New Lombard Street, Ten Years On

What follows is a Foreword I wrote for the Japanese translation of New Lombard Street, coming out later this year:

The Global Financial Crisis (GFC) of 2007-2009 served as the first real stress test of the global financial system we had been building over the preceding decades.  I refer here to the market-based credit system which had grown up parallel to the traditional bank-based credit system, but outside the regulatory and backstop mechanisms that constrained and supported that traditional system.

As a teacher of Money and Banking, I had been following these developments for some fifteen years, and had been using my courses to build my own understanding of how the new system worked.  From the beginning it seemed clear to me that the new system was likely to exhibit the same “inherent instability of credit” as the old; it was just a matter of time, although it was not possible in advance to know where exactly the system would break.  Thus, in August 2007, when LIBOR spiked 100 basis points above Fed Funds, it caught my eye and I started paying very close attention.  Chapter 6 of this book more or less records my contemporaneous attempt to understand what was happening, in each stage of the deepening crisis, and to learn the lessons that the crisis had to teach.

As I say in the book, I was convinced that the market-based credit system was here to stay, and so my goal was to learn how exactly its inherent instability would manifest, in order to inform future regulation and backstops.  So far as I could see, the key thing to pay attention to was the dealer system.  Shadow banking is essentially “money market funding of capital market lending” and that means that on both sides of the balance sheet prices are determined in dealer markets.[1]  The inherent instability of credit is about getting those prices wrong.  In the boom, private liquidity provision drives the price of liquidity too low; in the crash, too high.

From this point of view, the GFC was a kind of Bagehot moment, when the Fed learned how to put a floor on a new kind of financial crisis.  Not only was the price of liquidity too high, but dealers had stopped making markets, and so the Fed stepped in to make them itself, first money markets and then eventually capital markets as well.  This, I urged in the book, was a new thing for the Fed, and I coined the phrase “dealer of last resort” in order to draw attention to it.

At the time the book was first published, however, mine was very much a minority view, especially in academia, but also in policy circles.  The dominant view was that market-based credit was driven largely by regulatory arbitrage, and that once regulatory loopholes were plugged, it would simply disappear.  Just so, the 2010 Dodd-Frank package of regulatory reforms largely punted on the whole matter of shadow banking.  Its goal was to protect the traditional banking system, and in particular to prevent shadow banks from ever again using the traditional banking system as a backdoor to gain access to the public purse.  Not liquidity, but solvency was the focus.  Policy makers did not think they needed to understand how shadow banking worked, they just needed to kill it.

Now comes the Covid Crisis of March 2020.  Notably, the traditional banking system came through the crisis more or less unscathed—thanks Dodd-Frank–but the important thing is that there was still a crisis, in effect a second stress test of the global market-based credit system which did not in fact disappear in the meanwhile, quite the contrary.  Indeed, for those who had been following developments throughout the decade, in particular the expansion of the offshore dollar market-based credit system in the Global South, it was a crisis waiting to happen.[2]  In the GFC, the important thing had been securitized mortgage credit originating in the United States, and funded in global dollar money markets.  In the Covid Crisis, the important thing was capital market lending to the Global South, funded in dollar money markets in the Global North.

In its response to the GFC, as recounted in the book, the Fed found itself repeatedly playing catchup, inventing new things but waiting for the “exigent circumstances” that would authorize their use under Section 13(3) of the Federal Reserve Act.  In the Covid Crisis, by contrast, the Fed had all these things already on the shelf, and it moved into action extremely quickly and forcefully in mid-March 2020.  Most important was the central bank liquidity swaps, which operated to backstop the collapsing private FX swap market that was key to the offshore dollar funding system.  (More specifically, swaps for the C6 and a few others, and the FIMA repo facility for everyone else.)[3]  This was the Fed acting as global dealer of last resort, in cooperation with other key central banks.

But that’s not all.  Dodd-Frank had not killed shadow banking, but it had succeeded in shifting private liquidity supply out of the traditional banking sector, where it was picked up by other non-bank financial intermediaries.  The Covid Crisis was a stress test for this new system of private liquidity supply, revealing its weakest links, two in particular, by way of example.  For one, hedge funds had become substantial sellers of market liquidity through their carry trade operations in the Treasury cash-futures basis, long Treasuries and short futures.  The dash for cash in the Covid Crisis threatened losses on such trades, prompting hedge funds to pull back, and producing disorderly conditions in the Treasury market, which the Fed quite promptly addressed using its own balance sheet.  For two, exchange traded funds (ETFs) had become substantial sellers of market liquidity through their operations in corporate bonds, promising daily liquidity in shares of a portfolio of illiquid assets, promises that they proved unable to keep during the Covid Crisis, and here too the Fed stepped in, offering its own balance sheet.[4]

