macroblog

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The Atlanta Fed's macroblog provides commentary on economic topics including monetary policy, macroeconomic developments, financial issues and Southeast regional trends.

Authors for macroblog are Dave Altig and other Atlanta Fed economists.


December 04, 2013


Is (Risk) Sharing Always a Virtue?

The financial system cannot be made completely safe because it exists to allocate funds to inherently risky projects in the real economy. Thus, an important question for policymakers is how best to structure the financial system to absorb these losses while minimizing the risk that financial sector failures will impair the real economy.

Standard theories would predict that one good way of reducing financial sector risk is diversification. For example, the financial system could be structured to facilitate the development of large banks, a point often made by advocates for big banks such as Steve Bartlett. Another, not mutually exclusive, way of enhancing diversification is to create a system that shares risks across banks. An example is the Dodd-Frank Act mandate requiring formerly over-the-counter derivatives transactions to be centrally cleared.
 
However, do these conclusions based on individual bank stability necessarily imply that risk sharing will make the financial system safer? Is it even relevant to the principal risks facing the financial system? Some of the papers presented at the recent Atlanta Fed conference, "Indices of Riskiness: Management and Regulatory Implications," broadly addressed these questions and others. Other papers discuss the impact of bank distress on local economies, methods of predicting bank failure, and various aspects of incentive compensation paid to bankers (which I discuss in a recent Notes from the Vault).

The stability implications of greater risk sharing across banks are explored in "Systemic Risk and Stability in Financial Networks" by Daron Acemoglu, Asuman Ozdaglar, and Alireza Tahbaz-Salehi. They develop a theoretical model of risk sharing in networks of banks. The most relevant comparison they draw is between what they call a "complete financial network" (maximum possible diversification) and a "weakly connected" network in which there is substantial risk sharing between pairs of banks but very little risk sharing outside the individual pairs. Consistent with the standard view of diversification, the complete networks experience few, if any, failures when individual banks are subject to small shocks, but some pairs of banks do fail in the weakly connected networks. However, at some point the losses become so large that the complete network undergoes a phase transition, spreading the losses in a way that causes the failure of more banks than would have occurred with less risk sharing.

Extrapolating from this paper, one could imagine that risk sharing could induce a false sense of security that would ultimately make a financial system substantially less stable. At first a more interconnected system shrugs off smaller shocks with seemingly no adverse impact. This leads bankers and policymakers to believe that the system can handle even more risk because it has become more stable. However, at some point the increased risk taking leads to losses sufficiently large to trigger a phase transition, and the system proves to be even less stable than it was with weaker interconnections.

While interconnections between financial firms are a theoretically important determinant of contagion, how important are these connections in practice? "Financial Firm Bankruptcy and Contagion," by Jean Helwege and Gaiyan Zhang, analyzes the spillovers from distressed and failing financial firms from 1980 to 2010. Looking at the financial firms that failed, they find that counterparty risk exposure (the interconnections) tend to be small, with no single exposure above $2 billion and the average a mere $53.4 million. They note that these small exposures are consistent with regulations that limit banks' exposure to any single counterparty. They then look at information contagion, in which the disclosure of distress at one financial firm may signal adverse information about the quality of a rival's assets. They find that the effect of these signals is comparable to that found for direct credit exposure.

Helwege and Zhang's results suggest that we should be at least as concerned about separate banks' exposure to an adverse shock that hits all of their assets as we should be about losses that are shared through bank networks. One possible common shock is the likely increase in the level and slope of the term structure as the Federal Reserve begins tapering its asset purchases and starts a process ultimately leading to the normalization of short-term interest rate setting. Although historical data cannot directly address banks' current exposure to such shocks, such data can provide evidence on banks' past exposure. William B. English, Skander J. Van den Heuvel, and Egon Zakrajšek presented evidence on this exposure in the paper "Interest Rate Risk and Bank Equity Valuations." They find a significant decrease in bank stock prices in response to an unexpected increase in the level or slope of the term structure. The response to slope increases (likely the primary effect of tapering) is somewhat attenuated at banks with large maturity gaps. One explanation for this finding is that these banks may partially recover their current losses with gains they will accrue when booking new assets (funded by shorter-term liabilities).

Overall, the papers presented in this part of the conference suggest that more risk sharing among financial institutions is not necessarily always better. Even though it may provide the appearance of increased stability in response to small shocks, the system is becoming less robust to larger shocks. However, it also suggests that shared exposures to a common risk are likely to present at least as an important a threat to financial stability as interconnections among financial firms, especially as the term structure and the overall economy respond to the eventual return to normal monetary policy. Along these lines, I recently offered some thoughts on how to reduce the risk of large widespread losses due to exposures to a common (credit) risk factor.

Photo of Larry WallBy Larry Wall, director of the Atlanta Fed's Center for Financial Innovation and Stability

 

Note: The conference "Indices of Riskiness: Management and Regulatory Implications" was organized by Glenn Harrison (Georgia State University's Center for the Economic Analysis of Risk), Jean-Charles Rochet, (University of Zurich), Markus Sticker, Dirk Tasche (Bank of England, Prudential Regulatory Authority), and Larry Wall (the Atlanta Fed's Center for Financial Innovation and Stability).


December 4, 2013 in Banking, Financial System | Permalink

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April 22, 2013


Too Big to Fail: Not Easily Resolved

As Fed Chairman Ben Bernanke has indicated, too-big-to-fail (TBTF) remains a major issue that is not solved, but “there’s a lot of work in train.” In particular, he pointed to efforts to institute Basel III capital standards and the orderly liquidation authority in Dodd-Frank. The capital standards seek to lower the probability of insolvency in times of financial stress, while the liquidation authority attempts to create a credible mechanism to wind down large institutions if necessary. The Atlanta Fed’s flagship Financial Markets Conference (FMC) recently addressed various issues related to both of these regulatory efforts.

