Repairing the collateral damage
December 23, 2013

Global banking is in the midst of a broad transformation in both its funding structure and the instruments that underpin the security of transactions. The old system was built on retail funding and ran on cash, but the new system emphasizes wholesale funding and is lubricated by high-quality collateral such as U.S. Treasurys. Since the 2008 financial crisis, that key piece of the puzzle has been in short supply, inhibiting lending and money creation.

At one time, banks relied almost entirely on retail funding. Under this traditional model, banks use customer deposits to extend loans to businesses and consumers, generating revenue by charging higher interest rates than what they pay to depositors.

However, this model was susceptible to aEURoebank runs.aEUR? If depositors believed a bank was in deep trouble, they would panic and aEURoerunaEUR? in droves to withdraw their money. Such runs, which occurred periodically, would even affect healthy institutions, resulting in a cascade of insolvencies as banks sold assets at fire sale prices to meet the demand for withdrawals. This was resolved in 1993 by the establishment of the Federal Deposit Insurance Corp., which insured depositors against losses in the event of a bank failure.

In the 1970s, banks began to modify their traditional funding model by expanding their sources to include the wholesale markets, as shown in Figure 1A. In other words, banks issued more debt to other financial institutions, such as banks, insurers and other corporations, hedge funds and private equity firms. This enabled them to grow without relying as heavily on retail deposits as well as expand leverage and boost returns on equity.

Wholesale funding sources, also known as non-core or non-deposit liabilities, include repurchase agreements (or aEURoereposaEUR?), foreign currency debt, commercial paper, large-denomination certificates of deposits, federal funds, and brokered deposits. In particular, the share of short-term wholesale instruments that use collateral, especially repos, has increased considerably (see Figure 1B).

Figure 1

Sources: Federal Deposit Insurance Corp., Federal Reserve Bank of New York.

A problem arises with this model, too. If wholesale financiers believe that banks are in trouble, they may refuse to renew their funding. Ironically, this means that the contemporary banking system is still vulnerable to runs, but at the hands of participants in the wholesale market rather than retail customers. When banks canaEUR(TM)t roll over their short-term debt, nor obtain additional deposits or issue new equity, they may be forced to dump assetsaEUR"which is what happened during the height of the financial crisis, when the market seized up and the availability of repurchase agreements disappeared overnight.

Because wholesale funds in the form of debt are generally not insured like retail deposits, large institutions seek safety by putting their money into high-quality collateral, such as agency mortgage-backed securities, government Treasurys, and other short-term, liquid, and low-risk assets. In todayaEUR(TM)s banking industry, such securities serve as the underlying basis of trust for transactions.

Yet despite its importance, high-quality collateral has grown too scarce to meet the needs of the system. In the aftermath of the meltdown, many assets, including portions of the mortgage-backed securities and European sovereign bond markets, are no longer considered safe, and the loss has undermined large-scale lending and liquidity in the wholesale funding market.

In the evolution of the banking system, the government solved one problem early on, but a new one arose in its place. Washington may be the key to the current dilemma as well. The Federal Reserve holds abundant secure collateral in its coffers, largely accumulated through its bond buying program of the last five years. Its plan to slow those purchases, announced last week, is a step toward putting more high-quality securities into circulation. Eventually, much of the stockpile in the central bankaEUR(TM)s vault is likely to be released into the marketplace, which could have a sizable, even pivotal, effect. In the interests of mitigating systemic risk, it should do so sooner rather than later.

Ronnie Wiessbrod is a business and program development associate at the Milken Institute.


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