Money, Banking and Financial Markets

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Commentary

 
 
Posts tagged Maturity risk
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….

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Steve Cecchetti and Kim SchoenholtzTreasury, Treasuries, Liquidity, Market resilience, Federal Reserve, COVID-19, Monetary policy, Off- vs. on-the-run spread, Collateral, Reserve currency, Foreign exchange reserves, Foreign currency reserves, Liquidity risk, Maturity risk, Credit risk, Benchmark, Reference rate, Yield volatility, TRACE, Primary dealer, Automated trading systems, ATS
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
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….

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Steve Cecchetti and Kim SchoenholtzFederal Reserve, Central bank independence, Central bank asset mix, Safe assets, Liquidity risk, Maturity risk, Credit risk, Bond duration, Duration, Portfolio duration, Weighted-average maturity, Debt-to-GDP ratio, Effective lower bound, Financial stress, Bank run, Flight to quality, Asset neutrality, Treasury debt management, Policy reaction function