Financial Stability News

News about financial stability and central banking

Category Archives: Financial Stability

How to model financial instability

There is a frentic activity out there on how to revise the modelling paradigm to the new norm of financial instability. Andrew Haldane from the Bank of England has recently been very critical of the current generation of macro models, including the DSGE tradition, and he recently challenged economist to come up with something better.

This calls for an intellectual reinvestment in models of heterogeneous, interacting agents, an investment likely to be every bit as great as the one that economists have made in DGSE models over the past 20 years.

But even his boss, Mervin King has recently been skeptical of the mainstream modelling paradigm, and in reviewing the last 20 years of inflaiton targeting, he noted (in footnote 14!) that

Several interesting papers presented at a Federal Reserve conference in Washington in March 2012 analysed a wide variety of potential “financial frictions” that might create externalities that would justify a policy intervention. My concern is that there seems no limit to the ingenuity of economists to identify such market failures, but no one of these frictions seems large enough to play a part in a macroeconomic model of financial stability. So it is not surprising that it has proved hard to find examples of frictions that generate quantitatively interesting trade-offs between price and financial stabilit …

Where this will end is not clear yet. The DSGE camp held a conference recently showing strenght among the Northwestern crowd, which is particulary strong among central banks (including Norges Bank and Riksbanken).

ECB will host a conference this week with a more varied program, so it will be interesting to see if they arrive at some sort of consensus on the way forward.

One person to watch out for is Michael Kumhof from the IMF. He is a devoted DSGE person, but conduct interesting research within this framwork on income inequality, narrow banking and the future of oil. He will be at the ECB conference as a discussant of a paper by goodhart and tsomocos, that represent an alternative modelling strand.

Quite something to watch, although impossible to follow it all.

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Big banks are simply too big

Also investors may think so. As FT banking commentator Patrcik Jenkins notes in this post, banks are trading at very low book/values and investors may actually benefit from breaking up large conglomorate banks:

Shareholders appear to be coming to the view that banking conglomerates do not make economic sense. There are many factors subduing banks’ stock market values, including the eurozone crisis and global regulatory uncertainty. But another brake is investors’ fading faith in size for its own sake. Most western banks – especially the universal ones comprising retail and investment banking under one roof – are trading at a discount to the book value of their net assets.

This is a view that Andrew Haldane of the Bank of England also has voiced earlier, indicating that proposals for splitting trading and commerical banking actually may be in the banks best interest. A clean split – ala the Volcker rule – would then be preferable to a holding company solution as proposed by the UK Vickers commission. Time will tell which will be the choosen one.

IMF: Financial stability reform lagging behind

This VOX post by one of the leading authors of this years Global Financial Stability Report  Not making the grade: Report card on global financial reform | vox. argues that the pace of reform and restructuring of the financial sector is too slow. Important issues remain unresolved, including

  • Financial systems are still overly complex.
  • Banking assets are highly concentrated (Figure 3), with strong domestic interlinkages.
  • The too-important-to-fail issues are unresolved.
  • Banking systems are still over-reliant on wholesale funding (Figure 4)

There is still little progress (or politicla will?) to tackle the TBTF problem, and the financial system remain too complex. Shadow banking continue to be a problem, as well.

Key question is whether “traditional” program of reform, inkl. Basel 3, will deliver the required reforms in time? The lobbying pressure is intense, ref. the latest defeat of the SEC on money market reform. May be we need other approaches, ref. Haldane’s critique of Basel 3?

Debuty Governor Paul Tucker on how to avoid a new banking crisis

Somewhat old interview (August 1), but still interesting points about central bank lending to CCPs, how to solve the TBTF problem, and the need for more liquidity for trading activities:

Since then, I have wanted trading book positions to incorporate an element of capital against illiquidity risk, because these books get marked to market so even if there is no change in fundamentals but the market suddenly dries up, values will fall as a result and the net worth of the dealer or bank falls sharply.

And also about how to prevent a new “blow-out” of the financial system:

Risk: Do you see any danger in a more prescriptive approach to capital modelling?

