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.... Read More
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. Read More
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.... Read More
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.... Read More
When migrants send money across borders to their families, it promotes economic activity and supports incomes in some of the poorest countries of the world. Annual cross-border remittances are running about US$600 billion, three quarters of which flow to low- and middle-income countries. To put that number into perspective, total development assistance worldwide is $150 billion.
Yet, despite the remarkable technological advances of recent decades, remittances remain extremely expensive. On average, the charge for sending $200―the benchmark used by authorities to evaluate cost―is $14. That is, the combination of fees (including charges from both the sender and recipient intermediaries) and the exchange rate margin typically eats up fully 7% of the amount sent. While it is less expensive to send larger amounts, the aggregate cost of sending remittances in 2017 was about US$30 billion, roughly equivalent to the total non-military foreign aid budget of the United States!
In this post, we discuss remittances, why their costs remain high, and what might be done to lower them. Read More
Over the past 40 years, U.S. capital markets have grown much faster than banks, so that banks’ share of credit to the private nonfinancial sector has dropped from 55% to 34% (see BIS statistics here). Nevertheless, banks remain a critical part of the financial system. They operate the payments system, supply credit, and serve as agents and catalysts for a wide range of other financial transactions. As a result, their well-being remains a key concern. A resilient banking system is, above all, one that has sufficient capital to weather the loan defaults and declines in asset values that will inevitably come.
In this primer, we explain the nature of bank capital, highlighting its role as a form of self-insurance providing both a buffer against unforeseen losses and an incentive to manage risk-taking. We describe some of the challenges in measuring capital and briefly discuss a range of approaches for setting capital requirements. While we do not know the optimal level of capital that banks (or other intermediaries) should be required to hold, we suggest a practical approach for setting requirements that would promote the safety of the financial system without diminishing its efficiency.... Read More
When most people think of investment, what comes to mind is the purchase of new equipment and structures. A restaurant might start with construction, and then fill its new building with tables, chairs, stoves, and the like. This is the world of tangible capital.
We still need buildings and machines (and restaurants). But, over the past few decades, the nature of business capital has changed. Much of what firms invest in today—especially the biggest and fastest growing ones—is intangible. This includes software, data, market analysis, scientific research and development (R&D), employee training, organizational design, development of intellectual and entertainment products, mineral exploration, and the like.
In this post, we discuss the implications of this shift for the structure of finance. Tangible capital can serve as collateral, providing lenders with some protection against default. As a result, firms with an abundance of physical assets can finance themselves readily by issuing debt. By contrast, a company that focuses on software development, employee training, or improving the efficiency of its organization, will find it more difficult and costly to borrow because the resulting assets cannot easily be re-sold. That means relying more on retained earnings or the issuance of equity.... Read More
The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.
For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.
In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable.... Read More
Last month, the Federal Reserve Board published proposed refinements to its annual Comprehensive Capital Analysis and Review (CCAR) exercise—the supervisory stress test that evaluates the capital adequacy of the largest U.S. banks (34 in the 2017 test). In our view, the Federal Reserve has an effective framework for carrying out these all-important stress tests. Having started in 2011, the Fed is now embarking on only the seventh CCAR exercise. That means that everyone is still learning how to best structure and execute the tests. The December proposals are clearly in this spirit.
With this same goal in mind, we make the following proposals for enhancing the stress tests and preserving their effectiveness:
--- Change the scenarios more aggressively and unexpectedly, continuing to disclose them only after banks’ exposures are fixed. Read More
--- Introduce an experimental scenario (that will not be used in “grading” the bank’s relative performance or capital plans) to assess the implications of events outside of historical experience and to probe for weaknesses in the system.
--- As a way to evaluate banks’ internal models, require publication of loss rates or risk-weighted assets for the same hypothetical portfolios for which the Fed is disclosing its estimates.
--- Stick with the annual CCAR cycle....
Shortly after Lehman failed in 2008, investors began to flee from money market mutual funds (MMMFs). To halt the run, the U.S. Treasury guaranteed all $3.8 trillion in outstanding MMMF liabilities. That rescue created enduring moral hazard: the expectation that a future crisis will lead to another bailout.
