Regulatory reform has focused on banks and how much liquidity and capital they should hold, rather than on the evolution of the broader financial ecosystem that banks are only a part of. However, understanding this ecosystem is imperative, as it can influence the types of activities banks engage in and the types of liabilities they issue.

The financial ecosystem can be understood on two levels: first, by profiling the institutions that modern banks interact with on both their asset and liability sides and the needs of these institutions (questions of “who” and “what”), and second, by identifying the global macro drivers behind these institutional needs (questions of “why”).

Risk intermediation

Our analytical framework to understand what modern banks do is muddled by trying to draw parallels with what traditional banks do. Traditional banks engage in credit intermediation by issuing loans and insured deposits, linking ultimate borrowers with ultimate savers.

Modern banks do something quite different. Modern banks are dealer banks (Mehrling et al. 2013 ) that finance bond portfolios with uninsured money market instruments, and rather than linking ultimate borrowers with ultimate savers, they link cash portfolio managers and risk portfolio managers who in turn manage ultimate savers’ savings.

Cash and risk portfolio managers are ‘natural’ complements to each other. Cash portfolio managers are cash rich but ‘safety poor’ since they are too large to be eligible for deposit insurance. This drives them toward insured deposit alternatives such as collateralised repurchase agreements (or repos; see for example Pozsar 2011 and 2012 and Pozsar and McCulley 2012).

Risk portfolio managers, on the other hand, are securities rich but ‘return poor’ in the sense that they are mandated to beat their benchmarks. To that end, they employ the techniques of leverage, shorting, and derivatives.

In each and every one of these cases, risk portfolio managers repo securities out and cash in, and on the other side, cash portfolio managers repo securities in and cash out. Cash portfolio managers have their safety (thanks to the securities posted by risk portfolio managers as collateral) and risk portfolio managers have their enhanced return (thanks to the funding provided by cash portfolio managers in exchange for collateral).

Dealer banks are intermediaries between risk portfolio managers and cash portfolio managers. Risk portfolio managers interface with dealers on the asset side of dealers’ balance sheets and cash portfolio managers interface with dealers on the liability side of dealers’ balance sheets. In this process dealers intermediate risks (credit, duration, and liquidity risks) away from cash portfolio managers and toward risk portfolio managers using repos and derivatives. This is risk intermediation (see Figure 1, and Checki 2009, Pozsar and Singh 2012, and Claessens et al. 2012).

Figure 1. Risk intermediation

Source: Zoltan Pozsar expanding on "Bagehot was a shadow banker" (Mehrling et al 2013).

Dealers and the global financial ecosystem

Turning to questions of ‘why’, the secular rise of cash portfolio managers seeking ‘safety’ and risk portfolio managers seeking ‘alpha’ has been driven by macro imbalances – both global and local, and present and future (see Figure 2).1

Firstly, the secular rise of cash portfolio managers (or institutional cash pools – see Pozsar 2011) can be attributed to three factors.

On the global level, managed exchange-rate arrangements vis-à-vis the US dollar explain the rise of cash pools at foreign exchange reserve managers (in the form of foreign exchange reserves’ so-called liquidity tranches to the tune of roughly $1 trillion), and the secular increase in capital’s share of income explains the rise of cash pools at the largest global corporations (to the tune of $1.5 trillion).

On the local level, the rise of cash pools within the asset-management complex (around $3.5 trillion) is explained by consolidation among asset managers and the secular rise of outsourced portfolio management, the centralised liquidity management of fund complexes, securities lending, and derivative overlay investment strategies.

These examples reflect imbalances in the distribution of present incomes – between countries with structural current-account surpluses and deficits, and between capital and labour – and that ever more individual savers’ portfolios are managed by ever fewer asset managers.

Secondly, the secular rise of risk portfolio managers (or levered investment strategies) reflects imbalances between the present value of future pension promises that exceeds the expected present value of unlevered, long-only investment incomes. This is the principal driver of the trend that pension funds and endowments allocate an increasing share of their portfolios to hedge funds and custom-tailored separate accounts at asset managers. In an ever-lower yield environment, asset managers resort to techniques of leverage, shorting, and derivatives – with an aim to enhance returns and avoid major portfolio drawdowns. They are all aiming to provide equity-like returns with bond-like volatility.

