Kashkari on TBTF

Neel Kashkari, the new president of the Minneapolis Fed, is making a splash with a speech about too big to fail, and the need for a deeper and more fundamental reform than Dodd Frank.  I am delighted to hear a Federal Reserve official offering, in public, some of the kinds of thoughts that I and like-minded radicals have been offering for the last few years.

I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy.

Now is the right time for Congress to consider going further than Dodd-Frank with bold, transformational solutions to solve this problem once and for all.

From an economic point of view, now is indeed the right time -- calm before the storm. I'm not so sure now is a great time from a political view! But perhaps anti-Wall Street feelings from both parties can be harnessed to good use.

...When the technology bubble burst in 2000, it was very painful for Silicon Valley and for technology investors, but it did not represent a systemic risk to our economy. Large banks must similarly be able to make mistakes—even very big mistakes—without requiring taxpayer bailouts and without triggering widespread economic damage.

This is a key lesson. As Dodd-Frank spreads to insurance companies, equity mutual funds, and asset managers, we're losing sight of the idea that trying to stop anyone from ever losing money again is not a wise way to prevent a panic. It's the nature of bank liabilities, not their assets, that is the problem.

I learned in the crisis that determining which firms are systemically important—which are TBTF—depends on economic and financial conditions. In a strong, stable economy, the failure of a given bank might not be systemic. The economy and financial firms and markets might be able to withstand a shock from such a failure without much harm to other institutions or to families and businesses. But in a weak economy with skittish markets, policymakers will be very worried about such a bank failure.

In other words, the whole idea of designating an institution that is per se "systemic" is silly.

...there is no simple formula that defines what is systemic. I wish there were. It requires judgment from policymakers to assess conditions at the time.

Here I think Kashkari isn't really learning the lesson. If it's undefinable, even in words, and needs "judgment," then perhaps the idea really is empty.

More deeply, I think we need to apply much the same thinking to regulation that we do to monetary policy. At least in principle, most analysts think some sort of rule is a good idea for monetary policy. Pure discretion leads to volatility, moral hazard, time-inconsistency and so on. We should start talking about good rules for financial crisis management, not just ever greater power and discretion to follow whatever the "judgment" (whim?) of the moment says.

A second lesson for me from the 2008 crisis is that almost by definition, we won’t see the next crisis coming, and it won’t look like what we might be expecting. If we, or markets, recognized an imbalance in the economy, market participants would likely take action to protect themselves. When I first went to Treasury in 2006, Treasury Secretary Henry Paulson directed his staff to work with financial regulators at the Federal Reserve and the Securities and Exchange Commission to look for what might trigger the next crisis... We looked at a number of scenarios, including an individual large bank running into trouble or a hedge fund suffering large losses, among others. We didn’t consider a nationwide housing downturn. It seems so obvious now, but we didn’t see it, and we were looking. We must assume that policymakers will not foresee future crises, either.

This is an unusual and worthy expression of humility. Others advocate loading up the Fed with "macroprudential" regulation and "bubble pricking" tools, on the faith that this time, yes this time, they really will see it coming, and really will do something about it.  Regulators are not wiser, smarter, less behavioral, etc. than traders.

Speaking of the "resolution authority,"

Unfortunately, I am far more skeptical that these tools will be useful to policymakers in the second scenario of a stressed economic environment. Given the massive externalities on Main Street of large bank failures in terms of lost jobs, lost income and lost wealth, no rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008. They will be forced to bail out failing institutions—as we were. We were even forced to support large bank mergers, which helped stabilize the immediate crisis, but that we knew would make TBTF worse in the long term.

There are no atheists in foxholes, the saying goes.  Notice "forcing losses on creditors and counterparties." This is exactly right. "Bailouts" are not about saving the institution, they are about saving its creditors. We should always call them "creditor bailouts." And a run is in full swing, and when the hotlines to the Treasury are buzzing "if we lose money on this, then the world will end," anyone in charge will guarantee the debts.

I believe we must begin this work now and give serious consideration to a range of options, including the following:

• Breaking up large banks into smaller, less connected, less important entities.

Here, Kashkari caused a stir in the press. Bernie Sanders voiced approval. Since "breaking up" has no subject -- who is to do this and how? -- and no mechanism, I'll give Kashkari the benefit of the doubt that he had something more sophisticated in mind than brute force.

• Turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant).

Aha! My favorite simple solution, more capital!  I'm delighted to hear it. Of course (to whine a bit), banks don't "hold" capital, they "issue" capital -- it's a liability not an asset. And if they have so much capital that they virtually can't fail, what is this business about public utilities? And why in the world do they need regulation akin to that of a nuclear power plant? Given how regulation has spiraled costs, stultified innovation, and stopped expansion of the one scalable carbon-free energy source we have, that's a particularly unfortunate analogy. Or maybe it's an incredibly accurate analogy for just where Dodd-Frank style regulation will lead. The point is the opposite: with "so much capital that they virtually can't fail" they don't need the hopeless project of "systemic" designation, intensive asset risk regulation, and so forth.

• Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

A Pigouvian tax on short term debt -- after we get rid of all the subsidies for it -- is my other favorite answer.

The financial sector has lobbied hard to preserve its current structure and thrown up endless objections to fundamental change.

Many of the arguments against adoption of a more transformational solution to the problem of TBTF are that the societal benefits of such financial giants somehow justify the exposure to another financial crisis. I find such arguments unpersuasive.

This needs some explanation. Banks produce studies claiming that higher capital requirements or reduced amounts of run-prone short-term funding will cause them to charge more for loans and reduce economic growth. Kashkari is pointing out that these arguments are pretty thin, because the cost of not doing it is immense -- 10 percent or so of GDP lost for nearly a decade and counting is plausible.

Obviously, I don't agree with everything in the speech. Kashkari is a bit too vague about "contagion" "linkages" and so fort for my taste. But the good news is to have this conversation, and not settle in to implementing page 35,427 of Dodd Frank regulations, head in the sand, while we wait for the next crisis.

The rest of the speech outlines his plans to get the Minneapolis Fed working hard on these issues, and to push for them at the larger Fed. This is a project worth watching.

In case I haven't plugged it about 10 times, my agenda for these issues is in Toward a Run-Free Financial System and the many blog posts under the "banking" "financial reform" and "regulation" labels.

Institutions and experience

These are remarks I prepared for a symposium at Hoover in honor of George Shultz on his 95th birthday. Willie Brown was the star of the symposium, I think, preceded by a provocative and thoughtful speech by Bill Bradley.

Institutions and Experience

Our theme is “learning from experience.” I want to reflect on how we as a society learn from experience, with special focus on economic affairs. Most of these thoughts reflect things I learned from George, directly or indirectly, but in the interest of time I won’t bore you with the stories.

An English baron in 1342 tramples his farmers’ lands while hunting. The farmers starve. Then, insecure in their land, they don’t keep it up, they move away, and soon both baron and farmers are poor.

How does our society remember thousands of years of lessons like these? When, say, the EPA decides the puddle in your backyard is a wetland, or — I choose a tiny example just to emphasize how pervasive the issues are — when the City of Palo Alto wants to grab a trailer park, how does our society remember the hunter baron’s experience?

The answer: Experience is encoded in our institutions. We live on a thousand years of slow development of the rule of law, rights of individuals, property rights, contracts, limited government, checks and balances. By operating within this great institutional machinery, these “structures” as senator Bradley called them last night, these “guardrails” as Kim Strassel called them in this morning’s Wall Street Journal, our society remembers Baron hunter’s experience in 1342, though each individual has forgotten it.

Hounded out of business II

Nathaniel Popper at the New York Times Dealbook, writes "Dream of New Kind of Credit Union Is Extinguished by Bureaucracy" It's a worthy addition to the series of anecdotes on how regulation, especially discretionary actions of regulators, are killing investment and businesses.

Again, we collect anecdotes as a challenge to measurement. There is no data series on numbers of businesses driven away by regulation. Yet.

This is a good anecdote, as it illustrates a too little reported underbelly of financial regulation.

Mr. Kahle saw how hard it was for the employees at his firm to obtain loans, and more broadly, how the existing financial system had helped contribute to the financial crisis. He thought he could do things differently, and he aimed to prove it when he began applying to open a credit union in early 2011.

Since then, the credit union has faced a barrage of regulatory audits and limitations on its operations, ...Now, Mr. Kahle is giving up on his dream of creating a new kind of bank, ...

