If you’ve read Gorton, this is the next step, by Zoltan Pozsar. It emphasizes demand-side motives, from large corporate and financial cash holders, for finding something safer than deposits, given the cap on the FDIC guarantee. Here is one bottom line:
…if institutional cash pools continue to rely on banks as their credit and liquidity put providers of last resort, the secular rise of uninsured institutional cash pools relative to the size of insured deposits is going to make the U.S. financial system increasingly run-prone, not unlike it used to be prior to the creation of the Federal Reserve and the FDIC…
Another bottom line, my interpretation rather than any direct claim of the author, is that financialization of the economy, combined with some stagnation on the real side, may have led to permanently low rates on T-Bills, given their value as collateral. Maybe that is what low rates of interest are telling us.
For the pointer I thank Jeff Downing.
Yes; there’s plenty of financial capital, not enough entrepreneurs with good ideas about where to invest to make positive rates of return.
Financial regulation should include limits on AAA rated bonds; with separate ratings for commercial and gov’t. The larger the total amount of AAA (top) rated bonds/ instruments, the more fragile the system is. Part of reducing systemic risk should be limiting the total amount of AAA rated places.
There should be a rule like: for any rating agency, the total value of AAA rated commercial instruments cannot be larger than the previous year’s total GDP of that country. Such a rule in 2003-ish would have made new MBS / CDOs much less likely to get the top rating, and thus be used as Tier 1 capital by banks for their own capital requirements.
Once the cap is reached, for a new issue to get the top rating, some prior issue would have to be downgraded. In general, more volatility in ratings should lead to more short term uncertainty and greater fundamental scrutiny, with less total systemic risk.
If Treasurys are money, are they part of the shadow banking system and a form of inflation?
So Treasuries are like a bank account, being very liquid and so far reasonably safe, becoming a defacto deposit account.
So you have one of the 10 years that were just issued, below 3%. You wanted somewhere to put your money while Europe falls apart, etc. Demand was high, so yields are low.
In 3 years time Bernanke moves interest rates higher. Your 10 year is now worth less on the market, you lost money. If there is a sudden move, unexpected, everyone who has these low yield treasuries wants to get rid of them. If there are enough sellers, panicked enough, we end up with essentially a run on the bank, with the cascading liquidations from leverage and collateral requirements.
I wonder how constrained the Fed is by these considerations.
The “run-prone” financial system pre-Federal Reserve and FDIC may not have actually been that bad. From the link:
“I might add that the losses on bank deposits during the great financial panics of the U.S. National Banking Era (1863-1913) were reportedly in the order of 50 basis points.”
http://andolfatto.blogspot.com/2011/08/bad-rap-for-bond-raters.html
i agree that rates are likely to stay low, although I’d put more weight on your “Great Stagnation” hypothesis as a reason.
Tom,
I got that estimate from Gary Gorton’s work. But should stress that just because ultimate losses were small, this does not mean the financial panics were largely innocuous. Far from it. The disruption in the payments system was severe.
If equity levels in traditional banks were determined by bank executives and their creditors operating under market incentives, instead of by distortive guarantee policies and the political economy of bank regulation, wouldn’t there be less incentive for institutional depositors to seek alternatives outside of traditional banking, since their deposits in the traditional sector would be buffered by more equity?
Also, with regard to the paper’s implications for growing systemic risk due to supposedly depositor-driven growth in securitized banking, is it not true that the parts of the shadow banking system that did significantly contribute to the crisis were directly related to banks in the regulated system—and to the failure of regulators to properly deal with the institutions in their domains.
A very annoying paper for someone who prints it out in black and white.
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