Is the Fed our savior in financial regulation?

It seems odd to put up an actual substantive post on Christmas day, nonetheless here is my New York Times column on financial regulation.

Despite these problems, the United States may oddly enough be facing this new financial turmoil in a relatively safe position, though whether it’s safe enough remains to be seen. The Federal Reserve took the lead on future capital requirements just last week, but for the shorter run there is a more important Fed policy move. Starting in late 2008, as a response to our financial crisis, the Fed bought government and mortgage securities from banks on a very large scale.

Bank reserves at the Fed rose from virtually nothing to more than $1.6 trillion. Then the Fed paid interest on those reserves to help keep them on bank balance sheets.

It is estimated by Moody’s that America’s biggest banks now have liquid assets that are 3 to 11 times their short-term borrowings. In other words, it’s the cushion we’ve been seeking. Furthermore, a lot of those reserves sit in the American subsidiaries of large foreign-owned banks, protecting the European system, too.

This new safety comes not from regulatory micromanagement but rather from the creation of additional safe interest-bearing assets. While European economies have been losing safe assets through debt downgrades, the United States financial system has been gaining them.

Here is a relevant link from The Economist.  Here are links to Brad DeLong, David Wessel, and others, on related points.  Here is David Beckworth on safe assets.  The scarcity of safe assets is a critical theme today, and still we lack a satisfactory theory of collateral.  For instance, how many macroeconomists are well equipped to answer how “putting OTC derivatives on exchanges” will affect interest rates and output?

Here is another bit, which shows I have been changing my mind on interest on reserves:

The Fed’s stockpiled liquid reserves have met some heavy criticism. Hard-money advocates contend that they are a prelude to hyperinflation — although market forecasts and bond yields don’t bear this out — while proponents of monetary expansion have wished that banks would more actively lend out those reserves to stimulate the economy. That second view assumes that the financial crisis is essentially over, but maybe it’s not. As the euro zone crisis continues, it seems that Ben S. Bernanke has been a smarter central banker than we had realized.

Here is my earlier blog post, T-Bills as a substitute for financial regulation.  Here is my earlier post on monetary policy and bank recapitalization.  I view these as one piece, trying to explain why Bernanke has not been more aggressive with monetary policy along some dimensions.

The Fed (possibly) has foreseen that a scarcity of safe assets is a major macroeconomic problem — most of all in Europe — and has acted to limit this problem in the United States, even at the cost of having tighter money.  That means interest on reserves as a kind of synthetic T-Bills policy.  The interest induces demand to hold liquid reserves, which increases the buffer against a European financial implosion.  You can think of this policy as a substitute for the failure of regulators to get capital requirements right.

Overall, that means a monetary policy having to play the role of fiscal policy and regulatory policy, all at the same time.  No wonder so few people are happy with the outcome.

Through this lens, the Fed looks better, Congress, Dodd-Frank and the financial regulators look worse.  That dysfunctional government prevents an effective fiscal policy response — good and also politically sustainable projects — looks worse too.

Addendum: Arnold Kling comments.

Comments

Thanks for your hard work on Christmas Day! :)

What??

The US has had a tighter monetary policy. Must have missed that one, given QEII.

The Fed has been keeping interest rates low, so that banks will fix their balance sheets, and has scheduled a February stress test so that banks will not pass out money in end of the year bonuses, because they will need it in February. As to the regulatory point, to the howls of the financial community, the Fed has raised the capital requirements.

This is all very regulatory, but I suppose it is, as Clinton would say, depends on what you mean as regulatory.

Just waiting for the Brown Sugar Cake to come out of the oven... Merry Christmas.

"we lack a satisfactory theory of collateral"

Or perhaps (hence): a satisfactory theory of money (hence debt, and credit -- since all money is credit, and money can only be stored by lending it).

Revealed tellingly in the crazy usage: "money supply." Supply is a flow. But this refers to a(n imagined) stock, not a flow.

