At a very basic level, all QE does is exchange “new money” for fixed interest assets (up till now high quality government bonds of varying maturities and some corporates (UK)).
QE is meant to lower bond yields through the initial demand and the reduction of supply, but this is not a necessary condition (i.e the interest rate change on high quality securities), since the real prize is the rise in the price of risky assets through portfolio adjustment of cash percentage allocations.
Reducing the supply of high quality assets and increasing the supply of money aims to increase the liquidity in the market for less liquid risky assets.
Ostensibly, since the rise in the price of risky assets is also a proxy for those loans and leases on the books of the banks, QE is also intended to increase confidence in the banking system and the banking system’s confidence in its ability to make loans.
Perhaps less obvious, but in way probably more important, is the impact of QE on the risky assets used as collateral within the shadow banking system:
The shadow banking system, as defined by the Financial Stability Board is a “system of credit intermediation that involves entities and activities outside of the regular banking system”.
The reason for the development of the shadow banking system, according to a Fed Res. Bank. of St Louis article was to facilitate “the demand for safe, short-term investments from large, cash-rich financial and nonfinancial companies”, owing to the restrictions on deposit guarantees amongst other factors. The shadow banking system provided short term cash investments via two principal routes, according to the F.R.B.St.Louis, repurchase agreements and money market mutual funds, which themselves invested in short term commercial paper and asset backed investments.
By substituting entities such as banks, with long term views, for entities with shorter term liquidity and return requirements, you have increased the exposure of the banking system to the risk and volatility of the underlying loans. The ability to hold long term risk assets with short term funding is reduced as is the willingness to take risky positions with short term liabilities in long term assets. The market for loans has become more market directional and much more volatile.
Furthermore, this extra level of credit intermediation risks higher costs and a tranching of returns away from the traditional banking system. In a low interest rate environment with the Fed pushing down on interest rates, the traditional banking system is likely faced with lower overall returns and increased operational and balance sheet risks – note the ECB long term repurchasing operations designed to supplement the withering of demand from shadow banking.
While all the money in the system is still held by either the central and the deposit taking banking system, there are now many more intermediaries between the cash and the ostensible cash investor. This makes it all the more difficult to ascertain the relationship between money supply and loan/credit expansion and to what extent money supply is focussed on asset or productive capacity investment.
The shadow banking system depends even more on confidence in the prices of risky assets than traditional banking and it is likely that the increased need for QE type operations has been driven by the high shadow banking component of the financial system.
In short the shadow financial system, backed by high net worth individuals/cash rich corporates, want bank like returns without bank like risks, and this is clearly incompatible. You cannot shut up shop in a crisis, yet this is the risk the financial system is exposed to with a significant shadow banking presence.
So it would seem that QE, in the short term, primarily deals with liquidity issues in the shadow banking system, and this may well absorb much of the impact of quantitative easing on economic activity itself. This makes betting the farm on QE expectations all the more difficult for the average investor. Everything has just become far too complex, which is your typical biblical Tower of Babel moment.
I tend to agree with the FSB report comments than those of the Federal Res. Bank. of St. Louis that suggested shadow banking improved risk management and risk diversification. It can only diversify risk if the shadow banking system is both less volatile and uncorrelated with the traditional banking system – on the contrary it would appear that it is more volatile, more exposed to liquidity risks and imparts these liquidity risks on the banking system itself.