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Alyssa Cambron, Michael Fleming, Deborah Leonard, Grant Long, and Julie Remache
In August 2013, we wrote a series of blog posts on the use of the Federal Reserve’s System Open Market Account (SOMA) portfolio in monetary policy operations. Since the onset of the financial crisis, the Federal Open Market Committee (FOMC) has increased the size and adjusted the composition of the SOMA portfolio in efforts to promote the Committee’s mandate to foster maximum employment and price stability. Over time, these actions have also generated high levels of portfolio income, contributing in turn to elevated remittances to the U.S. Treasury. Today’s release of the New York Fed’s report Domestic Open Market Operations during 2013 offers an opportunity to update our blog series’ discussion of the portfolio’s income and unrealized gains and losses, and to revisit our counterfactual exercise exploring how the use of the portfolio to implement monetary policy has affected income.
This post is the fifth in a series of six Liberty Street Economics posts on liquidity issues.
One of the most innovative and potentially far-reaching consequences of regulatory reform since the financial crisis has been the development of liquidity regulations for the banking system. While bank regulation traditionally focuses on requiring a minimum amount of capital, liquidity requirements impose a minimum amount of liquid assets. In this post, we provide a conceptual framework that allows us to evaluate the impact of liquidity requirements on economic growth, the creation of systemic risk, and household welfare. Importantly, the framework addresses both liquidity requirements and capital requirements, thus allowing the study of trade-offs and complementarities between these regulatory tools. The reader will find a more detailed discussion in our recent staff report “Liquidity Policies and Systemic Risk.”
This post is the third in a series of six Liberty Street Economics posts on liquidity issues.
Imagine that many large and levered banks suffer heavy losses and must quickly sell assets to reduce their leverage. We expect the market price of the assets sold to decline, at least temporarily. As a result, any other financial institutions that happen to hold the same assets will experience balance sheet losses through no fault of their own —a negative fire-sale externality. In this post, we show that the vulnerability to fire-sale externalities was high during the crisis and that the capital injections of the government’s Troubled Asset Relief Program (TARP) helped reduce it considerably. In fact, we argue that given the total amount injected, TARP was close to optimal. Fire sales are difficult to isolate and observe directly, especially in a crisis when multiple shocks concurrently afflict the financial system. But it is a bit less difficult to quantify the vulnerability of the financial sector to fire-sale externalities. To do so, consider the following hypothetical sequence of events, which captures the main aspects of any fire sale:
Stock market circuit breakers halt trading activity on a single stock or an entire exchange if a sudden large price move occurs. Their purpose is to forestall cascading trading activity caused by gaps in liquidity or order errors. Whether circuit breakers achieve this goal is contentious. This post adds to the debate by analyzing intraday price formation on the Tokyo Stock Exchange (TSE) on May 23, 2013—the pinnacle of this past year’s volatility in Japanese stock markets. While no circuit breakers were triggered on the TSE, we focus on trading conditions before and after the daily lunch break, which halted trading amid heightened market volatility on that day. The data seem to indicate that the break did not stem price volatility; rather, its anticipation may have worsened trading conditions.
Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed
This post is the eighth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
The failure or near-collapse of some of the largest dealer banks on Wall Street in 2008 highlighted the profound complexity of the industry. In some ways, dealer banks resemble well-understood traditional banks, which use deposits they receive from savers to make loans to businesses and households. Unlike traditional banks, however, dealer banks rely on complex and unique forms of collateralized borrowing and lending, which often involve the simultaneous exchange of cash and securities with other large and sophisticated financial institutions. During normal times, such transactions are highly efficient methods for allocating scarce resources. During times of stress, in contrast, they’ve proven to be destabilizing for the individual firms and, as recent history has shown, the financial system at large.
This post is the seventh in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
Paraphrasing a famous Supreme Court opinion: “I know bank complexity when I see it.” This expression probably speaks to the truth that, if we look at a given banking organization, we ought to be able to state whether it is more or less “complex.” And yet, such an approach hardly offers any guidance if one wants to understand the intricacies of global banks and to monitor and regulate them. What should be the appropriate metrics? It seems to us that there is not a consensus just yet on what complexity might mean in the context of banking. The global dimension of a bank adds many layers, so focusing on global banks is bound to yield a more comprehensive take on the issue than examining purely domestic banking entities. Therefore, in this piece, we view complexity through the lens of the operations of global banks.
Nicola Cetorelli, James McAndrews, and James Traina
This post is the sixth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
In yesterday’s post, our colleagues discussed the historic changes in financial sector size. Here, we tackle a related question on dynamics—how has bank complexity evolved through time? Recently, academics and policymakers have proposed a variety of strong actions to curb bank complexity, stemming from the view that complex banks are undesirable. While the large banks of today are certainly complex, we lack a thorough understanding of how they got that way. In this post and in our related contribution to the Economic Policy Review (EPR) volume, we focus on organizational complexity, measured by the number and types of entities organized together under common ownership and control. Using a new data set of financial-sector acquisitions, we study the structural evolution of banks and its implications for policy. We argue that banks grew into increasingly complex conglomerates in adaptation to a changing financial sector.
This post is the fifth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
Building upon previous posts in this series that discussed individual banks, we examine the historical growth of the entire financial sector, relative to the rest of the economy. This sector’s historically large share of the economy today (see chart below) and its role in disrupting the functioning of the real economy during the recent financial crisis have led to questions about the social value of costly financial services. While new regulations such as the Dodd-Frank Act impose restrictions on financial activities and increase their costs, especially those of large firms, our paper suggests that there may be limits to what regulation can achieve. In particular, we show that financial growth has occurred in the more opaque and harder to regulate sectors: private firms, shadow banks, and small nonbank financial firms. Moreover, we find that the stock market values these opaque areas of finance more, suggesting that they may expand even faster in the future.
Allan M. Malz, Ernst Schaumburg, Roman Shimonov, and Andreas Strzodka
The rise in the ten-year Treasury rate last summer was perhaps the most dramatic since the 2003 bond market sell-off. This post explains how major changes in the composition of agency mortgage-backed securities (MBS) ownership caused by the large-scale asset purchase programs (LSAPs) may have prevented a major convexity event triggered by MBS duration extension hedging. In fact, MBS hedging activity remained muted by historic standards and likely contributed only modestly to the rise in interest rates.
The relative merits of algorithmic and high-frequency trading are most often discussed in the context of equity markets. In this post, we look at the foreign exchange (FX) spot market. The growth of algorithmic and high-frequency trading in this market has introduced new entrants as well as new complexities and challenges that have important implications for the liquidity landscape and the risk management framework in FX markets. This post focuses narrowly on an important measure of FX market efficiency, absence of arbitrage opportunities, to discuss the improvements in this particular measure of efficiency that have coincided with significant growth in algorithmic and high-frequency trading.
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