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The Banking System Is Both Too Big and Not Big Enough

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It's too big in the sense that the capacity to make loans far outweighs the demand for credit, yet it's not big enough to accommodate the demand for liquid savings.

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I think this cycle where investors favor liquid short term in lieu of illiquid long term assets is in the early innings, and with balance sheets already stretched, it's not clear to me that the system has the capacity to accommodate much more savings. Just as baby boomers overwhelmed the asset side of bank balance sheets during the consumption cycle, we may now see the cycle of savings overwhelm the liability side.

In a zero rate environment with rising capital ratio requirements, are banks going to expand their balance sheets to meet this demand for liquidity? As I wrote in Bond Market Strength Forged in the Fires of Adversity, this is a symptom of the Structural Trap that the boys over at the contrarian corner have been writing about (here and here). I argued that the banking system needs to shrink as credit capacity is simply too large in relation to the demand for money.

In August 2011 the IMF published a report by Zoltan Pozsar titled Institutional Cash Pools and the Triffin Dilemma of the US Banking System. Pozsar take a contrarian view of the so-called shadow banking system in that he believes it was demand driven by the massive amount of corporate cash looking for insured deposit alternatives for which the system is not able to accommodate (emphasis mine):

The Triffin dilemma is often used to articulate the US dollar's problems as the global reserve currency under the Bretton Woods system. Namely, as US dollars became more and more widely used as the world's reserve currency in the 1960s, their volume in circulation grew to exceed the amount of gold actually backing them. This was unsustainable and the dilemma was "solved" by President Nixon taking the dollar off gold in 1971.

In the present context, Treasury bills (or more broadly, short-term government guaranteed instruments) are like gold. Just as in the 1960s there were too many dollars relative to US gold reserves, today there is too much demand for safe, short-term and liquid instruments relative to the volume of (i) short-term, government guaranteed instruments; (ii) high-quality collateral to "manufacture" alternatives to short-term, government guaranteed instruments; and (iii) capital to support the safety, short maturity and liquidity of such alternatives.

These examples demonstrate that not unlike the soaring volume of US dollars relative to the volume of US gold reserves stretched the convertibility of the dollar in the 1960s, the rise of institutional cash pools and their safety preferences stretched the US banking system to its limits in its ability to guarantee cash pools' principal safety and redeemability on demand and at par and in unlimited amounts and in all states of the world.

The diagnosis that deposit-funded banks were the ultimate guarantors of institutional cash pools' principal balances is an important one given that the volume of uninsured institutional cash pools at $3.5 trillion is not far behind the volume of households' insured cash balances at $6 trillion (both as of the first quarter of 2011).

At just over 5%, uninsured institutional cash pools were a negligible fraction of insured deposits as recently as two decades ago, but account for over 55% of insured deposits today. In light of these developments, it is legitimate to ask whether the secular rise of institutional cash pools relative to the volume of insured deposits in the US financial system is making banks increasingly less able to backstop them.

The banking system is both too big and not big enough. It's too big in the sense that the capacity to make loans far outweighs the demand for credit, but by the same token, it's not big enough to accommodate the demand for liquid savings. If liquid deposits continue to dominate household net worth then this problem is only going to get worse.

Friday the bond market got word that the US Treasury requested that holders of over $2 billion in Treasury securities contact the Federal Reserve of New York by March 21 to address their large positions in an effort to probe the recent 10-year repo squeeze that saw nearly $80 billion in fails last Monday. Buried in Saturday's Wall Street Journal:

Regulators tuned into the irregular activity in the Treasury market when they saw some $80 billion worth of loans bust up last Monday in the more than $3 trillion repo market, where financial institutions take out short-term loans to fund themselves using Treasuries as collateral.

Market participants said the recent anomalies in the trading of 10-year Treasury notes stemmed largely from a recent increase in bets that Treasury prices would fall and yields would rise....

Back in 2009 we saw a similar repo squeeze when the 10-year yield went from 3.75% to 2.125% and back to 3.80%. However back then it wasn't speculative positions that were short, it was hedging. MBS holders who are naturally short volatility saw volatility spike and thus the need to hedge their negative convexity risk. This could be the case today.
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