{"id":641,"date":"2021-05-19T14:50:48","date_gmt":"2021-05-19T18:50:48","guid":{"rendered":"https:\/\/sites.bu.edu\/perry\/?p=641"},"modified":"2021-05-19T14:50:48","modified_gmt":"2021-05-19T18:50:48","slug":"new-lombard-street-ten-years-on","status":"publish","type":"post","link":"https:\/\/sites.bu.edu\/perry\/2021\/05\/19\/new-lombard-street-ten-years-on\/","title":{"rendered":"New Lombard Street, Ten Years On"},"content":{"rendered":"

What follows is a Foreword I wrote for the Japanese translation of New Lombard Street, coming out later this year:<\/em><\/p>\n

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.\u00a0 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.<\/p>\n

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.\u00a0 From the beginning it seemed clear to me that the new system was likely to exhibit the same \u201cinherent instability of credit\u201d 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.\u00a0 Thus, in August 2007, when LIBOR spiked 100 basis points above Fed Funds, it caught my eye and I started paying very close attention.\u00a0 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.<\/p>\n

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.\u00a0 So far as I could see, the key thing to pay attention to was the dealer system.\u00a0 Shadow banking is essentially \u201cmoney market funding of capital market lending\u201d and that means that on both sides of the balance sheet prices are determined in dealer markets.[1]<\/span><\/a>\u00a0 The inherent instability of credit is about getting those prices wrong.\u00a0 In the boom, private liquidity provision drives the price of liquidity too low; in the crash, too high.<\/p>\n

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.\u00a0 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.\u00a0 This, I urged in the book, was a new thing for the Fed, and I coined the phrase \u201cdealer of last resort\u201d in order to draw attention to it.<\/p>\n

At the time the book was first published, however, mine was very much a minority view, especially in academia, but also in policy circles.\u00a0 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.\u00a0 Just so, the 2010 Dodd-Frank package of regulatory reforms largely punted on the whole matter of shadow banking.\u00a0 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. \u00a0Not liquidity, but solvency was the focus.\u00a0 Policy makers did not think they needed to understand how shadow banking worked, they just needed to kill it.<\/p>\n

Now comes the Covid Crisis of March 2020.\u00a0 Notably, the traditional banking system came through the crisis more or less unscathed\u2014thanks 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.\u00a0 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]<\/span><\/a>\u00a0 In the GFC, the important thing had been securitized mortgage credit originating in the United States, and funded in global dollar money markets. \u00a0In the Covid Crisis, the important thing was capital market lending to the Global South, funded in dollar money markets in the Global North.<\/p>\n

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 \u201cexigent circumstances\u201d that would authorize their use under Section 13(3) of the Federal Reserve Act.\u00a0 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.\u00a0 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.\u00a0 (More specifically, swaps for the C6 and a few others, and the FIMA repo facility for everyone else.)[3]<\/span><\/a>\u00a0 This was the Fed acting as global dealer of last resort, in cooperation with other key central banks.<\/p>\n

But that\u2019s not all.\u00a0 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.\u00a0 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.\u00a0 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.\u00a0 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.\u00a0 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]<\/span><\/a><\/p>\n

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.\u00a0 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.\u00a0 The key thing that distinguished the Fed, so I argue, was its appreciation that, for the American case, liquidity was all about \u201cshiftability\u201d, so that managing money meant managing shiftability.\u00a0 Which assets would be shiftable to the Fed, under what conditions, and at what price?<\/p>\n

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.\u00a0 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\u2019s last resort intervention using liquidity swaps is mentioned but not highlighted.\u00a0 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.\u00a0 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.\u00a0 The Covid Crisis has now answered that question emphatically in the affirmative.<\/p>\n

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.\u00a0 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\u2014in 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.\u00a0 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.\u00a0 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.<\/p>\n

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.\u00a0 The Covid Crisis marks another decade into the story, which has revealed the weak spots in the system that built up since the GFC.\u00a0 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.\u00a0 The story continues.<\/p>\n

 <\/p>\n

References<\/strong><\/p>\n

Aldasoro, Inaki and Torsten Ehlers.\u00a0 2018.\u00a0 \u201cThe geography of dollar funding of non-US banks.\u201d\u00a0 BIS Quarterly Review<\/u> (December):\u00a0 15-26.<\/p>\n

Aramonte, Sirio and Fernando Avalos.\u00a0 2020.\u00a0 \u201cThe recent distress in corporate bond markets:\u00a0 cues from ETFs.\u201d\u00a0 BIS Bulletin<\/u> No. 6 (April 14).<\/p>\n

Arslan, Yavuz, Mathias Drehmann, and Boris Hofmann.\u00a0 2020.\u00a0 \u201cCentral bank bond purchases in emerging market economies.\u201d\u00a0 BIS Bulletin<\/u> No. 20 (June 2).<\/p>\n

Avdjiev, Stefan, Egemen Eren and Patrick McGuire.\u00a0 2020.\u00a0 \u201cDollar funding costs during the Covid-19 crisis through the lens of the FX swap market.\u201d\u00a0 BIS Bulletin<\/u> No. 1 (April 1)<\/p>\n

Mehrling, Perry, Zoltan Pozsar, James Sweeney, and Daniel Nielson. \u00a02014.\u00a0 \u201cBagehot was a Shadow Banker:\u00a0 Shadow Banking, Central Banking, and the Future of Global Finance.\u201d\u00a0 \u00a0In Shadow Banking Within <\/u>\u00a0and Across Borders<\/u>, edited by Stijn Claessens, Douglas Evanoff, George Kaufman, and Luc Laeven.\u00a0 World Scientific Publishing.\u00a0 Also available at https:\/\/papers.ssrn.com\/sol3\/papers.cfm?abstract_id=2232016<\/a><\/p>\n

Mehrling, Perry. \u00a02015.\u00a0 \u201cDiscipline and Elasticity in the Global Swap Network.\u201d\u00a0 International Journal of Political Economy<\/u> 44 No. 4 (October):\u00a0 311-324.<\/p>\n

Schrimpf, Andreas, Hyun Song Shin, and Vladyslav Shusko.\u00a0 2020.\u00a0 \u201cLeverage and margin spirals in fixed income markets during the Covid-19 crisis.\u201d \u00a0BIS Bulletin<\/u> No. 2 (April 2).<\/p>\n

[1]<\/span><\/a> The phrase is a later coinage but implicit in the book.\u00a0 See Mehrling et al (2014).<\/p>\n

[2]<\/span><\/a> Aldasoro and Ehlers (2018).<\/p>\n

[3]<\/span><\/a> Avdjiev, Eren and McGuire (2020), Arslan, Drehmann and Hofmann (2020).\u00a0 Mehrling (2015) develops the idea that the Fed\u2019s liquidity swaps during the crisis had become the permanent backstop of the international monetary system, which in fact they proved to be.<\/p>\n

[4]<\/span><\/a> Schrimpf, Shin, and Shusko (2020), Aramonte and Avalos (2020).<\/p>\n","protected":false},"excerpt":{"rendered":"

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.\u00a0 I refer here to the market-based credit system […]<\/p>\n","protected":false},"author":15789,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[1],"tags":[4,46,11,7,8],"_links":{"self":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts\/641"}],"collection":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/users\/15789"}],"replies":[{"embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/comments?post=641"}],"version-history":[{"count":1,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts\/641\/revisions"}],"predecessor-version":[{"id":642,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts\/641\/revisions\/642"}],"wp:attachment":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/media?parent=641"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/categories?post=641"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/tags?post=641"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}