The safe asset girdle on liquidity

We have mixed views about the phrase “maturity transformation”, found in economic and bank regulatory literature. We like it because it is suggestive of alchemy or developmental biology, and finance is full of alchemy. We don’t like some of the baggage that has been hung on the term, and while we will never defend tradition for its own sake, we wonder what is wrong with “asset/liability mismatch”, which to us seems clearer, and reminds us to think of both sides of the balance sheet. Maturity transformation has a one-off, static quality to it, and indeed some of the worst examples of maturity transformation excess are found in entities bound by structural rigidity and limited economic headroom, such as the SIVs. Whichever phrase is deployed, it captures a whole nest of risks, prime among those risks of liquidity and interest rates. These days, it is typically liquidity risk that lies behind the invocations of maturity transformation — and usually funding risk specifically.

Liquidity, of course, lies at the core of the fundamental problem of finance, namely those occasions when suppliers of liquidity act en masse to protect the value of their claims. Systemic liquidity risk management should not be fixed solely within the frame of the primary, or funding, markets, but should be expanded to the secondary markets as well. Both risk-taking and risk-shedding need to be included in the conceptual framework. Risk-taking would be very sclerotic without institutional connectedness within the domain of finance; firms develop particular comparative advantages, and trading between firms help to redistribute risk that naturally accumulates due to the advantage. Both asset/liability mismatch and connectedness fire up the potential for systemic instability, but they are intrinsic to the execution of finance, and always have been.

Liquidity risk can never be fully offset. It is both idiosyncratic and subject to system-wide impulses. Of course, you may say, that’s why the lender of last resort is such a hardy perennial. And a critical reason why governments and banks are forever joined in (unholy?) matrimony. A new frontier in this relationship has emerged, one where fiscal policy is called onto the field of play on an ongoing basis. There is the USD 3.6 trillion crisis-driven expansion of the Federal Reserve balance sheet, with US Treasuries and agency MBS on the asset side, and reserves and the RRP program on the liability side. There are certain regulations intended to shrink liquidity risk and promote safety and soundness that rely on what are termed “safe assets” in the economic literature. Included in this category are: Basle 3 Liquidity Coverage Ratio’s HQLA (High Quality Liquid Asset) holdings requirement; the SEC’s Money Market Fund Reform, which structurally favors government funds, and; system-wide margin requirements for derivatives under Title VII of the Dodd-Frank Act. As mentioned in our post of August 10, 2016, Federal Reserve Board Governor Tarullo floated the notion of a government-mediated substitute for short-term nonbank liabilities, among other possible solutions to the problem of so-called runnable funding. One can also point to the ongoing substantial operations of the US government-sponsored entities in the mortgage market.

In this context note the expansion of federal government debt through the crisis and recovery; for example, the growth of marketable Treasury securities over the past eight quarters through Q2 2016 exceeded the growth of National Income by a cumulative 5.2 percent (source: Board of Governors of the Federal Reserve System Financial Accounts of the United States, Data Download Program, release of September 16, 2016). The current (Q2 2016) ratio of total US Treasury securities outstanding to National Income is 96.6 percent, compared to 68.9 percent at the cyclical trough in Q2 2009. We hope to examine US government spending more carefully in the future, but will quickly note higher outlays as a percentage of GDP for the categories of Social Security and major health care throughout the recovery to the present, and increased (again, relative to GDP) nondefense discretionary and other mandatory spending over the period 2008-2013 (Martin 2016). By no means is monetary policy “the only game in town”. The fiscal expansion looks different than we expect it to look.

How this new frontier develops is unclear. We see the fiscal connection as largely circumstantial, but note that some eye it opportunistically. Expansion of safe assets has been tagged as a useful policy tool, variously through: the crowding out of private money-market instruments by US government instruments, ideally using the Federal Reserve’s RRP program, to engineer financial markets stability (Greenwood, Hanson and Stein 2016); stimulating aggregate demand in a “safety trap”, where the active constraint of the zero lower bound, high risk premia, and a shortage of safe assets feature (Caballero and Farhi 2016); allowing the relaxation of borrowing restrictions in normal times, due to the robustness and information-insensitive qualities of safe assets as collateral, in addition to generating wealth during crises (Gorton and Ordoñez 2013). A contrarian view has been articulated by Christopher A. Sims (2016), who notes a threat to Federal Reserve independence stemming from a large balance sheet, and unless inflation expectations are sent higher, no wealth effect resulting from increased government debt because of the impact of current or anticipated future taxes needed to service the debt.

We’ve traveled over quite an extensive range in the last two posts, but at the core, it all has to do with how safety and soundness is being engineered. It is our view that the money markets have been unfairly stigmatized as a source of systemic risk, and that the dismantlement of the money markets has gone too far. We see very little acknowledgement by regulators or academics of legitimate sources and uses of short-term funds; exceptions can be found in the expressions of some central bankers, such as Simon Potter (2016) who recognize the need for a viable money market in order to execute monetary policy. We question the limits of the achievement of safety and soundness through application of government and government-sponsored collateral. Some see advantages through information savings; we see potential for laziness, the same sort of laziness that became apparent through the easy acceptance of structured AAA-rated securities and of the GSEs in the 2000s. There are questions of collateral cost, interest rate risk, and the impact on safe asset quantities and rates that need further exploration.

We very much question the limits of the achievement of safety and soundness through repression. Banking policy has disfavored private residential mortgage origination, market making (through capital requirements – especially the Supplemental Leverage Ratio, the Comprehensive Capital Analysis and Review process, and the Volcker Rule), and short-term liabilities (via the capital levy for short-term borrowings and the Basle 3 Net Stable Funding Ratio) Who pays attention to the allocation of capital on a societal basis?

References

Caballero, Ricardo J. and Emmanuel Farhi. 2016. The safety trap. Harvard University OpenScholar Working Paper 233766. https://ideas.repec.org/p/qsh/wpaper/233766.html

Gorton, Gary B. and Guillermo Ordoñez. 2013. The supply and demand for safe assets. NBER Working Paper 18732.                     https://ideas.repec.org/p/nbr/nberwo/18732.html

Greenwood, Robin, Samuel G. Hanson and Jeremy C. Stein. 2016. The Federal Reserve’s Balance Sheet as a financial-stability tool. Prepared for the Federal Reserve Bank of Kansas City’s 2016 Symposium. https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-greenwood-hanson-stein-paper.pdf?la=en

Martin, Fernando M. 2016. US fiscal policy: reality and outlook. Federal Reserve Bank of St. Louis Economic Synopses, Number 10. https://research.stlouisfed.org/publications/economic-synopses/2016/05/20/u-s-fiscal-policy-reality-and-outlook/

Potter, Simon. 2016. Discussion of “Evaluating monetary policy operational frameworks” by Ulrich Bindseil. Remarks at the Federal Reserve Bank of Kansas City’s 2016 Symposium. https://www.newyorkfed.org/newsevents/speeches/2016/pot160826

Sims, Christopher A. 2016. Fiscal policy, monetary policy, and central bank independence. Prepared for the Federal Reserve Bank of Kansas City’s 2016 Symposium.                                            https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-sims-paper.pdf?la=en

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