Central Bank Policy

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Kirmet  SchoenholtzWhy European Banks Are Stressed Out by Professors Kim Schoenholtz, Anil Kashyap and Hyun Song Shin
Europe seems determined to repeat its mistake and undertake a second round of ineffectual stress tests on its banks. The 2010 version did little to alleviate banks' spiraling funding costs or to restore confidence in European markets. Unless the design of this year's tests is fundamentally different from last year's, Europe's crisis will persist...Read More

In the Media

“How to Contain a Financial Crisis Without Bailouts,” by Professor Bruce Tuckman, Forbes.com, March 22, 2012.

“Free the Fed,” by Professors Paul Wachtel, Kermit Schoenholtz, Forbes.com, April 1, 2010.

“Government money should have strings attached,” by Professors Viral Acharya, David Backus, Raghu Sundaram, FT.com, January 6, 2009.


"Bank Liquidity and Bubbles: Why Central Banks Should Lean against Liquidity" Viral Acharya, Hassan Naqvi, in New Perspectives on Asset Price Bubbles: Theory, Evidence and Policy, edited by Douglas Evanoff, George Kaufman and A.G. Malliaris, Oxford Univer

ABSTRACT (Click Here for Paper)
When liquidity chasing banks is high, loan officers (or risk-takers) inside banks expect future losses to be readily rolled over. This insurance effect induces them to relax lending standards. The resulting access to cheap credit can fuel asset price bubbles in the economy. To curb such risk-taking incentives at banks and the resulting asset bubbles, Central Banks should lean against bank liquidity. In particular, Central Banks should adopt a contractionary monetary policy in times of excessive bank liquidity.

“Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking,” Viral Acharya, Denis Gromb, Tanju Yorulmazer, American Economic Journal Macroeconomics, 2012.

ABSTRACT (Click Here for Paper)
We study the interbank lending and asset sales markets in which banks with surplus liquidity have market power, frictions arise in lending due to moral hazard, and assets are bank specific. Illiquid banks have weak outside options that allow surplus banks to ration lending, resulting in inefficient asset sales. A central bank can ameliorate this inefficiency by standing ready to fund illiquid banks, provided it is better informed than outside markets, or prepared to extend loss-making loans. This rationale for central banking and support in episodes that precede the modern central-banking era and informs debates on the supervisory and lender of last resort roles of central banks.

“The Seeds of a Crisis: A Theory of Bank Liquidity and Risk Taking Over the Business Cycle,” Viral Acharya, Hassan Naqvi, Journal of Financial Economics (November 2012).

ABSTRACT (Click Here for Paper)
We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, to induce effort, loan officers are compensated based on the volume of loans. Volume based compensation also induces greater risk-taking; however, due to lack of commitment, loan officers are penalized ex post only if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This ‘flight to quality' leaves banks flush with liquidity, lowering the sensitivity of bankers' payoffs to downside risks and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown.

“Stressed Out: Macroprudential Principles for Stress Testing,” David Greenlaw, Amit k Kashyap, Kermit Schoenholtz, Hyun Song Shin, Chicago Booth Research Paper, Working Paper, (February 13, 2012).

