Kathryn Judge is a professor of law at Columbia Law School and editor of the journal of Financial Regulation. Anil Kashyap is a professor of economics and finance at the University of Chicago and is a member of the Bank of England's financial policy committee. Kate and Anil join David on Macro Musings to discuss their work on the Task Force on Financial Stability that recently released a report on how to improve financial stability in the US. Specifically, they discuss the origins of the Task Force on Financial Stability, the dynamics of the Treasury Market over the past year, why money market funds are still vulnerable despite an evolving set of regulations, the importance of rich and timely data for regulatory bodies and Congress, normalizing a financial stability mandate across regulatory bodies, the outlook of financial stability over the next decade, and much more.
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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: Kate and Anil, welcome to the show.
Anil Kashyap: Thanks.
Kate Judge: Thank you.
Beckworth: It's great to get you on. And Kate, I believe was almost a year ago that you were on this show. It was last summer, or sometime around then. We were in the thick of things and we were talking about all the Fed’s facilities, were they kind of reaching beyond their mandate, were they doing credit facilities, kind of something we'd expect fiscal policy to do more. So that was a very eventful time. We were very busy and very engaged, but a good time. And Kate, you did get your nominal GDP targeting amount from that show. Is that right?
Judge: I do have my mug, and I have to say it's one of my husband's favorites. So we're grateful for it.
Beckworth: Fantastic. Well, I think you know Kate, if you've listened to the show that my dream is to get every member of the FOMC with a nominal GDP targeting mugs every morning they get their coffee, they're slowly being convinced of the merits of nominal GDP targeting. Anil, you'll get yours soon too. So happy to have you join the club. So you have this report and it was interesting to read that it actually was commissioned, or it started out in late 2019. So I believe Anil, you're a key part of the gayness going. So what's the history behind it? And then the reports being written, and then here we have the pandemic. How did the pandemic influence your original plans?
The Task Force on Financial Stability
Kashyap: Well, the idea that there was a up in financial stability in the United States is one that lots and lots of people had. Remember when they were doing this Fed listening tour at conference about their new policy framework. And they commissioned a set of papers around that. I had got asked to write one on the financial stability implications of monetary policy. And at the end of that paper, we suggested that they should look into the gaps, enter commission, get Congress to put together a commission to look at the problems. It was 10 years on from Dodd-Frank. There were lots of gaping holes that ended up being pretty apparent in March 2020.
Kashyap: And so we suggested this. That suggestion went nowhere but David Wessel heard about it and thought it was a good idea. And he set out to say, well, look, if Congress isn't going to do it, why don't we just do it? And that was the justice. And even by October 2019, some of the things we talk about, like disfunction in the treasury market had already happened in September, 2019. So when we first met, we had a list of issues we were going to talk about, and it wasn't like things that happened in March, 2020, or April, 2020 weren't already apparent on our list. That's kind of the sad state that we find ourselves in, that this has been here festering 10 years, and now maybe we'll get around to it. Let's hope.
Beckworth: Yeah. My suspicion was March 2020 only reinforced your concern about these issues. That it spoke to some of the challenges you were already writing about. Kate, did it have any bearing on what you were doing in this program?
Judge: Yeah. It was central in two ways. I mean, just as a background matter, I think one of the more dangerous interpretations of the past year is that actually, because the financial system came through relatively smoothly, that's a sign that it has the built-in resilience it needs to function during periods of distress. We see that very, very differently. As we talked about last time I was on the show, we had not only unprecedented support for the federal reserve, but just as importantly, if not more importantly, we had a Congress that was willing to act very aggressively with a whole variety of types of fiscal support. And so being able to say that the financial system was able to survive when it has that much life support being pumped into it is very different than saying, it's sufficiently resilient to deal with either external shocks or has happened in 2008 that we can trust is not going to have fragilities that arise from within and spill over to the real economy. So first of all, I think we remain very concerned.
One of the more dangerous interpretations of the past year is that actually, because the financial system came through relatively smoothly, that's a sign that it has the built-in resilience it needs to function during periods of distress. We see that very, very differently.
Judge: The second point, which Anil made and we'll go back to later in the show is it was striking I think to everybody on our task force, that so much of the dysfunction that we saw in March and April, 2020 mapped on to the list of the topics that we had already created the previous winter. And I think for us that was a disturbing sign that not only are there going to be things that go wrong when a pandemic hits, which we would expect, whether there were real sources of fragility that were being allowed to linger and allowed to fester and grow, which is a sign that there's something wrong with our regulatory processes.
Beckworth: Yeah. I want to go back to your first point you made Kate. If I look back over the past year, the two takeaways I had are the ones you just outlined. What is financial stability about? How was it maintained? Well, the Fed, it opened up its balance sheet almost to everybody and everything, central banks across the world, we now have money market funds that have access to the Fed’s balance sheet, central clearing facilities have access to it. There's a lot more that the Fed seems to do all these facilities as well, which may have been temporary, but they're just more and more reach of the Fed in the financial system. And that seems to have stemmed the flow. And I've had your friend, Lev Menand on the show before. We've talked about how the kind of shadow global banking system or the global dollar funding markets around the world increasingly rely on the Fed as a backstop when you have these crises and what can we do about them.
Beckworth But the other takeaway from last year was all the income support we got from the federal government. And so I have mixed feelings about that because on one hand, that to me might be a great way to move forward if it was a kind of a rules-based approach. As you guys know, I'm a fan of nominal GDP targeting, which can also be called nominal income level targeting, and that's purely monetary policy. But I can imagine a world where monetary policy and fiscal policy kind of work together in a very systematic manner and stabilize aggregate incomes. And that would help the financial system, but it wouldn't solve the underlying problems, I think, is your concern, correct?
Judge: That is part of the concern. And I would also say I'm very supportive of automatic stabilizers for a number of different reasons. And unfortunately we haven't moved in that direction. And while I'm very grateful for Congress's willingness to step up to the plate this time, I don't want to bank on them being equally willing to do so in the face of all of the shocks that the economy might face.
Beckworth: That's fair. I mean, it was very unusual last year. It took a lot to get Congress to the place where they were willing to do it.