The Basel capital standards are a series of international agreements on capital requirements reached by the Basel Committee on Banking Supervision. These requirements are referred to as “risk-weighted” because they tie the required amount of bank capital to an estimate of the overall riskiness of each bank’s portfolio. Put simply, riskier banks need to hold more capital under this system.

The first iteration of the Basel requirements, known as Basel I, required only 30 pages of regulation. But over time, banks adjusted their portfolios in response to the relatively simple risk measures in Basel I, and these measures became insufficient to characterize bank risk. The Basel Committee then shifted to a more complex system called Basel II, which allows the most sophisticated banks to estimate their own internal risk models subject to supervisory approval and use these models to calculate their required capital. After the financial crisis, supervisors concluded that Basel II did not require enough capital for certain types of transactions and agreed that a revised version called Basel III should be implemented.

At the FMC, Andrew Haldane from the Bank of England gave a fascinating recap of the Basel capital standards as a part of a broader discussion on the merits of complex regulation. His calculations show that the Basel accords have become vastly more complex, with the number of risk weights applied to bank positions increasing from only five in the Basel I standards to more than 200,000 in the current Basel III standards.

Haldane argued that this increase in complexity and reliance on banks’ internal risk models has unfortunately not resulted in a fair or credible system of capital regulation. He pointed to supervisory studies revealing wide disparities across banks in their estimated capital requirements for a hypothetical common portfolio. Further, Haldane pointed to a survey of investors by Barclays Capital in 2012 showing, not surprisingly, that investors do not put a great deal of trust in the Basel weightings.

So is the problem merely that the Basel accords have taken the wrong technical approach to risk measurement? The conclusion of an FMC panel on risk measurement is: not necessarily. The real problem is that estimating a bank’s losses in unlikely but not implausible circumstances is at least as much an art as it is a science.

Til Schuermann of Oliver Wyman gave several answers to the question “Why is risk management so hard?” including the fact that we (fortunately) don’t observe enough bad events to be able to make good estimates of how big the losses could become. As a result, he said, much of what we think we know from observations in good times is wrong when big problems hit: we estimate the wrong model parameters, use the wrong statistical distributions, and don’t take account of deteriorating relationships and negative feedback loops.

David Rowe of David M. Rowe Risk Advisory gave an example of why crisis times are different. He argued that the large financial firms can absorb some of the volatility in asset prices and trading volumes in normal times, making the financial system appear more stable. However, during crises, the large movements in asset prices can swamp even these large players. Without their shock absorption, all of the volatility passes through to the rest of the financial system.

The problems with risk measurement and management, however, go beyond the technical and statistical problems. The continued existence of TBTF means that the people and institutions that are best placed to measure risk—banks and their investors—have far less incentive to get it right than they should. Indeed, with TBTF, risk-based capital requirements can be little more than costly constraints to be avoided to the maximum extent possible, such as by “optimizing” model estimates and portfolios to reduce measured risk under Basel II and III. However, if a credible resolution mechanism existed and failure was a realistic threat, then following the intent of bank regulations would become more consistent with the banks’ self-interest, less costly, and sometimes even nonbinding.

Progress on creating such a mechanism under Dodd-Frank has been steady, if slow. Arthur Murton of the Federal Deposit Insurance Corporation (FDIC) presented, as a part of a TBTF panel, a comprehensive update on the FDIC’s planning process for making the agency’s new Orderly Liquidation Authority functional. The FDIC’s plans for resolving systemically important nonbank financial firms (including the parent holding company of large banks) is to write off the parent company’s equity holders and then use its senior and subordinated debt to absorb any remaining losses and recapitalize the parent. The solvent operating subsidiaries of the failed firm would continue in normal operation.

Importantly, though, the FDIC may exercise its new power only if both the Treasury and Federal Reserve agree that putting a firm that is in default or in danger of default into judicial bankruptcy would have seriously adverse effects on U.S. financial stability. And this raises a key question: why isn’t bankruptcy a reasonable option for these firms?

Keynote speaker John Taylor and TBTF session panelist Kenneth Scott—both Stanford professors—argued that in fact bankruptcy is a reasonable option, or could be, with some changes. They maintain that creditors could better predict the outcome of judicial bankruptcy than FDIC-administered resolution. And predictability of outcomes is key for any mechanism that seeks to resolve financial firms with as little damage as possible to the broader financial system.

Unfortunately, some of the discussion during the TBTF panel also made it apparent that Chairman Bernanke is right: TBTF has not been solved. The TBTF panel discussed several major unresolved obstacles, including the complications of resolving globally active financial firms with substantial operations outside the United States (and hence outside both the FDIC and the U.S. bankruptcy court’s control) and the problem of dealing with many failing systemically important financial institutions at the same time, as is likely to occur in a crisis period. (A further commentary on these two obstacles is available in an earlier edition of the Atlanta Fed’s Notes from the Vault.)

Thus, the Atlanta Fed’s recent FMC highlighted both the importance of ending TBTF and the difficulty of doing so. The Federal Reserve continues to work with the FDIC to address the remaining problems. But until TBTF is a “solved” problem, what to do about these financial firms should and will remain a front-burner issue in policy circles.

Photo of Paula Tkac By Paula Tkac, vice president and senior economist, and

Photo of Larry Wall Larry Wall, director of the Center for Financial Innovation and Stability, both in the Atlanta Fed’s research department

April 22, 2013 in Capital and Investment, Capital Markets, Financial System | Permalink

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Yes, solving the Too Big to Fail problem is really, really difficult if the people making policy don't want to solve it, as they evidently don't. Clearly, the political influence of such organizations is at work impeding the process. Sadly, the regulators/enablers (both international and domestic) are terrified of imposing the kind of "dumb but simple" workable solution that would drastically impact the business models of these very politically powerful organizations. No, let's keep putting increasingly sophisticated band aids on tumors--that's the spirit, fellows!

