Tag: Banks

Elham's Money View Blog Hot Spots and Hedges

Banks as Alternative Investment Funds?

Post author By Elham Saeidinezhad
Post date April 1, 2023

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 subscription lines.” 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.

Tags Banking Crisis, Banks, Derivatives, Hedge Funds, Interest Rate, Money View, Private Equities, SVB

Elham's Money View Blog Hot Spots and Hedges

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

Post author By Elham Saeidinezhad
Post date March 26, 2023

“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.

Tags Balance Sheet, Bank Run, Banks, Federal Reserve, FINANCIAL CRISIS, Hedge Funds, Money View, SVB

Elham's Money View Blog Hot Spots and Hedges

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

Post author By Elham Saeidinezhad
Post date March 21, 2023

“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.

Tags Banks, Dealers, Derivatives, FINANCIAL CRISIS, Interest Rate, March 2023 Banking Crisis, Monetary Policy, Money View, SVB, Swaps

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

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

Post author By Elham Saeidinezhad
Post date June 23, 2021

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.

Tags Banks, Federal Reserve, Funding Liquidity, Monetary Policy, Money Market Fund

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

Are the Banks Taking Off their Market-Making Hat to Become Brokers?

Post author By Elham Saeidinezhad
Post date October 17, 2020

“A broker is foolish if he offers a price when there is nothing on the offer side good to the guy on the phone who wants to buy. We may have an offering, but we say none.” Marcy Stigum

By Elham Saeidinezhad

Before the slow but eventual repeal of Glass-Steagall in 1999, U.S. commercial banks were institutions whose mission was to accept deposits, make loans, and choose trade-exempt securities. In other words, banks were Cecchetti’s “Financial intermediaries.” The repeal of Glass-Steagall allowed banks to enter the arena so long as they become financial holding companies. More precisely, the Act permitted banks, securities firms, and insurance companies to affiliate with investment bankers. Investment banks, also called non-bank dealers, were allowed to use their balance sheets to trade and underwrite both exempt and non-exempt securities and make the market in both the capital market and the money market instruments. Becoming a dealer brought significant changes to the industry. Unlike traditional banks, investment banks, or merchant banks, as the British call it, can cover activities that require considerably less capital. Second, the profit comes from quoting different bid-ask prices and underwriting new securities, rather than earning fees.

However, the post-COVID-19 crisis has accelerated an existing trend in the banking industry. Recent transactions highlight a shift in power balance away from the investment banking arm and market-making operations. In the primary markets, banks are expanding their brokerage role to earn fees. In the secondary market, banks have started to transform their businesses and diversify away from market-making activities into fee-based brokerages such as cash management, credit cards, and retail savings accounts. Two of the underlying reasons behind this shift are “balance sheet constraints” and declining credit costs that reduced banks’ profit as dealers and improved their fee-based businesses. From the “Money View” perspective, this shift in the bank’s activities away from market-making towards brokerage has repercussions. First, it adversely affects the state of “liquidity.” Second, it creates a less democratic financial market as it excludes smaller agents from benefiting from the financial market. Finally, it disrupts payment flows, given the credit character of the payments system.

When a banker acts as a broker, its income depends on fee-based businesses such as monthly account fees and fees for late credit card payments, unauthorized overdrafts, mergers, and issuing IPOs. These fees are independent of the level of the interest rate. A broker puts together potential buyers and sellers from his sheet, much in the way that real estate brokers do with their listing sheets and client listings. Brokers keep lists of the prices bid by potential buyers and offered by potential sellers, and they look for matches. Goldman, Merrill, and Lehman, all big dealers in commercial paper, wear their agent hat almost all the time when they sell commercial paper. Dealers, by contrast, take positions themselves by expanding their balance sheets. They earn the spread between bid-ask prices (or interest rates). When a bank puts on its hat as a dealer (principal), that means the dealer is buying for and selling using its position. Put another way, in a trade; the dealer is the customer’s counterparty, not its agent.

Moving towards brokerage activity has adverse effects on liquidity. Banks are maintaining their dealer role in the primary market while abandoning the secondary market. In the primary market, part of the banks’ role as market makers involves underwriting new issues. In this market, dealers act as a one-sided dealer. As the bank only sells the newly issued securities, she does not provide liquidity. In the secondary market, however, banks act as two-sided dealers and supply liquidity. Dealer banks supply funding liquidity in the short-term money market and the market liquidity in the long-term capital market. The mission is to earn spreads by always quoting bids and offers at which they are willing to buy and sell. Some of these quotes are to other dealers. In many sectors of the money market, there is an inside market among dealers.

As opposed to the bond market, the money market is a wholesale market for high-quality, short-term debt instruments, or IOUs. In the money market, dealing banks make markets in many money market instruments. Money market instruments are credit elements that lend elasticity to the payment system. Deficit agents, who do not have adequate cash at the moment, have to borrow from the money market to make the payment. Money market dealers expand the elasticity daily and enable the deficit agents to make payments to surplus agents. Given the credit element in the payment, it is not stretching the truth to say that these short-term credit instruments, not the reserves, are the actual ultimate means of payment. Money market dealers resolve the “payments management” problem by enabling deficit agents to make payments before they receive payments.

