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In a previous post, we showed that dealers sometimes enter into tri-party repo contracts to acquire excess funding capacity, and that this strategy is most prevalent for the agency mortgage-backed securities (MBS) and equity asset classes. In this post, we examine the maturity of the repos used to pursue this strategy and estimate the associated costs. We find that repos that generate excess funding capacity for equities and corporate debt have longer maturities than the average repo involving either of these asset classes. Furthermore, the premiums dealers pay to maintain excess funding capacity can be substantial, particularly for equities.
Security dealers sometimes enter into tri-party repo contracts to fund one class of securities with the expectation they will wind up settling the contract with higher quality securities. This strategy is costly to dealers because they could have borrowed funds at lower rates had they agreed to use the higher-quality securities at the outset. So why do dealers do this? Why obtain or arrange excess funding for the initial asset class? In this post, we discuss possible rationales for an excess funding strategy and measure the extent of excess funding capacity in the tri-party repo market. In a second post, we examine the maturities of repos used to generate excess funding capacity and estimate the costs of this strategy.
Anyone who has a savings account, has taken out a mortgage, or has been part of a business seeking new capital has relied on the smooth functioning of the institutions and markets that collectively perform financial intermediation. Because financial intermediation is so critical to the functioning of a modern economy, it is important to understand its inner workings—its fundamental features, recent innovations, lines of transmission to real economic activity, its imperfections, and its interactions with regulatory policies. As part of an ongoing effort to foster such an understanding, the New York Fed recently hosted the twelfth annual Federal Reserve Bank of New York–New York University Stern School of Business Conference on Financial Intermediation. In this post, we explore some of the discussions and findings from the May 5 conference, which focused on recent advances in the study of financial intermediation.
The global financial crisis has put financial stability risks—and the potential role of macroprudential policies in addressing them—at the forefront of policy debates. The challenge for macroeconomists is to develop new models that are consistent with the data while being able to capture the highly nonlinear nature of crisis episodes. In this post, we evaluate the impact of a macroprudential policy that has the government tilt incentives for banks to encourage them to build up their equity positions. The government has a role since individual banks do not internalize the systemic benefit of having more bank equity. Our model allows for an evaluation of the tradeoff between the size of such incentives and the probability of a future financial crisis.
Catherine Chen, Marco Cipriani, Gabriele La Spada, Philip Mulder, and Neha Shah
On October 14, 2016, amendments to Securities and Exchange Commission (SEC) rule 2a-7, which governs money market mutual funds (MMFs), went into effect. The changes are designed to reduce MMFs’ susceptibility to destabilizing runs and contain two principal requirements. First, institutional prime and muni funds—but not retail or government funds—must now compute their net asset values (NAVs) using market-based factors, thereby abandoning the fixed NAV that had been a hallmark of the MMF industry. Second, all prime and muni funds must adopt a system of gates and fees on redemptions, which can be imposed under certain stress scenarios. This post studies the effect of the amendments on the size and composition of the MMF industry and, in particular, whether MMF investors shifted their assets from prime and muni funds toward government funds in anticipation of the tighter regulatory regime.
Banks play a crucial role in the economy by channeling funds from savers to borrowers. The ability of banks to accomplish this intermediation has become an important element in understanding the causes and consequences of business cycles. In a recent staff report, I investigate how a positive deposit windfall translates into investments by banks. This post, the first of two, shows how the development of new energy resources has led to deposit inflows to banks and how that can be used to estimate banks’ investment decisions over the recent business cycle. The second post will look at factors that might explain the business cycle patterns observed below.
Marco Cipriani, Antoine Martin, and Bruno Maria Parigi
Since the financial crisis of 2007-09—and, in particular, the run on prime money market funds (MMFs) in September 2008—policymakers have been concerned that the funds’ fragility may render banks themselves more susceptible to risk. For instance, in a recent article and speech arguing in favor of MMF reform, New York Fed President Bill Dudley stated that MMF fragility may contribute to financial market systemic risk. The idea that the susceptibility of MMFs to runs may make the financial system more unstable seems intuitive, but is it correct? In this post, we show that the idea isn’t only intuitively appealing, it’s also sound from an economic theory standpoint: MMF fragility is indeed a concern for the stability of the banking system and a contributing factor to financial market systemic risk.
The financial crisis of 2007-09 highlighted the central role that financial intermediaries play in the propagation and amplification of shocks. Intermediaries increase leverage during the boom, which then makes them more vulnerable to adverse economic developments. In this post, we review evidence on the balance-sheet behavior of financial intermediaries and describe a channel that allows intermediaries to increase leverage during booms when asset market volatility tends to be low, which in turn forces them to dramatically reduce leverage once volatility increases. As shown during the financial crisis of 2007-08, the contraction of intermediary leverage is accompanied by increases in borrowing rates for households and a contraction of credit. The formal modeling of this amplification mechanism allows a welfare analysis of the tightness of regulatory capital requirements. We find that while loose capital constraints generate excessive risk-taking by intermediaries, tight funding constraints inhibit intermediaries’ risk-sharing and investment functions, which then lowers welfare.
In yesterday’s post, Nicola Cetorelli argued that while financial intermediation has changed dramatically over the last two decades, banks have adapted and remained key players in the process of channeling funds between lenders and borrowers. In today’s post, we focus on an important change in the way banks provide credit to corporations—the substitution of the so-called originate-to-distribute model for the originate-to-hold model. Historically, banks originated loans and kept them on their balance sheets until maturity. Over time, however, banks began increasingly to distribute the loans they originated. With this change, banks limited the growth of their balance sheets but maintained a key role in the origination of corporate loans, and in the process contributed to the growth of nonbank financial intermediaries.
It used to be simple: Asked how to describe financial intermediation, you would just mention the word “bank.” Then things got complicated. As a result of innovation and legal and regulatory changes, financial intermediation has evolved in a way that invites us to question whether it revolves around banks anymore. The centerpiece of modern intermediation is the advent and growth of asset securitization: loans do not need to reside on the originator’s balance sheet until maturity any longer, but they can instead be packaged into securities and sold to investors. With securitization, banks’ balance sheets get replaced by a longer and more complex credit intermediation chain (Pozsar, Adrian, Ashcraft, and Boesky 2010). This evolution literally changes the picture of intermediation, as the figure below suggests. From a bank-centered system, we go to one where multiple entities interact with one another along the sequential steps of the chain, and concomitantly we hear increasingly of shadow banking, defined recently by the Financial Stability Board as a system of “credit intermediation involving entities and activities outside the regular banking system.”
Liberty Street Economics features insight and analysis from economists working at the intersection of research and policy. The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan.
The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.
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