Liquidity requirements

FEMA for Finance

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….

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How to Ensure the Crisis Provision of Safe Assets

Changes in financial regulation are having a profound impact on the demand for safe assets—assets with a fixed nominal value that may be converted at all times without loss into the means of payment. Not only is demand for safe assets on the rise, but the ability of the private sector to produce them is being constrained by new rules that limit the extent and nature of things like securitizations.

So far, the fallout from increased demand and constrained supply looks reasonably benign. But for several years now, broad financial conditions have been very calm, with measures of financial volatility and stress at or near long-term lows. What will happen when the financial system comes under stress again? What if there is a drop in risk tolerance (or a surge in risk awareness) and a flight to safety that causes a jump in the demand for safe assets or a plunge in the supply? Or, as in 2008, what will happen if both materialize at the same time? We need to be ready.

As we will explain in more detail, central banks in advanced economies can satisfy the heightened need for safe assets under stress (as well as the precautionary demand in normal times) by offering commercial banks committed lines of credit for a fee against collateral, as the central banks in Australia and South Africa currently do. In our view, this mechanism for ensuring sufficient supply of safe assets in a crisis has important advantages compared to one in which the central bank operates perpetually—in good times and bad—with a very large balance sheet.

To see how this would work, we start with an explanation of post-crisis liquidity regulation....

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The Treasury's Missed Opportunity

Last week, the U.S. Treasury published the first of four reports designed to implement the seven core principles for regulating the U.S. financial system announced in President Trump’s Executive Order 13772 (February 3, 2017).

Seven years after the passage of Dodd-Frank, it’s entirely appropriate to take stock of the changes it wrought, whether they have been effective, and whether in certain cases they went too far or in others not far enough. President Trump’s stated principles provide an attractive basis for making the financial system both more cost-effective and safer. And much of the Treasury report focuses on welcome proposals to reduce the unwarranted compliance burden imposed by a range of regulations and supervisory actions on small and medium-sized depositories that—if adequately capitalized—pose no threat to the financial system. We hope these will be viewed universally as “motherhood and apple pie.”

Unfortunately, at least when considering the largest banks, our conclusion is that adopting the Treasury’s recommendations would sacrifice resilience to achieve cost reductions, yet with little prospect for boosting economic growth. Put simply, implementation of the Treasury plan would reduce regulation of the most systemic intermediaries, and in so doing, unacceptably reduce the resilience of the U.S. financial system....

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Monetary Policy and Financial Stability

In June 2015, a committee of Federal Reserve Bank Presidents conducted a “macroprudential tabletop exercise”—a kind of wargame—to determine what tools to use should risks to financial stability arise in an environment when growth and inflation are stable. The conventional wisdom—widely supported in policy pronouncements and in a range of academic studies—is that the appropriate tools are prudential (capital and liquidity requirements, stress tests, margin requirements, supervisory guidance and the like). Yet, in the exercise, the policymakers found these tools more unwieldy and less effective than anticipated. As a result, “monetary policy came more quickly to the fore as a financial stability tool than might have been thought.”

This naturally leads us to ask whether there are circumstances when central bankers should employ monetary policy tools to address financial stability concerns. Making the case for or against use of monetary policy to secure financial stability is usually based on assessing the costs and benefits of a policy that "leans against the wind" (LAW) of financial imbalances...

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The Regulatory Counterintelligence Agency

Some days the tone of the financial news matches that of the sports page. Adversaries appear to be locked in an epic battle, with the official sector setting regulations in an attempt to keep the system safe on one side,  and financiers pushing for rules that ensure profitability on the other. The skirmish over the level of large bank capital requirements and the clash over whether municipal bonds can be used to meet liquidity requirements are just two recent examples. (See our earlier posts here and here.)

Following the day-to-day struggle can make it hard to see who is winning. But if history is any guide, the financiers will prevail—to the benefit of their owners and managers—at the expense of systemic fragility.

Can we change this? Can we create a system with greater balance between the authorities and the institutions?

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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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How big should central bank balance sheets be?

In 2007, the Fed’s balance sheet was less than $1 trillion. Today, it is nearly $4.5 trillion. The U.S. experience is far from unique. Since 2007, global central bank balance sheets have nearly tripled to more than $22 trillion as of mid-2014. And, the increase is split evenly between advanced and emerging market economies (EMEs).

So what’s the right size? The answer depends on the policy goals and the nature of the financial system. In the case of the Fed, we expect that it will be able to achieve its long-term objectives with fewer than half of its current assets...

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Liquidity Regulation

Ever since Bagehot, central banks acting as lenders of last resort have tried to distinguish banks that are illiquid, who should be eligible for a loan, from banks that are insolvent, who should not. The challenge persists. As one analyst put it recently: “Liquidity and solvency are the heavenly twins of banking, frequently indistinguishable. An illiquid bank can rapidly become insolvent, and an insolvent bank illiquid.” The lesson is that the appropriate level of a bank’s capital and the liquidity of its assets are necessarily related.

Forged in the crucible of the financial crisis, Basel III took this lesson to heart, creating a new regime for liquidity regulation to supplement the capital rules that were originally developed 30 years before.

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Who does macropru for nonbanks?

A central lesson of the 2007-09 financial crisis is that we should be much more worried about financial intermediation performed outside the banking system. Even if banks are resilient, with capital buffers sufficient to withstand all but the largest shocks, other parts of the financial system can make it fragile. Indeed, making the banks safe may simply shift risk-taking elsewhere...

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Form vs. Function: Regulating Money Market Funds

Following the collapse of Lehman in 2008, a run on U.S. prime money market mutual funds (MMMFs) was halted only when the U.S. Treasury provided a blanket guarantee. (Prime MMMFs typically invest in corporate debt, including the debt of intermediaries.) Shortly thereafter, the Federal Reserve added emergency machinery (the “Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to encourage depositories to acquire illiquid assets from MMMFs...
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