassed the importance of private credit-creation in the traditional banking system. It also started to leak into the monetary policy decision-making process as the Fed started to consider the Treasury market condition when crafting its policies. At first glance, the Treasury market’s infiltration into monetary policy indicates a structural shift in central banking. First, the Treasury market is a component of the capital market, not the money market. Second, the conventional view of the Fed’s relationship with the Treasury governs that its responsibilities are mainly limited to managing the Treasury account at the Fed, running auctions, and acting as U.S. Treasuries registrar.

However, a thorough study of the traditional monetary policy would paint a different picture of the Fed and the U.S. Treasuries. Modern finance is only making the Fed’s role as a de-facto U.S. national debt manager explicit. The Fed’s primary monetary policy tool, the open market operation, is essentially monetizing national debt. Essentially, the tool enabled the Fed to monetize some portion of the national debt to control the quantity of bank reserves. The ability to control the level of bank reserves permitted the Fed to limit the level of bank intermediation and private credit creation. This allowed the Fed to focus on compromising between two objectives of price stability and full employment.

What is less understood is that the open market operation also helped the Fed’s two roles, Treasury’s bank and the bankers’ bank, to coexist privately. As private bankers’ bank, the Fed designs monetary policy to control the funding costs. As the Treasury’s bank, the Fed is implicitly responsible for U.S. debt management. The open market operation enabled the Fed to control money market rates while monetizing some portion of the national debt. The traditional monetary system simply helped the Fed to conceal its intentions as Treasury’s bank when designing monetary policy.

The point to emphasize is that the traditional central banking was only hiding the Fed’s dual intentions. The Fed could in theory monetize anything— from gold to scrap metals—but it has stuck largely to Treasury IOUs. One reason is that, unlike gold, there has never been any shortage of them. Also, they are highly liquid so the Fed can sell them with as much ease as it buys them. But, a third, and equally important reason is that in doing so, the Fed explicitly fulfilled its “role” as the manager of the U.S. national debt. All this correctly suggests that the Fed, despite its lofty position at the pinnacle of the financial system, has always been, and is, none other than one more type of financial intermediary between the government and the banking system.

The high-level relationship between the Treasury and the Fed is “inherent” and at the heart of monetary policy. Yet, nowhere along the central banking learning curve has been a meaningful examination of the right balances between the Fed’s two roles. The big assumption has been that these functions are distinctly separated from each other. This hypothesis held in the past when the banks stood between savers and borrowers as financial intermediaries. In this pre-shadow banking world, the money market and capital market were not interconnected.

Yet, the GFC revealed that more than 85 percent of the lending was based on securities lending and other credit products, including the repo. In repo, broker-dealers, hedge funds, and banks construct short-term transactions. They put up collateral—mostly U.S. Treasury securities —with an agreement to buy them back the next day or week for slightly more, and invest the proceeds in the interim. The design and conduct of the monetary policy intimately deepened on the availability and price of the U.S. Treasuries, issues at the heart of the U.S. national debt management.

The U.S. debt management and monetary policy reunion happened in the repo market. In a sense, repo is a “reserve-less currency system,” in the global funding supply chain. It is the antithesis of the reserve currency. In traditional reserve currency, central banks and major financial institutions hold a large amount of currency to use for international transactions. It is also ledger money which indicates that the repo transactions, including the securities lending of its, are computed digitally by the broker-dealers. The repo market is a credit-based system that is a reserve-less, currency-less form of ledger money.

In this world of securities lending, which has replaced traditional bank lending, the key instrument is not the dollar but the U.S. Treasury securities that are used as collateral. The U.S. national debt is being used to secure funding for private institutional investors. Sometimes lenders repledge them to other lenders and take out repo loans of their own. And the cycle goes on. Known as rehypothecation, these transfers used to be done once or twice for each posted asset but are now sometimes done six to eight times, each time creating a new money supply. This process is the de-facto modern money creation—and equally depends on the Fed’s role as Treasury’s bank and bankers’ bank.

