Central bank digital currencies
13 January 2021
Erasmus and Turing
11 January 2021
Brexit and Marxism
3 January 2021
What to do about the Covid financial system bailouts?
22 December 2020
The crypto-technical response to the Covid-19 bailouts
13 December 2020
The libertarian response to the Covid-19 financial turmoil
9 December 2020
The socialist response to the Covid-19 financial turmoil
4 December 2020
On the response of the financial authorities to Covid-19
2 December 2020
The Covid-19 bailouts and the future of the capitalist banking system
26 November 2020
Which programming language is best for economic research: Julia, Matlab, Python or R?
20 August 2020
ARM on AWS for R
15 June 2020
Low vol strategies
8 May 2020
Of Julia and R
8 May 2020
How to manipulate risk forecasts 101
30 April 2020
The five principles of correct riskometer use
27 April 2020
The problem with Backtesting
25 April 2020
The magic of riskometers
24 April 2020
Risk and scientific socialism
23 April 2020
Financial crises and epidemics
19 April 2020
Hayek and Corona
17 April 2020
Hayek et Corona
17 April 2020
Ignoring the Corona analysis
15 April 2020
The coronavirus crisis is no 2008
26 March 2020
Artificial intelligence as a central banker
6 March 2020
Systemic consequences of outsourcing to the cloud
2 December 2019
The dissonance of the short and long term
12 August 2019
Central banks and reputation risk
6 August 2019
The Brexit culture war
5 May 2019
All about BoB — The Bank of England Bot
29 April 2019
My tiny, tiny contribution to Apple's fall in profits
6 January 2019
The 2018 market in a 250 year context
1 January 2019
Short and long-term risk
3 December 2018
Perceived and actual risk
2 December 2018
Cryptocurrencies: Financial stability and fairness
9 November 2018
The October 2018 stock market in a historical context
1 November 2018
The hierarchy of financial policies
12 September 2018
Which numerical computing language is best: Julia, MATLAB, Python or R?
9 July 2018
Cryptocurrencies
26 June 2018
What are risk models good for?
3 June 2018
The McNamara fallacy in financial policymaking
1 June 2018
VIX, CISS and all the political uncertainty
20 May 2018
Here be dragons
30 March 2018
Low risk as a predictor of financial crises
26 March 2018
Cryptocurrencies don't make sense
13 February 2018
Yesterday's mini crash in a historical context
6 February 2018
Artificial intelligence and the stability of markets
15 November 2017
European bank-sovereign doom loop
30 September 2017
Do the new financial regulations favour the largest banks?
27 September 2017
The ECB Systemic Risk Indicator
24 September 2017
Finance is not engineering
22 September 2017
University of Iceland seminar
14 June 2017
Brexit and systemic risk
31 May 2017
Should macroprudential policy target real estate prices?
12 May 2017
Learning from history at LQG
13 April 2017
Is Julia ready for prime time?
12 March 2017
With capital controls gone, Iceland must prioritise investing abroad
12 March 2017
Competing Brexit visions
25 February 2017
Systemic consequences of Brexit
23 February 2017
Why macropru can end up being procyclical
15 December 2016
The fatal flaw in macropru: It ignores political risk
8 December 2016
Why it doesn't make sense to hold bonds
27 June 2016
On the financial market consequences of Brexit
24 June 2016
Cyber risk as systemic risk
10 June 2016
Big Banks' Risk Does Not Compute
24 May 2016
Interview on þjóðbraut on Hringbraut
21 May 2016
Farewell CoCos
26 April 2016
Will Brexit give us the 1950s or Hong Kong?
18 April 2016
Of Brexit and regulations
16 April 2016
IMF and Iceland
12 April 2016
Stability in Iceland
7 April 2016
Everybody right, everybody wrong: Plural rationalities in macroprudential regulation
18 March 2016
Of tail risk
12 March 2016
Models and regulations and the political leadership
26 February 2016
Why do we rely so much on models when we know they can't be trusted?
25 February 2016
Does a true model exist and does it matter?
25 February 2016
The point of central banks
25 January 2016
Volatility, financial crises and Minsky's hypothesis
2 October 2015
Impact of the recent market turmoil on risk measures
28 August 2015
Iceland, Greece and political hectoring
13 August 2015
A proposed research and policy agenda for systemic risk
7 August 2015
Are asset managers systemically important?
5 August 2015
Objective function of macro-prudential regulations
24 July 2015
Risky business: Finding the balance between financial stability and risk
24 July 2015
Regulators could be responsible for next financial crash
21 July 2015
How Iceland is falling behind. On Sprengisandur
12 July 2015
Greece on Sprengisandur
12 July 2015
Why Iceland can now remove capital controls
11 June 2015
Market moves that are supposed to happen every half-decade keep happening
14 May 2015
Capital controls
12 May 2015
What do ES and VaR say about the tails
25 April 2015
Why risk is hard to measure
25 April 2015
Post-Crisis banking regulation: Evolution of economic thinking as it happened on Vox
2 March 2015
The Danish FX event
24 February 2015
On the Swiss FX shock
24 February 2015
Europe's proposed capital markets union
23 February 2015
What the Swiss FX shock says about risk models
18 January 2015
Model risk: Risk measures when models may be wrong
8 June 2014
The new market-risk regulations
28 November 2013
Solvency II: Three principles to respect
21 October 2013
Political challenges of the macroprudential agenda
6 September 2013
Iceland's post-Crisis economy: A myth or a miracle?
21 May 2013
The capital controls in Cyprus and the Icelandic experience
28 March 2013
Towards a more procyclical financial system
6 March 2013
Europe's pre-Eurozone debt crisis: Faroe Islands in the 1990s
11 September 2012
Countercyclical regulation in Solvency II: Merits and flaws
23 June 2012
The Greek crisis: When political desire triumphs economic reality
2 March 2012
Iceland and the IMF: Why the capital controls are entirely wrong
14 November 2011
Iceland: Was the IMF programme successful?
27 October 2011
How not to resolve a banking crisis: Learning from Iceland's mistakes
26 October 2011
Capital, politics and bank weaknesses
27 June 2011
The appropriate use of risk models: Part II
17 June 2011
The appropriate use of risk models: Part I
16 June 2011
Lessons from the Icesave rejection
27 April 2011
A prudential regulatory issue at the heart of Solvency II
31 March 2011
Valuing insurers' liabilities during crises: What EU policymakers should not do
18 March 2011
Risk and crises: How the models failed and are failing
18 February 2011
The saga of Icesave: A new CEPR Policy Insight
26 January 2010
Iceland applies for EU membership, the outcome is uncertain
21 July 2009
Bonus incensed
25 May 2009
Not so fast! There's no reason to regulate everything
25 March 2009
Modelling financial turmoil through endogenous risk
11 March 2009
Financial regulation built on sand: The myth of the riskometer
1 March 2009
Government failures in Iceland: Entranced by banking
9 February 2009
How bad could the crisis get? Lessons from Iceland
12 November 2008
Regulation and financial models: Complexity kills
29 September 2008
Blame the models
8 May 2008

