Category Archive for: Financial System [Return to Main]

Wednesday, October 22, 2014

'Will the Big Banks Ever Clean Up Their Act?'

I am not convinced that telling the kids to be good or else -- when there's a history of not doing much to enforce the request -- will work:

Will the big banks ever clean up their act?, by Mark Thoma: Federal Reserve Bank of New York President William Dudley delivered a stern warning to the largest banks in a speech earlier this week. Either clean up your illegal and unethical behavior through "cultural change" from within, he said, or be broken into smaller, more manageable pieces.

In his conclusion, the warning was direct and explicit:

"...if those of you here today as stewards of these large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively. It is up to you to address this cultural and ethical challenge."

How can the needed change be accomplished? ...

Will this work? Will large financial firms take the threat that they might be broken up seriously? Will they even bother to implement the many suggestions Dudley made?

Regulators have been reluctant to break up big banks in the past out of fear that it might undercut their ability to finance very large projects and hurt their competitiveness in international markets. And given that this behavior is so pervasive and has endured for so long, regulators haven't been as tough as they could be in stopping it.

Maybe this time is different. Maybe financial firms believe regulators are serious, and they will change the culture that has allowed these problems to exist. Perhaps the threat to break up the banks if they continue to prove they are "too big to manage" is real.

Let's hope so, because the financial instability that can occur when large banks behave unethically or when they fail to comply with existing regulations can be very costly for the nation's economy.

But, again, I doubt asking banks to change their culture will be enough, they will need to be persuaded through other, stronger means. (If it was up to me, I would have broken them into smaller pieces long ago. I do not beleive the minimum efficient scale is anywhere near as large as the largest banks, their political and economic power is too strong, and they pose a risk for the economy when they misbehave or make big mistakes. Smaller banks don't solve all these problems, there can still be widespread, cascading bank failures for example, but it does reduce the risks.)

Wednesday, October 08, 2014

'Shadow Banking: U.S. Risks Persist'

I've noted this several times in the past, but it's worth pointing out again. The problems in the shadow banking sector are still present for the most part. From Tim Taylor:

Shadow Banking: U.S. Risks Persist: ...A "shadow bank" is any financial institution that gets funds from customers and then in some way lends the money to borrowers. However, a shadow bank doesn't have deposit insurance. And while the shadow bank often faces some regulation, it typically falls well short of the detailed level of risk regulation that real banks face. In this post in May, I tried to explain how shadow banking works in more detail. Many of the financial institutions at the heart of the financial crisis were "shadow banks." ...
Five years past the end of the Great Recession, how vulnerable is the U.S. and the world economy to instability from shadow banking? ... The IMF devotes a chapter in its October 2014 Global Financial Stability Report to "Shadow Banking Around the Globe: How Large, and How Risky?" ...
It is discomforting to me to read that for the U.S., shadow banking risks are "slightly below precrisis levels." In general, the policy approach here is clear enough. As the IMF notes: "Overall, the continued expansion of finance outside the regulatory perimeter calls for a more encompassing approach to regulation and supervision that combines a focus on both activities and entities and places greater emphasis on systemic risk and improved transparency."
Easy for them to say! But when you dig down into the specifics of the shadow banking sector, not so easy to do. 

Friday, September 26, 2014

'Why the Fed Is So Wimpy'

Justin Fox:

Why the Fed Is So Wimpy, by Justin Fox: Regulatory capture — when regulators come to act mainly in the interest of the industries they regulate — is a phenomenon that economists, political scientists, and legal scholars have been writing about for decades.  Bank regulators in particular have been depicted as captives for years, and have even taken to describing themselves as such.
Actually witnessing capture in the wild is different, though, and the new This American Life episode with secret recordings of bank examiners at the Federal Reserve Bank of New York going about their jobs is going to focus a lot more attention on the phenomenon. It’s really well done, and you should listen to it, read the transcript, and/or read the story by ProPublica reporter Jake Bernstein.
Still, there is some context that’s inevitably missing, and as a former banking-regulation reporter for the American Banker, I feel called to fill some of it in. Much of it has to do with the structure of bank regulation in the U.S., which actually seems designed to encourage capture. But to start, there are a couple of revelations about Goldman Sachs in the story that are treated as smoking guns. One seems to have fired a blank, while the other may be even more explosive than it’s made out to be. ...

Saturday, September 20, 2014

Finance Sector Wages: Explaining Their High Level and Growth

Joanne Lindley and Steven McIntosh:

Finance sector wages: explaining their high level and growth, by Joanne Lindley and Steven, Vox EU: Individuals who work in the finance sector enjoy a significant wage advantage. This column considers three explanations: rent sharing, skill intensity, and task-biased technological change. The UK evidence suggests that rent sharing is the key. The rising premium could then be due to changes in regulation and the increasing complexity of financial products creating more asymmetric information. ...

Wednesday, September 10, 2014

'The Biggest Lie of the New Century'

Barry Ritholtz:

The Biggest Lie of the New Century: Yesterday, we looked at why bankers weren't busted for crimes committed during the financial crisis. Political corruption, prosecutorial malfeasance, rewritten legislation and cowardice on the part of government officials were among the many reasons.
But I saved the biggest reason so many financial felons escaped justice for today: They dumped the cost of their criminal activities on you, the shareholder (never mind the taxpayer). ... Many of these executives committed crimes; got big bonuses for doing so; and paid huge fines using shareholder assets (i.e., company cash), helping them avoid prosecution.
As for claims, like those of white-collar crime defense attorney Mark F. Pomerantz, that “the executives running companies like Bank of America, Citigroup and JP Morgan were not committing criminal acts,” they simply implausible if not laughable. Consider a brief survey of some of the more egregious acts of wrongdoing: ...

Monday, September 08, 2014

What were they thinking? The Federal Reserve in the Run-Up to the 2008 Financial Crisis

At Vox EU:

What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis, by Stephen Golub, Ayse Kaya, Michael Reay: Since the Global Crisis, critics have questioned why regulatory agencies failed to prevent it. This column argues that the US Federal Reserve was aware of potential problems brewing in the financial system, but was largely unconcerned by them. Both Greenspan and Bernanke subscribed to the view that identifying bubbles is very difficult, pre-emptive bursting may be harmful, and that central banks could limit the damage ex post. The scripted nature of FOMC meetings, the focus on the Greenbook, and a ‘silo’ mentality reduced the impact of dissenting views.

Wednesday, September 03, 2014

Minority Mortgage Market Experiences and the Financial Crisis

Stephen Ross at Vox EU:

Minority mortgage market experiences leading up to and during the Financial Crisis, by Stephen L. Ross, Vox EU: The subprime lending crisis in the US triggered a broad financial panic that lead to the global recession. Domestically, it meant bankruptcy and disaster for many households. This column analyses racial discrimination in subprime lending. Careful estimation of a detailed dataset reveals across-lender effects to have substantially disadvantaged black and Hispanic borrowers.

The concluding paragraph:

... Minority homebuyers – especially blacks – tend to face a higher cost of mortgage credit and had substantially worse credit market outcomes during the recent downturn than white homebuyers with equivalent mortgage risk factors. In terms of the price of credit, a majority of the unexplained differences are associated with the lender from which the homebuyer obtained credit. These effects are felt most among minority borrowers with the lowest levels of education, and are likely due in part to the concentrated activity of subprime lenders in minority neighborhoods and a lack of knowledge of financial markets among minority borrowers with low levels of education. On the other hand, most of the racial differences in loan performance that are unexplained by traditional credit risk factors cannot be captured by controlling for the lender or other aspects of subprime lending. African-Americans and Hispanics appear to be more vulnerable to an economic downturn and to the associated risks of unemployment and housing price declines than observationally similar white homeowners. This higher vulnerability is most pronounced for borrowers who purchased their homes right before the onset of the financial crisis, even after controlling for the increased risk of negative equity associated with buying at the peak of the market. While the expansion of the subprime sector may have contributed to a higher cost of credit for black homebuyers, their concentration in high cost loans (and in the subprime market more generally) can explain only a small portion of the racial differences in foreclosure. Rather, a broad spectrum of black and Hispanic borrowers appear to be especially vulnerable to the economic downturn and associated shocks to their ability to meet their mortgage commitments.

Sunday, August 31, 2014

What Savings Glut?

