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Monday, June 22, 2009


the bank cash pile

i drew this up a couple weeks ago, but it is still quite salient.

via zero hedge -- david rosenberg on CNBC highlights the $1tn in accumulated cash assets on the systemic bank balance sheet as a potential sink for treasuries to finance government issuance.

this is a point in need of exploration. i've often alluded to richard koo, who would i think be first to tell you that such idle cash locked in banks is exactly the cash government should be borrowing.

so why aren't they? instead, it appears that long-end treasury yields are rising, steepening the yield curve in the face of a massive issuance schedule, while banks earn less than you might think from net interest margin.

well, the answer to some extent is that they are buying treasuries, as seen in the fed's h.8 report. but it would seem that, as was noted by the other talking head, the banks are simply not buying 10s and 30s, instead favoring the shorter durations. it is a commonplace that policy rates will be low for a long time, and that leaves the banks a surer risk-adjusted profit in buying, say, the three-year and waiting as the duration shortens and yield declines. this has been used to explain why treasury auctions for the middle of the curve have done rather better than those for the long end.

i further wonder, if i might think aloud for a moment, if the reason isn't that some banks are wary of funding long-duration treasury (or any other) investment profitably at yields too narrow to their cost of funding. as i've started to repeat as a mantra ad nauseum, american banks are heavily reliant on wholesale funding -- and wholesale funding can be expensive.

LIBOR is under 1% now and fed funds even less, if you have unpledged collateral and access to the window. but not very long ago LIBOR was 5%, and it is not entirely self-evident that such conditions cannot return in a reprise of the credit crunch. moreover, the financial times points out that not all banks can fund very near LIBOR.

[A]nalysts and bankers warn that Libor rates may not be telling the full story.

That is because there are wide differences between the rates at which individual banks can borrow. The biggest institutions are able to fund themselves at around Libor levels while smaller institutions have to pay, in some cases, more than 100 basis points above Libor. This is explained by continuing counterparty risk in what remains an uncertain economic environment.

That contrasts with the situation before the credit crisis when institutions paid similar rates to borrow.

Meyrick Chapman, fixed income strategist at UBS, says: “We should not build up our hopes that the fall in Libor is such a positive sign for the markets. We have a very tiered market, where many smaller banks are still having to pay relatively high rates to borrow.”

Lena Komileva, head of market economics at Tullett Prebon, adds: “What we are seeing is a huge difference in the price of borrowing for individual banks. There is a higher proportion of banks paying above Libor.”

is it possible that the banks are factoring a contingency where wholesale funding becomes much more expensive while long-duration treasury bonds do not rally -- or yields even rise from current levels, compelling banks to liquidate at a loss? in comparison to riding the duration of a three-year down to zero, it is a riskier trade.

perhaps most importantly in the bigger picture, however, banks are very probably faced in the intermediate term with weening themselves off a large measure of their wholesale funding through a combination of deposit growth and balance sheet reduction, a commitment at odds with growing the investment portfolio on the asset side. though now funded with the aid of the federal reserve, there has been a lot of discussion of 'exit strategies' to imply that central bank aid may not be indefinitely durable -- meaning that, sooner or later, the banks must cover their own assets. and that could be a big job -- in a domestically-chartered system with $8.6tn in assets, just $5.8tn is funded by nontransactional deposits, leaving a $2.8tn potential funding gap.

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As you know I'm a believer in the "banks buying treasuries" perspective... however in the short term they are just as likely to misjudge the macro outlook as anyone else and put money on reflation/inflation. Even PIMCO seems to be talking about buying TIPS and avoiding regular treasuries for fear of inflation! (Of course perhaps they are just trying to talk down prices).

"banks are very probably faced in the intermediate term with weening themselves off a large measure of their wholesale funding through a combination of deposit growth and balance sheet reduction, a commitment at odds with growing the investment portfolio on the asset side."

I agree that expensive liabilities seem likely to get paid down with available cash, shrinking balance sheets... But as I discussed in my previous writeup I linked regarding this, this leaves those repaid funding providers with available cash assets to invest (instead of wholesale deposits), and with aggregate private assets contracting, these funders seem as likely to buy treasuries on net as the banks would have been, IMO.

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hbl -- i'm pondering your point...

for example -- bank A uses cash to pay down an interbank funding liability to bank B. bank B does likewise to bank C. bank C does again to bank D. the same cash has eradicated three times its value in leverage -- and i have to imagine the multiplier is larger than that. the cash asset can be exchanged for treasuries, but the reduction in systemic balance sheet capacity before it is is a multiple of the cash.

as the current account imbalance narrows, i think it will really only once wholesale funding is reduced to much lower levels that cash can actually start to pile up in banks' investment portfolios (provided it cannot be lent).

fwiw -- it also has to be noted that much of the 'cash' on a corporate or financial balance sheet is really 'cash equivalents' and in fact already holding t-bills -- in other words, already funding the government to some extent. using the cash equivalents to buy t-bonds would mean selling t-bills in many cases.

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Regarding your bank A -> bank D deleveraging scenario, I agree with these mechanics... I hadn't argued that shrinking balance sheets would magnify purchasing power (and therefore potential treasury demand), I simply argued that such purchasing power is preserved whether or not each individual firm chooses to pay down liabilities (i.e., bank D has the same purchasing power bank A had). The key related point is that if public debt issuance does not grow faster than private debt contraction, all that is happening at a system-wide level is substitution of public debt for private debt, and public debt supply should see sufficient demand. [Of course Japan's public debt has grown much faster than private debt has shrunk, yet their JGB yields have declined regardless, so clearly other factors matter also, I'm just touching on the core point as I see it.]

On cash already being supportive of treasury issuance via t-bills -- I agree! (It's also a point I made here). Which is why I see the current run-up in yields as not driven by supply/demand inbalance (the latest flow of funds shows reduction in private lending slightly exceeding increase in public borrowing) or even expensive marginal cost of funds (since the phenonmenon has been global), but instead primarily reflation/inflation expectations. So for me the key question is simply whether reflation/inflation can succeed this time around before significant further deleveraging. The odds seem against it but maybe I'll be surprised.

P.S. Your blog has been better than ever in recent months. I can't figure out why it isn't better known (at least evidenced via links from other blogs I read).

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