New theoretical work shows that money markets remain fragile as long as there is a connection between asset prices, secured funding and unsecured funding. The degree of fragility depends on leverage in the financial system. Central banks can alleviate acute liquidity stress but cannot easily reduce financial system leverage. Hence fragility remains even with ultra-easy monetary conditions.

Ranaldo, Angelo, Matthias Rupprect and Jan Wrampelmeyer (2016), “Fragility of Money Markets”. University of St. Gallen, School of Finance, Working Papers of Finance, No. 2016/01, January 2016
http://www1.vwa.unisg.ch/RePEc/usg/sfwpfi/WPF-1601.pdf

The below are excerpts from the paper. Headings, links and cursive text have been added.

The conventional view on money market fragility

Asset shocks can lead to unsecured funding problems…namely an interest rate and a loss spiral. The former spiral describes the increase in the interest rate due to higher leverage and counterparty credit risk, making it costlier to roll over existing positions. The loss spiral describes the eroding effect on capital following a reduction in the market value of the borrower’s assets, enforcing a deleveraging process and further downward pressure on prices. Consequently, the loss spiral reinforces the interest rate spiral.”

Fragility with both secured and unsecured money markets

“Borrowers are…subject to liquidity risk due to the risk of higher margins in the secured market or higher interest rates in the unsecured market… Since money market liquidity is determined by both secured and unsecured funding liquidity, fragility crucially depends on the interrelation between money markets, and their interaction with the securities’ market liquidity.”

Markets can be fragile, when borrowers face funding problems in both the secured and the unsecured money market at the same time. In such a scenario, liquidity spirals arise in both funding markets simultaneously, mutually reinforce each other…For instance, when an asset shock increases market illiquidity and margins, leading to further downward price pressure, this increases leverage and thus unsecured interest rates.”

MM_FRAG01

“A shock to asset values can lead to mutually reinforcing liquidity spirals…in the unsecured and secured money markets… Even when banks have access to both secured and unsecured funding, the market can become fragile, in the sense that a small shock to the fundamental value of an asset can lead to a large, discontinuous drop in its market price with adverse feedback effects on funding markets.”

“Unsecured loans expose lenders to counterparty credit risk…In equilibrium…the spread between unsecured and secured interest rates is a risk premium which increases with the borrower’s leverage…The higher is a borrower’s leverage at the time of the shock, the more difficult it is to substitute a loss of secured funding liquidity in the unsecured market. This is because the shadow costs of capital in the secured market represent the marginal funding costs in the unsecured market when the capital constraint is binding. In other words, funding illiquidity spills over across funding markets if high leverage impairs the borrower’s ability to compensate a reduction in secured funding by raising more unsecured debt.”

“The spread between unsecured and secured rates is commonly used to proxy money market risk premiums and it is well-known that it tends to increase in times of crisis.”

“Funding structure and liquidity dynamics critically depend on the liquidity risk of borrowers’ asset portfolios. Assets with higher liquidity risk are funded more in the unsecured market, whereas low liquidity-risk assets are funded more in the secured market. Hence, when market participants re-allocate their asset positions towards safer assets, the corresponding effect on the liability side is a flight-to-secured-funding.”

The role of monetary and regulatory policy

“In times of immediate liquidity needs, financial institutions obtain funding in the secured (repo) market, borrow in the unsecured money market, or liquidate assets. If liquidity dries up in all of these markets simultaneously, bank failures can occur, which cause contagion and spillover effects throughout financial markets and urge central banks to intervene as the lender of last resort.”

“During the recent crises, central banks around the world have conducted conventional as well as unconventional monetary policy. Besides decreasing interest rates close to the zero lower bound, most central banks have provided emergency lending facilities for financial institutions to obtain funding liquidity at haircuts lower than in the market, where many distressed assets have even become ineligible as collateral. Moreover, the Federal Reserve intervened in the secondary market by purchasing distressed securities as well as liquid “near-money” bonds.”

“Central bank monetary policy can restore the socially optimal level of funding liquidity by an efficient combination of conventional policy (i.e., the interest-rate policy), and unconventional measures, namely purchasing assets (quantitative easing) or changing the haircuts for collateralized borrowing from the central bank. While central bank policy can prevent present fragility, it does not address banks’ excess leverage, creating future fragility by leaving banks unable to flexibly adjust their funding structure.”

“On the regulatory side, our model suggests that countercyclical maximum leverage ratios and capital buffers enhance banks’ resilience to future shocks more adequately than static measures. A capital buffer restrains borrowers from fully encumbering their capital for margins to obtain secured funding, and relaxes the capital constraint. However, it is not sufficient on its own, because it can induce banks to invest in low-margin assets, resulting in excess leverage and in larger vulnerability of banks to an asset shock. Thus, an important policy implication from our analysis is that a combination of a countercyclical leverage ratio, preventing excess leverage, and a capital buffer inversely linked to haircuts, easing funding strains in the secured market, counteract future fragility and make banks more resilient to adverse market situations.”