QE and its unintended consequences

In raising the possibility of QE2 at his Jackson Hole speech, Ben Bernanke mentioned two potential costs that would have to be assessed against any benefits of a QE - round #2, before the Fed makes a decision to that effect.

One had to do with the potential rise in inflation expectations due to perceptions that the Fed would have difficulties unwinding its vastly expanded balance sheet in the future.

The second had to do with economists’ insufficient understanding of the exact impact of central bank asset purchases on financial conditions (let alone aggregate demand). As Bernanke put it, “we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. […]. [U]ncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.”

Here, I want to add a few more potential risks into the list: Are there any unintended consequences of the Fed’s asset purchases (and low-for-long interest rates more broadly), other than a possible spike in inflation expectations? For the sake of brevity I’ll just keep a list format, with the intention to elaborate on each one of the issues separately in future pieces.

So the first concern has to do with the potential systemic risks associated with the behavior of institutions such as insurers and pension funds in an environment of low (and falling) long-term interest rates. For starts, falling interest rates have increased the net present value of their liabilities (and have lengthened their duration). This does not have to have a negative balance sheet impact, provided that the asset side of these institutions benefits from matching capital gains as interest rates fall.

However, news reports and market talk suggest that this is not what has happened: Before the Fed’s hint of QE2, expectations that long-term rates had to go up from record low levels saw many institutions holding conservative duration exposures on the asset side of their balance sheet. The result has been a smaller gain on the asset side (with the concomitant increase in the funding gap) and a recent push towards long-duration positions to address the duration mismatch between assets and liabilities. The “systemic” risk here is that, if and when long-term yields begin to rise, the unwinding of these positions can lead to a much sharper rise in yields and volatility in the bond market.

A second concern has to do with the hedging behavior of mortgage/MBS investors. Low interest rates increase the probability of refinancings and, as a result, reduce the expected duration of MBS securities (and the underlying mortgages). MBS investors hedge against this prepayment risk by holding instruments of long duration, such as long-term Treasuries or interest rate swaps. Once again, if and when interest rates start going up, unwinding these positions can become destabilizing, as everyone enters the market in the same direction. (The impact of this is of course mitigated by the fact that the Fed itself holds a substantial chunk of the mortgage market).

Third on the list is the potential build-up of leveraged positions (or “carry trades”) “thanks” to the Fed’s promise of low-for-long interest rates. The risk is that crowded carry positions can unwind fast once Fed rates begin to rise, especially since the earlier leverage build-up has pushed asset valuations to stretched levels.

Now, unlike many pundits out there, I do not believe there is an empirically established causality from the Fed's policy rates to investors’ leverage. For example, the academic literature has failed to find a definitive link between the level of advanced economy interest rates and emerging market spreads (which would be obvious beneficiaries of carry trades). What does matter is investors’ risk appetite (e.g. proxied by the VIX).

And here is the challenge for the likes of the Fed: Economists do not have a complete understanding of how monetary policy affects investors’ risk-taking behavior (the so-called “risk-taking channel"). But this does not mean that it’s something to ignore, simply because it doesn’t fit into some well-established theoretical framework. More so since the framework supporting the Fed’s asset purchase program (the “portfolio balance channel”) has little to say about the build-up of leveraged positions and any associated risk from their unwinding.

A final concern—and maybe the least interesting—is the impact of low interest rates on the viability of money market funds (MMFs). Low-for-long nominal rates, combined with new regulations to increase the liquidity and reduce the maturity and riskiness of MMF investments has been squeezing the sector’s profitability. Add to that the fixed expense ratios of around 0.2-1% of assets, and the low rates can force at least some of the less efficient MMFs to closure.

The reason this is the least interesting problem in my view is that the economic impact is unlikely to be meaningful. Users of MMFs tend to be high-quality corporate borrowers who could easily tap bank or capital market financing. True, the costs of borrowing might be marginally higher, but this is most likely dwarfed by the impact of record-low interest rates thanks to the Fed's policy.

Still, I thought I should mention it, first because some economists have raised this issue in the past, and second because I was personally amused by Bernanke’s own take on this concern. Here is Ben in 2004:

“In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman's classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact.”

That’s right… Bernanke (then-Fed Governor) responded by going philosophical, citing a supposed structural argument (something like, “MMFs are probably not that useful and zero interest rates can help eliminated them”), grounded on a much-debated theory (Friedman’s rule) to support a policy that is strictly cyclical in nature!

Anyway.. A mini-diversion from the main point, which is that the potential costs from further QE, and low-for-long yields more broadly, go beyond the possible rise in inflation expectations and the threat to the Fed’s credibility. Against this backdrop, any cost-benefit analysis should consider not only policymakers’ uncertainty over QE’s impact on aggregate demand but also their uncertainty about the potential risks for global financial stability.

The “E” and the “M” of the EMU

They say “do not believe anything until it’s been officially denied”. Just last Thursday, ECB President Jean-Claude Trichet categorically denied that the ECB had discussed buying government bonds of peripheral eurozone members.

A market sell-off and a hectic weekend later, it was time for a complete about-face… Per the ECB’s press release on Sunday night, “in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. […]

In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”

The significance of this move is huge, as far as killing speculators goes, but here I want to focus on a key policy dilemma that has emerged since the subprime (and now the eurozone) crisis ever began: The need for a separation between monetary and fiscal policy—what Trichet referred to as the difference between the “E” and the “M” of the EMU (or Economic and Monetary Union) at the ECB’s press conference on May 6th.

In the US for example, this separation was all but blurred by the Fed’s decisions to put its own balance sheet at stake in the bailouts of Bear Stearns, Citi and AIG and, more bluntly, by its decision to buy US Treasuries, GSE debt and mortgage-backed securities. In the event, Congress’ disgruntlement with the AIG saga, monetarists’ concerns about “debt monetization” and valid criticisms about the Fed’s decision to favor a specific sector—housing—with cheap credit, have served to raise questions about the appropriate limits of the Fed’s independence.

Does the European/ECB approach offer an alternative/better(?) route? In my view yes, notwithstanding the latest decision to purchase government bonds.

Ignoring the bond purchases for the moment, recall first that, at the height of the financial crisis, all failed banks were “dealt with” by their corresponding national governments, without any participation from the ECB. To the extent that saving insolvent banks was deemed desirable form a social or financial-stability perspective, the burden was assumed by the elected governments, with ultimate responsibility going to the taxpayers (who voted for them).

Meanwhile, the ECB did not remain idle—on the contrary: It was the first central bank to flood financial institutions with liquidity right at the onset of the crisis in August 2007; and in June 2009, it decided to provide as much funding as demanded by European financial institutions at a low, fixed rate for a 12-month maturity (longer than the Fed’s liquidity operations). In other words, the ECB demonstrated full flexibility and creativity when it came to preserving financial stability and fulfilling its LoLR functions (to illiquid but solvent institutions).

Given the faithful delineation between fiscal and monetary responsibilities, Sunday's decision to step into the government bond market may be seen as an aberration—or worse: A betrayal to the spirit of its price-stability mandate, let alone an anathema to the Germans.

I actually don’t think so. First of all, the interventions are described as—effectively—liquidity operations, to improve the functioning of monetary transmission. This is not a b.s. excuse for back-door debt monetization. Repo transactions using peripheral-economy debt as collateral have been increasingly dysfunctional, undermining the ability of some European financial institutions to fund themselves in private markets.

Now, why is that so different from the Fed’s MBS purchases, which, ultimately, were also aimed to help improve conditions in financial markets? It is different in many ways. First, unlike the MBS purchases, the ECB’s operations will be sterilized—that is, the objective is not to loosen monetary policy further but to relax financial conditions from the currently tight levels by improving funding for financial institutions (and governments).

Importantly, the Fed’s MBS purchases were unconditional: No actions were demanded on the beneficiaries of these purchases (the mortgage borrowers). In contrast, the ECB *had* to extract commitments for further fiscal consolidation from the eurozone governments, so that it could claim that (by its own judgment, rather than the now discredited rating agencies) peripheral government bonds are “safe” enough for its portfolio. We yet have to see whether such pledges will be met, but they are at least a start.

Mind you, the point goes beyond the “narrow” objective of securing the safety of the ECB’s balance sheet. It is about securing a commitment by the eurozone governments that they still see the EMU as a desirable objective and one that is worth making sacrifices for: Namely, further fiscal measures in line with the spirit of the Stability and Growth Pact, and structural reforms to restore competitiveness.

