Abstract
There are striking and terrifying similarities between the sudden failure of a heart and that of a financial system. In the medical literature, the former is referred to as sudden cardiac arrest. By analogy, I refer to its financial counterpart as a sudden financial arrest. In this article I describe the latter and its treatment guided by its medical counterpart.
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Notes
One way to get a sense of how much the market values the “too-big-to-fail” insurance provided by the government is to compare the cost of funding for small and large banks. Baker and McArthur (2009) compare the average costs of funding for banks with more than $100 billion in assets to the average costs for banks with less than $100 billion. They find that between the first quarter of 2000 and the fourth quarter of 2007, the large banks’ costs were 0.29 percentage points lower than the small banks, averaging across time. Between the fourth quarter of 2008 and the second quarter of 2009, the spread increased to 0.78 percentage points. Clearly, there are many reasons why larger and smaller banks can have different costs of funding: different types of assets, different amounts of leverage, and so on. Baker and McArthur (2009) take the difference between these spreads, 0.78 minus 0.29, as a crude upper-bound on the subsidy associated with the solidification of the “too-big-to-fail” policy after Lehman's collapse. This paper suggests an alternative interpretation: during boom times, the “too-big-to-fail” insurance was there but of little importance, while during the crisis, it became much more important and probably a source of stability.
It turns out that the Bank of America deal was never signed, but the perception that it had been was enough to contain the panic. The U.K. system was less successful in terms of the takers than it would have been socially optimal because it was voluntary and very expensive. Both aspects would be improved by the TICs framework.
For developed economies, the international liquidity shortage problem is much less significant, and it was appropriately dealt with through the swap arrangements between major central banks. These should remain in place, at least on a contingent (to sudden financial arrest) basis. A more delicate problem for these countries stems from the high degree of cross-border interconnectedness of their financial institutions and the potential arbitrage and free-riding issues that may emerge from differences in the type of financial defibrillators available. This raises international coordination issues not developed in this paper, but that obviously need to be addressed.
Haldane (2009) masterfully captures the essence of the counterparty uncertainty problem that can arise in a complex modern financial network, writing that “… knowing your ultimate counterparty's risk then becomes like solving a high-dimension Sudoku puzzle ….”
Michiyo Nakamoto and David Wighton, “Citigroup Chief Stays Bullish on Buy-Outs,” Financial Times, July 9, 2007. Available via the Internet: www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html?nclick_check=1.
The new issuance series is the sum over the following categories of asset-backed securities: home equity (subprime); commercial real estate; autos; credit cards; student loans; non-U.S. residential mortgages; and other. The data were provided by Tobias Adrian.
The procedure for estimating this was as follows: For equity, we simply tracked the evolution of each bank's market capitalization, excluding increases in the market cap owing to issues of new shares. For debt, we estimated the duration of each bank's long-term debt (including any preferred shares) from the maturity profiles described in the 10-K statements as of December 2007, assuming the interest rate was equal to the rate on 10-year treasuries plus the spread on five-year CDS for each bank, obtained from JPMorgan. Assuming an unchanged maturity profile, we then tracked the changes in the implied market value of each bank's long-term debt on the basis of the evolution of the CDS spread. The banks included in the calculation are the 19 banks that underwent the “stress tests,” plus Lehman, Bear Stearns, Merrill Lynch, Wachovia, and Washington Mutual.
The IMF uses a projection of macroeconomic variables and default rates to estimate losses on loans, and market values to estimate losses on subprime-related securities. To the extent that market prices of securities overreacted due to fire sales, our procedure understates the multiplier.
See Wessel (2009) for a fascinating account of some of the constraints faced by the U.S. Federal Reserve to act quickly during the crisis.
Bob Ivry, Mark Pittman, and Christine Harper, “Sleep-At-Night-Money Lost in Lehman Lesson Missing $63 Billion,” Bloomberg.com, September 8, 2009. Available via the Internet: www.bloomberg.com/apps/news?pid=newsarchive&sid=aLhi.S5xkemY.
James B. Stewart, “Eight Days,” The New Yorker, September 21, 2009.
