Optimal Settlement Speed

Over the past year, a series of events has shifted the attention of both experts and laypersons to the arcane processes that support trading and settlement in the U.S. securities markets. The massive volume of U.S. Treasury sales in March 2020 at the start of the COVID crisis boosted liquidity needs at precisely the time when resources were scarce, overwhelming the over-the-counter trading system and compelling unprecedented Fed interventions (see our earlier post). Similarly, the late-January 2021 episode involving extraordinary activity in GameStop, in large part through Robinhood (the broker-dealer), highlighted how a surge in equities trading volume can concentrate counterparty risk and trigger a jump in liquidity needs to settle those trades (see our earlier post). After filling the news for weeks, the equity market turmoil triggered Congressional hearings (see here and here).

In an effort to reduce both counterparty risk and liquidity needs, a number of observers are focusing on shortening the settlement period. Officials at the Depository Trust and Clearing Corporation (DTCC) are calling on the industry to halve the equities settlement period from two days (T+2) to one (T+1) by 2023. Others have called for far faster clearing, including nearly instant settlement (see here).

Times like these lead us to ask: how can we improve the efficiency and safety of the financial plumbing? We see plenty of room for progress in speeding settlement, thereby reducing both risk and liquidity needs during periods of stress. However, we also think that things can go too far (or too fast). In particular, we are deeply skeptical of calls for real-time settlement (T+0) for securities or foreign exchange transactions. In this post, we suggest why the optimal settlement period for some financial transactions is not zero….

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Stopping central banks from being prisoners of financial markets

Central banks are on the front lines in the fight to limit the impact of the pandemic. They are supporting virtually every aspect of the economy and the financial system. Combined with the massive fiscal support, these policies restored market stability, safeguarded financial institutions, and reduced suffering. Count us among those who firmly believe that everyone would be in worse shape had central banks and fiscal authorities not coordinated this aid as they did.

But, by providing such a broad backstop, the reliance of financial markets on that support can itself become a source of instability. This raises a set of very important and pressing questions: Have central banks’ actions over the past year made financial markets their masters? Can policymakers now be counted on to suppress financial volatility wherever it arises?

We surely hope not, but we see this as a legitimate concern. Fortunately, we also see a solution. Central bankers should strive to duplicate the success of their framework for interest rate policy. That is, they should be clear and transparent about their reaction function for all their policy tools. Knowing how policy will react, markets will respond directly to news regarding economic conditions, and less to policymakers’ commentary. Of course, central bankers cannot ignore shocks that threaten economic and price stability. But cushioning the economy against large financial disturbances does not mean minimizing market volatility….

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Thoughts on Deposit Insurance

Government guarantees have become the norm in the financial system. According to the latest Federal Reserve Bank of Richmond (2017) estimate, the U.S. government’s safety net covers 60% of private financial liabilities in the United States. Serious underpricing of government guarantees gives intermediaries the incentive to take risk that can threaten the entire financial system: the Great Financial Crisis of 2007-09 is the most obvious case in point.

Deposit insurance is arguably the oldest and most widespread form of government guarantee in finance. In the United States, Congress established the Federal Deposit Insurance Corporation (FDIC) at the depth of the Great Depression in 1933 to help prevent bank runs. Today, more than 140 countries have some type of deposit insurance scheme.

In this post, we briefly review the evolution of FDIC deposit insurance pricing. We highlight evidence that, largely because of Congressional mandates, the federal insurance guarantee was underpriced for many years. It is not until 2011, following the crisis of 2007-09, that the FDIC introduced the current framework for risk-based deposit insurance fees, bringing insurance premia closer to what observers would deem to be actuarially fair.

Going forward, as with any insurance regime, keeping up with the evolution of bank (and broader financial system) risks will require a willingness to update the deposit insurance pricing framework from time to time. That means adjusting pricing to reflect both the range of bank risk-taking at a point in time and—to ensure the sustainability of the deposit insurance fund without taxpayer subsidies—the evolution of aggregate risk….

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Limiting Central Banking

Since 2007, and especially over the past year, actions of public officials have blurred the lines between monetary and fiscal policy almost beyond recognition. Central banks have expanded both the scope and scale of their interventions in unprecedented fashion. This fiscalization risks central bank independence, thereby weakening policymakers’ ability to deliver on their mandates for price and financial stability. In our view, to find a way to back to the pre-2008 division of responsibilities, officials must establish clearer limits on what central banks can and cannot do.