On the response of the financial authorities to Covid-19

2 December 2020

The financial authorities have just bailed the financial system out for the second time in a decade. While the authorities are proud of having prevented a financial crisis, are we really better off? No, one cannot judge the policy intervention a success if it is only due to the promise of the intervention that the problem arose in the first place.

I just finished a piece on The Covid-19 bailouts and the future of the capitalist banking system, promising at the end to come up with some solutions. There are five alternatives: the official one discussed below, and four to come: socialism, laissez-faire, the crypto-technical and finally my take.

Central bank liquidity interventions saved us from a Covid-19 financial crisis, so, judged by that alone, the authorities did a great job. They certainly are proud, as you can read in the financial stability board’s (FSB) Holistic overview.

What happened in March and April was a bailout, not of any individual financial institution, but of the financial system. Government money and guarantees ensured the markets remained liquid, and privately owned financial institutions benefited mightily. In my book a bailout.

In the words of Neel Kashkari, the president of the Minneapolis Fed

I don’t know what the best policy solution is, but I know we can’t just keep doing what we’ve been doing, … As soon as there’s a risk that hits, everybody flees and the Federal Reserve has to step in and bail out that market, and that’s crazy. And we need to take a hard look at that.”

I am not against bailouts, per se, and don’t object, in principle, to the financial authorities calming the financial markets when they are heading for a disastrous financial crisis. As I will argue later, a key purpose of central banks is to help the financial system operate at higher levels of risk than it otherwise could do.

But it matters a great deal how it is done.

To start with, what objectives should the financial authorities have?

A common view is that of Olivier Blanchard, then the Chief Economist at IMF, back in 2009:

“Crises feed uncertainty. And uncertainty affects behaviour, which feeds the crisis.[…] So what are policymakers to do? First and foremost, reduce uncertainty.”

Precisely what the financial authorities did in 2020. It all sounds sensible, pouring oil on troubles waters. But, while seemingly laudable, the calming raises questions.

There is a crucial distinction between stabilising the financial system and protecting banks from the consequences of their actions, a point made by Bagehot back in 1873. In his principles of lending a last resort, as a response to a crisis:

  1. The central bank should lend freely;
  2. At a high rate of interest;
  3. On good banking securities.

In other words, the central bank has to respond and calm the markets, but in the process should not give the private sector a free ride. If a bailout is needed, the financial institutions should pay for it. And that is the crucial difference between the 2020 bailouts and Bagehot.

The bailouts Bagehot discussed were designed to help financial institutions monetise their temporarily illiquid assets, and the Bank of England knew exactly who got help and at what terms, allowing the bank to price the bailouts.

The most powerful interventions in 2020 were the Federal Reserve’s US dollar swap lines. Foreign creditors have access to dollar liquidity via their central banks, just like they already get in their own currencies.

