Why Lender-Of-Last-Resort Operations Are Inevitable

Lender-of-last-resort operations by central banks (or "bailouts of the financial system") are deservedly unpopular across the political spectrum. Malcontents have argued that risky lending ought to be handled by markets, and that deposits should be fully backed by reserves or Treasury bills. Unfortunately, the believers in these theories never bother to look at the economics of short-term lending. The money markets have the structure that they have for a reason, and they only will function if there is a lender-of-last-resort that is able to step in and prop the system up. Any attempts to make the system bailout proof would have far-reaching consequences into the structure of the economy.

The logic of my argument can be summarised as follows.

• Money market participants lack the analytical capacity to fully analyse the credit risk of short-term debt.
• Therefore, commercial paper ends up having to be backed by credit lines issued by banks. In turn, those credit lines are backed by discount window borrowing by the central bank.
• Attempting to sever those credit lines will either force the economy into industrial groups built around a financial firm that acts the group's financing arm, or will just go back in time and rebuild the merchant bank rediscounting system. These alternatives have drawbacks.

The reality that the implications of the reforms are not in the interest of any powerful groups makes their implementation extremely unlikely. Hence, the potential need for lender-of-last-resort operations will not plausibly go away.

Note that I am using "money market fund" in this article to refer to any fund that invests in money market instruments. This is distinct from a technical definition of money market funds, which operate under special regulations. Although this distinction may matter for retail investors, for institutional investors, what matters is the underlying instruments the fund invests in, not the ornamental wrapping around the fund.

Lack of Analytical Capacity in Money Markets

Many of those who call for the reform of the financial system put their faith in "market-based" approaches to lending. The belief that this will function is largely based on faith on free markets, without consideration of how the money markets actually function.

It is no accident that the serious financial crises in the post-1960s world generally started in money markets. (Hyman Minsky's works detailed the rise of the money market financing, and the associated crises.) As the business cycle rolls on, unwanted credit risk accumulates in the hands of those who are least able to analyse that risk. Many money market funds unfortunately fall into that role.

One important initial problem is that public money market investors are operating at a huge information disadvantage versus banks, and even specialist lenders like receivable factoring firms. They have to make lending decisions on low frequency public company data. This is enough for analysing long-term solvency risks, but not liquidity risk. This means that this works for corporate bonds, but not money market instruments, which are almost only exposed to borrower liquidity risk. The available information on a corporation's liquidity profile can be affected by end-of-period window dressing. Conversely, banks have a privileged view on at least some of their client's real-time liquidity situation. (A factoring firm will have a good view of transactions across the industry.)

The economics for money market fund analytic capability is terrible. There are two drivers. Firstly, fees are too low to support a large research staff. Secondly, the payoff for research is minimal. I discuss these in turn.

Imagine that we set up a money market fund that has attracted $1 billion in assets. That is smaller than some of the giant money funds, but is larger than the money market funds in smaller investment firm. Let is then make a very aggressive assumption that we could charge 10 basis points a year to hire analysis and trading personnel. (I apologise to any investment managers that sprayed coffee out of their nose when they read that.)

Ten basis points on $1 billion gives us $1 million to pay compensation. In Montreal, you used to be able to hire a junior credit analyst for $100,000/year salary, plus 50% to gives us $150,000 total compensation. (I have no idea what the current state of the market is.) A $1 million budget gives us a maximum team of six analysts and an intern (stagiaire). However, the numbers would be less than that, as we would need to hire portfolio managers/traders to execute trades, and they will not work as cheaply. So we are looking at a small team of analysts, at most.

Of course, the above numbers were wildly optimistic. A money market fund is lucky to get 10 basis points in fees in total, and so we also need to cover running expenses, risk management, back office, and marketing. (Plus, the firm may want to make a profit.)

The implication is that unless the money market fund is a behemoth, there are not going to be hundreds of credit analysts running around scouring for opportunities in the money markets.

The situation is even worse when you consider the risk profile of the money markets. A credit-investing firm normally tracks a pool of issuers. However, in order for the money market to function like an idealised market, investors have to be able to bid on a wider range of securities outside that pool.

Imagine that a investment broker calls you up and offers you $100 million of a security that is trading 20 basis points cheap to fundamentals. You have yet to analyse the company, but the initial pitch sounds interesting.

If the security is a 10-year bond, the 20 basis point cheapness translates (roughly) into $2 million excess return over the life of the bond. If the spread closes to fair value quickly, that profit will be front-loaded.That is enough excess return to justify digging further.

Imagine instead that it is a one-week maturity. If we round off the period to 1/50 of a year, the excess return over the life of the security is $4000. Do you really want to put $100 million of capital at risk to make $4,000? There is almost no incentive to dig into the issuer. (If you are already comfortable with the credit risk of the issuer, you might as well pick up the pennies off the road.) Money market credit analysis is generally going to piggy-back on the firm's corporate bond credit risk analysis. However, the low upside of these securities implies that the analysis will always have to be skewed towards the analysis of long-term bonds.

