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The Stability of Funding Models Economic Policy Review Federal Reserve Bank of New York February 2014 February Economic Volume 20 Number 1 20 Number Volume Policy Review Special Issue: The Stability of Funding Models Economic Policy Review Editor Kenneth D. Garbade Coeditors Meta Brown Richard Crump Marco Del Negro Jan Groen Andrew Haughwout Stavros Peristiani Editorial Staff Valerie LaPorte Michelle Bailer Karen Carter Mike De Mott Anna Snider Production Staff Jessica Iannuzzi David Rosenberg Jane Urry Federal Reserve Bank of New York research publications—the Economic Policy Review, Current Issues in Economics and Finance, Staff Reports, Research Update, and the annual publications catalogue—are available at no charge from the Research Group’s website. www.newyorkfed.org/research Follow us on Twitter: @NYFedResearch Federal Reserve Bank of New York Economic Policy Review February 2014 Volume 20 Number 1 Special Issue: The Stability of Funding Models Contents 1 Introduction Tanju Yorulmazer Articles: 3 Literature Review on the Stability of Funding Models Tanju Yorulmazer Financial intermediaries have an important role as liquidity providers—they perform maturity and liquidity transformation by issuing liquid, short-term liabilities while holding illiquid, long-term assets. But there is an inherent fragility associated with this role. This article provides a review of the economics literature on the stability of banks and other financial intermediaries, with a policy-oriented focus on their funding models. Yorulmazer employs the standard framework used in the literature to examine the fragility of intermediaries that conduct maturity and liquidity transformation. He then considers potential factors that make them more or less stable. Developments in the financial sector that may have affected the stability of funding models are also discussed. 17 Case Studies on Disruptions during the Crisis Tanju Yorulmazer The 2007-09 financial crisis saw many funding mechanisms challenged by a drastic reduction in market liquidity, a sharp increase in the cost of transactions, and, in some cases, a drying-up in financing. This article presents case studies of several key financial markets and intermediaries under significant distress at this time. For each case, Yorulmazer discusses the size and evolution of the funding mechanism, the sources of the disruptions, and the policy responses aimed at mitigating distress and making markets more liquid. The review serves as a reference on the vulnerabilities of funding structures and is useful for those considering the scope and design of reform efforts. 29 Stability of Funding Models: An Analytical Framework Thomas Eisenbach, Todd Keister, James McAndrews, and Tanju Yorulmazer With the recent financial crisis, many financial intermediaries experienced strains created by declining asset values and a loss of funding sources. In reviewing these stress events, one notices that some arrangements appear to have been more stable—that is, better able to withstand shocks to their asset values and/or funding sources—than others. Because the precise determinants of this stability are not well understood, gaining a better grasp of them is a critical task for market participants and policymakers as they try to design more resilient arrangements and improve financial regulation. This article uses a simple analytical framework to illustrate the determinants of a financial intermediary’s ability to survive stress events. An intermediary in the framework faces two types of risk: the value of its assets may decline and/or its short-term creditors may decide not to roll over their debt. The authors measure stability by looking at the combinations of shocks the intermediary can experience while remaining solvent. They study how stability depends on the intermediary’s balance-sheet characteristics, such as its leverage, the maturity structure of its debt, and the liquidity and riskiness of its asset portfolio. They also show how the framework can be applied to examine current policy issues, including liquidity requirements, discount window policy, and different approaches to reforming money market mutual funds. Tanju Yorulmazer Introduction he financial crisis of 2007-09 highlighted the fragility sources of the disruptions, and the policy responses that Tof many financial intermediaries and markets. As asset were implemented to mitigate distress and make markets values declined and funding sources dried up, a significant and intermediaries more liquid. We analyze the markets number of commercial banks, investment banks, and money for auction rate securities, commercial paper, asset-backed market mutual funds experienced distress, as did some commercial paper, and bilateral and tri-party repo, as market-based intermediation arrangements such as asset- well as credit commitments by banks, dollar funding of backed commercial paper. Borrowing rates and haircuts non-U.S. banks, and money market mutual funds. We also reached record-high levels and some funding markets consider the fragility associated with wholesale funding, using completely froze. These difficulties were severe enough the run on Northern Rock as our case study. to cause several institutions to fail and others to require In reviewing recent events, we find that some markets and extraordinary public support. intermediaries appear to have been more fragile—that is, less This special issue of the Economic Policy Review examines able to withstand shocks to their asset values and funding the stability of different “funding models,” or arrangements for sources—than others. The third paper develops a simple financial intermediation. The first of the three featured papers is analytical framework to analyze the factors that affect markets’ a review of the economics literature on the stability of financial and intermediaries’ ability to survive stress events. A financial intermediaries, with a focus on intermediaries’ funding intermediary faces two types of risk: the value of its assets may models. The paper discusses the standard framework used in decline, and/or its short-term creditors may decide not to roll the literature to analyze the fragility associated with financial over their debt. We measure the stability of the intermediary institutions that perform maturity and liquidity transformation by looking at what stress events it can survive, that is, what and the potential factors that amplify or mitigate such fragility. combinations of shocks to the value of its assets and to its Furthermore, it reviews developments in the financial sector funding it can absorb and still remain solvent. We also study that may have affected the stability of funding models. how the intermediary’s stability depends on balance sheet The second paper presents case studies of several major characteristics such as leverage, the maturity structure of financial markets and intermediaries that experienced its debt, and the liquidity and riskiness of its asset portfolio. significant distress during the crisis. For each case, we provide Finally, we employ our framework to analyze current policy a discussion of the size and the evolution of the market, the issues and recently proposed regulatory changes. Tanju Yorulmazer is a research officer at the Federal Reserve Bank of The views expressed are those of the author and do not necessarily reflect the New York. position of the Federal Reserve Bank of New York or the Federal Reserve System. [email protected] FRBNY Economic Policy Review / February 2014 1 Tanju Yorulmazer Literature Review on the Stability of Funding Models l Financial intermediaries perform maturity 1. Introduction and liquidity transformation by issuing liquid, short-term liabilities while holding illiquid, his article provides a review of the economics literature longer-term assets. Ton the stability of banks and other financial intermedi- aries, with a policy-oriented focus on their funding models. l This study discusses the intermediaries’ role We first discuss the standard framework used in the literature as liquidity provider and the inherent fragility to analyze the fragility of financial institutions that perform associated with it. maturity and liquidity transformation. Then we consider po- tential factors that amplify or mitigate such financial fragility. l Yorulmazer reviews the standard framework Finally, we review developments in the financial sector that of the literature to consider factors that make may have affected the stability of funding models. financial intermediaries more or less stable, such as the combination of deposit-taking and loan-making activities and the role of interbank markets for coinsurance against 2. The Standard Framework liquidity shocks. l The study also looks at developments in the 2.1 What Is Maturity Transformation and financial sector affecting the stability of Why Does It Cause Illiquidity? intermediaries. These include the shift of some activity to less regulated parts of the We begin by describing the standard framework used in the financial system and the growing importance literature—which is based on maturity transformation and the and size of the repo market. risk of a run and loss of significant funding sources—to think about the fragility of financial intermediaries. One important role played by financial intermediaries is maturity and liquidity transformation, namely, issuing liquid, short-term liabilities while holding illiquid, longer-term Tanju Yorulmazer is a research officer at the Federal Reserve Bank of The author thanks Todd Keister for his tremendous
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