Further, when dealers trade, they usually do not even know who their counterparty is. However, if banks become brokers, they need to “fine-tune” quotes because it matters who is selling and buying. Brokers prefer to trade with big investors and reduce their ties with smaller businesses. This is what Stigum called “line problems.” She explains a scenario where the Citi London offered to sell 6-month money at the bid rate quoted by a broker, and then, the bidding bank told the broker she changed her mind but had forgotten to call. In this situation, which is a typical one in the Eurodollar market, the broker would be committed to completing her bid by finding Citi a buyer at that price. Otherwise, the broker would sell Citi’s money at a lower rate and pay a difference equal to Citi’s dollar amount and would lose by selling at that rate. Since brokers operate on thin margins, a broker wouldn’t be around long if she often got “stuffed.” Good brokers take care to avoid errors by choosing their counterparties carefully.

After the COVID-19 pandemic, falling interest rates, the lower overall demand for credit, and regulatory requirements that limit the use of balance sheets have reduced banks’ profits as dealers. In the meantime, the banks’ fee-based businesses that include credit cards late-fees, public offerings, and mergers have become more attractive. The point to emphasize here is that the brokerage business does not involve providing liquidity and making the market while supplying liquidity in the money and capital market is the source of dealer banks’ revenue. Further, brokers tend to only trade with large corporations, while dealers’ supply of liquidity usually does not depend on who their counterparty is. Finally, as the payment system is much closer to a credit system than a money system, its well-functioning relies on money market instruments’ liquidity. Modern banks may wear one of two hats, agent (broker) or principal (dealers), in dealing with financial market instruments. The problem is that only one of these hats allows banks to make the market, facilitate the payment system, and democratize access to the credit market.

Tags Banks, Brokers, COVID-19, Dealers, FINANCIAL CRISIS, Funding Liquidity, Market Liquidity, Money View, Search For Stable Liquidity Providers

Elham's Money View Blog

The Paradox of the Yield Curve: Why is the Fed Willing to Flatten the Curve but Not Control It?

Post author By Elham Saeidinezhad
Post date October 1, 2020

By Elham Saeidinezhad

“From long experience, Fed technicians knew that the Fed could not control money supply with the precision envisioned in textbooks.” Marcy Stigum

In the last decade, monetary policy wrestled with the problem of low inflation and has become a tale of three cities: interest rate, asset purchasing, and the yield curve. The fight to reach the Fed’s inflation target started by lowering the overnight federal funds rate to a historically low level. The so-called “zero-lower bound restriction” pushed the Fed to alternative policy tools, including large-scale purchases of financial assets (“quantitative and qualitative easing”). This policy had several elements: first, a commitment to massive asset purchases that would increase the monetary base; second, a promise to lengthen the maturity of the central banks’ holdings and flatten the yield curve. However, in combination with low inflation (actual and expected), such actions have translated into persistently low real interest rates at both the yield curve’s long and short ends, and at times, the inversion of the yield curve. The “whatever it takes” large-scale asset purchasing programs of central banks were pushing the long-term yields into clear negative territory. Outside the U.S., and especially in Japan, central banks stepped up their fight against deflation by adopting a new policy called “Yield Curve Control,” which explicitly puts a cap on long-term rates. Even though the Fed so far resisted following the Bank of Japan’s footsteps, the yield curve control is the first move towards building a world that “Money View” re-imagines for central banking. The yield curve control embraces the “dealer of last resort” role of the Fed to increase its leverage over the yield curve, a chain of the private dealers. In the meantime, it reduces the Fed’s trace in the capital market and does not create as many dislocations in asset prices.

To understand this point, let’s start by translating monetary policy’s evolution into the language of Money View. In the traditional monetary policy, the Fed uses its control of reserve (at the top of the hierarchy of money) to affect credit expansion (at the bottom of the hierarchy). It also controls the fed funds rate (at the short end of the term structure) in an attempt to influence the bond rate of interest (at the long end). When credit is growing too rapidly, the Fed raises the federal fund’s target to impose discipline in the financial market. In standard times, this would immediately lower the money market dealers’ profit. This kind of dealer borrows at an overnight funding market to lend in the lend in term (i.e., three-month) market. The goal is to earn the liquidity spread.

After the Fed’s implementation of contractionary monetary policy, to compensate for the higher financing cost, money market dealers raise the term interest rate by the full amount (and perhaps a bit more to compensate for anticipated future tightening as well). This term-rate is the funding cost for another kind of dealer, called security dealers. Security dealers borrow from the term-market (repo market) to lend to the long-term capital market. Such operations involve the purchase of securities that requires financing. Higher funding cost implies that security dealers are willing to hold existing security inventories only at a lower price, and increasing long-term yield. This chain of events sketches a monetary policy transmission that happens through the yield curve. The point to emphasize here is that in determining the yield curve, the private credit market, not the Fed, sets rates and prices. The Fed has only some leverage over the system.

After the GFC, as the rates hit zero-lower bound, the Fed started to lose its leverage. In a very low-interest-rate condition, preferences shift in favor of money and against securities. One way to put it is that the surplus agents become reluctant to” delay settlement” and lower their credit market investment. They don’t want promises to pay (i.e., holding securities), and want money instead. In this environment, to keep making the market and providing liquidity, money market, and security dealers, who borrow to finance their short and long-term inventories, respectively, should be able to buy time. During this extended-time period, prices are pushed away from equilibrium. Often, the market makers face this kind of trouble and turn to the banks for refinancing. After GFC, however, the very low-interest rates mean that banks themselves run into trouble.

