The US needs urgently to raise its macropru game
Donald Kohn
Robert V. Roosa Chair in International Economics
Senior Fellow – Economic Studies
Implementing robust macroprudential policy—addressing threats to financial stability beyond those that were the focus of safety and soundness on an institution-by-institution basis or of investor protection market-by-market—was a constructive outcome of the legislative and policy response to the global financial crisis of 2008-09.
In the U.S., the Dodd-Frank Act of 2010 strengthened the hand of the Federal Reserve as it addressed the systemic risks in banks and bank holding companies, including those emanating from institutions that were “too big” or “too systemic” to fail. It also created two new institutions to look across the fragmented regulatory landscape to drive macroprudential policy addressing risks outside of banks: the Financial Stability Oversight Council (FSOC), which is chaired by the secretary of the Treasury and includes the heads of federal regulatory bodies, is charged with identifying and responding to risks to the financial stability of the United States, and the Office of Financial Research (OFR), which was created to support the work of FSOC through research and data gathering. FSOC’s powers are limited—it can designate systemically important institutions, and it can make recommendations to constituent regulators—but even those authorities have been infrequently used. The structures set up by Dodd-Frank have not led to consistent and effective macroprudential policies in the U.S.
The Biden administration, under the leadership of Janet Yellen at Treasury, intends to drive more active macropru policies, but at this still early stage of the administration, results are not yet evident. It is urgent they get on with the job. First, the “dash for cash” of March 2020 as the pandemic shutdown set in revealed a number of weaknesses in market-driven financial intermediation that required unprecedented and massive central bank intervention to prevent a total breakdown of the financial system that would have made an already dire economic situation much worse. We had hints of those weaknesses before the pandemic, but they became considerably more visible under stress. Moreover, the actions of the Federal Reserve and other central banks to counter their effects raise the possibility that private risk taking will be distorted by the expectation of future interventions in stress situations. The authorities need to move while memories are fresh and political support for corrective steps is at its highest.
The second reason for urgency is the current economic and financial situation. If the economic and financial situation evolves as seems to be expected in financial markets, credit will flow, and financial markets will continue to serve the needs of the economy. But the current situation is replete with fat tails—unusually large risks of the unexpected which, if they come to pass, could result in the financial system amplifying shocks, putting the economy at risk. At a recent FOMC meeting, the Board of Governors staff characterized financial vulnerabilities as “notable,” reflecting some asset valuations, leverage in corners of the financial system, and persistent structural issues.[1] Moreover, these vulnerabilities have arisen in the context of truly unprecedented circumstances, making it difficult, if not impossible, for policymakers or market participants to predict the future with confidence. There’s the virus, of course, and the public and private response to its evolution. In addition, fiscal policies are raising Federal debt-to-income to record peacetime levels and a new monetary policy framework has yet to play out in practice. Meanwhile, inflation has spiked to the highest levels in many years. Yet market participants appear to have priced in very low interest rates for a very long time even as the economy recovers and, judging from risk spreads and equity prices, are quite confident that higher debt levels can be serviced and sustained—even though a disproportionate increase in private debt has been among lower-rated business borrowers.[2]
Well-functioning U.S. financial markets are essential for well-functioning global finance. We saw all too clearly in 2008 how disruptions in U.S. markets can trigger a global financial meltdown and recession. Building resilience in the U.S. to risks that could readily materialize is essential to building confidence in a sustained global recovery from the pandemic. New legislation would be helpful in a number of dimensions—especially in reworking how FSOC and OFR function and making sure they are supported by a more prominent financial stability focus and analytical capability in constituent agencies. But U.S. agencies already have the tools to address many of the vulnerabilities that have lingered since the GFC and became so evident in March of 2020, and some new ones that have emerged more recently.[3]
Here’s a checklist of actions that do not require legislation. Notably, it is not a menu from which to pick a few “dishes” to make a macropru meal—all of these things should be addressed, and promptly.
Banking
The resilience of the banking sector was greatly strengthened after the Global Financial Crisis (GFC) by tightened and reformed capital requirements, stress tests of capital adequacy, liquidity requirements, and greater scrutiny of bank risk-management practices, with extra requirements in each area for systemically important banks whose failure would have significant knock-on effects. But more can be done to build resilience in banks and in securities markets where banks intersect with nonbank finance.