In that division of official labor, it is fiscal authorities that ought to make the unavoidably political choices that directly influence resource allocation. And governments should not conceal such fiscal actions on the balance sheet of the central bank. In a democracy, doing so lacks legitimacy and would become unsustainable….

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Is Inflation Coming?

For more than a generation, the U.S. inflation-targeting framework has delivered impressive results. From 1995 to 2007, U.S. inflation averaged 2.1% (as measured by the Federal Reserve’s preferred index). Since 2008, average inflation dropped to only 1.5%, but expectations have fluctuated in a narrow range: for example, the market-based five-year, five-year forward (CPI) inflation expectation rarely dipped below 1.5% and never exceeded 3%.

However, the pandemic brought with it many dramatic changes. Fiscal and monetary policy mobilized, responding swiftly to the economic plunge with a combination of extraordinary debt-financed expenditure and balance sheet expansion. As a matter of accounting and arithmetic, these actions have had a profound impact on the balance sheets of banks and households, spurring dramatic growth in traditional monetary aggregates. From the end of February to the end of May 2020, broad money (M2) grew from $15.5 trillion to $17.9 trillion—a 16% jump in just three months.

Won’t the record 2020 gain in M2 be highly inflationary? We doubt it, and in this post we explain why. At the same time, we highlight the chronic uncertainty that plagues inflation. In our view, the difficulty in forecasting inflation makes it important that the Fed routinely communicate how it will react to inflation surprises—even when, as now, policymakers wish to promote extremely accommodative financial conditions….

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GameStop: Some Preliminary Lessons

Volatility in the stock market is not new. But, even if one takes a broad perspective, the recent experience with GameStop is extraordinary. As we write, the story is far from over, with several U.S. stocks—like GameStop, AMC Entertainment and Express—still on something of a wild ride. The Securities and Exchange Commission seems poised to investigate. And, members of Congress are planning to hold hearings. We don’t have any particular insights into how or when this will end. That is, except to say that history teaches us that episodes like this typically end badly.

Since this is an unusual post, we begin with a very clear disclaimer: nothing in this blog should be construed either as investment advice or legal advice.

In our view, we can already draw three big lessons from the equity market events of the past week. The first is about how narratives and the limits to arbitrage can lead to unsustainable asset price booms. Second, short sellers are important for the efficiency of asset pricing and the allocation of capital. Moreover, with the ongoing rise of passive index investing, their potential role in keeping the U.S. equity market efficient will become more, not less, salient. Third, to keep the financial system safe and resilient, it is essential that clearing firms maintain sufficiently stringent margin and collateral requirements even if, on occasion, it limits a broker’s ability to implement trades for its clients….

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Open-end Funds vs. ETFs: Lessons from the COVID Stress Test

COVID-19 posed the most severe stress test for financial markets and institutions since the Great Financial Crisis (GFC) of 2007-09. By some measures, the COVID shock’s peak impact was larger than that of the GFC—both the VIX rose higher and intermediaries’ estimated capital shortfalls were bigger. As a result, the COVID experience provides a natural laboratory for testing the resilience of many parts of the post-GFC financial system.

For example, the March 2020 dysfunction in the corporate bond market highlights the extraordinary fragility of a market that accounts for nearly 60% of the debt and borrowings of the nonfinancial corporate sector. Yield spreads over equivalent Treasuries widened further than at any time since the GFC, with bond prices plunging even for instruments that have little risk of default. (See Liang for an excellent overview.)

In this post, we focus on how, because of the contractual agreement with their shareholders, an extraordinary wave of redemptions created selling pressure on corporate bond mutual funds that almost surely exacerbated the liquidity crisis in the corporate bond market. To foreshadow our conclusions, we urge policymakers to find ways to reduce the gap between the illiquidity of the assets held by corporate bond (and some other) mutual funds and the redemption-on-demand that these funds provide. To reduce systemic fragility, we also urge them—as we did several years ago—to consider encouraging conversion of mutual funds holding illiquid assets into ETFs, which suffered relatively less in the COVID crisis….

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Fix Money Funds Now

On September 19, 2008, at the height of the financial crisis, the U.S. Treasury announced that it would guarantee the liabilities of money market mutual funds (MMMFs). And, the Federal Reserve created an emergency facility (“Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to finance commercial banks’ purchases of illiquid MMMF assets. These policy actions halted the panic.