Understanding how modern money creation works has implications for the dollar’s status in the international monetary system. Some might argue that the dollar is losing its status as the global reserve currency. They refer to the collateralized repo market and argue that this market allows international banks operating outside the supervision of the Fed to create US dollar currency. Hence, the repo, not the dollar, is the real reserve currency. Such statements overlook the repo market’s structural reliance on the U.S. Treasury securities and neglect the Fed’s role as the de-facto manager of these securities. Shadow banking merely replaced the dollar with the U.S. Treasuries as the world’s key to funding gate. In the meantime, it combined the Fed’s two roles that used to be separate. Indeed, the shadow banking system has increased the importance of U.S. institutions.

The rising dominance of the repo market in the global funding supply chain, and the decline in collateral velocity, implies that the viability of the modern Eurodollar system depends on the U.S. government’s IOUs more than any time in history. US Treasuries, the IOU of the US government, is the most high-quality collateral. When times are good, repos work fine: The agreements expire without problems and the collateral gets passed back down the chain smoothly. But eventually, low-quality collateral lurks into the system. That’s fine, until markets hit an inevitable rough patch, like, March 2020 “Dash for Cash” episode. We saw this collateral problem in action. In March credit spreads between good and junkier debt widened and Treasury prices spiked as yields plummeted because of the buying frenzy. The interest rate on one-month Treasurys dropped from 1.61% on Feb. 18 to 0.00% on March 28. That was the scramble for good collateral. The reliance on the repo market to get funding indicates that no one will take the low-quality securities, and everyone struggles for good collateral. So whenever uncertainty is high, there will be a frenetic dash to buy Treasurys—like musical chairs with six to eight buyers eagerly eyeing one chair.

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Elham's Money View Blog

Can “Money View” Provide an Alternative Theory of Capital Structure?

By Elham Saeidinezhad

Liquidity transformation is a crucial function for many banks and non-bank financial intermediaries. It is a balance sheet operation where the firm creates liquid liabilities financed by illiquid assets. However, liquidity transformation is a risky operation. For policymakers and macroeconomists, the main risk is to financial stability caused by systemic liquidation of assets, also called “firesale.” In this paper, I emphasize an essential characteristic of firesale that is less explored—the order of liquidation. The order of liquidation refers to the sequence at which financial assets are converted into cash or cash equivalents- when the funds face significant cash outflow. Normally, economists explain assets’ order of liquidation by using theories of capital structure. However, the financial market episodes, such as March 2020 “Cash for Dash,” have revealed that firms’ behaviors are not in line with the predictions of such classical theories. Capital structure theories, such as “Pecking Order” and “Trade-off,” argue that fund managers should use their cash holding as the first line of defense during a liquidity crunch before selling their least liquid asset. In contrast to such prophecies, during the recent financial turmoil, funds liquidated their least liquid assets, even US Treasuries, first, before unhoarding their cash and cash equivalents. In this paper, I explore a few reasons that generated the failure of these theories when explaining funds’ behavior during a liquidity crisis. I also explain why Money View can be used to build an alternative framework.

Traditional capital structure theories such as pecking order differentiate financial assets based on their “adverse selection” and “information costs” rather than their “liquidity.” The pecking order theory is from Myers (1984) and Myers and Majluf (1984). Since it is famous, I will be brief. Assume that there are two funding sources available to firms whenever they hit their survival constraint: cash (or retained earnings) and securities (including debt and equity). Cash has no “adverse selection” problem, while securities, primarily equity, are subject to serious adverse selection problems. Compared to equity, debt securities have only a minor adverse selection problem. From the point of view of an external investor, equity is strictly riskier than debt. Both have an adverse selection risk premium, but that premium is significant on equity. Therefore, an outside investor will demand a higher rate of return on equity than on debt. From the perspective of the firm’s managers, the focus of our paper, cash is a better source of funds than is securities. Accordingly, the firm would prefer to fund all its payments using “cash” if possible. The firm will sell securities only if there is an inadequate amount of cash.