Kashyap: And further than that, imagine now that the Fed is talking about tapering its purchases. Imagine the Fed was in a position where the next time we have one of these disruptions, we see that the monetary policy was tightening, they were shrinking the balance sheet. Would you be confident that they would step in with this overwhelming firepower to just buy everything in sight and they've been signaling, we're getting ready to unwind? So the fact that it worked last time shouldn't lead us to have false comfort that you could just pull out this playbook and it's always going to work because the circumstances could be pretty different.
Beckworth: Yeah. The larger the Fed’s balance sheet gets, the more you worry that it'll have fewer degrees of freedom next time around crisis rolls upon us. All right, let's talk about the report. Now you have some guiding principles in it. Do you want to speak to them before we get into the actual areas?
Kashyap: We can. I mean the big one is just that we should be fixing a problem that exists. There ought to be some externality that you're attending to. And just because prices move a lot, that's not necessarily a problem. What's the problem is when something in one part of the system changes and then has unintended consequences or spillover effects elsewhere that knock-on problems. So we were very, very big about every chapter, for every recommendation, let's explain why the private sector on its own isn't going to attend to just fixing that, and why you actually need some change in the regulations or rules or whatever. So, we didn't want to just jump to conclusions saying, here's something that has to happen, we want to give a rationale and then how the recommendation we're making would attend to the problem we've identified and why at least loosely passes a cost benefit test.
Just because prices move a lot, that's not necessarily a problem. What's the problem is when something in one part of the system changes and then has unintended consequences or spillover effects elsewhere that knock-on problems.
Beckworth: Okay. So a key part of last year was this market meltdown in March of last year, and the treasury market was kind of central to the story. Anil, can you help us understand what the big takeaways, the lesson should be from what we saw last year in the treasury market?
What’s Going on with the Treasury Market?
Kashyap: Well, the kind of architecture underlying the treasury market had not kept up with the size of the use of the treasury market for various parts of the financial system. So we had, going back to Dodd-Frank, layered on a whole bunch of regulations that said, banks have to hold these treasuries to set by liquidity requirements. Then you had open-end funds having the whole treasury to meet liquidity demands. You had capital regulation that came in and made it expensive for broker dealers to intermediate the treasury market, the treasury market is not a cleared market. So it relies on the dealers to facilitate trading.
Kashyap: Dealer balance sheets have stagnated, and yet the need to trade or transact in the treasury market had grown. You had this imbalance and this imbalance that reared its head in September, 2019, where you saw a spike in treasury yields. So we knew that this was a problem, and people have been talking about it for a long, long time. And I’ve been writing about this for years. So there were a bunch of existing cracks in the system and then they got badly exposed. And I guess the telltale sign was, we actually had this short period before the Fed stepped in where you had the S&P dropping, the VIX spiking and treasury yields rising. So instead of being the flight to safety, you had a fear or run out of treasuries and that told you that there was something wrong in the plumbing, because it wasn't like the credit risk of the United States government had gone up. This was just about the plumbing not working.
We actually had this short period before the Fed stepped in where you had the S&P dropping, the VIX spiking and treasury yields rising. So instead of being the flight to safety, you had a fear or run out of treasuries and that told you that there was something wrong in the plumbing.
Beckworth: So is it fair to call it a dash for cash, as the term is often used? And I bring this up Anil because back on a great financial crisis period in the years after that, with the zero lower bound, a lot of discussion about how treasuries are perfect substitutes for reserves. But this experience seems to suggest otherwise, that people were literally running for reserves. Is that right or am I pushing that too?
Kashyap: I think you're exactly right. So I should say, I'm not speaking in any capacity for the Bank of England, but that's the Bank of England's preferred term is dash for cash. And there are certain things like posting margin where you actually really want to either give them a reserve or a bank deposit. And there were other times when people were having to meet redemptions where you needed to pay them out essentially with the bank deposits. So it became clear that during those few weeks before the Fed stepped in, people were really trying to turn treasuries into reserves and the market wasn't working very well. And that's one of the things that we hope will be fixed.
Beckworth: Well, let's speak to the recommendations that were made for the treasury market. Now, I know Anil, you covered the open-end funds and Kate, you're going to talk about the regulatory structure and process. But can either of you speak to the recommendations that your colleagues on this task force made for the treasury market.
Recommendations for Treasury Market Stability
Kashyap: I can start, maybe Kate will add in.
Kashyap: So I think wanted to reduce both the problems with the need to sell and the ability to buy smoothly in the treasury market. So one of the things that we wanted to do was make it easier for the dealers, to the extent they're still going to be involved in the trading to support market-making. And there's this technical capital regulation called the supplemental route leverage ratio that was passed after the GFC that was supposed to be a backstop to risk weighted capital requirements. But the upshot of that was to make certain low margin businesses expensive, because if you're just holding a treasury on your balance sheet, you don't have a lot of credit risks, you have no credit risk basically, you have limited interest rate risk probably, and yet you'd have to hold capital against that.
One of the things that we wanted to do was make it easier for the dealers, to the extent they're still going to be involved in the trading to support market-making.
Kashyap: And so guess what, you do that, the banks will conclude that they're not as interested in market-making. So we had several technical recommendations to try to reduce the cost of market-making. These can be implemented without releasing capital from the banking system. So we weren't trying to give the banks a free loan, or just say, you don't need as much capital, we just wanted to not make the SLR and this leverage ratio, the binding constraint on a business decision. These things were supposed to be there as kind of a backstop, and we didn't want them to be the front and center. So that was one set of things. Kate, do you want to talk about the facility?
Judge: Okay. I can jump in. So yeah, the two... I'll talk a couple of things. I mean, one, I'll mention quickly because since you've already discussed it on your show is we do support the idea of trying to explore centralized clearing. I mean, one of the interesting challenges there is it does seem like the structure of the market was one of the factors that exacerbated the dysfunction. I'll say also we don't see that as a complete solution. So I think some people saw that as the mechanism through which we could avoid these types of dysfunction. We see that there's just such a cemetery in terms of people try to unload that we don't see central clearing as a full solution. We do see market structure as being one of the challenges and central clearing as a helpful way of dealing with it.
