Issue #52: The Origins and Evolution of the Modern Monetary System
Part 8: "Liability Management" – Repo as a Liability Management Tool
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 first issue of this installment, 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.
In the second issue of this installment, I covered the first part of “liability management” and the re-emergence of wholesale finance, focusing on the development of the domestic federal funds market.
In the third issue of this installment, I covered the second part of “liability management” and the re-emergence of wholesale finance, focusing on the development of the international Eurocurrency/Eurodollar banking system.
In the fourth issue of this installment, I continued covering the development of the international Eurocurrency/Eurodollar banking system, focusing on the entrance of US banks into the Eurocurrency/Eurodollar borrowing and lending market.
In the fifth issue of this installment, I covered the third part of “liability management” and the re-emergence of wholesale finance, focusing on the development of large negotiable certificates of deposit (CDs).
In the sixth issue of this installment, I covered the fourth part of “liability management” and the re-emergence of wholesale finance, focusing on the development of bank holding companies (BHCs).
In the seventh issue of this installment, I covered the fifth part of “liability management” and the re-emergence of wholesale finance, focusing on the expansion of commercial paper (CP), and in particular how it, along with the passage of the Bank Holding Company Act of 1956, permitted banks even further flexibility in their management of their funding/financing sources.
If you have not had a chance to read Issue #8, Issue #11, Issue #16, Issue #28, Issue #33, Issue #41, and Issue #42 of Monetary Mechanics yet, I suggest you do before continuing below, as it contains important information, but here is a brief review for you if you need it.
A Summary of the Origins and Evolution of the Modern Monetary System
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.
The development of the private market for Federal Funds permitted large money-center banks to borrow reserves from small countryside banks, enabling large money-center banks to deliberately operate with a structural short position, where they lent more than they had reserves on hand, knowing that they could borrow the difference in the federal funds market, for the purpose of expanding their marginal lending activities. More importantly, the development of the private market for Federal Funds spearheaded the redevelopment of an informal interbank network that, together with other methods of liability management that I will soon cover in this and other issues of Monetary Mechanics, began to transform the model of banking from a deposit-facing one to an interbank-focused one.
As US dollar deposits found their way offshore and onto the balance sheets of banks in London, Paris, Frankfurt, and Zurich, the Eurocurrency/Eurodollar banking system emerged as a supranational, informal interbank network that linked the world’s various financial systems into one tightly woven web. Consequently, this evolution led to the emergence of a structure of international interest rates that were (and still are) distinct from, as well as largely independent of, national interest rates – a development that is without parallel in modern economic history.
As US dollar deposits found their way offshore, the onshore market also developed new and much more flexible forms of bank deposits that allowed banks to lock up funding/financing at flexible rates for longer periods, resulting in banks being able to “bid” for funding/financing. The development of large negotiable certificates of deposit (CDs) in 1961 transformed the traditionally illiquid retail and corporate time deposit into a truly liquid money market instrument. Consequently, this broadened and diversified the menu of liability management options offered to banks, permitting banks to better optimize their balance sheet structures, as well as permitting banks to circumvent the Federal Reserve and continue providing credit to their most important clients/customers, even in times of tight monetary policies.
During the same time as this evolution of new monetary techniques, new legal and regulatory measures also evolved, allowing banks to conduct a broader array of activities than before. The assortment of asset and liability management options available, first to one-bank holding companies and then later to multi-bank holding companies, facilitated the proliferation of all the aforementioned activities (e.g. federal funds borrowing/lending, eurocurrency/eurodollar banking, and large negotiable certificates of deposit), as well as permitted banks to provide novel types of liabilities (e.g. commercial paper). Consequently, the Bank Holding Company Act of 1956, and its amendments, constituted a landmark piece of financial legislation that formed one of the first steps in a long road of financial deregulation that broadened the range of permissible non-banking activities for banks.
The expansion of commercial paper (CP) during the 1960s and the 1970s added yet another option to the liability management repertoire of American banks. While commercial paper had been a staple of American finance for more than 100 years, it was the passage of the Bank Holding Company Act of 1956, which clarified the legal and regulatory status of BHCs, that enabled them to issue commercial paper from their nonbank subsidiaries, where it was exempt from reserve requirements, interest rate ceilings, and Federal Deposit Insurance Corporation (FDIC) insurance premiums.
In this issue of Monetary Mechanics, I will complete my coverage of certain changes to the money and banking paradigm that can collectively be called “liability management” and the re-emergence of “wholesale finance.” In this issue of Monetary Mechanics, I will cover the last major innovation in liability management, which is 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.
Dealers and the Dawn of the Repo Market
Repurchase agreements (a.k.a. repos) were first put into practice by the Federal Reserve Banks in 1916. After WWI, the Federal Reserve System tried to encourage the development of a money market mechanism that would expedite transfer of ownership for bankers’ acceptances and US Treasury certificates of indebtedness. However, it quickly became obvious that dealers in these two types of paper, if allowed direct access to Federal Reserve Banks, would have to be materially assisted. Although the Federal Reserve Act of 1913 did not authorize direct lending to dealers, the Federal Reserve System found an answer in the use of repo.