A very serious amplifier of stress in the March 2020 dash for cash was the counterintuitive and counterproductive behavior of Treasury securities prices, which fell, rather than rose, in the midst of a flight to liquidity and safety. Dysfunction in the Treasury market spills over in many ways to the broader financial markets and the economy since Treasuries are relied on for liquidity by market participants, for risk management, and as a pricing reference point. There were a number of contributors to this behavior, but one was the reluctance of private dealers, the largest of which are subsidiaries of systemically important bank holding companies, to flex their balance sheets to pick up the Treasury securities being offered in the market. The dealers were especially constrained by the risk-insensitive leverage ratio applied to systemically important bank holding companies, until the Federal Reserve temporarily exempted deposits at the Fed and Treasuries from its calculation. That exemption has lapsed, and with continuing Fed securities purchases, deposits at the Fed are a growing threat to making the leverage ratio salient again, which would constrain dealer market-making appetite. The Federal Reserve should permanently exempt deposits at the Fed from calculation of the leverage ratio.
This exemption, however, should not be allowed to reduce the capital required of banks, especially systemically important banks. There are a number of ways to keep this from happening, but one I favor is to raise risk-based requirements a bit on average through the cycle by activating the countercyclical capital buffer (CCyB). The Fed’s current practice is to leave this at zero unless it has identified the risk environment as already elevated. In this, it differs from many other authorities globally, who have targeted a positive CCyB in a normal risk environment, which enabled them to release that capital to back lending when the Covid-related shut down hit.
The argument for an active CCyB has been strengthened by experience in the pandemic. Evidence from both the U.S. and EU is that banks are reluctant to dip into their regulatory capital buffers to make loans under stress out of concern about market reactions and about supervisory constraints on earnings distributions. Studies have shown that banks with less headroom over buffers tended to lend less in the pandemic than banks with more headroom.[4] The beauty of the CCyB is that once released, it is not part of a regulatory capital buffer and is more available for use. Moreover, the recent changes to the Fed’s stress tests and capital requirements, including substituting a “stress capital buffer” derived from stress test results for elements of the capital stack, are likely to make capital requirements procyclical; adding an actively managed CCyB would counter this adverse macroprudential outcome.
The evident reluctance of banks to dip into regulatory buffers under stress suggests a reasonably sizable CCyB in “normal times” to release under stress would be a helpful countercyclical measure from a macroprudential perspective. The Financial Policy Committee at the Bank of England has established two percent as its target CCyB in a standard risk environment, twice what many other macropru authorities have set, in part by shifting capital from other elements of the stack.
The Federal Reserve should make the CCyB positive in normal risk environments and then manage it actively as risks build or materialize. As it implements a CCyB, the Fed should consider the appropriate level in the context of sterilizing a potential release of capital from adjusting the leverage ratio and the composition of the overall capital stack that would best support the resilience of the financial system and the economy.
Market-based finance
Credit has increasingly shifted to nonbank channels, especially to markets, responding to innovation and to regulatory arbitrage as bank regulation tightened. But elements in nonbank finance share the leverage and maturity and liquidity transformation characteristics of banks, making them also vulnerable to runs and fire sales that tighten credit and amplify business cycles. In many respects, however, vulnerabilities in market-based finance are harder to deal with than they are with banks. They are spread over many types of institutions and markets, subject to multiple regulators—and some parts are very lightly regulated, if at all. Market-based finance is global, facilitating arbitrage across borders and necessitating a globally agreed approach to regulation. And rapid technological change produces a constantly evolving set of instruments and players. Still, tools are available to address a number of vulnerabilities and the centrality of U.S. markets to global markets means that the U.S. should lead the effort.
As noted, well-functioning U.S. treasury markets are a critical element in keeping both bank and nonbank financing channels operating well. Leverage ratio reform is a necessary but not sufficient condition to bolstering Treasury market liquidity. In addition, the Treasury and the Fed should examine the costs and benefits of mandating central clearing for Treasuries and repos, which might free up dealer capital that would be available to be used for market making.[5] And the agencies need to gather and publish more complete data on market transactions to help both regulators and market participants better understand and anticipate market dynamics.[6]
Even with greater private-sector market making, circumstances could arise in which the Federal Reserve would need to step in to preserve well-functioning Treasury securities markets. To that end, backstop standing repo facilities for foreign official holders of Treasuries and for a wide variety of private market participants would put structures in place that could fill that role in a well-anticipated and transparent fashion. In that regard, the Federal Reserve’s recent announcement of two such facilities—one for foreign official institutions and another for dealers—was welcome.
But the repo facility for private parties is limited to the primary dealers and, over time, some depository institutions. To better guarantee Treasury market functioning, the Federal Reserve needs to design a repo facility that is available to a variety of large participants, like hedge funds and other leveraged investors that are playing an increasingly important role in the market. Such an extension would raise issues of counterparty risk and distortions to risk-taking incentives among lightly regulated entities; those can be dealt with through varying haircuts and by imposing a small ex ante fee on lightly regulated entities with access to the facility, but other approaches may also work.
