Josh Galper is the managing principal at Finadium, an independent consultancy in capital markets, and is deep in the trenches of the money markets, as well as the financial regulatory space. As a returning guest to the podcast, Josh rejoins Macro Musings to talk about some of the big changes we might see in financial regulation, especially as it relates to climate issues under the new Biden administration. David and Josh also discuss the prospects of negative interest rates in the US, the influence of the Financial Stability Board, and how to deal with Treasury and repo market stress in the future.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Josh, welcome back to the show.
Josh Galper: Thanks very much for having me.
Beckworth: Great to have you on. Now, I was checking and the last time you were on the show is about a year ago, almost a year to the date you were on a year-end special. We were talking about the repo crisis we had just experienced in September 2019. And who would have thought back then this year would have turned out the way that it did. I mean, what a year this has been. In fact, that podcast seems like an eternity ago looking back, but it's good to have you back on. How have you been doing?
Galper: Well, it's been certainly an upside down year. We're going to end fine at Finadium, but we've historically hosted quite a number of live events in both Europe and the US and all of those, of course, were canceled quite immediately. So, once we got over the upheaval of losing those events, then we got back down to work and focused on delivering what our clients needed from us, and that's worked out well. Certainly like every provider of content, moving from a live event to a webinar has globalized the competition in the space.
Galper: So we have found ourselves in a small group providing content and quite-focused content. It's really for market professionals. But where we used to would hold a New York event, now that same New York event is drawing people from Europe and Asia just as quickly as New York. It's different. I expect we'll be here for years to come, not worried about Finadium at all, but I do expect that the markets are continuing to change and we will need to change with it.
Beckworth: Yeah, very interesting. We recently had Adam Ozimek the show and he talked about how the nature of work is changing; more of remote work, more of these meetings like Zoom and such. So do you see your type of business also, at least some part of it, changing because of the pandemic permanently?
Galper: Well, there is a very strong desire in capital markets for people to meet and shake hands and talk face to face. That's not going away. But it's uncertain how firms are going to diversify geographically; what that will mean for people's comfort in traveling, decentralized events, spending two, three days away from the office, what automation is meaning for capital markets and how many people there will be working in key roles three to five years from now compared to today.
Galper: So I'm not prepared to make any kind of guess specifically about what will happen, but our indication so far are that we're not going to expect the same kind of critical mass of people who all want to come to New York for a few days to do business, to talk about capital markets events at a conference. There may be more demand for virtual and then smaller gatherings from time to time. So that upends the traditional big New York or a big London style conference, if that holds all true.
Beckworth: Yeah, very interesting. It'll be fascinating to see how this all unfolds next year and thereafter as we return to some kind of normalcy. Well, I have you on the day and you've graciously agreed to come on to talk about what may happen during the next four years under a Biden Administration. And I think a great way to kind of segue into that is to go back to our conversation last year where we were talking about repo markets and look at what happened in March. And eventually we want to go to the future, but even March, there's going to be some repercussions in terms of maybe a new financial regulations, some new innovations. And that surrounds the, what I call, March madness. We didn't have college basketball, but we had our own March madness in the capital markets and the money markets particularly when the treasury market practically froze up.
Beckworth: So I think many of our listeners know, but just to kind of recap, and there's been many great reports on this, the Treasury's office financial report, the Fed's financial stability report, BIS, a number of excellent reports, you probably have your own report for your clients, I imagine on this. But they all point to these sudden and large selling pressures from foreign reserve managers, mutual funds, hedge funds, and there's some debate on what role did hedge funds play, but I don't want to get into that now, but what we, I think, all agree on was that this dash for safety turned into a dash for cash and really put stress on the treasury markets.
Beckworth: The Treasury markets couldn't handle something so big so quick, and it has created a lot of pressure, and absent the Fed stepping in and buying up somewhere near a trillion dollars in a few weeks of treasuries, this could've turned out really bad, could've been a great financial crisis. But fortunately the Fed did step in, but it raises the question, what do we do to prevent this next time? What reforms could we implement? What new regulations? What new innovations?
Beckworth: And I've had a series of guests on the show over this past year, who've proposed different things. And we talked about one of them in our previous conversation, but I'll start with him, David Andolfatto and Jane Ihrig from the Fed. They have proposed a standing repo facility, and I think their argument would be, if you had that, it would've been easy to quickly turn all these treasuries into reserves into cash. And maybe just the knowledge of that would have dialed down the fear and not have led as much dash for cash, had they just known that the repo facility was standing there?
Beckworth: Darrell Duffie was on the show talking about doing more central clearing of Treasury markets, that was his solution. I had Carolyn Sissoko who questioned the extensive use of repos, maybe dialing back repos tied to long-term treasuries. And there's probably other proposals out there as well, but I would like to get your take on this. What do you think should be done or can be done to prevent something like March happening again?
Preventing Treasury Market Stress in the Future
Galper: Right. Well, thanks for bringing me into such illustrious company here. So I think that there's two key issues. One is actual capacity; how much can banks take on, how much can banks buy, sell, hold on their balance sheet? And two is perception. So on a matter of capacity, that's where something like Professor Duffie's central theory of US treasuries comes into play, where the idea is that that would create more capacity in the settlement process. If you think about perception, that's where you get to the standing repo facility, which you could argue that temporary open market operations are effectively now a version of the standing repo facility. But if you made it permanent, didn’t call it temporary, then everyone would simply know here's where the market is. This is going to be the top of the market no matter what. What you have right now in temporary open market operations is a very efficient process for providing liquidity to a select group.
