Deus Ex Macchiato

FED governor Daniel Tarullo gave an interesting speech recently; interesting because he is clearly trying to set out a regulatory agenda while uncomfortably aware that legislators, if anything like Brown Vitter is passed, might pull the rug out from under him. He therefore has to tread delicately. That doesn’t stop him from pushing the FED’s line, but they are gentle nudges.

His first real point is that liquidity reform has not made much progress:

we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs… But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions.

He has to admit that little has been done about too big to fail as it hasn’t, and the Senate has noticed

With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way… But questions remain as to whether all this is enough to contain the problem.

Indeed. He gives the standard spiel on more capital and/or liquidity risk regulation, as in Basel III. But then it gets interesting:

a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs.

Or, for that matter, a tax on them. Either would do.

Look at this for a lovely piece of politics. Tarullo says, as he would, that the FED should be allowed to complete its current agenda. But then he pays deference to the law makers:

the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks–whatever their merits and demerits–embody basic policy decisions that are properly the province of Congress

That leads him to trying to head the B-V posse off at the pass:

One approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

Is this just trying to kick the can down the road? Tarullo must know his chances of getting higher standards agreed in Basel are low. Equally he knows that unilateral action in the US will damage the competitiveness of US banks (while making them safer, of course). If he can’t persuade the Brown-Vitter crew to back off, and he can’t get Basel to agree to similar standards, he will have to doff his cap and do what the law requires. I would suggest, though, that that doesn’t mean that he will like it.

Posted in: Liquidity and liquidity risk, Regulation by David /
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My freezer is like equity, my TV is like debt.

Let me explain.

There is a push from electricity suppliers to distinguish appliances that need their power now – like TVs – from those that can wait a few minutes – like freezers. We might even imagine a situation where there are two types of plug connecting to two (virtual) networks with two tarifs: an expensive, power-on-demand one; and a cheaper, give me power when you can one (with some standard over how long it could be delayed etc.) This would typically be achieved using smart devices, so my freezer would say to the network that it needed half a kilowatt hour of electricity sometime in the next ten hours, and the network would deliver it when convenient, given the total load. The plug would contain a network as well as a power connector allowing the freezer to talk to the grid.

This allows much better peak management. You can deny power from freezers in that critical five minute commercial break at half time in the cup final, giving you a better chance of boiling all those kettles.

The problem with debt is not just that it is leverage, but also that it is demand liquidity. The debt holder can demand their payment now. (Thus contingent liquidity schemes like lines of credit are like pumped storage power: they allow a solvent but illiquid party to meet peak liquidity demand.) The two tarif idea is akin to suggesting that there is a place for delayable payment but otherwise senior contracts – like sub bonds but where it is genuinely acceptable to use the deferral feature. Indeed, Islamic finance has always had such an idea, and many firms in practice treat supplier invoices that way. The nice part about the smart freezer though is that there is in some sense a negotiation between the freezer and the grid: could we imagine a similar ‘I need $1M sometime in the next two days… OK I will get it to you on Tuesday at 7.30am’ idea in finance?

Posted in: Information Fusion, Liquidity and liquidity risk by David /
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Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader

started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.

The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.

Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.

The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.

On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.

The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.

Posted in: Legal Risk and Trade Documentation, Liquidity and liquidity risk, Markets by David /
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US GC repo is going lower, because, well, the Treasury has most of the assets, thanks to QE. Given that these assets are needed for collateralised funding and collateralised risk taking, that is having an impact. Izzy at Alphaville relays the following, very much along the line we have taken on this:

overly strict collateral policy, implemented post crisis, is now constraining the market’s ability to take on risk, because the ability to fund or run “risk-on” trades is determined by how many safe assets an institution has available for margin posting.

Risk positioning is increasingly being held back by a static pool of risk-free collateral.

Furthermore, if and when the risk positions sour, that divide only gets wider as further safe collateral calls are made, sucking more safe assets out of the system.

You can’t both demand that funding and risk taking are often collateralised then buy up most of the collateral without it having an impact.

Posted in: Clearing and Collateral, Economic Theory, Liquidity and liquidity risk, Markets by David /
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My paper Maintaining Confidence – Understanding and preventing a major financial institution failure mode has been published as an LSE Financial Markets Group special paper, and is available here. From the abstract:

This paper proposes the solvency/liquidity spiral as an failure mode affecting large financial institutions in the recent crisis. The essential features of this mode are that a combination of funding liquidity risk and investor doubts over the solvency of an institution can lead to its failure. We analyse the failures of Lehman Brothers and RBS in detail, and find considerable support for the spiral model of distress.

