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….

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….

Making the Treasury Market Resilient

Ensuring financial stability requires resilient institutions. That is why regulators around the world have strengthened capital and liquidity requirements for the largest financial intermediaries since financial crisis of 2007-09.

Making financial markets resilient is equally important. Repeated and sustained bouts of illiquidity and dysfunctionality in a key market can threaten the well-being of even the healthiest institutions.

In a global financial system that runs on dollars, the most important financial market is the one for U.S. Treasury securities. Yet, despite its importance and general reliability, the Treasury market occasionally suffers from serious disruptions. The strains in the Treasury market during the first half of March 2020 became an important motivation for the Federal Reserve’s unprecedented anti-COVID policy actions beginning that month (see here, here and here).

In the remainder of this post, we describe the COVID-induced troubles in the Treasury market and highlight Duffie’s compelling proposal to consider requiring central clearing of U.S. Treasuries. We endorse Duffie’s call to study such a mandate, and view this is as an important element of a broader effort to modernize and reinforce the financial infrastructure….

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….

What Should the Fed Own?

The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.

Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.

In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….

Ten Years After Bear

Ten years ago this week, the run on Bear Stearns kicked off the second of three phases of the Great Financial Crisis (GFC) of 2007-2009. In an earlier post, we argued that the crisis began in earnest on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. In that first phase of the crisis, the financial strains reflected a scramble for liquidity combined with doubts about the capital adequacy of a widening circle of intermediaries.

In responding to the run on Bear, the Federal Reserve transformed itself into a modern version of Bagehot’s lender of last resort (LOLR) directed at managing a pure liquidity crisis (see, for example, Madigan). Consequently, in the second phase of the GFC—in the period between Bear’s March 14 rescue and the September 15 failure of Lehman—the persistence of financial strains was, in our view, primarily an emerging solvency crisis. In the third phase, following Lehman’s collapse, the focus necessarily turned to recapitalization of the financial system—far beyond the role (or authority) of any LOLR.

In this post, we trace the evolution of the Federal Reserve during the period between Paribas and Bear, as it became a Bagehot LOLR. This sets the stage for a future analysis of the solvency issues that threatened to convert the GFC into another Great Depression.

Rewriting the textbook: covered interest parity

For decades, textbooks on international economics and finance built a part of their scaffolding on the foundation of a relationship called covered interest parity (CIP). CIP postulates that, in a world of free capital flows, currency-hedged returns on equivalent-risk assets will equalize across countries. For example, the return to investing in a 1-year U.S. Treasury bill will equal the return to purchasing euros, investing the proceeds in a 1-year German Government liability, and purchasing a contract guaranteeing the future euro/dollar exchange rate at which the euros will be converted back to dollars a year later. In practice, the CIP relationship was such a reliable feature of international fixed-income markets that for decades one could think of banks operating a nearly costless CIP machine to perform what many viewed as a riskless arbitrage.

Then, one day, the CIP machine broke down. It first stopped working in the Great Financial Crisis (GFC) of 2007-2009, when counterparty and liquidity risks both skyrocketed, raising the possibility of defaults and losses in executing the trades necessary. That is, CIP was not a riskless arbitrage.

As a wave of recent research highlights, the conventional, pre-crisis model of the CIP machine remains impaired even as the counterparty and liquidity risks that characterized the GFC have receded....

Commentary

Money, Banking, and Financial Markets