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, re-hypothecation 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 speaks to Manmohan Singh as he prepares to celebrate Christmas with his family in Washington DC.
Q: What do you make of some recent commentary that has used your research to build a case against, among other things, repo, re-hypothecation and the shadow-banking system?
A: I don’t think that people are linking the big and small pictures.
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| Manmohan Singh, Senior |
Re-hypothecation 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.
Q: Following the ECB’s final scheduled meeting of 2011, Draghi said he was aware of a shortage of eligible collateral among European banks. What does this mean for the financial system at large?
A: The events of the summer have not been conducive for the good collateral to stay in the system. The reduction in the stock of collateral and length of collateral chains that I mention in my papers is very likely to have increased this year. Markets have been even more timid given what we have seen in the eurozone. I would not expect to see a better collateral stock than $5 trillion. People are simply too scared of counterparty risks.
Every monetary transmission needs lubrication, and if it dries up, the machine probably won’t work as expected. Global financial lubrication cannot be ignored in the context of monetary policy; if financial lubrication is reduced then the objective of interest-rate policy cannot be passed into the real economy.
Q: What do the recent examples of failed banks, which have relied on short-term off-balance sheet funding like repo, reveal about this widespread practice, especially where the underlying assets have “disappeared”?
A: Once an intermediary transfers title in an asset and allows it to be re-pledged, it is no longer theirs and they are no longer facing the counterparty to who it has been re-pledged. The transfer of quality collateral, or securities which are scarce, such as German government bonds, allows the market to connect, and builds chains between institutions who have use and re-use the same piece of collateral various secured borrowings. These collateral chains are a necessary component of financial lubrication.
Repo is just one part of re-hypothecation, which also involves the re-use of source collateral in connection with securities lending, OTC derivatives trading and newer forms of collateralized lending like liquidity swaps.
Banks do rely on repo. Banks typically have access to a significant amount of collateral via reverse repos, security borrowings, OTC derivative margins and customer margin loans. When such pledged collateral comes in, they have the liberty to use it.
Q: What should the regulatory response be?
A: To date, regulatory efforts have focused on fortifying the equity base of the banking system and limiting the banking system’s leverage through leverage caps and capital adequacy requirements. Non-bank funding to banks was assumed to be sticky and mainly in the form of household deposits. As such, regulatory efforts need to focus on the sizeable volumes of bank funding coming from non-bank asset managers via source collateral and institutional cash pools.
Regulators may need to reconsider and fine-tune the leverage definitions of banks to incorporate collateral chains due to the sizeable volumes of pledged collateral that churn between banks and nonbanks.
Regulatory proposals, such as the Dodd-Frank Act and Basel III, that are pushing riskier activities outside the banking system, will likely increase the shadow banking world; thus its linkages to the traditional banking world warrants closer attention. More generally, the approach towards shadow-banking system may need some adaptation in key dimensions. Dynamic chains, for example, are quite different from the credit intermediation chains.
Q: The US has the biggest repo market in the world, and is home to some of the world’s largest banks and non-banks (such as hedge funds). So why does most of the re-hypothecation that supports the shadow-banking system occur in the UK?
A: The prevalence of re-hypothecation outside the US allows for a market clearing price for financial collateral in Europe [UK and continental Europe], in which rights of re-use have a strong legal underpinning.
Q: Does this make the UK a hub for excessive leverage and risk taking?
A: The EU legal framework for financial collateral is flexible enough to accommodate the preferences of the most prudent and risk-averse clients and counterparties. Whether or not sophisticated market participants strike bargains that offer them appropriate protection is a matter for them alone to decide.
Q: Much of the emphasis around systemic deleveraging in both academic and commercial circles has focused on price declines and falling balance-sheet capacity. What role does collateral play?
A: Most people think deleveraging is only about haircuts, where a security once worth 100 is now worth 60. These mark downs, however, also mean that the value of collateral is lower and as that falls, so does the velocity of collateral. In other words, deleveraging is as much (or more) about the length and elasticity of collateral chains as it is haircuts.
Q: What success have central banks had in encouraging good-quality collateral to stay in the system?
A: The less liquidity you have in the real economy, the more costs go up, central bank liquidity needs to go up and as balance sheets grow, we are unsure what the impact of unwinding them will be. Unwinding a central-bank balance sheet that is now three times larger than it was could lead to inflation.
We want to avoid a situation where people are taking lower-quality assets and dressing them up, putting lipstick on them and trying to get them to move again. We’ve seen what that kind of financial engineering can do.
Q: Finally, why did you chose to do your work within the IMF, rather than an academic institution? Wouldn¹t you have been more independent?
A: When I finished my doctorate in the mid nineties, the academic market for economists seeking meaningful research positions was in a downturn. After some assignments with the US Treasury funded by US AID, I opted for investment banking and am very glad that I took this path.
The experience that I gained as a market practitioner gives me a different perspective on the interpretation of primary data and drives my research in a different direction than some of the more traditional academic authors.