Some finance artefacts

I am back from my trip in North America, which led me to New York, where I saw some interesting finance artefacts in various locations. Here is a sample (click to enlarge):

World War finance propaganda

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The very first US Treasury warrant












Private bank notes

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Great Depression local government currencies printed to alleviate the lack of Fed money


US Treasury notes redeemable in gold


Various old bond certificates

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A share certificate owned by… Bernard Madoff


And the most curious of them all: a Disney-decorated US Treasury WW2 bond… Slightly strange mix


The mystery of collateral

Collateral has been the new fashionable area of finance and capital markets research over the past few years. Collateral and its associated transactions have been blamed for all the ills of the crisis, from runs on banks’ short-term wholesale funding to a scarcity of safe assets preventing an appropriate recovery. Some financial journalists have jumped on the bandwagon: everything is now seen through a ‘collateral lens’. The words ‘assets’, and, to a lesser extent ‘liquidity’ and ‘money’ themselves, have lost their meaning: all are now being replaced by ‘collateral’, or used interchangeably, by people who don’t seem to understand the differences.

A few researchers are the root cause. The work of Singh keeps referring to any sort of asset transfer between two parties as ‘collateral transfer’. This is wrong. Assets are assets. Securities are securities, a subset of assets. Collateral can be any type of assets, if designated and pledged as such to secure a lending or derivative transaction. Real estate, commodities and Treasuries can all be used as collateral. Money too. Unlike what Singh and his followers claim, a securities lender lends a security not a collateral. Whether or not this security is used as collateral in further transactions is an independent event.

This unfortunate vocabulary problem has led to perverse ramifications: all liquid assets, or, as they often say, collateral, are now seen as new forms of money (see chart below, from this paper). Specifically, collateral becomes “the money of the shadow banking system”. I believe this is incorrect. Collateral is used by shadow banks to get hold of money proper. Building on this line of reasoning, people like Pozsar assert that repo transactions are money… This makes even less sense. Repos simply are collateralised lending transactions. Nobody exchanges repos. The assets swapped through a repo (money and securities) could however be exchanged further. Depressingly, this view is taken increasingly seriously. As this recent post by Frances Coppola demonstrates, all assets seem now to be considered as money. This view is wrong in many ways, but I am ready to reconsider my position if ever Treasuries or RMBSs start being accepted as media of exchange at Walmart, or between Aston Martin and its suppliers. Others have completely misunderstood the differences between loan collateralisation and loan funding, which is at the heart of the issue: you don’t fund a loan, whether in the light or the dark side of the banking system, with collateral! The monetary base/high-powered money/cash/currency, is the only medium of settlement, the only asset that qualifies as a generally-accepted medium of exchange, store of value and unit of account (the traditional definition of money).

Singh M2 and Collateral

There is one exception though. Some particular transactions involve, not a non-money asset for money swap, but non-money asset for another non-money asset swap. This is almost a barter-like transaction, which does occur from time to time in securities lending activities (the lender lends a security for a given maturity, and the borrower pledges another security as collateral). Nonetheless, the accounting (including haircuts and interest calculations) in such circumstances is still being made through the use of market prices defined in terms of the monetary base.

Still, collateral seems to have some mysterious properties and Singh’s work offers some interesting insights into this peculiar world. The evolution of the collateral market might well have very deep effects on the economy. The facilitation of collateral use and rehypothecation, as well as the requirements to use them, either through specific regulatory and contractual frameworks, through the spread of new technology, new accounting rules or simply through the increased abundance of ‘safe assets’ (i.e. increased sovereign debt issuance), might well play a role in business cycles, via the interest rate channel. Indeed, by facilitating or requiring the use of increasingly abundant collateral, interest rates tend to fall. The concept of collateral velocity is in itself valuable: when velocity increases, interest rates tend to fall further as more transactions are executed on a secured basis. Still, are those transactions, and the resulting fall in interest rates, legitimate from an economic point of view? What are the possible effects on the generation of malinvestments?

