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Banks and Markets: Substitutes,
Complements, or Both?*



n traditional banking arrangements,
households hold their savings in the form of
deposits at the bank, which makes loans to
both firms and households and holds these
loans to maturity. But in the United States, and to a
lesser extent in other developed countries, markets have
increasingly taken over the roles traditionally played
by banks. The shift of financing activity from banks to
financial markets, as well as their continued coexistence,
raises a number of questions. In this article, Mitchell
Berlin discusses some of these questions, such as: What
factors determine the relative importance of banks and
markets in a financial system in which the two types of
finance coexist? Why do so many borrowers continue to
use a mixture of bank loans and bonds? And perhaps
most important: How does the mix of banks and market
finance affect the real economy? That is, how much
households save, how firms invest, and how fast the
economy grows.
Banks play a central role in most
developed financial systems. In traditional banking arrangements, households hold their savings in the form
Mitchell Berlin is
a vice president
and economist in
the Philadelphia
Fed’s Research
He is also head
of the Banking
and Financial
Markets section.
This article is available free of charge at

of deposits at the bank, which makes
loans to both firms and households
and holds these loans to maturity. But
in the United States, and to a lesser
extent in other developed countries,
markets have increasingly taken over
the roles traditionally played by banks.
Since the 1980s, a larger share of firms’
borrowing has shifted from bank loans
to bonds (Figure 1). In addition, securitized assets — in which loans are pack*The views expressed here are those of the author and do not necessarily represent the views
of the Federal Reserve Bank of Philadelphia or
the Federal Reserve System.

aged with other loans into marketable
securities — have become an increasingly dominant channel for consumer
finance in the U.S. (Figure 2) and
in Europe (Figure 3).1 While some
breathless observers have predicted the
ultimate decline of traditional banking altogether, most recognize that
modern financial systems involve a
mix of banks and markets. This is true
even at the level of the individual firm.
Firms with ready access to stock and
bond markets continue to borrow from
banks. And following the disruptions
in the asset-backed securities market
during the recent financial crisis, it no
longer seems obvious that the consumer loan market will be so heavily
dominated by securitized loans.
The shift of financing activity
from banks to financial markets, as
well as their continued coexistence,
raises a number of questions. What
factors determine the relative importance of banks and markets in a financial system in which the two types
of finance coexist? Why do so many
borrowers continue to use a mixture of
bank loans and bonds? And perhaps
most important: How does the mix
of banks and market finance affect
the real economy? That is, how much
households save, how firms invest, and
how fast the economy grows.
Before going further, we need
to clarify some terms. I use the polar
In their review article, Gary Gorton and
Andrew Metrick explain how securitization
works and discuss the underlying economics of
securitization at length.

Business Review Q2 2012 1

Bank Loans as a Share of Corporate Debt
$ billions
1945 50









95 2000 05


Source: Flow of Funds, Federal Reserve Board. Total corporate debt is the sum of
commercial paper, corporate bonds, and bank loans

Total U.S. Asset-Backed Securities Outstanding
$ billions






Source: Gorton and Metrick

Total European Asset-Backed Securities
$ billions

terms bank loans and bonds, banks and
markets, in order to simplify a complicated world. Intermediaries such as
finance companies, insurance companies, and even some hedge funds may
act much like commercial banks if they
hold a large share of a firm’s debt, even
though they are not funded by deposits.2 However, it will sometimes be
important to think about banks more
narrowly as deposit-taking firms. I use
the term bonds to refer to widely held
securities — including securitized loans
— that may be held in households’
portfolios but may also be held (and
traded) by various types of intermediaries, including commercial banks.
Thus, when a commercial bank originates credit card loans that are packaged into asset-backed securities and
actively traded by the bank’s trading
subsidiary, I will classify these as market activities, not banking activities.
Banking economists have viewed
banks as specialists in producing information about borrowers before the
loan is made (screening) and monitoring their activities closely until the
loan is repaid. For example, a banker
will examine a borrowing firm’s books
to forecast future earnings growth,
visit the firm’s factory to examine the
quality of the firm’s receivables, and
even talk to the firm’s customers to
make judgments about the firm’s ability to pay. There is substantial empirical evidence for this view of banks,
but the view that banks monitor firms
while markets do not is too stark.
Better said, banks and markets use different technologies for screening and
monitoring borrowers.
Banks Monitor Firms Using
Covenants. Business loans made by
banks typically include covenants,
a fundamental tool in bank lending. Broadly, covenants come in two
varieties. Some covenants place direct



