Tuesday, 28 January 2014

Repo Pros and Cons

I was discussing repos with someone the other day.  The issue was whether the use of repos was a good thing or not.

In a repo, one party (the borrower) sells securities to another (the lender) and simultaneously agrees to buy them back at a later date at a fixed price.  This is similar to borrowing money and providing the securities as collateral, as the borrower gets the use of cash for a period of time at a known cost, whilst retaining full exposure to the risks and rewards of the securities.

There are a few differences.  With a repo, the lender has full use of the securities and can sell them or use them as collateral himself.  Also, the amount of securities is adjusted (usually daily) for changes in the market value, so that the value of the collateral tracks the amount of cash provided apart from intra-day movements.  (The value of the collateral to be maintained is typically slightly higher than the amount of cash).

Concerns have been raised about pro-cyclicality of repo finance and its potential to exacerbate market price movements.   If the price of securities falls, the borrower is required to provide more securities as collateral.  This reduces the overall amount that can be borrowed against the total portfolio, forcing the borrower to reduce his overall holdings.  This forced sale of securities pushes down the price yet further.   In this sense, repos seem to create a hard-wired feedback loop.

Whilst this is certainly an important issue to be aware of, the point I want to make here is that this is a function of leverage, not repos specifically.  Compared with the same level of borrowing, but on an unsecured basis, repos are better.  Credit risk is a deadweight loss to the economy.  The uncertainty associated with the exposure has negative utility for the lender, but no positive utility for the borrower.  Use of collateral to reduce this risk therefore has an overall benefit.  Repos provide a very efficient way of using collateral.

So, a repo will in general always be better than an unsecured borrowing.  The problem with repos is that, because of these same advantages, they allow greater leverage.  It is the extra leverage that creates the additional risks to financial stability, not the structure of the repos themselves.

If there is concern about financial stability, the ideal solution would be to limit the amount that is borrowed, but to allow that as much of that borrowing as possible to be structured as repo or other secured borrowing.

Monday, 13 January 2014

The Cross-Currency Liquidity Exposures of Banks

I recently attended a very interesting presentation by William Allen, formerly of the Bank of England, on international liquidity.

Much of this concerned the use of central bank swap lines in response to the financial crisis.  One of the immediate consequences of the collapse of Lehmans, was a substantial repatriation of short term cross-currency investment.  For example, European banks had large short term dollar borrowings funding longer term dollar assets.  The pressure on US money market funds led to a lot of this funding being pulled, leaving the banks trying to fund the gap.  And although the Fed was providing liquidity in the US, the state of the interbank market meant that not much of that was finding its way to the foreign banks.

The interesting thing about this is that the liquidity crisis affecting banks in many countries was substantially taking place in a currency that was not their domestic one.  And whilst a central bank's ability to provide liquidity support in its own currency is theoretically unlimited, that is not the case in a foreign currency.  Central banks with large foreign reserve holdings may be able to cope.  Otherwise, the central bank swap lines provide a way for them to get hold of the currency.  Thus, to deal with the pressure on European banks post-Lehmans, the ECB exchanged euro for dollars with Fed, using the dollars to provide liquidity to the banks.

Nevertheless, it highlights an important issue when it comes to thinking about the role of banks in the economy.  Many economists would consider that the health of the banking sector is an important factor in the state of the economy due to the consequences for the flow of credit to the non-financial sector.  But even those models that attempt to incorporate some representation of banking tend to assume an essentially domestic operation.  In reality, banking is very international.  Over 50% of the assets of UK resident monetary financial institutions are denominated in currencies other than sterling (over 30% for those MFIs that are also UK owned)*.  The implications for credit exposures are reasonably well understood as a result of global fallout from problems with US sub-prime.  The implications for liquidity are perhaps less well known, but it raises important issues about the abilities of central banks to deal with bank runs.  The monetary authority may exercise a high degree of control over its national currency, but not necessarily over its national jurisdiction.

Overall, there was good central bank co-operation in the crisis, which went a long way to preventing things getting even worse.  However, cross-currency exposures of banks will remain an important risk issue going forward.  

* Figures for November 2013.  Source: Bank of England.

Thursday, 9 January 2014

Yield Differentials and Liquidity Benefits

I recently had an interesting discussion with the ever thought-provoking JP Koning in the comments section of his recent post.  The issue concerns a comment made by Stephen Williamson on why the yield on Treasury bills might be below that on reserves.  Williamson suggests that this could be because reserves are actually less liquid than T-bills.  This is based on the fact that T-bills can be held more widely - anyone can hold T-bills, but reserves may only be held by certain banks.  I think Koning and I broadly agree on the key issues here.

We might write the total yield (Y) on an asset (a) as the net of three items, the expected cash return (R) plus the liquidity benefit (L) less some valuation of the credit risk (C).

Ya = Ra + La - Ca

Then we might suppose that in equilibrium the return on each asset will be equal - otherwise people will sell assets with lower yields and buy ones with higher yields.  So for T-bills (t) and reserves (h), we have:

Rt + Lt - Ct = Rh + Lh - Ch

Now, we can assume that the credit risk on T-bills and reserves is the same (Ct = Ch).  So, we can deduce the difference in liquidity returns from the difference in monetary returns:

Lt - Lh = Rh - Rt

As Rh is greater than Rt, this suggests that the marginal liquidity benefit on T-bills is greater than that on reserves.  Could this be because T-bills can be held more widely held?  Although, that might sound right, the problem is that when we think about liquidity of an asset, what we are thinking about is how easily that asset can be converted into "money".  For banks, that means reserves.  And how can any asset be more convertible into reserves than reserves themselves?

