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March 08, 2013
Will the Next Exit from Monetary Stimulus Really Be Different from the Last?
Suppose you run a manufacturing business—let's say, for example, widgets. Your customers are loyal and steady, but you are never completely certain when they are going to show up asking you to satisfy their widget desires.
Given this uncertainty, you consider two different strategies to meet the needs of your customers. One option is to produce a large quantity of widgets at once, store the product in your warehouse, and when a customer calls, pull the widgets out of inventory as required.
A second option is to simply wait until buyers arrive at your door and produce widgets on demand, which you can do instantaneously and in as large a quantity as you like.
Thinking only about whether you can meet customer demand when it presents itself, these two options are basically identical. In the first case you have a large inventory to support your sales. In the second case you have a large—in fact, infinitely large—"shadow" inventory that you can bring into existence in lockstep with demand.
I invite you to think about this example as you contemplate this familiar graph of the Federal Reserve's balance sheet:
I gather that a good measure of concern about the size of the Fed's (still growing) balance sheet comes from the notion that there is more inherent inflation risk with bank reserves that exceed $1.5 trillion than there would be with reserves somewhere in the neighborhood of $10 billion (which would be the ballpark value for the pre-crisis level of reserves).
I understand this concern, but I don't believe that it is entirely warranted. My argument is as follows: The policy strategy for tightening policy (or exiting stimulus) when the banking system is flush with reserves is equivalent to the strategy when the banking system has low (or even zero) reserves in the same way that the two strategies for meeting customer demand that I offered at the outset of this post are equivalent.
Here's why. Suppose, just for example, that bank reserves are literally zero and the Federal Open Market Committee (FOMC) has set a federal funds rate target of, say, 3 percent. Despite the fact that bank reserves are zero there is a real sense in which the potential size of the balance sheet—the shadow balance sheet, if you will—is very large.
The reason is that when the FOMC sets a target for the federal funds rate, it is sending very specific instructions to the folks from the Open Market Desk at the New York Fed, who run monetary policy operations on behalf of the FOMC. Those instructions are really pretty simple: If you have to inject more bank reserves (and hence expand the size of the Fed's balance sheet) to maintain the FOMC's funds rate target, do it.
To make sense of that statement, it is helpful to remember that the federal funds rate is an overnight interest rate that is determined by the supply and demand for bank reserves. Simplifying just a bit, the demand for reserves comes from the banking system, and the supply comes from the Fed. As in any supply and demand story, if demand goes up, so does the "price"—in this case, the federal funds rate.
In our hypothetical example, the Open Market Desk has been instructed not to let the federal funds rate deviate from 3 percent—at least not for very long. With such instructions, there is really only one thing to do in the case that demand from the banking system increases—create more reserves.
To put it in the terms of the business example I started out with, in setting a funds rate target the FOMC is giving the Open Market Desk the following marching orders: If customers show up, step up the production and meet the demand. The Fed's balance sheet in this case will automatically expand to meet bank reserve demand, just as the businessperson's inventory would expand to support the demand for widgets. As with the businessperson in my example, there is little difference between holding a large tangible inventory and standing ready to supply on demand from a shadow inventory.
Though the analogy is not completely perfect—in the case of the Fed's balance sheet, for example it is the banks and not the business (i.e., the Fed) that hold the inventory—I think the story provides an intuitive way to process the following comments (courtesy of Bloomberg) from Fed Chairman Ben Bernanke, from last week's congressional testimony:
"Raising interest rate on reserves" when the balance sheet is large is the functional equivalent to raising the federal funds rate when the actual balance sheet is not so large, but the potential or shadow balance sheet is. In both cases, the strategy is to induce banks to resist deploying available reserves to expand deposit liabilities and credit. The only difference is that, in the former case, the available reserves are explicit, and in the latter case they are implicit.
The Monetary Policy Report that accompanied the Chairman's testimony contained a fairly thorough summary of costs that might be associated with continued monetary stimulus. Some of these in fact pertain to the size of the Fed's balance sheet. But, as the Chairman notes in the video clip above, when it comes to the mechanics of exiting from policy stimulus, the real challenge is the familiar one of knowing when it is time to alter course.
By Dave Altig, executive vice president and research director of the Atlanta Fed
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October 04, 2012
Trends in Small Business Lending
The Atlanta Fed's latest semiannual Small Business Survey is active through October 22, 2012. If you own a small business and would like to participate, send an e-mail to SmallBusinessResearch@atl.frb.org.
In our previous survey conducted in April 2012, we found that firms applying for credit at large national banks had notably less success than firms that applied to small banks.
We also found that the firms applying to large banks tended to be much younger than the firms that applied to small banks. We speculated that this "age factor" could be contributing to the lower overall success rates at large banks.
A difference between small businesses' success at large and small banks has also been documented by the online credit facilitator Biz2Credit. Biz2Credit works a bit like an online dating service—after answering a series of questions (and providing the typical financial documents required by lenders), small businesses are presented with five potential "matches." To determine the best five matches, Biz2Credit identifies what lenders are looking for—usually a certain credit score, a minimum number of years in business, an established banking relationship, and targeted industries.
The resulting credit applications are the basis for the Biz2Credit Small Business Lending Index. Biz2Credit also reports approval rates from the matching process for large banks, small banks, credit unions, and alternative lenders. These approval rates are plotted on the chart below.
