Home (and Solvency) Bias at the Fed

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Yves here. I’m behind in giving my impressions of the INET conference on Finance and Society in DC, which has gotten more attention for its all-women roster than its content. In some ways, that is not surprising, given that the overwhelming majority of the speakers were either currently in or had a history of being in policy positions, and hence have the well-ingrained habit of speaking in code, and to the extent they admit to problems being serious, of steering clear of suggesting remedies commensurate with the seriousness of the issues.

Perry Mehrling, who teaches at Bard and has expertise in payment systems and complex financial products (among other things) does the important service of providing the highlights of the presentations by and conversation between Janet Yellen and Christine Lagarde. Lagarde, who is a remarkably theatrical speaker, took advantage of the fact that the IMF does not regulate banks to make a few pointed remarks on widespread cultural failings, admittedly in hackneyed terms such as “tone at the top” and “fish rot from the head. Nevertheless, more and more officials are admitting this is a major issue. For instance, Mark Carney of the Bank of England fingered as a potential systemic risk).

By Perry G. Mehrling, Professor of Economics at Barnard. Originally published at his website

At the INET conference in DC yesterday, Janet Yellen and Christine Lagarde both gave brief statements, and then they asked each other questions, back and forth, until the moderator called time. No surprises in any of it, perhaps, but still a useful check on the current thinking of the leaders of the Fed and the IMF respectively, and as such a sign of where new thinking is yet needed.

Yellen emphasized the origin of the 2007-2009 crisis in “distorted incentives”, two incentives in particular. First, short term interest rates were too low, so encouraging excessive expansion of credit. Second, regulation of the “non-bank” credit sector was too lax, so encouraging credit expansion to happen there rather than in traditional banks. Today, she says, “risks to financial stability are moderated, not elevated”, thanks to new higher capital requirements mainly, but also other reforms focused on banks mainly, not so much non-banks.

In all her remarks, Yellen spoke very much as the leader of the Fed, and her concern was narrowly limited to stability in the U.S. financial system, not the larger global scene. That larger scene however is of course the central concern of Lagarde, and so it is significant that Lagarde’s statement was distinctly less reassuring.

Citing the IMF’s most recent Global Financial Stability report, Lagarde chose to emphasize current “rotation”, from bank to non-bank credit, from sovereign credit to non-sovereign, from bank solvency to market liquidity, and from the advanced countries to the developing and emerging countries. From this point of view, she said, the regulatory job is not completed. Indeed, rotation means that the regulatory job is a work in progress.

In Q&A she got more specific, reminding the audience of the pre-crisis days when every bank boasted its “global” presence with a world map showing the location of every branch office. Since then, under pressure from their regulators, banks have sold their foreign branches to native local or regional banks, in effect reducing their footprints back to their home country. The implication is clear. Global credit is non-bank credit, and that’s where the risks have been building up.

In Q&A Yellen got more specific as well. In response to a question about how the zero interest rate policy squares with the need to better align incentives, she dutifully noted all the distortions caused by the six-years-now zero interest rate policy: compression in term premia, risk premia, interest margins and so forth, as people reach for yield. But this incentive distortion, unlike the one that caused the crisis, has a defensible social purpose, she says.  It is needed to move the economy back to full employment and to meet price stability objectives. The mechanism for that move, she suggests, has been balance sheet repair.

So there you are. At the global level, we see Brazilian firms issuing bonds that are funded in dollar money markets; this is money market funding of capital market lending, my definition of shadow banking. The key to financial stability in such arrangements, as we learned in the crisis, is the continued willingness of private profit-seeking dealers to make markets, both capital markets (the bonds) and money markets (the funding).  Yellen’s closing words reminded her audience that broker dealers were not on the radar of the Fed before the crisis, but, she reassured, they are now and the new capital requirements apply to all the broker dealers under the Fed’s supervision.

The question I would have asked, had questions been taken from the audience, is whether these regulations make it more or less likely that dealers will be willing and able to support markets in times of turmoil.  In other words, have we successfully constructed a robust dealer network of first resort that is willing and able to absorb the next dislocation?  Or will the next one once again rely on the central bank backstop as dealer of last resort?

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  1. OpenThePodBayDoorsHAL

    No mention of that fact that we’ve replaced central banks with self-funding hedge funds that can “never” get a margin call. And precisely how do they intend to “regulate” things like SOEs in China with gargantuan non-performing loans, a tiny bond market to package risk out to investors, opaque accounting, triple-hypothecated collateral. Um and don’t remind anyone that “breaking the buck” on MMMFs is now baked into the formula, I bet that’ll surprise Grandma when she sees her statement. And Fannie back out giving 3% home price rebates…for people who put 3% down. It’s the same banker game as ever, passed down through the centuries. Step 1. Extend credit way beyond the borrower’s ability to repay; Step 2. Grab the collateral when he defaults; Step 3. If the collateral ends up being worthless, cry to the elites/government for a bailout. They then “squeeze the poor some more” until the torches and pitchforks come out. Sigh.

  2. Linus Huber

    “Or will the next one once again rely on the central bank backstop as dealer of last resort?”

