Really great links - What is the Fed thinking? - Time-varying capital requirements - Stress testing central banks

Arnold Kling - Cynical explanation for the Fed's actions - "If the Fed were to make a dramatic change, it would have to explain what it is doing. This is always a problem for the Fed, where part of the mystique comes from its vague communication about policy. Even worse, it probably would have to be specific about the target that it is aiming for, such as future nominal GDP (Scott Sumner's favorite) or inflation (DeLong's choice). Any time you announce a target ahead of time, you do two things:
        a) you reduce the significance of the open market committee. With the target in place, policy is set. What the Fed does in the money market to try to hit the target becomes an operational/technical question, not a policy question. So a lot of people lose the prestige that they enjoy when policy is subject to frequent reviews and can be changed ad hoc.
        b) you run the risk of missing the target (what if that nutcase Kling turns out to be correct about monetary impotence?), and that would damage the Fed's prestige, perhaps irreparably.
        So, from a status-preservation point of view, I can understand why the Fed would not do what seems to make the most economic sense from a textbook macro perspective."

Samuel Hanson, Anil Kashyap, Jeremy Stein - A Macroprudential Approach to Financial Regulation (pdf) - Time-Varying Capital Requirements - "One intuitively appealing response to the problem of balance-sheet shrinkage is to move to a regime of time-varying capital requirements, with banks being asked to hold higher ratios of capital to assets in good times than in bad times. This way, when an adverse shock hits, banks can draw down their buffers, and continue operating with less pressure to shrink. Kashyap and Stein (2004) argue that time-varying capital requirements emerge as an optimal scheme in a model where the social planner maximizes a welfare function that weights both: i) the microprudential objective of protecting the deposit insurance fund; and ii) the macroprudential objective of maintaining credit creation during recessions. The idea is that in bad times, when bank capital is scarce and credit supply is tight, it is optimal for a planner concerned with both objectives to tolerate a higher probability of bank failure than in good times.
        A challenge in designing such a regime is that in bad times, the regulatory capital requirement is often not the binding constraint on banks. Rather, as the risk of their assets rises, the market may impose a tougher test on banks than do regulators, refusing to fund institutions that are not strongly capitalized.5 Table 1 shows that, as of 2010Q1, the four largest U.S. banks had an average ratio of total Tier 1 capital to risk-weighted assets (RWA) of 10.7%, and an average ratio of Tier 1 common equity to RWA of 8.2%.6 These are both well above the regulatory standard, which requires a ratio of total Tier 1 capital to RWA of 6% for a bank to be deemed “well capitalized”. Thus even as we emerge from a deep financial crisis, the regulatory constraint is manifestly non-binding.
        This implies that in order to achieve meaningful time-variation in capital ratios, the regulatory minimum in good times must substantially exceed the market-imposed standard in bad times. Thus if the market-imposed standard for equity-to-assets in bad times is 8%, and we want banks to be able to absorb losses of, say, 4% of assets without pressure to shrink, then the regulatory minimum for equity-to-assets in good times would have to be at least 12%.
        Moreover, a loss on the order of 4% of assets is actually less severe than the experience of the major banks during the recent crisis; the IMF (2010) estimates that cumulative credit losses at U.S. banks from 2007 to 2010 will be on the order of 7% of assets. Using this figure, one could argue for a good-times regulatory minimum ratio of equity-to-assets of 15%. Either way, these are high values, significantly higher than obtained from a microprudential calculation that asks only how much capital is needed to avert failure."

Terrence Keeley - Now let us stress-test the central banks - "The European Central Bank, Federal Reserve and Bank of England have the advantage of denominating the bulk of their assets and liabilities in the same currencies. With combined balance sheets of 20 per cent of their collective GDP, however, their credit and interest rate exposures are no less worrisome than the foreign currency translation risks faced by their Swiss and Asian counterparts.
        It is now estimated that the European System of Central Banks (ESCB) owns as much as 40 per cent of Greek and 20 per cent of Spanish government bonds outstanding. Depending on their severity, federal debt restructurings for Greece and Spain could generate billions in losses for the ESCB. In the case of the Fed, with more than a trillion dollars’ worth of US mortgages now in hand, a 1 per cent increase in US interest rates could generate marked-to-market losses of as much as $50bn. This is more than the entire profit the Fed paid to the US Treasury last year."

Administrivia - Subheading of the blog was changed from "Delicious Journeys Through Macroeconomics for the Purpose of Making Central Bankers Visibly Uncomfortable in the Presence of Really Great Links about Their Errors" to ""If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008".