Galper: Part of the open questions about the standing repo facility are, who exactly would it provide liquidity to? For example, it could provide liquidity to every FICC clearing member, and that would actually be quite a change from the temporary open market operations, or it could provide liquidity to only primary dealers, and then rely on those primary dealers to get liquidity elsewhere into the market where it's needed. There are certainly mechanisms, there are certainly capacity for removing future concern about the ability of the large banks. And those are the players, I think, really that we need to be looking at here about their ability to intermediate, whether in the cash treasury market or the repo market.
Galper: So if you focus on how to alleviate the strains, the pressures that are occurring there, I think that's going to flow out correctly through to the rest of the market. And I think the Fed is going to have to be still there as a player, a buyer of last resort, even if only on a contingency basis, and in the repo market as an expensive place to do business. I'd add also that we're seeing many reports now, including just one today from the financial stability board, on non-bank financial intermediation. And there are calls including from US regulators to revisit mutual funds regulation to see how involved they are, and should they be prohibited, limited in some way, or are better organized around their repo market participation.
If you focus on how to alleviate the strains, the pressures that are occurring there, I think that's going to flow out correctly through to the rest of the market. And I think the Fed is going to have to be still there as a player, a buyer of last resort, even if only on a contingency basis, and in the repo market as an expensive place to do business.
Galper: My response to these calls would be that's all nice and fun, but I don't think that's really where you need to look, because if there is sufficient liquidity in the banking system and that liquidity is backstopped by the Fed, which ordinarily in a moderate US treasury issuance scenario, I wouldn't get too interested in, but the level of US treasury issuance that's going on now, and is expected to occur with a number of years, there's just no way that global... There's not enough buyers for these assets. Banks don't want them on their balance sheets. It really comes back to the Fed to be the buyer when there are no others.
Beckworth: Very interesting. Let me ask this question. So you have the point about there's going to be an increased supply of debt issuance going forward, so the normal infrastructure may not be able to handle this capacity, this level of debt issuance, but also the pandemic itself is a tell event, right? Should we worry about tell events much? If we plan for something as big as March and it doesn't happen for another 30 years, who knows, it maybe could happen in a decade. We had the great recession a decade ago, so maybe I shouldn't be so optimistic, but are we in any sense overreacting by trying to respond to the shortcomings in March?
Galper: No, I don't think this is an overreaction. I think this is pretty appropriate. And I think the real questions are here, that... The real question is how much control does the Fed have over, for example, the repo market? Right now, there's a corridor of 15 basis points that the Fed allows major market participants effectively to trade in because under zero basis points, participants can turn to the reverse repo facility, and over 15 basis points in an overnight basis, there's a temporary open market operations. So the question here in my mind is more, Federal Reserve, are you willing to go to a corridor of 30 basis points or 50? Or as the folks at the St. Louis Fed said earlier last year, how about 250? That to me would be an appropriate way for the Fed to signal that it is the provider of liquidity of last resort without more closely dictating what market rates should be.
The question here in my mind is more, Federal Reserve, are you willing to go to a corridor of 30 basis points or 50? Or as the folks at the St. Louis Fed said earlier last year, how about 250? That to me would be an appropriate way for the Fed to signal that it is the provider of liquidity of last resort without more closely dictating what market rates should be.
Beckworth: One other question on this, and we'll move on to the Biden administration, but the Bank of Canada actually buys a certain percent of the new debt issue just on a regular basis, unlike the Fed has to go into secondary markets to open market operations. You think there's any merit in doing that, opening up the Fed a direct channel to the treasury. And I know the reasons we don't do that is because we're worried about debt monetization and funny business occurring, but is there any discussion or anyone talking about that possibility?
Galper: I've not heard that. Now that said, it's pretty well known that the Fed is a 24/7 research facility. So if anybody's thinking about it, it's going to be there. And I wouldn't be surprised if they're having conversations, just nothing I particularly have heard about.
Beckworth: Yeah, it seems like it would be worth considering given that this point you're raised about, it's going to be this high level of debt issuance going forward, and just to make the money markets flow smoothly, maybe having some direct purchase might come in useful. Of course, there needs to be rules, boundaries, guardrails to prevent that from being abused. But I think the Bank of Canada gives us a good example. They are a well-run bank; central bank, and they seem to do well with purchasing a small share.
Galper: I will point out, before we move on, that folks who are interested in modern monetary theory, the idea that the Fed would buy directly from the US treasury is basically there. Now, we're one or two steps removed, but you let the Fed become a buyer at direct auction, and that's modern monetary theory as far as I can see it.
Beckworth: Well, I would also say, to the extent the Fed would begin doing yield curve control or... That's also moving in that direction, right? And you do think, look, we're in a world of low, low rates. They've been trending down for years and maybe things will change, maybe all this debt issuance will finally be the straw that breaks the camel's back, but I'm not sure that it is. And if this trend continues and we're stuck at low, low rates, we do end up with something de facto like yield curve control, where the Fed’s... Rates are basically at close to zero, or just above zero, and the Fed’s just, I don't know, tinkering on the margins, but definitely a lot of interesting questions here. And I could spend the whole show talking to you about them, but I know you have some interesting things to say about what might happen under the Biden administration.