Source: Gorton and Metrick
2 Q2 2012 Business Review




Debt held by a small number of lenders is often
called private debt.

restrictions on firm’s activities, for example, restrictions on large new investments by the firm without the bank’s
approval. The second type requires the
firm to maintain various measures of
financial health and the ability to pay,
for example, a minimum net worth
ratio (the ratio of equity to total assets)
or a minimum ratio of short-term to
total assets.
A key feature of bank loan covenants is that they are set tightly and renegotiated frequently.3 In their sample
of bank loans, Ilia Dichev and Douglas Skinner examine two covenants
frequently included in loan contracts
and show that most firms maintain financial ratios just above the level that
would put the firm in default; indeed,
most firms are just in compliance when
the contract is signed.4
The flip side of tight covenants
is that it is easier for a single lender to
renegotiate loan terms with a borrower
than it is for widely dispersed bondholders. In his working paper, Michael
Roberts found that loan contracts
were renegotiated about once a year.
For the most part, firms renegotiating
contracts are not financially distressed,
although Roberts and Amir Sufi found
that covenant violations were most
common in difficult economic environments. Over the life of the loan
contract, the firm’s business environment changes and contracts are adjusted to meet new realities — but only
after the bank takes a close look into
the firm’s financial health.
Ease of renegotiation doesn’t mean
that every default is cured through renegotiation or that the terms on which
loans are renegotiated are typically
easy for the firm. Covenant violations

lead to real constraints on the firm’s
behavior; the finding that the mass of
firms are just in compliance provides
indirect evidence that firms would
be operating at lower liquidity or net
worth levels if they were not constrained by covenant restrictions. More
directly, Sufi finds that, following a
covenant violation, both the used and
unused portions of a firm’s line of credit are typically reduced by between 15
and 25 percent, while Sudheer Chava
and Roberts find that real investment
declines by 13 percent.5
You might understand why a bank

debt markets, some mixture of shortand long-term bonds and internally
generated funds may be preferable
to the tight covenants and intrusive
monitoring typical of bank lending.6
Furthermore, much of the banking industry is regulated and regulatory costs
are ultimately passed onto banks’ customers, including borrowers. To avoid
these costs, all firms have an incentive
to limit their borrowing from banks.
Although I have focused here on
covenants and renegotiation, researchers have also highlighted repeated
lending between a single bank and

A key feature of bank loan covenants is that
they are set tightly and renegotiated frequently.
would like to keep a tight rein on borrowers; after all, a firm with high net
worth and liquid assets is more likely
to pay back the loan. But why would
a firm accept such restrictions, and
what types of firms would choose to
use bank loans with tight covenants?
From the firm’s point of view, tight
covenants may be attractive because
the bank can profitably lend at a lower
loan rate when the bank is better
protected against loss. Without tight
restrictions, many small firms and risky
firms would simply find any outside
funding to be too expensive. And we
will examine in some detail the reasons why many larger firms will prefer
to borrow using a mixture of bank
loans and bonds; broadly, the reason
is that a mix of bank loans and bonds
often lowers the firm’s total borrowing
costs. But for low-risk firms that can
afford the costs of borrowing on public

borrower, a lending relationship, as a
distinctive feature of bank lending. In
a lending relationship, banks build up
information about the borrowing firm
over time. In addition, researchers
have found evidence that banks use
firms’ deposit accounts as a mechanism for banks to monitor borrowing
Markets Monitor by Aggregating
Investors’ Information. Nobel laureate Friedrich von Hayek first proposed
the idea that market prices incorporate
the information of market participants and, thus, provide guideposts to
making economic decisions: buy, sell,
invest. In financial markets, mutual
fund managers, hedge fund managers,
and other investors buy and sell stocks,
bonds, and derivative securities based
on their own research and the research

However, even large firms that seldom borrow
from banks retain backup lines of credit with
banks to call on when financial markets are

My article with Loretta Mester formalizes this
view of bank lending

Dichev and Skinner focus on the current ratio
(short-term debt over total assets) and net worth
ratio because they are common and relatively
standardized across loan contracts.