Aside from their legal form as mutual funds, MMMFs functioned much like banks engaged in the transformation of liquidity, credit and (to some extent) maturity. Similar to banks that redeem deposits at face value, they promised investors a fixed share value of $1 (a “buck”) on demand. Unlike depositories, however, MMMFs had no capital, no deposit insurance, and—at least officially—no access to the lender of last resort. So, when the Reserve Primary Fund “broke the buck” (by failing to redeem at the $1 par value) in September 2008, MMMF investors panicked.
Somewhat surprisingly, it took until 2014 for the Securities and Exchange Commission (SEC) to resolve political conflicts and introduce significant rule changes for MMMFs (see our earlier posts here and here). The SEC now requires that institutional prime MMMFs—which (like Reserve Primary) frequently invest in short-term corporate liabilities—operate like other mutual funds with a floating net asset value (NAV). The same rule applies to institutional municipal MMMFs. Retail MMMFs, as well as those investing in federal government (and agency) securities, are exempt.
In light of a recent legislative proposal to water it down, in this post we review the impact of the SEC’s 2014 reform. To highlight our conclusions: (1) it did not go far enough to reduce run risk; (2) aside from temporary dislocations, it has not raised nonfinancial sector funding costs by more than would be accounted for by reducing the implicit taxpayer guarantee for MMMFs; and (3) reversing the floating-NAV requirement would weaken the safety of the U.S. financial system.... Read More
After nearly a decade of negotiations, last month, the Basel Committee on Banking Supervision completed the Basel III post-crisis reforms to capital regulation. The final standards include refinements to: credit risk measurement and the computation of risk-weighted assets; the calculation of off-balance-sheet exposures and of the requirements to address operational risk; and the leverage ratio requirement for global systemically important banks (G-SIBs).
In this post, we focus on revisions to the way in which banks compute risk-weighted assets. To foreshadow our conclusion: the new approach adds unnecessarily to regulatory complexity. If the concern is that current risk-based requirements result in insufficient capital, it would be better simply to raise the requirements. Read More
Many features of our financial system—institutions like banks and insurance companies, as well as the configuration of securities markets—are a consequence of legal conventions (the rules about property rights and taxes) and the costs associated with obtaining and verifying information. When we teach money and banking, three concepts are key to understanding the structure of finance: adverse selection, moral hazard, and free riding. The first two arise from asymmetric information, either before (adverse selection) or after (moral hazard) making a financial arrangement (see our earlier primers here and here).
This primer is about the third concept: free riding. Free riding is tied to the concept of a public good, so we start there. Then, we offer three examples where free riding plays a key role in the organization of finance: credit ratings; schemes like the Madoff scandal; and efforts to secure financial stability more broadly.... Read More
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. Read More
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.... Read More
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.... Read More
In response to the financial crisis of 2007-2009, Congress created the Financial Stability Oversight Council (FSOC), a committee of the chiefs of the U.S. regulatory agencies, chaired by the Treasury Secretary, to monitor and secure the stability of the financial system. Critical to this task is the FSOC’s authority to designate nonbanks as “systemically important financial institutions” (SIFIs).
On November 17, the U.S. Treasury issued a report assessing the FSOC’s designation process. Treasury calls on the FSOC to adopt a strategy that prioritizes the regulation of activities or functions—affecting whole sectors of the financial industry—over regulation based on entity or legal form (such as the designation authority). For the most part, we find this sensible, as this focus reduces the scope for regulatory arbitrage that an entities-only approach may foster (see here).
However, we doubt that activities-based regulation alone will be sufficient to limit systemic risk. Our overall conclusion is that the Treasury’s approach sets the bar for FSOC designation too high, diminishing its deterrence effect on undesignated nonbanks. In the end, a sensible focus on both entities and activities is needed to fulfill one of FSOC’s key objectives—to restore market discipline. Adopting the Treasury’s proposed framework will not meet the goal, set out in the President’s Core Principles for Regulating the U.S. Financial system (see Executive Order 13772), of preventing taxpayer-funded bailouts.... Read More
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.... Read More
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.... Read More
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.)....
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.... Read More