Our model suggests that a key determinant of the financial stability of many large banks is the confidence of the funding markets. This has consequences for the design of financial regulation, suggesting that capital requirements, liquidity rules, and disclosure should be explicitly constructed so as not just to mitigate solvency risk and liquidity risk, but also to be seen to do so even in stressed conditions.

Posted in: Liquidity and liquidity risk, Regulation by David /
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The new revisions to the Basel III LCR do not, of course, water it down to homeopathic quantities, but I love the phrase so much I wanted to use it nonetheless.

Basel proposes:

• the definition of high quality liquid assets (HQLA) has been expanded to include lower-rated corporate bonds (A+ to BBB-);
• certain equities with 50% haircut
• as well as certain RMBS rated AA or higher with 25% haircuts.
• The aggregate of these additional assets are subject toa limit of 15% of the HQLA.

The Basel Committee has also agreed to a timetable for phase-in of the new standard. Banks’ LCR will need to reach 60% in 2015, increasing by10% p.a. until 2019, instead of a 100% requirement in 2015.

My snap judgement is that this can probably be met by most banks in the current liquidity environment. Whether it will act as a constraint later is less clear.

Posted in: Basel, Liquidity and liquidity risk by David /
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From a presentation by Eurex Repo:

GC Pooling − Take advantage of collateralized funding

Benefits
…
• Zero regulatory costs due to trading via Eurex Clearing depending on country of residence

This is entirely accurate, I am sure. But should it be? As I said earlier, the idea that repo, especially repo with `Re-use of collateral and pledge to ECB’ of those notoriously safe assets, European sovereign bonds (cf. Fuzzy Corzine, late of this parish), attracts no capital at all worries me. I’m pretty sure that this door will only be bolted well after the horse has fled, though.

Posted in: Liquidity and liquidity risk by David /
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Like many, I am reading the FSB report on shadow banking. The most important issue here is the fifth workstream, securities lending and repo — yet the proposals seem, well, a little bland. Here are the suggestions in brief:

1. Improving regulatory reporting
2. Improving market transparency
3. Improving corporate disclosures
4. Improving reporting by fund managers to end-investors
5. Introducing minimum standards for haircut practices
6. Limiting risks associated with cash collateral reinvestment
7. Addressing risks associated with re-hypothecation of client assets
8. Strengthening collateral valuation and management practices
9. Evaluating the establishment or wider-use of central clearing where appropriate
10. Changing bankruptcy law treatment of repo and securities lending transactions

All good stuff, but if a money market fund requires something like capital because it is bank-like, shouldn’t there be capital requirements for all repo rather than Basel II’s safe harbour (zero capital for certain qualifying transactions)? And, if not, on what basis is liquidity risk being `traded off’ against systemic and credit risks? Just askin’.

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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(Yes, that is a theme for this week. I’ll get over it after that.)

Can a Basel III liquiidity buffer every be used? The point is that banks have to have this buffer at all times, which means that they can never use it without triggering supervisory intervention. So do they in fact have more liquidity risk than prior to Basel III?

Posted in: Liquidity and liquidity risk, Regulation by David /
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Back in the mists of time, I heard about a trade whereby a Japanese fund paid an investment bank a (small) fee in exchange for the promise that they would make a quote on a large portfolio of illiquid equities if requested to do so. The bank didn’t promise to quote ‘at market’, just that they would quote. They could have quoted a single yen, but of course there would have been serious reputational implications to doing that, especially in Japan. So in effect the fund was paying for a liquidity risk backstop.

This came to mind when I read this post on a Sober Look about differences between bilateral and triparty repo haircuts during the crisis:

When a firm lent money to Lehman via repo on a bilateral basis, Lehman placed the collateral for this loan into the lender’s securities account – at Lehman. Once Lehman filed for bankruptcy, it would not pay back the money borrowed. The securities account where the collateral was sitting however was frozen by the court. By the time the lender was able to access her collateral and sell it, it had sometimes declined in value so much that the proceeds did not cover the loan balance.

On the other hand if the collateral was held by a third party such as State Street or BoNY, as soon as Lehman couldn’t pay, the lender was able to access and liquidate the collateral. Thus the differences in haircuts are not driven by the repo agreement itself… It’s driven by the fact that in a bilateral agreement it may take longer to access the collateral and liquidate it, potentially increasing losses. That risk of a longer liquidation period in the case of a default increased the bilateral haircut levels.

The difference between bilateral and triparty haircuts, in other words, represents a kind of liquidity risk premium. You could either deal with this in margin, or get paid a fee to take the risk in a bilateral repo that the triparty margin wasn’t adequate – as in the ‘pay for a quote trade’. You could even support the risk with capital. But in any case there is a risk there that needs to be understood, managed, and for which the risk taker requires a return.