An example: let’s imagine that a legal framework clarification or modification, and/or regulatory change, increases the use and velocity of safe collateral (government debt). New technological improvements also facilitate the accounting, transfer, and controlling processes of collateral. This increases the demand for government debt, which depresses its yield. Motivated by lower yield, the government indeed issues more debt that flow through financial markets. As the newly-enabled average velocity of collateral increases substantially, more leveraged secured transactions take place and at lower interest rates. While banks still have exogenous limits to credit expansion (as the monetary base is controlled by the central bank), the price of credit (i.e. endogenous money creation) has therefore decreased as a result of a mere regulatory/legal/technological change.

I have been wondering for a while whether or not such a change in the regulatory paradigm of collateral use could actually trigger an Austrian-type business cycle. I do not yet have an answer. Implications seem to be both economic and philosophical. What are the limits to property rights transfer? How would a fully laisse-faire market deal with collateral and react to such technological changes? Perhaps collateral has no real influence on business fluctuations after all. There is nevertheless merit in investigating further. I am likely to explore the collateral topic over the next few months.


PS: I will be travelling in North America over the next 10 days, so might not update this blog much.

* There are many many flaws in Frances’ piece. See this one:

But suppose that instead of a sterling bank account, a smartcard or a smartphone app enabled me to pay a bill in Euros directly from my holdings of UK gilts? This is not as unlikely as it sounds. It would actually be two transactions – a sale of gilts for sterling and a GBPEUR exchange. This pair of transactions in today’s liquid markets could be done instantaneously. I would in effect have paid for my meal with UK government debt.

She fails to see that she would have paid for her mean with Sterling, not with government debt! Government debt must be converted into currency as it is not a medium of exchange/settlement.

Breaking banks won’t help economic recovery

In contrast with the bank-bashing environment of the post-crisis period, voices are increasingly being raised to moderate regulatory, political and judiciary risks on the banking system.

Last week, Gillian Tett wrote an article in the FT tittled “Regulatory revenge risks scaring investors away”. She says:

Last month [Roger McCornick’s] project team published its second report on post-crisis penalties, which showed that by late 2013 the top 10 banks had paid an astonishing £100bn in fines since 2008, for misbehaviour such as money laundering, rate-rigging, sanctions-busting and mis-selling subprime mortgages and bonds during the credit bubble. Bank of America headed this league of shame: it had paid £39bn by the end of 2013 for its transgressions. When the 2014 data are compiled, the total penalties will probably have risen towards £200bn.

She argues that “legal risk is now replacing credit risk.” This is a key issue. Banks have already been hit hard by new regulatory requirements, which sometimes require a fundamental restructuring of their business model. The consequences of this framework shift is that profitability, and hence internal capital generation, remain subdued, weakening the system as a whole. Banks now reporting double digit RoEs are more the exceptions than the rule. Moreover, low profitability also reduces the banks’ ability to generate capital externally (i.e. capital raising) because they do not cover their cost of capital. This scares investors away, as they have access to better risk-adjusted investment opportunities elsewhere.

The enormous amounts raised through litigation procedures make such a situation even worse. Admittedly, banks that purposely bypassed laws or committed frauds should be punished. But, as The Economist argues this week in a series of articles called “The criminalisation of American business” (see follow-up article here), the “legal system has become an extortion racket”, whose “most destructive part of it all is the secrecy and opacity” as “the public never finds out the full facts of the case” and “since the cases never go to court, precedent is not established, so it is unclear what exactly is illegal”:

This undermines the predictability and clarity that serve as the foundations for the rule of law, and risks the prospect of a selective—and potentially corrupt—system of justice in which everybody is guilty of something and punishment is determined by political deals. America can hardly tut-tut at the way China’s justice system applies the law to companies in such an arbitrary manner when at times it seems almost as bad itself.

