Monday, March 14, 2016

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out.

In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers.

To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as far as removing these requirements, it did reduce them and allowed workarounds like "sweeps." But the shadow banking system never stopped growing.

In negative rate land, everything is flipped around. Central bank reserve requirements no longer act as a tax on banks, they can be a subsidy. The Danmarks Nationalbank, Swiss National Bank and Bank of Japan have resorted to a strategy of tiering, where only a small portion of bank reserves are charged a negative rates (say -0.5%) while the rest (the inframarginal amount) can be deposited at the central bank where it earns 0%. Setting a 0.5% penalty on the marginal amount has been enough to drive interest rates on short term government bills and overnight lending rates to -0.5%. Banks that can invest some portion of their funds at 0% rather than the going market rate of -0.5% are getting a nice gift. They can in turn pass this windfall on to their customers by protecting them from negative rates. Shadow banks, which don't have  access to these subsidies because they don't have accounts at the central bank, are at a competitive disadvantage; they must invest all their funds at the going market rate of -0.5% and will therefore have to share the pain with their customers by reducing deposit rates into negative territory. This growing deposit rate gap should lead to retail and corporate flight from shadow bank deposits into protected regulated bank deposits.

We've certainly seen this in Japan. Around ten MMMFs quickly closed their doors to new funds after the Bank of Japan reduced rates to -0.1%. And now money reserve funds (MRFs) are clamouring for protection from negative rates. So while it used to be a disadvantage to be a subjugated bank and good to be a shadow bank, in negative rate land it's the exact opposite. Better to be shackled than to be free.

By the way, I'm wondering if this is why the ECB decided not to introduce tiered deposit rates last week, pointing to the "complexity of the system." Europe has a relatively large MMMF industry compared to Japan; perhaps it wanted to avoid any financial turbulence that might be set off by subsidies that benefit one set of bankers but not the other.


  1. Yes, one of the consequences of IOR is re-intermediation of debt markets into the banking system. Purely private money markets will fade. Negative rates likely accelerate the process, but capital markets too will likely become more boutique-like playgrounds for HNW money.

    Add your cashless economy to this bank-only mix, and you have quite a prospective mechanism for control over consumption - right down to your daily calorie and carbon allotments.

    1. Is it indeed the case that central banks that have been paying IOR for years (Bank of Canada, Reserve Bank of New Zealand) have no shadow banking system?

    2. Hi JP - "no shadow banking system" is a bit of a hurdle for proof, eh? There could be a dollar or two here or there.

      That said, Yes, Canada indeed very much squelched its shadow banking system big-time with the IOR introduction of the late 1990s. Money market funds, CP, Repo, ABS, ABCP -- they all barely grew in the '00s and '10s.

      What did explode in Canada was the NHA MBS market, which I don't really consider very shadowy -- it's government insured after all.

      I have to consider that, because of the gross surfeit of reserves globally, market rates will likely remain lower than IOR rates for some long while (if market rates worked in any case, why the need for IOR).

      IOR subsidizes membership in the banking system, so you get more of it. Add volatility plus the size of private/shadow-versus-public/sunlight banking systems means that the shadow banking systems have weaker balance sheets. They will always eventually capitulate to central bank backed funding when volatility strikes.

      With IOR, the private shadow banking system is on a random walk to oblivion. They are the mayfly private district of the banking system. (There are probably adverse selection issues in this new IOR world as well.)

      Bottom line, directing seignorage proceeds into the banking system has drastic consequences for private markets.

      If you really want a historical parallel to the introduction of IOR in 2008 on the private/shadow system, try the annihilation of the non-member banks 20 years after the founding of the Federal Reserve.

      There's a reasonable argument to be made that it's all about eliminating competition to the Federal Reserve System. The Fed pulls commercial discount bill funding in 1930-31 ---> nonmember banks get destroyed --> the Fed acquires the right to hold US Treasury assets in bulk.

      ...and the Fed gets to default on their gold liability!

      Similarly, bank reserves barely grow from '95-'08 --> shadow bank and I-bank leverage expands (unsurprisingly) --> IOR is installed, and shadow banking/i-banks are absorbed by the FR system.

      ...and the Fed gets to default on their physical currency liability!

    3. Can you tell me what happened in 1930-31? Are you saying that the Fed at one point allowed non-members access to the discount window but pulled it?

      Interesting points about Canada. I know that we don't have money market mutual funds up here. We had the ABCP crisis in '08 but it was peanuts compared to what happened in the U.S.

      "...and the Fed gets to default on their physical currency liability!"

      Interesting analogy. If the Fed goes cashless, it still has a public inflation target that disciplines it. When it went off of gold, the dollar completely lost its tether.

      "There's a reasonable argument to be made that it's all about eliminating competition to the Federal Reserve System. "

      How does the Fed's new overnight reverse repo facility (ON RPP) fit in to your story?

    4. Well, yes, JP, the Fed appears to have put the squeeze on funding from '30-'31. The number of nonmember banks halved, and nonmember distress increased by a multiple of member banks. Specifically, the Fed slashed its discount bills, resulting in their balance sheet being the same size in 1932 as it was in 1929. They simply put the liquidity squeeze on, and nonmember banks suffered more.

      The parallels are uncanny. The Federal Reserve starved the banking system of reserves from 1920-1933; and again in '96-'08 -- around 13 years each of uncollateralized banking leverage, and then a huge bust.

      Massive power grab for seignorage proceeds followed in both '32 and '08 - first by ditching grubby CP and acquiring Treasurys; then claiming the proceeds of Treasurys via IOR.

      The dollar has still very much on a tether post gold, ie the Treasury strong dollar policy. The relative prices -- whether FX or goods -- still serve as targets.

      The real question is the populace's claim on Fed liabilities. First a gold default, now a currency default.

      It's an incremental takeover of the entire US economy by the Federal Reserve System: i.e. all transactions exclusively clearing in a banking system that also exclusively defines the unit of account and claims seignorage proceeds.

      The Fed's ONRPP simply manages the decline of the shadow banks. It will become as irrelevant as Fed Funds.