Judge: And then another approach that we endorse that again has been talked about quite a bit and finally embraced, we're still trying to figure out the details, is a standing repo facility. I mean, one of the things that we've seen now is the Fed has had to step in on a number of different occasions. And once they're having to regularly step in to be able to provide support to market functioning, it makes sense instead of having emergency after emergency, having to be called to instead create the facility that allows the additional flex in the system. And we see a standing repo facility as providing that type of flex.
Beckworth: Yeah. I should let our listeners know that we are recording this on July 28th. And just today, the Fed announced this, I guess, a permanent standing repo facility. Because as you mentioned, they temporarily use them during these periods of stress. So we have quite a big day for those of us who were interested and curious as to what the Fed would actually do with the standing repo facility. Anil, did you have something you wanted to add?
Kashyap: Yeah. I just want to say one perspective which our proposal differ from some others is, we recognize that if... First of all, the point of this facility is to say, you're always going to be able to finance your treasury securities. And if you know you have to finance them, maybe you don't sell them to worry if you can't finance them. As Kate said, we're not assuming that's going to solve everything, but we think that could go a long way. We thought that does mean though that certain people will be able to take more leverage in the system if you know you can fund these things. And if you essentially put floor on the price of treasuries or a cap on the yield, that's going to lead to somewhat more leverage in those systems.
One of the things that we've seen now is the Fed has had to step in on a number of different occasions. And once they're having to regularly step in to be able to provide support to market functioning, it makes sense instead of having emergency after emergency, having to be called to instead create the facility that allows the additional flex in the system. And we see a standing repo facility as providing that type of flex.
Kashyap: So one thing about our recommendation, and it's not clear exactly how the Fed proposed to do this, is that we want to charge a fee for the people that were going to have access to this facility. And we wanted to mandate that some people had to sign up for the facility whether they wanted to or not. So for example, these principle trading firms that are market makers normally, but then step out of the market during stress would be mandated in our world to sign up for the facility so that if their normal line business was to get support by taking out tail risk, they would be paying for some of the cost of that risk support.
Beckworth: So this is kind of in the spirit of the budget rule, that you charge the penalty rate if you're going to tap into these resources?
Kashyap: Yes. But we want to charge a fee also for people who might not even end up accessing the facility. But if you're active in the market most of the time, then you are benefiting essentially from a cross subsidy from the times when the stress hits, maybe you don't end up using the facility. We would price the facility in a budget-like way, but we're also going to share the cost so that everybody who's normally active in the market would be forced to sign up.
Judge: Yeah. And that's an important clarification. I mean, I think the core idea is we've often understood it from budget is use the penalty rate when it comes to the actual borrowing and under the budget idea, that's just a way to ensure it remains the backstop and that people are first looking to counterparties in the market. But of course that proves quite challenging when actually there's positive externalities, we're having people use a facility and you want to encourage borrowing during times of distress. So what we're doing is actually shifting some of the cost bearing to the outside of the periods of distress. So it's a similar idea, but one that we think is more likely to be time consistent.
Beckworth: So going back to the supplemental leverage ratio. So some people say what we're seeing now is that the overnight reverse repo facility is taking the job or taking on the role that the relaxation of the SLR during this past year did, it's sucking in all the reserves that would have otherwise been absorbed by the banking system, bigger balance sheet capacity. I'm reading in the tea leaves here. But I think part of the challenge that the Fed face was just political pressure to maintain the SLR. And so I guess my question, bigger question in all of this is, are these proposals, these recommendations politically viable? Can we get this package of... We got one out of three done, we've got two more to go. Do you see it as something that we can do within the next few years?
Kashyap: Well, I think the first thing you have to point out is that the cost of financial crises are huge. Okay. And let's start with that. And so taking out a little bit of insurance is worth it. The second point I would make is that this doesn't have to be a giveaway to the banks. You can keep the amount of capital in the banking system the same. This idea of carving out the SLR is not something that's just angels on the other end. So, the Bank of England did this, and they did it in a way by just raising the rate on the rest of the leverage ratio to carve out reserves.
I think the first thing you have to point out is that the cost of financial crises are huge. Okay. And let's start with that. And so taking out a little bit of insurance is worth it. The second point I would make is that this doesn't have to be a giveaway to the banks.
Kashyap: You can do this kind of thing where you hold the level of capital constant, but you just make it more relevant for some activities than for others. And I think it's important to recognize, no one wanted the leverage ratio to be the binding constraint on a business model. That was Basel one. We learned that it's risky and sensitive and you don't want people running their businesses worrying about that. So it might've been a good idea to have a leverage ratio and an SLR, but stepping back and looking at where we wound up when we've added on all the liquidity requirements, I think there's time to have a rethink, and even Dan Tarullo would tell you that.
Beckworth: Yeah. I've had Bill Nelson on the show before. I think you both know him. And he's made this comment that when the SLR was first, I guess, written up by Fed staffers, the expectation would be that the Fed’s balance sheet would shrink and get really small, but instead it's gotten really, really large and we've voted up the system with all these trillions and trillions of dollars of reserves that originally weren't a part of the plan when this rule was written. So as you guys mentioned in your report, you want to dynamic processes as times change, facts change, you want to kind of keep up with that.
Beckworth: One more question on these proposals for the treasury market. I was talking to Pat Parkinson on the podcast and I asked him, would there be any resistance to the increased use of central clearing in the treasury market? And I believe it was him that said there could be some from the people who currently do this same business. It might take some business away from some Wall Street firms. I mean, do you see any pushback from them?
Kashyap: So as you know, Pat was involved in this G30 report that was also released today. And one of the things that they pointed out is after that report was drafted. A bunch of the principal trading firms had actually written a report on central clearing and actually said, we actually think that this would be good for the market.
Kashyap: The way that we currently do it might be inconsistent with the way you're going to clear. But we think that there was adjustments, this could be palatable. So I didn't know that report had come out. It was just a couple of weeks ago, but they thought that with some tweaks, it was not a deal buster at all.
Kashyap: I mean, it has to do with who's got access to the clearing facility and under what rules and all of this. And if it was both, had to make sure everybody could have access to it.
