Hagendorff and Vallascas argue that the risk weights used to calculate banks’ capital adequacy fall significantly short of true portfolio risks. Capital arbitrage may have undermined Basel II capital regulation and could do the same for Basel III in the future.
Central banks and equity market distress
A short Bundesbank paper presents evidence that the Federal Reserve, the ECB, and the Bank of England have long used policy rates to stabilize financial markets in times of distress. This would suggest that implicit ‘central bank puts’ are not new and that central banks’ tendency to stabilize markets in the past has not prevented serious market dislocations.
How fear of disaster affects financial markets
Fear of economic disasters, such as depressions, is more frequent than their actual occurrence. People tend to perceive a growing risk of disaster as they see economic conditions deteriorate. A new Federal Reserve paper illustrates that this pro-cyclicality of fears can trigger fluctuations in equity prices that go well beyond the actual changes in economic conditions, consistent with actual historical experience. Disaster fears also can make asset returns partly predictable.
The importance of central bank collateral frameworks
A new ECB paper illustrates the power of a central bank’s collateral framework as a policy tool. The collateral framework influences overall monetary conditions, helps preserving financial stability, and functions even at the zero lower bound for policy rates. Liquidity regulation can be an important complement, since by themselves generous collateral buffers might invite moral hazard and encourage excessive reliance on short-term funding.
The ultimate policy options of the European Central Bank
In case of further negative shocks the ECB has three final policy options. First, it could nudge its refinancing rate close to zero and become the first large central bank to introduce a negative deposit rate. Second, it could revive long-term repo operations, probably with a link to private credit and collateral enhancement, and accompanying cuts in minimum reserves and sterilization operations. Third, as a final recourse, the ECB could invoke its right to buy both public and private securities for the purpose of preserving price stability. This final step would raise most difficult operational issues, far more so than quantitative easing in other currency areas.
A review of Fed forward guidance and maturity extension
The Federal Reserve’s forward guidance and maturity extension policies demonstrated how non-conventional monetary policy operates through both “signaling effects” and “portfolio effects” Forward guidance reduced yields beyond the guidance period. It was treated by markets as a broader commitment to lasting accommodation, underscoring the power of signaling. The Maturity Extension Program, by contrast, raised shorter-dated rates, even within the forward guidance window, illustrating the general importance of the “portfolio effect”.
Sovereign Wealth Funds: The very basics
Sovereign wealth funds now hold assets worth roughly 4% of global GDP, and are governed by politically-mandated investment objectives. A new IMF paper gives an overview of size, types, investments and governance structures of these institutions.
How to reduce excessive public debt
An empirical IMF paper suggests that public debt reduction can support medium-term growth, if it is focused on cuts in non-investment spending. Such benign fiscal consolidation is less likely, however, when the private sector is credit constrained and fails to benefit from lower public borrowing, as has been the case after the 2008 financial crisis. In this case more balanced and gradual fiscal adjustment may be required to mitigate the negative growth effect.
A brief history of monetary policy and asset price booms
A new NBER paper reminds us of historical episodes when loose monetary policy contributed to asset price booms and busts. The paper also provides econometric evidence that low policy rates usually support asset prices. This history may not dissuade central banks from running highly accommodative policies at present, but explains the importance of accompanying macro-prudential measures.
Commodity exchange prices: The curious case of aluminum
Goldman Sachs Research takes another look at soaring warehouse queues and fears of price distortions in the aluminum market (see previous post here). A case can be made that inventories have risen as consequence of a supply surplus, rather than distortions. The price of physical metal, traded outside the exchange, appears to evolve in line with fundamentals. By contrast, the exchange price trades at a discount, because it only entitles to a warrant for cheapest delivery and not to physical metal at the required location. The variation of this discount constitutes basis risk for producers or consumers that use it for hedging, compromising the validity of the London Metals Exchange prices.
