The Other Trilemma: Governing Global Finance

Courses in international economics usually introduce students to the impossible trinity, also known as the trilemma of open-economy macroeconomics: namely, that a fixed exchange rate, free cross-border capital flows, and discretionary monetary policy are incompatible. Why? Because, in the presence of free capital flows under a fixed exchange rate, private currency preferences (rather than policymakers) determine the size of the central bank balance sheet and hence the domestic interest rate. We’ve highlighted this problem several times in analyzing China’s evolving exchange rate regime (see here and here).

While many students learn that a country can only have two of the three elements of the open-economy trilemma, few learn that there also exists a financial trilemma. That is, financial stability, cross-border financial integration, and national financial policies are incompatible as well. The logic behind this second trilemma is that increases in financial integration reduce the incentives for national policymakers to act in ways that preserve financial stability globally. Put differently, as the benefits from financial stability policies spread beyond borders, the willingness to bear the costs of stabilizing the system at the national level decline. This has the important implication that, if we are to sustain increasing financial integration, then we will need greater international coordination among national financial regulators (see here, or for a much broader case for international economic governance, see Rodrik)....

An Open Letter to Congressman Patrick McHenry

Dear Vice Chair McHenry,

We find your January 31 letter to Federal Reserve Board Chair Janet Yellen both misleading and misguided.

It is in the best interest of U.S. citizens and our financial system that the Federal Reserve (and all the other U.S. regulators) continue to participate actively in international financial-standard-setting bodies. The Congress has many opportunities to hold the Fed accountable for its regulatory actions, which are very transparent. We hope that the new U.S. Administration will support the Fed’s efforts to promote a safe and efficient global financial system.

Your letter is filled with false assumptions and assertions....

Are European Stress Tests Stressful Enough?

We are huge fans of stress tests. In many ways, they are the best macroprudential tool we have for reducing the frequency and severity of financial crises.

The idea behind stress tests is simple: see if all financial institutions can simultaneously withstand a major negative macroeconomic event—a big fall in real output, a large decline in equity and property prices, a substantial widening of interest-rate spreads, an adverse move in the exchange rate. And, importantly, assume that in response to these adverse circumstances banks have no way to sell assets or raise equity. That is, the stress test asks whether each intermediary can stand on its own without help in the middle of an economic maelstrom. But for stress tests to be effective, they must be truly stressful. The tempest has to be the financial equivalent of a severe hurricane, not just a tropical storm.

This brings us to the latest European Banking Authority (EBA) 2016 stress tests. As we mentioned recently, the European financial system may be the biggest source of systemic risk globally. So, these tests are important not just for Europe, but for the world as a whole. Unfortunately, they just aren’t severe enough, so there is little reason to be confident about the resilience of European finance...

Brexit Stress Test

The U.K. Brexit referendum is providing us with the first significant test of our sparkling new regulatory system. Everyone knew about the referendum months in advance, giving them plenty of time to prepare. Yet, we are left with some fundamental questions related to global financial stability. Do banks have sufficient capital and liquidity to withstand the “shock?” Will financial markets continue to serve their key functions? Or, is the financial system only as strong as its weakest link? Will turmoil once again prompt liability holders to run, triggering asset fire sales, and compelling central banks once again to do whatever it takes to keep avert a meltdown?

As the rating agencies might say, we are on “stress watch” with a negative outlook. Or, to mix metaphors, numerous lights are flashing yellow, so we are worried...

Global Finance Requires More Global Cooperation

“We have listened to the wisdom of an old Russian maxim, doveryai, no proveryai—trust, but verify.” President Ronald Reagan at the signing of the INF Treaty, December 8, 1987.

In July 2010, central bank governors and supervisors from the 28 jurisdictions that make up the Basel Committee membership were hammering out the agreement on new capital and liquidity requirements now known as Basel III. There was a large sticking point. Some members were standing firm on their desire to have higher capital requirements. Others felt that this would make credit more expensive and less plentiful.

Had agreement not been reached, those insisting on more capital might have said: “Go ahead, be permissive. But if you let your banks operate with low levels of capital, we’ll restrict our banks from doing business with them.” Fortunately, it didn’t come to that....

The right direction

The recent international agreement to improve the loss-absorbing capacity of globally active banks is an important move in the right direction. But financial regulators should go significantly further to make these banks and the global financial system resilient...

Commentary

Money, Banking, and Financial Markets