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….

The Extraordinary Failures Exposed by Silicon Valley Bank's Collapse

The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”

Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.

In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:

First, to regain credibility, supervisors need to do an immediate review of the unrealized losses on the balance sheets of all 45 banks with assets in excess of $50 billion.
Second, they should perform a speedy and focused stress test on each of these banks to assess the impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)
Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.
Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.
Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.

To improve Fed policy, improve communications

Since May 2021, we have criticized the Federal Reserve’s lagging response to surging inflation. In our view, both policy and communications were inadequate to address the looming challenge. Early this year, we argued that the Fed created a policy crisis by refusing to acknowledge the rise of trend inflation, maintaining a hyper-expansionary policy well after trend inflation reached levels far above their 2% target, and failing to articulate a credible low-inflation policy.

Against this background, we commend the FOMC for its recent efforts. Not only is policy moving quickly in the right direction, but communication improved markedly. In particular, despite the increasing likelihood of a near-term recession, Chair Powell made clear that price stability is necessary for achieving the second part of the Fed’s dual mandate. We suspect that the combination of the Fed’s recent promise to make policy restrictive, along with its improved communications, is playing a key role in anchoring longer-term inflation expectations.

In this post, we focus on central bank communication and its link to policy setting. By far the most important goal of communication is to clarify the authorities’ reaction function: the systematic response of central bank policy to prospective changes in key economy-wide fundamentals—usually inflation and the unemployment rate.

To anticipate our conclusions, we argue for two changes to the FOMC’s quarterly Summary of Economic Projections to better illuminate the Committee reaction function. First, we encourage publication of more detail on individual participants’ responses to link individual projections of inflation, economic growth, and unemployment to the path of the policy rate. Second, we see a role for scenario analysis in which FOMC participants provide their anticipated policy path contingent on one or more adverse supply shocks that present unappealing policy tradeoffs (for example, between the speed of returning inflation to its target and the pace at which the unemployment rate returns to its sustainable level)….

Central Banks' New Frontier: Interventions in Securities Markets

In his 2016 book The End of Alchemy, our friend and former Bank of England Governor Mervyn King provided a template for financial reform aimed at reducing the frequency and severity of crises. At the time, we were very cautious for two reasons. First, we believed that adoption of King’s framework would vastly increase the influence of central banks on private financial markets, something that could ultimately lead to a misallocation of resources in the economy and to a diminution of the independence of monetary policy that is necessary for securing price stability. Second, we doubted that most central banks had the technical capacity to implement the proposal.

Well, the landscape has changed significantly. During the pandemic, central banks intervened massively in private securities markets and there now appears to be no turning back. In a number of jurisdictions, monetary policymakers broadened the scale and scope of their lending and intervened directly in financial markets, going significantly beyond even their extraordinary actions during the 2007-09 financial crisis. As a result, we likely will be paying the costs that we feared could accompany the implementation of King’s proposal, so we might as well reap the benefits.

In this post, we discuss central banks’ pandemic interventions and the type of infrastructure needed to support them. We then review King’s proposal, highlighting how adopting his approach would make the financial system safer, while radically simplifying the role of regulators and supervisors ….

Can vacancies plunge without a significant rise of unemployment?

The primary objective of central bankers is to maintain low and stable inflation. While this task was never easy, the recent bout of large, adverse supply shocks—from the pandemic to the Russian invasion of Ukraine—combined with massive demand stimulus (both fiscal and monetary) made the task of securing price stability far more difficult.

Our favored indicator of the inflation trend, the Dallas Fed’s trimmed mean PCE price index, rose at a 4.4% annual rate over the past six months, and seems to be accelerating. Furthermore, while activity has slowed, the U.S. labor market remains extraordinarily tight: there are nearly two vacancies for each person who is unemployed—well above the peaks of the early 1950s and the late 1960s.