Several types of open-end funds faced very large redemptions in March, including both money market funds and corporate bond and loan funds; to meet those demands, funds turned in part to selling the Treasuries they held for liquidity purposes, so these redemptions disrupted Treasury, corporate bond, and commercial paper markets. The scale of the redemptions is not surprising. Many mutual funds offer their investors much greater liquidity—an ability to redeem by tomorrow at tonight’s closing price—than the liquidity of the underlying securities they hold, which often trade in illiquid markets or simply don’t trade at all, like commercial paper. This mismatch creates a first mover advantage—an incentive to get out while the fund has Treasuries to sell—before redemptions by other investors force fire sales of less liquid assets, depressing prices. The SEC must change regulations to align the liquidity offered investors with the liquidity of the underlying assets in the fund. There are a variety of ways to do this—and the choice for money market funds might differ from the best choice for bond funds. Swing pricing forces early redeemers to pay the price of the liquidity they are getting; where that isn’t possible, as is argued for money market funds, alternatives may work to properly price liquidity under stress, like penalizing redemptions under some circumstances or holding back a portion of the investment.
Another source of elevated demand for liquidity in March 2020 arose from initial margining at central counterparties in derivative and securities markets. According to users, a lack of transparency and predictability about margining methodologies contributed to unexpected demands for cash during the “dash for cash.” But in addition, margin requirements rose substantially as markets became much more volatile. From the perspective of the clearinghouses, this made good sense, and in fact central counterparties remained functioning and viable during an extremely stressful market episode. But here is a case of the micro and macroprudential impulses in conflict as the interest of each clearinghouse added to overall market stress. The CFTC and the SEC should draw on the systemic perspectives of the Fed and Treasury to make margins in CCPs less procyclical with more through-the-cycle methodologies.
This is a formidable list—and I could have added more. Much of it is already under consideration in the U.S. and in global groups, like the FSB. Each element will draw opposition from private parties fearing added costs and counting on intervention from the fiscal and monetary authorities to contain the next market crisis. All of it will require a careful balancing of costs and benefits—but most explicitly and importantly taking account of the costs to society, beyond the costs to market participants, of repeated episodes of financial instability.
Other jurisdictions
The risk environment in the financial markets of many other advanced economies is quite similar to that facing the U.S. Asset prices are elevated and leverage in some sectors has ballooned as market participants count on low interest rates persisting for a very long time. But uncertainties abound as the global economy emerges from a global pandemic after application of unprecedented monetary and fiscal policies. And, until the U.S. raises its macropru game, they are vulnerable to disruptions emanating from U.S. markets.
Many authorities outside the U.S. have utilized a wider array of macropru tools than has the U.S. Given the risk environment, now is the time to make sure domestic institutions and markets would be resilient to severe shocks. Where requirements were adjusted or eased in response to the onset of the pandemic, they should be restored to former settings now that economies are recovering and credit is flowing readily. For example, CCyBs cut in March 2020 to encourage bank lending should be raised as quickly as is consistent with the commitments and forward guidance given when the reductions were announced. Where the “dash for cash” revealed new vulnerabilities that can be addressed in individual jurisdictions, actions should be taken to build resilience—for example, if the margining at CCPs and the behavior of highly leveraged investors in domestic sovereign bond markets amplified stress. Where effective remediation is not possible in global markets without the participation of the U.S., other authorities should work closely with U.S. authorities in international fora to build consensus around best practices that can be implemented globally, including in the United States.
[1] Darrell Duffie highlighted the potential for central clearing to economize on dealer capital. https://www.brookings.edu/research/still-the-worlds-safe-haven/
[2] Notably, the recommendations of the G-30 group on Treasury market functioning are broadly aligned with those of the Task Force. https://group30.org/publications/detail/4950
[3] https://www.federalreserve.gov/econres/feds/un-used-bank-capital-buffers-credit-supply-shocks-at-SMEs-during-the-pandemic.htm. And for similar findings away from the U.S.: https://www.bis.org/bcbs/publ/d521.pdf.
[4] https://www.federalreserve.gov/newsevents/pressreleases/monetary20210818a.htm
[5] https://www.ft.com/content/32a57864-d983-46b0-bbfa-85fd2d2361e5
[6] Much (though not all) of what follows is based on the recommendations of a Chicago Booth-Brookings Task Force on Financial Stability that I co-chaired. https://www.brookings.edu/research/report-of-the-task-force-on-financial-stability/. I have also drawn on my talk to the Kansas City Fed’s Jackson Hole symposium. https://www.brookings.edu/research/building-a-more-stable-financial-system-unfinished-business/
The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation.