...the troubles faced by his Internet Archive Federal Credit Union point to how difficult it can be to try out anything new in the heavily regulated industry.

An essay. It's an overview of what a growth-oriented policy program might look like. Regulation, finance, health, energy and environment, taxes, debt social security and medicare, social programs, labor law, immigration, education, and more. There is a more permanent version here and pdf version here. This version shows on blogger, but if your reader mangles it, the version on my blog or one of the above will work better.

I wrote it the Focusing the presidential debates initiative. The freedom of authors in that initiative to disagree is clear.

Economic Growth

Growth is central

Sclerotic growth is the overriding economic issue of our time. From 1950 to 2000 the US economy grew at an average rate of 3.5% per year. Since 2000, it has grown at half that rate, 1.7%. From the bottom of the great recession in 2009, usually a time of super-fast catch-up growth, it has only grown at two percent per year.² Two percent, or less, is starting to look like the new normal.

Small percentages hide a large reality. The average American is more than three times better off than his or her counterpart in 1950. Real GDP per person has risen from $16,000 in 1952 to over $50,000 today, both measured in 2009 dollars. Many pundits seem to remember the 1950s fondly, but $16,000 per person is a lot less than $50,000!

If the US economy had grown at 2% rather than 3.5% since 1950, income per person by 2000 would have been $23,000 not $50,000. That’s a huge difference. Nowhere in economic policy are we even talking about events that will double, or halve, the average American’s living standards in the next generation.

Even these large numbers understate reality.

Lazear on Dodd-Frank and Capital

Ed Lazear has a nice WSJ oped, "How not to prevent the next financial meltdown." (Also available here via Hoover.) The main points will not be new to readers of this blog, or my much longer essay but the piece is admirable for putting the basic points so clearly and concisely.

The core problem of focusing on institutions not activities:

The theory behind so-called systemically important financial institutions, or SIFIs, is fundamentally flawed. Financial crises are pathologies of an entire system, not of a few key firms. Reducing the likelihood of another panic requires treating the system as a whole, which will provide greater safety than having the government micromanage a number of private companies.

A crisis is a run:

The risks to a system are most pronounced when financial institutions borrow heavily to finance investments. If the value of the assets falls or becomes highly uncertain, creditors—who include depositors—will rush to pull out their money. The institution fails when it is unable to find a new source of funds to meet these obligations.

Greece and Banking, the oped

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog. This was published August 5, so today I'm allowed to post it in its entirety. You've probably seen it already, but this blog is in part an archive. If not, here is the whole thing, with my preferred first paragraph.
Local pdf here.

Greece's Ills [and, more importantly, the Euro's] Require a Banking Fix 

Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 

Too much debt, part II

"China to flood economy with cash" reads today's WSJ headline. When you read the article, however, you find it's not quite true. China to flood economy with debt is more accurate.

The expected move to free up more funds for lending—by reducing the deposits banks must hold in reserve—is directly aimed at countering the effects of a weaker currency,

The People’s Bank of China’s latest planned move, which could come before the end of this month or early next month, would involve a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing 678 billion yuan ($106.2 billion) in funds for banks to make loans.

I had hoped the world learned this lesson in the financial crisis. Equity is great. When things go bad, shareholders lose value by prices falling, but they cannot run and the firm cannot fail if it does not pay equity holders.

Financial crises are always and everywhere about debt, especially short term debt. Lending more, encouraging more bank leverage, reducing reserves and margin requirements, means that when the downturn comes a needless wave of runs and defaults follows.

Inevitably, it seems, another downturn will come, another set of books will have been found to have been cooked, and then we will find out who lent too much money to whom. US investment banks, 2008, strike one. Greece, 2010, strike 2. China, 2015, strike 3? Do we no longer bother closing the barn doors even after the horse leaves?

This story should also give one pause about the wisdom of "macro-prudential" policy, by which wise central bankers are supposed to presciently open and close the spigots of leverage to manage asset prices.

Europa hat die Banken missbraucht

An editorial in Süddeutche Zeitung, on Greece, banks and the Euro, summarizing some recent blog posts.

