The Economist - USA (2020-07-25)

56 Finance & economics The EconomistJuly 25th 2020

2 firms like Evercore and Financial Technol-

ogy Partners have blossomed alongside es-

tablished names like Lazard—to even trad-

ing stocks and bonds. Banks were once the

dominant traders of equities and fixed in-

come. But market structure has evolved,

says Paul Hamill of Citadel Securities, a

broker-dealer set up by Ken Griffin, foun-

der of Citadel, a hedge fund.

The firm is one of the largest equity

traders in America. (When Slack, a cor-

porate-messaging service, went public last

year it listed directly via Citadel Securities.)

Jane Street Capital, another non-bank trad-

ing firm, has also found success intermedi-

ating equity markets.

Citadel Securities has expanded into

trading fixed income too, in part thanks to

regulations that pushed securities like in-

terest-rate swaps onto central clearing

platforms, making competition easier. Mr

Hamill says there are a few big institutions

that conduct full-scale Treasury trading; all

are large banks, except for Citadel Securi-

ties. The firm may apply to become a prim-

ary dealer—ie, an institution that can buy

bonds from the government and trade di-

rectly with the Fed. This would make it the

second non-bank to earn the privilege: Am-

herst Pierpont, a smaller broker-dealer,

was designated a primary dealer in 2019.

That banks have a fight on their hands is

clear. They are less profitable in a world

where they must hold low-yielding safe as-

sets and carry huge safety buffers. Accord-

ing to Michael Spellacy of Accenture, a con-

sultancy, banks earn half of the roughly

$1trn in annual revenues that all global

firms make by intermediating capital mar-

kets. But of the $100bn in economic profits,

which take into account the cost of capital

and other expenses, they capture just 10%.

For borrowers and investors, the con-

tinuing clout of capital markets and the

emergence of innovative new firms has

meant more competition in the financial

system. Prospective homebuyers can

choose the lender that offers the best ser-

vices. Mid-sized firms struggling to access

bank loans can turn to a wealth of newly

minted private-credit funds instead.

What does the shift mean for risk in the

system? The role that banks play in maturi-

ty transformation means that they are al-

ways exposed to runs, jeopardising the

provision of credit to businesses and

households. Whether the evolution of the

financial system is risky depends on how

bank-like shadow banking is.

Thefsb has tried to identify the finan-

cial firms most susceptible to sudden,

bank-like liquidity or solvency panics, and

which pose a systemic risk to the economy.

Pension funds and insurance firms are ex-

cluded as they match their long-term li-

abilities with long-term assets. Worldwide

the exercise identified $51trn (or 59% of

gdp) in “narrow” shadow investments, al-

most three-quarters of which are held in

instruments “with features that make

them susceptible to runs”. This slice has

grown rapidly, from $28trn in 2010 (or 42%

of gdp). At the end of 2018, America’s share

of the risky bucket stood at $15.3trn. Its

commercial banks, with assets of $15.6trn,

were only just bigger.

The riskiest types of shadow banks, says

the fsb, include fixed-income funds and

money-market funds, which are large in

America; companies that make loans and

might be dependent on short-term fund-

ing, such as retail-mortgage or consumer-

credit providers; broker-dealers, which

trade securities; and entities that do secur-

itisation-based credit intermediation,

such as creating collateralised-loan obliga-

tions that bundle corporate loans which

are then sold to investors. Tellingly, it was

many of these markets that seized up in

March and April.

With a growing number of capital-mar-

kets functions and a great deal of credit-

provision to firms sitting outside the bank-

ing system, policymakers have once again

found their customary tools do not work as

well as they might like. In the financial cri-

sis, both banks and non-banks were caught

up in the panic. This time there has been no

concern that banks might fail. Even in the

worst case dreamt up by the Fed for this

year’s stress tests, core capital ratios fell

from an average of 12% across the 33 biggest

banks in America to a still-chunky 9.9%.

Rather than acting as a lender of last re-

sort to the banking system, therefore, the

Fed has been forced to act as a market-

maker of last resort. The crisis of 2007-09

was an audition for this role, with some ex-

perimental interventions. Now the Fed has

intruded into a bewildering array of finan-

cial markets (see chart 4). It stepped in to

calm the Treasury market, and to revive the

corporate-bond market, which had ceased

functioning, by promising to buy bonds. It

has provided funding to the repo market—

where Treasuries are swapped overnight

for cash—as it did in September 2019, when

the market sputtered. It is providing li-

quidity to money-market mutual funds,

which take cash from individuals and park

it in very short-term investments like Trea-

sury bills, in the hope that investors can be

paid promptly when exiting such funds.

And it has bought up mortgage-backed se-

curities—the ultimate output of retail-

mortgage providers.

The cold light of day

The Fed was able to soothe investors

through the power of its announcements;

it has so far lent only $100bn through its

schemes. But Stephen Cecchetti and Ker-

mit Schoenholtz, two scholars, have calcu-

lated the scale of each of the implicit guar-

antees. Adapting their figures, we estimate

that the Fed has promised to lend, or to buy

instruments, to the tune of more than

$4trn in credit markets with a total out-

standing value of $23.5trn. That is backed

by a $215bn guarantee from the Treasury,

potentially exposing the Fed to losses.

The sheer breadth of the intervention

takes the Fed into new territory. As the

Bank for International Settlements, a club

of central bankers, noted in its recent an-

nual report, the consequences of bailing

out capital markets on such a scale could

linger. “The broad and forceful provision of

liquidity has stemmed market dysfunc-

tion, but it has also shored up asset prices

across a wide risk spectrum. This could af-

fect the future market pricing of risk.”

Banks’ stagnation may be no bad thing:

credit provision has grown more competi-

tive, and is probably becoming less reliant

on a handful of large risky institutions. But

when banks malfunction, regulators at

least know where to look. When so much

activity takes place in the shadows, they

risk fumbling in the dark. 7

Bigmarkets,bigstick

UnitedStates,Fedpurchaseschemes,$trn

Maximumpotentialsize

offacilities,July 2020

Sources:FederalReserve;S.Cecchettiand

K.Schoenholtz;TheEconomistestimates

4

Asset-backed securities

Money-market

mutual funds

Commercial paper

Municipal debt

Paycheck Protection

Programme

Main Street lending

Corporate credit

Primary dealers

0 2.01.51.00.5

Market size,

June 2020, $trn

1.8

1.1

0.8

3.9

0.5

2.9

11

2.0