Foreign exchange reserve managers’ needs are somewhat similar to those of pension funds, for whom the maintenance of foreign exchange pegs is a negative carry proposition – the bonds issued to sterilise the exchange of foreign currency to domestic currency yield more than the foreign-currency bonds reserves are held in, which is a fiscal cost.2 To minimise these costs, reserve managers also employ the techniques of leverage, shorting, and derivatives – as well as securities lending – to enhance their returns.

Figure 2. Dealers and the global financial ecosystem

Source: Zoltan Pozsar.

Four goals shaping dealers’ balance sheets

Thus, from a bird’s-eye perspective the modern financial ecosystem has five groups of players, each with a well-defined goal.

CIOs at pension funds, foreign central banks and sovereign wealth funds – the first group – are tasked with reducing their underfundedness. They do this by allocating more of their portfolios to hedge funds and separate accounts – the second group – whose managers (risk portfolio managers) employ leverage, shorting, and derivatives in order to beat their benchmarks.

Treasurers (or cash portfolio managers) – the third group – are tasked with not losing any money on the cash pools they manage. They shun credit, duration, and liquidity risks, and invest cash on a collateralised basis. Importantly, these cash pools are the byproducts of the decisions of sovereign and corporate CEOs – the fourth group – who are tasked with generating growth in the real economy and profits, respectively.

The goals of these market participants – asset-liability matching for CIOs, beating benchmarks for hedge funds (risk portfolio managers), liquidity at par for treasurers (cash portfolio managers), and growth for CEOs – represent nominal rigidities in the system that drive what dealers – the fifth group – do.

Dealers’ role is to make markets and intermediate risks away from cash portfolio managers and toward risk portfolio managers – enabling them to preserve their wealth in the present and to help meet their promises in the future, respectively.

Dealers for the most part engage in risk intermediation through their matched book positions, and only engage in risk transformation through their inventory positions (either in the form of a portfolio of securities or derivatives), which – as more than ‘just’ brokers – dealers accumulate through their market-making activities. These risk positions are the key determinants of dealers’ equity needs (see Figure 3).

Figure 3. Four goals shaping dealers’ balance sheets

Source: Zoltan Pozsar.

This is the broadest perspective in which we can understand the rise of the shadow banking system. It explains why it is misleading to think about credit, duration, and liquidity transformation, and more appropriate to think about the intermediation of these risks between cash and risk portfolio managers across the financial ecosystem and – by inference – the real economy. That is, credit to the real economy is extended either through dealers’ securities inventories or via credit intermediation chains that go from cash portfolio managers through dealers’ matched repo books to risk portfolio managers to fund leveraged bond portfolios.

A three-level policy problem

On the regulatory side, one can approach the financial ecosystem at three different levels: the dealer level, the portfolio manager level, or the global macro level (see Figure 4). To date, however, regulatory reform has mostly focused on dealer banks – their capitalisation, funding, proprietary trading activities, and separation from retail banking.

However, focusing on dealers only – while leaving risk and cash portfolio managers’ and their CIO and CEO masters’ needs unaddressed – will only shift problems around without solving them. Ultimately, the policy extremes are:

  • Aiming to reduce the imbalances in present and future incomes, or
  • Accommodating the system as it is by giving the dealers at its core access to official liquidity (dealer of last resort – see Mehrling 2010 and also Pozsar et al. 2010, Carney 2013, and Bank of England 2013).

In either case, the fundamental problem we are dealing with is a financial ecosystem that has outgrown the safety net that was put around it many years ago. Today we have new types of savers (cash portfolio managers versus retail depositors), new types of borrowers (risk portfolio managers to fund pensions versus ultimate borrowers to finance investments and consumption) and new types of banks (dealer banks that do securities financing versus traditional banks that finance the real economy more directly via loans) to whom discount window access and deposit insurance do not apply.

These twin pillars of the official safety net were erected around traditional, deposit-funded banks to address retail runs. In contrast, the crisis of 2007–09 was a crisis of institutional runs where cash portfolio managers ran on dealers, and dealers ran on risk portfolio managers. But importantly – as the examples above demonstrate – beyond the institutional façade of the ecosystem it is ultimately real wealth and promises that are at stake.