I think the MMters are getting closer to explaining money realistically. Might even have arrived, but I'm still behind.

So essentilly, the Fed is accepting high unemployment now so that we have a chance to weather the coming sovreign debt crisis reasonably intact? I hope they are that far-sighted.

If true, Obama is in a real bind - he can't admit to such a policy, or his own party will crucify him. At the same time, he is prevented from making the only intervention we know will goose employment figures in the short term, loosening the money supply.

Nobwonder he's grouchy.

If true, this still means that taxpayers or the central bank are in effect taking up loses resulting from ill considered banking decisions.

Incentives work, even perverse ones -> Maybe the way to make banks behave sanely is to, in effect, pay them to behave sanely.

That is, rather trying to control money and credit supply via buying bonds and setting rates, maybe the fed can more directly get the behavoir it wants by adjusting interest rates on reserves, holding stress tests however often is necessary to keep bankers on edge, etc.

Wnat more lending? Lower interest on reserves and adjust the stress test rules.

Question of the Day - is this is a new "channel" for monetary policy that can supplant the old ones?

2nd Question - at what point does failure to reduce unemployment itself become a bigger risk to our economy, especially in the face of European stress? I wouldn't want us to face a euro collapse with huge bank reserves and 25% unemployment.

For some time many have been asking "when will the Fed shrink its balance sheet?". I've been saying to my undergrad money & banking class for a couple of years that Bernanke might be intent on a permanently larger balance sheet, with the interest rate on reserves serving as a de facto regulatory instrument; the Fed can fine-tune this as it sees fit over the business cycle or according to its perception of financial sector risk-taking.

Even if this hasn't been Ben's original intention, it's certainly possible, and calls into question the need for the 'conventional' regulatory agenda with its enormous inside lags and regulatory capture. One could argue that the interest on reserves is too crude an instrument, but (i) it's not like the various Basels are amazing, and (ii) I'm sure clever central bankers can think up _other_ ways to smuggle in capital/liquidity requirements under the guise of 'regular' monetary policy.

Safe assets? You mean like MBS's and European debt?
....
OH wait!
What seems like a "shortage" of safe assets, is really just a demographic lack of young people in wealthy countries.

That second view assumes that the financial crisis is essentially over, but maybe it’s not.

There's the $100T question.

You only need liquidity when you need it, but then you really really need it, and you can't get it.

"It is estimated by Moody’s that America’s biggest banks now have liquid assets that are 3 to 11 times their short-term borrowings. In other words, it’s the cushion we’ve been seeking. Furthermore, a lot of those reserves sit in the American subsidiaries of large foreign-owned banks, protecting the European system, too."

A cushion is only useful if you can draw it down in times of crisis.

Wait... this is idiocy. On one hand you are exclaiming the need for more risk free assets and on the other hand you are praising the fed for buying (and thus increasing demand for) risk free assets?

Tyler, make up your mind. Should the fed expand its balance sheet or should we have more risk-free assets available in the market?

The reserve accounts are liabilities, therefore growth in reserves funds asset growth for the Fed.

The reserve accounts are risk free and pay higher interest than cash.

So the Fed having a larger balance sheet and banks holding more risk free assets are not mutually exclusive.

By funding long term risky assets with short term risk free funding, banks can take opposite positions. A question of interest is how the Fed will unwind this position when banks resume lending and the reserve accounts shrink.

Perhaps I don't understand the situation too well, but if the Fed has loaded up on assets of dubious quality, they are unlikely to be able to unwind them for 100 cents on the dollar. So some of the vast liquidity currently sloshing around in the form of bank reserves can't be mopped up, surely, and will therefore find its way at last into the broader economy. In this scenario, future inflation is already baked into the cake, as it were... there's just a long delay between cause and effect. Or am I missing something?

It seems to me you understand perfectly well.

"The reserve accounts are liabilities, therefore growth in reserves funds asset growth for the Fed."
1) All debt financial assets are liabilities for someone else.

