About Robin L. Lumsdaine

Robin L. Lumsdaine is Senior Fellow of International Finance at the Center for Financial Stability and the Crown Prince of Bahrain Professor of International Finance at American University’s Kogod School of Business.

Financial Markets are More Forward-looking Than We Thought: Fed Funds Futures Prices Ahead of FOMC Decisions

Much of the literature related to Federal Open Market Committee (FOMC) decisions focuses on their post-announcement effects. There is ample evidence that asset prices and volatilities only respond to ‘surprises’ – that is, when the actual target decision differs from the market’s expectation (e.g. Bomfim 2003, Bernanke and Kuttner 2005, Gürkaynak et al. 2005), mirroring the findings of a substantial body of work considering the effects of macroeconomic announcements (e.g. Ederington and Lee 1993, Jones et al. 1998).

In addition, there is an equally large literature that investigates whether FOMC target rate decisions are predictable via macroeconomic announcements, Fed funds futures, or the yield curve (e.g. Lange et al. 2003 Hamilton 2008) or a combination of these, and literature on anticipation of Federal Reserve actions (e.g. Lucca and Moench 2015). Within this literature, there is some evidence that anticipatory effects develop gradually and that Fed funds futures may not fully capture the effects of FOMC decisions on this market.

For the most part, both sets of literature focus on the days immediately surrounding an FOMC decision. There is good reason for this, as is evident when considering extreme examples: first, the instant before the decision reflects all available information, hence providing the most accurate pre-announcement expectation; and second, the instant immediately after the decision is the point of fullest response, before the reaction begins to dissipate or is marred by reactions to other information. Such instant before versus instant after comparisons are the motivation behind much of the event study literature.

The view from the trading floor

Anyone who has been near the Treasury desk on a trading floor on the day of an FOMC decision knows the typical pattern surrounding such announcements. The minutes leading up to the announcement give meaning to the phrase “the calm before the storm”. And as soon as the statement is made, a frenzy of activity ensues – reflecting both the surprise reaction of some market participants and the position adjustment of those for whom the “future path of policy” (Gürkaynak et al. 2005) has suddenly been revealed.

Having been on a trading floor in 2004 when the Fed began a steady programme of tightening following a protracted period of being on hold at historically low levels, I know anecdotally that traders generally don’t wait until 2:14pm to adjust their positions in anticipation of a 2:15pm announcement. They ‘set up’ much farther in advance, both to handle any last-minute orders that customers might have and to be ready to respond to trade requests in the aftermath of an announcement.

It is for this reason that I and my co-authors, Dick van Dijk and Michel van der Wel, decided to investigate the extent to which financial market participants set up for Federal Reserve decisions (van Dijk et al. 2016). Our focus on anticipatory effects blends the future path of policy idea of Gürkaynak et al. (2005) with the foresight model specified in Leeper et al. (2013).

To consider this possibility of early anticipatory set-up, we design a comprehensive regression framework that enables us to investigate how the Fed funds futures market is shaped by scheduled FOMC announcements, as well as Federal Reserve communications in the form of speeches and testimony of members of the Board of Governors of the Federal Reserve System, and how those effects interact with announcements of macroeconomic variables during the six months preceding a scheduled target rate decision.

Quantifying the respective contributions of macroeconomic announcements and Federal Reserve officials’ communications to the evolution of daily changes in Fed funds futures prices is the main focus of our study.

We find that the anticipation (or ‘set-up’) occurs over a much longer horizon than previously thought. Furthermore, these effects decline as the FOMC meeting nears: earlier FOMC decisions and surprises in macroeconomic announcements affect Fed funds futures prices more strongly than more recent ones; and Fed funds futures volatility tends to be lower in the days leading up to an FOMC meeting than in the weeks or months preceding it. We argue therefore, that in order to identify fully how information shapes financial market expectations, it is necessary to look much farther back in time.

In contrast to the conventional wisdom that financial markets are reactionary and instantaneous, our work suggests a more methodical approach to digesting central bank communications and macroeconomic announcements, one that considers not only the latest news but how that in turn shapes the path of future policy decisions. In short, financial markets are more forward-looking than we had thought.

One of the challenges in quantifying how the financial markets are affected by Federal Reserve communications over longer periods of time is that other news, such as the release of major economic indicators, also plays a role. By looking at both items together, we find that macroeconomic indicators and central bank officials’ congressional testimony are of comparable importance.

