Home (and solvency) bias at the Fed

At the INET conference in DC yesterday, Janet Yellen and Christine Lagarde both gave brief statements, and then they asked each other questions, back and forth, until the moderator called time. No surprises in any of it, perhaps, but still a useful check on the current thinking of the leaders of the Fed and the IMF respectively, and as such a sign of where new thinking is yet needed.

Yellen emphasized the origin of the 2007-2009 crisis in “distorted incentives”, two incentives in particular. First, short term interest rates were too low, so encouraging excessive expansion of credit. Second, regulation of the “non-bank” credit sector was too lax, so encouraging credit expansion to happen there rather than in traditional banks. Today, she says, “risks to financial stability are moderated, not elevated”, thanks to new higher capital requirements mainly, but also other reforms focused on banks mainly, not so much non-banks.

In all her remarks, Yellen spoke very much as the leader of the Fed, and her concern was narrowly limited to stability in the U.S. financial system, not the larger global scene. That larger scene however is of course the central concern of Lagarde, and so it is significant that Lagarde’s statement was distinctly less reassuring.

Citing the IMF’s most recent Global Financial Stability report, Lagarde chose to emphasize current “rotation”, from bank to non-bank credit, from sovereign credit to non-sovereign, from bank solvency to market liquidity, and from the advanced countries to the developing and emerging countries. From this point of view, she said, the regulatory job is not completed. Indeed, rotation means that the regulatory job is a work in progress.

In Q&A she got more specific, reminding the audience of the pre-crisis days when every bank boasted its “global” presence with a world map showing the location of every branch office. Since then, under pressure from their regulators, banks have sold their foreign branches to native local or regional banks, in effect reducing their footprints back to their home country. The implication is clear. Global credit is non-bank credit, and that’s where the risks have been building up.

In Q&A Yellen got more specific as well. In response to a question about how the zero interest rate policy squares with the need to better align incentives, she dutifully noted all the distortions caused by the six-years-now zero interest rate policy: compression in term premia, risk premia, interest margins and so forth, as people reach for yield. But this incentive distortion, unlike the one that caused the crisis, has a defensible social purpose, she says.  It is needed to move the economy back to full employment and to meet price stability objectives. The mechanism for that move, she suggests, has been balance sheet repair.

So there you are. At the global level, we see Brazilian firms issuing bonds that are funded in dollar money markets; this is money market funding of capital market lending, my definition of shadow banking. The key to financial stability in such arrangements, as we learned in the crisis, is the continued willingness of private profit-seeking dealers to make markets, both capital markets (the bonds) and money markets (the funding).  Yellen’s closing words reminded her audience that broker dealers were not on the radar of the Fed before the crisis, but, she reassured, they are now and the new capital requirements apply to all the broker dealers under the Fed’s supervision.

The question I would have asked, had questions been taken from the audience, is whether these regulations make it more or less likely that dealers will be willing and able to support markets in times of turmoil.  In other words, have we successfully constructed a robust dealer network of first resort that is willing and able to absorb the next dislocation?  Or will the next one once again rely on the central bank backstop as dealer of last resort?

15 comments on “Home (and solvency) bias at the Fed

  1. crossfire on said:

    Prof Mehrling, what would be your answer to your question on impact of regulation on liquidity? 🙂

    Since dealers are profit motivated, shouldn’t increased regulation almost always lead to decreased willingness of dealers to provide liquidity?

    • Anonymous on said:

      There is more to it than that. Matched book dealing has been moving to CCP platforms, which have greater lender of last resort support than when the same dealing happened on balance sheet of investment banks. Non-matched book dealing is happening on balance sheets that have greater capital buffers. So maybe there is more resilience, but also maybe not. We will know soon.

  2. Prof Mehrling, speaking of ‘distorted incentives’, are you aware of _The End of Banking_[1] — http://www.endofbanking.org — by pseudonymous authors ‘Jonathan McMillan’? I think it usefully extends Admati & Hellwig’s _The Bankers’ New Clothes_ to what they think (and I’m persuaded) is the real root of the banking problem, which isn’t just lack regulatory capital per se, but: “that shadow banking takes place over a daisy-chain of balance sheets… Eventually, the daisy-chain ends up in a money market mutual fund that promises their shareholders a $1 net-asset-value at any time.”[2]

    Their proposed solution? Establish a ‘systemic solvency rule’, viz. http://blogs.reuters.com/breakingviews/2015/01/16/review-why-banking-is-flawed-and-how-to-fix-it/

    “It starts with an accounting distinction. Bank assets would be classified either as real, in other words claims on physical or distinct immaterial objects; or as financial, assets which appear as liabilities on the balance sheet of some other institution.

    “Next, regulators would ensure that financial assets were 100 percent-backed by common equity. And lastly, in a combined regulatory and accounting change, the value of a company’s real assets would have to be greater or equal to the value of the total of its liabilities.

    “This final fix is where the book goes beyond previous proposals to mend finance through concepts such as narrow- or limited-purpose banking. The implication of McMillan’s recommendation is that many derivatives, for which a counterparty’s losses could be infinite, would be banned. What’s more, the intended application to financial and non-financial companies alike would include shadow banking, addressing the so-called ‘boundary problem’ of regulation that other approaches to improve the system fail to solve.”

    [1] summarized here…

    “…the functions of money and credit are separated and assigned to the public and the private spheres, respectively… public authorities would retain control of money creation, but credit creation would become fully disintermediated. […] But how do you prevent the formation of inside money [shadow banking] given that even non-financial firms are making strides in this capacity?

