Financial stress

What Should the Fed Own?

The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.

Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.

In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….

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Financial Crisis: The Endgame

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….

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Market liquidity and financial stability

Everyone seems to be worried about market liquidity – the ability to buy or sell a large quantity of an asset with little or no price impact. Some observers complain that post-crisis financial regulation has reduced market liquidity by forcing traditional market makers – say, in corporate bonds – to withdraw. Others focus on episodes of sudden, unforeseen loss of liquidity – for example, in the equity and Treasury markets – suggesting that structural changes (such as the spread of high-frequency algorithmic trading) are now a source of fragility. We’ve written about these issues before (here and here).

But it is worth taking a step back to ask exactly what it is that we care about. The answer turns out to be complex, so working out remedies will be a big challenge...

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