Bank Debt Overhang andFinancial Market Liquidity
Darrell DuffieGSB Stanford
Working Group on Economic PolicyResearch Lunch Talk
November 6, 2017
Duffie Bank Debt Overhang and Financial Market Liquidity 1
Focus: Bank-intermediated OTC markets
c1
d1
c2
d2 d3c3
c4
c6
c7
c5
Duffie Bank Debt Overhang and Financial Market Liquidity 2
Policy Implications
1 More financial stability from higher bank capital requirements andbetter failure resolution.
2 The leverage-ratio rule needlessly raises the cost of access to bankbalance sheets for safe asset intermediation. Better: raise risk-basedcapital requirements.
3 A new finding: Debt funding costs for banks are appropriatelyheightened by more effective failure resolution, but this has furtherincreased the cost of access to bank balance sheets.
4 Policies should speed the development of intermediation methods thatrequire less space on bank balance sheets, such as centralcounterparties and more competitive all-to-all trade platforms.
Duffie Bank Debt Overhang and Financial Market Liquidity 3
Conventional 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 aprofit that exceeds the value transfer to creditors. (Myers, 1977)
Duffie Bank Debt Overhang and Financial Market Liquidity 4
SLR is more binding than risk-based capital ratiosResults 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); stressedSLR less the G-SIB minimum of 5%.
Data source: Board of Governors of the Federal Reserve, 2017.Duffie Bank Debt Overhang and Financial Market Liquidity 5
European Banks Delever as Reporting Days Approach
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
Duffie Bank Debt Overhang and Financial Market Liquidity 6
Impact of 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
Duffie Bank Debt Overhang and Financial Market Liquidity 7
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
GC
F−
trip
arty
rat
e sp
read
(ba
sis
poin
ts)
0
5
10
15
20
25
(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-partyrepo rates. Data sources: Bloomberg and BNY-Mellon. (b) Figure source: AntoineMartin, FRBNY (2016).
Duffie Bank Debt Overhang and Financial Market Liquidity 8
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).
year
CD
S r
ate
2004 2006 2008 2010 2012 2014 2016
050
100
150
200
250
300
US banksEuropean banks
(b) 5-year dealer credit spreads
Duffie Bank Debt Overhang and Financial Market Liquidity 9
Cross-currency basis−
25
0−
20
0−
15
0−
10
0−
50
05
0B
asis
Po
ints
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
Figure 2: Short-Term Libor-Based Deviations from Covered Interest Rate Parity:This figure plots the 10-day moving averages of the three-month Libor cross-currency basis,measured in basis points, for G10 currencies. The covered interest rate parity implies thatthe basis should be zero. One-hundred basis points equal one percent. The Libor basis isequal to y$,Libort,t+n − (yLibort,t+n − ρt,t+n), where n = three months, y$,Libort,t+n and yLibort,t+n denote theU.S. and foreign three-month Libor rates, and ρt,t+n ≡ 1
n(ft,t+n − st) denotes the forward
premium obtained from the forward ft,t+n and spot st exchange rates.
50
(c) 3-month USD cross-currency basis.Source: Du, Tepper, and Verdelhan(2017)
one−monththree−monthsix−monthone−year
2004 2006 2008 2010 2012 2014 2016
050
100
150
200
year
US
D L
IBO
R−
OIS
spr
ead
(bas
is p
oint
s)
(d) LIBOR-OIS spreads. Data source:Bloomberg.
Duffie Bank Debt Overhang and Financial Market Liquidity 10
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 valueadjustment (FVA), a debt-overhang cost.
Duffie Bank Debt Overhang and Financial Market Liquidity 11
Example: CIP arbitrage can be bad for 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 creditquality as that of our bank’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 of approximately $0.25.
I However, the value of the trade to our shareholders is negative, because,conditional on dealer survival, the expected incremental payoff to equity is
$100.25 − $100.35 = − $0.10. Conditional on default, equity gets nothing.
Duffie Bank Debt Overhang and Financial Market Liquidity 12
New finding: Dealer credit spreads are lower boundson excess intermediation returns
2002 2004 2006 2008 2010 2012 2014 2016
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)
Data: Bloomberg
Duffie Bank Debt Overhang and Financial Market Liquidity 13