These findings understate the constraints
covenants impose on firms because they don’t
include the costs of the decisions the firm took
to avoid breaching or renegotiating a contract.
For example, firms may forgo a profitable investment in preference to seeking a change in its
loan contract.

Degryse and coauthors review the literature
on lending relationships, and Loretta Mester
and coauthors, among others, provide empirical
evidence for the monitoring role of deposits.

Business Review Q2 2012 3

of information specialists such as ratings agencies and industry analysts.
Stated somewhat simplistically, based
on their research, investors seek to buy
securities that they believe will rise in
price and to sell those securities that
they believe will decline in price. Securities prices rise and fall accordingly.
But how does all this buying and
selling affect firms’ real decisions? The
market for corporate control is one
channel. For example, Alon Brav and
coauthors have recently examined
the role of hedge funds in the market
for corporate control between 2001
and 2006. Some hedge funds specialize in buying up the securities (stocks
or bonds) of underperforming firms
and using their financial stake to put
pressure on the firms’ managers or to
get rid of current management. The
fund’s investors gain if a firm’s performance improves and its stock or bonds
increase in value. Indeed, Brav and
coauthors find that just the announcement of a hedge fund’s intent to play
an active role increases a firm’s stock
price, on average, and these gains are
not reversed. Alex Edmans and coauthors provide evidence that a decline
in a firm’s stock price significantly
increases the likelihood of a takeover
A second channel is the direct
effect of market prices on management
decisions. A growing body of evidence
shows that managers’ investment decisions are affected by the firm’s stock
price. Furthermore, managers’ investment decisions appear to be improved
when stock prices are more informative.8
How Does the Shift from
Banks to Markets Affect Information Production? To date, researchers
have only started to think about the

implications for the larger economy of
changes in the information environment when activity shifts from banks
to markets.9 For example, Christine
Parlour and Guillaume Plantin demonstrate that the option to securitize
assets may inefficiently reduce banks’
information production about borrow-

See Yaron Leitner’s Business Review article
for an accessible account of the theory and
evidence on the effects of market prices on
managerial decisions.


markets may also provide incentives to
produce too much information. They
show that fund managers who make
their living trading securities produce information to gain a bargaining
advantage over other traders. In their
model, much of the research simply affects the distribution of gains between

To date, researchers have only started to think
about the implications for the larger economy
of changes in the information environment
when activity shifts from banks to markets.
ers’ financial health. This happens if
the bank has large cost savings from
shifting assets off its books. To see why,
imagine the bank did produce information about borrowers, hoping to sell
well-performing loans at a higher price
by certifying when a loan is healthy.
But rational buyers will be suspicious of
the bank’s claims and demand a large
discount in the fear that the bank
was selling them a lemon, a troubled
loan being passed off as a healthy one.
Thus, producing information about the
firm will not be profitable for the bank.
When the gains from moving loans off
the bank’s books are large, the loans
will be sold, but only at a price so low
that the bank can’t profitably produce
information. And since no information
is produced, neither the bank nor the
buyer of the loan knows whether the
loan is healthy or troubled.10
From another perspective, Vincent Glode and coauthors argue that

Arnoud Boot and Anjan Thakor’s and
Fenghua Song and Thakor’s articles are notable
exceptions. Both articles contain models in
which banks and markets coexist. My distinction between close monitoring and aggregating
information follows theirs.

traders: what one trader (and his
investors) gain and another trader (and
his investors) lose. The information
doesn’t increase the total profits shared
by investors, only the distribution of
these profits.
Insights such as these are a starting point for developing a deeper
understanding of how incentives to
produce information change with an
evolving mix of financial activities
carried out through banks and through
Competition in financial markets
increased dramatically in the last quarter of the 20th century, in significant
part due to deregulation, with banks
facing increased competition on both
sides of their balance sheets.11 (See
Deregulation and Competition.) Smaller
and riskier firms that could only have
borrowed from banks in the past could
now borrow directly on bond and stock
markets. One indicator of this trend
is the decline in the age of firms going
public. Between 1970 and 2000, the
I focus here on competition from financial
markets rather than competition between
banks. More competition between banks has
much the same effect as competition from
financial markets.


