By Economic Strategist, Hottinger Investment Management
Money and banking are essential social institutions. Both have a long history extending to 3000BC and the Babylonians of present-day Iraq. There, we find not just our first evidence of civilisation but also the first banking system. Under the Code of Hammurabi, ancient temples would accept surplus deposits of barley and silver and make interest-bearing loans. Priests would record these on cuneiform tablets, a forerunner to the balance sheets that banks use today to account for their assets and liabilities.
Fundamentally, not much has changed since then. Money still has two core functions. On the one hand, it is a commodity that serves as the medium of exchange, oiling the wheels of commerce. On the other, money is a form of debt that reflects a claim that its holders have on society. You are willing to hold cash or deposits in the bank because you expect that at some point in the future, you will be able to exchange them for valuable goods and services. Your bank account is like a social credit score, reflecting how much society owes you. But because it is not fully legally binding, you have to trust that the system will be maintained.
Trust has therefore always been a core part of finance and the bankers who underwrite the economy have a responsibility to maintain it. So when in 2008 queues of savers stood outside branches of Northern Rock, anxious to withdraw their cash on reports that the bank was struggling to fund itself, it was clear that trust had broken down. The run on Northern Rock was the first such event in the United Kingdom for over 150 years, and it revealed how precarious the world of banking can be.
How banking works
Whereas in Mesopotamia the state was the lender, today we rely on a network of private-sector banks to issue credit to fund productive activities. Observing how banks create credit in a modern economy, we can see how they enjoy an enormous privilege. Before discussing shadow banking, let us consider the ordinary model of bank lending, which Figure 1 illustrates.
Figure 1. A bank makes a new loan by creating deposits to fund it
Conventional wisdom says that banks simply lend out other people’s deposits, but while that is somewhat true, it is misleading. In most cases, banks simply create new deposits when they want to lend to a borrower, subject to some key constraints.
To ensure that trust is maintained in the financial system, governments have allowed private-sector banks to create money and enjoy lender of last resort facilities from the state’s Central Bank if they meet key regulatory requirements.
The main ones are reserve requirements and capital requirements; these essentially make it costly for banks to issue too many loans. Reserves are deposits that private-sector banks hold at Central Bank and regulations require that banks hold a minimum proportion of their assets as reserves at the Central Bank or in cash, so they can settle payments. Capital requirements state that banks should hold a minimum level of equity relative to the volume and risk of the assets they hold on their balance sheets. These ensure that owners of the bank absorb as much of the bank’s losses as possible, and not depositors.
Banks can meet their reserve requirements by borrowing reserves in the ‘inter-bank’ market. They can also borrow directly from the Central Bank, which sets the interest rate on reserves and promises to satisfy any excess demand for reserves. Banks need to do this if they want to keep issuing new loans, but it is costly. The state, through the Central Bank, can attempt to control the creation of private bank credit by changing the interest rate upon which it charges for loans of its reserves and which passes through into the inter-bank market and then onwards to the wider economy. When the economy is strong, the central bank raises interest rates, thereby making reserves more expensive and banks less willing to lend.
This model works when banks make good quality loans and investments in ventures that are at least likely to generate the return of the capital they provide. The problem with Northern Rock was that it was throwing good money after bad, borrowing resources in the ‘inter-bank’ market and investing in sub-prime US mortgage-backed securities (MBS) that it believed were much safer than they were. When it emerged that sub-prime borrowers couldn’t make good on their loans, Northern Rock struggled to repay its own inter-bank loans. With no other bank willing to lend to it, Northern Rock ran its reserves down and eventually called on the Bank of England for emergency funding.
Introducing shadow money to the banking system
But Northern Rock’s story is mostly one of bad banking, and less one of shadow banking. Shadow banking involves issuing shadow money, and both banks and non-banks can do this. Daniela Gabor and Jakob Vestergaard, who are experts in the field, define shadow money as “repo liabilities, promises backed by tradable collateral”. A ‘repo’ or repurchase agreement is a loan of funds for a short period to an institution that sends to the lender securities such as government bonds or asset-backed securities as collateral or security.
It is useful to think of currency, bank deposits and shadow money as parts of a hierarchy, as Gabor and Vestergaard introduce. Banks that issue deposits promise to convert these deposits into state-issued currency at par or one-for-one. Likewise shadow money, reflected by repos, represents a promise to convert the asset that the lender holds as collateral, the reverse repo, into bank deposits at par.
Let’s begin with a bank issuing a repurchase agreement (or repo) to a money fund of an institutional investor. Figure 2 illustrates the situation.
Figure 2. A bank borrows from a money market fund. The arrows shows that the repo is backed by mortgage backed securities that the bank held prior to the transaction. The bank sends these securities to the money fund, which now becomes the legal holder of the securities until maturity
Here the bank is able to expand its balance sheet without needing to increase its reserves. It does this by borrowing the liquid funds from the institutional investor in a repurchase agreement and sending assets (here, mortgage-backed securities) to the lender as security. Bank X invests the cash from the fund in assets that yield a higher return than the rate it pays on the repo, and the institutional investor holds the ‘reverse repo’. In the early 2000s, before the crash, these assets were often mortgage-backed securities (MBS) – both pledged as security for and bought from the proceeds of repos.
Banks have clear incentives to issue repos; they can avoid the expense of acquiring more reserves and they can delay final settlement in bank deposits. Equally, cash-rich institutional investors – such as money market funds (MMFs), which invest the cash reserves of pension funds and insurers – enjoy benefits from financing repos. These funds like repos because they provide collateralised deposits for money that cannot qualify for the government guarantee for bank deposits (£85,000 per person in the UK) and they have features such as daily collateral valuation and shortfall correction, which provide security. The loans are also very short-term, often overnight, giving lenders greater control.
