Money, Banking and Financial Markets

Commentary

Commentary

 
 
Posts tagged Risk pricing
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 ….

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Steve Cecchetti and Kim SchoenholtzMarket maker of last resort, Lender of last resort, Central bank, Central bank independence, Financial stability, Pandemic, Collateral, Haircut, Central bank intervention, Central bank asset purchases, Pawnbroker for all seasons, PFAS, Fair value, Risk pricing, Stress test, Stress scenario, CCAR, Corporate Credit Facility, Common Eurosystem Pricing Hub, CEPH, Eurosystem, Collateral framework, Federal Reserve, Bank of England, ECB, Riksbank, Bank of Canada
Thoughts on Deposit Insurance

Government guarantees have become the norm in the financial system. According to the latest Federal Reserve Bank of Richmond (2017) estimate, the U.S. government’s safety net covers 60% of private financial liabilities in the United States. Serious underpricing of government guarantees gives intermediaries the incentive to take risk that can threaten the entire financial system: the Great Financial Crisis of 2007-09 is the most obvious case in point.

Deposit insurance is arguably the oldest and most widespread form of government guarantee in finance. In the United States, Congress established the Federal Deposit Insurance Corporation (FDIC) at the depth of the Great Depression in 1933 to help prevent bank runs. Today, more than 140 countries have some type of deposit insurance scheme.

In this post, we briefly review the evolution of FDIC deposit insurance pricing. We highlight evidence that, largely because of Congressional mandates, the federal insurance guarantee was underpriced for many years. It is not until 2011, following the crisis of 2007-09, that the FDIC introduced the current framework for risk-based deposit insurance fees, bringing insurance premia closer to what observers would deem to be actuarially fair.

Going forward, as with any insurance regime, keeping up with the evolution of bank (and broader financial system) risks will require a willingness to update the deposit insurance pricing framework from time to time. That means adjusting pricing to reflect both the range of bank risk-taking at a point in time and—to ensure the sustainability of the deposit insurance fund without taxpayer subsidies—the evolution of aggregate risk….

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Steve Cecchetti and Kim SchoenholtzDeposit insurance, Insurance, Insurance pricing, Government guarantee, Risk, Risk pricing, Moral hazard, Incentives, Federal Deposit Insurance Corporation, FDIC, Bank runs, Financial instability, Deposit Insurance Fund, Quiet Period, Risk scorecard, Leverage, Funding risk, Bank failure, Loss given failure, Pro-cyclical, Assessment base, Regulatory arbitrage, Actuarially fair, Market price of risk, COVID-19