In the book, I tell the story about how the Fed became the dealer of last resort, tracing the story back to the origins of the Fed in 1913 and the particular challenge of supplying liquidity for what was then a rapidly developing nation.  It is a kind of biography of the Fed, centering on its intellectual formation during the trials of Great Depression and World War, from which it emerged into maturity after the 1951 Fed-Treasury Accord.  The key thing that distinguished the Fed, so I argue, was its appreciation that, for the American case, liquidity was all about “shiftability”, so that managing money meant managing shiftability.  Which assets would be shiftable to the Fed, under what conditions, and at what price?

This history then provides the frame for understanding the GFC, which the Fed resolved by standing ready to shift mortgage backed securities onto its own balance sheet.  However, this biographical way of telling the story has the unfortunate effect of obscuring somewhat the global character of the crisis; the global character of the Fed’s last resort intervention using liquidity swaps is mentioned but not highlighted.  The problem back then was American mortgages, which just happened to be held in off-balance sheet SIVs and in off-shore global banks, and the solution was for the American central bank to stand ready to shift those positions onto its own balance sheet.  The book leaves hanging the question whether the Fed would be prepared to act similarly in a different kind of crisis revolving around a different set of dollar assets.  The Covid Crisis has now answered that question emphatically in the affirmative.

Indeed, the question left hanging by the Covid Crisis is exactly the opposite one, not so much whether the Fed would intervene but whether it intervened too quickly or too much.  Pricing the central bank liquidity swaps at only 25 basis points away from covered interest parity, enabling hedge funds to limit their losses by exiting from their Treasury carry trades, and supporting the price of corporate bond ETFs which included high-yield bonds—in all these ways the Fed put a floor on the crisis, and in doing so backstopped the new non-bank institutions of private liquidity supply.  The question is not only whether the price was right in all these instances, but also even more whether these institutions are really fit for purpose going forward.  A central bank that recognizes, as the Fed now does, its responsibility as dealer of last resort is led inevitably to consider institutional reform that reduces the likelihood that it will be called upon to fulfill that responsibility.

The book is a biography of the Fed, but the story is not over, as the Fed not only remains alive but now apparently quite affirmatively embraces its role as global dealer of last resort.  The Covid Crisis marks another decade into the story, which has revealed the weak spots in the system that built up since the GFC.  In decades to come, both private and public learning from that experience will lead to institutional change that will be tested by the next crisis.  The story continues.

References

Aldasoro, Inaki and Torsten Ehlers.  2018.  “The geography of dollar funding of non-US banks.”  BIS Quarterly Review (December):  15-26.

Aramonte, Sirio and Fernando Avalos.  2020.  “The recent distress in corporate bond markets:  cues from ETFs.”  BIS Bulletin No. 6 (April 14).

Arslan, Yavuz, Mathias Drehmann, and Boris Hofmann.  2020.  “Central bank bond purchases in emerging market economies.”  BIS Bulletin No. 20 (June 2).

Avdjiev, Stefan, Egemen Eren and Patrick McGuire.  2020.  “Dollar funding costs during the Covid-19 crisis through the lens of the FX swap market.”  BIS Bulletin No. 1 (April 1)

Mehrling, Perry, Zoltan Pozsar, James Sweeney, and Daniel Nielson.  2014.  “Bagehot was a Shadow Banker:  Shadow Banking, Central Banking, and the Future of Global Finance.”   In Shadow Banking Within  and Across Borders, edited by Stijn Claessens, Douglas Evanoff, George Kaufman, and Luc Laeven.  World Scientific Publishing.  Also available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2232016

Mehrling, Perry.  2015.  “Discipline and Elasticity in the Global Swap Network.”  International Journal of Political Economy 44 No. 4 (October):  311-324.

Schrimpf, Andreas, Hyun Song Shin, and Vladyslav Shusko.  2020.  “Leverage and margin spirals in fixed income markets during the Covid-19 crisis.”  BIS Bulletin No. 2 (April 2).

[1] The phrase is a later coinage but implicit in the book.  See Mehrling et al (2014).

[2] Aldasoro and Ehlers (2018).

[3] Avdjiev, Eren and McGuire (2020), Arslan, Drehmann and Hofmann (2020).  Mehrling (2015) develops the idea that the Fed’s liquidity swaps during the crisis had become the permanent backstop of the international monetary system, which in fact they proved to be.

[4] Schrimpf, Shin, and Shusko (2020), Aramonte and Avalos (2020).