Cyber Instability

When terrorists attacked the World Trade Center on September 11, 2001, they also attacked the U.S. financial system. In addition to destroying critical financial infrastructure, the collapse of the twin towers closed the New York Stock Exchange and disrupted the payments system that links U.S. intermediaries, threatening to shut down banks, ATM machines and credit card operations across the country. Only extraordinary intervention by the Federal Reserve kept the system afloat (see, for example, Rosengren).

We have long argued that financial stability is a vital common resource (see here). As ECB Board member Cœuré suggests in the opening quote, the same applies to financial cybersecurity—the protection of financial information and communications technologies (ICT) and their associated networks from failures and attacks. The events of 9/11 and their aftermath dramatically highlighted the link between stability and cybersecurity. Moreover, because our financial system is so deeply reliant on ICT and on large, global networks, these two objectives are more closely linked than ever before: ensuring one means guarding the other.  

In this post, we highlight the pervasiveness of cyberthreats as a source of operational risk in finance. Consistent with the Presidential Policy Directive 21 and a recent Presidential Executive Order aimed at strengthening cybersecurity, the U.S. government has designated financial services infrastructure as critical to national and economic security (see here). Nevertheless, numerous challenges—ranging from the availability of reliable data to the ever-changing nature of the attacks themselves—make the goal of safeguarding financial ICT networks very difficult. To be effective, cybersecurity efforts require mechanisms for preventing successful attacks, limiting their impact, and promoting quick, reliable recovery. Reducing vulnerability and contagion while boosting cyberresilience is a very tall order….

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Fiscal Sustainability: A Primer

Nobody likes taxes, so public spending frequently exceeds revenues, leading governments to borrow. These budget deficits are a flow that add to the stock of debt. Since the Great Financial Crisis of 2007-2009, public debt in a number of advanced economies has surged. In the United States. the Congressional Budget Office (CBO) recently projected that―in the absence of policy changes―federal debt held by the public is headed for record highs (as a ratio to GDP) in coming decades.

Importantly, there is a real (inflation-adjusted) limit to how much public debt a government can issue (see Sargent and Wallace). Beyond that limit, the consequences are outright default or, if the debt is in domestic currency bonds that the central bank acquires, inflation that erodes its real value leading to a partial default.

Ultimately, debt sustainability requires that a country’s ratio of public debt to GDP stabilize. Otherwise, debt eventually will rise above the real limit and trigger default or inflation. In this note, we derive and interpret a simple debt-sustainability condition. The condition states that the government primary surplus―the excess of government revenues over noninterest spending—must be at least as large as the stock of outstanding sovereign debt times the difference between the nominal interest rate the government has to pay and the rate of growth of nominal GDP. If it is not, then the ratio of debt to GDP will explode….

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Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

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Italeave: Mother of all financial crises

After years of calm, fears of a currency redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. We have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post).

And, given Italy’s high public debt, a significant easing of its fiscal stance within monetary union could revive financial instability, rather than boost economic growth. Depositors fearing the introduction of a parallel currency (to finance the fiscal stimulus) would have incentive to shift out of Italian banks into “safer” jurisdictions. Argentina’s experience in 2001, when the introduction of quasi-moneys by the fiscal authorities undermined monetary control, is instructive….

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To Form a More Perfect Union

On 31 May 2018, Vítor Constâncio completes 18 years on the Governing Council of the European Central Bank (ECB)—8 as Vice President and 10 as Governor of the Bank of Portugal before that. Ahead of his departure, Vice President Constâncio delivered a valedictory address setting out his views on what needs to be done to make European Monetary Union (EMU) (and what people on the continent refer to as the “European Project”) robust.

Before we get to his proposals, we should emphasize that we continue to view political shifts as the biggest challenge facing EMU (see our earlier posts here and here). The rise of populism in recent euro-area member elections is not conducive to the risk-sharing needed to sustain EMU over the long run. Without democratic support, investor fears of redenomination risk—associated with widening bond yield spreads and, possibly, runs on the banking systems of some national jurisdictions—will continue to resurface whenever political risks spike or local economic fortunes ebb. This latent vulnerability—resembling that of a fixed-exchange rate regime with free movement of capital—diminishes the prospect for strong and stable economic growth in the region as a whole.

