From financial crisis to financial reforms? Implementation of the Dodd-Frank Act

From financial crisis to financial reforms? Perhaps the Federal Reserve of United States completed its cycle with the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).

Chairman Ben S. Bernanke released its testimony on the Implementation of the Dodd-Frank Act.

The Bernank’s testimony says that

One of the Federal Reserve's most important Dodd-Frank implementation projects is to develop more-stringent prudential standards for all large banking organizations and nonbank firms designated by the council. Besides capital, liquidity, and resolution plans, these standards will include Federal Reserve- and firm-conducted stress tests, new counterparty credit limits, and risk-management requirements. We are working to produce a well-integrated set of rules that will significantly strengthen the prudential framework for large, complex financial firms and the financial system.

Good! This will put checks on their market participants’ risk taking measures and lending practices.

The testimony also says that

Complementing these efforts under Dodd-Frank, the Federal Reserve has been working for some time with other regulatory agencies and central banks around the world to design and implement a stronger set of prudential requirements for internationally active banking firms. These efforts resulted in the adoption in the summer of 2009 of more-stringent regulatory capital standards for trading activities and securitization exposures. And, of course, it also includes the agreements reached in the past couple of months on the major elements of the new Basel III prudential framework for globally active banks. Basel III should make the financial system more stable and reduce the likelihood of future financial crises by requiring these banks to hold more and better-quality capital and more-robust liquidity buffers. We are committed to adopting the Basel III framework in a timely manner.

It is good to know that the Federal Reserve has been serious in implementing Basel III framework for their banks. The good quality assets and high liquidity buffers by these banks will help in preventing the financial crisis further.

What the act says?

The nice brief summary of the Dodd-Frank Act compiled by United States Senate Committee on Banking, Housing and Urban Affairs is mentioned here. It aims to create a sound economic foundation to grow jobs, protect consumers, rein in wall street and big bonuses, end bailouts and too big to fail and most important, prevent another Financial Crisis.

In testimony words,

The act also requires supervisors to take a macro-prudential approach; that is, the Federal Reserve and other financial regulatory agencies are expected to supervise financial institutions and critical infrastructures with an eye toward not only the safety and soundness of each individual firm, but also taking into account risks to overall financial stability.

To conclude, the Dodd-Frank Act is a major step forward for financial regulation in the United States which may provide a starting step for others to follow.

Happy Reading!

-       Amar Ranu

Policy Tools post Global Financial Crisis – US Perspective

Since 2008, the world economy is in bad shape! Post the Lehman fall in Wall Street in 2008, the contagion effect ran scathe through the entire global economy. The governments in conjugation with their respective Central Banks announced a series of monetary and fiscal policies which helped in containing the reversal in growth and boost the economy. Also many countries announced bail out programs for many of its big institutions who had over leveraged themselves and became a victim of sub-prime crisis.

It is largely considered that the world biggest economy, United States defines the path of the market and the world market swings around it. Since the financial crisis that emerged in summer of 2007, the Federal Reserve used various liquidity and credit programs and other monetary policy tools. These tools aimed at addressing severe liquidity strains in key financial markets, cultivating faster economic recovery by lowering the longer-term interest rates and providing ready available credit to troubled and fractured financial institutions.

Here is a brief about the different policy tools used by Federal Reserve; these tools are widely used by other countries too.

Open Market Operations – The Federal Reserve considers it as the principal tool for implementing monetary policy. The objective of OMO can be a desired price (Federal Funds rate) or a desired quantity of reserves. The federal funds rate is the interest rate at which the depository institutions lend balances at the Federal Reserve to other depository institutions overnight (similar to Call rate in India).

However, Fed objectives on OMOs have varied over the years. During the 1980s, it concentrated on attaining the specified level of the federal funds rate and in 1995, it explicitly targeted federal fund rates. Table 1 explains the movement of Fed’s fund rates.

The Discount Rate – It is the interest rate charged by the Federal Reserve Bank to commercial banks and other financial institutions on loans under its lending facility – the discount window (Similar to Call Money in Overnight Segment). The Federal Reserve Bank offers three discount windows to depository institutions – primary credit, secondary credit and seasonal credit, each with its own discount rate. All discount window loans are fully secured.

In the primary credit program, the loans are extended for a very short term (usually overnight) for financially sound institutions. Those institutions which are not eligible for primary credit may apply for a secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities. The rates charged are minimum in Primary Credit followed by Secondary Credit while the discount rate for seasonal credit is an average of selected market rates.

Reserve Requirements

Against specified deposit liabilities, the banks are required to hold a minimum percentage of holding in reserve in the form of vault cash or deposits with Federal Reserve Banks. Reservable liabilities consist of net transaction accounts, non-personal time deposits and Eurocurrency liabilities. Since Dec 27, 1990, non-personal time deposits and Eurocurrency liabilities have had a reserve ratio of zero. Beginning Oct 2008, the Federal Reserve Banks will pay interest on required reserve balances and excess balances. The table 2 shows the reserve requirements as decided by Federal Reserve.

Interest on Required Balances and Excess Balances

The Federal Reserve pays interest on required reserve balances – balances held with Federal Reserve to satisfy reserve requirements and on excess balances – balances held in excess of required reserve balances and contractual clearing balances.

The interest rate on required reserve balances and excess balances is determined by the Federal Reserve Board. It gives the Federal Reserve an additional tool for the conduct of monetary policy.

Term Asset-Backed Securities Loan Facility

The Term Asset-Backed Securities Loan Facility (TALF) is a funding facility that will help market participants meet the credit needs of households and small businesses by supporting the issuances of asset-backed securities (ABS) collateralized by loans of various types to consumers and businesses of all sizes.

Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans.

Term Deposit Facility

It is a new tool announced in 2010 by which the Federal Reserve can manage the aggregate quantity of reserve balances held by depository institutions. It will facilitate the implementation of monetary policy. Funds placed in term deposits are removed from the accounts of participating institutions for the life of the term deposit and thereby drain reserve balances from the banking system. Reserve Banks will offer term deposits through the Term Deposit Facility (TDF), and all institutions that are eligible to receive earnings on their balances at Reserve Banks may participate in the term deposit program.

While the above mentioned policy tools are currently operative, some of the programs has been wound down on improved economic scenario. The Money Market Investor Funding Facility expired on Oct 30, 2009, and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility were closed on February 1, 2010. Also, the final Term Auction Facility auction was conducted on March 8, 2010.

The world dynamics has changed; so with geo-political issues. PIIGS (Portugal, Ireland, Italy, Greece, Spain), once a flying and splendid investment horizon have been on the verge of sovereign crisis. We believe that the Keynesian has left a strong theory to be followed by US which have initiated many quantitative programs – QE-I (worth Trillion dollars) followed by QE-II (worth US$ 600 billion). 

Happy Reading!

Source: Federal Reserve

Aiding the economy: What the Fed did and why

Aiding the economy: What the Fed did and why?

For a quite long time, all the economies have been struggling to keep pace or evolve after the worst financial crisis (last we had in 1930s). More monies were pumped into throughout the world amounting into trillion of dollars - US had QE-I followed by QE-II and various other measures by other countries too.
QE II may be a fait accompli but the Fed Governor justifies it citing the high unemployment rate and low inflation. Read his opinion Aiding the economy: Why the Fed did and why
Enjoy reading!