Joe Stiglitz in a review of Martin Wolf's new book "The Shifts and the Shocks":

... If I have a point of difference with Wolf’s analysis, it is that he ... is insufficiently critical of the “savings glut” hypothesis advanced by former Federal Reserve chairman Ben Bernanke, among others, which presents what used to be a virtue (savings) as a vice, shifting blame to China and (less vocally) to Germany. Yet the investment needs of today are staggering: for infrastructure in the developing world, let alone in the US; for retrofitting the global economy to cope with global warming; even for small and medium-sized enterprises starved of capital in much of the world. This should make it obvious that the problem is not an excess of savings but a financial system that is more fixated on speculation than on fulfilling its societal role of intermediation ... in which scarce savings are allocated to the investments of highest social returns.

The problem goes beyond a "financial system that is more fixated on speculation":

It is striking how much Wolf, like so many advocates of financial reform, focuses on protecting us against the banks: making sure that they don’t engage in excessive risk-taking... Wolf doesn’t dwell much on some of the more antisocial aspects evidenced in the aftermath of the crisis: the market manipulation (as in the Libor and forex scandals), the anti-competitive practices, the predatory and discriminatory lending, the lack of transparency, the fraudulent behavior. Presumably, this is because he believes, or hopes, that even too-big-to-fail and too-big-to-jail banks won’t be politically powerful enough to continue such behavior unimpaired. But he says too little about what might be done to make banks actually fulfill the societal role that they should be playing. ...

Friday, August 22, 2014

Minority Mortgage Market Experiences During the Financial Crisis

Via Vox EU:

Minority mortgage market experiences leading up to and during the financial crisis, by Stephen L. Ross, Vox EU: The foreclosure crisis that followed the subprime crisis has had significant negative consequences for minority homeowners. This column reviews recent evidence in the racial and ethnic differences in high cost loans and in loan performance. Minority homeowners, especially black homebuyers, faced higher price of mortgage credit and had worse credit market outcomes during the crisis. This is largely due to the fact that minority borrowers are especially vulnerable to the economic downturn. ...

Tuesday, August 19, 2014

'Irrational Exuberance Meets Secular Stagnation'

Antonio Fatás:

Irrational exuberance meets secular stagnation: Robert Shiller warns us in the New York Times about the potential risks of high stock market valuations in the US. According to Shiller "the United States stock market looks very expensive right now". Brad DeLong and Dean Baker disagree with Shiller and argue that stock prices might look higher than historical averages but this could be ok given other changes in the economic environment. ... But there are ... reasons why the historical average might not be relevant...

Monday, August 04, 2014

Paul Krugman: Obama’s Other Success

Financial reform is working:

Dodd-Frank Financial Reform Is Working, by Paul Krugman, Commentary, NY Times: ...The Dodd-Frank reform bill ... is working a lot better than anyone listening to the news media would imagine. Let’s talk, in particular, about two important pieces of Dodd-Frank: creation of an agency protecting consumers from misleading or fraudulent financial sales pitches, and efforts to end “too big to fail.”
The decision to create a Consumer Financial Protection Bureau shouldn’t have been controversial, given what happened during the housing boom. ...
Of course, that obvious need didn’t stop the U.S. Chamber of Commerce, financial industry lobbyists and conservative groups from going all out in an effort to prevent the bureau’s creation or at least stop it from doing its job, spending more than $1.3 billion in the process. Republicans in Congress dutifully served the industry’s interests...
At this point, however, all accounts indicate that the bureau is in fact doing its job, and well... But what happens if a crisis occurs anyway?
The answer is that, as in 2008, the government will step in to keep the financial system functioning; nobody wants to take the risk of repeating the Great Depression.
But how do you rescue the banking system without rewarding bad behavior? ...
The answer is that the government should seize troubled institutions when it bails them out, so that they can be kept running without rewarding stockholders or bondholders who don’t need rescue. In 2008 and 2009, however, it wasn’t clear that the Treasury Department had the necessary legal authority to do that. So Dodd-Frank filled that gap, giving regulators Ordinary Liquidation Authority, also known as resolution authority, so that in the next crisis we can save “systemically important” banks and other institutions without bailing out the bankers.
Bankers, of course, hate this idea; and Republican leaders like Mitch McConnell tried to help their friends with the Orwellian claim that resolution authority was actually a gift to Wall Street, a form of corporate welfare, because it would grease the skids for future bailouts. ...
Did reform go far enough? No. In particular, while banks are being forced to hold more capital, a key force for stability, they really should be holding much more. But Wall Street and its allies wouldn’t be screaming so loudly, and spending so much money in an effort to gut the law, if it weren’t an important step in the right direction. For all its limitations, financial reform is a success story.

Monday, July 21, 2014

'Truth or Consequences: Ponzi Schemes and Other Frauds'

Cecchetti & Schoenholtz:

... A well-functioning financial system is based on trust. Widespread belief in honesty and integrity are essential for intermediation. That is, when we make a bank deposit, purchase a share of stock or a bond, we need to believe that terms of the agreement are being accurately represented. Yes, the value of the stock can go up and down, but when you think you buy an equity share, you really do own it. Fraud can undermine confidence, and the result will be less saving, less investment, less wealth and less income.
Unfortunately, in a complex financial system, the possibilities for fraud are numerous and the incidence frequent. Most cases are smaller and more mundane than Madoff or Ponzi. But they are remarkably common even today, despite enormous public efforts to prevent or expose them. One website devoted to tracking financial frauds in the United States lists 67 Ponzi schemes worth an estimated $3 billion in 2013 alone. ...

See also: Four years after passage, House keeps trying to kill Dodd-Frank.

Friday, July 18, 2014

'Did the Banks Have to Commit Fraud?'

Dean Baker:

Did the Banks Have to Commit Fraud?: Floyd Norris has an interesting piece discussing Citigroup's $7 billion settlement for misrepresenting the quality of the mortgages in the mortgage backed securities it marketed in the housing bubble. Norris notes that the bank had consultants who warned that many of the mortgages did not meet its standards and therefore should not have been included the securities.
Towards the end of the piece Norris comments:
"And it may well be true that actions like Citigroup’s were necessary for any bank that wanted to stay in what then appeared to be a highly profitable business. Imagine for a minute what would have happened in 2006 if Citigroup had listened to its consultants and canceled the offerings. To the mortgage companies making the loans, that might have simply marked Citigroup as uncooperative. The business would have gone to less scrupulous competitors."
This raises the question of what purpose is served by this sort of settlement. Undoubtedly Norris' statement is true. However, the market dynamic might be different if this settlement were different.
Based on the information Norris presents here, Citigroup's top management essentially knew that the bank was engaging in large-scale fraud by passing along billions of dollars worth of bad mortgages. If these people were now facing years of prison as a result of criminal prosecution then it may well affect how bank executives think about these situations in the future. While it will always be true that they do not want to turn away business, they would probably rather sacrifice some of their yearly bonus than risk spending a decade of their life behind bars. The fear of prision may even deter less scrupulous competitors. In that case, securitizing fraudulent mortgages might have been a marginal activity of little consequence for the economy.
Citigroup's settlement will not change the tradeoffs from what Citigroup's top management saw in 2006. As a result, in the future bankers are likely to make the same decisions that they did in 2006.

Thursday, July 17, 2014

'Debt, Great Recession and the Awful Recovery'

Cecchetti & Schoenholtz:

Debt, Great Recession and the Awful Recovery: ... In their new book, House of Debt, Atif Mian and Amir Sufi portray the income and wealth differences between borrowers and lenders as the key to the Great Recession and the Awful Recovery (our term). If, as they argue, the “debt overhang” story trumps the now-conventional narrative of a financial crisis-driven economic collapse, policymakers will also need to revise the tools they use to combat such deep slumps. ...
House of Debt is at its best in showing that: (1) a dramatic easing of credit conditions for low-quality borrowers fed the U.S. mortgage boom in the years before the Great Recession; (2) that boom was a major driver of the U.S. housing price bubble; and (3) leveraged housing losses diminished U.S. consumption and destroyed jobs.
The evidence for these propositions is carefully documented... The strong conclusion is that – as in many other asset bubbles across history and time – an extraordinary credit expansion stoked the boom and exacerbated the bust. Of that we can now be sure.
What is less clear is that these facts diminish the importance of the U.S. intermediation crisis as a trigger for both the Great Recession and the Awful Recovery..., while the U.S. recession started in the final quarter of 2007, it turned vicious only after the September 2008 failure of Lehman. ...
What about the remedy? Would greater debt forgiveness have limited the squeeze on households and reduced the pullback? Almost certainly. ...
The discussion about remedies to debt and leverage cycles is still in its infancy. House of Debt shows why that discussion is so important. Its contribution to understanding the Great Recession (and other big economic cycles) will influence analysts and policymakers for years, even those (like us) who give much greater weight to the role of banks and the financial crisis than the authors.

