Leverage

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....

Read More

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....

Read More

An Open Letter to the Honorable Randal K. Quarles

Dear Mr. Quarles,

Congratulations on your nomination as the first Vice Chairman for Supervision on the Board of Governors of the Federal Reserve System. We are pleased that President Trump has chosen someone so qualified, and we are equally pleased that you are willing to serve.

Assuming everything goes according to plan, you will be assuming your position just as we mark the 10th anniversary of the start of the global financial crisis. As a direct consequence of numerous reforms, the U.S. financial system—both institutions and markets—is meaningfully stronger than it was in 2007. Among many other things, today banks finance a larger portion of their lending with equity, devote more of their portfolios to high-quality, liquid assets, and clear a large fraction of derivatives through central counterparties.

That said, in our view, the system is not yet strong enough. In your new role, it will be your job to continue to fortify the financial system to make it sufficiently resilient.

With that task in mind, we humbly propose some key agenda items for the first few years of your term in office. We divide our suggestions into five broad categories (admittedly with significant overlap): capital and communications, stress testing, too big to fail, resolution, and regulation by economic function....

Read More

China: Deleveraging is Hard to Do

For the first time in nearly three decades, Moody’s recently downgraded the long-term sovereign debt of China, lowering its rating from Aa3 to A1. As is frequently true in such cases, the adjustment was overdue. Since China’s massive fiscal stimulus in 2008, the government has experienced a surge in contingent liabilities, as its (implicit and explicit) guarantees fueled an extraordinary credit boom that continues today.

While the need to foster financial discipline is obvious, the process will be precarious. Ning Zhu, the author of China’s Guaranteed Bubble, has compared the scaling back of state guarantees to defusing a bomb. China’s guarantees have distorted incentives and risk taking for so many years that stepping back and allowing market forces to operate will inevitably impose large, unanticipated losses on many people and businesses. Financial history is replete with failed policy efforts to address credit-fueled asset price booms, such as the current one in China’s real estate. There is no safe mechanism for economy-wide deleveraging.

China’s policymakers are clearly aware of the dangers they face and are making serious efforts to address them. This year, authorities have initiated a new crackdown aimed at reducing the systemic risks that have been stoked by the credit boom. This post focuses on that policy effort, including the background causes and what will be needed (aside from good fortune) to make it work....

Read More

Regulating Wall Street: The Financial CHOICE Act and Systemic Risk

With the shift in power in Washington, among other things, the people newly in charge are taking aim at financial sector regulation. High on their agenda is repeal of much of the Dodd-Frank Act of 2010, the most far-reaching financial regulatory reform since the 1930s. The prime objective of Dodd-Frank is to prevent a wholesale collapse of financial intermediation and the widespread damage that comes with it. That is, the new regulatory framework seeks to reduce systemic risk, by which we mean that it lowers the likelihood that the financial system will become undercapitalized and vulnerable in a manner that threatens the economy as a whole.

The Financial CHOICE Act proposed last year by the House Financial Services Committee is the most prominent proposal to ease various regulatory burdens imposed by Dodd-Frank. The CHOICE Act is complex, containing provisions that would alter many aspects of Dodd-Frank, including capital requirements, stress tests, resolution mechanisms, and more. This month, more than a dozen faculty of the NYU Stern School of Business (including one of us) and the NYU School of Law published a comprehensive study contrasting the differences between the CHOICE Act and Dodd-Frank.

Regulating Wall Street: CHOICE Act vs. Dodd-Frank considers the impact both on financial safety and on efficiency. In some cases, the CHOICE Act would slash inefficient regulation in a manner that would not foster systemic risk. At the same time, the book highlights the key flaw of the CHOICE Actthe failure to address systemic risk properly....

Read More

Liquidity Transformation and Open-end Funds

In the aftermath of Britain’s July 2016 vote to exit the European Union, six U.K. open-end property funds with nearly £15 billion in assets suspended redemptions. These funds had routinely engaged in an extreme version of liquidity transformation: offering investors the ability to convert their shares into cash daily on demand, while holding highly illiquid commercial properties. Fortunately, the overall sector was small, and its post-referendum disruption neither spilled over broadly to funds holding other assets, nor prompted a wave of fire sales that might have undermined the balance sheets of leveraged intermediaries. Nevertheless, the episode was of sufficient concern that the U.K. Financial Conduct Authority (FCA) is now reviewing its “regulatory approach to open-ended funds that invest in illiquid assets” (see here).

The FCA is not alone in its concerns. Other regulators have been looking closely at risks associated with the liquidity transformation performed by open-end funds. And, interest in the official sector has been accompanied by a wave of academic research on liquidity management in open-end funds that generally buttresses the regulators’ concerns. In this piece, we briefly highlight the work of the regulators, summarize the research, and finally reprise our proposal to convert open-end funds into exchange-traded funds (ETFs).

Read More

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

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

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 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

Bank Capital and Monetary Policy

Capital—the excess of assets over liabilities—determines solvency, so policymakers are used to thinking of it as a tool for keeping banks and the banking system safe. House Financial Services Chair Hensarling’s proposal to allow banks to opt for a simple capital standard that would substitute for other regulatory oversight is just the most recent example.