Beckworth: Well, I think great news so far. Again, one of the three big areas you've covered in terms of recommendations happened today just before the show started, which is quite remarkable. And again, the devil's in the details. We'll have to see whether this kind of lives up to what you guys have expected. So let's move on to the areas that you two have specifically focused on in the report. And Anil we'll continue on with you. You did the section on open-ended funds. And I believe, and correct me if I'm wrong, probably the best known version of this are money market funds. But you also highlight in your report, there's open-ended bond funds as well. So we want to speak to both of those.
Beckworth: But what's, I guess, remarkable to me, from the outside looking in is that money market funds had a problem in 2008 and they had a problem again in 2020, and there were reforms. There were reforms along the way. And in fact, some of the reforms some have argued, I think you argued as well, made things worse. What's the term? The gate...
Kashyap: Yeah. Gates to liquidity.
Beckworth: Yeah. Gates to liquidity. Yeah. So talk us through the history here. How did we end up at this point where money market funds are still vulnerable?
Why Are Money Market Funds Still Vulnerable?
Kashyap: Okay. Kate may know more than I on some parts of this, but my rendering would be, after 2008 and it was clear that there were some runs and something had to be done. There was discussion of various options at the time. One was to make money funds or all of these kinds of funds hold capital, actually, because if you've got securities that have no credit risk, you might think, well, you don't have to hold a lot of capital, but they have a lot of liquidity risk, then that doesn't really wash so well. And if you look at what prime money funds hold, it's certificates of deposit and commercial paper that don't trade. And it's true. If you can hold them all the way to maturity, there's little credit risks. But if you have to sell commercial paper, even AAA paper that's 27 days from maturity, good luck getting a cool price, especially in stress.
Kashyap: So one idea was to go ahead and make them hold capital. They said that would bankrupt the business. So that was dead. A second, was to do a floating net asset value, which was ultimately adopted. That was a concern for people because they thought that the prices that go into calculating the net asset value are mostly mark to model. These securities don't trade. What's the right answer for a piece of commercial paper that's got 27 days til mature? Well, you hold it par. You really had to sell it. In an extreme situation, you wouldn't get that. So the NABS float, but if you look it's 0.99997, or 1.00002 and it doesn't actually float very much. So they went to that and then they said, the second thing that we're going to do is to say, well, you have to hold a liquidity buffer to manage outflows.
Kashyap: The problem with that was, they then said, and if your liquidity buffer gets below a certain threshold, then you actually have to close access to the fund. Well, guess what, when people can see the gates going to come down in three days, they try to get out today. And that was pointed out. Kara Stein, who was an SEC commissioner at the time these things were adopted and argue against them, was a member of the task force. I think she deserves an ‘I told you so’ moment for basically having foretold all of what went wrong. It must've been frustrating to her, but she's been vindicated now, she's back with some other recommendations. She worked on this for a while with us as well. So we think the answer for the prime funds is to kill what we call the first mover advantage, where the fact that we think these things are illiquid, right now they're marked at par.
So we think the answer for the prime funds is to kill what we call the first mover advantage, where the fact that we think these things are illiquid, right now they're marked at par.
Kashyap: If you actually start, and they're going to start going down, Kate's smart, she sees that this is underway, so she tries to get out while they're still marked at par. Anil is slow, he doesn't figure it out. And they start having to market step down does he get out. And then David comes in and says, oh my gosh, they're getting out, I got to get out too and you get this self-fulfilling dynamic. So the way to kill that is when Kate tries to get out, make her eat the cost of the transactions that she is generating. So if she's selling stuff, it's to push the prices down, let her redeem at a price that reflects the best of her actions. Instead of getting out of par, say, well, actually if we sell this, we're going to push the price down a little bit.
Kashyap: When you want to get your money back, you're going to get it back at a discounted rate. So that's swing pricing and we would like to do that for prime money funds. We think that could help and that that would have reduced some of the stress. The incentive to run would have been lower, the pressure to fell treasury securities would have been lower. I mean, open-end funds interact quite a bit with the stress and the treasury market, because a lot of the big sales were coming from these open-end funds. So that was one set of observation. We think that the government funds actually themselves held up pretty well. The money market fund... Well, just government securities are what runs, they didn't have a lot of selling pressure. In fact, some people piled into them. So we don't think you need to do anything special there.
Kashyap: Bond funds on the other hand and loan funds were big, big sellers of treasuries. The high yield bond market shut down, a lie. Well, if it turns out the bond funds have all these high yield bonds at big price concessions, because they're meeting the redemptions, turns out then you get this fire sale where the high yield bond prices are extremely depressed. Well, if you're an investor that's thinking, I could buy a high yield bond or a primary high yield bond, the secondary ones trading at 50 cents. He says, he's willing to issue a new one at 75. Well, guess what, I won't buy the new one. So if you get a deep, persistent fire sale in the secondary market, it backs into the primary market. And that's the externality that's a big, big deal that we wanted to kill off. And so we think for some of these ones, you just really need big swings, or you might even just say, it's inconsistent to offer daily liquidity for certain types of funds. You should have to give a weeks notice or a months notice or something so that they have time to sell in an orderly way.
Beckworth: So is this why the Fed stepped in with its bond facilities? Because these bond funds and loan funds were tanking?
Kashyap: Yeah. And after the fact, in the event, they didn't actually have to buy so many corporate bonds. Once it was clear there was a buyer of last resort, the people that were panicked and selling quit. On the other hand, part of the reason for calling it the dash for cash is, they really had to buy the treasuries. The Treasury market didn't stabilize. There's a very good paper by Annette Vissing-Jorgensen, who points out one of the ways that you really know that people needing cash was there was one day, I think it was the 18th or 19th of March, where the Fed had fully ramped up its treasury purchase program, but was a day behind on its MBS program.
Once it was clear there was a buyer of last resort, the people that were panicked and selling quit. On the other hand, part of the reason for calling it the dash for cash is, they really had to buy the treasuries. The Treasury market didn't stabilize.
