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Introduction
I am currently working on a book about the comings and goings of monetary-policy instruments and targets over the life of the Federal Reserve System. The tentative title of the project is Banking on Bullsh*t. The idea is to demonstrate that, as the Regulatory Dialectic model predicts, policy instruments, targets, and indicators lose their effectiveness (i.e., wear out) over time and have to be replaced or supplemented with new ones.
A secondary theme is to show that the macroeconomic effects of policies that target small movements in very short-term interest rates are minor. Building controversy over quarter-point movements in the federal funds rate distracts from the important distributional consequences of cumulative swings in policy over the business cycle.
Current institution
Publications
Publications (310)
This essay is part of a larger work on the history of Federal Reserve policymaking entitled Banking on Bull. The study seeks to explain why the instruments of central banking inevitably break down over time. A big part of the explanation is that policymakers want accounting measures of bank net worth to be flexible enough to allow bankers and regul...
Dodd-Frank is an example of counterfeit reform. It is designed principally to benefit very big banks and it has helped these banks to increase their market share greatly during the last 10 years. The Act provides lesser and contradictory forms of costs and comfort to smaller US bankers and taxpayers, foreign bankers (especially the managers of Deut...
I review emergency Federal Reserve credit-allocation programs and explain why
they are only a bandaid solution.I stress the importance of finding ways to smooth the re-contracting problem that exists in commercial and residential real estate.
Explaining that the Fed's efforts to supply "liquidity" cannot erase the distributional effects of the country's massive need for recontracting, especially in the real estate and real estate finance sectors.
Purpose
This paper explains the value of interpreting the design of a country's financial safety net as an exercise in incomplete social contracting.
Design/methodology/approach
Safety net contracts unlucky financial institutions and customers to transfer some or all of what would otherwise be ruinous losses to taxpayers in other sectors. Their ca...
Company law in the US and UK fails to acknowledge that authorities’ propensity to rescue giant banks from the consequences of insolvency creates an implicit contract that assigns taxpayers a coerced and badly structured equity stake in too-big-to-fail institutions. The entrenched managerial norm of maximizing stockholder value abuses this stake. It...
This paper analyzes the link between Kamakura Risk Information Services (KRIS) data on megabank default probabilities and credit spreads. It develops an " eyeball " test for the extent of individual-bank " zombieness " whose grade turns on how weakly a bank's credit spread responds to movements in KRIS default probabilities calculated over differen...
This paper analyzes the link between Kamakura Risk Information Services (KRIS) data on megabank default probabilities and credit spreads. It develops an “eye-ball” test for the extent of individual-bank “zombieness” whose grade turns on how weakly a bank’s credit spread responds to movements in KRIS default probabilities calculated over different h...
This paper analyzes the link between Kamakura Risk Information Services (KRIS) data on megabank default probabilities and issuer credit spreads. It develops an “eye-ball” test for the extent of individual-bank “zombieness.” The test focuses on how strongly or weakly a bank’s credit spread responds to movements in KRIS default probabilities over dif...
This paper focuses on the adverse long-run and distributional effects of stealthy zero-haircut rescues of US and EU megabanks by central bankers during the Great Financial Crisis and its aftermath. It explores movements in the crisis and postcrisis behavior of credit spreads at a sample of US and EU megabanks and develops a method for determining t...
During a financial crisis, the immediate benefits of rescuing insolvent lenders and their creditors with subsidized loans and blanket guarantees tempts regulators and politicians to ignore or downplay the taxpayer burdens that blanket rescues entail. This anti-egalitarian policy strategy would seem doubly attractive to the central bank responsible...
Company law in the US and UK fails to acknowledge that authorities’ propensity to rescue giant banks from the consequences of insolvency assigns taxpayers a coerced and badly structured equity stake in too-big-to-fail institutions. The entrenched managerial norm of maximizing stockholder value lends a misplaced legitimacy to efforts by TBTF manager...
This paper applies Schein's model of organizational culture to financial firms and their prudential regulators. It identifies a series of hard-to-change cultural norms and assumptions that support go-for-broke risk-taking by megabanks that meets the everyday definition of theft. The problem is not to find new ways to constrain this behavior, but to...
This paper proposes a theoretically based and easy-to-implement way to measure the systemic risk of financial institutions using publicly available accounting and stock market data. The measure models the credit enhancement taxpayers provide to individual banks in the Merton tradition (1974) as a combination put option for the deep tail of bank los...
