Kate Judge and Anil Kashyap on How to Improve US Financial Stability

Episode Summary

Executive Summary: Kate Judge and Anil Kashyap discuss their Task Force on Financial Stability report, arguing that the U.S. financial system remains fragile despite surviving the pandemic with heavy Fed and fiscal support. They recommend fixing Treasury market plumbing, reforming open-end funds, and overhauling regulatory structure and data collection so supervisors can detect and address evolving systemic risks earlier.

Main Topics: Treasury market fragility and market plumbing (Priority: 5/5): The guests explain that the Treasury market’s structure did not keep pace with its growing centrality to the financial system. Dealer balance-sheet constraints, capital rules, and the absence of central clearing and a standing repo backstop contributed to dysfunction in March 2020 and in September 2019. Standing repo facility and central clearing (Priority: 5/5): They support a permanent standing repo facility and increased use of central clearing, while stressing that these are partial solutions. They also argue the facility should be priced and structured so users internalize some of the costs of the support it provides. Open-end fund reform: money market and bond funds (Priority: 5/5): The discussion focuses on run-prone prime money market funds and rapidly growing bond funds. They argue floating NAV alone is insufficient; swing pricing and, for some funds, longer redemption notice periods are needed to remove first-mover advantage and fire-sale externalities. Regulatory fragmentation and FSOC reform (Priority: 4/5): Kate Judge argues that fragmented U.S. regulation and an unclear financial stability mandate left important risks unaddressed. The report calls for stronger FSOC leadership, clearer stability mandates for agencies, and dedicated offices within regulators to focus on systemic consequences. Data gaps and upgrading the Office of Financial Research (Priority: 4/5): The guests say regulators still lack basic data on market functioning and nonbank activity, especially in stress periods. They propose strengthening the OFR into a more powerful data and resilience hub with better interagency coordination and reporting. Dynamic regulation and the need for continuous updating (Priority: 4/5): A recurring theme is that financial regulation must evolve as the financial system changes. Static rules can become effectively deregulatory over time, so the report emphasizes ongoing review, horizon scanning, and periodic reassessment of systemic threats.

Key Arguments: The pandemic did not prove the system was resilient; it showed resilience was purchased with extraordinary Fed liquidity support and massive fiscal backstops. Treasury market dysfunction reflected structural imbalance: demand for Treasury transactions grew faster than dealer balance-sheet capacity under post-crisis regulations. Central clearing and a standing repo facility can improve market functioning, but should not be viewed as complete solutions to Treasury market fragility. A standing repo facility should be priced so participants bear some cost of the backstop, reducing moral hazard and ensuring the facility remains a true backstop. Prime money market fund reforms after 2008 did not eliminate run risk because floating NAV alone does not solve first-mover advantage. Swing pricing is intended to force redeeming investors to bear the liquidity costs they impose, reducing incentives for runs and fire sales. Bond funds create spillovers because forced selling in secondary markets depresses prices and can shut down primary issuance. The U.S. regulatory architecture is too fragmented; agencies need explicit financial stability mandates and dedicated staff to analyze systemic spillovers. The Office of Financial Research should be strengthened because regulators still lack critical market data and interagency information sharing remains inadequate. Financial stability oversight should be dynamic, with regular reevaluation of designated firms and risks as markets evolve beyond banks and into nonbanks.

Data Points: Task force commission start date: 2019 - The report originated in late 2019, before the pandemic, as a response to perceived gaps in U.S. financial stability oversight. Treasury market stress: September 2019 and March 2020 - The speakers cite the 2019 Treasury yield spike and the March 2020 dysfunction as evidence the problem predated the pandemic. Fed policy response timing: July 28 - David Beckworth notes the episode was recorded on the day the Fed announced a permanent standing repo facility. FSOC voting members: 10 - Kate Judge describes FSOC as having 10 voting members and 5 non-voting members. FSOC non-voting members: 5 - Part of the structural description of the Financial Stability Oversight Council. Leverage ratio reference: SLR - The supplemental leverage ratio is discussed as a key regulatory constraint that discouraged Treasury market making. Prime fund net asset value change: 0.99997 to 1.000002 - Anil Kashyap cites these figures to illustrate that floating NAVs barely move in normal times. Task force review cycle: Every 3 years - They propose periodic review of key actors like hedge funds and insurers for systemic risk designation or monitoring. FSOC membership: 10 voting / 5 non-voting - Repeated as part of the proposed stability-governance framework. Regulatory structure: Hundreds of pages of SEC release - Kate notes the SEC rulemaking process was extremely long and did not adequately understand market functioning.

Pivotal Quotes: "we should be fixing a problem that exists" — Anil Kashyap: Explaining the report’s guiding principle that regulation should target identifiable externalities and spillovers. "The fact that it worked last time shouldn't lead us to have false comfort that you can just pull out this playbook and it's always going to work" — Kate Judge: On why the pandemic response should not be mistaken for proof that the system is inherently resilient. "daily redemptions, were built on a lie" — Mark Carney (quoted by Anil Kashyap): Used to illustrate the mismatch between promised liquidity and the actual liquidity of underlying bond assets.

Implications: The report argues that crisis management is not enough: the U.S. needs permanent market-structure fixes, stronger oversight institutions, and better data. For investors and regulators, that means higher scrutiny of nonbanks, tighter fund liquidity rules, and more active systemic-risk monitoring.