Ending Too Big to Fail

More than six years after the Dodd-Frank Act passed in July 2010, the controversy over how to end “too big to fail” (TBTF) remains a key focus of financial reform. Indeed, TBTF—which led to the troubling bailouts of financial behemoths in the crisis of 2007-2009—is still one of the biggest challenges in reducing the probability and severity of financial crises. By focusing on the largest, most complex, most interconnected financial intermediaries, Dodd-Frank gave officials a range of crisis prevention and management tools. These include the power to designate specific institutions as systemically important financial institutions (SIFIs), a broadening of Fed supervision, the authority to impose stress tests and living wills, and (with the FDIC’s “Orderly Liquidation Authority”) the ability to facilitate the resolution of a troubled SIFI. But, while Dodd-Frank has likely made the U.S. financial system safer than it was, it does not go far enough in reducing the risk of financial crises or in ensuring credibility of the resolution mechanism (see our earlier commentary here, here and here). It also is exceedingly complex.

Against this background, we welcome the work of the Federal Reserve Bank of Minneapolis and their recently announced Minneapolis Plan to End Too Big to Fail (the Plan). While the Plan raises issues that require further consideration—including the potential for regulatory arbitrage and the calibration of the tools on which it relies—it is straightforward, based on sound principles, and focuses on cost-effective tools. In this sense, the Plan represents a big step forward...

Read More

Policy rules

Monetary economists like rules. Traditionally, they worry that policymakers will sacrifice the long-term benefits of price stability for the more immediate gratification of higher growth. Realizing how hard it is to resist temptation, politicians have delegated monetary policy to a central bank that is independent, but subject to a mandate that constrains their discretion. This institutional setup helped lower inflation in the advanced economies from a median exceeding 10 percent in the late 1970s and early 1980s to about 2 percent by the late 1990s.

But, convinced that overly accommodative financial conditions in the first few years of the century spurred the credit accumulation that fed the 2007-09 financial crisis, there is a push to constrain central banks further by requiring that they publish and account for their actions with reference to a simple policy rule...

Read More

Monetary Policy and Financial Stability

In June 2015, a committee of Federal Reserve Bank Presidents conducted a “macroprudential tabletop exercise”—a kind of wargame—to determine what tools to use should risks to financial stability arise in an environment when growth and inflation are stable. The conventional wisdom—widely supported in policy pronouncements and in a range of academic studies—is that the appropriate tools are prudential (capital and liquidity requirements, stress tests, margin requirements, supervisory guidance and the like). Yet, in the exercise, the policymakers found these tools more unwieldy and less effective than anticipated. As a result, “monetary policy came more quickly to the fore as a financial stability tool than might have been thought.”

This naturally leads us to ask whether there are circumstances when central bankers should employ monetary policy tools to address financial stability concerns. Making the case for or against use of monetary policy to secure financial stability is usually based on assessing the costs and benefits of a policy that "leans against the wind" (LAW) of financial imbalances...

Read More

A Primer on Securities Lending

Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.

Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post...

Read More

Bank of Japan at the Policy Frontier

Since Governor Haruhiko Kuroda took office in March 2013, the Bank of Japan (BoJ) has been the most aggressively expansionary advanced-economy central bank. Its announcement last month of a “new framework for strengthening monetary easing”—coming only six months after introducing negative policy rates—distances it even further from the pack.

That a central bank is willing to assess its performance transparently and to consider new approaches to achieving its key goals is something we have come to expect. While it’s much too early to tell whether the latest BoJ innovations will be more successful, there is reason to be skeptical. No less important, the new approach involves risks to the central bank and to financial market stability that may not be fully appreciated. Given the difficulties that other advanced-economy central banks seem to be having in raising inflation and inflation expectations, how the BoJ fares is of interest far beyond Japan.

