Fed Paper on ABCP and Banks
The Federal Reserve Board posted an April "International Finance Discussion Paper" entitled, "Revenge of the Steamroller: ABCP as a Window on Risk Choices." It's "Abstract" says, "We empirically examine financial institutions' motivations to take systematic bad-tail risk in the form of sponsorship of credit-arbitrage asset-backed commercial paper vehicles. A run on debt issued by such vehicles played a key role in causing and propagating the liquidity crisis that began in the summer of 2007. We find evidence consistent with important roles for both owner-manager agency problems and government-induced distortions, especially government control or ownership of banks." The paper's introduction explains, "We use credit-arbitrage asset-backed commercial paper (credit-arb ABCP) vehicles to offer evidence on the reasons major banks exposed themselves to systematic bad-tail risk in the period leading up to the financial crisis that began in 2007. By systematic bad-tail risk we mean exposure to large losses in low-probability states of the world, especially states in which such losses are unusually costly, such as when risk premiums are high. In July of 2007, just before a run on their liabilities began, credit-arb ABCP vehicles had about $700 billion in assets. Most were sponsored by banks that provided their vehicles with committed backup lines of credit and other support, so sponsors bore the vehicles' risks. When vehicles experiencing ABCP runoffs turned to their sponsors for funding, the sponsors sought large amounts of new funding in interbank and other money markets. Most sponsors were European banks but most vehicle assets and liabilities were denominated in U.S. dollars; thus, sponsoring banks were forced to raise funds outside their home money markets and their national central banks were not immediately able to provide dollar liquidity support. This increased the cost to sponsors and also helped transmit the ABCP shock throughout the global financial system."