4 Q2 2012 Business Review

More formally, Parlour and Plantin show that
when the gains from selling are large, the only
equilibrium is a pooling equilibrium without
information production.

Deregulation and Competition


n the asset side, the deregulation of underwriting fees in 1973
and commercial bank entry into investment banking made it
cheaper for firms, especially smaller firms and riskier firms, to
gain access to public debt and stock markets.* The securitization of mortgages was largely the result of the collapse of the
savings and loan industry in the 1980s, which was primarily
driven by the deregulation of deposit rates in 1980. This technology was then adapted to a wide range of loans, providing access to securities markets to a whole new range of borrowers, mainly households. Finally,
the dismantling of barriers first to intrastate and then to interstate banking
increased competition between banks for borrowers’ business. On the liability
side, competition from money market funds — beginning in the 1970s — increased households’ access to financial markets. While money market funds did
not develop strictly because of deregulation, they were an innovation that was
largely driven by regulatory arbitrage; money market funds could hold commercial paper without the capital requirements that were first imposed by regulators
on banks in the 1980s.
* In addition to these regulatory changes, Michael Milkin’s recognition that portfolios of junk
bonds would yield predictable returns expanded high-risk firms’ access to public debt markets. His
discovery may be thought of as a “technological” advance in financial markets.

median age of a firm undertaking an
initial public offering — selling stock to
the public for the first time — declined
from around 40 years to five years,
with the most dramatic decline in the
1970s following the deregulation of underwriting fees.12 Household borrowers
also gained access to securities markets
via securitized mortgages and credit
card loans; these assets were increasingly moved off banks’ balance sheets.
On banks’ liability side, depositors
could now choose to invest their savings in securities through a wide range
of intermediaries that held securities
instead of loans, for example, mutual
funds or hedge funds.
As a general rule, competition
lowers fees and increases the variety
and availability of financial services.
But some of the distinctive services
These numbers are from the article by Jason
Fink and coauthors. The median age increased
to 12 years by 2006, suggesting that market participants reacted to the excesses of the Internet
boom of the late 1990s by demanding more
seasoning before a firm could go public.

provided by banks depend on crosssubsidies among bank customers.
Cross-subsidization is feasible only
when banks have market power over
their customers.
Firms’ Access to Markets Undermines Lending Relationships.
Financial economists have found convincing evidence that firms in a longterm lending relationship with a bank
are less likely to be required to post
collateral and less likely to be denied
loans. In essence, banks make loans
to young firms and risky firms that are
profitable only if the firm sticks with
the bank and pays higher than purely
competitive loan rates in the future.
So, in a bank loan portfolio, the profits
from older and safer firms subsidize the
loans to younger and riskier firms.
This works only as long as the
bank has some market power over older
and safer borrowers. If it is easy and
cheap for a firm to go public and to sell
securities, the bank can’t charge the
firm a high loan rate or maintain its accustomed level of control over the firm’s

