RD News 17Feb12

• BIS: Hervé Hannoun (Dep GM) Monetary policy in the crisis: testing the limits of monetary policy
• Central banks are increasingly seen by market participants as all-powerful, able to intervene without any limit.
• The trend towards unlimited intervention combined with ultra-low interest rates does not only have potentially serious side effects on the functioning of the market economy, it also gives rise to three major risks:
• financial dominance
• exchange rate dominance
• fiscal dominance
• The ultimate possible consequence is an inflation surprise that could severely damage central banks' hard-earned credibility.
• To prevent these risks from materialising, we need to forge a consensus on what could be called "the new frontier of monetary policy" in order to refocus monetary policy on maintaining lasting price stability. This also implies that central banks should reject the market illusion of unlimited intervention and the associated theory of the "printing press".

• NY Fed: Release of the Tri-party Repo Infrastructure Reform Task Force's Final Report + Statement
• The tri-party repo market's infrastructure exhibits significant structural weaknesses that undermine market stability in a stressed environment.
• Three fundamental areas of concern identified by policymakers at the Federal Reserve:
• (1) market participants' overreliance on intraday credit from tri-party clearing banks,
• (2) risk management practices that are vulnerable to procyclical pressures,
• (3) the absence of an effective and transparent process for the orderly liquidation of a defaulted broker-dealer's collateral.
• Completed improvements:
• the establishment of automated collateral substitution functionality for most trades in the market
• the implementation of a 3-way trade confirmation process for all tri-party repo transactions.
• improved transparency in the tri-party repo market by publishing a monthly report on market size, collateral composition and margining practices.
• Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged.
• Ideas include restrictions on the types of collateral that can be financed in tri-party repo and the development of an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealer's default.
• Ending tri-party repo market participants' reliance on intraday credit from the tri-party clearing banks remains a critical financial stability policy goal.
• While the bulk of the work on operational changes will fall to the clearing banks and FICC, borrowers and investors in the tri-party repo market will also need to modify their credit and liquidity risk management practices to realize the promise of these operational changes.
• Dealers should be taking steps to reduce their reliance on short-term financing and investors should be taking actions to ensure their credit risk management policies and practices are robust to stress events. Such actions can help to ensure that market participants better internalize and price the costs associated with the credit and liquidity risks they bear in tri-party repo transactions.

• Andy Haldane: The Doom Loop
• Consider the effects of the too-big-to-fail problem on risk-taking incentives. If banks know they will be bailed out, those holding their debt will be less likely to price the risk of failure for themselves. Debtor discipline will therefore be weakest among those institutions where society would wish it to be strongest. This encourages them to grow larger still: the leverage cycle isn’t merely repeated, but amplified. The doom loop grows larger. The biggest banks effectively benefit from a disguised, and growing, state subsidy.
• The best proposals for reform are those which aim to reshape risk-taking incentives on a durable basis.
• Under the so‑called Basel III agreements struck in 2010, banks’ minimum equity capital ratios will rise fivefold over the next decade, from 2 per cent to close to 10 per cent of assets for the largest global banks.
• A 10 per cent capital ratio translates into bank leverage of roughly 25. So even once Basel III is in place, an unexpected loss in a bank’s assets of just 4 per cent will be enough to render it insolvent.
• Voting rights could be extended across a wide group of stakeholders, but weighted by stake. Governance and control would then be distributed across the whole balance sheet, curbing the profit-seeking incentives of the equity minority, while weighting voting rights by size of portfolio to avoid the inertia of mutuality. Bank governance would then be a wealth-weighted democracy, a hybrid of the mutual and joint-stock models.

• BIS: Stochastic Herding in Financial Markets: Evidence from Institutional Investor Equity Portfolios
• A structural model of herding behavior in which feedback arises due to mutual concerns of traders over the unobservable "true" level of market liquidity.
• In a herding regime, random shocks are exacerbated by endogenous feedback, producing a dampened power-law in the uctuation of largest sales.
• A stock's realized illiquidity propagates herding and raises the probability of observing a sell-off. The distribution function itself has desirable properties for evaluating "tail risk".

• Reuters: EU to consult on shadow banking rules
• Draft EU rules are being readied for consultation on the shadow banking system.
• As banking regulation is tightened, incentives are created for some activities to be conducted outside of the banking system, in less regulated institutions.
• The draft reportedly recognises the “potentially useful” role of shadow banking in intermediation, but that a range of measures, from registration through to fully macroprudential tools, might be recommended.
• Possibility that banks may be required to limit their exposure to shadow banking entities, or include such entities when calculating capital, liquidity and leverage buffers.
• Paper may be published as soon as March, with a public hearing on 27 April.