Saturday, December 10, 2011

Rehypothecation and fractional reserve lending

What do these two scenarios have in common:

1. A bank taking its stock of deposits from net savers and using it fund its lending to others, who are net borrowers.

2. A shadow bank taking collateral posted by its own clients and using that same collateral in its own borrowing from other lenders

If you were zero hedge, you would say they are both examples of fractional reserve lending. At its surface, you would be correct (though I would clarify that the second scenario is more like a mirror image of the first, or more specifically, fractional reserve borrowing).

Shadow banks are back in the forefront due to the escalating Euro crisis, as we see panicked 'shadow bank' lenders increasing their collateral requirements from their borrowers who used PIIGS bonds as collateral, as the value of PIIGS bonds falls. This use of collateral to raise funding in the repo market is called hypothecation. From Reuters:

[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.

…..Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.

Zero hedge:

So let's see: a Prime Broker taking posted collateral, then using the same collateral as an instrument for hypothecation with a net haircut, then repeating the process again, and again... Ring a bell? If you said "fractional reserve lending" - ding ding ding. In essence what re-hypothecation, and subsequent levels thereof, especially once in the shadow banking realm, allows Prime Brokers is to become de facto banks only completely unregulated and using synthetic assets as collateral.

I half agree with zero hedge, in that the first scenario above seems like fractional banking, but it's more than fractional, since banks can and do lend funds even though they don't have the deposits to 'fund' the loans yet. Banks don't lend their deposits, it's loans that create deposits - or net new money. Most loans are purely 'electronic debit and credit' debt transactions made by commercial banks, and balance out as an increase in loans (assets) of the financial system automatically increases its liabilities (deposits). Most don't even have to result in actual newly-printed currency circulating the system if the payments and transfers remain electronic.

But unlike shadow banks raising funds via rehypothecation, commercial bank lending has less danger of turning into a bank run because of the lender of last resort function of the central bank. For as long as banks have adequate capital on their books, the system can be considered sound most of the time. When and if a loan goes sour, it is this equity capital that gets depleted first, and only once all capital has been written off, does its deposit base get into some kind of danger (because the bank might close and depositors will be unable to access their deposit). But a lender of last resort always makes sure that the bank will always have the reserves it needs to pay out its obligations to its depositors.

This kind of safety net comes with a cost though - regulation. Thus far, so-called shadow banks have been free of this regulation simply because they don't deal in retail deposits. Shadow banks will argue that they don't need the safety net of a lender of last resort because their retail clients are not looking for the safety (and the lower yields that go with it) of a commercial bank, otherwise they would have made their dealings with a commercial bank.

But with the repeated financial crises magnified globally by these inter-connected and often too big to fail shadow banks, is it still fair to say they don't need a government safety net? How many more bailouts before we face up to reality?

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