This paper examines limit distributions for federal bank-examination ratings begun between 1984 and 2014. At the height of the crisis our methods show that over 90 percent of large banks were headed toward failure. In retrospect, one can see that focusing supervisory discipline on accounting net worth created incentives that drove a considerable am...
a professor of finance at Boston College and grantee at the Institute for New Economic Thinking, studies the dangerous risk-taking of giant banks. He sees the cultures of Wall Street and regulators coming together to turn taxpayers into victims of theft and great harm. Like extreme drunk drivers before MADD or smokers on airplanes prior to the 1980...
This paper applies Schein's model of organizational culture to financial firms and their prudential regulators. It identifies a series of hard-to-change cultural norms and assumptions that support go-for-broke risk-taking by megabanks that meets the everyday definition of theft. The problem is not to constrain this behavior, but to criminalize it b...
In the US, an individual or corporation can buy protection against losses from adverse events in diverse ways. Protections can be crafted in at least three economically equivalent, but legally different contractual forms: an insurance contract, a swap contract, or a contingent-claim security. Although each of these contracts is bilateral in form, t...
Shadowy Banking is safety-net arbitrage. It employs hard-to-regulate substitutes for products and activities performed straightforwardly within the traditional banking sector. The shadows obscure organizational and transactions strategies that circumvent regulatory restraints and extract subsidies by adaptive innovation. Because credit support kick...
Shadowy Banking is safety-net arbitrage. It employs hard-to-regulate substitutes for products and activities performed more straightforwardly within the traditional banking firms. The shadows obscure organizational and transactions strategies that circumvent regulatory restraints and extract subsidies by adaptive innovation. Because credit support...
This essay shows that government credit-allocation schemes generate incentive conflicts that undermine the quality of bank supervision and eventually produce banking crisis. For political reasons, most countries establish a regulatory culture that embraces three economically contradictory elements: politically directed subsidies to selected bank bo...
Too Big to Fail policies make taxpayers into disadvantaged equity investors in favored firms. Taxpayers deserve to receive dividends and disclosure rights on this equity. One way to do this would be to establish trusteeships with the right to issue treasury stock if dividends are interrupted.
Government safety nets give protected institutions an implicit subsidy and incentives to expand their risk-taking. Standard accounting statements do not record the value of this subsidy and forcing subsidized institutions to show more accounting capital will do little to curb their enhanced appetite for risk. In this paper, I propose new accounting...
US product-liability laws unwisely treat credit-rating organizations (CROs) as if they produce opinions rather than empirically-based economic research. In principle, trained professionals gather time-varying information ("financial news") and analyze it statistically to reduce it to a single dimension, allegedly for the benefit of investors, which...
Banks and governments have not been required to account for the way in which, when important firms fall deeper into distress, implicit and explicit taxpayer guarantees absorb much of the markdowns that would otherwise have to occur.
This paper proposes a theoretically sound and easy-to-implement way to measure the systemic and stand-alone risk of financial institutions using publicly available accounting and stock market data. The measure models the credit enhancement taxpayers provide to individual banks as a put option on bank assets, a tradition that originated with Merton...
It is easier for regulated institutions to circumvent the rules than for regulators to come to grips with innovative forms of circumvention. Shadowy banking covers any financial organization, product, or transaction strategy that, thanks to authorities' politically and career driven "rescue reflex," can extract subsidized guarantees from national a...
The strategies of financial stabilization embodied in the Dodd-Frank Act and Basel III ignore the efficiency and distributional issues raised by back-door bailouts. Neglecting the role of influence-driven incentive conflict in macroeconomic and financial stabilization helps regulators to avoid blame for sowing misconceptions, nontransparencies, and...
Panel participants:George Kaufman, Loyola University - ChicagoEdward Kane, Boston College & NBERChester Spatt, Carnegie Mellon University
This paper proposes a theoretically sound and easy-to-implement way to measure systemic risk of banks using publicly available accounting and stock market data. The measure models credit risk of banks as a put option on bank assets, a tradition that originated with Merton (1974). We extend his contribution by expressing the value of banking-sector...
Government officials everywhere acknowledge a responsibility for overseeing systemic risk. But before one can begin to control
a target variable (even something as straightforward as the temperature of a room), one must define the variable comprehensively
and fashion from this definition one or more verifiable metrics for monitoring the target. Off...
