We learned from a mention in FT Alphaville (an article "Shadow banking – from Giffen goods to Triffin troubles") about a recent IMF Working Paper entitled, "Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System by Zoltan Pozsar, which sheds some light about the institutional cash management space beyond money market funds, and proposes renaming the "shadow" banking system the "market-based financial system". The paper's Abstract says, "Through the profiling of institutional cash pools, this paper explains the rise of the "shadow" banking system from a demand-side perspective. Explaining the rise of shadow banking from this angle paints a very different picture than the supply-side angle that views it as a story of banks' funding preferences and arbitrage. Institutional cash pools prefer to avoid too much unsecured exposure to banks even through insured deposits. Short-term government guaranteed securities are the next best choice, but their supply is insufficient. The shadow banking system arose to fill this vacuum. One way to manage the size of the shadow banking system is by adopting the supply management of Treasury bills as a macroprudential tool."
Posner, who previously wrote about "shadow" banking at the New York Federal Reserve Bank, writes, "This paper aims to answer the question why the bulk of institutional cash pools are not invested directly in deposits in the traditional banking system but in deposit alternatives and primarily in the so-called "shadow" banking system. It analyzes the portfolio allocation rationale of institutional cash pools with the aim to better understand the systemic risks inherent in their allocations presently. To the best of the author's knowledge, this paper is the first to study the phenomenon of institutional cash pools and to ask why wholesale funding markets have grown, what the growing presence of institutional cash pools means for financial stability, and whether, in the context of the rise of institutional cash pools, the effectiveness of an official safety net for banks and deposits only has been eroding over time."
He explains, "The paper builds on other analyses that link the recent financial crisis to demand for safe assets (see Acharya and Schnabl (2009), Caballero (2010), and Bernanke (2011)). According to these views, the financial crisis was driven by an insatiable demand from the rest of the world for safe, high-quality (that is, AAA) debt instruments, which the U.S. financial system produced through the securitization of lower-quality ones. This paper adds two new dimensions to these views. `First, it differentiates between demand for long-term AAA assets (the focus of the above papers) and short-term AAA assets (the focus of the present paper). Second, it expands the discussion of the demand for AAA assets from foreign central banks' demand for long-term AAA assets, to U.S. domiciled, but globally active non-financial corporations' and U.S. domiciled institutional investors' demand for short-term AAA assets. Throughout this paper, the demand for short-term AAA assets is referred to as the demand for insured deposit alternatives (see Gorton (2010), Stein (2010) and Krishnamurthy and Vissing-Jorgensen (2010)), and demand for them is explained by the secular rise of institutional cash pools."
Pozsar continues, "In the context of the global savings glut, institutional cash pools' demand for short-term AAA assets can be viewed as the flipside of foreign central banks' demand for long-term AAA assets. In turn, cash pools' demand for short-term AAA assets is the principal source of marginal demand for maturity transformation in the financial system. The paper has five conclusions. First, insured deposit alternatives dominate institutional cash pools' investment portfolios relative to deposits. The principal reason for this is not search for yield, but search for principal safety and liquidity. Second, between 2003 and 2008, institutional cash pools' demand for insured deposit alternatives exceeded the outstanding amount of short-term government guaranteed instruments not held by foreign official investors by a cumulative of at least $1.5 trillion; the "shadow" banking system rose to fill this gap. From this perspective, the rise of "shadow" banking has an under-appreciated demand-side dimension to it."
He adds, "Third, institutional cash pools' preferred habitat is not deposits, but insured deposit alternatives. This is to say that institutional cash pools' money demand is satisfied by non-M2 types of money. This is because institutional cash pools' money demand is not for transaction purposes, but for liquidity and collateral management as well as investing purposes, which aren't best met by deposits, but by Treasury bills and repos. Fourth, the larger institutional cash pools and their demand for insured deposit alternatives grows relative to the supply of short-term government guaranteed instruments in the financial system, the less effective deposit insurance and lender of last resort access for banks only will be as stabilizing forces in times of crises. Fifth, an elegant way to solve the financial system's fragility due to the rise of institutional cash pools and "shadow" banking would be to issue more Treasury bills and to explicitly incorporate the supply management of bills into the macroprudential tool kit. While not without costs or alternatives, this approach is less troublesome and complicated than the alternative of intense real-time monitoring and regulation of the shadow banking system."
Finally, the intro explains, "The paper has six remaining sections. Section II measures the size of institutional cash pools in the non-financial corporate sector in the U.S. and globally, and among institutional investors in the U.S. Section III discusses the philosophy of how institutional cash pools attain security for their funds. Section IV discusses the portfolio allocation details of institutional cash pools and -- in light of these details -- highlights the gap between the accounting concept of cash equivalents and the scope of traditional monetary aggregates. Section V discusses the U.S. banking system's Triffin dilemma. Section VI provides policy recommendations and asks whether Basel III, higher deposit insurance limits and the repeal of Regulation Q will adequately deal with the secular rise of institutional cash pools and the systemic risks their safety preferences engender. Finally, Section VII concludes with offering an alternative, "non-arbitrage" explanation of the raison d'etre of the "shadow" banking system, and accordingly, proposes to rename it the market-based financial system."