They also talk about the desirability of "new financial contracts that place the burden of bearing the risk of house price declines primarily on wealthy investors (rather than on borrowers) who can better afford it."

Sunday, July 13, 2014

'Why Macroeconomists, Not Bankers, Should Set Interest Rates'

Simon Wren-Lewis:

Why macroeconomists, not bankers, should set interest rates: More thoughts on the idea that interest rates ought to rise because of the possibility that the financial sector is taking excessive risks: what I called in this earlier post the BIS case, after the Bank of International Settlements, the international club for central bankers. I know Paul Krugman, Brad DeLong, Mark Thoma, Tony Yates and many others have already weighed in here, but - being macroeconomists - they were perhaps too modest to draw this lesson. ...

Saturday, July 12, 2014

'The Collapse of the French Assignat and Its Link to Virtual Currencies Today'

In case you missed this in links, I thought it was interesting:

Crisis Chronicles: The Collapse of the French Assignat and Its Link to Virtual Currencies Today, by James Narron and David Skeie, Liberty Street Economics: In the late 1700s, France ran a persistent deficit and by the late 1780s struggled with how to balance the budget and pay down the debt. After heated debate, the National Assembly elected to issue a paper currency bearing an attractive 3 percent interest rate, secured by the finest French real estate to be confiscated from the clergy. Assignats were first issued in December 1789 and initially were a boon to the economy. Yet while the first issues brought prosperity, subsequent issues led to stagnation and misery. In this edition of Crisis Chronicles, we review how fiat money inflation in France caused the collapse of the French assignat and describe some interesting parallels between the politics of French government finance in the late 1700s and more recent fiscal crises.

Remembering John Law and the Mississippi Bubble
It was not without grave reservation that the National Assembly elected to pursue a new issue of paper currency. Some who spoke out against issuing the assignat recalled the wretchedness and ruin to which their families were subjected during John Law’s tenure as head of French finance and the Mississippi Bubble of 1720. But there was also great political willpower against raising taxes of any sort and deficits were already high. So the only option was to turn to the printing press once again.
But this time, the National Assembly was convinced it would be different. The currency would be secured by confiscated church property...[continue reading]...

Wednesday, July 09, 2014

'Lifting the Veil on the U.S. Bilateral Repo Market'

Via the Liberty Street Economics blog at the NY Fed, should we worry as much about the bilateral repo market as we do about the tri-party market (which played a key role in the financial crisis and remains vulnerable to another "run on the shadow banking system")?:

Lifting the Veil on the U.S. Bilateral Repo Market, by Adam Copeland, Isaac Davis, Eric LeSueur, and Antoine Martin, Liberty Street Economics: The repurchase agreement (repo), a contract that closely resembles a collateralized loan, is widely used by financial institutions to lend to each other. The repo market is divided into trades that settle on the books of the two large clearing banks (that is, tri-party repo) and trades that do not (that is, bilateral repo). While there are public data about the tri-party repo segment, there is little to no information on the bilateral repo segment. In this post, we update a methodology we developed earlier to estimate the size and composition of collateral posted for bilateral repos, and find that U.S. Treasury securities are the dominant form of collateral for bilateral repos. This new finding implies that the collateral posted for bilateral repos is of higher quality than the collateral posted for tri-party repos. ...

Sunday, July 06, 2014

'Keynesian Yellen versus Wicksellian BIS'

Gavyn Davies:

Keynesian Yellen versus Wicksellian BIS, by Gavyn Davies: The Bank for International Settlements (BIS) caused a splash last weekend with an annual report that spelled out in detail why it disagrees with central elements of the strategy currently being adopted by its members, the major national central banks. On Wednesday, Fed Chair Janet Yellen mounted a strident defence of that strategy in her speech on “Monetary Policy and Financial Stability”. She could have been speaking for any of the major four central banks, all of which are adopting basically the same approach [1].
Rarely will followers of macro-economics have a better opportunity to compare and contrast the two distinct intellectual strands in the subject...
Paul Krugman correctly points out that the BIS has been wrong in the past about the threat of inflation. Furthermore, their supply-led analysis of the real economy probably underestimates the pervasive importance of demand shocks during most economic cycles (see Mark Thoma). But the risk of financial instability is another matter entirely. It is optimistic to believe that macro-prudential policy alone will be able to handle this threat. The contrasting needs of the real economy and the financial sector present a very real dilemma for monetary policy.
The BIS was right about the dangers of risky financial behaviour prior to the crash. That caused the greatest demand shock for a century. Keynesians, including the Chair of the Federal Reserve, should be more ready to recognise that the same could happen again.

Inadequate demand calls for low interest rates to try to stimulate spending, but does the threat of financial instability necessarily call for higher rates? If so, which should prevail? As I see it (1) lack of demand is the bigger threat right now, (2) if financial instability looks like the bigger problem at some point in the future, then macroprudential policy targeted at the specific problem should be the first line of defense, (3) and, if it is "optimistic to believe that macro-prudential policy alone will be able to handle this threat," that is, if macroprudential policy alone is not enough to eliminate the threat, then, and only then, should interest rates by raised beyond where they would be given the state of aggregate demand.

As I said a few days ago:

"I think the macroprudential approach is correct. Using interest rates to deal with pockets of financial instability is too blunt of an instrument, e.g. it hits all industries, not just the ones where the instability is suspected and it may not directly address the particular problem generating the instability. It's much better to target the sectors where the problems exist, and to shape the policies to directly address the underlying problem(s)."

But let me conceded one point. If we wait until we can be sure that a dangerous bubble exists, and to see if macroprudential policy will be sufficient, it may be too late to raise interest rates to try to pop the bubble -- it may be past the point of no return. But I still prefer pricking the bubble with targeted policy rather than raising interest rates and causing a slowdown in a wide variety of markets, almost all of which are not a threat to the economy.

Thursday, July 03, 2014

'The Financial Instability Argument for Raising Rates'

Simon Wren-Lewis responds to calls to raise interest rates to promote financial stability:

The financial instability argument for raising rates: ... Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. ...
I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. ...
However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused. ... So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery. ...
As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. ... Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.
So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.

Jane Yellen on how to deal with financial instability:

... Well, I think my main theme here today is that macroprudential policies should be the main line of defense, and I think the efforts that we’re engaged in in the United States but all countries coordinating through the — through Basel, through the Financial Stability Boards — the efforts that we are taking to globally strengthen the resilience of the financial system: more capital, higher quality capital, higher liquidity buffers, stronger and — arrangements for central clearing of derivatives that reduce interconnectedness among systemically important financial institutions, strengthening of the architecture of payments and clearing system dealing with risks we see in areas like tri-party repo. ...
I would also put resolution planning which we’re engaging in actively as among those measures. And, you know, as I mentioned, I think cyclical policies and sector-specific policies that we’re seeing many emerging markets take steps that can be used, particularly when we see problems developing in housing or a particular sector. These are really promising.
I don’t think we yet understand how they work. When they can be effective, how we should use them. I hope this will be an area for the IMF and for us of active research so we can better deploy those tools, capital — countercyclical capital charges.
But I think importantly, I’ve not taken monetary policy totally off the table as a measure to be used when financial excesses are developing because I think we have to recognize that macroprudential tools have their limitations. ... So to me, it’s not a first line of defense, but it is something that has to be actively in the mix. ...

Paul Krugman says "It’s about sadomonetarism, not stability."

I think the macroprudential approach is correct. Using interest rates to deal with pockets of financial instability is too blunt of an instrument, e.g. it hits all industries, not just the ones where the instability is suspected and it may not directly address the particular problem generating the instability. It's much better to target the sectors where the problems exist, and to shape the policies to directly address the underlying problem(s).

Wednesday, July 02, 2014

'Monetary Policy and Financial Stability'

Janet Yellen:

... Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.

To that end, I will briefly lay out my current assessment of financial stability risks and their relevance, at this time, to the stance of monetary policy in the United States. In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector. Moreover, the improvements in household and business balance sheets have been accompanied by the increased safety of the financial sector associated with the macroprudential efforts I have outlined. Overall, nonfinancial credit growth remains moderate, while leverage in the financial system, on balance, is much reduced. Reliance on short-term wholesale funding is also significantly lower than immediately before the crisis, although important structural vulnerabilities remain in short-term funding markets.

Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a "reach for yield" in the face of persistently low interest rates. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures. But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.

