Category: Interesting External Papers

This post is really late, I know. But I’m catching up slowly!

The Bank of Canada has released the Bank of Canada Review: Summer 2012 with the articles:

• Measurement Bias in the Canadian Consumer Price Index: An Update
• Global Risk Premiums and the Transmission of Monetary Policy
• An Analysis of Indicators of Balance-Sheet Risks at Canadian Financial Institutions

The first article, by Patrick Sabourin, makes the point:

Commodity-substitution bias reflects the fact that, while the weights of items in the CPI basket are held constant for a period of time, a change in relative prices may cause patterns in consumer spending to change. If, for example, the price of chicken were to increase considerably following supply constraints, consumers would likely purchase less chicken and increase their consumption of beef, since the two meats may be perceived as substitutes for each other. The CPI, however, assumes that consumers would continue to purchase the same quantity of chicken following a price change. This means that the measured change in the CPI will overstate the increase in the minimum cost of reaching a given standard of living (i.e., there is a positive bias).

I’ve always had trouble with this concept. I love beef. I despise chicken. As far as I am concerned, there is a separate quality adjustment that must be made that would mitigate, if not completely offset, the substitution adjustment when beef becomes too expensive and I have to eat chicken.

And, I am sure, this occurs for every other possible substitution. Although I might try explaining to my girlfriend that Coach handbags have become too expensive and I will follow theoretically approved procedure and get her, say, a plastic shopping bag for Christmas instead.

The second article, by Gregory H. Bauer and Antonio Diez de los Rios examines the relationship between long- and short-term interest rates:

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• An important channel in the transmission of monetary policy is the relationship between the short-term policy rate and long-term interest rates.
• Using a new term-structure model, we show that the variation in long-term interest rates over time consists of two components: one representing investor expectations of future policy rates, and another reflecting a term-structure risk premium that compensates investors for
  holding a risky asset.

• The time variation in the term-structure risk premium is countercyclical and largely determined by global macroeconomic conditions. As a result, long-term rates are pushed up during recessions and down during times of expansion. This is an important phenomenon that central banks need to take into account when using short-term rates as a policy tool.
• We illustrate this phenomenon by showing that the “conundrum” observed in the behaviour of long-term interest rates when U.S. monetary policy was tightened during the 2004–05 period was actually part of a global phenomenon.

In their model:

The long-term rate is decomposed into two terms in the following equation:
…
The first term involves market expectations, that is, the average expected 1-year interest rate over the next 10 years. In our model, we use the 1-year interest rate in country j as a proxy for that country’s policy rate. Observed yields will, on average, equal the expectations component only under the “expectations hypothesis,” which has been statistically rejected in many studies.

The rejection of the expectations hypothesis is typically attributed to the existence of the second term in equation (1), a time-varying term-structure risk premium. The risk premium represents the extra compensation that investors require for holding a 10-year bond. In our model, agents hold portfolios for one year, and the prices of long-term bonds may change considerably over that period, necessitating a higher expected rate of return. Several studies have focused on the properties of the term-structure risk premium (see Cochrane and Piazzesi (2005) and their references).
…
The second real-world aspect of the model consists of the constraints placed
on the time-varying risk premium, the second component of equation (1). Previous work has shown that imposing restrictions on the term-structure risk premium makes the forecast values of interest rates more realistic than those in unrestricted models.7 Our model restricts risk premiums on bonds through its assumption of global asset pricing; i.e., in integrated international markets, only global risks carry significant risk premiums. As a result, the term-structure risk premium on any bond is driven by the bond’s exposure to the global level and slope factors only. The local factors, while helping to explain prices at a point in time, do not affect expected returns (i.e., changes in prices), since investors can eliminate their effects by diversifying with a global portfolio.

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This effect is evident during the financial crisis of 2007–09. While short-term U.S. rates fell by 263 basis points, long-term U.S. rates decreased by a mere 23 basis points. This occurred because, although the Fed succeeded in lowering expectations of future policy moves by 224 basis points (Table 2), the term-structure risk premium rose by 190 basis points.
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The analysis in this article demonstrates the extent to which the global term-structure risk premium as well as monetary policy actions influence long-term interest rates. The risk premium is countercyclical to the global business cycle and thus may affect long-term interest rates in the opposite direction to that related to central bank policy actions. As a result, central banks need to take these forces into account in appropriately calibrating their policy response. Indeed, given the current low level of long-term rates, understanding movements in the global risk premium is important for the monetary policy decision-making process.

Since monetary policy may affect expectations and the term-structure risk premium differently, the levels of these two components may, in turn, affect the macroeconomy in various ways. For these reasons, understanding the effects on growth and inflation of movements in market expectations and the global term-structure risk premium is an important aim for future research.

The third article, by David Xiao Chen, H. Evren Damar, Hani Soubra and Yaz Terajima, will be of interest to students of Canadian banking and regulation thereof:

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• This article compares different types of Canadian financial institutions by examining over time ratios that are indicators of four balance-sheet risks—leverage, capital, asset liquidity and funding.
• The various risk indicators have decreased during the past three decades for most of the non-Big Six financial institutions in our sample and have remained relatively unchanged for the Big Six banks, resulting in increasing heterogeneity in these indicators of balance-sheet risks.
• The observed overall decline and increased heterogeneity in the risk indicators follow certain regulatory changes, such as the introduction of liquidity guidelines on funding in 1995 and the implementation of bank specific leverage requirements in 2000. This suggests that regulatory changes have had significant and heterogeneous effects on the management of balance sheets by financial institutions and, given that these regulations required more balance-sheet risk management, they contributed to the increased resilience of the banking sector.

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Of particular interest is the funding ratio, defined as:

we define a funding ratio as the proportion of a bank’s total assets that are funded by wholesale funding (a relatively less stable funding source than retail (personal) deposits, for example):

Funding ratio (%) = 100 x (Non-personal deposits + repos)/Total assets.

