The Big Picture

Too-Big-to-Fail: The Role of Metrics
10 Tuesday PM Reads
Has the Dollar Really Lost 97% of Its Value? (No)
10 Tuesday AM Reads
Kiron Sarkar: Summarizing Developments
The Bubble in Bubbles

Posted: 20 Nov 2013 02:00 AM PST

Too-Big-to-Fail: The Role of Metrics
Narayana Kocherlakota – President
Federal Reserve Bank of Minneapolis, November 18, 2013

Thanks for the introduction, Ron. It's a great pleasure to address all of you tonight. First off, let me say welcome to the Minneapolis Fed. I see this workshop as being one more step on an important intellectual journey for the Federal Reserve Bank of Minneapolis. That journey has been going on for many years—long before I became president of the Bank in 2009. As most of you know, my head of supervision, Ron Feldman, and my predecessor, Gary Stern, literally wrote the book on too-big-to-fail nearly 10 years ago.¹ Like many others—and for the good of the country—I hope that our too-big-to-fail journey is complete before another decade passes. The work that all of you are doing is critical to making that hope a reality.

My theme tonight is that metrics should play a key role in the regulation and management of the too-big-to-fail (TBTF) problem. I will proceed in three steps. I'll first define what I see as the TBTF problem. As you will hear, I see the TBTF problem as being about a particular kind of misallocation of resources—more specifically, excessively risky investments that are incented by the prospect of governmental absorption of losses that would otherwise be endured by creditors of financial institutions. Here, I want to emphasize the word "prospect." In my formulation of the TBTF problem, it's the expectation of government transfers that creates the problematic distortion, not the realization of those transfers.

I'll next turn to why I see metrics as being essential to the management of the TBTF problem. Without metrics, policymakers—and the public they serve—can have no true insight into the effectiveness of the current management of the problem. As this group well knows, any given measure of the size of the TBTF problem is imperfect. But I will argue that the imperfection of any single measure implies that policymakers should track progress using many measures, not ignore all of them.

Finally, I'll talk about two aspects of the use of metrics in the management of the TBTF problem: why it is important to use measures besides size and why it may be important to assess the robustness of TBTF measures to certain kinds of shocks.

My remarks today reflect my own views, and are not necessarily those of others in the Federal Reserve System.

Defining the TBTF Problem

Let me start, then, by defining what I mean by the TBTF problem. I use this term to refer to a type of inefficiency in the allocation of societal resources. In particular, I'm referring to the excessively risky investments that are incented when creditors of a financial institution believe that there is some likelihood that at least some of their losses will be absorbed by the government.

I know that the nature of this inefficiency is familiar to all of you in this room, but let me talk through it more carefully. Imagine first that creditors did not anticipate any form of governmental loss absorption. Then, if a financial institution decided to increase the risk level of its investment portfolio, its debt holders would face a greater risk of loss. By way of compensation for that greater risk, they'd demand a higher yield. As a result, in the absence of government guarantees, financial institutions would find it more costly to obtain debt financing for highly risky investments than for less risky ones. This effect, on the margin, would curb a firm's appetite for risk.

But now suppose instead that a financial institution's creditors believe that they are partially insulated from losses. Then, those creditors do not demand a sufficiently high yield when they lend to riskier institutions. Financial institutions take on too much risk, because they are no longer deterred from doing so by the high cost of debt finance.

There are two particular aspects of this definition that are worth noting. First, it is an ex ante definition—I'm not referring to the ex post manifestation of governmental loss absorption in the form of transfers or bailouts. In my formulation, the damage to society through the misallocation of resources has already occurred by the time the government actually makes transfers or undertakes bailouts. To be clear—like many other observers, I do find it troubling when governments use funds from relatively poor taxpayers to protect relatively rich bank bondholders from losses. But I'm not using the term TBTF problem to refer to concerns about this kind of redistribution.

Second, the definition emphasizes the role of creditor beliefs about prospective governmental transfers. The beliefs of other parties are much less relevant. For example, to the management or board of directors of a given financial institution, the TBTF problem simply means that their costs of debt finance are relatively unaffected by the amount of risk in their firm's investment portfolio.

The Need to Use Metrics

As I've defined it, the TBTF problem involves a misallocation of resources. At the direction of legislators, bank regulators and bank supervisors have taken a variety of steps intended to reduce or end this misallocation. As a result, the public knows that large financial institutions have more and better capital than they did five years ago. As well, the public also knows that these institutions have constructed lengthy plans—so-called living wills—that describe their strategies for rapid and orderly resolution in the event of material financial distress or failure.

