Issue #53: The Origins and Evolution of the Modern Monetary System
Part 9: "Securitization" – Repo as a Driver of Securitization
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 to the eighth issues of this installment, I covered “liability management,” particularly the novel banking techniques that were developed primarily during the 1950s and the 1960s, which permitted banks to invert the traditional model of banking, by permitting them to “bid” for non-deposit liabilities in order to fund/finance their desired levels of assets.
These innovations in “liability management” included the development of the domestic federal funds market, the development of the international Eurocurrency/Eurodollar banking system, the issuance of negotiable certificates of deposit (CDs), the issuance of commercial paper (CP) by bank holding companies (BHCs), and the (re)development of the repurchase agreement (repo) market by government securities dealers.
These innovations in “liability management” introduced elasticity in a once dormant banking system, as well as lifted the post-Great Depression constraints on bank balance sheet capacity.
In this and the following issues of Monetary Mechanics, I will cover the birth of “market-based finance,” a phenomenon that is primarily characterized by the disintermediation of traditional banks and banking techniques in favor of securitization. Securitization includes, as mentioned above, the proliferation of mortgage-backed securities, high-yield bonds, and the first asset-backed securities, as well as the increased issuance of corporate bonds (as opposed to loans). In addition to the increasing importance of liquid and tradable securities, securities dealers also played an increasingly important part in this new world. There is an apt analogy to be made between the function of banks in the period of bank-based finance and the function of securities dealers in the period of market-based finance – securities dealers started to function as financial intermediaries, borrowing and lending funds and securities, finally transforming into bona fide “shadow banks.”
In this issue of Monetary Mechanics, I will cover the changes in repo contracting conventions that occurred primarily during the 1980s, something that made the birth of “market-based finance” possible in the first place.