Monday, December 26, 2011

Is There a Global Shortage of Safe Assets?

David Beckworth has channeled Gary Gorton to write:

One of the key problems facing the world economy right now is a shortage of assets that investors would feel comfortable using as a store of value.  There is both a structural and cyclical dimension to this shortage of safe asset problem, with the latter being particularly important now given the recent spate of negative economic shocks to the global economy… 
Okay, so why does this safe asset shortage ultimately matter?  The first reason is that many of these safe assets serve as transaction assets and thus either back or act as a medium of exchange.  AAA-rated MBS or sovereigns have served as collateral for repurchase agreements, which Gary Gorton has shown were the equivalent of a deposit account for the shadow banking system.   The disappearance of safe assets therefore means the disappearance of money for the shadow banking system.  This creates an excess money demand problem for institutional investors and thus adversely affects nominal spending.  The shortage of safe assets can also indirectly cause an excess money demand problem at the retail level if the problems in the shadow banking system spill over into the economy and cause deleveraging by commercial banks and households.  

The logic here makes a lot of sense. Just as bank deposits serve in important ways as “money”; so other safe assets are used in a currency-like fashion in financial markets. Loss of faith in these assets can drive market exchange in financial markets into turmoil — as Gary Gorton argues happened with previously AAA-rated mortgage-backed securities and repurchase agreements.

I’ve grown skeptical of this line of thinking, however, after reading Jeffrey Friedman’s (and Vladimir Kraus') excellent book, Engineering a Financial Crisis. Friedman focuses on the distortions in bank actions caused by Basel financial regulation, and I think his argument is relevant in this case. There are three reasons here I can think of that the “global safe asset shortgage” might be overblown:

1. AAA-rated assets aren’t the only safe ones. Beckworth tallies up the number of AAA-rated assets worldwide, and find that their aggregate amount — including Treasuries, etc. — Is actually decreasing, due to downgrades of various bonds.  

But buying a AAA-rated asset isn’t the only way to ensure you own a risk-free security Alternatively, one could buy credit default protection on a riskier asset. Purchasing a risky asset and credit protection is economically equivalent to purchasing a risk-free asset; and credit default swaps are priced accordingly. Practically speaking, this is what banks did in order to hedge their holdings of risky European debt -- they bought credit protection to get out of credit risk. Further ratings drops don’t effect the immediate economic future of a bank whose holdings of risky debt are fully insured - short of the CDS counterparty going bankrupt, or Europeans conspiring to negate CDS contracts as they recently did.     

And the global supply of CDS is enormous. There is something like $43 trillion in sum notional value of credit default swaps. Now, netting out all of the various contracts and figuring out how much actual additional risk protection the CDS market provides is tricky. But certainly it seems this is a massive source of safe assets for any risk averse entity that wants them. 

Now, it may be the case that you actually need AAA-rated assets to use as a medium of exchange; so CDS contracts don’t help with that precise problem. But certainly it would seem that the presence of a massive asset class economically equivalent to AAA-rated assets should change our judgement of whether or not safe assets are scarce. If nothing else, we might expect that “true” AAA rated assets may start to be used exclusively for repos; while banks wishing to hold safe assets would switch to holding risky assets + credit insurance. 

2. Repos blew up due to bankruptcy laws. Why would you try to fund a shadow bank with repurchase agreements? In Beckworth’s piece, this is treated as a given — we just happen to have  a sophisticated banking system that relies on this particular form of short-term liability. 

However, as Mike Konczal and others have mentioned the repo market really took off after the 2005 bankruptcy law reform. That law granted repos and other derivatives prioritized status in the event of bankruptcy; and so dramatically raised the incentives to finance a shadow bank using these sorts of short-term debts. 

Yet there’s no reason in general to run a financial system on this type of risky short-term debt. No lawe decrees that short-term collateralized lending needs to be such a large part of a sophisticated banking system that sits apart from the normal loan-deposit world. This is as much a product of specific rules and regulations that encourage re-writing contracts in the form of derivatives; as it is of a general preference for “safe” assets.