Posted by: William Meyer | April 23, 2013 at 09:37 AM

Nice summary of the problems here. In addition to the problems you mention, I worry about a couple of others. One was noted recently by Sarah Gordon in the FT. She writes:


There is a compelling body of evidence suggesting that the people most likely to go into the riskier areas of financial services are precisely those least suited to judging risk. Susan Cain’s recently published book Quiet cites a series of studies that suggest that extroverts tend to be attracted to the high-reward environments of investment banking, deals and trading. And, troublingly, these outgoing people also tend to be less effective at balancing opportunity and risk than some of their more introverted peers. (http://www.ft.com/intl/cms/s/0/a917de18-abef-11e2-9e7f-00144feabdc0.html#axzz2Rxxxb9nc)

A second thing that makes me nervous is the fact, as you point out, that the FDIC an exercise its new powers to resolve a systemically important institution only if the Fed and the Treasury agree to let it do so. Would the Treasury really be able to resist political pressures and make such a decision objectively? Even the Fed, independent though it is, might find it hard to do so.

Posted by: Ed Dolan | April 30, 2013 at 12:56 PM

There is waiting in the Platonic cave a critically important paper that derives Campbell's Law and Goodhart's Law from Goedel's incompleteness theorem. As long as we allow a financial system to exist in which ever more complex debt instruments are allowed to be created, then for every control regime devised by some Basel XXXIV or whatever, there will be a new class of derivatives that escapes those regulations and destabilizes the system.

There are three possible ways to escape this endless escalation of risk-creating games: (1) impose a formal language for creating financial instruments that has been proven to be sub-Turing in its expressive power, (2) implement institution-scale TBTF, preventing any single institution or implicit consortium of institutions from acquiring enough significance to endanger the system as a whole, or (3) implement sovereign TBTF, preventing the failure of any nation-state from endangering the financial systems of others. It's not too late to start considering mechanisms to allow the Eurozone to spin off disruptive members in the same way that a lizard sheds its tail when in mortal danger. Cyprus is almost there already.

Unfortunately the US cannot spin off insolvent states, much as some of them might wish to leave. If only we could let North Carolina go, and take the Bank of America with it!

Good luck!

Posted by: George McKee | April 30, 2013 at 10:04 PM

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May 31, 2012


What is shadow banking?

What is shadow banking? Announcing a new index—hat tip to Ryan McCarthy—Deloitte offers its own definition:

"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.

David AltigBy Dave Altig, executive vice president and research director at the Atlanta Fed

May 31, 2012 in Banking, Financial System, Money Markets | Permalink

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How has liquidity varied in the U.S., or perhaps OECD countries, since WWII? How have taxes affected the emergence of "shadow banking" if at all?

Posted by: Tom Shillock | June 01, 2012 at 12:53 PM

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December 16, 2011


Maybe this time was at least a little different?

Earlier this week, Derek Thomson, a senior editor at The Atlantic, began his article "The Graph That Proves Economic Forecasters Are Almost Always Wrong" with some observations that don't really require a graph:

"As the saying goes: 'It's hard to make predictions. Especially about the future.' Thirty years ago, it was obvious to everybody that oil prices would keep going up forever. Twenty years ago, it was obvious that Japan would own the 21st century. Ten years ago, it was obvious that our economic stewards had mastered a kind of thermostatic control over business cycles to prevent great recessions. We were wrong, wrong, and wrong."

In a recent speech, Dennis Lockhart—whom most of you recognize as president here at the Atlanta Fed—offered his own thoughts on why forecasts can go so wrong:

"… you may wonder why forecasters, the Fed included, don't do a better job. To answer this question, let me suggest three reasons why forecasts may be off.

"While it's relatively trivial in my view, the first reason involves missing the timing of economic activity. An example of that was mentioned earlier when I explained that GDP for the third quarter had been revised down while the fourth quarter is expected to compensate.

"A second reason that forecasts miss the mark is, in everyday language, stuff happens.

"To be a little more precise, unforeseen developments are a fact of life. In my view, the energy and commodity shocks early in the year had a significant impact on growth in the first half of 2011. The tsunami-related supply disruptions, though temporary, were an exacerbating factor. In fact, a lot of shocks or disruptions are quite temporary and don't cause one to rethink the narrative about where the economy is likely going.

"Which brings me to the third reason why economic prognostications go off track: we, as forecasters, simply get the bigger story wrong.

"What I mean by getting the bigger story wrong is failing to understand the fundamentals at work in the economy."

"Getting the bigger story wrong" is Simon Potter's theme in the New York Fed's Liberty Street Economics blog post, "The Failure to Forecast the Great Recession":

"Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank's economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out:

1.  Misunderstanding of the housing boom …

2. A lack of analysis of the rapid growth of new forms of mortgage finance …

3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy …


"However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation."

Potter does not implicate any of his Federal Reserve brethren, but you can add me to the roll call of those having made each of the mistakes on the list.

Should we have known? A powerful narrative that we should have has taken hold. The boom-bust cycle associated with large bouts of asset appreciation and debt accumulation has a long history in economics, and the theme has been pressed home in its most recent incarnation by the work of Carmen Reinhart and coauthors, including the highly influential book written with Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly.

Unfortunately, even seemingly compelling historical evidence is not always so clear cut. An illustration of this, relevant to the failure to forecast the Great Recession, was provided in a paper by Enrique Mendoza and Marco Terrones (from the University of Maryland and the International Monetary Fund, respectively), presented last month at a Central Bank of Chile conference, "Capital Mobility and Monetary Policy." What the paper puts forward is described by Mendoza and Terrones as follows:

"… in Mendoza and Terrones (2008) we proposed a new methodology for measuring and identifying credit booms and showed that it was successful in identifying credit boom events with a clear cyclical pattern in both macro and micro data.

"The method we proposed is a 'thresholds method.' This method works by first splitting real credit per capita in each country into its cyclical and trend components, and then identifying a credit boom as an episode in which credit exceeds its long-run trend by more than a given 'boom' threshold, defined in terms of a tail probability event… The key defining feature of this method is that the thresholds are proportional to each country's standard deviation of credit over the business cycle. Hence, credit booms reflect 'unusually large' cyclical credit expansions."

