Reforming the US macroprudential regulatory architecture

US financial system may be neighbor’s envy especially before the 2008 crisis but its regulatory system is owner’s envy. It is a mess with multiple regulators and chaos. How US financial system grew despite such poor regulatory structure is something worth looking. There are some who will argue size is one thing but efficiency is another. US financial system grew in size tracking the economy but its efficiency has followed the regulatory system.

Kathryn Judge and Anil Kashyap in this voxeu article suggest a way forward to reform the macropru regulatory structure of US. The post is based on this yet another report on reforming the US system.

That a shock the size of the Covid-19 pandemic would trigger distress in financial markets is far from surprising. What is surprising is how much of the distress arose in domains that could have been identified posing a potential threat to stability well before the pandemic hit. This column explores how the US financial regulatory regime is falling short and proposes reforms to increase the likelihood that policymakers will identify and address threats to stability – before they harm the real economy. 

Fundamentals vs. policies: Can the US dollar’s dominance in global trade be dented?

Georgios Georgiadis, Helena Le Mezo, Arnaud Mehl and Cédric Tille in this ECB working paper analyse what drives USD’s dominance in trade:

The US dollar plays a dominant role in the invoicing of international trade, albeit not an exclusive one as more than half of global trade is invoiced in other currencies. Of particular interest are the euro, with a large role, and the renminbi, with a rising role. These two currencies are well suited to contrast the roles of economic fundamentals and policies, as European policy makers have taken a neutral stance in contrast to the promotion of the international role of the renminbi by the Chinese authorities. We assess the drivers of invoicing using the most recent and comprehensive data set for 115 countries over 1999-2019.

We find that standard mechanisms that foster use of a large economy’s currency predicted by theory – i.e. strategic complementarities in price setting and integration in cross-border value chains – underpin use of the dollar and the euro for trade with the United States and the euro area. These mechanisms also support the role of the dollar, but not the euro, in trade between non-US and non-euro area countries, making the dollar the globally dominant invoicing currency. Fundamentals and policies have played a contrasted role for the use of the renminbi.

We find that China’s integration into global trade has further strengthened the dominant status of the dollar at the expense of the euro. At the same time, the establishment of currency swap lines by the People’s Bank of China has been associated with increases in renminbi invoicing, with an adverse effect on dollar use that is larger than for the euro.

 

Market Power and Monetary Policy Transmission

Romain A Duval ; Davide Furceri ; Raphael Lee ; Marina M. Tavares in this IMF working paper:

We show that firms’ market power dampens the response of their output to monetary policy shocks, using firm-level data for the United States and a large cross-country firm-level dataset for 14 advanced economies. The estimated impact of a firm’s markup on its response to a monetary policy shock is large enough to materially affect monetary policy transmission. We also find some evidence that the role of markup in monetary policy transmission, while independent from other channels, is greater for firms whose characteristics — notably size and age — are likely to be associated with greater financial constraints. We rationalize these findings through a simple partial equilibrium model in which borrowing constraints amplify disproportionately low-markup firms’ responses to changes in interest rates.

Macroprudential Limits on Mortgage Products: The Australian Experience

Nicholas Garvin, Alex Kearney and Corrine Rosé in this RBA paper evaluate impact of macroprudential policy on Australian banks:

The Australian Prudential Regulation Authority implemented 2 credit limits between 2014 and 2018. Unlike similar policies in other countries, these imposed limits on particular mortgage products – first investor mortgages, then interest-only (IO) mortgages. With prudential bank-level panel data, we empirically identify banks’ credit supply and interest rate responses and test for other effects of these policies.

The policies quickly reduced growth in the targeted type of credit while total mortgage growth remained steady. Banks met the limits by raising interest rates on targeted mortgage products and this lifted their income temporarily. The largest banks substituted into non-targeted mortgage products while smaller banks did not. Practical implementation difficulties slowed effects of the (first) investor policy, and led to some disproportionate bank responses, but had largely been overcome by the time the (second) IO policy was implemented.