To resolve this, we first need to note that it is only reserve banks that are in a position to bring about the equilibrium implied from our equation.  Such a bank will derive both a higher cash return and a higher liquidity benefit from holding reserves rather than holding T-bills.  So if the bank should find itself holding T-bills for liquidity purposes, it would make sense to sell them and hold the reserves instead.

However, it can only sell the T-bills it actually holds.  Once it has sold these, the equation changes.   In principal, the bank can short T-bills by borrowing and selling them, but it then has to collateralise the stock loan.  The reserves cannot be used for collateralisation, so it has to obtain the collateral from elsewhere at a cost.  So the no-arbitrage condition is different for the long position to the short position, and we may well find that we end up in the corner solution, where reserve banks do not hold T-bills for liquidity purposes (although they may hold them for other purposes, for example as trading stock).

In that case, the price of T-bills gets determined by the no-arbitrage condition of other investors.  As those investors cannot hold reserves, the returns on reserves are irrelevant.  We therefore need to make the comparison with bank deposits (d).

Rt + Lt - Ct = Rd + Ld - Cd

Now, however, the credit risk cannot be taken to be the same.  T-bills will generally be seen as a better credit risk and T-bill yields will therefore normally be below that of deposits.  Furthermore, the excess reserve position means that banks will tend to pay deposit rates below that of the rate on reserves.  The net effect is a T-bill yield below the cash return on reserves.

So, it is certainly the case that the yield differential is a result of the fact that only certain parties can hold reserves.  However, this does not mean that reserves are yielding lower marginal liquidity benefits than T-bills for anyone in a position to hold both.

Friday, 3 January 2014

IS/LM, AS/AD and the Exchange Rate

Lars Christensen has a post in which he uses an Aggregate Supply / Aggregate Demand (AS/AD) diagram to talk about monetary offset in the eurozone.  This is the idea that if the central bank is pursuing an inflation target, then fiscal policy can have no effect because it will be automatically be countered by monetary policy.  A good description of monetary offset is here.

This reminded me of one of the things that puzzled me when I first learned about AS/AD and its interaction with IS/LM.

In the standard IS/LM model, the IS curve and the LM curve each describe a different relationship between the interest rate and real GDP.  Each assumes that certain other variables are fixed, including the general price level.  Thus for any given price level, we can deduce a level of real GDP from where the IS curve meets the LM curve.  This also determines the interest rate.

The relationship between the price level and real GDP gives us our aggregate demand curve.  This is usually assumed to be downward sloping, so that as the price level falls, GDP rises (although it has been argued that it might be upwards sloping in certain circumstances). 

To determine where we are on the aggregate demand curve, we combine it with an aggregate supply curve.  Here, the convention is to draw an aggregate supply curve that slopes upwards in the short run, but is vertical in the long run.  The idea is that price stickiness in the short run limits price rises so that changes in demand create real changes in output, but in the long run, once prices have fully adjusted, output must return to its equilibrium level.  (AS/AD is sometimes done by references to changes, rather than absolute levels, i.e. as inflation against real GDP growth).

So far, this is all pretty standard.  There's plenty of stuff there to question the validity of, but the issue I want to look at is to do with the exchange rate.

The first thing to note is that the position of the short run AS curve depends on the exchange rate.  A depreciation of the exchange rate will increase the effective price of foreign goods.  This will tend to increase the price of domestic goods that compete with foreign goods: exports or domestic substitutes for imports.  At the same time, higher import costs will potentially reduce real wages.  To the extent that there is also real wage stickiness, nominal wages will rise by more than they otherwise would.  So, a depreciation will move the short run AS curve upwards.

Again, this should not be controversial and I have see it discussed before, but it's often not mentioned.

The interesting bit comes though when we try to combine this with what is going on with IS/LM.  The issue here is that one of factors influencing the exchange rate is the interest rate.  We already know that a change in either the IS curve or the LM curve will shift the AD curve.  However, because it also has an impact on the interest rate we can now see that it will also move the short run AS curve.

This seems to me to be fairly obvious.  I learned this stuff in the 80s and I'd say, in fact, that it's quite hard to explain what happened to the UK economy in the early 80s without taking these things into account.  But surprisingly, it was never discussed, even with the derivations of IS/LM (Mundell-Fleming and IS/LM/BP) that are supposed to deal with the open economy.  Yet it impacts on the validity of the results of those models.

How does this relate to monetary offset?  Well the point is that we can no longer assume a fixed AS curve when considering the impact of changes in the balance of fiscal and monetary policy.  If monetary policy is tightened in response to expansionary fiscal policy, we would expect the exchange rate to appreciate and for the short run AS curve to move outwards.  So even if the result is to leave the AD curve where it is, there is no way for monetary offset to leave both inflation and growth unchanged.

I should say that this is as much about flaws in the whole IS/LM framework as it is about monetary offset.  Trying to extend the framework to incorporate this feedback gets very messy as it turns out that the position of the whole AS curve depends on where it crosses the AD curve.  It's one of the reasons I gave up on IS/LM.