Kashyap: And on that day, once they go in with overwhelming force, treasury yields start to fall and MBS prices keep rising. Now, those two markets are as tightly integrated as anything. And so that's a pretty good indicator that people really needed the cash. Was show me the money. I don't care if they're going to buy it tomorrow even, that's not good enough. So in the bond case, once they just put in the backstop. And my explanation for that is people weren't using high yield bonds as a bank account. They were doing it with bond funds and some of these other things, where they thought all it costs for the money, I'll get some extra yield and I know I can get it out. For the really illiquid bonds, they weren't that crazy. So just saying, there's going to be a buyer of last resort worked better there.
Beckworth: Yeah. I read that paper and that was very fascinating where she made the case that for the treasury market, it was the actual purchase that calm the markets. So it wasn't the announcement effect, whereas the bond fund facility, it was the announcement. So very interesting and raises a whole lot of interesting questions. I don't want to go too far afield here, but kind of the Wallace neutrality view of open market purchases, Gauti Eggertsson with Michael Woodford. This idea that QE outside of panics and crisis don't do a whole lot, but this would be a case where clearly it was a panic, the Fed stepped in and the actual act of doing something made a big, big difference.
Judge: David, can I jump in quickly to complement?
Judge: I mean, Anil did a great job summarizing both kind of how we got here, how things went wrong and what we want to do about it. I just wonder if I could just compliment it in two ways. First, this distinction between swing pricing and floating NAV, I didn't realize how much confusion there was around the distinction until we released this report. And I've talked to a number of my colleagues in the field who are incredibly capable.
Judge: And when we use the term swing pricing, think all we are doing is echoing the efforts to you to do NAV. And this really comes through in the bond funds. Though we see the money market mutual funds, and it's a critical difference. So NAV just means, okay, if there's some credit risk here or something else that's actually affecting the value of the underlying. And realistically, these are mark to model markets, then that's going to come through in the NAV.
Judge: But that doesn't take into account the cost of demanding liquidity during these periods of distress when everybody is running for liquidity. So you expect there to be a significant haircut that's automatically going to be imposed. And so the idea of swing pricing in both of these different areas is not that you're just taking into account what NAV otherwise would look like, you are specifically creating a mechanism where you are having to internalize the costs of demanding liquidity during this period of distress when liquidity is really precious.
Judge: So the first mover advantage right now makes it so everybody has an extra incentive to run to the exit, even if they have no immediate need for liquidity. Once you're forced to internalize that, you're still going to have access to liquidity, at least in most of the circumstances we're envisioning. But you're going to have to pay a price for it. So really the only people who are then going to be rushing to the exit are the people who really need the cash, which they're going to be some and not the people are just doing it because they realized that they're going to be able to get a higher value if they can cash out today's NAV, which is not going to take into account the selling pressure that these very structures are going to bring about.
Judge: The other comment quickly. Anil did a great job of describing kind of the history of the SEC here has been really messy. It wasn't interesting vote. It was a three-two vote, and you actually had both Republican and a democratic commissioner dissenting. But it was a messier process in other ways. This was the only time the financial stability oversight council took the initial step at least of using its authority to tell a primary regulator to do something because the SEC really dragged its feet. The process took an incredibly long time. You have a release that's hundreds of pages long. Still didn't actually understand how this market works as we can now see, also didn't understand what the short term impact was going to be. The short-term impact was everybody went to government funds and the Federal Home Loan Bank massively grew in size to be able to fund this.
The first mover advantage right now makes it so everybody has an extra incentive to run to the exit, even if they have no immediate need for liquidity. Once you're forced to internalize that, you're still going to have access to liquidity, at least in most of the circumstances we're envisioning. But you're going to have to pay a price for it.
Judge: In the issuing rule, there were a dozen different instruments that they thought the investors might go to. They said, is a heterogeneous group of investors, they're going to go all over the place. It wasn't true at all. You look at the announcement and people just move to government funds. Some people stuck around, some people moved to government funds. So it was indicative to us of right now there's a lot of activity that is under the SEC jurisdiction that really requires them to understand financial stability and collateral consequences and what's driving investors in ways that are not just, let's give them the information and trust that they will do well with it. So it's a sign for us of the need to beef up the agency. It's not criticizing any of the individuals who were involved, but it is a sign that having this kind of traditionally market-based regulator charged with these issues under its current mandate is really not getting us the outcomes that we need.
Beckworth: Okay. That's a great point. And we're going to come to your section in a minute. We talked about this in more depth. But the difference between the NAV and the swing price, and you made a point in the paper to say they compliment each other, that they're not the same, that they're going to compliment each other. And I guess here's my question. Wasn't the run in March mostly on prime money market funds? Is that fair?
Kashyap: Yes. The bond funds. I mean the bond funds-
Beckworth: The bond funds too.
Beckworth: Within the family of just money market funds, it was the prime funds and didn't they have floating in NAVs? So, I mean, wasn't it sufficient?
Kashyap: I think that's a way of pointing out what Kate was saying, is that the fact is that the stuff that trades doesn't trade much. And until the moment of stress, it's all trading around par. And then in stress, you have this huge price impact when you try to go on and unload it and then it just takes a while. To see that the NAVs would drift down as they sell more and more and more. And some of it was people trying to get their money out, not just because the liquidity, because they thought that the thing was going to gate and they couldn't get trapped behind the gate because they needed the liquidity. So you had a whole set of dynamics that were reinforcing and it was one way bet.
Kashyap: There was no cost in getting out. It was let me get out, and if I lose half a percent by pushing my way out, it's still better than getting caught behind the gate. So ultimately the first mover advantage can come just because you've got something who's promise is inconsistent with the underlying markets liquidity. Mark Carney, when he was governor of the Bank of England used to say, these whole things, these daily redemptions were built on a lie because the average bond trades once a month, how do you put together a bunch of trade once a month and say, oh, get out any day. It works but not during stress.
Beckworth: Fascinating. Now in the report, you outlined how much these bond funds have grown over the past decade. So moving forward, do you see more concerns arising from the bond funds or the money market funds?
Kashyap: Well, the prime funds keep shrinking, thank goodness, and the bond funds keep growing. So I'm at least as worried about the bond funds. And I think people probably been burned a little bit on the prime fund. So I prized if you can see them growing, whereas the bond funds are, they double basically in the last gate. So I see that is more of a problem.