Trichet’s tough talk on May 6th aimed at highlighting exactly that—the limits of monetary policy in preserving financial and economic stability, when the political will to do so is lacking:

“We cannot substitute for the governments. The governments have their decisions to take while we have our own role as an independent central bank, and of course we expect each authority to fulfill its own responsibilities.”

What are the lessons here, including for the U.S. of A.? The first is the realization that, unfortunately, politicians are unlikely to get their act together until things are at the brink of falling apart. And even then, political will may be hard to muster in the midst of the crisis. Trichet’s “bluff”(?) worked in finally stirring bold action. Bernanke had to step in and bail out the likes of AIG with Fed money. But once the emergency is over, any fiscal burdens must be transferred from the Fed’s books to of the US Treasury.

The second is that there was, in fact, an alternative to the MBS/Treasury purchases... which was to buy none! Instead, like the ECB, Fed operations could have focused solely on securing ample liquidity to the financial system, in line with its mandate of safeguarding financial stability. Indeed, as I argued here, the effectiveness of the so-called “portfolio balance” channel over and above the positive impact of the MBS purchases on bank liquidity is dubious. Let alone the hoped-for impact on inflation… has anybody seen the recent US inflation numbers?! (OK, OK, we can’t know the counterfactual!)

The third lesson is that monetary policy cannot be oblivious to fundamental imbalances in the economy, whether these take the form of fiscal imbalances, current account imbalances or large indebtedness in the household, corporate or financial sectors. This applies even to those central bankers fixated with (product price) stability. The reason is that the resolution of such imbalances is often “non-linear”—as in, abrupt and brutal and one that will tend to undermine the very price stability that the central bank claims to defend.

The eurozone came close to its "non-linear" experience by seeing the viability of the euro falling apart. The US (along with the rest of the world) felt it first hand, in the fourth quarter of 2008 and its ugly aftermath.

Both these instances suggest that Trichet may actually be wrong: The “M” and the “E” cannot be that separate after all.

The good, the bad and the irrelevant

If I’m not mistaken, the Senate election last week was held not in Michigan, nor in Mississippi, but in Massachusetts: America’s highest-ranked state by health-insurance coverage and education, and the third-highest by per-capita income.

If I’m also not mistaken, the winning candidate lured voters not with his ruthless bank-bashing (on the contrary!), but by flagging himself as an “independent” with a (supposedly) fiscally conservative agenda.

Against this backdrop, the knee-jerk reaction that came out of the White House shortly after Tuesday’s results is not just bad (polarizing, desperate) politics; it’s also bad policy—irrelevant and potentially harmful policy.

Starting with irrelevant: The proposed “Volcker Rule”, which would prohibit banks “to own, invest or sponsor hedge funds [or] private equity funds” or engage in proprietary trading does exactly nada to address the causes of the financial crisis. These were:

(a) the inability of banks and their regulators to grasp, let alone contain, the level of systemic risk resulting from their highly leveraged operations;

(b) abundant liquidity, easy credit and the search for yield (call it greed if you like); and

(c) as a result of (a) and (b), too little capital to support the ballooning debt in the financial system and the real economy (esp. households).

Constructive initiatives to address systemic risk and capital adequacy are already underway, with high-level institutions like the Bank of International Settlements preparing proposals in these areas. These would include more effective and transparent rules for loss provisions, pro-cyclical capital buffers, a resolution framework for “too big to fail” institutions and stricter liquidity requirements.

What does the Volcker Rule add to this discussion? What… you said more protection to the taxpayer from the high risk takers?! Well, no.

Basically, the Volcker “rule” is grounded on an erroneous assumption: That only institutions that receive deposits from the man on the street are worth stabilizing with taxpayer money (e.g. through deposit guarantees) because of their special role in economic growth.

But this is clearly misplaced. Non-bank financial institutions such as money market funds, finance companies and securities lenders/dealers are absolutely instrumental for the flow of corporate finance and household credit. As such, they are very much “systemic” from an economic growth point of view. One can only recall the complete meltdown of the US and the global economy when Lehman was allowed to fail! Lehman was not a "bank"—yet it warranted an orderly resolution, which—at that stage—had to risk taxpayer money.

In light of this, the relevant policy response is not to --effectively-- force financial institutions to make a choice between their deposit-taking (ie banking) services and their "non-bank" activities. Instead, it is to recognize that what are seen as "non-bank" services are often very much "bank-like" and should be regulated approrpiately with the view of promoting sensible risk-taking across the balance sheet.

By "bank-like" I mean, first of all, maturity transformation. Take finance companies: They borrow short-term commercial paper to invest in instruments like mortgage-backed securities, which are backed by long-term assets. That's not far from plain vanilla banking. I also mean liquidity services: For example, securities dealers take deposits from their hedge fund customers, which are redeemable on demand, but then use the cash to fund their activities in credit market instruments whose liquidity can dry up instantly. This prompts funding uncertainties and a potential run on the dealers... and thus needs to be addressed.

Yet, rather than a targeted regulatory proposal, we get the Volcker rule--a waste of precious political capital and resources for a measure that is ultimately irrelevant!

Then you have the greed problem—and a problem it is! But containing it requires effective regulation, not populist one-off measures (which can backlash).

So what type of regulation can be effective in reining in greed in executive pay? Once again, some initiatives are already underway. The Federal Reserve for example has made a set of recommendations to better align incentive compensation with the risks undertaken by financial sector employees and also with their long-term performance.

But more may need to be done--if, for example, high executive pay turns out to be the by-product of an unduly monopolistic environment in the financial sector, which in turn leads to abnormally high earnings. Indeed, as I argued here back in November, a comprehensive assessment of the benefits and costs of the financial sector’s existing market structure and the identification of measures to improve it should be a top policy priority.

Yet, what we get is a bank tax! OK, may-be one can justify it by the extraordinary, government-backed recovery in financial markets and the, admittedly, business-as-usual attitude by some banks in the sphere of bonuses until it was too late. But it may also end up being harmful: If competition in the financial sector is limited, banks will have the market power to pass on the cost of business to their customers! And this can’t be good for lending nor for the economy more broadly.

Beyond the irrelevance of the proposals, what is far more disappointing is the new tone coming out of the leadership. Here you have the sober, Harvard-educated President, who excited many an independent voter with his intellectual approach to politics and policy back in 2008, employing an increasingly populist vocabulary.

Not only does this alienate independents further. It also raises the level of political risk for businesses and the markets, undermining the one visible achievement this Administration can claim credit for: The restoration of some sense of stability and order in financial markets and, with it, the recovery of a substantial amount of households’ financial wealth and confidence more broadly.

It would really be a shame if the (mis)reading of an electoral outcome ignited a policy agenda that is ill-focused, time-consuming and potentially unsettling. One can only hope it’s not too late to change tack.

Bringing stability to the Stability and Growth Pact

With the financial crisis bringing formerly unglamorous professions into the spotlight (economists, accountants), a new one has come to claim its share: Statistics!

Last week, a report by the European Commission (the EU’s executive arm) on the egregious shortcomings of Greek budget statistics sent Greece’s sovereign CDS spreads to levels only below those of Dubai, Vennie and Argentina!

Without wishing to belittle statisticians, I’d like to suggest that, from a policy perspective, the focus on Greece is a convenient distraction from the much bigger problem facing the eurozone: The fact that the Stability and Growth Pact (SGP), both by its design and its implementation, has failed to bring stability to the eurozone (I’ll leave “growth” aside for now). Instead, the institutional framework underpinning the European Monetary Union (EMU)—of which the SGP is a critical component—has been responsible for the imbalances within the eurozone that are now undermining its stability.

The starting point here is that, in the absence of appropriate disciplinary mechanisms, governments have a tendency to spend beyond their means. This is not some abstract conjecture but a well-established fact, validated by empirical evidence and grounded on political economy arguments widely discussed in the academic literature (e.g. by Harvard’s Alberto Alesina).

Given this “natural” propensity, there is a need for a set of disciplinary mechanisms to work at different levels:

• Reputational/Cultural: In some countries, the “culture” of (or voters’ preference for) fiscal discipline is very strong. In that case, governments have a lot to lose (reputation and elections) by not adhering to fiscally responsible policies.
• Rules-based fiscal framework: Empirical research (e.g. by Henning Bohn or James Poterba, who examine the fiscal performance of different US states) has found stricter and better enforceable budget rules to be associated with better fiscal outcomes.
• Market discipline: In theory, markets should also help impose discipline by raising the cost (pecuniary and reputational) of unrestrained policies. (In practice, however, markets often fail to provide such discipline by reacting too late and in a non-linear fashion due to myopic behavior, benchmarking, etc).
• Discipline imposed indirectly by the monetary authority. Provided that the central bank is sufficiently independent, it could help counteract the destabilizing effects of government dissaving with a monetary policy that encourages the build-up of private saving.

