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Policy Brief 13-14: Shadow Deposits As a Source of Financial Instability

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Policy Brief 13-14: Shadow Deposits As a Source of Financial Instability Policy Brief NUMBER PB13-14 MAY 2013 resort. In China, shadow deposits are wealth management Shadow Deposits as a Source products, short-term fi nancial products off ered as an alterna- tive to traditional savings deposits, most of which are principal of Financial Instability: unguaranteed and thus lack the implicit government support enjoyed by traditional deposits. In both countries the origin of shadow deposits was regulatory arbitrage, giving ordinary Lessons from the American investors a way to bypass the restrictions placed on traditional deposits. Th e controlled interest rates on traditional deposits in Experience for China both the United States and China fell below prevailing market rates. Shadow deposits emerged as a way to off er savers the Nicholas Borst convenience and perceived safety of a deposit while off ering a higher interest rate than that earned on traditional deposits. Th ey can off er these higher rates precisely because they are Nicholas Borst, research associate and China program manager, has been with the Peterson Institute for International Economics since 2011. He also exempt from many of the costly safeguards put upon banks. edits the Institute’s China blog, China Economic Watch. Before joining the Shadow deposits have grown into an important source Institute, Borst was a consultant at the International Finance Corporation of funds in both the United States and China, particularly and the Multilateral Investment Guarantee Agency. in the short-term fi nancing markets. Th ese deposits are also the component of the shadow banking system where ordinary © Peterson Institute for International Economics. All rights reserved. investors are most likely to be involved. While money market mutual funds were thought for decades to be relatively safe and Th e fi nancial regulation architecture in both the United States boring, the global fi nancial crisis forever altered this percep- and China developed during eras when retail deposits and bank tion. Relatively small losses in the commercial paper market loans were the primary mode of fi nancial intermediation. Th e precipitated a run on money market mutual funds, leading to function of banks is to transform short-term deposits into long- investor losses and freezing short-term fi nancing markets in the term loans, while providing liquidity for depositors. Experience United States. Th e crisis revealed the inherent risks in shadow has taught regulators hard lessons that this activity must be sub- deposits as well as their role in increasing fi nancial instability. ject to prudential safeguards, including reserve requirements, Th e more recent emergence of shadow deposits in China principal protection for depositors, and access to a lender of last has been much more rapid and has coincided with a dramatic resort. Without these protections, short-term deposits are sub- decline in the role of bank loans in new credit growth. In a few ject to bank runs that can destabilize the entire fi nancial system. short years, wealth management products have grown from a Over the years, however, fi nancial innovations have led to the small number of specialized fi nancial products aimed at sophis- buildup of short-term pools of funding outside the confi nes of ticated investors to near universal availability at China’s major these protections. Th ese shadow deposits play a role similar to banks with widespread participation by retail customers. Moral traditional deposits, taking short-term funds from individuals hazard is prevalent in the wealth management product market and businesses and providing credit to borrowers. because even small-scale defaults have been averted through In the United States, shadow deposits take the form of government intervention. A real crisis, therefore, has yet to test money market mutual funds, deposit-like funds that are not the market. US experience in regulating shadow deposits off ers protected by deposit insurance, lack capital buff ers, and are useful lessons for China to guide its own fi nancial development off ered by institutions without access to the lender of last in a healthier direction. 