As we wrote last Wednesday (Crane Data News "Vulnerabilities Remain in Money Funds, Cash, Says OFR Annual Report"), the U.S. Department of the Treasury's Office of Financial Research (OFR) recently released its "2013 Annual Report, which "identifies threats to financial stability and tools to monitor them." Below, we excerpt more from the report, this time focusing on "The Supply and Demand for Short-Term Funding." The OFR report says, "Investor runs on short-term funding instruments played a critical role in the recent financial crisis. Private sources provided liquidity and credit backstops in short-term funding markets. When investors doubted the safety of those guarantees, they quickly withdrew their funding, and this stress was transmitted and amplified through the financial system. Although those markets have stabilized, they remain vulnerable to runs and fire sales. Analysis is important to ascertain the nature of such vulnerabilities."
It explains (starting on page 50), "This section describes a preliminary analysis of the supply and demand for short-term funding instruments and markets. Following tradition, we analyze the uses or demand for short-term funds -- the ways that issuers use money-like liabilities to fund longer-term assets. We also analyze the sources or supply of such funds -- the characteristics of the purchasers and the nature of their preference for such money market instruments. Focusing on both sources and uses highlights gaps both in the available data and in the analysis of economic forces that drive the market for money market instruments."
The report continues, "Financial intermediaries often finance long-term, illiquid investments with short-term, liquid liabilities, such as commercial paper and repos. Nonbank financial companies using such short-term funding vehicles may be exposed to runs and other vulnerabilities as the activities of liquidity and maturity transformation create potential mismatches, and their funding instruments aren't protected by deposit insurance or access to liquidity from the central bank. Creditors worried about the creditworthiness of their claims may withdraw funding, potentially resulting in significant losses that can lead to fire sales and failure. The recent financial crisis highlighted these vulnerabilities."
It tells us, "To reduce the apparent risk and cost of credit in such liquid funding vehicles, issuers made use of private credit and liquidity guarantees -- such as bank-provided, standby lines of credit for commercial paper. During the crisis, investors realized that those guarantees could be withdrawn or had doubts about the capacity of private firms to provide such guarantees. Liquidation of opaque, risky collateral by nonbank intermediaries promoted fire sales, which were intensified by runs on their funding sources, resulting in a dramatic, rapid deleveraging, and contraction in both sides of balance sheets."
The OFR adds, "Despite that shrinkage, securitization and short-term, wholesale funding vehicles remain important features of a market-based financial system. More than 60 percent of credit transactions are intermediated outside insured depository institutions. New requirements for higher capital and liquidity by traditional banks and their parent holding companies may create incentives to move activities to more lightly-regulated institutions. Accordingly, analysis of short-term funding markets remains an important aspect of financial stability monitoring. In this preliminary analysis, we examine both the borrowers who use short-term funding and the investors who supply it. However, the data available to describe and quantify the short-term funding marketplace are not sufficiently detailed to create a complete picture of both supply and demand. We identify the nature of these gaps and suggest ways to fill them."
The report discusses "Market-Based Financing and Money Market Instruments," saying, "Market-based financing, or credit intermediation outside the commercial banking system, gave rise to financial stability concerns during the crisis. In this analysis, we focus specifically on the demand for, and supply of, money-market instruments that were considered "cash-equivalents" before the crisis. Investors held such assets in their portfolios because of their apparent low risk and high liquidity. Nonbank financial intermediaries conducted transformation of maturity, credit, and liquidity by creating or issuing such money-like liabilities. As noted earlier, however, these entities do not have explicit access to central bank liquidity or public sector guarantees (see Pozsar and others, 2012). So when these nonbank firms came under stress, investors ran. Analyzing both the demand for, and supply of, such instruments helps in understanding the risk of runs in short-term, wholesale funding markets."
It says, "Money market instruments are large-denomination debt instruments with low credit risk and short maturity (less than one year, and often less than one week). Demand for these instruments reflects a natural preference by many investors for liquidity, the ability to exchange their investments for cash on short notice at a particular price. Because of their short maturity and low credit risk, money market instruments are treated by many investors as though they guarantee payout at full or par value. Investors in money market instruments include retail investors. They also include institutional cash pools -- large, short-term cash balances of nonfinancial corporations and institutional investors (see Pozsar, 2011). Institutional cash pools allow a wide variety of financial firms, nonfinancial companies, foreign official sector investors such as central banks, and institutional investors such as mutual funds and pension funds to invest their surplus cash. Money market instruments include short-term obligations of the U.S. Treasury (Treasury bills) and commercial banking short-term obligations, such as uninsured certificates of deposits (large CDs), as well as short-term liabilities of shadow banks."
The OFR Annual Report continues, "From the perspective of investors in money market instruments, Treasury bills and short-term obligations of commercial banks are close substitutes for the short-term liabilities of shadow banking. However, there is a crucial difference: Treasury bills are backed by the full faith and credit of the U.S. government, and even uninsured large CDs of commercial banks are backstopped by access to the Federal Reserve's discount window. In contrast, shadow banking liabilities, which typically offer higher yields, are usually backed only by private -- not public -- guarantees. In some cases, these private guarantees may be provided by commercial banks, but even in such cases, nonbank liabilities are more distant from public sector backstops."
It adds, "Investors in money market instruments run when shocks trigger fears of default and prices of these instruments decline sharply, undermining the belief that the instruments can be redeemed at par. To avoid the adverse effects on the real economy from historical bank runs and subsequent failures of banks, governments have long chosen to provide banks with access to the lender of last resort and deposit insurance, while subjecting them to prudential regulation to reduce the moral hazard associated with this access. Absent such backstops, run risk is present in any short-term liability that finances a (even slightly) longer term asset. But different types of short-term instruments -- commercial paper, repos, money fund shares -- have different degrees of run risk. For example: If even a small money market fund breaks the buck, it can trigger a run on similar funds, which occurred with the Reserve Primary Fund on September 16, 2008."
