How Did We Get Here and Does the Financial Crisis Suggest the Need for Structural Reforms?

How Did We Get Here and Does the Financial Crisis Suggest the Need for Structural Reforms Dr. Robert A Eisenbeis Fourth Annual Rocky Mountain Economic Summit and Retreat Friday, July 27, 2012 Jackson Hole, WY

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Problems Exposed • Questions have arisen about the effectiveness and efficacy of low interest rates policies, unconventional monetary policy interventions and efforts to affect the slope of the yield curve.

• How did we get to this point?

• What if any role has financial structure played in affecting the efficacy of policy?

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Large complex financial institutions relied heavily upon short term funding to carry longer term assets. The decline in housing prices set off severe financial distress in early 2007 resulted in spreads widening that accelerated in the fall of 2007

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The asset-backed CP Market Declined 50% from $1.2 Trillion to $700 B in Fall 2008

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Financial CP Declined at Start of Phase II and Non-Financial Declined at Start of Phase III

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Phase I. Was Treated from a Policy Perspective as a Traditional Liquidity Problem

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The Fed Creates a Number of Programs to Provide Funds to Primary Dealers

Phase 1.

Phase 2.

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Fed Switched Mode From Supporting Individual Institutions to Supporting Markets and Providing Liquidity

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The Cause Was Housing Price Decline

• That lack of access over the period of 2007-2009, combined with losses, resulted in the failures or disappearance of several primary dealers including • Countrywide • Bear Sterns-acquired by JPMorgan Chase • Lehman Brothers - failed • Merrill-Lynch-acquired by Merrill-Lynch • Freddie and Fannie went into conservatorship, Wamu was merged into JPMorgan Chase and AIG was rescued Florida Office One Sarasota Tower 2 N. Tamiami Trail, Suite 303 Sarasota, FL 34236

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Rates and Spreads Settled Down in 2009

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Bank Lending Declined and Excess Reserves Increased-

Did Financial Structure Play a Role in Blunting the Effectiveness of Monetary Policy

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But Real GDP Growth Has Been Dismal

• Real GDP Averaged 1.5% Q1-2009 • 1.8% Last 6 quarters • Unemployment has come down but still stands at 8.2% • Despite the huge injection of liquidity and reserves, bank lending hasn’t picked up to support the expansion

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The crisis exposed two critical and as yet unresolved problems

• When the primary dealers experience financial distress monetary policy can be frustrated • When the critical tri-party repo market freezes up and creates a bottleneck, then policy too can be frustrated - that market is critical to the implementation of open market operations. It is the main market through which the desk and primary dealers interact with each other.

– This market evolved in an ad hoc way and instead of being an organized exchange it is a private sector duopoly run by JPMorgan Chase and Bank of NY Mellon who extend trillions of dollars in daylight overdrafts. These firms are the operational hub and are interlinked to all the world’s major financial institutions – The market lacks transparency, has no federal oversight, raises the specter of conflicts of interest because of the two firms’ access to information on counterparty transactions and ability to meet collateral requirements, and poses systemic risk should either or both experience financial distress

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What Can Be Done? Primary Dealers • Primary dealer system evolved when daily bids were transmitted by runner in NY to the Desk • Bids are now submitted and accepted electronically, but bids are still limited to the primary dealers • Given current technology, there is no reason that daily participation needs to be limited to primary dealers and could be opened up to all member institutions that meet predefined prudential standards • In essence, the primary dealer system should be eliminated and the Fed should emulate the ECB that deals with approximately 500 counter parties – Technology is such that the entire bid process could be easily automated and securities and/or reserves allocated accordingly – Additionally, funding stress could also be limited by having the desk stand ready to buy and sell securities continuously at the target funds rate Florida Office One Sarasota Tower 2 N. Tamiami Trail, Suite 303 Sarasota, FL 34236

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What Can Be Done? Tri-party Repo Market

• Move to a centralized clearing platform – Be it stand alone – Government operated – eg. The Fed or – Separately operated affiliate or subsidiary

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Move to a Centralized Clearing Platform

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Advantage of Centralized Clearing Platform

• • • •

Limits risk transfers Reduces systemic risk Controls liquidity problems Other needed reforms – – – – –

Asset substitution rules Loss sharing arrangements Increased supervision and monitoring Limit daylight overdrafts or eliminate them Possibly impose margin requirements like futures exchanges – Modify rules so that repos are structured without recourse to limit unwinding problems Florida Office One Sarasota Tower 2 N. Tamiami Trail, Suite 303 Sarasota, FL 34236

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Conclusion • We have experienced a series of shocks to the financial system and have been forced to engage in new and untried policy remedies • Whether they are working or will ultimately get us out of the present situation remains to be seen • But it seems clear that market structure is a problem and it doesn’t seem that Dodd-Frank has helped us to address the critical problems exposed by the crisis.

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