Much like we saw in the Small Business Survey, Biz2Credit reports that small firms have had consistently less success in obtaining credit at large banks.
Confirming our results encourages us that our April observation was a good one. But confirmation isn't explanation—what accounts for the different experiences small businesses have in securing credit from small banks versus big banks? And so, we dig deeper.
Note: According to Biz2Credit, its index is based on 1,000 of the 10,000-plus applications submitted each month. To be included, the business has to have at least a 680 credit score, be at least two years old, and have an established relationship with the bank to which it is applying. Selection methods are also applied to provide for national representation.
By Ellyn Terry, senior economic research analyst at the Atlanta Fed
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June 28, 2012
Young versus mature small firms seeking credit
The ongoing tug of war between credit supply and demand issues facing small businesses is captured in this piece in the American Prospect by Merrill Goozner. Goozner asks whether small businesses are facing a tougher borrowing environment than is warranted by current economic conditions. One of the potential factors identified in the article is the relative decline in the number of community banks—down some 1,124 (or 13 percent of all banks from 2007). Community banks have traditionally been viewed as an important source of local financing for businesses and are often thought to be better able to serve the needs of small businesses than large national banks because of their more intimate knowledge of the business and the local community.
The Atlanta Fed's poll of small business can shed some light on this issue. In April we reached out to small businesses across the Sixth Federal Reserve District to ask about financing applications, how satisfied firms were that their financing needs were being met, and general business conditions. About one third of the 419 survey participants applied for credit in the first quarter of 2012, submitting between two and three applications for credit on average. As we've seen in past surveys (the last survey was in October 2011), the most common place to apply for credit was at a bank.
For the April 2012 survey, the table below shows the average success of firms applying to various financing sources (on a scale of 1 to 4, with 1 meaning none of the amount requested in the application was obtained, and 4 meaning that the firm received the full amount applied for). The table also shows the median age of businesses applying for each type of financing.
The results in the table show that for credit applications, Small Business Administration loan requests and applications for loans/lines of credit from large national banks tended to be the least successful, whereas applications for vendor trade credit and commercial loans/line-of-credit from community banks had the highest average success rating.
Notably, firms applying for credit at large national banks were typically much younger than firms applying at regional or community banks. If younger firms generally have more difficulty in getting credit regardless of where they apply, it could explain why we saw less success, on average, among firms applying at larger banks.
To investigate this issue, we compared the average application success among young firms (less than six years old) that applied at both regional or community banks and at large national banks, pooling the responses from the last few years of our survey. The credit quality of borrowers is controlled for by looking only at firms that applied at both types of institutions. What we found was no significant difference in the average borrowing success of young firms applying for credit across bank type—it just does seem to be tougher to get your credit needs met at a bank if you're running a young business. Interestingly, we also found that more mature firms were significantly more successful when applying at regional or community banks than at large national banks—it seems to be relatively easier for an established small business to obtain requested credit from a small bank.
While this analysis did not control for other factors that could also affect the likelihood of borrowing success, the results do suggest that Goozner's question about the impact of declining community bank numbers on small business lending is relevant. If small businesses are generally more successful when seeking credit from a small bank, will an ongoing reduction in the number of community banks substantially affect the ability of (mature) small businesses to get credit? More detailed insights from the April 2012 Small Business Credit Survey will be available soon on our Small Business Focus website, and we will provide an update when they are posted.
Ellyn Terry, senior economic research analyst, both of the Atlanta Fed's research department
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May 31, 2012
What is shadow banking?
"Shadow banking is a market-funded, credit intermediation system involving maturity and/or liquidity transformation through securitization and secured-funding mechanisms. It exists at least partly outside of the traditional banking system and does not have government guarantees in the form of insurance or access to the central bank."
As the Deloitte study makes clear, this definition is fairly narrow—it doesn't, for example, include hedge funds. Though Deloitte puts the size of the shadow banking sector at $10 trillion in 2010, other well-known measures range from $15 trillion to $24 trillion. (One of those alternative estimates comes from an important study by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky from the New York Fed.)
What definition of shadow banking you prefer probably depends on the questions you are trying to answer. Since the interest in shadow banking today is clearly motivated by the financial crisis and its regulatory aftermath, a definition that focuses on systemically risky institutions has a lot of appeal. And not all entities that might be reasonably put in the shadow banking bucket fall into the systemically risky category. Former PIMCO Senior Partner Paul McCulley offered this perspective at the Atlanta Fed's recent annual Financial Markets Conference (video link here):
"...clearly, the money market mutual fund, that 2a-7 fund as it's known here in the United States, is the bedrock of the shadow banking system...
"The money market mutual fund industry is a huge industry and poses massive systemic risk to the system because it's subject to runs, because it's not just as good as an FDIC bank deposit. We found out that in spades in 2008...
"In fact, I can come up with an example of shadow banking that really didn't have a deleterious effect in 2008, and that was hedge funds with very long lockups on their liability. So hedge funds are shadow banks that are levered up intermediaries, but by having long lockups on their liabilities, then they weren't part and parcel of a run because they were locked up."
