How the Financial System Works

1 How the Financial System Works1-A Map of Money Flows in the Global Financial Ecosystem -by Zoltan PozsarAn Appendix to the paper Shadow Banking: The Money View (Pozsar, 2014)Senior AdviserOffice of Financial Research, Treasury2. The Hierarchy of The Hierarchy of The Dealer The Hierarchy of The Macro Policy core institutions:Central bank,..Source: Pozsar (2014)3 Central Bank (Federal Reserve)Source: Pozsar (2014)4 Four core institutions:Central bank, banks (small and big),..Central Bank (Federal Reserve)Banks (retail)Banks (wholesale)Source: Pozsar (2014)5 Four core institutions:Central bank, banks (small and big), dealers,..Central Bank (Federal Reserve)Dealer Banks Banks (retail)Dealer Banks Banks (wholesale)Source: Pozsar (2014)6 Four core institutions:Central bank, banks (small and big), dealers and money Bank (Federal Reserve)Dealer Banks Money FundsBanks (retail)Dealer Banks Money FundsBanks (wholesale)Four core money claims:Currency.

2 Source: Pozsar (2014)7 Central Bank (Federal Reserve)Dealer Banks CurrencyMoney FundsBanks (retail)Dealer Banks Money FundsLiabilitiesBanks (wholesale)Source: Pozsar (2014)8 Four core money claims:Currency, deposits,..LiabilitiesBanks (wholesale)Deposits(o/n)Banks (retail)Dealer Banks DepositsMoney Funds(o/n)Central Bank (Federal Reserve)Dealer Banks CurrencyMoney FundsSource: Pozsar (2014)9 Four core money claims:Currency, deposits, repos,..(o/n)LiabilitiesBanks (wholesale)Deposits(o/n)Banks (retail)Dealer Banks DepositsMoney FundsRepos(o/n)Central Bank (Federal Reserve)Dealer Banks CurrencyRepos(o/n)Money FundsSource: Pozsar (2014)10 Four core money claims:Currency, deposits, repos and constant NAV shares.

3 (o/n)LiabilitiesCNAVs(o/n)Banks (wholesale)Deposits(o/n)CNAVsBanks (retail)Dealer BanksDepositsMoney Funds(o/n)Repos(o/n)Central Bank (Federal Reserve)Dealer Banks CurrencyRepos(o/n)Money FundsSource: Pozsar (2014)11 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesPrivate assets:P-Bills -CD, CP, ECP, -bonds, RMBS, ABSL iabilitiesDepositsCNAVs(o/n)(o/n)Repos(o /n)(o/n)Banks (wholesale)Money Funds(o/n)Private AssetsBanks (retail)Dealer BanksDeposits(o/n)Money FundsCNAVsAssetsPublic AssetsCentral Bank (Federal Reserve)Dealer Banks CurrencyReposSource: Pozsar (2014)12 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesPrivate assets:P-Bills -CD, CP, ECP, -bonds, RMBS, ABSL iabilitiesCNAVs(o/n)Deposits(o/n)(o/n)Pr ivate AssetsBanks (retail)Dealer Banks DepositsMoney Funds(o/n)CNAVsDealer Banks T-NotesCurrencyRepos(o/n)AssetsPublic AssetsCentral Bank (Federal Reserve)Banks (wholesale)Money Funds(o/n)ReposSource: Pozsar (2014)13 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesT-Repos Treasury reposPrivate assets.

4 P-Bills -CD, CP, ECP, -bonds, RMBS, ABSL iabilitiesDepositsCNAVs(o/n)(o/n)Repos(o /n)(o/n)Banks (wholesale)Money Funds(o/n)Private AssetsBanks (retail)Dealer Banks (o/n)T-NotesMoney Funds CNAVsAssetsPublic AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) T-NotesCurrencyT-BillsT-ReposSource: Pozsar (2014)14 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesT-Repos Treasury reposT-CNAVs Treasury CNAVsPrivate assets:P-Bills -CD, CP, ECP, -bonds, RMBS, ABSL iabilitiesDepositsCNAVs(o/n)(o/n)Repos(o /n)(o/n)Banks (wholesale)Money Funds(o/n)Private AssetsBanks (retail)Dealer Banks (o/n)T-NotesMoney Funds (government-only)T-BillsT-CNAVsAssetsPub lic AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) T-NotesCurrencyT-BillsT-ReposSource: Pozsar (2014)15 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesT-Repos Treasury reposT-CNAVs Treasury CNAVsPrivate assets.

5 P-Bills -CD, CP, ECP, -bonds, RMBS, AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk)T-NotesCurrencyT-BillsT-Repos(o/n)M oney Funds (government-only)T-BillsT-CNAVsPrivate AssetsBanks (retail)Dealer Banks P-LoansDepositsMoney Funds (o/n)(o/n)Banks (wholesale)Deposits(o/n)(o/n)ReposLiabil itiesCNAVs(o/n)Source: Pozsar (2014)16 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesT-Repos Treasury reposT-CNAVs Treasury CNAVsPrivate assets:P-Bills -CD, CP, ECP, -bonds, RMBS, (o/n)(o/n)P-Loans(o/n)(o/n)Banks (wholesale)Money Funds T-NotesMoney Funds (government-only)Private AssetsBanks (retail)Dealer Banks P-LoansDeposits(o/n)ReposT-BillsT-CNAVsA ssetsPublic AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) (o/n)Source: Pozsar (2014)17 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesT-Repos Treasury reposT-CNAVs Treasury CNAVsPrivate assets:P-Bills -CD, CP, ECP, -bonds, RMBS, ABSP-Repos private (o/n)(o/n)P-Loans(o/n).