I don't speak German, so I don't know how the translation went, but it sounds great to me:

Die jüngste Griechenland-Krise rückt das größte Strukturproblem des Euro in den Vordergrund: Unter dem Dach einer gemeinsamen Währung müssen Staaten genauso wie Firmen pleitegehen können. Banken müssen international offen sein, sie dürfen nicht vollgepackt sein mit den Schuldtiteln lokaler Regierungen. So war der Euro ursprünglich konzipiert. Leider haben Europas Politiker die erste Prämisse vergessen und sind zur zweiten gar nicht erst vorgedrungen. Jetzt ist es Zeit, beides in Angriff zu nehmen.... 

The English version:

Greek Lessons for a Healthy Euro

The most recent Greek crisis brings to the foreground the main structural problem of the euro: Under a common currency sovereigns must default just like corporations default. And banks must be open internationally, not stuffed with local governments’ debts.

This is how the euro was initially conceived. Alas, europe’s leaders forgot about the first and never got around to the second. It’s time to fix both.

Greenspan for Capital

Alan Greenspan joins the high-capital banking club, in an intriguing FT editorial

If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.

20 to 30 percent used to be the sort of thing one could not say in public without being branded some sort of nut.

Alan also echoes the main point. Banks need lots of regulators micromanaging their investment decisions, because taxpayers pick up the bag for their too-high debts. Banks with lots of capital do not need asset micro-regulation:

...An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.

Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.

A double bravo.

However, to be honest, I have to nitpick a bit on what seems like the right answer for some of the wrong reasons.

A Capital Fed Ruling

The Fed just released it's latest missive to the big banks, and the answer is capital, lots more capital.

Three cheers for the Fed.

They are increasingly understanding that no matter how much they try to micromanage asset decisions, it's impossible to regulate away risk from the top. And "liquidity" will vanish the minute it's needed. Joke version -- liquidity standards are like requiring everyone on an airplane to carry a thousand bucks, so they can buy a parachute if the engines blow up. Just who will be buying "liquid" assets in the next crash?

So,  just raise capital, lots more capital, and slowly let the rest fade away.

A minor complaint: The Fed did it right but said it  wrong.

..under the rule, a firm that is identified as a global systemically important bank holding company, or GSIB, will have to hold additional capital...

No, capital is not "held." Capital is issued. Capital is a source of funds, not a use of funds. Capital is not reserves.  Please all, stop using the word "hold" for capital.

"A key purpose of the capital surcharge is to require the firms themselves to bear the costs that their failure would impose on others," Chair Janet L. Yellen said. "In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. Either outcome would enhance financial stability."

Issuing (not holding!) more capital does not make firms "bear costs." Firms never bear costs. They pass costs on to customers, workers, shareholders, or (especially for banks!) the government.  The slight argument for higher "costs" is that equity gets to leverage with less subsidized too-big-to-fail debt; that's not a cost, that's a reduction in subsidy. If (if) the cost of equity capital is high by some MM failure, then equity receives higher returns and borrowers pay higher costs. This is a surprising quote. Ms. Yellen is usually accurate in such matters.

But that's a minor complaint. I'd rather they raise capital and explain it wrong rather than the other way around. And of course, I'd rather they keep going. I'm also a skeptic that big banks are "systemic" and little banks are not, and thus should be allowed to continue with sky high leverage. But we'll get there.

Update:

A reader asks why I'm so persnickety about language. In this case, it's important. I think everyone recognizes that more capital leads to more financial stability. When an equity-financed bank loses money, share prices decline, but there are no failures or freezes. However, if you think capital is "held," and it "costly," then you think that banks shifting to issuing equity or retaining dividends to obtain funds has a cost to the economy, and regulators should require as little capital as possible. If you recognize that capital is issued, does not tie up funds, does not reduce the amount available for lending, then your mind is open to obtaining financial stability with lots and lots more capital.

Greece vs Puerto Rico and what's "systemic."

How is a Greek default different from a Puerto Rican default?

Answer: because Puerto Rico doesn't have its own banking system. It can't shut down banks. Banks in Puerto Rico are not loaded up on Puerto Rico debt, so depositors are not in danger if the state government defaults.

Puerto Rico, like Greece, uses a common currency. But there is no question of PRexit, that people wake up one morning and their dollar bank accounts are suddenly PR Peso bank accounts. So they have no reason to run and get cash out.

