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Discussion Paper
What’s Your WAM? Taking Stock of Dealers’ Funding Durability
One of the lessons from the recent financial crisis is the need for securities dealers to have durable sources of funding. As evidenced by the demise of Bear Stearns and Lehman Brothers, during times of stress, cash lenders may pull away from firms or funding markets more broadly. Lengthening the tenor of secured funding is one way for a dealer to mitigate the risk of losing funding when market conditions are strained. In this post, we use clearing bank tri-party repo data to examine the degree to which dealers are lengthening the maturities of their sources of funding. (Aggregate statistics ...
Report
The risk of fire sales in the tri-party repo market
This paper studies the risk of "fire sales" in the tri-party repo market, a large and important market where securities dealers find short-term funding for a substantial portion of their own and their clients' assets. We distinguish between fire sales of assets by a dealer who, facing a run that could lead to default, sells securities to generate liquidity, and fire sales of assets by repo investors after a dealer's default has occurred. While fire sales do cause damage no matter how they arise, the tools available to lessen the harm from the two types of fire sales are different. We find ...
Working Paper
Collateral Reuse and Financial Stability
The isolated effects of collateral reuse on financial stability are ambiguous and understudied. While greater collateral reuse can guarantee more payments with fewer assets, it can also increase the exposure to potential drops in collateral price. To analyze these tradeoffs, we develop a financial network model with endogenous asset pricing, multiple equilibria, and equilibrium selection. We find that more collateral reuse decreases the likelihood of the worst equilibrium (crisis), with varying effects depending on the network structure. Therefore, collateral reuse can unambiguously improve ...
Discussion Paper
At the N.Y. Fed: Workshop on the Risks of Wholesale Funding
The Federal Reserve Banks of Boston and New York recently cosponsored a workshop on the risks of wholesale funding. Wholesale funding refers to firm financing via deposits and other liabilities from pension funds, money market mutual funds, and other financial intermediaries. Compared with stable retail funding, the supply of wholesale funding is volatile, especially during financial crises. For instance, when a firm relies on short-term wholesale funds to support long-term illiquid assets, it becomes vulnerable to runs by its wholesale creditors, as seen during the recent financial crisis. ...
Working Paper
Contagion in Debt and Collateral Markets
This paper investigates contagion in financial networks through both debt and collateral markets. We find that the role of collateral is mitigating counterparty exposures and reducing contagion but has a phase transition property. Contagion can change dramatically depending on the amount of collateral relative to the debt exposures. When there is an abundance of collateral (leverage is low), then collateral can fully cover debt exposures, and the network structure does not matter. When there is an adequate amount of collateral (leverage is moderate), then collateral can mitigate counterparty ...
Discussion Paper
Financial Vulnerability and Macroeconomic Fragility
What is the effect of a hike in interest rates on the economy? Building on recent research, we argue in this post that the answer to this question very much depends on how vulnerable the financial system is. We measure financial vulnerability using a novel concept—the financial stability interest rate r** (or “r-double-star”)—and show that, empirically, the economy is more sensitive to shocks when the gap between r** and current real rates is small or negative.
Discussion Paper
Financial Stability and Interest Rates
In a recent research paper we argue that interest rates have very different consequences for current versus future financial stability. In the short run, lower real rates mean higher asset prices and hence higher net worth for financial institutions. In the long run, lower real rates lead intermediaries to shift their portfolios toward risky assets, making them more vulnerable over time. In this post, we use a model to highlight the challenging trade-offs faced by policymakers in setting interest rates.
Discussion Paper
Can Decentralized Finance Provide More Protection for Crypto Investors?
Several centralized crypto entities failed in 2022, resulting in the cascading failure of other crypto firms and raising questions about the protection of crypto investors. While the total amount invested in the crypto sector remains small in the United States, more than 10 percent of all Americans are invested in cryptocurrencies. In this post, we examine whether migrating crypto activities from centralized platforms to decentralized finance (DeFi) protocols might afford investors better protection, especially in the absence of regulatory changes. We argue that while DeFi provides some ...
Discussion Paper
How Does Market Power Affect Fire-Sale Externalities?
An important role of capital and liquidity regulations for financial institutions is to counteract inefficiencies associated with “fire-sale externalities,” such as the tendency of institutions to lever up and hold illiquid assets to the extent that their collective actions increase financial vulnerabilities. However, theoretical models that study such externalities commonly assume perfect competition among financial institutions, in spite of high (and increasing) financial sector concentration. In this post, which is based on our forthcoming article, we consider instead how the effects ...