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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Lisa at FT Alphaville, linking to some Citi research, suggests that there are the following measures for bonds. The italics are Lisa’s comments; mine are in roman.

1. Absolute number of block trades. These are defined as a trade size of over $5m for high-grade bonds, and $1m for high-yield. Once they have the count over the last 60 days, they logarithmically rank them within their own sector (high-grade or high-yield).
2. Consistency of block trading activity. Consider the first factor more closely — if there were, say, 45 block trades in the 60-day window but they were all on one day, that doesn’t exactly shout liquidity! If, on the other hand, the trades were spaced out, that’s probably a better sign. This factor also involves a logarithmic ranking.

Why would you want it? Well, if you needed to sell. That much is obvious. What is perhaps less obvious is that high quality but illiquid assets are good for some investors, like pension funds, who are often hold to maturity, and who can get paid to take illiquidity risk. Indeed arguably pension funds should not be invested much in liquid assets at all as they are paying for liquidity that they don’t need. What everyone needs to know, though, is whether they are receiving sufficient compensation for the liquidity risk they are taking. These measures at least help in that judgement.

3. Client trading activity. This is where the Citi strategists start to get creative, and where it also becomes apparent that they are building this liquidity measure for their clients. Here they count up the number of trades that actually involved a client rather than just the Street selling to the Street, i.e. client-to-dealer rather than dealer-to-dealer. Additionally, they adjust this variable by factor 1) above.

   This makes sense; interdealer pass the parcel can easily go away, whereas genuine two way client flow is more durable.

4. Market balance. This is a measure of the amount of two-way activity seen in the client trades of the previous factor. If there are as many client buys as sells, then it’s more likely that trades can be executed without moving the market. This factor is also weighted by 1) above.

   A thousand sellers and one buyer, even if all the trades clear is likely not durable liquidity; if the buyer exits (cf. ABS CDOs buying RMBS mezz tranches) then the market disappears.

5. Compensation for non-default-related spread volatility. This (pace Alphaville) is straightforward; if the liquidity premium is highly variable, then the market is patchy, whereas if it is more or less constant, then prices only move when there is a change in fundamentals. This isn’t pure liquidity, but it is correlated with trading activity, so it is a useful measure.

It is commonplace to add to these additional measures:

1. Price impact of a trade. Roughly, how much you move the market when you do a big trade.
2. Recovery time. This is simply how long it takes prices to recover after a ‘big’ trade hits the market, whatever ‘big’ means.
3. Bid/offer spread. Lower spreads tend to mean better liquidity.
4. Quote availability. While a quote does not mean that you can trade, no quotes tend to imply that it is harder to trade.

Posted in: Liquidity and liquidity risk by David /
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Four telling graphs, from a great presentation by Citi’s Matt King (HT FT Alphaville).

First, the importance of the repo market:

Second, the growing importance of collateralized borrowing (and the decline of the interbank market):

Third, the trend towards the use of ‘safe’ collateral:

Fourth, where the bad stuff ends up:

So… what do we have? It’s hard for a bank to borrow unsecured. It’s hard for it to borrow secured in the private market unless they have the best collateral. But, riding to the rescue (kinda), is the ECB, where you can pledge some of that dodgy collateral. This state of affairs is not sustainable in the long term, though; we need to do something to get banks to trust each other again.

Posted in: Clearing and Collateral, Credit, Liquidity and liquidity risk by David /
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Mario Draghi said:

The interbank market is not functioning, because for any bank in the world the current liquidity regulations make – to lend to other banks or borrow from other banks – a money losing proposition. So … regulation has to be recalibrated completely.

Posted in: Basel, Liquidity and liquidity risk by David /
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It is relatively simple to see the liquidity of a bond. You see how many times a day (or week, or year) it trades.

A commenter on a prior post suggested that the number and spread of these quotes is also a useful indicator of liquidity. I’d agree, with the caveat that a quote is not necessarily good in the size you have, nor is it necessarily a firm commitment to trade.

For OTC derivatives markets, though, things become murkier. This is because most derivatives have a maturity, and as time passes, that gets shorter. Your on-the-run five year swap today becomes a four year 51 week swap next week, and that isn’t liquid.

The problem is typically solved with a model. We build yeild curves, credit spread curves, vol surfaces and so on. The liquid instruments define points on these curves which the model is calibrated to; everything else follows by interpolation. (Or, if you want to take significantly more risk, extrapolation.) A model in this setting is just a fancy interpolator.

The advantage of this system is that it allows market participants – mostly – to price things that don’t trade. You can get a quote on your four year 51 week swap despite the fact that that particular instrument won’t trade this week precisely because its price is in a reasonably clear relationship to that of the five year swap that does trade.

