Collateral damage August 16, 2012 at 6:30 am

Four telling graphs, from a great presentation by Citi’s Matt King (HT FT Alphaville).

First, the importance of the repo market:

Repo importance

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

Repo vs Unsecured

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

Safe Collateral

Fourth, where the bad stuff ends up:

Unsafe Collateral

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.

3 Responses to “Collateral damage”

  1. Sorry for the naive question, but what’s wrong with unsecured interbank lending disappearing permanently?

    Doesn’t that simply diminish the risk of systemic failure, as a given bank failure ends up with the central bank owning the dodgy loans, rather than the failure spreading around taking down the whole system? It makes the central bank/government role in bank regulation more direct via the collateral acceptance rules, but if they cock up it limits contagion, as the central bank has an unlimited ability to book losses on that dodgy collateral (nominally, and the tools to sponge back excess inflationary liquidity if any).

    If the central bank has tight standards, it could restrict the total volume of credit offered by the banking sector compared to the old school model, but that seems fair enough given the central bank/government guarantee on deposits. Wilder stuff belongs to non-bank credit intermediaries who can’t misuse the deposit guarantees.

  2. Thanks CIG. Three points.

    First, the declining importance of unsecured vs. secured liabilities makes (insured) deposits riskier. Senior debt is either pari passu with or junior to deposits. Secured debt is senior to them. That’s bad for deposit insurers, i.e. the state.

    Second, market discipline works via the unsecured credit market. Do something bad, your credit spread goes up, and you learn not to do it again because you suffer a higher cost of funds. Mostly borrowing secured blunts that feedback mechanism.

    Finally, there isn’t enough collateral. There certainly isn’t enough palpably safe collateral. What we are seeing already is a huge squeeze on the (considered) safe stuff – arguably that is why bund repo is negative and BTP isn’t. If we want banks to mostly borrow secured, then we need to provide them with enough assets to do that, or open the central bank window even wider to fill the gap.

  3. I didn’t realise that secured lending was above deposits (despite it really being obvious from the structure, silly me).

    I guess you could close the circle by making deposits secured: require collateral pledged at the central bank or at the deposit insuring institution, matching the amount of insured deposits. The consequence of that could be interesting (I can barely guess) but perhaps not necessarily negative. If that leads to less deposits so be it, at the end of the day people who want safe deposits can always buy the real thing (the sovereign’s bonds) via a brokerage account, it’s not obvious to me what do we gain from banks being allowed to issue synthetic sovereigns, that are unsecured yet behave as if they were.

    As for the shortage of collateral, I agree this is something that needs fixing, the central bank should issue the relevant paper in the relevant quantity. Using debt notes from the fiscal authorities is a really poor proxy. They’re not even a risk free asset if you assume real central bank independence.