On AI and Financial Stability

Artificial intelligence (AI) progress over the past five years is triggering a broad new wave of interest. In sectors ranging from healthcare to transportation, many firms as well as governments hope that AI will cut costs, improve quality, broaden access, and create new goods, services and markets. Meanwhile, AI firms are rushing to create “artificial general intelligence” (AGI) that would surpass human cognition. From there, it seems like only a short step to fully autonomous robots.

In this post, we focus on the impact of AI on financial stability. To foreshadow our conclusions, current forms of AI are likely to amplify existing threats to financial stability. To prepare, public authorities need to adapt their tools (such as capital and liquidity requirements) to safeguard financial stability. Looking further forward, the prospect of autonomous “AI agents” – which can gather and assess information as well as make and implement decisions – means that the day could soon come when timely human intervention to protect the financial system will no longer be feasible. Instead, only agents acting at speed (and with information) at least comparable to those of private-sector AIs will be able to keep finance safe. To address these challenges regulators and supervisors need to invest heavily in AI—hardware, software and skilled personnel. Put simply, only public AI will be able to mitigate the risks that private AI creates.

Steve Cecchetti and Kim SchoenholtzNovember 15, 2024

A National Strategy for Bitcoin? Sell it all now!

A recent Wall Street Journal editorial highlighted the stiff competition for the “dumbest economic policy” proposed during the current U.S. Presidential campaign. High on the list are tariffs, food price controls, and opposition to the acquisition of U.S. Steel by a Japanese firm. We suggest adding to this list the recent proposals to establish a national stockpile, or even a strategic reserve, of Bitcoin. Rather than accumulating Bitcoin, we urge policymakers to quickly sell whatever they have or receive.

In the past, we argued that, rather than elaborating a regulatory framework that helps legitimize crypto, authorities should simply let it burn (see here and here). However, now that the SEC has granted U.S. asset managers the authority to offer spot Bitcoin exchange-traded products (ETPs) and the Europeans have a articulated a full set of rules (MiCA), it is no longer feasible for authorities to simply ignore crypto. Even so, the fact that we now need to regulate crypto is surely not a justification for the U.S. government to hoard Bitcoin.

Thoughts on the FOMC's Monetary Policy Strategy Review -- Part 4 of 4: Communication

When it comes to central bank communication, we have a simple guiding principle: the financial system and the real economy should respond to data, not to policymakers.

Monetary policymakers cannot reduce uncertainty associated with things like evolving technology, natural disasters, wars, changing preferences, fiscal surprises and the like. However, they can avoid adding to these fundamental sources of uncertainty by communicating clearly in advance how they will react to unexpected events. Put another way, central bankers can best achieve their inflation and economic objectives if policy is largely systematic and everyone understands their reaction function.

Ideally, this means that policymakers’ public statements will have an impact on financial markets and conditions only when they contain information about either the reaction function itself or about policymakers’ updated assessment of economic conditions. It also means that the reaction function should be stable most of the time, so that observers do not need to wait for a central bank to act to understand how monetary policy will respond to shocks.

Steve Cecchetti and Kim SchoenholtzSeptember 13, 2024

Thoughts on the FOMC's Monetary Policy Strategy Review -- Part 3 of 4: Policy Tools

To meet their objectives of low, stable inflation combined with high, stable employment, and a resilient financial system, monetary policymakers use various tools to influence financial conditions. In the first two parts of this series on the FOMC’s monetary policy strategy, we discussed the asymmetries of the current framework (see here), and the inflation target itself (see here). Now we turn to policy implementation, arguing that the FOMC should consider modifying its current toolkit as part of a new strategy.

Specifically, we ask whether the federal funds rate remains the appropriate target interest rate and how it is that policymakers should view asset purchases. We also address possible restrictions on balance sheet policy that the FOMC could consider. We will discuss forward guidance – the remaining policy tool – in the fourth part of this series that focuses on communication.

Steve Cecchetti and Kim SchoenholtzSeptember 9, 2024

Thoughts on the FOMC's Monetary Policy Strategy Review -- Part 2 of 4: Is 2 Percent Still the Solution?

Last week, in the first of a four-part series regarding the FOMC's upcoming Monetary Policy Strategy Review, we briefly characterized the Committee's 2020 policy strategy, and then focused on its asymmetry and inflation bias. In this second part of the series, we discuss the level of inflation that the FOMC should target.

For more than three years, inflation has exceeded the 2-percent level that policymakers have targeted – either de facto or de jure – for three decades. This recent experience of above-target inflation raises the question whether the FOMC should raise its inflation target to 3 percent or 4 percent or even higher. A number of economists – including Laurence Ball, Olivier Blanchard , and Jason Furman – answer yes. However, after considering the key benefits and costs of raising the inflation target, we argue that the Fed should continue to set its target at 2 percent.

Steve Cecchetti and Kim SchoenholtzSeptember 3, 2024 Comment

Thoughts on the FOMC's Monetary Policy Strategy Review: Part 1 of 4

Four years ago, at the conclusion of its first policy strategy review, the Federal Reserve’s Open Market Committee (FOMC) expressed the intention "to undertake roughly every five years a thorough public review of its monetary policy strategy, tools and communications practices." As Chair Powell highlighted recently, that review is set to begin in the next few months. With this prospect in mind, now is an excellent opportunity to highlight those elements of the current strategy that are most in need of attention.

