Liquidity risk management.

Liquidity and solvency are the heavenly twins of banking, frequently indistinguishable. An illiquid bank can rapidly become insolvent, and an insolvent bank illiquid. As Tim Congdon noted, (FT, September 2007), in the 1950s liquid assets were typically 30 percent of British clearing banks’ total assets, and these largely consisted of Treasury Bills and short dated government debt. Currently, such cash holdings are about ½ percent and traditional liquid assets about 1 percent of total liabilities. Nor have prior standards relating to maturity transformation been maintained. Increasing proportions of long-dated assets have been financed by relatively short-dated borrowing in wholesale markets. Bank conduits financing tranches of securitised mortgages on the basis of three month asset-backed commercial paper is but an extreme example of this. Northern Rock is another. Such time inconsistency issues are hard to resolve, especially in the middle of a (foreseen) crisis; it is worth noting that many, though not all, of the aspects of this present crisis were foreseen by financial regulators. They just did not have the instruments, or perhaps the will, to do anything about it. If, when trouble strikes, the lifeboats are manned immediately, with extra liquidity being provided on easy terms, then there is encouragement to the banks to build even more densely on the flood plain. Why should the banks bother with liquidity management when the Central Bank will do all that for them? The banks have been taking out a liquidity ‘put’ on the Central Bank; they are in effect putting the downside of liquidity risk to the Central Bank. What is surely needed now is a calm and comprehensive review of what the principles of bank liquidity management should be.

Global Macroeconomic and Financial Supervision: Where Next?

The overriding practical problem now is the tension between the global financial and market system and the national political and power structures. The main analytical short-coming lies in the failure to incorporate financial frictions, especially default, into our macro-economic models. Neither a move to a global sovereign authority, nor a reversion towards narrower economic nationalism, seems likely to take place in the near future. Meanwhile, the adjustment to economic imbalances remains asymmetric, with almost all the pressure on deficit countries. Almost by definition surplus countries are “virtuous”. But current account surpluses have to be matched by net capital outflows. Such capital flows to weaker deficit countries have often had unattractive returns. A program to give earlier and greater warnings of the risks of investing in deficit countries could lead to earlier policy reaction, and reduce the risk of crisis.

George Osborne’s proposed ‘credit easing’ measures must incentivise banks to increase their lending to small businesses: they are vital to the recovery of employment and the wider economy

Chancellor George Osborne is set to announce “credit easing” measures in his Autumn Statement, aimed at getting banks to lend on more affordable terms and in greater volume to under-served segments of the economy. Charles Goodhart OBE FBA and Morgan Stanley’s Jonathan Ashworth believe ‘quasi-fiscal’ policies could provide a larger and more sustained boost to the economy, particularly when focused on small and medium-sized enterprises, historically a key driver of job creation

Monetary transmission lags and the formulation of the policy decision on interest rates

Monetary theory ; Monetary policy ; Interest rates

Asset Prices and the Conduct of Monetary Policy

In simple backward-looking structural models of the economy the optimal monetary policy rule is given by a Taylor-type interest rate rule, with the interest rate being a function of current and lagged inflation rates and the current and lagged output gap. Such a rule is optimal because current and past inflation rates and output gaps are sufficient statistics for future inflation and demand conditions, which are targeted by the central bank. We show that future demand conditions and CPI inflation in the G7 countries are also determined by the exchange rate and property and share prices. Taking the UK as an example we discuss the implications of this finding for the conduct of monetary policy and show that disregarding asset price movements leads to a sub-optimal outcome for the economy in terms of inflation and output gap variability. This result not only obtains because the information contained in asset prices about future demand conditions is ignored, but also because their omission from the model introduces considerable biases, so that monetary policy would be based on a mis-specified model of the economy. We also show how a Financial Conditions Index (FCI), a weighted average of the short-term real interest rate, the real exchange rate, real property and real share prices can be derived based on the estimated models. The derived FCI appears to be a useful predictor of future CPI inflation.

What Can Academics Contribute to the Study of Financial Stability?

There were hardly any banking crises between 1939 and 1971, so their later reemergence came as a surprise. Central bank supervisors responded practically by discovering and encouraging the adoption of current best practice in risk management by individual banks, without much theoretical input, whereas economists have mostly focused on models which abstract from default. But default is central to analysis of financial stability. Shubik pioneered introducing default into formal models, and we aim to develop this further. Meanwhile, estimating the probability of default (PD) for individual, or groups of, banks is central to the Basel II process.

The Rise of China as an Economic Power

In the twenty years since the Cultural Revolution, China has maintained fast real growth. This occurred despite China having similar problems to other transitional economies, eg loss-making State Owned Enterprises (SOEs), eroding fiscal revenues and inflation, (Section 3). Although China initially adopted the Soviet central planning model, after the 1950s break Chinese planning changed towards a regionally-based system with local planning (Section 2). In contrast to the centrally-based, functionally-specialized (U form or unitary structure) Soviet model, the Chinese-economy is organized on a multi-layer-multi-regional (M form) basis. This encouraged development of small size township and village enterprises (TVEs), the main engine of Chinese growth. Power and control remained with the Party and the State, but was diffused much more widely, regionally and locally. This allowed initiatives at lower (political) levels to establish institutions, both in agriculture (the 'household responsibility system') and industry (TVEs), without state protection. Even among regionally controlled SOEs, 'tournament rivalry' between regions, etc, and between SOEs and TVEs provided competition.

The transition from national currencies to the Euro.

We initiated a survey to examine whether the transition from national currencies to the Euro involved significant increases in transaction times. Based on our sample of 42 observations, we found that the pure transaction time for making change did actually increase, while queuing time increased only in small shops. This increase in transaction time represented a more significant welfare loss than most estimated studies of shoe-leather cost have previously found.

The Regulatory Response to the Financial Crisis

There are, at least, seven aspects relating to financial regulation where the recent, and still current, financial turmoil has thrown up issues for discussion. These include: 1. The scale and scope of deposit insurance; 2. Bank insolvency regimes, also known as ‘prompt corrective action’; 3. Money market operations by Central Banks; 4. Commercial bank liquidity risk management; 5. Procyclicality of capital adequacy requirements (and mark-to-market), Basel II; lack of counter-cyclical instruments; 6. Boundaries of regulation, conduits, SIVs and reputational risk; 7. Crisis management:- (a) domestic, within countries, e.g. UK Tripartite Committee; (b) cross-border; how to bear the burden of cross-border defaults? This paper describes how the current crisis has exposed regulatory failings, drawing largely on recent UK experience, and suggests what remedial action might be undertaken.financial regulation, bank insolvency, deposit insurance, liquidity, Basel II, procyclicality