"So the Fed having a larger balance sheet and banks holding more risk free assets are not mutually exclusive."
2) Reserve accounts are only available to banks. Everyone else has to buy treasuries. However, the price of treasuries has been bid up so high that no one wants to buy them, except for the fed. So, while what you say may apply to banks, and they will be able to get arbitrage from it, it does not apply to the broader economy.

What applies to the broader economy is that banks are building a larger capital buffer; that is good. The negative consequence is that they aren't lending very much. But lending is a matter of both supply and demand, and there doesn't seem to be much demand for loans.

Lend those reserves to whom? For what?

IMO banks aren't merely raising capital leverage ratios merely because it is socially desirable. They don't appear to have profitable lending opportunities. Low interest rates and flattening the yield curve doesn't exactly help their net interest margins.

I think their is still a fairly high probability the crisis is not over, and even current capital ratios may not be high enough. But with low lending, there will be lower levels of earning assets going forward.

Recent regulations have attacked noninterest income too. It's hard to see where financials will make their earnings forecasts next year unless they drastically cut overhead expenses.

Your theory of interest on reserves as a de facto supply of T Bill is interesting. But does it satisfactorily explain what banks would do if these interest payments were eliminated? Are T bills riskier than we realize or less liquid than we hope?

Tyler wrote:

The Fed (possibly) has foreseen that a scarcity of safe assets is a major macroeconomic problem — most of all in Europe — and has acted to limit this problem in the United States, even at the cost of having tighter money. That means interest on reserves as a kind of synthetic T-Bills policy. The interest induces demand to hold liquid reserves, which increases the buffer against a European financial implosion. You can think of this policy as a substitute for the failure of regulators to get capital requirements right.

Were this true, the Fed still could have created a threshold of reserves after which the IOR was negative and then expanded its balance sheet further to ease the tight money. Thus, still creating a pool of synthetic t-bills and not needlessly tightening policy.

The "global shortage of risk-free assets" narrative might explain a number of seemingly incongruous bubbles in recent years.

Bubbles arise as money seeks out pseudo-risk-free assets, like Greek debt in 2007 or "AAA" tranches of toxic mortgages, or (arguably) US treasury bonds and muni bonds today. Even vastly overpriced Chinese real estate (sitting empty!) is best explained in terms of local savers latching onto a counterfeit "safe" asset class in the absence of a non-negative real interest rate on savings accounts and an inability to invest abroad.

Demographic trends will only greatly increase the demand for "risk-free" assets. Aging investors, obviously, tend to take money out of the stock market and put it into bonds. The liability-driven investing strategies increasingly pursued by pension funds also represent a flight from risk.

This is a recipe for an unstable world, as successive waves of serial bubble-blowing send money piling into the "risk-free" asset-class-du-jour, only to flee each one in turn when stratospheric price levels pop. Timely reform is impossible, because the bubble itself makes idiots out of any Cassandra who proposes urgent remedies: in 2007 Greece, we can easily picture some Krugmanopoulos mocking doomsayers who urge budget reforms. Low interest rates, he would say, are all the empirical proof you need that large deficits don't matter. And who can argue, when markets lend to you at rates comparable to Germany? Until suddenly they don't.

Given that historically low US treasury rates are best interpreted in terms of a flight-from-risk bubble rather than a true indication of fiscal health, what happens when this latest bubble pops? This is of more than merely academic interest to most readers of this blog.

We can pretty much dismiss the possibility that anyone is prepared to "contemplate a world without a risk-free asset". We will live in such a world -- indeed, we already do -- but no one will be prepared to contemplate it. The demand for risk-free asset classes will remain unabated, which means that someone will inevitably supply a counterfeit version thereof in vast quantities, whether it be Wall Street alchemists or some government. And the game will go on for yet another round.

