NYU Economics Research Paper (Independent Study) - Fall 2010
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Fundamentals of Shadow Banking-UMKC
- 1. Fundamentals of Shadow Banking Perry Mehrling UMKC, Kansas City April 30, 2014
- 2. 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
- 3. Hierarchy of Money and CreditFigure 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
- 4. Dynamics • Elasticity and Discipline, Boom and Bust
- 5. 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
- 6. 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)
- 7. 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 1227 Securities Borrowed 389 Repo 1418 Securities Lent 91 Net (loans) 107
- 8. Economics of the Dealer Function • Treynor, 1987
- 9. Funding Liquidity vs. Market Liquidity, Interface of Banking and Dealers
- 10. 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
- 11. Capital Finance, indirect Capital Market Federal Reserve Banking Money Repo Rate Target Fed Funds Commercial Paper Treasury Bills C&I lending Credit Corporate Bonds Treasury Bonds Mortgage lending
- 12. International Dollar, indirect Asia US Europe Reserve Currency International Dollar Key Currency Yen, Renminbi Domestic Dollar DM, Euro National Currency, National Credit
- 13. 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
- 14. 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 Asset Credit Default Swap Interest Rate Swap FX Swap $ Repo $ Repo Capital Credit Default Swap Interest Rate Swap FX Swap
- 15. “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 RMBS CDS IRS MM funding MM funding “deposits” “deposits” Capital CDS IRS Assets Liabilities Credit Default Swaps Interest Rate Swaps Credit Default Swaps Interest Rate Swaps
- 16. 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
- 17. 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 100 CDS 0 IRS 0 MM 100 MM 100 Deposit 100 Deposit 100 Capital 100 CDS 0 IRS 0 Assets Liabilities CDS 0 IRS 0 CDS 0 IRS 0
- 18. 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 90 CDS 10 IRS 0 MM 100 MM 100 Deposit 100 Deposit 100 Capital 90 CDS 10 IRS 0 Assets Liabilities CDS 10 IRS 0 CDS 10 IRS 0
- 19. 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 90 CDS 10 IRS 0 MM 100 MM 100 Deposit 100 Deposit 100 Capital 90 CDS 10 IRS 0 Assets Liabilities CDS 10 IRS 0 CDS 10 IRS 0
- 20. 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
- 21. Shadow Banking Boom • Absorbing net order flow from Asset Manager distorts funding cost, risk premium → BOOM
- 22. Shadow Banking Bust Capital 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
- 23. Shadow Banking Bust • Absorbing new order flow from Shadow Bank distorts funding cost, risk premium → CRISIS
- 24. Backstopping Market Making, First Resort Capital Funding Bank Global Money Dealer Asset Manager Derivative Dealer Assets Liabilities Assets Liabilities Assets Liabilities RMBS CDS IRS MM funding MM funding Reserves “deposits” Capital “deposits” Capital CDS IRS Assets Liabilities CDS IRS Reserves CDS IRS Capital
- 25. Shadow Banking and Traditional Banking Capital Funding Bank Global Money Dealer Asset Manager Derivative Dealer Assets Liabilities Assets Liabilities Assets Liabilities RMBS CDS IRS FXS MM funding MM funding Reserves Liquidity put “deposits” Capital “deposits” Capital CDS IRS FXS Assets Liabilities CDS IRS FXS Reserves Liquidity Put CDS IRS FXS Capital
- 26. Backstopping Market-making, Last Resort • Global Money Dealer • Derivative Dealer • Traditional Bank • Central Bank (or C5) Assets Liabilities MM funding Reserves Liquidity put “deposits” Assets Liabilities CDS IRS FXS Reserves Liquidity put CDS IRS FXS Assets Liabilities Reserves Liquidity put CB Liquidity put GMD Liquidity put DD Assets Liabilities Reserves Liquidity put CB
- 27. 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 $1.7 MBS/GSE .9 Other .3 TOTAL 2.9 Currency $1.0 Reserves 1.6 Other .3 TOTAL 2.9 [TBill $2.6 [Tbond 2.6 [Risky Secs .9 Other .3 TOTAL 6.4? Curr./Res. $2.6] Tbill 2.6] Tbond .9] Other .3 TOTAL 6.4?
- 28. 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 $1.7 MBS/GSE .9 Other .3 TOTAL 2.9 Currency $1.0 Reserves 1.6 Other .3 TOTAL 2.9 Other .3 TOTAL 6.4? OIS $2.6 IRS 2.6 CDS .9 Other .3 TOTAL 6.4
- 29. 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
- 30. Bagehot
