The Buildup of Global Financial Fragility in the Euphoric Economy
Junji Tokunaga and Gerald Epstein
The Changes of Financial Conditions in the Euphoric Economy
As demonstrated in Figure 2, gross capital flows expanded rapidly from 2004 to 2007 in the run-up to the global financial crisis. The rapid expansion of gross capital flows reflected, in part, the overstretched nature of balance sheets at large, complex financial institutions (LCFIs), which was attributed to changes in both the credit demand-side (i.e., ultimate borrower) and the credit supply-side (i.e., ultimate lender) in the global shadow banking system during the period; these led to both the U.S. housing bubble and global safe assets shortage. We here discuss how these changes of financial condition influenced the balance sheets of LCFIs.
First of all, the U.S. housing bubble led LCFIs to hold “excess capacity” in their balance sheet. The U.S. economy had been experiencing a housing bubble since the beginning of the 2000s. Then the U.S. experienced a euphoric economy from 2004 to 2006, in that housing prices had rapidly surged during this period. The euphoric economy, characterized by an underestimation of market risk and credit risk, also led to the rise in the value of collateral assets. As Adrian and Shin  point out, the rising values of collateral assets encouraged LCFIs to hold the excess capacity in their balance sheets. In response to the excess capacity, LCFIs actively adjusted their balance sheets in order to expand the overall size of their balance sheets. On the liabilities side, the rising values of collateral assets such as asset-backed securities (ABS) and collateralized debt obligations (CDO) allowed LCFIs to take on more short-term dollar financing in wholesale funding market, such as repos, thus leading to the further increase in leverage and risk-taking. On the asset side, LCFIs purchased long-term “AAA” assets whose underlying assets were located in the U.S. housing market, especially the subprime mortgage market, which were previously shut out of the credit market but drastically expanded during the euphoric economy from 2004 to 2006. As a result, balance sheets at LCFIs became overstretched during the euphoric economy.
In turn, the deeper question is how LCFIs could attract short-term dollar financing that allowed them to overstretch their balance sheet. What is importan there is that an enormous number of institutional cash pools played a critical role in the short-term dollar funding that expanded their balance sheets. As Ponzar  points out, there was a virtually insatiable demand for dollar-denominated safe, short-term and liquid instruments from institutional cash pools, whose size had increased since the 1990s. The volume of institutional cash pools rose from $100 billion in 1990 to over $2.2 trillion at their peak in 2007. The institutional cash pools sought to invest part of their abundant cash funds in alternative assets to insured deposits—that is, safe, short-term and liquid instruments, including short-term government guaranteed instruments and a broad range of privately-guaranteed instruments that were created in the shadow banking system.
Notably, there was an insufficient supply of short-term government-guaranteed instruments to serve as deposit alternatives, in comparison with the huge demand for dollar-denominated safe, short-term and liquid instruments from institutional cash pools. This shortage, which implies the excess demand for dollar-denominated safe, short-term and liquid assets, has been estimated to amount to $1.1, $1.6 and $1.6 trillion in 2005, 2006 and 2007, respectively. Thus, the global financial system experienced an imbalance between the global demand for dollar-denominated safe, short-term and liquid debt instruments and the limited supply of the assets—that is, the growing of the global safe assets shortage, as Caballero  and Gourinichas  stress.
In response to the excess demand for dollar-denominated safe, short-term and liquid assets, LCFIs endogenously created privately dollar-denominated money market instruments in the global shadow banking system. In other words, the creation of privately money market instruments indicates that LCFIs could elastically increase their short-term dollar financing—that is, the endogenously elastic finance of the global dollar—in the global shadow banking system.
Institutional cash pools rushed to invest some part of their cash in the holdings of privately money market instruments that were created by LCFIs in the global shadow banking system. In fact, during 2006-2008, the average institutional cash pool held about 20% of its portfolio in bank deposits; about 10% in short-term government-guaranteed instruments; and about 60% in short-term, privately-guaranteed instruments, which can further be split into 20% held in collateralized private money market instruments and nearly 40% in government-only and globally-diversified prime money market mutual funds.
In short, the changes in financial condition of both ultimate borrowers and ultimate lenders induced LCFIs to tend to overstretch their balance sheets during the euphoria economy, relying on an endogenously elastic finance of global dollars in the global shadow banking system.
The Buildup of Global Financial Fragility
On the one hand, the dynamic process of balance sheet expansion at LCFIs, driven by the highly elastic finance of the global dollar, enhanced global financial intermediation by increasing global liquidity during the euphoric economy.
Since the 2000s, the development of the global shadow banking system has facilitated the rapid growth of the volume of credit funding that is not channeled through the traditional global banking system. This funding is defined as “non-core liabilities” in the shadow banking system, which is distinct from “core (deposit-based) liabilities” in the traditional banking system, as explained in Chen et al . Figure 9 indicates that global liquidity development, which reflects the development of both the traditional (core) and shadow banking (non-core) system of the euro area, Japan, the U.K. and the U.S. since the end of 1990s. While the two components of global liquidity, which reflected the increase in both core and non-core liabilities, were roughly equal at the end of the 1990s, the non-core liabilities in the global shadow banking system had become more important thereafter.
On the other hand, it would be reasonable to conjecture that the dynamic process of balance sheet expansion at LCFIs contributed to the buildup of global financial fragility that led to the global financial crisis. Euphoric expectations, as well as underestimations of credit risk and market risks, from 2004 to mid-2007 allowed for the faster collateral expansion. This environment facilitated the global dollar expansion that enabled LCFIs to pursue excessive leverage and risk-taking for purchasing long-term “AAA” assets, leading to the dynamic process of balance sheet growth at LCFIs during the euphoric economy.
It is important to emphasize that the endogenous highly-elastic finance of global dollar expansion entailed greater vulnerability to drastic changes in the market value of collateral assets and major adverse shocks, making LCFIs fragile in the face of value changes and shocks during the downturn. It turned out that a significant decline in collateral triggered a drastic contraction of balance sheets during the global financial crisis, when a drastic increase of market and credit risk was driven by the end of the euphoric economy.
In short, the dynamic process of balance sheet expansion at LCFIs in the global shadow banking system, driven by the endogenous highly elastic finance of global dollar during the euphoric economy, contributed to the build up of the global financial fragility that led to the global financial crisis.
 As Adrian and Shin  note, models of risk and economic capital dictate active management of their overall value at risk (VaR) through adjustments of their balance sheets for financial intermediaries. Furthermore, Shin  called the excess capacity in their balance sheet a “global banking glut.”
 Borio and Disyatat  stress that the unsustainable expansion in credit and asset prices (“financial imbalances”) results from “overstretched balance sheets” that means too soft financial constraints on the private and official sector.
 Ponzar , p.5.
 Ponzar , pp.9-10.
 Ponzar , pp.12-13.