Fintech and the digital transformation of financial services: implications for market structure and public policy

Erik Feyen, Jon Frost, Leonardo Gambacorta, Harish Natarajan and Matthew Saal in this BIS paper:

The digital transformation of financial services gives rise to a set of important policy issues regarding competition, regulatory perimeters and ensuring a level playing field. Potential outcomes regarding competition, concentration and market composition include a “barbell” outcome composed of a few large providers and many niche players. Authorities must coordinate across financial regulation, competition, and industry regulatory bodies to manage trade-offs between stability and integrity, competition and efficiency, and consumer protection and privacy.

Is dollar or any other currency a meme?

Never really thought about currency as a meme! AS in they have value because government says so.

JP Koning in his super moneyness blog says that currencies are not memes. They drive their values from balance sheets of central banks and are subject to credit analysis. Whereas cryptocurrency analysis is just meme analysis:

“Currencies are not memes that only have value because governments say they do,” writes Brendan Greeley for the Financial Times. 

I agree with him.

The dollar-as-meme claim is often made by cryptocurrency enthusiasts. That this idea would emanate from the cryptocurrency community makes sense, since cryptocurrency prices are a purely meme-driven phenomenon. There is no cryptocurrency for which this is more apparent than Dogecoin, a cryptocurrency started as a joke and sustained by shiba inu gifs, but it applies equally to Doge’s older cousin, Bitcoin. The harder you meme the higher a cryptocurrency’s price, as the image at top suggests.

And so for cryptocurrency analysts, getting a good understanding of a given coin’s value is a matter of picking through its underlying memes and meme artists. 

But if cryptocurrency analysis is ultimately just meme analysis, what sort of analysis applies to dollars?

Dollars issued by banks are secured by the banks’ portfolio of loans, Greeley reminds us. And so they are subject to credit analysis, not meme analysis. An analyst appraises the quality of the bank’s investments in order to determine the soundness of the dollar IOUs the bank has issued.

As for central banks like the Fed, they are just special types of banks, says Greeley, and so the dollars they issue are also subject to credit analysis.  

The idea that the money issued by central banks—so-called fiat money—is subject to the same credit analysis as any other type of debt security is a point I’ve also made on this blog. There are certainly some odd features about Fed dollars or Bank of Japan yen, but ultimately they are just another form of credit.

More in the post…

What will the bank of the 21st century look like?

One of the biggest questions facing the scholars of money and banking is:  What will the bank of the 21st century look like?

Dennis Beau, First DG of Banque De France in this brief speech shares his perspective:

India’s CBDC: RBI working towards a phased implementation strategy and examining use cases

RBI Deputy Governor T Rabi Shankar in a speech yesterday (22-Jul-2021) spoke on CBDC and RBI’s take on it.

Central Banks across the globe are engaged in exploring CBDCs and a few countries have also introduced proofs of concept / pilots on CBDC. The High Level Inter-Ministerial Committee (November 2017) constituted by Ministry of Finance, Government of India (GoI) to examine the policy and legal framework for regulation of virtual / crypto currencies had recommended the introduction of CBDCs as a digital form of fiat money in India. Like other central banks, RBI has also been exploring the pros and cons of introduction of CBDCs since quite some time.

Generally, countries have implemented specific purpose CBDCs in the wholesale and retail segments. Going forward, after studying the impact of these models, launch of general purpose CBDCs shall be evaluated. RBI is currently working towards a phased implementation strategy and examining use cases which could be implemented with little or no disruption. Some key issues under examination are – (i) the scope of CBDCs – whether they should be used in retail payments or also in wholesale payments; (ii) the underlying technology – whether it should be a distributed ledger or a centralized ledger, for instance, and whether the choice of technology should vary according to use cases; (iii) the validation mechanism – whether token based or account based, (iv) distribution architecture – whether direct issuance by the RBI or through banks; (v) degree of anonymity etc. However, conducting pilots in wholesale and retail segments may be a possibility in near future.

On legal matters:

Although CBDCs are conceptually no different from banknotes, introduction of CBDC would require an enabling legal framework since the current legal provisions are made keeping in mind currency in paper form. Under the Reserve Bank of India Act, 1934, the Bank is empowered to “…regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage” (Preamble).

The Reserve Bank derives the necessary statutory powers from various sections of the RBI Act – with respect to denomination (Section 24), form of banknotes (Section 25), status as legal tender (Sec 26(1)) etc. There is a need to examine consequential amendments to other Acts like The Coinage Act, 2011, FEMA, 1999, Information Technology Act, 2000 etc.

