NY Fed President Wants To Subsidize Shadow Banking More, Or Get Rid Of It, One Or The Other

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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:

Through the tri-party repo market, the two large clearing banks were providing a large amount of intraday credit to securities firms each day to facilitate the daily “unwind” of the prior day’s transactions. In the run-up to the crisis, the daily “unwind” practice helped make tri-party repo look like a very liquid investment while still being an apparently highly durable source of funding. This masked the underlying risks and contributed to weak risk management practices. ... Reducing the market’s dependency on intraday credit will make the market more resilient to future stress events, by forcing all participants to consider the credit and liquidity risks they are exposed to.

That is sort of a funny last sentence; there are those who would argue that the whole point of the shadow banking system - of collateralized repo - is to replicate the money-like, don't-consider-the-credit-and-liquidity-risks-you're-exposed-to nature of old-fashioned deposit-guaranteed banking, only without the guarantees, or the capital requirements.1

And without the deposit insurance. So fixing the unwind only goes so far:

In particular, the risk that investors will run at the first sign of trouble persists. That is because the costs of running are very low relative to the potential costs of staying put. The potential costs of staying are elevated in part because investors often don’t have the capacity to take possession of the collateral or liquidate the collateral in an orderly way should a large dealer fail. Both aspects result in run risk, fire sale risk and potential financial instability. ...

[One] option is to have a mechanism or process to facilitate the orderly liquidation of a defaulted dealer’s collateral. One could imagine a mechanism that was funded by tri-party repo market participants and potentially backstopped by the central bank. This would have the advantage of dealing with the entire tri-party repo market and not artificially favoring one type of collateral over another. It would also push against the underpricing of liquidity and credit risk during good times by forcing market participants to pay for the costs of a liquidation facility up front.

Because no single market participant has a strong incentive to develop such a mechanism, however, sustained regulatory pressure may be required to reach such a solution. From the perspective of the tri-party repo borrowers and investors, the status quo undoubtedly is viewed as superior because neither group is forced to fully bear the externalities associated with their actions. Instead they anticipate that emergency liquidity would be made available in the event of a future systemic crisis.

He doesn't seem all that sanguine about this and ends up turning to two more activist-regulatory solutions, either restricting the use of short-term wholesale funding2 or, rather more generously, backstopping the repo/money-market/shadow-banking system with Fed money:3

Which path to go down—limit wholesale funding or backstop it more broadly—would depend in large part on the social value of the capital markets-based activities presently being financed in unstable short-term wholesale markets and the utility of short-term wholesale funding for lenders.

What do you think the odds are that the political-regulatory system will come to the conclusion that "the social value of the capital markets-based activities presently being financed in unstable short-term wholesale markets" is high?

I was mostly tickled by the idea of the sort of triparty-repo mutual aid society, in which the market participants - possibly with "sustained regulatory pressure" - all chip in to some sort of rescue fund to step in as a lender of last resort and orderly liquidator of repo collateral. One way to think about shadow banking is that, despite its spooky name and attendant acronyms, it is sort of old-fashioned banking: it looks a bit like banking did before the rise of deposit insurance and capital regulation. And before deposit insurance, banks did more or less set up rough forms of primitive deposit insurance:

During the 19th century, the banks themselves developed increasingly sophisticated ways to respond to panics. The response was centered on private bank clearinghouses. Originally organized to be an efficient way to clear checks, these coalitions or clubs of banks evolved into much more. ... [I]n the panics of 1893 and 1907, the clearinghouses issued new money, called clearinghouse loan certificates, directly to the public, in small denominations. These were liabilities of the clearinghouse members jointly and served the purpose of providing a kind of deposit insurance. The clearinghouse loan certificate was a remarkable innovation, resulting from individual private banks finding a way to essentially become a single institution, responsible for each other's obligations during a panic ....4

And now Dudley is pondering something similar for the tri-party repo market. He may not be all that optimistic, but I don't know. I think it's at least possible that the modern banking system can, with hard work and "sustained regulatory pressure," reach the level of technology that it managed in the 19th century.

Fixing Wholesale Funding to Build a More Stable Financial System [FRBNY]
Fed's Dudley floats even broader revamp of wholesale funding [Reuters]
Fed’s Dudley Says Short-Term Markets Still Risky [RTE]

1.Though with haircuts. Here is a chart showing the average repo haircut for, say, equities is 8%; the average haircut for ABS is 7%.


3.Really the headline is a needlessly extreme characterization of that, sorry. But it's fixed in this footnote, so.

4.That's from page 33 here. It's a fascinating history and I oversimplify wildly; in particular the response was not mainly to do an orderly liquidation of failed banks, but rather to jointly suspend convertibility out of all banks, and stop publishing financial information on all banks, to make runs on one bank less likely.