Table of Contents

Protecting Financial Stability in the Aftermath of World War I: The Federal Reserve Bank of Atlanta's Dissenting Policy

Eugene N. White, Rutgers, The State University of New Jersey

Optimism, Financial Literacy and Participation

Anders Anderson, Swedish House of Finance
Forest Baker, LinkedIn Corporation
David T. Robinson, Fuqua School of Business, Duke University, National Bureau of Economic Research (NBER)

The Risks of Shadow Insurance

Daniel Schwarcz, University of Minnesota Law School

To Eliminate Over-the-Counter Systemic Risk, Replace the OTC Markets with a Common Cash and Futures Trading Platform

James Kurt Dew, Tecnológico de Monterrey

Mortgage Insurance as a Macroprudential Tool: Dealing with the Risk of a Housing Market Crash in Canada

Thorsten V. Koeppl, Queen's University (Canada) - Department of Economics
James MacGee, University of Western Ontario - Department of Economics

The Evolving Role of Economic Analysis in SEC Rulemaking

Joshua T. White, University of Georgia

Taming the Basel Leverage Cycle

Christoph Aymanns, University of Oxford
Fabio Caccioli, University College London - Financial Computing and Analytics Group, Department of Computer Science
J. Doyne Farmer, University of Oxford
Vincent W. C. Tan, University of Oxford


REGULATION OF FINANCIAL INSTITUTIONS eJOURNAL

"Protecting Financial Stability in the Aftermath of World War I: The Federal Reserve Bank of Atlanta's Dissenting Policy" Fee Download
NBER Working Paper No. w21341

EUGENE N. WHITE, Rutgers, The State University of New Jersey
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During the 1920-1921 recession, the Federal Reserve Bank of Atlanta resisted the deflationary policy sanctioned by the Federal Reserve Board and pursued by other Reserve banks. By borrowing gold reserves from other Reserve banks, it facilitated a reallocation of liquidity to its district during the contraction. Viewing the collapse of the price of cotton, the dominant crop in the region, as a systemic shock to the Sixth District, the Atlanta Fed increased discounting and enabled capital infusions to aid its member banks. The Atlanta Fed believed that it had to limit bank failures to prevent a fire sale of cotton collateral that would precipitate a general panic. In this previously unknown episode, the Federal Reserve Board applied considerable pressure on the Atlanta Fed to adhere to its policy and follow a simple Bagehot-style rule. The Atlanta Fed was vindicated when the shock to cotton prices proved to be temporary, and the Board conceded that the Reserve Bank had intervened appropriately.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

"Optimism, Financial Literacy and Participation" Fee Download
NBER Working Paper No. w21356

ANDERS ANDERSON, Swedish House of Finance
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FOREST BAKER, LinkedIn Corporation
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DAVID T. ROBINSON, Fuqua School of Business, Duke University, National Bureau of Economic Research (NBER)
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We measure financial literacy in a large sample of LinkedIn members, complementing a standard set of questions with a method that allow us to isolate and distinguish optimism and self-confidence. Like previous work, we find that high literacy respondents are more likely to save for a rainy day, plan for retirement, and are more likely to pay attention to fees when choosing credit cards. However, this is mostly driven by perceived, rather than actual, financial literacy: controlling for self-perceptions, actual literacy has low power to predict financial engagement. Moreover, behavior biases drive participation among low literacy respondents and are associated with mistaken beliefs about financial products and a lower willingness to accept financial advice. This has important implications for policy and for the design of institutions aimed at increasing literacy and protecting consumers from fraud.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

