Notes from the Vault
- Systemic risk in financial markets is the risk or probability of a breakdown in the ability to transact in an economy using customary procedures.
- Regulation can reduce systemic risk by changing the behavior of financial market participants and by making the financial system more resilient to shocks.
- Members of the general public are deleveraging—reducing their debt—and the federal government is running substantial deficits, effectively undoing some of the private deleveraging.
- A standard Keynesian analysis indicates that such government deficits can reduce adverse effects of deleveraging on output and employment.
- The ability to counteract possible negative effects on output and employment presupposes that the general public either is unaware that higher deficits today are likely to be associated with higher taxes in the future or else is unable to respond to that realization.
- Credit default swaps (CDSs) continue to be controversial, with concern that trades in them drive prices of government debt down.
- Evidence from the CDS spread for one country—Ireland—indicates that its CDS spread has been reacting to news about developments in Ireland, Greece, and the European Union.
- This examination of Ireland's CDS spreads is consistent with the proposition that the spreads reflect fundamental developments, not mindless speculation.
- The so-called global financial crisis was not truly global because many countries did not have a financial crisis.
- Nevertheless, the effects of the crisis have extended far beyond the countries that experienced crises themselves.
- Evidence indicates that rapid credit growth and high leverage before the financial crisis in the United States and in some other countries left many countries vulnerable to adverse effects of the crisis.
- Some banks apparently are too big to fail. It's unlikely that any policy will eliminate too big to fail or the effects of some firms being too big to fail.
- Contingent convertible bonds are one likely way to reduce the bad effects of some banks being too big to fail.
- Macroprudential supervision may be able to reduce the bad effects of some banks being too big to fail, but there are many unanswered questions including, even a basic approach.
- The Federal Reserve Bank of Atlanta's 2010 Financial Markets Conference examined the financial system after the 2008 crisis, including structured finance and credit rating agencies.
- An important innovation associated with structured finance is the creation of differentiated securities, called tranched securities, that receive payments based on a portfolio of assets. Such differentiated securities were the basis of some collateralized debt obligations (CDOs), which played a significant role in the financial crisis of 2008.
- Credit rating agencies were instrumental in creating CDOs, and that role spotlights problems with their current place in U.S. securities markets.
- A bailout need not benefit the owners of a firm much or even at all. Much of the benefit may flow to holders of the firm's debt.
- The bailouts of Fannie Mae and Freddie Mac provide an excellent case study for learning about bailouts.
- The biggest cost of an expected bailout can be distortion of investment toward firms with a bailout guarantee and encouragement of riskier activities, because the government and ultimately taxpayers bear the risk normally borne by holders of the firms' debt.
- "Too big to fail" policies are not about bank size per se but rather about the impact of financial firms' failure on financial stability and the real economy.
- Abolishing all government authority to engage in too big to fail policies may only delay bailouts in the event of major financial instability that affects the real economy.
- Critical stumbling blocks to the true elimination of too big to fail policies include the problems of resolving cross-border financial groups and dealing with the too-many-to-fail problem.
- A speculator is someone who assumes a risk with the hope of gain.
- Buyers of credit default swaps are in a similar position to short sellers of stock in some ways: They sell what they don't own and hope to gain from adverse developments affecting the underlying security.
- Complaints about speculators in the credit default swap market are more about the information reflected in market prices than the actual trading in credit default swaps.
- "Too big to fail" is a policy that results from authorities' choices that shield creditors of failed banks from losses in the failed bank.
- Too big to fail creates a situation in which banks' creditors expect to receive funds from others, such as taxpayers, when banks are unable to pay their obligations.
- While the FDIC Improvement Act of 1991 was expected to reduce the likelihood of banks being too big to fail, events during the 2008 financial crisis clearly indicate that too big to fail is alive and well, at least in financial crises.
- Excess reserves generally are not excess in the sense of being surplus or extra.
- In the 1930s, excess reserves were considered to be surplus, and increases in reserve requirements during that decade were designed to mop up those excess reserves.
- Banks responded to increases in reserve requirements by reducing deposits and restoring some of the excess reserves. This historical observation indicates that reductions in excess reserves are best approached with caution.
This article is revised from the original version published January 19, 2010.
Notes from the Vault was on hiatus after the March/April 2012 post; it restarted in March 2013.