The institutional cash pools and the demand for safe assets

Gillian Tett points to a possible explanation for the massive investor flight to US Treasuries despite its ratings downgrade by S&P last week. She has an interesting interpretation of an excellent working paper by an IMF economist Zoltan Pozsar that traces the rise of the shadow banking sector over the past two decades to an explosive growth in institutional cash pools during the same time and their preference for safety and counter-party risk diversification.

The paper highlights the spectacular growth in volumes of institutional cash pools in recent years, on the back of the rise of the asset management sector and centralized treasury operations by companies. From just $100 bn two decades back, institutional cash managers now control between $2,000bn and $4,000bn globally. The share of cash held by individual companies has exploded from just over $100 mn across the world to an estimated $75bn with individual securities lenders, $20bn with asset managers, and $15bn with large US companies.





The practice was to invest this liquid cash pool in bank accounts. However, once the US FDIC limited deposit insurance to only upto the first $100,000 of any account from 1990, investors started searching for alternative short-term, liquid, and risk-free investment opportunities. Repurchase deals (backed by collateral), money market funds (often implicitly backed by banks), and highly rated short term securities (such as triple A rated asset backed commercial paper or mortgage bonds) were natural options.

Zoltan Pozsar also finds that institutional cash pools prefer not being intermediated through the traditional banking system, as they prioritize principal safety and portfolio diversification over yield and are hesitant (in many cases due to fiduciary reasons) to take on too much direct, unsecured exposures to banks through even insured deposits. The author writes,

"Between 2003 and 2008, institutional cash pools’ cumulative demand for short-term government guaranteed instruments (as alternatives to insured deposits) exceeded the supply of such instruments by at least $1.5 trillion. The “shadow” banking system rose to fill this vacuum, through the creation of safe, short-term and liquid instruments. Thus, from this perspective the "shadow" banking system was just as much about networks of banks, investment banks and asset managers working together to respond to institutional cash pools’s preference to invest cash at a distance from banks as it was about banks’ funding preferences and off-balance sheet banking. From this perspective, the rise of "shadow" banking has an under-appreciated demand-side dimension to it...

In other words, what looks like undesirable regulatory arbitrage from the perspective of regulated institutions, was desired portfolio diversification from the perspective of institutional cash pools. This is to say that if regulatory arbitrage inspired the pejoratively-sounding term shadow banking, cash portfolio diversification could imply renaming it to market-based banking."

Consequently, it should come as no surprise that in 2007, just 16-20% of these funds were invested in bank deposits, while the rest went into Treasuries, commercial papers, and securities traded in the shadow banking sector, whose emergence coincided with and was maybe even caused by the rapid growth in the institutional cash pools. Once the shadow banking system froze in the aftermath of the sub-prime meltdown, these cash pools have been left with Treasuries as the only remaining investment avenue with the required depth.

The US-EU debt crisis has exacerbated the market uncertainty and accelerated the flight to the safety of US Treasuries. In simple terms, even with all the downside risks associated with the US economy, its government securities appear the least risky among all available alternatives required to accommodate this huge cash pool.

To raise rates or not : RBI's monetary policy review dilemma

The build-up to the third quarter review of the monetary policy later this month has naturally re-ignited the inflation-growth trade-off debate. Should interest rates be raised in light of the recent spurt in inflation to 7.31%, well above RBI estimates?

Those advocating raising rates point to the rise in inflation and the need to exit the unprecedented monetary loosening of the past eighteen months. Opposers point to the supply-side reasons for food and fuel inflation and argue that any increase in rates would nip in the bud the fledgling signs of economic recovery. This blog has consistently taken the latter position though the argument gets more complex with every passing day.

In an excellent op-ed in Mint, Renu Kohli draws attention to the falling real interest rates on various instruments. The real policy repo rate is in negative territory at minus 3.79% and the real yield on 10 year securities is close to zero. These rates have dropped by half over the past three months.



As she writes, the growth signals are mixed. However, she does point to certain real inflationary concerns - annualized, three-month moving average of manufacturing inflation in the range of 4.5-6% since August; rise in long-term interest rates by a full two percentage points in the year to January 2010 despite the loosening; widening nominal spreads between short term T-Bills and long-term G-Secs indicate inflationary expectations etc. Coupled with the negative real policy rate, these signals will surely increase the pressure on RBI to act to raise rates and re-align interest rates.