"The Risks of Shadow Insurance" Free Download
Georgia Law Review, Forthcoming

DANIEL SCHWARCZ, University of Minnesota Law School
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In a shadow insurance transaction, a life insurer purchases reinsurance from an affiliated company that is licensed as a captive insurer but is not an “authorized? reinsurer. Such transactions have been scrutinized in recent years by the Federal Insurance Office, the Financial Stability Oversight Council, the Federal Reserve Bank, the New York Department of Insurance, and the National Association of Insurance Commissioners, among others. Nonetheless, the precise mechanisms by which shadow insurance may pose risks to policyholders, the insurance industry, and the broader financial system remain sketchy. At least partially for this reason, substantial debate continues to exist regarding the extent to which traditional tools of state insurance regulation adequately address the risks of shadow insurance. This Article contributes to the debate by describing four distinct risks posed by different types of shadow insurance transactions. First, such transactions create reinsurance default risk, or the risk that captive reinsurers will default on their obligations to the underlying insurers. Second, they can expose insurers to recapture risk, or the prospect that an insurer will be forced to unwind the reinsurance transactions that are part of a larger shadow insurance scheme. Third, shadow insurance can create correlated parent company risk by magnifying the prospect that a single financial shock will similarly affect multiple individual companies within a broader financial conglomerate. Finally, certain types of shadow insurance transactions can generate interconnectedness risk by increasing the connections between the insurance and banking sectors. The Article suggests that state insurance regulation has traditionally focused almost exclusively on reinsurance default risk, while ignoring and potentially even exacerbating the three other risks posed by shadow insurance.

"To Eliminate Over-the-Counter Systemic Risk, Replace the OTC Markets with a Common Cash and Futures Trading Platform" Free Download

JAMES KURT DEW, Tecnológico de Monterrey
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This article considers a transactions platform that eliminates the fragmented, complex, risky over-the-counter (OTC) markets. It jointly clears OTC cash, futures, and a newly designed futures-friendly derivative (FFD) eliminating Clearing Counterparty (CCP)-traded derivatives.

Rapid change in payments and clearing technology leave a limited time for existing markets to improve the product before being overwhelmed by dark pool-inspired market evolution. The futures exchange-managed CCPs are still too risky and needlessly complex. The credit expended in trading may be greatly reduced, and resulting greater simplicity may send the quant the way of the alchemist. To survive, OTC and futures clearing must become simpler, cheaper, and safer.

The Introduction summarizes the existing unnecessary complexity and systemic risk and its remedy. The Second Section provides details. The Third Section proposes one example improvement that leaves the door open to migrate OTC clearing to dark pools. The final section concludes.

"Mortgage Insurance as a Macroprudential Tool: Dealing with the Risk of a Housing Market Crash in Canada" Free Download
C.D. Howe Institute Commentary 430

THORSTEN V. KOEPPL, Queen's University (Canada) - Department of Economics
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JAMES MACGEE, University of Western Ontario - Department of Economics
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Canada’s mortgage insurance risk needs a better backstop fund, according to a new report released today by the C.D. Howe Institute. In “Mortgage Insurance as a Macroprudential Tool: Dealing with the Risk of a Housing Market Crash in Canada,? authors Thorsten V. Koeppl and James MacGee suggest an era of steadily rising house prices and high mortgage debt warrants concern over the potential exposure of Canada’s mortgage insurance system – and taxpayers.

"The Evolving Role of Economic Analysis in SEC Rulemaking" Free Download
Georgia Law Review, Forthcoming

JOSHUA T. WHITE, University of Georgia
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A series of recent judicial setbacks has rapidly elevated the role of economic analysis and economists at the SEC. I discuss key organizational responses following the 2011 D.C. Circuit decision in Business Roundtable v. SEC. Significantly greater resources were allocated to the SEC’s Division of Economic and Risk Analysis (DERA). Net program costs assigned to DERA grew by over 70% in the subsequent three fiscal years, representing five times larger growth than any other division or office at the Commission. During this period, DERA doubled its staff of Ph.D. financial economists tasked with conducting cost-benefit analyses of rulemaking initiatives. In 2012, DERA also established new guidance on how the SEC would conduct economic analysis. I examine its effect using the risk retention rulemaking from the Dodd-Frank Act, which encompassed the periods before and after the new guidance. This case study reveals that the new guidance resulted in more rigorous and responsive SEC economic analysis. It also illustrates the importance of a well-defined economic baseline, which I contend is often equally as important as quantifying the costs and benefits of a proposed rulemaking action.