Banks in New York are also not loaded up on Puerto Rico debt. US bank regulators haven't said that those banks can pretend Puerto Rico debt is risk free.

If a Puerto Rican bank fails, any large US bank can quickly take it over and keep it running.

A Puerto Rican government default will be a mess. Just like the default of a large business in Puerto Rico. But it will not mean a bank run, crisis, and economic paralysis.

So here is a big lesson of the Greek debacle: In a currency union, sovereign debt must be able to default, without shutting down the banks, just as corporations default. Banks must not be loaded up on their country's sovereign debt. Bank regulation must treat sovereign default just like corporate default. It can happen, and banks must diversified and capitalized to survive it.  Banks must be free to operate across borders.  A common currency needs a firm commitment that it will not be abandoned.

In financial regulation, the big debate rages over what is "systemic,"  with the latest absurd idea to extend that designation to equity asset managers. (More later.) All that discussion starts with statements that  sovereign debt or anything backed by sovereign debt or sovereign guarantees is safe and per se not "systemic." Sovereign debt still counts as risk free in almost all banking regulation.

Greece should reinforce the lesson: Sovereign debt is a prime source of "systemic" danger. That is especially true of small governments in a currency union. A government is just a highly leveraged financial institution and insurance company.

Wrong answers:

- Fiscal union. The US is not necessarily going to bail out Puerto Rico. Or Illinois. Or their creditors. People keep saying a currency union needs fiscal union, but it is not so.

- National deposit insurance is really not central either. The banks operating in Puerto Rico are not in danger, so they don't need deposit insurance protection.

Update: A colleague pointed me to this excellent article on banks holding their own sovereign debt by Lucrezia Reichlin and Luis Garicano.

Greek roll-over

The latest Greek debt "crisis" poses an interesting puzzle. (Quotes because it's hard to call something that's been going on this long a "crisis.") Greece needs to come up with $300 million euros by Friday to pay off the IMF. And the most likely source of this money is... the IMF.

What's going on here? Obviously, Greece was going to need decades to pay off loans, in the sense of running primary surpluses to actually work down debt. Why lend Greece money for a short amount of time, then institute regular "crises" about rolling over the debt?

Bank at the Fed

"Segregated Balance Accounts" is a nice new paper by Rodney Garratt, Antoine Martin, James McAndrews, and Ed Nosal.

Currently, large depositors, especially companies, have a problem. If they put money in banks, deposit insurance is limited. So, they use money market funds, overnight repo, and other very short-term overnight debt instead to park cash. If you've got $10 million in cash, these are safer than banks. But they're prone to runs, which cause little financial hiccups like fall 2008.

But there is a way to have completely run-free interest-paying money, not needing any taxpayer guarantee: Let people and companies invest in interest-paying reserves at the Fed. Or, allow narrow deposit-taking: deposits channeled 100% to reserves at the Fed.

(I'm being persnickety about language. I don't like the words "narrow banking." I like "narrow deposit-taking" and "equity-financed banking," to be clear that banking can stay as big as it wants.)

That's essentially what Segregated Balance Accounts are. A big depositor gives money to a bank, the bank invests it in reserves. If the bank goes under, the depositor immediately gets the reserves, which just need to be transferred to another bank. This gets around the pesky limitation that the Fed is not supposed to take deposits from people and institutions that aren't legally banks.

Tucker and Bagehot at Hoover

I had the pleasure last week of attending the conference on Central Bank Governance And Oversight Reform at Hoover, organized by John Taylor.

Avoiding the usual academic question of what should the Fed do, and the endless media question will-she-or-won't she raise rates, this conference focused on how central banks should make decisions. Particularly in the context of legislation to constrain the Fed coming from Congress, with financial dirigisme and "macro-prudential" policy an increasing temptation, I found these moments of reflection quite useful.

Some of the issues: Should the Fed follow an "instrument rule," like the Taylor rule? Should it have "goal," like an inflation target, but then wide latitude to do what it takes to attain that goal? What structures should implement such a rule? Implicit in a rule that the Fed should do things, like target inflation and employment, is an implicit rule that it should ignore others, like asset prices, exchange rates and so on. (I think this is much too often overlooked. As financial reform should start by delineating what is not systemic, and hence exempt from regulation, monetary policy rules should start by saying what the Fed should ignore.) Should that limitation be more explicit? What's the right governance structure? Should we keep the regional Feds? How should Fed meetings be conducted? Is "transparency" the enemy of productive debate? How much discretion can an agency have while remaining independent?  And so on.