As officials seek to identify the events and circumstances that generated the 2007–2009 financial crisis, they are attracted
to explanations that deflect blame from themselves and the organizations they serve. The resulting array of seemingly authoritative
explanations creates forward-looking policy turbulence. Conflicts between alternative crisis...
The success of any treatment plan depends on how completely the problems it targets have been diagnosed. The precrisis bubble in securitization can be traced to incentive conflict that allows national safety nets to subsidize leveraged risk-taking. Safety-net subsidies encouraged regulation-induced innovations that enabled firms to take hard-to-mon...
This paper evaluates the redistribution of gains surrounding regulatory relaxations in 1996 and 1997 and ultimate passage of the Financial Services Modernization Act (FSMA) of 1999. Gains in financial institution stocks may come from projected increases in efficiency, increases in the bargaining power of financial institutions, or greater access to...
This paper models and estimates ex ante safety-net benefits at a sample of large banks in US and Europe during 2003-2008. Our results suggest that difficult-to-fail and unwind (DFU) banks enjoyed substantially higher ex ante benefits than other institutions. Safety-net benefits prove significantly larger for DFU firms in Europe and bailout decision...
Banks are in the business of taking calculated risks. Expanding the geographic footprint of an organization’s profit-making activities changes the geographic pattern of its exposure to loss in ways that are hard for regulators and supervisors to observe. This paper tests and confirms the hypothesis that differences in the size and character of safe...
This timely collection of papers probes into the major issues that are at the heart of our current financial market crises. The coverage of banking topics include the changing nature of intra and inter-bank markets, bank lending behavior, risk and risk-taking, the role of liquidity, return and maturity transformation issues. Issues on international...
This chapter, focuses on the adoption of an explicit deposit insurance scheme (EDIS), what factors influence safety net design, and if these same factors are able to affect risk-shifting controls as well. The chapter assumes that the crafting of a country’s financial safety net is an exercise in incomplete contracting where the counterparties are m...
To be effective, programs of regulatory reform must address the incentive conflicts that intensify financial risk-taking and undermine government insolvency detection and crisis management. Subsidies to risk taking that large institutions extract from the financial safety net encourage managers to make their firms riskier, harder to supervise, and...
This paper contributes empirically to our understanding of informed traders. It analyzes traders' characteristics in a foreign exchange electronic limit order market via anonymous trader identities. We use six indicators of informed trading in a cross-sectional multivariate approach to identify traders with high price impact. More information is co...
Banks are in the business of taking calculated risks. Expanding the geographic footprint of an organization’s profit-making activities changes the geographic pattern of its exposure to loss in ways that are hard for regulators and supervisors to observe. This paper tests and confirms the hypothesis that differences in the character of safety-net be...
Officials must understand why and how the public lost confidence in the federal government’s ability to manage financial turmoil. Officials outsourced to private parties responsibility for monitoring and policing the safety-net exposures that were bound to be generated by weaknesses in the securitization process. When the adverse consequences of th...
Assets securitized by private companies reached a peak of nearly $12 trillion in 2008, an amount nearly equal to the entire stock of credit intermediated in traditional ways by the world's banking systems. Failures of care and diligence in the origination, rating, and securitization of subprime mortgages led to a collapse in the prices of securitiz...
To realign supervisory and market incentives, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) adjusts two principal features of federal banking supervision. First, it requires regulators to examine insured institutions more frequently and makes them accountable for exercising their supervisory powers. Second, the Act empo...
This chapter explores correspondences between the costs and benefits of financial and circus safety nets. The author stresses the idea that the character of a country's net cannot be static. It must adapt promptly to changes in the market, legal, bureaucratic, and ethical problems it is intended to alleviate.
Safety nets expand over time for two re...
European Union (EU) financial safety nets are social contracts that assign uncertain benefits and burdens to taxpayers in
different member countries. To help national officials to assess their taxpayers’ exposures to loss from partner countries,
this paper develops a way to estimate how well markets and regulators in 14 of the EU-15 countries have...
The intensity of the crisis in financial markets has surprised nearly everyone. The authors search out the root causes of the crisis, distinguishing them from scapegoating explanations that have been used in policy circles to divert attention from the underlying breakdown of incentives. Incentive conflicts explain how securitization went wrong, why...