And here is what they find:

"In this paper, we apply this method to data for 61 countries (21 industrialized countries, ICs, and 40 emerging market economies, EMs), over the 1960-2010 period. We found a total of 70 credit booms, 35 in ICs and 35 in EMs, including 16 credit booms that peaked in the critical period surrounding the recent financial crisis between 2007 and 2010 (again with about half of these recent booms in ICs and EMs each)…

"The results show that credit booms are associated with periods of economic expansion, rising equity and housing prices, real appreciation and widening external deficits in the upswing of the booms, followed by the opposite dynamics in the downswing."

That certainly sounds familiar, and supports the "we should have known" meme. But the full facts are a little trickier. Mendoza and Terrones continue:

"A major deviation in the evidence reported here relative to our previous findings in Mendoza and Terrones (2008) is that adding the data from the recent credit booms and crisis we find that in fact credit booms in ICs and EMs are more similar than different. In contrast, in our earlier work we found differences in the magnitudes of credit booms, the size of the macroeconomic fluctuations associated with credit booms, and the likelihood that they are followed by banking or currency crises.

"… while not all credit booms end in crisis, the peaks of credit booms are often followed by banking crises, currency crises of Sudden Stops, and the frequency with which this happens is about the same for EMs and ICs (20 to 25 percent for banking and currency for banking crisis, 14 percent for Sudden Stops)."

Their notion still supports the case of the "we should have known" camp, but here's the rub (emphasis mine):

"This is a critical change from our previous findings, because lacking substantial evidence from all the recent booms and crises, we had found only 9 percent frequency of banking crises after credit booms for EMs and zero for ICs, and 14 percent frequency of currency crises after credit booms for EMs v. 31 percent for ICs."

In other words, based on this particular evidence, we should have been looking for a run on the dollar, not a banking crisis. What we got, of course, was pretty much the opposite.

No excuses here. Speaking only for myself, I had the story wrong. But the conclusion to that story is a lot clearer now than it was in the middle of the tale.

David AltigBy Dave Altig, senior vice president and research director at the Atlanta Fed

 

December 16, 2011 in Business Cycles, Financial System, Forecasts | Permalink

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When your currency is the global reserve currency, there is nothing
available in sufficient size to run TO. Therefore, a run ON the dollar
was an impossibility. The ONLY other possibility was the only one remaining, a run on the Banking System.

Posted by: Robert K | December 18, 2011 at 01:13 PM

Indeed, you can't predict economic events. No kidding.

However, that fact means you must also give up attempts to control the economy.

If you cannot predict any future, how do you navigate to one particular desired future?

There is no actual evidence over 50-year periods that any country has successfully done so. Economists have destroyed a lot of countries in their attempts, however.

Abolish the Fed.

Posted by: Lew Glendenning | December 18, 2011 at 08:51 PM

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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."

Or, as explained by The Wall Street Journal:

"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.

David AltigBy Dave Altig, senior vice president and research director at the Atlanta Fed

 

December 2, 2011 in Banking, Federal Reserve and Monetary Policy, Financial System, Monetary Policy | Permalink

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Laziness is no excuse for ignorance, but sometimes information isn't easy to find. Although, the press will report what sells, others lack the...ability and know-how to find the information they are looking for sometimes.

A question the tech & internet industry pose for the future is;

"how can information we are looking for find us?"

A good starting point for answering this is, how do we find information?

Posted by: Jake Lopata | December 02, 2011 at 02:48 PM

Stock markets' reaction to a 50 bps cut in swap rates is no measure of the success of the policy, but a reaction to the optics of central bank coordination. As to the Fed's extraordinary support to banks and the subsequent secrecy, that is troubling. You may say the Depression was avoided, but if it worked, why are we back in the soup with the same sort of action required?

Posted by: demandside | December 03, 2011 at 09:31 AM

"...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."

Dave Altig,
senior vice president and research director
at the Atlanta Fed
.
.
Could the second statement make you appear a bit foolish?
.
.
"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 Bloomberg article includes commentary
broadly supporting Fed actions,
even if not all details of the implementation."

Dave Altig,
senior vice president and research director
at the Atlanta Fed
.
.
Were there crimes committed Dave?
.
.
"...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? "

Dave Altig,
senior vice president and research director
at the Atlanta Fed
.
.
No.


Posted by: Abner Doon | December 03, 2011 at 05:51 PM

First and foremost the Federal Reserve continually using equity reactions to gauge policy appeal is getting absurd. The stock market voting mechanism is becoming more polluted and distorted by the day. As a result, signal is beginning to look a lot more like noise and its relative usefulness as signal is diminishing.

Swap lines to the ECB are only as good as the ECB as an institution exists. While Europe as a continent has been around for the ages, ECB as an institution has not. To lend dollars cheaper to an institution that is failing to keep its own house in order strikes me as dangerous in itself, let alone lending these dollars at lower rates than they are available to our own banks.

Which brings me to my final point. The problems now are not about liquidity, they are about credit. The institutions that have kept their leverage at 50:1, never marked down their books and never took the opportunity to raise capital during good times should be punished. The fed has kept the 'too big to fail' problem alive and now it is exporting this policy as well.

Posted by: brian | December 13, 2011 at 07:38 AM

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May 27, 2011


"Secret loans" that were not so secret

I confess to be more than a little surprised when yesterday's morning reading turned up the following headline, from Bloomberg's Bob Ivry:

"Fed Gave Banks Crisis Gains on Secretive Loans Low as 0.01%"

The crux of the story found its way to the Wall Street Journal's Real Times Economics blog:

"Credit Suisse Group AG, Goldman Sachs Group Inc. and Royal Bank of Scotland Group Plc each borrowed at least $30 billion in 2008 from a Federal Reserve emergency lending program whose details weren't revealed to shareholders, members of Congress or the public. The $80 billion initiative, called single-tranche open-market operations, or ST OMO, made 28-day loans from March through December 2008, a period in which confidence in global credit markets collapsed after the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc. Units of 20 banks were required to bid at auctions for the cash. They paid interest rates as low as 0.01 percent that December, when the Fed's main lending facility charged 0.5 percent."