Banks fines

Estimates of capital shortfall at European banks vary between EUR84bn and as much as EUR300bn (another firm, PwC, estimates the shortfall at EUR280bn). Compare those amounts with the hundreds of billions Euros paid or about to be paid by banks as litigation settlements, and it is no surprise that banks have to deleverage to comply with regulatory capital ratio deadlines and upcoming stress tests… Such high amounts, if justified, could probably have been raised by prosecutors at a slower pace in the post-crisis period without endangering the economic recovery (banks’ balance sheets would have been more solid more quickly, which would have facilitated the lending channel of the monetary transmission mechanism).

In the end, regulatory regime uncertainty strikes banks twice: financial regulations keep changing (and new ones are designed), and opaque litigation risk is at an all-time high. Banks are now very risk-averse, depressing lending and international transactions. This seems to me to replicate some of the mistakes made by Roosevelt during the Great Depression. Despite all the central banks’ money injection programmes, this may not be the best way out of an economic crisis…


PS: Commenting on the forthcoming P2P lender Lending Club IPO, Matt Levine argues that:

But Lending Club can grow its balance sheet all it wants. Lending Club is not a bank. So it’s not subject to banking regulation, which means that it can do a core function of banking much more efficiently than an actual bank can.

He is (at least) partly right. By killing banks, regulatory constraints are likely to trigger the emergence of new types of lenders.

Wait… Isn’t it what’s already happened (MMF and other shadow banking entities…)?

A couple of comments on ‘House of Debt’

I just read House of Debt, the latest book by Mian and Sufi, which got a relatively wide coverage in the media, so I thought I should write a quick post about it.

House of Debt

Overall, it’s a good book, accessible for those who do not have a background in economics or finance. What I particularly liked about the book is its emphasis on leverage. The boom in household and business leverage over the past two decades inevitably fuelled an unsustainable boom in aggregate spending. Bringing indebtedness back to more ‘normal’ values also inevitably reduces spending power*. Yet, too many economists seem to take this pre-crisis trend as normal.

They are also right to advocate letting banks fail, as well as question the non-monetary banking intermediation channel (as proposed by Bernanke in his famous article Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression) and the effectiveness of monetary policy following a debt boom.

However, the authors never explain the underlying causes of the leverage boom and the crisis. It seems to be assumed that financial innovations (i.e. securitization mostly) appear all of a sudden, enabling an unsustainable boom to take place. What role did monetary policy play during the period? Or banking regulation? Those questions remain unanswered. Yet, as I’ve been explaining for now close to a year, the combination of those two factors was critical in triggering the boom in financial innovation, leverage, and malinvestments. I wish Mian and Sufi had provided their thoughts on that topic in their book.

They provide evidence that house prices increased the most in counties with inelastic housing supply. Still, they also strongly increased in those with elastic housing supply… They focus on the Asian ‘savings glut’, which would have flowed into the US. Perhaps, but it doesn’t mean that the Fed rate wasn’t too low, and many countries all around the world also experienced booming housing markets. Moreover, mortgage delinquencies started when the Fed increased its base rate… Despite being a US-centric book, there is also no discussion of the particular populist political framework at play in designing both the peculiar US banking system and the crisis, as described by Calomiris and Haber.

As a result, they seem to identify the rise in securitization as a fraud. I believe this is not the case. Banks started holding securitized assets on their balance sheet because of their beneficial capital treatment. There is little sign that they tried to originate bad assets to defraud naïve investors. Indeed, take a look at the chart below (from a recent post): banks also invested in such products and self-retained tranches of those they had originated throughout the boom period, and continue to do so. This points to ignorance of the risks. Not fraud.

Stein Banks Securities Portfolio

I encourage you to read the book for its very good data gathering. Despite some of its (relatively minor) flaws, the book does much to debunk some myths through the appropriate use of empirical evidence.

* This doesn’t mean that there wasn’t also an excess demand for money at that time. Just that a decreased money supply through debt deflation exacerbated the problem.