Ibid., footnote 10.
The Lehman episode highlights the difficulty of predicting the fallout from the resolution of a major financial institution when the possibility of sudden financial arrest is impending. There have been several proposals from academia and policymakers to create mechanisms for orderly resolutions, but resolving a major financial institution, especially during times of panic, inevitably involves an amount of uncertainty that can easily generate catastrophic consequences.
In an October 13, 2008 article in the Wall Street Journal (“Summers Outlines Risks to Recovery”) Alan Krueger, Assistant Secretary for Economic Policy, is quoted as pointing to a near-complete lack of information on such critical variables as hedge fund positions, the interconnections among financial institutions and mortgage-refinancing activity. He argued that “… the economic crisis has given an unintended stress test of our economic and financial indicators.”
See Segoviano and Goodhart (2009) for another interesting attempt to measure banking interconnectedness and stability.
The solvency requirement is nice in theory but a real practical problem during an episode of sudden financial arrest, when the distinction between a solvent and an illiquid institution is highly arbitrary, as most asset prices become uninformative. This turns the Bagehot principle (that is, how regulators determine which firms are insolvent) into yet another source of uncertainty.
See, for example, Caballero (2009a and 2009b), Mehrling and Milne (2008), and Milne (2009) for real-time proposals.
This is a reminder that a taxpayers’ “deal mentality” during a sudden financial arrest episode can be highly counterproductive (Caballero, 2009c). Also, it is important to note that each bank is more likely to know its own financial health and hence be less affected by Knightian uncertainty with respect to its own financial health than are its creditors. For this reason, a bank may reject an expensive insurance deal even when outsiders faced with the same option would accept it.
If there is a concern that TICs will be activated too frequently without sufficient evidence of systemic risk, one could contemplate making activation subject to several “keys,” as with the systemic risk exemption in the FDIC Improvement Act (that is, the president has to sign off, as does two-thirds of the U.S. Federal Reserve board and the FDIC). I owe this example to Morris Goldstein.
Caballero and Kurlat (2009a) argue that TICs would have been an effective policy tool to address the recent crisis. They provide an illustrative example of how these TICs could have been used.
Although European banks also experienced a currency mismatch problem at some stage during the recent crisis, this was expediently solved by a swap mechanism between the Federal Reserve and the ECB. The U.S. Federal Reserve also established dollar liquidity swap lines with the central banks of Australia, Brazil, Canada, Denmark, the United Kingdom (Bank of England), Japan, Korea, Mexico, New Zealand, Norway, Singapore, Sweden, and Switzerland. The swap lines with the ECB and Swiss National Bank were established on December 12, 2007, and the others were established subsequently. In addition, the U.S. Federal Reserve established foreign-currency liquidity swap lines with the Bank of England, ECB, Bank of Japan, and Swiss National Bank should the U.S. Federal Reserve need to borrow foreign currency in the future. A far more problematic issue for these economies is the political concerns that arise from utilizing domestic financial defibrillators when there is significant cross-border interconnectedness among their financial systems. In this context there is a free-rider problem that further delays an already-slow policy response during sudden financial arrest episodes. This coordination problem can be reduced through different international conferences such as the G7 or others, which are the mechanisms used for most other macroeconomic policy coordination issues. This process can be further facilitated by having cross-pledges proportional to these cross-border exposures. That is, the United Kingdom would stand behind a share of the U.S. TICs, were these to be activated, and vice-versa.
See Caballero and Panageas (2007 and 2008) for models and calibrations of the hedging gains for emerging markets subject to sudden stops in net capital inflows and terms-of-trade shocks.
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Additional information
*Ricardo J. Caballero is Chairman of the Department of Economics at the Massachusetts Institute of Technology. This paper was presented as the Mundell-Fleming Lecture at the Tenth Jacques Polak Annual Research Conference at the International Monetary Fund in Washington held November 5–6, 2009. The author thanks Viral Acharya, Olivier Blanchard, Morris Goldstein, Bengt Holmström, Pablo Kurlat, Juan Ocampo, and conference participants for their comments, as well as Jonathan Goldberg for outstanding research assistance.