Beckworth: So I want to move to those, give you a chance to speak to them. And in particular, I want to talk about climate risk and how we should think about it in terms of financial regulation, what the Fed is doing, what the Treasury is doing. And just to motivate this, Josh, I want to read an article that came out in the Financial Times, a few paragraphs from it. Today is December 16, we're recording this. The show will come out in January, but yesterday on the 15th, the Financial Times had a big story. It was carried in all the major papers, but it says *Fed Joins Central Bankers Backing Paris Climate Goals.* Here's the first few paragraphs.
Beckworth: “The US Federal Reserve has joined a consortium of central bankers supporting the Paris climate goals as it becomes more outspoken on the risk climate change poses to the global economy. The move came as the Network for Greening the Financial System, the NGFS, which includes 75 central banks, published a survey of its members plans for grappling with climate change. The Fed is one of eight new members to join the group this month and follow a pledge by President Elect Joe Biden to rejoin the Paris Climate Accord, which is a requirement.” The article then goes on and talks about how the ECB has already done this, and they're very active.
Beckworth: And how Christine Lagarde is really big into at least talking about this point, buying green bonds and going green. And that in fact the ECB’s even criticized the article mentions for buying bonds from corporations that pollute and they have other environmental problems. So this is a hot topic. I think you alluded to in our pre-conversation, it's going to be a big topic next year. But where do we even start thinking about this? How do we think about this? What does it actually mean? So maybe walk us through some way of thinking about how we should be considering these issues moving forward.
Climate Change and the Financial System Moving Forward
Galper: Sure. So, big question there. To start, so we've got this big, big, huge topic about climate change. Let's then get a little bit more specific and let's talk about climate risk. So this is the risk to financial markets, the risk to investors, that the value of their assets would go down in a hurry, the risk to central banks and financial regulators that the economies that they manage could be severely adversely affected due to climate events. So that's the part of the conversation that we're playing in here. When we talk about climate change, there's a lot of other places, of course, that are of concern and where people are doing a lot of work, but this conversation about the Fed, the Network for Greening the Financial System, the piece that we at Finadium are interested in really focuses on climate risk.
So this is the risk to financial markets, the risk to investors, that the value of their assets would go down in a hurry, the risk to central banks and financial regulators that the economies that they manage could be severely adversely affected due to climate events. So that's the part of the conversation that we're playing in here.
Beckworth: All right, let me ask a follow-up question. So you said how climate risk affect your assets’ value, for example. So I can think of two scenarios. I can think of something like more hurricanes, more weather events, which would be sudden, and you lose everything. Or I could think of a more gradual, there's erosion on beachfront property over the next 10 years, and so your investment in real estate goes down gradually. Are we looking at both types of risks, low and quick ones in this framework?
Galper: Yes, we're looking at both types of risks. We're looking at acute events that occur like your hurricane or a fire, we're looking at slow climate change that might not only erode shorelines, but also might change, for example, agricultural patterns. And these are big long-term trends. Many of these are big long-term trends, others can happen as we've seen multiple times in 2020, others can happen in one part of the world or impact one industry more than others. The question then becomes, how do you figure that out? How do you look at what models can be used? How do you forecast what some of those impacts might look like? So that you're, as a regulator or as a market participant, you're not surprised, sort of know what's coming. Okay, we see that risk, we're aware of it. And that now we're right here at the beginning of that conversation.
Galper: And I think that's what makes this topic so important is that it's huge. It's going to affect everyone globally, every market participant, every regulator globally, this will impact us. And the only, the things to do now are to figure out how to best quantify that risk, how to best organize the reporting structures around it, the data around it, to then have a real conversation about where the exposures lie. This is tough. This is tough stuff. And that's where we get to the Biden administration, where I'll make the argument that I think the next 12 months are going to bring this conversation really to the fore.
Galper: I don't necessarily think the big questions are going to get answered, but I think we're going to see a real push towards starting to get to some answers. And part of that is in fact the Fed joining the Network for Greening the Financial System. When I saw that announcement by the way, my first thought was, at last, finally, really, it took this long. Good. Good for you. Let's move forward. And I'd like to say, I, myself, as a professional, I don't have a judgment call about whether climate risk should be done or shouldn't be done. I just think it's going to be done. I think it's going to be a topic and this is why it bears such a serious conversation at this point.
I'd like to say, I, myself, as a professional, I don't have a judgment call about whether climate risk should be done or shouldn't be done. I just think it's going to be done. I think it's going to be a topic and this is why it bears such a serious conversation at this point.
Beckworth: Okay, so it's important to deal with this risk, if you care about the future of your assets' values, your portfolio, your investments. So that makes a lot of sense. You would do that with any type of risk, right, if you're smart. So it makes sense to do this. And there's a lot of different ways you could take this, and there's concerns about, is the Fed going into mission creep into areas where it's not qualified, but I could imagine the Fed hiring maybe meteorologists and climate scientists to add to its modeling. But I'm curious, how do we think about the Treasury, the Fed? How do they wrap their arms around this? They need data, they need models. Any thoughts on that?
