Repo

Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

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A Primer on Securities Lending

Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.

Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post...

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Liquidity Runs

Despite mixed evidence, concerns about a decline of bond market liquidity persist. The typical worry is that a sudden decline in bond demand will cause prices to plunge and have serious knock-on effects.

Naturally, the issue merits attention: episodes in which market liquidity disappears rapidly can be disruptive (witness the flash crashes and flash rallies in various equity and bond markets in recent years). However, these incidents tend to be fleeting. Instead, from the perspective of financial stability, funding liquidity is the greater source of vulnerability...


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The Scandal is What's Legal

If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]

But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....

 

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Can Margin Requirements Improve Financial Resilience?

Eight years after the financial crisis began, the regulatory reforms it spawned continue apace. Over the past year, regulators introduced total loss absorbing capacity (TLAC) and the liquidity coverage ratio (LCR) to make banks more resilient. And, with an eye toward strengthening market function, authorities continue to push for central clearing of derivatives (CCPs).

Overlapping with these goals—and extending to nonbanks—is the recent move to establish standards for margin requirements in securities transactions: that is, the maximum amount that someone can borrow when using a given security as collateral...

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How the Fed will tighten

Before the financial crisis, tightening monetary policy was straightforward. The Federal Open Market Committee (FOMC) would announce a rise in the target for the federal funds rate in the overnight interbank lending market, and the open market desk would implement it with a small reduction in the quantity of reserves in the banking system.

Matters are no longer so simple. The unconventional policies designed first to avert a financial and economic collapse, and then to spur growth and employment, have left the banking system with reserves that are so abundant that it would be impossible to tighten policy in the conventional manner.

So, as the FOMC moves to "normalize" monetary policy after years of extraordinary accommodation, how, precisely, will the Fed tighten monetary policy? ...

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Dodd-Frank: Five Years After

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.

How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.

Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five:

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Reverse Repo Risks 

Since the collapse of Lehman Brothers in September 2008, the Federal Reserve has stabilized the financial system and put the economy back on a path to sustainable growth. This task involved creating a colossal balance sheet, which now stands at $4.37 trillion, more than four times the pre-Lehman level ($940 billion). As textbooks (like ours) teach, along with this increase in Fed assets has come an increase in reserve liabilities (which represent deposits by banks at the Fed). Today, banks’ excess reserves (that is, the extra reserves beyond those that banks must hold at the Fed) are at $2.56 trillion, compared to virtually zero prior to the crisis.

Getting the money and banking system back to normal requires doing something to manage these excess reserves ...
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Reforming Tri-Party Repo

The principles for designing a safe financial infrastructure are a bit like those for making a safe bridge or building. Safety-minded engineers should design the most critical components as simply and reliably as possible. They should use shock absorbers to reduce the frequency of failures, and establish backup mechanisms to limit their consequences.

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What will the Fed use as its operating target?

In 2012, the Federal Reserve’s Open Market Committee (FOMC) clarified its long-run goals of price stability and maximum sustainable employment in a strategic statement that included for the first time a numerical inflation objective. While these ultimate objectives have evolved over the years, the FOMC’s operating instrument has been unchanged at least since 1981, when it began to target the federal funds rate -- the overnight interest rate on unsecured interbank loans. Since December 16, 2008, the target has been 0.00 to 0.25 percent, effectively at the zero lower bound for nominal interest rates. The history of the federal funds rate target is shown in the accompanying figure (and here). 

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