Understanding the role of debt in the financial system – Bengt Holmstrom (January 2015)

The notes below summarise what I took away from a paper by Bengt Holmstrom that explores the ways in which money markets are fundamentally different from stock markets and what policy implications flow from his interpretation of those differences. Holmstrom argues that focus and purpose of stock markets is price discovery for the purpose of allocating risk efficiently. Money markets, in contrast are about obviating the need for price discovery in order to enhance the liquidity of the market. Over-collateralisation is one of the features of the money market that enable trading to occur without the need to understand the underlying risk of the assets that are being funded .

Holmstrom appears to have written the paper in response to what he believes to be misconceived attempts to reform credit markets in the wake of the recent financial crisis. These reforms have often drawn on insights grounded in our understanding of stock markets where information and transparency are key requirements for efficient price discovery and risk management. His paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why information insensitivity is the natural and desired state of the money markets.

 1. Introduction

Holmstrom notes that one of the puzzles of the GFC was how people traded so many opaque instruments with a seeming ignorance of their real risk. The tendency to see this as a conspiracy by bankers to confuse and defraud customers has in turn prompted calls to make money market instruments more transparent. While transparency and disclosure is essential for risk pricing and allocation, Holmstrom argues that this is not the answer for money markets because they operate on different principles.

 “I will argue that a state of “no questions asked” is the hallmark of money market liquidity; that this is the way money markets are supposed to look when they are functioning well.”


“Among economists, the mistake is to apply to money markets the lessons and logic of stock markets.”

“The key point I want to communicate today is that these two markets are built on two entirely different, one could say diametrically opposite, logics. Ultimately, this is because they serve two very different purposes. Stock markets are in the first instance aimed at sharing and allocating aggregate risk. To do that effectively requires a market that is good at price discovery.

 “But the logic behind transparency in stock markets does not apply to money markets. The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.”

“Why does this matter? It matters because a wrong diagnosis of a problem is a bad starting point for remedies. We have learned quite a bit from this crisis and we will learn more. There are things that need to be fixed. But to minimise the chance of new, perhaps worse mistakes, we need to analyse remedies based on the purpose of liquidity provision. In particular, the very old logic of collateralised debt and the natural, but sometimes surprising implications this has for how information and risk are handled in money markets, need to be properly appreciated.”

While the paper offers a useful insight into why transparency is not necessarily of value in the money markets, I struggled with Holmstrom’s emphasis on the value of opacity. I think it is equally important that money market instruments not be overly complex. A “no questions asked” state will also be facilitated by simple instruments that are easy to understand and have less that can go wrong.

2. Pawn shops to repos

 The obvious attraction of collateralised lending is that over-collateralistion obviates the need to discover the exact price of the collateral. A safe lower bound is all that is needed. Holmstrom argues that, while the basic principles have been repurposed in the modern money markets, collateralised lending is not new. It is a long standing feature of many financial systems that can be traced back to the pawn shops that emerged during the Tang Dynasty (China circa 650 AD). This financial institution predates the emergence both of joint stock companies (in France and Sweden early in the early 13th century) and of the stock exchange (in Amsterdam in the early 17th century). This for Holmstrom suggests

“… that any institution that has survived nearly intact for so long must be based on very robust and efficient economic principles. The explosive growth in shadow banking is the most recent testimony to the enduring logic of collateralised lending as illustrated by the pawn shop”

“Today’s repo markets, which play such a prominent role in shadow banking and also in the crisis, are close cousins of pawn brokering with similar risks for the parties involved. In a repo the buyer of the asset (the lender) bears the risk that the seller (the borrower) will not have the money to repurchase the asset and just like the pawnbroker, has to sell the asset in the market instead. The seller bears the risk that the buyer of the asset may have rehypothecated (reused) the posted collateral and cannot deliver it back on the termination date.”

“There is one significant functional difference between pawning and repo. In pawning the initiative comes from the borrower who has a need for liquidity. In repo the motive is often the opposite: someone with money wants to park it safely by buying an asset in a repo (or reverse repo as it is called from the lender’s perspective). This feature played a key role in the rapid rise of shadow banking that preceded the crisis…”

3. Money markets versus stock markets

In this section of the paper, Holmstrom contrasts money markets with stock markets, showing how different they are in most respects. Each system displays a coherent internal logic that reflects its purpose but these purposes are in many respects polar opposites.

Stock markets are primarily about risk sharing and price discovery. As a consequence, these markets are sensitive to information and value transparency. Traders are willing to make substantial investments to obtain this information. Liquidity is valuable but equity investors will tend to trade less often and in lower volumes than debt markets. These markets provide some funding but that is not their primary function.