How the Treasury and the Fed Should Approach Climate Risk
Galper: Yeah, so this work has been going on for quite some time actually in the private sector and then picking up in the public sector. Some of the best work in fact has been organized or has been assembled from a diverse group of characters by the Network for Greening the Financial System. Last September, they put out case studies, which covered about 35 different methodologies, if we're looking at climate risk. The easiest one to get your head around is loans. So we can look at a corporate bond and we can say, is that bond connected to green lending in some way? Or is there a climate friendly reason for the company borrowing this money? And there've been some very successful corporate bond issues in the last couple of years that have said, we're going to use this money, where the issuers said, we're going to use this money for a climate friendly purpose, and we're going to prove that to you; investor.
Galper: And if we don't, we're going to pay you more on the bond than what we're offering now. So that's the easy part. The harder part is when you get to the potential impact of climate change on the value of securities that are held in a portfolio. So let's apply this to a bank's balance sheet. If a bank is holding a wide variety of securities, government debt, corporate bonds, equity securities, asset-backed securities, all sorts of things, if there's a fire in California, the question then becomes, how are the value of those assets going to be impacted?
Galper: When you start to think about that question, that's the rabbit hole. That's where things get really hard really quick. There are some companies now that have started to produce VAR models; value at risk. There's another project that's been working on, expected shortfall; the expected shortfall method as a means of determining risk in the climate space. And all of these models themselves have validity. You can argue the merits of VAR and many have and will continue to, but the models themselves are fine. The trouble is what are the data that are feeding those models. And that's, I think, where everyone working on this topic has come to the conclusion of we're really not there yet, but that in turn feeds the very interesting part of the conversation about the potential engagement of the Biden administration. Shall I go on?
Beckworth: Yeah, no, no. I think this is useful. So I'll just mention, with Janet Yellen at the helm of Treasury, it seems likely that FSOC will really ramp up what it does in the Office of Financial Research. And I know this is part of the story, right, you think.
Galper: I do think. Yes. So we, in the United States, we have this very interesting organization called the Office of Financial Research created out of Dodd-Frank whose mandate is to organize data or part of its mandate is to organize data, to be a data resource for all things risk exposure related. It is meant to be the data organization for a wide variety of regulators and really the FSOC; the Financial Stability Oversight Council to really be its mechanism for understanding risk exposure. Under the Trump administration, the OFR; the Office of Financial Research has seen its budget cut, and really its work capability is reduced.
Galper: It's also become much more of a US Treasury source of information as opposed to aggregating the data capabilities of all US regulators. I don't know if the mandate would really be to centralize the data capabilities, but at least to be able to robustly know where everything lies, to organize it, and be able to provide it back to other regulators as needed. So I think the really interesting part here when you get to the data conversation of climate risk measurement is that we in the US, we have this federal agency that has the mandate already of maintaining and organizing financial risk data. I think in the Biden administration, as they get more serious about climate risk, I think the Office of Financial Research becomes a central point or a potential central point for how all the metadata get organized.
Galper: And by metadata, I mean the underlying data that's going to impact the value of a security due to climate risk. So it's convoluted stuff, but we have the mechanisms, we have the tools. And especially now, again, using the idea that the Fed joining the Network for Greening the Financial System as a linchpin, I think that this could be the trigger that starts the real process in motion of how are we going to get to that conversation to say, this is the methodology used to measure climate risk on assets.
I think in the Biden administration, as they get more serious about climate risk, I think the Office of Financial Research becomes a central point or a potential central point for how all the metadata get organized. And by metadata, I mean the underlying data that's going to impact the value of a security due to climate risk.
Galper: And then behind that, here are the sources of data used to feed that methodology. This is not cocktail party stuff. This is stuff that's going to put somebody to sleep really quick, but when you get to the nuts and bolts of how are you going to do this, how is this thing going to work, that's I think the opportunity and the challenge that's facing not just the Biden administration, but also the global financial services industry over the next couple of years. I'd point out also that the US is relatively late to the game on these topics. The Bank of England has taken the most proactive approach in 2021. They are going to have climate stress tests, the ECB; the European Central Bank, they have a requirement for a self-assessment from European banks in the first part of 2021.
Galper: But this move by the Fed, this is the first time that we're seeing a national US regulator take a more direct action for engagement. And let me also caveat that the CFTC put out a really excellent report a couple months ago about the potential impact of climate risk to US financial markets. It was a stellar report, maybe even more surprising by the fact that it came out under the current presidential administration. So you had, for the first time, the US regulator say, "We have a real problem here." And they worked very well to define what that problem was. And then the next step, of course, is what do you do about the problem.
Beckworth: Yeah, let's come back to what you do about the problem. I have some questions on that. Let me go back to the OFR; the Office of Financial Research. Correct me if I'm wrong, but they already have a mandate from Congress, it's the law, that they can collect much of this data, right? They're supposed to have access to data from all these member financial institutions. So, it should be relatively easy for them to get the data for this project?
Galper: No, no.
Galper: So, yes, they can ask for data, but when you're talking about modeling climate risk, then you're thinking about things like, how do you know the value of shipping companies in the event that the oceans get warmer, or if there's an oil spill in the Gulf of Mexico, what does that do to the various supplier and customer chains that impact different companies? This gets back to the idea of metadata. So, yes, the OFR can collect data from financial institutions and from other regulators. It's never been a particular problem as far as I've seen. But when you get to the harder question about what methodologies are going to be used, are going to be accepted by a regulator for measuring climate stress on a bank's balance sheet or an insurance company. And then how are you going to know that the regulated entity has used supporting data to feed its model that you can then validate?
