Macroprudential Policy and Financial Markets

1. Macroprudential Policy and Financial Markets by David Longworth John Weatherall Distinguished Fellow, Queen’s Adjunct Professor, Carleton University Former Deputy Governor, Bank of Canada

2. Introduction: The Crisis • Similar to many earlier crises, preceded by: • Strong growth in credit/GDP in many countries • Strong growth in real house prices (US, UK, etc.) • Different from many earlier crises: • Run on the shadow banking system • Repo, ABCP, financial CP, U.S. MMFs • System had expanded rapidly, providing s-t financing • Several financial markets froze • Many markets became dislocated • Market volatility soared • New macroprudential regulation, little on markets

3. Outline • Shadow Banking and Regulation • Related Literature • Market Failures • Macroprudential Regulation • Regulation and Financial Market Volatility • Concluding Comments

4. 1. Shadow Banking and Regulation • Re-regulation thus far has focussed on: • Banking (capital and liquidity) • Market transparency (IOSCO) • Financial Infrastructure (CCPs, OTC derivatives) • Little emphasis: re-regulation of fin. markets • This will change as FSB looks at shadow banks • FSB focusing on systemic risks arising from: • “activities that generate maturity and/or liquidity transformation, that involve flawed credit risk transfer and that create or facilitate leverage”

5. 1. Shadow Banking and Regulation • FSB notes in particular the possibility of: • Repeat of runs on shadow banking system • A build-up in leverage exacerbating procyclicality • A high degree of interconnectedness with banking • After a general study, FSB now focusing on: • Banks’ interaction with shadow banking entities • Money market funds • Other shadow banking entities • Securitization • Activities related to repos and securities lending

6. 1. Shadow Banking and Regulation • Main parts of shadow banking system • Finance companies • Asset-backed commercial paper (ABCP) • Money market funds (MMFs) • Repo market • Cash-collateral securities lending market • Derivative transactions between banks and non-banks • Prime brokerage to hedge funds • Securitization • Miscellaneous (mortgage brokers, monoline insurers, hedge funds)

7. 1. Shadow Banking and Regulation • Size of system • Measured by short-term debt instruments, repos, money market funds, asset-backed securities, and GSE –associated mortgage finance • Cdn. $1.2 trillion in Canada; US$16 trillion in US • Within 15% of size of traditional bank liabilities

8. 1. Shadow Banking and Regulation Source: from information in Chapman et al. (2011)

9. 2. Related Literature • Morris & Shin (2008): liquidity & leverage for broker dealers • Adrian & Shin (2009): securitization allowing leverage; regulate leverage and maturity mismatch • Gorton & Metrick (2010b): safe instruments become unsafe; two types for MMFs, narrow funding banks for securitization; minimum haircuts • Tarullo (2010) comments on G&M: wholesale change requires a complete cost-benefit analysis

10. 2. Related Literature • Tucker (2010) what might be required for each type of shadow banking • Hanson et al. (2011) and Stein(2010): regulation of haircuts and proportion of AAA from a given pool • Kashyap et al. (2010) model: bank, shadow bank, three types of households with durable housing and a non-durable good. Regulation cannot provide Pareto improvements but can make house price crashes less costly by making households worse off in normal times.

11. 2. Related Literature • Regulation of minimum haircuts would lead to less variation in leverage of non-bank financial institutions and therefore less variation in asset prices (Geanakoplos, 2010) • Adrian and Shin (2009), Gordon and Metrick (2010b) provide evidence that much of upswing in credit is financed by short-term instruments such as repos and commercial paper and not by core bank deposits. • Greater regulation of shadow banks could therefore lead to less of a procyclical upswing as well as less chance of a “run” in the downturn

12. 3. Market Failures • Two negative externalities arising from specialness of banks to customers: • Failure of one specific bank leads to loss of access to future credit for small and medium-sized customers • Failure or severe weakening of several banks will likely lead to a credit crunch • Three negative externalities arising from specialness of banks to each other • Informational contagion from asset similarities • Interconnectedness means failure of one bank leads to prolonged uncertainty regarding exposed banks • When liquidity problems are widespread, liquidity-margin-leverage cycles can arise and can lead to fire sales • In boom, excessive credit expansion leads to resource misallocation

13. 3. Market Failures • Two negative externalities arising from specialness of shadow banks to customers: • Finance companies may be relied on uniquely by customers in a particular niche • Failure or weakness of finance company sector could lead to a credit crunch, particularly for certain categories of borrowers • Three externalities arising because banks and shadow banks can be special to each other • Informational contagion from common exposures • Interconnectedness can be significant (e.g., Lehmann) • Shadow banks and banks alike affected by liquidity-margin-leverage cycles and fire sales