The reason why the money markets can function is that there is a reliance on the credit lines backing commercial paper programmes. If the issuer has a hard time issuing commercial paper to roll over the facility, it is expected to draw down the credit line (and probably enter into restructuring talks with the credit line issuer). The role of the money markets is to provide funding; the serious credit analysis is done when the commercial paper programme is being set up. (The corporate bond market has the capacity to take on more of the credit analysis tasks.)

All Credit Lines Lead to the Central Bank

In order for a credit line to be credible, it needs some form of backstop. Banks are in the liquidity management business, and at worst, they can use the discount window. The historical experience of the Bank of England resulted in an evolution towards this model.

Non-banks struggle to offer credit lines. Unless they themselves engage in the credit line equivalent of fractional reserve lending, they would need to hold an offsetting position in Treasury bills to match the amount of the credit line. This structure is economically equivalent to lending the entire amount of the credit line to the borrower. However, that is a large non-diversified exposure, and there are not a lot of investors that are interested in doing that.

In other words, if the authorities want to eliminate the special privileges of banks, they are effectively axing the credit line business. In turn, that wipes out the existing model for the money markets.

Economic forces would result in one of three outcomes, or a hybrid mixture of the three.

1. Short-term lending is cut off for most firms.
2. There will be oligopoly controlling short-term lending, and firms will fall into the orbit of finance providers.
3. Specialist lenders will rebuild a rediscounting system.

Short-Term Lending Cut Off

It is much easier to build a boutique firm that specialises in buying long-term corporate debt, particularly low quality. There is enough potential for excess returns to pay for analyst salaries.

If we reform banks so that they have no inherent advantages in short-term lending and cannot provide credit lines, we could just cut smaller firms off from short-term credit. They issue either long-term debt or equity. An economy without short-term debt is going to be relatively safe, we just need to look at the lack of crises in the aftermath of World War II. But as Hyman Minsky argued, once the trauma of the Great Depression wore off, borrowers and lenders became increasingly aggressive. 

There is a large desire in the private sector to hold cash instruments, and there is a large desire by the business sector to borrow short term. One of the economic roles of the financial system is to intermediate those desires. Attempting to abolish short-term financing by firms is most likely going to end up with financial innovations to work around the regulations. Meanwhile, it would be very easy for a "no bailout" policy to go horribly wrong in the near-term, as firms would need to restructure their balance sheets to match the new reality. The end result is that such reforms would be unpopular across the business community, dangerous, and face immediate pressure of being nullified by financial innovation.

Keiretsu System

The only way a money market fund could survive in world without credit lines is to be very large. It could then have the resources to employ a large staff of analysts. By definition, we cannot have a lot of very large funds; we would end up with an oligopoly.

Imagine you are a borrower that in some way competes with the owner of the money market fund. Do you think you would get funding? Of course not.

Economic forces would force firms into the orbit of one of the large financial funds. There would be pressure for the businesses in these groups to align their interests. The end result would resemble the Japanese keiretsu system, with an industrial group built around a financial firm, although it would likely be more informal than the Japanese structure.

Such a model can be successful; it worked for Japan, and the South Korean chaebols. If these industrial groups are lean and hungry, they can be an extremely dynamic force. The risk is that devolve into protected, senile, giants -- like the American automotive industry of the 1970s.

Erecting huge barriers to entry into finance or industry thus poses a risk to the long-term dynamism of the economy.

It may be that the previous discussion was alarmist; perhaps concentration rules might force some diversity of funds. For example, if a fund is limited to holding 10% of an issuers' paper, it would imply that there would have to be at least 10 funds holding the paper. The problem is that it would be very difficult for a small or medium firm to attract credit coverage from 10 or more large funds. Realistically speaking, funds aimed at institutional investors would arise that could take more concentrated lending positions. Since the funds' clients are institutions, they would be able to bypass concentration limits that would apply to public funds.

Rediscounting

The alternative approach would be for merchant banks to lend to industrial firms, and they themselves borrow in the money markets. For example, they could buy a receivable at a discount, and then borrow against that receivable by discounting it again (rediscounting) with an end investor. This is the old merchant bank money market model. Such specialist lenders still exist, such as receivables factoring.

End investors have a greatly reduced analysis burden. They only need to track the fortunes of a handful of merchant banks, plus some extremely large non-financial issuers, including governments.

This will work well, until it doesn't. The money markets using this structure were prone to runs when the credit of any of the merchant banks was called into question. This is why the credit line model evolved in the first place.

Concluding Remarks

Attempting to eliminate the possibility of bailouts by clamping down on banks is not an easy task. Either market-based intermediaries will step in -- and require eventual bailouts -- or else it would require a restructuring of the economic structure. Short-term finance would be expensive, and might require moving into the orbit of a finance firm.

(c) Brian Romanchuk 2018