Money markets, in contrast, are primarily about liquidity and funding. The price discovery process is much simpler while trading is much higher volume and more urgent.

Money markets

“The purpose of money markets is to provide liquidity. Money markets trade in debt claims that are backed, explicitly or implicitly, by collateral. Often the collateral is itself debt … I will suggest a robust logic for using debt as collateral a bit later. For now, let me take debt as given and focus on the simple fact that, if the collateral used for trading in repo markets, for instance, is itself debt, price discovery is going to be even more difficult. By design, there was no need to discover the exact value of the collateral backing the initial debt. And, now that this debt is used as collateral for the repo, it will be even more difficult to discover the underlying value. “

 “People often assume that liquidity requires transparency, but this is a misunderstanding. What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. Without symmetric information adverse selection may prevent trade from taking place or in other ways impair the market (Akerlof (1970)).”

“Trading in debt that is sufficiently over-collateralised is a cheap way to avoid adverse selection. When both parties know that there is enough collateral, more precise private information about the collateral becomes irrelevant and will not impair liquidity.”

“From here it is a short step to see that obfuscation may be beneficial. When neither side has an informational advantage to start with, the market will be free of fears of adverse selection and therefore very liquid. This blissful state of “symmetric ignorance” may be broken by public information that makes some trader’s private information relevant”

” The desire to circumvent price discovery is a natural consequence of lending.  Price discovery in a bilateral setting is typically very costly (bond markets are different, but even they are quite illiquid). Gross characteristics, such as credit ratings, the term of the loan and the amount of the loan are, of course, essential for agreeing on a price. So are reference prices …. This type of information acquisition is best described as due diligence. Traders want to make sure that … the price is in the right ball park. There is no precise price discovery in the sense of the stock markets. Even bonds that are traded on exchanges suffer from thin trading, so posted prices are often proxies for what a bond could be sold for. The spreads are big.”

“Information-sparseness in money markets manifests itself in other ways too. There are no analysts monitoring money markets and relatively few that follow bond markets. The information of most interest in bond markets concerns interest rates and prepayment risks. Interest rates are available continuously and prepayment risks are not a source of adverse selection even though traders use different models for evaluating such risks. When new bonds are issued, the issue is typically sold in a day or less. Little information is given to the buyers. It is very far from the costly and time-consuming road shows and book-building that new stock issues require in order to convey sufficient information.” 

Holmstrom argues that liquidity requires symmetric information about the value of the security, not transparency. Symmetric information reduces the risk of adverse selection that arises when some participants in the market have information that others do not. It is not necessary for the information to be better (i.e. true). The problem arises simply because the risk of asymmetry in information impedes trading.

It is easy to see how over-collateralisation is a simple way to remove the information asymmetry problem. Deliberate “obfuscation”, for me at least, is hard to justify but the point I think is that trading liquidity is enhanced when the pay off is deeply insulated from risk. “Symmetric ignorance” is perhaps a better term.

Stock markets

The main purpose of stock markets is to share and allocate risk … Over time, stock markets have come to serve other objectives too, most notably governance objectives, but the pricing of shares is still firmly based on the cost of systemic risk (or a larger number of factors that cannot be diversified). Discovering the price of systemic risk requires markets to be transparent so that they can aggregate information efficiently.     

Unlike money markets, which tend to involve few participants with large unit trades, stock markets benefit from having a large number of small investors. The average volume of daily trade on the New York stock exchange is of the order of $100 billion with substantial volatility. The value of each order is small. By comparison, the daily turnover in repo markets is several trillion dollars,

Holmstrom cites various evidence to support his argument that stock markets are not a significant source of funding for firms underscoring their role for risk sharing. A study by Colin Mayer (1990) of investments by private firms over the period 1970–85 in five developed countries found that equity issues are a very small percentage (less than 5%) of the aggregate funding of net investments. The principal source of funding came from retained earnings (about 70%) and from bank loans and bonds (about 25% split equally). The Mayer study is a bit dated but the observation that equity markets play a minor role in funding rings true.           

 The importance of price discovery in stock markets goes hand in hand with the traders’ incentives to acquire information. Every piece of information about the value of a firm is relevant for pricing its shares. This is reflected in the billions of dollars that investment banks and other analysts and individuals spend on learning about firms. A continuous flow of information is brought into the stock market, maintaining the relevance and accuracy of prices. Equity is information-sensitive while debt is not.

