Tuesday, 24 September 2013

Collateral Shortages and the Availability of Credit

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.


  1. excellent post


    "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."

    ... bingo

    we need much more of clear macro thinking (like yours) on this issue of collateral

  2. Thanks Nick for the redirect from MR. Good thoughts. Agree with you, but when I made the same point to David Beckworth he still asserts (riffing off of Singh) that "These assets [collateral and the shortage thereof] are the high powered money of the shadow banking system" .. this type of shortage is repeated almost without proof.

    1. Thanks for the link. It's good to see someone else questioning this - I'd thought I was going out on a bit of a limb here. This idea that collateral shortage is a big problem seems to get repeated quite often (FT Alphaville has done a few posts on it as well), but I don't feel it has been properly thought through.

    2. BTW one item I forgot when writing the Beckworth comment was the use of high quality collateral as international reserves. China alone has ~$2T in USD reserves, but everyone will agree it is for exchange rate control rather than transactional.

  3. "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. "

    The fed should just provide reserve accounts to non-banks and even the broader public. As a matter of fact the fed is actually considering doing this according to one of their recent statements.

  4. Great post Nick.

    Same thoughts as mine.

    I don't understand why people at FT Alphaville keep repeating their mystical story over and over again.

    Of course the repo market is important and the financial crisis (as opposed to the economic crisis) was a "run on the repo" as some good Fed publications have argued but there is some literature inspired by that and says strange things.

    Also, there seems to be some authors writing on the repo market economics who seem to be of the view (implicitly) that somehow because the repo market, money is endogenous - as if, if the repo market had been small, money would have been exogenous.

    1. Yes - there is some pretty muddled thinking behind going from observing the very real "run on repo" to concluding that more good collateral is needed. My previous post was intended to demonstrate the mechanics a bit, to hopefully show how these things go together.

  5. There may be some story around this.

    Recently Brad Delong wrote a post challenging FT Alphaville


    According to Delong: when the Fed buys Treasuries, the private sector has deposits instead of Treasuries and so there is no shortage of collateral at all since deposits is as good a collateral as Treasuries.

    However, there may be some story around this. Imagine I have cash. It is strange to think of borrowing keeping cash as collateral. If however, I have Treasuries, I can keep that as collateral and borrow. Something of that sort.

    1. "there is no shortage of collateral at all since deposits is as good a collateral as Treasuries"

      Bank money does have default risk (Cyprus!). In any case, if you are a banking system, using "bank money" to clear payments doesn't offer any safety. I found an example of a large private payment system where government collateral is used as high-powered money in the financial sector, namely the Canadian
      payments system. http://www.bankofcanada.ca/wp-content/uploads/2010/06/dsouza1.pdf
      In 2007, $30B in collateral was needed for a $3.6T banking sector, $1.7T economy. (For comparison, the Canadian monetary base was $50B in 2007.)

      In other scenarios, e.g. collaterallizing derivative positions, "cash" is fine (see my comment to Beckworth above.)

    2. I'm not sure what you're saying there, Ramanan. If you want to hold an investment, then you might decide you'd rather hold Treasuries to cash, but if you want to spend, having Treasuries is never going to be better than having the cash. It might be almost as good as, but it can't be better.

    3. Nick,

      Yeah I think in my last para, I said some non-sense but still think there is some effect there. Imagine a bond rerepoed multiple times. When the expiry of the repo contract arrives, I have to find it because at the beginning of the repo, I may have received the Treasury and sold it. This may create some squeeze.

  6. "Bank money does have default risk (Cyprus!). "

    True jt26.

    However in recent times, the perceived default risk on US banks is low so Delong's argument is that Fed buying US Treasuries doesn't lead to a shortage of collateral because the unit selling the bonds now has cash/deposits instead of Treasuries. It is not as if the Fed has gone and destroyed some assets out there.

  7. I read also your previous post on the topic linked here with a matrix of Leveraged Fund, Unleveraged Funds, Banks and CB all exchanging repos and reverse repos and your 1st table struck me as a concise description of the 2008 Lehman crisis or also the 2011 Euro banks crisis.
    Playing with the numers it is easy to see that a -20% drop in "Good Collateral" at the Leveraged institutions (hedgies, Goldmans...) can translate into a 4 times bigger hit to overall credit in this circuit and some market crash. Pardon me the non so subtle comment, but is there any reason to think that this Good Collateral 3 times Pledged game has any impact on the economy other than producing capital gains for leveraged speculative players that will be reversed in the next crash ? Sorry for not adding some technical input, but I am publishing a book on the Eurocrisis in my country and I was going to use your neat tables to explain why our BTP are so sought after as "Good Collateral" in the financial world. Ando also why, following for instance Warren Mosler that kindly will preface the book, they shoud be abolished since we have bigger problems here rather than be providers of Good Collateral.
    Anyway do you think the economy will suffer if we take away some GC from the "players" ? From all I understand (I also have some graduate and MBA learning and I am a trader I am inclined we could do without

    1. Hi gz,

      Thanks for your comments. I had Lehmans in mind, when I wrote that original post.

      I have really only attempted to address one specific issue here, which is whether and how collateral availability "matters" to credit creation. There are other aspects of it. For example, collateral availability is important to investors like money market funds, as it affects the availability of secured vs unsecured lending opportunities.

      Your question is quite general, but overall I would tend to agree that there are much more pressing problems than collateral shortage, so it would be a small price to pay for policies with better impact elsewhere.

  8. This comment has been removed by the author.