Improving resilience: banks and non-bank intermediaries

Debt causes fragility. When banks lack equity funding, even a small adverse shock can put the financial system at risk. Fire sales can undermine the supply of credit to healthy firms, precipitating a decline in economic activity. The failure of key institutions can threaten the payments system. Authorities naturally respond by increasing required levels of equity finance, ensuring that intermediaries can weather severe conditions without damaging others.

Readers of this blog know that we are strong supporters of higher capital requirements: if forced to pick a number, we might choose a leverage ratio requirement in the range of 15% of total exposure (see here), roughly twice recent levels for the largest U.S. banks. But as socially desirable as high levels of equity finance might be, the fact is that they are privately costly. As a result, rather than limit threats to the financial system, higher capital requirements for banks have the potential to shift risky activities beyond the regulatory perimeter into non-bank intermediaries (see, for example here).

Has the increase of capital requirements since the financial crisis pushed risk-taking beyond the regulated banking system? So far, the answer is no. However, in some jurisdictions, especially the United States, the framework for containing systemic risk arising from non-bank financial institutions remains inadequate….

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Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

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