Related Content
U.S. Economy
Report of the Task Force on Financial Stability
Glenn Hubbard, Donald Kohn, Laurie Goodman, Kathryn Judge, Anil Kashyap, Ralph Koijen, Blythe Masters, Sandie O’Connor, and Kara Stein
Tuesday, June 29, 2021
Up Front
What is swing pricing?
Anil Kashyap, Donald Kohn, and David Wessel
Tuesday, August 3, 2021
2021
Jun
29
Past Event
Task Force on Financial Stability: Report release
1:30 PM –
3:00 PM EDT
Online only
Technological capacity and firms' recovery from Covid-19
by Sebastian Doerr, Magdalena Erdem, Guido Franco, Leonardo Gambacorta and Anamaria IllesBased on a large sample of firms in 17 countries, this paper shows that businesses headquartered in countries with better digital capabilities – as measured by their position in the World Digital Competitiveness Ranking – had higher revenues during the pandemic relative to their pre-pandemic trend.
Cross-border crisis simulation exercise in South America
This report sets out general findings and recommendations on a range of topics, including crisis management tools; recovery and resolution planning; liquidity and resolution funding; domestic decision-making procedures; and cross-border cooperation and information-sharing.
A taxonomy of sustainable finance taxonomies
Sustainable finance taxonomies can play an important role in scaling up sustainable finance and, in turn, in supporting the achievement of high-level goals such as the Paris Accord and the UN sustainable development goals. This paper develops a framework to classify and compare existing taxonomies. Several weaknesses emerge from this classification and comparison, including the lack of usage of relevant and measurable sustainability performance indicators, a lack of granularity and lack of verification of achieved sustainability benefits. On this basis, the paper proposes key principles for the design of effective taxonomies.
Regulating stablecoins isn’t just about avoiding systemic risk
It’s good news that financial regulators are focused on figuring out what to do about stablecoins because their growth is creating significant risks. But there’s a bigger picture here than how to bring these new instruments within the regulatory perimeter, or how to regulate crypto generally, even though these are important. The bigger issue is how do we modernize our payments system? This should be a Biden administration priority because it would help low-income people in particular.
Timothy G. Massad
Senior Fellow – The John F. Kennedy School of Government, Harvard University
Former Chairman – Commodity Futures Trading Commission
Former Assistant Secretary – Treasury for Financial Stability
The connection between stablecoins and helping low-income people might seem unlikely because stablecoins are primarily used today to speculate on cryptocurrencies. While their growth has led financial regulators to worry about potential systemic risks, that growth is partly because of deficiencies in our payments system, and those deficiencies are a major reason why the U.S. lags behind other developed nations in financial inclusion. Stablecoins have potentially much broader application. Properly regulated, they are one means—although clearly not the only means—of curing some of those payment system deficiencies. Thus, financial regulators should not only address the risks that stablecoins pose but keep their aim on that broader goal of modernizing our payments system and improving access to the financial system.
This paper discusses (1) why stablecoins are a problem; (2) how we should regulate stablecoins; and (3) the bigger picture about modernizing payments and improving financial access.
The risks of stablecoins
Stablecoins are digital tokens whose value is pegged to the dollar (or another currency or asset). They serve to grease the wheels of the crypto industry, enabling investors to easily transfer value between different crypto exchanges and cryptocurrencies without converting back and forth into dollars. Settlement is instant, thus avoiding delays of other means of payment. This function coupled with explosive growth in the crypto currency market explains why the market capitalization of stablecoins has increased from $20 billion twelve months ago to over $120 billion today1.
Figure 1: Market capitalization of stablecoins, January 2017 to August 2021
Stablecoins are currently not regulated in any meaningful way. While some issuers have state licenses, these impose minimal requirements. There are no standards requiring issuers to protect reserves or maintain liquidity. I have written about how a sudden spike in demand for repayment could cause a stablecoin to “break the buck” the same way the Reserve Primary Fund did in September of 2008, which triggered a run on money market mutual funds that was only stopped when the Treasury issued a guarantee of money market mutual fund liabilities.
Related Content
2021
Sep
30
Past Event
Regulating cryptocurrencies and future technologies: A conversation with Manuel P. Alvarez
12:00 PM –
1:00 PM EDT
Washington
Financial Regulation
Can fintech improve health?
Aaron Klein
Friday, September 24, 2021
Financial Regulation
Where are the Biden financial regulators?
