Darrell Du e GSB Stanford Belgian Research Financial Form ...€¦ · Market-to-book equity ratios of systemic dealer banks Dealers: GSïMSïLEHïBSCïMER Banks: CïBACïJPM*ïWFC

Post-crisis bank regulations and financial market liquidity

Darrell DuffieGSB Stanford

Belgian Research Financial FormNational Bank of Belgium

Brussels, June, 2018

Based in part on research with Leif Andersen, Antje Berndt, Yang Song, and Yichao Zhu

Duffie Post-crisis bank regulations and financial market liquidity 1

A bank-intermediated over-the-counter market

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d2 d3c3

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c5


Implications of post-crisis regulations for market efficiency

1 More financial stability from higher bank capitalization and bail-in failure resolution.

2 Increased cost of access to bank balance sheets.

• The leverage-ratio rule has reduced incentives to intermediate safe assets.

• Bail-in failure resolution has significantly increased bank funding costs.

3 Market infrastructure and new competition rules lower the need for balance-sheet space.


Dealer balance sheet

assets

debt

equity


More equity to fund more assets

assets

debt

equity

old assets

new assets

debt

new equity

equity


Legacy shareholders have subsidized creditors

assets

debt

equity

old assets

new assets

debt

new equity

equity

Higher capitalization implies a value transfer from legacy shareholders to creditors.


Debt overhang

assets

debt

equity

old assets

new assets

debt

new equity

equity

For shareholders to break even, the new assets must be purchased at a profit that exceeds thevalue transfer to creditors. (Myers, 1977)


Leverage ratio rule is more binding than risk-based capital rulesResults of the Fed’s 2017 stress tests for the largest US dealer banks

JPM CITI BAML GS MS

CET1 (CCAR)CET1 (DFAST, adj.)SLR (CCAR)SLR (DFAST, adj.)

02

46

810

Exc

ess

capi

tal r

atio

(%

)

CCAR: stressed CET1 after assumed payouts, less 4.5%; stressed SLR less 3.0%.DFAST, adjusted: stressed CET1 (no payouts) less (4.5% + G-SIB surcharge); stressed SLR less the G-SIBminimum of 5%.

Data source: Board of Governors of the Federal Reserve, 2017.Duffie Post-crisis bank regulations and financial market liquidity 8

European banks reduce their balance sheets at quarter ends

Daily collateral outstanding in the tri-party repo market and the Federal

Reserve’s overnight reverse repo (ON RRP) facility

0

100

200

300

400

500

600

1/2016 4/2016 7/2016 10/2016 1/2017 4/2017

U.S. banks European banks Other banks Fed (ON RRP)

Figure Source: Egelhov, Martin, Zinsmeister, Federal Reserve Bank of New York, August, 2017.

Notes: Banks headquartered in the euro area and Switzerland report leverage ratios as a snapshot of their value on the last day of each quarter, while their U.S. counterparts report quarterly averages. Totals only include trades backed by Fedwire-eligible securities–that is, U.S. Treasury and agency securities.

Billions of dollars


Impact of the leverage-ratio regulationon repo intermediation costs to legacy shareholders

old assets

old debt

equity

repo asset repo claim

old assets

repo asset

old debt

repo claim

equity

new equitysafe assets


Impact of SLR on UST repo market efficiency

13−Q1 13−Q3 14−Q1 14−Q3 15−Q1 15−Q3 16−Q1 16−Q3 17−Q1 17−Q3 18−Q10

5

10

15

20

25

GC

F−

trip

arty

rat

e sp

read

(ba

sis

poin

ts)

(a) bid-ask spreads up39

Decline in GCF net lending volume

(b) inter-dealer positions down

Figure: (a) Average within-quarter difference between overnight GCF and Tri-party repo rates. Data sources:Bloomberg and BNY-Mellon. (b) Figure source: Antoine Martin, FRBNY (2016).


Cross-currency basis and bank funding costsFunding value adjustments now leave wider arbitrage bounds on the basis

Five-Year Cross-Currency Basis: G10 Currencies

−100

−50

050

Basis

Poin

ts

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

AUD CAD CHF DKK EUR

GBP JPY NOK NZD SEK

(a) 5-year USD cross-currency basis. Source: Du,Tepper, and Verdelhan (2017).

US banksEuropean banks

2004 2006 2008 2010 2012 2014 2016 2018

050

100

150

200

250

300

year

CD

S r

ate

(b) 5-year dealer credit spreads


CIP arbitrage can be costly to dealer shareholdersDebt overhang cost for funding synthetic dollar deposits

assets

debt

equity

old assets

EUR→USD

old debt

USD debt

equity

To benefit shareholders, the trade profit must exceed the funding value adjustment (FVA), adebt-overhang cost.


Funding cost to shareholders

old assets

EUR→USD

old debt

USD debt

equity

funding value adjustment (FVA)

A debt-funded safe arbitrage is not valuable to bank shareholders unless it’s excess yield isabove the bank’s credit spread. Source: Andersen, Duffie, Song (2018)


Credit spreads: funding-cost wedge and arbitrage bounds

2002 2004 2006 2008 2010 2012 2014 2016 2018

050

100

150

200

250

year

one−

year

IBO

R−

OIS

spr

ead

(bas

is p

oint

s) EURIBOR−OIS (Eonia)USD−LIBOR−OIS (Fed funds)

Figure: Spreads between one-year IBOR and OIS rates. Data source: Bloomberg.


At a given solvency level, big-bank credit spreads are higherTime fixed-effects in the relationship between CDS rates and distance to default

Big banksAll other firms

2002 2004 2006 2008 2010 2012 2014 2016

01

23

45

67

year

CD

S ti

me

fixed

effe

ct

Based on panel regression, from work in progress with Antje Berndt.


GSIB 5-year credit spread at annual default probability of 0.5%Before adjusting for pre-crisis bailout protection

Big banks

2002 2004 2006 2008 2010 2012 2014 2016

050

100

150

200

250

year

CD

S r

ate

(bas

is p

oint

s)

Based on panel regression, from work in progress with Antje Berndt.


Sovereign support has been removed from GSIB ratings

Other firmsGSIBs

2002 2004 2006 2008 2010 2012 2014 2016 2018

02

46

810

12

year

Ref

ined

rat

ing

Group medians of refined ratings. Data source: Moody’s Investor Services.


Average leverage of systemic banks and investment banks

Dealers: GS−MS−LEH−BSC−MERBanks: C−BAC−JPM*−WFC

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

05

1015

2025

3035

40

year

Leve

rage

Data source: 10K filings. J.P. Morgan includes preceding mergers, pro forma.Duffie Post-crisis bank regulations and financial market liquidity 19

Market-to-book equity ratios of systemic dealer banks

Dealers: GS−MS−LEH−BSC−MERBanks: C−BAC−JPM*−WFC

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

01

23

4

year

Mar

ket−

to−

book

equ

ity r

atio

Data source: 10K filings. J.P. Morgan includes preceding mergers, pro forma.Duffie Post-crisis bank regulations and financial market liquidity 20

Funding Costs to Dealer ShareholdersFrom work with Andersen and Song: The marginal increase in the value of the dealer’s equity per dollar of adebt-funded asset purchase is

p∗π − δCOV∗ − FVA,

where

I p∗ is the dealer’s risk-neutral probability of survival to term.

I π is the trade profit (P&L).

I δ is the risk-free discount.

I COV∗ is the risk-neutral covariance of the asset payoff and dealer default event.

I FVA is the funding value adjustment p∗δST , where S is the dealer’s credit spread and T is the term.

The extra marginal cost to dealer shareholders when a fraction α of the funding must be equity isα(1− p∗ − FVA), which annualizes to roughly αS (assuming a loss given default of 0.5).

