fundamentals of shadow banking-umkc
DESCRIPTION
Slides for seminar @ UMKC, presented by Dr. Perry Mehrling. The Fundamentals of Shadow Banking: The Dealer ModelTRANSCRIPT
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