In this context, a closer examination of the credit markets is on order. One of the most salient features of banks across the world over the past year or so has been their persistent reluctance to lend. In India too, the massive liquidity injections and monetary easing by RBI have not translated into expansion in the credit markets and the broad money supply has been steadily declining since the middle of last year. The year-on-year growth in M3 supply as on 22.1.2010 was 17.1% compared to 20.2% at the same time last year. Bank credit to the commercial sector has been very weak at 13.4% compared to 22.3% for the same period last year. Encouragingly there are signs that this may be picking up since November, driven in part by the festival season and year end lending and spending.



Credit to the government sector has been declining and stabilizing to its normal levels after the massive borrowings of the last year. Bank credit to government has been growing at an y-o-y rate of 32.8%, lower than last year's 33.7%. The inflationary impact due to the government borrowings may not be as high as feared, though there is always the danger of the lagged impact of inflationary forces due to the massive spurt in government borrowings.



These aforementioned money market indicators appear to point to the credit markets continuing to remain subdued. Banks continue to park their excess reserves in the safety of government securities, as evidenced by the sustained daily reverse repo transactions in the range of Rs 90,000 - 100,000 Cr. Far from the economy showing any signs of over-heating, the credit markets appears to indicate cautious optimism.

It is an altogether different matter that the larger businesses have fortunately been able to mobilize resources through the non-bank sources. The Commercial Paper market has rebounded nicely with declining spreads and increasing issues. However, credit support from the non-bank sources have largely eluded the medium and small scale industries who continue to remain dependent on banks for meeting their credit requirements.

There is no denying the fact that the RBI has to exit its monetary loosening. Asset bubbles may be in the process of getting inflated in the equity markets. Real estate markets too shows signs of rebounding. It is clear that instead of investments and consumption, a substantial portion of the credit unleashed by the RBI may have found its way into the asset markets.

Draining off this excess liquidity is important and it is reasonably clear that this exit, which already started with the increase in the SLR by 100 basis points late last year, can proceed apace. This would mean increasing the CRR from 5%. In fact, a series of increases in CRR over the next six months is almost inevitable.

About the repo rates, it needs to be borne in mind that though the WPI-based core inflation is in the range of 4.5-6%, it remains within acceptable range in comparison to the historic levels for the Indian economy. It is amply clear that the rise in food prices cannot be controlled by raising rates or other demand side interventions. It is arguable that the fiscal stimulus spending measures have contributed substantially towards the nascent signs of economic recovery. It is important that all policy measures necessary to strengthen this recovery be in place. Increasing rates would adversely affect investments which are already constrained by the weakness in the economic environment.

However, it is important that RBI reiterate its commitment to aggressively fighting inflation when the need arises. This would re-assure the markets and investors, and to that extent keep a lid on inflationary expectations. This may be appropriate and even adequate for this time.

Update 1
As expected, the RBI left the repo and reverse repo rates untouched.
The RBI Governor's statement on the Third Quarter Review is available here. The CRR was raised by three-quarters of a percentage point, to 5.75%, to become operational in two stages, a move that is expected to drain off Rs 360 billion (about $7.8 billion) from the Indian financial system. See this excellent summary of the situation by Tamal Bandyopadhyay.



The RBI raised the baseline GDP growth projections to 7.5% from the 6% forecast made in October 2009, by assuming a near zero growth in agricultural production and continued recovery in industrial production and services sector activity. The baseline projection for WPI inflation for end-March 2010 was raised to 8.5% from 6.5% made in October. It also revised downwards the non-food credit growth projection for 2009-10 to 16%, and based on this projected credit growth and the remaining very marginal market borrowing of the government, the projected M3 growth in 2009-10 was reduced to 16.5%.

Why lending rates are not coming down?

The reluctance of banks to lower retail and commercial lending rates despite the steep rate cuts by the RBI remains a big concern for the Government. There are a number of reasons adduced for this reluctance - high cost of capital, global financial market turmoil induced counter-party risk perceptions etc. Here are a few other reasons.