We document that macroeconomic releases have stronger effects on days when Federal Reserve officials are silent (for example, during the ‘blackout period’ – that is, the 7-10 days preceding an FOMC announcement). In contrast, we find that congressional testimony is more important when it coincides with days when important macroeconomic information is released.

Our finding of large anticipatory set-up emphasizes the importance of clarity in central bank communications. The potential importance of these communications has been recognized by the Federal Reserve itself, through a series of decisions since 1994 designed to increase transparency.

An implication of our results, showing that Fed funds futures volatility declines as the FOMC announcement draws near, is that the Fed’s policy rate intentions have been well-understood by the financial markets.

In the paper, we also demonstrate that failure to look back far enough results in inferences that attribute much less significance to both Fed communications and macro announcements in shaping Fed funds futures prices, suggesting that previous studies’ effects may have been understated.


Bernanke, BS, and KN Kuttner (2005), “What Explains the Stock Market’s Reaction to Federal Reserve policy?”, Journal of Finance 60(3): 1221-57.

Bomfim, AN (2003), “Pre-announcement Effects, News Effects, and Volatility: Monetary Policy and the Stock Market”, Journal of Banking and Finance 27(1): 133-51.

van Dijk, D, RL Lumsdaine, and M van der Wel (2016), “Market Set-up in Advance of Federal Reserve Policy Rate Decisions”, Economic Journal 126 (May): 618-53; earlier version of available as National Bureau of Economic Research (NBER) Working Paper No. 19814.

Ederington, L, and J Lee (1993), “The Short-run Dynamics of the Price Adjustment to New Information”, Journal of Financial and Quantitative Analysis 30(1): 117-34.

Gürkaynak, RS, BP Sack, and ET Swanson (2005), “Do Actions Speak Louder than Words? The Response of Asset Prices to Monetary Policy Actions and Statements”, International Journal of Central Banking 1 (May): 55-93.

Hamilton, JD (2008), “Assessing Monetary Policy Effects Using Daily Federal Funds Futures Contracts”, Federal Reserve Bank of St. Louis Review 90(4): 377-93.

Jones, CM, O Lamont, and RL Lumsdaine (1998), “Macroeconomic News and Bond Market Volatility”, Journal of Financial Economics 47(3): 315-37.

Lange, J, B Sack, and W Whitesell (2003), “Anticipations of Monetary Policy in Financial Markets”, Journal of Money, Credit, and Banking 35(6): 889=909.

Leeper, EM, TB Walker, and SCS Yang (2013), “Fiscal Foresight and Information Flows”, Econometrica 81(3): 1115-45.

Lucca, DO, and E Moench (2015), “The Pre-FOMC Announcement Drift”, Journal of Finance 70(1): 329-71.


Brief on “The Intrafirm Complexity of Systemically Important Financial Institutions”

The Financial Stability Board (FSB) describes a systemically important financial institution, or SIFI, as a financial institution “whose disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.”

Regulatory efforts traditionally have focused on the size aspect of this definition, often by delineating a specific threshold (e.g., $250bn in total consolidated assets) that would subject a firm to increased supervisory scrutiny.  Yet despite the ease of implementation, a size-based threshold is in many ways unsatisfactory, precisely because it does not take into account the level of complexity of a firm’s business activities. In addition, size is but one of the criteria mentioned in the SIFI definition.

Further, much of the academic literature has concentrated on the interconnectedness among financial participants, with the goal of identifying central “nodes” – i.e., those firms that are central to maintaining the interrelationships within the network.

In contrast, there has been comparatively little development of metrics concerning the complexity of the individual firms that comprise the system – the other key attribute highlighted in the SIFI definition.  My new paper with coauthors Daniel Rockmore (Dartmouth College), Nick Foti (University of Washington), Gregory Leibon (Dartmouth College) and J. Doyne Farmer (Oxford University) takes on this challenging task by proposing complexity metrics that are designed to inform supervisory judgment regarding the SIFI designation.

In our paper, we use the structure of an individual firm’s control hierarchy (a network representation of the institution and its subsidiaries) as a proxy for institutional complexity. This mathematical representation (and various associated metrics) provides a consistent way to compare the complexity of firms with often very disparate business models.