In a normal crisis, as the dealer system absorbs the imbalances due to the shift in preferences into its balance sheet, the Fed tried to do the same thing and take the problem off the balance sheet of the banking system. The Fed usually does so by expanding its balance sheet. The Fed’s willingness to lend to the banks at a rate lower than they would lend to each other makes it possible for the banks to lend to the dealers at a rate lower than they would otherwise charge. Putting a ceiling on the money rate of interest thus indirectly puts a floor on asset prices. In a severe crisis, however, this transmission usually breaks down. That is why after the GFC, the Fed used its leverage to put a floor on asset prices directly by buying them, rather than indirectly by helping the banks to finance dealers’ purchases.

The fundamental question to be answered is whether the Fed has any leverage over the private dealing system when interest rates are historically low. The Fed’s advantage is that it creates reserves, so there can be no short squeeze on the Fed. When the Fed helps the banks, it expands reserves. Hence the money supply grows. We have seen that the market makers are long securities and short cash. What the Fed does is to backstop those short positions by shorting cash itself. However, the Fed’s leverage over the private dealer system is asymmetric. The Fed’s magic mostly works when the Fed decides to increase elasticity in the credit market. The Fed has lost its alchemy to create discipline in the market when needed. When the rates are already very low, credit contraction happens neither quickly nor easily if the Fed increases the rates by a few basis points. Indeed, only if the Fed raises the rates high enough, it can get some leverage over this system, causing credit contraction. Short of an aggressive rate hike, the dealer system increases the spread slightly but not enough to not change the quantity of supplied credit. In other words, the Fed’s actions do not translate automatically into a chain of credit contraction, and the Fed does not have control over the yield curve. The Fed knows that, and that is why it has entered large-scale asset purchasing programs. But it is the tactful yet minimal purchases of long-term assets, rather than massive ones, that can restore the Fed’s control over the yield curve. Otherwise, the Fed’s actions could push the long-term rates into negative territory and lead to a constant inversion of the yield curve.

The yield curve control aims at controlling interest rates along some portion of the yield curve. This policy’s design has some elements of the interest rate policy and asset purchasing program. Similar to interest rate policy, it targets short-term interest rates. Comparable with the asset purchasing program, yield curve control aim at controlling the long-term interest rate. However, it mainly incorporates essential elements of a “channel” or “corridor” system. This policy targets longer-term rates directly by imposing interest rate caps on particular maturities. Like a “corridor system,” the long-term yield’s target would typically be set within a bound created by a target price that establishes a floor for the long-term assets. Because bond prices and yields are inversely related, this also implies a ceiling for targeted maturities. If bond prices (yields) of targeted maturities remain above (below) the floor, the central bank does nothing. However, if prices fall (rise) below (above) the floor, the central bank buys targeted-maturity bonds, increasing the demand and the bonds’ price. This approach requires the central bank to use this powerful tool tactfully rather than massively. The central bank only intervenes to purchase certain assets when the interest rates on different maturities are higher than target rates. Such a strategy reduces central banks’ footprint in the capital market and prevents yield curve inversion- that has become a typical episode after the GFC.

The “paradox of the yield curve” argues that the Fed’s hesitation to adopt the yield curve control to regulate the longer-term rates contradicts its decision to employ a corridor framework to control the overnight rate. Once the FOMC determines a target interest rate, the Fed already sets the discount rate above the target interest rate and the interest-on-reserve rate below. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. A corridor operating framework can help a central bank achieve a target policy rate in an environment in which reserves are anything but scarce, and the central bank has used its balance sheet as a policy instrument independent of the policy interest rate.

In the world of Money View, the corridor system has the advantage of enabling the Fed to act as a value-based dealer, or as Mehrling put it, “dealer of last resort,” without massively purchasing assets and constantly distorting asset prices. The value-based dealer’s primary role is to put a ceiling and floor on the price of assets when the dealer system has already reached their finance limits. Such a system can effectively stabilize the rate near its target. Stigum made clear that standard economic theory has no perfect answer to how the Fed gets leverage over the real economy. The question is why the Fed is willing to embrace the frameworks that flatten the yield curve and reduce its influence. In the meantime, it is hesitant to adopt the “yield curve control,” even though this framework boosts the Fed’s leverage by empowering the Fed to set an explicit cap on longer-term rates.

Tags Banks, Dealers, Federal Reserve, Monetary Policy, Money View, Yield Curve

Elham's Money View Blog

Is Monetary Policy Divorcing from Money Market and Uniting with Capital Market?

Post author By Elham Saeidinezhad
Post date August 28, 2020

By Elham Saeidinezhad

“The pronouncements and actions of the Federal Reserve Board on monetary policy are a charade.” Fischer Black

As the US Department of Treasury builds the points along the yield curve, the bank reserves are losing relevance in explaining short-term money market rates’ behavior. Central banks assume that they can create a close link between the best form of money (reserve) and monetary policy. They use the supply of reserves precisely to achieve the target interest rate. Since the 2008-09 Great Financial Crisis (GFC), however, the relationship between money and monetary policy has become unstable. After the COVID-19 pandemic, for instance, the Fed’s actions more than doubled the supply of bank reserves, from approximately $1.5 trillion in March to more than $3 trillion in June. In theory, such a massive increase in the supply of reserves should reduce the money market rates. Yet, short-term money market rates have been surprisingly steady, despite the enormous increase in reserves during the great lockdown. Fed economists recognize the over-supply of short-term US Treasury bills (a money market instrument) as the leading cause of the puzzling behavior in money market rates and call it “friction.”

