Issue #51: Understanding Balance Sheet Capacity
Part 1: A General Overview
In Issue #20 of Monetary Mechanics, I introduced the concept of “balance sheet capacity.”
I talked about this idea recently on an interview with Jack Farley (@JackFarley96) and Joseph Wang (@FedGuy12) for Blockworks’ Forward Guidance podcast, which you can watch here:
I also scratched the surface of this idea recently in the second half of this Twitter thread here:
However, due to my dissatisfaction with my ability to completely and coherently explain this concept, as well as my increasing awareness of the fact that this concept is an important yet frequently poorly understood feature of modern financial markets, I am going to use this issue of Monetary Mechanics to break this difficult concept down into digestible pieces.
Let’s start with a series of anecdotes:
A Taiwanese life insurer funds/finances its holdings of US dollar-denominated securities by rolling a series of 3-month foreign exchange swaps with a large Japanese bank.
The aforementioned large Japanese bank funds/finances a portion of its foreign exchange swap book by issuing US dollar-denominated liabilities (e.g. certificates of deposit, commercial paper, etc.) to US dollar-denominated money market funds (not necessarily located in the US) or by getting a US dollar-denominated interbank loan.
A US corporation issues floating rate credit at LIBOR + 250 bps, as it is unable to issue credit at fixed rates. This US corporation hedges its interest rate risk by engaging in a floating-for-fixed interest rate swap with a large US dealer bank. While it waits for a suitable investment, it stores the excess funds in a US dollar-denominated money market fund not located in the US that invests in the US dollar-denominated liabilities of the large Japanese bank.
The aforementioned large US dealer bank posts initial margin for its interest rate swap with the US corporation using collateral acquired from reverse repo with a small non-bank dealer, swapping the small non-bank dealer’s non-pristine collateral for US Treasury securities held by a pension fund (i.e. performing a collateral swap or a collateral transformation trade).
The aforementioned small non-bank dealer funds/finances its holdings of securities by repos with a global systemically important bank (G-SIB).
Meanwhile, all of the above financial institutions use risk models that are partially based on value-at-risk (VaR) models built on a 30-day lookback period and a 95% confidence interval.
While this series of anecdotes is stylized, this is a not entirely unrealistic snapshot of the hundreds of trillions of dollars of cross-border financial assets and liabilities that exist at any given point in time around the globe.
What is the point in presenting these examples in such an explicit manner?