By quantifying the level of complexity of a firm, the approach also may prove useful should firms need to reduce their level of complexity either in response to business or regulatory needs.  The network encoding and associated metrics open the door for the use of simulations to assess potential changes in complexity. Such simulations could provide a helpful tool for understanding the supervisory implications of altering a firm’s control hierarchy in the process of winding down a firm (such as in the case of the dismantling of Lehman Brothers), or in arranging a rapid acquisition, (e.g., in the cases of the JP Morgan Chase acquisition of Bear Stearns, the Wells Fargo acquisition of Wachovia, or the Bank of America acquisition of Washington Mutual).

More generally, these metrics provide a means of comparing the organizational possibilities with an eye toward reducing, rather than increasing, systemic risk in the wake of a change in firm structure.

We apply our proposed metrics to a sample of 29 firms: 19 banks that have received the SIFI designation, five that have not, and five insurance companies.  Between 2011 and 2013, firms appear to have reduced their complexity.  Contrary to conventional wisdom, the results suggest that some of the SIFI-designated institutions may not pose any greater supervisory challenge than their non-SIFI counterparts, since there is little difference in the complexity of their control hierarchies. In contrast, the insurance companies in the sample are more complex according to the metrics presented in the paper, despite being smaller in size, having fewer subsidiaries, and being less geographically or industry-diverse than the banks.

A pdf version of this brief can be downloaded here.

“The Intrafirm Complexity of Systemically Important Financial Institutions,” by Robin L. Lumsdaine, Daniel N. Rockmore, Nick Foti, Gregory Leibon, and J. Doyne Farmer can be downloaded via SSRN (http://ssrn.com/abstract=2604166).

Basel III Final Rule to Be Released Today

Today the Federal Reserve is expected to vote on revised capital regulations, widely known as the US version of Basel III, with the other agencies likely to follow suit.  I am excited about this, in part because it brings back fond memories from November 2, 2007, the day the Basel II Final Rule was approved.   Just as then, it is my hope that today’s new regulations will both strengthen individual institutions and reduce systemic risk.  But this time around I am not waiting nervously outside the Board room and I was not involved in the writing of The Rule.

Although the exact details of the regulations should be released later today, there are unlikely to be any major surprises.   For now, let me just mention two certainties:

  • It is not going to be perfect.   I know firsthand the challenges of rulemaking, trying to meet the varying needs of all constituents, as well as making sure that definitions and regulations are consistent with tax, legal, accounting, and other frameworks.   Lack of perfection isn’t a bad thing.  It is part of the policy process, a result of a lot of hard work that has gone in to trying to reach consensus on something that is incredibly complex and can apply to a diverse set of institutions.
  • “Final” is a misnomer.  The financial crisis occurred before the Basel II Final Rule could be implemented.   But even prior to Basel II, its predecessor (now referred to as “Basel I”) was revised more than 20 times.   In fact just six days ago the Basel Committee on Banking Supervision released a Consultative Document (Revised Basel III leverage ratio and disclosure requirements), suggesting the revision process has already begun.

I’m guessing that most Fed-watching market participants have been more focused on the exit-timing of quantitative easing than the timing of the Basel III Final Rule.  But a cursory glance at the Fed’s website highlights nearly as many speeches (year-to-date) by Fed officials on the topic of banking regulation as on the economy or monetary policy.   So it’s worth taking notice.  Some important links to documentation leading up to today’s Basel III Final Rule are included below.

The Final Rule documents should be available via press release later today, as well as published in the Federal Register.

Notice of Proposed Rulemaking (issued June 7, 2012).

Public comments received in response

Bank for International Settlements Basel III documents

Bloomberg News Breach

My fascination with the information available on Bloomberg began in January 1999, the first time I had ever seen a Bloomberg terminal (also my first day on a trading floor). I remember someone running over to tell us the Brazilian real was depreciating and typing something on the computer keyboard (BRL <Crncy> GIP, I later learned). And I remember being captivated as I watched the axes of the intraday graph recalibrate in real-time as the currency went into freefall.