4. The optimality of debt.

Default and contingent price discovery

“…. there are several senses in which debt incurs low information costs. It is important to distinguish between them in order to understand the multiple reasons why debt is cheap. Some are especially relevant for trading debt and using debt as collateral as is done extensively within shadow banking.”

Holmstrom argues that the debt holder only has to make a rough judgement of value so long as they have sufficient margin of safety (or over-collateralisation) and that this is hugely valuable in supporting the capacity of the money markets to provide the funding/liquidity the financial system needs. The point he is making the value of liquidity seems very similar to the one that Claudio Borio made in the paper discussed here regarding the value of elasticity in the money supply.

Precise valuation is only required in the event of default. Also note that bankruptcy as a process to determine value can be a very expensive process. In the case of a financial institution, you not only have to deal with the value of the collateral, you must also factor in the ways in which liquidation destroys the value of the business. Even if funding is locked in, the loss of liquidity for depositors in particular represents a loss of business value

5. Purposeful opacity

“Because debt is information-insensitive … traders have muted incentives to invest in information about debt. This helps to explain why few questions were asked about highly rated debt: the likelihood of default was perceived to be low and the value of private information correspondingly small.”

In building his argument for the value of debt being information insensitive, and against increased transparency, Holmstrom cites various other markets in which “intentional opacity” is a design feature.

De Beers sell “wholesale” diamonds in a way that does not give its buyers the opportunity … to pick out the best ones to buy

Car auctions… Buyers are allowed to inspect the cars externally before the auction, but they cannot open the doors or the hood… When a car goes on the block, buyers can open the doors and the hood to do some additional checks. But these are perfunctory: the total time a car is on the block(including the bidding) averages about a minute and a half.

Purposeful opacity can enhance liquidity in money markets, too. Here are some examples.    

Money market mutual funds have daily information about their investment positions and the book value … [which] … change constantly … Yet, the funds do not have to report the daily NAV … They only have to file quarterly reports with the SEC and even then the reported value is … the NAV 30 days ago. It is a purposeful effort to avoid a continuous flow of information into the market.

Coarse bond ratings provide another example of what appears to be purposeful opacity… Finer credit ratings would increase the frequency of re-rating bonds and therefore add costs, but given the relatively infrequent re-ratings in normal times, this argument seems weak. Coarseness is more likely an effort to make approximately equal collateral look equal in the eyes of the investors

Money itself is very opaque about the underlying collateral. No one knows what exactly backs up government money. But the beauty of money is that even if I do not know the exact value of the collateral backing my government’s promise, neither does anyone else. So we are “symmetrically ignorant” – a blissful state in money markets 

Bubbles … Even though investors may be aware that they are riding a bubble … no one is likely to have private information about when this will happen

Clearing houses … the private organisation of bank clearing houses that were common in the second half of the 19th century … cleared checks, but they also provided mutualised insurance in times of crisis. During panics, clearing houses would close ranks and make individual debt the shared obligation of all their member banks. The clearing house issued loan certificates which individual banks could buy in exchange for their impaired assets … At the same time, the clearing house would no longer report on individual data of its member banks. The data were sparse to begin with … but shutting down all information still increased the level of opacity”

This part of the paper I found less convincing. Holmstrom cites of “purposeful opacity” in other domains but it does not follow that this opacity is desirable. The clearing house example seems valid but the others less so. The example of how De Beers sells diamonds, for example, seemed to be something that allows them to sell diamonds at a higher price because they can. The social or economic value was less obvious. Coarse bond ratings look to me like an approach that is intended to focus attention on long term value while minimising the impact of short term noise. The short term perspective on bond values is readily available in market prices so I don’t see how the “coarse” bond rating obscures this.

 6. Panics: The ill consequences of debt and opacity

Holmstrom addresses the downsides of debt and opacity …

“Over-collateralised debt, short debt maturities, reference pricing, coarse ratings, opacity and “symmetric ignorance” all make sense in good times and contribute to the liquidity of money markets. But there is a downside. Everything that adds to liquidity in good times pushes risk into the tail. If the underlying collateral gets impaired and the prevailing trust is broken, the consequences may be cataclysmic”

“The occurrence of panics supports the informational thesis that is being put forward here. Panics always involve debt. Panics happen when information-insensitive debt (or banks) turns into information-sensitive debt … A regime shift occurs from a state where no one feels the need to ask detailed questions, to a state where there is enough uncertainty that some of the investors begin to ask questions about the underlying collateral and others get concerned about the possibility”

These events are cataclysmic precisely because the liquidity of debt rested on over-collateralisation and trust rather than a precise evaluation of values. Investors are suddenly in the position of equity holders looking for information, but without a market for price discovery. Private information becomes relevant, shattering the shared understanding and beliefs on which liquidity rested (see Morris and Shin (2012) for the general mechanism and Goldstein and Pauzner (2005) for an application to bank runs).

