Not just an empty suit.
Hi! It's Ask a Banker! Once again, I'm a former banker, current Dealbreaker editor and occasional answerer of questions here. Send more questions to email@example.com with "ask a banker" in the subject line, or ask on Twitter (@planetmoney). This week's question comes from Ellen in Minneapolis and I think you'll like it:
Q. Please explain what the tri-party repo market and (commercial?) paper market are and why they are important.
We may need to start at the end — "why they are important" — because while Ellen might just be curious about tri-party repo, there's some chance that no one else cares. One classic way to make people care is to swap boring-sounding terms for scary-sounding terms, since everyone likes to be scared. So:
SHADOW BANKING! Is SHADOW BANKING scary enough for you?
Tri-party repo and commercial paper are key parts of the shadow banking system. And shadow banking is like banking, only shadier, which is saying something.
This requires a quick detour into: What is banking?
Banks take your money, lend it to someone else, and give it back to you when you want it back. Of course, instead of me putting money in a checking account at Chase, and my neighbor taking out a mortgage from Chase, I could just lend money to my neighbor directly. Why not do that? Why do we need a bank? Here are three reasons.*
1. Credit intermediation. Banks decide who should get loans. I don't know if my neighbor is going to pay back any money I lend him, and I don't have any expertise in finding out. The bank — hopefully — does.
2. Diversification. Even if my neighbor is a trustworthy guy, he might still end up unable to pay back his mortgage. If I lend him all my money and he's hit by a bus, that's bad for me. (Worse for him, but this is Ask A Banker, not Ask A Humanitarian.) Banks take money from lots of savers and give it to lots of borrowers, so any one borrower's default doesn't hurt any one saver too badly.
3. Maturity transformation. My neighbor wants to pay back his mortgage over 30 years; I want to be able to get my money back whenever I walk by an ATM. Banks solve this through another sort of diversification: everyone can take their money out at any given time, but only a fraction of them will. Mostly. Sometimes this function breaks down, and people try to take out more money than the bank can access quickly. This is called a "run on the bank," and it is bad, and much of modern banking is structured around preventing it.
So those are the textbook reasons to put your money in a bank rather than just lending it to some random guy. But in the real world there are some good reasons not to put your money in banks. One is: Banks aren't always all that good at banking. Perhaps you've noticed. Why would you give all your money to Citibank?
For you and me, the answer is mostly "deposit insurance": If Citi loses all your money, the U.S. government will give it back to you. The government charges banks for this insurance, and also regulates to make sure that banks are healthy and at least try not to lose your money.
Deposit insurance covers accounts of up to $250,000. That's more than enough for most people. But if you are, say, a big company that needs to keep a lot of cash around to pay all your workers, you're going to have way more than $250,000 lying around. You could just put money in uninsured bank deposits, but that approach is pretty risky, because, y'know, banks.
There's also interest. Different places to park your money for short periods of time pay different amounts of interest. If you're parking a lot of money, you might want to park it at a place that pays more interest than your local intergalactic bank.
Investors who want yield or safety that banks can't provide turn to shadow banking: institutions that provide some of the credit intermediation, diversification and maturity transformation benefits of banking, but without being banks. And without being regulated like banks.
Let's say you're a corporate treasurer and you have $50 million that you need to have constant access to, to pay bills and stuff. It's what you call "cash" on your corporate balance sheet. One thing you could do is just keep it in literal cash — a pile of 5 million $10 bills in the break room — but no one does this for logistical reasons. (How do you get it to your Dubuque office?)
Another thing you could do is put it in a checking account at a bank, but with $50 million you're taking a lot of risk that your bank won't blow itself up tomorrow, and getting 0.00% interest on $50 million isn't that appealing.
But what if someone else — say a hedge fund, or an investment bank — came to you and asked to borrow $50 million, and told you that you could get it back whenever you wanted, on one day's notice? That's the same deal your bank is offering, except that it's a hedge fund or investment bank, which is even riskier than your local savings bank.
Ah, but the hedge fund says: I'll give you collateral! And I'll pay you interest! So it'll be safer than leaving your money at the bank, and maybe more lucrative. Here's how it'll work:
1. Today, you give me $50 million, and I give you high-quality bonds worth, say, $55 million.
2. Tomorrow, you give me back my bonds, and I give you back $50 million plus a teeny bit of interest.**
Even more important, the way it works when it doesn't work is:
1. Today, you give me $50 million, and I give you bonds worth $55 million.
2. Tomorrow, I'm bankrupt/nowhere to be found.
3. So you sell my bonds for, let's say, $54 million, and still get your money back with interest.***
4. So that's nice.
This is called "repo," which is a dumb word. First of all, it's short for "repurchase," which you might note doesn't contain an "o." Second, it's probably better to think of it as a secured loan — a loan with bonds (or stocks, etc.) as collateral — than as a "repurchase."
But technically, yes, I'm selling you those bonds for $50 million today, and we're agreeing that I'll repurchase them tomorrow for $50 million plus interest, so, sure, "repurchase."
The collateral serves some of the same purpose, for shadow banking, as the government guarantee serves for regular banking: it protects the person looking for a place to park cash. It's not quite as good as the government guarantee, since there's always the possibility that the collateral will lose value faster than you can sell it. (Often when the borrower is going bust, markets are crashing, so maybe that $55 million of bonds is now worth only $45 million.) But it's pretty good, particularly if, as is often the case, the borrower is handing over U.S. Treasury bonds. In a sense, having U.S. Treasury collateral for your loans is as good as a government guarantee.****
In any case, you get collateral worth more than what you lend. The difference is called the "haircut," and it's what makes repo feel safe. Typical haircuts range from 2 percent for U.S. Treasuries to 5 to 15 percent for stocks.