In the trade-off theory, another popular conventional capital structure theory, a firm’s decision is a trade-off between tax-advantage and capital-related costs. In a world that firms follow trade-off theory, their primary consideration is a balance between bankruptcy cost and tax benefits of debt. According to this approach, the firm might optimize its financing strategies, including whether to make the payments using cash or securities, by considering tax and bankruptcy costs. In most cases, these theories suggest that the firms prefer to use their cash holdings to meet their financial obligations. They use securities as the first resort only if the tax benefit of high leverage exceeds the additional financial risk and higher risk premiums. The main difference between pecking order theory and trade-off theory is that while the former emphasizes the adverse selection costs, the latter highlights the high costs of holding extra capital. Nonetheless, similar to the pecking order theory, the trade-off theory predicts that firms prefer to use their cash buffers rather than hoarding them during a financial crisis.

After the COVID-19 crisis, such predictions became false, and both theories underwent a crisis of their own. A careful examination of how funds, especially intermediaries such as Money Market Funds, or MMFs, adjusted their portfolios due to liquidity management revealed that they use securities rather than cash as the first line of defense against redemptions. Indeed, such collective behavior created the system-wide “dash for cash” episode in March 2020. On that day, few funds drew down their cash buffers to meet investor redemptions. However, contrary to pecking order and trade-off theories, most funds that faced redemptions responded by selling securities rather than cash. Indeed, they sold more of the underlying securities than was strictly necessary to meet those redemptions. As a result, these funds ended March 2020 with higher cash levels instead of drawing down their cash buffers.

Such episodes cast doubt on the conventional theories of capital structure for liquidity management, which argues that funds draw on cash balances first and sell securities only as a last resort. Yet, they align with Money View’s vision of the financial hierarchy. Money View asserts that during the financial crisis, preservation of cash, the most liquid asset located at the top of the hierarchy, will be given higher priority. During regular times, the private dealing system conceals such priorities. In these periods, the private dealing system uses its balance sheets to absorb trade imbalances due to the change in preferences to hold cash versus securities. Whenever the demand for cash exceeds that of securities, the dealers maintain price continuity by absorbing the excess securities into their balance sheets. Price continuity is a characteristic of a liquid market in which the bid-ask spread, or difference between offer prices from buyers and requested prices from sellers, is relatively small. Price continuity reflects a liquid market. In the process, they can conceal the financial hierarchy from being in full display.

During the financial crisis, this hierarchy will be revealed for everyone to see. In such periods, the dealers cannot or are unwilling to use their job correctly. Due to the market-wide pressing need to meet payment obligations, the trade imbalances show up as an increased “qualitative” difference between cash and securities. In the course of this differentiation, there is bound to be an increase in the demand for cash rather than securities, a situation similar to the “liquidity trap.” A liquidity trap is a situation, described in Keynesian economics, in which, after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest. In this environment, investors would prefer to reduce the holding of their less liquid assets, including US Treasuries, before using their cash reserves to make their upcoming payments. Thus, securities will be liquidated first, and cash will be used only as a last resort.

The key to understanding such behaviors by funds is recognizing that the difference in the quality of the financial instruments’ issuers creates a natural hierarchy of financial assets. This qualitative difference will be heightened during a crisis and determines the capital structure of the funds, and the “order of liquidation” of the assets, for liquidity management purposes. When the payments are due and liquidity is scarce, firms sell illiquid assets ahead of drawing down the cash balances. In the process, they disrupt money markets, including repo markets, as they put upward pressure on the price of cash in terms of securities. Thus, during a crisis, the liability of the central banks becomes the most attractive asset to own. On the other hand, securities, the IOUs of the private sector, become the less desirable asset to hold for asset managers.

So why do standard theories of capital structure fail to explain firms’ behavior during a liquidity crisis? First, they focus on the “fallacious” type of functions and costs during a liquidity crunch. While the dealers’ “market-making” function and liquidity are at the heart of Money View, the standard capital structure theories stress the “financial intermediation” and “adverse selection costs.” In this world, the “ordering” of financial assets to be liquidated may stem from sources such as agency conflicts and taxes. For Money View, however, what determines the order of firesaled assets, and the asset managers’ portfolio is less the agency costs and more the qualitative advantage of one asset than another. The assets’ status determines such qualitative differences in the financial hierarchy. By disregarding the role of dealers, standard capital structure models omit the important information that the qualitative difference between cash and credit will be heightened, and the preference will be changed during a crisis.

