Wednesday, December 28, 2011

Repo & Euro Financials' Intermediation of Shadow Banking

Despite a less-worse Italian auction this morning, the Euro took a rather ominous swan dive this morning on the wholly unsurprising announcement that the ECB’s balance sheet has swelled to an all-time high of €2.73 trn.    With the market otherwise fairly dull (aside from the odd story about JPMoMo sticking it to some infants and widows with a BBG headline comparing the House of Dimon to the Wehrmacht) I figure I’d take the time to succinctly re-cap my views on Europe, which I briefly touched on in my post last week.

I’m not negative on LTRO per se.  I just think that the necessity of LTRO speaks volumes about the dire funding situation of Euro banks and to the inability of the EU as a federal body to summon the political will to act comprehensively and decisively.  As we lose count of the number of EU interventions lets not forget that this is a slow-rolling, snowballing crisis that has been mounting for more than a year, during the course of which the EU has lost its credibility as a crisis manager.  In LTRO we have yet another stop-gap, backdoor solution that barely responds to the immediate problems while leaving little possibility of further rapid expansion should the situation fail to improve on its own.  A significant improvement in the policy environment notwithstanding, I don’t feel that this is a particularly likely outcome. 

LTRO may look impressive at first glance.  However, with €291.6bn maturing from the ECB’s 7 day main repo operation (MRO) and €169bn of MRO financing rolled on 12/21 against a further €140.6bn of older LTRO maturing (with only €29.7bn rolled), the actual new credit extended is significantly less.  Net this refinancing against a slight increase in fixed-term deposits (€3.5bn) and 45.7 bn moved from October’s 12 mo. LTRO, the new 3-year LTRO adds only €206.5bn in new repo financing extended to financials.  It’s worth noting that this covers only about 60% of the approximately €350bn of sub/unsecured/and otherwise currently un-rollable debt maturing in the coming year.  

This might hurt...
While I alluded to the fact that the issuance demands of Euro financials are fairly immaterial when compared to the looming sovereign funding needs in 2012, one aspect that I failed to give sufficient attention to is the larger irrelevance of debt issuance to the funding of the European financial system.  The larger concern are the wholesale funding markets on which European banks are heavily reliant.  To say that the limited attention given to the repo market's importance in funding modern finance, its immense size, and the critical role of European banks in intermediating repo is concerning is perhaps an understatement.  With that, I offer to you a handful of thought provoking papers that are particularly relevant to where we stand today.

For those unfamiliar with the mechanics of repo and the shadow banking system, the work of Gary Gorton at Yale is a good place to start.  He provides a narrative of repo as the modern day institutional intra-bank equivalent of traditional deposit banking, albeit on a much larger scale and no less susceptible to panic and runs than its more prosaic forebear.  He fairly convincingly argues that rising haircuts and the attendant evaporation of repo money was likely the immediate cause of the 2008 crisis and nicely summarizes the events that caused a gradual and then very sudden flight of liquidity responsible for the wholesale insolvency of the banking system.  With a similar tightening dynamic beginning to manifest itself in Europe it is worth getting familiar with.  As the repo market is estimated at having been somewhere between $10-12trn in the US at its peak by Manmohan Singh and James Aitken, it was comparable in size to the assets of the US banking system.  Although probably about half that size in the US today, it is difficult to understate just what an important piece of today’s financial infrastructure it is.  In light of the sums involved here LTRO becomes even less impressive and instead makes one wonder whether this only foreshadows what is to come.

Hyun Song Shin at Princeton has elaborated on these efforts by attempting to construct a model of global flow of funds that integrates the critical role played by financial intermediaries in dictating credit flows, in contrast to the more traditional literature which treats financials as an afterthought to 'real' economic activity.  This is a pretty neat little paper and does a good job of highlighting the significant role European banks play in the shadow banking system while further alluding to the problematic reliance on Basel risk-weightings in EU bank regulation which have tightened financial-sovereign linkages into a barbed noose:

“The permissive bank risk management practices epitomized in the Basel II proposals were already widely practised within Europe as banks became more adept at circumventing the spirit of the initial 1988 Basel I Accord. Basel II was subsequently codified most thoroughly in the European Union through the EU’s Capital Adequacy Directive (CAD).  In contrast, US regulators have been more ambivalent toward Basel II, and chose to maintain relatively more stringent regulations (at least, in the formal regulated banking sector) such as the cap on bank leverage.”

The importance of Euro banks to the shadow system is further re-iterated by their reliance on the Fed’s term auction facility TAF during 2008, as Shin highlights:

As if this wasn’t enough to keep you up at night, Aitken & Singh also provide a further reminder of the problematic regulatory environment in Europe:

“Our understanding from legal sources is that the EU law does not establish a quantitative cap on the rehypothecation of collateral pledged to broker-dealers akin to that found in the U.S. SEC Rule 15c3–3. EU law permits the parties to strike their own bargain as to how much (if any) collateral may be subject to rights of reuse. The regulatory regime for broker-dealers and their customers may lead to some re-thinking due to the litigation involving Dexia in 2009.  However, changes are still distant from being finalized and it is impossible to say at this stage what changes (if any) can be expected as regards limiting rehypothecation right”

In this light, it is clear that further deterioration would demand a significant expansion of LTRO of a scale that would likely draw attention from the Merkel/Bundesbank establishment and the public at large.  Given the current dialogue surrounding central bank LOLR operations in general and the public’s inability to understand the subtleties of repo transactions its not hard to imagine Das Bild et. al. expressing moral outrage over the unrestricted give away of hundred of billions of euros to overcompensated, too-big-to-fail bankers who stupidly loaned money to profligate lazy southerners.  To some extent they’d be right, as the Bundesbank & the German government/taxpayers are ultimately on the hook via TARGET for their share of the losses incurred by any busted periphery banking system/central bank, but to do so is to ignore the demands that are required to maintain a currency union.  

Despite the willingness of Paul Krugman, Cullen Roche, and their ‘bottomless pool of central-piggy-bank monopoly money’ brethren to denounce Milton Freidman as being an irrelevant idiot incapable of understanding the esoteric but desirable dark arts of debt monetization, he was likely right all along about the Euro.  With the ECB-cum-pan-European pawn lender expanding its collateral guidelines to include any piece of paper with the letters ‘IOU’ scrawled on it, the linkages between European financials, central banks, and the ultimate solvency of the sovereigns behind them grows ever tighter.  Determining the immediate origins of a potential crisis is impossible, but the tenuous position of the European financial system and the sheer number of avenues through contagion can spread suggest that caution is to be warranted as we enter 2012.    

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