NYU Stern

Money Market

Featured Piece

viral AcharyaA Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market,” Viral Acharya, T.Sabri Oncu, (April 2012).

ABSTRACT

One of the several regulatory failures behind the global financial crisis that started in 2007 has been the regulatory focus on individual, rather than systemic, risk of financial institutions. Focusing on systemically important assets and liabilities (SIALs) rather than individual financial institutions, we propose a set of resolution mechanisms, which is not only capable of inducing market discipline and mitigating moral hazard, but also capable of addressing the associated systemic risk, for instance, due to the risk of fire sales of collateral assets. Furthermore, because of our focus on SIALs, our proposed resolution mechanisms would be easier to implement at the global level compared to mechanisms that operate at the level of individual institutional forms. We, then, outline how our approach can be specialized to the repo market and propose a repo resolution authority for reforming this market.

In the Media


The battle over money funds,” by Professors Thomas Cooley, Kim Schoenholtz, Reuters, March 7, 2012.

“Money Funds too Big to be Ignored,” by Professors Marcin Kacperczyk, Philipp Schnabl, American Banker, April 14, 2010.


Papers

“Federal Liquidity Options: Containing Runs on Deposit-Like Assets without Bailouts and Moral Hazard,” Bruce Tuckman, Journal of Applied Finance 22(2), Working paper, 2012.

ABSTRACT (Click here for Paper)
In response to the 2008 runs on deposit-like assets, namely repo and money market funds, the Fed created new liquidity facilities for nonbanking institutions and the Treasury guaranteed certain money market fund balances. These extraordinary actions, while justified by officials as necessary to preserve the financial system, did rescue nonbanks by exposing the public to unprecedented risks. Since 2008, despite legislation and regulation, deposit-like assets are still vulnerable to runs. The fallback policy to contain such runs is still ad hoc lending by the Fed. Bailouts, though officially outlawed, may very well be justified and used again. And, finally, because the implicit safety net of government action is still in place, moral hazard remains a feature of the financial landscape. This paper proposes that the Fed auction Federal Liquidity Options (FLOs) as the exclusive means of providing liquidity to nonbanks in a crisis. Having issued FLOs that encompass a sufficient quantity and breadth of collateral, authorities will be able to claim, with credibility, that no additional emergency lending programs or bailouts will be required to safeguard the viability of solvent nonbanks. In the resulting policy regime, the Fed does not rescue individual firms or industries but fulfills its contractual obligations under options previously sold at market-determined prices. Furthermore, with the cost of contingent liquidity internalized by the purchasers of FLOs, and with other extraordinary provisions of liquidity credibly renounced, moral hazard will drop significantly.

“A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market,” Viral Acharya, T.Sabri Oncu, (April 2012).

ABSTRACT (Click Here for Paper)
One of the several regulatory failures behind the global financial crisis that started in 2007 has been the regulatory focus on individual, rather than systemic, risk of financial institutions. Focusing on systemically important assets and liabilities (SIALs) rather than individual financial institutions, we propose a set of resolution mechanisms, which is not only capable of inducing market discipline and mitigating moral hazard, but also capable of addressing the associated systemic risk, for instance, due to the risk of fire sales of collateral assets. Furthermore, because of our focus on SIALs, our proposed resolution mechanisms would be easier to implement at the global level compared to mechanisms that operate at the level of individual institutional forms. We, then, outline how our approach can be specialized to the repo market and propose a repo resolution authority for reforming this market.

"How Safe are Money Market Funds", Marcin Kacperczyk, Philipp Schnabl, Working Paper (April 2012).

ABSTRACT (Click Here for Paper)
We examine the risk-taking behavior of money market funds during the financial crisis of 2007-10. We show that as a result of the crisis: (1) money market funds experienced an unprecedented expansion in their risk-taking opportunities; (2) funds had strong incentives to take on risk because fund inflows were highly responsive to fund returns; (3) funds sponsored by financial intermediaries that also ordered non-money market mutual funds and other financial services took on less risk, consistent with their sponsors internalizing concerns over negative spillovers to the rest of their business in case of a run; (4) funds sponsored by financial intermediaries with limited financial resources took on less risk, consistent with their sponsors having limited ability to stop potential runs. These results suggest that money market funds' risk-taking decisions trade of the benefits of fund inflows with the risk of causing negative spillovers to other parts of fund sponsors' business.