Thus began my interest in the role the media plays in shaping financial market perception. In the interest of full disclosure, I have an unpublished working paper, “What the Market Watched: Bloomberg News Stories and Bank Returns as the Financial Crisis Unfolded,” that considers whether it was possible to glean information about market participants’ perceptions using Bloomberg’s readership statistics. So I was naturally drawn to recent stories (e.g., like this Washington Post article) on the access Bloomberg reporters had to information on subscribers’ activity and how that information was used.

Firms using customers’ information to benefit/enhance/promote their business is nothing new; on the contrary it is something we regularly agree to whenever we check that “I have read and agree to the Terms and Conditions” box on virtually everything we sign up for. The concept of targeted marketing is based on this practice. Sure there are differences between activity monitored via computer algorithm versus via actual person. But the fact is (and I am hardly the first to point it out) that we have become rather lax about our privacy…in a wide variety of contexts. Yet whenever a story hits about a firm using information they collect for specific business purposes (see, for example, this CNN article on retailers’ use of price discrimination), some amount of outrage often ensues.

Concerns over a firms’ ability to track and use information about online activity arise with any browser or website. And while a browser enables identification of an organization’s use (via the IP address), any site requiring a login potentially enables identification of a specific user.

This is not just about ethics but about cybersecurity. While some work is being done to strengthen disclosures regarding what firms do with information they collect and how it might be shared outside the firm, there is comparatively little effort spent on who inside a firm has access, how the information is stored, and what the shelf-life of such information might be. And the more these incidents are viewed as isolated to a specific “rogue” individual or groups of individuals at the organization, rather than a systemic reflection of the strength of a firm’s information security protocols, the greater the operational risk.

Outrage is a natural reaction to some of the more egregious uses of information. But until we become more proactive rather than reactive about safeguarding information, the risk that such information will be used inappropriately remains.

Cyprus update

This morning’s agreement outlining a solution to the stalemate that has gripped Cyprus for more than a week was an important development.    The official Eurogroup statement can be found here .

Among the key provisions:

  • Financial assistance up to EUR 10bn for Cyprus
    Reiteration of the deposit guarantee for depositors holding less than EUR 100,000.
  • Laiki bank (the #2 bank in Cyprus) will be split into two – a “good” bank that will be subsumed into the Bank of Cyprus (the #1 bank) and a “bad” bank that will be wound down.
  • Temporary capital controls (e.g., limits on daily withdrawals) to ensure orderly reopening of banks in Cyprus that have been closed since March 16.
  • Uninsured deposits (those over EUR 100,000) remain frozen pending recapitalization of the Bank of Cyprus. The recapitalization will occur “through a deposit/equity conversion of uninsured deposits with full contribution of equity shareholders and bond holders”. The target capital ratio for the recapitalization is 9%.

As noted in my NY Times interview this morning, this is definitely an improvement over the previous proposal and provides some hope that the situation in Cyprus will remain contained.

Some Thoughts on the Cyprus Situation

Watching the Cyprus situation unfold, I have to admit to being amazed / captivated / distraught / panicked (not necessarily in that order). Many times over the past few days I have started to write something only to stop because I didn’t know what to say that hasn’t already been said. But here are a few thoughts about the proposal (vetoed Tuesday in Cyprus’ parliament) that depositors share some of the burden:

(1) It was such a surprise that we’re not even sure what to call it.

This is a bit of an overstatement, I know, because there certainly was a precedent for foreign deposits being at risk of loss after the European Free Trade Association ruling in January regarding Iceland’s limited responsibility to its foreign depositors [1]. But the Cyprus proposal did generate a wide variety of phrases to describe the mandatory participation of depositors, e.g., tax, levy, seizure. The term expropriation also comes to mind – a “deposit grab” for short.

But here’s another way to think about it – an unprecedentedly-negative nominal interest rate. When I first started covering the inflation-linked bond market, I remember highlighting a key distinction between real and nominal yields – the former could be negative whereas the latter could not, in part because no one would tolerate paying a bank to hold their funds when they had a mattress as an alternative. Over time, however, our tolerance for negative nominal yields has increased, albeit mainly under the veil of transactions fees. And while the discussion over quantitative easing often centers on what happens when a central bank reaches the zero lower-bound, in practice there have been some brief examples where the bound has been breached [2]. Perhaps the deposit-grab has taken quantitative easing to a whole new level.