The more narrow Deloitte definition is thus very much in the spirit of the systemic risk definition. But even though this measure does not cover all the shadow banking activities with which policymakers might be concerned, other measures of the trend in the size of the sector look pretty much like the one below, which is from the Deloitte report:
The Deloitte report makes this sensible observation regarding the decline in the size of the shadow banking sector:
"Does this mean that the significance of the shadow banking system is overrated? No. The growth of shadow banking was fueled historically by financial innovation. A new activity not previously created could be categorized as shadow banking and could creep back into the system quickly. That new innovation might be but a distant notion at best in someone's mind today, but could pose a systemic risk concern in the future."
Ed Kane, another participant in our recent conference, went one step further with a familiar theme of his: new shadows are guaranteed to emerge, as part of the "regulatory dialectic"—an endless cycle of regulation and market innovation.
In getting to the essence of what the future of shadow banking will (or should) be, I think it is instructive to consider a set of questions that were posed at the conference by Washington University professor Phil Dybvig. I'm highlighting three of his five questions here:
"1. Is creation of liquidity by banks surplus liquidity in the economy or does it serve a useful economic purpose?
"2. How about creation of liquidity by the shadow banking sector? Was it surplus? Did it represent liquidity banks could have provided?...
"5. If there was too much liquidity in the economy, why? Some people have argued that it was because of too much stimulus and the government kept interest rates too low (and perhaps the Chinese government had a role as well as the US government). I don't want to take a side on these claims, but it is an important empirical question whether the explosion of the huge shadow banking sector was a distortion that was an unintended side effect of policy or whether it is an essential feature of a healthy economy."
Virtually all regulatory reforms will entail costs (some of them unintended), as well as benefits. Sensible people may come to quite different conclusions about how the scales tip in this regard. A good example is provided by the debate from another session at our conference on reform of money market mutual funds between Eric Rosengren, president of the Boston Fed, and Karen Dunn Kelley of Invesco. And we could see proposals by the Securities and Exchange Commission in the future to enact further reforms to the money market mutual fund industry. But whether any of these efforts are durable solutions to the systemic risk profile of the shadow banking sector must surely depend on the answers to Phil Dybvig's important questions.
By Dave Altig, executive vice president and research director at the Atlanta Fed
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December 02, 2011
The ongoing lender of last resort debate
Two days do not a policy success make, and it is a fool's game to tie the merits of a policy action to a short-term stock market cycle. But at first blush it does certainly appear that Wednesday's announcement of coordinated central bank actions to provide liquidity support to the global financial system had a positive effect. The policy is described in the Board of Governors press release:
"The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank… have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013."
"Under the program, the Fed lends dollars to other central banks, which in turn make the dollars available to banks under their jurisdiction. The action Wednesday made these emergency Fed loans cheaper, lowering their cost by half a percentage point.
"When the Fed launched the swap lines, it saw them as critical to its efforts to tame the financial storm sweeping the globe. Banks in Europe and elsewhere hold U.S. mortgage securities and other U.S. dollar securities. They get U.S. dollars in short-term lending markets to pay for these holdings. In 2008, when dollar loans became scarce, foreign banks were forced to dump their holdings of U.S. mortgages and other loans, which in turn pushed up the cost of credit for Americans.
"The latest action was at least in part an attempt to head off a repeat of such a spiral."
It is at least interesting that this most recent Fed action occurs as criticism of its past actions to address the financial crisis has once again arisen. The immediate driver is another installment in a series of Bloomberg reports that parse recently released details from Fed lending programs during the period from 2007 to 2009.
I have in the past objected to the somewhat conspiratorial tone in which the Bloomberg folks have chosen to cast the conversation. I certainly do not, however, think it objectionable to have a cool-headed conversation on what we can learn from the Fed's actions during the financial crisis and how it might inform policy going forward. Following on the latest Bloomberg article, Felix Salmon and Brad DeLong have taken up that cause.
It may be useful to start with my institution's official answers to the question: Why did the Federal Reserve lend to banks and other financial institutions during the financial crisis?
"Intense strains in financial markets during the financial crisis severely disrupted the flow of credit to U.S. households and businesses and led to a deep downturn in economic activity and a sharp increase in unemployment. Consistent with its statutory mandate to foster maximum employment and stable prices, the Federal Reserve established lending programs during the crisis to address the strains in financial markets, support the flow of credit to American families and firms, and foster economic recovery."
Neither Salmon nor DeLong argues with this assertion, and even the Bloomberg article includes commentary broadly supporting Fed actions, even if not all details of the implementation. More controversial is this observation from the Fed's frequently asked questions (FAQs):
"The Federal Reserve followed sound risk-management practices under all of its liquidity and credit programs. Credit provided under these programs was fully collateralized to protect the Fed—and ultimately the taxpayer—from loss."
Here is where opinions start to diverge. From DeLong:
"In the fall of 2008, counting the Fed and the Treasury together, a peak of 90% of Morgan Stanley's equity—the capital of the firm genuinely at risk—was U.S. government money. That money was genuinely at risk: had Morgan Stanley's assets taken another dive in value and blown through the private-sector's minimal equity cushion, it would have been taxpayers whose money would have been used to pay off the firm's more senior liabilities. 'Fully collateralized' the loans may have been, but had anything impaired that collateral there was no way on God's Green Earth Morgan Stanley—or any of the other banks—could have come up with the money to make the government whole."