What the public does not know is whether the adoption of these steps has been associated with a material change in the size of the TBTF problem. My main theme tonight is that policymakers can only identify and document progress in the reduction of the TBTF problem by using measures of the magnitude of the TBTF problem.

The good news is that it is clear what we want to measure. The heart of the TBTF problem is that some financial institutions are able to borrow too cheaply in light of the risks in their investment portfolios. What we need to measure, then, is the size of that subsidy to debt finance. Of course, as this group well knows, that conceptual formulation of the problem only gets us so far. Actually constructing reliable measures of this subsidy has a number of challenges—and that's why this workshop is important.

Admittedly, at this point in time—and probably for some time to come—every measure has to be seen as imperfect. Some might conclude from these imperfections that it would be inappropriate to track progress with respect to TBTF using any of these measures. I cannot emphasize how wrong I believe this conclusion to be. Rather than using no measures, policymakers should be tracking all measures that are viewed as being at least somewhat informative about the size of the subsidy.

Here, I find an analogy from the monetary policy part of my job to be helpful. The Federal Open Market Committee is charged by Congress with promoting price stability and maximum employment. There are relatively uncontroversial metrics that we can use to track progress on the former objective. But it is not as obvious how we should track progress with respect to the latter objective. Every possible metric—be it the unemployment rate or the employment-population ratio—has its own flaws.

But the response of the FOMC is hardly to abandon metrics altogether. Instead, monetary policymakers track labor market performance using a large number of measures. For example, in a speech earlier this month, the president of the St. Louis Federal Reserve, James Bullard, depicted recent labor market improvement along a variety of dimensions using an elegant spider chart.² I could well see similar charts as being useful in providing the public with assessments of the size of the TBTF problem for a given financial institution.

Two Comments

Let me close by offering two comments about TBTF metrics.

The first comment is again aimed more at people outside this room than inside it. Some observers are drawn to using the size of a financial institution as a sufficient statistic for the magnitude of the TBTF problem associated with that institution. After all, it's called the too-big-to-fail problem! This kind of approach would suggest that society can best manage the too-big-to-fail problem by capping the size of financial institutions.

I do agree with these observers that the size of a financial institution is likely to be a useful source of information about the magnitude of that institution's TBTF problem. At the same time, though, policymakers should guard against relying too much on this single metric. We should always keep in mind that the term too-big-to-fail is highly misleading. The TBTF problem is about creditor perceptions of loss protection. Creditors might well see the smaller of two institutions as being more likely to receive that protection, if the smaller institution is engaged in some kind of activity that is seen by government agencies as being especially vital. Thus, if we go back to 2008, government funds were used to facilitate the purchase of Bear Stearns by JP Morgan Chase. No such government funds were made available to facilitate the resolution of Lehman—and Lehman was certainly larger than Bear Stearns.

The second comment is about the need to assess the robustness of TBTF measures to particular kinds of shocks. I defined the TBTF problem in terms of the subsidy to debt finance created by the possibility of governmental loss absorption. Certainly, policymakers can only claim success with respect to the TBTF problem if the current measures of that subsidy are low.

However, they may want to accomplish more. The TBTF subsidy to a financial institution is generated by its creditors' perceptions of government loss absorption. The subsidy will be worth little if creditors believe that the institution's assets have little risk, so that it is highly unlikely that the institution will ever incur losses for the government to absorb. It may be prudent for supervisors and regulators to also check that the subsidy remains small if creditors begin to perceive the institution's asset risk as materially larger. I see such robustness checks as being challenging to implement with existing TBTF metrics.

Conclusions

Let me wrap up by returning to my main theme: the need to use metrics in the management of the TBTF problem, however imperfect those metrics might be.

Basically, the issue comes down to accountability. Again, I find a monetary policy analogy to be helpful. As monetary policymakers, my colleagues on the FOMC and I are accountable for keeping the economy at maximum employment. We are well aware that we need metrics to demonstrate that we are making progress with respect to that responsibility. No one metric is perfect—and so we refer to a wide variety of somewhat informative measures. And the Federal Reserve System spends a great deal of time trying to develop other—again imperfect—measures to supplement those that we already have.

I see the TBTF problem as highly similar. Supervisors and regulators have been made accountable by Congress for ending the TBTF problem. They need to be able to demonstrate clear progress to the public with respect to that responsibility. They can only do so using the metrics in this workshop and metrics that will be developed in workshops still to come.