“Rollover Risk and Market Freezes,” Viral Acharya, Douglas Gale, Tanju Yorulmazer, The Journal of Finance, (August 2011).

ABSTRACT (Click Here for Paper)
The debt capacity of an asset is the maximum amount that can be borrowed using the asset as collateral. We model a sudden collapse in the debt capacity of good collateral. We assume short term debt that must be frequently rolled over, a small transaction cost of selling collateral in the event of default, and a small probability of meeting a buy-to-hold investor. We then show that a small change in the assets fundamental value can be associated with a catastrophic drop in the debt capacity, the kind of market freeze observed during the crisis of 2007-08.

“Do Global Banks Spread Global Imbalances? Asset-Backed Commercial Paper during the Financial Crisis of 2007-2009,” Viral Acharya, Philipp Schnabl, IMF Economic Review, 98(3), 2010.

ABSTRACT (Click Here for Paper)
The global imbalance explanation of the financial crisis of 2007-09 suggests that demand for riskless assets from countries with current account surpluses created fragility in countries with current account deficits, most notably, in the United States. We examine this explanation by analyzing the geography of asset-backed commercial paper (ABCP) conduits set up by large commercial banks. We show that both banks located in surplus countries and banks located in deficit countries manufactured riskless assets of $1.2 trillion by selling short-term ABCP to risk-averse investors, predominantly U.S. money market funds, and investing the proceeds primarily in long-term U.S. assets. As negative information about U.S. assets became apparent in August 2007, banks in both surplus and deficit countries experienced difficulties in rolling over ABCP and as a result suffered significant losses. We conclude that global banking flows, rather than global imbalances, determined the geography of the financial crisis.

“Systemic Risk and the Tri-Party Repo Clearing Banks,” Bruce Tuckman, Center for Financial Stability Policy Paper, (February 2, 2010).

ABSTRACT (Click Here for Paper)
This paper first explains how the design of the tri-party repo system, while solving various operational problems in the secured funding markets, actually creates significant systemic risk. More precisely, by giving broker-dealers use of their security collateral during the day the system effectively transfers the intra-day risk of a broker-dealer default from many secured lenders to the two clearing banks. This paper then argues that imposing capital requirements and risk charges on this intraday risk will force the industry to correct the existing systemic risk on its own. Furthermore, as an added benefit, these requirements and charges will, by leveling the playing field in the provision of services to the secured funding market, spur competition and innovation. Finally, this paper argues that the alternate policy proposals mentioned above will not be as effective in stabilizing and strengthening the secured funding market.

“Market Liquidity and Funding Liquidity,” Markus Brunnermeier and Lasse Pedersen, The Review of Financial Studies, 2009.

ABSTRACT (Click Here for Paper )
We provide a model that links an asset's market liquidity (i.e., the ease with which it is traded) and traders' funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and margin requirements, depends on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality,” and (v) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums.

“When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009,” Marcin Kacperczyk, Philipp Schnabl,Journal of Economic Perspectives,Working Paper, (November 2009).

ABSTRACT ( Click Here for Paper)
Commercial paper is one of the largest money market instruments and has long been viewed as a safe haven for investors seeking low risk. However, during the financial crisis of 2007-2009, the commercial paper market experienced twice the modern-day equivalent of a bank run with investors unwilling to refinance maturing commercial paper. We analyze the supply of and demand for commercial paper and show that, in contrast to previous turbulent episodes, the crisis centered on commercial paper issued by, or guaranteed by, financial institutions. We describe the importance of Federal Reserve's interventions in restoring stability of the market. Finally, we propose three possible explanations for the sharp decline of the commercial paper market: substitution to alternative sources of financing by commercial paper issuers, adverse selection, and institutional constraints among money market funds.