Conclusion In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macroprudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions. An important contributor to the progress made in the United States has been the lessons we learned from the experience gained by central banks and regulatory authorities all around the world. The IMF plays an important role in this evolving process as a forum for representatives from the world's economies and as an institution charged with promoting financial and economic stability globally. I expect to both contribute to and learn from ongoing discussions on these issues.

Monday, June 30, 2014

'How Securitization Really Works'

I didn't realize the share of the securitization market that is government-backed was so high. This is from Cecchetti & Schoenholtz:

How securitization really works: ... The success of U.S. securitization – as an alternative to bank finance – is a key factor behind the current push of euro-area authorities to increase securitization. ... Because finance is predominantly bank based in Europe – and banks faced heightened capital requirements – governments and potential borrowers are anxious to shift at least some financing into capital markets (including bonds and equities). ...
Yet, emulating American securitization ... probably means providing government guarantees at a scale that people currently do not envision. ...
To see what we mean, we can look at a few numbers regarding U.S. securitization. According to the Federal Reserve’s flow of funds statistics (the Z.1 release), total securitization stood at $9,360.4 billion as of end-March 2014... But government-backed securitizations – these are mortgages, student loans and the like – accounted for $7,721 billion of this total... That is, only 18% of U.S. securitization – primarily auto loans and credit card debt – are free from government guarantees! Even at the peak of private-sector securitization in mid-2007 ... the government-backed share exceeded 60%. ...
To put these numbers into perspective, we can look at another part of the U.S. financial system: insured bank deposits. You may be surprised to learn that ... only ... 61% of bank deposits are government backed ... versus 82% of securitizations. ...
We believe that U.S. government backing of securitizations can (and should) be scaled back... Nevertheless, it also seems difficult to jumpstart a large-scale securitization market in Europe without sizable public support. ...
The bottom line: If the euro area wishes to get securitization going in a big way, it will still need more of the mutual insurance among nations that has been so difficult to achieve. That doesn’t seem to be in the cards for now.

Friday, June 27, 2014

'How to Avoid the Next Crash'

From the editors at BloombergView:

How to Avoid the Next Crash: ... Many central banks, led by the U.S. Federal Reserve, have innovated boldly when it comes to monetary policy. They have pumped money into the financial system. They have provided banks with emergency loans. They have started providing "forward guidance" in an attempt to stabilize markets. Some even pay negative interest rates on reserves as a way to encourage private lending. Many countries have overhauled their financial regulatory systems as well.
There is a third category of innovation, however -- known as macroprudential policy -- that has lagged behind. It shouldn’t.
As the name suggests, macroprudential policies are a kind of hybrid: financial regulations attuned to the condition of the system as a whole, rather than the soundness of particular banks or other institutions. ...
Few deny the need for macroprudential policy. If speeches and conferences on the topic were a measure of progress, there'd be no cause for concern. Sadly, they aren't. Governments should develop a sense of urgency before it's too late.

For me, stopping the equivalent of bank runs within the shadow banking system -- a big problem during the financial crisis that has not yet been fully addressed -- is a top priority.

Thursday, June 26, 2014

'Are the Rating Agencies About to Get Their Comeuppance?'

Barry Ritholtz:

Are the Rating Agencies About to Get Their Comeuppance?: This week in encouraging news, we learn that the Securities and Exchange Commission may finally be pursuing one of the prime enablers of the financial crisis — the ratings companies. Previously, it was reported that disclosure violations were on the SEC’s radar, but truth be told, those are minor offenses.
The SEC’s Office of Credit Ratings, a division whose sole purpose is essentially to oversee Moody’s and Standard & Poor’s, seems to be stirring. ... Multiple cases have reportedly been referred to the SEC’s enforcement division, and new regulations are due.
And a welcome change it would be. Of all the players that helped cause the financial crisis, the ratings companies have gotten off scot-free. Banks have had massive fines while many mortgage and derivative underwriters have had their garbage securities put back to them at great cost. Since 2008, there have been 388 mortgage companies that have gone bankrupt. All of that junk paper found its way into AAA-rated securitized products and derivatives. The penalty for Moody’s and S&P has been essentially nil. ...[continue]...

It may be "encouraging news" but why has it taken so long?

Wednesday, June 25, 2014

'Speculation, Trading, and Bubbles'

For those who might be interested, an excerpt from a new book by José A. Scheinkman, Speculation, Trading, and Bubbles (with contributions by Sanford J. Grossman, Patrick Bolton, Kenneth J. Arrow, and Joseph E. Stiglitz):

 

Monday, June 23, 2014

Bank Failure, Relationship Lending, and Local Economic Performance

John Kandrac (a former Ph.D. student):

Bank Failure, Relationship Lending, and Local Economic Performance, by John Kandrac, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series: Abstract Whether bank failures have adverse effects on local economies is an important question for which there is conflicting and relatively scarce evidence. In this study, I use county-level data to examine the effect of bank failures and resolutions on local economies. Using quasi-experimental techniques as well as cross-sectional variation in bank failures, I show that recent bank failures lead to lower income and compensation growth, higher poverty rates, and lower employment. Additionally, I find that the structure of bank resolution appears to be important. Resolutions that include loss-sharing agreements tend to be less deleterious to local economies, supporting the notion that the importance of bank failure to local economies stems from banking and credit relationships. Finally, I show that markets with more inter-bank competition are more strongly affected by bank failure. [Download Full text]

Thursday, June 19, 2014

Did Timothy Geithner Pass the Test?

In case you missed this:

Does He Pass the Test?, by Paul Krugman: Midway through Timothy Geithner’s Stress Test, the former treasury secretary describes a late-2008 conversation with the then president-elect. Obama “wanted to discuss what he should try to accomplish.” Geithner’s reply was that his accomplishment would be “preventing a second Great Depression.” And Obama shot back that he didn’t want to be defined by what he had prevented.
It’s an ironic tale for Geithner to be telling, although it’s not clear whether he himself realizes just how ironic. For Stress Test is meant to be a story of successful policy—but that success is defined not by what happened but by what didn’t. America did indeed manage to avoid a full replay of the Great Depression—an achievement for which Geithner implicitly claims much of the credit, and with some justification. We did not, however, avoid economic disaster. By any plausible accounting, we’ve lost trillions of dollars’ worth of goods and services that we could and should have produced; millions of Americans have lost their jobs, their homes, and their dreams. Call it the Lesser Depression—not as bad as the 1930s, but still a terrible thing. Not to mention the disastrous consequences abroad.
Or to use one of the medical metaphors Geithner likes, we can think of the economy as a patient who was rushed to the emergency room with a life-threatening condition. Thanks to the urgent efforts of the doctors present, the patient’s life was saved. But while the doctors kept him alive, they failed to cure his underlying illness, so he emerged from the procedure partly crippled, and never fully recovered.
How should we think about the economic policy of these past seven or so years? ...

Saturday, May 31, 2014

Are Banks Too Large?

At Vox EU:

Are banks too large?, by Lev Ratnovski, Luc Laeven, and Hui Tong: Summary: Large banks have grown and become more involved in market-based activities since the late 1990s. This column presents evidence that large banks receive too-big-to-fail subsidies and create systemic risk, whereas economies of scale in banking are modest. Hence, some large banks may be ‘too large’ from a social perspective. Since the optimal bank size is unknown, the best policies are capital surcharges and better bank resolution and governance.

Thursday, May 22, 2014

'A Note on the Lender of Last Resort'

Cecchetti & Schoenholtz:

A note on the lender of last resort: ...In responding to queries about the Federal Reserve’s actions on the fateful Lehman weekend in mid-September 2008, various officials noted that the law does not allow the Federal Reserve to lend to an insolvent institution. As we reconsider the role of central bank lending, this is one principle, dating back to Walter Bagehot in the 19th century, that it is important to understand and maintain.
There are three big reasons that a central bank should not lend to a bankrupt institution. The first is that, by lending secured to an insolvent commercial bank, the central bank further subordinates bond holders. ... These actions pick winners and losers. In democracies, such choices are typically the prerogative of elected officials, not central bankers.
Second, lending to an insolvent institution by itself does not put an end to its fragility. Ultimately, the institution must be liquidated or re-capitalized. Postponing this resolution is usually costly. ...
Third, when people find out that the central bank is willing to lend to insolvent banks – and they will find out – then any bank that borrows will be suspected of being bankrupt. The resulting stigma will impair the useful function of the lender of last resort...
The real problem in 2008 was that there was no resolution regime in place that would allow ... big intermediaries to fail without disrupting the entire global financial system. ... Dodd-Frank ... created a new resolution mechanism... However, that regime ... remains untested...
Importantly, Dodd-Frank also narrowed the legal form of recipients eligible for Fed discount loans, contrary to the broad latitude suggested by Bagehot. ... Post Dodd-Frank, the discount window is for banks only. Others will have to seek liquidity elsewhere, even if they are solvent.