Beckworth: Do you think some of the bond fund growth is from investors who were formerly in the prime funds and they still want that flavor? It's money that can turn around quickly, but a little more risk, maybe a little more yield. I mean, was there any kind of substitution going on between those two funds?
Kashyap: I'm sure there was. And there was also the case though that because of the capital regulation, the banks may not have wanted to make some loans, people who can issue. I mean, a lot of the bonds that are issued are right on the border of being investment grade or not. So there was a lot more expansion of that type of credit. I mean, a big theme to the whole report was you push on one part of the balloon and it pops out over here. So we crank down on bank regulation right after 2008, '09. We left non-bank largely unattended to, look what our report is about, it's almost all about non-bank stuff. And that's largely because there wasn't a lot of attention paid to that part of Dodd-Frank, but also because we push more activity into those parts of the financial system.
Beckworth: All right. Well, let's move along to chapter eight, which I believe is Kate's chapter, regulatory structure and process. And Kate, I want to read an excerpt from a piece that you two actually wrote together, but I'm going to address it to you, Kate. And this is from your VoxEU piece is titled, “Reforming the macro potential regulatory architecture in the US.” So it echoes some of the same themes as the chapter eight in the report. But this paragraph here reads, that a shock the size of the pandemic would trigger distress in the financial markets is far from surprising. What is surprising is how much of the distress arose in domains that could have been identified posing a potential threat to stability well before the pandemic hit, and yet each remain largely unaddressed. So Kate, why did they remain largely unaddressed? Help us understand this.
Improving Regulatory Structure and Process
Judge: I mean, I think the core challenge is that as we know well, in the US we do have this incredibly fragmented regulatory regime. And more importantly, not only is authority fragmented across all these regulators, but other than the Fed, even there some would question whether it's clear. The clarity of the financial stability mandate really isn't there. So there are those who take the view that Dodd-Frank in creating the Financial Stability Oversight Council. So if you recall kind of rewind the clock, we knew we had this incredibly fragmented system. We had market regulators and prudential regulators, the two generally didn't talk to each other and viewed the world quite differently. And then we also had specialty regulators and housing, and these other domains. The crisis hit, it was clear that the inability of the different regulators to work well together and the real inability of the market regulators to understand some of the challenges to the system, contributed to the crisis.
In the US we do have this incredibly fragmented regulatory regime. And more importantly, not only is authority fragmented across all these regulators, but other than the Fed, even there some would question whether it's clear. The clarity of the financial stability mandate really isn't there.
Judge: There were a lot of proposals to restructure. We fully support those types of approaches. So we don't come out with our own approach only because there've been so many other reports, but just to be clear, I think everybody does feel like if you want to engage in some consolidation, we think that would be a great move in the right direction. But shy of that, we think that you could actually do a lot more with the blueprint that Dodd-Frank created. So what Dodd-Frank created was this financial stability oversight council. It is 10 voting members, five non-voting members, and basically all of the key federal financial regulators are part of the FSOC. So someone would take the view that by virtue of their FSOC membership, they have a financial stability mandate. However, we've not seen any of the primary regulators really internalize a stability or resilience mandate in their activities.
Judge: Oftentimes they've actually specifically disavowed that they have such a mandate. And just as importantly, they don't yet have the skills or the manpower or the expertise that you would need to really make stability and resilience and systemic consequences of their actions consistent priority in their rulemaking and in their other activity. So one of the key changes that we want to bring about is to say, everybody who's currently a member of FSOC, among their mandates clarify that they do have a mandate to promote stability and resilience, and to create an office within each of these different regulators that is specifically charged with reporting directly to the chair of the agency and trying to take into account the systemic consequences of the agency's actions.
Judge: And so there's a number of other things, and Anil and I will go through them, but one of the key things is right now we know market based intermediation is a huge source of threat, is what emerged, it was at the front end of the last crisis. If you go back to 2007 and you go back to 2008, it spilled over to the banks, it all started in the market base system of intermediation. We didn't really manage to deal with that in Dodd-Frank. And we see new risks continuing to emerge there. So we think the only way you're going to deal with that is getting the primary regulators who already have jurisdiction over those areas really on board, but both clarifying their mandate and giving them the experts.
Beckworth: So Kate, before we go to some of the specifics in making FSOC stronger, more effective, I was watching the two of you in your presentation of this at the Brooking Center. And David Wessel made this comment I thought it was kind of funny, but maybe also informative. He said, Yellen was eager to flex the FSOC's muscles, but quickly learn it didn't have much muscle. Explain what happened, because originally there were a number of financial firms that were under the watch of FSOC and then under the last administration they kind of were taken off the list. Is that what it is, muscular atrophy for the FSOC? They just have to get back into practice and adopt these changes that you guys have outlined?
Judge: I can go further than that. I think that is certainly a part of the problem. And I do think we saw a particularly striking degree of atrophy. I think the bigger problem is it was never as strong as it needed to be, given the cost associated with financial instability. So we actually think that the overall framework made sense, but you really need to both beef up power at the level of the leadership, but really the financial stability oversight council as a stability oversight council is only going to really promote stability if those members feel like their role, something that they're going to be held accountable for is promoting stability.
One of the key changes that we want to bring about is to say, everybody who's currently a member of FSOC, among their mandates clarify that they do have a mandate to promote stability and resilience, and to create an office within each of these different regulators that is specifically charged with reporting directly to the chair of the agency and trying to take into account the systemic consequences of the agency's actions.
Judge: So again, it's clarified the mandate, but then we also put into place a whole variety of different procedural mechanisms trying to further that. So we think just telling somebody to do something is probably not going to be enough to bring about meaningful change. And so part of what we also do is create a new undersecretary for financial stability so that we have somebody in a leadership role, who's at a high level of leadership role, who's constantly doing the horizon scanning, looking at the big picture, looking at how things are moving, looking at the trends, understanding where risks could be arising, having the office of the treasury that was charged with overseeing the FSOC also come out with a report that is not signed by other members of the FSOC, but is really just coming out from treasury saying, here's what's changing, here are the risks we see, here's what we think that needs to be done.