Even though CBDCs will be a primarily technology driven product, it will be desirable to keep the legislation technology neutral to enable coverage of a variety of technology choices.

However, this bit on credit creation needs some updating:

CBDCs, depending on the extent of its use, can cause a reduction in the transaction demand for bank deposits. Since transactions in CBDCs reduce settlement risk as well, they reduce the liquidity needs for settlement of transactions (such as intra-day liquidity). In addition, by providing a genuinely risk-free alternative to bank deposits, they could cause a shift away from bank deposits which in turn might reduce the need for government guarantees on deposits (Dyson and Hodgson, 2016).

At the same time reduced disintermediation of banks carries its own risks. If banks begin to lose deposits over time, their ability for credit creation gets constrained. Since central banks cannot provide credit to the private sector, the impact on the role of bank credit needs to be well understood.

Plus, as banks lose significant volume of low-cost transaction deposits their interest margin might come under stress leading to an increase in cost of credit. Thus, potential costs of disintermediation mean it is important to design and implement CBDC in a way that makes the demand for CBDC, vis‑à‑vis bank deposits, manageable.

As Bank of England researchers (followed by other central banks) showed that banks first create credit which comes back as deposits. So banks are never really credit constrained and certainly not by deposits. The contraints are more on real economy side i.e. whether banks can identify are economic opportunities and so on.   Another constraint is regulations.

Ending shadow banking means ending modern central banking

Anantha Nageswaran in his GoldStandardSite blog quotes from this Prospect magazine article by Ann Pettifor.

Ann argues how central banks have allowed shadow banking to proliferate.

The vast “shadow banking” system, which has grown out of the same flawed monetary thinking, is another matter. Comprising pension funds, hedge funds, insurance companies and other investment vehicles, it now manages a $200 trillion stock of assets, dwarfing that $2 trillion cryptocurrency valuation, and also vastly exceeding the annual income (or GDP) of the world as a whole, estimated at $86 trillion. Being in the shadows, then, no longer means being on the margins.

Central bankers have permitted and sometimes encouraged this sector to expand beyond the regulatory frameworks of governments. But the real roots are deeper, lying in the great structural shift of pension privatisation. Between 1981 and 2014, 30 countries fully or partially privatised their public mandatory pensions. Coupled with cross-border capital mobility, the move to private retirement savings steadily generated vast cash pools for institutional investors.

Today one asset management firm, BlackRock, manages in excess of $8 trillion of the world’s savings. Such companies have outgrown the capacity of “main street” banks to provide services. No traditional commercial bank could absorb these sums; few governments are willing to guarantee individual accounts of more than $100,000. The new form of “banking” answered the need to accommodate the enormous sums of globalised capital.

Like pawnbrokers, who practised an earlier form of unregulated credit, shadow banks exchange the savings they hold for collateral. But instead of watches and wedding rings, they lend out on the strength of government bonds and other securities.

Replete with cash, they can provide “liquidity” on a vast scale to businesses or investors who need it. In return, the borrowers offer up a security—and write an IOU offering to repurchase it later, at a higher price. This markup is, in effect, the interest on the loan. These repurchase deals are struck in the “repo” markets which form the heart of the shadow banking system.

Note that this whole system avoids reliance on the social construct of credit, upheld by trust and enforced by law, which traditional banks had to work within. Instead, the system is one of deregulated exchange in which cash is simply one more commodity—no more regulated than any other.

She goes onto argue how QE programs of central banks have allowed shadowy banking to continue.

The reason why emergency injections of money are increasingly needed is that the shadow banking system is structurally prone to volatility and debt crises. The borrower’s promise to repurchase an asset at a higher price is relatively easy to uphold when the value of that asset remains stable. But the value of assets can rise or fall suddenly, which in this system can set in train self-amplifying feedback loops—with catastrophic consequences.

Anantha goes a step further that ending shadow banking will mean end of modern day central banking:

It clarifies a lot of things, actually. In other words, without QE, the shadow banking system will cease to exist. If it ceases to exist, then the real economy crashes. So, central bankers can assuage themselves by saying that by providing the liquidity that the leveraged shadow banking system needs, they are indirectly supporting the real economy or preventing the real economy from collapsing.