Peter Conti-Brown
Tuesday, August 17, 2021
Although stablecoins are currently not used widely outside of the crypto industry, they have the potential for much broader application. Stablecoins first garnered wide attention in June 2019 when Facebook proposed creating “a simple global currency”2 or stablecoin called Libra that would be pegged to a basket of fiat currencies including the dollar and the euro. That proposal provoked harsh criticism, both because of its sponsor3 as well as its design. Central bankers feared it would undermine sovereign currencies and monetary policies4. The proposal has since been renamed Diem and redesigned as a set of stablecoins, each tied to an individual fiat currency. It is not operational, in part, because Facebook promised in Congressional hearings that it would not launch the idea unless regulators approved, and they have not done so. Other stablecoin issuers did not ask for permission, and their tokens have grown enormously, which has finally prompted regulators to consider acting.
How to regulate stablecoins
In July, Treasury Secretary Yellen convened the President’s Working Group on Financial Markets (PWG) to discuss stablecoins. The PWG does not have any power to actually do anything about stablecoins, however. Instead, Treasury staff will soon issue a report that will recommend a path forward, which could include a mix of recommendations for actions by different regulatory agencies and potentially Congress.
The best option is to have the Financial Stability Oversight Council (FSOC) commence a review. Under Title VIII of the Dodd Frank Wall Street Reform and Consumer Protection Act, the FSOC can require regulation of a “payment activity” that it determines “is, or is likely to become, systemically important.”5 The FSOC has broad powers to get information from institutions engaged in an activity that it has reasonable cause to believe meets the standard for such a designation. That type of inquiry is much needed given the lack of transparency about stablecoins.
The law sets forth criteria for making the systemically important designation, which include size as well as the effect that the failure or disruption of the activity would have on critical markets, financial institutions, or the broader financial system. Under Title VIII, the FSOC has designated two operators of business payment systems as systemically important financial market utilities, but it has never designated an activity generally nor an entity engaged primarily in retail payments. The “likely to become” phrase is not in Title I, under which FSOC designated four entities following the global financial crisis. It is clearly relevant to the concern that, unless regulated, stablecoins could continue to grow dramatically.
Having been a member of the FSOC for three years, I believe an FSOC review will be useful even if it decides against a systemically important designation. The FSOC can still be the forum for making a sound choice among the alternative paths, which involve different regulators who comprise the FSOC. There is a good argument that stablecoins could be regulated as bank deposits under existing law. Section 21 of Glass Steagall (which survived despite repeal of much of that law) prohibits anyone from receiving a bank deposit unless subject to regulatory oversight under specific exceptions.
There is also the option of regulating stablecoins as securities or as money market funds. Securities and Exchange Commission chair Gary Gensler has suggested he might move to do so and has referred to the PWG report as something that his staff is working on with Secretary Yellen. Although I have compared stablecoin risks to those of money market funds, I do not think that is the best way to regulate them. They are fundamentally payment devices and not investments. Classifying them as securities would also appear to pre-empt a systemic importance determination as part of the payment authority given by Dodd Frank since the definition of “payment, settlement and clearing activity” for purposes of FSOC’s jurisdiction excludes “any offer or sale of a security under the Securities Act.” The PWG report will presumably indicate which path of this fork the Biden administration will pursue.
Another option is to recommend to Congress that it enact new authority. Various bills have been introduced to address stablecoins, including one that would limit issuance to entities that are banks. But at a time when the Biden administration and Congress already have many weighty legislative priorities, rapid enactment of legislation seems doubtful.
If the FSOC does reach a determination of systemic importance, the Federal Reserve would be charged with developing “risk management standards” that “promote robust risk management; promote safety and soundness; reduce systemic risks; and support the stability of the broader financial system.”6
The path chosen may affect the comprehensiveness of the regulatory framework that can be created, though we should put in place what we can now and add to it later if necessary. Ideally, we need a framework that includes not just traditional prudential regulation standards, but also operational risk measures, consumer protection standards, and standards to achieve interoperability. Regulators should require that reserves are invested in bank deposits, Treasuries, or other safe, liquid assets, and that there are liquidity requirements. If the Federal Reserve were to broaden who is eligible for a master account, then stablecoin providers which are not banks could park reserves at the Fed, an option some would argue is even safer because it would avoid the operational risk of a particular bank. Regulators should require a capital buffer even if reserves are invested in cash or other safe assets. That is because capital can protect against other types of losses, such as operational ones. Regulators may also want to ban the payment of interest to discourage users from maintaining large deposits. That plus requiring reserves to be invested in cash or other safe assets would likely mean that stablecoins would be attractive only as payment instruments, not as investments. A prohibition on interest would put stablecoins at a disadvantage relative to bank deposits if interest rates rise, but regulators might desire that in these early days of the industry. Compliance with “know your customer,” anti-money laundering, and other laws combatting the financing of terrorism is crucial.