And from Salmon:
"The Fed likes to say that it wasn't taking much if any credit risk here: that all its lending was fully collateralized, etc etc. But it's really hard to look at that red line and have a huge amount of confidence that the Fed was always certain to get its money back. Still, this is what lenders of last resort do. And this is what the ECB is most emphatically not doing."
As Salmon's comment makes clear, he does not view these risks as a repudiation of the appropriateness of what the Fed did during the crisis. And if I read Brad DeLong correctly, his main complaint is not about the programs per se, but on the pricing of the support provided to banks:
"When you contribute equity capital, and when things turn out well, you deserve an equity return. When you don't take equity—when you accept the risks but give the return to somebody else—you aren't acting as a good agent for your principals, the taxpayers.
"Thus I do not understand why officials from the Fed and the Treasury keep telling me that the U.S. couldn't or shouldn't have profited immensely from its TARP and other loans to banks. Somebody owns that equity value right now. It's not the government. But when the chips were down it was the government that bore the risk. That's what a lender of last resort does."
I wish that we could stop commingling TARP and the Fed's liquidity programs. At the very least, the legal authorities for the programs were completely distinct, and the Federal Reserve did not have any direct authority for the implementation of the TARP program. But that is probably beside the point for the current discussion. What is germane is the observation that the TARP funds did come with equity warrants issued to the Treasury. So in that case, there was the equity stake that DeLong urges.
As for the Fed programs, here again is a response taken from Fed FAQs:
"As verified by our independent auditors, the Federal Reserve did not incur any losses in connection with its lending programs. In fact, the Federal Reserve has generated very substantial net income since 2007 that has been remitted to the U.S. Treasury."
This observation does not, of course, repudiate Felix Salmon's point that losses may have been incurred, or the DeLong argument that the rates paid for loans from the Fed were not high enough by some metric. Nor should turning a profit be seen as proof that lending policies were sound (just as incurring losses would not be proof that the policies were foolhardy). But doesn't the record at least provide some support for a case that the Fed used reasonable judgment with respect to its lending decisions and acted as prudent steward of taxpayer funds even as it took extraordinary measures to address the worst financial crisis since the Great Depression?
In fact, the main point raised by Felix Salmon is not that risks were taken, but that those risks were not communicated in a transparent way:
"And it's frankly ridiculous that it's taken this long for this information to be made public. We're now fully ten months past the point at which the Financial Crisis Inquiry Commission's final report was published; this data would have been extremely useful to them and to all of the rest of us trying to get a grip on what was going on at the height of the crisis. The Fed's argument against publishing the data was that it 'would create a stigma,' and make it less likely that banks would tap similar facilities in future. But I can assure you that at the height of the crisis, the last thing on Morgan Stanley's mind was the worry that its borrowings might be made public three years later. When you need the money, and the Fed is throwing its windows wide open, you don't look that kind of gift horse in the mouth."
One thing I wish to continually stress is that we should be clear about what Bloomberg refers to as "secret loans." One last time from the Fed FAQs:
"All of the Federal Reserve's lending programs were announced prior to implementation and the amounts of support provided were easily tracked in weekly and monthly reports on the Federal Reserve Board's website."
So the missing information was not about the sums of money being lent but the exact details of who was receiving those loans. In most cases, these loans were not targeted to specific institutions, but obtained from open funding facilities such as the Term Auction Facility. And, though you can argue the point, stigma was a real concern, as Chairman Bernanke has testified:
"Many banks, however, were evidently concerned that if they borrowed from the discount window, and that fact somehow became known to market participants, they would be perceived as weak and, consequently, might come under further pressure from creditors. To address this so-called stigma problem, the Federal Reserve created a new discount window program, the Term Auction Facility (TAF). Under the TAF, the Federal Reserve has regularly auctioned large blocks of credit to depository institutions. For various reasons, including the competitive format of the auctions, the TAF has not suffered the stigma of conventional discount window lending and has proved effective for injecting liquidity into the financial system."
Salmon argues that this resolution to the stigma problem would not have been weakened by the current rules that require reporting the lending specifics with a lag. It is a reasonable argument (in what is, as an aside, a balanced and reasoned article by Salmon), and reasonable people can disagree. In any event, lagged reporting of details on the recipients of Fed loans is now the law. As a consequence, if such liquidity programs are needed again we can only hope that Felix Salmon's beliefs turn out to be true.
UPDATE: The Board of Governors has posted a response to recent reports on the Federal Reserve's lending policies.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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July 30, 2010
Some observations regarding interest on reserves
One of the livelier discussions following Federal Reserve Chairman Ben Bernanke's testimony to Congress on monetary policy has revolved around the issue of the payment of interest on bank reserves. Here, for what it's worth, are a few reactions to questions raised by that discussion:
Is interest paid on reserves (IOR) a free lunch?
"… in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money. The Fed is, essentially, leaving $100 bills on the sidewalk."
I'm not sure exactly where the "25 times" comes from, but it seems to me that the most obvious transaction would be to borrow in the overnight interbank lending market—the federal funds market—and then "lend" those funds to the Fed by placing them in the Fed's deposit facility. The differential between the return on those options is a good deal lower than a multiple of 25.