New research at last asks the right questions on RWAs

A new piece of research by the US Treasury Department’s Office of Financial Research has started questioning the use and definitions of Basel regulations’ risk-weighted assets (RWAs), which they view as a “rather curious scheme”… RWAs are critical in the Basel framework as they have been underlying regulatory capital ratios since the introduction of Basel 1 back in 1988. Readers of this blog know that I blame RWAs for being a major factor in the economic distortions and resources misallocation that directly led to the crisis (reduction in business lending, jump in real estate lending, securitizations and sovereign lending…) (see also here… and everywhere on this blog).

The authors’ thesis is similar to mine (emphasis added):

This is a rather curious scheme, if we consider that risk is not ordinarily considered additive. One might construe the additive formulation as conservative, but capital requirements affect which assets a bank chooses to hold, so the choice of risk weights affects a bank’s asset mix and not just the overall risk of its portfolio. A risk-weighting scheme may be conservative in its effect on overall risk and yet introduce unintended distortions in the levels of different kinds of lending activities. […]

For our investigation, we take a risk-weighting scheme to have two primary interlinked objectives: to limit the overall risk in a bank portfolio and to do so without an unintended distortion of the mix of assets held by the bank. The first of these objectives is common to all capital regulation, but the second is specific to a risk-weighting scheme because risk weights implicitly assign prices (in terms of additional capital) to asset categories and thus inevitably create incentives for banks to choose some assets over others.

They add that the literature supporting the use (and validating the level) of risk-weights is rather thin, unlike the literature on the nature of banks’ capital (the so-called ‘Tiers’), which has been the focus of most new regulatory measures while RWAs have remained pretty much unchanged.

They propose to tie risk-weights to asset profitability and develop a mathematical framework to help regulators to do so (as they are unlikely to obtain enough information to accurately set their level). This is interesting, but I’d rather get rid of risk-weights altogether: market actors can already assess banks’ profitability vs. asset mix risk and invest accordingly. There is also another issue with such a scheme: assets that do not appear profitable (and hence risky) at first do not necessarily mean they are not, as secured real estate markets demonstrated over the last decade. Moreover, ‘riskier’ business lending rates are currently lower than ‘safer’ mortgage lending ones. Profitability of riskier assets is sometimes subdued, either for relationship purposes (in order to generate revenues elsewhere), and/or if lending terms/collateral nature/haircuts are deemed reasonable. I have to admit that I did not have the time to read their mathematical description in depth and I might be missing something.

Meanwhile, the BoE’s Funding for Lending Scheme still struggles to revive lending to UK businesses. As policy-makers are unlikely to read this blog, perhaps this new research will help?


PS: I extracted the following chart from an FT blog post published yesterday and added Basel 1 to it (which introduced risk-weights and led to a decline in business lending). US real GDP growth seems to start declining exactly when business lending falls below trend (compare with second chart):

US GDP Growth Basel 1

US lending Basel

Some new (more or less useful) research

A few noticeable papers have been published recently. They are not particularly ground-breaking but some offer interesting insights and datasets. Here are summaries:

- The Effects of Unconventional Monetary Policies on Bank Soundness, an IMF working paper by Lambert and Ueda, is an interesting piece of research though its results are no surprise:

Unconventional monetary policy is often assumed to benefit banks. However, we find little supporting evidence. Rather, we find some evidence for heightened medium-term risks. First, in an event study using a novel instrument for monetary policy surprises, we do not detect clear effects of monetary easing on bank stock valuation but find a deterioration of medium-term bank credit risk in the United States, the euro area, and the United Kingdom. Second, in panel regressions using U.S. banks’ balance sheet information, we show that bank profitability and risk taking are ambiguously affected, while balance sheet repair is delayed. (my emphasis)

I’m not a great fan of the first part of their study, in which they run a regression between monetary policy events and banks’ share prices, credit spreads and CDS spreads: they do not take into account government support, which considerably affects the perceived creditworthiness of a number of banks. Their second part (what I highlighted in the abstract above) is more interesting though not that surprising. I have already described many times how profitability, and hence internal capital generation, were subdued in a close to zero interest rate environment.

