Russian Sanctions: Questions and Answers

This post is authored jointly with our friend and colleague, Professor Richard Berner, Co-Director of the NYU Stern Volatility and Risk Institute.

Russia’s invasion of Ukraine is altering global security and economic relationships. In this post, we focus on the financial and trade sanctions imposed on Russia. These sanctions are the most powerful and costly punishments imposed on a major economy at least since the Cold War. Their speed, breadth and coordinated global support appear unprecedented.

Not surprisingly, the impact is immediately visible. The damage to the Russian economy and financial system includes, but is not limited to, a plunge of the ruble (by about 40 percent versus the dollar over the past month amid heightened volatility); runs on domestic banks; a sharp hike in the central bank’s policy rate; imposition of capital controls; shutdown of the Russian stock market; collapse in the value of Russian companies traded on foreign stock exchanges; removal of Russian equities from global indexes; and the collapse of Russia’s sovereign credit rating to junk status.

The purpose of this post is to pose and provisionally answer a series of questions raised by this new sanctions regime.…

Thoughts on Deposit Insurance

Government guarantees have become the norm in the financial system. According to the latest Federal Reserve Bank of Richmond (2017) estimate, the U.S. government’s safety net covers 60% of private financial liabilities in the United States. Serious underpricing of government guarantees gives intermediaries the incentive to take risk that can threaten the entire financial system: the Great Financial Crisis of 2007-09 is the most obvious case in point.

Deposit insurance is arguably the oldest and most widespread form of government guarantee in finance. In the United States, Congress established the Federal Deposit Insurance Corporation (FDIC) at the depth of the Great Depression in 1933 to help prevent bank runs. Today, more than 140 countries have some type of deposit insurance scheme.

In this post, we briefly review the evolution of FDIC deposit insurance pricing. We highlight evidence that, largely because of Congressional mandates, the federal insurance guarantee was underpriced for many years. It is not until 2011, following the crisis of 2007-09, that the FDIC introduced the current framework for risk-based deposit insurance fees, bringing insurance premia closer to what observers would deem to be actuarially fair.

Going forward, as with any insurance regime, keeping up with the evolution of bank (and broader financial system) risks will require a willingness to update the deposit insurance pricing framework from time to time. That means adjusting pricing to reflect both the range of bank risk-taking at a point in time and—to ensure the sustainability of the deposit insurance fund without taxpayer subsidies—the evolution of aggregate risk….

Contagion: Bank Runs and COVID-19

There are currently more than 85,000 confirmed cases of COVID-19 in at least 60 countries. Yet, we know very little about this pathogen, except that everyone is worried. And, with the number of cases rising each day, intensifying concerns probably will lead many people to behave in ways that undermine economic activity. They will shy away from places where the virus can be transmitted. That means avoiding mass transit, schools, and workplaces.

Moreover, many people will stay away until they are confident that the disease is manageable. That confidence probably requires an effective treatment, a very low likelihood of infection, or both. Not surprisingly, many observers are reducing their projections for economic growth this year, while financial market participants anticipate easier monetary policy to cushion the shock.

The challenge of re-establishing public confidence that it is safe to venture out bears striking similarity to the one that authorities face in stemming a bank run. Our ability to identify and quarantine people infected with COVID-19 is analogous to our ability to recognize and isolate a bank bordering on insolvency. This and other similarities suggest that the means we use to control bank runs also may be useful in managing the economic consequences of an emerging pandemic like COVID-19….

Pitfalls of a Reserves-only Narrow Bank

Since retiring from the Federal Reserve in mid-2016, our friend Jamie McAndrews has been very busy. Unlike most of us, he is putting his ideas into action: in 2015, he and a number of his colleagues, proposed the creation of segregated balance accounts (SBAs). As they write, “SBAs are accounts that a bank or depository institution (DI) could establish at its Federal Reserve Bank using funds borrowed from a lender.” Their proposal is that a bank would offer a special account that it is fully collateralized by a deposit at the Federal Reserve. Furthermore, the SBA deposits would be remunerated at the interest rate the Fed pays on excess reserves (the IOER), minus a small fee for the bank.

We have no expertise whatsoever in determining whether the Fed has legal grounds for denying TNB a Master Account—the subject of the court case in the opening quote. But we do have concerns about SBAs and narrow banks: we worry that they would shrink the supply of credit to the private sector and aggravate financial instability during periods of banking stress. Compared to what may be large costs, we suspect that the benefits would be small….

Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

The Future of the Euro

In 2012, the ECB faced down a mortal threat to the euro: fears of redenomination (the re-introduction of domestic currencies) were feeding a run away from banks in the geographic periphery of the euro area and into German banks. Since President Mario Draghi spoke in London that July, the ECB has done things that once seemed unimaginable, helping to support the euro and secure price stability.

So far, it has been enough. But can the ECB really do “whatever it takes”? Ultimately, monetary stability requires political support. Without fiscal cooperation, no central bank can maintain the value of its currency. In a monetary union, stability also requires a modicum of cooperation among governments.

Recent developments in France have revived concerns about redenomination risk and the future of the euro....

Making Banking Safe

Professor Mervyn King, our friend, NYU Stern colleague and the former Governor of the Bank of England, has written a wonderfully insightful and thought-provoking new book, The End of Alchemy. His goal is not just to explain the sources of the 2007-09 crisis, but to provide a template for financial reform that would reduce the frequency and severity of future crises. In the end, Professor King proposes a radical structural change intended to make banking safe while preserving the intermediation function that is critical to modern economies.

The alchemy to which Professor King refers in his book’s title is banks’ traditional function of transforming high-risk, illiquid and long-maturity assets into low-risk, liquid and short-term liabilities. But, in the presence of limited liability for the banks’ owners and the government safety net (in the form of deposit insurance and the lender of last resort that remove both solvency and liquidity risk for the depositors), banks’ incentive is to transform too much. Holding assets that are overly risky, insufficiently liquid and too long-term makes banks fragile and run-prone, providing fodder for systemic crises....

The dollar is now everyone's problem

The global financial crisis started in 2007 when European banks came under increasing strain. If forced to specify the crisis kickoff, we would pick Thursday, August 9, the day that BNP Paribas halted redemptions from three investment funds because it couldn’t value their holdings of U.S. mortgages. Responding to the ensuing market scramble for liquidity, the ECB injected €95 billion that day into the European banking system and the Federal Reserve put $24 billion in theirs. Today, with the benefit of hindsight, these numbers appear quaint, but then they seemed enormous...

Regulating Money Market Mutual Funds: An Update

The SEC has finally acted. On July 23, the SEC issued 859 pages of new rules for the operation of some money market funds. (You can find a mercifully short description here.) To summarize our reaction: we are underwhelmed! It is hard to see how the new rules will reduce systemic risk in any meaningful way...

Update on Target2 Balances: Limited progress

Observers of the euro-area financial crisis typically focus on the yield spreads on peripheral government long-term bonds (compared to German yields) as the “fever thermometer” of the crisis. On that basis (see chart below), the crisis looks like it is over: after peaking in 2012, spreads rapidly receded following European Central Bank (ECB) President Mario Draghi’s promise to do “whatever it takes” to save the euro. Indeed, in Ireland, Italy, and Spain, yields themselves have now sunk to the lowest levels since the euro was created in 1999...

Commentary

Money, Banking, and Financial Markets