Issue #11: The Origins and Evolution of the Modern Monetary System
Part 2: "Liability Management" – The Re-Emergence of Wholesale Finance (The Private Federal Funds Market)
Recall that there are a few fundamental innovations that have radically transformed our monetary and banking system in the post-WWII era:
Liability Management (a.k.a. “wholesale finance”) – the expansion of banking strategy that transformed banks from passive acceptors of deposits to aggressive operators in the money market. This includes federal funds borrowing/lending, repo, commercial paper, money market funds, eurocurrency/eurodollar banking, and much more.
Securitization (a.k.a. “market-based finance”) – the disintermediation of traditional commercial bank lending in favor of bonds and the pooling of illiquid, untradable loans to form liquid, tradable securities. This includes the proliferation of mortgage-backed securities, high-yield bonds, increased IG corporate bond issuance vs. loans, and other asset-backed securitizations. This also coincided with the advent of the pension system, which indirectly funneled America’s future retirement savings into the financial market.
OTC Derivatives and Value-at-Risk (VaR) – combined with Basel risk-weightings, these innovations introduced increasingly esoteric and mathematical definitions of “money-ness,” resulting in the redefinition of money as “bank balance sheet capacity.” This also cemented the shift of bank business models towards fee-generating, off-balance sheet banking activity as opposed to maturity transformation based on net interest margin or balance sheet expanding arbitrage.
In the previous issue of this installment on the origins and evolution of the modern monetary system, I covered “asset management” (the traditional model of banking, in the form of deposit-taking and lending), which we can build upon to begin to understand exactly how and why our modern financial system is so different from the textbook description of deposits, reserve requirements, and money multiplication.
If you have not had a chance to read Issue #8 of Monetary Mechanics yet, I suggest you read (or re-read) that before continuing below, as it contains important information, but here is a brief review for you if you need it:
Commercial banks create new money (deposits) when they extend new loans. Banks are simultaneously limited by statutory reserve requirements (prior to March 2020) and, more importantly, by self-imposed liquidity constraints. Banks need reserves to settle transactions and payments with other banks, such as when deposits are transferred, or when an individual or business pays another in bank deposits. In a world without a private market for Federal Funds, daylight overdrafts on Fedwire, or the ability to regularly borrow from the Federal Reserve’s discount window, banks depended on attaining and retaining deposits to replenish their reserves.
These limitations defined the relatively more repressed financial regime of the early post-WWII era (as contrasted against that of the 1960s-2010s). Prior experiments with the liberalization of money and banking in the early 20th century, coupled with the subsequent Great Depression and the period of financial repression during WWII, left people skeptical about the benefits of a liberalized money and banking system.
In this issue of Monetary Mechanics, I will cover certain changes to the money and banking paradigm that can collectively be called “liability management” and the re-emergence of “wholesale finance.” While there is a myriad of other financial and regulatory developments that I could fill an entire book (if not several books) about, I will attempt to cover some of the most important developments that are still relevant to and required for the functioning of our monetary and banking system today.
In this issue of Monetary Mechanics, I will cover the first major innovation in liability management, which is the development of the private Federal Funds (FF) borrowing market in the early 1950s. Since there are too many important topics to cover here all at once, in future issues of Monetary Mechanics, I will also attempt to cover:
The creation of bank holding companies (BHCs) in 1956
The creation of large negotiable certificates of deposit (CDs) in 1961
Eurocurrency/Eurodollar banking and borrowing practices, first by European (primarily London) banks, followed by American banks in the late 1960s
The issuance of commercial paper (as well as other wholesale liabilities)
The development of the repurchase agreement (repo) market by government securities dealers shortly after WWII
Before I begin, I want to emphasize that I believe this is the single most important yet misunderstood transformation in the global monetary and banking system in the post-WWII era. This is perhaps due to the fact that many academics, analysts, and financial market participants choose to focus heavily on the development of the “shadow banking” sector during the 1980s and the 1990s (including securitization, ABCP conduits, OTC derivatives, the repeal of the Glass-Steagall Act, etc.).
