Understanding Wholesale Funding and its dark side

This paper has been pending for a long long time and I finally managed to read it this weekend. Unlike the various 2007 crisis papers which focus on the macro picture, this one looks at the micro picture and a specific point at that. It looks at wholesale funding of financial firms. The wholesale funding pattern of banks has been seen as the main villain in this crisis. The authors point substantial light on the main issue:

Commercial banks increasingly use short-term wholesale funds to supplement traditional retail deposits. Existing literature mainly points to the “bright side” of wholesale funding: sophisticated financiers can monitor banks, disciplining bad ones but refinancing solvent ones. This paper models a “dark side” of wholesale funding. In an environment with a costless but imperfect signal on bank project quality (e.g., credit ratings, performance of peers), short-term wholesale financiers have lower incentives to conduct costly information acquisition, and instead may withdraw based on negative but noisy public signals, triggering inefficient liquidations.

The authors show that the “dark side” of wholesale funding dominates the “bright side” when bank assets are more arm’s length and tradable (leading to more relevant public signals and lower liquidation costs): precisely the attributes of a banking sector with securitizations and risk transfers. The results shed light on the recent financial turmoil, explaining why some wholesale financiers did not provide market discipline ex-ante and exacerbated liquidity risks ex-post. 

Another instance of something seen as only good in finance/economics seems to be having a other side as well.  Wholesale funding was all projected to be all very nice and good. The issues were seen with retail deposits….Retail deposit funding is back in vogue though it also has its limitations. 

It is a very important paper. Wholesale funding is increasingly getting popular. The regulators need to be aware of its shortcomings and this paper is a good guide.

I initially thought the paper to be too technical (and hence kept skipping it). But it has a pretty simple model and explains the basic idea well. Only when authors do a more deep dive into the model does it become difficult to understand..

Update:

The paper has been presented at 2 conferences – BIS and Bundesbank. Comments on the paper are here – BIS and Bundesbank.

Advertisements

2 Responses to “Understanding Wholesale Funding and its dark side”

  1. Why were Asian Banks not impacted in this crisis? « Mostly Economics Says:

    […] funding.  As this crisis showed, deposit funding is seen as more stable form of funding than the wholesale funding. But this was not because of some policy move. Overall, deposits grew faster than credit in 2000-06 […]

  2. chinese wholesalers Says:

    Hmm, interesting post.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.


%d bloggers like this: