The liquidity of capital markets under new banking regulations - PowerPoint PPT Presentation

The liquidity of capital markets under new banking regulations Darrell Duffie Stanford University Baffi Lecture Banca d’Italia, September 15, 2017 Duffie Capital market liquidity and banking regulations 1

A bank-intermediated bilateral OTC market c 1 c 2 c 5 d 1 c 3 c 6 d 2 d 3 c 7 c 4 Duffie Capital market liquidity and banking regulations 2

Regulatory Implications for Capital Market Efficiency More financial stability from higher bank capitalization and BRRD. 1 The leverage-ratio rule distorts market making away from safe assets. 2 Debt funding costs for banks are heightened by BRRD, increasing balance sheet costs. 3 The local monopoly power of banks is mildly reduced by MiFID. 4 Duffie Capital market liquidity and banking regulations 3

Dealer balance sheet debt assets equity Duffie Capital market liquidity and banking regulations 4

More equity to fund more assets debt debt assets old assets equity equity new assets new equity Duffie Capital market liquidity and banking regulations 5

Legacy shareholders have subsidized creditors debt debt assets old assets equity equity new assets new equity Higher capitalization implies a value transfer from legacy shareholders to creditors. Duffie Capital market liquidity and banking regulations 6

Debt overhang debt debt assets old assets equity equity new equity new assets For shareholders to break even, the new assets must be purchased at a profit that exceeds the value transfer to creditors. (Myers, 1977) Duffie Capital market liquidity and banking regulations 7

SLR is more binding than risk-based capital ratios Results of the Fed’s 2017 stress tests for the largest US dealer banks 10 CET1 (CCAR) CET1 (DFAST, adj.) SLR (CCAR) 8 SLR (DFAST, adj.) Excess capital ratio (%) 6 4 2 0 JPM CITI BAML GS MS CCAR: stressed CET1 after assumed payouts, less 4.5%; stressed SLR less 3.0%. DFAST, adjusted: stressed CET1 (no payouts) less (4.5% + G-SIB surcharge); stressed SLR less the G-SIB minimum of 5%. Data source: Board of Governors of the Federal Reserve, 2017. Duffie Capital market liquidity and banking regulations 8

European Banks Delever as Reporting Days Approach Daily collateral outstanding in the tri-party repo market and the Federal Reserve’s overnight reverse repo (ON RRP) facility U.S. banks European banks Other banks Fed (ON RRP) Billions of dollars 600 500 400 300 200 100 0 1/2016 4/2016 7/2016 10/2016 1/2017 4/2017 Figure Source: Egelhov, Martin, Zinsmeister, Federal Reserve Bank of New York, August, 2017. Notes: Banks headquartered in the euro area and Switzerland report leverage ratios as a snapshot of their value on the last day of each quarter, while their U.S. counterparts report quarterly averages. Totals only include trades backed by Fedwire-eligible securities–that is, U.S. Treasury and agency securities. Duffie Capital market liquidity and banking regulations 9

Impact of the leverage-ratio regulation on repo intermediation costs to legacy shareholders repo asset repo asset repo claim repo claim old debt old debt old assets old assets equity equity new equity safe assets Duffie Capital market liquidity and banking regulations 10

Impact of SLR on UST repo market efficiency 25 GCF−triparty rate spread (basis points) 20 15 10 5 0 13−Q1 13−Q3 14−Q1 14−Q3 15−Q1 15−Q3 16−Q1 16−Q3 17−Q1 (a) bid-ask spreads up (b) inter-dealer positions down Figure: (a) Average within-quarter difference between overnight GCF and Tri-party repo rates. Data sources: Bloomberg and BNY-Mellon. (b) Figure source: Antoine Martin, FRBNY (2016). Duffie Capital market liquidity and banking regulations 11

Cross-currency basis and bank funding costs Funding value adjustments now leave wider arbitrage bounds on the basis 50 300 US banks European banks 250 0 200 Basis Points CDS rate 150 −50 100 50 −100 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2004 2006 2008 2010 2012 2014 2016 AUD CAD CHF DKK EUR year GBP JPY NOK NZD SEK (a) 5-year USD cross-currency basis. Source: Du, (b) 5-year dealer credit spreads Tepper, and Verdelhan (2017). Duffie Capital market liquidity and banking regulations 12

Cross-currency basis 50 200 one−month 0 USD LIBOR−OIS spread (basis points) three−month six−month one−year −50 150 Basis Points −100 100 −150 −200 50 −250 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 0 2004 2006 2008 2010 2012 2014 2016 AUD CAD CHF DKK EUR year GBP JPY NOK NZD SEK (c) 3-month USD cross-currency basis. (d) LIBOR-OIS spreads. Data source: Source: Du, Tepper, and Verdelhan (2017) Bloomberg. Duffie Capital market liquidity and banking regulations 13

CIP arbitrage can be costly to dealer shareholders Debt overhang cost for funding synthetic dollar deposits EUR → USD USD debt debt old debt assets old assets equity equity To benefit shareholders, the trade profit must exceed the funding value adjustment (FVA), a debt-overhang cost. Duffie Capital market liquidity and banking regulations 14

Funding cost to shareholders EUR → USD USD debt old debt old assets funding value adjustment (FVA) equity Duffie Capital market liquidity and banking regulations 15

