One comment on the low interest rates issue: I generally think about the equity premium puzzle via a Volker fence model. The institutions which own Treasuries (e.g. banks) do so with massive amounts of cheap leverage, and those are the only assets they’re allowed to hold with that much leverage. For individuals without access to cheap leverage, it rarely makes sense to hold large amounts in Treasuries—stock returns are so much higher, because the cheap leverage of banks pushes down the returns on Treasuries. So we get this split model, where there’s one class of investors which determines Treasury rates and a mostly-separate class which determines equity prices, with a regulatory barrier between the two (namely, bank leverage regulations).
Epistemic status: properly checking the numbers on this is still on my todo list, but the qualitative predictions look realistic and it matches how financial institutions actually work in practice.
The institutions which own Treasuries (e.g. banks) do so with massive amounts of cheap leverage, and those are the only assets they’re allowed to hold with that much leverage.
I’m curious about this. What source of leverage do banks have access to, that cost less than interest on Treasuries? (I know there are retail deposit accounts that pay almost no interest, but I think those are actually pretty expensive for the banks to obtain, because they have to maintain a physical presence to get those customers. I doubt those banks can make a profit if they just put those deposits into Treasuries. You must be talking about something else?)
The money markets are the main direct source of cheap (short-term) liquidity for banks; the relevant interest rates are LIBOR, fed funds, and repo. My current understanding is that retail deposits are ultimately the main source of funds in these markets—some banks (think Bank of America) specialize in retail and net-lend into the overnight money markets, while others net-borrow.
That money goes into Treasuries by default—i.e. whenever banks don’t have anything higher-margin to put it into. That is a profitable activity, to my understanding, at least in the long term. It’s borrowing short-term (overnight) and lending long-term (Treasury term), thereby getting paid to assume interest rate risk, which is exactly the main business of a bank.
In case people want to know more about this stuff, most of my understanding comes from Perry Mehrling’s coursera course (which I recommend), as well as the first third of Stigum’s Money Markets.
True, though I would guess that bank holdings dwarf those, even looking at marginal investors. Banks not holding stocks is the more important side of this model, because that’s the part which allows Treasury yields to be systematically lower than they “should” be compared to stocks.
One comment on the low interest rates issue: I generally think about the equity premium puzzle via a Volker fence model. The institutions which own Treasuries (e.g. banks) do so with massive amounts of cheap leverage, and those are the only assets they’re allowed to hold with that much leverage. For individuals without access to cheap leverage, it rarely makes sense to hold large amounts in Treasuries—stock returns are so much higher, because the cheap leverage of banks pushes down the returns on Treasuries. So we get this split model, where there’s one class of investors which determines Treasury rates and a mostly-separate class which determines equity prices, with a regulatory barrier between the two (namely, bank leverage regulations).
Epistemic status: properly checking the numbers on this is still on my todo list, but the qualitative predictions look realistic and it matches how financial institutions actually work in practice.
I’m curious about this. What source of leverage do banks have access to, that cost less than interest on Treasuries? (I know there are retail deposit accounts that pay almost no interest, but I think those are actually pretty expensive for the banks to obtain, because they have to maintain a physical presence to get those customers. I doubt those banks can make a profit if they just put those deposits into Treasuries. You must be talking about something else?)
The money markets are the main direct source of cheap (short-term) liquidity for banks; the relevant interest rates are LIBOR, fed funds, and repo. My current understanding is that retail deposits are ultimately the main source of funds in these markets—some banks (think Bank of America) specialize in retail and net-lend into the overnight money markets, while others net-borrow.
That money goes into Treasuries by default—i.e. whenever banks don’t have anything higher-margin to put it into. That is a profitable activity, to my understanding, at least in the long term. It’s borrowing short-term (overnight) and lending long-term (Treasury term), thereby getting paid to assume interest rate risk, which is exactly the main business of a bank.
In case people want to know more about this stuff, most of my understanding comes from Perry Mehrling’s coursera course (which I recommend), as well as the first third of Stigum’s Money Markets.
Thanks! I’ve been hoping to come across something like this, to learn about the details of the modern banking system.
My impression is that most individual investors and pension funds put a significant part of their portfolio into bonds.
True, though I would guess that bank holdings dwarf those, even looking at marginal investors. Banks not holding stocks is the more important side of this model, because that’s the part which allows Treasury yields to be systematically lower than they “should” be compared to stocks.