Would transparency have helped contain the contagion?

“A strong believer in the informational efficiency of markets would argue that, once trading in credit default swaps (CDS) and then the ABX index began, there was a liquid market in which bets could be made both ways. The market would find the price of systemic risk based on the best available evidence and that would serve as a warning of an imminent crisis. Pricing of specific default swaps might even impose market discipline on the issuers of the underlying debt instruments”

The risks discussed in this section of Holmstrom’s paper are a variation on the saying attributed to Mark Twain that “It Ain’t What You Don’t Know That Gets You Into Trouble. It’s What You Know for Sure That Just Ain’t So”. Your perspective on market efficiency is also probably relevant to how you respond to this part of the paper. The main point, it seemed to me, was that transparency is not the answer for the money market. Money markets are not “investing” money, they mostly trade on the basis that there is no need to ask questions because the assets are well covered. Their primary risk/reward lever is deciding where they want to sit in the loss hierarchy.

In theory, risk markets might anticipate some of these adverse events. But to the extent that they did, then it is likely that the crisis would not occur because you would not get the surprise factor that triggers panic. Having risk markets act as a source of loss absorption and market discipline is useful but it is not something that you want to rely on entirely.

 7. Shadow banking

 “The rapid growth of shadow banking and the use of complex structured products have been seen as one of the main causes of the financial crisis. It is true that the problems started in the shadow banking system. But before we jump to the conclusion that shadow banking was based on unsound, even shady business practices, it is important to try to understand its remarkable expansion. Wall Street has a hard time surviving on products that provide little economic value. So what drove the demand for the new products?”

 “It is widely believed that the global savings glut played a key role. Money from less developed countries, especially Asia, flowed into the United States, because the US financial system was perceived to be safe … More importantly, the United States had a sophisticated securitisation technology that could activate and make better use of collateral … Unlike the traditional banking system, which kept mortgages on the banks’ books until maturity, funding them with deposits that grew slowly, the shadow banking system was highly scalable. It was designed to manufacture, aggregate and move large amounts of high-quality collateral long distances to reach distant, sizable pools of funds, including funds from abroad.”

Looking at it in reverse, the shadow banking system had the means to create a lot of “parking space” for foreign money. Securitisation can manufacture large amounts of AAA-rated securities provided there is readily available raw material, that is, assets that one can pool and tranche”

“I am suggesting that it was an efficient transportation network for collateral that was instrumental in meeting the global demand for safe parking space.”

 “The distribution of debt tranches throughout the system, sliced and diced along the way, allowing contingent use of collateral”

“Collateral has been called the cash of shadow banking (European repo council (2014)). It is used to secure large deposits as well as a host of derivative transactions such as credit and interest rate swaps.”  

There is a relatively recent, but rapidly growing, body of theoretical research on financial markets where the role of collateral is explicitly modelled and where the distinction between local and global collateral is important

“Viewed through this theoretical lens, the rise of shadow banking makes perfectly good sense. It expanded in response to the global demand for safe assets. It improved on traditional banking by making collateral contingent on need and allowing it to circulate faster and attract more distant capital. In addition, securitisation created collateral of higher quality (until the crisis, that is) making it more widely acceptable. When the crisis hit, bailouts by the government, which many decry, were inevitable. But as just discussed, the theory supports the view that bailouts were efficient even as an ex ante policy (if one ignores potential moral hazard problems). Exchanging impaired collateral for high-quality government collateral, as has happened in the current crisis (as well as historically with clearing houses), can be rationalised on these grounds.”

I also struggled with this part of the paper. As I understand him, Holmstrom argues that the shadow banking system provides a useful service to the economy and that attempts to reduce the risk of financial crises should not be allowed to damage this alternative source of finance and liquidity. I suspect that Holmstrom’s conclusion regarding the value of shadow banking depends on the value he assigns to efficiency but I still struggle with the idea that a government bail out is good policy on efficiency grounds. That said, I think we should still recognise that efforts to restrict the size of the regulated banking system will tend to result in business migrating to the shadow banking sector. Demand will always create pressure for these types of assets to be created and markets to be created.