Problem start to arise when the benchmarks themselves become illiquid or otherwise doubtful. The whole system relies on the benchmarks being liquid, so that the are known prices to interpolate between.

This brings us to Libor. If banks don’t lend to each other for three or six months, then 3m and 6m Libor are conjectural. That means that the benchmark swaps (and the Eurodollar futures) are themselves uncertain in value, and liquidity in them might start to decline. At that point you won’t be able to price any interest rate derivative.

Now, I don’t claim that this will happen. But without a floating rate that the market has confidence in, there has to be some risk of it. For me, this is a far more important financial stability issue than Mr. Diamond’s employment status.

Posted in: Derivatives, Hedging and Convexity, Liquidity and liquidity risk by David /
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Via Alea, I found an interesting article in Euromoney about a presentation by JPMorgan’s Michael Ridley. He was discussing the parlous state of secondary bond market liquidity in Europe is one of the most worrying by-products of the region’s bank-funding crisis. Primary volumes in the first quarter were excellent, but secondary volumes remain low. Apparently bonds are often cheaper in the primary market than in the secondary market, and the challenging market liquidity situation is not improving.

The volume figures quoted in the article are rather scary:

Explaining that the US bank traded 5,000 names last year, Ridley noted that of the top 1,000 bonds, just eight traded more than three times a day. Twenty-six traded twice a day, 134 once a day and 832 traded just three times a week. Ridley added that 145,000 bonds on the bank’s books did not trade at all in 2011.

If you buy a corporate bond in the primary market, you should plan on a worst case holding period of ‘until maturity’.

Posted in: Credit, Liquidity and liquidity risk, Markets by David /
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Benoît Cœuré, Member of the Executive Board of the ECB, recently gave an important speech. It has quite a lot in it so even the bullet point version isn’t that short, but I promise you that it is worth thinking about his essential argument.

• Money markets around the world came under severe stress during the recent financial crisis and in the subsequent sovereign debt crisis, with interest rate spreads jumping to unprecedented levels and market activity declining significantly in many market segments.
• Opacity in banks’ balance sheets, coupled with uncertainty about the real valuation of their assets, led to acute tensions in the markets for credit instruments… Off-balance sheet entities became unable to roll over short-term financing in the US asset-backed commercial paper market. These events reinforced each other and generated uncertainty about both the solvency and liquidity of money market participants. Counterparties could not distinguish good banks from bad.
• Liquidity was no longer flowing from cash-rich banks to cash-poor banks.
• The Eurosystem introduced a fixed-rate full allotment regime in its refinancing operations, offering unlimited liquidity to banks at predictable cost against an expanded set of eligible collateral. The rise in the liquidity deposited with the Eurosystem after October 2008 was a direct consequence of this new regime and a symptom of a malfunctioning money market.
• Stress in the Euro unsecured money market continued beyond 2008, with a reduced turnover and preference for lending at shorter maturities.
• Dispersion in banks’ access to funding increased considerably in the euro area, with banks domiciled in countries under sovereign strains facing severe constraints even in obtaining secured funding.
• Deep and liquid money markets, not unlike other markets in the economy, play an important part in information aggregation and price discovery. They also help to ensure market discipline.
• Money markets play a central role in monetary policy transmission in the euro area.
• It is important that the Basel 3′s new liquidity regulations do not hamper the functioning of funding markets. This applies in particular to the calibration of the run-off rates for interbank funding and to the asymmetrical treatment of liquidity facilities extended to financial firms.
• The regulators’ welcome push to OTC derivatives towards CCPs may also have an effect on both the unsecured and secured money market segments. Such a move will lead to an increased need for high-quality collateral. The supply of safe assets is finite and the pool of “good” collateral is dwindling as the creditworthiness of certain sovereigns is questioned by market participants. The more good collateral is pledged to the CCPs, the less is left to use in the secured money market, and the fewer assets are available to other creditors in the event of default, making it difficult to obtain unsecured refinancing. This strengthens the need to find ways to identify or produce new assets that can be used as collateral and to mitigate the pro-cyclical consequences of credit ratings and of market valuation.

Posted in: Bank Run, Euro, Eurocrisis, Liquidity and liquidity risk by David /
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Another interesting idea from last week’s meeting: what is the closest that you can get to global liquidity management in a bank with subsidiaries instead of branches? It is an interesting question because, whether banks like it or not, subsidiarisation is a growing trend. Local regulators, understandably, aren’t comfortable with branches whose funding depends on some distant global treasurer, and where the money may disappear at any moment. Thus they are demanding local subs: local balance sheets for local people (aka the Royston Vasey theory of global bank regulation).