Thanks to all of you for listening and for coming to Minneapolis.

~~~

PDF version

Narayana Kocherlakota

Note

* I thank David Fettig, Terry Fitzgerald, and Ron Feldman for their help in preparing these remarks.

Endnotes

1 Stern, Gary H., and Ron J. Feldman. 2004. Too Big to Fail: The Hazards of Bank Bailouts. Brookings Institution Press.

2 Bullard, James. 2013. "The Tapering Debate: Data and Tools." Presentation at Financial Forum, St. Louis Regional Chamber, St. Louis, Mo., Nov. 1. Slide 13.

10 Tuesday PM Reads

Posted: 19 Nov 2013 01:30 PM PST

My afternoon train reading:

• Here Are Some Issues With That Report About How The Unemployment Rate Was Faked Before The 2012 Election (Business Insider)
• What will you spend in retirement? (Fidelity)
• Why you need a healthy amount of uncertainty in an economy (Quartz)
• Lars Peter Hansen, the Nobel Laureate in the Middle (NY Times)
• Mauboussin: On Complex Adaptive Systems (Compounding My Interests)
• Supply and Demand: A Market Analysis of Chicago’s Heroin Trade, and its Residual Criminal Aspects, Written by a Junkie (New City)
• U.S. Inequality in Six Charts (New Yorker)
• Bartlett: Medicare Part D: Republican Budget-Busting (Economix)
• Here's what's wrong with Rand Paul's 'Audit the Fed' bill (Washington Post)
• NASA spin-off technologies (Wikipedia

What are you reading?

U.S. REITs Are On Sale

Source: BCA

Has the Dollar Really Lost 97% of Its Value? (No)

Posted: 19 Nov 2013 10:30 AM PST

One of the favorite tropes of the "End the Fed" crowd is the "falling purchasing power of the U.S. dollar." Google that phrase, and you will be rewarded with 91,100,000 results. (drop the "U.S." and it doubles to 187,000,000 results).

The problem is, nearly all of these arguments are wrong.

As Matt Busigin of Macrofugue points out (echoed by Joe Wiesenthal of Business Insider), measuring the buying power of cash by functionally burying it in Mason Jars in the backyard is a misleading and inappropriate metric.

Continued here

10 Tuesday AM Reads

Posted: 19 Nov 2013 07:15 AM PST

Good Tuesday morning:

• Alan Greenspan: Why I Never Saw It Coming (Foreign Affairs)
• Benefits of Studying Insiders' Trading Patterns (WSJ)
• 4 Reasons Japan Could Continue to be the Land of the Rising Stock Market (BlackRock)

Continues here

Kiron Sarkar: Summarizing Developments

Posted: 19 Nov 2013 06:30 AM PST

Summarised below are some of the key events last week.

• Mrs Yellen confirmed her dovish bias during the course of her testimony ahead of her appointment as Chairperson of the FED - which looks very likely. She stressed that "labour markets and the economy (are) performing short of their potential", adding that unemployment "was still too high". Furthermore, she added that "It's important not to remove support when the recovery is fragile". In the Q&A's she suggested that the true level of unemployment in the US was likely over 10%, as opposed to the 7.3% rate in the Octobers non farm payroll (NFP) report. She added that inflation was below the FED's threshold of 2.0% and implied that she did not see inflation as a threat at present. In addition, she stated that she did not see any bubbles forming. Essentially, she stuck to the Bernanke script. Her general tone was dovish, especially in the Q&A's, which suggests that she will be in no hurry to start the tapering process early, preferring to see the US recovery further embedded before the FED tightens monetary policy. The markets took her remarks positively and rose, with the DOW and the S&P closing at record highs. As long as she can persuade her colleagues, I continue to believe that tapering will not start before March of next year – indeed, there is an outside chance that it may be delayed even further. The November NFP report will be scrutinised very carefully.

• Japanese Q3 GDP declined to +1.9% on an annualised basis, down from +3.8% in Q2, mainly due to a widening trade deficit, together with lower capital expenditure. Consumption was also relatively weak – Japanese companies have not increased salaries and wages, which suggests that consumption will weaken further as inflation rises due to the weakening Yen. The value of exports were higher, but in volume terms, marginally lower. The Yen declined to over 100 against the US$ and importantly, over 135 against the Euro. Mr Kuroda defined the 2.0% inflation target as a "sustainable target", which suggests that the BoJ may well ramp up its bond buying programme. If inflation rises to 2.0%, how can 10 year Japanese bonds yield just 0.62%, as they do at present. Yes, the majority of Japanese bonds are owned by the Japanese, but will they continue to buy bonds which yield well below prevailing inflation – I doubt it. That suggests that the BoJ will be the only major buyer of government bonds. It is clear that the BoJ is pressing for a weaker Yen, combined with much higher inflation, to reduce the level of accumulated debt. However, the Japanese government has not pursued the structural changes that are necessary to revitalise its economy. As we all know, Japan’s fiscal position is dire. The only conclusion that I can draw is that the BoJ is set to monetise Japanese debt. However, will other countries sit back and watch the Yen depreciate materially. I very much doubt it. Clearly, the Nikkei is responding positively to the weaker Yen, though investors will have to hedge against the currency depreciation. I expect the Yen will weaken further. I have been a sceptic of "Abenomics" and remain so. Furthermore, I believe that a number of countries will begin to criticise the policy to devalue the Yen. The issue of competitive devaluations looks set to return.

