A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

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Bitcoin and Fundamentals

Bitcoin is all the rage, again. Last week, the price rose above $10,000 for the first time. Following a Friday announcement by the Commodity Futures Trading Commission, the Chicago Mercantile Exchange, the CBOE Futures Exchange, and the Cantor Exchange appear poised to launch Bitcoin futures or other derivatives contracts, with Nasdaq likely to follow. Portfolio advisers are encouraging cryptocurrency diversification. In London’s Metro, advertisements assure potential investors that “Crypto needn’t be cryptic.” And, as skyrocketing prices gain headlines, less sophisticated investors are diving in.

The danger is that investors will interpret the surging price itself (and the associated hullabaloo) as a sufficient signal to buy, fueling an asset price bubble (and, eventually, a painful crash).

No one can ever say with certainty when an asset price boom is a bubble. Nevertheless, it makes sense to ask what fundamental services Bitcoin provides. More specifically, have the prospects for those services improved sufficiently over the past year to warrant the 10-fold increase in price that has vaulted Bitcoin’s market capitalization into the range of the top 50 U.S. firms?

We strongly doubt it....

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GDP at Risk

For several decades, central bankers have been the key risk managers for the economy and the financial system. However, they failed spectacularly to anticipate and prevent the financial crisis of 2007-2009. The financial regulatory reforms since the crisis—capital and liquidity requirements, resolution regimes, restructuring of derivatives markets, and an evolving approach to systemic risk assessment and (macroprudential) regulation—have all been directed at improving the resilience of the system to help sustain strong and stable economic growth. As a result, the likelihood of another crisis-induced plunge in GDP is much lower today than it was a decade ago.

But we still have plenty of work to do. We are at an early stage in the process of building a financial stability policy framework that corresponds to the inflation-targeting framework which forms the basis for monetary policy. Such a framework requires measurable financial stability objectives that are akin to a price index, tools comparable to an interest rate, and dynamic models that help us to understand the link between the two.

In this post, we describe a step forward in developing such a framework: the concept and measurement of GDP at risk....

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Cash is king, but $100 bills are for crooks

People have been saying for years that cash will disappear. So far, they have been spectacularly wrong. Over the past decade, the face value of U.S. dollar paper currency in public hands has doubled. Today, there is nearly $1.6 trillion in banknotes outstanding, more than 80 percent of which is in $100 bills (see chart)! In fact, there are thirty-nine $100 bills in circulation for each of the 326 million residents of the United States.

Why is 90 percent of the U.S. increase in circulation accounted for by $100 bills? One possible explanation is that, with nominal interest rates near zero, the opportunity cost of holding cash has dwindled, reducing the incentive to deposit rising inventories of cash in a bank. The second, and more compelling, reason for the big increase in large-denomination notes is more troubling: it facilitates illicit activity. Money laundering, tax evasion, drug dealing, human trafficking, and a whole host of other criminal activities run on cash. Big banknotes are a convenient way to transfer funds anonymously with finality. A $100 bill weighs less than a gram, so $1,000,000 weighs roughly 10kg and is small enough to fit in a medium-size briefcase.

To put it simply, most of the U.S. currency in circulation is almost surely being used by criminals....  

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Banking the Unbanked: The Indian Revolution

Financial inclusion—providing universal access to financial services and encouraging their use—is an important means for promoting economic development. As of 2014, the World Bank estimated that there were still 2 billion adults without a bank account, and many others with only a tenuous connection to the financial system (see Global Findex). Better access will boost the efficiency of the payments system, promote household savings and access to credit, and improve people’s ability to manage risk. And, as it does all of these things, financial inclusion has the potential to reduce inequality and increase economic growth. In other words, reducing the multitudes of those that are unbanked will improve the fate of the poorest of the poor. (For more detail, see our earlier post.)