Read More

Policy and Measurement

Policy, especially monetary policy, is about numbers. Is inflation close to target? How fast is the economy growing? What fraction of the workforce is employed?  And, what is the relationship between the policymakers’ tools and their objectives? Answering all of these questions requires measuring a broad array of economic indicators, with consumer prices high on the list. In this post, we discuss some of the pitfalls in measuring prices.

Price indices of the sort that we use today have been around since the late 19th century. In the United States, near the end of World War I, the National Industrial Conference Board starting constructing and publishing a cost-of-living index. This work was eventually taken over by the Bureau of Labor Statistics (BLS). Over the past century, the theory of price indexes (see, for example, here and here) and the means of measurement have both moved forward substantially.

With the advent of inflation targeting, price indices have taken on a new prominence. If monetary policymakers are going to focus on controlling inflation—setting numerical targets for which they are then held accountable—then the construction of the price index itself becomes an issue. What is included and how can become critical to the way policy is conducted and to the achievement of the stated objective, namely price stability....

Read More

Rewriting the textbook: covered interest parity

For decades, textbooks on international economics and finance built a part of their scaffolding on the foundation of a relationship called covered interest parity (CIP). CIP postulates that, in a world of free capital flows, currency-hedged returns on equivalent-risk assets will equalize across countries. For example, the return to investing in a 1-year U.S. Treasury bill will equal the return to purchasing euros, investing the proceeds in a 1-year German Government liability, and purchasing a contract guaranteeing the future euro/dollar exchange rate at which the euros will be converted back to dollars a year later. In practice, the CIP relationship was such a reliable feature of international fixed-income markets that for decades one could think of banks operating a nearly costless CIP machine to perform what many viewed as a riskless arbitrage.

Then, one day, the CIP machine broke down. It first stopped working in the Great Financial Crisis (GFC) of 2007-2009, when counterparty and liquidity risks both skyrocketed, raising the possibility of defaults and losses in executing the trades necessary. That is, CIP was not a riskless arbitrage.

As a wave of recent research highlights, the conventional, pre-crisis model of the CIP machine remains impaired even as the counterparty and liquidity risks that characterized the GFC have receded....

 

Read More

Clinton versus Trump on Financial Regulation

Will the U.S. Presidential election have an impact on financial regulation? The answer depends on who becomes President, the priorities of the winner, and the inclinations of the Congress. That said, we thought it would be useful to examine what the candidates say they will do. To summarize, we find Republican nominee Trump’s call to “dismantle Dodd-Frank” deeply troubling. By comparison, our differences with Democratic nominee Clinton are relatively minor.

Read More

How risky are the big U.S. banks?

Readers of this blog know that we are great fans of the Stern Volatility Lab’s estimates of systemic risk. Like many observers, including leading regulators, we find market-value rather than book-value measures of bank equity more useful for timely monitoring of systemic risk created by individual intermediaries. Equity prices are available in real time, rapidly incorporate bank-specific and economy-wide information, and are forward-looking. This makes them particularly helpful in assessing the impact of big events, like this summer’s Brexit referendum (see our earlier post).

So, based as it is on market indicators of bank risk, not surprisingly we share the recent assessment of Sarin and Summers (expressed in their September 2016 Brookings paper) that the increase of book capital in the banking system since the financial crisis ought not give rise to regulatory complacency. We have argued repeatedly for raising capital requirements (see, for example, here) and, like those authors, believe that we need mechanisms for the virtually automatic recapitalization of banks in a crisis (see here). 

Read More

Transparent stress tests?

This month, the Committee on Capital Market Regulation (CCMR) published a paper criticizing the procedures the Federal Reserve uses in conducting its stress tests. The claim is that, in its annual Comprehensive Capital Analysis and Review (CCAR), the Fed is violating the Administrative Procedures Act of 1946 (APA). The CCMR’s proposed solution is more transparency. As big fans of both stress tests and transparency in general, and of the CCAR in particular, we find this legal challenge very troubling.

We believe that making the stress tests more transparent in the ways that the CCMR suggests would make them much less effective. This would do serious damage to financial stability policy and (ultimately) increase the likelihood of another crisis... 