Such oversight, mixed with the existing confusion about the non-bank intermediaries’ business model, will be fatal for understanding their behavior during a crisis. The difficulty is that standard finance theories assume that non-bank intermediaries, such as MMFs, are in the business of “financial intermediation,” where the risk is transferred from security-rich agents to cash-rich ones. Such an analysis is correct at first glance. However, nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by price changes rather than by traditional intermediation. A careful review of the MMFs balance sheets can confirm this viewpoint. Such examination reveals that these funds, rather than transforming the risks, “pool” them. Risk transformation is a defining characteristic of financial intermediation. Yet, even though it appears that an MMF is an intermediary, it is mainly just pooling risk through diversification and not much transforming risk.

Comprehending the MMF’s business as pooling the risks rather than transforming them is essential for understanding the amount of cash they prefer to hold. The MMF shares have the same risk properties as the underlying pool of bonds or stocks by construction. There is some benefit for the MMF shareholders from diversification. There is also some liquidity benefit, perhaps because open-end funds typically promise to buy back shares at NAV. But that means that MMFs have to keep cash or lines of credit for the purpose, even though it will lower their return and increase the costs for the shareholders.

Finally, another important factor that drives conventional theories’ failure is their concern about the cash flow patterns in the future and the dismissal of the cash obligations today. This is the idea behind the discounting of future cash flows. The weighted average cost of capital (WACC), generally used in these theories, is at the heart of discounting future cash flows. In finance, discounted cash flow analysis is a method of valuing security, project, company, or asset using the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management, and patent valuation. In this world, the only “type” of cash flow that matters is the one that belongs to a distant future rather than the present, when firms should make today’s payments. On the contrary, the present, not the future, and its corresponding cash flow patterns, is what Money View is concerned about. In Money View’s world, the firm should be able to pay its daily obligations. If it does not have continuous access to liquidity and cannot meet its cash commitments, there will be no future.

The pecking order theory derives much of its influence from a view that it fits naturally with several facts about how companies use external finance. Notably, this capital structure theory derives support from “indirect” sources of evidence such as Eckbo (1986). Whenever the theories are rejected, the conventional literature usually attributes the problem to cosmetic factors, such as the changing population of public firms, rather than fundamental ones. Even if the pecking order theory is not strictly correct, they argue that it still does a better job of organizing the available evidence than other theories. The idea is that the pecking order theory, at its worst, is the generalized version of the trade-off theory. Unfortunately, none of these theories can explain the behavior of firms during a crisis, when firms should rebalance their capital structure to manage their liquidity needs.

The status of classical theories, despite their failures to explain different crises, is symptomatic of a hierarchy in the schools of economic thought. Nonetheless, they are unable to provide strong capital structure theories as they focus on fallacious premises such as the adverse selection or capital costs of an asset. To build theories that best explain the financing choices of corporates, economists should emphasize the hierarchical nature of financial instruments that reliably determines the order of liquidation of financial assets. In this regard, Money View seems to be positioned as an excellent alternative to standard theories. After all, the main pillars of this framework are financial hierarchy, dealers, and liquidity management.

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Elham's Money View Blog Search For Stable Liquidity Providers Series

Do Distributional Effects of Monetary Policy Passthrough Debt than Wealth?

By Elham Saeidinezhad

Who has access to cheap credit? And who does not? Compared to small businesses and households, global banks disproportionately benefited from the Fed’s liquidity provision measures. Yet, this distributional issue at the heart of the liquidity provision programs is excluded from analyzing the recession-fighting measures’ distributional footprints. After the great financial crisis (GFC) and the Covid-19 pandemic, the Fed’s focus has been on the asset purchasing programs and their impacts on the “real variables” such as wealth. The concern has been whether the asset-purchasing measures have benefited the wealthy disproportionately by boosting asset prices. Yet, the Fed seems unconcerned about the unequal distribution of cheap credits and the impacts of its “liquidity facilities.” Such oversight is paradoxical. On the one hand, the Fed is increasing its effort to tackle the rising inequality resulting from its unconventional schemes. On the other hand, its liquidity facilities are being directed towards shadow banking rather than short-term consumers loans. A concerned Fed about inequality should monitor the distributional footprints of their policies on access to cheap debt rather than wealth accumulation.

