contemporary issues in

banking and finance

lecture 18:
Central Banks and
the Market

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 Shadow Banking

Unregulated shadow banks fund

themselves with uninsured commercial
paper, which may or may not be
backstopped by liquidity lines from real
banks. Thus, the shadow banking system
is particularly vulnerable to runs—
commercial paper investors re- fusing to
re-up when their paper matures, leaving
the shadow banks with a liquidity crisis—a
need to tap their back-up lines of credit
with real banks and/or to liquidate assets
at fire sale prices. (Mc- Culley, 2007)

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Shadow Banking

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Shadow Banking

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 Shadow Banking
Debtors
Govt Clearing Hedge Funds
Banks
Loans

Tri-party Bilateral Mortgage

repo clearing Repo Bilateral
Lending Banks
Repo
Tri-party
Money Market Repo
Mutual Funds Dealer/Brokers
(MMFs) ABS

Tri-party
Special Purpose
Repo
Creditors Vehicles (SPFs)
ABCP
ABS
Securities
Conduits
Lenders (SLs) ABCP

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Shadow Banking

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 Mehrling

► “The Money View”

► Today’s shadow banking looks a lot like
Bagehot’s world in the 19th century.
► All the action is in the wholesale money
markets
► Network of promises to pay
► Minsky: “everyone can create money; the
problem is to get it accepted” (1986, p. 228)
► Key question: who provides the liquidity
backstops?

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 Endogenous money and
shadow banking

► Loans create deposits

► Investment spending by firms can never be
constrained by lack of saving — only by lack of
finance.
► Investment is not constrained by saving
► Assumption is that households save and lend
and firms borrow and invest.
► In recent period, opposite is the case:
► Shadow banking accommodates saving
without investment.

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 Hierarchy of money
► Mehrling: distinguish money (the means of
final settlement) from credit (a promise to
pay money, or means of delaying final
settlement)
► Merhling: “What looks like money at one level
of the system looks like credit from the
standpoint of the level above.”
. . . there is no other case in which a claim
to a thing can, within limits to be sure,
serve the same purpose as the thing itself:
you cannot ride on a claim to a horse, but
you can pay with a claim to money. But
this is a strong reason for calling money
what purports to be a claim to legal
money, provided it does serve as means of
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 Endogenous money in Minsky

Banking is not money lending; to lend, a

lender must have money. The
fundamental banking activ- ity is
guaranteeing that some party is
creditworthy
(Minsky, 1986, p. 256)
► Two types of monetary endogeneity in
Minsky
► Deposit creation when lending
► Liability management to increase
leverage and layering
► Two (or more) types of money
► Deposits and Cash.
► Near-monies: MMFs shares, commercial
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Liability management

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Liability management

Asset Liabilitie
s
Reserve s
Demand
s Deposits Time
Treasuri Deposits
es Commercial
Loans Paper

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Liability management

Asset Liabilitie
s
Reserve s
Deposi
s ts ABS
Treasuri Repo
es
Loans

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 Hierarchy of money

The net payments of dealers and money

funds, and those of all other actors in the
broader financial ecosystem, are settled
using demand deposits, and net deposit
flows between banks are settled via trans-
fers of reserves between banks’ reserve
accounts maintained at the central bank.
The vast majority of credit and money
claims in the ecosystem begin life as a
loan and the creation of a demand deposit
in equal amounts.
Poszar, (2014), ‘Shadow Banking: The Money
View’, pp. 9, 33.
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 Lender of last resort:
The Bagehot Rule

Lend freely to illiquid but solvent institutions,

against what is good collateral in normal times
at high rates.

