Banks

The Future of Deposit Insurance

This post is authored jointly with our friend and colleague, Thomas Philippon, Max L. Heine Professor of Finance at the NYU Stern School of Business

Deposit insurance is a key regulatory tool for limiting bank runs and panics. In the United States, the Federal Deposit Insurance Corporation (FDIC) has insured bank deposits since 1934. FDIC-insured deposits are protected by a credible government guarantee, so there is little incentive to run.

However, deposit insurance creates moral hazard. By eliminating the incentive of depositors to monitor their banks, it encourages bank managers to rely on low-cost insured deposits to fund risky activities. In the extreme, with 100% deposit insurance coverage, banks would have virtually no incentive to issue equity or debt.

Against this background, and in light of the events of March-April 2023, we ask what is to be done about deposit insurance. To prevent bank runs, should there be an increase in the legal limit? If so, how can authorities balance the costs of runs and panics against the costs associated with moral hazard, while keeping in mind the potential financial burden on the public? Or, are there alternatives?

We emphasize three promising ways to enhance deposit insurance: a higher insurance cap for small and medium-sized enterprises (SMEs), new resolution rules, and the option to purchase supplementary deposit insurance. In addition, and as regular readers of this blog might expect, we also think that higher capital requirements should be part of the solution: if we require that banks increase the degree to which they finance their assets with capital (rather than deposits), the risk of runs and panics would decline even without raising the cap on deposit insurance….

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SEC Money Market Fund Reform Proposals Fall Far Short, Again

As the principal regulator of U.S. money market mutual funds (MMMFs), the SEC has a duty to end the market distortions and moral hazard that repeated public rescues create. There have been two MMMF bailouts, so far. The first came at the height of the Great Financial Crisis of 2008, while the second followed in the March 2020 COVID crisis. While the Treasury provided guarantees only once, the Federal Reserve offered emergency liquidity assistance both times.

These repeated government interventions encourage MMMF managers to behave in ways that make future liquidity crises more likely. Moreover, there is no credible way for the Fed to promise not to intervene should a systemic disruption again loom in short-term funding markets. The only realistic means to end the subsidies created by the implicit promise of future bailouts is to force MMMFs to be far more resilient than they are today.

Against this background, the SEC’s December 2021 MMMF reform proposals are seriously disappointing. In this post, we start with basic facts about the scale and mix of MMMFs today. We then describe the SEC’s proposals, before focusing on their key shortcomings. We hope that the public comments that the SEC receives will motivate it, at the very least, to conduct a serious quantitative assessment of introducing capital requirements for the most vulnerable MMMFs, to re-assess the scale of additional liquid assets needed for MMMF resilience in the absence of a Fed backstop, and to propose ways to enhance the effectiveness and utility of MMMF stress tests….

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Central Bank Digital Currency: The Battle for the Soul of the Financial System

While the conflict is largely quiet and out of public view, we are in the midst of an epic battle for the soul of the financial system. Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable.

The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilization can lead to a very unstable global system that thwarts monetary control.

Central bank digital currency (CBDC) can take many forms. While some may be benign, the most radical version—one that is universally available, elastically supplied, and interest bearing—has the potential to trigger destabilizing financial shifts, weaken the supply of credit, and undermine privacy….

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An Economic Zombie Survival Guide

Everyone surely hopes that zombies will remain confined to the growing list of horror movies. But unless we shut them down, insolvent firms can become economic zombies that suffocate innovation and growth.

As the COVID pandemic continues, policymakers will face some difficult decisions. Many businesses are coming under increasingly severe financial stress. Some, like dry-cleaning establishments that rely on laundering clothing for office workers, have limited prospects even after the pandemic subsides. But there are others that have a bright post-COVID future if they can hold on long enough. Without a way to distinguish these two groups, we face an unpleasant choice of either creating zombies or allowing viable firms to perish.

In our view, the solution to this problem is to reinforce and modify the bankruptcy process. This means ensuring that there are sufficient resources to restructure the debts of those whose expected future profits exceed their liquidation value, while allowing the remainder to close. In the case of large corporations, we can make use of Chapter 11. For smaller firms, if it is not already too late, we need a low-cost mechanism more tailored to their needs.

In the remainder of this post, we discuss these two related issues: zombie firms and the use of bankruptcy procedures to identify and sustain viable firms.

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Sources of Finance: Internal versus External

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

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

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

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Bank Capital and Stress Tests: The Foundation of a Thriving Economy

We submitted this statement to the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Financial Services of the U.S. House of Representatives for its hearing on July 17, 2018.

We appreciate the opportunity to submit the following statement on the occasion of the hearing entitled “Examining Capital Regimes for Financial Institutions.” We welcome the Subcommittee’s further examination of the existing regulatory approach for prudentially regulated financial institutions.