Dismissing the effects of unequal access to cheap credit on inequality is not an intellectual mishap. Instead, it has its root in an old idea in monetary economics- the quantity theory of money– that asserts money is neutral. According to monetary neutrality, money, and credit, that cover the daily cash-flow commitments are veils. In search of the “veil of money,” the quantity theory takes two necessary steps: first, it disregards the payment systems as mere plumbing behind the transactions in the real economy. Second, the quantity theory proposes the policymakers disregard the availability of money and credit as a consideration in the design of the monetary policy. After all, it is financial intermediaries’ job to provide credit to the rest of the economy. Instead, monetary policy should be concerned with real targets, such as inflation and unemployment.

Nonetheless, the reality of the financial markets makes the Fed anxious about the liquidity spiral. In these times, the Fed follows the spirit of Walter Bagehot’s “lender of last resort” doctrine and facilitates cheap credits to intermediaries. When designing such measures, the Fed’s concern is to encourage financial intermediaries to continue the “flow of funds” from the surplus agents, including the Fed, to the deficit units. The idea is that the intermediaries’ balance sheets will absorb any mismatch between the demand-supply of credit. Whenever there is a mismatch, a financial intermediary, traditionally a bank, should be persuaded to give up “current” cash for a mere promise of “future” cash. The Fed’s power of persuasion lies in the generosity of its liquidity programs.

The Fed’s hyperfocus on restoring intermediaries’ lending initiatives during crises deviates its attention from asking the fundamental question of “whom these intermediaries really lend to?” The problem is that for both banks and non-bank financial intermediaries, lending to the real economy has become a side business rather than a primary concern. In terms of non-bank intermediaries, such as MMFs, most short-term funding is directed towards shadow banking businesses of the global banks. Banks, the traditional financial intermediaries, in return, use the unsecured, short-term liquidity to finance their near-risk-free arbitrage positions. In other words, when it comes to the “type” of borrowers that the financial intermediaries fund, households, and small-and-medium businesses are considered trivial and unprofitable. As a result, most of the funding goes to the large banks’ lucrative shadow banking activities. The Fed unrealistically relies on financial intermediaries to provide cheap and equitable credit to the economy. In this hypothetical world, consumers’ liquidity requirements should be resolved within the banking system.

This trust in financial intermediation partially explains the tendency to overlook the equitability of access to cheap credit. But it is only part of the story. Another factor behind such an intellectual bias is the economists’ anxiety about the “value of money” in the long run. When it comes to the design of monetary policy, the quantity theory is obsessed by the notion that the only aim of monetary theory is to explain those phenomena which cause the value of money to alter. This tension has crept inside of modern financial theories. On the one hand, unlike quantity theory, modern finance recognizes credit as an indispensable aspect of finance. But, on the other hand, in line with the quantity theory’s spirit, the models’ main concern is “value.”

The modern problem has shifted from explaining any “general value” of money to how and when access to money changes the “market value” of financial assets and their issuers’ balance sheets. However, these models only favor a specific type of agent. In this Wicksellian world, adopted by the Fed, agents’ access to cheap credit is essential only if their default could undermine asset prices. Otherwise, their credit conditions will be systemically inconsequential, hence neutral. By definition, such an agent can only be an “institutional” investor who’s big enough so that its financial status has systemic importance. Households and small- and medium businesses are not qualified to enter this financial world. The retail depositors’ omission from the financial models is not a glitch but a byproduct of mainstream monetary economics.

The point to emphasize is that the Fed’s models are inherently neutral about the distributional impacts of credit. They are built on the idea that despite retail credit’s significance for retail payment systems, their impacts on the economic transactions are insignificant. This is because the extent of retail credit availability does not affect real variables, including output and employment, as the demand for this “type” of credit will have proportional effects on all prices stated in money terms. On the contrary, wholesale credit underpin inequality as it changes the income and wealth accumulated over time and determines real economic activities.

The macroeconomic models encourage central bankers to neglect any conditions under which money is neutral. The growing focus on inequality in the economic debate has gone hand in hand to change perspective in macroeconomic modeling. Notably, recent research has moved away from macroeconomic models based on a single representative agent. Instead, it has focused on frameworks incorporating heterogeneity in skills or wealth among households. The idea is that this shift should allow researchers to explore how macroeconomic shocks and stabilization policies affect inequality.