Galper: So, for example, you and I could sit around and we could say, oh, it's a really cold day in New England. That's going to slow people down. Tomorrow could be a blizzard. Schools are going to close, won't be buses or cars on the road, that's going to mean less oil being used, right? So for the microcosm of the New England economy, that's going to mean that oil stocks won't see as much revenue. But what if you play that out on a much broader scale and say, okay, you've got forest wildfires up and down the West Coast. who are all the different players impacted there? What's the geospatial data analysis that's required to understand, not just the companies that operate in those geographies, but also the behaviors of the consumers, and what that does and what they do as this plays out throughout financial markets?
Galper: This is an acute example, that, of course, at some point wildfires get under control, people move back home, they rebuild their homes, et cetera. But the challenge then of the climate stress methodologies, climate risk methodologies is being able to say, "Here's how we're going to model an acute event, a long-term, a 30 year time horizon." And at that point, a regulator may need to step in and say, "We require you to use this methodology." And then the regulated institution would logically say, "Well, that's great. Where are we going to get all the data to feed that?" And that's where I believe the OFR would come in as a data repository of the supporting inputs for that kind of climate risk methodology.
Beckworth: Okay, so let me step back from this and just say a few things that come to mind here. This sounds very ambitious, maybe almost too ambitious. From my experience, working with macro models, you try to model the US economy, you need a lot of information... If you're going to try to figure out the effect of fires up and down the coast of California, there's a lot of information you need to get, right? As you said, all the people affected, all the businesses, hence the term metadata.
Beckworth: We struggle with macro models. One, getting sufficient data. Data has gotten better. I'll recognize that. But even then, how do we interpret, apply, think? And then over 30 years, man, those are some Herculean hurdles there to clear. Do we have any evidence that we have models that are very useful at this point? Are we just talking about developing these models and getting the data?
Modelling Climate Risk and Incentivizing Good Behavior
Galper: There are prototypes of models. And like you, the macro modeling environment, I've done a lot of work there myself, and it's something I actually quite enjoy for its complexity. And I can tell you with some great certainty that I don't think there's ever going to be a climate risk model that nails it, but there are climate risk models already that, looking historically, can more or less replicate what happened. And the challenge is always going to be what's the closest you can get to a decent model that uses a realistic amount of data that you have. We are never going to model everything. We're not going to do that. But the conversation that we're stepping into now is, what is that balance of a model that's, “yeah, that's good enough, that's realistic enough, we can roll with this.”
I can tell you with some great certainty that I don't think there's ever going to be a climate risk model that nails it, but there are climate risk models already that, looking historically, can more or less replicate what happened. And the challenge is always going to be what's the closest you can get to a decent model that uses a realistic amount of data that you have.
Beckworth: Yeah. And that's true in any profession, right? You have a small business, you've got to project firm revenues for next year, and it's probably going to be off. It's probably not going to be perfect. And on any really big question, you have to have some kind of model, sometime it's an implicit model in your head, sometimes it's explicit. And so we need to be modest and aim for the best but understand, with some humility, that we may not nail it perfectly every time as you said.
Beckworth: Well, let's talk about the implications for policy, right? And I can think of, in general terms, a carrot and stick approach to this. So maybe you can walk us through that. Given we have the models, given we have the data. We've cleared that hurdle. What do policymakers do with it to incentivize good behavior?
Galper: There's a couple of ways to look at this. The way that I'm most comfortable with is the financial stability risk question. So for any regulator, one of their very principal requirements is to ensure financial stability risk. They do that through a variety of means, including stress tests, including leverage ratio, liquidity coverage ratio, net stable funding ratio, et cetera, various Basel rules and domestic implementations. So I could easily see climate risk becoming another element of measurement. That's an easy thing to put on paper that has tremendous impact across capital markets. Because if you think about, for example, liquidity coverage ratio as a tax on a bank's balance sheet, then climate risk could become another tax.
Galper: I don't know honestly how it gets avoided. Every passing year that there are more climate events and administrations, governments around the world that want to understand the impact of those climate events on their financial institutions, I think they have to ask the question. I think the last four years we've seen, in the US administration, [they haven’t] been too interested, but the Biden administration is coming in quite strong on these topics. And I think we're going to see the implementation first of trial run, but then of some sort of global standard; very possible coming out of the Basel Committee on Banking Supervision that says, here is the climate stress test.
Galper: That's, I think, really where the dominoes start to fall across capital markets, because then you're going to have assets that are more or valued on a bank's balance sheet, or on an insurance company's balance sheet, or acceptable as collateral in repo or OTC derivatives markets because of that climate risk cost. So I think that's our next step. And I think it will come out of the regulatory community.
Beckworth: So, Josh, it sounds like what you're saying is that this climate risk could be used as another way to maybe require more capital funding on a bank's balance sheet, if they're holding assets that might be risky in terms of climate risk. So, more buffer because this asset might lose value in an acute crisis, right? A hurricane hits, fire erupts. Is that one way to look at this?
