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Nicola Cetorelli, Fernando Duarte, and Thomas Eisenbach
Update: A technical appendix has been added to the post.
According to conventional wisdom, an open-ended investment fund that has a floating net asset value (NAV) and no leverage will never experience a run and hence never have to fire-sell assets. In that view, a decline in the value of the fund’s assets will just lead to a commensurate and automatic decline in the fund’s equity—end of story. In this post, we argue that the conventional wisdom is incomplete and then explore some of the systemic risk consequences of investment funds’ vulnerabilities to fire-sale spillovers.
In a recently released New York Fed staff report, we present a forward-looking monitoring program to identify and track time-varying sources of systemic risk. Our program distinguishes between shocks, which are difficult to prevent, and the vulnerabilities that amplify shocks, which can be addressed. Drawing on a substantial body of research, we identify leverage, maturity transformation, interconnectedness, complexity, and the pricing of risk as the primary vulnerabilities in the financial system. The monitoring program tracks these vulnerabilities in four sectors of the economy: asset markets, the banking sector, shadow banking, and the nonfinancial sector. The framework also highlights the policy trade-off between reducing systemic risk and raising the cost of financial intermediation by taking pre-emptive actions to reduce vulnerabilities.
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.”
The financial crisis of 2007-09 highlighted the central role that financial intermediaries play in the propagation and amplification of shocks. Intermediaries increase leverage during the boom, which then makes them more vulnerable to adverse economic developments. In this post, we review evidence on the balance-sheet behavior of financial intermediaries and describe a channel that allows intermediaries to increase leverage during booms when asset market volatility tends to be low, which in turn forces them to dramatically reduce leverage once volatility increases. As shown during the financial crisis of 2007-08, the contraction of intermediary leverage is accompanied by increases in borrowing rates for households and a contraction of credit. The formal modeling of this amplification mechanism allows a welfare analysis of the tightness of regulatory capital requirements. We find that while loose capital constraints generate excessive risk-taking by intermediaries, tight funding constraints inhibit intermediaries’ risk-sharing and investment functions, which then lowers welfare.
On September 16, 2008, Reserve Primary Fund, a money market fund (MMF) with $65 billion in assets under management, announced that losses in its portfolio had caused the value of shares in the fund to drop from $1.00 to $0.97. The news that an MMF had “broken the buck” spread panic quickly to other MMFs. In the two days following Reserve’s announcement, investors withdrew approximately $200 billion (10 percent of assets) from so-called “prime” MMFs, which, like Reserve, mainly invest in privately issued short-term securities. The massive redemptions and resulting strains on MMFs contributed to a freezing of the markets that provide short-term credit to businesses and financial institutions and a sudden spike in short-term interest rates. Responding to these severe disruptions, the Treasury Department intervened on September 19 with a government guarantee of the value of MMF shares, and the Federal Reserve announced on the same day a facility designed to provide liquidity to MMFs. These unprecedented actions stopped the run on MMFs (for more analysis of the run in 2008, see McCabe, 2010). In this post, we discuss why MMFs are a source of financial fragility and the need for reforms to mitigate the risks they pose to the financial system and the economy.
The 2007-09 financial crisis spread to markets and institutions around the world, demonstrating why global systemic risk is a major concern in modern financial markets. Funding difficulties in one country can spill over to other countries via internationally active institutions, and the risk of dire financial outcomes can be transmitted across the globe. Because the crisis caused sudden and significant damage to people’s wealth and income, efforts to prevent a recurrence are imperative. The task will be a challenging one, however, owing to the complexity of modern financial markets, institutions, and regulatory regimes.
Wonk alert: technical content During the 2007-09 financial crisis, we saw that losses spread rapidly across institutions, threatening the entire financial system. Distress spread from structured investment vehicles to traditional deposit-taking banks and on to investment banks, and the failures of individual institutions had outsized impacts on the financial system. These spillovers were realizations of systemic risk—the risk that the distress of an individual institution, or a group of institutions, will induce financial instability on a broader scale, distorting the supply of credit to the real economy. In this post, we draw on our working paper “CoVaR”—issued in the New York Fed’s Staff Reports series—to do two things: first, propose a new measure of systemic risk and, second, outline a method that can help bring about the early detection of systemic risk buildup.
Liberty Street Economics features insight and analysis from economists working at the intersection of research and policy. The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan.
The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.
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