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Macroprudential Policy and Financial Markets

Macroprudential Policy and Financial Markets. by David Longworth John Weatherall Distinguished Fellow, Queen’s Adjunct Professor, Carleton University Former Deputy Governor, Bank of Canada. Introduction: The Crisis. Similar to many earlier crises, preceded by:

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Macroprudential Policy and Financial Markets

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  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

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