Orderly liquidation of bankcrupt Banks

FED is proposing new measures  to prevent the chaotic crash of banks and  orderly liquidation of financial institution can be done.

Introduction of GC(General Collateral) repo

GC Repos

Understanding the US Interbank GCF Repo® Market

Intrabank and Interbank GCF Repo-

The “intrabank GCF Repo” trades that use the same clearing bank can settle without the need for the clearing banks to communicate. In contrast, “interbank GCF Repo” involves both clearing banks and requires some communication between the two. This difference is important because intrabank trades mostly conform to the road map for repo settlement set forth by the Tri-party Repo Infrastructure Reform Task Force, but interbank trades don’t. Indeed, settling an interbank GCF Repo currently requires the clearing banks to extend large amounts of credit.

Good series to read on Market Liquidity

Introduction to a Series on Market Liquidity.

Value at risk Shock

On october 15th, There was a turmoil in the US treasury security market. The yield on the benchmark 10 year US government bond dropped by 33 basis point to 1.86% before settling to 2.13%. This does not look much move but market participant confirmed that this was seven standard deviation move from the intraday average. Such event can occurs only once in 1.5bn years.

After this huge market volatility analyst tried to figure out the reason and even trader and regulators also wanted a understanding.
One of the explanation is provided as VaR shock. After the financial crisis, major dealer banks have curbed the capital allocation to the market making activity and VaR limits have imposed to trader or desk. If VaR limit gets breached than trader or desk has to sell off these positions. With the shockwaves of late 2008 now gradually receding, and a period of low market volatility taking its place, these VaR models have been indicating that the risk of investors sustaining large losses is very low.That means investors may be subject to a so-called “VaR shock” in the event that volatility returns to markets.

This is what happened in the market as yields dropped in the market and computer algorithms used by market making systems start buying more treasuries in order to stem their losses.

Lower risk appetite at the big dealer banks have created the effect of reducing liquidity in trading security. Market liquidity get worse in selloff periods and dealers positions, long or short, declines in the sell off periods. Dealers reduction in net positions is associated with the reduction in dealer's risk,VaR. 

“VaR-based analysis leads to self-reinforcing loops,” a group of banks warned in a presentation to the US Treasury weeks before October 15. “An unexpected increase in volatility might come from broad-based selling of assets wanting to de-risk in front of a turn of policy.”

Libor Reforms

ICE Benchmark Administration (IBA), the new administrator of Libor has published a position paper on the future evolution of Libor. Following major reforms were proposed by the FSB on July 2014 for the major interest rate benchmark.

• Strengthening the existing IBORs and other potential reference rates based on unsecured bank funding costs by underpinning them to the greatest extent possible with transactions data (“IBOR+”)  
• Developing alternative, nearly risk-free reference rates (RFR) since FSB Members believe that certain financial transactions, including many derivatives transactions, are better suited to reference rates that are closer to risk-free.

Another concern was raised that reference rate should be based exclusively in actual transactions. But this can be applicable only  for the currencies or markets that have enough liquidity and actual transactions. When conditions in the local market do not allow pure transaction rates (ones derived mechanically from transacted data without use of expert judgement), authorities should work with and guide the private sector to promote rates which are derived on a waterfall of different data types: underlying market transactions first, then transactions in related markets, then committed quotes, and then indicative quotes.

IBA has proposed many reforms and it is expects the market participant's view by Dec 2014.Focus is on making the whole process including Libor definition , calculation methodologies used by individual banks, submitting Libor rates and selecting the final Libor rates, more objective and completely transparent.

I agree with Prof Jayanth that submitter should not do the interpolation for the missing points in the Libor calculation as this can be more efficiently done by the administrator.

Another important proposed change is to change the trimming of the top and bottom quartiles allows for the exclusion of outliers from the final calculation. This trimming methodology was benefited to counter manipulations. From this perspective, ‘topping and tailing’ may be less relevant in that it would adjust a rate that had already been calculated formulaically from observable and testable evidence. As mentioned in the position paper currently several alternatives of this approach are being evaluated. If this smoothing of submitted Libor rates gets hanged than it can have large impact on rate and on it's volatility.

Could be a Minsky Moment, Ultra low volatility

"Stability is destabilising" is the idea given by the Hyman Minsky,American economist who died in 1996, grew up during the Great Depression, an event which shaped his views and set him on a crusade to explain how it happened. 

Idea of Minsky, which was largely ignored till 2008 credit crisis, is very simple and it challenges the external shock theory, only external shock can disturb economic equilibrium. 

Minsky who long ago wrote – paraphrased – that if and when markets are perceived as being stable, it’s that very perception will make them unstable, because stability, i.e. low volatility, will drive investors into riskier asset purchases. The Fed’s manipulation-induced ultra-low rates have achieved just that, and now they’re surprised? Now fed ants uncertainty and for this rates needs to be increased.

Market is all about people and there has to be certain uncertainty, if you take uncertainty from their life than how are they going to react to  it definitely taking more and more risk as they believe nothing can't happen to them.Free market now looks like distant past as we are now living in controlled economy.

Minsky discussed more ideas such as Minsky Moment, when the whole house of cards falls down, Three stages of debts and preferring words to math and models. 

US interest rate: Potential Shock

A good read by IMF on potential shock for the global market, depends on how and when US will exit from it's unconventional monetary policy.

If US exits bumpy the result could lead to a faster rise in US long-term treasury rates that impacts other bond markets.This could have implications not only for emerging markets, as widely discussed, but, also for other advanced economies.

Bilateral and tri-party repo haircut differences duering the Financial Crisis

The Odd Behavior of Repo Haircuts during the Financial Crisis & Blog on bilateral and tri-party repo haircut differences: they can’t explain it.

Size of the Fed balance sheet

A good read on Fed balance sheet size and asset buying program. 

Fed balance sheet size. 

Lender of last resorts & dealers of last resorts

Be the "Lender of last resorts" in crisis period is a classical advise given by the Walter Bagehot to central banks. Walter mentioned, in 1873, that in time of crisis central banks must lend freely but at high rate.
But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.

But in sub prime crisis Fed had to be not only the lender of last resort but also "Dealer of last resort" and later it acted as private capital market. 
Below is the snap shot of how balance sheet of Fed changed during the crisis time. Size of balance sheet increased from almost 1 trillion to 2.5 trillion between Jul 2008 to Jan 2010.




Fed responded to crisis initially with selling  off treasury securities and lent out the proceeds through various extended discount facility. After the collapse of Lehman and AIG, money market was almost frozen both domestically and internationally. Banks were not willing to lend each other. Repo collateral haircuts reached to record high and even banks were not accepting the mortgage securities as collateral. In this scenario Fed did even more and shifted much of the wholesale money market onto its own balance sheet. This is referred as Dealer of last resort. 
Once emergency situation was over than Fed replace the temporary loans of various financial sector with permanent ones like mortgage securities.