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Monday, August 15, 2022

Primer: Leveraged Financial Firms

This article discusses the basic concepts around leveraged financial firms (entities). This is expected to turn into an early section in my banking primer. The key take away from this discussion is that the distinction between bank and non-bank finance is somewhat smaller than is popularly suggested. The difference lies in the infrastructure needed to gather and service deposits, but the balance sheet structure can be largely replicated by non-bank financial firms. This explains why banks and non-banks blend into each other in the absence of regulations to the contrary.

Types of Lenders

The interest here are financial firms (or legal entities) that are lending money in the form of loans or via debt securities. This puts aside financial firms that make equity or real estate investments, make markets, trade commodities, etc.

For such firms, the asset side of the balance sheet is always the same: debt instruments with varying maturity dates. Short-dated instruments might be labelled “cash,” but that is essentially decorative — it is a portfolio of fixed income instruments (not necessarily traded in markets).

The differences between the types I describe show up on the other side of the balance sheet. That is, how are the assets financed?

All Equity Financing

The least exciting structure is one that is entirely equity — the owner(s) of the fixed income portfolio do not borrow against it.

Examples include.

  • Individuals/trusts with bond portfolios.

  • Individuals who lend to other individuals/small firms.

  • Mutual funds (unit trusts) that own bonds on behalf of unit holders.

  • Mortgage-backed securities that pass through all payments to owners of the securities.

  • Cautious pension funds.

Securities Portfolio With Securities-Based Leverage

The next case is where the owner of a portfolio of fixed income securities “applies leverage” to the portfolio using standard mechanisms from securities markets. “Applying leverage” is the funky way of saying “borrow against the security portfolio,” which means that there are now liabilities in the owner’s capital structure.

Means of borrowing include the following.

  • Margin loan from a broker.

  • The use of repurchase agreements (“repo”).

  • A bank loan with securities collateral.

  • Financial derivatives can be used to create the economic equivalent of borrowing to buy securities.

Examples of such firms would be investors with margin accounts, hedge funds, and more adventurous pension funds.

Why Use Leverage?

The use of leverage allows the entity to have a larger portfolio than it would if it did not borrow. As long as its borrowing cost is less than the yield on its assets, it generates more interest income than it would without borrowing. If there are capital gains on the loans, the return on equity is larger since the ratio of portfolio size to equity is larger.

The downside is that losses — capital losses, and credit losses on the portfolio — are also magnified as percentage of equity.

A Firm With “Customised” Liabilities

Relying on “market based” financing has its problems. If the portfolio does not consist of securities, there is no public market value that could be used for the collateral. Furthermore, lending that is sensitive to the market value of collateral has a short term focus: the firm may face a margin call at the wrong time, and be forced to liquidate positions. The lenders may also wish to cut their exposure to the firm even if the collateral value allows for more borrowing.

The way to develop a more robust structure is to customise the liability structure: issue different classes of debts at different maturities. These could be privately placed long-term loans, or bond issuance by a larger firm.

The equity of the firm will absorb the initial losses from the fixed income portfolio, so the credit risk of its debt instruments is lower than its asset portfolio. This equity protection explains why the firm can hope to borrow at a yield below that of its assets.

Since firms target a return on equity that is greater than bond yields, this is the standard structure for corporations. However, it can be emulated by investment vehicles like Collateralised Debt Obligations (CDOs). A CDO will issue different classes of securities, with the lower rungs absorbing credit losses first. This allows financial engineers to finance a portfolio of risky debts — like residential mortgages before the Financial Crisis — by issuing securities that allegedly match the risk preferences of investors. (Going into the Financial Crisis, there were more investors interested in AAA-rated securities than there were issuers of these securities. By stuffing mortgages into a CDO, the least risky class (tranche) could be rated AAA (oops), while the riskier classes had greater yields that attracted “yield hungry” investors (or to use the technical term, suckers).

Maturity Mismatch

(I wrote about this in a fairly recent article, so will cut this section short.)