The graphic below, which captures the yield movements of the ten year government securities, 91 day T-Bills, and Commercial Paper (the upper bounds of the rate ranges) issued by corporate India to finance its regular operations, reveal a few things about this reluctance. As can be seen, not only have both the rates been increasing, the spread too has been widening alarmingly.



1. The yields on 10 year G-secs, an indicator of the medium term inflation prospects, have been hovering in the 7-8% range. Conventionally, this should be in the range between the repo (5.5%) and reverse repo (4%) rates. This indicates that the markets have priced in higher inflationary expectations, which does not portend well for the longer term interest rates.

2. The CP rates have been going up continuously since April 2008, a fair representation of the credit risk perception inherent in the market. However, in keeping with the flight to short term T-Bills and the declining short-term inflationary trends, the yields on the 91 day T-Bills have been showing downard trend. Most ominously, the spread between the 10 year G-Secs and CP have been widening sharply, and is well past an alarming 10%, reaching 11% plus by end of January. Without this spread closing gap, there is limited possibility of the credit squeeze easing and banks opening their lending taps to normalcy.

Update
Thanks to Amol Agarwal for pointing out the mistake about the G-sec yields hardening being an indication of inflation. Actually, it ought to have been "G-Secs have hardened in anticipation of higher interest rates in future".

He also makes two other important points
1. The declining yields enabled many banks to profit substantially. But with yields hardening since January, the profit cushion dispappears, and may make banks even less willing to lend.
2. CP yields have risen due not only to credit risk, but liquidity risk, as the lower trading in these instruments has incrased the liquidity premium.

Observations on increase in government borrowings

Faced with increasing demand for a third round of fiscal stimulus and declining tax revenues, the Government of India have decided to borrow an additional Rs 46,000 Cr between February 20 and March 20. This would take the overall borrowings of the Government for the financial year to Rs 2,71,000 Cr, as against the budget estimates of Rs 1,35,000 Cr. A few observations on this

1. The "liquidity preference" of banks, with the resultant flight to government securities, means that there will be no dearth of buyers for this debt. In the natural course, this demand for safe government securities, coupled with low and declining inflation, should have meant lower yields on them.

2. The RBI has been purchasing government securities in large quantities in recent weeks as part of its liquidity injections to un-freeze the credit markets. This too has acted to raise bond prices and lower yields.

3. However, the announcement of additional borrowings elicited an immediate response from the debt markets, driving up the yields on long term Treasuries in expectation of higher future interest rates. In recent weeks, the yields on the benchmark ten year government bonds have risen steeply from a very low 4.86% in January to 6.43%, well outside the repo rate (5.5%) and reverse repo rate(4%) band, another indication that the markets are pricing for expected higher interest rates in the future. It is being estimated that this benchmark rate could stabilize above 7% for the medium term atleast, thereby anchoring inflationary and interest rate expectations. This signal is not desirable as it would immediately generate negative expectations among businesses about borrowings and investments.

4. The higher long term yields will, at some time in future, also have the effect of crowding out private borrowings, as businesses get put-off by the higher cost of capital. This is not so much a problem now as the economy slows down, given the reluctance of private businesses to make investments. During such times, only government investments can bring the idle resources and capacity to full use.

5. There is also a self-fulfilling dimension to this. Higher yields only makes government securities even more attractive for already risk averse banks, thereby "crowding out" private borrowers even more.

6. The high level of borrowings required are yet another reason for the RBI to lower interest rates. Besides reducing the immediate debt service burden, it would also give it enough room to manouevre when it comes to rasing rates as inflationary signals invariably show up sometime later.

7. The borrowings will drive the fiscal deficit, including the states and off-balance sheet entities, well past 10% of GDP (Some predict it to be around 13%, including all off-balance sheet liabilities). This raises questions about how the government will unwind the debts it is running up. The prospects of higher interest rates in the future bodes ill for exiting from this debt burden. Further, in such uncertain economic times, such macroeconomic imbalances can be heavily penalized by the markets, with potentialy disastrous consequences on the rupee exchange rate and our external balance.

8. It is therefore necessary that these costly borrowings be spent on those measures that deliver the largest bang for the buck. And tax cuts, by way of which the government has already doled out over Rs 50,000 Cr in corporate welfare to boost the bottom-lines, are surely not the most effective way of stimulating the economy. More so developing economies like India where the price transmission belt is riddled with imperfections.