(2) Banks more generally face a deposit catch-22

What this situation in Cyprus has highlighted is just how important deposits are to the health of the financial system. At some level, this was already known – on one hand, deposits are a source of liquidity for a bank. It’s one of the reasons why when a bank fails, its deposits are usually quickly taken over by another institution (related to the reputation point above, this also means that deposit guarantees are rarely required to pay out). But just as quickly as they appear, deposits can also evaporate. More deposits means more liabilities, requiring a bank to hold more capital to protect itself from a potential erosion. As a result, deposits are linked to capital ratios.

One way to reduce the liability side of a bank’s balance sheet and hence improve its capital position is by shrinking its deposits. The direct threat the proposal posed to deposits, even though rejected, suggests that the objective may be fast achieved. Hence the proposal that depositors share some of the burden may have been a misguided attempt to provide much-needed liquidity while at the same time improving the capital position of the banking sector.

(3) Reputation has taken a huge hit

Whenever I talk about the recent financial crisis, one of the things I highlight is the importance of reputation when confronted with challenges. Like regulatory capital, reputation serves as a buffer providing a firm, or a sovereign, with the ability to overcome difficulties. Without it, things can quickly spiral out of control.

The proposal that emerged over the weekend on Cyprus has irreparably damaged reputation at a time when it is most needed. Gone is the credibility of political leaders – just one week before the proposal was announced, Cyprus’ president said losses on depositors were “out of the question”. This is reminiscent of assurances various banking chief executives made in the early stages of the financial crisis – our confidence has been thoroughly undermined. Gone also is the credibility of the European deposit guarantee. Now that a deposit-grab has been put on the table, it is hard to envision a clear path to reopening the banks in Cyprus while avoiding a massive deposit outflow (as I write this, the “bank holiday” has been extended through the weekend).

[1] Duxbury, Charles, and Charles Forelle, “Iceland Wins Case on Deposit Guarantees,” Wall Street Journal, January 28, 2013, available at http://online.wsj.com/article/SB10001424127887323375204578269550368102278.html.

[2] Keister, “Why Is There a “Zero Lower Bound” on Interest Rates?” Liberty Street Economics blog, Federal Reserve Bank of New York, November 16, 2011, available at http://libertystreeteconomics.newyorkfed.org/2011/11/why-is-there-a-zero-lower-bound-on-interest-rates.html.

Is MetLife a SIFI?

Now that MetLife has completed its deregistration from bank holding company status, its attention turns to the next phase of its regulatory gameplan, trying to convince regulators that it does not have the stature of a Systemically Important Financial Institution (SIFI). A Bloomberg article today had some interesting quotes from MetLife executives regarding the challenges the company faces should it receive the SIFI designation.

The company is trying to make a business case for why it should be exempt from such a designation. They claim not to be systemically-linked. One wonders whether AIG would have made the same claim pre-collapse.

As noted in last week’s post, less than six months ago, MetLife was the sixth-largest bank holding company, behind Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, and Goldman Sachs. While admittedly the firm has been shedding assets and paring business lines (e.g., its exit from long-term care insurance), it is hard to believe that much has changed to alter the level of its systemic importance. It participated in the 2009 stress tests that the Fed conducted among 19 of the largest financial institutions and has continued to be included in the annual Comprehensive Capital Analysis and Review (CCAR) exercises that have been held since then, failing the most recent one (the results of which were released in March 2012). Results from the most recent stress tests are scheduled to be released in two parts; the first (stress tests using scenarios mandated by Dodd-Frank) will be released tomorrow (March 7) at 4:30pm while the results of the new CCAR will be released one week later (March 14 at 4:30pm).

The above-mentioned article quoted one executive as saying that increased costs [associated with the SIFI designation] would force the company to raise prices, inhibit risk-taking, and curtail business activities. These remedies are exactly what one would expect in the face of challenging economic times ahead.

MetLife is understandably frustrated at the extent to which they perceive regulators to be inhibiting their ability to do what they want since as a result of their CCAR failure, MetLife’s proposed capital plan was rejected by the Fed. Yet forcing large companies to recognize the negative externalities that could result from their actions is an important part of ensuring financial stability and the central principle behind SIFI designation.

The argument that MetLife has a very different business model from many other SIFIs has its merits. But that point should be part of a larger debate regarding the inclusion of the insurance industry as a whole. If its industry peers are included, so should MetLife be, regardless of whether it is a bank holding company or not.

