The aim of this article is to present a more comprehensive approach to the way we conceptualize, regulate and measure the financial eco-system than what has been done to date. It provides a global macro context for the intellectual framework developed by the Shadow Banking Colloquium at INET (see Mehrling et al, 2013) to better understand shadow banking.
Regulatory reform to date has focused on banks and how much liquidity and capital they should hold, rather than on the evolution of the broader financial eco-system that banks are only a part of. However, understanding the eco-system is imperative, as it can influence the types of activities banks engage in and the types of liabilities they issue.
Understanding the financial eco-system can be done at two levels: first, by profiling the institutions that modern banks interact with on both their asset and liability sides and the needs of these institutions (questions of “who” and “what”), and second, by identifying the global macro drivers behind these institutional needs (questions of “why”).
Our analytical framework to understand what modern banks do is muddled by trying to draw parallels with what traditional banks do. Traditional banks engage in credit intermediation by issuing loans and insured deposits, linking ultimate borrowers with ultimate savers.
Modern banks do something quite different. Modern banks are dealer banks (Mehrling et al, 2013) that finance bond portfolios with un-insured money market instruments, and rather than linking ultimate borrowers with ultimate savers, they link cash portfolio managers and risk portfolio managers (PMs) who in turn manage ultimate savers’ savings.
Cash and risk PMs are “natural” complements to each other. Cash PMs 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 collateralized repurchase agreements (or repos; see for example Pozsar, 2011 and 2012 and Pozsar and McCulley, 2012).
Risk PMs 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.
In each and every one of these cases, risk PMs repo securities out and cash in, and on the flipside, cash PMs repo securities in and cash out. Cash PMs have their safety (thanks to the securities posted by risk PMs as collateral) and risk PMs have their enhanced return (thanks to the funding provided by cash PMs in exchange for collateral).
Dealer banks are intermediaries between risk PMs and cash PMs. Risk PMs interface with dealers on the asset side of dealers’ balance sheet and cash PMs interface with dealers on the liability side of dealers’ balance sheet. In this process dealers intermediate risks (credit, duration and liquidity risks) away from cash PMs and toward risk PMs using repos and derivatives. This is risk intermediation (see Figure 1, and Checki, 2009, Pozsar and Singh, 2012 and Claessens et al, 2012).
Figure 1: Risk Intermediation
Dealers and the Global Financial Eco-System
Turning to questions of “why”, the secular rise of cash PMs seeking “safety” and risk PMs seeking “alpha” has been driven by macro imbalances – both global and local, and present and future (see Figure 2).
Firstly, the secular rise of cash PMs (or institutional cash pools, see Pozsar, 2011) can be attributed to three factors.
On the global level, managed exchange rate arrangements vis-à-vis the U.S. dollar explain the rise of cash pools at FX reserve managers (in the form of FX reserve’s so-called liquidity tranches to the tune of roughly $1 trillion), and the secular increase in capital’s share of income versus labor’s share of income explains the rise of cash pools at the largest global corporations (to the tune of $1.5 trillion).
On the local level, the rise of cash pools within the asset management complex (around $3.5 trillion) is explained by consolidation among asset managers and the secular rise of outsourced portfolio management, the centralized liquidity management of fund complexes, securities lending and derivative overlay investment strategies.
These examples reflect imbalances in the distribution of present incomes – between countries with structural current account surpluses and deficits, and between capital and labor – and that ever more individual savers’ portfolios are managed by ever fewer asset managers.
Secondly, the secular rise of risk PMs (or levered investment strategies) reflects imbalances between the present value of future pension promises that exceeds the expected present value of unlevered, long-only investment incomes. This is the principal driver of the trend that pension funds and endowments allocate an increasing share of their portfolios to hedge funds and custom-tailored separate accounts at asset managers. In an ever-lower yield environment, asset managers resort to techniques of leverage, shorting, securities lending and derivatives with an aim to enhance returns and avoid major portfolio drawdowns. They are all aiming to provide equity-like returns with bond-like volatility.
FX reserve managers’ needs are somewhat similar to those of pension funds, for whom the maintenance of FX pegs is a negative carry proposition: the bonds issued to sterilize the exchange of foreign currency to domestic currency yield more than the foreign currency bonds reserves are held in, which is a fiscal cost. To minimize these costs, reserve managers also employ the techniques of leverage, shorting and derivatives as well as securities lending to enhance their returns.
Figure 2: Dealers and the Global Financial Eco-System
Four Goals Shaping Dealers’ Balance Sheets
Thus, from a bird’s eye perspective the modern financial eco-system has five groups of players, each with a well-defined goal.
CIOs at pension funds, foreign central banks and sovereign wealth funds – the first group - are tasked with reducing their underfundedness. They do this by allocating more of their portfolios to hedge funds and separate accounts – the second group - whose managers (risk PMs) employ leverage, shorting and derivatives in order to beat their benchmarks.
Treasurers (or cash PMs) – the third group - are tasked with not losing any money on the cash pools they manage. They shun credit, duration and liquidity risks and invest cash on a collateralized basis. Importantly, these cash pools are the byproducts of the decisions of sovereign and corporate CEOs – the fourth group - who are tasked with generating growth in the real economy and profits, respectively.
The goals of these market participants – asset-liability matching for CIOs, beating benchmarks for hedge funds (risk PMs), liquidity at par for treasurers (cash PMs), and growth for CEOs – represent nominal rigidities in the system that drive what dealers – the fifth group - do.
Dealers’ role is to make markets and intermediate risks away from cash PMs and toward risk PMs, enabling them to preserve their wealth in the present and to help meet their promises in the future, respectively.