14. 4. Macroprudential Regulation • Transparency and infrastructure • Informational contagion can be greater when there is a lack of transparency • Case in point: Canadian non-bank ABCP • Transparency especially important at times of stress • Infrastructure improvements getting some emphasis: • Regulation of central counterparties • Establishment of trade repositories • Clearing of standardized OTC derivatives by CCPs

15. 4. Macroprudential Regulation • Finance Companies • One type of shadow bank possibly special to customers • If not special to customers, regulation not necessary • If special to customers, should be regulated like banks • The new liquidity requirements for banks would then mean a significant cut-back in short-term market financing, particularly through financial commercial paper

16. 4. Macroprudential Regulation • Asset-backed commercial paper • Comes about from longer-term assets (loans) being financed through commercial paper, with bank-provided liquidity line • Significant maturity mismatch, as well as potential liquidity call on bank • BCBS has been working on appropriate capital charge • BCBS also looking at implications of banks going beyond legal obligation for reputational reasons (more capital?) • If ABCP held by non-leveraged parties, then only further regulation needed would be for transparency • If ABCP held by regulated leveraged financial institutions, needs to be taken account of in their liquidity regulations • Effect on markets

17. 4. Macroprudential Regulation • Money market funds • Most MMFs are of a constant net-asset-value type • Can’t be guaranteed if credit risk and no capital • This suggests that only constant NAV MMFs should be: • Those who hold only risk-free assets (TBs) or • Those who are regulated like banks (capital, liquidity) • Other MMFs would be allowed, but would be non-constant NAV funds, like other mutual funds • Effect on markets

18. 4. Macroprudential Regulation • Repo markets and haircuts, derivative markets, and cash collateral securities lending Typical haircuts (%) on term repos (Prime counterparties) (Source: CGFS, 2010)

19. 4. Macroprudential Regulation Liquidity-Margin Spiral Source: Brunnermeier and Pedersen, Longworth, Carney

20. 4. Macroprudential Regulation • Repo markets allow financing of securities • The lower the haircuts, the higher the leverage • Geanakoplos: greater leverage, greater volatility • When there is a continuum of beliefs about fundamental price • CGFS (2010) recommends “through-the-cycle” haircuts with possible countercyclical add-ons • Derivative contracts can replicate; initial margins regulation • Cash collateral from securities lending reinvested in repo market in risky assets • Effect on markets

21. 4. Macroprudential Regulation • Creation and selling of ABS (Securitization) • Four elements destroyed market • Poor mortgage underwriting • Better regulation of mortgage brokers or banks they work with • No “skin in the game” for mortgage originators • Regulations for “skin in the game”: keeping exposure to mortgages • Lack of transparency of ABS and CDOs • Regulation of transparency • Poor rating techniques by credit rating agencies • Code of conduct for CRAs and better techniques • Also discussed in literature: narrow funding banks • Effect on markets

22. 4. Macroprudential Regulation • Broker dealers and prime brokerage • Large US investment banks have all “disappeared” • Greatest concern about large broker dealers is their relationship with hedge funds (prime brokerage) • Relationship significantly determines changes in leverage of hedge funds • Deal with through regulation of haircuts and initial margin • Hedge funds park extra cash, and can “run” • Appropriate banking regulation for “banks” and “bank-like” large broker dealers

23. 4. Macroprudential Regulation • Other parts of shadow banking system • Mortgage brokers can be regulated as banks or regulations can be make clear to banks that they must take full responsibility for what broker does for them • If prime brokerage and haircuts/margins regulated, then hedge funds need merely report (systemic as a herd?) • Monoline insurers: appropriate regulation of insurance industry and of banks holding insured products (no direct implications for financial markets)

24. 5. Regulation & Market Volatility • Volatility is a symptom, so should not be regulated • Appropriate macroprudential regulation of banks and shadow banking system should have three effects on volatility of financial market prices and of amplitudes of spreads in fixed income markets • Restrained credit growth (capital regulation) and higher haircuts in booms should mean lower declines in price volatility and lower increases in prices in booms • Macroprudential regulation should reduce probability of large busts, so in bad times increases in price volatility and declines in prices should be lower • In particular, in bad times declines in leverage will be less so forced sales of assets should be smaller and be associated with a lower decline in prices

25. 6. Concluding Comments • Macroprudential regulation of the shadow bank sector may well have significant effects on: • The existence or definition of certain financial markets and their size, • The nature of repo markets • The behaviour in financial markets • MMFs require more regulation • Financial commercial paper: less prominent • ABCP, MBS, ABS: transparency and more • Haircuts: regulated minimums and add-ons in booms • Volatility and amplitude over cycle of financial prices will be affected by these macroprudential regulations