A higher funding ratio indicates that a bank relies on greater market-based funding and is therefore more exposed to adverse shocks in the market that could disrupt continuous funding of its assets.

The Funding Ratio is of great interest due to Moody’s recent highlighting of:

the large Canadian banks’ noteworthy reliance on confidence-sensitive wholesale funding, which is obscured by limited public disclosure, increases their vulnerability to financial markets turmoil.

The BoC paper also highlights the eagerness of the politicians to inflate the housing bubble:

In addition, the growing popularity of mortgage-loan securitization in the late 1990s, following the introduction of the Canada Mortgage Bonds Program, raised the percentage of mortgage loans on bank balance sheets, especially among large and medium-sized financial institutions.(note)

Note reads: Increasing demand for mortgage loans caused by demographic shifts and lower down-payment
requirements has also played a role. See Chen et al. (forthcoming) for more details.

The authors conclude:

This article analyzes the balance-sheet ratios of Canadian financial institutions. Overall, various measures of risk have decreased over the past three decades for most non-Big Six institutions and have remained relatively unchanged for the Big Six banks. We find that smaller institutions, particularly trust and loan companies, generally have lower leverage and higher capital ratios than other types of financial institutions, including the Big Six banks. They also have larger holdings of liquid assets and face lower funding risk compared with other financial institutions. The observed overall decline and increased heterogeneity in risk (as measured by divergent trends in the leverage, capital and asset-liquidity ratios) followed certain regulatory changes, such as the introduction of liquidity guidelines on funding in 1995 (which preceded a sharp decline in, and more dispersion of, funding ratios among non-Big Six institutions) and the implementation of bankspecific leverage requirements in 2000 (which preceded a divergence in leverage ratios between the Big Six and non-Big Six institutions). This suggests that regulatory changes had significant and heterogeneous impacts on the management of balance sheets by financial institutions, resulting in the increased resilience of the banking system. While market discipline may have also played a role, more research is needed to identify changes in the degree of market discipline in the Canadian banking sector.

Given the observed variation in behaviour among Canadian financial institutions, continued analysis of different types of institutions can enable a more comprehensive assessment of financial stability. Understanding the different risks faced by various types of financial institutions improves the framework that the Bank of Canada uses to monitor developments of potential risks in the banking sector.

The statement that “This suggests that regulatory changes had significant and heterogeneous impacts on the management of balance sheets by financial institutions, resulting in the increased resilience of the banking system.” strikes me as being a little bit fishy. Regulatory change did indeed have “significant and heterogeneous impacts on the management of balance sheets by financial institutions”, but whether this resulted “in the increased resilience of the banking system.” has not been addressed in the paper. That was the intention, certainly, and may well be true, but a cause and effect relationship has not been demonstrated.

Manfred Gärtner and Björn Griesbach have published a paper titled Rating agencies, self-fulfilling prophecy and multiple equilibria? An empirical model of the European sovereign debt crisis 2009-2011. The introduction for the paper was reproduced badly on the link provided; there’s another version on Scribd:

We explore whether experiences during Europe’s sovereign debt crisis support the notion that governments faced scenarios of self-fulfilling prophecy and multiple equilibria. To this end, we provide estimates of the effect of interest rates and other macroeconomic variables on sovereign debt ratings, and estimates of how ratings bear on interest rates. We detect a nonlinear effect of ratings on interest rates which is strong enough to generate multiple equilibria. The good equilibrium is stable, ratings are excellent and interest rates are low. A second unstable equilibrium marks a threshold beyond which the country falls into an insolvency trap from which it may only escape by exogenous intervention. Coefficient estimates suggest that countries should stay well within the A section of the rating scale in order to remain reasonably safe from being driven into eventual default.

The literature review shows some controversy:

Among the first to put rating agencies into the game, in the sense that ratings might have an influence on outcomes if multiple sunspot equilibria exist, were Kaminsky & Schmukler (2002). In a panel regression they show that sovereign debt ratings do not only affect the bond market but also spill over into the stock market. This effect is stronger during crises, which could be explained by the presence of multiple equilibria. As a consequence they claim that rating agencies contribute to the instability in emerging financial markets. Carlson & Hale (2005) argue that if rating agencies are present, multiple equilibria emerge in a market in which otherwise only one equilibrium would exist. The purely theoretical paper is an application of global game theory and features heterogeneous investors. Boot, Milbourn & Schmeits (2006) arrive at the opposite conclusion: ratings serve as a coordination mechanism in situations where multiple equilibria loom. Using a rational-herd argument, they show that if enough agents base their investment decisions on ratings, others rationally follow. Since ratings have economic consequences, they emphasize that the role of rating agencies is probably far greater than that of the self-proclaimed messenger.

“Multiple sunspot equilibria”? I had to look that one up:

‘Sunspots’ is short-hand for ‘the extrinsic random variable’ (or ‘extrinsic randomizing device’) upon which agents coordinate their decisions. In a proper sunspot equilibrium, the allocation of resources depends in a non-trivial way on sunspots. In this case, we say that sunspots matter; otherwise, sunspots do not matter. Sunspot equilibrium was introduced by Cass and Shell; see Shell (1977) and Cass and Shell (1982, 1983). Sunspot models are complete rational-expectations, general-equilibrium models that offer an explanation of excess volatility.

The authors regress a nine-factor model:

• Rating
• GDP Growth
• GDP per capital
• Budget Surplus
• Primary Surplus
• Debt Ratio
• Inflation
• Bond Yield
• Credit Spread

These indicators explain 60 percent of the variance of sovereign bond ratings in our panel. All estimated coefficients possess the expected signs, though not all are significantly different from zero. Ratings are found to improve with higher income growth and income levels, or with better overall and primary budget situations. Ratings deteriorate when the debt ratio, inflation or government bond yields go up.
…
Applying the test proposed in Davies (1987), the null hypothesis of no break was rejected, and the break point was found to lie between a BBB+ and a BBB rating.23 Regression estimates for the resulting two segments are shown as regressions 2a and 2b in Table 3. The differences between the two segments are striking. The slope coefficients differ by a ratio of ten to one. While, on average, a rating downgrade by one notch raises interest rates by 0.3 percentage points when ratings are in the range between AAA and A-, which comprises seven categories, a downgrade by one step raises the interest rate by 3.12 percent once the rating has fallen into the B segment or below.