Turning to the need for change, the current framework has three significant shortcomings…

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Making Unelected Power Legitimate

Through what administrative means should a democratic society in an advanced economy implement regulation? In practice, democratic governments opt for a variety of solutions to this challenge. Historically, these approaches earned their legitimacy by allocating power to elected officials who make the laws or directly oversee their agents.

Increasingly, however, governments have chosen to implement policy through agencies with varying degrees of independence from both the legislature and the executive. Under what circumstances does it make sense in a democracy to delegate powers to the unelected officials of independent agencies (IA) who are shielded from political influence? How should those powers be allocated to ensure both legitimacy and sustainability?

These are the critical issues that Paul Tucker addresses in his ambitious and broad-ranging book, Unelected Power. In addition to suggesting areas where delegation has gone too far, Tucker highlights others—such as the maintenance of financial resilience (FR)—where agencies may be insufficiently shielded from political influence to ensure effective governance. His analysis raises important questions about the regulatory framework in the United States.

In this post, we discuss Tucker’s principles for delegating authority to an IA. A key premise—that we share with Tucker—is that better governance can help substitute where simple policy rules are insufficient for optimal decisions….

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Finance and the Blockchain: A Primer

Blockchain is all the rage. We are constantly bombarded by reports of how it will change the world. While it may alter many aspects of our lives, our suspicion is that they will be in areas that we experience only indirectly. That is, blockchain technology mostly will change the implementation of invisible processes—what businesses think of as their back-office functions.

In this post, we briefly describe blockchain technology, the problem it is designed to solve and the impact it might have on finance.

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Universal Central Bank Digital Currency?

Digital currency is all the rage. Bitcoin has more than one thousand crypto cousins. There is even a token called dentacoin, whose issuers claim it will transform dentistry! In the past, we have been clear in our views. We agree with BIS General Manager Agustín Carstens: these are exactly like past attempts of people to issue their own private money. As Carstens said on another occasion, these tokens are “a combination of a bubble, a Ponzi scheme and an environmental disaster.”

Regardless of whether the blockchain will revolutionize dental health, the appearance of cryptocurrencies has driven central banks to think about one particular aspect of their business: paper currency issuance.

In this post, we expand on some aspects of our earlier discussion of central bank digital currency (CBDC). What is it and what would its wider introduction mean for the financial system? Our conclusion is unambiguous: Watch out what you wish for! ….

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On the Distribution of Wealth

In an effort to understand the dynamics of the distribution of consumption, income and wealth, over the past decade, there has been an explosion of research. While important debates about measurement and data interpretation continue, a range of evidence points to two important conclusions. First, over the past two centuries, the global income distribution has become far more equal. But, while the gap between countries is now much smaller, in recent decades, inequality within some advanced countries, especially in the United States, has risen.

Rather than income or consumption, in this post we focus on the distribution of wealth. Wealth affects welfare in at least two key ways. First, in the presence of borrowing constraints, it provides a buffer against fluctuations of income, allowing households to smooth consumption in the face of temporary bouts of illness or unemployment. Second, it provides the basis for household spending in retirement. .

As we will see, the distribution of wealth is far less equal than that of income. Moreover, recent research shows that, following the Great Financial Crisis of 2007-2009, the U.S. wealth distribution has become decidedly more unequal. As a result, a large portion of U.S. households appears to have little scope for meeting retirement needs out of their current net worth, making federal insurance programs key to their future well-being.

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Alternative Reference Rates: Meeting the Challenges

Guest post by Richard Berner, Executive-in-Residence (Center for Global Economy and Business) and Adjunct Professor, NYU Stern School of Business

In response to the fragility of LIBOR and other interest-rate benchmarks, regulators globally are working with industry to identify sturdy alternatives. Despite significant progress, concerns persist that the transition to these new reference rates will be disruptive.

While these concerns are legitimate (see Eclipsing LIBOR), both U.S. and global authorities and market participants have begun to address them in ways that should go a long way to managing the risks. In this post, we review why LIBOR’s persistent fragility makes reform critical, and examine progress on some of the ongoing reforms....