I think a couple of clarifying points are in order. First, these transactions were hardly, in my view, "secretive." On March 7, 2008, the following was posted on the New York Fed's website (with similar information provided by the Board of Governors):

"The Federal Reserve has announced that the Open Market Trading Desk will conduct a series of term repurchase (RP) transactions that are expected to cumulate to $100 billion outstanding. This initiative is intended to address heightened pressures in term funding markets. These transactions will be conducted as 28-day term RP agreements in which primary dealers may elect to deliver as collateral any of the types of securities—Treasury, agency debt, or agency mortgage-backed securities—that are eligible as collateral in its conventional RP operations."

The magic words in the Bloomberg piece are apparently "details weren't revealed." While it is true that specific transactions with specific institutions were not published in real time, the overall results of the auctions (both total purchases and the lowest interest rate paid) were posted each day (as noted in the Bloomberg article), and the list of potential counterparties (the primary dealers) was (and is) available for all to see. I suppose we could have a reasonable debate about how much information is required to support the claim that "details" were made available. But I have a hard time with the notion that publicly announcing the program, offering details on size and prices in each day's transactions, and providing general information about the entities in the game constitutes "secretive."

Another aspect of the Bloomberg piece that I question is the claim that the transactions were "loans" provided under an "emergency lending program." That language is quite imprecise and evokes the thought of the lending programs that relied on the authority granted under "unusual and exigent circumstances" by section 13(3) of the Federal Reserve Act.

The Bloomberg article does not help in avoiding possible confusion on this point by including this passage:

"Congress overlooked ST OMO when lawmakers required the central bank to publish its emergency lending data last year under the Dodd-Frank law."

But as the New York Fed's public notice made clear at the time, this was not outside of the Fed's standard authorities—and not unprecedented (emphasis added):

"When the Desk arranges its conventional RPs, it accepts propositions from dealers in three collateral 'tranches.' In the first tranche, dealers may pledge only Treasury securities. In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities. In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities. With the special 'single-tranche' RPs announced today, dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities. The Desk has arranged single-tranche transactions from time to time in the past."

Finally, identifying the one auction where the Fed "paid interest rates as low as 0.01 percent" is misleading. To begin with, the 0.01 percent refers to the so called "stop-out" rate, which is the lowest rate paid by bidders in any particular auction. The operations in question were multi-price auctions, so the lowest rate cannot be assumed to be the average rate paid on the repo transactions. In any event, the program was terminated after two auctions when the stop-out rate hit the very low levels the Bloomberg article referred to.

More generally, the auction rates in these ST OMOs tracked short-term funding rates over the course of the program's existence:


The interest rates associated with all operations obviously fell as the provision of market liquidity became more aggressive after the failure of Lehman Brothers. You are free to object to that response, but singling out ST OMO as secretive or special in anyway isn't, in my opinion, justified.

Update: Felix Salmon weighs in.


Photo of Dave AltigBy Dave Altig
senior vice president and research director at the Atlanta Fed



May 27, 2011 in Federal Reserve and Monetary Policy, Financial System, Monetary Policy | Permalink

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David, firstly and above all, great blog. However, I am with Bloomberg on this one. The fact is that the transactions were so commercially sensitive that the details were necessarily obfuscated. Announcing the creation of the ST OMO, its expected cumulative total and auction rates is one thing.. Stating that a single dealer had borrowed in excess of $30bn in a single transaction, or that more than one dealer had done so at the same time, even without any names being publicised, would have been just too sensitive; thus the statements were framed to allow people to underestimate the size and concentration of the program. By definition this is acting in a secretive manner.

Posted by: Timothy Murphy | May 27, 2011 at 06:14 PM

I believe the larger point of the issue was that it was largely only European banks that used this facility extensively. The implication being that it was a backdoor bailout to the big European banks.

Posted by: mindrayge | May 28, 2011 at 03:20 AM

" To begin with, the 0.01 percent refers to the so called "stop-out" rate, which is the lowest rate paid by bidders in any particular auction. The operations in question were multi-price auctions, so the lowest rate cannot be assumed to be the average rate paid on the repo transactions."
Indeed, the weighted average was 0.104

Posted by: Alea | May 28, 2011 at 02:19 PM

Keep in mind the most publicized acronym of that time was TARP. I've done a fair amount of reading in my quest to discover how the American financial sector went on life support, and this is the first I've read anything around the ST OMO loans.

From the Bloomberg article: "The records don’t provide exact loan amounts for each bank. Smith, the New York Fed spokesman, would not disclose those details. Amounts cited in this article are estimates based on the graphs."

Sounds a bit secretive to me. If it's open record, why not divulge the amounts each bank got? What's the issue with that? It's actually quite important to know how much our most successful banks were borrowing at very low interest rates from the Fed during that dim and dark time. Or is Bloomberg just way off with that assertion?

From Dave Altig's response: "Another aspect of the Bloomberg piece that I question is the claim that the transactions were "loans" provided under an "emergency lending program." That language is quite imprecise..."

Are ST OMO loans regular occurrences? Or were they done to help banks survive an extraordinary time? If they're not regularly offered, it sounds like they were created to help banks in the months leading up to the crash - and that they were indeed a part of a massive Fed intervention to help banks stay afloat.

Frankly, since the crash, there are many Americans outside of bankers who could have used very low interest loans and the other extraordinary interventions offered by the Fed. But most Americans have to get their loans from the banks rescued by the Feds, and those banks charge their customers quite a lot more than .01%.

Posted by: Main Street Muse | May 29, 2011 at 09:32 PM

I agree and I have posted a similar objection on my blog - http://www.insidejob.com/profiles/blogs/is-st-omo-the-same-as :
The only legitimate objection to the Single-tranche RP program is that it was left out of the Dodd-Frank disclosure at the Fed's website. With so much anti-Fed feeling, its is important for the Fed to announce that it will treat Single-tranche RP just like the other Fed programs explicitly named in Dodd-Frank and post the data as quickly as possible.