Monday, May 19, 2014

Paul Krugman: Springtime for Bankers

Heckuva job?:

Springtime for Bankers, by Paul Krugman, Commentary, NY Times: By any normal standard, economic policy since the onset of the financial crisis has been a dismal failure. It’s true that we avoided a full replay of the Great Depression. But employment has taken more than six years to claw its way back to pre-crisis levels...
Now Timothy Geithner, who was Treasury secretary for four of those six years, has published a book, “Stress Test,” about his experiences. And basically, he thinks he did a heckuva job. ...
Much of Mr. Geithner’s book is devoted to a defense of the U.S. financial bailout, which he sees as a huge success story — which it was, if financial confidence is viewed as an end in itself. ... But where is the rebound in the real economy? Where are the jobs? ...
One reason for sluggish recovery is that U.S. policy “pivoted,” far too early, from a focus on jobs to a focus on budget deficits. Mr. Geithner denies ... any responsibility for this... That doesn’t match independent reporting, which portrays Mr. Geithner ridiculing fiscal stimulus as “sugar” that would yield no long-term benefit.
But fiscal austerity wasn’t the only reason recovery has been so disappointing..., the burden of high household debt, a legacy of the housing bubble, has been a big drag on the economy. And there was, arguably, a lot the Obama administration could have done to reduce debt burdens without Congressional approval. But it didn’t... Why? According to many accounts, the biggest roadblock was Mr. Geithner’s consistent opposition to mortgage debt relief — he was, if you like, all for bailing out banks but against bailing out families.
“Stress Test” asserts that no conceivable amount of mortgage debt relief could have done much to boost the economy. But the leading experts on this subject are ... Atif Mian and Amir Sufi, whose just-published book “House of Debt” argues very much the contrary. ...
In the end, the story of economic policy since 2008 has been that of a remarkable double standard. Bad loans always involve mistakes on both sides — if borrowers were irresponsible, so were the people who lent them money. But when crisis came, bankers were held harmless for their errors while families paid full price.
And refusing to help families in debt, it turns out, wasn’t just unfair; it was bad economics. Wall Street is back, but America isn’t, and the double standard is the main reason.

Thursday, May 15, 2014

'Are Banks Too Large?'

I don't think this issue can be addressed without also considering the political power of large banks -- their ability to shape legislation in their favor in a way that increases the risk of financial meltdown:

Are Banks Too Large? Maybe, Maybe Not, by Luc Laeven, Lev Ratnovski, and Hui Tong, iMFdirect: Large banks were at the center of the recent financial crisis. The public dismay at costly but necessary bailouts of “too-big-to-fail” banks has triggered an active debate on the optimal size and range of activities of banks.
But this debate remains inconclusive, in part because the economics of an “optimal” bank size is far from clear. Our recent study tries to fill this gap by summarizing what we know about large banks using data for a large cross-section of banking firms in 52 countries.
We find that while large banks are riskier, and create most of the systemic risk in the financial system, it is difficult to determine an “optimal” bank size. In this setting, we find that the best policy option may not be outright restrictions on bank size, but capital—requiring  large banks to hold more capital—and better bank resolution and governance.
Large banks increase systemic, not individual bank risk
Large banks have significantly grown in size, and become more involved in market-based activities since the late 1990s..., the balance sheet size of the world’s largest banks increased two to four-fold in the 10 years prior to the crisis. ...
Also, large banks appear to have a distinct, seemingly risky business model. They tend to simultaneously have lower capital..., less stable funding..., more market-based activities..., and be more organizationally complex..., than smaller banks. ...
In addition, our study confirms that large banks create most of systemic risk in today’s financial system. ... Large banks create especially high systemic risk when they have insufficient capital or unstable funding. And, large banks create high systemic risk...
Too-big-to-fail and empire building
What drives the size and the business model of large banks? Our study suggests the following:
Implicit too-big-to-fail subsidies ... This predisposes large banks to use leverage and unstable funding, and to engage in risky market-based activities.
Possible empire building. ...
Economies of scale. While a good explanation for the size of large banks, recent studies suggest that they are modest. ...
Optimal bank size inconclusive
The evidence that large banks respond to too-big-to-fail and empire building incentives, and in process create systemic risk suggests that banks might become “too large” from a social welfare perspective. But there is an important caveat. We know too little about the value that large banks bring to their customers (e.g., large global corporations). The potential for economies of scale in large banks cannot be dismissed. As a result, we cannot draw conclusions as to the socially optimal bank size. And it also implies that outright restrictions on bank size or activities may be imprecise and hence costly. ...

Tuesday, April 29, 2014

'Narrow Banks Won't Stop Bank Runs'

This is from a new blog by Stephen Cecchetti and Kermit Schoenholtz:

Narrow Banks Won't Stop Bank Runs: Every financial crisis leads to a new call to restrict the activities of banks. One frequent response is to call for “narrow banks.” That is, change the legal and regulatory framework in a way that severely limits the assets that traditional deposit-taking banks can hold. One approach would require that all liabilities that are demandable at par be held in the form of deposits at the central bank. That is, accounts that can be withdrawn without notice and have fixed net asset value would face a 100% reserve requirement. The Depression-era “Chicago Plan” had this approach in mind.
In the aftermath of the financial crisis of 2007-09, Lawrence Kotlikoff, Jeremy Bulow and Paul Klemperer, John Kay, and, most recently, John Cochrane, and Martin Wolf have resurrected versions of narrow banking. All of these proposals, both the old and the new, have a common core: banks should be split into two parts, neither of which would supposedly be subject to runs. ...
Naturally, we share the objective of these reformers: preventing bank runs. The key issue is how to do so and at what cost. We suspect that narrow banking would be costly in terms of economic performance, yet unlikely to achieve this goal. ...
We know that a combination of transparency, high capital and liquidity requirements, deposit insurance and a central bank lender of last resort can make a financial system more resilient. We doubt that narrow banking would.

(The original post is much more detailed.)

Monday, April 28, 2014

New Research in Economics: Central Banking For All: A Modest Case for Radical Reform

Via Nicholas Gruen:

Central Banking For All: A modest Case for Radical Reform (Download): This paper offers a  radical option for banking reform: government should offer central banking services not just to commercial banks, but directly to citizens.
Key Findings
Nicholas Gruen argues the UK and other countries need radical banking reform This can be achieved by a simple change: giving ordinary people the same right to use central banks’ services as big commercial banks have. Though they enjoy high margins and/or fees, banks add little value to ‘commodity services’ like customer accounts and highly-collateralised mortgages like older ones that are partially paid off which are basically riskless.
There’s widespread agreement that the UK needs better banks and a better deal for bank customers. This report by Nicholas Gruen, economist and founding chairman of Kaggle and The Australian Centre for Social Innovation, proposes a simple but radical solution.
Gruen argues that in the age of the internet, the Bank of England can now extend the services it currently offers only to banks to everyone in the UK. In particular, it should offer (for instance through National Savings & Investments) simple, cheap deposit and savings accounts to all, paying interest at Bank Rate. Second, it should offer to guarantee any well-collateralised mortgage (for instance a residential mortgage for less than 60 per cent of the value of the collateral).
At the moment, commercial banks provide these services at a cost (both in terms of worse rates, fees with their margins inflated by their funder’s knowledge that they are implicitly government guaranteed).
By cutting out the middle-man in the form of the banks, Gruen argues customers would get a better deal, and private competitors providing finance could focus on the provision of finance where the efficient pricing of risk is essential – most particularly residential finance above 60 per cent of the value of collateral.
Policy Recommendations
The government should allow the Bank of England to provide central banking services directly to anyone who wants them, not just banks. The Bank should offer to fund or guarantee any well-collateralised mortgage (e.g. with less than 60 per cent of the property value outstanding) The Bank should, through National Savings and Investments, offer simple deposit and savings accounts to anyone who wants them with no upper limits, paying Bank Rate of interest.

Sunday, April 27, 2014

'Is the Stock Market Getting Bubbly?'