India’s unprecedented effort to “bank the unbanked” through the Pradhan Mantri Jan Dhan Yojana (PMJDY), or “Prime Minister’s People’s Wealth Scheme,” is by far the largest such undertaking. Launched merely three years ago, on August 28, 2014, the mission to provide no-frills, no-minimum-balance (hereafter, JDY) bank accounts to every adult (including the one-fifth of the population living below the poverty line and the large rural population with limited access to physical bank branches) has been remarkably successful. As of this writing, more than 300 million people have opened JDY accounts. And, while initial readings suggested limited use, over time, JDY account holders look to be learning about the benefits, so that use is rising toward levels observed for bank accounts of comparable individuals. Put differently, by lowering bank transactions costs, hundreds of millions of people who lacked access to financial services are revealing a latent demand....

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Managing Risk and Complexity: Legal Entity Identifier

Prior to the financial crisis, even an informed observer might have naïvely believed that the CEOs of big financial firms could simply push a button to view the current exposure of their firms to any other firms in the world. Or, if less technologically advanced, they could call their chief risk officers or chief financial officers to obtain end-of-day positions.

Not even close. By the time that Lehman failed in September 2008, large financial holding companies had evolved into extremely complex structures with hundreds or thousands of subsidiaries for which the parent companies lacked consolidated information technology and risk-management systems. The multiplicity of information systems meant that different parts of the same firm employed varying names and codes to identify the same counterparty. Fixing this, merging all of the information structures and ensuring consistency, would have been an expensive proposition that managers (compensated out of current profits) had incentive to delay.

Correcting these deficiencies in the financial infrastructure is not a trivial matter. Simplifying the problem requires the creation of a unique, universal, and permanent identification system for both institutions (financial and nonfinancial) and instruments. Realizing the nature of the opportunity and the challenge, in November 2011, the G20 called for the creation of a global legal entity identifier (LEI). Importantly, everyone realized that given the massive size of the financial system that supports both domestic and cross-border activity, the solution had to be global. (For pioneering analyses, see work by the Federal Reserve and the Office of Financial Research. For up-to-date information on the LEI, see here.)....

 

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Treasury Round II: The Capital Markets Report

Earlier this month, the U.S. Treasury published the second of four planned reports designed to implement the core principles for regulating the U.S. financial system announced in President Trump’s February 2017 Executive Order. This report focuses on capital markets. We wrote about the first report—regarding depository institutions—in June (see here). Future reports are slated to address “the asset management and insurance industries, and retail and institutional investment products and vehicles” and “nonbank financial institutions, financial technology, and financial innovation.”

A central motivation for all this work is to review the extensive regulatory reforms enacted in the aftermath of the 2007-09 financial crisis. President Trump’s stated principles provide an attractive basis for evaluating the effectiveness of Dodd-Frank in making the financial system both more cost-effective and safer. Where have the reforms gone too far? Where have they not gone far enough?

Much of the capital markets report focuses on ways to reduce the regulatory burden, and many of the proposals—which address issues ranging from initial public offerings (IPOs) to securitizations to financial market utilities (FMUs)—could improve market function. However, while they would involve a large number of changes—most of which can be implemented without new legislation (see table)—none of the 100-plus recommendations seem terribly dramatic, nor are they likely to have much impact on the goal of promoting economic growth.

Our overall reaction is that Treasury’s predispositions—which were more clearly evident in the earlier report—encourage doubts. To us, the numerous proposals look lopsided in favor of providing “regulatory relief” even where systemic concerns may persist....

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In Defense of Regulatory Diversity

Guest post by Lawrence J. White, Robert Kavesh Professor in Economics, NYU Stern School of Business

The U.S. regulatory landscape--especially with regard to financial regulation—is maddeningly complex.  It is easy to make a case for a drastic simplification, and the authors of this blog have done so here. But there is value in diversity—including regulatory diversity. Consequently, with regard to the regulatory framework, as is true of most other areas of political economy, we need to consider the costs as well as the benefits of any proposed changes.

Let’s start with the undeniable complexity of U.S. financial regulation: Consider the following array of agencies and jurisdictions (an alphabet-soup glossary appears at the end)...

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Resolution Regimes for Central Clearing Parties

Clean water and electric power are essential for modern life. In the same way, the financial infrastructure is the foundation for our economic system. Most of us take all three of these, water, electricity and finance, for granted, assuming they will operate through thick and thin.

