Brad Setser

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The shadow financial system – as illustrated in three new papers that cut through the London fog

by Brad Setser
March 8, 2009

Gordon Brown wants to shine a bit more light on the shadow financial system (hat tip IPEZone). One plank of his G-20 action plan is:

“reform of international regulation to close regulatory gaps so shadow banking systems have nowhere to hide”

It isn’t exactly clear though why Brown needs the cooperation of the other members of the G-20 to do increase transparency here: an awful lot of the shadow financial system is based in the UK. If the UK collected the kind of detailed data that the US collects in the TIC, a large part of the shadow financial system would either emerge from the shadows or a lot of banks – and bankers – would need to migrate. And given how much trouble has emerged from the shadows, a bit more transparency about what goes on in the UK might have helped the world’s regulators (and the IMF) do a better job of providing a bit more “early warning” of budding problems.

Think of the various less-than-transparent actors that have set up shop in London

— Many sovereign wealth funds.
— A lot of the SIVs set up by US (and European) banks were legally domiciled in the UK
— Some credit hedge funds
– And most importantly, a host of European banks with large dollar books (think of them as badly regulated credit hedge funds) ran a large part of the dollar exposure through London.

There was a reason, after all, why residents in the UK were the largest purchaser of US corporate debt over the past few years. Corporate debt – in the US balance of payments data – includes asset-backed securities. Foreign purchases of such debt soared – especially from 2004 to 2007 – before falling off a cliff during the crisis.

Three recent papers – one from the Bank of Spain and two in the latest BIS quarterly – have shed a bit of light on the true nature of the all the flows through the UK over the past few years. Had there been an international “early warning” system that was on the ball – and had the UK been willing to collect the data on flows through the UK in the face of inevitable complaints that such efforts would drive business abroad – it might well have picked up on some of these flows as a sign of brewing trouble in global financial markets.

One potential warning sign: during the peak of its lending and credit boom, the US couldn’t finance its external deficit by borrowing from private creditors. That is the conclusion of Enrique Alberola and Jose Maria Serena’s recent Bank of Spain working paper – a paper that investigation into the role central banks and sovereign wealth funds played in financing the US current account deficit.*

Alberola and Serena used the same basic technique that I have used in the past to estimate official flows. Rather than work off the US data – which misses official flows through London – they worked off the IMF’s data on global reserves and national data on the balance of payments of countries with large sovereign funds. They estimated the dollar share of the reserves of countries that don’t report data on the currency composition of their reserves to the IMF (they used a conservative 60% share) and the dollar share of sovereign wealth funds (40% or so) and came to the same conclusion that I reached: at their peak, the total growth in the dollar assets of central banks and sovereign wealth funds exceeded the US current account deficit:

“the importance of sovereign external assets [sovereign wealth funds and central bank reserves] increased in the last years, surpassing the trillion dollars in 2007 and thus representing over half of gross capital inflows into the US last year.”

In 2007, gross inflows were bulked up by the two-way flow associated with the shadow banking system for at least part of the year; the fact that sovereign flows exceeded the current account deficit and represented half of the gross flows is truly incredible. When revised balance of payments data data for 2008 comes out, the “sovereign” share of gross flows will be even larger.

Alberola and Serena also try to place the debate over sovereign funds in the context of the debate over imbalances – rather than say a debate over “investment protectionism.” They note that the money sovereign funds recycled into external assets helped sustain the US deficit:

“reserves and SWF assets should be jointly considered for the assessment of global imbalances. Both are official capital outflows from developing to developed countries, both hinder internal adjustment in current account surplus countries, both help to cover the financing needs of deficit countries, in particular the US and therefore both contributed to sustain[ed] global imbalances.”

I couldn’t agree more.

Obviously, though, much has changed in the last two quarters. Global reserve growth likely turned negative in the fourth quarter of 08 as private capital fled the emerging world – and the Gulf’s sovereign funds are now net sellers of the financial asset of the world’s mature economies. But Alberola and Serena’s work still highlights that the official sector has accounted for a large fraction of the global flow of funds over the past few years, and a bit more transparency from the countries assembled around the G-20’s table (China especially, but the Saudis could do more too …) would help bring some flows out of the shadows. The UK could help fill in the data on the global flow of funds by making a real effort to track the money flowing in (and out) of the UK. Efforts to bring shadowy flows to the light shouldn’t hinge on the willing of China, Saudi Arabia and the Emirates to increase their transparency.