That makes sense, at least qualitatively – default probabilities are not linear by notch, according to the agencies.

Now they get to the really controversial part:

This means that at sovereign debt ratings outside the A-segment, i.e. of BBB+ or worse, a downgrade generates an increase in the interest rate that justies or more than justies the initial downgrade, and may trigger a spiral of successive and eventually disastrous downgrades. Only countries in the A-segment of the rating scale appear to be safe from this, at least when the shocks to which they are exposed are only small. However, this only applies when marginal rating shocks occur. Larger shocks, and these have not been the exceptions during Europe’s sovereign debt crisis, may even jeopardize countries which were in secure A territory. We may illustrate this by looking at the impulse responses of equation (11) to shocks of various kinds and magnitudes. This provides us with insolvency thresholds that identify the size of a rating downgrade required to destabilize the public finances of countries with a given sovereign debt rating.
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When rating shocks last, however, as has apparently been the case for the eurozone’s PIGS members, much smaller unsubstantiated rating changes may play havoc with government bond markets and suce to run initially healthy countries into trouble, as shown in Figure 6(b). In this scenario, an arbitrary, yet persistent, downgrade by two notches would trigger a downward spiral in a country with an AA rating. Rising interest rates would call for further downgrades, which would appear to justify the initial downgrade as an apparently good forecast.

And then they get to the real meat:

A more detailed look at the dynamics of the effect of debt rating downgrades on interest rates revealed that at least for countries with sovereign debt ratings outside the A range even erroneous, arbitrary or abusive rating downgrades may easily generate the very conditions that do actually justify the rating. Combined with earlier evidence that many of the rating downgrades of the eurozone’s peripheral countries appeared arbitrary and could not be justified on the basis of rating algorithms that explain the ratings of other countries or ratings before 2009, this result is highly discomforting. It urges governments to take a long overdue close look at financial markets in general, and at sovereign bond markets in particular, and at the motivations, dependencies and conflicts of interest of key players in these markets.

This paper has S&P’s shorts in a knot, and they have indignantly replied with a paper by Moritz Kraemer titled S&P’s Ratings Are Not “Self-Fulfilling Prophecies”:

In questioning the agencies’ integrity, the authors appear to suggest that the agencies follow some hidden agenda that has led them to act “abusively”. As is usually the case with conspiracy theories, little by way of evidence or persuasive rationale is offered to explain who benefits from the agencies’ supposed “strategic” or “disastrous” downgrades. Alas, the reality is not nearly as spectacular: rating agencies take their decisions based on their published criteria and are answerable to regulators if they fail to do so.

The authors also claim that the agencies’ rating actions “cannot be justified” because they do not accord with a mechanistic “ratings algorithm” of the authors’ own devising. Apart from the fact that ratings are subjective opinions as to possible future creditworthiness (and, like other opinions, neither “right” nor “wrong”), the authors fail to justify why their algorithm has more merit than the published comprehensive methodologies of the rating agencies. Nevertheless, so persuaded are the authors of their own algorithm they admonish the agencies for “manipulating the market by deviating” from the authors’ “correct rating algorithm”!

Standard & Poor’s, for one, long ago rejected an algorithmic approach to sovereign ratings as simplistic and unable to account for the subtleties of a sovereign’s political and institutional behavior.

Even more seriously:

At the heart of the paper’s confusion is its treatment of causality and correlation. The paper suggests that investors react to rating changes by asking for higher interest rates when a rating is lowered, but provide no evidence for their claim. In fact, the authors probably cannot provide such evidence as their data set has merely an annual observation frequency. To show causality, the paper should present data that played out during a period bounded by at least two yearly observation points. With such limited data, one cannot determine what came first: rating action or interest movement, or, indeed, whether one caused a change in the other at all!
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The suggestion that in Europe’s financial crisis, the underlying pattern was one of ratings causality is effectively contradicted by the fact that spreads did not react for several years to our downgrades (starting in 2004) of several eurozone periphery countries.
…
Until early 2009, the CDS-market traded swaps on Portugal as though it were a ‘AAA’ credit (i.e. four notches above our rating at the time). When sentiment changed rapidly, the market “downgraded” Portugal to around ‘B’ in 2010, a full eight notches below the S&P rating at the time. Suggesting that the relatively modest rating changes had caused this massive sell-off appears far-fetched.

And then they get downright nasty:

We note that under the paper’s algorithm Greece should have been downgraded by a mere 0.15 notches between 2009 and 2011. In our view, the algorithm therefore would have entirely missed the Greek default in early 2012, the largest sovereign restructuring in financial history. By contrast, far from having acted in an “arbitrary or abusive” manner, Standard & Poor’s anticipated Greece’s default well before it occurred.

The Bank of Canada has released the Bank of Canada Review – Spring 2012 with articles:

• On the Adjustment of the Global Economy
• On the Adjustment of the Global Economy
• Understanding Systemic Risk in the Banking Sector: A MacroFinancial Risk Assessment Framework
• Conference Summary: New Developments in Payments and Settlement

They have also released the June 2012 Financial System Review with articles:

• The Resolution of Systemically Important Financial Institutions
• Reducing Systemic Risk: Canada’s New Central Counterparty for the Fixed-Income Market
• An Improved Framework for Assessing the Risks Arising from Elevated Household Debt

The article by Pothik Chatterjee, Lana Embree and Peter Youngman on central clearing chants the familiar slogan:

The introduction of an appropriately risk-controlled CCP for the fixed-income market improves this market’s resilience by mitigating counterparty credit risk, thus reducing the potential for disruptions to be transmitted through the financial system.

