Monday, 10 August 2015

The "Moneyness" of Shadow Bank Liabilities

I was recently involved in an interesting discussion regarding the sense in which shadow bank liabilities might be considered money.  Along with many people, I feel that there is a qualitative difference between claims on banks and claims on non-banks, but I find it hard to put my finger on exactly what that difference is.

One possible approach is simply to say that claims on non-banks are not generally transferred to others as a means of payment for goods, services or other assets.  However, this answer overlooks the fact that bank deposits are not transferred as payment either.  Instead, what happens if I make a payment to you is that the balance of my account is reduced as consideration for my bank procuring that the balance of your account (potentially with another bank) is increased.  This may look very much like I have transferred a deposit to you, but the distinctuion is important.

Shadow bank liabilities are generally held by large institutional investors, so it's useful to look at how investors like this manage their funds.  Such investors will typically hold their liquid funds in a range of short term investments.  The most liquid of these, between one day and the next, will be overnight instruments.  These may be simple overnight bank deposits, but they may also be overnight repo (reverse repo from the cash investor's viewpoint) or other instruments, which may be with a bank or a non-bank.

To make and receive payments during the day, investors will have transaction accounts with banks.  These will typically pay little or no interest overnight.  They may also have provision to be overdrawn, either during the day - if payments are to be made from the account before receipts are confirmed - or overnight.  It is inefficient for institutions with large liquid asset pools to carry a significant positive or negative balance in their transaction account overnight.  Such institutions will therefore seek to place as much of their net cash inflow into overnight instruments during the course of the day.

At the start of each new business day, all of the overnight money placed the previous day has to be reinvested.  Likewise, all of the institutions that had borrowed through these overnight instruments need to refinance.  The money markets are therefore most liquid at the beginning of the day when there are lots of buyers and sellers.  As the day goes on and more and more positions are filled, the market becomes thinner and it can become harder for someone trying to match a position to get a good price.  Money managers will therefore try and estimate their daily cashflow and place it as early as possible, rather than wait till the end of the day.

When money is placed into an overnight instrument, the value is agreed at which it will be redeemed the next day.  However, there is no guarantee of the current day's value.  If an investor places $100 early in the day and then changes his mind later in the day, he cannot expect to get $100 back.  It will depend on what has happened in the money market during the day and may be less or more than the $100 placed.  The only certain value is the redemption value the next day.

In contrast, balances in transaction accounts retain their value during the day.  So $100 paid in early in the day may be paid out as $100 later in the day.  When we compare this with overnight instruments, it seems that that this is much more money-like, whereas overnight instruments, including deposits, are more like what we think of as bonds, albeit with a very short maturity.

I'm not sure that this enables us to answer the question of whether shadow bank liabilities are money.  However, I think there are some useful observations that can be made.

1.  Transaction accounts are qualitatively different to overnight instruments, and shadow banks are not on the whole in the business of operating such accounts.  We could think of transaction accounts alone as being money, as these are the only means with which general payments can be made, and everything else as bonds.  However, this approach makes it difficult to say anything meaningful about the quantity of money.  The balance of transaction accounts is managed down to minimal levels by the end of the day, which is the only point in time at which the balances can be meaningfully measured.  The picture given by the end of day balances bears little relationship to all the activity that takes place during the day.

2.  From point of view of the holder, the liquidity of an overnight instrument does not depend on whether it is issued by a bank or a non-bank.  When we come to think about implications for the financial markets generally and the real economy, we should not therefore expect investors to behave differently when they hold bank claims as opposed to non-bank claims.  In this sense, there is nothing special about banks.  

3.  When a payment is made between transaction accounts, one account is credited and one is debited.  If both accounts start at zero, this means one balance becomes positive and one becomes negative.  Negative balances can be avoided if the account from which the payment is made is positive in the first place.  Either way, each payment has balance sheet implications for the bank (or system of banks) providing the accounts.

We have looked at a situation where holders of liquid assets attempt to manage their transaction account balances to close to zero by the end of each day.  However, this process involves a mass of individual transactions with little coordination.  If a bank processes a payment from one account, it cannot be sure that this will be covered by subsequent receipts, so it faces a potential credit exposure.  In order for a bank to be able to do this, it therefore needs a balance sheet of some size.  Part of this will be constituted by the issue of overnight instruments.

So, whilst bank issued overnight instruments may be no more money-like that those issued by non-banks, in the hands of investors, they are important in creating the balance sheet depth necessary for banks to be able to process payments through transaction accounts.  It's not so much that overnight bank deposits are money, but rather that they facilitate monetary exchange.