That episode drove home what we all knew: MMMFs are vulnerable to runs. Everyone also knew that the Treasury and Fed bailout created enormous moral hazard. Yet, the subsequent regulatory efforts to make MMMFs more resilient and less bank-like have proven to be half-hearted and, in some cases, counterproductive. So, to halt another run in March 2020, the Fed revived its 2008 emergency liquidity facilities.

We hope the second time’s the charm, and that U.S. policymakers will now act decisively to prevent yet another panic that would force yet another MMMF bailout.

In this post, we briefly review key regulatory changes affecting MMMFs over the past decade and their impact during the March 2020 crisis. We then discuss the options for MMMF reform that the President’s Working Group on Financial Markets identifies in their recent report. Our conclusion is that only two or three of the report’s 10 options would materially add to MMMF resilience. The fact that everyone has known about these for years highlights the political challenge of enacting credible reforms.

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Big Tech, Fintech, and the Future of Credit

Lenders want to know that borrowers will pay them back. That means assessing creditworthiness before making a loan and then monitoring borrowers to ensure timely payment in full. Lenders have three principal tools for raising the likelihood of that firms will repay. First, they look for borrowers with a sufficiently large personal stake in their enterprise. Second, they look for firms with collateral that lenders can seize in the event of a default. Third, they obtain information on the firm’s current balance sheet, its historical revenue and profits, experience with past loans, and the like.

Unfortunately, this conventional approach to overcoming the challenges of asymmetric information is less effective for new firms that have both very short credit histories and very little in the way of physical collateral. As a result, these potential borrowers have trouble obtaining funds through standard channels. This is one reason that governments subsidize small business lending, and why entrepreneurs are forced to pledge their homes as collateral.

Well, new solutions have emerged to overcome this old problem. In this post we discuss how technology is increasing small firms’ access to credit. By using massive amounts of data to improve credit assessments, as well as real-time information and platform advantages to enforce repayment terms, technology companies appear to be doing what traditional lenders have not: making loans to millions of small businesses at attractive rates and experiencing remarkably low default rates.

The biggest advances are in places where financial systems are not meeting social needs….

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Where Governments Should Spend More

As a result of the pandemic, U.S. general government debt (federal, state, and local obligations combined) has surged above 130 percent of GDP, more than double what it was in 2007. And, recent U.S. experience is far from unique. Looking at the G20, average public debt rose from 52% of GDP in 2007 to 74% in 2019 and is projected to reach 91% next year.

Unsurprisingly, as government debt increases, the debate over public spending heats up. Are these high debt ratios sustainable? Should we be cutting spending and raising taxes to reduce what will otherwise be a large financial burden on future generations?

In this post, we emphasize that not all government spending is created equal. Investment in physical infrastructure, as well as in education and health—especially for children—can boost future GDP. Moreover, delaying inevitable outlays can boost long-run costs. As a result, a failure to make productive, self-financing investments due to concerns about the debt would be not only tragic, but counterproductive….

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What's in store for r*?

It is amazing how things we once thought impossible, or at least extremely improbable, can become commonplace. Ten-year government bond yields in most of Europe and Japan are at or below zero. And, for U.S. Treasurys, the yield has been below 1 percent since March.

A confluence of factors has come together to deliver these incredibly low interest rates. Most importantly, inflation is far lower and much more stable than it was 30 years ago. Second, monetary policy remains extremely accommodative, with policy rates stuck around zero (or below!) for the past decade in Europe and Japan, and only temporarily higher in the United States. Third, the equilibrium (or natural) real interest rate (r*)—the rate consistent in the longer run with stable inflation and full employment—has fallen by roughly 2 percentage points since 2008 and is now only 0.5% or lower.

How long will this go on? What’s in store for r*? Focusing on the United States, in this post we discuss the large post-2007 decline in r* that followed a gradual downward trend in prior decades. After considering various possible explanations, we focus on the change in U.S. saving behavior. Around 2008, there was an abrupt increase in household savings relative to wealth and income. Combined with increased foreign demand for U.S. assets, this appears to be a key culprit behind the recent fall in r*.

We doubt that this will change anytime soon….