Unfortunately, most eurozone members have not seen any of these applied with sufficient force. For starts, governments’/voters’ preference for fiscal conservatism is highly idiosyncratic (see Finland vs. Italy or Greece) or temporary (e.g. will to adjust in the run-up to EMU accession followed by a pause/reversal). As such, it cannot possibly be taken for granted in a monetary union of 16 members (and potentially more).

In the case of monetary policy, post-EMU interest rates were way below “optimal” for countries like Spain, Ireland or Greece. Their national inflation rates were consistently above the eurozone average, while residuals from a Taylor-like rule post-EMU have been far more negative for these countries than for Germany or France (or Finland!). This is not to say that monetary policy was necessarily inconsistent with the ECB’s mandate of price stability; I’m just highlighting here the well-known fact that this particular disciplinary mechanism does not work in a monetary union.

Market “discipline”, too, has been anything but… Eurozone members’ long-term yields “miraculously” converged towards those of Germany (spreads were uniformly around 25-35 bps!) despite vast differences in fiscal positions and track records of adjustment.

With three out of four disciplinary mechanisms out or order, the burden falls on the fiscal rules. In fact, precisely because the other mechanisms are dysfunctional, a monetary union should have extra-strict fiscal rules with extra-strict enforcement mechanisms. But that’s not what Europe got for itself.

The SGP has been lame in more than one respect. In terms of design, the 3% deficit limit, which triggers the switch from the SGP’s “preventive” (and softer) recommendations to its “corrective” (and stricter) prescriptions, misses “the” point of debt sustainability.

First, by being too weak a benchmark to promote adjustment during recoveries;
Second, by invariably creating incentives to use one-off measures, creative accounting and statistical misreporting to meet the “3%” limit;
and, third, by allowing heavily indebted members to operate under the soft, “preventive” framework when they should instead be in a permanent “corrective” phase until their debt levels decline to an acceptable benchmark (say 60% of GDP… make it 80%!).

When it comes to enforcement, well, here we are entering the ultimate territory of lameness! First, once again, the process relies heavily on the corrective arm (i.e. after countries are in trouble with high deficits) rather than the preventive arm. This means that, even when/if countries eventually adjust back to a "3%" deficit, they end up there with much higher debt levels.

On top of that, a country is not automatically deemed to be in a state of excess deficit once it crosses the 3% limit; instead, the process involves first an “opinion” by the European Commission, which is then pondered about and decided upon by the European Council of Finance Ministers! Yes, that’s the very same guys whose budgets are under scrutiny!

This sham has led to all sorts of self-serving shenanigans—like, when the Council refused to issue an early warning to Germany back in 2002, or when the Council came at loggerheads with the Commission in 2003 by refusing to adopt a decision that France and Germany were running excess deficits. (The case had to go to the European Court of Justice, which vindicated the Commission).

Against this backdrop, Greece’s case is only a symptom of a broader plague of fiscal misconduct, including by “core” economies like Germany, France or Italy. While their numbers may look less provocative than Greece’s, they are far more consequential from an institutional and macro-stability perspective.

So what should change? Here are a few proposals, either from the literature or (to my knowledge) from me:

1. Enhance the SGP definition of “corrective” trigger to include debt/GDP levels. In this context, place highly indebted members under a permanent “corrective” process of adjustment until debt to GDP declines to a more acceptable level.

2. Do away with the 3% limit on the fiscal deficit, which is subject to all sorts of creative accounting, and set instead a limit on the public sector borrowing requirement. Discrepancies between Greece’s (and not just Greece’s) deficit and its borrowing requirement (after adjusting for financing items) had been raising eyebrows for years, so it’s baffling why this “cleaner” rule has not been brought to the fore. Besides, this rule would be more direct in controlling the debt/GDP level than the deficit-based rule.

3. Adopt strict, legally binding budget rules in the national legislatures, to be monitored by non-partisan fiscal councils. Governments should be made accountable to their parliaments for missing fiscal targets, both the “preventive” ones and the “corrective” ones.

4. Establish “rainy day” funds at the national level, with a rules-based contribution system that ensures a stricter enforcement of countercyclical policies, esp. in “good” times.

5. Establish a eurozone-wide “insurance-against-crisis” scheme: There may be a case for taking explicitly into account the negative externality due to misconduct by a minority of the membership. Countries could make contributions to an insurance fund, reflecting (a) their size and (b) their riskiness (debt level in excess of, say, 60% of GDP). This would boost the incentive to bring debt down, as well as establish predictability about the orderly resolution of a crisis situation.

In sum, safeguarding the “stability” objective of the SGP (and the EMU more broadly) will take bold measures focusing on stricter and more effective rules and enforcement mechanisms, In their absence, eurozone leaders and their array of supranational institutions might as well call a summit to give the Pact a different name!

Ben and his Avatar

I can’t help noting the coincidence of Bernanke’s nomination as both “Man of the Year” and “The Definition of Moral Hazard” in the same week as the release of Avatar... And while Ben has probably settled on which “body” he belongs to, representatives of the voting public have yet to make up their mind.

The recent Senate Banking Committee hearing on his reappointment is evidence of Congress' dilemma: While his re-election as Fed Chairman is coming closer to materializing in recognition of his multibillion dollar rescue(/bailout) of the entire economy, Congress has doubts about the Fed’s future role as financial regulator and supervisor.

In fact, under the current draft financial regulatory reform bill, financial supervision and regulation responsibilities (including those of the Fed) would be consolidated under a single federal bank regulator (other than the Fed).

Given the obvious turf issues, Ben is already fighting back, using every occasion to make the case for maintaining and indeed enhancing the Fed’s supervisory authority. But turf matters aside, the proposed reform may be actually doing the Fed a favor.

The starting point here is that international experience does not offer paradigms of an “optimal” institutional structure for financial supervision and regulation. For example, countries with very different institutional frameworks (e.g. the UK, the eurozone or Japan) have all experienced a major financial crisis recently or in the past.

Then, the case for assigning the roles of both monetary policy and financial supervision/regulation to one and the same institution (the central bank) has to be made at a conceptual level, based on arguments of efficiency and effectiveness:

1) Does the Fed have a comparative advantage in supervising financial institutions?
2) Does the Fed’s role as banking supervisor help inform monetary policy and make the latter more effective?
3) Is the mandate of banking supervision critical for the Fed’s effective execution of its non-monetary policy roles, notably its role as a lender of last resort (LoLR)?

So let’s take these one by one. The weakest argument in support of the Fed as banking supervisor is, in my view, that the Fed has a comparative advantage in fulfilling that role. At the Senate Banking Committee hearing, Bernanke argued that Fed staff have “unparalleled expertise”, being trained economists with a deep grasp of monetary issues. In his view, these skills would become even more valuable as banking supervision expands to include a macro-prudential/systemic perspective.

Sorry Ben, but we don't buy that. To start with, the Fed staff’s “unparalleled expertise” failed abysmally to grasp the scale of banks’ problems at both the micro and macro level, not just before but also well into the crisis. Aside from that, the “right expertise” can always be hired by the institution that needs it. It’s no sexier for a bank supervision expert, or a macroeconomist for that matter, to work for the Fed than for another institution, if the latter is the one with the lead authority in his/her area of expertise.

A stronger argument is that the Fed’s role as banking supervisor can help inform its monetary policy decisions and make the latter more effective. Existing academic literature is inconclusive on this topic, though I personally think that current research efforts (exploring the links between monetary policy and the behavior of financial institutions) will provide more solid support. Nonetheless, the argument is made controversial by the Fed’s own practice and by Bernanke’s view that the best tool to address “excessive” risk taking in the financial sector is not monetary policy.

Re. the former, Ben admitted at the hearing that “in normal times”, FOMC meetings (on monetary policy) spend very little time, if any, on the state of the financial sector. Of course we all know now (with the benefit of hindsight) that what the FOMC viewed as “normal times” were not normal at all.