Therefore, if neither of the above policy options (that is, shrinking imbalances or broadening the safety net) are palatable, the third option is to offer partial solutions and to recognise that the ecosystem’s existing needs will be met by new structures that need to be understood and monitored to avoid new systemic excesses.3

However, we cannot monitor what we don’t measure. The Flow of Funds accounts don’t address the measurement of the ecosystem described above.

Figure 4. A three-level policy problem

Source: Zoltan Pozsar.

We cannot monitor what we do not measure

The Flow of Funds have been designed to show who borrows, who lends, and through what types of instruments. However:

  • It offers no hints as to the asset–liability mismatches at pension funds and foreign exchange reserve managers;
  • It does not cover hedge funds and separate accounts, which make up an increasing share of institutional investors’ portfolios;
  • It does not provide a breakdown of dealers’ matched repo books to gauge the volume of funding passed on to hedge funds and asset managers, or the purpose of that funding – whether it was to fund a bond position, to post cash collateral for securities borrowed, or to raise liquidity for margin.

Moreover, the Flow of Funds accounts end where derivatives begin – derivatives effectively separate the flow of risks (credit, duration, and foreign exchange risks) from the flow of funds – and hence looking at exposures to bonds without looking at accompanying derivatives makes the Flow of Funds accounts’ usefulness somewhat limited. Furthermore, without a sense for these measures, our ability to understand asset price dynamics is also limited.

To improve on this, the Flow of Funds accounts should ideally incorporate measures of structural asset–liability mismatches, and be augmented with a set of Flow of Risks satellite accounts and a set of Flow of Collateral satellite accounts in order to tabulate the types of collateral that back the flow of funds and risks across the ecosystem.

Disclaimer: The views expressed here are those of the author and do not necessarily represent those of the institutions with which he is affiliated.
Author's note: I am grateful to Elena Liapkova-Pozsar for very helpful discussions and comments on earlier drafts.


Bank of England (2013), “Liquidity insurance at the Bank of England: developments in the Sterling Monetary Framework”, October.

Carney, Mark (2013), “The UK at the heart of a renewed globalisation”, speech at an event to celebrate the 125th anniversary of the Financial Times, London, 24 October.

Checki, Terrence J (2009), “Beyond the Crisis: Reflections on the Challenges”, rxemarks at the Foreign Policy Association Corporate Dinner, New York City, December 2.

Claessens, Stijn, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh (2012), “Shadow Banking: Economics and Policy”, IMF Staff Discussion Note 12/12.

Mehrling, Perry (2010), The New Lombard Street: How the Fed Became the Dealer of Last Resort, Princeton University Press.

Mehrling, Perry, Zoltan Pozsar, James Sweeney, and Daniel H Neilson (2013), “Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance”, working paper.

Pozsar, Zoltan (2011), “Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System”, IMF Working Paper No. 11/190.

Pozsar, Zoltan (2012), “A Macro View of Shadow Banking: Do T-Bill Shortages Pose a New Triffin Dilemma?”, in Franklin Allen, Anna Gelpern, Charles Mooney, and David Skeel (eds.), Is U.S. Government Debt Different?: 35–44.

Pozsar, Zoltan and Paul McCulley (2012), “Does central bank independence frustrate the optimal fiscal–monetary policy mix in a liquidity trap”, Global Society of Fellows Working Paper 26.

Pozsar, Zoltan and Manmohan Singh (2012), “The Nonbank-Bank Nexus and the Shadow Banking System”, IMF Working Paper 11/289.

Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky (2010), “Shadow Banking”, Federal Reserve Bank of New York Staff Report 458.

1 Excess returns can come in two basic forms: pure alpha (through smart portfolio selection, market timing, and hedges) or alpha masquerading as levered beta.

2 Unlike foreign exchange reserves’ liquidity tranches discussed above, this section refers to foreign exchange reserves’ long-duration segments, where search for yield is more prevalent.

3 Partial solutions include increased Treasury bill issuance or access to the Fed’s full allotment reverse repo facility to absorb some of cash portfolio managers’ money demand. However, these policy measures only address cash portfolio managers’ needs, but not those of risk portfolio managers.

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