Dean Baker:

Is the Stock Market Getting Bubbly?: Washington Post columnist Steve Pearlstein argues it is, taking issue with fellow columnist Barry Ritholtz who says it isn't. I'm going to come down in the middle here.
The market is somewhat above its historic levels relative to trend earnings. Pearlstein cites Shiller who puts the price to earnings ratio at 25 to 1, compared to a historic average of 16. ... I would agree that stock prices are somewhat above trend, but not by quite as large a margin as Shiller.
To get some perspective, at the peak of the stock bubble in early 2000, the S&P peaked at just under 1530. The economy is almost than 70 percent larger today (in nominal dollars), which would mean that the S&P would be over 2600 today if it were as high relative to the economy. If we throw in that the economy is still operating at 5 percent below its potential then the S&P would have to be over 2700 now to be as high relative to the economy as it was at the peak of the stock bubble. With a Friday close of 1863, we can see the market is at a level that is a bit more than two thirds of its 2000 bubble peak, relative to the size of the economy.
It also is much lower relative to the economy than it was in 2007 when almost no one was talking about a stock bubble. The S&P peaked at just over 1560 in the fall of 2007. Taking into account the economy's 18 percent nominal growth over this period, and the fact that we are still 5 percent below potential GDP, the S&P would have to be over 1900 today to be as high relative to potential GDP as it was in 2007. Given recent patterns, it certainly doesn't make sense to talk about a bubble for the market as a whole.
However, there are some points worth noting. The social media craze has allowed many companies with no profits and few prospects for making profits to market valuations in the hundreds of millions or even billions of dollars. That sure looks like the Internet bubble. Some of these companies may end up being profitable and worth something like their current share price. The vast majority probably will not.
The other point is that the higher than trend price to earnings ratio means that we should expect to see lower than trend real returns going forward. This is an important qualification to Ritholtz's analysis. While there is no reason that people should fear that stocks in general will take a tumble, as they did in 2000-2002, they also would be nuts to expect the same real returns going forward as they saw in the past.
With a price to earnings ratio that is roughly one-third about the long-term trend, they should expect real returns that are roughly one-third lower than the historic average. This means that instead of expecting real returns on stock of 7.0 percent, they should expect something closer to 5.0 percent. That might still make stocks a good investment, especially in the low interest rate environment we see today, but probably not as good as many people are banking on.
In short, there is not much basis for Pearlstein's bubble story, but we should also expect that because of higher than trend PE ratios stocks will not provide the same returns in the future as they did in the past. Anyone who thinks we can better have their calculator checked.

'Is A Banking Ban The Answer?'

Paul Krugman:

Is A Banking Ban The Answer?: OK, a genuinely interesting debate on financial reform is taking place. I’m not even sure where I stand. But it’s certainly worth talking about.
Atif Mian and Amir Sufi draw our attention to proposals to either mandate or create strong incentives for 100-percent reserve banking, coming from Martin Wolf and, more surprisingly, John Cochrane. Equally surprising — at least to me — is that Cochrane seems more aware of the difficulties of the issue. ... So, three thoughts.
First, Wolf’s omission is a big one. If we impose 100% reserve requirements on depository institutions, but stop there, we’ll just drive even more finance into shadow banking, and make the system even riskier.
Second, Cochrane’s proposal calls for a remarkable amount of government intervention in finance; it makes liberal proposals for a transactions tax look like minor nuisances. Cochrane insists that we can easily run our economy without dangerous short-term private debt — that we can easily set things up so that the manager of your index fund sells a tiny piece of your stock portfolio every time you use a debit card at 7-11. Is this right?
Third, and on a quite different note: Are we really sure that banking problems are the whole story about what went wrong? I’ve made this point before, but look at any measure of financial stress: what you see is a huge peak in 2008 that quickly went down:
Yet ... we’re still depressed and many advanced countries are now on the edge of deflation, more than five years later. This strongly suggests that while bank runs may have brought things to a head, the problems ran deeper; in particular, I’m strongly of the view (based in part on Mian and Sufi’s work) that broader issues of excess leverage, and the resulting balance-sheet problems of many households, are key. And neither 100% reserves nor a repo tax would have addressed that kind of leverage. ...

Monday, April 14, 2014

FRBSF Economic Letter: How Important Are Hedge Funds in a Crisis?

Another one that may be of interest:

How Important Are Hedge Funds in a Crisis?, by Reint Gropp, FRBSF Economic Letter: Before the 2007–09 crisis, standard risk measurement methods substantially underestimated the threat to the financial system. One reason was that these methods didn’t account for how closely commercial banks, investment banks, hedge funds, and insurance companies were linked. As financial conditions worsened in one type of institution, the effects spread to others. A new method that more accurately accounts for these spillover effects suggests that hedge funds may have been central in generating systemic risk during the crisis.

Paul Krugman: Three Expensive Milliseconds

 What is the "true cost of our bloated financial industry"?:

Three Expensive Milliseconds, by Paul Krugman, Commentary, NY Times: Four years ago ... Spread Networks finished boring its way through the Allegheny Mountains of Pennsylvania. Spread’s tunnel was ... a fiber-optic cable that would shave three milliseconds — three-thousandths of a second — off communication time between the futures markets of Chicago and the stock markets of New York. ...
Who cares about three milliseconds? The answer is, high-frequency traders, who make money by buying or selling stock a tiny fraction of a second faster than other players. ...
Think about it..., spending hundreds of millions of dollars to save three milliseconds looks like a huge waste. And that’s part of a much broader picture, in which society is devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return.
How much waste are we talking about? A paper by Thomas Philippon of New York University puts it at several hundred billion dollars a year. ...
What are we getting in return for all that money? Not much, as far as anyone can tell. ...
But if our supersized financial sector isn’t making us either safer or more productive, what is it doing? One answer is that it’s playing small investors for suckers, causing them to waste huge sums in a vain effort to beat the market. Don’t take my word for it — that’s what the president of the American Finance Association declared in 2008. Another answer is that a lot of money is going to speculative activities that are privately profitable but socially unproductive. ...
 It’s ... hard ... to see how the three-millisecond advantage conveyed by the Spread Networks tunnel makes modern America richer; yet that advantage was clearly worth it to the speculators.
In short, we’re giving huge sums to the financial industry while receiving little or nothing — maybe less than nothing — in return. Mr. Philippon puts the waste at 2 percent of G.D.P. Yet even that figure, I’d argue, understates the true cost of our bloated financial industry. For there is a clear correlation between the rise of modern finance and America’s return to Gilded Age levels of inequality.
So never mind the debate about exactly how much damage high-frequency trading does. It’s the whole financial industry, not just that piece, that’s undermining our economy and our society.

Saturday, April 12, 2014

Have We Repaired Financial Regulations Since Lehman?

"The 2008 financial crisis led to the worst recession in the developed world since the Great Depression. Governments had to respond decisively on a large scale to contain the destructive impact of massive debt deflation. Still, several large financial institutions and thousands of small-to-medium-sized institutions collapsed or had to be rescued, numerous non-financial businesses closed, and millions of households lost their savings, jobs, and homes. Five years later, we are still feeling these effects. Will the financial reforms introduced since the onset of the crisis prevent another catastrophe? This keynote panel titled 'Have We Repaired Financial Regulation Since Lehman' at the Institute for New Economic Thinking's "Human After All" conference in Toronto."

Featured speakers: Anat Admati, Richard Bookstaber, Andy Haldane, and Edward Kane, moderated by Martin Wolf.

Thursday, April 10, 2014

'Pseudo-Mathematics and Financial Charlatanism'

"Past performance is not an indicator of future results":

Pseudo-mathematics and financial charlatanism, EurekAlert: Your financial advisor calls you up to suggest a new investment scheme. Drawing on 20 years of data, he has set his computer to work on this question: If you had invested according to this scheme in the past, which portfolio would have been the best? His computer assembled thousands of such simulated portfolios and calculated for each one an industry-standard measure of return on risk. Out of this gargantuan calculation, your advisor has chosen the optimal portfolio. After briefly reminding you of the oft-repeated slogan that "past performance is not an indicator of future results", the advisor enthusiastically recommends the portfolio, noting that it is based on sound mathematical methods. Should you invest?
The somewhat surprising answer is, probably not. Examining a huge number of sample past portfolios---known as "backtesting"---might seem like a good way to zero in on the best future portfolio. But if the number of portfolios in the backtest is so large as to be out of balance with the number of years of data in the backtest, the portfolios that look best are actually just those that target extremes in the dataset. When an investment strategy "overfits" a backtest in this way, the strategy is not capitalizing on any general financial structure but is simply highlighting vagaries in the data. ...
Unfortunately, the overfitting of backtests is commonplace not only in the offerings of financial advisors but also in research papers in mathematical finance. One way to lessen the problems of backtest overfitting is to test how well the investment strategy performs on data outside of the original dataset on which the strategy is based; this is called "out-of-sample" testing. However, few investment companies and researchers do out-of-sample testing. ...

