Financial Globalization and Instability

Azim Premji Winter SchoolJanuary 15, 2013

The challenge of financial globalization

• Globalization– Supply chains, Trade flows, Labor mobility– State law/policy vs. private international

• Financial– Capital Markets, Cross-border lending, FDI – Real/equilibrium vs. hierarchy/instability

• Global dollar funding market– E.g. Asian financial crisis, 2007-9 GFC

Shadow banking as characteristic institutional form

“Money market funding of

Capital market lending”

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

Backstopping Global Funding Markets

Transformation of the Fed

A Bagehot Moment

Touching the Elephant

Economics View

• Monetary Walrasianism– Marschak, Patinkin, Tobin, Friedman: Md(.) = Ms

• QThM: MV=PT• NIPA: C+I+G=Y

• Arrow-Debreu Walrasianism– Intertemporal GE, DSGE:

β(1+r) = E{U’(Ct)/U’(Ct+1)}

• Practical Macro (accounting models, flows)– Flow of Funds:

∑iS(i,j) = ∑iU(i,j), ∑jS(i,j) = ∑jU(i,j)

Finance View

• Asset pricing: Pk = ∑(1/1+r)tCEt

• Modern:– CAPM, ERi = Rf + βi(ERm-Rf)– “Banking in a World without Money” (1970)

• Practical finance:– “Economics of the dealer function”– “Funding Liquidity and Market Liquidity”

The Money ViewResources from the Past

1. Copeland (1952): A Moneyflow Economy 2. Minsky (1957): The Survival Constraint

3. Hawtrey (1919): Hierarchy of Money and Credit, Inherent Instability

4. Hicks (1989): Centrality of the Dealer Function

5. Bagehot (1873): Central Bank as Dealer of Last Resort

Money and Banking defined

• Money = “transferable credit”– “inside” not “outside”– “public” and “private” hybrid– Payment system as credit clearing

• Banking = “swap of IOUs”– On-balance sheet: “loans create deposits”– Derivatives, e.g. Interest Rate Swaps– Banks as money dealers, market makers

Simple Hierarchy of Market Makers Asset Market Maker Price

Gold

Central Bank Exchange Rate

Currency

Banking System Par

Deposits

Security Dealers Interest Rate

Securities

Leverage vs. Liquidity

Equity Finance Bond Finance Money Finance

• Leverage: Equity vs. Bond – Modigliani-Miller Thm, vs. bankruptcy (insolvency)

• Liquidity: Bond vs. Money– Minsky: Hedge, Speculative, Ponzi (illiquidity)– Timing (mis)match of cash inflows/outflows

Assets Liabilities Assets Liabilities Assets Liabilities

PV(Future earnings)

Bonds 10Equity 90

PV(Future Earnings)

Bonds 90Equity 10

Bonds 100 Deposits 90Equity 10

Liquidity, Old and New

Money Finance Shadow Bank Asset Manager

• Survival Constraint, old and new– Payment system clearing– Collateral system clearing• Secured lending• Derivative settlement

Assets Liabilities Assets Liabilities Assets Liabilities

Bonds 100 Deposits 90Equity 10

Bonds 100CDS 0

‘Deposits’ 100 ‘Deposits’ 10 CDS 0Equity 10

Making Markets, Money and Risk

Capital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

Assets Liabilities Assets Liabilities Assets Liabilities

RMBSCDSIRSFXS

MM funding MM funding “deposits” “deposits” CapitalCDSIRSFXS

Assets Liabilities

Credit Default SwapsInterest Rate SwapsFX Swaps

Credit Default SwapsInterest Rate SwapsFX Swaps

Backstopping Markets: Funding and Market Liquidity

• Global Bank (money)

• Derivative Dealer (risk)

• Central Bank (or C5)

Assets Liabilities

MM fundingLiquidity put (funding)

“deposits”

Assets Liabilities

CDSIRSFXSLiquidity put (market)

CDSIRSFXS

Assets Liabilities

Liquidity put (funding)Liquidity put (market)

Regulation I: Systemic Risk “Inherent Instability of Credit”

• Hawtrey (1919) Currency and Credit• Minsky (1986) Stabilizing an Unstable

Economy• Adrian and Shin (2010) “Liquidity and

Leverage”

Centrality of the Dealer Function

• Treynor, 1987

Funding Liquidity and Market Liquidity

Boom Order Flow: Asset Manager > Capital Funding Bank

Bust Order Flow: Capital Funding Bank > Asset Manager

Bust Order Flow: Dealer Funding Stress

Fed Balance Sheet Transformed

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?

Regulation II: Plumbing Collateral and Payment Flows

• Aitken and Singh (2010) “The (sizable) role of rehypothecation in the shadow banking system.”

• Minsky, “survival constraint”, settlement in the payments system

Why is Backstop Needed?

CFB GMD AM

DD

• Abstracting from Counterparty Risk– Lending (RMBS collateral as security)– 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 Collateral 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

“Making” Markets, Money and Risk

Capital Funding Bank Global Money Dealer Asset Manager

Derivative Dealer

Assets Liabilities Assets Liabilities Assets Liabilities

RMBSCDS, IRS

MM funding MM funding

Liquidity Reserves

“deposits”

Capital Reserves

“deposits” CapitalCDS, IRS

Assets Liabilities

CDS, IRSLiquidity Reserves

CDS, IRSCapital Reserves

Implications for development

• Tapping global dollar funding markets, for domestic currency lending==FX risk

• National central bank as dollar liquidity backstop• C5 (and IMF) as crisis backstop for NCB– Japan, Switzerland, BoE, ECB, Fed?– IMF

• Normal backstop?– Payments system—home country NCB– Collateral system--???

Implications for development

• Tapping global dollar funding markets, for domestic currency lending==FX risk

• National central bank as dollar liquidity backstop• C5 (and IMF) as crisis backstop for NCB– Japan, Switzerland, BoE, ECB, Fed?– IMF

• Normal backstop?– Payments system—home country NCB– Collateral system--???

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