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.