In fact, as many have noted before, the puzzle is why the gap between the funds rate and the deposit rate exists at all. As explained on the New York Fed's FAQ sheet:
"With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk's ability to keep the federal funds rate around the target for the federal funds rate."
It didn't quite work out that way, so clearly there is a limit to arbitrage. But if you really think that an 8 basis point spread between the effective funds rate and the deposit rate is a problem, the best approach would be, in my opinion, to address the institutional arrangements that are limiting arbitrage in the funds market. (Some of those features are discussed here and here.)
What is the opportunity cost of not lending?
That said, certainly the real issue about the IOR policy concerns the presumed incentive for banks to sit on excess reserves rather than putting those reserves into use by creating loans. This, from Bruce Bartlett, is fairly representative of the view that IOR is, at least in part, to blame for the slow pace of credit expansion in the United States:
"… As I pointed out in my column last week, banks have more than $1 trillion of excess reserves—money that the Fed has created that banks could lend immediately but are just sitting on. It's the economic equivalent of stuffing cash under one's mattress.
"Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves—a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute."
OK, but the spread that really matters in the bank lending decision is surely the difference between the return on depositing excess reserves with the Fed versus the return on making loans. In fairness, it does appear that this spread dropped when the IOR was raised from its implicit prior setting of zero…
… but it's also pretty clear that this development largely reflects a general fall in market yields post-October 2008 as much is it does the increase in IOR rate:
And here's another thought: As of now, the IOR policy applies to all reserves, required or excess. Consider the textbook example of a bank that creates a loan. In the simple example, a bank creates a loan asset on its book by creating a checking account for a customer, which is the corresponding liability. It needs reserves to absorb this new liability, of course, so the process of creating a loan converts excess reserves into required reserves. But if the Fed pays the same rate on both required and excess reserves, the bank will have lost nothing in terms of what it collects from the Fed for its reserve deposits. In this simple case, the IOR plays no role in determining the opportunity cost of extending credit.
Of course, the funds created in making a loan may leave the originating bank. Though reserves don't leave the banking system as a whole, they may certainly flow away from an individual institution. So things may not be as nice and neat as my simple example. But at worst, that just brings the question back to the original point: Is the 25 basis point return paid by the central bank creating a significant incentive for banks to sit on reserves rather than lend them out to consumers or businesses? At least some observers are skeptical:
"Barclays Capital's Joseph Abate…noted much of the money that constitutes this giant pile of reserves is 'precautionary liquidity.' If banks didn't get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn't see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum."
Are there good reasons for paying interest on reserves?
Even if we concede that there is some gain from eliminating or cutting the IOR rate, what of the costs? Tim Duy, quoting the Wall Street Journal, makes note (as does Steve Williamson) of the following comment from the Chairman:
"… Lowering the interest rate it pays on excess reserve—now at 0.25%—could create trouble in money markets, he said.
" 'The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,' he said.
" 'Because if rates go to zero, there will be no incentive for buying and selling federal funds—overnight money in the banking system—and if that market shuts down … it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.' "
Professor Duy interprets this as aversion to the possibility that "the failure to meet expectations would be the real cost to the Federal Reserve," but I would have taken the words for exactly what they seem to say—that the skills and infrastructure required to maintain a functioning federal funds rate might atrophy if cutting the rate to zero brings activity in the market to a trickle. And that observation is relevant because of the following, from the minutes of the April 27–28 meeting of the Federal Open Market Committee:
"Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee's objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy."
"Normal" may not mean the exact status quo ante, but to the extent that federal funds targeting is a desirable part of the picture, it sure will be helpful if a federal funds market exists.
Even if you don't buy that argument—and the point is debatable—it is useful to recall that the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:
"… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank's desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.
"… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank."
Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.
That is not to say that these risks or efficiency costs unambiguously dominate other considerations—for a much deeper discussion I refer you to a recent piece by Tom Sargent. But they should not be lost in the conversation.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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June 30, 2010
Keeping an eye on Europe
In June, a third of the economists in the Blue Chip panel of economic forecasters indicated that they had lowered their growth forecast over the next 18 months as a consequence of Europe's debt crisis. When pushed a little further, 31 percent said that weaker exports would be the channel through which this problem would hinder growth, while 69 percent thought that "tighter financial conditions" would be the channel through which debt problems in Europe could hit U.S. shores.
Tighter financial conditions also were mentioned by the Federal Open Market Committee in its last statement, where the committee noted, "Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad."
In his speech today, Atlanta Fed President Dennis Lockhart identified the European sovereign debt crisis as one of the sources of uncertainty for the U.S. economy that he believes "have clouded the outlook." President Lockhart explicitly expressed his concern that Europe's "continuing and possibly escalating financial market pressures will be transmitted through interconnected banking and capital markets to our economy."
Negative effects from the European sovereign debt crisis can be transmitted to the U.S. economy through a number of financial channels, including higher risk premiums on private securities, a considerable rise in uncertainty, and sharply increased risk aversion. Another important channel is the direct exposure of the U.S. banking sector—both through holdings of troubled European assets and counterparty exposure to European banks, which not only have a substantial exposure to the debt-laden European countries but have also been facing higher funding costs. The LIBOR-OIS spread has widened notably (see the chart below), liquidity is now concentrated in tenors of one week and shorter, and the market has become notably tiered.