Posted by: Michael Hirasuna | May 30, 2011 at 10:44 AM

Loans now become a need of not only business persons but also others too. Who wants to get loans on very low interests so they can easily fulfill their basic needs.

Posted by: business cas advance | June 01, 2011 at 07:19 AM

This is exactly how the dollar is losing its monetary value. The feds keep pumping cash into our economy with no backing. They keep flooding these useless paper dollars into our economy with no gold, and they don't expect inflation to occur???

This will keep happening until we hit a state of hyperinflation and then we will be so screwed when our salaries are the same, yet a loaf of bread will cost over $100!

Posted by: cash advance | June 11, 2012 at 12:37 PM

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April 13, 2011


How has the financial system changed? (And what to do about it)

The subject of this post's title was, in essence, the centerpiece of the most recent edition of the Atlanta Fed's annual Financial Markets Conference, convened this year in Stone Mountain, Ga. (just outside Atlanta). In terms of formal papers, the conference was bookended by work that came to very similar conclusions but from very different angles. From the vantage point of recent developments in micro banking structure, Arnoud Boot offered this diagnosis:

"A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability."

Taking the very long view, Moritz Schularick presented (from a paper co-authored with Alan Taylor) pretty compelling evidence that the ongoing shift from relationship banking to transactions-based banking has fundamentally altered the nature of financial developments on real activity in modern economies:

"We first document and discuss our newly assembled dataset on money and credit, aligned with various macroeconomic indicators, covering 14 developed countries and the years from 1870 to 2008. This new dataset allows us to establish a number of important stylized facts about what we shall refer to as the 'two eras of finance capitalism.' The first financial era runs from 1870 to 1939. In this era, money and credit were volatile but over the long run they maintained a roughly stable relationship to each other, and to the size of the economy measured by GDP. The only exception to this rule was the Great Depression period: in the 1930s money and credit aggregates collapsed. In this first era, the one studied by Friedman and Schwartz, the 'money view' of the world looks entirely plausible. However, the second financial era, starting in 1945, looks very different. With the banking sector progressively more leveraged in the second financial era, particularly towards the end, the divergence between credit supply and money supply offers prima facie support for the credit view as against a pure money view; we have entered an age of unprecedented financial risk and leverage, a new global stylized fact that is not fully appreciated."

If there was agreement on increasing threats to financial stability, what to do about it (unsurprisingly) was somewhat more controversial. On the microprudential front, several conference participants—Viral Acharya, for example—looked to greater capital buffers as a key to greater financial stability. Others—George Kaufman commenting on Boot's paper, for instance—were more inclined to rely on market solutions. Boot, for his part, was highly skeptical of the self-correcting market forces and, while sympathetic to greater reliance on bank capital, believes much more is required:

"What we have also argued is that market discipline might be rather ineffective. We described this as a paradox. When particular strategies have momentum in financial markets, the market as a whole may underestimate the risks that these entail. How then can we expect market discipline to work? It appears to us that market discipline might not be present when banks follow financial market inspired strategies. Things are even worse because these strategies will lead to a high correlation in actual exposures between financial institutions because all see the same opportunities and hence herding occurs. Systemic risk would then be considerable and not checked by market discipline."

Earlier in the paper, Boot puts forward:

"We believe that heavy handed intervention in the structure of the banking industry—building on the Volcker Rule—might ultimately be an inevitable part of the restructuring of the industry. It could address complexity but also help in containing market forces that might run orthogonal to what prudential concerns would dictate (as the insights on market discipline in section 6 suggest). For now, the structural interventions in the banking industry are rather tentative. Other measures such as higher capital and liquidity requirements are clearly needed. But these primarily focus on individual institutions while a more system-orientation is crucial to identify externalities and interlinkages (Goodhart, 2009; and Calomiris, 2009). Anti-cyclical capital surcharges and other measures and surcharges depending on the degree of interconnectedness are needed as well to add some further comfort. We tend to subscribe to John Kay's (2009) notion of redundancy: having comfort in the stability of the financial sector dictates building redundancy into the regulatory and supervisory structures of banking."

With respect to "system-oriented" signals, Schularick was clear where he and his co-author think their research leads:

"These new results from long-run data, if they pass scrutiny, inform the current controversy over macroeconomic policy practices in developed countries. Specifically, the pre-2008 consensus argued that monetary policy should follow a 'rule' based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst."

Credit and bank capital—along with sound fiscal policy and a little good luck—do appear to have been key to how well different economies fared during the recent financial crisis. At least that is the conclusion reached in a study by Stephen Cecchetti and his co-authors from the Bank of International Settlements:

"The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part."

As we seek to shore up our financial timber to avoid a repeat of recent history, it is appropriate to remember that, while it is good to be lucky, fortune is probably not arbitrary in choosing where it will shine.


Photo of Dave Altig By Dave Altig
senior vice president and research director at the Atlanta Fed



April 13, 2011 in Financial System, Money Markets | Permalink

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Banking is one of many oligopolies that are government ignores.

"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices." (Adam Smith, The Wealth of Nations, 1776).

What does the American auto industry, the health care industry, wall street firms and the banking industry all have in common; other than they were all on the brink of failure?

These are industries where the production side of the industry is no longer a free market with many producers competing head-to head to earn the business of consumers, or customers, of the industry. Instead each of these industries are controlled by a relatively small number of very large corporations that have transformed these markets into oligopolies.

Adam Smith when he discussed “rational self interest” and competitive markets in his book Wealth of Nations, envisioned many consumers buying goods and services from many producers with everyone looking out for their self-interest. By keeping markets “free”, producers pursue their rational self-interest and this best meets the needs of the consumers and the citizens of our country, who are also looking out for their self-interest. Under this system, what is in the producers self interest is to provide the best product possible to the consumer, while striving to be a low cost producer for their niche.