Aside from that, this de facto separation of monetary policy decisions from financial stability issues is revealing of the Chairman’s intellectual belief (which he has stated time and again) that financial sector “excesses” should be addressed by appropriate regulation instead of interest rate policy. If Ben insists on that view, the case for uniting the authority for monetary policy and banking supervision/regulation under the Fed is pretty tenuous, at least on the grounds of making monetary policy more effective.

Bernanke’s strongest case in support of the Fed’s role as supervisor is based on the critical role it can play (not in preventing but) in managing financial crises—i.e. once they happen! The argument has a number of dimensions including, inter alia:

First, when a financial institution is under distress, the Fed can benefit immensely by its own in-house supervisors, who can assess the state of the institution, evaluate its collateral against which it might lend to it (under its LoLR function) and, thus, protect the taxpayer.

Second, the Fed’s role as banking supervisor, in conjunction with its mandate as overseer of the payments system, is critical for allowing it to understand the systemic implications of the distress in an individual institution, and therefore assess the tradeoffs between providing support to a failing institution or letting it fail.

These arguments have merit but do not necessarily make the Fed’s supervisory role absolutely essential. For example, provided that there are officially-established communication links between the Fed and the supervisory agency, the Fed would have access to all the information it needs to assess the situation. Indeed, the distressed institution itself would cooperate in the provision of information, as it happened when Bear Stearns went under.

But what is more important here is to weigh the benefits of the Fed having its own people managing the nitty-gritty details of a bailout with the political costs (to the Fed) associated with that role. The backlash from (what was inevitably seen as) the Fed’s gross failure to protect the taxpayer in the AIG bailout (legal excuses notwithstanding) highlights the political risks of too direct an involvement by the Fed with decisions that ultimately belong to the fiscal authority.

In my view, this political risk is a cost sufficiently large to tilt the balance against granting the Fed the lead role as financial supervisor, notwithstanding the benefits mentioned above. Mistakes, or actions perceived as inequitable and unfair, will always be made, especially in a crisis situation, so an arm’s length involvement by the Fed can actually help safeguard its monetary policy independence—an independence that should remain sacrosanct.

As a result of the bailout mess, the Fed has now found itself engaged in a PR exercise to defend not only the details of its bailout actions but also the rationale and soundness of its monetary policy decisions. It’s still unclear whether it’s winning. But, maybe a cleaner way to go is to avoid altogether the public’s confusion between “Ben: Man of the year” and his “Moral Hazard” avatar.

Greece should seek a precautionary standby… now!

Eurozone bond markets have for years now been operating under the assumption of a new “impossible trinity” (1/): That you can’t have a single currency, a (virtually) independent fiscal policy and a no-bailout clause all at the same time.

This assumption has continued to prevail even after the recent budgetary shenanigans in Greece (and fiscal slippages also elsewhere in the eurozone), judging from the latest pricing of Greek sovereign CDS.

While much wider than in early October, when the new government took office, Greek 5yr CDS spreads, at 200bps on Friday, still price in just a 6-8% probability of a credit event. (By comparison, Dubai Holding’s spread closed at 1870bps and Ukraine’s at 1350bps).

Markets are probably right… Most likely, Greece will deliver a series of fiscal consolidation promises to the Euro group (of eurozone finance ministers), will become subject to enhanced surveillance by the European Council under the Maastricht Treaty’s “excessive deficit procedure” (EDP) and, as such, obtain an implicit financial backstop from its eurozone fellows…

But here are the problems with this approach:

First, Greece (and some other vulnerable eurozone members) would be better off with an explicit financial backstop, not an implicit one. The EU’s backstop will always have to be implicit to avoid moral hazard and complacency by the Greeks, the Irish, etc. However, an explicit backstop would be much more effective in stabilizing the Greek bond markets and in curbing uncertainty about potential financing troubles.

Second, any EU backstop would likely come after a crisis hit, instead of being pre-emptive. That’s lousy policy, not least because, were a crisis to hit, it would raise uncertainty and possibly spread to other markets, even if the EU were quick to step in. It's also lousy because there is absolutely no excuse for not having a crisis-prevention framework into place (over and above Greece’s own policy promises, for what they’re worth): Greece’s fiscal quagmire has been known for a long while, so policymakers would not exactly be caught by surprise!

Third, the European Commission/Council have a truly hopeless track record of enforcing fiscal consolidation or structural reforms on eurozone members. This means that whatever plan is laid out for Greece, it could lack the credibility to pass the “rating agencies’ test”, let alone the “markets’ test.” Ongoing uncertainty and lack of credibility would only breed volatility, which is neither good for Greece nor for investors still recovering from the Great Panic of 2008. In addition, to the extent that the Europeans prove, once again, incapable of enforcing fiscal and structural reforms, implementation slippages by Greece would set a dangerous precedent for other eurozone members to follow.

Fourth, direct involvement by eurozone governments in Greece’s fiscal plan (and, if need be, bailout) raises issues of conflicts of interest. It could turn out, a couple of years later, that Greece cannot put its finances in order.

This is not just a thought experiment by the way: Greece’s fiscal problems are deep-rooted and structural—a symptom of endemic problems, including an over-bloated and unproductive public sector, a pervasive culture of tax evasion, and widespread corruption at every imaginable level, from politics to the judiciary to the hospitals! This has hurt not only the government’s ability to put its finances in order; it has also hurt Greece’s competitiveness as a place to do business, undermining future growth (and, in turn, the fiscal dynamics).

If fiscal consolidation measures and structural reforms fail to deliver the necessary correction, the next route to follow may have to be debt restructuring. And here, the Europeans have too much at stake: Almost 70% of Greece’s near-EUR300 billion debt is held by foreigners, with a big chunk of it by French, German, Italian and other eurozone institutions (per the BIS). It is easy to see why the Europeans would not be “neutral” negotiators, and likely force too big a burden of adjustment on the Greek side.

This may sound “fair” on the surface, yet consider that these guys have completely failed to impose even a modicum of market discipline in recent years, being lured by the appeal of Greek debt as a euro-denominated product with an easy spread!

So here is a better and cleaner way to go: Greece should seek a “precautionary standby arrangement” (SBA) from the International Monetary Fund (IMF).

Under the SBA, Greece would commit to a combination of deficit-reducing and structural policy measures over 2-3 years (frontloading the former to sharpen the “teeth” and credibility of the SBA). The arrangement would be precautionary, with no IMF resources drawn in the baseline scenario where Greece faces no financing gap. However, Greece would have immediate access to Fund resources in an adverse scenario of financing troubles due to either a Greek-related or an “exogenous” market turmoil.

The advantages of this route compared to an EU solution are enormous in my view:

1. Greece would enjoy an explicit financial backstop rather than an implicit one.

2. The backstop would help prevent any crisis from happening, instead of cleaning up the mess ex post facto.

3. Provided the SBA has “teeth”, the seal of the IMF would be a great palliative for the markets, helping impart credibility to a government that has none.

4. By laying out specific benchmarks/conditionalities, compliance with these would be easy to monitor by the markets and by the Greek public, reinforcing government accountability.

5. The Maastricht Treaty’s “no-bailout” clause would remain intact, while the ECB would be able to maintain its autonomy over monetary policy and liquidity provision decisions, which would fortify the credibility of the euro.

6. The arm’s length (or, at least, indirect) involvement of Eurozone governments to the process would avoid the conflicts of interest I mentioned above.

7. Finally, Greece could set an example for other eurozone members to follow, helping maintain stability across the eurozone.

It is easy to see why some European policymakers might balk at this idea, out of concern it would amount to an acknowledgement of failure to deal with bread-and-butter problems in their own back yard. As a matter of fact, it is! The Stability and Growth Pact needs major rethinking (more on this in a subsequent piece).

But while Europe’s economic integration goes through yet another phase of soul searching, let the necessary measures of fiscal and economic stabilization proceed in a clean and orderly way.



1/ The original “impossible trinity” in international economics is the argument that you can’t have a fixed exchange rate, an autonomous monetary policy and free international capital flows all at the same time.

On Carry and Other Tales...

I’m amazed with the number of academics, journalists and “pundits” in my field who keep on talking about “the carry trade” as if it’s some sort of cult… “The end of carry as we know it”… “Carry-trade silence”… “Carry makes a comeback!”…

Since last week, the carry trade has also found a mother, a father and some heavyweight patrons (like the Fed) who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions.

I want to use this post to respond to some of the points raised in these op-eds, notably with regard to the role of policy in feeding carry trades and, in turn, asset bubbles. But before I get there, let me deal with the cult notion first...