The issue is that most changes to macroeconomic modeling are cosmetical rather than fundamental. Despite the developments, the models still examine inequality through income and wealth disparity rather than equitable access to cheap funding. For small businesses and non-rich consumers, the models identify wealth as negligible. Nonetheless, they assume the consumption is sensitive to income changes, and consumers react little to changes in the credit conditions and interest rates. Thus, in these models, traditional policy prescriptions change to target inequality only when household wealth changes.

At the heart of the hesitation to seriously examine distributional impacts of equitable access to credit is the economists’ understanding that access to credit is only necessary for the day-to-day operation of the payments system. Credit does not change the level of income and wealth. In these theories, the central concern has always been, and is, solvency rather than liquidity. In doing so, these models dismiss the reality that an agent’s liquidity problems, if not financed on time and at a reasonable price, could lead to liquidations of assets and hence insolvency. In other words, retail units’ access to credit daily affects not only the retail payments system but also the units’ financial wealth. Even from the mainstream perspective, a change in wealth level would influence the level of inequality. Furthermore, as the economy is a system of interlocking balance sheets in which individuals depend on one another’s promises to pay (financial assets), their access to funding also determines the financial wealth of those who depend on the validations of such cash commitments.

Such a misunderstanding about the link between credit accessibility and inequality is a natural byproduct of macroeconomic models that omit the payment systems and the daily cash flow requirement. Disregarding payment systems has produced spurious results about inequality. In these models, access to liquidity, and the smooth payment systems, is only a technicality, plumbing behind the monetary system, and has no “real” effects on the macroeconomy.

The point to emphasize is that everything about the payment system, and access to credit, is “real”: first, in the economy as a whole, there is a pattern of cash flows emerging from the “real” side, production and consumption, and trade. A well-functioning financial market enables these cash flows to meet the cash commitments. Second, at any moment, problems of mismatch between cash flows and cash commitments show up as upward pressure on the short-term money market rate of interest, another “real” variable.

The nature of funding is evolving, and central banking is catching up. The central question is whether actual cash flows are enough to cover the promised cash commitments at any moment in time. For such conditions to be fulfilled, consumers’ access to credit is required. Otherwise, the option is to liquidate accumulations of assets and a reduction in their wealth. The point to emphasize is that those whose access to credit is denied are the ones who have to borrow no matter what it costs. Such inconsistencies show up in the money market where people unable to make payments from their current cash flow face the problem of raising cash, either by borrowing from the credit market or liquidating their assets.

The result of all this pushing and pulling is the change in the value of financial wealth, and therefore inequality.  Regarding the distributional effects of monetary policy, central bankers should be concerned about the effects of monetary policy on unequal access to credit in addition to the income and wealth distribution. The survival constraint, i.e., agents’ liquidity requirements to meet their cash commitments, must be met today and at every moment in the future.

To sum up, in this piece, I revisited the basics of monetary economics and draw lessons that concern the connection between inequality, credit, and central banking. Previously, I wrote about the far-reaching developments in financial intermediation, where non-banks, rather than banks, have become the primary distributors of credit to the real economy. However, what is still missing is the distributional effects of the credit provision rather than asset purchasing programs. The Fed tends to overlook a “distributional” issue at the heart of the credit provision process. Such an omission is the byproduct of the traditional theories that suggest money and credit are neutral. The traditional theories also assert that the payment system is a veil and should not be considered in the design of the monetary policy. To correct the course of monetary policy, the Fed has to target the recipients of credit rather than its providers explicitly. In this sense, my analysis is squarely in the tradition of what Schumpeter (1954) called “monetary analysis” and Mehrling (2013) called “Money View” – the presumption that money is not a veil and that understanding how it functions is necessary to understand how the economy works.

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Elham's Money View Blog Search For Stable Liquidity Providers Series

Monetary Framework and Non-Bank Intermediaries: RIP Banking Channel?

