Here’s a chart for anyone interested in the origins of the so-called deposit crisis:
It comes from the widely cited recent IMF working paper by Zoltan Pozsar and suggests there are too few banks to meet the demand for safe places to put burgeoning institutional cash pools. It’s the flip side to the increasing amount of cash held by US corporations, rich people and asset managers throughout the last two decades. Chart from the paper’s appendix (click to expand, please note the nominal scale):
Pozsar’s paper is a crisp introduction to the demand side of the “shadow banking” system. As he explains, the typical explanation for its rise is a supply argument: that the search for yield and abritrage opportunities encouraged the growth of money market funds and use of repurchase agreements, or repos. Tyler Cowen notes that this builds on arguments by the excellent Gary Gorton.
Pozsar doesn’t reject the idea that the financial crisis (and current woes) was caused in part by the search for safe yet yielding AAA assets. But he draws a distinction between the demand for long-term AAA assets and for short-term AAA assets, the latter being the focus of his paper. The former is covered in FT Alphaville’s post on the AAA bubble, and in papers by academics such as Ricardo Cabellero (and Ben Bernanke) on the shortage of AAA assets.
In addition, Pozsar’s paper is a useful backgrounder to FT Alphaville’s Izabella Kaminska’s recent posts on the Federal Reserve’s struggles to avert troubles in short-term markets. Both have at their heart the idea that safety and liquidity — not yield — are the main motivations for short-term allocation decisions; hence US Treasuries (or money) can look like Giffen goods.
Without any more ado, then, here is Pozsar’s summary of his five conclusions (emphasis ours, with comments in the margins):
First, insured deposit alternatives dominate institutional cash pools’ investment portfolios relative to deposits. The principal reason for this is not search for yield, but search for principal safety and liquidity.
Second, between 2003 and 2008, institutional cash pools’ demand for insured deposit alternatives exceeded the outstanding amount of short-term government guaranteed instruments not held by foreign official investors by a cumulative of at least $1.5 trillion; the “shadow” banking system rose to fill this gap. From this perspective, the rise of “shadow” banking has an under-appreciated demand-side dimension to it.
Third, institutional cash pools’ preferred habitat is not deposits, but insured deposit alternatives. This is to say that institutional cash pools’ money demand is satisfied by nonM2 types of money. This is because institutional cash pools’ money demand is not for transaction purposes, but for liquidity and collateral management as well as investing purposes, which aren’t best met by deposits, but by Treasury bills and repos.
These cash pools, writes Pozsar, emerged due to (1) globalisation and inequality; (2) more centralised liquidity management by investment funds; and (3) derivative-based investment styles (such as ETFs) that require separately managed cash pools.
So, there was and is a lot of cash sloshing about. Pozsar then notes that 90 per cent of instutional cash pools are subject to management policies where safety is the primary objective. But as the opening chart shows, there wasn’t enough capacity in the “real” banking system to meet this demand. (One criticism of this excellent paper is that it relies too much on the implicit assumption that because funds are obliged to seek safety they actually do so.)
Thus, instead of placing unsecured deposits at banks, institutional investors invested in insured deposit alternatives such as T-bills or money market funds, according to Pozsar. Which brings him to his fourth — and most important – conclusion:
Fourth, the larger institutional cash pools and their demand for insured deposit alternatives grows relative to the supply of short-term government guaranteed instruments in the financial system, the less effective deposit insurance and lender of last resort access for banks only will be as stabilizing forces in times of crises.
Pozsar argues that we were recently faced with a form of Triffin dilemma, typically used to purport the paradox that the US dollar’s reserve and “risk-free” status inherently carries risk because the origin country needs to continue to run a current account deficit.
In this case, in both the long- and short- term markets, the US failed “at a task no less than endogenously creating private alternatives to Treasury bills, that had the same degree of safety and liquidity than the real T-bills that were in short supply.”
The problem was “solved” in 2008 in two ways, adds Pozsar. First, via the Fed’s emergency lending facilities. Second, via the increase in issuance of short-term T-bills, which led to the big increase in M2 supply that FT Alphaville mentioned in this post.
But the problem hasn’t really been solved, of course. Despite an increase in the FDIC’s insured deposit limit (to $250,000 from $100,000), a temporary unlimited insurance on noninterest bearing transaction accounts, and the repeal of regulation Q, uninsured cash pools still account for 55 per cent of insured deposits, up from 5 per cent in 1990. Check out this version of the chart at the top of the post, updated for the $250,000 limit:
And, as Gillian Tett argues, with parts of the shadow banking sphere all but collapsed, this cash has flooded into money market funds and repo operations. T-bills are thus at a huge premium — so much so that investors are willing to accept near negative yields, especially with the Fed cutting down supply. (This is also kind of why there’s an argument for why QE3 is a bad idea: gobbling up T-bills when they’re in high demand could push rates down further when there is no longer much of a floor.)
Pozsar doesn’t comment much on asset prices but he’s certainly worried about what this all means for the US financial system:
In light of these developments, it is legitimate to ask whether the secular rise of institutional cash pools relative to the volume of insured deposits in the U.S. financial system is making banks increasingly less able to backstop them.
Indeed, if institutional cash pools continue to rely on banks as their credit and liquidity put providers of last resort, the secular rise of uninsured institutional cash pools relative to the size of insured deposits is going to make the U.S. financial system increasingly run-prone, not unlike it used to be prior to the creation of the Federal Reserve and the FDIC.
In order to avoid this, he proposes more active management of short-term markets by the US treasury and Federal Reserve:
Fifth, an elegant way to solve the financial system’s fragility due to the rise of institutional cash pools and “shadow” banking would be to issue more Treasury bills and to explicitly incorporate the supply management of bills into the macroprudential tool kit. While not without costs or alternatives, this approach is less troublesome and complicated than the alternative of intense real-time monitoring and regulation of the shadow banking system.
Which, presumably, would mean he also thinks a direct repeat of QE2 would be a bad idea.
If you’re interested in more Pozsar check out this paper from 2010.
Related links:
Shadow Banking – Zoltan Pozsar / NY Fed (2010)
When a government bond becomes a Giffen good – FT Alphaville
Regulating the shadow banking system – Marginal Revolution (2010)
Cash-rich investors choose crazy Treasury returns – FT (Gillian Tett)