Example: CIP arbitrage can be bad for shareholders ◮ Suppose the one-year USD risk-free rate is zero. ◮ Our bank has a one-year credit spread of 35 basis points. ◮ We borrow $100 with one-year USD commercial paper, promising $100.35. ◮ We invest $100 in one-year EUR CP, swapped to USD, with the same all-in credit quality as that of our bank’s CP, and uncorrelated. ◮ Suppose the EUR CP, swapped to dollars, promises $100.60, for a basis of − 25bps. ◮ We have a new liability worth $100 and a new asset worth $100.65/1.0035 ≃ $100.25, for a trade profit of approximately $0.25. ◮ However, the marginal value of the trade to our shareholders is negative, because, conditional on dealer survival, the expected incremental payoff to equity is $100.25 − $100.35 = − $0.10. Conditional on default, equity gets nothing. Duffie Capital market liquidity and banking regulations 16

Funding Costs to Dealer Shareholders From work with Andersen and Song: The marginal increase in the value of the dealer’s equity per dollar of a debt-funded asset purchase is p ∗ π − δ COV ∗ − FVA , where ◮ p ∗ is the dealer’s risk-neutral probability of survival to term. ◮ π is the trade profit (P&L). ◮ δ is the risk-free discount. ◮ COV ∗ is the risk-neutral covariance of the asset payoff and dealer default event. ◮ FVA is the funding value adjustment p ∗ δST , where S is the dealer’s credit spread and T is the term. The extra marginal cost to dealer shareholders when a fraction α of the funding must be equity is α (1 − p ∗ − FVA) , which annualizes to roughly αS (assuming a loss given default of 0.5). For safe assets, the shareholder breakeven “arbitrage” yield is thus the total annualized funding cost to shareholders of roughly (1 + α ) S . Duffie Capital market liquidity and banking regulations 17

When should a dealer arbitrage the USD-JPY CIP basis? 400 300 200 100 0 12/31/14 3/31/15 3/30/15 9/30/15 12/30/15 3/31/16 6/30/16 9/30/16 1w deviation 1m deviation 3m deviation ✭❛✮ ▲❡✈❡❧ ♦❢ ❨❡♥ ❈■P ❉❡✈✐❛t✐♦♥s Source: Du, Tepper, and Verdelhan (2016). Duffie Capital market liquidity and banking regulations 18 ✭❜✮ ❚❡r♠ ❙tr✉❝t✉r❡ ♦❢ ❨❡♥ ❈■P ❉❡✈✐❛t✐♦♥s ❋✐❣✉r❡ ✼✿ ■❧❧✉str❛t✐♦♥ ♦❢ ◗✉❛rt❡r✲❊♥❞ ❉②♥❛♠✐❝s ❢♦r t❤❡ ❚❡r♠ ❙tr✉❝t✉r❡ ♦❢ ❈■P ❉❡✈✐❛t✐♦♥s ✿ ■♥ ❜♦t❤ ✜❣✉r❡s✱ t❤❡ ❜❧✉❡ s❤❛❞❡❞ ❛r❡❛ ❞❡♥♦t❡s t❤❡ ❞❛t❡s ❢♦r ✇❤✐❝❤ t❤❡ s❡tt❧❡♠❡♥t ❛♥❞ ♠❛t✉r✐t② ♦❢ ❛ ♦♥❡✲✇❡❡❦ ❝♦♥tr❛❝t s♣❛♥s t✇♦ q✉❛rt❡rs✳ ❚❤❡ ❣r❡② s❤❛❞❡❞ ❛r❡❛ ❞❡♥♦t❡s t❤❡ ❞❛t❡s ❢♦r ✇❤✐❝❤ t❤❡ s❡tt❧❡♠❡♥t ❛♥❞ ♠❛t✉r✐t② ❞❛t❡s ♦❢ ❛ ♦♥❡✲♠♦♥t❤ ❝♦♥tr❛❝t s♣❛♥s t✇♦ q✉❛rt❡rs✱ ❛♥❞ ❡①❝❧✉❞❡s t❤❡ ❞❛t❡s ✐♥ t❤❡ ❜❧✉❡ s❤❛❞❡❞ ❛r❡❛✳ ❚❤❡ t♦♣ ✜❣✉r❡ ♣❧♦ts ♦♥❡✲✇❡❡❦✱ ♦♥❡✲♠♦♥t❤ ❛♥❞ t❤r❡❡✲♠♦♥t❤ ❈■P ▲✐❜♦r ❈■P ❞❡✈✐❛t✐♦♥s ❢♦r t❤❡ ②❡♥ ✐♥ r❡❞✱ ❣r❡❡♥ ❛♥❞ ♦r❛♥❣❡✱ ✺✷ r❡s♣❡❝t✐✈❡❧②✳ ❚❤❡ ❜♦tt♦♠ ✜❣✉r❡ ♣❧♦ts t❤❡ ❞✐✛❡r❡♥❝❡ ❜❡t✇❡❡♥ ✸✲♠♦♥t❤ ❛♥❞ ✶✲♠♦♥t❤ ▲✐❜♦r ❈■P ❞❡✈✐❛t✐♦♥ ❢♦r t❤❡ ②❡♥ ✐♥ ❣r❡❡♥ ❛♥❞ ❜❡t✇❡❡♥ ✶✲♠♦♥t❤ ❛♥❞ ✶✲✇❡❡❦ ▲✐❜♦r ❈■P ❞❡✈✐❛t✐♦♥ ❢♦r t❤❡ ②❡♥ ✐♥ r❡❞✳