- Identifying Excessive Credit Growth and Leverage, an ECB staff working paper by Alessi and Detken, is also interesting given the methodology but… seems to be stating the obvious. According to the paper, some of the best indicators of ‘excess leverage’ in the economy are…bank credit/GDP or the debt service ratio… (see table below)

ECB Leverage Indicators

- A little older, Banks as Patient Debt Investors, is an introductory speech to forthcoming research by Jeremy Stein, member of the Board of Governors of the Fed. This is perhaps the most interesting and theoretical of the papers I have read over the past few days and I am looking forward to dissecting the final published version. This is Stein:

I have argued that there is a synergy between banks’ stable funding model and their investing in assets that have modest fundamental risk but whose prices can fall significantly below fundamental values in a bad state of the world. This synergy helps explain both why deposit-taking banks might have a comparative advantage at making information-intensive loans and, at the same time, why they tend to hold the specific types of securities that they do.

He makes some interesting remarks, though I have the impression that he misstates the actual accounting treatment of ‘Available for Sales’ assets, which he uses to justify his model. This might lead him to the wrong conclusions. A fall in the value of AFS assets will indeed not affect net income but will negatively affect equity/capitalisation through the bank’s comprehensive income statement, possibly undermining some of his conclusions or some of his reasoning. However, it is too early to judge, and I’ll read the whole finished paper once it is published.

Stein also presented an interesting chart to back his research. Most of US banks’ securities portfolios are comprised of assets that benefit from low risk-weights under Basel. I would have liked to see this chart starting from the 1970s (i.e. pre-Basel era).

Stein Banks Securities Portfolio


PS: I wish to thank Ben Southwood, from the Adam Smith Institute, for providing me with some of those links

Free banking: the track record

Sam Bowman, from the Adam Smith Institute, just published a very good paper arguing that, in case it decides to declare its independence, Scotland should ‘sterlingise’ and recreate a free banking system similar to the one it used to have in the 18th and 19th century. This report has been featured in many newspapers today (BBC, City AM, The Scotsman, The Guardian, The Wall Street Journal, The Huffington Post, The Telegraph…). Whether or not the current socialist-minded Scottish government is likely to implement such radical liberalisation of its banking system is another issue…

In this report, Sam Bowman also reproduces two very important tables (originally from George Selgin’s article Are banking crises free markets phenomena) highlighting the track record of free (or mostly free) and regulated banking from the late 18th till the early 20th century. Guess which type of banking system was more stable…

‘Unfree’/regulated banking:

Unfree Banking Track Record

Free/lightly regulated banking:

Free Banking Track Record

Secular stagnation: factoring in banking regulation

David Beckworth wrote a good post on the secular stagnation hypothesis, highlighting the problem with the interpretation of the natural rate by secular stagnation theorists. This is Beckworth:

First, real interest rates adjusted for the risk premium have not been in a secular decline. Everyone from Larry Summers to Paul Krugman to Olivier Blanchard ignore this point in the book. They all claim that real interest rates have been trending down for decades. The editors of the book, Coen Teulings and Richard Baldwin, even claim that this development is the ‘prima facie’ evidence for secular stagnation. What they are doing wrong is only subtracting expected inflation from the observed nominal interest rate. They also need to subtract the risk premium to get the natural interest rate, the interest rate at the heart of the story. For it is the natural interest rate that is affected by expected growth of technology and the labor force.

He is right. But I believe there is more to the story.

This is Beckworth’s chart highlighting the apparent secular decline in interest rates as believed by secular stagnation adherents. I added to it Basel 1, Basel 2 and Basel 3 introductions (red lines) and discussions (orange area) (unlike in Europe, only a few US banks had implemented Basel 2 when the crisis started):

Secular Stagnation Basel 1

What is striking is the fact that Treasury yields started declining exactly when Basel 1 was being discussed and implemented. There is a clear reason for this: Basel introduced risk-weighted assets, and government securities were awarded a 0% risk-weight, meaning banks could purchase them and hold no capital against them. As I have described before, banks were then incentivised to pile in such assets to maximise RoE, as a quick risk-adjusted return on capital calculation demonstrates. Basel 1 also introduced risk-weights for other asset classes such as business and mortgage lending. Structural changes in lending* and government securities markets occurred directly post-Basel. I believe this is no coincidence.

