Collateral Damage

Gary B. Gorton is Frederick Frank Class of 1954 Professor of Finance and Toomas Laarits is a PhD Candidate at Yale School of Management. This post is based on their recent paper.

In a classic banking panic, holders of demand deposits want their cash back because they do not trust the value of the banks’ loan portfolios backing the deposits. Deposit insurance solves this problem. A banking panic in the current financial system is different. In the crisis of 2007-8 the holders of short-term debt, in the form of repo, came to distrust the bonds used as collateral and increased haircuts, generating a run on the banking system (see Gorton and Metrick (2012) and Gorton, Laarits, and Metrick (2017)). Have the many post-crisis legal and regulatory changes mitigated this problem? Or, have they instead exacerbated the shortage of good collateral, resulting in collateral damage?

These are tough questions to answer—it is hard enough to evaluate individual policy and legal changes, much less the aggregate of the changes. Since the start of the crisis, central banks have purchased large amounts of safe debt. Some sovereign debt is no longer considered safe. Regulatory requirements, such as the liquidity coverage ratio, have rendered large swaths of collateral immobile. And to the extent new laws and regulations constrain private short-term debt issuance, they also create an incentive to find new ways to produce private debt—a new shadow banking system.

We provide one approach to gauge the resiliency of post-crisis financial system in a short paper. prepared for a forthcoming edition of Banque de France Financial Stability Review.

Specifically, we focus on measures of the convenience yield, defined as the yield spread accepted by investors looking to hold a safe and liquid asset. A high convenience yield means that investors are paying a large premium for holding safe and liquid investments, implying either that the demand for such assets is high, the supply is low, or both. The convenience yield can thus summarize the scarcity of safe debt, implicitly incorporating various supply and demand shocks. In our paper, we compare measures of the convenience yield over three periods: pre-crisis (2001 to mid 2007), crisis (mid 2007 to 2012), and since.

We find evidence that shortage of safe debt is higher now than before the financial crisis: while measures of the convenience yield have dropped from the crisis-era highs, they have generally not returned to pre-crisis levels. Further, we find evidence of a private response to aggregate safe asset shortage in the form of short maturity commercial paper issuance when convenience yields are high, or when supply of Treasury Bills is low. Overall, our evidence suggests that there is a shortage of safe debt now compared to the pre-crisis period, implying that the seeds for a new shadow banking system to grow exist.

The complete paper is available here.

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