Galper: That is one way to look at it, yes. So, that's the financial risk point of view. If you're holding an asset that could lose value in an acute climate event, then you need to hold more of a buffer to support that asset. That of course makes the transaction more expensive, or the asset more expensive. That will lead to banks and other regulated entities saying, logically, do we want to hold this asset?
Galper: In the collateral space, we talk about cheapest to deliver. What's the asset that's the least expensive for an institution to deliver as collateral such that the other institution will accept it, it's got to be an acceptable asset to begin with. But if you then apply a climate risk tax or a climate risk element across capital markets, that changes the calculus entirely about what that cheapest to deliver is. So, yes, it does, it would require an institution to hold more buffer, to hold more capital against certain assets, but more importantly, I think, it creates an incentive for behavior change that we've already seen with Basel rules to encourage institutions to do business in sorts of ways that reduce that negative exposure on the balance sheet.
If you then apply a climate risk tax or a climate risk element across capital markets, that changes the calculus entirely about what that cheapest to deliver is. So, yes, it does, it would require an institution to hold more buffer, to hold more capital against certain assets, but more importantly, I think, it creates an incentive for behavior change that we've already seen with Basel rules to encourage institutions to do business in sorts of ways that reduce that negative exposure on the balance sheet.
Beckworth: Yeah, that makes a lot of sense. So the bank saw the first part of the regulatory process, but then it reverberates out through the entire market so that if the banks are going to pay less for a certain asset, that's going to be manifested in market prices and trading and everything else. So the tip of the spear is that regulation, that requirement for more capital funding. This reminds me of this fundamental approach to financial regulation, maybe it's fundamental. It's two views, broadly speaking. And that is one, we go in and we apply all these regulations. We look at liquidity ratios, we look at all these different measures, metrics, and we apply some additional buffer you've got to carry, right? And there's a lot of them. We've talked about them before.
Beckworth: There's a maze of them. It keeps lawyers employed and people like you employed because it's a maze of financial regulation. So, that's one approach. The other approach is you say, look, let's don't do all these regulations, let's just require a much larger capital buffer; 15% capital. I'm putting some high numbers up there. We're a long ways from that. But a simple approach would be just look, fund with more capital at a high level, so you can bear the risk of climate change. You can bear the risk of a big global financial crisis. But I know that's not the world we live in, so I'll get off my soap box and come back to the reality. You're in the real world, Josh, and you got to wrestle with clients who deal with this on a regular basis in 2021. And this discussion will be about these new regulatory metrics or innovations there.
Galper: Yes. So you make a great point in that if you were to have something like a 15% leverage ratio, you would take out the political conversation entirely. You would simply say, "Banks, make sure you have enough assets to be financially stable." And you'd leave it at that. The reality is that politics is going to dictate this conversation. So the fact that the Biden administration is coming in has already signaled very strongly that they're going to be active on climate issues. Broadly speaking, climate risk will be a subset of that conversation. And such, you could realistically expect then that the people appointed into senior regulatory positions at CFTC, SEC, the Fed when that comes around, will be asked about their views on climate risk and more or less be expected to drive their organizations to be requiring more accounting.
Galper: So then we leave that 15% leverage ratio far behind, and we're the much slipperier slope of where politics live and the desires of politicians and regulators to change industry behavior. And that's what I think is actually going to happen in practice. When you look at changing industry behavior then, the next part of the conversation is, how specifically do you do it? And that gets us back to the beginning of our conversation, which is the nuts and bolts of the methodologies. You could have, for example, a climate stress test that asks some very easy questions. Are you prepared? Yes, we're prepared.
Galper: How did you do in the last one? Yeah, we did fine. And leave it at that. I don't think that that's what's going to happen. I think we're going to be looking at quantitative metrics that look to model the sudden and transitional impact of climate risk on financial stability. And we're already seeing this play out in practice around the world from different regulators, where in the US, once the Fed gets really involved, that becomes the most impactful part of the puzzle for how banks look at climate risk internally, and then how it plays out throughout the industry.
I think we're going to be looking at quantitative metrics that look to model the sudden and transitional impact of climate risk on financial stability. And we're already seeing this play out in practice around the world from different regulators, where in the US, once the Fed gets really involved, that becomes the most impactful part of the puzzle for how banks look at climate risk internally, and then how it plays out throughout the industry.
Beckworth: So, Josh, the question then is, who will be the key people that will implement this new regulatory framework under the Biden administration? So what do you see as the most important agencies and maybe positions? And you mentioned the Fed; the Fed's an important one. They’re one of the most important bank regulators, financial system stability regulators in the country. I know the Treasury secretary chairs FSOC, which is probably, I don't know, the mothership of... I'm not sure if that's the right analogy. But what positions do you think are most important in implementing the Biden administration's vision?
The Key Institutions for Change in the Biden Administration
Galper: Yeah, I think the key one is going to be the vice chair for supervision at the Fed. Currently, that's, of course, Randal Quarles, but his term as vice chair for supervision ends in October 2021. So that means we're under a year away from a vice chair for supervision who might look a lot like the previous vice chair who was Daniel Tarullo. Tarullo’s visions of regulation were much more supervisory oriented, much more reporting oriented, much higher requirements for banks than what Quarles has indicated thus far. Now, and that may not be entirely fair because Quarles certainly has been quite proactive about bank regulation, but at the same time, he's also raised a lot of questions about, are these regulations effective? Let's rationalize where we can.
