The Abstract: Jackson Hole Symposium Papers

Highlights from research presented at this weekend's Jackson Hole Symposium, which was all about the credit crunch:

The Fed's Liquidity Facilities May Just Be Window-Dressing
Franklin Allen of U Penn and Elena Carletti of the University of Frankfurt write:

"In normal times high quality asset backed securities and Treasuries are close substitutes for collateral in the money markets. However, in crisis times they are not because the possibility of default will cause a flight to quality. This leads to a demand for Treasuries rather than asset backed securities. It is desirable for central banks to meet this demand to improve the efficiency of the money markets. However, in times of stress there is a also a heightened demand for Treasuries for window dressing purposes at quarter and year end. Meeting this increased demand for Treasuries is not desirable as it removes an important market discipline. It is important that current facilities that allow asset backed securities to be swapped for Treasuries be evaluated in this light."

Why the Fed Should Be Stability Watch-Dog
Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton argue that changes to he size of broker-dealer balance sheets matter more for future economic activity than the same for commercial banks. And what drives the size of balance sheets is the federal funds rate. That's because the fed funds rate is closely linked to short-term rates in money markets. This helps explain why the yield curve is a good predictor of economic activity since it's "a harbinger of a slowdown in balance sheet growth."

Adrian and Shin also show that the Fed has typically raised rates when balance sheet growth declined and vice versa. "In other words, monetary policy has tended to accentuate the fluctuations in the size of financial intermediary balance sheets." (except during times of crisis)

This dynamic means that since the financial system as whole lends long while borrowing for the near-term, a spike in short-term rates will be felt somewhere along the line. Since financials do affect the real economy, Adrian and Shin contend that "contrary to the commonly encountered view that monetary policy and policies toward financial stability should be conducted separately, the perspective provided by our study suggests that they are closely related."

Will Standalone Investment Banks Disappear?
Charles Calomiris of Columbia argues that investment banks didn't rush to turn themselves into commercial banks after Glass-Steagall was repealed in 1999 in order to avoid regulation. This worked because, even though they couldn't issue deposits, the banks could still fund themselves through repos.

But permanent access to the Fed's discount window, if it were to happen, would mean that investment banks could, in all likelihood, be regulated in much the same way as commercial banks. (Though not everyone thinks that's the right thing to do.) Combine this with the fact that the Bear Stearns rescue revealed that the risk associated with repos is greater than the risk associated with normal deposits leads Calomiris to hypothesize that "it is quite possible that many or all stand-alone investment banks will decide to become deposit issuing banks."

The Panic of 2007
In detailing how the credit crunch started and what tighter regulation might mean, Yale's Gary Gorton hints at where the next problem could crop up from:

"Entrepreneurs will take risk in some form, somewhere. In a global environment, one where capital is extremely fluid, and risk can be moved quickly with derivatives, it will be difficult for national regulators to constrain entrepreneurs. The trends are already clear. Talent is increasingly moving to the least regulated platform: hedge funds."

How to Make Capital Requirements Work
Anil Kashyap and Raghuram Rajan of the University of Chicago and Jeremey Stein of Harvard argue that capital requirements for banks that ignore market conditions "are analogous to forcing a homeowner to hold a fixed fraction of his house's value in savings, as a hedge against storm damage -- and then not letting him spend down these savings when a storm hits. Given this restriction, the homeowner will have no choice but to sell the damaged house and move to a smaller place -- i.e., to suffer an economic contraction."

The researchers argue that "a better approach is for the homeowner to buy an insurance policy that pays off only in the contingency when it is needed, i.e. when the storm hits. Similarly, for a bank, it may be more efficient to arrange for a contingent capital infusion in the event of a crisis, rather than keeping permanent idle capital sitting on the balance sheet."

Mistakes Made by the Fed

Willem Buiter presented perhaps the most controversial paper at the conference,summarized nicely WSJ's Sudeep Reddy:

"Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst marks to the Fed, saying it's too close to Wall Street and financial markets -- responding to their needs to the detriment of the wider economy. Mr. Buiter, a former member of the BOE's Monetary Policy Committee, said the Fed overreacted to the economic slowdown -- misjudging the importance of financial stability to the overall economy -- and created a deeper inflation problem as a result."

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