This paper traces the financial institution crisis of 2007-2008 to a breakdown in the incentives of regulators, supervisors, managers, and investors to perform adequate due diligence on securitized investments. Investors allowed their trust in the reputations of credit rating firms and the giant financial firms that manufactured highly rated tranch...
This chapter explains how deposit insurance is capable of being either explicit or implicit. The former refers to coverage that is contractual obligations, while the latter refers to coverage that is conjectural. This study, then, add some new data points to the evidence and analysis in the chapter for the purpose of providing more guided decisions...
Drawing on an original cross-country dataset on deposit insurance systems, an assessment of the impact of deposit insurance on banking outcomes and the policy implications for developing countries.
Explicit deposit insurance (DI) is widely held to be a crucial element of modern financial safety nets. For this reason, establishing a DI system is fre...
Drawing on an original cross-country dataset on deposit insurance systems, an assessment of the impact of deposit insurance on banking outcomes and the policy implications for developing countries.
Explicit deposit insurance (DI) is widely held to be a crucial element of modern financial safety nets. For this reason, establishing a DI system is fre...
Drawing on an original cross-country dataset on deposit insurance systems, an assessment of the impact of deposit insurance on banking outcomes and the policy implications for developing countries.
Explicit deposit insurance (DI) is widely held to be a crucial element of modern financial safety nets. For this reason, establishing a DI system is fre...
Regulatory change is driven by competitive struggle. Regulatees struggle with each other for customers and with regulators to lessen the burden of the rules being enforced. Regulators compete for regulatees and for the confidence of customers and the general public.
Competition among regulators is imperfect. Along with better rules, new entrants mu...
This paper identifies factors that influence decisions about a country's financial safety net, using a comprehensive data set covering 180 countries during the 1960-2003 period. Our analysis focuses on how private interest-group pressures, outside influences, and political-institutional factors affect deposit-insurance adoption and design. Controll...
The international financial crisis manifests itself in Ireland not only as a crisis of the banking system, but also as a major fiscal crisis, aggravated by years of soft revenue policy and a housing bubble that has burst spectacularly. The severe drop in economic output results in a crisis of employment and a definitive end to the ‘Celtic Tiger’ er...
This paper attempts to develop rigorous, if somewhat less than fully operational, definitions of the twin concepts of individual nation and world international liquidity. These definitions make the international liquidity of an individual country (Zi, in the case of country i) a probability-weighted sum of its foreign assets, liabilities, lines of...
In order to test the general applicability of Paretian welfare principles and to explain intermittent changes in Church regulations, this paper explores the economic implication of Roman Catholic moral philosophy. As a first step, Catholic (or Scholastic) ethical norms are incorporated into the familiar form of individual and social welfare functio...
Basel II consists of supervisory guidelines negotiated by representatives of central banks and national regulatory commissions
that were members of the Basel committee on Banking Supervision (BCBS). The BCBS is itself a regulatory response to globalization,
which is connecting national safety nets in market-driven ways. A country’s financial safety...
Financial safety nets are incomplete social contracts that assign responsibility to various economic sectors for preventing, detecting, and paying for potentially crippling losses at financial institutions. This paper uses the theories of incomplete contracts and sequential bargaining to interpret the Basel Accords as a framework for endlessly rene...
In 1986 the American Bankers Association asked five banking academics to assess and recommend policy options to improve the banking system's efficiency, performance, and safety. The report these five economists produced, Perspectives on Safe and Sound Banking: Past, Present, and Future, has in many ways served as a roadmap for ensuing bank regulato...
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail be...
Considered as a social contract, a financial safety net imposes duties and confers rights on different sectors of the economy. Within a nation, elements of incompleteness inherent in this contract generate principal-agent conflicts that are mitigated by formal agreements, norms, laws, and the principle of democratic accountability. Across nations,...
This paper studies competition among alternative regulatory bodies for authority over innovative financial contracts. In the United States, this rivalry embraces not only the Commodity Futures Trading Commission and the Securities and Exchange Commission, but state and federal deposit-institution regulators and various private regulatory cooperativ...
This paper provides a survey on studies that analyze the macroeconomic effects of intellectual property rights (IPR). The first part of this paper introduces different patent policy instruments and reviews their effects on R&D and economic growth. This part also discusses the distortionary effects and distributional consequences of IPR protection a...
