At the end of January, Japan’s became the latest central bank to drop deposit rates into negative territory, joining the likes of the ECB, Sweden, Switzerland and Denmark. This now means that something like 25% of the world economy on a GDP basis is operating on a fee-for-deposit basis. What does this mean for collateralized financing markets? So far, not what the Japanese expected it to mean. The move was aimed at driving capital deposits away, into private markets, and at devaluing the Yen as a defense against the precipitous drop in the Yuan. Apart from a brief stock market uptick in the days following, none of this has occurred.
Capital markets are becoming increasingly critical and cynical about central bank policy. As reported in the Australian Financial Review (Japan Recovery a Temporary Reprieve, February 20, 2016), both Deutsche Bank and Morgan Stanley, amongst others, have been pointed and stark in their criticism of negative interest rates.
“Analysts at Deutsche Bank have likened the policy to weapons of mass destruction. ‘Central banks must stop the proliferation now…. Negative rates don’t stimulate beyond currency devaluation.’
Morgan Stanley analysts agreed, labelling negative interest rates ‘a dangerous experiment’, which risked encouraging banks to shrink their loan books – the exact opposite of what central banks are hoping for.”
The problem faced by securities finance markets in particular is that all normal market and economics-based mechanisms for establishing yield-based repo rates; for valuing RWA and RWR; and for pricing in cost of funds are now upside down for more than one-quarter of the global market. Strategies that transfer capital through collateralized financing transactions across currencies and markets are subject to increasingly unstable and unpredictable players – central banks themselves. In January of this year, we warned that central bank intervention was becoming more of the problem than the solution, and was introducing risks into the system that none of the new regulatory capital and risk standards were designed to handle. (Rate games adding to complexity in collateralized financing markets, Securities Finance Monitor, January 13, 2016). We still think this is true.
Securities finance markets (and fixed income in particular) are on the classic horns of a dilemma. Market regulatory structure is making the private flow of interbank liquidity more and more costly; at the same time central banks are pushing markets to increase the capital flow. There seems to be an unreasonable expectation that private institutions should subsidize growth policies by absorbing unprofitable risks and losses in one way or the other – either through draconian capital costs in the interbank financing markets, or through yield burning losses on central bank deposits.
We have long stated that commercial bank lending to finance the “real economy” – the growth central banks are trying to encourage – cannot occur without efficient, cost effective and profitable securities finance markets to move capital on a collateralized basis and disperse risk. Now we’ll add that “you can’t have your cake and eat it too.” If you are seeking to loosen up the flow of capital, you must loosen up the restrictions on the flow of capital between banks. It is that simple. No amount of quantitative easing, no level of penalty for secure deposit, and no amount of rate distortion will make it happen.