What Risk Professionals Want

As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.

A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” ….

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E Pluribus Unum: single vs. multiple point of entry resolution

Addressing the calamity posed by the failure of large, global financial intermediaries has been high on the post-crisis regulatory reform agenda. When Lehman Brothers―a $600 billion entity―failed, it took heroic efforts by the world’s central bankers to prevent a financial meltdown. The lesson is that a robust resolution regime is a critical element of a resilient financial system.

Experts have been hard at work implementing a new mechanism so that the largest banks can continue operation, or be wound down in an orderly fashion, without resorting to taxpayer solvency support and without putting other parts of the financial system in danger. To enhance market discipline, the shareholders that own an entity and the bondholders that lent to it must face the consequences of poor performance.

How can we ensure that healthy operating subsidiaries of G-SIBs continue to serve their customers even during resolution? Authorities have proposed a solution that takes two forms: “single point of entry (SPOE)” and “multiple point of entry (MPOE).” A key difference between these two resolution methods is that the former allows for cross-subsidiary sharing of loss-absorbing capital and cross-jurisdictional transfers during resolution, while the latter does not. The purpose of this post is to describe SPOE and MPOE. We highlight both the relative efficiency of SPOE and the requirements for its sustainability: namely, adequate shared resources, an appropriate legal framework and a credible commitment among national resolution authorities to cooperate….

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Ten Years After Bear

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.

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Time Consistency: A Primer

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....

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Resolution Regimes for Central Clearing Parties

Clean water and electric power are essential for modern life. In the same way, the financial infrastructure is the foundation for our economic system. Most of us take all three of these, water, electricity and finance, for granted, assuming they will operate through thick and thin.

As engineers know well, a system’s resilience depends critically on the design of its infrastructure. Recently, we discussed the chaos created by the October 1987 stock market crash, noting the problems associated with the mechanisms for trading and clearing of derivatives. Here, we take off where that discussion left off and elaborate on the challenge of designing a safe derivatives trading system―safe, that is, in the sense that it does not contribute to systemic risk.

Today’s infrastructure is significantly different from that of 1987. In the aftermath of the 2007-09 financial crisis, authorities in the advanced economies committed to overhaul over-the-counter (OTC) derivatives markets. The goal is to replace bilateral OTC trading with a central clearing party (CCP) that is the buyer to every seller and the seller to every buyer....

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The Other Trilemma: Governing Global Finance

Courses in international economics usually introduce students to the impossible trinity, also known as the trilemma of open-economy macroeconomics: namely, that a fixed exchange rate, free cross-border capital flows, and discretionary monetary policy are incompatible. Why? Because, in the presence of free capital flows under a fixed exchange rate, private currency preferences (rather than policymakers) determine the size of the central bank balance sheet and hence the domestic interest rate. We’ve highlighted this problem several times in analyzing China’s evolving exchange rate regime (see here and here).

While many students learn that a country can only have two of the three elements of the open-economy trilemma, few learn that there also exists a financial trilemma. That is, financial stability, cross-border financial integration, and national financial policies are incompatible as well. The logic behind this second trilemma is that increases in financial integration reduce the incentives for national policymakers to act in ways that preserve financial stability globally. Put differently, as the benefits from financial stability policies spread beyond borders, the willingness to bear the costs of stabilizing the system at the national level decline. This has the important implication that, if we are to sustain increasing financial integration, then we will need greater international coordination among national financial regulators (see here, or for a much broader case for international economic governance, see Rodrik)....

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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....

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Ending Too Big to Fail: Resolution Edition

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....

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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....

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The Lender of Last Resort and the Lehman Bankruptcy

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...

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Living Wills or Phoenix Plans: Making sure banks can rise from their ashes

Wills are for when you die. Living wills guide your affairs when you lose the capacity to act. We’re all mortal and fragile – not just people, but firms and banks, too. The Dodd-Frank Act of 2010 requires systemic intermediaries (and many others) to create “living wills” to guide their orderly resolution in bad times.

In August, these Dodd-Frank living wills made front-page business news when the FDIC and the Fed rejected those submitted by the biggest banks as inadequate. That should come as no surprise. In their current form, we doubt that living wills would do much to secure financial stability...

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A note on the lender of last resort

With the publication of former Treasury Secretary Timothy Geithner’s book Stress Test comes a reconsideration of the many aspects of government intervention during the years of the financial crisis. Should banks have been nationalized? Should the fiscal stimulus have been larger? Should underwater households have received mortgage assistance? 
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