Read More

Reforming mutual funds: a proposal to improve financial market resilience

U.S. capital markets are the deepest and broadest in the world, fortifying the country’s financial system and making its assets both liquid and attractive. A major part of this capital market advantage is due to the role played by mutual funds, which provide retail investors with a low-cost means of diversifying risk while earning a market return on their savings.

However, a growing class of mutual funds—those that hold mostly illiquid assets—appear to be a potential source of systemic risk. In this post we explain why, and then go on to suggest a change that is simple to implement and might mitigate the problem.

Read More

Inflation and Fiscal Policy

Why is it proving so difficult to raise inflation? For generations after World War II, this was not something that worried economists. Yet, today, even as central banks lower policy rates close to zero (or below) and expand their balance sheets beyond what anyone previously imagined possible (see chart), inflation remains stubbornly below target in most of the advanced world.

Nowhere is this problem more profound than in Japan, where mild deflation was the norm for nearly two decades and where inflation still remains well shy of the Bank of Japan’s 2% target. Even as monetary policymakers expanded the central bank’s balance sheet by nearly one-third of GDP and nudged its policy rate slightly below zero, consumer price inflation (as measured by our preferred trend measure, the 10% trimmed mean) has slipped from 0.9% to 0.1% over the two years to July 2016...

Read More

Saving for retirement

The biggest question facing anyone considering retirement is financial: are my savings sufficient to provide for my lifestyle for the rest of my life? For the fortunate among us, the answer is yes. But for a large fraction of the population, the answer is likely no.

The typical U.S. household has few retirement savings. The National Institute on Retirement Security reports that the median for near-retirement households is $12,000, while that for all households is only $3,000. Most people are relying on government social security to meet their retirement needs.

There are many reasons for this. One is the reduction in the fraction of employers offering any retirement plan at all, and another is the shift away from defined-benefit (DB) and toward defined-contribution (DC) pension plans. The result is that many individuals face risks that they are not equipped to bear, and many households need to save substantially more than they would have had these changes not occurred....

Read More

Opportunities in Finance

“We’re really only at 1% of what is possible, and probably even less than that. […] We should be building great things that don’t exist.”     Larry Page, Google I/O 2013 Keynote

With the summer coming to an end, professors everywhere are greeting a new group of students. So, our thoughts turn to the opportunities and challenges that those interested in finance will face over the course of their careers.

Like many important activities, finance is constantly evolving, so the “facts” that students learn in classes today will almost certainly change rapidly. With that in mind, we always strive to find a set of core principles that will endure, so that students can build a career based both on a set of specialized skills and on a broad capacity to imagine where finance and the financial system are heading...

Read More

Negative Nominal Interest Rates (again)

There is an obsession with negative nominal interest rates. People seem to think that they make no sense. And, there is a fixation with keeping track of the fraction of sovereign debt that is trading at negative nominal rates. (At this writing, the number is approaching one-third of the total outstanding.) Clearly many central bankers believe that setting the policy rate below zero is a legitimate use of this conventional instrument, a point that we have supported in the past. But the fact that people are so disturbed prompts us to ask why. In this post, we first discuss why we are confused by this reaction, and then try to identify what might account for it....

Read More

The FOMC's Prudent Caution

Imagine Fed Governor Rip van Winkle waking from a 10-year nap to find that trend inflation is only a bit shy of the 2% target, the unemployment rate is close to its long-run steady state, and the Fed’s balance sheet is five times larger than when he fell asleep. As we wrote two years ago, you could forgive him for expecting the federal funds rate to be closer to 4% than ½%. And, you would understand his astonishment when he learns that financial market expectations of policy tightening have collapsed amid continued economic expansion.