I was going to post thoughts on he whole conference, but John Taylor just posted an excellent summary, so I'll just point you there.

My job was to discuss Paul Tucker's (ex Deputy Governor of the Bank of England) thoughtful paper, "How Can Central Banks Deliver Credible Commitment and be “Emergency Institutions" Paul's paper starts to think deeply about independent regulatory agencies in general, and monetary and fiscal policy together. My discussion is narrower. I'll pass on the discussion (pdf here) as today's blog post, as it might be interesting to blog readers.

Comments on “How Can Central Banks Deliver Credible Commitment and be “Emergency Institutions” By Paul Tucker

May 21 2015

Let me start by summarizing, and cheering, Paul’s important points.

The standard view says that perhaps monetary policy should follow a rule, but financial-crisis firefighting needs discretion; a big mop to clean up big messes; flexibility to “do what it takes”; “emergency” powers to fight emergencies.

I think Paul is telling us, politely, that this is rubbish. Crisis-response and lender-of-last-resort actions need rules, or “regimes,” even more than monetary policy actions need rules. At a basic level any decision is a mapping from states of the world to actions. “Discretion” just means not talking about it.

More deeply, you need rules to constrain this mapping, to pre-commit yourself ex-ante against actions that you will choose ex-post, and regret. Monetary policy rules guard against “just this once” inflations. Lender of last resort rules guard against “just this once” bailouts and loans.

But you need rules even more, when the system responds to its expectations of your actions. And preventing crises is all about controlling this moral hazard.

Bailout barometer

The Richmond Fed updated its "bailout barometer," at left. Post here and longer report here. (WSJ coverage here)

I found the numbers and the table from the longer report interesting as well. Guaranteeing more than half of financial sector liabilities is impressive. But most of us don't know how large financial sector liabilities are. GDP is about $17 Trillion. $43 Trillion is a lot.

This is only financial system guarantees. It doesn't include, for example, the federal debt. It doesn't include student loans, small business loan guarantees, direct loan guarantees to businesses, the ex-im bank and so on and so forth. It doesn't include non-financial but likely bailouts like auto companies, states and local governments, their pensions, and so on.

Guaranteeing debt subsidizes things off budget. Of course, the chance that the government will have to simultaneously pay all these claims at once in full is small. But the chance that substantial debt guarantees might have to be paid is no longer vanishing.

The right to herd

Just when you thought financial regulation couldn't get more expansive and incoherent, our Justice Department comes in to defend morons' right to herd.

As explained in the Wall Street Journal at least, Mr. Navinder Singh Sarao is now under arrest, fighting extradition to the US, and his business ruined, for "spoofing" during the flash crash.

What is that? The Journal's beautiful graph at left explains.

The obvious question: Who are these traders who respond to spoofing orders by placing their own orders? Why is it a crucial goal of law and public policy to prevent Mr. Sarao from plucking their pockets? Is "herding trader" or "momentum trader" or "badly programmed high-speed trading program" or just simple "moron in the market" now a protected minority?

Why is Mr. Sarao being prosecuted and not all the people who wrote badly programmed algorithms that were so easily spoofed? If this caused the flash crash (how, not explained in the article) are they not equally at fault?

I don't mean by this a defense of the crazy stuff going on in high speed trading. As explained here, I think one second batch auctions are a much better market structure.  But the whole high speed trading thing is largely a response to SEC regulations in the first place, the order routing regulation, discrete tick size regulation, and strict time precedence regulation. A fact which will probably not enter at Mr. Sarao's trial (he doesn't seem to have billions for a settlement) and will give him little comfort in jail.

And maybe, just maybe, there is something more coherent here than the Journal lets on. I'll keep reading hoping to find it and welcome comments who can.

A larger thought. We still really want to rely on regulators to spot all the problems of finance and keep us safe from more crashes?

