Manmohan Singh: Unwinding Balance Sheets

2017-09-01 IMI

This article appears in OMFIF's fourth annual Global Public Investor. This is an edited version of an article which appeared in FT Alphaville. The views expressed are those of the author and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. Manmohan Singh is Senior Financial Economist at the International Monetary Fund. Federal Reserve policy-makers have begun discussing when to start reducing the US central bank’s $4.5tn balance sheet. Minutes of their March and April meetings suggest the Fed will approach this subject cautiously out of concern that any decision to shrink the balance sheet might be seen as tightening monetary policy. Letting the balance sheet shrink would release ‘good’ collateral such as US Treasury securities while reducing the excess reserves which commercial banks keep on deposit at the Fed. These were deposited when the Fed carried out its quantitative easing purchases of trillions of dollars in securities. Many of the securities were bought from non-bank financial firms like pension funds, insurers and asset managers which held the proceeds in depository institutions. Those banks in turn deposited money at the Fed, where it earned interest (only banks can earn interest on excess reserves). Non-banks are likely to reuse good collateral, rather than sizeable deposits at banks which have remained idle. There may not be a one-to-one relationship between policy rate increases and the unwinding of central bank balance sheets. New regulations instituted to make the financial system safer require banks to hold more ‘high quality liquid assets’. Both US Treasuries and excess reserves count as high quality liquid assets. But this is where the similarity ends. Good collateral, when pledged, is constantly reused in a process similar to money creation which takes place when banks accept deposits and make loans. That is why good collateral and excess reserves differ in their implications for market functioning. It is possible the relation between the two is not positive. US Treasuries in the hands of the market, with reuse, are likely to improve liquidity, while excess reserves have remained idle. Increasing the availability of good collateral creates incentives for the reuse of other, less desirable collateral. Most collateral is exchanged as a portfolio of securities, rather than as individual securities. Research suggests the collateral reuse rate – defined as the volume of secured transactions divided by the stock of source collateral – is below two on average, down from around three before the 2008 financial crisis. The reuse rate is unlikely to rise since collateral does not flow in a vacuum but needs bank balance sheets to move. But private sector balance sheets remain congested by deposits, a by-product of QE. Assuming there is no change in regulations, a lower level of deposits will allow collateral reuse to increase, as balance sheet space at banks becomes more available. Deposits have taken too much balance sheet space, with excess reserves at the Fed at over $2tn. They were close to zero before the 2008 financial crisis. At present, there is sizeable demand for good collateral and it is reflected in the prices. As seen in the past year, policy rate increases may not percolate to the long end of the yield curve. The reverse is true too, because the investor base is very different for the short and long end of the curve. From the time of the Fed’s rate increase in December 2015 until the eve of the presidential election on 8 November 2016, the yield on 10-year US Treasury notes declined. The yield fell to 1.8% from 2.3% despite sizeable sales of Treasuries by many emerging markets throughout 2016. The unwinding of central bank balance sheets may not result in tightening. Collateral released from the asset side of the Fed balance sheet to the market, with reuse, is a far better provider of liquidity for the financial system than the reduction in banking system deposits. Although the Dodd-Frank Act and Basel accords make it more expensive for collateral to be reused, the increase in the balance sheet space of the banking system may outweigh the regulatory cost. Thus, a leaner central bank balance sheet, if it doesn’t result in a tightening effect, could justify a much higher policy rate in this cycle. There are sound theoretical reasons why, in normal times, lean balance sheets allow central banks to focus on their core mandate. As central banks contemplate balance sheet unwinding, they must keep in mind the collateral reuse perspective.

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Manmohan Singh: Unwinding Balance Sheets

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