It’s a broad intervention, benefiting the entire market, including those individual institutions who did not partake. It is impossible to apply Bagehot’s rules to FX swap lines since we cannot easily identify the beneficiaries, (the direct beneficiaries typically pay a small fee) and hence price them correctly.

However, the reason the swap lines were needed is because they exist.

If the central banks promise to provide liquidity when is market turmoil, of course the private banks will take full advantage. The effectiveness of the interventions does not prove they were needed, except, if one only does static analysis.

And, the ultimate reason for disregarding Bagehot’s advice is that the cost of not doing anything is higher than the cost of intervention. We don’t have to price the bailouts, they already pay for themselves. Correct, but only if one looks at the 2020 turmoil in isolation, disregarding how we got there, and what it heralds.

So what is the problem with the liquidity bailouts in 2020?

The the holistic FSB document, which analysis is static, is only looking at the crisis in isolation and disregarding the long-term consequences. The policy view expressed is:

  1. There was excessive market turmoil;
  2. We as authorities have to provide liquidity to calm the markets, but we really don’t want to;
  3. And afterwards regulate the parts of the system that needed liquidity to prevent a recurrence.

That analysis raises four issues: Two philosophical and two practical.

The economic profession went off the rails in the 1950s and 1960s, after John Maynard Keynes passed and before the pathbreaking work of Robert Lucas. The prevailing view in these lost years was that one could model and control the economy in a static framework. Achieve policy objectives — high growth, low unemployment, low inflation — by just tweaking the parameters of a static model. The financial authorities and the governments loved it. This way of doing economics made them feel powerful, even omnipotent.

Except, just like the other idiocies of the economic policy of the era, such as industrial policy, it didn’t work. The Lucas critique showed us why. Expectations matter and economic agents react to policies in a way that undermines the policy objective. All we got was the word of the 1970s stagflation — inflation and stagnation.

Industrial policy is now coming back, and so is static economic policymaking via the doctrine of macroprudential regulations.

What undermines the static approach is crystallised in the difference between 2008 and 2020. In 2008, it was mostly banks that were affected, so over the subsequent decade, we sharply increased the level of regulations. And they worked so well that when the next liquidity crisis came along, the banks did OK, but now the risk had spilled over to the shadow banking sector.

You see, the economic agents that comprise the financial system do not take regulations lying down, they react to them, changing the financial system in the process. Once the regulations take effect, they apply to a system that no longer exists.

The Lucas critique.

In the ensuing cat and mouse game, the private sector financial institutions have the advantage.

The second philosophical problem is a fallacy of composition. Even if we manage to make every financial institution prudent, that does not mean the system is safe. The reason is shock absorption. If some shock comes along, a prudent financial institution has to react, selling its risky assets to stay within its prudential constraints. But, because every financial institution is prudent, there is nobody to buy, so we end up with a vicious feedback spreading to ever more assets and asset classes, even causing a financial crisis.

And now I get to one of the practical problems, procyclicality. The other is moral hazard, but as I discussed that in the last piece, I won’t repeat it here.

The most potent force of financial stability is diversity. The more financial institutions see the world differently and react differently, the more stable the system is. If I react to a shock by buying and my buddy Bob by selling, our reaction in aggregate is random noise.

Why Baron Rothschild was so prescient when he wrote two and half centuries ago that the best time to buy property was in the middle of a Civil War. We need the Baron Rothschilds, today the Soros’ and Buffetts’, someone who can buy in crises unhindered by constraints, someone who sees an opportunity in turmoil. For such individuals and entities to exist, they cannot be regulated, and have to be able to invest in the way they see best, unencumbered by anybody else’s views.

Procyclicality is driven by financial institutions having the same beliefs and action. If they see the world in the same way and are compelled to react to it in the same way, financial institutions behave as a crowd — they are procyclical.

The most powerful force of homogeneous beliefs and actions is those financial regulations that force banks to model risk with similar methodologies and mandate particular reactions to that risk. The main driver of those regulations is the Basel Committee, the progenitor of the Basel Accords.

It is, however, the holistic FSB document that is most interesting when it comes to the 2020 turmoil. The FSB makes two points. First, that the official response to the Covid-19 liquidity turmoil was correct. And the second, that those financial institutions that are not banks — shadow banks — should be brought under the same regulatory umbrella as the banks, the idea being that since the banks came out of the Covid-19 shock relatively unscathed, the bank regulations worked well and should be applied to the rest of the system.

I think both points are incorrect.

The financial institutions will be strengthened in the belief that the authorities are ready to step in to bail them out in times of market turmoil, and the beliefs and actions of financial institutions will be harmonised, reducing diversity and increasing procyclicality. Both will increase systemic risk and destabilise the financial system.

When the next crisis comes along, the forces of monoculture and regulations will be even stronger, calling into question the need for the private sector financial system, the topic of my next piece.


Roadmap

Thanks

Several friends and colleagues have commented on this series. Robert Macrae and Nikola Tchouparov gave me excellent comments that significantly improved the pieces. We don’t always, or even usually, agree, and all opinions are mine alone.

© All rights reserved, Jon Danielsson, 2021