However, the problem arises, again, when the underlying asset fails to return capital. This explains why U.S. banks Bear Stearns and Lehman Brothers went under; they relied on $250bn in overnight repo financing for their portfolio of mortgage-backed securities. When the underlying assets failed to deliver, lenders refused to roll over funding. Northern Rock was also involved in sourcing funds from MMFs in wholesale markets.
Money market funds – which are supposed to be safe havens – infamously ‘broke the buck’, as net asset values fell below $1 per share. This meant $1 today did not yield at least a $1 tomorrow, breaking the cardinal rule of risk-free money.
When the underlying mortgages failed, these banks were also shut out of funding markets and triggered a global panic. Figure 3 shows how this can work.
Here, Bank A, which is speculating on sub-prime MBS, lends these securities in a repo agreement to Bank B, which – in return – sends cash to A by creating new deposits. Bank B has pre-existing loans to Bank C via the inter-bank market, which it used to buy its own sub-prime MBS.
In the extreme case that the value of sub-prime MBS falls significantly as the underlying mortgage holders default on their debts, it is possible for all three banks to fail because none of the banks has sufficient equity capital to absorb the losses. Even Bank C can fail if it can’t recover the loan from Bank B. That’s why banking markets seized up in 2007-8 and why central banks and treasury departments had to step in to restore trust.
Figure 3. An illustration of how shadow banking can create a systemic banking crisis
Research from SIFMA shows that while the US repo market is still a sizeable market, it relies on better collateral today than it did ten years ago. Furthermore, as a result of regulations after the financial crisis, such as the Volcker Rule in the U.S. and the global Basel III rules on capital adequacy, in theory speculation in large banks has rapidly declined and these banks hold much safer assets on their balance sheets, including government bonds.
However, shadow banking still matters because it has the potential to affect the stability of the financial system. This holds whether or not banks deal in shadow money with each other or with non-bank institutions such as hedge funds, money market funds and insurers. Banks still issue shadow money though repos to investors who buy securities in the market.
How shadow banking works among non-banks
As banks have reduced their role in repo markets, money market funds have increased funding, while real estate investment trusts (Reits), mutual funds and hedge funds have become more active borrowers. Yet the same issues of trust and financial stability apply to when both sides of the trade are non-banks. Figure 4, for example, demonstrates how hedge funds can dangerously scale up their balance sheets using a single asset as security.
Figure 4. A demonstration of how an asset used in a repo transaction can be ‘rehypothecated’ to generate leverage
Here, a low-risk hedge fund (A) wants to build up a portfolio of investment-grade corporate bonds and engages in a repo agreement with another hedge fund (B), which exchanges some of its clients’ cash reserves for collateral from A. Hedge Fund A sends as security to B government bonds that it initially held. Hedge Fund B is now in a position to scale up its own portfolio of corporate bonds as it is now the legal owner of A’s security. B enters into its own repo agreement with another hedge fund (C), which provides client money to B again in exchange for the security over government bonds. However, B chooses to use the government bonds pledged by A as security for its repo in a process called ‘rehypothecation’ – i.e., the reuse by a creditor of collateral posted by a debtor.
In this scenario, Fund A is exposed to greater risk that its collateral is not returned because Fund C has first claim over it if Fund B fails to honour its repo agreement with C. Hedge Fund B may not be able to make good on its debts to the Fund C because it is already highly leveraged with repo agreements with other fund providers and has invested in corporate bonds that have a high default risk. In other words, if B’s corporate bonds go sour and B cannot make payment, then Fund C keeps Fund A’s bonds, while Fund A would have to attempt to salvage other assets from B’s balance sheet.
This is how shadow banking involving non-banks can create leverage, but banks can also turbo-charge this by issuing repos backed against new deposits. For example, Fund C could engage in its own round of rehypothecation with a commercial bank and use the proceeds to buy corporate bonds. This exposes Fund A to even more risk – to the health of Funds B and C, while Fund B is exposed to the activities of Fund C.
Risks can also work in the other direction if the collateral underpinning the repo is weak. For example, if the repos were backed with high-risk corporate debt and not government bonds, then each repo provider (B to A, C to B and the Bank to C) is exposed to not just the risk that the party to which it extended the repo fails to repay, but also the risk that the underlying collateral it holds falls in value and that the borrower cannot meet the shortfall.
In either scenario, one can see that shadow banking among non-banks can put clients’ money at risk even in funds that have sound investments.
The next bubble?
There are issues within corporate debt markets, particularly in the US. Companies have been increasing their leverage over recent years and there is risk that as interest rates rise and earnings fall, some firms could struggle to repay. The striking growth in collateralised loan obligations (CLOs), through which issuers pool together corporate loans from already highly indebted companies and sell them to institutional investors, has not escaped the attention of cautious investors, nor has the decline in overall credit quality. We need more research into who is financing these products and whether there is a dangerous connection between banks and non-banks that could lead to risks not just to investors but to the financial and economic system as a whole.
Despite its mysterious name, shadow banking is not inherently bad. It is, however, a financial innovation that does not escape the basic requirements of finance and money. The system works when good money chases good ideas, when risks and exposures are adequately understood, when debts are honoured and when there is transparency and accountability. The risk with shadow banking is that we cannot as easily guarantee those things, and until we get a grip on this new form of finance, we may continue to face unexpected events.
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