1750 Massachusetts Avenue, NW Washington, DC 20036 Tel 202.328.9000 Fax 202.659.3225 www.piie.com NUMBER PB13-14 MAY 2013 DEVELOPMENT OF MONEY MARKET MUTUAL Act tried to address this competitive disadvantage by forcing FUNDS IN THE UNITED STATES states to off er national banks the same branching rights as local banks. Th is put national banks on equal footing with state Th e fi rst money market fund in the United States was cre- banks but also prevented interstate banking as most states had 1 ated in 1971. Th e catalyst for its creation was a mismatch restrictions on it and national banks were now beholden to state between short-term interest rates and the controlled rate on banking rules (Neely 1994). Th e Bank Holding Company Act savings deposits (fi gure 1). Due to infl ation spikes during the of 1956 further limited interstate banking by prohibiting bank 1970s, short-term market interest rates shot up signifi cantly holding companies headquartered in one state from acquiring a above the regulated level allowed on savings deposits. Savers bank in another state. thus had the opportunity to purchase low-risk assets such as Money market mutual funds, registered as investment US treasuries and earn a higher return than what was available companies under the Investment Company Act of 1940 and on savings deposits. Investors began withdrawing funds from regulated by the Securities and Exchange Commission (SEC), traditional deposits and moving into these higher-yielding were not subject to the same interest rate and interstate regu- money-like securities (Luttrell, Rosenblum, and Th ies 2012). lations as traditional banks. Th is regulatory gap paved the way Money market funds emerged as a way to organize this be- for money market mutual funds to grow rapidly. Previously, the havior and off er this investment channel to small investors. regulatory ceiling on deposit rates had not been much of an issue as it was typically set above the market rate on deposits and US experience in regulating shadow treasuries. Th e increase in short-term interest rates in the 1970s, deposits offers useful lessons for however, changed this, and money began pouring into money market mutual funds. Without restrictions on interstate opera- China to guide its own financial tions, once money market mutual funds began attracting funds away from traditional deposits they were able to grow quickly development in a healthier direction. into nationwide enterprises. Th e regulatory restrictions that put banks at a disadvan- Money market mutual funds were made possible by two tage relative to money market funds were eventually lifted. Depression-era banking laws, the Glass-Steagall Act of 1933 Th e McFadden Act and Bank Holding Company Act were and the McFadden Act of 1927. Regulation Q of the Glass- repealed by the Riegle-Neal Interstate Banking and Branching Steagall Act prohibited banks from paying interest on demand Effi ciency Act of 1994. Regulation Q of the Glass-Steagall Act deposits and gave the Federal Reserve the power to set interest was eliminated by the Depository Institutions Deregulation rate ceilings on time deposits. Th e rationale behind Regulation and Monetary Control Act of 1980, which gradually lifted all Q was that fi erce competition for deposits amongst banks in interest rate controls on savings deposits by 1986. Th e Garn- the 1920s had led to bank failures during the Great Depression. St. Germain Depository Institutions Act of 1982 allowed By setting a maximum interest rate, banks would be prevented banks to off er a true alternative to money market funds in the from promising unsustainably high interest rates to savers and form of money market deposit accounts (Luttrell, Rosenblum, making increasingly risky loans to preserve their net interest and Th ies 2012). margins. Despite the lifting of interest rate and interstate banking Th e McFadden Act was the other restriction placed on restrictions, money market mutual funds continued to grow banks that allowed money market mutual funds to develop because of several regulatory advantages. First, money market quickly. Th is federal legislation was initially passed to give na- mutual funds do not pay deposit insurance to the Federal tional banks equal competitive footing with state banks. Prior to Deposit Insurance Corporation (FDIC). Second, money market the act, some state banks were allowed branching rights within mutual funds are exempt from reserve requirements required by a state’s borders while all national banks were prohibited from the Federal Reserve. Th ird, money market mutual funds have branching. To avoid these restrictions, many national banks no capital requirements lowering their costs of funds relative began giving up their national charters and leaving the Federal to banks, which are required to maintain capital buff ers. Th ese Reserve System (Rajan and Ramcharan 2013). Th e McFadden advantages mean money market funds can pay higher rates to depositors than banks could off er on traditional deposits. 1. Th e fi rst money market mutual fund was the Reserve Primary Fund. Of note, this same fund would fail in 2008 and precipitate a general run on Th e peak value of total fi nancial assets of money market money market mutual funds. mutual funds was $3.76 trillion in 2008, equivalent to 32 per- 2 NUMBER PB13-14 MAY 2013 Figure 1 US interest rate controls in the 1960s and 1970s percent 14 Federal funds rate Treasury bill rate 12 Regulation Q deposit ceiling (6 months to 1 year) 10 8 6 4 2 0 61 64 67 77 ay 1970 July 19 M June 1960 April 1963 June 19 March 1973 August 1974 January 1959 October 1971 January 1976 February 1966 November 19 December 1968 November 1978 September 19 Sources: Federal Reserve Bank of St.
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