Take a look at the following chart. Until the 1980s, the volume of US government securities on US banks’ balance sheet was pretty much constant. Everything changed from the 1980s onward:

Secular Stagnation Basel 2

As a share of banks’ total assets (see chart below), US government securities literally spiked after Basel 1 was introduced, only to decline (as a share of total assets) as banks started piling in other assets that benefited from generous capital treatments such as securitisations and insured mortgages (though this doesn’t mean demand faded as banks balance sheets grew quickly over the period, just that demand for other assets was even stronger). Post-crisis, Basel 3 renewed the demand for US sovereign debt as it 1. modified the capital treatment of some previously lowly-weighted assets and 2. introduced minimum liquidity requirements (LCR) as well as margins and collateral requirements that require the use of high-quality liquid assets such as Treasuries.

Secular Stagnation Basel 3

We identify the same pattern as a share of total securities on US banks’ balance sheet**:

Secular Stagnation Basel 4

The demand for Treasuries also boomed throughout the financial sector due to those margin/collateral/liquidity requirements that apply (mostly post-Basel 3), not only to commercial banks, but also to broker dealers and investment managers:

Secular Stagnation Basel 5

All those regulations evidently artificially increase demand for US government-linked securities, pushing their yields down.

But I guess you’re going to tell me that Beckworth’s adjusted risk-free Treasury yield was actually stable over the whole period (chart below). Actually, unlike what Beckworth claims, it does look like there is a slight decline since the end of the 1980s. Moreover, ups and downs almost exactly coincide with banks decreasing/increasing their relative holdings of Treasuries (see above, third chart). Finally, there is also another option: that the natural (risk-free) rate of interest’s trajectory was in fact upward, which would be hidden by financial regulations’ artificially-created demand…

Secular Stagnation Basel 6

However, this analysis is incomplete: it does not account for foreign banks’ demand for Treasuries, which is also a widely-held asset as part of banks’ liquidity buffers (and in particular when their own sovereign fails…). I unfortunately don’t have access to such data.

In the end, the use of Treasury yield (even adjusted) as an estimate of the natural rate of interest is unreliable given the numerous microeconomic variables that distort its level.


* See this chart from one of my previous posts:

US lending Basel

** Post-WW2’s very high figures (close to 100%) reflect the low level of corporate securities issued following the Great Depression and WW2, the high issuance volume of US sovereign debt to fund the war, as well as restrictions on banks’ securities holding to facilitate such wartime issuances.

Macroprudential policy tools: a primer (guest post by Justin Merrill)

In case you hadn’t heard, there’s a new fad in central banking called “macroprudential regulation.” During the Great Moderation there was a belief that low and stable inflation would be sufficient to stabilize financial markets and the economy. When the Great Moderation turned into the Great Recession, this paradigm shifted, but I’m afraid that the wrong conclusions are being drawn. In a series of posts, I shall explain what macroprudential policies are, who some popular people making the arguments for them are and what the risks of the policies are.

Most places I’ve read about macroprudential policies are vague in their description and only list a couple of the tools that central bankers/regulators can use. The policies are intended to prevent systemic risk by preventing/diffusing concentrations of risk. I hope to provide here a nearly comprehensive list of the tools. Conceptually, the tools can be categorized into four categories and theoretically all of the following risks may contribute to asset bubbles or financial instability:

  • Leverage/Market Risk
    • Reducing leverage is intended to reduce the risk of insolvency in case of a fall in asset prices.
  • Liquidity
    • Increasing liquidity reduces the risk that payments won’t be made to creditors and may curb fire-sales from credit crunches.
  • Credit Quality
    • Controlling credit quality intends to prevent future non-performing loans from debtors that would be most susceptible to economic shocks.
  • FX/Capital Controls
    • FX/Capital controls attempt to prevent hot money from pushing up asset prices and prevents firms from being over-exposed to FX risk from unhedged positions.