Update: Craig Pirrong excellent commentary here via a good FT alphaville post. Great quote:

The complaint alleges that Sarao employed the layering strategy about 250 days, meaning that he caused 250 out of the last one flash crashes. [my emphasis] I can see the defense strategy. When the government expert is on the stand, the defense will go through every day. “You claim Sarao used layering on this day, correct?” “Yes.” “There was no Flash Crash on that day, was there?” “No.” Repeating this 250 times will make the causal connection between his trading and Flash Clash seem very problematic, at best.

Update 2: Reading various commentaries that I can't find to cite any more, I realize that "front running" more than "herding" is the protected class. You "spoof" by putting in a bunch of orders just outside the current spread. The algorithms that respond to that think this behavior means some big orders coming, so try to front run those by buying. They cross the spread to take the small order you put on the other side. Or so the story goes. In any case, viewed as spoofers vs. front-runners it's harder still to have sympathy for the latter.

Update 3: Good Bloomberg View coverage from Matt Levine  and John Arnold, the source of the above front-running observation.

Blanchard on Countours of Policy

Olivier Blanchard, (IMF research director) has a thoughtful blog post, Contours of Macroeconomic Policy in the Future. In part it's background for the IMF's upcoming conference with the charming title Rethinking Macro Policy III: Progress or Confusion?” (You can guess my choice.)

Olivier cleanly poses some questions which in his view are likely to be the focus of policy-world debate for the next few years.  Looking for policy-oriented thesis topics? It's a one-stop shop.

Whether these should be the questions is another matter. (Mostly no, in my view.)

As a blogger, I can't resist a few pithy answers. But please note, I'm mostly having fun, and the questions and essay are much more serious.

A New Structure for U. S. Federal Debt

A new paper by that title, here.

I propose a new structure for U. S. Federal debt. All debt should be perpetual, paying coupons forever with no principal payment. The debt should be composed of the following:

1. Fixed-value, floating-rate debt: Short-term debt has a fixed value of $1.00, and pays a floating rate. It is electronically transferable, and sold in arbitrary denominations. Such debt looks to an investor like a money-market fund, or reserves at the Fed. 
2. Nominal perpetuities: This debt pays a coupon of $1 per bond, forever. 
3. Indexed perpetuities: This debt pays a coupon of $1 times the current consumer price index (CPI).
4. Tax free: Debt should be sold in a version that is free of all income, estate, capital gains, and other taxes. Ideally, all debt should be tax free. 
5. Variable coupon: Some if not all long-term debt should allow the government to vary the coupon rate without triggering legal default. 
6. Swaps: The Treasury should manage the maturity structure of the debt, and the interest rate and inflation exposure of the Federal budget, by transacting in simple swaps among these securities.

Of these, I think the first is the most important. Think of it as Treasury Electronic Money, or reserves for all. Why?

Duffie and Stein on Libor

Darrell Duffie and Jeremy Stein have a nice paper, "Reforming LIBOR and Other Financial-Market Benchmarks" I learned some important lessons from the paper and discussion.

Libor is the "London interbank offering rate." If you have a floating rate mortgage, it is likely based on Libor plus a percentage.

In its current form, LIBOR is determined each day (or “fixed”), not based on actual transactions between banks but rather on a poll of a group of panel banks, each of which is asked to make a judgmental estimate of the rate at which it could borrow.

As soon as money changes hands, there is an incentive to, er, shade reports in the direction that benefits the trading desk.

Revelations of widespread manipulation of LIBOR and other benchmarks, including those for foreign exchange rates and some commodity prices, have threatened the integrity of these benchmarks.. 

or report a rate that makes your bank look better (lower rate) than it really is:

During the financial crisis of 2007-2009...Some banks did not wish to appear to be less creditworthy than others... The rates reported by each of the panel of banks polled to produce LIBOR were quickly published, alongside the name of the reporting bank, for all to see. As a result, there arose at some banks a practice of... understating true borrowing costs when submitting to a LIBOR poll. 

On RRP Pro and Con

Thanks to a comment on the last post, I found The Fed working paper explaining Fed's thinking about overnight reverse repurchases, Overnight RRP Operations as a Monetary Policy Tool: Some Design Considerations by Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio Natalucci, and Julie Remache.

(I should have found it on my own, as it's the top paper on the Fed's working paper list.) Cecchetti and Shoenholtz also comment here

My main question was just what "financial stability" concerns the Fed has with RRP, and this paper explains.