By Elham Saeidinezhad

The Fed is banking on non-bank intermediaries, such as money market funds (MMFs), rather than banks for monetary normalization. The short-term funding market reset after the famous FOMC meeting on June 16, 2021. The Fed explicitly brought forward forecasts for tighter monetary policy and boosted inflation projections. However, it is essential to understand what lies beneath the Fed’s message. Examining the “timing” of the Fed’s normalization and the primary “beneficiaries” unveils a modified FRB/US model to include the structural change in the intermediation business. Non-bank intermediaries, including MMFs, have become primary lenders in the housing market and accept deposits. In doing so, they have replaced banks as credit providers to the economy and have boosted their role in transmitting monetary policy. Following the pandemic, the timing of the Fed’s policies can be explained by the MMFs’ balance sheet problems. This shift in the Fed’s focus towards non-bank intermediaries has implications for the banks. Even though normalization tactics are universally strengthening MMFs, there are creating liability problems for the banking system.

A long-standing trend in macro-finance, the increased presence of the MMFs in the market for loanable funds, alters the Fed’s FRB/US model and informs this decision. The FRB/US model, in use by the Fed since 1996, is a large-scale model of the US economy featuring optimizing behavior by households and firms and detailed descriptions of the real economy and the financial sector. One distinctive feature of the Fed’s model compared to dynamic stochastic general equilibrium (DSGE) models is the ability to switch between alternative assumptions about economic agents’ expectations formation and roles. When it comes to the critical question of “who funds the real economy?” it is sensible to assume that non-bank financial entities, including MMFs, have replaced banks to manage deposits and lend. On their liabilities side, MMFs have become the savers’ de-facto money managers. This industry looks after $4tn of savings for individuals and businesses. On their asset sides, they have become primary lenders in significant markets such as housing, where the Fed keeps a close watch on.

Traditionally, two essential components of the FRB/US model, the financial market and the real economy, depended on the banks lending behavior. The financial sector is captured through monetary policy developments. Monetary policy was modeled as a simple rule for the federal funds rate, an interbank lending rate, subject to the zero lower bound on nominal interest rates. A variety of interest rates, including conventional 30-year residential mortgage rates, assumed to be set by the banks’ lending activities, informs the “federal funds target.” To capture aggregate economic activity, the FRB/US model assumed the level of spending in the model depends on intermediate-term consumer loan rates, again set by the banking system. The recent FOMC announcement sent a strong signal that the FRB/US model has been modified to capture the fading role of the banks in funding the economy and setting the rates.

One of the factors behind the declining role of the banking system in financing the economy is the depositors’ inclination to leave banks. Notably, most of this institutional run on the banking system is self-inflicted. After the pandemic, the Fed and government stimulus packages pointed to an influx of deposits that could enter the banking system. However, due to banks’ balance sheet constraints, managing deposits is costly for at least two reasons. First, the scarcity of balance sheet space implies banks have to forgo the more lucrative and unorthodox business opportunities if they accept deposits. Second, as the size of banks’ balance sheets increases, banks are required to hold more capital and liquid assets. Both are expensive as they reduce banks’ returns on equity. These prudential requirements are more binding for the large, cash-rich banks. Thus, post COVID-19 pandemic, cash-rich banks advised corporate clients to move money out of their firms and deposit them in MMFs. Pushing deposits into MMFs was preferable as it would reduce the size of banks’ balance sheets. The idea was that non-bank money managers, who are not under the Fed’s regulatory radar, would be able and willing to manage the liquidity.

Effectively, bankers orchestrated run on their own banks by turning away deposits. Had the Fed overlooked such “unnatural” actions by banks, they could undermine financial stability in the long run. Therefore, after the COVID-19 pandemic, the Fed expanded access to the reverse repo programs to include non-bank money managers, such as MMFs. In doing so, the Fed signaled the critical status of the MMF industry. The Fed also crafted its policies to strengthen the balance sheet of these funds. For example, Fed lifted limits on the amount of financial cash the companies could park at the central bank from $30bn to $80bn. The absence of profitable investments has compelled MMFs to use this opportunity and place more assets with the reverse repurchase program. The goal was to drain liquidity from the system, slow down the downward pressure on the short-term rates, and improve the industry’s profit margin. The Fed’s balance sheet access drove the MMFs to a higher layer of the monetary hierarchy.