Dealers for the most part engage in risk intermediation through their matched book positions and only engage in risk transformation through their inventory positions (either in the form of a portfolio of securities or derivatives), which - as more than “just” brokers - dealers accumulate through their market making activities. These risk positions are the key determinants of dealers’ equity needs (see Figure 3).
Figure 3: Four Goals Shaping Dealers’ Balance Sheets
This is the broadest perspective in which we can understand the rise of the shadow banking system and why it is misleading to think about credit, duration and liquidity transformation and more appropriate to think about the intermediation of credit, duration and liquidity risks between cash and risk PMs across the financial eco-system and, by inference, the real economy more broadly. That is, credit to the real economy is extended either through dealers’ securities inventories or via credit intermediation chains that go from cash PMs through dealers’ matched repo books to risk PMs to fund leveraged bond portfolios.
A Three Level Policy Problem
On the regulatory side, one can approach the financial eco-system at three different levels: the dealer level, the PM level or the global macro level (see Figure 4). To date, however, regulatory reform has mostly focused on dealer banks – their capitalization, funding, proprietary trading activities and separation from retail banking.
However, focusing on dealers only, while leaving risk and cash PMs’ and their CIO and CEO “masters’” needs unaddressed will only shift problems around but not solve them. Ultimately, the policy extremes are (1) aiming to reduce the imbalances in present and future incomes, or (2) accommodating the system as it is by giving the dealers at its core access to official liquidity (dealer of last resort, see Mehrling, 2010 and also Pozsar et al, 2010, and the BoE’s recently updated SMF, 2013).
In either case, the fundamental problem we are dealing with is a financial eco-system that has outgrown the safety-net that has been put around it many years ago. Today we have new types of savers (cash PMs vs. retail depositors), new types of borrowers (risk PMs to fund pensions vs. ultimate borrowers to finance investments and consumption) and also new types of banks (dealer banks that do securities financing vs. traditional banks that finance the real economy more directly via loans) to whom discount window access and deposit insurance do not apply.
These twin pillars of the official safety net were erected around traditional, deposit-funded banks to address retail runs. In contrast, the crisis of 2007-2009 was a crisis of institutional runs where cash PMs ran on dealers and dealers ran on risk PMs. But importantly, as the examples above demonstrate, beyond the institutional façade of the eco-system it is ultimately retail wealth and promises that are at stake.
Therefore if neither of the above policy options (that is, shrinking imbalances or broadening the safety net) are palatable, the third option is to offer partial solutions and to recognize that the eco-system’s existing needs will be met by new structures that need to be understood and monitored to avoid new systemic excesses.
But we cannot monitor what we don’t measure. The Flow of Funds accounts don’t address the measurement of the eco-system described above.
Figure 4: A Three Level Policy Problem
We Cannot Monitor What We Do Not Measure
The Flow of Funds have been designed to show who borrows, who lends and through what types of instruments. But it offers no hints as to the asset-liability mismatches at pension funds and FX reserve managers; it does not cover hedge funds and separate accounts which make up an increasing share of institutional investors’ portfolios; it does not provide a breakdown of dealers’ matched repo books to gauge the volume of funding passed on to hedge funds and asset managers, or the purpose of that funding: whether it was to fund a bond position, to post cash collateral for securities borrowed, or to raise liquidity for margin.
Moreover, the Flow of Funds accounts end where derivatives begin: derivatives effectively separate the flow of risks (credit, duration and FX risks) from the flow of funds and hence looking at exposures to bonds without looking at accompanying derivatives makes the Flow of Funds accounts’ usefulness somewhat limited. And without a sense for these measures our ability to understand asset prices dynamics is also limited.
To improve on this, the Flow of Funds accounts should ideally incorporate measures of structural asset-liability mismatches and be augmented with a set of Flow of Risks satellite accounts and a set of Flow of Collateral satellite accounts in order to tabulate the types of collateral that back the flow of funds and risks across the eco-system.
Risk PMs’ bond portfolios are getting more and more leveraged and bonds are becoming more and more valuable as collateral for cash PMs. Leveraged bond portfolios (through the techniques of funding, shorting, securities lending and derivatives) help risk PMs beat their benchmarks to help CIOs achieve asset-liability matching in an ever-lower yield environment, and collateral gives cash PMs a sense of safety in a financial eco-system with an increasingly outdated safety net.
In this system, credit intermediation is just a byproduct. Risk PMs go to work every day not to lend to the real economy but beat their benchmark or to generate absolute returns. In this sense, shadow banking is primarily about the financing of pre-existing securities, rather than credit extension to the real economy, which is just a second derivative.
Credit, maturity and liquidity transformation is only the tip of the iceberg in understanding shadow banking and the contribution of Pozsar et al (see Pozsar et al, 2010) should be viewed in that light. Importantly, we must also ask why these activities are being undertaken, and the answer here is: to manage future and present imbalances.
Dealing with the shadow banking system –- the system that grew up to intermediate these imbalances -- will either have to involve moderating these imbalances via entitlement, currency and tax reforms or giving it some form of an official backstop. Like in 1913 and 1933 it is retail assets that are at stake, but this time around they are harder to see due to the veil of institutional investors managing them.
 Excess returns can come in two basic forms: pure alpha (through smart portfolio selection, market timing and hedges) or alpha masquerading as levered beta.
 Unlike FX reserves’ liquidity tranches discussed above, this section refers to FX reserves’ long-duration segments where search for yield is more prevalent.
 These include increased Treasury bill issuance or access to the Fed’s full allotment reverse repo facility to absorb some of cash PMs’ money demand. However, these policy measures only address cash PMs’ but not risk PM’s needs.