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Setting Bank Capital Requirements

Bank capital requirements are the focus of contentious and heated debates. Since they limit banks’ ability to take on risk and leverage, owners and managers almost always argue for lowering them. To reduce the likelihood of using public funds for further bailouts, both libertarians and progressives argue strenuously that they should be higher. Focusing on the balance between the social benefits of a more resilient financial system and the social costs of curtailing liquidity and loan provision, academicians usually conclude that current levels are too low. So, with well-financed banks and their lobbyists on one side, and a cohort of advocates armed with academic research on the other, regulators are caught in the middle. To whom should they listen?

The answer to this question is an empirical one, so it is important to base any conclusions on a fair and balanced reading of the evidence. Regular readers of this blog will be unsurprised that we continue to maintain that bank capital requirements should be higher than they were even before the Federal Reserve started began its stealth campaign to relax them several years ago. If we were to pick a number, we would start with a leverage ratio—the ratio of common equity to total assets (including off-balance sheet exposures)—that is in the range of 10 to 15 percent, and possibly higher. The risk-weighted equivalent would be about twice as high in the United States (or three times as high in Europe). (The exact numbers depend on the intricacies of accounting standards.) The one thing we would not be arguing for is a further erosion of capital requirements from their current level.

We start with a short reminder about why we need capital requirements in the first place….

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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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Patience vs FAIT: Which is key in the new FOMC strategy?

The Federal Open Market Committee’s (FOMC) policy strategy update incorporates two key changes. The first is a shift to flexible average inflation targeting (FAIT), while the second is a move to what we will call a patient shortfall strategy. FAIT represents a shift in the direction of price-level targeting in which the FOMC intends to make up for past inflation misses (see our previous post). As Fed Governor Brainard recently explained, the strategy of increased patience, embedded in language that focuses on employment “shortfalls” rather than “deviations,” reflects reduced willingness to act preemptively against inflation when the unemployment rate (u) declines below estimates of its sustainable level (call it u*).

The Committee will need to explain what these two changes mean for the determinants of policy—what we think of as their reaction function. For example, FAIT implies that the FOMC’s short-term inflation objective will change over time—possibly even from meeting to meeting. For the policy to have its intended impact of shifting inflation expectations, we all need to know the Fed’s inflation target. Similarly, having downgraded the role of the labor market as a predictor of inflation, the central bank will need to explain how it aims to control inflation going forward. While patience is the broad message, pointing to a more backward-looking approach to control, it seems likely that attention will shift to other inflation predictors. But again, if this shift is to have the intended impact on expectations, it is important that the Fed be clear about how it is forecasting inflation.

In this post, we compare the practical importance of these two strategic shifts. Our conclusion is that, while neither appears very large on average, the patient shortfall strategy looks to be the more important of the two….

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The Fed's New Strategy: More Discretion, Less Preemption

On August 27, marking the conclusion of the Fed’s first strategic review, the Federal Open Market Committee released an amended version of their fundamental policy guide—the Statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC adopted a form of flexible average inflation targeting (FAIT). Partly because the new strategy largely confirms recent Fed behavior, the response in financial markets was minimal. Indeed, market-based long-run inflation expectations were virtually unchanged this week. Perhaps the only noticeable development was a modest steepening at the very long end of the yield curve.

In this post, we identify three key factors motivating the Fed review and highlight three principal shifts in the FOMC’s strategy. In addition, we identify several critical questions that the FOMC will need to answer as it seeks to implement the new policy framework. Specifically, the shift to FAIT implies a change in the Committee’s reaction function. How does this reformulated objective influence the FOMC’s systematic response to changes in economic growth, unemployment, inflation and financial conditions? Under FAIT, the effective inflation target over the coming years also now depends on past inflation experience. What is that relationship?

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Average Inflation Targeting

The Federal Open Committee’s first-ever comprehensive monetary policy review looks to be coming to an end. Since the announcement on November 15, 2018, the Fed has focused on strategies, tools, and communications practices, and engaged the public through numerous Fed Listens events, including a conference at which invited experts proposed new approaches (see our earlier post). At its July meeting, the FOMC discussed potential changes to its Statement on Longer-Run Goals and Monetary Policy Strategy—the “foundation for the Committee’s policy actions”—with the aim of finalizing those changes soon. And, Chairman Powell is scheduled to speak this week about the “Monetary Policy Framework Review” at the annual Jackson Hole Economic Policy Symposium.

