Peter Stella has an interesting post on VOX on the implications of collateral supply for different approaches to running down the large balances of reserves held in the banking system as a result of QE operations.
Stella has written a number of papers and articles on the workings of the repo market often looking at the impact of collateral shortages on overall lending volume. Together with Manmohan Singh, he has probably done the most to raise the issue of collateral availability and its implications.
In this most recent article, Stella compares two alternatives for managing a drain of large amounts of excess reserves. The first is to simply offer banks term deposit facilities with the central bank. This would effectively convert their holdings of short term claims on the central bank into a longer term one. The second is a central bank reverse repo programme. This would involve the central bank selling assets from its portfolio with an agreement to repurchase at a fixed price after a period of time.
Stella is in favour of the latter and believes that it will facilitate more credit creation. He has two reasons for thinking this.
The first reason relates to banks balance sheets and the leverage ratio. To understand this point, it is useful to note that non-banks cannot hold reserves. Therefore, when the central bank acquires asset from non-banks, this necessarily involves adding both an asset and a liability to the balance sheet of the banking sector. Reserves (assets of the banks) go up and deposits (liabilities of the banks) go up.
Although this may involve little risk to the bank, it is not without consequence. Whilst holdings of reserves do not attract a capital requirement, they are included in the measurement of assets for the leverage ratio. Where banks are constrained not by capital, but by overall leverage, holdings of reserves may be effectively crowding out lending to the private sector.
Switching reserves into term deposits will do nothing to change this. However, if the central bank conducts reverse repo with the non-bank private sector, that will simultaneously drain reserves and reduce deposits, thereby eliminating the middle-man role required of banks. For banks subject to a leverage ratio constraint, that may free up lending capacity.
It is hard to tell how important this is. Certainly some banks have indicated that they expect to be impacted by the leverage ratio, over and above the normal capital requirements. But how much difference that will make in the long run is another matter. My own feeling is that is there would be some effect, but it may not be that great.
It is worth noting however that this aspect has nothing do with collateral. The important distinction here is between arrangements transacted with banks and those transacted with non-banks. If the central bank was to offer term deposit facilities to non-banks, this would achieve the same reduction in bank balance sheets as a reverse repo programme.
The second argument concerns the role of collateral chains in credit creation. Stella points out that increased bank reserves do not in fact facilitate greater bank lending, as is suggested by the money multiplier model. However, high grade collateral, according to Stella is crucial to the volume of lending within the non-bank sector, because of the amount of this that is carried out through repo. Collateral shortages squeeze this form of lending.
I have written about collateral availability and the impact on loan volume before (here). As discussed in that post, I do think there are good reasons why we might expect to see a positive correlation between the level of repo business and the amount of eligible collateral available to the market.
However, the point I wish to make here is that, in almost every case, the credit creation associated with collateral availability is ultimately only financing the actual holding of that collateral. It is not going to finance new expenditure on produced goods.
If we are concerned about low levels of lending, the sort of thing we are probably focused on is a small businesses that wants to incur investment expenditure but cannot raise the funds. We want to see more bank lending so that this type of expenditure can take place.
Making more collateral available to the market does nothing to facilitate this. The small businessman cannot use the extra collateral available to help raise the funds he needs. Banks might be prepared to provide him with repo finance, but to take advantage of that he has to get hold of that collateral in the first place. He can only do that by using the very funds he raises to buy or repo in the collateral. The only people who can benefit from repo funding are those who are looking to take a position in the underlying collateral or others in the collateral chain.
This is not to say that this type of finance has no macroeconomic effect. The use of repo serves to increase demand for the underlying collateral, which pushes up asset prices generally (see again my earlier post). However, it is important to understand that is only through this effect on asset prices that any potential macroeconomic benefit is arising - there is no separate credit creation for the real economy that is being facilitated. It therefore needs to be assessed in the context
Other things being equal, more liquidity is a good thing. I'd therefore be inclined to take the view implied by Stella that draining reserves through a reverse repo programme available to non-banks is better than a bank only term deposit facility. However, I think it would be a mistake to confuse any impact on the repo market with a potential improvement in finance availability for the real economy.