"Taming the Basel Leverage Cycle" Free Download

CHRISTOPH AYMANNS, University of Oxford
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FABIO CACCIOLI, University College London - Financial Computing and Analytics Group, Department of Computer Science
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J. DOYNE FARMER, University of Oxford
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VINCENT W. C. TAN, University of Oxford
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Effective risk control must make a tradeoff between the microprudential risk of exogenous shocks to individual institutions and the macroprudential risks caused by their systemic interactions. We investigate a simple dynamical model for understanding this tradeoff, consisting of a bank with a leverage target and an unleveraged fundamental investor subject to exogenous noise with clustered volatility. The parameter space has three regions: (i) a stable region, where the system always reaches a fixed point equilibrium; (ii) a locally unstable region, characterized by cycles and chaotic behavior; and (iii) a globally unstable region. A crude calibration of parameters to data puts the model in region (ii). In this region there is a slowly building price bubble, resembling a "Great Moderation", followed by a crash, with a period of approximately 10-15 years, which we dub the "Basel leverage cycle". We propose a criterion for rating macroprudential policies based on their ability to minimize risk for a given average leverage. We construct a one parameter family of leverage policies that allows us to vary from the procyclical policies of Basel II or III, in which leverage decreases when volatility increases, to countercyclical policies in which leverage increases when volatility increases. We find the best policy depends critically on three parameters: The average leverage used by the bank; the relative size of the bank and the fundamentalist, and the amplitude of the exogenous noise. Basel II is optimal when the exogenous noise is high, the bank is small and leverage is low; in the opposite limit where the bank is large or leverage is high the optimal policy is closer to constant leverage. We also find that systemic risk can be dramatically decreased by lowering the leverage target adjustment speed of the banks.

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BANKING & FINANCIAL INSTITUTIONS EJOURNALS

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Social Science Electronic Publishing (SSEP), Inc., Harvard Business School, National Bureau of Economic Research (NBER), European Corporate Governance Institute (ECGI)
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Advisory Board

Regulation of Financial Institutions eJournal

EDWARD I. ALTMAN
Senior Advisor, Credit and Debt Markets Research Program, New York University (NYU) - Salomon Center, Max L. Heine Emeritus Professor of Finance, New York University (NYU) - Department of Finance

DENNIS R. CAPOZZA
Professor of Finance and Dykema Professor of Business Administration, University of Michigan, Stephen M. Ross School of Business

DONALD CHEW
Morgan Stanley Investment Management

J. DAVID CUMMINS
Joseph E. Boettner Professor, Temple University - Risk Management & Insurance & Actuarial Science

DOUGLAS W. DIAMOND
Merton H. Miller Distinguished Service Professor of Finance, University of Chicago - Booth School of Business, National Bureau of Economic Research (NBER)

EUGENE F. FAMA
Robert R. McCormick Distinguished Service Professor of Finance, University of Chicago - Finance

STEPHEN FIGLEWSKI
Professor of Finance, New York University - Stern School of Business

STUART I. GREENBAUM
Bank of America Professor of Managerial Leadership, Washington University in St. Louis - Olin Business School

MICHAEL C. JENSEN
Co-Founder, Chairman, Managing Director and Integrity Officer, Social Science Electronic Publishing (SSEP), Inc., Jesse Isidor Straus Professor of Business Administration, Emeritus, Harvard Business School, Research Associate, National Bureau of Economic Research (NBER), Fellow, European Corporate Governance Institute (ECGI)

JONATHAN M. KARPOFF
Washington Mutual Endowed Chair in Innovation Professor of Finance, University of Washington - Michael G. Foster School of Business

KENNETH LEHN
Professor of Business Administration, University of Pittsburgh - Finance Group

STANLEY R. PLISKA
University of Illinois at Chicago - Department of Finance

CHARLES I. PLOSSER
President, Federal Reserve Bank of Philadelphia, National Bureau of Economic Research (NBER)

KATHERINE SCHIPPER
Duke University - Fuqua School of Business

ALAN SCHWARTZ
Sterling Professor of Law, Yale Law School

G. WILLIAM SCHWERT
Distinguished University Professor of Finance and Statistics, University of Rochester - Simon Business School, National Bureau of Economic Research (NBER)

RENE M. STULZ
Everett D. Reese Chair of Banking and Monetary Economics, Ohio State University (OSU) - Department of Finance, National Bureau of Economic Research (NBER), Fellow, European Corporate Governance Institute (ECGI)

ROSS L. WATTS
Erwin H. Schell Professor of Management, Massachusetts Institute of Technology (MIT) - Sloan School of Management