Central Banking in the Era of Shadow Banks

May. 22, 2024

How do 'shadow banks'—unregulated non-bank financial intermediaries—affect central banks' ability to manage liquidity crises? Traditional monetary tools are now insufficient to ensure financial stability, as reflected in recent central bank policies. “The question now is to understand how the system functions with all these tools and whether the constant reliance on Fed intervention to keep these markets stable is an issue,” says SHoF researcher Adrien d’Avernas.

The introduction of new regulations to address moral hazard issues, such as bailout expectations and implicit guarantees following the Great Financial Crisis, has pushed financial activities outside traditional banking, including hedge funds, money market funds, and insurance companies, which now play a crucial role in financial intermediation.

Consequently, central banks have had to adapt their monetary policy tools to reach these non-traditional entities, d’Avernas, Swedish House of Finance (SHoF) researcher and recipient of this year’s Hans Dalborg Award, said during his award presentation. He explained the implications of these changes and the evolving role of central banks in maintaining financial stability:

The Shift to Shadow Banking

Post-crisis regulatory changes have addressed some moral hazard problems. However, these changes have fundamentally altered the financial system. Constrained by stringent leverage ratio regulations (rules that require banks to maintain a minimum level of equity capital relative to their total assets), traditional banks have seen a significant portion of financial intermediation migrate to shadow banks.

These institutions, operating outside the conventional regulatory framework, necessitate new approaches from monetary authorities to ensure effective policy transmission. To guarantee the transmission of the policy rate to these institutions, central banks have adopted unconventional monetary policy tools such as quantitative easing (QE) and various lending and borrowing facilities.

In this new regime, the Federal Reserve (Fed) has become a dominant player in short-term money markets. This omnipresence is unlikely to wane, raising questions about the long-term costs and implications of such persistent interventions.

Costly Balance Sheet for Banks

One significant outcome of leverage ratio regulations is that it has become more expensive for banks to hold assets. Raising equity is costly due to debt overhang and tax implications. This cost disparity becomes particularly evident when the yield on Treasuries (government bonds) exceeds the repo rate (the interest rate on short-term loans through repurchase agreements).

However, leverage ratio regulations restrict banks' ability to engage in cost-free arbitrage, limiting their market activities. Hedge funds play a significant role in determining the prices of long-term U.S. Treasury securities by holding substantial long positions (investments that profit from price increases) in these Treasuries.

Fragile Funding of Hedge Funds

During the COVID market turmoil, hedge funds' funding dried up, forcing them to sell Treasuries, which led to a drop in Treasury prices. This instability potentially undermines U.S. Treasuries' status as a "safe haven" investment, typically considered low-risk and reliable during market turbulence.

“And that is breaking with a very important historical correlation,” d’Avernas said.

“During volatile times, people want more of this safe asset. So what happened here? At the beginning of COVID, there was a dash for cash. The supply of funding to the repo market suddenly shrank, hedge funds did not have any funding anymore, they needed to sell all these Treasuries, and the selling pressure made the price of these Treasuries decrease.”

The Fed’s Balancing Act

Quantitative easing has expanded the Fed's balance sheet to unprecedented levels necessary to manage the zero lower bound and reach unregulated financial intermediaries. Attempts to tighten this balance sheet, such as the 2018 initiative, were quickly reversed due to spikes in repo rates, demonstrating the delicate balance the Fed must maintain.

The September 2019 spike in repo rates, where rates soared to 6% in a single day, highlighted the fragility of liquidity in the market. Despite an abundance of central bank liquidity, regulatory constraints on banks' lending capacity created shortages necessitating Fed intervention. This incident underscored the limitations imposed by intraday liquidity regulations and the crucial role of the Fed as a stabilizing force in the repo market.

With banks restricted by leverage and intraday liquidity regulations, the Fed often finds itself as the dealer-of-last-resort. To ensure effective monetary policy transmission, the Fed must navigate a complex landscape, sometimes borrowing and lending simultaneously. This dynamic essentially forces the Fed to provide the very balance sheet space it restricts through regulation.

By understanding these dynamics, we can better appreciate the challenges central banks face in this new financial landscape. As shadow banks continue to grow in influence, central banks must continually adapt their strategies to maintain stability and effective policy transmission.

“But at what cost?” d’Avernas asks. “It is unclear what they are.”