    “In the authors’ opinion it’s all down to accounting standards. Their key proposition, consequently, is to redefine what constitutes technical solvency as… The total value of financial assets of a company has to be less than or equal to the value of its equity. As they explain: ‘This reading highlights that companies have to back assets that are someone else’s liability with their own funds, that is, equity. Companies cannot finance credit with someone else’s credit’.

    “Over in the public outside-money world, meanwhile, the authors propose that money issuance be fully digitised so that policymakers are able to charge both liquidity fees (negative interest rates) or to distribute unconditional income as and when needed for price stability reasons. As they conclude, in this way the intimate link banking creates between money and credit is broken: ‘It assigns the current payment function exclusively to money. The monetary authority can exert full control over the quantity of money in circulation, because credit can no longer be transformed into money. Under a systemic solvency rule, credit creation does not lead to money creation.’ ”

    cf. http://krugman.blogs.nytimes.com/2015/05/06/the-fed-does-not-control-the-money-supply/ & http://worthwhile.typepad.com/worthwhile_canadian_initi/2015/05/why-cant-central-banks-monetise-something-else.html – “a legal restrictions theory of lowflation”

    [2] airing their concerns about P2P/’marketplace’ lending…

    see also…

    • samantha ekanayake on said:

      can you explain more about “bank to non bank credit” mention in global financial stability report.

  3. Yanbo Chen on said:

    Prof Mehrling,
    thank you for your post and clear explanation for Yellen’s and Lagarde’s statements.
    At least they gave more concise words and regulations, but actually we don’t know how it works until next turmoil happens.

  4. Amogha Sahu on said:

    Prof. Mehrling,

    You spoke about the transition to a higher interest rate for the Fed as being reminiscent of the 40’s transition from war finance back to markets, Do you think the financial system ‘rotation’ that Christine Lagarde spoke about between non-bank to bank credit complicTes that metaphor slightly? Because it seems like agents have moved elsewhere to find credit and certain markets are still functioning well, rather than markets being subordinated to state aims like in the war.

    • Anonymous on said:

      Yes, it does. I think the problem central banks are facing today is similar to what they faced at the end of WWII, namely transition from war finance when all the prices are administratively set to markets where decentralized private dealers make prices. You are right that there currently prices at which capital assets and money funding trades. The issue is whether they are distorted by central bank intervention (yes), and what will happen when that distortion is removed (dunno).

  5. Victor Hong on said:

    Dear Professor Mehrling,

    This is in relation to the Fed’s use of low/zero interest rates for ‘defensible social purpose’. Could it be possible that the Fed’s efforts be focused mainly on reviving the American economy, at the cost of causing ‘misaligned incentives’ for developing and emerging economies?

    If so, what measures can developing or emerging economies undertake to mitigate future interest rate hikes or even the current use of low/zero interest rates?

  6. Joseph R. Bozzi on said:

    How about a floating reserve requirement for individual banks. Each bank customer is put into a group and rated, based on individual risk( i.e. job, credit score). So, someone with a higher risk — Banks will be required to keep 30% reserves on $100 deposit. instead of 10% reserve requirement?

    • Arslan Saeed on said:

      I don’t think there’s such a thing as a bad depositor – if s/he opens a checking account with the bank, s/he retains full right to withdraw as and when required. If I am not mistaken, these reserves are mainly to ensure the Fed can insure deposits of customers and prevent a bank run. As far as bad loan customers is concerned, the Basel Accord sets out requirement for banks to set aside capital based on the kinds of loans they are giving out.

  7. Joseph R. Bozzi on said:


    I believe, the classical theory, seems most effective in emerging markets. I believe economic models or theories change over time. Classical economics worked well, after the revolution. Classical economics doesn’t work so well now. But, the classical theory might work well in an emerging market. What do you think?

  8. Fiscal policy is the best counter-stabilisation tool available to any government

    “The reality is that policy makers have very little idea of the speed and magnitude of monetary policy impacts (interest rate changes) on aggregate demand. There are complex timing lags given how indirect the policy instrument is in relation to its capacity to influence final spending.

    Further there are unclear distributional effects – creditors gain when rates rise, debtors lose. What will be the net effect? Central bankers do not know the answer to that question.

    Monetary policy is also a blunt policy instrument that has no capacity to target specific segments of the spending population or regions.

    Fiscal policy expansion is always indicated when there is a spending gap. It is a direct policy tool ($s enter the economy immediately) and can be calibrated and targetted with more certain time lags. Liquidity trap or not, fiscal policy is the best counter-stabilisation tool available to any government.”


    Modern Monetary Theory in Canada

  9. Solvency bias is likely due to the fact that the Fed can create its own liquidity. In my opinion, the accounting rules governing a central bank must be stricter than currently recognized.

    Fractional-reserve at the commercial level can create risk-assessed liquidity, while central bank liquidity remains politically controllable.

  10. Perry,

    “The question I would have asked, had questions been taken from the audience, is whether these regulations make it more or less likely that dealers will be willing and able to support markets in times of turmoil. In other words, have we successfully constructed a robust dealer network of first resort that is willing and able to absorb the next dislocation? Or will the next one once again rely on the central bank backstop as dealer of last resort?”

    As usual, you’re well ahead of the curve.

    FT article, June 11th: http://on.ft.com/1Tpjfi7

    “Treasury volumes raise liquidity concerns.”
    World’s most actively traded market ‘not functioning as normal’

    shows that the very issue to which you have alluded is already showing symptoms. Given that this is happening in a relatively benign environment; this has to elevate the concern as you’ve posed it.

    I suspect, from what I’ve learned of you, that when you ask a question it is usually rhetorical, if only to you initially. The rest of us just play catch up 🙂

    I’d love to hear your interpretation of what is happening currently and what you obviously already know about the risks as you see it looking forward.

    Any chance of a blog on this?