Apprehensive of driving down long term bond prices, the Government have announced that it will not raise the additional Rs 46,000 Cr by market borrowings or overseas borrowings. It has also ruled out private placement by the RBI. Therefore the only options left are to either monetize by printing money or to draw from the account created to keep the rupee funds collected by issuing bonds under the Market Stabilization Scheme (MSS) (the bonds were issued to sterilize the rupees released on forex market interventions to keep rupee from appreciating). Of the two the latter looks are more plausible alternative since it would not have any immediate "crowding out effect".

The borrowings are not likely to have any adverse immediate impact in crowding out private borrowings or raising interest rates. The credit market freeze and anemic economic expectations means that both the banks are not coming forward to lend and the businesses are not willing to make investments by borrowings. Further, the low and declining inflation means that there will be no pressure to raise interest rates. To this extent the Government is blessed with favourable macro-economic environment to sustain large borrowings. The challenge will be to unwind these positions once the economic growth picks up and inflationary pressures start showing up.

Update 1
As expected the Government have entered into an MoU with the RBI to de-sequester the MSS funds, so as to enable the Government to mop up its borrowings without having any impact on interest rates. Rs 45,000 crore will be transferred in instalments from the 'MSS cash account' to the normal cash account of the Central Government by March 31. An equivalent amount of government securities earlier issued under the MSS would now form part of the normal market borrowing of the Centre, according to the RBI.

More banking sector observations

In continuation to the previous post, here are a few more observations on the banking sector

1. The graphic below indicates that the private sector and foreign banks have been more reluctant to pass on the benefits of the RBI rate cuts. Interestingly, the domestic private banks are more conservative in their lending rates than even the foreign banks, whose reactions may be partially explained by the problems faced by their parent banks in US. Further, the lending-deposit rate differentials for private banks is 6.75-8%, almost double that of the 3.75-4% for public sector banks. If despite these margins and cushions, the private sector banks have seen higher growth in NPAs relative to the public sector banks, then it raises questions about their competitiveness and operational performance. Does it mean that the public sector banks in India are more efficient, atleast to the extent of the core banking activity of managing lending and deposit taking?



2. The foreign and domestic private sector banks also appear to have suffered a crisis of confidence among depositers. This is indicated by the sharp drop in growth in their deposits compared to their public sector counterparts. The deposits grew by just 12.1% and 13.4% for foreign and private banks respectively in 2008, as against 34.1% and 26.9% repsectively for 2007. In contrast, the deposit grew at the same 24.2% in both years for public sector banks. Does this mean that like in the US, when the times were good, the former engaged in less than prudent practices like offering more than sustainable deposit rates to attract deposits?



3. There is some validity in the reasoning by banks that they are constrained in their ability to lower depsoit rates, especially given the need to shore up reserves in these uncertain times. Banks can lower their lending rates only if they lower their deposit rates commensurately. However, the prevailing high interest rates on small savings instruments like Public Provident Fund (PPF), at 8%, puts a clear floor on lowering deposit rates. In the circumstances, if banks lower deposit rates more aggressively, there could be a flight of deposits from banks to these instruments and similar others like post office savings accounts.

4. Announcing the quarterly credit policy review, the RBI Governor made a direct mention of the fact that the "transmission of the policy interest rate signal" while effective in the money and government securities market, has failed in the credit markets. Since October 2008, the RBI has reduced repo rate from 9% to 5.5%, reverse repo rate from 6% to 4%, and CRR from 9% to 5%, all of which coupled with liquidity injections have released Rs 3,88,045 Cr into the banking system. Despite such extraordinary measures, the credit markets remain trapped in the high rate vortex.

Update 1



The Businessline reports that banks have delivered impressive profit growth in the December quarter, with the average net profit growth for the top-20 banks standing at 58% and a median net profit growth standing at 44%, riding on higher treasury income (as yields fell, bond portfolios appreciated in value and mark to market losses were written back), higher margins (due to the CRR cut and lower provisions, which are freed up for lending), and still high lending rates. Further, the Net Interest Margins (NIMs) of these banks are also at a very healthy, even unsustainably high, range of 3-4%. These figures would appear to indicate considerable comfort and cushion for these banks to lower their lending rates.