Sovereign wealth funds (and central banks that started to act like sovereign funds at the tail end of the boom) aren’t the only – or even the most important – “dark” financial flow. The shadow financial system that grew up in London and elsewhere was primarily populated by leveraged private investors.

Two papers (one on US money market funds’ role funding European banks and one on European banks dollar funding needs) in the BIS quarterly shed some light on the role European financial institutions played in the rise – and the subsequent fall – of US credit markets.

The first paper – by Baba, McCauley and Ramaswamy – explains how US money market funds were a crucial channel for transmitting the financial stress caused by Lehman’s default to Europe’s banks (and then back to US credit markets).

It turns out that Lehman (and no doubt other investment banks) and European banks both borrowed heavily from the US money markets. In effect, they shared a common creditor – “prime” money market funds – and when Lehman’s default led the reserve primary fund to break the buck and massive withdrawals from “prime” money market funds – European banks lost access to dollar financing. Baba, McCauley and Ramaswamy write: “the run on US dollar money market funds after the Lehman failure stressed global interbank markets because the funds bulked so large as suppliers of US dollars to non-US banks.”

This isn’t really news. There is a reason why the Fed lent $600 billion to European central banks so those central banks – the Fed was making up for collapse of dollar funding from US money market funds. (see graph 6 on p.77)

Baba, McCauley and Ramaswamy highlight the huge growth in the dollar assets of European banks over the last eight years. Those assets increased from $2 trillion to around $8 trillion (with Swiss banks accounting for about ½ the total). That growth “outran their retail dollar deposits,” making Europe’s banks reliant on wholesale dollar funding in much the same way that the growth in the assets of the US broker dealers made them reliant on wholesale funding. US money market funds that weren’t limited to Treasury and Agency paper happily met this need: “competition to offer investors higher yields, however, led them to buy the paper of non-US headquartered firms to harvest the Yankee premium.”

The BIS estimates that US money market funds were supplying $1 trillion of credit to non-US banks in mid-2008 (dollar denominated European money market funds supplied another $180b ….). That is far more dollar financing than supplied by the offshore dollar deposits of the world’s central banks: “by contrast, central banks … provided only $500 billion to European banks at the peak of their holdings in the third quarter of 2007.”

Still, those looking for a direct (rather than indirect) link between central bank reserve growth and boom in lending to US households can find a link here. A fraction of central bank dollar reserves were held in deposit in European banks – and another fraction was invested in onshore and offshore dollar-denominated money market funds. European banks used those sources of dollar “funding’ to buy securities backed by loans to US households. The growth in their balance sheets undoubtedly explains the huge increase in cross border flows (outflows from US money market funds financed the inflows associated with European banks purchases of US securities) during the boom years – and large corporate debt purchases through the UK.

The second BIS paper — by Patrick McGuire and Goetz von Peter on the “US dollar shortage in global banking” — uses the BIS banking data (actually, I would say that they tortured the banking data, as the data didn’t yield its secrets without a tremendous amount of effort) to estimate European banks need for dollar funding. It is superb.

The results are interesting, to say the least. They confirm that the losses that money market funds that held Lehman paper were a key channel of contagion, as European banks depended on US money market funds to meet their need for dollar funding.

Among other things, McGuire and von Peter find:

— “European banks experienced the most pronounced growth in foreign claims relative to underlying measures of economic activity.”
— “After 2000, some banking systems took on increasingly large net on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off balance sheet, the buildup of large net US dollar positions exposed these banks to funding risk , or the risk that their funding positions could not be rolled over.”
— “A lower bound estimate of banks’ funding gap … shows that the major European banks funding needs were substantial ($1.1 to $1.3 trillion by mid-2007).”
— UK banks, for example, borrowed in pounds sterling [some $800b] in order to finance their corresponding long positions in US dollar, euros and other foreign currencies. By mid-2007 their long US dollar positions surpassed $300b, on an estimated $2 trillion in gross US dollar claims. Similarly, Germany and Swiss banks net dollar books approached $300b by mid-2007, while that of Dutch banks surpassed $150b …. ” Setser note: this created large positions that needed to be hedged, and meant that if UK banks couldn’t raise a lot of sterling funding to swap into dollars, they would need to go out into the market and borrow dollars directly …
— The term structure of the fx swaps Eurpoean banks used to transform their pound and euro funding into dollars “are even short-eterm on average” than dollars borrowed on the interbank market.
— “these estimates suggest that European banks’ US dollar investments in non-banks [read holdings of dollar securities and corporate loans] were subject to considerable funding risk …. The major European banks US dollar funding gap reached $1.1-1.3 trillion by mid-2007. Until the onset of the crisis European banks had met this need by tapping the interbank market ($400 billion) and borrowing from central banks ($380 billion) and used FX swaps ($800 billion) to convert (primarily) domestic currency funding into dollars.”