There is no doubt that these developments profoundly transformed the nature and function of commercial banking, as well as the rest of the financial system. However, I believe that the groundwork for this monumental transition was laid long before, and, as a result, we can only tackle the problems that the financial system faces today by understanding the changing of bank behavior that facilitated banks’ shift from passive acceptors of deposits to active operators in the money markets.
Due to quantitative data limitations, I will utilize mostly qualitative data in the form of narrative exposition and evidence from reputable sources. However, I will also utilize objective numerical measures where available, accessible, and relevant.
The Private Federal Funds Market
The first significant development in liability management is the re-emergence of the private Federal Funds (FF) borrowing market in the US in the late 1950s.
Recall from earlier that banks are limited by both general reserve requirements and interbank settlement and liquidity requirements. The development of the private FF market allowed city banks, which typically had more plentiful lending opportunities, to borrow reserves from country banks, which typically had less plentiful lending opportunities, but an abundance of deposits. This allowed the city banks to expand their marginal lending activities and, as a result, facilitated additional money creation.1
This greatly benefitted both parties – large city banks were able to increase their lending activities while small country banks were able to be compensated for their excess reserve balances. By 1960, this led to a situation in which large city banks, figuring that they would always be able to buy all the FF they needed (on the basis of being large well-connected banks with solid reputations), began to deliberately operate with a structural short position. They figured, why not use FF borrowing for 10% of their overall needs?2
The development of the private FF market is less important for the precise amount of extra balance sheet expansion and money creation that it permits, but more important for the fact that it enabled elasticity in the medium of exchange and flexibility in managing a bank’s asset and liability structure.3 Prior to the development of the private FF market, banks often kept more reserves than required (a behavior that was especially enhanced in the 1930s), resulting in an uneven distribution of reserves in the banking system (uneven relative to lending opportunities).
The private FF market was the first wholesale (i.e. interbank) market to emerge since 1929, and banks rapidly reacquainted themselves with the idea of trading interbank liabilities, buying and selling funds, and managing liquidity on both sides of their balance sheet. Thus, the development of the private FF market (and the wholesale interbank market in general) was essentially a “re-development” that moved the conduct of banking and bank-like activities away from the traditional depository base and towards trading with other financial market participants.4
This is of critical consequence as it relates to the oft-forgotten human element in banking and finance.
From the Federal Reserve Bank of New York’s 1977 Quarterly Review:
There is no central physical marketplace for Federal funds [or repurchase agreements], the market consists of a loosely structured telephone network connecting the major participants… The Federal funds and term Federal funds transactions are normally “unsecured”… For this reason, unsecured Federal funds transactions are done only by institutions that enjoy a very high degree of mutual confidence.5
From Marcia Stigum:
[Banks] will sell Fed funds only to banks which they have established lines of credit, and they will sell to these banks only up to the amount of the lines granted. In establishing a line to another bank, the selling bank will consider the other bank’s reputation in the market, its size, its capital structure, and any other factors that affect its creditworthiness. The selling bank may also consider whether the buying bank is at times also a seller of funds. A bank that is always a buyer is viewed less favorably than one that operates both ways in the market. Selling funds is also important for a would-be buyer because the Fed funds market is one into which some banks have to buy their way. They do this by selling funds to a bank for a time and then saying to that bank, “We sell funds to you, why don’t you extend a line to us?”6
This represented a historic and revolutionary step forward. Since the Great Depression, the only liquidity management that banks performed was on the assets side of their balance sheet – what mixture of reserves, securities, and loans to maintain given the available investment opportunities and probable demand for liquidity from their depositors. Now, banks managed liquidity risk on both sides of their balance sheet – they had to ensure that they had enough liquid reserves and securities to meet potential outflows and to secure FF borrowing when desired.7
This constituted the beginning of a larger and longer shift in bank behavior from simply “attracting” and “maintaining” deposits towards “buying” deposits and deposit-substitutes (i.e. other types of funding) in the open market at market-related rates.8 Furthermore, this also constituted the beginning of the development of an informal interbank network of financial institutions responsible for carrying out some of the most important functions in the monetary and banking world.
