Peter Stella has an interesting post on VOX on the implications of collateral supply for different approaches to running down
the large balances of reserves held in the banking system as a result of QE
operations.
Stella has written a number of papers and articles on the
workings of the repo market often looking at the impact of collateral shortages
on overall lending volume. Together
with Manmohan Singh, he has probably done the most to raise the issue of
collateral availability and its implications.
In this most recent article, Stella compares two
alternatives for managing a drain of large amounts of excess reserves. The first is to simply offer banks term
deposit facilities with the central bank.
This would effectively convert their holdings of short term claims on
the central bank into a longer term one.
The second is a central bank reverse repo programme. This would involve the central bank selling
assets from its portfolio with an agreement to repurchase at a fixed price
after a period of time.
Stella is in favour of the latter and believes that it will
facilitate more credit creation. He has
two reasons for thinking this.
The first reason relates to banks balance sheets and the
leverage ratio. To understand this point, it
is useful to note that non-banks cannot hold reserves. Therefore, when the central bank acquires
asset from non-banks, this necessarily involves adding both an asset and a
liability to the balance sheet of the banking sector. Reserves (assets of the banks) go up and
deposits (liabilities of the banks) go up.
Although this may involve little risk to the bank, it is not
without consequence. Whilst holdings of
reserves do not attract a capital requirement, they are included in the
measurement of assets for the leverage ratio. Where
banks are constrained not by capital, but by overall leverage, holdings of
reserves may be effectively crowding out lending to the private sector.
Switching reserves into term deposits will do nothing to
change this. However, if the central
bank conducts reverse repo with the non-bank private sector, that will simultaneously
drain reserves and reduce deposits, thereby eliminating the middle-man role
required of banks. For banks subject to
a leverage ratio constraint, that may free up lending capacity.
It is hard to tell how important this is. Certainly some banks have indicated that they
expect to be impacted by the leverage ratio, over and above the normal capital
requirements. But how much difference
that will make in the long run is another matter. My own feeling is that is there would be some
effect, but it may not be that great.
It is worth noting however that this aspect has nothing do
with collateral. The important
distinction here is between arrangements transacted with banks and those
transacted with non-banks. If the
central bank was to offer term deposit facilities
to non-banks, this would achieve the same reduction in bank balance sheets as a
reverse repo programme.
The second argument concerns the role of collateral chains
in credit creation. Stella points out
that increased bank reserves do not in fact facilitate greater bank lending, as
is suggested by the money multiplier model.
However, high grade collateral, according to Stella is crucial to the
volume of lending within the non-bank sector, because of the amount of this
that is carried out through repo.
Collateral shortages squeeze this form of lending.
I have written about collateral availability and the impact
on loan volume before (here). As discussed in
that post, I do think there are good reasons why we might expect to see a
positive correlation between the level of repo business and the amount of
eligible collateral available to the market.
However, the point I wish to make here is that, in almost
every case, the credit creation associated with collateral availability is ultimately only financing the actual holding of that collateral. It is not going to finance new expenditure on
produced goods.
If we are concerned about low levels of lending, the sort of
thing we are probably focused on is a small businesses that wants to incur
investment expenditure but cannot raise the funds. We want to see more bank lending so that this
type of expenditure can take place.
Making more collateral available to the market does nothing
to facilitate this. The small
businessman cannot use the extra collateral available to help raise the funds
he needs. Banks might be prepared to
provide him with repo finance, but to take advantage of that he has to get hold
of that collateral in the first place.
He can only do that by using the very funds he raises to buy or repo in the collateral. The only people who can benefit from repo
funding are those who are looking to take a position in the underlying
collateral or others in the collateral chain.
This is not to say that this type of finance has no
macroeconomic effect. The use of repo serves
to increase demand for the underlying collateral, which pushes up asset prices
generally (see again my earlier post).
However, it is important to understand that is only through this effect
on asset prices that any potential macroeconomic benefit is arising - there is
no separate credit creation for the real economy that is being facilitated. It therefore needs to be assessed in the
context
Other things being equal, more liquidity is a good
thing. I'd therefore be inclined to take
the view implied by Stella that draining reserves through a reverse repo
programme available to non-banks is better than a bank only term deposit
facility. However, I think it would be a
mistake to confuse any impact on the repo market with a potential
improvement in finance availability for the real economy.