3. It's all Basel's Fault Anyway. The final thing I think this narrative gets wrong is the motivation for why people want safe assets. The focus from Beckworth and Gorton is on AAA-rated assets used in their capacity as money. However, banks and other financial institutions also hold enormous amounts of AAA-rated securities that they store on their balance sheets. This fits in, say, with how we typically think of safe assets — as non-risky assets that some financial intermediary wants to hold on their balance sheet for some amount of time, not just as collateral to buy something else. There isn't a hard line between those two uses, but it certainly seems that there's a large pile of AAA-rated securities that aren't just functioning in the capacity of money. 

Here Jeffrey Friedman’s book comes in useful. Friedman notes the impact of Basel-I and Basel-II reforms on the capital consequences of asset holdings. Particularly after Basel-II prioritized the role of ratings agencies, banks started to face dramatically different consequences from holding “safe” and “risky” assets — as determined by credit agencies.

If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response. 
The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo. 

For instance, here is a recent news story from Australia, a country that (by virtue of low government debt) has relatively few safe assets. Liquidity coverage ratios required for Basel-III leave Australia in a problem, due to the local shortage of safe assets. The Reserve Bank of Australia describes in detail their response:

The issue in Australia is that there is a marked shortage of high quality liquid assets that are outside the banking sector (that is, not liabilities of the banks). As a result of prudent fiscal policy over a large run of years at both the Commonwealth and state level, the stock of Commonwealth and state government debt is low. At the moment, the gross stock of Commonwealth debt on issue amounts to around 15 per cent of GDP, state government debt (semis) is around 12 per cent of GDP.[1] These amounts fall well short of the liquidity needs of the banking system. To give you some sense of the magnitudes, the banking system in Australia is around 185 per cent of nominal GDP. If we assume that banks’ liquidity needs under the liquidity coverage ratio (LCR) may be in the order of 20 per cent of their balance sheet, then they need to hold liquid assets of nearly 40 per cent of GDP.
In addition to government debt, the Basel standard also includes balances at the central bank in its definition of high-quality liquid assets (level 1 assets in the Basel terminology). That is, the banks’ exchange settlement (ES) balances at the RBA are also a liquid asset. Hence, one possible solution to the shortage of level 1 assets would be for banks to significantly increase the size of their ES balances to meet their liquidity needs. While this is possible, it would mean that the RBA’s balance sheet would increase considerably. The RBA would have to determine what assets it would be willing to hold against the increase in its liabilities, and would be confronted by the same problem of the shortage of assets in Australia outside the banking system. Similarly, the government could increase its debt issuance substantially with the sole purpose of providing a liquid asset for the banking system to hold. Again, it would be confronted with the problem of which assets to buy with the proceeds of its increased debt issuance. Moreover, it would be a perverse outcome for the liquidity standard to be dictating a government’s debt strategy. 
However, the Basel Committee acknowledges that there are jurisdictions such as Australia where there is a clear shortage of high quality liquid assets. In such circumstances, the liquidity standard allows for a committed liquidity facility to be provided by the central bank against eligible collateral to enable banks to meet the LCR.

It’s clear reading this description that the shortage of safe assets refers only to a shortage of assets declared safe by the Basel committee. Australia, absent international banking regulations, had no problem running a safe banking system. Yet the new banking regulations left Australia’s banks as exposed. The response, bizarrely enough, is a central bank that is acting as a shadow bank — adopting maturity mismatch in order to supply assets to banks that Basel will count as safe for the purposes of regulation. 

From my perspective, it seems that this decade-long obsession with safe assets is due in large part to financial institutions facing systematically different incentives. They went with repos because those were guaranteed even in bankruptcy. Financial institutions loaded up on AAA-rated mortgage-backed securities and sovereign paper — not just on the medium of exchange side, but also on their long-term balance sheet — because Basel wrongly declared these to be “risk-free.” Subsequent downgrades led to financial carnage; but the root of the problem lay in the assumption that credit ratings could substitute for prudential management by banks themselves. The global “shortgage” or demand for safe assets was really a demand for ways to conduct regulatory arbitrage; and the growth in structured products (as well as sovereign European debt) was a supply-side response to that demand.