Euromoney just published an interview with IMF Economist Manmohan Singh. A link is here. Singh has written extensively on securities financing, collateral chains, shadow banking, and re-hypothecation — all things near and dear to us. We have referred to his writings in Finadium research pieces (here is a link) as well as other www.secfinmonitor.com posts (including this one where his paper was cited for things he never really wrote….a link is here). He knows what he is talking about. We’ll summarize what we think are the interesting parts of the interview and do a little editorializing.
Singh says, “Re-hypothecation is not a four-letter word. The financial system needs lubrication, and collateral chains help markets get completed. They connect the hedge fund with assets with someone who needs collateral. The question is do we need short or long chains? People can argue that financial stability improves with shorter chains, but if the chain is down to two counterparties, then there is a clear risk of liquidity drying up.” In www.secfinmonitor.com posts we have used some of the same language to debunk the near-visceral reaction some have to securities finance in general and re-hypothecation specifically.
When asked what failed banks “which have relied on short-term off-balance sheet funding like repo, reveal about this widespread practice, especially where the underlying assets have ‘disappeared’?” Singh explained that, yes, assets get re-pledged and leave the control of the pledger, creating a collateral chain. But “these collateral chains are a necessary component of financial lubrication.” He also noted, “Repo is just one part of re-hypothecation, which also involves the re-use of source collateral in connection with securities lending, OTC derivatives trading and newer forms of collateralized lending like liquidity swaps.” Putting aside the assertion in the question that all securities finance is off-balance sheet (which is a.) not true and b.) a code word for “evil” these days), Singh says that collateral chains are necessary to make the system function.
Asked about what the regulatory response should be, his answer was very interesting. He felt “regulatory efforts need to focus on the sizeable volumes of bank funding coming from non-bank asset managers via source collateral and institutional cash pools. Regulators may need to reconsider and fine-tune the leverage definitions of banks to incorporate collateral chains due to the sizeable volumes of pledged collateral that churn between banks and nonbanks.” Liquidity rules on Basel III focus on the type of collateral and the timing of the flows, not on who are the counterparties. Singh seems to say that there should be a difference made between bank and non-bank (e.g. shadow bank) counterparties. This is even more important since, according to Singh, “Regulatory proposals, such as the Dodd-Frank Act and Basel III, that are pushing riskier activities outside the banking system, will likely increase the shadow banking world; thus its linkages to the traditional banking world warrants closer attention. More generally, the approach towards shadow-banking system may need some adaptation in key dimensions. Dynamic chains, for example, are quite different from the credit intermediation chains.” In other words, the unintended consequence of the regulations will be to push activity outside of the traditional banks (and often the regulator’s grasp), so it might be a good idea to pay attention to where the business is moving.
Asked, “Much of the emphasis around systemic deleveraging in both academic and commercial circles has focused on price declines and alling balance-sheet capacity. What role does collateral play?” Singh said “Most people think deleveraging is only about haircuts, where a security once worth 100 is now worth 60. These mark downs, however, also mean that the value of collateral is lower and as that falls, so does the velocity of collateral. In other words, deleveraging is as much (or more) about the length and elasticity of collateral chains as it is haircuts.” This goes back to collateral churn – how many times the paper ticks over in the market. Singh’s papers have likened collateral velocity to the velocity of money – when it goes down, there is less liquidity and the markets can more easily seize up. Reducing collateral velocity shouldn’t be an objective, intended or otherwise.