The one standout looks to be ICICI. Despite profitting from a sharp boost in their treasury income (it rose to Rs 976 crore against Rs 282 crore last year), the Y-o-Y profits grew just 3.4%, against the sector average of 58%. Add in the fact that its NIM is also relatively low at 2.4%, and the NPAs have registered a relatively larger increase. Do we have some cause for concern?

Reality Check - TIPS, TED, and VIX

TED spread is the interest rate difference between three month futures contracts for LIBOR (rate charged by banks on each other for three-month loans in dollars) and US T-Bills. It is a measure of credit risk in the money markets which represents the fear in the banking system. A high TED spread indicates increased default risk, and reflects higher borrowing cost for banks. During the height of the credit squeeze in October-November 2008, the TED had become "the consensus indicator of the depth of the current financial crunch". A long term perspective of the TED is available here. The latest TED spread values are available here.

TED spreads have declined as dramatically in recent weeks as it rose from early September of last year. After touching 4.6% on October 10, 2008, when inter-bank lending almost frooze, the TED has fallen to 0.98% by January 13, 2009. This indicates the relative calmness that has been restored in the credit markets, especially the market for Commercial Paper (CP). At its lowest, the TED spread can be as low as 20 basis points, as it was in early 2007.

Felix Salmon draws attention to a plausible reason for this steep decline. The flooding of the banking sector with liquidity through direct cash injections and by opening unlimited auction windows by Central Banks across the world, may have contributed to the steep fall in the TED spread. With so much liquidity available, banks have evidently had limited incentive in approaching the 3-month LIBOR for funds. Further, since inter-bank lending has dried up, any TED spread figure is likely to be a misleading figure. All this in turn means that the low TED spreads are no indicator of any proportionate decrease in credit risks.



Treasury Inflation Protected Securities (TIPS) are inflation indexed bonds issued by the US Treasury, whose principal is adjusted to the Consumer Price Index (CPI), the common measure of inflation. By comparing the difference in coupon values of TIPS bond with a standard nominal Treasury bond across the same maturity dates, we can have a measure of the bond markets expected inflation rate.

And as the latest spreads show, the news on this is not encouraging, with the spread being almost zero, indicating deflationary expectations. In fact, the TIPS spreads have been converging sharply over the last quarter of 2008.



VIX is the Chicago Board Options Exchange Volatility Index, which measures the implied volatility of S&P 500 index options for 30 day period, by using a weighted blend of prices for a range of options on the index. Assuming S&P 500 is broad measure of the equity markets, a high VIX corresponds to greater volatility. The VIX, often called the "fear index" or "investor fear gauge", is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis. VIX values above 30 indicates large amount of equity market volatility.

The latest VIX of 46.1 is indicative of the high volatility associated with the equity markets. However, on the positive side, it has been on the decline, after reaching alarmingly high figure of around 90.



As the three indicators show, the VIX and TIPS spreads are causes for continuing concern, while the decline in TED may be attributed more to the unprecedented actions of the Central Banks than any actual lowering of credit risks.

Investing at 0% rate!

Finally, the bottom has been breached! In the recent weeks, investors, both foreign and domestic, have been flocking to safe and liquid US T-Bills thereby driving down yields dramatically. Investors in the short term money market funds, driven by fears of a major impending depression, are pulling money out of mutual funds and hedge funds, forcing portfolio managers to sell more risky assets and hold Treasuries, which are easier to sell. Foreign investors are using American government securities to protect themselves against the falling value of their own currencies.

This NYT report just about sums up the scare driven flight to safety that has gripped the credit markets in the US and made the Fed virtually irrelevant,

"Investors accepted the zero percent rate in the government’s auction on Tuesday of $30 billion worth of short-term securities that mature in four weeks. Demand was so great even for no return that the government could have sold four times as much. In addition, for a brief moment, investors were willing to take a small loss for holding another ultra-safe security, the already-issued three-month Treasury bill!"

Credit crunch and Indian banks

Following on the heels of the ECB, Bank of England, and other Central Banks, the RBI has finally cut (full text of press release here) the benchmark repo rate by 100 basis points to 6.5% and reverse repo rate by the same margin to 5%. Now that the proverbial horse has been taken to water, the eagerly awaited answer is whether the banks will pass on the benefits to borrowers by way of lower lending rates?

