The end of the short end?

“The first necessity of a central bank, charged with responsibility for the management of the monetary system as a whole, is to make sure it has an unchallengeable control over the total volume of bank money created by its member banks.”

(J.M. Keynes, A Treatise on Money: The Applied Theory of Money [London: Macmillan, 1971], 201)


Keynes’ expression of the necessity of monetary control certainly chimes with us, though we put the notion somewhat differently. The outward-facing goal of a central bank should be unchallengeable control. The managed reality will always be different because complete control over the creation of money and credit is impossible, to say nothing of how the vicissitudes of risk might alter credit and money markets. Although Keynes’ quote refers only to control over money creation of member banks, shadow banking was part of the American scene in the Roaring ’20s; some details are provided in R.W. Goldschmidt’s 1933 book The Changing Structure of American Banking. (We like the phrase “bootleg banking” that was used in the 1920s and 30s.) The Federal Reserve’s challenge was, and is, particularly difficult given the vitality of the US banking and finance sector. Yet the aim should not be to squash the vitality, which should be seen as a force to acquire, preserve and enhance capital, but to keep that vitality from becoming destructive.

In pursuit of control, regulators have targeted money markets, which are viewed as inherently fragile. Repo has been particularly vilified. A recent salvo came from Federal Reserve Board member Daniel Tarullo (2016) in a speech titled “Exploring Shadow Banking: Can the Nation Avoid the Next Crisis?” In this short speech, a close connection is drawn between shadow banks, short-term liabilities (Governor Tarullo uses the term runnable liabilities), and asset/liability duration mismatch. Despite the title, most of the speech is focused on short-term liabilities. Regulatory intent is stated on page 4: “…I continue to believe that the post-crisis work to create a solid regime to promote financial stability cannot be deemed complete without a well-considered approach to regulating runnable funding outside, as well as inside, the regulatory perimeter.” A number of candidate controls on short-dated paper are sketched out: restriction — including the ultimate in restriction, “outright prohibition”; restructuring, potentially involving the federal government, and; forms of taxation.

We do not disagree with many of Governor Tarullo’s observations on the squidginess of short-term funding. A firm’s over-reliance on short-term funding can, of course, precipitate early death in unsettled conditions. A positively-sloped yield curve is enormously tempting as a source of income — we’ve seen it firsthand, and have had to fight inclinations to fund short. (Is it wrong to use a positively-sloped yield curve as a source of income? All we know for sure is that competitive forces will drive it to happen.) Still, there is a legitimate place for money market instruments in the non-public sector. Inventory finance, factoring, warehousing, trade receivables, trading positions, and some credit card receivables are examples of short-lived financial assets. On the other side are cash management needs of firms and individuals. Many of these agents are willing to sacrifice some liquidity for a bit more yield. To help ensure robust markets, we recommend regulators and market participants examine sources and uses of funds, securities structures, market conventions, market size and depth, and governing documentation with an eye to promote ongoing market stability. An element of diversity in capital markets is a very good thing.

But we do not agree with singling out money markets as the origination point of systemic catastrophic funding and liquidation risks. The regulatory concept of “runnable funding” seems to be predicated mainly on maturity and concepts of what money represents, and less so on considerations of structure or (non-sovereign) credit.  For example, in the view of Governor Tarullo (2016, 2), “As has been frequently observed, the recent financial crisis began, like most banking crises, with a run on short-term liabilities by investors who had come to doubt the value of the assets they were funding through various kinds of financial intermediaries. The difference, of course, was that the run was not principally on depository institutions, as in the 1930s, but on asset-backed commercial paper programs, broker-dealers, money market funds, and other intermediaries that were heavily dependent on short-term wholesale funding.”

Our take is that price gapping and uncertainty were at the heart of the panic, and we saw panic spread across the entire curve. Although we do not deny the commotion caused by the perilous fall in asset-backed commercial paper (ABCP) outstandings from August 2007 (see Graph 1), and the incendiary nature of the Reserve Fund’s breaking of the buck in September 2008, we do not characterize the Noughts Panic as having been set off by the money markets, and that because the short-end is typically the first out the exits. The crisis played out in a complex way.

Certain ABCP conduits, overseas asset-backed funds and structured investment vehicles (SIVs) suffered structural flaws that put them at greater risk of run, including the composition of their book of business, and poorly-qualified sources of funds. But CP outstandings of financial issuers, shown in Graph 1, continued to climb through May 2008, after the collapse of Bear Stearns. CP outstandings of nonfinancial corporate issuers held firm throughout the turmoil. Graph 3 shows that money market fund outstandings expanded every quarter except for Q2 2008, only pulling back for a long spell beginning in Q1 2009.