ABSTRACT (Click Here for Paper)
Since the conference version of this report in February 2011, bank stress tests have been almost continuously in the news. In the United States, the Dodd-Frank Act mandates annual stress tests for key institutions. In early 2011, the Federal Reserve conducted the fi rst test under the Act on major banks, and is currently conducting the second test, the results of which will be announced in early 2012. Europe completed a stress test in July 2011 that ignored many principles of this report. Like the prior European tests in 2010, the 2011 version is now deemed to have failed, so that yet another European stress test exercise is contemplated. We offer a framework for evaluating these exercises. The starting point is to contrast micro- and macro-prudential principles for stress tests. Microprudential stress tests emphasize the traditional role of bank capital as a buffer against loss, shielding the deposit insurance agency. The focus is on resolving insolvent banks and on “prompt corrective action” to protect taxpayers. The Basel capital ratio is key. The U.S. savings and loan crisis of the early 1980s is the motivating event. Macroprudential stress tests focus on whether the banking system as a whole has the balance sheet capacity to support the economy. A central goal is averting runs on systemic banks by wholesale creditors that lead to a contraction of credit and damage to the broader economy. To avoid aggregate deleveraging in periods of distress, remedies focus on raising new capital measured in total dollars (or euros), rather than on merely satisfying capital ratios. We argue for the macroprudential approach and propose five principles.
First, banks have to be suffi ciently solvent to avert runs. The “run point” of a systemic bank often entails significantly higher capital than the bare solvency point.
Second, even solvent banks may be required to refrain from depleting capital if the system as a whole does not meet the higher macroprudential criteria. For shareholders, one dollar inside the bank should be worth more than one dollar in dividends. But, in any case, supervisors should consider more than just private benefits and costs. Had U.S. supervisors suspended dividends in the summer of 2007, $80 billion of capital could have been retained in the 19 banks that were subject to the 2009 Supervisory Capital Assessment Program. That sum is roughly half of the public recapitalization funds that these banks received.
Third, the remedy to undercapitalization should be stated in dollar (or euro) amounts, not capital ratios. The objective is to maintain the balance sheet capacity of the banking system as a whole. That capacity depends on the level of equity in the system. After a shock, targeting the ratio of equity to assets invites banks to meet the goal by shedding assets and exacerbating the credit crunch.
Fourth, stress scenarios should consider both sides of the balance sheet, and explicitly consider fi re sales, runs by wholesale creditors, common exposures and credit crunch risks.
Fifth, liquidity rules, in addition to capital requirements, should be part of the overall framework of macroprudential oversight. By means of an illustrative example, this paper highlights the need for a macroprudential approach, and explains why the potential economic costs are much higher when banks are systemic. We then provide a diagnostic framework using bank equity and CDS prices (and correlations between them) that can help in the formulation of corrective measures. We also review a range of empirical evidence regarding large intermediaries in the light of our framework. Taken together, this evidence suggests that the fi nancial systems in both the United States and Europe remained stressed even in early 2011, well after the crisis peaked: First, based on the level of CDS prices, the default risk of U.S. intermediaries at the onset of the 2009 stress tests was perceived to be much higher than before the crisis. After the U.S. stress test, CDS prices fell substantially, but remained elevated as of early 2011 compared to highly rated non financial companies. European banks also faced elevated CDS prices at the time of the 2010 stress test, and only a few institutions have experienced signifi cant declines, indicating that perceived default risk was persistently high.
Second, the correlations between equity returns of intermediaries remained higher after the stress tests than they were in 2006, prior to the crisis. Even banks with less elevated CDS prices show equity returns
that are positively correlated with their competitors bearing higher CDS prices. Thus, bad news for one bank is bad news for all. This persistent pattern suggests that, even in early 2011, there were virtually no institutions seen as capable of absorbing weaker organizations in a fi re sale. Otherwise, bad news for weaker fi rms might be viewed as good news for potential saviors.
Third, the correlations between equity returns and banks' own-CDS prices remained negative for almost all of the institutions. A substantial negative correlation is to be expected if an institution is thinly capitalized because news that raises the value of its equity will lower the default risk on debt. For well capitalized fi rms, however, this correlation should be weak or non-existent.
Finally, the macroprudential perspective also provides important lessons for the 2011 Europe financial crisis. The bulk of the report analyzes the state of conditions in the runup to early 2011. This analysis anticipated the failure of the July 2011 European tests. We have added an epilogue that updates the empirical work to cover the developments in Europe through 2011. We continue to argue that the troubles in Europe will persist until the European banks are capitalized to the degree that they can withstand losses on their sovereign bond holdings without triggering a run or a widespread deleveraging that undermines the supply of credit.

“The Dark Side of Liquidity Creation: Leverage and Systemic Risk,” Viral Acharya, Anjan Thakor, (December 2010).

ABSTRACT (Click Here for Paper)
This paper exposes a fundamental tension between the micro-prudential objective of subjecting banks to greater discipline through debt markets and the macro-prudential objective of containing systemic risk. We show that banks are illiquid due to the inability of bankers to credibly pre-commit to asset choices. Bank debt can reduce this illiquidity by disciplining bankers with the threat of premature liquidations. However, the liquidation of a bank's assets leads creditors of other banks to update their priors on common shocks affecting asset values, giving rise to contagion and liquidations throughout the system. Thus, liquidity creation induced by the disciplining role of bank debt has the benefit of generating more information about common asset-value shocks, but it comes at the cost of greater systemic risk, risk that is not fully internalized by banks in choosing privately optimal levels of leverage. We then consider implications of a lender of last resort (LOLR) that intervenes to bail out banks when faced with the prospect of a contagion. While LOLR interventions can diminish the incidence of contagion and thereby reduce systemic risk, they also carry the misfortune of eliminating efficient liquidations. . In particular, by reducing creditor incentives to intervene in banks, the LOLR can preclude the discovery of "early warnings" of a banking crisis and risk the emergence of a delayed but more severe crisis.

"Two Monetary Tools: Interest Rate and Haircuts," Adam Ashcraft, Nicolae Garleanu, and Lasse H. Pedersen (September 2010).

ABSTRACT (Click Here for Paper)
Paper argues that loans provided by central banks can be a more powerful tool for lowering yields and stimulating economic activity than reducing the interest rate. Reducing the interest rate decreases the required returns of low-haircut assets but may increase those of high-haircut assets, since it may increase the shadow cost of capital for constrained agents. A reduction in the haircut of an asset unambiguously lowers its required return and can ease the funding constraints on all assets.
NBER Macroeconomics Annual, 2010.

"How Central Bankers See It: the First Decade of ECB Policy and Beyond,” Stephen G. Cecchetti, Kermit L. Schoenholtz, NBER, Working Paper, (November 2008).

ABSTRACT (Click Here for Paper)
In this history of the first decade of ECB policy, we also discuss key challenges for the next decade. Beyond the ECB's track record and an array of published critiques, our analysis relies on unique source material: extensive interviews with current and former ECB leaders and with other policymakers and scholars who viewed the evolution of the ECB from privileged vantage points. We share the assessment of our interviewees that the ECB has enjoyed many more successes than disappointments. These successes reflect both the ECB's design and implementation. Looking forward, we highlight the unique challenges posed by enlargement and, especially, by the euro area's complex arrangements for guarding financial stability. In the latter case, the key issues are coordination in a crisis and harmonization of procedures. As several interviewees suggested, in the absence of a new organizational structure for securing financial stability, the current one will need to function as if it were a single entity.