… but does admit …

Given the centrality of the underlying market, the Bank considers that CDCS could pose systemic risk if appropriate risk controls are not in place (i.e., it is systemically important).

It has long been a puzzle to me just exactly why all these art-school dweebs who control politics and regulation are in favour of a system subject to single-point failure as opposed to a network. Can networks freeze? Sure:

During the financial crisis, the Canadian fixed-income repo market, like those in other countries, experienced periods of illiquidity as a result of lenders of cash taking measures to reduce their credit exposures to borrowers. When many lenders undertook these measures simultaneously, the amount of financing available was abruptly reduced, creating severe funding pressures in the repo market.

I always thought that reducing exposure to dubious credits was what bankers are paid to do, but I’m just old fashioned that way. I agree that sometimes this can go too far and lead to an unjustified and harmful credit lock-up, but this does not prove that single-point systems are better; if for no other reason than that is the point at which the central bank is supposed to step in and provide liquidity at above market rates – an alternative which is not discussed.

The authors also point out:

The decrease in repo activity was relatively more pronounced in Canada than in other jurisdictions, since repo business accounted for a greater share of the balance sheets of domestic banks than it did for their global competitors.

Sadly, they do not provide a business purpose for this statistic, nor do they discuss the regulatory implications of this preference.

However, they do disclose that a major source of the industry’s enthusiasm for such a move is regulatory arbitrage via elimination of the gross position:

To minimize the potential contraction of the repo market resulting from balance-sheet pressures during future stressful periods, members of the Investment Industry Association of Canada (the industry) sought ways to increase netting efficiencies in order to offset repo and reverse repo transactions on the asset and liability sides of the balance sheet.[footnote] The industry concluded that an appropriately designed CCP would allow them to reduce their balance-sheet exposures to the repo business by netting offsetting positions without changing their underlying repo activity. Using a CCP would therefore create a more resilient and efficient balance sheet that could absorb financial shocks with greater ease.

[Footnote] Without a CCP, if a bank transacts in both a repo and a reverse repo for the same security and term, but with different counterparties, both a liability and an asset are created on the bank’s balance sheet. If both trades are novated by a CCP, however, the bank would have offsetting trades with the same counterparty, allowing the counterparties to net the trades and not create separate assets and liabilities on their balance sheets.

Sure – just like netting out all deposits and loans would help shrink the balance sheet, too.

Credit risk is addressed as follows:

As depicted in Figure 3, in the event that CDCC faced a credit loss in closing out a member’s positions, the defaulter’s variation and initial margin and clearingfund contributions would be used first to absorb these losses. If this were insufficient, CDCC would use its capital to absorb the next $5 million of losses. If these funds were still not enough, residual losses would be borne by the surviving members’ contributions to the clearing fund. Members would be obliged to make an
additional “top-up” contribution to the clearing fund of up to 100 per cent of the value of their original contribution.

So clearly, another incentive to support the scheme is the ability to collectivize credit risk. You want to do a $20-billion deal with the Bank of Porky’s Corners? No problem! Other guys are worrying about credit quality and in the event of default your competitors will bear most of the cost!

But don’t worry about default. Everybody knows that a 22-year-old regulator with a degree in Medieval Horticulture and a certificate in boxtickingology can make much more judicious credit decisions than any dumb old banker.

You don’t actually have the $20-billion you’re lending to the Bank of Porky’s Corners and you have to fund it yourself with a reverse-repo? Again, no problem! You’ll be able to net out your repo positions and the offsetting transactions won’t attract any capital charge! Jack it up to the skies, man! If you can make a margin of a millionth of a beep, it’s all profitable! It’s all free money!

But that’s not the best part. The best part is:

Completion of the second phase will allow interdealer brokers to offer anonymous trading for repos cleared by the CCP, which are known as “blind” repos.

No moral hazard there, no sir!

Should all of CDCC’s private sources of liquidity be insufficient to manage a default, the Bank of Canada has the discretion to act as liquidity provider of last resort on a secured basis.

There’s no mention of this being done at a stiff premium to market (which didn’t happen during the crisis anyway).

Update, 2012-7-14: Note that the provisions for covering losses are equivalent to Unfunded Contingent Capital – whereas the BCBS speaks approvingly of pre-funded Contingent Capital and so does OSFI boss Dickson. The fact that the CCP’s notional capital is unfunded is a serious flaw in the scheme.

Mind you, though, I have no intrinsic objection to the idea of a CCP … but if it lends like a bank and borrows like a bank, it should be capitalized like a bank and regulated like a bank.

The Boston Fed has released the 11H2 Research Review highlighting:

• Public Policy Discussion Papers
  • An Economic Analysis of the 2010 Proposed Settlement between the Department of Justice and Credit Card Networks
  • Classroom Peer Effects and Student Achievement
  • Securitization and Moral Hazard: Evidence from Lender Cutoff Rules
  • Quantifying the Role of Federal and State Taxes in Mitigating Income Inequality
  • Economic Literacy and Inflation Expectations: Evidence from a Laboratory Experiment
  • Do Borrower Rights Improve Borrower Outcomes? Evidence from the Foreclosure Process
  • Account-to-Account Electronic Money Transfers: Recent Developments in the United States
• Working Papers
  • House Price Growth When Kids Are Teenagers: A Path to Higher Intergenerational Achievement?
  • Customer Recognition and Competition
  • On the Distribution of College Dropouts: Household Wealth and Uninsurable Idiosyncratic Risk
  • Trade Adjustment and Productivity in Large Crises
  • Trends in U.S. Family Income Mobility, 1969–2006
  • The Role of Expectations in U.S. Inflation Dynamics
  • Further Investigations into the Origin of Credit Score Cutoff Rules
  • Core Competencies, Matching, and the Structure of Foreign Direct Investment
  • Managing Self-Confidence: Theory and Experimental Evidence
  • Games with Synergistic Preferences
  • The Great Recession and Bank Lending to Small Businesses
  • The Great Recession and Bank Lending to Small Businesses
  • Inflation Dynamics When Inflation Is Near Zero
  • Designing Formulas for Distributing Reductions in State Aid
  • Childhood Lead and Academic Performance in Massachusetts
• Public Policy Briefs
  • Potential Effects of an Increase in Debit Card Fees
  • Inflation Expectations and the Evolution of U.S. Inflation
• Research Reports
  • State Foreclosure Prevention Efforts in New England: Mediation and Financial Assistance