There should also be operational resilience standards. This is a huge area of risk often overlooked in commentary that focuses on stablecoin financial risks. Stablecoins run on decentralized blockchains and smart contracts. The software for the various layers of operation could have flaws or could be vulnerable to attack. The largest stablecoins run on multiple blockchains but are separate and distinct tokens on each such blockchain, as a recent post by Neha Narula of MIT explains. That means risks associated with the integrity and reliability of the blockchains and software are multiplied. In addition, a stablecoin could become too large in relation to the capacity of the blockchain itself. Federal Reserve staff are presumably becoming knowledgeable about these issues through their collaboration with MIT to design a hypothetical central bank digital currency platform.
The regulatory framework should also include requirements for adequate disclosure of information to customers, rights of recourse, and standards on protection of customer information, including on how a customer’s data can be used. The Consumer Financial Protection Bureau may have a role to play in this regard. Finally, we may want to create standards that ensure interoperability between different stablecoins to avoid a fragmented system.
One other advantage of an FSOC process is that the presence of representatives of state banking and securities regulators on the council may help figure out how state regulation of stablecoins—which exists, but is quite limited—should mesh with federal standards.
Both the PWG and the FSOC are well suited to examining risks generated by financial markets. The PWG was created in response to the 1987 stock market crash; the FSOC was created in response to the 2008 global financial crisis. But whatever path is chosen for going forward, the goal should be not just to regulate risks of this particular innovation but to address deficiencies in the payment system that are a principal reason for the growth of stablecoins.
How regulating stablecoins can advance financial inclusion
While stablecoin usage has largely been in the crypto industry, their impact has already been broader. As Federal Reserve chairman Powell said in discussing Facebook’s Libra proposal, the concept “lit a fire” under central bankers to consider central bank digital currencies (CBDCs). Both stablecoins and CBDCs are ways to remedy deficiencies of our payments system and potentially enhance financial inclusion. As financial regulators address the risks of stablecoins, they should articulate that larger goal of modernizing our payments system and increasing access to the financial system.
Banks handle the vast majority of U.S. dollar payments in a safe and well-tested manner. But the system is characterized by relatively high cost, weak competition, and insufficient innovation. Americans pay significantly more than Europeans for payment services, particularly because of high fees paid for credit cards. The system is also slow relative to real-time payments increasingly common in other countries.
Most Americans might say the system is fine. We don’t notice interchange fees paid by merchants because they are rolled into prices, and our credit cards give us free revolving credit, cash back, frequent flyer miles, or other rewards. Nor is anyone who has some savings likely to be inconvenienced if a check takes a couple days to clear.
But the flaws of the system weigh much more heavily on those in lower-income brackets. Those who live paycheck to paycheck are at risk of incurring significant overdraft fees when checks don’t clear quickly. The fact that approximately 70%7 of those who use check cashing services have bank accounts is clear evidence that something is wrong with the payments system. In addition, because people with lower incomes have fewer credit cards—they use more prepaid cards and debit cards, which don’t offer the same benefits—the credit card costs embedded in prices fall disproportionately on them.
It is shocking that with a financial system as sophisticated as ours, 25% of American households are unbanked or “underbanked,” according to the FDIC. The latter term means they have a bank account but use nonbank options like check cashing services or payday lenders, often to avoid even more expensive bank overdraft charges. Moreover, as Aaron Klein has written in an excellent new paper, the key issue is access to digital money, and low-income people are at a distinct disadvantage in that regard.
Stablecoins are one way to speed up payments, as are CBDCs. The original Libra proposal focused on its potential financial inclusion benefits. While some might regard that as window dressing by Facebook, the fact is that slow and expensive payments burden low income people in many ways. Remittances—a $700 billion market of sending money from one country to another—is a prime example, as the average cost exceeds 6%.
A retail CBDC could be a means of providing bank accounts as well.8 Of course, the banking industry is quick to cry out that this would disintermediate the banking system—because deposits would leave commercial banks and move to the Fed—and result in less lending and credit creation. But there are many design choices for CBDCs. One option is to create no frills, minimal retail accounts with deposit limits, which might help the unbanked and underbanked without draining away significant deposits. We could also mandate banks to provide such low or no-cost accounts.
These are not the only solutions, and some will argue that existing private and public sector initiatives are sufficient to modernize the system. The Federal Reserve’s new real-time payments system, FedNow, is due to be operational in 2023 and that will surely help. But it needs to be coupled with regulatory changes that will create more competition, or banks may only offer those services within their “walled gardens”.
The real issue is increasing competition—either from new private sector entrants or effectively from the government through a CBDC. Regulators can’t fix the system’s deficiencies as they move to regulate stablecoins, but they can frame the issue in that context. The big picture is that stablecoins have grown enormously because they offer distinct advantages in speed. Banks have not sufficiently modernized the system nor addressed financial inclusion. Changes in regulation may be needed to permit greater competition and facilitate innovation. The Biden administration should make this a national priority.
