The manipulation of the London Interbank Offered Rate (LIBOR) began more than a decade ago. Employees of leading global firms submitted false reports to the British Banking Association (BBA), first to influence the value of LIBOR-linked derivatives, and later (during the financial crisis) to conceal the deterioration of their employers’ creditworthiness. U.S. and European regulators reported many of the details in 2012 when they fined Barclays, the first of a dozen financial firms that collectively paid fines exceeding $9 billion (see here). In addition to settling claims of aggrieved clients, these firms face enduring reputational damage: in some cases, management was forced out; in others, individuals received jail terms for their wrongdoing.
You might think that in light of this costly scandal, and the resulting challenges in maintaining LIBOR, market participants and regulators would have quickly replaced LIBOR with a sustainable short-term interest rate benchmark that had little risk of manipulation. You’d be wrong: the current administrator (ICE Benchmark Administration), which replaced the BBA in 2014, estimates that this guide (now called ICE LIBOR) continues to serve as the reference interest rate for “an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years [our emphasis].” In short, LIBOR is still the world’s leading benchmark for short-term interest rates.
Against this background, U.K. Financial Conduct Authority CEO Andrew Bailey, recently called for a transition away from LIBOR before 2022 (see here). In this post, we briefly explain LIBOR’s role, why it remains an undesirable and unsustainable interest rate benchmark, and why it will be so difficult to replace (even gradually over several years) without risking disruption. Read More
During the 2016 campaign, then-candidate Donald Trump discussed his broad experience with debt. He would bring the skills and sensibilities of a real estate mogul to government debt management, and the result would be a better deal for the American public. He even broached the idea of renegotiating the obligations of the U.S. Treasury.
Well, the day of reckoning has arrived. The Treasury has announced that by the end of September, it will face a shortfall. Without the authority to issue additional debt, the government will not be able to pay all of its bills—including the interest on the outstanding debt. In response, President Trump has threatened the Congress: either fund the wall along the Mexican border, or he will shut down the government.
If the U.S. government fails to meet its obligations for any significant period, we will all be big losers. A government that cares about the people—both now and in the future—would never willingly inflict such a wound. Read More
In the summer of 2008, Fannie Mae and Freddie Mac’s financial positions deteriorated sharply: the result of inadequate capital (equity financing) for the risks in the residential mortgages that they held and had securitized. On September 6, 2008, their regulator, the Federal Housing Finance Agency (FHFA), removed senior management and placed these government-sponsored enterprises (GSEs) into conservatorships. Since then, the FHFA and the U.S. Treasury (which extended almost $188 billion to keep them solvent through 2011) have run them... 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
When it comes to domestic payments, the U.S. financial system still lags the efficiency in several advanced economies. The reasons are easy to find. First, other countries have leapfrogged outdated technologies. In the United States, checks remained dominant well after their technological sell-by date partly as a result of government support. The other key factor delaying a shift to alternative payment mechanisms is the importance of what economists call a network externality. That is, the more people who use one form of payment, the more valuable that method is to the people who are already using it. And, by the same token, the more expensive it is for someone to move away from the prevailing mechanism.
With these considerations in mind, two years ago the Fed convened the Faster Payments Task Force (FPTF), a group of more than 300 experts and interested parties from a wide range of backgrounds with the objective to “identify and evaluate alternative approaches for implementing safe, ubiquitous, faster payments capabilities in the United States.” Earlier this month, the FPTF issued its second and final report, which contains a set of 10 recommendations for making the payments system faster, cheaper and more secure.... Read More
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).... 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
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
Guest post by Prof. Lawrence J. White, Robert Kavesh Professor in Economics, NYU Stern School of Business
The major credit rating agencies (CRAs)—Moody’s, Standard & Poor’s (S&P), and Fitch—contributed significantly to the financial crisis of 2007-09. Their excessively high initial ratings of residential mortgage-backed securities (RMBS) helped fuel the bubble of mortgage finance that ultimately burst, with near catastrophic consequences for the U.S. financial sector.
These disastrous failings motivated the post-crisis urge to tighten regulation of the CRAs. It’s not hard to share the (metaphorical) desire—reflected in the Dodd-Frank Act of 2010—to grab them by the lapels and shout “Do a better job!”
There is, however, a better way, albeit one that is less intuitive and possibly less gratifying: namely, eliminate—or at least greatly reduce—the regulation of the CRAs. This would encourage entry into the credit rating business, stimulate innovation and, eventually, improve the efficiency of capital markets.... Read More
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.... Read More
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.... Read More
How will financial innovation alter the role of central banks? As the structure of banking and finance changes, what will happen to the mechanisms and frameworks for setting monetary and financial policy? Over the past several decades, with the development of inflation targeting, central banks have delivered price stability. And, improved prudential policies are making the financial system more resilient. Will fintech—ranging from the use of electronic platforms to algorithm-driven transactions that supplant the traditional provision and implementation of financial services—change any of this?
