After nearly a decade of negotiations, last month, the Basel Committee on Banking Supervision completed the Basel III post-crisis reforms to capital regulation. The final standards include refinements to: credit risk measurement and the computation of risk-weighted assets; the calculation of off-balance-sheet exposures and of the requirements to address operational risk; and the leverage ratio requirement for global systemically important banks (G-SIBs).

In this post, we focus on revisions to the way in which banks compute risk-weighted assets. To foreshadow our conclusion: the new approach adds unnecessarily to regulatory complexity. If the concern is that current risk-based requirements result in insufficient capital, it would be better simply to raise the requirements.

A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

Bitcoin and Fundamentals

Bitcoin is all the rage, again. Last week, the price rose above $10,000 for the first time. Following a Friday announcement by the Commodity Futures Trading Commission, the Chicago Mercantile Exchange, the CBOE Futures Exchange, and the Cantor Exchange appear poised to launch Bitcoin futures or other derivatives contracts, with Nasdaq likely to follow. Portfolio advisers are encouraging cryptocurrency diversification. In London’s Metro, advertisements assure potential investors that “Crypto needn’t be cryptic.” And, as skyrocketing prices gain headlines, less sophisticated investors are diving in.

The danger is that investors will interpret the surging price itself (and the associated hullabaloo) as a sufficient signal to buy, fueling an asset price bubble (and, eventually, a painful crash).

No one can ever say with certainty when an asset price boom is a bubble. Nevertheless, it makes sense to ask what fundamental services Bitcoin provides. More specifically, have the prospects for those services improved sufficiently over the past year to warrant the 10-fold increase in price that has vaulted Bitcoin’s market capitalization into the range of the top 50 U.S. firms?

We strongly doubt it....

GDP at Risk

For several decades, central bankers have been the key risk managers for the economy and the financial system. However, they failed spectacularly to anticipate and prevent the financial crisis of 2007-2009. The financial regulatory reforms since the crisis—capital and liquidity requirements, resolution regimes, restructuring of derivatives markets, and an evolving approach to systemic risk assessment and (macroprudential) regulation—have all been directed at improving the resilience of the system to help sustain strong and stable economic growth. As a result, the likelihood of another crisis-induced plunge in GDP is much lower today than it was a decade ago.

But we still have plenty of work to do. We are at an early stage in the process of building a financial stability policy framework that corresponds to the inflation-targeting framework which forms the basis for monetary policy. Such a framework requires measurable financial stability objectives that are akin to a price index, tools comparable to an interest rate, and dynamic models that help us to understand the link between the two.

In this post, we describe a step forward in developing such a framework: the concept and measurement of GDP at risk....

FSOC and Systemic Risk: Treasury's Report

In response to the financial crisis of 2007-2009, Congress created the Financial Stability Oversight Council (FSOC), a committee of the chiefs of the U.S. regulatory agencies, chaired by the Treasury Secretary, to monitor and secure the stability of the financial system. Critical to this task is the FSOC’s authority to designate nonbanks as “systemically important financial institutions” (SIFIs).

On November 17, the U.S. Treasury issued a report assessing the FSOC’s designation process. Treasury calls on the FSOC to adopt a strategy that prioritizes the regulation of activities or functions—affecting whole sectors of the financial industry—over regulation based on entity or legal form (such as the designation authority). For the most part, we find this sensible, as this focus reduces the scope for regulatory arbitrage that an entities-only approach may foster (see here).

However, we doubt that activities-based regulation alone will be sufficient to limit systemic risk. Our overall conclusion is that the Treasury’s approach sets the bar for FSOC designation too high, diminishing its deterrence effect on undesignated nonbanks. In the end, a sensible focus on both entities and activities is needed to fulfill one of FSOC’s key objectives—to restore market discipline. Adopting the Treasury’s proposed framework will not meet the goal, set out in the President’s Core Principles for Regulating the U.S. Financial system (see Executive Order 13772), of preventing taxpayer-funded bailouts....

Cash is king, but $100 bills are for crooks

People have been saying for years that cash will disappear. So far, they have been spectacularly wrong. Over the past decade, the face value of U.S. dollar paper currency in public hands has doubled. Today, there is nearly $1.6 trillion in banknotes outstanding, more than 80 percent of which is in $100 bills (see chart)! In fact, there are thirty-nine $100 bills in circulation for each of the 326 million residents of the United States.

Why is 90 percent of the U.S. increase in circulation accounted for by $100 bills? One possible explanation is that, with nominal interest rates near zero, the opportunity cost of holding cash has dwindled, reducing the incentive to deposit rising inventories of cash in a bank. The second, and more compelling, reason for the big increase in large-denomination notes is more troubling: it facilitates illicit activity. Money laundering, tax evasion, drug dealing, human trafficking, and a whole host of other criminal activities run on cash. Big banknotes are a convenient way to transfer funds anonymously with finality. A $100 bill weighs less than a gram, so $1,000,000 weighs roughly 10kg and is small enough to fit in a medium-size briefcase.