The carry trade is NOT a cult… “Carry trade” is another way of describing “risk-taking” in financial markets. Anyone who invests their money in anything riskier than a safe, cash-like asset (e.g. US Treasury bills or money market funds) is effectively a carry trader: They are short cash and long a risky asset such as a stock, a corporate bond, a foreign currency, etc.

Indeed, the term “carry” is a literal description of that risk-taking process: When you buy shares in Microsoft, for example, you decide to forego the safety of a US T-bill and instead “carry” the risks embedded in Microsoft’s stock: Risks related to the company’s management, its capital structure, the growth and/or regulatory outlook of the IT industry and so on. Similarly, investors in a foreign currency have to “carry” risks related to the foreign country’s external imbalances, inflation prospects, politics, etc.

Now, to be fair, what many refer to as “carry trades” in the press are leveraged investments. In the above examples, investors use their own capital to make the risky investment. But when they are leveraged, they borrow multiples of their capital short-term and invest the funds in higher-yielding products (e.g. asset-backed securities or currencies like the Brazilian real) to make the spread.

The principle is exactly the same as before—risk taking—only that the use of leverage helps multiply profits in good times (and totally destroy them in bad times!).

OK... now to 2009. Since March this year, most risky assets have seen stellar returns, be it global stocks, corporate bonds, emerging market assets, higher-yielding currencies, etc. How big a role has the “carry trade” played in driving this price action?

Let’s see… One important driver has been the positive surprises in some parts of the real economy (remember those “green shoots”?) As a result, investors revised upwards their baseline forecasts on the economy. In statistical terms, their distribution of expected returns shifted to the right (i.e. a higher mean).

A second driver was the Herculean backstop measures by governments and central banks the world over, aimed at eliminating extreme downside risks. These basically cut off the left (negative) tail of investors’ expected-return distribution.

Neither of these can be said to have encouraged “carry trades” in the leveraged sense. But by shifting the distribution of expected payoffs from risky assets in a favorable way, both factors encouraged (some) investors get out of safe assets and take on risk.

Then you have the Fed’s (and other major central banks’) low-for-long interest rate policy. Is that contributing to “carry trades” and/or to asset price bubbles? There are at least three ways in which the low-for-long interest rates can impact asset prices:

First, the policy “condemns” investors to earning near-zero return on their cash assets for an extended period. This, together with a restored confidence, helps push investors out of zero-yielding cash towards riskier assets.

Asset flow data are supportive of such shifts, but it is important to understand that the low interest rate is only one of the drivers: Factors that changed the mean and the shape of the expected return distribution were arguably more important—recall that in the midst of the panic of 2008, investors were willing to sit on US Treasuries with negative (but certain) yield!

Second, the low interest rates are helping asset prices by boosting the profitability of banks. Think about it: Banks borrow short-term (e.g. depositors’ money or in money markets) and invest in long-term, higher-interest-rate assets like corporate or mortgage loans.

By fixing their borrowing rates at near zero, the Fed is helping banks make profits even in a difficult lending environment. In turn, this helps prevent the negative feedback loop we saw last year, when financial institutions fire-sold their risky investments to preserve their capital, driving down asset prices.

Third, the low-for-long rate can arguably encourage the fresh build up of leveraged carry trades: Investors could borrow short-term at low rates and invest in riskier assets like equities.

Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009--even as new capital was raised. True, we don’t have data yet for Q3, when asset prices kept shooting higher. But then, please, show me data that point to an ongoing “highly leveraged carry trade”! I’d love to see them, along with many in the markets who try to assess systemic risk on a real-time basis!

Even (even) if leverage were indeed occurring, the point that “traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets” is grossly unfair: The “minus 20%” is the ex post cost of borrowing in dollars to invest in a basket of major foreign currencies, following the dollar’s depreciation since March.

But this ex-post analysis completely ignores the tremendous amount of uncertainty surrounding investors’ forecasts back then. No offence to my female cohorts in the industry, but it took gigantic balls to re-enter that market, especially when a LOT of asset managers were already deep underwater and capital preservation was the ultimate priority.

So to recap—low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Importantly, based on available data, leverage has yet to manifest itself as the key driver of the price action.

Now, this doesn’t mean that systemic risk is not rising. In fact, IF that were so, the Fed should take notice. But is that so?

Some cite as evidence of systemic risk the high correlation between different risk assets recently (equities, commodities, EMs, etc). I’m not convinced: Since everything collapsed in tandem last year, the recovery in risk appetite should make everything recover in tandem. In other words, the high correlation is not necessarily a cause of alarm at this juncture.

Still.. high correlation means that, if there is a negative surprise, risk assets will all move down in tandem again. Which would be pretty bad! But here is the real crux of the debate: Have the prices of risky assets already moved “too much, too soon, too fast”? Are we already in bubble territory and, hence, at risk of a sharp correction as soon as “reality” strikes?

Well, it depends on your outlook of “reality” in the coming months/years, and on your framework for translating that outlook into a forecast for asset prices. It could indeed turn out that the world is in much worse shape than the average investor thinks (/hopes!)

But let’s get this straight: It is one thing to claim that current valuations reflect forecasts that are overly optimistic given the “true” state of the economy; and it’s another thing to say that the Fed’s low-for-long interest rates are feeding highly leveraged carry trades, which are in turn feeding asset bubbles.

I personally see the Fed’s promise of low interest rates for an extended period (or the ECB’s term lending at low fixed rates) as a plea to investors to take on risk. The idea is to help assets reflate; support consumption through positive wealth effects; and help lending to the real economy through positive valuation effects on collateral.

Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. We’ll find out “the truth” about the future when it happens. And some will get the chance to say “I told you so!”. But given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

PS My apologies to those who have recently received some of my old posts, looks like Blogger has gone about recylcing old ideas, please ignore them if they recur, I seem to have no control over this!

The plain vanilla option for bank reform

I’m taking a quick break from my blog break to throw in some food for thought re. the bank-reform debate, which has been simmering in earnest.

I also feel pretty energized after a mind-blowing trip to Asia, which has forced me to rethink the definition of “construction boom”, “shopping mall” and... “exotic cuisine”!

Anyway, at the crux of the reform debate are measures to prevent banks from engaging in the risk-taking behavior that led to, yeap, “the worst financial crisis since the Great Depression.” Proposals have targeted, inter alia, bankers’ pay, with the view of curtailing greed and short-termism; and bank capital requirements, to basically make banks’ risky activities more expensive and less procyclical.

Personally, I’m against the former, and not because I have any particular affinity for bankers (unless they are economists!). I just happen to think that, per Econ 101, employee compensation, together with the return to shareholders, should be both derived from a firm’s profit-maximization exercise—provided this exercise also internalizes the systemic implications of the bank’s own risk-taking behavior.

Put differently, if we can make financial institutions pay explicitly for what is now an implicit, unpaid-for insurance provided by the taxpayer against a systemic banking crisis, I see no reason why banks cannot distribute any left-over profits to their workers and capital owners as they please.

For this same reason, while I partly see the logic of the second proposal—to introduce counter-cyclical capital requirements—, I don’t think it’s enough to do “the job”: Yes, it might well discourage banks from engaging in “excessive” risk-taking behavior in good times; but it still does not make banks pay in advance for the next financial bailout which, believe me, will happen again at some point.

Against this backdrop, one idea for making banks pay for systemic-risk insurance was put forward in a paper presented at the 2009 Jackson Hole symposium by MIT economists Ricardo Caballero and Pablo Kurlat.

Accordingly, banks would pay a fee to the Fed in exchange for potential access to insurance, which would be triggered if systemic risk exceeded a certain threshold. This access to insurance would take the form of "TICs" (or Tradable Insurance Credits)—securities that would be issued by the Fed to the fee-paying bank, providing access to Fed guarantees on a pre-specified pool of the bank’s assets.

The paper has some interesting insights and, actually, a somewhat different tilt than the issue I’m raising in this piece (Their point is, in part, that there is a need for a new policy tool to help remove market uncertainty about the depth of bank losses during a systemic financial crisis). So I recommend that you read the whole thing.

Insights aside, I think this type of proposal suffers from a number of flaws, some of which are fundamental. On top of that, it is far more complicated than what I think is a more straightforward solution, which could not only help generate a less procyclical risk-taking behavior, but also address the need to make the now implicit insurance explicit. Let me explain:

Flaw number one in the Caballero-Kurlat approach is the fact that the guarantees would cover a financial institution’s assets (instead of its liabilities).