Her conclusion is quite appropriate:

Whenever the vast shadow banks wobble, there is the threat of a disastrous contraction of the credit for the real economy, which could bring everything crashing down. As long as the system is allowed to stand, there is no alternative to taxpayer-backed central banks rescuing private markets.

The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks. And if footloose capital responds by skipping across borders and away from oversight, then we may also need to look at controls on that front too. Only then will the world stand any chance of kicking the QE habit, address those dangerous imbalances and finally escape this grim shadowland of money.

But, on their own, central banks will be afraid to do the job of deconstructing and reconstructing. It is a political project because, in reality, it would amount to cutting both shadow banking and central banking to size. That is why central bankers would resist it actually. Ending the last forty years of financialisation will also end central banking as it has evolved in the last forty years. Central bankers will go back to operating in the shadows, if shadow banking were to be ended!

Will politicians be up to the task? I doubt.

The risk is that, in doing so, the ‘House of cards’ aka ‘the real economy’ will collapse. No one wants it on their watch. If the world of shadow banking has to end, it will happen through exogenous shocks. Both QE (i.e., modern central banking) and the world of shadow banking have to collapse from being unable to bear the sheer weight that they have grown into.

Hmm..worth thinking about..

Global reflation?

BIS Bulletin on rising inflation across countries:

• Inflation has risen in many countries. In conjunction with a rebound in GDP growth and evidence of significant bottlenecks in some sectors, this has prompted concerns that the low inflation era of recent decades could be nearing its end.
• A closer look at the data reveals that the pickup in inflation can be ascribed largely to base effects, increases in the prices of a small number of pandemic-affected items and higher energy prices. A common thread through these causes is that their effect on inflation is likely to be temporary.
• A more persistent increase in inflation would likely require a material pickup in labour costs and an unmooring of inflation expectations. However, wage growth remains contained and the medium-term inflation expectations of professional forecasters and financial markets show little sign of de-anchoring. These developments are consistent with medium-term inflation moving towards central bank targets.

The turnaround story of Indian Overseas Bank

G Balachander of Hindu Business Line in this article explains the turnaround of IOB.

In 2017, R Subramaniakumar and his team embarked on a massive turnaround programme, with a multi-pronged strategy under which it used INR surplus swap option, rebalanced its portfolio by significantly reducing exposure to large corporates, brought in huge HR focus, and perfected the IT systems.

Many details in the article.

70 years of Central Bank of Sri Lanka: 1950-2020

Central Bank Sri Lanka (CBSL) completed its 70 years in 2020.

CBSL released a special publication commemorating the 70 years. As of now the publication is available on sale. The central bank has put up volumes of earlier anniversaries on the website.

The Central Bank of Sri Lanka (CBSL) has published a special publication on the history of currency used in Sri Lanka, titled “The 70 Year Journey of Currency Issue and Management” co-authored by Retired Director Communications of CBSL, Ms. Shellomi H Gunawardena and Retired Senior Manager of CBSL, Mr. W M K Weerakoon.

The authors have utilized their years of experience at the Currency Department of CBSL, in compiling this publication, to be used as a reference for bankers, students, numismatists, and others who would be interested in the history pertaining to currency in Sri Lanka. The book carries attractive colour illustrations of currency notes and coins used in Sri Lanka from ancient times with historical narratives, which also provide a glimpse of the political, economic and cultural background of the country over the past 70 years.

The publication consists of 7 chapters. Chapter 1 provides a historical account of the formation of the CBSL and its role in currency issue and management. Chapter 2 describes the currency notes and coins that were in circulation at around the time the CBSL was established. Chapter 3 discusses currency coins issued by CBSL and Chapter 4 discusses currency notes issued by the Central Bank. Chapter 5 comprises commemorative notes and coins issued by the CBSL, which also includes a special section on the coin series issued to represent the 25 Administrative Districts of Sri Lanka. Security features of currency notes are discussed in Chapter 6 while Chapter 7 covers the legal framework within which currency is issued and managed in Sri Lanka.

The publication, in English, is available for purchase by individuals and bookshops at Rs. 1,000 per copy, at the Publication Sales Counter of the Economic History Museum (EHM), located at the Central Point Building, Chatham Street, Colombo 1.

