Negative Nominal Interest Rates and Banking

The financial crisis of 2007-2009 taught us many lessons about monetary policy. Most importantly, we learned that when financial systems are impaired, central banks can backstop both illiquid institutions and illiquid markets. Actively lending to solvent intermediaries against a broad range of collateral, purchasing assets other than those issued by sovereigns, and expanding their balance sheets can limit disruptions to the real economy while preserving price stability.

We also learned that nominal interest rates can be negative, at least somewhat. But in reducing interest rates below zero―as has happened in Denmark, Hungary, Japan, Sweden, Switzerland and the Euro Area―policymakers face concerns about whether their actions will have the desired expansionary effect (see here). At positive interest rates, when central bankers ease, they influence the real economy in part by expanding banks’ willingness and ability to lend. Does this bank lending channel work as well when interest rates are negative?

Why should there be any sort of asymmetry at zero? Banks run a spread business: they care about the difference between the interest rate they charge on their loans and the one they pay on their deposits, not the level of rates per se. In practice, however, zero matters because banks are loathe to lower their deposit rates below zero….

Assessing Housing Risk

Housing debt typically is on the short list of key sources of risk in modern financial systems and economies. The reasons are simple: there is plenty of it; it often sits on the balance sheets of leveraged intermediaries, creating a large common exposure; as collateralized debt, its value is sensitive to the fluctuations of housing prices (which are volatile and correlated with the business cycle), resulting in a large undiversifiable risk; and, changes in housing leverage (based on market value) influence the economy through their impact on both household spending and the financial system (see, for example, Mian and Sufi).

In this post, we discuss ways to assess housing risk—that is, the risk that house price declines could result (as they did in the financial crisis) in negative equity for many homeowners. Absent an income shock—say, from illness or job loss—negative equity need not lead to delinquency (let alone default), but it sharply raises that likelihood at the same time that it can depress spending. As it turns out, housing leverage by itself is not a terribly useful leading indicator: it can appear low merely because housing prices are unsustainably high, or high because housing prices are temporarily low. That alone provides a powerful argument for regular stress-testing of housing leverage. And, because housing markets tend to be highly localized—with substantial geographic differences in both the level and the volatility of prices—it is essential that testing be at the local level….

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….

Pitfalls of a Reserves-only Narrow Bank

Since retiring from the Federal Reserve in mid-2016, our friend Jamie McAndrews has been very busy. Unlike most of us, he is putting his ideas into action: in 2015, he and a number of his colleagues, proposed the creation of segregated balance accounts (SBAs). As they write, “SBAs are accounts that a bank or depository institution (DI) could establish at its Federal Reserve Bank using funds borrowed from a lender.” Their proposal is that a bank would offer a special account that it is fully collateralized by a deposit at the Federal Reserve. Furthermore, the SBA deposits would be remunerated at the interest rate the Fed pays on excess reserves (the IOER), minus a small fee for the bank.

We have no expertise whatsoever in determining whether the Fed has legal grounds for denying TNB a Master Account—the subject of the court case in the opening quote. But we do have concerns about SBAs and narrow banks: we worry that they would shrink the supply of credit to the private sector and aggravate financial instability during periods of banking stress. Compared to what may be large costs, we suspect that the benefits would be small….

Illuminating GDP

Satellites are great. It is hard to imagine living without them. GPS navigation is just the tip of the iceberg. Taking advantage of the immense amounts of information collected over decades, scientists have been using satellite imagery to study a broad array of questions, ranging from agricultural land use to the impact of climate change to the geographic constraints on cities (see here for a recent survey).

One of the most well-known economic applications of satellite imagery is to use night-time illumination to enhance the accuracy of various reported measures of economic activity. For example, national statisticians in countries with poor information collection systems can employ information from satellites to improve the quality of their nationwide economic data (see here). Even where governments have relatively high-quality statistics at a national level, it remains difficult and costly to determine local or regional levels of activity. For example, while production may occur in one jurisdiction, the income generated may be reported in another. At a sufficiently high resolution, satellite tracking of night-time light emissions can help address this question (see here).

But satellite imagery is not just an additional source of information on economic activity, it is also a neutral one that is less prone to manipulation than standard accounting data. This makes it is possible to use information on night-time light to monitor the accuracy of official statistics. And, as we suggest later, the willingness of observers to apply a “satellite correction” could nudge countries to improve their own data reporting systems in line with recognized international standards….

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….

Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

Mutual Funds, "Common Ownership" and Ownership Concentration

Guest post by Richard Berner, Executive-in-Residence (Center for Global Economy and Business) and Adjunct Professor, NYU Stern School of Business

America faces two interrelated long-term challenges: rising longevity and inadequate retirement saving. The combination of declining private, defined-benefit pension plans and concerns about the viability of federal entitlements has intensified these challenges. While the economic recovery has raised confidence about retirement resources at the margin (see here), workers and retirees remain concerned about how they will meet future basic expenses, medical needs or the cost of long-term care.

Those developments mean that achieving saving goals increasingly must rely on individuals’ thrift and intelligent, efficient investing. Tax-advantaged vehicles that encourage saving (like 401k and IRA accounts), and efficient investment vehicles like mutual funds that follow market-wide stock price indexes are cornerstones of that system.

Yet, some scholars of industrial organization claim that collective investment vehicles―mutual funds, exchange-traded funds (ETFs), and the like―involve “common ownership” that results in softened competition by the firms included in their portfolios (see here, here and here). And, key antitrust enforcers, like the European Competition Commissioner, are looking carefully at this issue. In this post, I argue that the evidence for a causal link between the rise of collective investment vehicles and diminished competition is weak, and far from sufficient to justify interventions that would diminish the attractiveness of these saving mechanisms….

Sources of Finance: Internal versus External

It ought not be surprising that borrowing can be difficult. In good times, households usually can obtain financing to purchase a house or car. But these loans are secured with collateral that is easy to resell. Even so, some measures suggest that it is currently more difficult than under “normal” conditions to obtain mortgage finance (see the Urban Institute’s Housing Credit Availability Index on page 16).

With firms, credit has been rising significantly in recent years—across advanced and emerging economies alike (see the BIS measures through 2017 here). Yet, commercial borrowers, especially small and medium sized enterprises, complain loudly when they feel that their ability to succeed is being hampered by overly cautious lenders. And, since lenders often find it difficult to both assess a business’s prospects and to monitor effort once a loan is made, aside from periods of euphoria borrowing can be quite difficult.

As we discuss in our primers on adverse selection and moral hazard, information asymmetries make external funding—either through equity or debt—expensive. And, while the entire financial system is designed to reduce these costs, they are still quite high….

Trump v. Fed

Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.

Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets, and despite the stimulative monetary and fiscal policies in place….

Commentary

Money, Banking, and Financial Markets