PT: This is a genuine consultation by the Basel Committee, but I would point out that there are something like 15 million people unemployed in the western world because finance imploded, and finance imploded because the rules of the game in finance were inadequate. That’s a terrible price to pay. So this business of debating exactly how to calibrate things, this is for grown ups. It’s not about whether we – if the following rich assumptions hold – can optimise capital levels. It’s about whether we can avoid having a financial system that is fragile in ways that have very high social costs.

Agree fully with Tucker!

Bank of England will be subject to 3 reviews

According to FT today, the Bank of England will be subject to three independent reviews, of its LLR role during the crisis, of its current liquidity policies and of the MPC inflation forcasets.

This is not surprising, as pressure has been building for some time to subject the BoE’s crisis performance to scrutiny. Also, there has been reports of too much group-think within the bank, and too much hierarchy within the Court of King Mervyn.

The reviews are welcome, but one wonder why their Financial Stability Reviews are not subject to review as well. After all, it was that part of the bank that was supposed to take appropriate measures to guard financial stability.

SEC officials oppose money fund reform report

It looks like Mary Schapiro at SEC will have problems getting her proposals for money market reform through her own board. According to this Reuter report three of five members are currently opposed to new changes to regulation of MMF. This reform package is by many considered the most important remaining element of the changes needed to stabilize the financial system. But the industry is dead against any changes, not surprisingly since they are up against the wall of low returns and high costs. In the meantime MMF continue to provide banks with unstable funding, so we will have to wait for the next big crisis to hit and MMF will withdraw their funding again. Not a terrible stable system this!

For the industry view, see the IOSCO report

Money and Collateral

A new IMF WP by Singh and Stella has already attracted a lot of comments on FT Alphaville and Zero Hedge blogs. They note that thee is a shortage of safe capital instruments out there, and suggest that Governments should issue more Treasuries to accommodate the shadow asking systems demand for safe and liquid assets over and  beyond what they can get inguaranteed bank deposit accounts. However, you can as well argue atshe size of he shadow banking should be reduced, for further arguments see my WP on shadow banks and the limits to central bank liquidity support http://www.levyinstitute.org/publications/?doctype=13.

The Financial System Five Years from Now

The IMF hosted a one day conference end of March on the structural challenges in banking and on shadow banking. Some of the presentations and papers have now been posted (unfortunately not all). See in particular presentation by Arnoud Boot, which gives an interesting overview of the issues, but provides more questions than answers. Andrei Shleifer et al. have a paper on shadow banking where they show how vulnerable the financial system becomes if tail risk is ignored and securitization allowed. They support some form of regulation, preferably through a leverage ratio.

Shadow banking and central bank liquidity support

Global liquidity provision is highly pro-cyclical. The recent financial crisis has resulted in a
flight to safety. Severe strains in key funding markets have led central banks to employ highly unconventional policies to avoid a systemic meltdown. Bagehot’s advice to “lend freely at high rates against good collateral” has been stretched to the limit to meet the liquidity needs of dysfunctional financial markets.  As the eligibility criteria for central bank borrowing have been tweaked, it is legitimate to ask how elastic the supply of central bank currency should

I address this question in a new Working Paper from Levy Institute: Shadow banking and the limits of central bank liquidity support. The paper review the recent expansion in central bank liquidity support, including their collateral polices, and then suggests that central banks should not unconditionally supply liquidity to a banking system that is growing uncontrolled. Stricter controls are required unless central banks again will have to underwrite dysfunctional markets.

The paper also provides input to the ongoing Krugman – Keen discussion on banking. See especially section 6 on excessive global credit and section 7 on A new view of banking.

http://www.levyinstitute.org/publications/?docid=1513

Dallas Fed: End too-big-too-fail NOW

Dallas Fed Governor Richard W. Fisher has been very vocal on the TBTF issue, lastly in a speech in November last year where he wanted to “get an international accord that would break up these institutions”.

Now the annual report for 2011 is out for Dallas Fed and it is in its entirety devoted to the TBTF issue; title of the report: Choosing the Road to Prosperity – Why we must end too big to fail – NOW. Quote:

As a nation we face a distinct choice. We can perpetuate too big to fail, with its inequities and dangers, or we can end it. Eliminating TBTF won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.