Galper: Further as chair of the financial stability board, Quarles has had really an out-sized influence globally in the conversation of bank regulation and also regulation for non-bank financial intermediation. Since Quarles could be rolling off of his position in 2021; October 2021, that gives the Biden administration the opportunity to not only appoint a new Fed board member, which there's an open seat, but also to appoint a new vice chair for supervision who could potentially, and this is definitely a big if, take that conversation about climate risk and financial stability to a much more advanced state and really enter it into the practices of risk oversight at financial institutions. This could be the big move.
That gives the Biden administration the opportunity to not only appoint a new Fed board member, which there's an open seat, but also to appoint a new vice chair for supervision who could potentially, and this is definitely a big if, take that conversation about climate risk and financial stability to a much more advanced state and really enter it into the practices of risk oversight at financial institutions. This could be the big move.
Beckworth: And that's interesting because some of us Fed watchers have been talking about the big Fed chair discussion next year, because Jay Powell's term will end next year as well. So 2022 will be a new Fed chair, could be Jay Powell, could be someone else. And we were all thinking, Oh, this is going to be the big question next year, but maybe the vice chair for supervision might be an even bigger question. If the Biden administration really is passionate about this vision of climate risk and dealing with it. Let me go back to this point you made about the influence the vice chair has. So he obviously is a big regulator within the Fed, but also you mentioned his influence via the financial stability board. Maybe explain to our listeners, why is this body so important? What does it do? Why is it so influential in giving power to the vice chair?
The Influence of the Financial Stability Board
Galper: Sure. So, first of all, let me separate those two questions if I could. The financial stability board is incredibly influential because it is a major tool of the advanced economies in setting the financial agenda; financial stability agenda as their name of course implies. They are a research firm, they're a policy organization. What they have to say drives a lot of the regulatory conversation around the world. The chair of that organization is not inherently also the vice chair for financial supervision at the Fed. It just so happens that Quarles is currently the chair. So those two pieces should be kept separate, but regardless of who the chair is, the US will certainly have major inputs into the financial stability boards work plan. And if the US is much more focused on climate risk than it has been, then you can expect that the FSB will not only continue its current work on climate risk, and it has been actively engaged, but also to be getting much more into the teeth of not just talking about climate risk as an issue, which it has been, and many others have been, but getting much more to the specifics of, okay, what kind of risk exposure are we talking about here? How are we going to measure this thing? And that, as noted earlier, that's the real work.
The financial stability board is incredibly influential because it is a major tool of the advanced economies in setting the financial agenda; financial stability agenda as their name of course implies. They are a research firm, they're a policy organization. What they have to say drives a lot of the regulatory conversation around the world.
Beckworth: What role would FSOC play in this climate risk discussion?
Galper: The FSOC has a major role to play here, and to think again to the idea that climate risk might be one of the metrics that the Biden administration would use to evaluate potential heads of the regulatory agencies. Starting from the US Treasury, Janet Yellen of course will be chair of the FSOC, the FSOC could say quite publicly, we are getting quite serious about climate risk and all of our regulated entities should be prepared to first do a self-assessment. And then also to engage in discussion with us, particularly for banks, about what the methodologies are going to be to measure climate risk. And these methodologies would come out in draft form just like the net stable funding ratio papers, where banks would then have an opportunity to come back and say, we think this works, we don't think that works, could you give us a little more time here, that sort of thing.
Galper: Once the FSOC says that it's going to get involved, that's again where I think the office of financial research comes back to the fore as the FSOC’s implementation arm for understanding data management. Here I'd actually like to draw attention to a very interesting paper that came out recently from a fellow named Greg Feldberg, who was previously a director at the Office of Financial Research. And what he published on, it actually came out from the Brookings Institution earlier in December 2020, what he was focused on was about data strategy, US data strategy. And I think he is spot on in that the US has known for years that it needs to have a data strategy in financial risk, the OFR is the institution to manage that strategy.
Galper: But it has really been placed in a position, downgraded. It's been downgraded from where it could be. I think to do this right, to do climate risk right, the play is for FSOC to say, yes, we're doing it. And then to say, Office of Financial Research, you have the mandate. So, get those methodologies straight, get the data for the methodologies and not just the results of the climate risk stress tests, which there will be, but importantly, what are institutions going to need to be able to make those methodologies run correctly? And if it winds up being an independent firm, like an MSEI who now has a climate VAR tool that they're marketing, then the Office of Financial Research could be in a position of auditing those tools, of being the US agency that validates those tools to say, "Yes, we know how they work. We believe that these approved tools do the job that is meant to be done by these regulations."
Galper: Right now, none of that chain of conversation exists, but we're not even on the board. All that exists right now are self-commitments by banks, self-affirmations, agreements with the UNEP financial objectives. But nowhere is there any sort of regulation that says, here are the models, here's the idea of the model. You can use your own model if you want, but you have to prove that it works. And then some mechanism for actually making that approval happen. So that's I think really the, getting back to the FSOC, that's the FSOC’s real contribution here is saying, we're here, we're in the game, and we have this agency that we can mandate to actually get some implementation done.
Beckworth: Well, Josh, this has been very interesting discussion and I think 2021 will be a big year for all of us to follow to see how this conversation on climate risk unfolds in the financial regulatory space. I want to transition in the minutes we have left to some work you've been doing recently. I know you've been thinking a lot about negative interest rates as well. So tell us what you've been thinking about and your insights into it.
