Plainly, this reuse of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, ie the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the Indonesian bonds are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.
To get an idea on magnitudes, at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral; since this is pledged for credit, the volume of pledged assets is a good measure of the private credit creation. For the same period, the primary source collateral (from hedge funds and custodians on behalf of their clients) that was intermediated by the same banks was about $3.4 trillion. So the ratio (or reuse rate of collateral) was about three times as of end-2007.
For comparison to the $10 trillion figure, the US M2 was about $7 trillion in 2007, so this credit-creation-via-collateral-chains is a major source of credit in today’s financial system. Figure 1 shows the amounts for big banks in the US and Europe.
Figure 1. Pledged collateral that can be reused with large European and US banks
An example
As this process is unfamiliar to many non-specialists, consider another example. Figure 2 illustrates how a piece of collateral (eg, US Treasury bond) may be used by a hedge fund to get financing from a prime-broker (say, Goldman Sachs).
The same collateral may be used by Goldman to pay Credit Suisse on an OTC derivative position where Goldman was ‘out-of-the-money’ to Credit Suisse. And then Credit Suisse may finally pass the US Treasury bond to a money market fund that will hold it for a short tenor (or till maturity). Notice that the same Treasury bond has been used three times as collateral for extensions of credit – from the original hedge fund owner to the money market fund.
Figure 2. An example of a collateral chain
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This article first appeared on Vox.