To put it simply, most of the U.S. currency in circulation is almost surely being used by criminals....

Banking the Unbanked: The Indian Revolution

Financial inclusion—providing universal access to financial services and encouraging their use—is an important means for promoting economic development. As of 2014, the World Bank estimated that there were still 2 billion adults without a bank account, and many others with only a tenuous connection to the financial system (see Global Findex). Better access will boost the efficiency of the payments system, promote household savings and access to credit, and improve people’s ability to manage risk. And, as it does all of these things, financial inclusion has the potential to reduce inequality and increase economic growth. In other words, reducing the multitudes of those that are unbanked will improve the fate of the poorest of the poor. (For more detail, see our earlier post.)

India’s unprecedented effort to “bank the unbanked” through the Pradhan Mantri Jan Dhan Yojana (PMJDY), or “Prime Minister’s People’s Wealth Scheme,” is by far the largest such undertaking. Launched merely three years ago, on August 28, 2014, the mission to provide no-frills, no-minimum-balance (hereafter, JDY) bank accounts to every adult (including the one-fifth of the population living below the poverty line and the large rural population with limited access to physical bank branches) has been remarkably successful. As of this writing, more than 300 million people have opened JDY accounts. And, while initial readings suggested limited use, over time, JDY account holders look to be learning about the benefits, so that use is rising toward levels observed for bank accounts of comparable individuals. Put differently, by lowering bank transactions costs, hundreds of millions of people who lacked access to financial services are revealing a latent demand....

Managing Risk and Complexity: Legal Entity Identifier

Prior to the financial crisis, even an informed observer might have naïvely believed that the CEOs of big financial firms could simply push a button to view the current exposure of their firms to any other firms in the world. Or, if less technologically advanced, they could call their chief risk officers or chief financial officers to obtain end-of-day positions.

Not even close. By the time that Lehman failed in September 2008, large financial holding companies had evolved into extremely complex structures with hundreds or thousands of subsidiaries for which the parent companies lacked consolidated information technology and risk-management systems. The multiplicity of information systems meant that different parts of the same firm employed varying names and codes to identify the same counterparty. Fixing this, merging all of the information structures and ensuring consistency, would have been an expensive proposition that managers (compensated out of current profits) had incentive to delay.

Correcting these deficiencies in the financial infrastructure is not a trivial matter. Simplifying the problem requires the creation of a unique, universal, and permanent identification system for both institutions (financial and nonfinancial) and instruments. Realizing the nature of the opportunity and the challenge, in November 2011, the G20 called for the creation of a global legal entity identifier (LEI). Importantly, everyone realized that given the massive size of the financial system that supports both domestic and cross-border activity, the solution had to be global. (For pioneering analyses, see work by the Federal Reserve and the Office of Financial Research. For up-to-date information on the LEI, see here.)....

Treasury Round II: The Capital Markets Report

Earlier this month, the U.S. Treasury published the second of four planned reports designed to implement the core principles for regulating the U.S. financial system announced in President Trump’s February 2017 Executive Order. This report focuses on capital markets. We wrote about the first report—regarding depository institutions—in June (see here). Future reports are slated to address “the asset management and insurance industries, and retail and institutional investment products and vehicles” and “nonbank financial institutions, financial technology, and financial innovation.”

A central motivation for all this work is to review the extensive regulatory reforms enacted in the aftermath of the 2007-09 financial crisis. President Trump’s stated principles provide an attractive basis for evaluating the effectiveness of Dodd-Frank in making the financial system both more cost-effective and safer. Where have the reforms gone too far? Where have they not gone far enough?

Much of the capital markets report focuses on ways to reduce the regulatory burden, and many of the proposals—which address issues ranging from initial public offerings (IPOs) to securitizations to financial market utilities (FMUs)—could improve market function. However, while they would involve a large number of changes—most of which can be implemented without new legislation (see table)—none of the 100-plus recommendations seem terribly dramatic, nor are they likely to have much impact on the goal of promoting economic growth.

Our overall reaction is that Treasury’s predispositions—which were more clearly evident in the earlier report—encourage doubts. To us, the numerous proposals look lopsided in favor of providing “regulatory relief” even where systemic concerns may persist....

In Defense of Regulatory Diversity

Guest post by Lawrence J. White, Robert Kavesh Professor in Economics, NYU Stern School of Business

The U.S. regulatory landscape--especially with regard to financial regulation—is maddeningly complex. It is easy to make a case for a drastic simplification, and the authors of this blog have done so here. But there is value in diversity—including regulatory diversity. Consequently, with regard to the regulatory framework, as is true of most other areas of political economy, we need to consider the costs as well as the benefits of any proposed changes.

Let’s start with the undeniable complexity of U.S. financial regulation: Consider the following array of agencies and jurisdictions (an alphabet-soup glossary appears at the end)...

Commentary

Money, Banking, and Financial Markets