However, for the Money View scholars, dividing the money market from the capital market, assuming that prices in each market are solely determined by its supply and demand flow, has never been an effective way of understanding interest rates. In the Money View world, similar to Fischer Black’s CAPM, the arbitrage condition implies that both the quantity and the price of money are ultimately determined by private dealers borrowing and lending activities that connect different markets rather than the stance of monetary policy alone. Dealers engage in “yield spread arbitrage,” in which they identify apparent mispricing (i.e., temporary fluctuations in supply or demand) at one segment of the yield curve, and takes a position. Dealers take “positions,” which means they speculate on how prices of assets with similar risk structure but different term-to-maturity, will change. In the meantime, they hedge interest rate exposures by taking an opposite position at another segment of the yield curve.

The point to emphasize is that short-term money markets and long-term capital markets are, in fact, not separate. As a result, prices in each market are not solely determined by the flow of supply and demand in that particular market. By taking advantage of the arbitrage opportunity, the dealers act as “porters” of liquidity from one market to another and connect prices in different markets in the process. The instruments that allow the dealers to transfer liquidity and solidify markets are repos and reverse repos, where capital market assets are used as collaterals to borrow from the money market, or vice versa. The Money View’s strength in understanding price dynamics comes from its ability, and willingness, to understand the dealers whose business connects different points of the yield curve and determines the effectiveness of the monetary policy.

During the COVID-19 pandemic, two separate but equally essential developments (aka distortions) occurred along the yield curve. In the long-term capital market, the Treasury has introduced a new class of safe assets, a 20-year Treasury bond, with a high yield (corresponding to the lowest accepted bid price) of 1.22 percent. Effectively, the US Treasury added a new point to the long-term end of the yield curve. In the short-term money market, the Fed injected a massive amount of reserves to reduce money market rates. The standard view suggests that such an increase in the supply of reserves would reduce the money market rates. The idea is that banks are the only institutions that hold these extra reserves. Due to balance sheet constraints, such as banks’ regulatory requirements, higher reserve holding implies higher banks’ costs. Therefore, banks reduce their short-term rates to signal their willingness to lend. In practice, however, short-term rates remained unchanged.

This dynamic in money market rates can be explained by the recent developments in the Treasury market, a segment of the capital market, and actions of the dealers who took advantage of the consequent arbitrage opportunity along the yield curve, i.e., the high spread between the short-term money market and the long-term risk-free Treasury rates. The dealers increased demand in the short-term money market both for hedging, and financing the newly issued Treasury bonds, put upward pressure on short-term rates. In contrast, the Fed’s activities put downward pressure on these rates. Observe that an increase in private demand for short-term funding (due to yield spread arbitrage) and an increase in the supply of reserves by the Fed (due to monetary policy) have opposing effects on short-term rates. Thus, it should not be surprising that despite the excessive reserve supply after the pandemic, the money market rates have remained stable. Understanding this kind of arbitrage along the yield curve is essential in understanding the behavior of short-term rates and the monetary policy’s effectiveness.

What is missing in this literature, but emphasized in the Money View framework, is acknowledging the hybridity between the money market and the capital market. The close link between the US Treasury market and the money market is a feature of the shadow banking or the new market-based finance. It is no friction. More importantly, the dealers’ search for “arbitrage” opportunities implies that individual securities markets are not separate. Speculators are joining the different markets into a single market. In doing so, they bring about a result that is no part of their intention, namely liquidity. As the Treasury creates an additional risk-free, liquid, point along the yield curve, it creates more arbitrage opportunities. Such developments make the yield curve an even more critical tool of examining the monetary policy effects. In the meantime, the traditional framework of supply and demand for bank reserves to control the short-term money market rate is losing its pertinence.

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Tags Banks, COVID-19, Dealers, Monetary Policy, Money View, Shadow Bnaking

Elham's Money View Blog

Is the Government’s Ambiguity About the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans?

Post author By Elham Saeidinezhad
Post date May 12, 2020

By Elham Saeidinezhad

The COVID-19 crisis has created numerous risks for small and medium enterprises (SMEs). The only certainty for SMEs has been that the government’s support has been too flawed to mitigate the shock. The program’s crash is not an accident. As mentioned in the previous Money View blog, one of the PPP loan design flaws is the government’s reliance on banks to act traditionally and intermediate credit to SMEs. Another essential, yet not well-understood design flaw at the heart of the PPP loan program is its ambiguity about the secondary market. The structure I propose to resolve such uncertainty focuses on the explicit government guarantee for the securitization of the PPP loans, similar to the GSE’s role in the mortgage finance system.

Such flaws are the byproduct of the central bank’s tendency to isolate shadow banking, and its related activities, from traditional banking. These kinds of bias would not exist in the “Money View” framework, where shadow banking is a function rather than an entity. “Money market funding of capital market lending” is a business deal that can happen in the balance sheet of any entity- including banks and central banks. One way to identify a shadow banker from a traditional banker is to focus on their sources and uses of finance. A traditional banker is simply a credit intermediary. Her alchemy is to facilitate economic growth by bridging any potential mismatch between the kind of liabilities that borrowers want to issue (use of finance) and the nature of assets that creditors want to hold (source of funding). Nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by “price changes” in the capital market, where securities are traded, rather than by traditional intermediation. Further, banks are reluctant to act as a financial intermediary for retail depositors as they have already switched to their more lucrative role as money market dealers.