So what will be the next pseudo-risk-free asset class, after US Treasuries are played out? Well, after America's real estate bubble popped in 2008 and its economy lurched into recession, American debt paradoxically became the safe harbor for flight-from-risk... could that same sequence happen with China in a few years time? Forced to rethink unsustainable export-driven growth, picking up the pieces after a property crash, needing to bailout its banks and its profligate state and local governments, China just might opt to finance the transition to internal consumption by issuing renminbi-denominated bonds on international markets in quantities massive enough to meet global risk-free demand.

It's hard to see how it could be anyone but China... no other country has the size or the track record of consistently beguiling foreign investors. And it has to be a country, because investors will be too leery of any new toxic exotic instruments churned out on Wall Street assembly lines. China has the means to do it, and soon they may have the motive (or the dire necessity). And that implies that China, despite the eloquent and well-researched warnings of Jim Chanos, Michael Pettis and others, could likely be the next bubble that ought to burst for every logical reason... but doesn't.

Most insightful comment of the entire thread. Though I tend to disagree with the end about China. I don't think anything can really replace the US when that "risk free" asset class annihilates.

Nothing can replace it, but something will. The demand is relentless. If none exists, we will invent one anyway and pretend.

I posited in late 2008 that this crisis would be over when there was nothing left to lose. I may have been too right.

Zerohedge posted a analysis from Citi from 2008 where it describes the pool of money looking for safe returns that will and does decide at any point whether something is safe or not. That is why we see things like European bonds where no one shows up. They just won't buy if they see any risk. The money is large investment entities such as pension funds and the like, very large pool of money. They are shrinking and not getting returns so are becoming (my opinion) more volatile and less predictable and will probably drive instability in the search for it.

Just wait till Japan starts imploding. They can borrow cheap now, that can change in an instant and the cost of servicing their immense debt will be more than they can tax and borrow.

This isn't going to end well.

+1 for using the term Krugmanopolous.

Interesting. I don't know enough about economics but I'be been trying to figure out a theory for why we appear to be at "the end of interest". This plays into that idea. We're in a new age where collateral is more valuable to big banks than interest.

Excellent comment.

The Fed shores up the system, creating a safer asset to liability ratio in the essential component parts of the system, the large banks---but the large banks are socially corrupt, in fact they're run by perverse materialistic gamblers, and the money they're being made resilient with, if it becomes a liability (in the form of inflation), will be a weight on common people, not on bankers... And this is a good thing? Ho. Ho. Ho.

Mightn't a shortage of safe assets be the same as an excess of cash?

We don't have an agreed definition/theory of risk. I suspect this is why we talk about unicorns like "risk free assets".

Translation of marginal, econo-junk think:

Despite THE WORST RECESSION SINCE THE GREAT DEPRESSION, the BANKING SYSTEM may oddly enough be facing this new CAPITALIST CRISIS in a relatively safe position (OH, PLEASE GOD HELP US), though whether it’s safe enough remains to be seen. The Federal Reserve took the lead on future capital requirements AND MADE IT HARDER FOR US TO GAMBLE IN THE MARKETS just last week, but for the shorter run there is a more important Fed policy move. Starting in late 2008, as a response to THE financial crisis CREATED BY US, the Fed bought government and mortgage securities from banks on a very large scale, THUS PUTTING TRILLIONS OF DOLLARS OF JUNK AND WORTHLESS MORTGAGE PAPER ONTO THE BACKS OF TAXPAYERS. PLEASE GOD, DONT LET THE 99% FIND OUT WHAT IS GOING ON!!

You really do not understand the nature of the Fed. Read about it on Wikipedia for an introduction.

"The scarcity of safe assets is a critical theme today, and still we lack a satisfactory theory of collateral. "

Tyler, how can there be a scarcity of safe assets? If banks demand more safe assets to hold in anticipation of potential liquidity events, but the quantity of safe assets is declining, the price of safe assets will rise to meet the demand for safe assets. You can't have a scarcity of safe assets in today's financial world. I've never seen one.

Unless of course the central bank is holding down rates artificially.

Comments for this post are closed