• The Chinese official news agency released details of the policy objectives agreed by the Party at their recent meeting. Generally, they included a number of reforms that are welcome and, indeed, necessary to rebalance the Chinese economy by encouraging domestic consumption, whilst relying less on fixed asset expenditure. The 1 child policy is to be loosed somewhat. There was some relaxation of the Hukou system which limits internal migration. SOE's are to give up more of their profits to build social infrastructure. There was also a reference to property taxes and the ability of the rural community to have more property rights. In addition, the PBoC is to deepen the reforms and open up the financial sector. Currency convertibility was mentioned. The key message was that China would allow markets a more "decisive" role in allocating resources. The main issue, however, is whether these broad principles will be translated into actual policy, accompanied by the necessary legislation. A number of the proposals will not benefit a number of powerful vested interests and I would expect a tendency to water down such reforms. In addition, the actual policies/legislation will take quite a long time to finalise – it looks as if a 2020 deadline has been set. Interestingly, defence related stocks rose materially following statements that China would increase its military expenditure. Politically, Mr Xi looks as if he will head up a National Security Commission, which is important as the Communist Party relies on the armed forces for its support.

• The EuroZone's Q3 GDP came in at just +0.1%, lower than the +0.3% in Q2. French Q3 GDP declined by -0.1%, whilst Italy extended its recession. German Q3 GDP came in at +0.3% Q/Q, in line with expectations, though below the +0.7% in Q2. The EU has warned a number of countries that the may well fail the debt and deficit rules, including France and Spain. Recently, a number of countries have not focused as rigidly as is required to meet such rules and I suspect that this trend will continue. Further austerity is going to be a very hard sell. The market largely ignored the poor French data, but I continue to be highly concerned about the country. President Hollande just does not seem to have taken the action necessary and I have no confidence that he will. The disinflationary trends in the EZ appear to be continuing, which will pose a major problem, given the level of debt in a number of EZ countries. Inflation is just +0.7%, with the likelihood that it will decline further in coming months. Indeed, a number of EZ countries are actually suffering from deflation. On a more positive note, Ireland and Spain announced that they would exit the bailout programme. The EZ is bumbling along with very low and/or negative growth. It is hard to see how growth will pick up – the risks are to the downside. The disinflationary forces in the EZ are truly worrying – I suspect that the ECB will be forced to act. Its mandate is to keep inflation below, but close to 2.0%, which suggests to me that it has flexibility if it wants to, especially with a current inflation rate of just +0.7%.

• Negotiations over the establishment of the Single Resolution Mechanism in the EU to deal with undercapitalised banks failed to reach a conclusion. The Germans rejected the idea of using the ESM (in effect they have a veto), as proposed by the a number of countries, including France and Spain. They suggest a fund be set up, which would be financed by levies on the banks and that rules relating to bail ins by creditors and depositors be brought forward. In addition, the Germans do not want the European Commision to be the arbiter of the rules governing the Single Resolution Mechanism – they suggest it should be Council of the European Union, which is made up of representatives of EU countries. The ECB, which takes over EZ financial supervision has stressed that there is a need for a "strong and independent" European resolution mechanism, which clearly must be right. However, will that be the case?. The EU has set a year end deadline to reach an agreement on this matter, which looks unlikely, especially if it is to be meaningful. A number of fudges are already evident. Some 5 years into the financial crisis, the EZ has failed to resolve the problems of a number of its banks. This issue will become much more important in the coming year, especially as the ECB is to conclude its assessment/stress tests of the largest banks by November next year. It is expected that some banks will fail the stress tests. The big question remains – who will provide the backstop in case the private sector does not come up with the necessary capital to recapitalise those banks which fail the stress tests. You could argue that the ECB's actions will force the politicians to act, though the relevant banks will have to accept a pretty tough deal. As a result, EZ banks are reducing their balance sheets to try and meet the more stringent ECB capital rules, which will hurt their economies. A number of EZ financials have underperformed, given the current situation, a trend I expect will continue.