The end is to stay the panic. And for this

pur- pose there are two rules:–First. That
these loans should only be made at a very
high rate of in- terest. . . . Secondly. That
at this rate these ad- vances should be
made on all good banking securi- ties, and
as largely as the public ask for them
(Bage- hot, 1873)
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 Bagehot’s world
► Banks lents to merchants and industrialists by
discounting bills of exchange
► Banks would manage their daily cashflow by
raising or lowering the discount rate
► Bank of England initially just another
commercial bank.
► Eventually, become “bankers’ bank” —
reserves at BoE used to settle between
banks.
► BoE took on ‘lender of last resort’ role
domestically by issuing reserves according to
Bagehot rule in times of stress
► Lender of last resort function still
discussed in Bagehot’s terms
► But structure of banking system has
changed a lot since those Bagehot’s days. 17 /
 The modern world (US before
the crisis)

► Until now we have assumed that

commercial banks obtain loans directly
with the Central Bank when short of
liquidity; the reality is more complex.
► We will use the example of the Federal Reserve
system and the Federal Funds market.
► In general, reserve balances are obtained
by repo borrowing by banks.

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 The repo market

► Recall that repos are short-term loans

backed by
collateral.
► Treasury securities are the most
commonly used collateral.
► The Fed deals with primary dealers in
government securities.
► These institutions offer a bid-ask spread
and fund their inventories using repos
backed by treasury securities.

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 Repo

► A short-term collateralised loan

► Legal form: purchase and sale of the collateral
► Possibility of ‘rehypothecation’: use of the
collateral by original lender for borrowing
► Often collateralised using government bonds
► Provides a connection between publicly and
privately issued assets (liabilities)

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 Three dollar money markets

► Repo market
► Fed Funds
► LIBOR
LIBOR > FedFunds > Repo (1
)

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 The federal funds system

► Banks usually obtain reserves by

borrowing and lending in the overnight
Federal Funds market.
► Banks usually aim to maintain close to
zero reserves.
► When the Federal Funds market as a whole is
short of liquidity banks sell securities to
primary dealers in order to obtain reserves.

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 Liquidity management
► The Fed doesn’t intervene directly in the
Federal Funds market.
► Fed regulates liquidity through repo
transactions
with primary dealers
► This leads to a distinction between market
liqidity
and funding liquidity
► Primary dealers essentially convert funding
liquidity from the Fed into market liqidity
for the banking system.
► Treasury repo rate to primary dealers has
replaced discount rate on bills of exchange
► Transmitted through arbitrage operations
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 Three phases of LOLR

Grad, Mehrling and Neilson (2011), “The

evolution of last-resort operations in the
global credit crisis”

► Private Lender of Last resort (LOLR)

► Public LOLR
► Public Dealer of last resort (DOLR)

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private LOLR

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private LOLR

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public LOLR

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public DOLR

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 Crisis
management
► So far, described the workings of the
system in “normal” times; what about in
crisis conditions?
► Repo lending involves sale and
repurchase of securities
► This price is usually lower than the
market price
and is called the haircut.
► The haircut means that the loan is
overcollateralised as insurance against
market moves and non-payment.
► We can think of this as similar to banks only
offering up to 90% loan-to-value mortgages
(although not the case pre-crisis).
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 Crisis
management
► Securities as collateral are marked to
market – recorded on balance sheets at
current prices
► If securities prices fall, banks may find
themselves
unable to obtain reserves
► Bagehot’s in normal times rule doesn’t
apply to profit-seeking commercial
banks.
► Banks would no longer lend to each
other in non-Treasury repo markets
► Response of Federal Reserve:
► Widened range of institutions it
would transact with
► Widened range of eligible 32 /
 Mehrling’s Conclusion

► Lender of last resort—provision of

funding liquidity—no longer
sufficient in world of collateralised
lending (repo)
► Support for asset prices is essential—
market liquidity
► Fed’s role has shifted to market-maker
of last resort

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 Endogenous shadow bank
expansion?
The net payments of dealers and money
funds, and those of all other actors in the
broader financial ecosystem, are settled
using demand deposits, and net deposit
flows between banks are settled via trans-
fers of reserves between banks’ reserve
accounts maintained at the central bank.
The vast majority of credit and money
claims in the ecosystem begin life as a
loan and the creation of a demand
deposit in equal amounts.
Poszar, (2014), ‘Shadow Banking: The Money
View’, pp. 9, 33.
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