We are academic experts in financial regulation with extensive knowledge of the financial industry. Our experience includes working with private sector financial institutions, government agencies and international organizations. In our view, a strong and resilient financial system is an essential foundation of a thriving economy. The welfare of every modern society depends on it. The bedrock of this foundation is that banks’ capital buffers are sufficient to withstand significant stress without recourse to public funds. Furthermore, it is our considered view that the benefits of raising U.S. capital requirements from their current modest levels clearly outweigh the costs.

To explain this conclusion, we start with a definition of bank capital, including a discussion of its importance as a mechanism for self-insurance. We then turn to capital regulation and a discussion of stress testing….

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Ten Years After Bear

Ten years ago this week, the run on Bear Stearns kicked off the second of three phases of the Great Financial Crisis (GFC) of 2007-2009. In an earlier post, we argued that the crisis began in earnest on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. In that first phase of the crisis, the financial strains reflected a scramble for liquidity combined with doubts about the capital adequacy of a widening circle of intermediaries.

In responding to the run on Bear, the Federal Reserve transformed itself into a modern version of Bagehot’s lender of last resort (LOLR) directed at managing a pure liquidity crisis (see, for example, Madigan). Consequently, in the second phase of the GFC—in the period between Bear’s March 14 rescue and the September 15 failure of Lehman—the persistence of financial strains was, in our view, primarily an emerging solvency crisis. In the third phase, following Lehman’s collapse, the focus necessarily turned to recapitalization of the financial system—far beyond the role (or authority) of any LOLR.

In this post, we trace the evolution of the Federal Reserve during the period between Paribas and Bear, as it became a Bagehot LOLR. This sets the stage for a future analysis of the solvency issues that threatened to convert the GFC into another Great Depression.

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Adverse Selection: A Primer

Information is the basis for our economic and financial decisions. As buyers, we collect information about products before entering into a transaction. As investors, the same goes for information about firms seeking our funds. This is information that sellers and fund-seeking firms typically have. But, when it is too difficult or too costly to collect information, markets function poorly or not at all.

Economists use the term adverse selection to describe the problem of distinguishing a good feature from a bad feature when one party to a transaction has more information than the other party. The degree of adverse selection depends on how costly it is for the uninformed actor to observe the hidden attributes of a product or counterparty. When key characteristics are sufficiently expensive to discern, adverse selection can make an otherwise healthy market disappear.

In this primer, we examine three examples of adverse selection: (1) used cars; (2) health insurance; and (3) private finance. We use these examples to highlight mechanisms for addressing the problem....

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Modernizing the U.S. Payments System: Faster, Cheaper, and more Secure

When it comes to domestic payments, the U.S. financial system still lags the efficiency in several advanced economies. The reasons are easy to find. First, other countries have leapfrogged outdated technologies. In the United States, checks remained dominant well after their technological sell-by date partly as a result of government support. The other key factor delaying a shift to alternative payment mechanisms is the importance of what economists call a network externality. That is, the more people who use one form of payment, the more valuable that method is to the people who are already using it. And, by the same token, the more expensive it is for someone to move away from the prevailing mechanism.

With these considerations in mind, two years ago the Fed convened the Faster Payments Task Force (FPTF), a group of more than 300 experts and interested parties from a wide range of backgrounds with the objective to “identify and evaluate alternative approaches for implementing safe, ubiquitous, faster payments capabilities in the United States.” Earlier this month, the FPTF issued its second and final report, which contains a set of 10 recommendations for making the payments system faster, cheaper and more secure....

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The Map is the Message: Regional Feds versus Euro-area NCBs

Some time ago, we wrote about how the Fed and the ECB’s governance and communication were converging. Our focus was on the policy, governance and communications framework, including the 2% inflation objective, the voting rotation, post-meeting press conference, prompt publication of meeting minutes, and the like.

But important differences are built into the legal design of these two systems. Perhaps the most important one is the contrasting roles of the regional Federal Reserve Banks and that of the National Central Banks (NCBs)...

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Banking the Masses

Just three years ago, the World Bank estimated that 2½ billion adults (15 years and above) had no access to modern finance: no bank deposit, no formal credit, and no means of payment other than cash or barter. Stunningly, the Bank now estimates that even as the global population has increased, the number of “unbanked” has dropped by 20 percent. Between 2011 and 2014, 700 million adults have gained at least basic financial access via banks or mobile phone payments systems...

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Capital regulation: it’s complicated!

Many people criticize the way in which bank capital regulation is done.  They know that banks can and do game complicated regulatory rules, a form of regulatory arbitrage. One focus of their criticism is risk weighting – the idea that banks should hold capital commensurate with the riskiness of their assets.  The more risky the loans and securities a bank holds, the bigger the capital buffers should be to ensure that banks and the banking system are robust. 

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