Hagendorff and Vallascas argue that the risk weights used to calculate banks’ capital adequacy fall significantly short of true portfolio risks. Capital arbitrage may have undermined Basel II capital regulation and could do the same for Basel III in the future.
Sovereign wealth funds now hold assets worth roughly 4% of global GDP, and are governed by politically-mandated investment objectives. A new IMF paper gives an overview of size, types, investments and governance structures of these institutions.
A new NBER paper reminds us of historical episodes when loose monetary policy contributed to asset price booms and busts. The paper also provides econometric evidence that low policy rates usually support asset prices. This history may not dissuade central banks from running highly accommodative policies at present, but explains the importance of accompanying macro-prudential measures.
From 2015 banks will have to satisfy new liquidity standards. Of particular importance is the liquidity coverage ratio, which requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress. This will complicate the conduct of monetary policy and affect short-term yield curves, which will probably price some regulatory term premium.
Ricardo Caballero and Emmanuel Farhi from MIT and Harvard propose an interesting and relevant formal model of safe asset shortage. While safe asset supply is constrained by the fiscal capacity of sovereigns and financial innovation, demand may be in a secular ascent (driven for example by collateralization and population aging). The resulting shortfall can result in a structural drag on economic growth and impair the effectiveness of fiscal and monetary policies, with some resemblance to the Keynesian liquidity trap.
Even in a huge market like U.S. fixed income, dealer balance sheet management these days can impair liquidity. New Federal Reserve research suggests that during the 2013 treasury sell-off dealers reduced their own positions rather than absorbing client flows and decided to limit their market making.
A DB paper suggests that the rising median age of the world’s population will increase savings ratios. The trend is reinforced by macro policies aimed at generating external surpluses or at least restraining deficits. The onus of absorbing the resulting savings glut may fall on the United States, which issues the world’s anchor currency. Irrespective of whether it accepts that role, cost of capital for the world as a whole is likely to be compressed by the savings glut.
Capital regulation reform could lead to excessive bank asset encumbrance and distortions in funding markets, as unsecured institutional creditors face an increased risk of statutory bail-in. Excessive asset encumbrance could undermine a bank’s resolution in distress. Rising costs of unsecured bank debt could lower its share below what is required for loss absorption.
Another Federal Reserve paper on shadow banking emphasizes its systemic risks. In particular, shadow banking seems to have a tendency to accumulate tail risks, relies on fragile funding conditions (without official backstop), and is subject to pronounced pro-cyclicality. Shadow banking activity is tied to core regulated institutions and, hence, is a valid concern for broad financial stability.
The OTC derivatives reform is nearing completion. It is designed to contain derivatives-related credit and contagion risk through standardization, multilateral netting, and adequate collateralization. However, new risks may arise, due to the enhanced importance of a small group of global banks, institutional weaknesses of central counterparties, limited collateral availability, and cyclicality of margins,
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