As engineers know well, a system’s resilience depends critically on the design of its infrastructure. Recently, we discussed the chaos created by the October 1987 stock market crash, noting the problems associated with the mechanisms for trading and clearing of derivatives. Here, we take off where that discussion left off and elaborate on the challenge of designing a safe derivatives trading system―safe, that is, in the sense that it does not contribute to systemic risk.

Today’s infrastructure is significantly different from that of 1987. In the aftermath of the 2007-09 financial crisis, authorities in the advanced economies committed to overhaul over-the-counter (OTC) derivatives markets. The goal is to replace bilateral OTC trading with a central clearing party (CCP) that is the buyer to every seller and the seller to every buyer....

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Black Monday: 30 Years After

On Monday, October 19, 1987, the Dow Jones Industrial Average plunged 22.6 percent, nearly twice the next largest drop—the 12.8 percent Great Crash on October 28, 1929, that heralded the Great Depression.

What stands out is not the scale of the decline—it is far smaller than the 90 percent peak-to-trough drop of the early 1930s—but its extraordinary speed. A range of financial market and institutional dislocations accompanied this rapid plunge, threatening not just stocks and related instruments (domestically and globally), but also the U.S. supply of credit and the payments system. As a result, Black Monday has been labeled “the first contemporary global financial crisis.” And, a new book—A First-Class Catastrophe—narrates the tense human drama that it created for market and government officials. A movie seems sure to follow.

Our reading of history suggests that it was only with a great dose of serendipity that we escaped catastrophe in 1987. Knowing that fortune usually favors the well prepared, the near-collapse on Black Monday prompted market participants, regulators, the lender of last resort, and legislators to fortify the financial system.

In this post, we review key aspects of the 1987 crash and discuss subsequent steps taken to improve the resilience of the financial system. We also highlight a key lingering vulnerability: we still have no mechanism for managing the insolvency of critical payment, clearing and settlement (PCS) institutions....

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Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

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Operational Risk and Financial Stability

Recent disasters—both natural and man-made—prompt us to reflect on the relationship between operational risk and financial stability. Severe weather in sensitive locations, such as Hurricane Irma in Florida, raises questions about the resilience of the financial infrastructure. The extraordinary breach at Equifax highlights the public goods aspect of data protection, with potential implications for the availability of household credit.

At this stage, it’s important to pose the right questions about these operational shocks and, over time, to draw the right lessons. We expect that systemic financial intermediaries’ risk managers, members of their boards, their regulators, and their ultimate legislative overseers are currently in the midst of an intensive review of exposures (and that of the financial system as a whole) to these risks.

So, what is operational risk (OR)? The Basel Committee for Banking Supervision (BCBS) defines OR as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”....

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Why the central bank should be a leading supervisor

Should central banks be a leading supervisor, including supervising systemically important institutions? This is a question that members of the U.S. Congress periodically raise.  Our answer is unequivocally yes. As the lender of last resort, as the monetary policy authority, and as the organization responsible for overseeing the health and stability of the overall financial system—what we could call a systemic regulator—the central bank needs to be a leading supervisor....

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Eclipsing LIBOR

The manipulation of the London Interbank Offered Rate (LIBOR) began more than a decade ago. Employees of leading global firms submitted false reports to the British Banking Association (BBA), first to influence the value of LIBOR-linked derivatives, and later (during the financial crisis) to conceal the deterioration of their employers’ creditworthiness. U.S. and European regulators reported many of the details in 2012 when they fined Barclays, the first of a dozen financial firms that collectively paid fines exceeding $9 billion (see here). In addition to settling claims of aggrieved clients, these firms face enduring reputational damage: in some cases, management was forced out; in others, individuals received jail terms for their wrongdoing.

You might think that in light of this costly scandal, and the resulting challenges in maintaining LIBOR, market participants and regulators would have quickly replaced LIBOR with a sustainable short-term interest rate benchmark that had little risk of manipulation. You’d be wrong: the current administrator (ICE Benchmark Administration), which replaced the BBA in 2014, estimates that this guide (now called ICE LIBOR) continues to serve as the reference interest rate for “an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years [our emphasis].” In short, LIBOR is still the world’s leading benchmark for short-term interest rates.