• UK inflation, which historically has been higher than a number of EZ countries, declined to +2.2% in October, below the +2.7% in September. The Bank of England's (BoE) quarterly report also suggested that unemployment was declining faster that had been thought previously. Indeed, the report suggests that there is a 50/50 chance that unemployment will decline to the BoE's 7.0% threshold by Q4 2014. I have no doubt that if this threshold is met, the BoE will reduce its unemployment threshold to 6.5% or possibly even lower. I cannot see the BoE in any hurry to raise rates and/or to strengthen Sterling.
Overview

Mrs Yellens remarks suggest that she will be in no hurry to start tapering, so long as she can persuade her colleagues. As a result, markets continue to drift higher, with the Dow, S&P and Nasdaq set to rise above 16,000, 1,800 and 4,000 respectively, which should physiologically help the markets. EM's did sell off following the October NFP report, which resulted in fears of an earlier tapering, though the thought of more liquidity following Mrs Yellens comments, has helped these markets. The economic situation in Russia looks as if its deteriorating, with Brazil and South Africa facing weakness as well. The reform plans announced by China are meaningful and will ultimately benefit the economy – the issue is whether they will be implemented as proposed and when. I remain unconvinced as to "Abenomics", in particular as the Japanese have not pursued the structural and labour reforms that they so desperately need. The policy seems to be to increase inflation and weaken the Yen.

I remain deeply concerned about Europe – the EZ economy looks as if it is stalling or indeed worse. Politically, I just cannot see EZ politicians getting their act together, let alone agreeing on policies to stimulate growth. Germany is still to form a coalition government. The economic situation in France looks dire.

Subject to geopolitical risks, there are some signs that Brent will decline. WTI is declining, given increased US supply. Clearly lower oil prices will benefit the global economy. A deal with Iran looks more likely, though President Obama confirmed that it would not involve the lifting of oil sanctions, at least initially.

Whilst I continue to believe that the liquidity based rally will continue, given the positive momentum and the lack of alternatives, I believe that risk is rising. The global economy seems to be weakening. Cisco suggested weakness in the global economy, though did not affect markets generally. The recent performance of tech IPO's looks as if investors are buying the relevant equities more in hope rather than on a realistic valuation. It is difficult to time markets and, given the recent performance, shorting markets looks premature. However, investors seem to be becoming complacent, which can be seen from the VIX, which is trading at very low levels – currently around 12. The positive view for equities is that the major central banks are unlikely to tighten monetary policy anytime soon, which I believe will be the case, combined with a lack of alternatives. However, equities are no longer cheap, with sell side analysts stating that they are fairly valued. Next years earnings outlook looks unimpressive. Following the major rally this year, how much more upside is there? Personally, I believe that it is time to start to look at wealth preservation, by buying downside protection and de risking equity portfolios. Markets just appear far too complacent at present.

I continue to believe in a stronger US$, particularly in the medium to longer term. The US$ has appreciated against other currencies, though the Euro has not weakened by as much as I had thought – indeed, in recent days its has rallied from its lows. Most countries, including the US, Japan, UK and even Switzerland have taken measures to devalue their currencies. However, the EZ has not. Can this last, given the disinflationary forces in Europe – I very much doubt it. I suspect that even German manufacturers are beginning to feel the pain of the Euro strength. It is deemed difficult for the ECB to go for outright QE, but Draghi has proved to be far more market savvy than his predecessor and, whilst the ECB is likely to cut its main refi rate further and announce a further LTRO, these measures will prove to be insufficient. As a result, at some stage, I believe that the ECB may have no choice but to pursue QE – clearly positive for markets. Furthermore, EZ banks have to be fixed. Without that I just can’t see how Europe recovers. All of this suggests to me that volatility will increase.

Kiron Sarkar
17th November 2013

The Bubble in Bubbles

Posted: 19 Nov 2013 05:00 AM PST

Source: Barron’s

If you have been paying any kind of attention to the mainstream media the past few years, you may have noticed quite a bit of bubble chatter. We have a tech IPO bubble and a stock bubble and of course a bond bubble. This is caused by a global central bank QE bubble. We had an Apple bubble, we had a fraud bubble, we had a derivatives bubble and a subprime bubble. Silicon Valley is having a start up bubble, and parts of south Florida and Manhattan are having mini real estate bubbles. The gold and oil bubble came and went. The cover of Barron's this weekend was literally a bubble – the second such bubble cover in two years.

We have had so many bubbles that, as I first addressed in 2011, we are having a "bubble in bubbles."

What say we step back and put this into a bit of context?