Some term funding markets were very wobbly or shut completely ahead of the ABCP problems that began in late July/early August 2007. For example, it was reported that USD 60 billion worth of leveraged finance transactions were pulled in the wake of the Bear Stearns hedge fund restructuring in June 2007 (“Credit Chill Freezes Leveraged Deals”, Victoria Howley, Kate Haywood and Marietta Cauchi, Wall Street Journal, August 3, 2007).  The market for subordinated credit card asset-backed securities disappeared in 2007, and issuers had to self-insure in order to continue to issue senior securities, including CP, the market for which was roiled and shrunk but not shut.

Graph 1

Source: Board of Governors of the Federal Reserve System, Economic Research and Data, Commercial Paper, release of June 9, 2016, via Data Download Program
Source: Board of Governors of the Federal Reserve System, Economic Research and Data, Commercial Paper, release of June 9, 2016, via Data Download Program

Catastrophic funding and liquidation risks reside throughout the financial system, because “failure to roll” in the short end can be accompanied by widespread “bid wanted” or refusal to participate in a new issue in term markets. Secondary markets for term securities can be vehicles of value destruction that may bankrupt through depleted capital, prohibitively high cost-of-funds, and/or impeded new credit commitments. The Reserve Fund event was brutal and devastating, but that was one in a series of post-Lehman failures, the others aided before the point of declared insolvency: AIG, Washington Mutual, Wachovia, Merrill Lynch. After Lehman’s insolvency, it was not possible for financial firms to borrow in term debt or securitization markets, forcing the federal government to improvise guarantees for those markets.

One of the more extreme structural changes proposed by Governor Tarullo centers on solutions involving the substitution of US government credit for private credit. To examine this notion fully would expand the current post past tolerable limits (some of you might be thinking we’re there already!) and so will be taken up in the future.

What we will say here about the “safe assets” approach that Governor Tarullo raises is this. Does the government have a natural monopoly over the very broad realm of money? We’re unfamiliar with any such defense. Money and credit are not fully distinct bodies. (Note in this discussion we ignore the unnatural phenomenon of negative interest rates.) The economic concept of money, as the universal means of exchange, is fully charged with liquidity. In practice there are gradations between forms of money, which are many. Unless a transaction is truly spot, there will be some discount or rate or time value or spread or drop or roll or contango involved. Gating access to money so that a time delay is built into settlement changes the terms of the trade and its compensation. The most easily recognized such near-money instrument in the US might be the savings account. Or consider the market for Fed funds: under normal circumstances not currently applicable, the Federal Reserve carries out policy through open market operations intending to affect the interest rate on overnight funds demanded or supplied by banks for purposes of settlement. Money marches out the curve by a day and becomes credit — and not even, as intraday credit exists. Uncertainty can never be fully expunged, but steps can be taken to solidify and strengthen confidence. Instead of restricting money markets, the question might become, to what extent can and should the Federal Reserve act to preserve price stability in credit and money markets?

Consideration of these risks gives us pause to ask whether all financial markets are more inherently unstable than they were, say, 25 years ago, given the sheer volumes of funds, their concentration by counterparty, and heightened sensitivity to information flows courtesy of ubiquitous media. Additionally, ultra-low interest rates, increasing application of algorithms to direct flows, and policy itself in some cases could render markets more unstable. Getting rid of private money markets will not turn that tide.

Graph 2

Source: Board of Governors of the Federal Reserve System, Z.1 Financial Accounts of the United States, L.108, Domestic Financial Sectors, release of June 9, 2016, via Data Download Program.
Source: Board of Governors of the Federal Reserve System, Z.1 Financial Accounts of the United States, L.108, Domestic Financial Sectors, release of June 9, 2016, via Data Download Program.

Postscript note attached to Graph 2: From the FDIC Quarterly Banking Profile, Table 111-C, as of March 31, 2016. For all FDIC-insured banks (not the scope shown in Graph 2), USD millions:

Total assets                              16,389,090

Total domestic deposits           11,154,728

Total insured deposits               6,669,378 (59.8% total domestic deposits)


Graph 3

Source: Board of Governors of the Federal Reserve System, Z.1 Financial Accounts of the United States, L.108, Domestic Financial Sectors, release of June 9, 2016, via Data Download Program.
Source: Board of Governors of the Federal Reserve System, Z.1 Financial Accounts of the United States, L.108, Domestic Financial Sectors, release of June 9, 2016, via Data Download Program.


Tarullo, Daniel K. 2016. Exploring shadow banking: can the nation avoid the next crisis? Opening remarks at Center for American Progress and Americans for Financial Reform Conference, Washington DC, July 12. Board of Governors of the Federal Reserve System.

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