For safe assets, the shareholder breakeven “arbitrage” yield is thus the total annualized funding cost to

shareholders of roughly (1 + α)S.


When should a dealer arbitrage the USD-JPY CIP basis?

0100

200

300

400

12/31/14 3/31/15 3/30/15 9/30/15 12/30/15 3/31/16 6/30/16 9/30/16

1w deviation 1m deviation 3m deviation

(a) Level of Yen CIP Deviations

−300

−200

−100

0100

200

12/31/14 3/31/15 3/30/15 9/30/15 12/30/15 3/31/16 6/30/16 9/30/16

3m−1m deviation 1m−1w deviation

(b) Term Structure of Yen CIP Deviations

Figure 7: Illustration of Quarter-End Dynamics for the Term Structure of CIPDeviations: In both �gures, the blue shaded area denotes the dates for which the settlementand maturity of a one-week contract spans two quarters. The grey shaded area denotesthe dates for which the settlement and maturity dates of a one-month contract spans twoquarters, and excludes the dates in the blue shaded area. The top �gure plots one-week,one-month and three-month CIP Libor CIP deviations for the yen in red, green and orange,respectively. The bottom �gure plots the di�erence between 3-month and 1-month LiborCIP deviation for the yen in green and between 1-month and 1-week Libor CIP deviationfor the yen in red.

52

Source: Du, Tepper, and Verdelhan (2016).Duffie Post-crisis bank regulations and financial market liquidity 22

Central counterparties reduce need for balance-sheet space

c1

d1

c2

CCP

d2 d3c3

c4

c6

c7

c5


Compression eliminates space used for redundant swaps

d1

d2

d5

d3

d4

10

40

60

50

40

d1

d2

d5

d3

d4

10

40

20

10

0

Figure: Counterparty exposures and initial margin are reduced without changing market exposures. Providersinclude TriOptima, which has eliminated over $1 quadrillion notional of swaps.


A bank-intermediated bilateral OTC market

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c5


Improving trade competitionObjective: Migration of actively traded products to all-to-all trade platforms

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CLOBd1

d2c2

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c5c4

c6


OTC competition after Dodd-Frank and MiFIDBuy-side firms request quotes at multilateral trading platforms

c1

MTP

d1 d2


Excessive fragmentation across platforms

c1MTP1

d1

d2

MTP2

d2

d3


Reducing fragmentation improves competition

c1

MTP

d1

d2

d3


At corporate bond platformsDealer competition lowers buy-side trade costs

-‐10

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Cost in Basis Points

Number of dealers responding

Investment Grade

High Yield

Source: Hendershoc and Madhavan (2014) Source: Hendershott and Madhavan (2016)Duffie Post-crisis bank regulations and financial market liquidity 30

Now typical fragmented two-tiered OTC markets

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d1

c2

CLOB

d2

MTP1

d3c3

MTP2

c6

c7

MTP3

c5


Appendix: How CIP arbitrage costs dealer shareholdersI Suppose the one-year USD risk-free rate is zero.

I Our bank has a one-year credit spread of 35 basis points.

I We borrow $100 with one-year USD commercial paper, promising $100.35.

I We invest $100 in one-year EUR CP, swapped to USD, with the same all-in credit quality as that of ourbank’s CP, and uncorrelated.

I Suppose the EUR CP, swapped to dollars, promises $100.60, for a basis of −25bps.

I We have a new liability worth $100 and a new asset worth $100.65/1.0035 ' $100.25, for a trade profit ofapproximately $0.25.

I However, the marginal value of the trade to our shareholders is negative, because, conditional on dealersurvival, the expected incremental payoff to equity is

$100.25 − $100.35 = − $0.10. Conditional on default, equity gets nothing.


Documents

Darrell Du e GSB Stanford Belgian Research Financial Form ...€¦ · Market-to-book equity ratios of systemic dealer banks Dealers: GSïMSïLEHïBSCïMER Banks: CïBACïJPM*ïWFC