Click here for more on the Fed’s capital planning and stress testing program (links externally to the Fed website).
Click here for more on the Fed’s release dates of the supervisory stress tests and the CCAR.

MetLife Is No Longer a Bank Holding Company

On February 14, MetLife, Inc. announced it had completed its deregistration and is no longer a bank holding company.

This came as no surprise; more than two years ago the company made known its intentions (see here for a piece I wrote at the time) and since then has actively sought to shed banking-related assets. Yet its deregistration is significant, in part because it is at odds with the regulatory push to improve financial stability and reduce systemic risk. By shedding its bank holding company status, MetLife loses the Federal Reserve as its primary regulator.

As of 9/30/12, MetLife ranked 6th in total assets among the Top 50 holding companies (see current Top 50 list here). By virtue of its participation in the 2009 Supervisory Capital Assessment Program (SCAP), its size and holding company status meant that it would be required to participate in the upcoming round of Comprehensive Capital Analysis and Review (CCAR), the stress tests conducted by the Federal Reserve (see page 62381 and particularly footnote 19 of the Federal Register notice detailing this). MetLife was one of four companies that “failed” the CCAR in March 2012 and has been critical of both the stress tests and capital regulations being applied to insurance companies in the same way as banks.

Without its BHC status, it’s not clear that MetLife still will be subject to the next CCAR or the rigorous supervisory oversight that comes with being a BHC. Arguably the oversight of the insurance regulators and potential designation as systemically important by the Financial Stability Oversight Council will substitute.

MetLife was ahead of the game five years ago when a wave of companies scrambled to become bank holding companies in order to have access to the Fed’s lending facilites; unlike many of those other companies, MetLife had been a BHC well before that time.

In the immediate aftermath of the 2008 crisis, regulatory attention has focused on the risk the largely unregulated shadow banking system poses to financial stability. As a result the shadow banking system was hit hard, according to CFS estimates (see here) but more recently has shown signs of recovering. It just got a large boost from MetLife joining its ranks.

For more information on the shadow banking system, see:
Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky (2010), “Shadow Banking,” Federal Reserve Bank of New York Staff Report No. 458, revised February 2012, available here (links to external NY Fed website).

New Bowles-Simpson Proposal

On Tuesday the dynamic bipartisan duo Erskine Bowles and Alan Simpson was at it again –releasing a new/updated set of recommendations for dealing with our debt situation. Although the exact details differ, seven of the 11 principles outlined in the summary closely resemble those given in the original 2010 Fiscal Commission Report (available here). Of interest, therefore, are the looming risks to economic stability highlighted in the four new principles. They are (the exact wording from their proposal is highlighted below in bold):

(1) the threat of sequestration (Replace Dumb Cuts with Smart Reforms),
(2) the increasing debt burden (Protect the Full Faith and Credit of the U.S. Government),
(3) the changing demographic landscape (Get Serious About Population Aging), and
(4) the rising cost of health care (Bend the Health Care Cost Curve).

There is already plenty of discussion out there regarding sequestration since its deadline looms. Here is why I think the other three are so vital for the financial future of the US.

Protect the Full Faith and Credit of the U.S. Government:  In addition to the magnitude of the debt burden, the front-loaded US Treasury maturity structure is worrying (see “Treasury Maturities: The Other Fiscal Problem” by CFS President Lawrence Goodman). With a large proportion of debt maturing in the near-term, coincident timing of a Treasury rollover of that debt and a Fed exit from quantitative easing could result in the perfect storm, raising borrowing costs substantially. Put another way, one wonders whether the threat of substantially ballooning borrowing costs may limit the speed at which the Fed can raise interest rates.

Get Serious About Population Aging / Bend the Health Care Cost Curve:  I’ve been quite vocal with my view that the changing demographic landscape is one of the biggest risks to global financial stability (see “The Market for Long-Term Care Insurance and Systemic Risk“). Anecdotally just consider the number of countries and corporations that have highlighted the necessity of pension and healthcare reforms – and the hostility from current and future beneficiaries that any proposed modifications generated. I’m glad to see this topic garnering greater attention – policies that address financial stability and systemic risk have implications for healthcare and vice versa. Unintended consequences can result when policy debate about one occurs without consideration of the other.