The Bank of Canada has released the Bank of Canada Review: Winter 2011-12, a special issue devoted to Household Finances and Financial Stability, with articles:

• What Explains Trends in Household Debt in Canada? by Allan Crawford and Umar Faruqui
• Household Borrowing and Spending in Canada by Jeannine Bailliu, Katsiaryna Kartashova and Césaire Meh
• Medium-Term Fluctuations in Canadian House Prices by Brian Peterson and Yi Zheng
• Household Insolvency in Canada by Jason Allen and Evren Damar

Jennifer Ryan of Bloomberg reports that U.K.: Banks to Split Consumer, Investment Arms:

The U.K. will force banks to separate their investment and consumer businesses as part of its acceptance of the findings of the John Vickers-led Independent Commission on Banking, business secretary Vince Cable said.

“Tomorrow, the government is going to launch this initiative on the banks, accepting in full the Vickers commission,” he told BBC television today. “We’re going to proceed with the separation of the banks, the casinos and the business lending parts of the banks.”

Former Bank of England Chief Economist Vickers recommended in a Sept. 12 report that banks build fire breaks between their consumer and investment banks and boost the amount of loss- absorbing equity and debt they hold to between 17 percent and 20 percent. Since 2007, the government has had to spend, pledge and loan 850 billion pounds ($1.3 trillion) to rescue British banksChancellor of the Exchequer George Osborne will say in Parliament tomorrow that the government will enact the reforms stemming from the report and the Treasury will publish its response. The changes are to be implemented by 2019.

The units inside the fire breaks will include all checking accounts, mortgages, credit cards and lending to small- and medium-sized companies, the report said in September. As much as a third of U.K. bank assets, or about 2.3 trillion pounds, will be included, the document said. Trading and investment banking activities will be excluded from the ring-fence. Standard & Poor’s said Sept. 14 the elements of a bank outside the ring fence face a credit-ratings cut as they won’t be able to count on government support.

This is echoed by the Guardian and the BBC, but journalists rarely do anything more than copy each other’s press releases anyway, so whether one can use the word “confirmed” is a matter of luck.

If it’s true – and if the attempt is successfull – I’m very pleased. As I said on March 24, 2008:

As I have stated so many times that Assiduous Readers are fed up to the back teeth with the incessant drone – we want a shadow banking system! We want to ensure that there are layers of regulation, with the banks at the inner core and a shock-absorber comprised of brokerages that will serve as a buffer between this core and a wild-and-wooly investment market. This will, from time to time, require (or, at least, encourage) the Fed to step in and take action, but the alternative is worse.

The Independent Commission on Banking has a refreshingly focussed website. In his opening remarks, Sir John Vickers made the points:

Structural separation would bring three main benefits:

• it would help insulate vital UK retail banking services from global financial shocks, which is of particular importance given the way that major UK banks combine retail banking with global wholesale/investment banking;
• it would make it easier and less costly to sort out banks – whether retail or investment banks – that still got into trouble despite greater loss-absorbing capacity. This is all part of getting taxpayers off the hook for the banks; and
• it would be good for competitiveness because UK retail banking can be made safer while international standards apply to the global wholesale and investment banking activities of UK banks.

The separation is intended to take place as follows:

We are recommending a strong ring-fence – otherwise there would be little point in having one – but also a flexible one. This in essence is how it would work.

Only ring-fenced banks would supply the core domestic retail banking services of taking deposits from ordinary individuals and SMEs and providing them with overdrafts.

Ring-fenced banks could not undertake trading or markets business, or do derivatives (other than hedging retail risks) or supply services to overseas (in the sense of non-European) customers, or services (other than payments services) resulting in exposures to financial companies.

Other activities – such as lending to large domestic non-financial companies – would be allowed either side of the fence.

The aggregate balance sheet of UK banks exceeds £6 trillion – more than four times annual UK output. On the basis above, between a sixth and a third of the balance sheet would be inside the fence.

The degree of capital required for core banks will be awesome:

The other element of reform for financial stability concerns the ability of banks, especially those of systemic importance, to bear losses. On this our main recommendations are:

• that large ring-fenced banks should have equity capital of at least 10% of risk-weighted assets and corresponding limits on overall leverage;
• that the retail and other activities of large banks should have primary loss-absorbing capacity – equity plus long-term unsecured debt (‘bail-in bonds’) that readily bears loss at the point of failure – of 17%-20% of risk-weighted assets.
• Remaining unsecured debt should also bear loss on failure if necessary; and depositor preference, so that insured deposits rank above all other unsecured debt.

The complete Final Report: Recommendations weighs in at a whopping 363 pages. I am quite disappointed at the discussion of “bail-in” debt:

First, the authorities should have a ‘primary bail-in power’ to impose losses in resolution on a set of pre-determined liabilities that are the most readily lossabsorbing. This should include the ability to be able to write down liabilities to recapitalise a bank (or part thereof) in resolution.46 As described in Paragraph 4.63, the class of (non-capital) liabilities that bears loss most readily is long-term unsecured debt. The Commission’s view is therefore that all unsecured debt with a term of at least 12 months at the time of issue – ‘bail-in bonds’47 – should be subject to the primary bail-in power.
…
Second, the authorities should have a ‘secondary bail-in power’ that would allow them to impose losses on all unsecured51 liabilities beyond primary loss-absorbing capacity (again, including the ability to write down liabilities to re-capitalise a bank) in resolution, if such loss-absorbing capacity does not prove sufficient.

