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Bank Funding, Liquidity, and Capital Adequacy

A Law and Finance Approach

José Gabilondo

Focusing primarily on the banking system in the United States, this book offers an innovative framework that integrates a depository bank’s liquidity and its capital adequacy into a unified notion of funding that helps to explain how the 2007–2008 crisis unfolded, why central banks succeeded in resolving the crisis, and how the conceptual legacy of the crisis and its resolution led to lasting changes in bank funding regulation, including new objective requirements for bank liquidity. To provide a comparative context, the book also examines the funding models of non-bank intermediaries like dealer banks and insurers.
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Chapter 3: Other funding models

José Gabilondo

Extract

In addition to the depository bank, three other financial intermediaries are active in the credit market: dealer banks; insurers; and passive investment vehicles. Each is a regulatory silo with a distinctive legal regime. Some – such as the dealer bank and the private defined-benefit plan – are based on federal law. Others – such as insurers, public defined-benefit plans, and most special-purpose vehicles – revolve primarily around state law, although any contact with capital markets means complying with federal securities laws. This chapter examines their respective funding practices.In effect, each of these silos revolves around a funding model particular to its defining business lines. Dealer banks serve as brokers and dealers in securities markets. Reflecting their large asset portfolios, dealer banks borrow heavily for the short-term – often overnight – pledging securities as collateral and maintaining a rough match between their assets and liabilities. Income assurance entities such as insurers and pensions make long-term promises in exchange for premium inflows. While these inflows reduce the insurer’s need to borrow, this profile produces a mismatch between long-term liabilities and liquid assets, that is, the converse of the depository bank’s borrow-short/lend-long approach. Passive vehicles, like asset managers and special-purpose entities, pool funds for investment while shifting liquidity risk to their investors or to contractual counterparties.Writing after the 2007 crisis, Darrell Duffie analyzed the failure dynamics of a certain kind of non-bank intermediary that had played an important role in the financial crisis – the dealer bank. After registering as broker-dealers with the U.S. Securities and Exchange Commission, dealer banks...

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