Banks in the most affected countries (Greece, Portugal, Ireland, Spain, and Italy) and other European banks perceived as having a sizeable exposure to those countries have to pay higher rates and borrow at shorter tenors. Although for now U.S. banks can raise funds more cheaply than many European financial institutions, some analysts believe that there's a risk that the short-term offshore dollar market may become increasingly strained, leading to funding shortages and, conceivably, forced asset sales.
Bank for International Settlements data through the end of December of last year show that the U.S. banking system's risk exposure to the most vulnerable EU countries appears to be manageable. U.S. banks' on-balance sheet financial claims vis-á-vis those countries, adjusted for guarantees and collateral, look substantial in absolute terms but are rather small relative to the size of U.S. banks' total financial assets (see the chart below). The exposure to Spain is the biggest, closely followed by Ireland and Italy. Overall, the five countries account for less than 2 percent of U.S. banks' assets.
U.S. exposure to developed Europe as a whole, however, is much higher at $1.2 trillion, so U.S. financial institutions may feel some pain if the European economy slows down markedly. How likely is a marked slowdown? It's difficult to determine, of course, but when asked about the largest risks facing the U.S. economy over the next year, the Blue Chip forecasters put "spillover effects of Europe's debt crisis" at the top of their list.
By Galina Alexeenko, economic policy analyst at the Atlanta Fed
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May 28, 2010
How "discouraged" are small businesses? Insights from an Atlanta Fed small business lending survey
Roughly half of U.S. workers are employed at firms with fewer than 500 employees, and about 90 percent of U.S. firms have fewer than 20 employees. While estimates vary, small businesses are also credited with creating the lion's share of net new jobs. Small businesses are, in total, a big deal. Thus, it is no surprise that there is congressional debate going on about how to best aid small businesses and promote job growth. Many people have noted the decline in small business lending during the recession, and some have suggested proposals to give incentives to banks to increase their small business portfolios. But is a lack of willingness to lend to small businesses really what's behind the decline in small business lending? Or is it the lack of creditworthy demand resulting from the effects of the recession and housing market distress?
Economists often face such identification dilemmas, situations in which we would like to know whether supply or demand is the driving factor behind changes within a market. Additional data can often help solve the problem. In this case we might want to know about all of the loans applied for by small businesses, whether the loans were granted and at what rates, and specific information on loan quality and collateral. Alas, such data are not available. In fact, the Congressional Oversight Panel in a recent report recommends that the U.S. Treasury and other regulators "establish a rigorous data collection system or survey that examines small business finance" and notes that "the lack of timely and consistent data has significantly hampered efforts to approach and address the crisis."
We at the Federal Reserve Bank of Atlanta have also noted the paucity of data in this area and have begun a series of small business credit surveys. Leveraging the contacts in our Regional Economic Information Network (REIN), we polled 311 small businesses in the states of the Sixth District (Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee) on their credit experiences and future plans. While the survey is not a stratified random sample and so should not be viewed as a statistical representation of small business firms in the Sixth District, we believe the results are informative.
Indeed, the results of our April 2010 survey suggest that demand-side factors may be the driving force behind lower levels of small business credit. To be sure, when asked about the recent obstacles to accessing credit, some firms (34 firms, or 11 percent of our sample) cited banks' unwillingness to lend, but many more firms cited factors that may reflect low credit quality on the part of prospective borrowers. For example, 32 percent of firms cited a decline in sales over the past two years as an obstacle, 19 percent cited a high level of outstanding business or personal debt, 10 percent cited a less than stellar credit score, and 112 firms (32 percent) report no recent obstacles to credit. Perhaps not surprisingly, outside of the troubled construction and real estate industries, close to half the firms polled (46 percent) do not believe there are any obstacles while only 9 percent report unwillingness on the part of banks.
These opinions are reinforced by responses detailing the firms' decisions to seek or not seek credit and the outcomes of submitted credit applications.
Of the 191 firms that did not seek credit in the past three months, 131 (69 percent) report that they either had sufficient cash on hand, did not have the sales/revenues to warrant additional debt, or did not need credit. (Note the percentages in the chart above reflect multiple responses by firms.) These responses likely reflect both the impact of the recession on the revenues of small firms as well as precautionary/prudent cash management.
The administration has recently sent draft legislation to Congress for a supply-side program—the Small Business Lending Fund (SBLF)—to address the funding needs of small businesses. The congressional oversight report raises a good question about the potential effectiveness of supply-side programs:
"A small business loan is, at its heart, a contract between two parties: a bank that is willing and able to lend, and a business that is creditworthy and in need of a loan. Due to the recession, relatively few small businesses now fit that description. To the extent that contraction in small business lending reflects a shortfall of demand rather than of supply, any supply-side solution will fail to gain traction."
That said, one way that a supply-side program like SBLF would make sense, even if low demand is the force driving lower lending rates, is if there are high-quality borrowers that are not applying for credit merely because they anticipate that they will be denied. We could term these firms "discouraged borrowers," to co-opt a term from labor markets (i.e., discouraged workers).
If a program increased the perceived probability of approval, either by increasing approval rates via a subsidization of small business lending or merely by changing borrower beliefs, more high-quality, productive loans would be made.