Why is that a problem? It is, because it would make extremely difficult the failure of any too-big-to-fail financial institution, even if such an institution “deserved” to fail. This would unduly protect the owners of such an institution, despite what might have been excessive risk-taking, lack of oversight and/or sheer incompetence on their side.

As an example, rewind to March 2008, when a (clearly systemic) financial institution in the name of Bear Stearns is at the brink of going bust. Now, an eventuality of that nature is bound to trigger a TIC-like guarantee by the Fed to every financial institution holding TICs, including Bear Stearns.

This is despite the fact that Bear Stearns may be actually insolvent and thus “deserving” to fail (yes, we can debate this, but in a separate forum). The distinction between a liquidity and a solvency crisis is practically irrelevant in the TIC framework.

So this is how it would go… Bear Stearns is about to fail, systemic risk rises unexpectedly, Fed guarantees are triggered, Bear Stearns is saved, systemic risk subsides and all ends well… only that the principle of efficient resource allocation has been wildly damaged: The most short-sighted, over-levered and incompetent bankers on Wall Street are still allowed to roam around, feeling good and getting ready to go back into the game.

To be sure, the Fed (or the relevant supervising institution) might still decide to declare Bear Stearns bankrupt and wind it up, while providing guarantees to the remaining financial institutions. But that would trigger follow-up complications:

E.g. how would we (and the Fed) know ex ante that, urrrh, Lehmans or AIG, say, are soundly-managed institutions deserving to survive, courtesy of the Fed’s guarantees? Or, if the Fed were to trigger its guarantees on a selective basis, what would that do to market uncertainty—the very problem the TIC proposal was meant to address?

But let me go to the second fundamental flaw of the Caballero/Kurlat proposal: Which is that it confuses the roles of the fiscal and monetary authorities in a crisis resolution framework. Contrary to what they suggest, the provision (and, ultimately, the cost) of any guarantees on any financial institution should be the role of the fiscal authority (ie the Treasury), NOT the Fed.

True, the Fed did provide backstops against certain assets or liabilities of financial (and non-financial) institutions during the 2008 crisis, as the crisis escalated. But that was due to (a) the absence of a systematic framework for crisis resolution; and (b) the inability of Treasury and Congress to respond proactively to the dramatic events that unfolded. Yet, what we need is not the Fed taking the lead in what is essentially a fiscal activity; but a solution that would help avoid the need for the Fed to get financially involved, for the sake of its financial and political independence.

So here is an idea: Extend the FDIC’s deposit-insurance framework to the entire financial sector. In other words, get financial institutions (i.e. not just commercial banks) to pay a fee to a dedicated FDIC-like fund, which would be financial subsumed to the Treasury. This fund would be available to cover the liabilities of a financial institution (i.e. its creditors, up to a given amount and level of seniority), if that institution failed.

If you think this provides too nice a treatment to the creditors covered, think again: These guys would now be getting paid much less for their lending to the bank, since the default risk would now be minimal thanks to the explicit insurance the bank is paying to the government.

Importantly, the scheme could be so designed to address the need to discourage excessive risk-taking as well as a heavily procyclical behavior on the part of financial institutions: For example, the fee could be a function on an institution’s leverage, appropriately defined; and it could also be time-varying, in tune with the business cycle, to discourage heavily procyclical behavior.

What are the advantages of this approach?

* First, it allows for the failure of insolvent, poorly-managed institutions, inlcuding systemically important ones.
* Second, it makes financial institutions explicitly pay for the insurance that taxpayers have been implicitly providing to them.
* Third, it can be designed to be countercyclical and incentive-compatible.
* Fourth, it provides provides a more predictable framework for crisis resolution than the status quo, notably with regard to the treatment of the different parts of the capital structure, if it were to fail. Uncertainty about the treatment of shareholders and creditors of different seniorities was a major driver of the market volatility that prevailed in 2008 and early 2009.
* Finally, it makes it clear that any net costs from the resolution of a failed financial institution will be borne by the fiscal authority instead of the Fed.

So here you go, my first wonkish piece for the first official day of Fall. Pretty plain vanilla, dare I say, compared to some of the alternatives out there. And, believe me, after weeks of heated policy debates over silk-worm skewers, bamboo fungus appetizers and live squid entrees, plain vanilla sounds good to me!

Giving up the dollar addiction

There is a whiff of irony in hearing Asian government officials nagging about the potential debasement of the dollar, and then seeing them going to buy the very currency they love to hate.

Yet, that’s exactly what's been happening: Since the beginning of the year, Asian central banks have resumed their foreign exchange (FX) reserve purchases, accumulating more than $75 billion on aggregate. Peanuts by the standards of recent years, though not if one puts the number in the context of collapsing global trade and finance. Evidently, some addictions are hard to give up!

Admittedly, in some cases (e.g. Korea) the buying has been simply recuperating reserves lost in the midst of last winter’s global financial meltdown and the sudden stampede of foreign capital.

But still: At more that $5 trillion, emerging Asia’s reserves remain $870 billion higher than their end-2007 levels ($460 billion excluding India and China), making a clown out of anyone who dares suggest they are not “adequate”.

So where does one stop? Some have suggested that, as emerging markets continue to attract foreign capital flows, build up larger foreign liabilities and liberalize further their capital account, reserve adequacy considerations would justify more reserve accumulation going forward.

Frankly, I see this as a very narrow-minded argument: Reserve adequacy does not have to be achieved through reserve accumulation. But let me first discuss the framework…

The costs and the benefits: One way to assess reserve adequacy was laid out most recently in a 2008 IMF working paper titled “Are Emerging Asia’s Reserves Really Too High?” At the crux of the argument lies a cost-benefit analysis of the “optimal” level of reserves. It goes like this:

As in most things in life, when you hold FX reserves there are benefits and costs. The benefits stem from the central bank’s ability to employ those reserves in order to cushion the economy from a major disruption due to a sudden investor stampede—i.e. when foreign (and even domestic) investors decide to take their money out of the country.

The benefits of holding reserves are then larger when the probability that a country experiences a “sudden stop” of capital flows is high; and when the sudden stop can generate a very large loss of output, employment and so on, if left uncontrolled.

But reserves also involve an opportunity cost. For example, to avoid a rise in inflation, the central bank may need to absorb (or “sterilize”) the money it creates from its purchases of reserves. It will do so by selling securities domestically, on which it will have to pay interest. So when this interest is higher than that earned on the FX reserves there is a net cost.

Based on this framework, the “optimal” level of reserves is the level at which the marginal benefit from holding an extra dollar of reserves equals the cost of that extra dollar. And, per the authors’ estimations, as of late 2007, reserves in most Asian countries were more or less optimal, except for China, Taiwan and Malaysia where they were (already) unquestionably excessive.

Abstracting from any reservations one may have about some of the authors’ assumptions (and I do), there is a broader question here: How should a policymaker use this framework in order to assess (and achieve) reserve adequacy?

Reserve accumulation is not the only path to reserve adequacy: Think again of the cost-benefit framework for reserve adequacy. An obvious application of this framework is to answer the following question:

How much reserves do I need to accumulate as an “insurance” against sudden stops, given the probability of a sudden stop and given my economy’s vulnerabilities to it?

But policymakers can use the framework to tackle a different challenge: Change the “givens”!

Policy can aim, for example, at speeding up reforms that make the economy more resilient to violent moves in capital flows, in order to reduce the resulting output loss (and, hence, the need for FX reserves).

The list of reforms is long but at the top are certainly measures to increase the depth, liquidity and sophistication of local capital markets, and develop viable hedging tools (including for interest rate and foreign exchange risk) to facilitate a better management of balance-sheet risks by banks, companies and households.

Another “given” that could be changed by policy is the probability of a sudden stop. You see, while the recent stampede from emerging markets was very much driven by the shenanigans of banks in the developed world, in the past “stops” have often been driven by bad policies in the emerging economies themselves.

The opportunity cost of reserves may be higher than you think: On top of policies to change the “givens”, there is also a case for revisiting the concept of the opportunity cost of holding reserves. The IMF paper presents three different approaches to measuring this cost (of which the fiscal cost of sterilization I mentioned above is one). But there is a fourth one: The difference between the rate of return on US Treasury bills and the return from investing the money at home.

The opportunity cost seen this way will likely exceed the one measured by all three approaches in the paper. After all, high expected returns in emerging markets are the very reason foreigners enter those markets in the first place. But a higher opportunity cost means that the “optimal” reserves should be lower: A government would be better off investing part of its net export proceeds at home, instead of amassing reserves.