In a series of four posts, we will address the following issues regarding the current strategy: (1) its asymmetry and inflation bias; (2) the inflation target; (3) the policy toolkit; and (4) communications and forward guidance. In this post, we briefly characterize the functioning of the 2020 strategy, and then turn to the first topic on our list: the asymmetry and bias in the current strategy.

Steve Cecchetti and Kim SchoenholtzAugust 26, 2024

Ten Precepts for 21st Century Regulators

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one in place 15 years ago. Yet, the events of March 2023 make clear that the progress thus far is simply not enough. To ensure resilience, we need to do more.

To steer the process of further reform, we propose a set of 10 precepts that those who make the rules should keep in mind as they refine the prudential framework. These practical guidelines lead us to conclusions that mirror those in a recent post: regulation should be more rule-based (less reliant on supervisory insight or discretion); simpler and more transparent; stricter and more rigorous; and more efficient in its use of resources. Concretely, this approach means increasing capital and liquidity requirements; shifting to mark-to-market accounting; and improving the transparency, flexibility and severity of capital and liquidity stress tests.

Steve Cecchetti and Kim SchoenholtzSeptember 18, 2023

Reforming the Federal Home Loan Bank System

We authored this post jointly with our friend and colleague, Lawrence J. White, Robert Kavesh Professor of Economics at the NYU Stern School of Business.

Some government financial institutions strengthen the system; others do not. In the United States, as the lender of last resort (LOLR), the Federal Reserve plays a critical role in stabilizing the financial system. Unfortunately, their LOLR job is made harder by the presence of the Federal Home Loan Bank (FHLB) system—a government-sponsored enterprise (GSE) that acts as a lender of next-to-last resort, keeping failing institutions alive and increasing the ultimate costs of their resolution.

We saw this dangerous pattern clearly over the past year when loans (“advances”) from Federal Home Loan Banks (FHLBs) helped postpone the inevitable regulatory reckoning for Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank (see Cecchetti, Schoenholtz and White, Chapter 9 in Acharya et. al. SVB and Beyond: The Banking Stress of 2023).

From a public policy perspective, FHLB advances have extremely undesirable properties. First, in addition to being overcollateralized, these loans are senior to other claims on the borrowing banks—including those of the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve: If the borrower defaults, the FHLB lender has a “super-lien.” Second, there is little timely disclosure about the identity of the borrowers or the amount that they borrow. Third, they are willing to provide speedy, low-cost funding to failing institutions—something we assume private lenders would not do.

In this post, we make specific proposals to scale back the FHLB System’s ability to serve as a lender to stressed banks….

Making Banking Safe

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one we had 15 years ago. Today, banks and some nonbanks face more rigorous capital and liquidity requirements. Improved collateral rules for market-making activities can dampen shocks. And, some institutions are subject to well-structured resolution regimes.

Yet, the events of March 2023 make clear that the system remains fragile. The progress thus far is simply not enough. What else needs to be done?

In a new essay, we address this critical question. Our assessment of the banking system turmoil of 2023 leads us to several obvious conclusions, some of which clearly escaped both bank managers and their supervisors. Perhaps the simplest and most significant is that banks can survive either risky assets or volatile funding, but not both. Another is that supervisors are willing to treat some banks as systemic in death, but not in life.

We also draw two compelling lessons from the recent supervisory and resolution debacles. First, a financial system which relies heavily on supervisory discretion is unlikely to prove resilient. Second, authorities with emergency powers to bail out intermediaries during a panic will always do so. That is, policymakers are incapable of making credible commitments to impose losses on depositors and others. In our view, the only way to address this commitment problem is to prevent crises….

NYU Stern White Paper -- SVB and Beyond: The Banking Stress of 2023

Starting in 2009, coalitions of willing NYU Stern faculty (and their colleagues) published four timely books examining financial instability and regulatory reform. The first—Restoring Financial Instability: How to Repair a Failed System—appeared during the financial crisis of 2007-09 at a time when the Federal Reserve was still working on the watershed stress tests which brought an end the emergency. Later books addressed the Dodd-Frank Act (2010), the failures of Fannie Mae and Freddie Mac (2011), and the CHOICE Act (2017).

SVB and Beyond: The Banking Stress of 2023, the next in this series, discusses the implications of the recent banking turmoil. Written by a set of Stern faculty (together with several non-NYU co-authors), the 10 essays in this volume analyze the financial and economic causes of the 2023 U.S. banking failures and propose specific remedies for the extraordinary supervisory and accounting failures that contributed to them. (One of us is a co-editor of the new White Paper; and both of us are contributing authors.)

We hope that you will take the time to read SVB and Beyond: The Banking Stress of 2023, which is available as an e-book here.

Steve Cecchetti and Kim SchoenholtzJuly 17, 2023

Commentary

Money, Banking, and Financial Markets