Fundamentals of Shadow Banking

Perry MehrlingUMKC, Kansas City

April 30, 2014

The Money View

• Banking as a Payments System– Copeland (1952): A Moneyflow Economy – Minsky (1957): The Survival Constraint

• Banking as a Market Making System– Hawtrey (1919): Hierarchy of Money and Credit– Hicks (1989): Centrality of the Dealer

Function– Bagehot (1873): Dealer of Last Resort

Hierarchy of Money and Credit

Figure 3: Simple Hierarchy of Market Makers

Asset Market Maker Price

Gold

Central Bank Exchange Rate

Currency

Banking System Par

Deposits

Security Dealers Interest Rate

Securities

Dynamics

• Elasticity and Discipline, Boom and Bust

Dealers Make Markets, “Supply” Market Liquidity

• Security Dealers– Equities, Bonds

• Money Dealers– Banks—Spot, Term, Forward– Foreign Exchange—Spot, Term, Forward

• Derivative Dealers– Swaps: Interest Rate, Credit Default, FX

What is a Dealer?

• Supermarkets as one-sided dealers– Buying (bid) wholesale– Selling (ask) retail– Inventories absorb fluctuation in supply, demand

• Price stability• Risk of loss

• Security dealers as two-sided dealers– Buying and selling retail– Inter-dealer market, buying and selling wholesale– Inventories positive (long) or negative (short)

US Government Security Dealers

• March 19, 2014 (in billions)

• Net Outright Positions– Treasury 50, GSE 33, MBS 89– Corporates 39, State 12, ABS 17

Assets (Securities in) Liabilities (Securities Out)

Reverse Repo 1227Securities Borrowed 389

Repo 1418Securities Lent 91Net (loans) 107

Economics of the Dealer Function

• Treynor, 1987

Funding Liquidity vs. Market Liquidity, Interface of Banking and Dealers

Central Banking and the Dealer System

• War (inside spread) == Government Bank– Fed fixes price of government debt, bills and bonds, by buying

whatever market does not (also supports bank purchase)Federal Reserve U.S. Treasury

• Peace (outside spread) == Bankers’ Bank– Dealer system creates the price, with Fed backstop by accepting

government debt (all maturities) at discount window– Indirect support for non-government debt through private dealer

arbitrage

Assets Liabilities Assets Liabilities+bills, bonds +Money +Money +bills, bonds

Capital Finance, indirectCapital Market Federal Reserve Banking

Money Repo Rate Target Fed Funds

Commercial Paper Treasury Bills C&I lending

Credit Corporate Bonds Treasury Bonds Mortgage lending

International Dollar, indirectAsia US Europe

Reserve Currency International Dollar

Key Currency Yen, Renminbi Domestic Dollar DM, Euro

National Currency, National Credit

What is shadow banking?

“Money market funding of

Capital market lending”

• Global ($) funding of local (FX) lending• Market pricing, both money and capital• Key role of market-making institutions• Key role of central bank as backstop

Shadow Banking as Global Finance

Shadow Bank Asset Manager

Note: Treat “insurance” as contingent asset and liability; alternatively, treat “risk exposure” as contingent asset and liability

Assets Liabilities Assets Liabilities

FX Risky AssetCredit Default SwapInterest Rate SwapFX Swap

$ Repo $ Repo CapitalCredit Default SwapInterest Rate SwapFX Swap

“Making” Markets, Money and Risk

Capital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

• Markets (money and risk), not institutions• Functional differentiation, not institutional

Assets Liabilities Assets Liabilities Assets Liabilities

RMBSCDSIRS

MM funding MM funding “deposits” “deposits” CapitalCDSIRS

Assets Liabilities

Credit Default SwapsInterest Rate Swaps

Credit Default SwapsInterest Rate Swaps

Shadow Banking and Real Activity

Deficit Agents Intermediation Surplus Agents

• Global Financial Risk Intermediation – Surplus may fund Investment (machine, house, road)– Surplus may fund Dissaving (profits, wages, taxes)– Demand for (risk free) dollar assets may drive supply

Assets Liabilities Assets Liabilities Assets Liabilities

Due to Risky Assets--Business--Household--Gov’t

Risk Capital--Business--Household--Gov’t

Due from

Liquidity and Shadow Banking

CFB GMD AM

DD

• Abstracting from Counterparty Risk– Lending (RMBS collateral and rehypothecation)– Derivatives (Pre-funding and hedging)