Finally, one would have thought that the current crisis has opened the eyes of reserve managers to another factor affecting the cost of holding reserves: The fact that reserve accumulation by many countries collectively can lead to adverse global outcomes, even when from an individual country’s perspective it might look like an optimal decision ex ante.

In other words, while it may make sense for, say, Taiwan individually to continue accumulating reserves, when everyone does it we get large global imbalances, artificially low global yields and tremendous risks to global financial stability. Risks that are not “priced in” the cost-benefit optimization framework above.

Sadly, the noises coming out of Asia betray a continued “addiction” to reserve accumulation. Even while concerns about the dollar’s future are becoming louder and louder, the solution proposed is… a new currency to park FX reserves!

In the end all the talk about the dollar’s debasement or a new global monetary system is just blabber and a distraction from the real policy challenge facing emerging markets: How to achieve reserve adequacy without relying on more reserve accumulation!

Sayonara Japan, Hello America!

After Geithner’s earnest declaration that “we are not Sweden” I felt compelled to go back and read through the details of past banking crises just to see what makes us so different. Following which, I fear our Treasury Secretary will have to make a bit more effort to convince me how we are going to avoid becoming Japan.

The parallels have been drawn many a time, including in a fairly recent NBER paper, whose eerie timeline of Japan's steps to resurrect the financial sector left me wondering: Is it short memory, self-denial, inflated egos or what, that’s driving our own policymakers into trying to reinvent the wheel?

I’m not going to go through Japan’s measures one by one (I strongly recommend reading the NBER paper for that). I want to focus instead on how to avoid repeating Japan’s mistakes in dealing with banks' undercapitalization problem. So here we go:

What to aim for: Let’s start with a vision… One of the most interesting parts of the paper (for me) is its discussion of the Japanese authorities’ disregard of evidence of “overbanking” and a need for consolidation in the sector.

“Instead, the only objective that was pursued forcefully as part of the recapitalization was that banks were required to increase their lending, especially to small and medium firms. The recapitalized banks were required to report the amount of loans to small and medium firms every six months.”

The parallel with the US is clear: The US approach up till now has lacked a vision with regard to the desirable size and structure of the banking system. If anything, the authorities plan to make it bigger by providing subsidized leverage to what would effectively be new “banks,” while “old” banks unload their burdens so that they can go ahead and… lend more.

Some have countered that before you get to repair the Titanic, you have to prevent it from sinking. Maybe. But to take the analogy further, to me it looks like we are wasting our efforts unloading our “family gold” into the ocean, instead of employing some of our limited resources to plug the holes.

Put it differently, (and as in Japan), the rescue efforts have been (and are being) applied to all institutions indiscriminately, without careful auditing to assess each financial institution’s health or the outlook of its future viability.

Think of the Treasury’s Capital Assistance Program, which applied to the “selected” institutions on a mandatory basis, needed or not; or the PPIP which is designed to benefit whichever bank has assets for sale, regardless of whether some banks may eventually have to fail. Not to mention the billions already wasted on AIG.

If the current course of action were to continue, the outcome would look like this: A recapitalization that is too small to solve the problem; yet too large by any standard of social equity and fairness. A banking sector that is too large to be sustainable without meaningful consolidation. And a bunch of carcasses left in banks’ books, as banks eagerly wait for a turnaround in the markets to lift asset prices and help them close their (true) capital hole. Japan all over.

Here is a better approach, building on the Japanese experience:

Step 1: “In Japan the recovery started with the toughening of the regulatory audits.”

Frankly, I don’t see (the substance of) why the authorities have been resisting conducting an evaluation of banks’ health on a mark-to-market basis. The taxpayer is in with his wallet either way, whether it’s in the form of new bank capital or of subsidized funding to private participants in the PPIP, TALF, etc.

But still. The point is that we need a consistent and transparent process to estimate the size of the capital gap in each bank. If mark-to-market is a non-starter, the estimates could be based on the valuations of the so-called “Third Party Valuation Firms”, i.e. the entities used by the Treasury to assign preliminary prices for the pools of assets banks put for sale under the PPIP.

(Incidentally, I don't think the stress tests can do the job, and you can see here why. Neither will the PPIP, but I’ll have to discuss why in another post).

Step 2: “[..] the 1999 recapitalization, together with the introduction of a scheme for orderly closure of systemically important banks through nationalization in 1998, ended the acute phase of the banking crisis.” (my emphasis)

Just to clarify, this is not (necessarily) a call for nationalization, but… For me, one of the most positive developments coming out of the Treasury has been the government’s request for authority to take over systemically important financial institutions at the brink of default (see here). If granted, it could be a powerful tool in helping execute the government’s vision (to the extent they develop one) as to the desirable/feasible size of the banking system, by allowing the (orderly) wind-downs of weak institutions, including systemic ones.

Step 3: “One important ingredient were the changes initiated in late 2002 and early 2003 at the behest of Heizo Takenaka, who […] called for (1) more rigorous evaluation of bank assets, (2) increasing bank capital, and (3) strengthening governance for recapitalized banks” (my emphasis)

The Administration’s attitude towards bank governance has been gentle at best; yet it should be a core element of a comprehensive bank strategy. I continue the quote:

“In August 2003, the FSA also issued business improvement orders to fifteen recapitalized banks and financial groups, including five major ones (Mizuho, UFJ, Mitsui Sumitomo, Mitsui Trust, and Sumitomo Trust) for failing to meet their profit goals for March 2003. They were required to file business improvement plans and report their progress each quarter to the FSA.

UFJ Holdings was found to have failed to comply with its revised plan in March 2004 and received another business improvement order. The CEOs of UFJ Holdings, UFJ Bank, and UFJ Trust were forced to resign, and the salaries for the new top management were suspended. The dividend payments (including those on preferred shares) were stopped. Salaries for the other directors were cut by 50%, their bonus had already been suspended, and the retirement contributions for the management were also suspended. The number of regular employees was reduced and their bonuses were cut by 80%.”

I am personally encouraged by the Administration’s decision to take a tougher line on GM and I can only hope that it adopts a similar approach towards banks—involving changes in banks’ management and the requirement for business restructuring and viability plans.

As a concluding note, here is another quote from the paper:

“The main problem with the Japanese approach was that the banks were kept in business for far too long with insufficient capital. This limited the banks willingness to recognize losses and they took extraordinary steps to cover up their condition and in doing so retarded growth in Japan. The U.S. policymakers seem to appreciate that this was extremely costly and appear to be trying to avoid it.”

Let’s hope that America's efforts to avoid Japan's mistakes go beyond “appearances,” because the similarities are too scary to allow us to imagine a different outcome.

Going around in circles on the toxic assets

Who would have thought there might come a day when we’d be asked to compete for our share in a pile of junk?!

Harvard’s Lucian Bebchuk suggests precisely that. His proposal for “jumpstarting the market for troubled assets” has been featured in various media sources, including the FT (here), Bebchuk himself (here) and, recently, by Mark Thoma (here).

Bebchuk’s basic idea is this: In order to encourage price discovery for the toxic assets lying in banks’ balance sheets, the government should allow multiple private funds to compete for them. In addition, to drive down its own participation, the government should make the private funds compete for the public funding made available for purchases of toxic assets under the Public Private Investment Fund plan (PPIF).

Interesting idea but, alas, I don’t think it does the job! I'm about to give a fairly lengthy argument why it doesn't, and what should be done. So if the term “discount rate” makes you yawn, I recommend scrolling down to the conclusion. Here we go:

The assumption driving PPIF is that the current “market” prices for toxic assets considerably understate their “fair” price due to the illiquidity of markets, a high cost of funding of potential buyers, etc. If only banks could sell their toxic stuff at prices closer to “fair”! Their health would by and large be restored and the government would need to pay far less for bank recapitalizations!

The PPIF, in theory, solves these problems (a) by providing partial government funding, thus lowering potential buyers’ cost of capital; and (b) by encouraging a simultaneous buying action on a massive scale, to address the current problem of (a lack of) collective action, whereby early, lone movers get burned.

In practice, however, nothing is solved unless market participants have a sense of what is “fair.” How can we find out? Bebchuk says by having multiple private funds compete for the toxics. Let’s see how/if that would work:

The problems with the theory: Think of a toxic asset—a mortgage backed security (MBS), say, backed by subprimes. And say I am an investor lured by the idea of teaming up with Geithner to buy a few millions worth of MBS junk of the above variety.

