Illiquidity

Reforming the Federal Home Loan Bank System

We authored this post jointly with our friend and colleague, Lawrence J. White, Robert Kavesh Professor of Economics at the NYU Stern School of Business.

Some government financial institutions strengthen the system; others do not. In the United States, as the lender of last resort (LOLR), the Federal Reserve plays a critical role in stabilizing the financial system. Unfortunately, their LOLR job is made harder by the presence of the Federal Home Loan Bank (FHLB) system—a government-sponsored enterprise (GSE) that acts as a lender of next-to-last resort, keeping failing institutions alive and increasing the ultimate costs of their resolution.

We saw this dangerous pattern clearly over the past year when loans (“advances”) from Federal Home Loan Banks (FHLBs) helped postpone the inevitable regulatory reckoning for Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank (see Cecchetti, Schoenholtz and White, Chapter 9 in Acharya et. al. SVB and Beyond: The Banking Stress of 2023).

From a public policy perspective, FHLB advances have extremely undesirable properties. First, in addition to being overcollateralized, these loans are senior to other claims on the borrowing banks—including those of the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve: If the borrower defaults, the FHLB lender has a “super-lien.” Second, there is little timely disclosure about the identity of the borrowers or the amount that they borrow. Third, they are willing to provide speedy, low-cost funding to failing institutions—something we assume private lenders would not do.

In this post, we make specific proposals to scale back the FHLB System’s ability to serve as a lender to stressed banks….

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The Extraordinary Failures Exposed by Silicon Valley Bank's Collapse

The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”

Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.

In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:

  • First, to regain credibility, supervisors need to do an immediate review of the unrealized losses on the balance sheets of all 45 banks with assets in excess of $50 billion.

  • Second, they should perform a speedy and focused stress test on each of these banks to assess the  impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)

  • Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.

  • Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.

  • Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.

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FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

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Financial Crisis: The Endgame

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

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

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

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

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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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Regulatory quakes and tremors

If there were a regulatory Richter scale that measured the shaking of the financial system, the 2010 Dodd-Frank Act would register about 8, while the 2011 Basel III framework might be a bit above 7.  (For reference, the 1906 San Francisco earthquake was a 7.8). Fortunately, this shaking is mostly for the better – helping to make the financial system more resilient in the long run.

The new “Bailout Prevention Act” of Senators Vitter and Warren also might be an 8 on the shaking scale, but it would be a true disaster, because it undermines the Fed’s role as crisis lender of last resort. In contrast, the Senate Banking Committee’s new discussion draft of a “Financial Regulatory Improvement Act of 2015” is probably a 2 or a 3. If enacted, it will be “felt slightly by some people” but probably won't do much damage...

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The dollar is now everyone's problem

The global financial crisis started in 2007 when European banks came under increasing strain. If forced to specify the crisis kickoff, we would pick Thursday, August 9, the day that BNP Paribas halted redemptions from three investment funds because it couldn’t value their holdings of U.S. mortgages. Responding to the ensuing market scramble for liquidity, the ECB injected €95 billion that day into the European banking system and the Federal Reserve put $24 billion in theirs. Today, with the benefit of hindsight, these numbers appear quaint, but then they seemed enormous...

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A note on the lender of last resort 

With the publication of former Treasury Secretary Timothy Geithner’s book Stress Test comes a reconsideration of the many aspects of government intervention during the years of the financial crisis. Should banks have been nationalized? Should the fiscal stimulus have been larger? Should underwater households have received mortgage assistance?
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