Modern finance emphasizes that no risk is eliminated in the process of “credit intermediation,” only transferred, and sometimes quite opaquely. Such a conviction gave birth to the rise of market-based finance. In this world, a shadow banker, sometimes a bank, uses its source of funding, usually overnight loans, to supply “term-funding” in the wholesale money market. In doing so, it acts as a dealer in the wholesale money market. Also, financial engineering techniques, such as securitization, by splitting the securitized assets into different tranches, allows a shadow banker to “enhance credit ” while transferring risks to those who can shoulder them. The magic of securitization enables a shadow banker to tap capital-market credit in the secondary market. Ignoring the secondary market is a fatal problem in the design of PPP loans.

To understand the government pandemic stimulus program for the SMEs, let’s start by understanding the PPP loan structure. The U.S. Treasury, along with financial regulators such as the Fed, adopted two measures to facilitate aid to SMEs under the CARES Act. First, the Fed announced the formation of the Paycheck Protection Program Loan Facility (the “PPPLF”). This program enables insured depository institutions to obtain financing from the Fed collateralized by Paycheck Protection Program (“PPP”) loans. The point to emphasize here is that the Fed, in essence, is the ultimate financier of such loans as banks could use the credits to SMEs as collateral to finance their lending from the Fed. Second, PPP loans are assigned a zero-percent risk-weight for purposes of U.S. risk-based capital requirements. This feature is essentially making PPP loans exempt from risk-based (but not leverage) capital requirements when held by a banking organization subject to U.S. capital requirements.

Despite the promising appearance of such programs, the money is not flowing towards SMEs. One of the deadly flaws of this program is that it overlooks the importance of the secondary market. Specifically, ambiguity exists regarding the Small Business Administration (SBA)’s role in the secondary market due to the nature of the PPP loans and how they are regulated. The CARES Act provides that PPP loans are a traditional form of the SBA guaranteed loan. Such a statement implies that the PPP loans would not be 100% guaranteed in the secondary market as the SBA guaranteed loans are subject to certain conditions that should be satisfied by the borrower. First, the SBA wants to ensure that the entity claiming a right to payment from the SBA holds a valid title to the SBA loan. Second, the SBA requires the borrower to fulfill the PPP’s forgiveness requirements. Securitization requires the consent of the SBA. What is not mentioned in the CARES Act is that the SBA’s existing regulations restrict the ability of such loans to be transferred in the secondary market. Such restrictions block the credit to flow to the SMEs.

Under such circumstances, free transfer of PPPs in the secondary market could result in chaos when the PPP loans are later presented to the SBA by the holder for forgiveness or guarantee. Some might propose to ask for approval from the SBA before the securitization process. Yet, prior approval requirements for loan transfers, even though it might reduce the confusion mentioned above, hinder the ability to transfer newly originated PPP loans into the secondary market. Given that the PPP entails a massive amount of loans – $349 billion – to be originated in a short period, transfer restrictions could have a material impact on the ability to get much-needed funding to small businesses quickly. The program’s failure to notice such a conflict is a byproduct of the government’s tendency to ignore the role of the secondary market in the success of programs that aims at providing credit to retail depositors.

A potential solution would be for a government agency, such as the Small Business Administration (SBA), to guarantee the PPP loans in the secondary market in the same manner as Fannie Mae and Freddie Mac do for the mortgage loans. Fannie Mae and Freddie Mac are government-sponsored enterprises (the GSEs) that purchase mortgages from banks and use securitization to enhance the flow of credit in the mortgage market. The GSEs help the flow of credit as they have a de facto subsidy from the government. The market believes that the government will step in to guarantee their debt if they become insolvent. For the case of the PPP loans, instead of banks keeping the loans on their balance sheet until the loan was repaid, the bank who made the loan to the SMEs (the originator) should be able to sell the loan to the SBA. The SBA then would package the PPP loans and sells the payment rights to investors. The point to emphasize here is that the government both finance such loans in the primary market- the Fed accepts the PPP loans as collateral from banks- and ensures the flow of credit by securitizing them in the secondary market. Such a mechanism provides an unambiguous and ultimate guarantee for the PPP loans in the credit market that the government aims at offering anyways. This kind of explicit government guarantee could also help the smooth flow of credit to SMEs, which has been the original goal of the government in the first place.

Money View, through its recognition of banks as money market dealers in market-based finance and originators of securitized assets, could shed some light on the origins of those complications. Previously in the Money View blog, I proposed a potential solution to circumvent banks and directly injecting credit to the SMEs, through tools such as central bank digital currencies (CBDC). In this piece, the proposal is to adopt the design of the mortgage finance system to provide unambiguous government support and resolve the perplexities regarding marketing PPP loans in the secondary market. Until this confusion is resolved, banking entities with regulatory or internal funding constraints may be unwilling to originate PPP loans without a clear path for obtaining financing or otherwise transferring such credits into the secondary market. Such failures come at the expense of retail depositors, including small businesses.

Acknowledgment: Writing this piece would not be possible without a fruitful exchange that I had with Dr. Rafael Lima Sakr, a Teaching Fellow at Edinburgh Law School.

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Tags Banks, COVID-19, Dealers, FINANCIAL CRISIS

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

Can Central Bank Digital Currency Contain COVID-19 Crisis by Saving Small Businesses?

Post author By Elham Saeidinezhad
Post date April 24, 2020

By Elham Saeidinezhad and Jack Krupinski

This Piece Is Part of the “Search For Stable Liquidity Providers” Series. It is also a follow up to our previous Money View article on the banking system during the COVID-19 crisis.