Judge: We're not going to have that water down by having to get additional signatories. And then all of those other FSOC members are going to have to come up with their our own appendix where they're talking about from their own view. Here's what we're seeing, here's what we think needs to be done, here's what we are doing, here's a new tool that we need. So Congress, we really don't have the authority that we need to address an emerging threat disability. Please give us this additional tool or authority to deal with it, but we have a much more iterative process where you have multiple different voices creating more transparency and doing so in a way that gets everybody focused on, well, what are the consequences for stability?
Judge: And so it's partly the market regulators we've talked about, also the prudential regulators, again, not to fault them, they're charged with safety and soundness. They had a very long laundry list of things to do to implement under Dodd-Frank. But as we've discussed, there were consequences of their actions in terms of market functioning, market liquidity, and also where activity move. We didn't talk about housing, but now we have suddenly non-banks playing this huge role in mortgage origination and mortgage servicing. Again, that ended up not exploding. We got lucky housing prices went up rather than down. But there's a whole variety of ways. We saw collateral consequences that had not been taken to account initially. And there was no structure in place where they had to go back and say, "Okay, well, we did this. Now it's three years later, what happened? How much of that did we see? What is it we didn't see? How was it we can see more of that next time."
Judge: So there are a bunch of different mechanisms that we try to put in place that allow the overall regulatory structure and the rules to continue to evolve. Because we know at this point, both because of innovation and because of efforts to minimize the cost of regulatory compliance, the financial system is going to change and where the deficiencies lie are going to move and where those threats potentially lie are going to move
Beckworth: Well, you spoke to one of the recommendations, new FSOC leadership is under secretary for financial stability, which is a great idea. You also mentioned the FSOC annual report and all the other members would have their own kind of, I guess, version of a report and then the appendix. But let's talk about another area. You mentioned addressing regulatory and data gaps. And this is where the Office of Financial Research comes in, and you guys actually come and want to completely rename it at least and I think change it around a bit. So tell us about that.
Role of the Office of Financial Research
Judge: Yeah. And I don't know. Anil can jump in at any point here too, because we all worked on all of these. I mean, I think we both or the overall task force view that the impetus behind the creation of the Office of Financial Research was precisely the right concern. One of the key challenges is regulators in 2007 and 2008, didn't have the information they needed to see where risks had moved. You go back to the FMC minutes, it's an amazing, you're like Randy Kroszner there, Anil's colleague now saying, the battle days, all the risks were on the balance sheet was originated to distribute. They don't look at the balance sheet. I think it is, we don't know exactly where they landed. And there's just a bunch of ways where I think data standardization could also improve private risk management in addition to improving of course, public oversight.
Judge: But we are also going back to the fragmentation point. We have this balconies at times regulatory system. They're not necessarily sharing information, and so if you have a lot of different actors who were each getting small slices of the bigger picture, it's natural that they're not going to be able to necessarily understand, well, what are the feedback effects that might arise during periods of distress? And it's those types of feedback effects you're oftentimes going to want to have to identify if you're going to want to figure out where is there a threat to stability. So the idea of beefing up the OFR, making it into a controller for data and resilience, really giving them a full seat at the table as part of FSOC and otherwise enhancing its ability to really fulfill what was originally asked to do, is an effort to say let's create an overall more coordinated approach to data standardization and information collection. So that way there's just more oversight, both of particular activities, particular systems, but also potentially the way they interact across the broader system.
Kashyap: Let me give one example of this. If you look back to what we do and don't know about March, 2020, just even basic things like treasury trading patterns or things that we don't know, if there had been the version of the CDR that Kate just described, that stuff would have been collected. We'd probably have a version of something like trace, the way that corporate bond trading is reported so that people could have looked at exactly what went wrong, who was selling, who was buying, what were the prices and all of that. And they're just example after example of that, where just basic information seems not to be there and yet no one's doing anything about it.
Beckworth: Yeah. It was interesting. In preparing for the show, I went back and read Laurie Logan's speech on her take on what happened in March. And she brings up this very point. She goes, well, as best as we can tell, because we don't have data, complete data on hedge funds and these other actors who had a part. And I was like, huh, I bet you, this is exactly what they're after, getting that data. Here's the thing though, don't they already have legal authority? Didn't Congress empower them originally to go get this data? I mean, they have the legal authority, don't they?
Kashyap: They do. But take the lead example. So Kate and I were both at different times on the Financial Research Advisory Committee to the OFR. So we've seen this up close and personal. Dodd-Frank was crystal clear, they were supposed to be able to look at all the stress testing data to be able to do detailed stress tests on everybody. And yet, despite that being crystal clear on the law, there was all kinds of roadblocks thrown up by different agencies saying, well, we don't really have data sharing arrangements so that we can trust the confidential data that we get, because basically the agencies didn't want anybody looking over their shoulders.
Kashyap: So you have a situation where there's no doubt if you read the plain intent of the law, but the OFR was supposed to get all this. They still don't have it. They still haven't written much about it. And that's straight down the middle and think about stuff slightly off the side. And then think about something where a product has evolved, take leveraged loans. I mean, nobody was talking about leveraged loans in 2008, yet when it came time to figure out if they blew up, holding them, who would be the forced sellers. There was a plot where there was a difference of opinion between the Bank of England and the federal reserve about the size of the market, where the difference was in trillions.
Beckworth: Wow. That's remarkable.
Judge: And just to back this up. I mean, one of the challenges was, I think Anil correctly summed up the intent as its bonded in the statutory texts. But there was also still the need to get the information from the primary regulators. So part of the idea was look, if it's already seeing another regulator, you can't go directly to the regulated entity, you have to work through that regulator. And that makes some sense because you don't want duplicative demands being made on regulated entities. But that created a real challenge when there wasn't the clarity that these other regulators had an obligation to work in good faith and to work closely and to support the mission of the OFR.
Judge: So when we deal with that in part by dealing with the mandate, the other primary regulators. But we also put procedures into place. We're not assuming that people aren't suddenly going to kind of be really happy to work closely with one another. So we also say, if you have agency that's going to engage in new information or data collection, they actually have to consult with OFR before they issue that new rule. So there's a bunch of mechanisms that are going to be in place that again are not meant to slow down other activity that we want to have happen, but to encourage and really prompt more ongoing engagement among all of the different bodies to help address both the information gaps, but also the other challenges that we see.
