Liquidity coverage ratio

The Future of Deposit Insurance

This post is authored jointly with our friend and colleague, Thomas Philippon, Max L. Heine Professor of Finance at the NYU Stern School of Business

Deposit insurance is a key regulatory tool for limiting bank runs and panics. In the United States, the Federal Deposit Insurance Corporation (FDIC) has insured bank deposits since 1934. FDIC-insured deposits are protected by a credible government guarantee, so there is little incentive to run.

However, deposit insurance creates moral hazard. By eliminating the incentive of depositors to monitor their banks, it encourages bank managers to rely on low-cost insured deposits to fund risky activities. In the extreme, with 100% deposit insurance coverage, banks would have virtually no incentive to issue equity or debt.

Against this background, and in light of the events of March-April 2023, we ask what is to be done about deposit insurance. To prevent bank runs, should there be an increase in the legal limit? If so, how can authorities balance the costs of runs and panics against the costs associated with moral hazard, while keeping in mind the potential financial burden on the public? Or, are there alternatives?

We emphasize three promising ways to enhance deposit insurance: a higher insurance cap for small and medium-sized enterprises (SMEs), new resolution rules, and the option to purchase supplementary deposit insurance. In addition, and as regular readers of this blog might expect, we also think that higher capital requirements should be part of the solution: if we require that banks increase the degree to which they finance their assets with capital (rather than deposits), the risk of runs and panics would decline even without raising the cap on deposit insurance….

Read More

Cyber Risk, Financial Stability and the Payments System

Cyber risk remains at the top of the list of risks to the financial system, and the financial system is well known as the primary target for hackers (see here, here and here). In response, financial institutions expend huge resources on protecting their information systems—by one estimate, well over $100 billion. Yet, private sector actions to prevent cyber losses fall short due to a glaring externality: since the damage is likely to spill over to other financial firms and to markets, individual firms cannot reap the full benefits of preventing cyber attacks.

To get a sense of the financial stability risks associated with cyber fragility, we need to understand the financial system in some detail. Unfortunately, financial networks are highly complex and vary significantly across markets and functions. They also evolve meaningfully over time. On top of these enormous challenges, assessing network vulnerabilities frequently requires institution- or transactions-level information that is normally not publicly available.

This brings us to the important recent work of Eisenbach, Kovner and Lee (EKL), who study the vulnerability of the U.S. large-value interbank payments system, Fedwire, to a cyber attack on one of the principal nodes of the payments network—namely, one of the top five banks. In this post, we highlight EKL’s analysis as a model for the assessment of cyber-driven network risks. We suggest how central bankers should react to a cyber attack on the payments system, and speculate about what is needed to prevent, as well as mitigate, cyber risks….

Read More

The Federal Home Loan Banks: Two Lessons in Regulatory Arbitrage

There is an important U.S. government-sponsored banking system that most people know nothing about. Created by an act of Congress in 1932, the Federal Home Loan Banks (FHLBs) issue bonds that investors perceive as having government backing, and then use the proceeds to make loans to their members: namely, 6,800 commercial banks, credit unions, insurance companies and savings associations. As the name suggests, the mission of the (currently 11) regional, cooperatively owned FHLBs is “to support mortgage lending and related community investment.” But, since the system was founded, its role as an intermediary has changed dramatically.

With assets of roughly $1 trillion, it turns out that the FHLBs—which operate mostly out of the public eye—have been an important source of regulatory arbitrage twice over the past decade. In the first episode—the 2007-09 financial crisis—they partly supplanted the role of the Federal Reserve as the lender of last resort. In the second, the FHLBs became intermediaries between a class of lenders (money market mutual funds) and borrowers (banks), following regulatory changes designed in part to alter the original relationship between these lenders and borrowers. The FHLBs’ new role creates an implicit federal guarantee that increases taxpayers’ risk of loss.

In this post, we highlight these episodes of regulatory arbitrage as unforeseen consequences of a complex financial system and regulatory framework, in combination with the malleability and opaqueness of the FHLB system.…

Read More

The Brave New World of Monetary Policy Operations

Prior to the Lehman failure in 2008, the Federal Reserve controlled the federal funds rate through open market operations that added to or subtracted from the excess reserves that banks held at the Fed. Because excess reserves typically were only a few billion dollars, the funds rate was very sensitive to small changes in the quantity of reserves in the system.

The Fed’s response to Lehman and its aftermath included large-scale asset purchases that led to a thousand-fold increase in excess reserves. Consequently, since 2008, small open-market operations of a few billion dollars no longer alter the federal funds rate. Instead, the Fed introduced administered rates to change its policy stance. The most important of these—the interest rate that the Fed now pays on excess reserves (IOER)—sets a floor below which banks will not lend to other counterparties (since an overnight loan to the Fed is the safest rate available).

Until very recently, the Fed’s ability to control the federal funds rate seemed well in hand….

Read More

Liquidity Regulation is Back

Modern bank regulation has two complementary parts: capital and liquidity requirements. The first  restricts liabilities given the structure of assets and the second limits assets based on the composition of liabilities.

While capital regulation―especially in its risk-based form―is a creation of the last quarter of the 20th century, liquidity regulation is much older. In fact, the newly implemented liquidity coverage ratio (LCR) harks back to the system in place over 100 years ago. In the United States, before the advent of the Federal Reserve in 1914, both national and state-chartered banks were required to hold substantial liquid reserves to back their deposits (see Carlson). These are the reserve requirements (RR) that remain in effect in most jurisdictions today, the United States included.   

In this post, we briefly examine the long experience with RR as a way to gain insight regarding the LCR. We draw two conclusions. First, we argue strongly against using the LCR as a monetary policy tool in advanced economies with well-developed financial markets. Like RR, it is simply too blunt and unpredictable. Second, for the LCR to work as a prudential policy tool, it should probably be supplemented by something like a fee-based line of credit at the central bank....

Read More

Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

Read More

How to Ensure the Crisis Provision of Safe Assets

Changes in financial regulation are having a profound impact on the demand for safe assets—assets with a fixed nominal value that may be converted at all times without loss into the means of payment. Not only is demand for safe assets on the rise, but the ability of the private sector to produce them is being constrained by new rules that limit the extent and nature of things like securitizations.

So far, the fallout from increased demand and constrained supply looks reasonably benign. But for several years now, broad financial conditions have been very calm, with measures of financial volatility and stress at or near long-term lows. What will happen when the financial system comes under stress again? What if there is a drop in risk tolerance (or a surge in risk awareness) and a flight to safety that causes a jump in the demand for safe assets or a plunge in the supply? Or, as in 2008, what will happen if both materialize at the same time? We need to be ready.

As we will explain in more detail, central banks in advanced economies can satisfy the heightened need for safe assets under stress (as well as the precautionary demand in normal times) by offering commercial banks committed lines of credit for a fee against collateral, as the central banks in Australia and South Africa currently do. In our view, this mechanism for ensuring sufficient supply of safe assets in a crisis has important advantages compared to one in which the central bank operates perpetually—in good times and bad—with a very large balance sheet.

To see how this would work, we start with an explanation of post-crisis liquidity regulation....

Read More

The Scandal is What's Legal

If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]

But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....

 

Read More