The COVID-19 crisis created numerous financial market dislocations in the U.S., including in the market for government support. The federal government’s Paycheck Protection Program offered small businesses hundreds of billions of dollars so they could keep paying employees. The program failed to a great extent. Big companies got small business relief money. The thorny problem for policymakers to solve is that the government support program is rooted in the faith that banks are willing to participate in. Banks were anticipated to act as an intermediary and transfer funds from the government to the small businesses. Yet, in the modern financial system, banks have already shifted gear away from their traditional role as a financial intermediary between surplus and deficit agents. Part l used the “Money View” and a historical lens to explain why banks are reluctant to be financial intermediaries and are more in tune with their modern function as dealers in the wholesale money markets. In Part ll, we are going to propose a possible resolution to this perplexity. In a monetary system where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most, including small and medium enterprises, who have no access to the capital market.

The history of central banking began with a simple task of managing the quantity of money. Yet, central bankers shortly faced a paradox between managing “survival constraint” in the financial market and the real economy. On the one hand, for banks, the survival constraint in the financial market takes the concrete form of a “reserve constraint” because banks settle net payments using their reserve accounts at the central bank. On the other hand, according to the monetarist idea, for money to have a real purchasing power in terms of goods and services, it should be scarce. Developed by the classical economists in the nineteenth and early twentieth centuries, the quantity theory of money asserted that the quantity of money should only reflect the level of transactions in the real economy.

The hybridity between the payment system and the central bank money created such a practical dilemma. Monetarist idea disregarded such hybridity and demanded that the central bank abandon its concern about the financial market and focus only on controlling the never-materializing threat of inflation. The monetarist idea was doomed to failure for its conjectures about the financial market, and its illusion of inflation. In the race to dominate the whole economy, an efficiently functioning financial market soon became a pre-condition to economic growth. In such a circumstance, the central bank must inject reserves or else risk a breakdown of the payments system. Any ambiguity about the liquidity problems (the survival constraint) for highly leveraged financial institutions would undermine central banks’ authority to maintain the monetary and financial stability for the whole economy. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn’t take much of a write-down to produce technical insolvency.

This essential hybridity, and the binding reality of reserve constraint, gave birth to two parallel phenomena. In the public sphere, the urge to control the scarce reserves originated monetary policy. The advantage that the central bank had over the financial system arose ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. Central bankers recognized that they could use this scarcity to affect the price of money, the interest rate, in the banking system. It is the central bank’s control over the price and availability of funds at this moment of necessity that is the source of its control over the financial system. The central bank started to utilize its balance sheet to impose discipline when there was an excess supply of money, and to offer elasticity when the shortage of cash is imposing excessive discipline. But ultimately central bank was small relative to the system it engages. Because the central bank was not all-powerful, it must choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter. Such difficult tasks motivated people to call central banking as the “art,” rather than the “science”.

In the private domain, the scarcity of central bank money significantly increased the reliance on the banking system liabilities. By acting as a special kind of intermediary, banks rose to the challenge of providing funding liquidity to the real economy. Their financial intermediation role also enabled them to establish the retail payment system. For a long time, the banking system’s major task was to manage this relationship between the (retail) payment system and the quantity of money. To do so, they transferred the funds from the surplus agents to the deficit agents and absorbed the imbalances into their own balance sheets. To strike a balance between the payment obligations, and the quantity of money, banks started to create their private money, which is called credit. Banks recognized that insufficient liquidity could lead to a cascade of missed payments and the failure of the payment system as a whole.

For a while, banks’ adoption of the intermediary role appeared to provide a partial solution to the puzzle faced by the central bankers. Banks’ traditional role, as a financial intermediary, connected them with the retail depositors. In the process, they offered a retail payment- usually involve transactions between two consumers, between consumers and small businesses, or between two small to medium enterprises. In this brave new world, managing the payment services in the financial system became analogous to the management of the economy as a whole.

Most recently, the COVID-19 crisis has tested this partial equilibrium again. In the aftermath of the COVID-19 outbreak, both the Fed and the U.S. Treasury coordinated their fiscal and monetary actions to support small businesses and keep them afloat in this challenging time. So far, a design flaw at the heart of the CARES Act, which is an over-reliance on the banking system to transfer these funds to small businesses, has created a disappointing result. This failure caught central bankers and the governments by surprise and revealed a fatal flaw in their support packages. At the heart of this misunderstanding is the fact that banks have already switched their business models to reflect a payment system that has been divided into two parts: wholesale and retail. Banks have changed the gear towards providing wholesale payment-those made between financial institutions (e.g., banks, pension funds, insurance companies) and/or large (often multinational) corporations- and away from retail payment. They are so taken with their new functions as dealers in the money market and originators of asset-backed securities in the modern market-based finance that their traditional role of being a financial intermediary has become a less important part of their activities. In other words, by design, small businesses could not get the aid money as banks are not willing to use their balance sheets to lend to these small enterprises anymore.

In this context, the broader access to central bank money by small businesses could create new opportunities for retail payments and the way the central bank maintains monetary and financial stability. Currently, households and (non-financial) companies are only able to use central bank money in the form of banknotes. Central bank digital currency (CBDC) would enable them to hold central bank money in electronic form and use it to make payments. This would increase the availability and utility of central bank money, allowing it to be used in a much more extensive range of situations than physical cash. Central bank money (whether cash, central bank reserves or potentially CBDC) plays a fundamental role in supporting monetary and financial stability by acting as a risk-free form of money that provides the ultimate means of settlement for all payments in the economy. This means that the introduction of CBDC could enhance the way the central bank maintains monetary and financial stability by providing a new form of central bank money and new payment infrastructure. This could have a range of benefits, including strengthening the pass-through of monetary policy changes to the broader economy, especially to small businesses and other retail depositors, and increasing the resilience of the payment system.