The new Bowles-Simpson proposal also contained an outline of “Four Steps to Deficit Reduction (2014-2023)”. In Step 3 they reiterate their call for adopting a chained CPI for indexing (i.e., of entitlements like social security). I continue to be concerned about how this proposal might be implemented, specifically with respect to its redistributive implications (see “Changing Inflation Won’t Solve Budget Woes“). We must be careful that such a change will still “Protect the Disadvantaged” (one of Bowles-Simpson’s earlier recommendations that was reiterated in their new proposal).

See also:Budget Solutions: Then and Now“, by Susan Hering and Lawrence Goodman.

Additional Details on Liquidity Coverage Ratio Changes

Monday’s announcement that the Basel Committee on Banking Supervision (“BCBS”) had made changes to its liquidity coverage rules was largely met with accusations that regulators were softening their stance, “caving” to industry pressure (e.g., see here for a particularly critical example).

At first glance, one can see how these accusations came about. Most changes involved a relaxation of what had been initially proposed. For example, a wider range of securities was included in the definition of High Quality Liquid Assets (“HQLA”) and the deadline for compliance was extended from 2015 to 2019. A complete summary of these changes can be found here (links externally to BIS website). More generally, concerns about regulatory capture and undue industry pressure routinely surface. Hence it is not surprising that such arguments also were prevalent in Monday’s coverage on this topic.

I would instead argue that such modifications are an important part of the policy process. In fact, in the US, modifications are to be expected, as Federal agencies are required to both solicit and address all comments received on their proposals prior to implementation. A good description of the rulemaking process for Federal regulations in the US can be found via these two external websites:

Overview of rulemaking process:
Executive Order 12866 and the comment period:

One of the most important aspects of this process is that it provides for direct public involvement in the regulatory process via an open comment period, generally required to be a minimum of 60 days. Not every country does this.

Note that Federal agencies are not required to incorporate the comments, only to address them. But clearly solicitation of comments without any intent to modify is disingenuous. From what I’ve seen of the rulemaking process, regulators know they are not infallible and genuinely value helpful feedback. The presence of a comment/modification process helps to temper the risk of a “knee-jerk” response to a crisis. And even with legislation that has come about quite quickly (e.g., the Dodd-Frank Act), modifications continue to be part of the process (see Steven Lofchie’s Jan 4 post). There is much to be gained from regulators and those in the industry they regulate engaging in discussion and learning from each other.

The BCBS employed a similar process for its liquidity coverage ratio (LCR) standards (see here for the full document). First published in December 2010, Monday’s revision incorporated feedback received since the initial publication.

An extended transition period is a relatively common regulatory response. The use of a transition period is a helpful and constructive way to articulate a high standard while simultaneously providing a path to achieve it. The tremendous growth-by-acquisition that the banking sector experienced over the past decade has led to increasingly complex IT structures that understandably cannot be modified overnight in response to new regulatory requirements. As a cost center, IT is rarely a top priority for firms rushing to complete a merger; yet is often given as a reason those same firms need a more gradual implementation schedule of proposed regulation. Thus at least some of the frustration regarding the delay to 2019 should be channeled into forcing banks to upgrade their IT infrastructure. This would not only help them to meet regulatory requirements more quickly; it would also improve their ability to identify and mitigate risks.

Two other considerations that are worth mentioning. First, times are still challenging. Regulators need to be careful that they do not make definitions so stringent that firms would need to scramble in order to be in compliance, shedding assets that were not included in the HQLA definition and rushing to gather those that did make the cut. Such activity might further destabilize an already fragile recovery.

In addition, we should keep in mind there is nothing magical about the initially proposed thresholds. Yet it is all too tempting to evaluate each modification via comparison to its initially proposed threshold, an example of a well-documented cognitive bias known as “anchoring” (Tversky and Kahneman, 1974). Which is the more appropriate threshold may be anybody’s guess – but I prefer the one that has the benefit of two more years of experience and feedback from a wide variety of constituents.

Regulators should be applauded for carefully and thoughtfully considering feedback.  If they have gone too far in their response, rest assured more modifications will result.  And thankfully there will be ample opportunity for comment.

See also: Amos Tversky and Daniel Kahneman, “Judgment under Uncertainty: Heuristics and Biases,” Science, September 27, 1974, pp.1124-1131