Negative or Dual Interest Rates in the US
Galper: Sure, sure. So, of course, there've been negative interest rates in Europe and Japan for years. We recently looked at the question of, could there be a negative US interest rates in the US? And more importantly, what would the Fed do to avoid negative US interest rates? I think it's widely accepted that no one likes negative interest rates anywhere in the world. I've never met anyone who said, "Yeah, that's a great idea. Let's do that first." This is more the thing that someone will do, like a regulator would do eighth or tenth, or twentieth and the list of good options. So for central banks around the world then, operating in zero or close to zero interest rate environments, the greatest concern is avoiding the negative rate situation. In trading, negative rates occur all the time, but quite a big difference to have negative rates occurring in the market versus having a benchmark rate that's negative.
For central banks around the world then, operating in zero or close to zero interest rate environments, the greatest concern is avoiding the negative rate situation. In trading, negative rates occur all the time, but quite a big difference to have negative rates occurring in the market versus having a benchmark rate that's negative.
Galper: So our thoughts here are that the Fed would go to quite some lengths to avoid negative rates in the US. Some ideas you mentioned earlier, yield curve control. I think that's entirely possible. Also, the idea of expanding that range of where repo rates trade the Fed between zero and 15 for overnight to something like 10 to 25. And here, interestingly, the Fed would still be operating in the zero to 25 basis points at its current interest rate target. It would simply move the window to a different range that would effectively make market participants trade higher than zero. This is going to be a tough one.
Galper: I think if the US economy improves next year, and the Fed is going to have a lot of comfort and hopefully we'll get over 2% inflation for long enough that the Fed will ultimately say, "Yes, we're going to move away from zero to 25 BPS, let's get up to 50 BPS." But if the US economy moves in the wrong direction, I think the Fed is going to be very strained. I think the other options are also unattractive, where there is a lot more fiscal debt spending, a lot more US Treasury issuance, which means then we're looking at something like a Fed balance sheet that could be in the 15 trillion range up from seven now.
Beckworth: It's huge.
Galper: It's wincing to think about. Yeah, it's huge. But I think that that's realistically the environment that we're in and that should be considered as a very possible outcome.
Beckworth: So Josh, that is interesting. And I like your point about yield curve control, because that's what Japan has done. They've used yield curve control in the ten-year to keep it from actually falling and to keep banks profitable, to put some positive spread for them. Another idea that has popped up a lot recently, and we've had some people on our show talk about it is the idea of dual interest rates. So one of the concerns, as in the case of Japan, is that when you go negative interest rates, you're going to hurt banks. Banks are not going to be profitable; financial firms in general.
Beckworth: The business of financial intermediation gets killed with negative interest rates, however if you can somehow keep a positive spread, so even if you go to negative rates, but can keep a positive spread between funding and lending prices, then you can keep financial firms afloat. So one idea is, and the ECB is doing it to some extent with its TLTROs, but in the case of the US would be maybe having a discount rate that's, for the sake of illustration, this is probably not a good number, say minus 2%, but you keep interest and excess reserves set above zero, like 1%.
Beckworth: So there's a spread there. Now, that'd be tempting for the bank just to borrow from the Fed and then go park it back at the Fed arbitrage at spread, but there'd be some requirement, that you've got to take those funds and you have to lend them to the real economy. You've got to do loans to cars, to homes, whatever it may be, but the idea is you're still making it profitable for banks. And I'm just wondering what your thoughts are based on your experience. You're deep in the money markets, you're right there where all the activity is. What would be the reception of something like that on Wall Street?
Galper: Well, I think on Wall Street, they might say, okay, that sounds all right, we've got a spread, we're good to go. But to point out, there already is something of multiple interest rates in the US, where the overnight benchmark funding rate, for example, in last few days has been eight basis points, and IOER is a 10. So it's already a mechanism for banks to be able to borrow money and reinvest if they want that two basis points spread, if they have nothing better to do. I think the bigger problem though, is that when you get into multiple rates, whatever they may be, I think that that caused a lot of confusion in the market and a sense of unfairness. I think it becomes more of a getting back into that political game, where I think you and I are in agreement that it would be ideal to not have politics in any form of this conversation.
Galper: That's unlikely to happen. But if you think about a country like Turkey, where they've had multiple rates and actually the initiative now of the new head of the central bank there is to get rid of these multiple rates because it doesn't help. It's really a hindrance to a productive, open market. I think we'll find if we were go to multiple rates, dual rates here in the US, that we have a similar frustration from the parties who would lose out in some way. For that reason, primarily I'm not in support. I think that there's other ways to manage the zero or close to zero interest rate environment. The Fed does have options. They're not out of options yet. It doesn't look great, but they're definitely not out of options.
Beckworth: Right. Right. Well, these are great questions because as we talked about earlier, at least I talked about earlier, it does appear we're on this downward trajectory over the long-term for interest rates. And again, maybe the pandemic will be a pivotal point and inflection point that changes that. But, for now, at least it appears we're stuck pretty close to zero, so interesting conversation to follow going forward. Well with that, our time is up. Our guest today has been Josh Galper. Josh, thank you so much for coming back on the show.
Galper: Hey, my pleasure. Thanks so much for having me.
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