In the March 2018 general election, two Italian political parties (the League and the Five Star Movement) that eventually formed the current government campaigned against many of the structures that are the foundation of the European Union. One part of their agreed policy program, a proposal that resurfaced in the past week, concerns the possibility of issuing mini-BOTs (which stands for Buoni del Tesoro). These would be small denomination “bonds”—non-interest-bearing, tradeable securities—issued by the Italian government to pay debts and usable to pay taxes or purchase goods and services provided by the state. Printed in the size and shape of currency notes, recipients could view them as a new means of exchange.
In this post, we discuss the possibility of Italy leaving the European Monetary Union, and why there is an increased incentive for the government to plan for an abrupt and unanticipated exit. The strategic analogy is to the appearance of a first-strike capacity that undermines nuclear peace. In our view, however, that appearance is misleading: any attempt to exit would not only be a disaster for Italy, as we explained in our post from a year ago, it would be the “mother of all financial crises” …. Read More
Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.
The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)
With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.
However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests…. Read More
Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.
The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.
In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.
In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system…. Read More
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…. 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
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.... Read More
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.... Read More
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
The failure of Lehman on September 15, 2008, signaled the most intense phase of the Great Financial Crisis of 2007-2009, fueling a run on a broad array of intermediaries. Following Congress’ approval of TARP funding that was used mostly to recapitalize U.S. financial firms, the mantra of U.S. regulators became “…we will not pull a Lehman” (Financial Crisis Inquiry Report, page 380). Thereafter, to ensure that another large institution did not fail, policymakers chose bailouts to contain the crisis. As a result, today we still have intermediaries that are too big to fail.
The autumn 2008 experience convinced many observers of the need for a robust resolution regime in which financial behemoths could be re-organized quickly without risk of contagion or crisis. The question was, and remains, how to do it. Dodd-Frank provided a two-pronged answer: the FDIC would first rely on the bankruptcy code (Title I), and second, on a resolution temporarily funded (if necessary) by government resources (Title II). The second piece is commonly known as Orderly Liquidation Authority (OLA), which is funded by the Orderly Liquidation Fund (OLF).
In response to dissatisfaction with parts of this solution, Congress and the President are working on refinements. Last month, the House passed a bipartisan revision of the bankruptcy code (Financial Institutions Bankruptcy Act, or FIBA) that would expedite the resolution of adequately structured intermediaries. And, on April 21, President Trump ordered a Treasury review of OLA, expressing concern that the OLF authorization to use government funds “may encourage excessive risk taking by creditors, counterparties, and shareholders of financial companies.”
This post considers FIBA and how it fits in with the existing Dodd-Frank resolution mechanism.... Read More
In 2012, the ECB faced down a mortal threat to the euro: fears of redenomination (the re-introduction of domestic currencies) were feeding a run away from banks in the geographic periphery of the euro area and into German banks. Since President Mario Draghi spoke in London that July, the ECB has done things that once seemed unimaginable, helping to support the euro and secure price stability.
So far, it has been enough. But can the ECB really do “whatever it takes”? Ultimately, monetary stability requires political support. Without fiscal cooperation, no central bank can maintain the value of its currency. In a monetary union, stability also requires a modicum of cooperation among governments.
Recent developments in France have revived concerns about redenomination risk and the future of the euro.... Read More
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
Readers of this blog know that we are great fans of the Stern Volatility Lab’s estimates of systemic risk. Like many observers, including leading regulators, we find market-value rather than book-value measures of bank equity more useful for timely monitoring of systemic risk created by individual intermediaries. Equity prices are available in real time, rapidly incorporate bank-specific and economy-wide information, and are forward-looking. This makes them particularly helpful in assessing the impact of big events, like this summer’s Brexit referendum (see our earlier post).
So, based as it is on market indicators of bank risk, not surprisingly we share the recent assessment of Sarin and Summers (expressed in their September 2016 Brookings paper) that the increase of book capital in the banking system since the financial crisis ought not give rise to regulatory complacency. We have argued repeatedly for raising capital requirements (see, for example, here) and, like those authors, believe that we need mechanisms for the virtually automatic recapitalization of banks in a crisis (see here). Read More
Professor Larry Ball, our friend and colleague, has written a fascinating monograph reexamining the September 14, 2008 failure of Lehman Brothers. Following an exhaustive study of documents from a variety of sources, Professor Ball concludes that the Fed could have rescued Lehman. The firm had sufficient collateral to meet its liquidity needs, and may have been solvent. The implication is that the worst phase of the financial crisis was preventable. (A short summary is available here.)
We are skeptical on several fronts—that Lehman was solvent, that policymakers had authority to lend to an insolvent institution, and that doing so would have limited the financial crisis... Read More
Professor Mervyn King, our friend, NYU Stern colleague and the former Governor of the Bank of England, has written a wonderfully insightful and thought-provoking new book, The End of Alchemy. His goal is not just to explain the sources of the 2007-09 crisis, but to provide a template for financial reform that would reduce the frequency and severity of future crises. In the end, Professor King proposes a radical structural change intended to make banking safe while preserving the intermediation function that is critical to modern economies.
The alchemy to which Professor King refers in his book’s title is banks’ traditional function of transforming high-risk, illiquid and long-maturity assets into low-risk, liquid and short-term liabilities. But, in the presence of limited liability for the banks’ owners and the government safety net (in the form of deposit insurance and the lender of last resort that remove both solvency and liquidity risk for the depositors), banks’ incentive is to transform too much. Holding assets that are overly risky, insufficiently liquid and too long-term makes banks fragile and run-prone, providing fodder for systemic crises.... Read More
The time has come to start weighing in on presidential candidate Donald Trump’s statements on economic policy. Today, we examine his comments about U.S. government debt. After saying that he is the “king of debt” and that he “loves debt,” Mr. Trump recently went on suggest that if interest rates were to rise, he would seek to “make a deal” on U.S. Treasury debt. In his words, “I could see long-term renegotiations where we borrow long term at very low rates.” He also called this action: “refinance debt with longer term.”
Mr. Trump appears to assume that his sensibilities as real estate mogul and dealmaker can be directly applied to government debt management policy. They cannot. Treasury securities bear absolutely no resemblance to the debt issued by Trump Entertainment Resorts, which went bankrupt in 1991, 2004, 2009, and 2014... Read More
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
Greece faces a stark choice: stay in the euro and implement the policies demanded by its creditors or exit and re-introduce its own national currency. The dimensions of this decision go far beyond economics, affecting Greece’s political and cultural identity for generations. Yet, even in a narrow sense – determining which option will lead to the best economic outcome for Greeks – the decision is complex and fraught with uncertainty... Read More
The Federal Open Market Committee (FOMC) recently ended another round of large-scale asset purchases, so now is a good opportunity to take stock of what Fed policy has achieved since the peak of the financial crisis in fall 2008.
Back in 2002, then-Governor Ben Bernanke gave a speech entitled “Deflation: Making Sure "It" Doesn't Happen Here.” His message was that the experience of the 1930s taught us the importance of using aggressive monetary accommodation to avoid deflation. As Chairman of the Federal Reserve Board during the financial crisis of 2007-2009, Bernanke and his colleagues took actions that their 1930s predecessors had not. The result was a Great Recession, not another Great Depression... Read More
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