Assets Liabilities Assets Liabilities Assets Liabilities

RMBS 100CDS 0IRS 0

MM 100 MM 100 Deposit 100 Deposit 100 Capital 100CDS 0IRS 0

Assets Liabilities

CDS 0IRS 0

CDS 0IRS 0

Value Fluctuation and Payment Flows

CFB GMD AM

DD

• Blocking a liquidity spiral (firesale of RMBS, CDS)– Lender of Last Resort to GMD, DD– Dealer of Last Resort for RMBS, CDS

Assets Liabilities Assets Liabilities Assets Liabilities

RMBS 90CDS 10IRS 0

MM 100 MM 100 Deposit 100 Deposit 100 Capital 90CDS 10IRS 0

Assets Liabilities

CDS 10IRS 0

CDS 10IRS 0

Value Fluctuation and Payment Flows

CFB GMD AM

DD

• Blocking a liquidity spiral (firesale of RMBS, CDS)– Lender of Last Resort to GMD, DD– Dealer of Last Resort for RMBS, CDS

Assets Liabilities Assets Liabilities Assets Liabilities

RMBS 90CDS 10IRS 0

MM 100 MM 100 Deposit 100 Deposit 100 Capital 90CDS 10IRS 0

Assets Liabilities

CDS 10IRS 0

CDS 10IRS 0

Shadow Banking Boom

Capital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

• Net demand for money, absorbed by dealer• Net demand for risk, absorbed by dealer

Assets Liabilities Assets Liabilities Assets Liabilities

+“deposits” +“deposits” +Capital+CDS+IRS

Assets Liabilities

+Credit Default Swaps+Interest Rate Swaps

Shadow Banking Boom

• Absorbing net order flow from Asset Manager distorts funding cost, risk premium → BOOM

Shadow Banking BustCapital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

• Net demand for funding, absorbed by dealer• Net demand for insurance, absorbed by dealer

Assets Liabilities Assets Liabilities Assets Liabilities

+RMBS+CDS+IRS

+MM funding

+MM funding

Assets Liabilities

+Credit Default Swaps+Interest Rate Swaps

Shadow Banking Bust

• Absorbing new order flow from Shadow Bank distorts funding cost, risk premium → CRISIS

Backstopping Market Making, First Resort

Capital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

Assets Liabilities Assets Liabilities Assets Liabilities

RMBSCDSIRS

MM funding MM fundingReserves

“deposits”Capital

“deposits” CapitalCDSIRS

Assets Liabilities

CDSIRSReserves

CDSIRSCapital

Shadow Banking and Traditional Banking

Capital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

Assets Liabilities Assets Liabilities Assets Liabilities

RMBSCDSIRSFXS

MM funding MM fundingReserves

Liquidity put

“deposits”Capital

“deposits” CapitalCDSIRSFXS

Assets Liabilities

CDSIRSFXSReservesLiquidity Put

CDSIRSFXSCapital

Backstopping Market-making,Last Resort

• Global Money Dealer

• Derivative Dealer

• Traditional Bank

• Central Bank (or C5)

Assets Liabilities

MM fundingReservesLiquidity put

“deposits”

Assets Liabilities

CDSIRSFXSReservesLiquidity put

CDSIRSFXS

Assets Liabilities

ReservesLiquidity put CB

Liquidity put GMDLiquidity put DD

Assets Liabilities

ReservesLiquidity put CB

Central Bank as Market Backstop

Dec 15, 2011 Dec 15, 2011 (restated)

• Fed as Dealer of Last Resort– Global Money Dealer (OIS) [and FX swap]– Global Derivative Dealer (IRS, CDS)

Assets Liabilities Assets Liabilities

Treasuries $1.7MBS/GSE .9Other .3

TOTAL 2.9

Currency $1.0Reserves 1.6Other .3

TOTAL 2.9

[TBill $2.6[Tbond 2.6[Risky Secs .9Other .3

TOTAL 6.4?

Curr./Res. $2.6]Tbill 2.6]Tbond .9]Other .3

TOTAL 6.4?

Central Bank as Market Backstop

Dec 15, 2011 Dec 15, 2011 (restated)

• Fed as Dealer of Last Resort– Global Money Dealer (OIS) [and FX swap]– Global Derivative Dealer (IRS, CDS)

Assets Liabilities Assets Liabilities

Treasuries $1.7MBS/GSE .9Other .3

TOTAL 2.9

Currency $1.0Reserves 1.6Other .3

TOTAL 2.9

Other .3

TOTAL 6.4?

OIS $2.6IRS 2.6CDS .9Other .3

TOTAL 6.4

Re-imagining Central Banking

• The Challenge of Financial Globalization– Integration of Money and Capital Markets– Integration of Global Funding Markets (FX)

• (Global) Lender (Dealer) of Last Resort• (Non-bank global) Regulation and Supervision• (C5) Monetary (and Credit) Policy

Bagehot