Perhaps the most important issue on the review agenda is the FOMC’s inflation-targeting strategy. Since 2012, the FOMC has explicitly targeted an inflation rate of 2% (measured by the price index of personal consumption expenditures). A key objective of FOMC strategy is to anchor long-term inflation expectations, contributing not only to price stability, but also to “enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.” Yet, since the start of 2012, PCE inflation has averaged only 1.3%, prompting many policymakers to worry that persistent shortfalls drive down expected inflation (see, for example, Williams). And, with the Fed’s policy rate now back down near zero, falling inflation expectations raise the expected real interest rate, tightening financial conditions and undermining policymakers’ efforts to drive up growth and inflation.

In this note, we discuss one alternative to the current approach that has gained wide attention: namely, average inflation targeting. The idea behind average inflation targeting is that, when inflation falls short of the target, it creates the expectation of higher inflation. And, should inflation exceed its target, then it would reduce inflation expectations. Even when the policy rate hits zero, the result is a countercyclical movement in real interest rates that enhances the effectiveness of conventional policy….

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Making the Treasury Market Resilient

Ensuring financial stability requires resilient institutions. That is why regulators around the world have strengthened capital and liquidity requirements for the largest financial intermediaries since financial crisis of 2007-09.

Making financial markets resilient is equally important. Repeated and sustained bouts of illiquidity and dysfunctionality in a key market can threaten the well-being of even the healthiest institutions.

In a global financial system that runs on dollars, the most important financial market is the one for U.S. Treasury securities. Yet, despite its importance and general reliability, the Treasury market occasionally suffers from serious disruptions. The strains in the Treasury market during the first half of March 2020 became an important motivation for the Federal Reserve’s unprecedented anti-COVID policy actions beginning that month (see here, here and here).

In the remainder of this post, we describe the COVID-induced troubles in the Treasury market and highlight Duffie’s compelling proposal to consider requiring central clearing of U.S. Treasuries. We endorse Duffie’s call to study such a mandate, and view this is as an important element of a broader effort to modernize and reinforce the financial infrastructure….

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Has the U.S. Distribution of Wealth Worsened?

Wealth inequality in the United States is obvious to everyone. The Federal Reserve’s triennial Survey of Consumer Finance (SCF) documents the glaring and persistent divide between rich and poor, confirming that ownership of financial and real assets in the United States has been highly concentrated for decades (see our earlier post). The most recent 2016 estimates suggest that the top 10% of the wealth distribution own nearly three-quarters of all marketable assets, with the top 1% owning more than half of that. And, Saez and Zucman (SZ) estimate that the U.S. distribution has been getting worse, with the top 1% share of marketable wealth rising by more than 10 full percentage points since 1989.

But, as Catherine, Miller and Sarin (CMS) recently highlight, adding in the present discounted value of Social Security benefits (net of taxes) to construct a more comprehensive measure of wealth alters these patterns. First, according to CMS’s estimates, the share of marketable wealth in total wealth has plunged by more than 18 percentage points since 1989. Second, over the past three decades, the top 1% share of total wealth has risen only modestly, while the share owned by the top 10% has declined somewhat.

In this post, we highlight the CMS results, and decompose their changes in total wealth shares into two parts: the changes in marketable and Social Security wealth shares accruing to each group, and the aggregate decline over time of marketable wealth as a share of total wealth. We show that the latter dominates the overall trend in this more comprehensive measure of inequality….

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Cyber Risk, Financial Stability and the Payments System

Cyber risk remains at the top of the list of risks to the financial system, and the financial system is well known as the primary target for hackers (see here, here and here). In response, financial institutions expend huge resources on protecting their information systems—by one estimate, well over $100 billion. Yet, private sector actions to prevent cyber losses fall short due to a glaring externality: since the damage is likely to spill over to other financial firms and to markets, individual firms cannot reap the full benefits of preventing cyber attacks.

To get a sense of the financial stability risks associated with cyber fragility, we need to understand the financial system in some detail. Unfortunately, financial networks are highly complex and vary significantly across markets and functions. They also evolve meaningfully over time. On top of these enormous challenges, assessing network vulnerabilities frequently requires institution- or transactions-level information that is normally not publicly available.

This brings us to the important recent work of Eisenbach, Kovner and Lee (EKL), who study the vulnerability of the U.S. large-value interbank payments system, Fedwire, to a cyber attack on one of the principal nodes of the payments network—namely, one of the top five banks. In this post, we highlight EKL’s analysis as a model for the assessment of cyber-driven network risks. We suggest how central bankers should react to a cyber attack on the payments system, and speculate about what is needed to prevent, as well as mitigate, cyber risks….

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