Home (and solvency) bias at the Fed

At the INET conference in DC yesterday, Janet Yellen and Christine Lagarde both gave brief statements, and then they asked each other questions, back and forth, until the moderator called time. No surprises in any of it, perhaps, but still a useful check on the current thinking of the leaders of the Fed and the IMF respectively, and as such a sign of where new thinking is yet needed.

Yellen emphasized the origin of the 2007-2009 crisis in “distorted incentives”, two incentives in particular. First, short term interest rates were too low, so encouraging excessive expansion of credit. Second, regulation of the “non-bank” credit sector was too lax, so encouraging credit expansion to happen there rather than in traditional banks. Today, she says, “risks to financial stability are moderated, not elevated”, thanks to new higher capital requirements mainly, but also other reforms focused on banks mainly, not so much non-banks.

In all her remarks, Yellen spoke very much as the leader of the Fed, and her concern was narrowly limited to stability in the U.S. financial system, not the larger global scene. That larger scene however is of course the central concern of Lagarde, and so it is significant that Lagarde’s statement was distinctly less reassuring.

Citing the IMF’s most recent Global Financial Stability report, Lagarde chose to emphasize current “rotation”, from bank to non-bank credit, from sovereign credit to non-sovereign, from bank solvency to market liquidity, and from the advanced countries to the developing and emerging countries. From this point of view, she said, the regulatory job is not completed. Indeed, rotation means that the regulatory job is a work in progress.

In Q&A she got more specific, reminding the audience of the pre-crisis days when every bank boasted its “global” presence with a world map showing the location of every branch office. Since then, under pressure from their regulators, banks have sold their foreign branches to native local or regional banks, in effect reducing their footprints back to their home country. The implication is clear. Global credit is non-bank credit, and that’s where the risks have been building up.

In Q&A Yellen got more specific as well. In response to a question about how the zero interest rate policy squares with the need to better align incentives, she dutifully noted all the distortions caused by the six-years-now zero interest rate policy: compression in term premia, risk premia, interest margins and so forth, as people reach for yield. But this incentive distortion, unlike the one that caused the crisis, has a defensible social purpose, she says.  It is needed to move the economy back to full employment and to meet price stability objectives. The mechanism for that move, she suggests, has been balance sheet repair.

So there you are. At the global level, we see Brazilian firms issuing bonds that are funded in dollar money markets; this is money market funding of capital market lending, my definition of shadow banking. The key to financial stability in such arrangements, as we learned in the crisis, is the continued willingness of private profit-seeking dealers to make markets, both capital markets (the bonds) and money markets (the funding).  Yellen’s closing words reminded her audience that broker dealers were not on the radar of the Fed before the crisis, but, she reassured, they are now and the new capital requirements apply to all the broker dealers under the Fed’s supervision.

The question I would have asked, had questions been taken from the audience, is whether these regulations make it more or less likely that dealers will be willing and able to support markets in times of turmoil.  In other words, have we successfully constructed a robust dealer network of first resort that is willing and able to absorb the next dislocation?  Or will the next one once again rely on the central bank backstop as dealer of last resort?