Friday, January 3, 2014

Banking: Shadow and Conventional

In the previous post, I contrasted the use of gold coins and a very simple version of "shadow banking."   Holding and trading T-bills as a money substitute provided both private and social benefits.     A breakdown in the ability to trade T-bills would lead to potentially severe macroeconomic disruption too.   On the other hand, with a fiat currency, trading T-bills as a money substitute still provided private benefits, but no social benefits.   Further, some disruption in trading T-bills so that the private benefits disappeared would not create macroeconomic disruption--all that is necessary is open market purchases of the T-bills.

Suppose instead of using bags of gold or bundles of fiat currency notes, money mostly takes the form of bank deposits.   Payments are made by writing checks or the electronic equivalent.   Banks accept payments at par and settle up net clearing balances.   Competitive banks pay interest on deposits and fund a variety of assets, including T-bills.   

Now, let's suppose that some financial and other firms begin to hold T-bills and trade them as a money substitute.    A buyer first sells T-bills.   The proceeds are credited to the buyer's transactions  account at a bank.   The buyer then makes a purchase from a seller.   The funds are transferred to the sellers account.   If the seller also uses T-bills as a money substitute, the seller purchases T-bills.   The funds are then removed from the seller's account.   Obviously, this purchase requires double the transactions.   The buyer had to sell T-bills to fund the purchase and the seller purchased T-bills with the receipts from the sale.   These transactions represent social costs, but there is no reason to expect that these social costs deviate much from the private costs faced by the buyer and seller.

What is the private benefit?   By holding T-bills rather than deposits, those using T-bills as a money substitute gain the difference between the interest rate banks pay on transactions accounts and the yield on  T-bills.    Of course, that benefit is directly a private loss to the banks, and so the social benefit is really the banks' cost of intermediation.

Since banks use deposits to fund a variety assets, the use of T-bills as a money substitute would tend to reduce the yield on them.   Of course, those who would otherwise borrow from banks would need to obtain funding elsewhere.    Some of those who were holding T-bills might purchase other assets.   The government might even adjust its funding to take advantage of the lower yields on T-bills.

Since banks can (and do) secure deposits with government bonds, risk is not an issue.   To the degree that the added transactions cost of using T-bills as a money substitute are less than what it costs banks to intermediate T-bills, the use of T-bills as money substitutes would appear efficient.   Still, any social gain is likely minimal.   And, of course, it is possible that the cost of intermediating T-bills is so low that there is a net social loss.

Why would T-bills be used as a money substitute even if it were inefficient?   Suppose the banks form a cartel, and agree to stop paying interest on transactions accounts.   To control cheating on the agreement, they convince government to enforce the regulation.   They come up with some plausible rationale--competition for deposits leads to excessively risky asset portfolios.

With this price control, the private benefit to using T-bills as money substitutes is similar to the scenario where money is a bag of gold coins or packets of currency.    Of course, this private benefit is at the expense of the rents that the banks would have made.   Small depositors find managing their money balances too costly, and so earn no interest and banks earn rents at their expense.   Large depositors use T-bills as money substitutes to reduce their deposit balances.    The added transactions costs of trading the T-bills is a way to reduce the private burden of an undesirable regulation.

Those who would have held the government debt that is now being used as money substitutes instead use their funds in other ways.   Similarly, those that would have borrowed from the banks must fund their operations in other ways.    The first pass assumption should be that this makes the financial system less efficient.    Too much other finance, and too little activity financed by banks.   Of course, if banks just held T-bills, then there is no such loss.   The banks would hold fewer T-bills and those using them as a money substitute would hold more.

Now, through  some truly odd turns of events, suppose that the government repeals the regulation on deposit interest rates solely for households.   Thankfully, households are no longer exploited, but still, firms are motivated to minimize their transactions balances and instead use money substitutes.   They don't earn interest on their deposits.   Perhaps this is some kind of rent-seeking equilibrium, but it is hard to see how it is efficient.   Why not just have the banks hold the T-bills (and perhaps other assets) and pay competitive interest to the firms?     Well, there would be less business for the bond dealers making markets in the securities and the firms' own money market traders would need to find new work.

Suppose that a loss of trust in those trading the T-bills develops, and so firms switch to holding deposits.   This is a private calamity for those trading T-bills, including the firms' own money managers.   But the social problem is easily solved.   The banks just buy the T-bills that would have been held by the firms.

Finally, suppose interest rates on T-bills fall.   This makes the benefit of trading T-bills as a money substitute smaller.   The price ceiling on business deposits becomes less relevant.   Presumably, the result would be for firms to hold deposits in banks instead of T-bills.   Again, the simple solution is for the banks to purchase the T-bills.  