By the way, US banks were net borrowers from the rest of the world – but most of their borrowing came from a few Caribbean islands – and those islands borrowed heavily from “non-bank” counterparties in the US. The BIS doesn’t think this represents a true external flow: “this could be regarded as an extension of US banks domestic activity since it does not reflect (direct) funding from non-banks outside the United States.”

The subprime crisis in August 2007 put these funding arrangements under stress. And they effectively collapsed after Lehman, leading to a scramble for dollars – or a “dollar shortage.” In the fourth quarter, the US government was a net LENDER to the rest of the world. Inflows from central banks were dwarfed by the $400 billion in swap lines the US provided European central banks. That is rather strange; deficit countries usually aren’t net lenders … but, well, a lot of institutions really were desperate for dollars.

The main source of stress on European banks came from the withdrawal of money market funding and the difficulties obtaining currency swaps. But it seems like European banks also lost another source of dollar funding: the world’s central banks.

Emerging economies were facing their own liquidity shortage – and emerging market banks in particular. Their home central bank helped them out. Countries with lots of dollar reserves though didn’t need to turn to the Fed for dollars. They could withdraw dollars from European banks and put them on deposit in their local banking system.

“A portion of the US dollar foreign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some money authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars. Market conditions made it difficult for banks to respond to these funding pressures by reducing their dollar assets …. “

That links the work of the BIS back to the work of the Alberola and Serena of the Bank of Spain. It was long argued that official investors were intrinsically stabilizing investors – and thus that they would never trigger a funding crisis or add to market distress. And it is certainly true that central banks haven’t triggered a dollar crisis. Indeed, they almost certainly prevented one in 2006 and 2007 when they added crazy sums to their reserves, preventing the dollar from falling against a host of emerging currencies. At the same time, central bank reserve managers haven’t been a stabilizing force in the credit market during this crisis.

— Central bank reserve managers – led by China and Russia – shifted massively out of Agencies and into Treasuries. And that shift came after a long period when central banks kept buying Agency bonds even as (in retrospect) the quality of the Agencies balance sheet was eroding, as they were lending against collateral inflated by housing bubble.
— Central banks shifted dollars out of European banks short of dollars to their home countries banking system.

The first flow represents a flight to safety. The second flow represents a flight from the risk associated with global banks – but putting funds on deposit in shaky local banks isn’t necessarily the safest of investment either. It was a flow driven by the banks need to stabilize their own markets.

In both cases the offsetting flow – the flow that prevented an even deeper crisis than we have seen to date – came from the US Federal Reserve. They should get a bit of credit.

I don’t blame the central bank reserve managers for adding to the distress in dollar-denominated credit markets. Central bank reserve managers’ core mission is to safeguard their countries external assets and meet their own countries need for hard currency financing, not to stabilize the international financial system. But I do think that there should have been a bit more discussion of the various ways the actions of central banks could add to a crisis. And perhaps the central banks – and the IMF — shouldn’t have been quite so willing to argue that official investors were an intrinsically stabilizing presence in the market.

*It is striking that this paper came from the Bank of Spain, not the IMF. While the Bank of Spain was delving into the role the official sector played in financing the US deficit, the IMF’s 2007 article IV report by contrast emphasized private flows, arguing that the United States comparative advantage at producing complex financial products would sustain external demand for US assets. Bad call. There is no hint in the IMF’s analysis that most such demand was coming from the SIVs US banks had set up in London/ European banks that relied on US money market funds to support their dollar balance sheets.
**It is notable, at least to me, that the regulators focused on the risk Lehman’s failure posed to the CDS market but not – at least from what has been reported – on the risk that Lehman’s failure posed to the money markets, and thus to all the institutions that relied on the money markets for financing. This suggests to me that the regulators didn’t fully understand the role European banks were playing in US credit markets – or how exactly they funded their positions – until the crisis made their funding needs acute. I suspect that it took the crisis for the researchers at the BIS to be able to figure out how to use the BIS data to estimate European banks need for wholesale dollar funding.

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