 8. Some policy implications

 “The design of money market policies and regulations should recognise that money markets are very different from stock markets. Lessons from the latter rarely apply to the former, because markets for risk-sharing and markets for funding have their own separate logic. The result is two coherent systems with practices that are in almost every respect polar opposites.”

“Debt and institutions dealing with debt have two faces: a quiet one and a tumultuous one …. The shift from an information-insensitive state where liquidity and trust prevails because few questions need to be asked, to an information-sensitive state where there is a loss of confidence and a panic may break out is part of the overall system: the calamity is a consequence of the quiet. This does not mean that one should give up on improving the system. But in making changes, it is important not to let the recent crisis dominate the new designs. The quiet, liquid state is hugely valuable.”

 A crisis ends only when confidence returns. This requires getting back to the no-questions-asked state ….

Transparency would likely have made the situation worse

 European stress tests are a case in point
           The European stress tests in the summer of 2011 were not successful, partly because they did not consider the scenario of Greece defaulting, which led to implausibly small recapitalisation needs. In response to this, detailed information about the balance sheets of banks was made available for review, so that investors could make their own judgments about the likelihood and costs of a Greek default.
           What did eventually calm the European money markets? Governor Draghi’s statement “we will do whatever it takes – and you better believe it is enough”. This is as opaque a statement as one can make. There were no specifics on how calm would be re-established, but the lack of specific information is, in the logic presented here, a key element in the effectiveness of the message. So was the knowledge that Germany stood behind the message – an implicit guarantee that told the markets that there would be enough collateral, but not precisely how much.
       

“By now, the methods out of a crisis appear relatively well understood. Government funds need to be committed in force (Geithner (2014)). Recapitalisation is the only sensible way out of a crisis. But it is much less clear how the banking system, and especially shadow banking, should be regulated to reduce the chance of crisis in the first place.  The evidence from the past panic suggests that greater transparency may not be that helpful.”

“The logic of over-capitalisation in money markets leads me to believe that higher capital requirements and regular stress tests is the best road for now.”

“Transparency can provide some market discipline and give early warning of trouble for individual banks. But it may also lead to strategic behaviour by management. The question of market discipline is thorny. In good times market discipline is likely to work well. The chance that a bank that is deemed risky would trigger a panic is non-existent and so the bank should pay the price for its imprudence. In bad times the situation is different. The failure of a bank could trigger a panic. In bad times it would seem prudent to be less transparent with the stress tests (for some evidence in support of this dichotomy, see Machiavelli (1532)).”

 Holmstrom argues that the liquid state of the money market is hugely valuable but that it also inevitably creates the conditions for a crisis. He argues that we have a good idea of how we should respond to a crisis (government stand ready to provide liquidity coupled with a credible mechanism for recapitalising the banks) but it is less clear how the banking system, and shadow banking in particular, should be regulated to reduce the risk of a crisis in the first place.

Even though debt markets are typically at the heart of a financial crisis, he suggests that one reliable insight is that increased transparency in the money markets is not the answer. This is because this market tends to operate on a “no questions asked” or “information insensitive” basis. That is not a bug to be fixed, that is a feature that enables the money market to perform the function of providing liquidity.

9. Concluding remarks

 Does the rise of shadow banking mean that the ancient logic of pawning is about to be replaced? The growing enthusiasm for covered bonds could be a harbinger of what lies ahead. Covered bonds are quite transparent. Banks are obliged to report regularly and in detail on the cash flow and substitutions in the asset pools that secure covered bonds. I see this development as a reflection of the general principle that financial intermediaries substitute information for collateral when collateral is expensive and do the reverse when collateral is cheap (Holmstrom and Tirole (1997)). Over-collateralisation is becoming more expensive, because there are fewer safe assets in the aftermath of the crisis. At the same time, the cost of monitoring is shrinking due to better information technology. More intensive monitoring is the logical consequence. This may shift the balance towards more transparent, more globally traded assets. Whether this is a permanent shift or a temporary one remains to be seen. The expense associated with running information-intensive money markets is likely to curb their use. Information-sparse debt is unlikely to disappear any time soon.


 “…. there is a danger in the logic of money markets: if their liquidity relies on no or few questions being asked, how will one deal with the systemic risks that build up because of too little information and the weak incentives to be concerned about panics. I think the answer will have to rest on over-collateralisation, stress tests and other forms of monitoring banks and bank-like institutions.”
       

The distinction between risk sharing markets and funding markets is important and useful I think. It offers analytical support for why deposits (at a minimum) should be insulated from risk. It also explains why banks should target a strong investment grade rating for their senior debt.

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