The fundamental problem with the financial markets in India today is the apparent reluctance of banks to lend to businesses. Though the dramatic cuts in reserve ratios and repo rates, LAF auctions, and repurchase of MSS bonds in past few weeks have relased an additional Rs 3,00,000 Cr into to the banking system, not much of this has found its way into financing investments in the economy. Instead, the banks have preferred to invest in the safety of low yielding Treasury securities and the RBI.

There have been many reasons attributed to this reluctance. The uncertainty surrounding the financial markets and the effects of the sub-prime mortgage crisis have become so deep that counter party risks are very high. Safety and not returns have become the first priority for banks.

Another area of concern for the banks is the high cost of their present liabilities, especially with the strong possibility that rates will fall steeply in the coming months. The average cost of working funds for banks is well over 7%, with at least 30-35% of the deposits priced upwards of 9%. The expectations of rate cuts and plummeting equity markets has also led to the shift of assets and cash surpluses by many coporates and Public Sector Units to the safety of bank deposits. The banks too, faced with capital scarcity, have been competing with each other in attracting these deposits, often offering very high rates. The result of this is that many banks may not be in a position to pass on the full beneifts of rate cuts to its borrowers without seriously undermining their balance sheets.

The banks in turn argue that they have not been reluctant, but have been weighed down by the sharply increased demand for funds from the corporate sector which has been squeezed off its other regular sources of funds. Businesses have four major sources of investment funding - equity markets, external commercial borrowings, profits and bank loans. The first two, which formed 40% of the funds for Indian industry in 2007-08, has dried up, while the third is declining with the economy. This has left banks as the primary source of funds, thereby sharply increasing the demand for bank loans (credit growth has been at a scorching annualized rate of 28%). The banks have been clearly unable or unwilling to meet this increased demand, despite the dramatic increase in liquidity.

Here is a brief on the major credit market indicators.

Treasury Securities
Investors have taken money out of stocks, corporate bonds and money market funds to buy safe assets, thereby forcing down the yields on Treasuries. A declining yield is an indicator of greater concern with the financial markets. The most appropriate measure of the flight to safety is the Statutory Liquidity Ratio (SLR), which is presently in the range of 26%, against the mandatory requirement of only 24% (and effective requirement of only 21.5%).

The reverse repo window of the RBI has been witnessing heightened activity in since the middle of November, with banks queing upto deposit their surpluses for the relatively meagre 6% returns offered. Despite the declining SLR, the investments to deposit ratio for banks has climbed from 28.27% to 30.48% over the past month. In October, banks lent just Rs 27,000 Cr, whereas they invested Rs 90,000 Cr in G-Secs.

Expectations of rate cuts and the hope of making significant risk-free profits (especially at such bleak times) from the greater chances of capital gains from rising bond prices (as rates fall, yields decline, thereby pushing up bond prices) has been another incentive for banks to invest in long dated government securities.

Contrary to conventional bond market wisdom which says that yields rise as maturity lengthens, yield curve had become inverted - long-term yields lower than short-term yields. Inverted yield curves indicate tight immediate credit conditions besides uncertainty about the future. Though it has flattened out in the past few days, the 91-days Treasury Bill and the benchmark Government Security of 10-year residual maturity are both being quoted at the same, around 7% yield, underscoring the deep concerns about declining economic activity.

Commercial Paper
CP or short term debt issued by the larger private businesses, often for a few days, and purchased mainly by banks and financial institutions, has dried up. This is indicated by the widening spreads between rates on Government securities and CPs of the same maturities. Higher spreads have made it difficult for both businesses and banks to run their daily operations. The CP market has virtually ground to a halt, as the spreads with T-Bills for even AAA rated companies have ballooned to more than 600 basis points.

Call money rates
Overnight rates at which banks borrow capital to meet their daily working capital requirements had reached very high levels of over 24%, indicating the magnitude of the credit crunch. Typically, overnight call money rates move in the band between the repo and reverse repo rates. However, these rates have fallen to around 6% in recent days and the repo auctions under the Liquidity Adjustment Facility (LAF) has stopped attracting bids, an indication of the easing of the liquidity conditions.