This is a very broad topic, some of which we have written about in previous posts. This post considers an innovation suggested by Barrdear and Kumhof at the Bank of England: that central banks should offer universal, unlimited access to deposit accounts. What would this “central bank digital currency” mean for the financial system? Does it make sense for central banks to compete with commercial banks in providing deposit accounts?
We doubt it. It is not an accident that—at virtually every central bank—only commercial banks today have interest-bearing deposits. Changing this would pose a risk of destabilizing the financial system.... Read More
Economists build models around simple facts to isolate what drives behavior. In macroeconomics, perhaps the most famous of these facts has been the observed stability of the shares of income paid to labor and to capital. At least since Kaldor wrote 60 years ago, this pattern of income distribution has been at the top of the list of regularities to be explained by theories of economic growth.
Well, it turns out that what was stable for much of the 20th century looks as if it is unstable in the 21st. For at least the past 15 years, and possibly for several decades, labor’s share of national income has been declining and capital’s share has been rising in most advanced and many emerging economies.
It is important that we understand why labor's share has declined, and whether that decline will continue. The answer could influence a range of policies, from education and training to taxation and transfers. In what follows, we describe what we know about the evolution of labor's share (including key measurement issues) and highlight several explanations of the observed decline that have recently been proposed. Read More
Economists have debated the relationship between inflation and unemployment at least since A.W. Phillips’s study of U.K. data from 1861 to 1957 was published 60 years ago. The idea that a tight or slack labor market should result in faster or slower wage gains seems like a natural corollary to standard economic thinking about how prices respond to deviations of demand from supply. But, over the years, disputes about this Phillips curve relationship have been and remain fierce.
As the U.S. labor market tightens, and unemployment approaches levels we have not seen in more than 15 years, the question is whether inflation is going to make a comeback. More broadly, how useful is the Phillips curve as a guide for Federal Reserve policymakers who wish to achieve a 2-percent inflation target over the long run?
To anticipate our conclusion, despite evidence of a negative relationship between wage inflation and unemployment, central banks ought not rely on a stable Phillips curve for setting monetary policy. Read More
The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).
A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.
But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust.... Read More
Guest post by Professor Lawrence J. White, NYU Stern School of Business
Overshadowed by the media attention to the proposed repeal of Obamacare, the House Financial Services Committee recently approved substantial changes in financial regulation. The House of Representatives may soon consider the proposed bill—the Financial CHOICE Act—which would make major changes in the Dodd-Frank Act.
However, when financial regulation is being discussed, there is a large elephant that isn’t in the room, but really should be: Walmart. Starting in the mid-1990s, Walmart made two separate efforts to enter banking in the United States, but was repelled both times. After its second effort was rebuffed in 2007, Walmart gave up this effort in the United States (but has since entered banking in Canada and in Mexico).
One question to ask might be, “Why should Walmart be allowed to enter banking?” But a more relevant question would be, “Why shouldn’t Walmart be allowed to enter banking?” …. Read More
With Sunday’s election of President Emmanuel Macron, voters confirmed that France remains a bedrock of the euro area, buttressing the region’s financial markets. But political risks to the euro have not disappeared. In coming months, concerns probably will turn to Italy, where the leader of one popular party has called for a referendum on leaving the euro area, and where parliamentary elections must be held before 20 May 2018.
From an economic perspective, Italy stands on a knife-edge. The economy is smaller and less productive than it was in 2001, while government debt has jumped by 30 percent. As long as interest rates remain low, and the government continues to run a primary budget surplus, the situation is only mildly unsustainable (with the debt/GDP ratio creeping higher). But even a small problem at home or abroad could drive funding costs higher and expose Italy’s precarious state.
Would independent Italian monetary policy, controlled by the Banca d’Italia in Rome, be sufficient to bring Italy back from the precipice and promote economic growth? We doubt it. In the long run, the most effective way to ensure debt sustainability is to implement growth-enhancing structural reforms. Nothing about Italy’s membership in the monetary union prevents this. The problem is a lack of political will... 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
For at least the past 30 years, the rate of U.S. business formation has been falling and the average age of existing firms has been rising. Since 2000, two other things have happened: productivity growth has slowed, while many skilled jobs have disappeared. Startups are thought be a key source of innovation in the economy and of net job creation. At the same time, as Schumpeter’s notion of creative destruction suggests, the death of old firms is a critical part of the renewal process. So, the declining trend of entry and exit has people worried that U.S. business dynamism is ebbing (see our earlier post).
How concerned should we be? To be completely honest, we don’t really know; at least, not yet. But the answer is important, because it can help orient the U.S. economic policy framework to support the creation of successful businesses that generate high-quality jobs. In this post, we summarize some new research aimed at helping us understand what the decline in business formation really means. Does it signal a fall in the number of successful firms that contribute substantially to business value added, productivity, and employment? Or, is it a decline in the formation of firms that never exceed a tiny scale and have little impact on the broader economy? Read More