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

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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)

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5

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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

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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

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