Beckworth: So you have a number of recommendations across a number of sectors. We've talked about, open-end funds, we've talked about the regulatory structure FSOC, can all of these recommendations be done without going through Congress, or does Congress need to be involved in it?
Judge: Congress needs to be involved. I mean, we think that there's a lot of progress that can be made without Congress's involvement. And so we do think that there's room to move in the direction of a lot of recommendations. You mentioned previously the fact that right now there are zero designated entities. One of the big problems was we had regulatory perimeter that wasn't dynamic enough to deal with the fact that systemic threats were moving outside of the banking system.
Judge: So we allowed FSOC to designate non-banks systemically significant. And apart from financial market utilities, we currently have no designations. So one of the things we recommend is every three years look at the key actors in different domains. So who are the most leveraged head funds, who are the largest insurance companies, and at least look at a balance case of what the threats they might pose to stability and the result might be, they should be designated, it very well might be, designations not appropriate, but there is additional tools that we need to understand or to monitor to address threats that they might post. So that's the type of thing that the executive could do right now without Congress becoming involved.
Judge: That being said, we do see the need for congressional action for a lot of these changes. And we think that's healthy. I mean, I think part of what we're trying to do here, by making things like their reporting central is not only to make the information publicly available, but also to make it available to Congress and to try to normalize both for regulators and for Congress, for all of the different lawmakers that are involved in the space, the notion that the financial system is going to change. And because the financial system is going to change, we're going to have to have a constantly evolving regulatory structure.
I think part of what we're trying to do here, by making things like their reporting central is not only to make the information publicly available, but also to make it available to Congress and to try to normalize both for regulators and for Congress, for all of the different lawmakers that are involved in the space, the notion that the financial system is going to change. And because the financial system is going to change, we're going to have to have a constantly evolving regulatory structure.
Judge: So Congress should expect to have to provide new tools. Regulators should expect to have to revise the rules. So the fact that we've identified an emerging threat is not necessarily a sign of failure. It's not addressing that threat where it starts to become a failure. And so we really want to create a system where people understand and expect that the nature and cost associated regulatory burdens and just the rate of innovation means that things are going to change and we have to be prepared to, we're not going to say ahead of it, but at least say, a step or two behind rather than 10 steps behind, particularly when we're talking about threats to the stability of the overall financial system.
Kashyap: And just one more thing on that. I mean, Kate just said it, but let me emphasize. Dodd-Frank kind of had this blunt tool of designation and cram capital in there, or what the Fed come look at you. Some of the things that need to get fixed would just require new tools. And we don't really have a process now where somebody stepping back and just saying what's missing. And we think that the combination of the structure of the report, where there'd be these mandated thought experiments, well, what would happen if this blew up?
Kashyap: And then if it did, what would we need to do would be a very healthy dialogue to have in peace time or when the sun is shining rather than after the flood has happened. So I think that the structure here is to me, probably the most important two things in the report are the two things we talked about, fixing the treasury market because that's the anchor of everything, but then also giving the regulators a fighting chance to keep up with the evolution of what's going on. And just cementing this idea that it's evolve or die. You have to have the regulators evolving continuously.
Beckworth: Yeah. That's a great part of your report. And your approach is this dynamic updating approach. Well, we're about out of time. I want to end with one question and that's the outlook. Are you guys seeing a glass half full or half empty when it comes to these ideas being implemented over the next, say five years, 10 years? What do you think the outlook is?
Financial Stability Outlook Over the Next Decade
Kashyap: I think it's uncertain. I think the good news is there's a lot of internationally in some of these things. So between the Basel process, the financial stability board, there's already a lot of work going on. It's going to move in the direction of fixing some of these things. But in other cases, I mean, take insurance, we didn't talk about insurance much. I mean, that's a backwater, there's not a lot of expertise and there's really no urgency to tend to some of the problems we talked about there, otherwise clearing. Again, that's been a festering problem and there's no big driver in that direction.
Kashyap: So I'm hopeful that maybe if we could get the changes that Kate was just describing to the reporting function, if you ask lots of people, they would point out these problems and say, look, we've got to do something about it. And maybe you could crescendo to get something done. And before I sign off, let me just say one other thing, there was a group effort on all of this. You couldn't have Sandy O'Connor or Blythe Masters or Ralph Koijen here talking about all the things that the three of them worked on the law we're talking about. Laurie Goodman, you should have on talk about the housing and Don Khon and Glenn Hubbard, if he could get them. So all of this stuff was done by all of us and we each greatly learned from other people on this taskforce
Judge: Actually, can I pick up on that quickly? So one of the things that I think was very helpful and hopeful about the task force is you do have a very diverse group. So you have people who are coming from industry, you have a politically diverse group, academic who have very different, different backgrounds. But by working together and gathering the facts and trying to understand what is going on, there were times we disagreed in certain areas, but you really did come up with the report that's a consensus report. And there's a lot of very real recommendations. So, I mean, part of what's interesting about financial stability that's hopeful is I don't think it has to fall prey to some of the tensions that are preventing action right now. I think there can be actually a lot of broad agreement, not perfect agreement but broad agreement.
Judge: That being said, I also am very, very concerned. After 2008, we all knew we had to do something about stability. So it became really hot, everybody was talking about financial stability. There was a lot of political will in Washington, there was a lot of focus more broadly in academia as people reoriented the work that they were doing towards trying to understand what are the threats that exist. And that energy is really waiting. And I think it really is during the periods where things seem good enough that nobody wants to put in the efforts and the investments and the time that you need to maintain stability. And precisely because of financial system keeps changing. If you just have a static set of rules, that is in effect deregulatory because the system is changing in a way that's going to weaken the ethicacy of those rules.
Judge: So I am on the one hand hopeful, if people are willing to say, let's think long-term, and let's make investments where we know we can, but there's a lot of low hanging fruit. But getting the will to make that happen, I would love to see it, but I do have some concerns.
Beckworth: Well, on that note, our time is up. Our guest today have been Kate Judge and Anil Kashyap. Kate and Anil, thank you so much for coming on the program.
Judge: Thank you, David.
Kashyap: Thank you, David.
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