There's plenty of "bilateral repo," which is just people with money — largely big Wall Street banks — lending to people with securities — other banks and hedge funds — directly. And then there is "tri-party repo," which is a coordinated market run by two banks, J.P. Morgan Chase and Bank of New York Mellon.
In this market, many of the people looking for a place to put their cash are money market funds (more on them later), and the borrowers are mostly Wall Street banks and some big hedge funds. It's tri-party because, besides the lender and the borrower, there's JPMorgan or BoNY in the middle of each trade as the custodian, which means that those two banks hold onto all the money and all the securities, and keep track of all the accounts.
In other words, tri-party repo market is an enormous series of entries into the computer systems at Bank of New York and JPMorgan, to the tune of $1.9 trillion of loans outstanding every day. It's the plumbing by which Wall Street banks and hedge funds get short-term funding to finance their investments, and by which money market funds and other cash investors invest their money.
Well, one way they invest their money. Another is commercial paper. Commercial paper, or CP, is kind of boring. It's just lending money to companies for a short time. For the companies, it's like issuing bonds, only instead of borrowing at a fixed rate for 5-10 years, they borrow at a fixed rate for, like, a week.
The companies that issue commercial paper are disproportionately banks and other financial firms. "Nonfinancial companies" — companies that make things other than money — account for under 20 percent of the more than $1 trillion of commercial paper outstanding.
So: CP is kind of like big bank deposits? Instead of putting $200 in the bank and being able to withdraw it at any time, you put $20 million in the bank and get it back — with interest — in a week or whatever.
Why buy CP if you're worried about banks? The answer is mostly that you wouldn't, but your money market fund would. You, Ellen, probably don't invest your spare cash directly in the tri-party repo or commercial paper markets, and neither do most corporate treasurers. But you may, and they do, invest your spare cash in money market funds. If you have a retirement account, and you think some of the money in that account is in "cash," chances are it's actually in a money market fund.
Money market funds are the gateway drug of shadow banking. They're mutual funds — pools of people's money — that invest in short-term, cash-like instruments. Some of them are limited to government bonds, but others invest in what we've been talking about. Repos. Commercial paper. Here is a list of holdings of one money market fund; note the preponderance of "Repurchase Agreement" and "Financial Company Commercial Paper" among its holdings.
Money market funds are like bank accounts, but often with higher yields, and with a diversification benefit: instead of putting all your money in one bank that might fail, you're putting it in a pool of money that buys the commercial paper of lots of banks (as well as repos), which are unlikely to fail all at once.
In these shadow banking markets, savers — people who put their money in money market funds, corporate treasurers, what have you — are lending money to hedge funds and banks to finance their purchase of long-term investments like loans, stocks and bonds. The savers have more or less ready access to their money, and more or less don't make individual credit decisions themselves. The intermediaries — money-market funds, hedge funds, banks, others — make the investing decisions. The ultimate borrowers — corporations, mortgage borrowers, etc. — get long-term money.
So there's an extra step or two, but shadow banking is a lot like, just, banking.
With an important difference: banking is a highly regulated beast.***** Shadow banking, not so much. Recent proposals to increase money market fund regulation have been met with howls of protest. And money market funds are relatively more regulated than lots of other shadow-banking bits.
This suggests one other reason why you might end up putting your money in a shadow bank than in a regular bank: the shadow bank is having more fun. It can offer a higher yield, lure you with promises (possibly true!) of greater safety, and just generally operate with lower levels of regulatory interference than a regular bank. But when things go bad in the shadow banking world, without deposit insurance or other protections, they tend to go even worse than they would in the banking world.
This kind of sets a limit on bank regulation. If you want to increase bank regulation, you have to consider not only "is this a good idea" but also "will this drive people from banks to shadow banking, and if so, will it end up making the system as a whole riskier instead of less risky?" If the answer is yes, you may find that you prefer banks as they exist to the shadowy things that might replace them.
* If you'd like a sophisticated and entertaining discussion of what banks do, try this delightful Interfluidity post. Here is another good, very classical explanation of banking.
** Here you will find prevailing "GC repo rates," which are around 0.20 — 0.25%. That's per year. So in the example in the text, I pay you back $50,000,273.97 ($50mm + [$50mm x .002 x 1/365]). Congratulations, you made $273.97 in interest on your $50 million! But it adds up; there's some $300bn of DTCC GCF repo traded each day.
*** And then you give me back the $3,999,726.03 that you have left over after selling the bonds and taking back your cash with interest, in theory. In practice we just sue each other forever.
**** In the narrow sense of "ignoring interest rate risk," whatever. Incidentally, this description of collateral as serving the function for shadow banking that deposit insurance serves for regular banking is motivated by the work of Zoltan Pozsar, among others. Basically if you find an economics paper about things like the "safe asset shortage," "collateral velocity," or "shadow banking," it's going to be delightful. I mean, if you like that sort of thing. But here you are in footnote ****** of a post about shadow banking so, y'know, what does that say about your tastes?
***** I know, you think: not regulated enough! And you might be right: modern banks are more or less creatures of the state, so the state has a significant interest in meddling in their affairs, and different people think the current level of meddling is too high, too low, or — very rarely — just right.