Macroeconomic policy under a managed float: a simple integrated framework
by Pierre-Richard Agénor and Luiz Awazu Pereira da SilvaThis paper presents a simple integrated macroeconomic model of a small, bank-dependent open economy with a managed float and financial frictions.
Central bank digital currencies – executive summary
A group of seven central banks (Bank of Canada, Bank of England, Bank of Japan, European Central Bank, Federal Reserve, Sveriges Riksbank and Swiss National Bank), together with the Bank for International Settlements, are working together to explore central bank digital currencies (CBDCs) for the public (“general purpose” or “retail” CBDC).
Big tech regulation: what is going on?
FSI Insights No 36, September 2021. This paper reviews various regulatory initiatives developed in China, the European Union and the United States to address new challenges presented by big techs.. It offers a typology of regulatory actions and focusses on five policy domains: competition, data, conduct of business, operational resilience and financial stability.
Enabling open finance through APIs: report on payment initiation
Report by the Consultative Group on Innovation and the Digital Economy (CGIDE) established at the BIS Representative Office for the Americas.
The risks of US-EU divergence on corporate sustainability disclosure
Sustainability disclosure is in vogue, with more than 80 percent of major global companies reporting on some aspects of their social and environmental impacts. This is partly driven by growing calls for transparency by civil society organizations and environmental, social, and governance (ESG) investors, who are demanding detailed and verified corporate sustainability information. ESG investments—assets that fulfill certain minimum social and environmental criteria—grew by more than 40 percent in 2020 in the U.S., and currently make up one-third of all assets under management. However, the process of classifying financial assets as ESG is unregulated in the U.S. Moreover, the data required to assess if ESG assets have achieved a positive social and environmental impact is often missing, incomplete, unreliable, or unstandardized.
The U.S. and the EU are pursuing different trajectories in regulating ESG investing and sustainability disclosures. The U.S. is following a laissez-faire approach with sustainable investing and disclosure being guided by voluntary, private-sector-led processes, protocols, and guidelines. Compliance is driven by peer pressure and the competitive drive to build an image as a sustainable, accountable business. In the absence of regulatory intervention, institutional investors that manage index funds—in particular BlackRock, Vanguard, and Mainstreet—have stepped in to take state-like roles by putting pressure on corporations to address systematic risks like climate change.
These voluntary mechanisms, however, have been criticized for being inadequate. Corporations are routinely accused of “greenwashing” their sustainability reports by overstating their positive environmental and social impact and downplaying negative ones. In the absence of detailed, verified information, asset managers can fall prey to greenwashing and classify securities of unsustainable companies as ESG assets. This leaves ESG investors with little assurance, legal or otherwise, that their money has been put to the intended use.
The EU priming for a green future
The EU, on the other hand, is following a systematic and centralized approach toward climate transition and sustainability disclosure. Its regulatory regime is underpinned by the European Climate Law that legally endorses the EU’s commitment to meet the Paris agreement. To achieve climate neutrality by 2050, the continental body has introduced a slew of regulatory measures that will accelerate capital allocation toward green investments.
One of these is the Corporate Sustainability Reporting Directive (CSRD) that was introduced in April 2021. It upgrades the 2014 nonfinancial reporting directive and seeks to improve the coverage and reliability of sustainability reporting. When the law comes into effect in 2023, the CSRD is expected to increase the number of European and Europe-based companies that disclose sustainability information by fourfold, to 49,000 in total.
The CSRD proposal applies the “double materiality” principle, requiring companies to disclose information that is material for the enterprise as well as for its societal stakeholders and/or the environment. For example, it requires companies to disclose the extent to which their activities are compatible with the goal of limiting global warming to 1.5 degrees Celsius. Importantly, the directive requires companies to seek “limited” assurance by third-party auditors.
The directive is also unique for requiring companies to report their sustainability performance using EU-wide disclosure standards. The European Financial Reporting Advisory Group (EFRAG), a private association with strong links with the European Commission, has been tasked with the difficult job of developing these disclosure standards. EFRAG intends to build on existing, third-party sustainability reporting standards and has initiated a collaboration with the Global Reporting Initiative (GRI), currently the most widely used reporting standard globally.
Alongside a similar sustainability disclosure law that regulates processes of ESG investing in financial institutions, the CSRD is expected to significantly improve transparency in European capital markets. These measures are also likely to increase the adoption of sustainability goals and targets among European corporations, further widening the existing disclosure gap between EU-based and U.S.-based corporations.