 

The European Central Bank moves beyond price stability

My new piece in Moneycontrol on the changes in ECB’s policy as announced in its strategy review.

Financial Dollarization in Emerging Markets: Efficient Risk Sharing or Prescription for Disaster?

Lawrence Christiano, Hüsnü Dalgic & Armen Nurbekyan in this NBER paper:

This paper pushes back against two views about the effects of dollarization.

First, there is a view that the dollar is a device by which rich countries provide business cycle insurance to emerging market (EME) countries. We find that the dollar is important for risk sharing, but the evidence suggests that it is primarily a device to shift business cycle risk across different people within individual EMEs and within rich countries rather than across countries.

Second, there is a widespread view that dollarization raises the risk of systemic banking and other crises. Although we identify sources of fragility in some aspects of dollarization, the common view that financial dollarization is a source of fragility is over-stated.

Our insurance view about financial dollarization and the lack of risks to financial stability emerges from a study of a large cross-country dataset, as well as case studies for Peru and Armenia.

We develop a simple model which formalizes the insurance view, which is consistent with the key cross-country facts on interest rate differentials, deposit dollarization and exchange rate depreciations in recessions.

A European and Rawlsian view on inequality, inclusive growth and monetary policy

Olli Rehn, Governor of the Bank of Finland, in this speech quotes Rawls to justify low for long interest rate policy of central banks:

In the euro area, national policies determine labour market outcomes. However, monetary policy can support full employment without prejudice to price stability. In the presence of a flattened Phillips curve, policies aiming at full employment are likely to have a moderate inflationary impact in the short term. Under such circumstances, monetary policy can also help us get closer to full employment.

In fact, considerations about labour-income and wealth inequality strengthen the case for a “lower for longer” strategy, when monetary policy is constrained by the effective lower bound. This is to my understanding in line with considerations that featured prominently in the Federal Reserve’s recent framework review and have contributed also to the new ECB monetary policy strategy, of which President Christine Lagarde informed the public earlier today.

So, let me ask, on the basis of these reflections: what should one as a central banker think about inequality and inclusive growth in the making of monetary policy? In my view, the philosophy of John Rawls is a most helpful guide here. One of his key insights, or one of his three principles of a just society, is that inequalities are acceptable only in case that they benefit the less well-off members of the society.

That is by no means a carte blanche for e.g. advocating tax cuts that benefit the richest or believing in some trickle-down theory of economic growth. But it implies that as the main impact of monetary policy in the proximity of effective lower bound has been to raise output and employment, and thus reduce income inequality by helping create millions of jobs and enhance the income of the previously unemployed and other less well-off members of the society, even if it had limited negative side-effects on wealth inequality, then the policy has been in line with the pursuit of a just society.

Linking Rawlsian thinking to monetary policy is interesting…

Monetary Policy Transmission in India: How is external benchmark linked lending rate working?

Avnish Kumar and Priyanka Sachdeva in the recent RBI bulletin, discuss how shift to external benchmark rate has impacted banks and monetary transmission:

The transmission of policy repo rate changes to deposit and lending rates of scheduled commercial banks (SCBs) has improved substantially since the introduction of external benchmark linked lending rate (EBLR) regime in October 2019.

Data collected from banks suggest that the share of outstanding loans linked to external benchmark in total floating rate loans has increased from as low as 2.4 per cent during September 2019 to 28.5 per cent by the end of 2020-21. The adoption of external benchmark-based pricing of loans has strengthened market impulses for a quicker adjustment in deposit rates.

Further, a combination of surplus liquidity conditions amidst weak credit demand conditions has enabled banks to lower their deposit rates. The lowering of deposit rates has resulted in the decline in cost of funds for SCBs, prompting them to reduce their MCLRs, and in turn their lending rates.

 

False information regarding the sale of e-kronas

There is no e-krona yet. But rumours of its sale have already started:

On certain websites and in social media, false information is circulating claiming that the Riksbank is selling e-kronas.

The Riksbank has also been contacted by individuals describing how they have been called by companies claiming to be selling e-kronas on behalf of the Riksbank. However, it has not been decided yet whether the Riksbank will issue an e-krona and it is not possible to buy them.