Also note that time-varying/dynamic/counter-cyclical rules are a popular concept and can be applied to possibly all of the following tools.

Leverage/Market Risk

  • Debt/equity ratios: Also commonly referred to as “capital” in the banking sector. Requiring more funding from equity reduces the risk of insolvency.
  • Margin requirements: Determines how much investment can be made with borrowed money. There is a high correlation between margin debt and asset prices.
  • Provisioning: Banks account for loss provisions in their financial statements. If they expect losses or are required to hold higher provisions, they will hold a higher equity buffer to offset the losses. If actual losses are less than expected, the bank records a profit.
  • Restrictions on profit distribution: If debt/equity ratios are above what regulators want, they may require the firm to retain earnings instead of pay dividends.
  • Collateral, hypothecation and haircuts: Regulators may determine which assets may be used as collateral, how much collateral is required for lending, and how much of a haircut is applied to the asset in the repo market. If market prices fall below the repo price the seller may not buy it back. Haircuts (over-collateralization) and margin calls are used to mitigate this risk. Repos and reverse-repos are being increasingly used by central banks as a new tool for an exit strategy from QE and since QE has drained the private markets of credit-worthy assets. Repos also can have broader participation than open market operations (OMOs), the Fed Funds market or deposits at the central banks. OMOs are restricted to primary dealers and deposits at the Fed are restricted to members of the Federal Reserve System and membership is restricted to qualifying commercial banks.
  • Too Big To Fail (TBTF) taxes: TBTF taxes have been proposed to reduce the concentration of risk or political power of a single firm as a sort of Pigouvian tax to offset externalities. The taxes could be an assessment on firms whose assets are above an arbitrary cutoff (such as $1 trillion), on firms whose assets exceed a percentage of GDP, or on firms that own above a certain percent of market share.


  • Reserve requirements: Reserve requirements are a unique item on this list since they are considered a traditional monetary policy tool. Even though use of changing reserve requirements fell out of favor as a traditional tool, it has gained renewed interest in conjunction with QE, especially in countries with pegged currencies, such as China. This allows the central bank to increase the monetary base without creating price or asset inflation.
  • Limits on maturity mismatch: Financial intermediaries such as banks generally engage in maturity transformation by borrowing short and lending long. This can create a funding risk if they are unable to roll over their debts at a reasonable rate. Also, the long dated assets they hold will have more convexity, which means they will be more sensitive to changes in interest rates.
  • Liquidity Coverage Ratios (LCR): Basel regulations require financial institutions to hold a level of highly liquid assets to cover their net outflows over a period of time.

Credit Quality

  • Caps on the loan-to-value (LTV) ratio: Requiring a larger down payment reduces the risk that the borrower will walk away in case of a decline in property value. It also helps the bank profitably resell the property in case of foreclosure.
  • Caps on the debt-to-income (DTI) ratio: DTIs help gauge the borrower’s ability to repay the loan.
  • Lending Policies- “No second homes” and risk weighting: Lending policies can target specific sectors of the economy or have specific goals. These can include requiring a larger down payment on second homes, increased risk weightings for real estate, discouraging foreign buyers, and discouraging house flipping by having higher taxes on short term sales.

FX/Capital Controls

  • Caps on foreign currency lending: Foreign currency lending that is unhedged exposes the borrower to FX risk.
  • Limits on net open currency positions/currency mismatch: Borrowing and investing in different currencies exposes FX risk.
  • Capital controls: Capital controls are used to prevent hot money flows in and out of a country that could fuel a boom and bust. Controls are also used for financial repression and increasing domestic investment. Additionally, capital controls are often used in conjunction with a fixed exchange rate, like in China. This is due to the Trilemma. If China wants to peg its currency to the USD and control its domestic interest rate for monetary policy, it must have capital controls. Otherwise, the higher interest rate in China would attract hot money deposits from abroad and there would be an asset boom. The alternatives to a pegged currency with capital controls are a floating exchange rate with free capital or a currency board with free capital.


