We came across an article “Shadow banking and the global financial ecosystem“ (Nov. 7, 2013) by Zoltan Pozsar of the Institute for New Economic Thinking. This is one of the most interesting articles on shadow banking we have seen in a while and strongly recommend you to read it. We hit some of the highlights.
Pozsar contends that one needs to understand not only whom the actors are in shadow banking, but also why they are doing what they do. He starts,
“…Modern banks are dealer banks (Mehrling et al. 2013) that finance bond portfolios with uninsured money market instruments, and rather than linking ultimate borrowers with ultimate savers, they link cash portfolio managers and risk portfolio managers who in turn manage ultimate savers’ savings…”
“…Cash portfolio managers are cash rich but ‘safety poor’ since they are too large to be eligible for deposit insurance. This drives them toward insured deposit alternatives such as collateralised repurchase agreements…”
“…Risk portfolio managers, on the other hand, are securities rich but ‘return poor’ in the sense that they are mandated to beat their benchmarks. To that end, they employ the techniques of leverage, shorting, and derivatives…”
He is describing the flow of cash from cash rich managers to leveraged portfolio managers. Pozsar is talking about (tri-party) repo and derivatives.
Why does this happen? The author cites three factors for the rise of cash portfolio managers:
- managed foreign exchange rate regimes, generating $1 trillion of liquidity
- cash pools at large global corporates, generating $1.5 trillion of liquidity
- cash accumulating at outsourced asset managers, including securities lending and derivatives, generating $3.5 trillion of liquidity
Who are the players we should be paying attention to in shadow banking? Pozsar says there are five:
- CIOs at pension funds, foreign central banks and sovereign wealth funds who invest in leveraged instruments to overcome their chronic underfunded liabilities.
- Hedge funds and separate account managers are charged by Group 1 to manage money and “…employ leverage, shorting, and derivatives in order to beat their benchmarks…”
- Cash portfolio managers, who “… shun credit, duration, and liquidity risks, and invest cash on a collateralised basis…”
- Corporate CEOs who “…who are tasked with generating growth in the real economy and profits, respectively…”
- Dealers who intermediate between everyone, and in particular “…make markets and intermediate risks away from cash portfolio managers and toward risk portfolio managers – enabling them to preserve their wealth in the present and to help meet their promises in the future, respectively…”
Sitting in-between the cash providers and investment managers are repo and derivatives books. Pozsan says to understand shadow banking, we must understand how these risks are intermediated.
“…This is the broadest perspective in which we can understand the rise of the shadow banking system. It explains why it is misleading to think about credit, duration, and liquidity transformation, and more appropriate to think about the intermediation of these risks between cash and risk portfolio managers across the financial ecosystem and – by inference – the real economy. That is, credit to the real economy is extended either through dealers’ securities inventories or via credit intermediation chains that go from cash portfolio managers through dealers’ matched repo books to risk portfolio managers to fund leveraged bond portfolios…”
So far, the author says, regulators are focused only on the dealer banks by mandating capitalization, funding, prop trading, and ring fencing from retail banking. But this avoids dealing with the underlying issues. One of those issues that must be addressed is the underfunding of pensions (among other financial obligations) that push portfolio managers to play catch-up by using leverage.
We must recognize that the world is no longer retail savers on one side and bank loans on the other managed by bankers hitting the golf course at 3pm. Likewise, we must acknowledge that the obvious fixes to shadow banking – reduce the future financial imbalances (e.g. fix the pension fund underfunding) or widening out the official safety net for institutions by giving dealer broad access to lender of last resort funding – are probably not happening anytime soon.
“…Today we have new types of savers (cash portfolio managers versus retail depositors), new types of borrowers (risk portfolio managers to fund pensions versus ultimate borrowers to finance investments and consumption) and new types of banks (dealer banks that do securities financing versus traditional banks that finance the real economy more directly via loans) to whom discount window access and deposit insurance do not apply…”
The first step, according to Pozsar, is to overcome to lack of measurement of the flow of funds in a.) dealer repo books, b.) “…asset–liability mismatches at pension funds and foreign exchange reserve managers…”, and c.) hedge funds and separate fund account managers. He says “the flow of funds accounting ends where derivatives begin”. So looking at bond flows without the accompanying underlying derivatives risk is “somewhat limited”.
Pozsar has a refreshing perspective on shadow banking and one we should all pay attention to.