In 2012 Cardiff Garcia wrote a nice summary of a Credit Suisse research note. The research note is a good explanation of the market-based credit system and implications for policy. Here I make some notes for myself, summarizing the article, part of an eventual post(?) about money creation and the efficiency of private money allocation vs. the resilience (stability?) of public money creation.
Main points
Liquid collateral is the lifeblood of the modern economy -- the main form of money for large firms, asset managers, and financial institutions. The collateral-based financial system reduces the need for the bank deposit system. As with any credit system, the velocity of money & collateral and the cost and availability of credit tends to be pro-cyclical.
Higher levels of economic activity make all forms of collateral more liquid, fostering optimistic expectations about future returns, leading to asset price bubbles [Minsky-esque]. And vice versa -- when a credit bubble busts, collateral shrinks, haircuts rise, LTV ratios fall. After major shocks the velocity of money and collateral falls steeply.
In response to these shocks, central banks must provide liquidity and/or the government must sell money-like collateral on a vast scale to preempt and prevent deflation. The fragility of the financial system as it de-levers leaves a deflationary undertow that can flare up quickly in response to new shocks [we saw this in the repo market as the Fed started decreasing the size of its balance sheet in 2019].
Collateral as lifeblood
Central banks have been undertaking credit and maturity transformation on a large scale (as well as their traditional role of assuring funding liquidity) to prevent a deleveraging of the financial system that would lead to a deflationary cascade of shrinking money, credit, and output.
"In our view, that is the response to a classic information problem after a credit shock -- heightened uncertainty as to who is solvent or not, and thus an excessive contraction in the natural stock of safe liquid collateral on which so much financing and funding now depends." [emphasis mine]
The stock of liquid private collateral not growing is the modern monetary equivalent of a large output gap. It's "not some arcane technical point; it is above all about jobs, hardship, and hope in the high foreclosure counties and states, where recovery in income, spending, and collateral values have clearly lagged the rest of the country."
Households' most valuable source of collateral is the house, also cars and other valuables. The household sector owned $20.8 trillion of real estate in 2007, $16.0 trillion in 2012. [links between this section and Mian, Straub, Sufi's 2020 Saving glut of the rich]
In financial markets, debt securities are the most common collateral. These include corporate bonds, money market securities (more info here), asset-backed securities (cards, cars, and student loans), and exclude agency mortgages (I think just for the purpose of summing values. The outstanding value was over $15.4 trillion in 2007 and below $13.6 trillion in 2012.
Debt securities serve most often as collateral in financial markets. For collateral, three factors matter:
- Value: how much is your house worth,
- Haircuts: how much can you borrow against your home equity, and
- Velocity: how many times can your house be used as collateral, i.e., rehypothecated
Shadow money
The IMF's Manmohan Singh estimated that collateral had a velocity or churn factor of roughly 3 in 2007 and 2.4 in 2012. This makes a big difference in the level of "Total Dealer Received Collateral" generated from a given amount of "Total Source Collateral".
The paper defines "shadow money" as the pool of debt securities that can easily be borrowed against. CS estimates shadow money based on the total outstanding value of various classes of debt, adjusted by each market's average repo haircut. If you've got a $100 bond and can easily borrow against it at a 5% haircut, you have $95 of shadow money and might not need to hold as much cash as you would if the haircut had been 10%. There was a negative correlation between levels of available HELOC credit and checking account balances -- as households had more credit they held less money.
The paper distinguishes between public and private shadow money. Public shadow money is based on the value of Treasury, mortgage-backed, and agency securities . Private shadow money is based on the value of corporate bonds, asset-backed securities, and non-agency mortgages [I think ~30% in 2020].
In 2008, private shadow money collapsed -- with negative net debt issuance, falls in the market value of debt, and sharp increases in repo haircuts. The S&P 500 moved in line with the level of private shadow money because equity prices are sensitive to deflationary risks. The drop also damaged real economic activity by tightening trade and inventory finance globally and causing a fall in business confidence.
Government then created a flood of safe collateral, sending the value of public shadow money soaring and offsetting the contraction in private shadow money. Central banks lowered interest rates and worked on other ways to improve the liquidity, value, and moneyness of public and private collateral through balance sheet operations.
"We believe this perspective [shadow money and market-based credit driving policy behavior more than the simultaneous shock to growth] shows a far more accurate and complete view of the money and credit dimension of this cycle, and offers a stark alternative to the traditional bank and money multiplier-based approach many people still use."
Effective money
CS defines "effective money" as shadow money + M2
- Public effective money = public shadow money + Monetary Base
- Private effective money = private shadow money + M2 - Monetary Base
(Note- not a big deal but I think this isn't perfectly consistent, since MB includes notes and coins in circulation, notes and coins in bank vaults, and Federal Reserve Bank credit (required reserves and excess reserves not physically present in banks), while M2 includes notes and coins in circulation but not in bank faults or FRB credit, as well as checking and savings accounts, and other types of deposit accounts and CDs worth less than $100,000.)
"Crucially, this chart and the shadow money perspective allows one to see that there has been (1) a huge and necessary change in the composition of the effective money stock, (2) a big reduction in the velocity of circulation of liquid collateral, (3) a sharp reduction in the value of illiquid collateral (houses [maybe today CRE to a greater extent]), (4) an increase in the "haircuts" on illiquid collateral (higher LTV ratios), and (5) a big increase in precautionary demand for money by firms and households."
It seems to me that only (1) is a policy response. (2) through (5) are driven by the private sector driven, even if policymakers eventually require things like higher LTV ratios. And (5) goes back to Keynes -- the precautionary motive as "the desire for security as to the future cash equivalent of a certain proportion of total resources" (GT p. 146).
"The net result cannot be reasonably characterized as posing a major inflationary threat -- at least until such time as financial system deleveraging is more complete, collateral values, especially house prices have recovered substantially, and overall private sector credit demand is growing strongly."
Key takeaways
Until output gaps close and private collateral begins to grow again
- Underlying deflation risks will persist.
- Central bank balance sheets and fiscal debt may need to expand further.
- Interest rates will stay in an historically low range, though not always as low as now.
- The more macroprudential regulation is driven by hostility to shadow banking (money and credit chains backed by safe liquid collateral) the longer the conditions above will last.
I need to know more to know whether I agree with all these takeaways, but overall they seem reasonable.
Coda
Perry Mehrling proposes a new regime for monetary policy in "Three Principles for Market-based Credit Regulation". Mehrling observes three fundamental risk exposures that the Fed is taking on now: "a kind of overnight index swap, a kind of interest rate swap, and a kind of credit default swap. In all three dimensions, the Fed is operating to support market liquidity, much as our idealized Global Money Dealer and Derivative Dealer do in their balance sheets. In all three dimensions, the Fed can be seen as adapting to its new role as liquidity backstop for the emerging new market-based credit system."
This is a new notion of a central bank. Instead of manipulating the level of bank reserves, policymakers now stand as guardians of collateral and collateral liquidity ... This is Bagehot for the collateral-based financial system".
In conclusion, shadow banking is not well understood but is "a core part of the complex ecosystem of fund flows that is the financial foundation of modern global capitalism." How much better do we understand it today?
Final final note
In today's FT Stephen Roach wrote that inflation may be the only way out. But I wonder- given the importance of collateral to money markets today, how much more destabilizing will it be when the bond markets that provide so much of the collateral "tremble" in response to eventual inflation.
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