I don’t particularly hang out with insurance and I assume that if you do today’s big angry report on captive reinsurance, by Benjamin Lawsky and his New York State Department of Financial Services,1 doesn’t come as much of a surprise. Still it’s fun for me because of its overlap with some of my favorite financial transactions. Like, here is the basic idea of reinsurance:
You’ve got a company (a New York State insurance company) that has insured some risks, and is required to hold reserves and be capitalized against those risks, and that seems unfair to that company, so it goes and finds another entity (a Cayman Islands reinsurance company) with less stringent capital requirements, and it buys reinsurance from that company, reducing its own capital requirements (it has no more exposure to the reinsured risk!) without 1-for-1 increasing the reinsurer’s capital requirements (better regulatory environment!), so there’s a positive-sum transaction.
This in a nutshell describes all capital arbitrage transactions in banking: a big bank has a risk that brings it capital requirements, it goes and finds a pension fund or hedge fund (or insurance company!) that is willing to bear that risk, the transfer of risk from bank to fund reduces aggregate capital requirements, and a trade is made. This is a sort of “shadow banking,” and in fact Lawsky’s report borrows the term as “shadow insurance” to describe mechanically similar reinsurance transactions.
The fun part is what Lawsky gets mad at, which is a trade that goes something like this: Read more »
A simple model of banking regulation and, like, counter-regulation goes something like this:
Regulators are conservative and dumb, and want to safeguard banks from bad risks even at the cost of preventing good risks,
Bankers are aggressive and smart, and want to take lots of good risks even at the cost of taking some bad risks, and
Sometimes bankers can find people to put up with their shit and sometimes they can’t.
“Put up with their shit” is meant in the broadest sense – Can banks defeat Dodd-Frank? Brown-Vitter? Is Lloyd Blankfein a hero or a villain? Jamie Dimon? Etc. – but one particularly interesting question is, if you’re trying to do trades that evade or bend or optimize or whatever regulation, will someone do those trades with you? You could write a history of recent finance with the answer to that question: in 2007 you could chuck all of your mortgage risk off-balance sheet via securitizations, in 2008 you … could not, and in 2013 if you’re looking for someone to provide regulatory capital relief all you have to do is call a Regulatory Capital Relief Fund. Six years peak-to-peak, same as the S&P.
You could probably use words like “bubble” in characterizing that cycle but I prefer the approach taken in this new NBER paper by Guillermo Ordoñez of Penn (free version here), both because it mathematically formalizes that basic model of regulation and counter-regulation in an interesting way, and because it is congenially cynical. As he puts it, “banks can always find ways around regulation when self-regulation becomes feasible, and it is indeed efficient for them to do so.” Bankers, of course, always think that it would be efficient for them to find ways around regulation. They only do so when they can find someone to trade with them. Read more »
One reason that it’s silly to get worked up about banks gambling with your deposits is that they’re mostly not. Your deposits have a tendency to be structurally senior, insured, at regulated subs, etc.; nothing all that bad will happen to them. Banks are gambling with your money market funds, and with the securities-lending proceeds from your mutual funds. Which are not insured, or particularly regulated, but which fund something like $1.9 trillion of securities dealers’ inventory through tri-party repo, as well as providing some $6 trillionish in other collateralized funding for dealer and hedge fund inventories. And this is really much worse, crisis-wise. Since deposits are insured, runs on them are rare. Runs on repo probably caused the financial crisis. Maybe.
NY Fed President William Dudley gave a pretty good speech about this stuff today; you should read it, or read some summaries here or here. The most fun parts for me had to do with the tri-party repo market.
First of all, if you’re following that market you may be aware that the Fed is moving to get rid of “the unwind,” in which
by day, cash investors deposit their cash at JPMorgan and BoNY and JPM/BoNY lend cash to securities dealers, but
by night, those cash investors lend the cash directly to the dealers in the freaky unregulated shadow banking market.
Those two activities sort of live on a continuum – traditional(ish) banking by day, shadow banking by night, but still the same provision of credit to the same people based on the same collateral. It’s just that during the day the cash investors’ risk is wrapped in the gentle embrace of the clearing bank; at night the cash investor snuggles up directly with the collateral. Dudley argues that this combined the risks of shadow banking with the complacency of regular banking: Read more »
The Financial Stability Board is … is a thing, first of all, did you know that? It’s not the Financial Stability Oversight Council, though it is as far as I can tell a global version of that with similar composition (senior regulators! in a room!) and obsessions (shadow banking! money market funds!). It’s also not the Systemic Risk Council, which is different, insofar as it’s just a thing that Sheila Bair made up. I am going to make up a thing – the “Systemic Stability Oversight Board” seems available – and if you ask me nicely I will invite you to join it and we will make beautiful, beautiful reports together.