Clearly large exposures issues prevent one sub lending another lots of funds; that is what the rules are meant to stop. But… what if one sub issues securities backed by its assets and these are bought by another sub? I am not recommending this, notice, just suggesting that anything you can do on the liability side of the balance sheet you can also do on the asset side, and if regulators prohibit too much liability management by local subs, then asset management becomes attractive. This is clearly a trend that will have to be watched.

Posted in: Liquidity and liquidity risk, Regulation by David /
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FT Alphaville had a good post last week, referencing a new paper by Brad DeLong that in turn discusses the early history of central bank liquidity provision. One paragraph in particular gave me pause for thought:

Bagehot never argued that central banks should lend only against good collateral. Bagehot was subtler than that, and less exclusive. What he argued was that central banks should lend against collateral that would be good “in ordinary times”.

What does this mean? It’s not entirely clear, but I would suggest that a modern version of this doctrine is that as lender of last resort the central bank should advance sums against collateral which are conservative given the expected eventual realised value of the collateral, but it should not consider the market value. Or, to put it another way, the Central Bank should ignore the non-default component of the credit spread in assessing collateral haircuts. That’s a pretty good formulation of the lender of last resort function: central banks should be willing, for a solvent institution, to keep it liquid long enough for it to be able to monetise the spread between assets and liabilities (or for the market to come to believe that that spread is positive, and so be willing to fund the bank privately).

Posted in: Liquidity and liquidity risk by David /
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Izzy Kaminska has a nice article on Alphaville that reiterates some of the points I have been making about central clearing (see for instance here or here or here). She is writing about central clearing and collateral/liquidity.

Once again, we would like to draw on the analogy to a game of musical chairs.

The game depends on there not being enough chairs for all participants. While the music plays, the lack of chairs doesn’t matter much. Nobody actually needs a chair to sit on. But any anticipation that the music might stop, and the rush to allocate chairs begins to create panic.

But rather than have one central authority available to distribute chairs in a calm and collected manner between all parties, we’ve opted to introduce a system which depends on multiple authorities grabbing whatever chairs they can for some players but not for others — in effect creating a have and have-not system.

Meanwhile, as the grabbing of good quality assets intensifies thanks to this process, the supply of high quality collateral across the overall system diminishes with it.

What’s more, as the best collateral gets absorbed by the CCPs and/or capital and liquidity reserves, that leaves everyone else handling the dregs.

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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In an important and interesting article on VoxEU, Singh and Stella discuss a new and to my mind convincing analysis of the money multiplier (or the lack thereof). It is well known that, despite a massive increase in central bank money, there has not been anything like the concommitant increase in credit that the multiplier would predict. Singh and Stella have two explanations:

The first relies on a correct interpretation of the liquidity needs and management of a modern financial system which comprises not only conventional banks but also financial institutions operating in their shadows. Such non-bank financial institutions do not have access to monetary base as they hold no reserves at the central bank. Instead they rely on their access to the repo market predicated on their ownership of what is perceived to be highly liquid collateral.

Due to this shift, the liquidity fulcrum of the pre-crisis US financial market was composed only partly of central bank liabilities—and it was a very small part. More importantly, the magnitude of the liquidity fulcrum was determined not by the monetary policy authorities but instead by market practice. The nature and volume of assets determined by the market to be acceptable collateral is the key.

I absolutely agree with this, which is why in the past I have suggested that the central bank consider not one but three policy tools; the rate at which it provides money (as usual), but also the amount and the collateral against which it will lend. Central banks should explicitly the implications of their definition of eligible collateral and, if necessary, change it. That is because collateral is in competition between being used at the central bank and being used in repo. As S&S explain:

The enormous increase in bank reserves reflects a substitution of monetary base largely for highly liquid government securities in private-sector portfolios. But as government securities serve as collateral in the private-credit market, the effective size of the market liquidity fulcrum is unchanged by such operations. Little wonder then that market liquidity conditions remain tight despite the increase in bank reserves. That is, although quantitative easing which merely swaps bank reserves for US Treasury bills increases the textbook monetary base and “should” lead to an increase in market credit, in our view this accomplishes virtually nothing in terms of easing liquidity pressures. It merely changes the composition of assets within a given sized liquidity fulcrum.

Central bank operations only create new liquidity if they take as collateral assets that are no longer accepted at full value as collateral in the market.

The part of the story that S&S are missing is the impact of capital. Banks don’t just need funds to lend, they also need capital to support the risk of lending. Add in that dynamic (and understand the impact of rehypothecation), and I think you have a much more convincing account of the money (de-) multiplier than the textbook one.

(HT FT Alphaville.)