As I have said so many times, I strongly dislike giving “the authorities” so much discretionary power. But at least it means that bank regulators will be treated to many excellent meals when the next crisis rears its head!

SEC Chairman Mary L. Schapiro used her Remarks at SIFMA’s 2011 Annual Meeting to discuss Money Market Fund reform, a topic which I consider very important for financial stability.

Ms. Schapiro said:

While the SEC’s new money market fund reforms were a critical first step, and many voices have said “you’ve done enough,” I believe additional steps should be taken to address the structural features that make money market funds vulnerable to runs.
…
As was stated in the FSOC Annual Report issued in July, the SEC – working with FSOC – is evaluating options to address the structural vulnerabilities posed by money market funds. We are focused in particular on a capital buffer option to serve as a cushion for money market funds in times of emergency and floating NAVs, which would eliminate the expectation of stability that accompanies the $1.00 stable NAV. Both of these reform options would ensure that investors who use money market funds realize the costs that might be imposed during rare market events.

The current focus on these two reform options is the result of a long and careful review conducted jointly with fellow financial regulators. In October 2010, the President’s Working Group released a Report on Money Market Funds.

The President’s Working Group report is titled Money Market Fund Reform Options and on its release:

The PWG now requests that the Financial Stability Oversight Council (FSOC), established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, consider the options discussed in this report and pursue appropriate next steps. To assist the FSOC in any analysis, the Securities and Exchange Commission, as the regulator of money market funds, will solicit public comments, including the production of empirical data and other information in support of such comments. A notice and request for comment will be published in the near future.

The 2011 Annual Report of the FSOC has been discussed on PrefBlog. Anyway, back to Schapiro:

While floating NAVs would reinforce what money market funds are – an investment – and what they are not – a guaranteed product – this option poses challenges for policymakers, particularly in fostering an orderly transition from stable NAVs to floating NAVs.
…
Another option, a capital buffer for money market funds, also holds promise. And much of the SEC staff’s energy, working jointly with staff from other FSOC member agencies, is focused on developing a meaningful capital buffer reform proposal. In addition, a capital buffer potentially could be combined with redemption restrictions in order to address incentives to run that may not be curtailed by a capital buffer alone.

I don’t remember seeing redemption restrictions being proposed before. Good old regulators! When in doubt, impose rationing, that’s the motto!

An express and transparent capital buffer would make explicit what for many, but not all, money market funds is implicit today: namely that there is a source of capital available to the fund in times of emergency. Today that source of capital comes from discretionary sponsor support. If a money market fund held a troubled security, for example, the fund’s sponsor – or the sponsor’s well-capitalized parent – might buy the security out of the fund’s portfolio.

Clearly such activity saved investors from losses and was in their interests. But it also had the perverse effect of lulling investors into the belief that losses were extremely remote, if not somehow impossible, due to sponsor support.
…
A dedicated capital buffer, or similar structure, could provide that type of cushion. It could mitigate the incentive for investors to run since there would be dedicated resources to address any losses in the fund
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In assessing potential capital buffer structures, we are examining the pros and cons of various sources of the capital. The capital in a money market fund could come from (1) the fund’s sponsor, (2) the fund’s shareholders, or (3) the market, through the issuance of debt or a subordinated equity class. In addition, we are closely examining the appropriate size of any capital buffer. A challenge is how to establish a capital buffer that offers meaningful protection against unexpected events, without over-protecting and unnecessarily interfering with the prudent and efficient portfolio management of the fund.

Capital buffers have achieved a good level of academic support, as reported on PrefBlog in the post Squam Lake Group on Money Market Fund Regulation.

In a speech picked by Reuters, the new Republican SEC commissioner Daniel Gallagher made a speech on the topic titled SEC Reform After Dodd-Frank and the Financial Crisis:

To put a finer point on it, in light of the extensive disclosures regarding the possibility of loss, money market funds should not be treated by investors or by regulators as providing the surety of federally insured demand deposits.

So what is prompting this urgency to reform money market funds? What are the particular risks that money market funds, as currently constituted, pose to investors and to the capital markets? What problem are we solving here?

Well, as the events following the Lehman bankruptcy and Primary Reserve’s breaking of the buck showed, investors are treating money market funds as being perfectly safe – disclosures nonwithstanding. And problem is the effect on financial stability of the breathtaking run on money market funds that followed.

Like it or not, US MMFs have a huge systemic importance, as pointed out in an opinion piece by two partners at Dechert LLP (a law firm) titled How the Dodd-Frank Act Should Affect Mutual Funds, Including Money Market Funds:

Money market funds are an intermediary of short-term credit to the economy. They hold over 40 percent of outstanding commercial paper and approximately 65 percent of short-term municipal debt. Money market funds also manage a substantial portion of U.S. business short-term assets (24 percent as of 2006). As of December 29, 2010, money market funds had approximately $2.8 trillion of assets, or approximately 25 percent of all U.S. fund assets. Of the $2.8 trillion in money market funds, more than $1.8 trillion was invested in institutional money market funds.

I don’t think that there can be any doubt regarding the role played by MMFs in financial stability. But back to Gallagher:

I’ll admit that I just posed a bit of a trick question. We cannot know what risks money market funds pose unless – and this brings me to my second point – we have a clearer understanding of the effects of the Commission’s 2010 money market reforms. For some reason, much of the discussion surrounding the current need for money market reform sweeps aside the fact that the Commission has already responded to the 2008 crisis by making significant changes to Rule 2a-7. Notably, those amendments only became effective in May 2010.

