Money, Banking and Financial Markets

Commentary

Commentary

 
 
Posts tagged Crisis mitigation
The Fed Goes to War: Part 3

For the second time this century, the Federal Reserve is a crisis manager. In this role, policymakers can lend to solvent but illiquid intermediaries (as the lender of last resort). They can backstop financial markets (as a market maker of last resort). And, when all else fails, they can take the place of dysfunctional private-sector intermediaries.

During the first financial crisis of the 21st century, the Fed’s response shifted from one role to the next as the crisis intensified. Yet, even compared to that massive crisis response, the Fed’s recent moves are breathtaking—in speed, scale and scope.

Indeed, with its most recent announcements on April 9, the Federal Reserve is committed to an unprecedented course of action to ensure the flow of credit to virtually every part of the economy. In carrying out its obligations under the newly enacted CARES Act, the Fed is effectively transforming itself into a state bank that allocates credit to the nonfinancial sectors of the economy.

Yet, picking winners and losers is not a sustainable assignment for independent technocrats. It is a role for fiscal authorities, not central bankers. Instead of using the Fed as an off-balance sheet vehicle for the federal government, we hope that Congress will shift these CARES Act obligations from the Federal Reserve to the Treasury, where they belong….

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Steve Cecchetti and Kim SchoenholtzCARES Act, Coronavirus, COVID-19, Crisis management, Crisis mitigation, Federal Resere balance sheet, Lender of Last resort, Balance sheet, Market maker of last resort, Commercial Paper Funding Facility, CPFF, Primary Dealer Credit Facility, PDCF, Money Market Mutual Fund Liquidity Facility, MMLF, Primary Market Corporate Credit Facility, PMCCF, Secondary Market Corporate Credit Facility, SMCCF, Term Asset-Backed Securities Loan Facility, TALF, Municipal Liquidity Facility, MLF, Main Street New Loan Facility, MSNLF, Main Street Expanded Loan Facility, MSELF, Paycheck Protection Program Lending Facility, PPPLF
FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

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Steve Cecchetti and Kim SchoenholtzFinancial crisis, Crisis prevention, Crisis mitigation, Guarantee, Emergency Guarantee Authority, EGA, Liquidity risk, Maturity risk, Credit risk, Illiquidity, Insolvency, Bank run, Lender of last resort, LOLR, Financial market utility, FMU, Too big to fail, TBTF, De facto bank, Shadow bank, Temporary Liquidity Guarantee Program, TLGP, Moral hazard, Single point of entry, Cybersecurity, Cyberattack, Capital requirements, Liquidity requirements, Stress test, Leverage, Bail-in, Bailout
Why the central bank should be a leading supervisor

Should central banks be a leading supervisor, including supervising systemically important institutions? This is a question that members of the U.S. Congress periodically raise.  Our answer is unequivocally yes. As the lender of last resort, as the monetary policy authority, and as the organization responsible for overseeing the health and stability of the overall financial system—what we could call a systemic regulator—the central bank needs to be a leading supervisor....

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Steve Cecchetti and Kim SchoenholtzCentral bank, Federal Reserve, Prudential supervision, Monetary policy, Central bank independence, Lender of last resort, Central bank lending, Financial stability, Systemic regulator, Bank of New York, September 11, OFHEO, OCC, Office of Thrift Supervision, Paul Volcker, Crisis mitigation, Stress test, Collateral, Solvency
Dodd-Frank: Five Years After

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.

How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.

Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five:

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Steve Cecchetti and Kim SchoenholtzDodd-Frank, Financial regulation, SIFI, Capital requirements, Financial market utility, Single point of entry, CCP, Derivatives netting, Crisis prevention, Crisis mitigation, GSE, MMMFs, Repo, SEC, Regulatory arbitrage, Shadow banks, FSOC, CFPB, FIO, Volcker Rule, Living will, Credit ratings