Central banks: an expanding regulatory toolkit

Following my latest post on central banks as the new central planners, a very recent New York Fed Staff Report by Adrian, Covitz and Liang demonstrates the extent of possible central banks’/regulators’ involvement in financial markets, and therefore in what ways they can control, or attempt to control, the allocation of resources within the financial system. Here is a summary of various classes of tools (most of them discretionary) that monetary and financial authorities can play with:

- Monetary policy: the authors classify monetary policy as a “broader tool” that “would affect the rates for all financial institutions”. Indeed, central banks not only set the short-term refinancing rates and reserve requirements and run open market operations, but now also have in place interest rates paid on excess reserves, fixed-rate full allotment reverse repos, as well as various temporary long-term lending facilities such as the BoE’s Funding for Lending Scheme or the ECB’s LTRO and TLTRO, and temporary liquidity facilities such as the ABCP MMF liquidity facility, and can decide what collateral to accept and what securities to purchase, way beyond the traditional Treasury-based OMO.

- Asset markets: central banks can regulate what they view as ‘imbalances’ in the valuation of some asset markets by tightening underwriting standards as well as “through regulated banks and broker-dealers by tightening standards on implicit leverage through securitization or other risk transformations, or by limiting the debt they provide to investors in either unsecured or secured funding markets, if the asset prices are being fuelled by leverage.” In the case of real estate markets and household burdens, central bankers can impose LTV restrictions* and other similar macro-prudential policies.

- Banking policies: central banks have under their control all traditional micro-prudential regulatory tools. In addition, Basel 3 provide them with some flexibility in setting macro-prudential regulatory tools that apply specifically to the banking system, such as counter-cyclical capital requirements (capital conservation buffer, equity systemic surcharge…). Other ad-hoc tools include: sectoral capital requirements (higher/lower capital charges/RWAs for specific asset classes), dynamic provisioning, stress tests…

- Shadow banking policies: harder to regulate, central banks could “address pro-cyclical incentives in secured funding markets, such as repo and sec lending, […] propose minimum standards for haircut practices, to limit the extent to which haircuts would be reduced in benign markets. Other elements of this proposal include consideration of the use of central clearing for sec lending and repo markets, limiting liquidity risks associated with cash collateral reinvestment, addressing risks associated with re-hypothecation of client assets, strengthening collateral valuation and management practices, and improving report, disclosures, and transparency.” Other direct tools include “the explicit regulation of margins and haircuts for macroprudential purposes.”

- Nonfinancial sector: “Tools to address emerging imbalances in asset valuations likely would also address building vulnerabilities in the nonfinancial sector. For example, increasing* [sic] LTVs or DTIs on mortgages, which could reduce a leverage-induced rise in prices, could also limit an increase in exposures of households and businesses to a collapse in prices, thereby bolstering their resilience.”

Given the increased scope of central banks’ operations, it is clear that market prices can be manipulated and distorted in all sort of ways. To be fair however, not all those powers are currently concentrated in the central bankers’ hands. In many countries, there are still a few different institutions that perform those tasks. Nevertheless, the trend is clear: most of those powers are increasingly taken over by and aggregated at central banks.

While this new paper advocates the use of such tools, it admits that their effectiveness and effects on the financial system and the broader economy remains untested and uncertain:

New government backstops to address the risks arising from shadow banking, of course, can be costly. First, an expansion along these lines would require a new regulatory structure to prevent moral hazard, which can be expensive and difficult to implement effectively. Second, an expansion of regulations does not reduce the incentives for regulatory arbitrage, but just pushes it beyond the beyond the existing perimeter. Third, there is a limited understanding of the impact that such a fundamental change would have on the efficiency and dynamism of the financial system.

In a subsequent guest post, Justin Merrill will investigate macro-prudential policy tools more in depth.


* The paper mistakenly describes those potential measures as “increasing” LTV ratios to mitigate house price and household indebtedness increases. I believe this is a typo, even though the same claim reappears several times throughout the paper (if not a typo then the authors have no clue how LTVs work…).


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