Sunday, April 06, 2014

'Superfluous Financial Intermediation'

Rajiv Sethi:

Superfluous Financial Intermediation: I'm only about halfway through Flash Boys but have already come across a couple of striking examples of what might charitably be called superfluous financial intermediation. This is the practice of inserting oneself between a buyer and a seller of an asset, when both parties have already communicated to the market a willingness to trade at a mutually acceptable price. If the intermediary were simply absent from the marketplace, a trade would occur between the parties virtually instantaneously at a single price that is acceptable to both. Instead, both parties trade against the intermediary, at different prices. The intermediary captures the spread at the expense of the parties who wish to transact, adds nothing to liquidity in the market for the asset, and doubles the notional volume of trade. ... [gives two examples] ....

Michael Lewis has focused on practices such as these because their social wastefulness and fundamental unfairness is so transparent. But it's important to recognize that most of the strategies implemented by high frequency trading firms may not be quite so easy to classify or condemn. For instance, how is one to evaluate trading based on short term price forecasts based on genuinely public information? I have tried to argue in earlier posts that the proliferation of such information extracting strategies can give rise to greater price volatility. Furthermore, an arms race among intermediaries willing to sink significant resources into securing the slightest of speed advantages must ultimately be paid for by investors. ...

I hope that the minor factual errors in Flash Boys won't detract from the book's main message, or derail the important and overdue debate that it has predictably stirred. By focusing on the most egregious practices Lewis has already picked the low-hanging fruit. What remains to be figured out is how typical such practices really are. Taking full account of the range of strategies used by high frequency traders, to what extent are our asset markets characterized by superfluous financial intermediation?

Friday, April 04, 2014

'The Legitimacy of High Frequency Trading'

Tim Johnson on high frequency trading:

The Legitimacy of High Frequency Trading: Mark Thoma brought my attention to a post by Dean Baker, High Speed Trading and Slow-Witted Economic Policy. High Frequency Trading, or more generically Computer Based Trading, is proving problematic because it is a general term involving a variety of different techniques, some of which appear uncontroversial, others appear very dubious.

For example, a technique I would consider legitimate derives from Robert Almgren and Neil Chriss' work on optimal order execution: how do you structure a large trade such that it has minimal negative price impact and low transaction costs. There are firms that now specialise in performing these trades on behalf of institutions and I don't think there is an issue with how they innovate in order to generate profits.

The technique that is most widely regarded as illegitimate is order, or quote, stuffing. The technique involves placing orders and within a tenth of a second or less, cancelling them if they are not executed. I suspect this is the process that Baker refers to that enables HFTs to 'front run' the market. Baker regards the process as illegitimate...

The problem I have with Baker's argument is that I do not think it is robust. ... [explains why] ...

The substantive question is whether I can come up with a more robust argument than Baker's, and I offer an argument at the bottom of this piece. ...

Tuesday, April 01, 2014

'High Speed Trading and Slow-Witted Economic Policy'

Busy morning, so I will take advantage of the Creative Commons license and do a quick post. This is from Dean Baker:

High Speed Trading and Slow-Witted Economic Policy, by Dean Baker: Michael Lewis' new book, Flash Boys, is leading to large amounts of discussion both on and off the business pages. The basic story is that a new breed of traders can use sophisticated algorithms and super fast computers to effectively front-run trades. This allows them to make large amounts of money by essentially skimming off the margins. By selling ahead of a big trade, they will push down the price that trader receives for their stock by a fraction of a percent. Similarly, by buying ahead of a big trade, they will also raise the price paid for that trade by a fraction of a percent. Since these trades are essentially a sure bet (they know that a big sell order or a big buy order is coming), the profits can be enormous.
This book is seeming to prompt outrage, although it is not clear exactly why. The basic story of high frequency trading is not new. It has been reported in most major news outlets over the last few years. It would be nice if we could move beyond the outrage to a serious discussion of the policy issues and ideally some simple and reasonable policy to address the issue. (Yes, simple should be front and center. If it's complicated we will be employing people in pointless exercises -- perhaps a good job program, but bad from the standpoint of effective policy.)
The issue here is that people are earning large amounts of money by using sophisticated computers to beat the market. This is effectively a form of insider trading. Pure insider trading, for example trading based on the CEO giving advance knowledge of better than expected profits, is illegal. The reason is that it rewards people for doing nothing productive at the expense of honest investors.
On the other hand, there are people who make large amounts of money by doing good research to get ahead of the market. For example, many analysts may carefully study weather patterns to get an estimate of the size of the wheat crop and then either buy or sell wheat based on what they have learned about the about this year's crop relative to the generally held view. In principle, we can view the rewards for this activity as being warranted since they are effectively providing information to the market with the their trades. If they recognize an abundant wheat crop will lead to lower prices, their sales of wheat will cause the price to fall before it would otherwise, thereby allowing the markets to adjust more quickly. The gains to the economy may not in all cases be equal to the private gains to these traders, but at least they are providing some service.
By contrast, the front-running high speed trader, like the inside trader, is providing no information to the market. They are causing the price of stocks to adjust milliseconds more quickly than would otherwise be the case. It is implausible that this can provide any benefit to the economy. This is simply siphoning off money at the expense of other actors in the market.
There are many complicated ways to try to address this problem, but there is one simple method that would virtually destroy the practice. A modest tax on financial transactions would make this sort of rapid trading unprofitable since it depends on extremely small margins. A bill proposed by Senator Tom Harkin and Representative Peter DeFazio would impose a 0.03 percent tax on all trades of stocks, bonds, and derivatives. This would quickly wipe out the high-frequency trading industry while having a trivial impact on normal investors. (Most research indicates that other investors will reduce their trading roughly in proportion to the increase in the cost per trade, leaving their total trading costs unchanged.)The Joint Tax Committee projected that this tax would raise roughly $400 billion over a decade.
A scaled tax that imposed a somewhat higher fee on stock trades and lower fee on short-term assets like options could be even more effective. Japan had a such tax in place in the 1980s and early 1990s. It raised more than 1 percent of GDP ($170 billion a year in the United States). Representative Keith Ellison has proposed this sort of tax for the United States.
If the political system were not so corrupt, such taxes would be near the top of the policy agenda. Even the International Monetary Fund has complained that the financial sector is under-taxed. However, because of the money and power of the industry the leadership of both political parties will run away from imposing any tax on the financial industry. In fact Treasury Secretary Jack Lew has been working to torpedo the imposition of such a tax in Europe. So look for lots of handwringing and outrage in response to Lewis' book. And look also for nothing real to be done. 

Wednesday, March 26, 2014

Video: Robert Shiller on Market Bubbles – And Busts

Sunday, March 23, 2014

'Secular Stagnation and Wealth Inequality'

Atif Mian and Amir Sufi:

Secular Stagnation and Wealth Inequality, by Atif Mian and Amir Sufi: Alvin Hansen introduced the notion of “secular stagnation” in the 1930s. Hansen’s hypothesis has been brought back to life by Larry Summers...
A brief summary of the hypothesis goes something like this: A normally functioning economy would lower interest rates in the face of low current demand for goods and services... A lower interest rate helps boost demand.
But what if ... real interest rates need to be very negative to boost demand, but prevailing interest rates are around zero, then we will have too much savings in risk-free assets — what Paul Krugman has called the liquidity trap. In such a situation, the economy becomes demand-constrained.
The liquidity trap helps explain why recessions can be so severe. But the Summers argument goes further. He is arguing that we may be stuck in a long-run equilibrium where real interest rates need to be negative to generate adequate demand. Without negative real interest rates, we are doomed to economic stagnation. ...
In our view, what is missing from the secular stagnation story is the crucial role of the highly unequal wealth distribution. Who exactly is saving too much? It certainly isn’t the bottom 80% of the wealth distribution! We have already shown that the bottom 80% of the wealth distribution holds almost no financial assets.
Further, when the wealthy save in the financial system, some of that saving ends up in the hands of lower wealth households when they get a mortgage or auto loan. But when lower wealth households get financing, it is almost always done through debt contracts. This introduces some potential problems. Debt fuels asset booms when the economy is expanding, and debt contracts force the borrower to bear the losses of a decline in economic activity.
Both of these features of debt have important implications for the secular stagnation hypothesis. We will continue on this theme in future posts.