But bank capital also is a critical factor in the transmission of monetary policy. When central banks ease, their actions are intended to encourage banks to lend and firms to borrow.  And, to put it simply: healthy banks lend to healthy firms, while weak banks lend to weak firms (if at all)....

Read More

Spillovers, spillbacks and policy coordination

Reserve Bank of India Governor Raghuram Rajan’s recent plea for increased coordination is merely the latest protest by emerging-market economy (EME) policymakers about the spillovers from advanced-economy (AE) monetary policy. Such complaints have been common since AE central banks first implemented unconventional policies in 2008. The most famous was Brazilian Finance Minister Guido Mantega’s September 2010 remark that “We’re in the midst of an international currency war.

The targets of these comments—policymakers in Europe, Japan and the United States—responded that the world would be better off if their economies grew. A deeper recession in the advanced world was surely in no one’s interest. Extraordinary monetary policy easing was therefore justified by both domestic and global concerns. U.S. and European policymakers further defended their actions by saying that their mandate was to promote price stability and sustainable growth domestically, which required taking account of the external impact of their policies only insofar as they then fed back onto their own economies. That is, while spillovers per se were not their responsibility, spillbacks were.

Debates over the potential benefits from international policy coordination have a long history...

 

Read More

Leverage and Risk

A highly leveraged financial system is one prone to collapse. This notion underlies modern financial regulation: the control of systemic risk requires controlling leverage. And, it is what drives proposals for high capital requirements and to tax leverage. But, as is always the case with regulation, the devil is in the details. For one thing, we need a way to measure leverage. This turns out to be a surprisingly difficult task. Second, while risk varies positively with leverage, risk-taking can increase without increasing leverage, so we need to think about all major forms of risk-taking that can threaten financial stability...

Read More

Liquidity Runs

Despite mixed evidence, concerns about a decline of bond market liquidity persist. The typical worry is that a sudden decline in bond demand will cause prices to plunge and have serious knock-on effects.

Naturally, the issue merits attention: episodes in which market liquidity disappears rapidly can be disruptive (witness the flash crashes and flash rallies in various equity and bond markets in recent years). However, these incidents tend to be fleeting. Instead, from the perspective of financial stability, funding liquidity is the greater source of vulnerability...


Read More

Bank resilience: yet another missed opportunity

Along with enormous misery, the financial crisis brought an opportunity for long-needed reform. At the top of the list was the clear need for more bank capital. To ensure resilience of the financial system, and protect the public purse, banks’ owners had to have much more skin in the game. That is, potential losses to equity holders had to go way up.

Unfortunately, the 2010 Basel III agreement missed this rare opportunity to make the financial system safe. And now, with the publication of the standards for what has come to be known as total loss-absorbing capacity (TLAC), the disappointment continues to grow. To understand why, we need to step back and address the big question for bank capital: how much is enough...?

Read More

Not so fast

GE’s planned sale of its financial division – GE Capital – looks like a home run for systemic regulators. It adds to a string of recent announcements that big intermediaries are responding to improved financial oversight. Deutsche Bank’s decision to shrink its investment banking business and sell Postbank is another example, as is the more general pruning of oversized balance sheets elsewhere: UBS assets are now less than half the pre-crisis level.

If the regulatory reforms in the United States and elsewhere really work to reduce systemic risk, the list of Systemically Important Financial Institutions (SIFIs) would become an historical artifact: either these financial behemoths become safer, or they go out of existence...

Read More

It's the leverage, stupid!

In the 30 months following the 2000 stock market peak, the S&P 500 fell by about 45%. Yet the U.S. recession that followed was brief and shallow. In the 21 months following the 2007 stock market peak, the equity market fell by a comparable 52%. This time was different: the recession that began in December 2007 was the deepest and longest since the 1930s.

The contrast between these two episodes of bursting asset price bubbles ought to make you wonder. When should we really worry about asset price bubbles? In fact, the biggest concern is not bubbles per se; it is leverage. And, surprisingly, there remain serious holes in our knowledge about who is leveraged and who is not.

Read More

A Primer on Bank Capital

When a financial system is hit by unforeseen, adverse events, bank capital is the first line of defense. Capital, or net worth, is the owners’ stake in the bank. Profits and losses from a bank’s activities alter its net worth, guiding investment and risk-taking. If losses wipe out its capital, the bank becomes insolvent – its assets are inadequate to cover its fixed liabilities – and typically fails...

Read More

Rolling the dice, again

The headline on Reuters at Mon Oct 20, 2014 6:05pm EDT read “U.S. regulator targeting lower down payments on mortgages.” At first, we thought perhaps the headline was from 2004, not 2014. After the financial crisis of 2007-2009, it seemed inconceivable that U.S. authorities would again put some of the largest U.S. intermediaries – or the taxpayers who provide for them – at risk of failure. Sadly, we were wrong...

Read More

Debt, Great Recession and the Awful Recovery

Debt has been reviled at least since biblical times, frequently for reasons of class (“The rich rule over the poor, and the borrower is slave to the lender.” Proverbs 22:7). In their new book, House of Debt, Atif Mian and Amir Sufi portray the income and wealth differences between borrowers and lenders as the key to the Great Recession and the Awful Recovery (our term). If, as they argue, the “debt overhang” story trumps the now-conventional narrative of a financial crisis-driven economic collapse, policymakers will also need to revise the tools they use to combat such deep slumps...
Read More