The impact of non-conventional monetary policy on banks

August 24, 2014

Non-conventional monetary policy seems to benefit banks’ balance sheets. After all, it offers cheap refinancing and credit market support. However, an empirical analysis by Lambert and Ueda casts doubt on that belief. Market measures of bank credit risk have mostly deteriorated in episodes of policy stimulus. Easy monetary policy has been encouraging risk-weighted asset accumulation and discouraging balance sheet repair.

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The Federal Reserve’s increased influence on financial markets

August 23, 2014

A new empirical study suggests that the Federal Reserve has exerted a stronger influence on fixed income, commodity, and currency markets since it started using non-conventional monetary policy. This is not because monetary policy shocks have been larger, but because their transmission has become more powerful and pervasive.

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The basic mechanics of shadow banking

August 17, 2014

Shadow banking creates liquidity outside the regulated banking system. Unlike traditional money, shadow money is constrained by the value of assets that serve as collateral. Therefore, shadow banking is vulnerable to market price declines. As shown in a new paper by Moreira and Savov, pro-cyclicality is compounded by collateral values falling more than asset prices when uncertainty is rising. This makes modern financial systems prone to collateral runs and liquidity crises.

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Japan’s war against deflation: progress and risks

August 16, 2014

More than a year after its launch, the impact of “quantitative and qualitative easing” seems pervasive. The Bank of Japan asserts that the output gap has closed, that inflation expectations have increased, and that the conquest of deflation would be in sight. The policy board has maintained its commitment to the 2% inflation target through forward guidance and large-scale JGB purchases. However, without successful fiscal consolidation and supply side reforms this policy poses new serious risks.

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A brief review of China’s vulnerabilities

August 8, 2014

The IMF’s latest staff report on China serves as a reminder of key vulnerabilities. With repressed real interest rates corporate leverage remains high and particularly so in state-owned enterprises. Shadow banking has exceeded 50% of GDP and is still growing. Economic growth and credit quality are exposed to an unbalanced real estate sector. And the augmented fiscal deficit is already close to 7.5% of GDP, due mainly to local governments’ net borrowing through financing vehicles.

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A lecture in euro area money markets

August 2, 2014

Paul Mercier, principal adviser at the ECB, has summarized the basics and recent history of euro area money markets. His tale emphasizes what investors often miss. First, the ECB balance sheet and excess liquidity are poor measures of lending conditions. Second, the great financial crisis has generated a structural rise in banks’ borrowing from the Eurosystem, over and above their liquidity needs. Third, full allotment policies in conjunction with (sub-) zero deposit rates have led to large and potentially volatile excess reserve holdings.

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Origins of financial market trends

July 27, 2014

A working paper explores sources of market price trends. It suggests that small trend changes in perceptions about “fundamentals” can set in motion a persistent adjustment in transacted prices. And even without any changes to “fundamentals” or “technicals” trends are plausible.

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Updated summary: U.S. non-conventional monetary policy

July 26, 2014

The arrival of short-term interest rates at the zero bound has changed U.S. monetary policy irrevocably. The Fed’s asset purchases have exceeded a quarter of concurrent GDP over the course of 6 years, compressing term and credit premiums by unprecedented margins, with no reversal in sight. Forward guidance has reduced market uncertainty and raised the credibility of a persistently expansionary stance. Excess stimulus and economic conditionality have become prevalent. The flipside is increased dependency of the financial system on the continuation of such accommodative conditions.

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The 1×1 of financial repression

July 12, 2014

Financial repression is a policy that channels cheap funding to governments, typically supported by accommodative monetary policy. After the global financial crisis various forms of financial repression have prevailed in most developed and many emerging countries. These policies have been effective in containing public debt but bear risks for future financial stability.

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Volatility markets: a practitioner’s view

July 6, 2014

Christopher Cole argues that volatility markets are about trading both known and unknown risks. These risks require different pricing and cause different “crashes”. Most portfolio managers either hold implicit short volatility or long volatility positions. After the great financial crisis, monetary policy has suppressed volatility, but steep volatility curves are indicating a “bull market in fear”.

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