    There is little doubt that the Fed again will have to act. The reason is rather simply; if you do not let them bleed for past misbehaviour, they will simply continue the same game of higher and higher leverage to feed their risk-free self-enrichment programs called moral hazard. I lost count of how many bankers are behind bars by now; was it 1 or zero?

  3. craazyman

    Wow. This one seems like a sleeping pill if there ever was one. What is it they give you when you get a colonoscopy? They put an IV in your arm and you feel a crackling in your electric aura and then you go unconscious. Michael Jackson’s doctor used to put him to sleep at night that way since he had bad insomnia. If you have insomnia forget Ambien or Xanax, even with a few glasses of wine. The IV stuff doesn’t mess around and leave you half awake twisting in your sheets in a groggy fog in shards of sleepless scattered anxiety.

    I guess all they did was talk. No new equations? That’s ridiculous. You can’t just talk and talk and talk and expect to come up with something new. You can fool a lot of people but not everybody. I bet a few people might have thought “This is nothing new at all. This is the same old yada yada and they’re not even trying for mathtematical rigor.” it seems lazy to me, speaking personally, not to at least attempt an equation or two. They don’t have to be perfect! You just wanna see some rigor and clear thinking on display. You can’t do that with word fog yada yada. I guess nobody cares though. Why be sentimental about it? It should be embarrassing, to be so sentimental. Nobody cares. As long as the wine and ore-derves are flowing and the conversation is lively and the money is coming out of the printing press and the audience isn’t in a coma. It’s not perfect, true, but at least it’s something. What is it? I don’t know. But I’m not a professor so who cares. I wonder if anybody in the audience was on their smart phone surfing Youtube for music videos — by Adele for example or by Lorde, the New Zealand starlet. it wouldn’t be entirely polite, but if somebody’s discrete about it, I bet nobody would care. I wouldn’t that’s for sure. It’s OK to space out, in my opinion

    1. Yves Smith Post author

      Actually. one of the issues that INET had in hosting this conference was that this was in essence a political conference. INET’s other conferences have all been based on economists presenting new work, which means summaries of papers (and therefore your equations and data).

      Merling can’t go much beyond the material he has to work with.

      1. craazyman

        shlt. you guys should get a medal just for going and sitting there while they talked. it seems unbearable, to me anyway, to sit through that (unless of course you could drink wine and eat ore-derves before hand, then you could sort of space out and let your mind wander). now that I’ve quit xanax it would be unbearable for me. I couldn’t take it without a sedative, but you guys not only sat through it, you gave us a debrief! that’s incredible. I wonder, just reflecting on that, if both of you should see a psychiatrist for an evaluation. You both might have a mental disorder. I think even a normal person can develop a mental disorder from thinking in the manner of an academic economist for more than a year or so. You’re probably way gone by now, given what you’ve done. maybe you’re the crazy person here, going to conferences like that. Think about that for a minute. No need to respond, you can think privately and reflect in your own mind.

  4. JEHR

    Re: Home and Solvency Bias at the Fed

    I decided to read Mark Carney’s Statement when I saw he had a sub-title, “Ending too-big-to-fail” but I must say that it was difficult to see exactly what he meant. Here is his paragraph:

    “Ending too-big-to fail
    “Agreement was reached last year on two key steps forward in ending too-big-to-fail for global systemically important banks (G-SIBs). The first agreement was on a proposal for a common international standard on the total loss absorbing capacity (TLAC) that G-SIBs must have. The second was an industry agreement to prevent cross-border derivative contracts being disruptively terminated in the event of a G-SIB entering resolution; national authorities will use regulatory and supervisory actions to support comprehensive industry adoption of the agreement.” (page 2, http://www.financialstabilityboard.org/wp-content/uploads/IMFC-Statement-April-2015-FSB-Chairman-Mark-Carney.pdf )

    So I re-wrote it in my own words so that I could understand the “two key steps forward:”
    The FSB has agreed on two steps to end TBTF for global banks: The first step is a proposal for a common international standard for losses that these banks can and must absorb (TLAC). The second step was to prevent derivative contracts between countries being ended and causing disruption if a global bank resolves to agree to these steps in the resolution. Authorities in each nation will use regulation and supervision to support the banks adopting the agreement.

    And generally Mark Carney is easy to understand. Why does he use this obfuscatory way of writing?

    1. Yves Smith Post author

      This is the section where he stuck his neck out a tak”

      Market conduct issues
      Misconduct in financial institutions has the potential to create systemic risks by undermining trust in financial institutions and markets.

  5. OpenThePodBayDoorsHAL

    “has the *potential* to undermine trust”???
    Geez, I guess when Charles Manson slit people’s throats it “had the potential” to affect their ability to stay alive.
    Read what the *Chair* of the SEC had to day about Deutsche Bank: “systematic, pervasive, widespread, long-term lawbreaking”. Number of Deutsche Bankers going to jail: Zero. I guess the building committed the crimes, not the people in the buildings.
    I think some richly-deserved jail time for bank criminals would “have the potential” to restore a semblance of trust. But oh, no, let’s use the RICO Act to jail some *teachers* who faked some test results.

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