Now, suppose I expect subprime borrowers to default with probability p over the life of the mortgages. Very simplistically, this means that, if I held the MBS to maturity, I’d get its face value with probability (1-p) and a recovery value (given default) with probability p. The “fair” price of the MBS will then be the weighted sum of these two values discounted back to present.

So now with my estimate of a “fair” price I go out and make a bid. In principle, I would like to bid below this “fair” price, so that I can pocket the upside. But what Bebchuk’s competitive process does, in theory, is to drive participants’ bids up to “fair.” The idea being to incur the minimum losses possible for the seller banks.

Sounds great, no? Problem is… “fair” depends on my discount rate (my cost of funding these securities). In turn, this depends on how much Geithner is prepared to put in. So I go and knock on Treasury’s door. Geithner opens and (per Bebchuk) confesses that, “as much as I like you, Chevelle, my heart lies with the American taxpayer, so we’ll make you compete for our cheap cash. Show us your money!”

I’m now in a dilemma. I can’t bid too low, because I’ll be thrown out of the game. But then, how high? The only variable I have to guide me is the MBS’ current “market” price. This determines the maximum amount of capital I can put in without going underwater. In fact, that’s exactly what I do: I bid near that upper boundary, to ensure I win the game.

But that’s no help for Geithner: At that level of my own participation, I’ll bid for the “market” price, banks will incur large losses (or they won’t sell!) and more taxpayer money will be needed for recapitalization.

In other words, Bebchuk's idea of competing for public cash simply shifts the form of the government's participation: It reduces the subsidy to private investors; but it increases the amount needed to recapitalize banks.

More problems in practice: In practice, there are other complications. First, it’s questionable whether we can find enough private players with the size and expertise to generate the level of competition that Bebchuk envisages.

Toxic assets are very diverse and, with a few exceptions, participating private funds will likely have only niche areas of expertise. The resulting “market” will be very segmented, with the concomitant implications for competition and liquidity.

Secondly, different private funds have different costs of capital. This means that competition for the government’s cash will provide a clear advantage to the big guys with lower cost of capital—the Blackrocks and PIMCOs of this world. This raises issues of fairness.

Conclusion (The scrollers can start here): Ultimately, the government is in this either way. So rather than going around in circles, Geithner should just try to solve the problem with an end-game in mind. It’d go something like this:

My To-Do List, by T.G.

1. Calculate the hole in the banking system on a mark-to-market basis
2. Assess the probability that its size will prompt a popular revolt
3. If higher than 70%, prepare for the orderly liquidation of selected financial institutions. Emphasis on “prepare”, “orderly” and “not screwing up” (again).
Note to self: In the (unlikely, of course) scenario where “orderly” demands the exercise of the N(uclear) option, convene urgently a panel of linguists to find a politically-acceptable term for the policy move.

4. Re-calculate the hole in the banking system that remains.
5. Now choose between:
(a) Bailing out the banks via recapitalization
(b) Subsidizing private funds sufficiently to get them to bid the “fair” prices you need to cover the banks’ hole.

The pros of (a): Faster and “cleaner”, probably.

The cons of (a): Americans' loathing for higher government ownership of banks. Americans bigger loathing for a fresh fat bailout for the bankers. An 83% probability that I receive their collective wrath, eggs and tomatoes within 12 months.

Pros of (b): The word “private” features prominently in the PPIF acronym.

Problems with (b): The fairness and fragmentation issues above; implementation delays, due to complexities in designing the terms and conditions for participation etc. (a la (TALF)
(Second note to self: If we went for (b), avoid at all costs giving the impression that the government will be effectively setting the prices for the toxic assets.)

6. Oh, and before I forget… file my tax returns by April 15th!

Digesting the N-word

Americans’ aversion to bank nationalization makes me think of my culinary distaste for jellyfish. In fact, it’s worse… I actually have no ideological objections to jellyfish quivering on a plate; it’s just when faced with the choice, I’d rather go for plain old chicken rice!

But here is my advice: Get over it!

First, because state-owned banks do not have to be as “repulsive” as you think. True, some strands of academic literature (including this one by La Porta & friends) have found that government ownership can negatively affect financial development: Growth in private-sector credit turns out to be lower; access to credit by small or medium enterprises lower; operating efficiency of state-owned banks lower; and overall financial stability also lower.

But these results are biased by the fact that state-owned banks tend to be found in countries where the government’s overall intervention in the economy is high, laws are inadequately enforced, institutions are weak and corruption prevalent. Indeed, when one controls for the weakness of the overall institutional environment, the negative impact of state ownership is much lower (per La Porta) or statistically insignificant (per other studies).

Similarly, researchers from the Inter-American Development Bank (IADB) found (here) that, while the profitability of state-owned banks tends to be lower than private banks in a global sample, this is not true when one focuses only on state-owned banks in industrialized economies. This suggests that given an appropriate institutional, regulatory and competitive structure, bank ownership per se is less relevant.

Finally, another paper by IADB economists finds that state-owned banks can (and do) take advantage of their more stable funding conditions and deposit base during downturns to increase lending to the private sector—that is, they can help reinforce the countercyclical objectives of monetary and fiscal policy (there are caveats with this finding, but I’ll leave those for another wonky blog).

“So ok,” you say, “I could digest state-ownership in theory. But this doesn’t mean I should actually order it! After all theory suggests that, at best, public banks are no worse than private banks, not that they are better!”

Fair point. But, in case you haven’t noticed, our private banks are already in zombie mode, burdened with toxic assets and unwilling to lend despite being flooded with Fed cash. The government’s financial commitments to the sector are already huge and getting bigger. And the government is already interfering with banks’ operations, be it mortgage modifications, commitments to lend or restrictions on executive pay.

This is the worst of every world: The equivalent of a nasty chicken & jellyfish mash! Why?

First, despite the enormous financial burdens on the taxpayer, the measures taken so far (recapitalization and bank debt guarantees) have not succeeded in restoring confidence in the sector, to bring down liquidity premia and reduce the private sector’s cost of capital.

And if you think that Geithner’s “plan” to team up with private investors to buy toxic assets is a better alternative to full government involvement, I’d argue that so long as the private sector’s cost of capital remains high, private investors will not go in, barring a very large participation by the government and/or the purchase of these assets at heavily marked down prices (with the obvious implications for bank recapitalization by, urrr, the government!). But I’ll discuss the (f)utility of Gethner’s plan in another blog.

Secondly, among the things that distinguish a “good” public bank from a “bad” one is governance: The public bank should have operational independence. Once the government sets a well-defined set of objectives for the public banks, it should be up to the banks’ management to decide how to achieve those objectives. This is to ensure that public banks are not plagued by the kind of political interference that has been detrimental in some developing economies.

Yet, what we are getting today is a government intervention that is the opposite of transparent, predictable and arms-length! The mandate of intervened banks remains undefined, the rules of the game have been changing half-way through and the government is increasingly interfering with banks’ operations.

And if Geithner’s stress tests were purported to be the uniform test for government intervention, for the moment they lack the transparency to be that—it’s even unclear what criteria will be used to assess bank solvency.

Finally, critical for a successful government intervention are measures to ensure a level-playing field for those banks that are NOT intervened. In Norway for example, nationalized banks were given restrictions on the expansion of their assets to ensure that they would not use their competitive advantage (cheaper funding costs) to displace private banks. But here, discussions in this area do not seem to have even begun. So we have a playing field full of potholes and with the players running blindfolded.

To tell you the truth, my own chicken-rice scenario would be to have the toxic assets removed from banks’ balance sheets by means of a government-owned (but independently managed) TALF-like vehicle; the assets purchased at heavily marked down prices (i.e. any upside goes to the taxpayers); and the resulting capital holes in the banks refilled (by the government and, ideally, some private sector participation), after wiping out existing shareholders and replacing their managements. The cleaned-up banks could then continue to operate as private concerns.

The problem with this, however, is that the resulting recapitalization costs may turn out to be prohibitive, if we are to use current “market” prices for the write-downs. In that case, nationalization would make more sense, since the government’s cost of capital is much lower (i.e. the present value of these assets higher) and since it can afford to hold the assets to maturity without the fear of a run.

As I mentioned, there are still many issues to address in a sequel to this post, e.g. which banks should be nationalized, how to do this without undermining the others, to how to go on about removing the toxic assets from the banks that are not intervened, etc.

But for now, I’ll just close with a confession: I have yet to try jellyfish myself, but it may well happen the day Citi becomes public. I hear it stings!