A Comparison Between Traditional Banking and Market Based Finance

I've been working on a paper using stylised balance sheets to look at the interaction between traditional banking and market-based finance.  The aim is to examine the reasons for shifts between these two intermediation models before and during the crisis and the implications for liquidity and solvency across the sector.  In this post, I just want to give a brief overview of the differences between the two techniques.

The diagram shows some simplified balance sheets.  These are not necessarily supposed to represent distinct entities, so much as different business models.

The assets of traditional banking consist of a loan portfolio and a holding of high quality liquid assets (HQLA).  The liabilities will be short term unsecured deposits with the balance forming capital (there will be other borrowings of a longer term nature, but we can ignore those here).

 The loan portfolio will be long dated assets which will generally be fairly illiquid, in that it is difficult to sell them at short notice for a price close to balance sheet valuation.  Given the short term nature of its deposit liabilities, the traditional bank is therefore running a maturity mismatch risk.

To deal with this mismatch, the bank maintains a holding of HQLA.  This might consist primarily of government securities, but central bank reserves would also be included in this.  In the event that it faced deposit withdrawals in excess of the rate of run-off on its loans, the bank would hope to cover this out of its HQLA holding.

The traditional bank is therefore running a kind of liquidity insurance.  It is offering liquidity to all of its depositors but covering this with a much smaller quantity of liquid assets.  Its risk is that more depositors wish to withdraw their deposits at once than it can cover out of liquid assets.

With market based finance the assets are all marketable instruments.  I have illustrated this here as securitised loans.  The underlying loans may be similar to those held as illiquid assets on the traditional bank's balance sheet.  The process of securitisation transforms these into a standardised tradeable instrument.  This means they can be bought and sold much more easily.  With sufficient market depth, there will be a continual market price for these securities and a holder will expect to be able to sell at close to that price.

Having liquid securities as its assets allows an entity using market-based finance to fund itself using secured financing, for example repo.  The repo funding provided by investors is effectively secured by underlying assets (the securitised loans).  The value of the security provided is slightly higher than the amount of funding and, critically, is adjusted every day for market movement.  This is only possible because the collateral is in the form of marketable securities with a transparent market price.  The level of additional security provided therefore only needs to cover possible day-to-day price movement.

In the market based finance model, all of the assets are used as collateral[1].  There is no pool of unencumbered liquid assets like the HQLA held by the traditional bank.  However, no such pool is needed, because the market based finance model is providing liquidity in a different way.  Rather than rely on a type of insurance as in traditional banking, the liquidity transformation relies on the marketability of the underlying assets.  Whereas a traditional bank would dip into its pool of unencumbered liquid assets to deal with a high level of withdrawals of its funding, an entity using market based finance would simply look to sell down its regular asset base.

Both business models face liquidity risks, but they manifest themselves differently.  The liquidity risk in traditional banking is that the HQLA holding is insufficient to cover withdrawals.  The liquidity risk in market based finance is that the liquidity of the assets fails.  For both models, the robustness of their liquidity strategies may change.

A depositor with a traditional bank is taking credit risk on the bank.  They do not know the intricate details of bank's balance sheet, so they are relying on the skills of the bank's management in making good business decisions.  They will however draw comfort from the level of capital which provides a cushion against loan losses.

A provider of finance in the form of secured funding takes much less risk on the borrower itself, relying instead on the collateral provided.  Some degree of over-collateralisation is needed to meet rating requirements or to cover haircuts, but generally the market based finance model requires lower levels of capital.

A number of developments within the financial intermediation sector in the run-up to the crisis and during it can be traced to the differences between these two business models.   These include changes in liquidity and solvency levels, changes in lending appetite including credit criteria, and changes in credit spreads.

---

[1] There will repos with a variety of different counterparties.  Distinct collateral is used for each counterparty; they do not share in the same collateral pool.

Stock Flow Ratios and the "Velocity of Collateral"

I've read a couple of good blog posts in the last few days which, although apparently unrelated, have an interesting connection.

The first is Brian Romanchuk's piece in which he gives a nice, clear account of the role of stock-flow norms in economic modelling.  He emphasises the importance of distinguishing between stock variables and flow variables.  Stocks represent the state of affairs at a specific point in time; flows are what occur during a period of time, or simply between two specific points of time.  Just as it is important to know what variables are stocks and what are flows, it is also important to distinguish different types of ratio: flows to flows, stocks to stocks, or stocks to flows.

The second is Scott Skrym's post on the "velocity of collateral" - a term used to highlight the way collateral is re-used in repo and other transactions, so that the same securities can be posted several times in so-called "collateral chains".  Skrym provides a good description of the way this works and, as always, some useful context from current trends in the repo market.

People who use the term "velocity of collateral" like to present it as analogous to the velocity of circulation of money.  We have a stock of eligible collateral, rather than a stock of money, and in each case we have a certain volume of transactions that the collateral, or money, is used in.

However, there is a confusion between stocks and flows that is creeping in here.  When the velocity of circulation of money is considered it is in terms of comparing the stock of money with a measure of flow.  Typically that flow is the monetary value of the transactions in a given period.  So we take a period of, a year say, and add up the value of each transaction that has taken place within that year. 

The unit of measurement for this value (being a flow) will be dollars per year.  In comparison, the unit of measurement for the money supply will be just dollars.  So when we divide the value of transactions by the stock of money, we get a measure of velocity of circulation which is expressed as number of times per year.  We can interpret this as being the number of times each dollar changes hands per year, on average[1].

When calculating the "velocity of collateral", however, the stock of collateral is compared with the volume of collateralised transactions outstanding at any given time.  This latter variable is a stock concept.  It is measured as a pure dollar value, not a value per unit of time.  This means that when we divide by the quantity of collateral, we get a number expressed as a pure ratio, not as a number per unit of time.

"Velocity of collateral" is a stock / stock ratio; velocity of money circulation is a stock / flow ratio.  They are very different concepts.  That is not to say that the thing that "velocity of collateral" measures does not matter; rather that we need to be wary of interpreting it as being comparable to the velocity of circulation of money.

---

[1] Although, as I have written previously, we should be careful with this interpretation.

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.

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.