Just how many discouraged borrowers are out there? The chart above illustrates that, indeed, 16 percent of all of our responding firms and 21 percent of construction and real estate firms might fall into this category. I add "might" because the anticipation of a denial may well be accurate but based on a lack of creditworthiness and not the irrational or inefficient behavior of banks. Digging into our results, we find that 35 percent of the firms who did not seek credit because of the anticipation of a denial also cited "not enough sales," indicating that a denial would likely have reflected underlying loan quality.
In the labor market, so-called "discouraged workers" flow back into the labor force when they perceive that the probability of finding an acceptable job has increased enough to make searching for work, and working, attractive again. We should expect so-called "discouraged borrowers" to do the same. That's because if they don't, the likely alternatives for them, at some point, would be to sell the business or go out of business. It seems unlikely that, facing such alternatives, a "discouraged" firm would not attempt to access credit. The responses of firms in our sample are consistent with this logic; 55 percent of those who did not seek credit in the past three months because of the anticipation of a denial indicated that they plan to seek credit in the next six months.
Our results also provide some interesting data on an assumption underlying the policy debate: that those small businesses are credit constrained. Of the 117 firms in the survey that that sought credit during the previous three months, the following chart illustrates the extent to which these firms met their financing needs.
Based on firm reports of the credit channel applications submitted in the previous three months, we created a financing index value for each firm. Firms that were denied on all of their credit applications have a financing index equal to 1, while firms that received all of the funding requested have an index level of 5. Index levels between 1 and 5 indicate, from lesser to greater, the extent to which their applications were successful. In the chart we plot data on the financing index levels of all firms in our sample and then split according to whether the firm is in construction and real estate. Among construction and real estate firms, 50 percent of firms had an index below 2.5, suggesting most did not get their financing requests meet. In contrast, the median index value of 4.7 for all other firms suggests that most of these firm were able to obtain all or most of the credit they requested. This difference between real estate–related firms and others is really not surprising given that the housing sector was at the heart of the financial crisis and recession. But it does suggest that more work needs to be done to analyze the industry-specific funding constraints among small businesses.
By Paula Tkac, assistant vice president and senior economist, of the Atlanta Fed
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May 13, 2010
Regulatory reform via resolution: Maybe not sufficient, certainly necessary
This macroblog post is the first of several that will feature the Atlanta Fed's 2010 Financial Markets Conference. Please return for additional information.
On Tuesday and Wednesday the Federal Reserve Bank of Atlanta hosted its annual Financial Markets Conference, titled this year Up From the Ashes: The Financial System After the Crisis. Much of the first day was devoted to conversations about rating agencies and their role in the economy, for better and worse. The second day was absorbed by the issues of too-big-to-fail, macroprudential regulation, and regulatory reform.
One theme that ran throughout the second day's conversations related to the two aspects of regulatory reform highlighted by Chairman Bernanke in his recent congressional testimony on lessons from the failure of Lehman Brothers:
"The Lehman failure provides at least two important lessons. First, we must eliminate the gaps in our financial regulatory framework that allow large, complex, interconnected firms like Lehman to operate without robust consolidated supervision… Second, to avoid having to choose in the future between bailing out a failing, systemically critical firm or allowing its disorderly bankruptcy, we need a new resolution regime, analogous to that already established for failing banks."
Though those two aspects of reform are in no way mutually exclusive, there is, I think, a tendency to lean to one or the other as the first most important contributor to avoiding a repeat of our recent travails. To put it in slightly different terms, there are those that would place greatest emphasis on reducing the probability of systemically important failures and those that would put greatest emphasis on containing the damage when a systemically important failure occurs.
"…the best chance for durable reform is to start with the assumption that failure will happen and construct a strategy for dealing with it when it does…
"In a world with the capacity for rapid innovation, rule-writers have a tendency to perpetually fight the last war…
"I am not arguing that … the 'Volcker rule,' derivative exchanges, trading restrictions, or any of the specific regulatory reform proposals in play are necessarily bad ideas. I am arguing that we should assume that, no matter what proposed safeguards are put in place, failure of some systemically important institution will ultimately occur—somewhere, somehow. And that means priority has to be given to the development of resolution procedures for institutions that are otherwise too big to fail."
At our conference this week, University of Florida professor Mark Flannery expressed concerns that, placed in an international context, a truly robust resolution process for failed institutions may be tough to construct:
"In principle, a non-bankruptcy reorganization channel for SIFIs [systemically important financial institutions] makes a lot of sense. But the complexity of SIFIs' organizational structures introduces some serious problems. Not only do SIFIs operate with a bewildering array of subsidiaries… but they generally operate in many countries. Without very close coordination of resolution decisions across jurisdictions, a U.S. government reorganization would likely set off a scramble for assets of the sort that bankruptcy is meant to avoid. Rapid asset sales could generate downward price spirals… with systemically detrimental effects. Second, supervisors would have to assure that SIFIs maintain the proper sort and quantity of haircut-able liabilities outstanding. Once a firm has been identified as systemically important, this may be a relatively straightforward requirement to impose, but there remains the danger that 'shadow' institutions will become systemically important, before they are properly regulated. (This is not a danger unique to the question of resolution.)
"I conclude that the international coordination required to make prompt resolution feasible for SIFIs is a long way off, if it can be achieved at all."
