IMF's Singh warns of the threat of collateral drought to global liquidity

IMF senior economist Manmohan Singh has become something of a celebrity since the summer. Several commentators have seized on his recent writings on collateralized lending, rehypothecation and the shadow banking system to make the case that the downfall of the financial system stems from the overleveraged, unregulated, off-balance-sheet shadow banking system. What Singh is saying, however, is that the shadow banking system is a necessary part of the monetary universe, and therefore something that regulators and policymakers must thoroughly understand if they are to have any success in improving economic performance. In an exclusive interview, Euromoney spoke to Singh as he prepared to celebrate Christmas in Washington DC.

What do you make of some recent commentary that has used your research to build a case against, among other things, repo, rehypothecation and the shadow banking system?

I don’t think that people are linking the big and small pictures. Rehypothecation is not a four-letter word. The financial system needs lubrication, and collateral chains help markets get completed. They connect the hedge fund with assets with someone who needs collateral. The question is do we need short or long chains? People can argue that financial stability improves with shorter chains, but if the chain is down to two counterparties, then there is a clear risk of liquidity drying up. We have tracked a $5 trillion reduction in global source collateral and associated chains. These are big numbers. Monetary policy cannot be achieved in a vacuum and collateral chains cannot be ignored.

Following the ECB’s final scheduled meeting of 2011, president Mario Draghi said he was aware of a shortage of eligible collateral among European banks.