Against this background, a large, recession-free disinflation seems highly unlikely to us (see our recent post). In theory, a plunge of vacancies could cool a very hot labor market without raising unemployment (see, for example, Waller). In practice, however, the behavior of the relationship between vacancies and unemployment since 1950—what is known as the Beveridge Curve—suggests that this is very unlikely (see Blanchard, Domash and Summers).

That is the subject of this post….

The Costs of Acting Too Little, Too Late

Central bankers that act too little too late risk inflation, recession, or both. Everyone, including the members of the Federal Open Market Committee, knows that the FOMC is late in its current campaign to restore price stability. This makes it essential that they do not do too little.

In this post, we highlight the continued gap between the lessons of past disinflations and the Fed’s hopes and aspirations. We find it difficult to square the FOMC’s latest projections of falling inflation with only modest policy restraint. Simply put, we doubt that the peak projected policy rate from the June Summary of Economic Projections (SEP) will be sufficient to lower inflation to 2% in the absence of a recession.

In our view, boosting the credibility of the FOMC’s price stability commitment will require not only greater realism, but a clarification of how policy would evolve if, as in past large disinflations, the unemployment rate rises by several percentage points. The overly sanguine June SEP simply does not address this key question. Indeed, no FOMC participant anticipates the unemployment rate to rise above 4½% over the forecast horizon….

Harry Potter's Monetary Policy Wand?

The Federal Open Market Committee (FOMC) is reassuring us that, so long as we are patient, price stability will return without further pain. But its narrative seems less grounded in historical experience and more like something Harry Potter might have conjured at Hogwarts. By the end of 2024, the Committee expects trend inflation (measured by the price index of personal consumption expenditures excluding food and energy) to drop by more than 3 percentage points while economic growth remains above (and the unemployment rate below) its sustainable level. And, all this magic materializes with the real (inflation-adjusted) policy rate barely turning positive.

The principal means by which the Fed affects the inflation outlook is by influencing financial conditions. Yet, having telegraphed its policy shift for months, the FOMC’s most recent actions on March 16—initiating a series of rate hikes and suggesting that balance sheet tapering could begin soon—barely affected the ease with which firms and households obtain financing. And, while financial conditions are indeed a bit tighter than six months ago—when about one-half of FOMC participants anticipated no interest rate hikes in 2022—these conditions remain quite accommodative (see here).

Is the FOMC’s current policy path consistent with its longer-term price stability goals? In this post, we address this question by exploring policymakers’ newly published projections. Our conclusion is that bringing the inflation trend back to 2% will require a tightening of financial conditions significantly beyond what the Fed currently envisions….

Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

Fed Monetary Policy in Crisis

The Federal Open Market Committee (FOMC) is facing a crisis of its own making. The crisis has four elements. Policymakers failed to forecast the rise in inflation. They failed to appreciate how persistent inflation can be. They are failing to articulate a credible low inflation policy. And, so far, there is little sign that monetary policymakers recognize the need to react decisively.

Our fear is that matters have now progressed to the stage where the Fed’s credibility for delivering price stability is at serious risk. And, as experience teaches us, the less credible the central bank, the more painful it is to lower inflation to target.

In this post, we discuss the policy crisis and suggest how to respond. In our view, the FOMC needs a plan to raise rates quickly and substantially. For the FOMC to ensure inflation returns to its target of 2%, policymakers likely will need to bring the short-term real interest rate into significantly positive territory. Put slightly differently, we suspect that the policy rate needs to rise to at least one percent above expected inflation.

Won’t a sharp policy tightening trigger a huge recession? In our view, credibility is the key to how much pain disinflation will cause. Applying the painful lesson of the 1970s and early 1980s leads us to conclude that the FOMC now needs to show clear resolve. Inflation rose very quickly over the past year, so it may still be possible to bring it down sharply without a recession. The more decisively policymakers act, the lower the long-run costs are likely to be. Failure to restore price stability in a timely way would almost surely render this expansion disturbingly short compared to recent norms.

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Money, Banking, and Financial Markets