We then run into The Great Maturity Mismatch — borrowers generally want to borrow at long maturities, but many entities want to have a large weighting to short-term liquid assets. Although bond fund holdings are long term, we also have to look at things like corporate treasuries. Although some people might be fixated on “holding money,” when we look at aggregate balance sheets, the proper term is “holding money market assets.”

In order to get balance sheets to balance, we see that there is a natural inclination for financial firms to issue short-term debt to finance long-term assets. This creates the potential for financial instability — if they cannot convince their lenders to roll over the financing, they would be forced to liquidate. This ties in to the well-known Financial Instability Hypothesis (FIH) of Hyman Minsky.

The key to the FIH is that it is not just some special thing that happened in the run up to the Financial Crisis — it is a natural tendency towards instability within the financial system created by economic incentives. The standard Post-Keynesian complaint is that these forces are glossed over by neoclassical economic theory, where everything comes down to optimising real output.

Banks Versus Non-Banks

What sets banks apart from non-banks is that instead of just issuing wholesale money market instruments, they also issue deposit liabilities. Deposit liabilities have advantages in practice over money market issuance — but not any firm can issue them. There are barriers to entry: regulatory oversight, as well as considerable capital needs. You generally need a branch network as well as the ability to access the payment system. Furthermore, branches are not just for attracting deposits, as they offer other services, with the most important being the availability of loan officers to make loans to small borrowers (e.g., small business loans, mortgages). A hedge fund might be able to replicate the maturity structure of a bank’s balance sheet, but it cannot offer the same financial services.

“Money Creation”

One might get excited about “banks creating money” — until we realise that is solely because some definitions of “money supply” just include bank deposits. As soon as we branch out to wider definitions of the “money supply,” we see that any issuer of those instruments are also “creating money.”

The previous assertion might cause distress in some quarters, so I will elaborate. There are admittedly superficial differences between non-bank and bank “money creation” since the non-bank system is built up on the payment system of formal banks, but this does not stop the creation of “monetary” instruments (an instrument that shows up in some monetary aggregate).

  • Formal banks create deposits “out of thin air” by extending a loan — the bank’s balance sheet instantly expands with both an asset (the loan) and a deposit liability.

  • A non-bank like a mutual fund also creates instruments that qualify as “money” typically through a transformation of existing “money.” For example, a money market fund (normally considered part of a wide monetary aggregate, like M3/M4) might get bank funds wired to it by a client. The client transforms its deposit asset “money” into money market fund “money.” However, the bank deposit “money” does not disappear — it remains on the balance sheet of the money market fund, which then typically buys commercial paper with it. This means that wider monetary aggregates grow by the amount of the increase in money market fund units outstanding.

If the non-bank financial firm is important enough, it could conceivably skip the need for formal banking to be in the process as well. We could imagine a poorly regulated money market fund exchanging its units with a firm in a exchange for the firm’s commercial paper. The money market fund grows its assets and liabilities “out of thin air.” Such behaviour is frowned up within the formal financial system, but I have seen such behaviour alleged within the more “dynamic” crypto trading environment.

The key point is that the special character of banks in “money creation” is their utility status with respect to the payments system, the actual balance sheet operations are not that distinct from any other issuer of money market paper.

Bank and Money Mysticism

If one were to look at the financial system without preconceptions, we see that banks and non-banks can end up with similar balance sheets, and end up behaving in similar ways. The difference is that banks are structured to deal with a multitude of retail/small business customers and are regulated on that basis, while non-banks operate in the corporate and financial world and are regulated on the basis that everyone involved is supposed to know what they are doing.

Unfortunately, it appears that the default is to approach money and banking with preconceptions. Since someone arbitrarily decided that bank deposits are “money” and “commercial paper” is not, we see anguished analysis of what banks are doing, while commercial paper issuers are quietly marching to the next financial crisis while being ignored.

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(c) Brian Romanchuk 2022

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