Large money-center banks, as chronic borrowers of FF, built up a synthetic FF short, as they designed their asset structures with the belief that they would always be able to roll over FF funding as needed.9 Such a synthetic FF short is reminiscent of the synthetic dollar short position held by European banks during the 2007-2008 financial crisis and by most foreign financial institutions today.
The final important implication of the development of the private FF market was its modification of the function of the Federal Reserve’s discount window. Between 1929 and 1965, the FF rate was usually below the discount window, because banks were able to borrow freely from the discount window to manage their short-term reserve requirements if and whenever the FF rate rose to too high of a level. However, with the fast development of the private FF market, the FF rate steadily rose above the discount window, because banks began to demand larger amounts of FF than were able to be supplied at the discount window, which finally fell into disuse. This is yet again another example of Milton Friedman’s interest rate fallacy – as the demand for FF borrowing increases, the EFF rate also increases.
Eventually, due to the robustness of the private FF market, a stigma about discount window borrowing began to develop. Because there was a large liquid market for FF borrowing, people equated banks being forced to borrow from the discount window with banks being shut out of the private market (most likely for good reason).
This is once again another example of the important yet subtle human element in banking and finance – complex incentive structures shape the psychological behavior of market participants and cause unexpected and emergent outcomes that are not always easily understood from a top-down perspective. Consequently, changes in this set of incentive structures and patterns of psychological behavior of market participants will lead to dramatically different outcomes even if there appears to be an absence of obvious reasons.
The EFF rate ultimately broke out above the discount window rate when Morgan Guaranty used their reputation to borrow above that rate in 1964. Until then, no bank dared to borrow above that rate, because they were afraid of signaling to others that their assets were rejected at the discount window.10 In fact, banks were so afraid of implicating themselves that they were actually losing money in the process due to the overly low FF rate at that point. There was no particularly obvious reason why it took so long for this to happen, but all it took was one bank to break that psychological barrier, which resulted in an entire paradigm shift in thought and action.11
At the same time as this transformation was happening in the US domestic money markets, other similar developments were also happening in international money markets, which became increasingly interconnected and globalized. These parallel innovations included Eurocurrency/Eurodollar banking and borrowing practices and negotiable certificates of deposit (CDs), which I will soon cover in the next issue of this installment on the origins and evolution of the modern monetary system.
https://www.richmondfed.org/~/media/richmondfedorg/publications/research/special_reports/instruments_of_the_money_market/pdf/chapter_02.pdf
Marcia Stigum, The Money Market: Myth, Reality, Practice, Dow Jones-Irwin, 1978.
https://www.federalreserve.gov/econres/notes/feds-notes/re-emergence-of-the-federal-reserve-funds-market-in-the-1950s-20190322.htm
The Federal Funds Market – A Study by a Federal Reserve System Committee, 1959.
Charles Lucas, Marcos Jones, and Thom Thurston, “Federal Funds and Repurchase Agreements,” FRBNY Quarterly Review, Summer 1977.
Marcia Stigum, The Money Market: Myth, Reality, Practice, Dow Jones-Irwin, 1978.
https://www.kansascityfed.org/documents/1562/1980-Approaches%20to%20Bank%20Liquidity%20Management.pdf
Stefano Battilossi, “The Eurodollar Revolution in Financial Technology: Deregulation, Innovation, and Structural Change in Western Banking in the 1960s-70s,” Working Papers in Economic History, November 2009.
Charles Lucas, Marcos Jones, and Thom Thurston, “Federal Funds and Repurchase Agreements,” FRBNY Quarterly Review, Summer 1977.
Marcia Stigum, The Money Market: Myth, Reality, Practice, Dow Jones-Irwin, 1978.
A relevant contemporary example is banks’ practice of holding excess amounts of reserves due to them not wanting to use the Federal Reserve’s daylight overdraft/intra-day credit offering, because, in the banks’ view, it would imply that they were in breach of their LCR requirements, even if this was not the original intention of the regulators and this is not written in the letter of the law. (source: https://podcasts.apple.com/us/podcast/why-repo-markets-went-crazy-why-december-could-be-even/id1056200096?i=1000456449570).