Against this background, U.K. Financial Conduct Authority CEO Andrew Bailey, recently called for a transition away from LIBOR before 2022 (see here). In this post, we briefly explain LIBOR’s role, why it remains an undesirable and unsustainable interest rate benchmark, and why it will be so difficult to replace (even gradually over several years) without risking disruption.

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Ninth Anniversary of the GSEs' Conservatorships: Not a Time to Celebrate

In the summer of 2008, Fannie Mae and Freddie Mac’s financial positions deteriorated sharply: the result of inadequate capital (equity financing) for the risks in the residential mortgages that they held and had securitized. On September 6, 2008, their regulator, the Federal Housing Finance Agency (FHFA), removed senior management and placed these government-sponsored enterprises (GSEs) into conservatorships. Since then, the FHFA and the U.S. Treasury (which extended almost $188 billion to keep them solvent through 2011) have run them...

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Adverse Selection: A Primer

Information is the basis for our economic and financial decisions. As buyers, we collect information about products before entering into a transaction. As investors, the same goes for information about firms seeking our funds. This is information that sellers and fund-seeking firms typically have. But, when it is too difficult or too costly to collect information, markets function poorly or not at all.

Economists use the term adverse selection to describe the problem of distinguishing a good feature from a bad feature when one party to a transaction has more information than the other party. The degree of adverse selection depends on how costly it is for the uninformed actor to observe the hidden attributes of a product or counterparty. When key characteristics are sufficiently expensive to discern, adverse selection can make an otherwise healthy market disappear.

In this primer, we examine three examples of adverse selection: (1) used cars; (2) health insurance; and (3) private finance. We use these examples to highlight mechanisms for addressing the problem....

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Looking Back: The Financial Crisis Began 10 Years Ago This Week

In his memorable review of 21 books about the 2007-09 financial crisis, Andrew Lo evoked Kurosawa’s classic film, Rashomon, to characterize the remarkable differences between these crisis accounts. Not only were the interpretations in dispute, but the facts were as well: “Even its starting date is unclear. Should we mark its beginning at the crest of the U.S. housing bubble in mid-2006, or with the liquidity crunch in the shadow banking system in late 2007, or with the bankruptcy filing of Lehman Brothers and the ‘breaking of the buck’ by the Reserve Primary Fund in September 2008?”

In our view, the crisis began in earnest 10 years ago this week. On August 9, 2007, BNP Paribas announced that, because their fund managers could not value the assets in three mutual funds, they were suspending redemptions. With a decade’s worth of hindsight, we view this as a propitious moment to review both the precursors and the start of the worst financial crisis since the Great Depression of the 1930s.

But, first things first: What is a financial crisis? In our view, the term refers to a sudden, unanticipated shift from a reasonably healthy equilibrium—characterized by highly liquid financial markets, low risk premia, easily available credit, and low asset price volatility—to a very unhealthy one with precisely the opposite features. We use the term “equilibrium” to reflect a persistent state of financial conditions and note that—as was the case for Humpty Dumpty—it is easy to shift from a good financial state to a bad one, but very difficult to shift back again....

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Modernizing the U.S. Payments System: Faster, Cheaper, and more Secure

When it comes to domestic payments, the U.S. financial system still lags the efficiency in several advanced economies. The reasons are easy to find. First, other countries have leapfrogged outdated technologies. In the United States, checks remained dominant well after their technological sell-by date partly as a result of government support. The other key factor delaying a shift to alternative payment mechanisms is the importance of what economists call a network externality. That is, the more people who use one form of payment, the more valuable that method is to the people who are already using it. And, by the same token, the more expensive it is for someone to move away from the prevailing mechanism.

With these considerations in mind, two years ago the Fed convened the Faster Payments Task Force (FPTF), a group of more than 300 experts and interested parties from a wide range of backgrounds with the objective to “identify and evaluate alternative approaches for implementing safe, ubiquitous, faster payments capabilities in the United States.” Earlier this month, the FPTF issued its second and final report, which contains a set of 10 recommendations for making the payments system faster, cheaper and more secure....

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