This consolidation of markets began in the late 1960's early 1970's in the auto industry when it was transformed from a free market to an industry that was controlled by three giant corporations and one union. As this transformation was occurring the auto company's and auto union's self-interest became separated from what the consumer wanted and/or needed. Competition between the companies broke down and this gave an opening for foreign competition to enter our markets and the beginning of the end of the American auto industry as we knew it.

Other industries saw what was happening in the auto industry and saw that government was not objecting so naturally they followed the same path with little concern on any ones part that we were losing our free market system to a more centralized market system of oligopolies. As a result we now have major markets where the producing entities self-interest is not always in line with the self-interest of the consumer. What is in the self-interest of the entities in these industries is to keep the oligopoly alive. Thus the creation of special interests and lobbyists.

These oligopolies have bought the protection of our representatives in Washington and state capitals. I am always baffled by the fact that corporations and unions cannot vote in this country, however they are allowed to buy votes with their contributions.

We lost track of a key ingredient that Adam Smith identified as necessary in order for “rational self interest” to work. There must be many producers. In too many industries, the number of producers has shrunk and the ones remaining have gotten “too big to fail”. This is true in the auto industry, the banking industry, wall street, health care and will soon be true in the computer software industry.

When discussing the health insurance industry proponents for this specific oligopoly site the fact that the bigger the insured pool, the lower insurance premiums can be. However, I submit that this "bigger pool savings" is more than offset by the fact that the rational self-interest of the companies is not totally aligned with the rational self interest of the insured. The insurance industries self-interest is to keep the oligopoly alive. The self-interest of the insured is to have as many insurance companies as possible clawing to get his business and thus ringing out all excessive cost, including unconscionable salaries for top executives, to earn the consumers business.

The liberals are right that regulation is required and conservatives are right that a free market is the best way to meet the needs and wants of our citizens. The common ground is that regulation is essential to make our markets more free. We have too many industries where companies have too much power, their self interest is not aligned with the citizens of this country and they are too big to fail.

It is time that our politicians breakaway from the shackles of oligopolies, special interests groups and lobbyists. Use antitrust legislation to bring back free markets.http://freeourfreemarkets.org

Posted by: sbanicki | April 13, 2011 at 04:31 PM

A very good post, thank you.

Transactions-oriented banking would seem to require a transactions-oriented regulatory tool-kit modeled after what is done in best-of-breed trading houses today: transactions that increase corporate risk get capital charges, and transactions that decrease it get capital credits. Note that this policy is applied to *transactions*. The balance-sheet provides the direction and intensity of the charges, but the charge is applied to the transaction.

While the details are certainly profoundly complicated, it does seem that transactions-oriented capital regulation has the potential to remediate liquidity problems. The expectations of late-entrants into a crowding market will be dampened by the higher capital charges. Momentum-trading will be less profitable. Counter-cyclic trade charges are a correction to the distribution of expectations of return that are proportional to market depth. It will decrease liquidity demand at precisely the time when liquidity is drying up.

If successful this policy allocates the costs of liquidity risk to the late-comers who actually cause the problem, and it protects the capital of the early-adopters who are the innovators in the market.

The downside is that this will tend to slow price competition in financial services. But in an industry that experiences 35% annual decline in profit margins, that might actually be a good thing. Extreme volatility in the profitability of financial services has the potential of rather spectacularly bad outcomes, as we have seen.

Posted by: Alan King | April 17, 2011 at 10:40 AM

Moritz Schularick's comments on "the divergence between credit supply and money supply" are interesting.

But the "divergence" is only the result of an error in measuring money supply, and this in turn is the result of viewing money not as the sum of credit plus currency but as cash balances. The error of viewing money as cash balances is an error common to the Austrians, the monetarists and the Keynesians. So far as I know only one economist has not agreed with this view: Joseph Schumpeter. And unfortunately, Schumpeter did not do any serious work on money.

In an era when currency is only about 50% of M1, a completely new model of money is required, one that views money as credit plus currency, not cash balances.

I have developed a complete model of money as credit but understanding it calls for unlearning a lifetime's thinking of money as cash balances.

In any case the end result, a graph showing what I call Corrected Money Supply from 2001 to 2011 can be viewed at http://www.philipji.com/Mc2001-2011.gif

If the fact that it accurately tracks the rise of money supply until the beginning of 2006 when housing starts ceased to grow, the contraction of money during the recession and its rise to dangerous levels in recent months is interesting, the logic behind the article can be seen at http://www.philipji.com/riddle-of-money/

In the absence of an accurate monetary aggregate any attempt to identify and prevent bubbles is impossible.

Posted by: Philip George | April 17, 2011 at 11:34 AM

I really like this concept. I just want to know as it consists of how many templates. Better-performing economies featured a better-capitalized banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part. Thanks for sharing this great post.

Posted by: home business | April 18, 2011 at 05:09 AM

Great article, short and precise. What bothers me although is the fact that the jury is impressed by a presentation like this. This just proves that the application of law often does not have anything to do with justice, but more so with who's better at presenting. While the details are certainly profoundly complicated, it does seem that transactions-oriented capital regulation has the potential to remediate liquidity problems. The expectations of late-entrants into a crowding market will be dampened by the higher capital charges. Momentum-trading will be less profitable. Counter-cyclic trade charges are a correction to the distribution of expectations of return that are proportional to market depth. It will decrease liquidity demand at precisely the time when liquidity is drying up. What bothers me although is the fact that the jury is impressed by a presentation like this. This just proves that the application of law often does not have anything to do with justice, but more so with "who's better at presenting".

Posted by: Business Plan | April 19, 2011 at 07:45 AM

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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.

I offered my views last month at the Third Transatlantic Economic Dialogue, hosted by Johns Hopkins University's Center for Transatlantic Relations.

"…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

May 13, 2010 in Banking, Financial System, Regulation | Permalink

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My thoughts on this are posted at my blog, www.pointsandfugures.com. To summarize them, we need a drastic change in the structure of the cash equity marketplace. We need to look at the role of each marketplace in the economy, and eliminate some traditional practices.

As far as OTC, we certainly should clear many of them. But there is not any way to safely clear all of them. Let the market decide.