6 (o/n)Banks (wholesale)Money Funds T-NotesMoney Funds (government-only)Private AssetsBanks (retail)Dealer Banks (credit desk)P-LoansDepositsP-BillsP-Notes(o/n)P -ReposT-BillsT-CNAVsAssetsPublic AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) (o/n)Source: Pozsar (2014)18 Two categories of assets:Public assets:T-Bills Treasury billsT-Notes Treasury notesT-Repos Treasury reposT-CNAVs Treasury CNAVsPrivate assets:P-Bills -CD, CP, ECP, -bonds, RMBS, ABSP-Repos private reposP-CNAVs private (o/n)(o/n)P-Loans(o/n)..(o/n)Banks (wholesale)Money Funds (prime)T-NotesMoney Funds (government-only)Private AssetsBanks (retail)Dealer Banks (credit desk)P-LoansDepositsP-BillsP-Notes(o/n)P -ReposT-BillsT-CNAVsAssetsPublic AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) (o/n)Source: Pozsar (2014)19 Deposits special function.

7 Banks form the backbone of the payments System and fa-cilitatethe net payments(via deposits) of all enti-ties that are lower in the System -hierarchy, including dealers and money AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) (o/n)T-NotesMoney Funds (government-only)Private AssetsBanks (retail)Dealer Banks (credit desk)P-LoansDepositsP-BillsP-Notes(o/n)P -Repos(o/n)..(o/n)Banks (wholesale)Money Funds (prime) (o/n)(o/n)P-LoansSource: Pozsar (2014)20 Storing payment surpluses:What happens with net pay-mentsurplusesat the end of the day? Through what ins-trumentsare money balances stored within the System ?For every institution, money is something is the intra- System hierarchy of (o/n)(o/n)P-Loans(o/n).

8 (o/n)Banks (wholesale)Money Funds (prime)T-NotesMoney Funds (government-only)Private AssetsBanks (retail)Dealer Banks (credit desk)P-LoansDepositsP-BillsP-Notes(o/n)P -ReposT-BillsT-CNAVsAssetsPublic AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk) (o/n)Source: Pozsar (2014)21 Intra- System money hierarchy:Reserves at the Fedare money for banks.(o/n)..P-LoansAssetsPublic AssetsCentral Bank (Federal Reserve)ReservesP-LoansDealer Banks (government desk)T-NotesCurrencyT-BillsT-Repos(o/n). .T-NotesMoney Funds (prime)Reserves(o/n)T-BillsT-CNAVsMoney Funds (government-only)Private AssetsBanks (retail)Dealer Banks (credit desk)ReservesDepositsP-BillsP-Repos(o/n) (o/n)(o/n).

9 (o/n)(o/n)(o/n)Banks (wholesale)DepositsP-BillsP-CNAVsSource: Pozsar (2014)22 Intra- System money hierarchy:o/n T-Repos with wholesale banks are money for dealers.(o/n)AssetsPublic AssetsCentral Bank (Federal Reserve)ReservesBanks (wholesale)..P-LoansDealer Banks (government desk)T-NotesCurrencyT-ReposT-Repos(o/n)( o/n)..T-Notes(o/n)Money Funds (government-only)T-BillsT-CNAVsPrivate AssetsBanks (retail)Dealer Banks (credit desk)ReservesDepositsP-BillsP-Repos(o/n) (o/n)(o/n).. Funds (prime)LiabilitiesReservesT-ReposP-Bills P-CNAVs(o/n)(o/n)(o/n)..Deposits(o/n)Sou rce: Pozsar (2014)23 Intra- System money hierarchy:o/n T-Repos w/ dealers are money for government (o/n)AssetsPublic AssetsCentral Bank (Federal Reserve)ReservesPrivate AssetsBanks (retail)(o/n)(o/n).

10 Dealer Banks (government desk)T-NotesCurrencyT-ReposT-Repos(o/n)( o/n)..T-NotesMoney Funds (government-only)ReservesDepositsP-Bills P-ReposT-ReposT-CNAVs(o/n)(o/n)(o/n)..De aler Banks (credit desk)(o/n)P-NotesBanks (wholesale)Money Funds (prime) (o/n)ReservesT-ReposP-BillsP-CNAVs(o/n)( o/n)Source: Pozsar (2014)24 Intra- System money hierarchy:o/n P-Repos with dealers are money for prime AssetsCentral Bank (Federal Reserve)Dealer Banks (government desk)T-NotesCurrencyT-ReposT-ReposReserv es(o/n)(o/n)(o/n)..T-Notes(o/n)(o/n)Mone y Funds (government-only) AssetsBanks (retail)Dealer Banks (credit desk)ReservesDepositsP-ReposP-Repos(o/n) (o/n)(o/n).. (wholesale)Money Funds (prime) (o/n)P-LoansDepositsP-Bills(o/n)(o/n)(o/ n)(o/n)(o/n).