Like the FSB did with their report about shadow banking1 released yesterday. “Shadow banking,” like “junk bonds,” is a term that sort of assumes the panic it sets out to create, and so the report dutifully provides a number that is bigger than another number:
The shadow banking industry has grown to about $67 trillion, $6 trillion bigger than previously thought, leading global regulators to seek more oversight of financial transactions that fall outside traditional oversight. … The FSB, a global financial policy group comprised of regulators and central bankers, found that shadow banking grew by $41 trillion between 2002 and 2011.
Holy crap look at that purplish line go! Oh wait that purplish line is just regular banks; shadow banks are the red line. Which also goes up. Just not as fast. If it worries you that shadow banks added $41 trillion in assets in 2002-2011, you might spare a thought for non-shadow banks adding, what, $80 trillion in assets? I submit to you that non-shadow banks have shadowy places of their own; I half-seriously submit to you that the term “shadow banking” functions to make regular banking sound less shadowy, like Disneyland in Baudrillard.2 Here it is in percentage terms: Read more »
It feels virtuous every so often to take glance over at the triparty repo market. You get a nice dose of horrified vertigo and then go back to your life and don’t think about it for a while and that always feels better. Now is a good time to get back to it, what with continued worrying about money-market funds – a core player in the market – and two interesting things this week about triparty repo: this testimony from Matthew Eichner of the Fed to a Senate subcommittee, and this report from Fitch.
Here is how I imagine triparty repo:
A bunch of money market funds and other cash investors keep $1.8 billion of cash at JPMorgan and Bank of New York Mellon, the “clearing banks” in the triparty system.
A bunch of securities dealers keep a pile of securities – worth, on a good day, more than $1.8bn – to JPM and BoNY Mellon.
The dealers need money to fund those securities, because what are they going to do, pay for them themselves?
Every afternoon, the cash investors and the securities dealers frantically negotiate which dealers swap their securities (at negotiated haircuts) for which cash investors’ cash.
Every night, the cash sleeps in the (notional) arms of the securities dealers, while the securities (and a promise to buy them back in the morning) sleep in the (notional) arms of the cash investors.
Every morning, the cash wakes up and springs from the dealers’ beds back into the waiting arms of the cash investors, and vice versa etc.
Which means that the dealers need to borrow cash to be able to give it back to the investors. Where do they get the money?
I am always afraid to wade into the world of collateral and repo and rehyp and whatnot because it is big and complicated and smarter people than I splash around in it, but this week has had some good stuff so let’s talk about it for a bit. NBER’s weekly dump of things you could read if you wanted to yielded up a trove of Gary Gorton, including a Gorton-Lewellen-Metrick paper about how much of our economy has historically been composed of safe assets (answer: 33%! weird) and a heavy-sledding but apparently good Gorton-Ordonez paper modelling financial crises as the effect of people deciding that “information insensitive” collateral should be information sensitive. There’s also an interesting paper by Krishnamurthy, Nagel and Orlov (let’s go with K-N-O) that maybe illuminates that point. It’s called “Sizing Up Repo,” and if you’re not already into this sort of thing, here is a picture describing exactly how clear the rest of this will be:
Heheheh no really. Anyway, the basic gist of this whole realm of literature goes something loosely like this:
1. Humans put money in banks and banks lend this money to companies and fulfill their basic role of financial intermediation.
2. Also, there’s a whole lot of other stuff that isn’t “banks” but serves some of the same role, that is, intermediate between human savers and companies that need money.
3. That other stuff is looooooooosely “shadow banking,” and a lot of it consists of humans – and corporations, endowments, etc. – putting their money into things – like money market funds, mutual funds, etc. – that then lend money to each other or the banking system via short-term money-like instruments that sort of fill functions similar to bank deposits. A lot of these instruments take the form of very short-dated loans backed by financial instrument collateral, roughly speaking “repo.”
4. Something broke in that system and helped cause the financial crisis.
The K-N-O paper is a contribution in that vein, and here is the point where I felt like I could stop reading because I had learned something: Read more »
A key insight from the enhanced BIS credit derivatives data is that non-rated multi-name credit risk sourced from multiple sectors has been transferred from derivatives dealers to IFGCs, SPVs and OFCs.
Yeah! Wh … what?
It’s from the quarterly review of the Bank for International Settlements, which is a delightful hodgepodge of hard-to-read charts, hard-to-read sentences, and general oblique glances at the guts of the global financial system. It is both glancing and gutsy. There are reams of tables. Give it a read.
The quote above is about this:
Everything clear now?
I love charts and all but I mostly think in stories, and I’m trying to parse together the story for these facts because they seem somehow important. It seems to go like this. Read more »