The Basel III capital regulation reforms introduced a non-risk based leverage ratio for banks. A new ECB paper shows that a leverage ratio requirement may have unintended negative consequences. It encourages banks that specialize on low-risk lending to raise their share of high-risk loans. And it could make overall bank portfolios more similar, increasing the contamination risk from negative surprises to expected default risks.
Understanding the ECB’s latest tool: TLTROs
On 5 June 2014 the European Central Bank announced Targeted Long-Term Repo Operations (TLTROs]. Their main purpose is to stimulate bank lending to non-financial corporations. The operations would offer conditional cheap funding to banks in large size and for maturities of up to four years. Private loan conditions should ease in response, particularly in the euro area periphery, but the impact on area-wide credit is uncertain. Also, TLTROs might effectively be used for government bond carry trades.
On public debt and economic growth
The view that high public debt is bad for growth, popularized by Reinhart and Rogoff, has failed to find much empirical support in academic research. A paper by Lof and Malinen presents evidence that over the past 55 years lower growth has typically preceded higher debt but higher debt has not usually preceded lower growth.
The idea of uncovered equity parity
Uncovered equity parity explains how equity portfolio rebalancing affects exchange rates. Outperformance of foreign stock markets, whether through the exchange rate or stock prices, leaves investors with excess exchange rate exposure. The reduction of this exposure then puts depreciation pressure on the foreign currency. A new Federal Reserve paper presents evidence for the essential parts of that theory.
The Federal Reserve’s strategy after tapering
William Dudley provided an update of the Fed’s strategy for normalizing monetary policy. Under appropriate economic conditions, policy rates could begin rising in 2015, a considerable time after open-ended asset purchases have ceased. Rates increases would be tempered by tightening financial conditions and are seen to converge on a level below 4%. Discretionary balance sheet reduction should follow, not precede, rates normalization. Large excess reserves are not expected to compromise control over short-term interest rates.
Why bond yield compression cannot easily be reversed
Non-conventional monetary policy has inflated central banks’ balance sheets and compressed long-term yields. A new BIS paper makes some points on why reversing this portfolio effect is problematic. The financial system has much greater exposure to government bond yield risk than in the past. Spillover risks for private debt and emerging markets are elevated. And conflicts may arise between central bank and public debt management policies, increasing uncertainty for markets.
How equity return expectations contribute to bubbles
An updated paper by Adam, Beutel, and Marcet claims that booms and busts in U.S. stock prices can be explained by investors’ subjective capital gains expectations. Survey measures of these expectations display excessive optimism at market peaks and excessive pessimism at market troughs.
How to recognize an asset price bubble
A new paper from the ETH Zurich defines bubbles as episodes of unsustainable and quickening asset price growth with accelerating corrections and rebounds. In order to recognize such patterns it is critical to focus on the broader picture and correct time scale, rather than concurrent detail. Bubbles arise from innovations, valuation uncertainty and various positive feedback mechanisms that make prices spiral away from equilibrium. A critical state is often indicated by asset prices growing faster than exponentially.
The rise of asset management
Bank of England’s Andrew Haldane has summarized the rise and risks of asset management in a recent speech. As demographics and economic development propel the industry to ever higher assets under management, self-reinforcing correlated dynamics become a greater systemic concern. Market conventions, accounting practices, regulatory changes and structural changes in the industry all contribute to this risk.
The China property market risk
Nomura research has summarized evidence of oversupply of residential property in China. Urban floor space per capita is now estimated to be higher than in some developed countries. Land conversion is still rising, while urbanization is slowing. Potential triggers for a sharp correction include interest rate liberalization, capital outflows and property taxes. A plunge in property activity would have serious economic and financial consequences.