The Rule 2a-7 amendments do not address the problem. Oh, they require a bit more liquidity, and they require a bit more box-ticking on credit quality – but the problem is, what if a money market fund holds a security that goes bust? There is no amount of box-ticking, no amount of analysis, that is going to eliminate that possibility.

First, I am hesitant about any form of so-called “capital” requirement, whether it takes the form of a “buffer” or of an actual capital requirement similar to those imposed on banks. Although I am not opposed to a bank-like capital requirement in principle, it is my understanding that the level of capital that would be required to legitimately backstop the funds would effectively end the industry.

His claim regarding his understanding is not footnoted, which is a shame.

However, if having sufficient capital would end the industry, then is the industry worth having? MMFs exist mainly for the purpose of doing an end-run around the banks – providing essentially the same services without having to submit to all the capital rules. In that sense, imposing a capital buffer rule that ends the industry can be seen more as a closing of a loophole than anything else.

In a very big sense, a bank with a large MMF operation can be viewed as simply having an unrecognized off-balance sheet obligation – something we’re trying to get away from!

I will note, however, that at least one industry participant has suggested the possibility of a stand-alone redemption fee. Although the details of the imposition of such a fee would need to be carefully considered, this suggestion avoids my worries about capital requirements. This minimal approach does not set up false expectations of capital protection, externalizes the costs of redemptions, and could be part of an orderly process to wind down funds when necessary. And, a meaningful redemption fee may cause a healthy process of self-selection among investors that could cull out those more likely to “run” in a time of stress. But despite my initial positive reaction to the notion of a redemption fee standing alone, grafting the fee onto a capital buffer regime will not assuage my concerns with such a capital requirement. Indeed, a combined approach retains all the problems of any capital solution, unless something significant is done to manage investor expectations regarding the level of protection provided.

His mention of a possible redemption fee has been left unfootnoted, but may be related to the paper by the Dechert partners referenced above:

The alternative suggested here is that, during a period of illiquidity, as declared by a money market fund’s board (or, alternatively, the SEC or another designated federal regulator), a money market fund may impose a redemption fee on a large share redemption approximately equal to the cost imposed by the redeeming shareholder and other redeeming shareholders on the money market fund’s remaining shareholders. For example, if redemptions in cash are expected to impact the market value of the fund’s remaining portfolio securities by an estimated dollar value or percentage, then the redeeming shareholders would be entitled to receive their principal value (i.e., the $1.00 NAV) minus the market impact that the redemptions have on the fund. Thus, during a period of declared illiquidity, a shareholder who insists upon making a large redemption of its shares would receive less than the full amount of its shares’ NAV. As soon as the declaration is withdrawn at the end of the period of illiquidity, money market funds would no longer be permitted to impose a redemption fee on redeeming shareholders and, once again, share transactions would occur at the $1.00 NAV.

I can’t say I’m very impressed with the redemption fee argument. Most importantly, it implies breaking the buck in all but name – there’s no insurance aspect to it, as there is with a capital buffer, or guarantees from a credible counterparty.

Update, 2011-12-23: Bloomberg’s editors suggest:

To add another level of security, regulators should consider one other change the industry has proposed: Allow funds to quickly close the door on redemptions when management deems it necessary. Hedge funds routinely used this lifesaver during the financial crisis. Few failed as a result. We would prefer that, instead of the industry deciding whether to shut the gate, which could leave millions of small investors in a cash crunch, the SEC make that decision in consultation with the Fed and the Treasury.

I don’t buy it. As soon as one MMF locks its doors, there will be a run on all the others. Additionally, there will be very grave effects on holders who need the money and to whom $0.98 now is worth a lot more than (maybe) $1.00 in two weeks.

The Bank of Canada has released the Financial Stability Review for December 2011 with articles:

• Risk Assessment
  • Macrofinancial Conditions
  • Key Risks
    • Global Sovereign Debt
    • Economic Downturn in Advanced Economies
    • Global Imbalances
    • Low Interest Rate Environment in Major Advanced Economies
    • Canadian Household Finances
  • Safeguarding Financial Stability
• Strengthening Bank Management of Liquidity Risk:
  The Basel III Liquidity Standards

• A Fundamental Review of Capital Charges Associated
  with Trading Activities

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Market-making activity has decreased, with U.S. primary-dealer inventories of corporate bonds falling in recent months (Chart 4).

It remains to be seen whether this is a normal reaction to the ebb and flow of trading activity, or whether the Volcker Rule – and all the other rules that have been introduced in the past few years – have permanently damaged corporate bond market liquidity.

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European banks’ access to U.S.-dollar funding has again come under mounting pressure, motivating the ECB to enhance its program to provide U.S.-dollar liquidity. Since European banks hold large amounts of assets denominated in that currency, they have a significant and persistent need for U.S.-dollar funding. This was heightened in recent months as U.S. money market mutual funds reduced their positions in European bank debt (Chart 10), shortened the maturities of their loans to euro-area banks and placed limits on overall counterparty credit exposure. In September, the ECB announced three 3-month U.S.-dollar liquidity operations, allowing financial institutions to secure financing in U.S. dollars beyond the year-end, which is typically a period when funding needs rise owing to seasonal factors. In addition, 1-week U.S.-dollar liquidity operations, which were set to expire in August 2011, have been extended until August 2012.

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With tensions in U.S.-dollar funding markets particularly acute as a result of rising counterparty concerns in Europe (Chart 11), a group of six central banks, including the Bank of Canada, took action on 30 November to extend U.S.-dollar swap lines with the U.S. Federal Reserve to 1 February 2013. The rate was lowered by 50 basis points, and the network of swap lines was expanded to include bilateral swaps among all pairs of currencies to provide financing if needed. For a number of the central banks involved, including
the Bank of Canada, the U.S.-dollar swap lines have been precautionary in nature, but the ECB has made use of its swap facility to provide U.S.-dollar financing to European banks.