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Liquidity Regulation is Back

Modern bank regulation has two complementary parts: capital and liquidity requirements. The first  restricts liabilities given the structure of assets and the second limits assets based on the composition of liabilities.

While capital regulation―especially in its risk-based form―is a creation of the last quarter of the 20th century, liquidity regulation is much older. In fact, the newly implemented liquidity coverage ratio (LCR) harks back to the system in place over 100 years ago. In the United States, before the advent of the Federal Reserve in 1914, both national and state-chartered banks were required to hold substantial liquid reserves to back their deposits (see Carlson). These are the reserve requirements (RR) that remain in effect in most jurisdictions today, the United States included.   

In this post, we briefly examine the long experience with RR as a way to gain insight regarding the LCR. We draw two conclusions. First, we argue strongly against using the LCR as a monetary policy tool in advanced economies with well-developed financial markets. Like RR, it is simply too blunt and unpredictable. Second, for the LCR to work as a prudential policy tool, it should probably be supplemented by something like a fee-based line of credit at the central bank....

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Size is Overrated

This month, in the guise of supporting community banks, the U.S. Senate passed a bill (S.2155) that eases regulation of large banks. We share the critics’ views that this wide-ranging dilution of existing regulation will reduce the resilience of the U.S. financial system.

In its best known and most publicized feature, the Senate bill raises the asset size threshold that Dodd-Frank established for subjecting a bank to strict scrutiny (such as the imposition of stress tests, liquidity requirements, and resolution plans) from $50 billion to $250 billion. In this post, we examine the role of asset size in determining the systemic importance of a financial intermediary. It turns out that (aside from the very largest institutions, where it does in fact dominate) balance sheet size is not a terribly useful indicator of the vulnerability a bank creates. We conclude that Congress should ease the strict oversight burden on institutions that pose little threat to the financial system without raising the Dodd-Frank threshold dramatically.

Judge makes an elegant proposal for accomplishing this. For institutions with assets between $100 billion and $250 billion, Congress should just flip the default. Rather than obliging the Fed to prove a mid-sized bank’s riskiness, give the bank the opportunity to prove it is safe. This approach gives institutions the incentive to limit the systemic risk they create in ways that they can verify. It also sharply reduces the risk of litigation by banks that the Fed deems risky...

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Tougher capital regulation pays off

Banks continue to lobby for weaker financial regulation: capital requirements are excessive, liquidity requirements are overly restrictive, and stress tests are too burdensome. Yes, in the aftermath of the 2007-09 financial crisis, we needed reforms, they say, but Basel III and Dodd-Frank have gone too far.

Unfortunately, these complaints are finding sympathetic ears in a variety of places. U.S. authorities are considering changes that would water down existing standards. In Europe, news is not promising either. These developments are not only discouraging, but they are self-defeating. Higher capital clearly improves resilience. And, at current levels of capitalization, it does not limit banks’ ability to support economic activity.

As it turns out, on this particular subject, there may be less of a discrepancy between private and social interests than is commonly believed. The reason is that investors reward banks in jurisdictions where regulators and supervisors promote social welfare through tougher capital standards....

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Ten Years After Bear

Ten years ago this week, the run on Bear Stearns kicked off the second of three phases of the Great Financial Crisis (GFC) of 2007-2009. In an earlier post, we argued that the crisis began in earnest on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. In that first phase of the crisis, the financial strains reflected a scramble for liquidity combined with doubts about the capital adequacy of a widening circle of intermediaries.

In responding to the run on Bear, the Federal Reserve transformed itself into a modern version of Bagehot’s lender of last resort (LOLR) directed at managing a pure liquidity crisis (see, for example, Madigan). Consequently, in the second phase of the GFC—in the period between Bear’s March 14 rescue and the September 15 failure of Lehman—the persistence of financial strains was, in our view, primarily an emerging solvency crisis. In the third phase, following Lehman’s collapse, the focus necessarily turned to recapitalization of the financial system—far beyond the role (or authority) of any LOLR.

In this post, we trace the evolution of the Federal Reserve during the period between Paribas and Bear, as it became a Bagehot LOLR. This sets the stage for a future analysis of the solvency issues that threatened to convert the GFC into another Great Depression.

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Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

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Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact.... 

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