Not an encouraging note, and the point is very well taken. Flannery concludes that we would be better served by focusing on changes that lie on the "avoiding failure" end of the reform spectrum: standardized derivative contracts, tying supervisory oversight to objective market-based metrics on the health of SIFIs, limitations on risky activities, and higher capital standards.
As I noted above, I am certainly not hostile to these ideas, and the answer to the question "should reform strategies be rules-based or resolution-based?" is surely "all of the above." But even if it will take a long time to develop better resolution procedures to address the types of problems that emerged in the past several years, I strongly argue that development of such procedures are necessary for the long-term, and work on these procedures should begin. And here, I have a relatively modest proposal, returning to my remarks:
"…there is a pretty obvious way to vet proposals that are offered. We have a couple of real-world case studies—Bear Stearns, Lehman, AIG. One test for any proposed resolution process would be to illustrate how that plan would have been implemented in each of those cases. This set of experiments can't be started too soon, and I think should move it to the top of our reform priorities."
Whether it be the specific provisions of reform bills winding their way through Congress or the "living will" idea championed this week by the Federal Deposit Insurance Corporation, I think we would do well to let the stress testing of those proposals begin.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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April 29, 2010
Consumer credit: More than meets the eye
A lot has been made (here, for a recent example) of the idea that banks have shown a surprising amount of reluctance to extend credit and to start making loans again. Indeed, the Fed's consumer credit report, which shows the aggregate amount of credit extended to individuals (excluding loans secured by real estate), has been on a steady downward trend since the fall of 2008.
Importantly, that report also provides a breakdown that shows how much credit the different types of institutions hold on their books. Commercial banks, which are the single largest category, accounted for about a third of the total stock in consumer credit in 2009. The two other largest categories—finance companies and securitized assets—accounted for a combined 45 percent. While commercial banks have been the biggest source of credit, they have not been the biggest direct source of the decline.
The chart above highlights a somewhat divergent pattern among the big three credit holders. This pattern mainly indicates that credit from finance companies and securitized assets has been on a relatively steady decline since the fall of 2008 while credit from commercial banks has shown more of a leveling off. These details highlight a potential misconception that commercial banks are the primary driver behind the recent reduction in credit going to consumers (however, lending surveys certainly indicate that standards for credit have tightened).
To put a scale on these declines, the aggregate measure of consumer credit has declined by a total of 5.7 percent since its peak in December 2008 through February 2010. Over this same time period, credit from finance companies and securitizations declined by 16.2 percent and 12.4 percent, respectively, while commercial bank credit declined by 5.5 percent. Admittedly, securitization and off-balance sheet financing are a big part of banks' activity as they facilitate consumers' access to credit. The decline in securitized assets might not be that surprising given that the market started to freeze in 2007 and deteriorated further in 2008 as many investors fled the market. Including banks' securitized assets that are off the balance sheet would show a steeper decline in banks' holdings of consumer credit.
A significant factor in evaluating consumer credit is the pace of charge-offs, which can overstate the decline in underlying loan activity (charge-offs are loans that are not expected to be paid back and are removed from the books). Some (here and here) have made the point that the declines in credit card debt, for example, reflect increasing rates of charge-offs rather than consumers paying down their balances.
How much are charge-offs affecting the consumer credit data? Unfortunately, the Fed's consumer credit statistics don't include charge-offs. However, we can look at a different dataset that includes quarterly data on charge-offs for commercial banks to get an approximation. We can think of the change in consumer loan balances roughly as new loans minus loans repaid minus net loans charged off:
Change in Consumer Loans = [New Loans – Loan Repayments] – Net Charge-Offs
Adding net charge-offs to the change in consumer loans should give a cleaner estimate of underlying loan activity:
If the adjusted series is negative, loan repayments should be greater than new loans extended, which would lend support to the idea that loans are declining because consumers are paying down their debt balances. If the adjusted series is positive, new loans extended should be greater than loan repayments and adds support to the hypothesis that part of the decline in the as-reported loans data is from banks removing the debt from their books because of doubtful collection. Both the as-reported and adjusted consumer loan series are plotted here:
Notably, year-over-year growth in consumer loans adjusted for charge-offs has remained positive, which contrasts the negative growth in the as-reported series. That is, the net growth in new loans and loan repayments shows a positive (albeit slowing) growth rate once charge-offs are factored in. Over 2009, this estimate of charge-offs totaled about $27 billion while banks' average consumer loan balances declined by about $25 billion. Thus, a significant portion of the recent decline in consumer loan balances is the result of charge-offs.
Nevertheless, in an expanding economy, little or no credit growth implies a declining share of consumption financed through credit. Adjusting consumer loans for charge-offs suggests that the degree of consumer deleveraging across nonmortgage debt is somewhat less substantial than indicated by the headline numbers.
All in all, the consumer credit picture is a bit more complicated than it appears on the surface. A more detailed look suggests that banks haven't cut their consumer loan portfolios as drastically as sometimes assumed. The large run-up in charge-offs has also masked the underlying dynamics for loan creation and repayment. Factoring in charge-offs provides some evidence that a nontrivial part of consumer deleveraging is coming through charge-offs.
By Michael Hammill, economic policy analysis specialist in the Atlanta Fed's research department
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