Posted in: Economic Theory, Liquidity and liquidity risk by David /
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My main concern about last week’s idea from Interfluidity of government inflation linked savings accounts was the impact it would have on bank funding. Essentially I was worried that fewer deposits at banks meant more repo/CP funding. Now I notice that this is a design rather than a feature:

Frankly, it’s better if more bank funding were “hot” and regulators were frequently on the hook to choose between support or resolution of banks. It’d require regulators to much more actively involve themselves in the asset-side of bank balance sheets. I think it was Minsky who pointed out that, back in the day, monetary policy consisted primarily of discounting against bank loans as collateral, and that fact meant that central banks had a much richer and deeper understanding of the bank activities than in today’s regime, where direct lending to banks is frowned upon. The current regime lets regulators usually feel pure (since they’re not lending to banks directly), and let banks pretend they are private businesses without direct state support, but good feelings among regulators and bankers don’t necessarily serve the public.

(From a comment to the original post.)

Now this is really interesting. Essentially the debate comes down the feasibility of anyone – a supervisor, a senior debt buyer, a (non-insured) depositor – having a good enough understanding of a bank such that they can exert meaningful discipline. If they can then they should, and maybe Basel’s famous pillor 2, market discipline, can do some good. The problem is that I am not sure that this is possible, at least with current disclosures. Could anyone really, given FSA’s resources say, understand a bank like HSBC or RBS or Barclays well enough to make a meaningful credit decision on them? I rather doubt it but I would love to be proven wrong.

Posted in: Accounting, Liquidity and liquidity risk by David /
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A minor spat in the finance blogosphere – no one died. This is hardly news I know. But for me this fight is unnecessary; both parties have some of the truth. John Cochrane first – his tagline is

As long as some firms are considered too big to fail, those firms will take outsized risks.

That seems pretty reasonable. His account of the mechanism at work around the Lehman failure has a measure of truth about it too:

After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad…

Buttressing this story, let us ask how—by what mechanism — did Federal Reserve and Treasury equity injections and debt guarantees in October eventually stop the panic? An increasingly common interpretation is that, by stepping in, the government signaled its determination and legal ability to keep the large banks from failing. That too makes sense in a way that most other stories do not. But again, it means that the central financial problem revolves around the expectation that banks will be bailed out.

I might quibble with that ‘central’, but certainly too-big-to-fail is a problem, and certainly it needs to be resolved.

Next, Economics of Contempt, who lays into Cochrane. They choose instead to emphasise the liquidity aspects of Lehman’s failure:

…the end result is that LBIE’s [Lehman's main London entity's] failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn’t be able to access their funds if either of the prime brokers failed…

And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, “broke the buck” because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn.

This is perfectly fair, and indeed the liquidity aspects of the crisis are rather less well understood than the solvency ones, so EoC is right to discuss them. Having another angle does not justify calling Cochrane’s piece ‘mind-boggling nonsense’ though.

Now, I do think that Cochrane goes astray in his account of the TARP, but I don’t think he is being duplictious, and he does show some sympathy for the complexity of the policy choices the authorities faced after Lehman. He’s good on the fragility of some of the structures such as ABCP conduits used to fund mortgages, and on the ‘huge initiative of mostly pointless regulation that would move derivatives and cds onto exchanges, regulate hedge funds, force loan originators to hold back some credit risk, and so forth’.

Give both of them a read, Cochrane and EoC. They both have worthwhile things to say. There’s plenty of crisis to go around, with no need for a fight.

Posted in: Liquidity and liquidity risk, Mortgages, Mother of all Bailouts, Regulation by David /
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From a recent speech by Benoît Cœuré, ECB Board member:

In normal times, private liquidity dominates official liquidity. But private liquidity is highly pro-cyclical and highly endogenous to the conditions that prevail in the global financial system. The inherent endogeneity of private liquidity means that it can easily evaporate in times of financial stress. The pro-cyclicality is documented via the strong interaction of private liquidity and the global risk appetite of financial institutions. Indeed, the global risk appetite is one of the main determinants of the multiplier that links levels of overall liquidity to levels of official liquidity.

It is really heartening to see the ECB thinking this way. Of course one cannot be sure what will come of it, but at least they are looking in the right places.

Posted in: Liquidity and liquidity risk by David /
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FT alphaville has a nice riff on the whole systemic risk of margin calls thing, discussing in particular the risk of variation margin calls in the ECB’s LTRO. They quote some Nomura research which makes a number of good points, but one dodgy one. The major thrust first:

The cost of the haircuts and existing funding costs on leveraged banks balance sheets means that the cost of funding from the ECB is not 1%.

True. You fund only 71% of the asset (assuming the collateral is a >5y corporate loan, which gets a 29% haircut at the ECB) at the ECB rate. The rest has to be borrowed unsecured*.