 

Reserve Bank of New Zealand lowers monetary stimulus

RBNZ lowered the monetary stimulus in its mon policy today:

The Monetary Policy Committee agreed to reduce the current stimulatory level of monetary settings in order to meet its consumer price and employment objectives over the medium-term. 

The Reserve Bank will halt additional asset purchases under the Large Scale Asset Purchase (LSAP) programme by 23 July 2021. The Committee will keep the Official Cash Rate (OCR) at 0.25 percent and the Funding for Lending Programme unchanged.

The global economic outlook continues to improve, providing ongoing price support for New Zealand’s export commodities. Global monetary and fiscal settings remain at accommodative levels supporting the recovery in economic activity. Rising vaccination rates across many countries are providing further economic impetus. However, the need to reinstate COVID-19 containment measures in some regions highlights the ongoing global health and economic risks posed by the virus.

 

The theory of average inflation targeting

In Aug-2020, Federal Reserve announced shifting to a new monetary policy regime of average inflation targeting. Under this policy, the central bank looks to target inflation averaging over a period. So say central bank targets 2% inflation rate, Actual inflation has been 1% for 12 months. Inflation becomes 2% in 13th month and is expected to rise.

In a normal IT, central banks will look to tighten policy. However in AIT, central bank will not hurry and instead look at average inflation over the two years to be 2%. So first year inflation was 1% and second year around 2.5%-3%, bringing average inflation in two years to 2%. The idea behind AIT is to tell markets that central bank will not start tightening policy as soon as inflation starts to go up.

President of NY Fed, John Williams in this speech explains the theory and research behind AIT:

Where have all the Asian Tigers gone?

Prof Jayati Ghosh in Proj Syndicate:

Consider four emerging-market economies that were widely touted as examples of “Asian success” and had briefly become the darlings of global financial markets: India, Indonesia, Malaysia, and Thailand. GDP growth in each of these countries has decelerated significantly in recent years. In India, annual growth slowed from 8% in 2016 to 4% in 2019, and even these figures are widely considered to be overestimates because of changes in the calculation process. Thailand’s economy, which was expanding by more than 7% per year at the start of the last decade, grew by only 2.3% in 2019, while growth in Malaysia declined from 7.4% to 4.3% over the same period. Only in Indonesia, where growth slipped from 6.2% in 2010 to 5% in 2019, was the slowdown relatively minor.

One obvious cause of this deceleration was the decline in investment rates. In Malaysia, Indonesia, and Thailand, this reflected a medium-term trend triggered by the 1997-98 East Asian Crisis, after which investment rates collapsed by at least a quarter, from previous highs of close to 40% of GDP to around 30%. In Malaysia, investment fell further during the 2010s, to only 19% of GDP by 2019. Investment in India also declined sharply, from 40% of GDP in 2010 to 30% in 2019. And investment in all of these countries decreased again during the pandemic year of 2020.

COVID-19 aside, why have investment rates come down? After all, these economies were the beneficiaries not only of positive stimuli from China, but also of active interest from global finance. They attracted capital of all kinds: foreign direct investment, portfolio flows, bond financing, and other external commercial borrowing. Why didn’t all of this generate higher investment and growth?

It turns out that unrestricted capital flows were actually the problem. Although inflows from non-residents were large and growing, so were residents’ outflows. As a consequence, net inflows were often small. Malaysia was in fact a net exporter of capital for much of the past decade, as was Thailand in some years. Even worse, the rates of return on these countries’ financial assets held abroad (whether by central banks or private investors) were significantly lower than those on financial assets inside the economy held by non-residents.

This differential led to significant annual seigniorage losses. In Thailand, for example, these losses amounted to as much as 5.2% of GDP each year in 2010-18 according to UNCTAD – far more than the net inflow of capital. And even where net capital inflows were positive, as in India and Indonesia, they did not translate into increased domestic investment or enable investment in desired sectors. Instead, central banks added to their foreign-exchange reserves in order to self-insure against possible capital flight and manage the exchange rate in the face of substantial capital movements.

 She says the emerging tigers could restart with capital account:

There is no magic bullet that can ensure “emerging” Asian economies actually emerge and live up to their huge promise. But a radical reconsideration of capital-account management in such countries would be a good place to start.