by Don Alexander, MBA
Associate, RSD Solutions Inc.
One major role of the financial system is efficient credit allocation. Changes happening in the modern credit creation process—referred to as “other deleveraging,” in the case of the ECB’s moves to expand the collateral it will accept—risk weakening the fabric of the market in ways that are not yet fully evident. It is this issue that is relevant for risk management.
This is discussed by Mammohan Singh & Peter Stella in a recent VOXEU communique The (Other) Deleveraging: What Economists Need to Know About the Modern Money Creation Process dated July 2nd. A more detailed report is available in an IMF working paper.
Traditional money creation is performed by banks (agents) taking deposits and transforming the maturity structure. This credit creation is regulated by the central bank through reserve requirements. The “money multiplier” depends upon inter-bank trust and when this is altered can create potential problems.
A second type of credit creation has developed through the use of collateral in the shadow banking system. In this process, hedge funds and custodians often use pledged assets similar to the lending-deposit-relending process used by the traditional banking system. This process creates another deleveraging process in which the credit creation process is controlled by three methods: (1) the size of the haircut (or reserves held against re-pledged assets); (2) the supply of assets used for re-pledging; and (3) reducing the re-pledging of pledged collateral (supply chain).
The authors note concerns about the second and (more importantly) the third way. When market tensions rise – especially when the health of banks comes under a shadow – holders of pledged collateral may not want to onward pledge to other banks. With fewer counterparties and elevated counterparty risk, can lead to decreased market liquidity, idle collateral, missed trades and deleveraging.
Concerns about asset quality have reduced credit quality and the ratio of pledged collateral (credit creation) to underlying assets has shrunk the interconnectedness of the banking system. This may be viewed positively from a financial stability perspective if one views each institution in isolation, but weakens the market’s overall structure. However, the vulnerabilities that have resulted from the weakened fabric of the market are not fully evident.
As the ‘other’ deleveraging continues, the financial system remains short of high-grade collateral that can be re-pledged. The ECB’s attempt to accept ‘bad’ collateral has distorted the good/bad collateral ratio. If this policy becomes part of central bankers’ standard toolkit, the fiscal aspects and risks associated cannot be ignored. The central banks have interposed themselves as risk-taking intermediaries with the potential to bring significant and negative unintended consequences.
It is the understanding of the unintended consequences that is important for risk management.
For more on this, follow the link: www.voxeu.org/article/other-deleveraging-what-economists
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