This increased availability of central bank money is likely to lead to some substitution away from the forms of payment currently used by households and businesses (i.e., cash and bank deposits). If this substitution was extensive, it could reduce the reliance on commercial bank funding, and the level of credit that banks could provide as CBDC would automatically give access to central bank money to non-banks. This would potentially be useful in conducting an unconventional monetary policy. For example, the COVID-19 precipitated increased demand for dollars both domestically and internationally. Small businesses in the U.S. are increasingly looking for liquidity through programs such as the Paycheck Protection Program Liquidity Facility (PPPLF) so that those businesses can keep workers employed. In the global dollar funding market, central banks swap lines with the Fed sent dollars into other countries, but transferring those dollars to end-users would be even easier for central banks if they could bypass the commercial banking system.

Further, CBDC can be used as intraday liquidity by its holders, whereas liquidity-absorbing instruments cannot achieve the same, or can do so only imperfectly. At the moment, there is no other short-term money market instrument featuring the liquidity and creditworthiness of CBDC. The central bank would thus use its comparative advantage as a liquidity provider when issuing CBDC. The introduction of CBDC could also decrease liquidity risk because any agent could immediately settle obligations to pay with the highest form of money.

If individuals can hold current accounts with the central bank, why would anyone hold an account with high st commercial banks? Banks can still offer other services that a CBDC account may not provide (e.g., overdrafts, credit facilities, etc.). Moreover, the rates offered on deposits by banks would likely increase to retain customers. Consumer banking preferences tend to be sticky, so even with the availability of CBDC, people will probably trust the commercial banking system enough to keep deposits in their bank. However, in times of crisis, when people flee for the highest form of money (central bank money), “digital runs” on banks could cause problems. The central bank would likely have to increase lending to commercial banks or expand open market operations to sustain an adequate level of reserves. This would ultimately affect the size and composition of balance sheets for both central banks and commercial banks, and it would force central banks to take a more active role in the economy, for better or worse.

As part 1 pointed out, banks are already reluctant to play the traditional role of financial intermediary. The addition of CBDC would likely cause people to substitute away from bank deposits, further reducing the reliance on commercial banks as intermediaries. CBDC poses some risks (e.g., disintermediation, digital bank runs, cybersecurity), but it would offer some new channels through which to conduct unconventional monetary policy. For example, the interest paid on CBDC could put an effective floor on money market rates. Because CBDC is risk-free (i.e., at the top of the money hierarchy), it would be preferred to other short-term debt instruments unless the yields of these instruments increased. While less reliance on banks by small businesses would contract bank funding, banks would also have more balance sheet freedom to engage in “market-making” operations, improving market liquidity. More importantly, it creates a direct liquidity channel between the central banks, such as the Fed, and non-bank institutions such as small and medium enterprises. Because central banks need not be motivated by profit, they could pay interest on CBDC without imposing fees and minimum balance requirements that profit-seeking banks employ (in general, providing a payment system is unprofitable, so banks extort profit wherever possible). In a sense, CBDC would be the manifestation of money as a public good. Everyone would have ready access to a risk-free store of value, which is especially relevant in the uncertain economic times precipitated by the COVID-19.

Tags Banks, COVID-19, Digital Currency, Federal Reserve, Monetary Policy, Money View

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

In a World Where Banks Do Not Aspire to be Intermediaries, Is It Time to Cut Out the Middlemen? (Part I)

Post author By Elham Saeidinezhad
Post date April 15, 2020

This Piece Is Part of the “Search For Stable Liquidity Providers” Series.

By Elham Saeidinezhad

“Bankers have an image problem.” Marcy Stigum

Despite the extraordinary quick and far-reaching responses by the Fed and US Treasury, to save the economy following the crisis, the market sentiment is that “Money isn’t flowing yet.” Banks, considered as intermediaries between the government and troubled firms, have been told to use the liberated funds to boost financing for individuals and businesses in need. However, large banks are reluctant, and to a lesser extent unable, to make new loans even though regulators have relaxed capital rules imposed in the wake of the last crisis. This paradox highlights a reality that has already been emphasized by Mehrling and Stigum but erred in the economic orthodoxy.

To understand this reluctance by the banks, we must preface with a careful look at banking. In the modern financial system, banks are “dealers” or “market makers” in the money market rather than intermediaries between deficit and surplus agents. In many markets such as the UK and US, these government support programs are built based on the belief that banks are both willing and able to switch to their traditional role of being financial intermediaries seamlessly. This intermediation function enables banks to become instruments of state aid, distributing free or cheap lending to businesses that need it, underpinned by government guarantees. This piece (Part l) uses the Money View and a historical lens to explain why banks are not inspired anymore to be financial intermediaries. In Part ll, we are going to propose a possible resolution to this perplexity. In a financial structure where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most.