The error comes when the discussion turns to capital:

In this case against a €100 asset there would be a €29 haircut and €5 capital charge giving €34 to fund through other sources.

Nope. The capital charge is funding too. If you have a €5 capital charge on a €100 asset, then 5% of it is equity funded and the rest is debt funded. Thus if the ECB haircut is 29%, you get 71% from the ECB and 5% from your equity investors leaving 24% to raise in the unsecured market.

Now, often people keep ROE separate from ‘cost of funds’, as this separate is typically convenient for reporting; but both equity and debt capital are funding. Thus in this separation the ‘cost of funds’ should be the cost of the debt needed to fund the asset, i.e. interest on €95, not on €100.

*The Alphaville article says ‘Unsecured funding is closed (to all but the bestest of the best), ergo the bank scrapes together assets to pledge for cash somewhere, running the gauntlet of the collateral crunch.’ That isn’t quite it as you don’t fund the haircut of a collateralized asset (the 29%) with more collaterized borrowing. You fund it unsecured, because you have to – you have used 100% of the asset you have to raise 79% of its value. All assets need funding, and there aren’t spare ones lying around to use as collateral as – roughly – anything you can use as collateral is being used to fund itself. This just follows from balance sheets, err, balancing.

Posted in: Capital Structure Arbitrage, Liquidity and liquidity risk by David /
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Gorton, Lewellen and Metrick have a new paper on safe assets (HT FT alphaville, see Timothy Taylor for more details). This is a topic I have blogged about several times before, so here are the highlights.

• The percentage of all U.S. assets that are “safe” has remained stable at about 33 percent since 1952 – the population of safe assets has been remarkably constant.
• However, demand comes from various souces. As Taylor, quoting Ricardo Caballero says “Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets.”
• Another source of demand is from collateralized funding transactions. Back to Gorton: “To the extent that debt is information-insensitive, it can be used efficiently as collateral in financial transactions, a role in finance that is analogous to the role of money in commerce. Thus, information-insensitive or “safe” debt is socially valuable.” It is, in fact, the thing that makes the repo market, and hence a lot of banking funding, work at all.
• Making pseudo-safe assets via securitization to meet this demand did not pan out so well.
• Hence it is encumbant on policymakers to ensure there is enough safe debt around to meet needs. Or, as Gorton puts it “regulators and policymakers must adroitly balance the need to improve financial stability with the simultaneous need to maintain enough liquid, safe debt in the economy to meet the demand for such debt.”

Posted in: Clearing and Collateral, Economic Theory, Liquidity and liquidity risk by David /
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FT alphaville suggests that targeting the GC repo rate could be a more efficient goal for the FED than targeting FED funds. I think that’s right. GC is much closer to real banks’ cost of funds than FED funds, and it’s (it seems) a bigger market.

The FED says that tri-party repo alone funds $2 trillion or more a day, while FED funds hovers in the hundreds of billions range. GC is harder to move, but more effective at influencing bank funding when you move it.

(More background from the ECB here.)

Posted in: Economic Theory, Liquidity and liquidity risk by David /
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Abstract:

The solvency/liquidity spiral was a major mode of large financial institution failure during the 2008 financial crisis. Many institutions began the crisis with significant funding liquidity risk. Initially unjustified investor doubts over an institution’s solvency caused a loss of confidence. This in turn caused the price and availability of funding to deteriorate, until in some cases this lead to failure. Thus a key factor in financial institution distress was loss of confidence caused by investor uncertainty over solvency.

As we show, the official accounts of the failures of Lehman Brothers and RBS provide substantial evidence for this failure mode. Our model has implications for confidence-enhancing regulatory and accounting policy, which we discuss. In particular, it suggests that minimum required capital is needed to keep investor confidence in a firm, and thus only capital above the minimum is available to absorb losses.

The full version is here.

Any comments would be much appreciated.

(Irritating geeky note: some folks have had some problems in the past with PDFs saved from Word 2010 not being readable on ipads. I think I have cured this problem here by saving an ISO 19005-1 compliant PDF, but please let me know if I haven’t.)

Posted in: Liquidity and liquidity risk, Publications, Regulation by David /
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I’m reading the FSA report into the RBS failure (so you don’t have to, and because I griped about it not yet being out last week, so I can’t really ignore it). I’ll post in coming days on various aspects of this long and juicy document, but for now let me concentrate on what I think is clearly the mechanism by which RBS failed: a solvency/liquidity spiral.

First, some quotes from the report.

RBS did not have a solvency problem.