Of course, this remains a private calamity for those trading the T-bills.   All of those extra transactions in T-bills generated income for them.   And those who traditionally worked so hard to manage their firms' cash positions now have nothing to do.    But, of course, much of their activity was inefficient waste all along.

Now, let's suppose that our money market traders respond to lower T-bill yields by trading commercial paper backed by securities backed by mortgages.   Sure, trading low yield T-bills as a money substitute might not be worth the extra transactions costs, but the need for "safe" collateral leads to a series of complicated financial transactions where banks make mortgages, sell them to investment banks who securitize them, and then fund portfolios of them by selling asset backed commercial paper.   This asset backed commercial paper can now be used as a money substitute.  

Rather than sell them and then make a purchase, it is possible to borrow against them, and then make a purchase.   By organizing this as a repurchase agreement, the lender avoids complications in a bankruptcy.  

Anyway, it turns out that many of the mortgages were only sound if housing prices continued to rise, and some of the senior mortgage backed securities also required rising housing prices to be low risk.   Those investment banks who were issuing asset backed commercial paper no longer could find lenders.     They had been borrowing new money to pay off claims as they came due, but that became impossible.  

And so rather than a shift out of T-bills to deposits as before, the shift is out of more exotic money market instruments into T-bills.   And as the yields on T-bills were driven down for many reasons, a shift from T-bills to more standard bank deposits.

Of course, my emphasis so far was on how trading money market instruments as a money substitute involves wasteful transactions costs.   But what about what the asset backed commercial paper was funding?   How can mortgages be funded?   Well, the banks originating the mortgages can hold them.   The firms that hold funds in checkable deposits rather than hold asset-backed commercial paper as a money substitute provide the banks with a source of funds for mortgages.

Yes, this is a private calamity for all of those who were involved in creating a shadow banking system all aimed at providing slightly higher yields to motivate firms to manage cash balances rather than just leave funds in their checking accounts.   Unfortunately, that shift, from banks selling mortgages to holding them as checkable deposits is not quite as simple as purchasing T-bills.    Mortgages are risky, and banks need capital as well as deposits.  

Still, the private interests of those who are involved in the shadow banking industry should not be confused with economic efficiency.



  1. It sounds from this (and your reply to my comment on your previous post) that you agree with the demand driven explanation for shadow banking, as set out for example in Pozsar 2011 ( Have I understood you right?

  2. Bill: "On the other hand, with a fiat currency, trading T-bills as a money substitute still provided private benefits, but no social benefits. Further, some disruption in trading T-bills so that the private benefits disappeared would not create macroeconomic disruption--all that is necessary is open market purchases of the T-bills."

    A hidden assumption in the quote above is that the economy is in a permanent state of monetary equilibrium that is achieved by an omniscient and omnipotent central bank. Knowledge problems do not exist. Public choice problems do not exist. (Knowledge problems and public choice problems are the reason why I support fractional reserve banking).

    Suppose there is a temporary shortage of fiat money. In this case, trading treasuries (T-bills and other treasury securities) as money provides strong private and social benefits. That was the case in late 2008-2009. As QE alleviates the shortage of fiat money, these private and social benefits progressively diminish.

    The endgame for QE was early 2013, when according to Fed's calculations 10 year treasuries were yielding less than what can be calculated from the expected path. In other words, term premium became negative. Accordingly, the fed reexamined the costs and benefits of QE. QE still had expansionary signaling effects. But the expected profit from QE purchases became negative, and the direct effect of QE became deflationary. As a result, the Fed started giving hints about tapering.

    Why is the direct effect of QE deflationary when the term premium is negative? While monetary base increases and we get more transactions that are facilitated by the monetary base, we get less transactions than are facilitated by treasury securities. The second effect is stronger, as evidenced by the shortage of treasury securities and negative sign on the term premium. A useful analogy for a deflationary QE is a scenario where the central bank chooses the wrong mix of denominations. We can compare the treasury shortage in the US in early 2013 to a shortage of coins and surplus of banknotes in some Latin American countries.

    Shadow banking system provides additional public and private benefits. Most importantly, it provides financial intermediation services when the public prefers to hold a different maturity structure of Treasury securities than the Treasury prefers to issue. It also provides a close substitute of base money to those parties that are not allowed to access base money. 10000 USD banknotes do not exist anymore, and the general public is unable to open accounts at the Fed. However, the Fed is working on solving this problem. The Fed is preparing an overnight, fixed-rate full allotment reverse repo program, where the Fed would create a new class of liabilities that are almost as convenient as T-bills.

    1. " were yielding less than what can be calculated from the expected path"
      should be read as
      " were yielding less than what can be calculated from the expected path of short term rates"