Stigum once observed that bankers have, at times, an image problem. They are seen as the culprits behind the high-interest rates that borrowers must pay and as acting in ways that could put the financial system and the economy at risk, perhaps by lending to risky borrowers, when interest rates are low. Both charges reflect the constant evolution in banks’ business models that lead to a few severe misconceptions over the years. The first delusion is about the banks’ primary function. Despite the common belief, banks are not intermediaries between surplus and deficit agents anymore. In this new system, banks’ primary role is to act as dealers in money market securities, in governments, in municipal securities, and various derivative products. Further, several large banks have extensive operations for clearing money market trades for nonbank dealers. A final important activity for money center banks is foreign operations of two sorts: participating in the broad international capital market known as the Euromarket and operating within the confines of foreign capital markets (accepting deposits and making loans denominated in local currencies).

Structural changes that have taken place on corporates’ capital structure and the emergence of market-based finance have led to this reconstruction in the banking system. To begin with, the corporate treasurers switched sources of corporate financing for many corporates from a bank loan to money market instruments such as commercial papers. In the late 1970s and early 1980s, when rates were high, and quality-yield spreads were consequently wide, firms needing working capital began to use the sale of open market commercial paper as a substitute for bank loans. Once firms that had previously borrowed at banks short term were introduced to the paper market, they found that most of the time, it paid them to borrow there. This was the case since money obtained in the credit market was cheaper than bank loans except when the short-term interest rate was being held by political pressure, or due to a crisis, at an artificially low level.

The other significant change in market structure was the rise of “money market mutual funds.” These funds provide more lucrative investment opportunities for depositors, especially for institutional investors, compared to what bank deposits tend to offer. This loss of large deposits led bank holding companies to also borrow in the commercial paper market to fund bank operations. The death of the deposits and the commercial loans made the traditional lending business for the banks less attractive. The lower returns caused the advent of the securitization market and the “pooling” of assets, such as mortgages and other consumer loans. Banks gradually shifted their business model from a traditional “originate-and-hold” to an “originate-to-distribute” in which banks and other lenders could originate loans and quickly sell them into securitization pools. The goal was to increase the return of making new loans, such as mortgages, to their clients and became the originators of securitized assets.

The critical aspect of these developments is that they are mainly off-balance sheet profit centers. In August 1970, the Fed ruled that funds channeled to a member bank that was raised through the sale of commercial paper by the bank’s holding company or any of its affiliates or subsidiaries were subject to a reserve requirement. This ruling eliminated the sale of bank holding company paper for such purposes. Today, bank holding companies, which are active issuers of commercial paper, use the money obtained from the sale of such paper to fund off-balance sheet, nonbank, activities. Off-balance sheet operations do not require substantial funding from the bank when the contracts are initiated, while traditional activities such as lending must be fully funded. Further, most of the financing of traditional activities happens through a stable base of money, such as bank capital and deposits. Yet, borrowing is the primary source of funding off-balance sheet activities.

To be relevant in the new market-based credit system, and compensate for the loss of their traditional business lines, the banks started to change their main role from being financial intermediaries to becoming dealers in money market instruments and originators of securitized assets. In doing so, instead of making commercial loans, they provide liquidity backup facilities on commercial paper issuance. Also, to enhance the profitability of making consumer loans, such as mortgages, banks have turned to securitization business and have became the originators of securitized loans.

In the aftermath of the COVID-19 outbreak, the Fed, along with US Treasury, has provided numerous liquidity facilities to help illiquid small and medium enterprises. These programs are designed to channel funds to every corner of the economy through banks. For such a rescue package to become successful, these banks have to resume their traditional financial intermediary role to transfer funds from the government (the surplus agents) to SMEs (the deficit agents) who need cash for payroll financing. Regulators, in return, allow banks to enjoy lower capital requirements and looser risk-management standards. On the surface, this sounds like a deal made in heaven.

In reality, however, even though banks have received regulatory leniency, and extra funds, for their critical role as intermediaries in this rescue package, they give the government the cold shoulder. Banks are very reluctant to extend new credits and approve new loans. It is easy to portray banks as villains. However, a more productive task would be to understand the underlying reasons behind banks’ unwillingness. The problem is that despite what the Fed and the Treasury seem to assume, banks are no longer in the business of providing “direct” liquidity to financial and non-financial institutions. The era of engaging in traditional banking operations, such as accepting deposits and lending, has ended. Instead, they provide indirect finance through their role as money market dealers and originators of securitized assets.

In this dealer-centric, wholesale, world, banks are nobody’s agents but profits’. Being a dealer and earning a spread as a dealer is a much more profitable business. More importantly, even though banks might not face regulatory scrutiny if these loans end up being nonperforming, making such loans will take their balance sheet space, which is already a scarce commodity for these banks. Such factors imply that in this brave new world, the opportunity cost of being the agent of good is high. Banks would have to give up on some of their lucrative dealing businesses as such operation requires balance sheet space. This is the reason why financial atheists have already started to warn that banks should not be shamed into a do-gooder lending binge.

Large banks rejected the notion that they should use their freed-up equity capital as a basis for higher leverage, borrowing $5tn of funds to spray at the economy and keep the flames of coronavirus at bay. Stigum once said that bankers have an image problem. Having an image problem does not seem to be one of the banks’ issues anymore. The COVID-19 crisis made it very clear that banks are very comfortable with their lucrative roles as dealers in the money market and originators of assets in the capital market, and have no intention to be do-gooders as financial intermediaries. These developments could suggest that it is time to cut out banks as middlemen. To this end, central bank digital currency (CBDC) could be a potential solution as it allows central banks to bypass banks to inject liquidity into the system during a period of heightened financial distress such as the COVID-19 crisis.

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Tags Banks, COVID-19, Dealers, Federal Reserve, Future of Money, Money View