Posted by: Jeff | May 15, 2010 at 06:33 PM

Does anyone at the Fed or within the banking system have a thought on the system as a whole?

We've been "at" capitalism now for a few hundred years. Seems odd that now, in 2010, we need some regulation that some previous authoritative body overlooked.

I'm hinting that the problem is not legal, it's physical. Our current manifestation of economy may in-itself be dying.

3 major crashes in one decade, and we almost went down again last week. What is "law" really going to do?

Posted by: FormerSSResident | May 15, 2010 at 07:04 PM

I genuinely do not understand why this is such a problem. The share price of any institution that fails ought to be zero, in which case, the institution can be taken into the temporary ownership of the government for, say, one cent per share. The government are then free, as the new owners, to dispose of the business as they see fit, either through an orderly liquidation or recapitalisation and sale. In that way, any systemic shock can be avoided. Except for petty political prejudice against nationalisation, which it ought to be possible to set aside in an emergency, what is the problem with that solution?

Posted by: RebelEconomist | May 16, 2010 at 02:57 PM

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May 11, 2010


Return of the swap lines

As the European Union jumped into crisis resolution mode with both feet and the European Central Bank (ECB) responded to the "exceptional circumstances" with measures to address severe tensions in financial markets, the Federal Reserve has made its own contribution to global economic stability by announcing the reestablishment of temporary U.S. dollar swap facilities with the ECB, Bank of Canada, Bank of England, Swiss National Bank, and (later) the Bank of Japan.

Swap lines are not new tools for central banks. In fact, we covered the basics of swap arrangements in September 2008, explaining the rationale at that time for the facilities thus:

"An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

"However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

"The currency swap lines were designed to inject liquidity, which can help bring rates down."

Yesterday's online edition of The Wall Street Journal's Real Time Economics blog makes note of a more recent, and very nice, primer from the Federal Reserve Bank of New York, co-authored by Michael Fleming and Nicholas Klagge. The Fleming-Klagge article describes a Libor-based measure of stress that was particularly acute in nondollar countries during the worst of the crisis that began in 2007.

"Because foreign banks secure much of their dollar funding through interbank loans, they can expect to face greater funding pressures during times of market stress. One way to measure such pressures involves examining the individual borrowing rates of the sixteen banks that make up the Libor survey 'panel.' The difference between the average borrowing rate of the panel's thirteen non-U.S. banks and the average borrowing rate of its three U.S. banks provides a rough proxy for the increased difficulty foreign banks face in trying to borrow dollars."

Did the currency swaps help bring this spread down? Here's a little informal evidence:

051110
enlarge

That's not proof, but it is not too hard to see why the New York Fed article would conclude with this answer to the WSJ's answer to the question "Did it Work?":

"Early evidence suggests that the swap lines were successful in smoothing disruptions in overseas dollar funding markets. Swap line announcements and operations were associated with improved conditions in these markets: Although measures of dollar funding pressures remained high throughout the crisis period, they tended to moderate following large increases in dollars lent under the swap line program. Moreover, the sharp decline in swap line usage as the crisis ebbed suggests that the pricing of funds offered through swap lines gave institutions an incentive to return to private sources of funding as market conditions improved."

You can find more information about the Federal Reserve's previous swap facilities here.

By Dave Altig, senior vice president and research director at the Atlanta Fed

May 11, 2010 in Federal Reserve and Monetary Policy, Financial System | Permalink

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Nice piece. The swap lines will also tend to limit dollar appreciation, which may not help the economies in the euro area.

Posted by: don | May 13, 2010 at 01:45 PM

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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.

042910a
(enlarge)

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:

  042910c

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:

042910b
enlarge

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

April 29, 2010 in Banking, Capital Markets, Financial System, Saving, Capital, and Investment | Permalink

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Very nice.

One can get a slightly broader data set by using FDIC statistics on all insured institutions (http://www2.fdic.gov/SDI/SOB/). It doesn't seem the results are substantially different: For end 2009 vs end 2008, an unadjusted drop of $29bn, vs an adjusted rise of $34bn.

Paul Kasriel recently did the same analysis for bank lending overall (full disclaimer - he mentions my website). http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/1004/document/ec042910.pdf

Posted by: Jim Fickett | May 01, 2010 at 07:31 PM

you could have boiled off a lot of filler here and had quite a nice compact post
regardless well worth reading thanx

Posted by: paine | May 02, 2010 at 01:56 PM

A question: when there are charge-offs, do they include the late-payment penalties and other fees or only original principal?

Posted by: Daniil | May 03, 2010 at 10:21 AM

Two other general observations: First, although clearly implied by the post above, some readers commenting around the net have not noticed that we DON'T KNOW what the net growth in new consumer loans is, overall. Since charge-off data are available only for FDIC-insured institutions, we can't make the second graph above for the other categories of lending.

Second, and related, Felix Salmon did a post in March, linked to above, in which he concluded that consumers were not paying their cards down; in fact they were borrowing more. But the data he used, from CardHub, was mistaken -- it did not make the distinctions made in the post above, and applied the Fed charge-off rate, which is only for commercial banks, to the full revolving debt balance, from all sources. Many people are still under the impression of what Salmon wrote, but in fact we do not know whether it is true.

@Daniil: charge-offs are only principal. The accounting, in which the principal balance of loans outstanding is reduced by charge-offs, would not make sense otherwise.

Posted by: Jim FIckett | May 03, 2010 at 11:43 PM

@Jim My question is not about that. It's the following. There's a balance of $1000. I miss 3 payments and the bank assesses $200 worth of late charges and resets the interest rate after first missed payment so that after 3 months (let's say that's when the bank charges off the loan) my loan to the bank is $1300. So my total debt goes up. I don't know what's on banks books as a result of this. Do they discharge the 1000? 1300?
And even if 1300, then the total 'borrowing' might still be going up not because people are borrowing, but because they are falling behind.

Posted by: Daniil | May 05, 2010 at 04:54 PM

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