Leverage in modern financial systems arises from bank balance sheets and off-balance sheet transactions that involve banks and other financial institution. Non-bank funding of banks and credit is large, rising, and not fully captured in official statistics. Collateralized transactions and wealth management products are important underappreciated parts of system leverage. The classic narrow focus on bank credit-to-GDP ratios does not only underestimate leverage in size, but also overestimates the stability of sources of funding.

Singh, Manmohan and Zohair Alam (2018), “Leverage—A Broader View”, IMF Working Paper, WP/18/62.

The post ties in with SRSV’s summary post on shadow banking.
The below are excerpts from the paper. Emphasis and cursive text have been added.

A broader view of financial system leverage

“[Financial system] leverage has two components: leverage from balance sheets of banks and leverage from the interconnectedness within the system…Leverage metrics commonly used in the literature are primarily based on bank balance sheet data. Typical leverage metrics include the ratio of total assets to capital, or some variant such as ratio of risk-weighted assets to Tier 1 capital…However, the determinants of bank credit are not limited to bank’s equity and leverage only. “

“[The below figure shows] an analytical framework that explains the nonbank–bank nexus…The diagram focuses on the pledged collateral market that underpins the understanding of nonbank leverage:”

“Dealer banks…play a central role in intermediating collateral and money flows; these dealer banks connect the nonbank space, and funnel collateral or money between various nonbanks such as money market funds, hedge funds, pension funds, insurers, and official sector accounts… Dealer banks interact with nonbanks (e.g., hedge funds) via derivatives, securities lending, repo agreements or prime-brokerage activities. Commercial banks interact with nonbanks (e.g., households, corporates, etc.) primarily via loan syndication, deposits and so forth. Ultimate borrowers are funded by both types of banks.”

Leverage arising from the interconnectedness within the financial system… is large, rising, and not fully accounted for in bank balance sheets…Transactions that are cross-border in nature, such as a large share of pledged collateral agreements or wealth management accounts… are not fully captured in the flow-of-funds statistics… BIS databases (such as Consolidated Banking Statistics) do not include some important off-balance sheet items.”

The pledged collateral market

“Pledged collateral represents a useful measure of non-bank funding to banks, which is a driver of bank credit…The pledged collateral used in financial transactions is probably at par with money.”

“It is important to understand how the pledged collateral market works. For overall ‘lubrication’ of its functioning, the financial system requires collateral or money for intraday debits and credits. The cross-border financial markets traditionally use ‘cash or cash equivalent’ collateral…to settle accounts or margin calls. Financial collateral does not have to be highly rated AAA/AA, as long as the securities (which can be either debt or equity) are liquid, mark-to-market, and part of a legal cross-border master agreement… In this way, collateral underpins a wide range of secured funding and hedging (primarily with OTC derivatives) transactions and is often preferred to cash settlement.”

“We [examine] data we have collected on pledged collateral funding of the largest 15 global systemically important banks (G-SIBs). We find that [pledged collateral] funding is large, and has been rising relative to the size of the banks’ balance sheet assets… Bank credit to the economy has not changed much since 2008. We find that nonbank funding, from balance sheet data, has risen by about 50 percent since the crisis in the U.S… The volume in the pledged collateral market has remained at USD6 trillion since 2009.”

“Finally, we estimate that fully accounting for pledged collateral transactions could increase bank leverage values by about a third at the G-SIB [global systemically important banks] level… Discussions with some market participants suggest that up to half (with a wide variance) of the pledged collateral activity may not be on-balance sheet.”

Underestimation of leverage and risks

“Nonbank funding (i.e., wholesale and household deposits) to banks is on the rise among economies with large and inter-connected financial systems…Omission of off-balance sheet items in the standard measures implies a substantial underestimation of bank leverage…The financial leverage metric needs to augment nonbank funding to banks [through]…off-balance sheet data where transactions between hedge funds funding from banks (i.e., prime brokerage) and other sizable collateral flows from repo or derivatives or securities lending business do not come to balance sheet, due to netting that is permissible under regulations…A similar case could be made for wealth-management products.”

Leverage issues for financial stability stem largely primarily from the 20–30 GSIBs—and not from all banks—that have a global footprint in niche transactions such as peddling pledged collateral or wealth management products, that may not be on the balance sheet.”

“The traditional view of a banking system is that total funding from nonbanks (the first term on right-hand side shown in red balloon) is relatively ‘sticky’. In other words, it is often assumed that, nonbank funding to banks predominantly reflects households’ deposits only (or M2, a metric that measures broad money) and the stock of household deposits is steady (in line with relatively slow-moving household wealth).”

“Over the past decade researchers have realized…that there is a broader non-M2 component that is neither ‘sticky’ nor dependent only on household assets. ..There are many avenues where banks interact with nonbanks and receive significant funding from the asset management complex. Thus, the credit creating capacity of banks is not limited by household deposits only…When we introduce nonbank firms and intermediation through the shadow-banking system, both individual banks and the whole banking system can quickly lever up….While households’ direct holdings of [deposits] reflect their own investment decisions, their indirect holdings of non-M2 [deposits] are not a reflection of their direct investment choices, but the portfolio choice and investment management techniques of their fiduciary asset managers. In addition, nonfinancial corporations like Microsoft, Amazon, Walmart, Apple also park cash with banks, or seek returns on their cash by investing with nonbanks.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.