So, why are both the current policy rate and expectations of the future rate so low? There are four powerful reasons. First, both investors and policymakers have lowered their estimates of the steady-state (or “natural”) real interest rate. That means that Fed policy today is less accommodative than Governor Rip’s 10-year-old perspective leads him to think. Second, Rip is surely startled to learn that, even with a tightening labor market and policy rates close to zero, market-based long-run inflation expectations have declined. Third, it seems unlikely that Rip would be thinking much about the policy asymmetry that occurs when the nominal interest rate is near the effective lower bound. That is, as post-crisis experience suggests, with policy rates near (or even below) zero, it is much easier for central banks to tighten when prices rise too quickly than it is to ease should prices start to fall. Fourth, the economy’s productive capacity may be endogenous: that is, it may be possible for trend growth to be higher than recent experience suggests...

Read More

Are European Stress Tests Stressful Enough?

We are huge fans of stress tests. In many ways, they are the best macroprudential tool we have for reducing the frequency and severity of financial crises.

The idea behind stress tests is simple: see if all financial institutions can simultaneously withstand a major negative macroeconomic event—a big fall in real output, a large decline in equity and property prices, a substantial widening of interest-rate spreads, an adverse move in the exchange rate. And, importantly, assume that in response to these adverse circumstances banks have no way to sell assets or raise equity. That is, the stress test asks whether each intermediary can stand on its own without help in the middle of an economic maelstrom. But for stress tests to be effective, they must be truly stressful. The tempest has to be the financial equivalent of a severe hurricane, not just a tropical storm.

This brings us to the latest European Banking Authority (EBA) 2016 stress tests. As we mentioned recently, the European financial system may be the biggest source of systemic risk globally. So, these tests are important not just for Europe, but for the world as a whole. Unfortunately, they just aren’t severe enough, so there is little reason to be confident about the resilience of European finance...

Read More

The World of ETFs

The first U.S. exchange-traded fund (ETF)—the SPY based on the S&P500—began trading in 1993. Since then, the number of such funds has grown dramatically, so that by mid-2016 there were more than 1,600 ETFs on U.S. exchanges valued at roughly $2.2 trillion. This means that ETFs are now roughly one-sixth the size of open-end mutual funds. And, with this ETF growth has come a broadening in their scope and character. Today, there are ETFs that include less liquid assets such as corporate bonds and emerging market equities, and there are funds that provide inverse or leveraged exposure to the underlying assets.

Given these trends, it is no surprise that ETFs have attracted regulators’ attention (see, for example, here and here). Should they be concerned? Is this a consumer protection issue? Do ETFs contribute to systemic risk? Or, is their design stabilizing? Might financial stability even be served by the conversion of all open-end mutual funds into ETFs? ...

Read More

The Lender of Last Resort and the Lehman Bankruptcy

Professor Larry Ball, our friend and colleague, has written a fascinating monograph reexamining the September 14, 2008 failure of Lehman Brothers. Following an exhaustive study of documents from a variety of sources, Professor Ball concludes that the Fed could have rescued Lehman. The firm had sufficient collateral to meet its liquidity needs, and may have been solvent. The implication is that the worst phase of the financial crisis was preventable. (A short summary is available here.)

We are skeptical on several fronts—that Lehman was solvent, that policymakers had authority to lend to an insolvent institution, and that doing so would have limited the financial crisis...

Read More

The China Debate

China’s rapid credit expansion is worrying. Will Chinese policymakers be able to contain the growth of credit without undermining economic growth and without triggering a banking or currency crisis? Aside from the consequences of Brexit, this is probably the most important issue facing global policymakers and investors today.

As it turns out, there are powerful arguments on both sides. The positives—high national savings and returns to investment, combined with the government’s broad tools for intervention—must be measured against a set of negatives—growing loan losses, the spread of shadow banking, large capital outflows, falling investment returns, and declining confidence in the government’s financial policy management. Against this complex background, it is no wonder that concerns and uncertainty are both high. What one can say confidently remains conditional:  things are very likely to end badly if the credit buildup continues amid slowing economic growth...

Read More