A change of heart at the SEC
Until recently, American regulators have been reluctant to mandate sustainability disclosure. At a recent Brookings webinar, Securities Exchanges Commission (SEC) Commissioner Hester Peirce offered the rationale why ESG rule-making is beyond the mandate of the SEC, reflecting the longstanding view among Republican commissioners at the SEC. Her long list of justifications includes some plausible ones, such as the broad and elastic nature of the ESG concept that would make it ill-suited as a domain of disclosure rule-making. Others were highly slanted, such as the contention that ESG disclosure could drive financial instability by leading to excessive allocation of capital to supposedly green technologies. This is ironic because the lack of ESG disclosure mandate is not slowing down the rapid growth of ESG investments; it is only making the process opaque and ineffective, making stock market volatilities more rather than less likely. In fact, the EU’s key justification for sustainability disclosure is preventing systemic risks that threaten financial stability.
The SEC, which now has a 3-2 Democratic majority and a Biden-appointed chairman, has of late shown keenness to play a more active regulatory role. In May 2020, its Investor Advisory Committee provided recommendations that urged the commission to set up mandatory reporting requirements on ESG issues. In December 2020, an ESG subcommittee issued a preliminary recommendation that called for the adoption of mandatory standards for disclosing material ESG risks. The recommendation, however, called for limited disclosure covering a narrow range of metrics tailored by industry, in a manner similar to the standards of the Sustainability Accounting Standards Board, while warning against the “highly prescriptive” standards that were purportedly adopted by the EU. In March 2021, the commission solicited public input on climate change disclosures, which revealed strong demand for mandatory sustainability disclosure.
Divergent disclosure laws
The SEC is thus set to adopt mandatory ESG disclosure rules, perhaps as early as October 2021. These rules, however, are likely to depart from the EU’s approach in a number of ways. First, an SEC regulation will target only publicly listed companies; the EU’s CSRD, on the other hand, covers large unlisted firms as well. Second, the SEC will mandate disclosure of a narrow range of outcomes related to climate risk and human capital, while the EU will mandate disclosure of a broader set of sustainability outcomes, including indirect outcomes through the value chain and relevant corporate strategies and processes. Third, given capacity constraints, the SEC will likely adopt less comprehensive, third-party disclosure standards as opposed to developing its own comprehensive standards as the EU intends to do. Facing pressure from Republican lawmakers and interest groups, the SEC’s measures are also likely to be timid, focusing only on protecting (ESG) investors through the narrow lens of financial materiality.
By comparison, the relatively wide coverage of the EU’s new disclosure law (CSRD) will lead to significant improvements in data availability. The use of uniform disclosure standards will also ensure that companies provide more detailed and comprehensive sustainability information. It is, however, less obvious how the directive will improve data quality and reliability. The requirement for limited assurance will reduce the most overt forms of greenwashing but is unlikely to eliminate disclosure of data with dubious quality. For example, such an assurance is unlikely to guarantee that a company used the most recent or robust method for assessing its carbon footprint.
The EU’s law is also unlikely to address the lack of standardization, which is to a degree inherent to ESG metrics. Sustainability disclosure will contain significant company-specific, qualitative data, including retrospective and forward-looking statements that are hard to quantify. The EU’s reporting standards will give managers significant discretion on what to disclose and how, and they impose different requirements for companies that differ by sector and size. More nuanced and detailed sustainability disclosure is more valuable to individual (ESG) investors though, at a macro level, this increases the cost of standardizing, comparing, and verifying the reported data. The search for the “holy grail” of the ideal ESG index will thus continue, hampered by the difficulty to converge on what categories of ESG are universally relevant, how to define their scope, which sets of metrics to use, and how to weigh and aggregate them.
A missed opportunity for coordination?
In both the EU and U.S., the move toward greater corporate transparency will help improve the existing power imbalance between shareholders and stakeholders. The lack of verified disclosure today discourages corporations from reporting unsavory business practices that have devastating societal and environmental impact. Greater transparency, stronger regulatory oversight, and more robust third-party ESG assessment can lead to better public understanding of the positive and negative externalities that corporations create, allowing the market to reward “good” ones and penalize “bad” ones. At the same time, given significant informational asymmetries and inevitable loopholes in principles-based disclosure standards, the tendency of corporations to understate their negative externalities is likely to persist, making greenwashing largely inescapable in the foreseeable future.
These challenges are further exacerbated by the lack of coordination to develop globally acceptable disclosure standards. Conflicting regulatory regimes between the U.S. and EU will harm trade and investment flows across the Atlantic and potentially globally. Frictions are already emerging in the context of the EU’s forthcoming carbon border adjustment mechanism, which will impose tariffs on imports from countries without carbon taxes. In the end, coordination at a global scale is needed to regulate corporate sustainability in a manner that does not sand the wheels of the global trading system.