Thursday, March 13, 2014

'The Free Market’s Weak Hand'

James Kwak:

The Free Market’s Weak Hand, by James Kwak:

“Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.”

That was Alan Greenspan back in 2003. This is little different from another of his famous maxims, that anti-fraud regulation was unnecessary because the market would not tolerate fraudsters. It is also a key premise of the blame-the-government crowd (Wallison, Pinto, and most of the current Republican Party), which claims that the financial crisis was caused by excessive government intervention in financial markets.

Market discipline clearly failed in the lead-up to the financial crisis. ... However, one thrust of post-crisis regulation has been to attempt to strengthen market discipline. This is consistent with the overall Geithner-Summers doctrine that markets generally work close to perfectly, and that regulation should mainly attempt to nudge markets in the right direction.

David Min (the lead rebutter of Wallison and Pinto’s theory of subprime mortgages, which relied on a made-up definition of “subprime”) has a new paper explaining why this is likely to fail. ...

Ultimately, one of Min’s suggestions is that we simply cannot rely heavily on market discipline as a means of constraining risk-taking by financial institutions. This leaves us with relatively unfashionable tools like higher capital requirements and structural reforms (size and complexity limits). But that’s not nearly sophisticated enough for the Geithner-Summers-Bernanke crew.

Sunday, March 02, 2014

'In Search of a Stable Electronic Currency'

Robert Shiller:

In Search of a Stable Electronic Currency, by Robert Shiller, Commentary, NY Times: ... Bitcoin’s future is very much in doubt. Yet whatever becomes of it, something good can arise from its innovations... I believe that electronic forms of money could give us better pricing, contracting and risk management. ...
Bitcoin has been focused on the wrong classical functions of money, as a medium of exchange and a store of value. ... It would be much better to focus on another classical function: money as a unit of account...
This has already begun to happen. ... For example, since 1967 in Chile, an inflation-indexed unit of account called the unidad de fomento (U.F.), meaning unit of development, has been widely used. Financial exchanges are made in pesos, according to a U.F.-peso rate posted on the website valoruf.cl. One multiplies the U.F. price by the exchange rate to arrive at the amount owed today in pesos. In this way, it is natural and easy to set inflation-indexed prices, and Chile is much more effectively inflation-indexed than other countries are. ...
With electronic software in the background, we can ... move beyond just one new unit of account to a whole system of them...
Bitcoin has been a bubble. But the legacy of the Bitcoin experience should be that we move toward a system of stable economic units of measurement — a system empowered by sophisticated mechanisms of electronic payment.

Thursday, February 20, 2014

'Random Variation'

James Kwak:

... I used to believe that no one could beat the market: in other words, that anyone who did beat the market was solely the beneficiary of random variation (a winner in Burton Malkiel’s coin-tossing tournament). I no longer believe this. I’ve seen too many studies that indicate that the distribution of risk-adjusted returns cannot be explained by dumb luck alone; most of the unexplained outcomes are at the negative end of the distribution, but there are also too many at the positive end. Besides, it makes sense: the idea that markets perfectly incorporate all available information sounds too much like magic to be true. ...

Sunday, January 19, 2014

'Rational Agents: Irrational Markets'

Roger Farmer:

Rational Agents: Irrational Markets: Bob Shiller wrote an interesting piece in today's NY Times on the irrationality of human action. Shiller argues that the economist's conception of human beings as rational is hard to square with the behavior of asset markets.
Although I agree with Shiller, that human action is inadequately captured by the assumptions that most economists make about behavior, I am not convinced that we need to go much beyond the rationality assumption, to understand what causes financial crises or why they are so devastatingly painful for large numbers of people. The assumption that agents maximize utility can get us a very very long way. ...
In my own work, I have shown that the labor market can go very badly wrong even when everybody is rational.  My coauthors and I showed in a recent paper, that the same idea holds in financial markets. Even when individuals are assumed to be rational; the financial markets may function very badly. ...
Miles Kimball and I have both been arguing that stock market fluctuations are inefficient and we both think that government should act to stabilize the asset markets. Miles' position is much closer to that of Bob Shiller; he thinks that agents are not always rational in the sense of Edgeworth. Miles and Bob may well be right. But in my view, the argument for stabilizing asset markets is much stronger. Even if we accept that agents are rational, it does not follow that swings in asset prices are Pareto efficient. But whether the motive arises from irrational people, or irrational markets; Miles and I agree: We can, and should, design an institution that takes advantage of the government's ability to trade on behalf of the unborn. More on that in a future post. ...

Tuesday, January 14, 2014

'Capital Markets Balkanization Should Not Prevent Regulation'

Adair Turner:

Adair Turner: Capital Markets Balkanization Should Not Prevent Regulation, by The Institute for New Economic Thinking: “Don’t worry about the balkanisation of global capital markets” – Adair Turner
Fears that bank regulation or capital controls could lead to a “balkanisation” of global capital markets are overstated and should not constrain policy action to address the problems created by volatile short term capital flows and excessive credit creation, says Adair Turner, Senior Fellow at the Institute for New Economic Thinking and former chairman of the United Kingdom Financial Services Authority.
Speaking at a conference in Delhi sponsored by the Reserve Bank of India, Turner focused on the links between the international monetary system and domestic financial stability. [For the text of the speech and presentation please see below.] ...
Ultimately, Turner rejected the idea that this would lead to a harmful fragmentation of global capital markets.
“Talk of such policies is often met by objections that this will lead to a dangerous ‘balkanisation’ of global capital markets, preventing the free flow of capital and stymieing its allocative efficiency benefits,” he said. “But since the evidence for the benefits of financial integration is at best elusive and ambiguous, some ‘balkanisation’ of short term international debt markets could be a good thing”.

Tuesday, December 17, 2013

'The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?'

Could it really be that no fraud was committed prior to the Great Recession? It's unlikely:

The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?, by Jed S. Rakoff, NYRB: Five years have passed since the onset of what is sometimes called the Great Recession. While the economy has slowly improved, there are still millions of Americans leading lives of quiet desperation: without jobs, without resources, without hope.
Who was to blame? Was it simply a result of negligence, of the kind of inordinate risk-taking commonly called a “bubble,” of an imprudent but innocent failure to maintain adequate reserves for a rainy day? Or was it the result, at least in part, of fraudulent practices, of dubious mortgages portrayed as sound risks and packaged into ever more esoteric financial instruments, the fundamental weaknesses of which were intentionally obscured?
If it was the former—if the recession was due, at worst, to a lack of caution—then the criminal law has no role to play in the aftermath. ... If the Great Recession was in no part the handiwork of intentionally fraudulent practices by high-level executives, then to prosecute such executives criminally would be “scapegoating” of the most shallow and despicable kind.
But if, by contrast, the Great Recession was in material part the product of intentional fraud, the failure to prosecute those responsible must be judged one of the more egregious failures of the criminal justice system in many years. Indeed, it would stand in striking contrast to the increased success that federal prosecutors have had over the past fifty years..., Michael Milken..., the so-called savings-and-loan crisis, which again had some eerie parallels to more recent events, resulted in the successful criminal prosecution of more than eight hundred individuals, right up to Charles Keating. And again, the widespread accounting frauds of the 1990s, most vividly represented by Enron and WorldCom, led directly to the successful prosecution of such previously respected CEOs as Jeffrey Skilling and Bernie Ebbers.
In striking contrast with these past prosecutions, not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis, and given the fact that most of the relevant criminal provisions are governed by a five-year statute of limitations, it appears likely that none will be. It may not be too soon, therefore, to ask why.
One possibility, already mentioned, is that no fraud was committed. This possibility should not be discounted. ... For example, the Financial Crisis Inquiry Commission, in its final report, uses variants of the word “fraud” no fewer than 157 times in describing what led to the crisis, concluding that there was a “systemic breakdown,” not just in accountability, but also in ethical behavior. ...[continue]...

Tuesday, December 03, 2013

'Five Years Later'

David Warsh on the "nature of what happened in September five years ago":

...George W. Bush was one of the heroes of the crisis. Despite the cavalier behavior of the first six years of his presidency, his last two years in office were pretty good – especially the appointment of Bernanke and Treasury Secretary Henry Paulson. Bush clearly shares credit with Obama for a splendid instance of cooperation in the autumn of 2008. (Bush, Obama and John McCain met in the White House on September 25, at the insistence of Sen. McCain, in the interval before the House of Representatives relented and agreed to pass the TARP bill. Obama dominated the conversation, Bush was impressed, and, by most accounts, McCain made a fool of himself.) ...

Much more here.