In my last post I asked whether we needed to include banks in macroeconomic models. My conclusion was that we might only need to do so if we wanted to explicitly model the way things like regulatory issues might shape the terms on which credit was extended.
As an example, I have looked here at the sort of developments that we might be able to represent and map out within a model. This relates to shift between traditional banking and market-based finance that, in my view, played an important role in the financial crisis. We could construct some balance sheets and behavioural rules and develop this into a model with a list of equations, but it's a lot easier just to look at some balance sheet movements.
The following draws on my distinction between traditional banking and market-based finance, as described in this post.
Shift to Market-Based Finance
The first development is an industry trend towards greater use of market-based finance. The main driver within the business is the more attractive capital treatment. At the same time, investors facing large exposures on unsecured bank risk are creating greater demand for collateral that can be used to back deposit substitutes.
The process takes time, but accelerates as deeper market makes assets more liquid and therefore more effective as collateral.
The diagram below shows the changes in the balance sheet of the financial sector. Loans are securitised and used to back issues of secured funding, with deposits repaid in the process. We can map this by refering to different capital costs and funding costs.
Balance Sheet Expansion
Liquid securitised loans can be held with a lower capital requirement, so the trend to Market-Based Finance leads to a reduction in capital usage. However actual capital levels are unchanged, leaving excess capital in the industry.
Rather than repay capital, banks try to use it by expanding their loan base. This requires relaxing credit criteria and reducing prime lending margins. (Average margins on new business may go or down, because of the increased share of sub-prime loans). Again, we can model this by making some assumptions about bank behaviour or deriving results from assumptions about profit maximisation with frictions in capital issuance.
A fall in prime lending margins on new business increase the book value of existing securitisations, as these are on mark-to-market valuation. This enhances bank profitability and contributes further to bank capital.
New loans create new deposits and the sectoral balance sheet grows as shown below.
Liquidity Crisis in Market-Based Finance
As average credit quality and margins decline, the system becomes more fragile.
If certain securitised portfolios cease to be acceptable as collateral, financial institutions dependent on secured funding may be forced to sell these assets. This further reduces the liquidity of the assets, which further reduces their use as collateral. It also reduces their market value.
Banks are forced to take assets back onto the traditional banking book incurring a higher capital charge. At the same time mark-to-market losses reduce actual bank capital.
These developments are shown below. Unsecured funding is repaid, expanding the stock of unsecured deposits. The value of securitised portfolios is written down with a corresponding reduction in capital.
Banks now face the following:
- Reduced actual capital levels
- Higher required capital
- Increased funding costs due to increased reliance on unsecured funding
They respond to this combination of factors by cutting back on lending.
All of this can be neatly modelled in a stock-flow consistent modelling format, although the number of equations required is quite large, as there's actually quite a lot going on here. This can be a useful exercise, as it helps form of sense of how these things play through and why they matter. However, I think it would be extremely difficult to use this to make forecasts. We can examine history and maybe also track and analyse current developments, but working out where it will go next is a different matter.