So, obviously, if your requirements are killing you, the best thing to do is reduce your requirements, right? That’s what has the Canadian banks salivating:

This deleveraging is likely to be accelerated by the requirement to boost core Tier 1 capital to 9 per cent of risk-weighted assets by mid-2012, which was announced as part of the 26 October package of measures. Given market conditions, it seems likely that the higher capital ratios will be achieved at least in part through asset sales, as well as retained earnings and capital issuance. In an extreme scenario where only asset sales are used, up to €2.5 trillion of disposals would be required to raise core Tier 1 capital ratios to 9 per cent by next June as agreed to by euro-area leaders. Based on last year’s earnings, and assuming that no dividends are paid, the lower bound for asset sales would be €1.4 trillion.

Asset sales are likely to be concentrated in non-core business lines. For instance, there are reports that European banks have been selling assets in emerging-market economies.
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Some European banks are also selling U.S.-dollar assets, which has the advantage of reducing the funding-currency
mismatch that has plagued them for the past several years.

With recent quarterly results, banks have also announced a number of cost-cutting measures, including downsizing trading desks and other capital market operations. This raises the possibility of a marked decrease in their market-making activities, especially since this appears to be a strategy being used by many banks in Europe and abroad.

Somewhat surprisingly, the FSR points out that the Europeans might have shot themselves in the foot:

Positions in credit default swap (CDS) markets are used to hedge sovereign risk exposures. Since a credit event triggering payments on sovereign CDSs would entail losses for institutions that have sold credit protection, there is a risk that this could be an important channel of contagion to other markets and institutions. At the same time, the usefulness of such protection is called into question by recent proposals for voluntary writedowns of Greek sovereign debt by 50 per cent without triggering a credit event. The resulting inability to hedge exposures to sovereign credit risk could further reduce investor demand for these securities.

Cheery news for pensioners:

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… and for those (ahem!) with high exposure to insurers:

Recent market developments have had a similar negative impact on the life insurance sector. Some large Canadian insurers reported sizable losses in
the third quarter, reflecting the impact of lower interest rates, the decline in equity markets and revisions to actuarial assumptions. The recent market turmoil has also intensified sensitivities to market risk. Equity hedging strategies designed to help mitigate the impact on profit and loss will be less effective under very stressful financial market conditions to the extent that these strategies may be subject to basis and counterparty risk. These issues are especially challenging for firms that have been more aggressive in providing guarantees on investment products and in operating with greater asset-liability mismatches.

To my disappointment, the article by Grahame Johnson on capital charges in the trading book glosses over what I consider to have been the most egregious, and most easily fixed, element of regulatory failure in the run-up to the Panic of 2007: the fact that regulators do not impose a surcharge on trading book positions based on the age of those positions:

Drawing the boundary between the trading book and the banking book on the basis of intent has proven to be vulnerable to misuse. Trading intent is extremely difficult
either to define or to enforce; as such, there is a risk that some assets that might not be readily tradable (or hedgeable) will be held in the trading book. As well, there is a potential for regulatory arbitrage, where firms move positions into whatever classification provides the most favourable capital treatment.

This incentive to move positions can work in both directions. For example, credit exposures generally require a lower amount of capital if held in the trading book (given the use of internal models that allow for the benefits of hedging). This provides a strong motivation to securitize credit and hold it in the trading book, even if it is ultimately impossible to sell the exposure. The banking book, on the other hand, does not require assets to be marked to market, which would allow institutions to avoid recognizing (temporary) losses. For securities that have seen sharp declines in market price (which the bank views as temporary), there is an incentive to move these positions to the banking book, where the short-term loss would not have to be recognized. Highly rated sovereign government bonds present an example of this second arbitrage opportunity. In a volatile market, a portfolio of high-grade sovereign bonds could require a significant capital charge in the trading book (based on movements in the market price of the bonds); yet if the holding was moved to the banking book, the securities would have a risk weight of zero and would therefore require no capital.

In addition, long term readers will remember that I also advocate a certain separation of function: banks should declare whether they are primarily traders or primarily bankers, and face a surcharge on their capital requirements for their secondary function.

The Bank of Canada has released the Bank of Canada Review: Autumn 2011 with major articles:

• The International Monetary System: An Assessment and Avenue for Reform
• Liquidity Provision and Collateral Haircuts in Payments Systems
• Extracting Information from the Business Outlook Survey: A Principal-Component Approach
• Modelling the Counterfeiting of Bank Notes: A Literature Review

The second article, on Liquidity provision, is by James Chapman, Jonathan Chiu and Miguel Molico, all of whom are bank employees. They explain:

The study presented in the following section argues that the central bank’s haircut policy can therefore directly affect liquidity in these markets and indirectly influence market participants’ choice of asset portfolios, as well as the pricing of credit and liquidity spreads. The central bank is concerned not only about its own exposure to credit risk, but also about the efficiency and stability of the financial system. Consequently, in setting its haircut policy, the central bank must consider the impact of the policy on the financial system and its participants.

A growing need for high quality collateral is forecast:

Policy-makers also face the challenge of a growing demand for high-quality collateral. Modern financial systems tend to utilize more collateral because of the increased private use of collateral, and because of the need to post additional collateral with payment and settlement systems. The G-20 countries committed to have all standardized over-the-counter derivatives contracts cleared by central counterparties (CCPs) by the end of 2012 to help strengthen the global financial system. Such an increase in CCP activity has the potential to increase the need for collateral. In addition, revisions to the core principles for financial market infrastructure, currently being considered by the Bank for International Settlements’ Committee on Payment and Settlement Systems and by the International Organization of Securities Commissions, will further increase the demand for collateral by financial market participants. The haircuts set by central banks are important parameters in determining the ability of financial systems to make the most efficient use of high-quality collateral.