“Many accounts of the events refer to RBS’s record £40.7bn operating loss for the calendar year 2008. But that loss is not in itself an adequate explanation of failure. Most of it indeed had no impact on standard regulatory measures of solvency:

• Of the £40.7bn loss, £32.6bn was a write-down of intangible assets, with impairment of goodwill contributing £30.1bn. Such a write-down signals to shareholders that past acquisitions will not deliver future anticipated value. But in itself, it had no impact on total or tier 1 capital resources, from which goodwill had already been deducted.
• In fact ‘only’ £8.1bn of the £40.7bn (pre-tax) operating loss resulted in a reduction in standard regulatory capital measures.

Given that RBS’s stated total regulatory capital resources had been £68bn at end-2007, and that it raised £12bn in new equity capital in June 2008 (when the rights issue announced in April 2008 was completed), an £8bn loss should have been absorbable.” (Page 38)

RBS had a liquidity problem…

“The immediate driver of RBS’s failure was … a liquidity run (affecting both RBS and many other banks)… it was the unwillingness of wholesale money market providers (e.g. other banks, other financial institutions and major corporates) to meet RBS’s funding needs, as well as to a lesser extent retail depositors, that left it reliant on Bank of England ELA after 7 October 2008.” (Page 43)

“The vulnerabilities created by RBS’s reliance on short-term wholesale funding and by the system-wide deficiencies were moreover exacerbated by the ABN AMRO acquisition” (Page 46)

… which was driven by concerns about its potential insolvency

“Potential insolvency concerns (relating both to RBS and other banks) drove that run.” (Page 43)

In other words, people were not sure RBS was solvent (even though it was)

“In the febrile conditions of autumn 2008, however, uncertainties about the asset quality of major banks and the potential for future losses played an important role in undermining confidence.” (Page 126)

“The inherent complexity of RBS’s financial reporting from end-2007, following the acquisition of ABN AMRO via a complicated consortium structure, also affected market participants’ view of RBS’s exposures.”

“It is clear that RBS’s involvement in certain asset classes (such as structured credit and commercial real estate) left it vulnerable to a loss of market confidence as concerns about the potential for losses on those assets spread.” (Page 135)

A significant factor in this was that RBS was seen to be too optimistic about what its assets were worth

“Deloitte, as RBS’s statutory auditor, included in its Audit Summary report to the Group Audit Committee a range of some £686m to £941m of additional mark-to-market losses that could be required on the CDO positions as at end-2007, depending on the valuation approach adopted… a revision of £188m was made to the valuation of these positions and was treated as a pre-acquisition [i.e. pre-ABN acquisition] adjustment. No other adjustment was made.

Deloitte advised the Group Audit Committee in February 2008 that an additional minimum write-down of £200m was required to bring the valuations of super senior CDOs to within the acceptable range calculated by Deloitte… The Board agreed that additional disclosures should be made in the annual report and accounts, but supported the view of RBS’s management that no adjustment should be made to the valuation.” (Page 150)

“those exposures [i.e. CDO positions] became a focus of concerns by market participants and thus played a significant role in undermining confidence in institutions active in these areas… RBS’s relatively high valuations of super senior CDOs were scrutinised by market comment in early 2008, and there was concern among market participants that further write-downs would be needed, at a time when RBS’s low core capital ratio was already a source of market comment.” (Page 151)

To conclude then

Liquidity risk and opaque/inadequate disclosures, which give rise to concerns about possible insolvency, are enough to doom a bank even if it actually remains solvent.

There will (I know, I know) be more on this tomorrow.

Posted in: Accounting, Liquidity and liquidity risk, Mother of all Bailouts, Reputational Risk by David /
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I am tempted to go after the MF Global rehypo story, but FT Alphaville and Reuters have done it well between them (albeit that the Reuters story is a little histrionic), so let me turn to the ECB, as promised, instead.

Specifically I want to look at some choices in central bank repo operations, and what their consequences are. This will be quick and dirty.

Difficult, isn’t it?

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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The highlights, from the ECB:

• To conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months. [3 years. Jeepers, 3 years!] and the option of early repayment after one year.
• To discontinue for the time being, as of the maintenance period starting on 14 December 2011, the fine-tuning operations carried out on the last day of each maintenance period.
• To reduce the reserve ratio, which is currently 2%, to 1% as of the reserve maintenance period starting on 18 January 2012. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions.
• To increase collateral availability by (i) reducing the rating threshold for certain asset-backed securities (ABS) [so that basically any obligation up to and including dry cleaning receipts will be eligible collateral at the ECB] and (ii) allowing national central banks (NCBs), as a temporary solution, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria. These two measures will take effect as soon as the relevant legal acts have been published.

I’ll give some comment tomorrow. Meanwhile though Reuters sets the tone: European shares fall on Draghi comments.

Posted in: Euro, Eurocrisis, Liquidity and liquidity risk by David /
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