The Fed might have improved the position of the MMFs in the monetary hierarchy. However, it could not expand the ability of the MMFs to invest the money fast enough. The mismatch between the size of the MMFs and the amount of liquidity in circulation created balance sheet problems for the industry. On the liabilities side, the money under management has increased dramatically as the large-scale economic stimulus from the Fed and the US government created excess demand for short-dated Treasuries and other securities. Therefore, assets in so-called government MMFs, whose investments are limited to Treasuries, jumped above $4tn for the first time. But, on the asset side, it was a shortage of profitable investments. The issue was that too much money was chasing short-term debt, just as the US Treasury started to scale back its issuance of such bills. This combination created downward pressure on the rates. The industry was not large enough to service a large amount of cash in the system under such a low-interest-rate environment.

The downward pressure on rates was intensified despite the Fed’s effort to include the MMFs in the reserve repurchase (RRP) facility. The dearth of suitable investments has compelled MMFs to place more assets with an overnight Fed facility. Yet, as the RRP facility paid no interest, it could not resolve a fundamental threat to the economics of the MMF industry, the lack of profitable investment opportunities. Once the post-pandemic monetary policy stance made the economics of the MMF industry alarmingly unsustainable, the Fed chose to start the normalization process and increase the RRP rates. The point to emphasize is that the timing of the Fed’s monetary policy normalization matches the developments in the MMF industry. 

This shift in the Fed’s focus away from the banks and towards the MMFs yields mixed results for the banks, although it is unequivocally helping MMFs. First, the increase in RRP has strengthened the asset side of MMFs’ balance sheets as the policy has created a positive-yielding place to invest their enormous money under management. Second, other normalization policies, such as the rise in the federal funds rate and interest on excess reserve (IOER), are increasing rates, especially on the short-term assets, such as repo instruments. This adjustment has been critical for the smooth functioning of the MMFs as the repo rate was another staple source of income for the industry. Repo rate, the rate at which investors swap Treasuries and other high-quality collateral for cash in the repo market, had also turned negative at times. Overall, the policies that supported MMFs also improved the state of the short-term funding as the MMF industry plays a crucial role in the market for short-term funding.

The Fed policies are creating problems for the liabilities side of specific types of banks, bond-heavy banks. As Zoltan Pozsar noted, the Fed’s recent move to stimulate the economy through the RRP rate hurts banks’ liabilities. Such policies encourage large corporate clients to direct cash into MMFs. The recently generated outflow following the normalization process is being forced on both cash-rich and bond-heavy banks. This outflow is in addition to the trend above, where cash-rich banks have deliberately pushed the deposits outside their balance sheets and orchestrated the “run on their own banks.” The critical point is that while cash-rich banks’ business model encourages such outflows, they will create balance sheet crises for the bond-heavy banks, which rely on these deposits to finance their long-term securities. The Fed recognizes that bond-heavy banks can not handle the outflows. Still, the non-bank financial intermediaries have become the center of the Fed’s policies as the main financiers of the real economy.

The Fed is relying on non-bank intermediaries rather than banks for monetary normalization. To this end, the Fed has modified its FRB/US model to capture MMFs as the source of credit creation. The new signals evolve within the new monetary framework are suggesting that new identification is here to stay. First, the financial market echoed and rewarded the Fed after making such adjustments to assume financial intermediation. The market for short-term funding was reset shortly after the Fed’s announcements. The corrections in the capital market, both in stocks and bonds, were smooth as well. Second, after all, the Fed’s transition to primarily monitor MMFs balance sheet is less of a forward-looking act and more of an adjustment to a pre-existing condition. Researchers and global market-watchers are reaching a consensus that non-bank financial intermediaries are becoming the de-facto money lenders of the first resort to the real economy.  Therefore, it is not accidental that the policy that restored the short-term funding market was the one that directly supported the MMFs rather than banks. Here’s a piece of good news for the Fed. Although the Fed’s traditional, bank-centric, “policy” tools, including fed funds target, are losing their grip on the market, its new, non-bank-centric “technical” tools, such as RRP, are able to restore the Fed’s control and credibility.