activities, and the scope for such crosssubsidies decreases. Supporting this
view of the decline in banks’ market
power over firms with access to public
markets, Carola Schenone shows that
the rate a firm pays on its bank loan
declines when the firm goes public.
In addition to losing older and safer borrowers to bond markets, banks’
more limited ability to cross-subsidize
across borrowers means that bank
loans to younger and riskier borrowers become increasingly arm’s length, in
the language of the banking literature.
Essentially, this terms means that the
bank screens the borrower when it
makes the loan but does not renegotiate loan terms or provide temporarily
concessionary rates if the firm is in
trouble. In turn, younger and riskier
firms find that borrowing exclusively
from a bank becomes relatively less attractive compared to selling bonds.
Banks Provide Less Liquidity
When Households Have Access to
Financial Markets. One of the traditional roles of banks is to allow households to put their money in checking
or savings accounts and allow them to
withdraw their money on demand. In
their classic article, Douglas Diamond
and Philip Dybvig demonstrate how a
bank can do so even while holding a
portfolio of mainly illiquid assets (e.g.,
loans), which have a higher yield than
liquid assets such as cash. Diamond
and Dybvig assume that investors have
no alternative to putting their funds in
the bank, a relatively accurate picture of the real world until the 1980s.
But what happens when some households have the alternative of investing
directly in securities markets? In his
follow-up article, Diamond explicitly
considers the effect of households’ acIn his model, he views households as if they
were trading for themselves, but you can just as
easily think of them as customers who can shift
their savings from a deposit to a mutual fund
or a hedge fund and have a manager trade on
their behalf.

Business Review Q2 2012 5

cess to financial markets.13
In Diamond and Dybvig’s model,
the feasibility of the banking arrangement depends on a cross-subsidy
among depositors. Some households
find that they need funds right away
— they face a liquidity shock — while
others have no immediate need for
funds. As long as households have no
alternative to the bank, the bank can
promise households access to their
funds on demand with only a small
penalty. But this is only possible if
households that don’t need their funds
will accept a lower rate than they
could get in the market; that is, they
are subsidizing the households that
withdraw funds.
As long as households are concerned that they may need their
funds at short notice — and as long
as only a fraction of households need
to withdraw funds at any time — this
arrangement is attractive to all households. Most households would prefer
to avoid being penalized whenever
a pressing need for funds arises, and
they would be willing to give up some
return for this assurance. You can
think of the bank as a type of insurance company that provides insurance
against liquidity shocks.14
Things change when some households have direct access to securities markets. Since it is unrealistic to
think that a bank can really tell why a
depositor needs to make a withdrawal,
the deposit rate has to be the same for
all households. This means two things:
(i) any subsidy paid to households
that withdraw funds to, say, make a
mortgage payment must also be paid

In addition to providing customers with more
liquidity, the bank also changes the mix of
investments in the economy. Specifically, the
bank holds a portfolio with a larger fraction of
illiquid (but high-yielding) investments than
individuals could hold in their own portfolios.
Without the bank, individuals would have to
hold lots of low-yield liquid investments (cash
in mattresses) to self-insure against liquidity

6 Q2 2012 Business Review

to those who withdraw their funds
to trade in the market; and (ii) only
households without access to securities
markets can be the source of the subsidy. So as more customers have easy
access to securities markets, the interest rate the bank can offer to households with immediate liquidity needs
decreases, and the liquidity insurance
offered by the bank becomes less valuable. In turn, even more activity shifts
from banks to markets.
Competition tends to make bank
services less unique and to shift activities from banks to markets. But this
doesn’t mean that the banking sector
will shrink until banks become niche
providers, serving only very small firms
and the most cautious and unsophisticated households. First, greater
competition doesn’t mean that market
power disappears completely. Furthermore, not all of the services provided

Competition tends to
make bank services
less unique and to
shift activities from
banks to markets.
by banks depend on monopoly power
and cross-subsidies. Perhaps most
important, bank loans and bonds are
Firms’ Optimal Financing Mix
Includes Bank Debt.16 Since the
1960s, financial economists have made
a huge effort to understand firms’ capi-

Broadly, two products are complements when
the cost of producing (or using) one good lowers
the cost of producing (or using) the other.

The theoretical description in this section includes insights from articles by Eric Berglof and
Ernst Ludwig von Thadden and by Cheol Park.

tal structure, that is, how much equity
and how much debt were chosen by
firms and why. Beginning in the 1990s,
theorists began to think more carefully
about the composition of firms’ debt,
e.g., short-term versus long-term debt,
bank debt versus public debt. More recently, empirical financial economists
have explored the structure of debt
contracts in much more detail.
Consider a firm that is large
enough to borrow in bond markets;
in principle, at least, the firm could
avoid borrowing from a bank altogether
and thus avoid the bank’s monitoring.
Indeed, the firm would gain maximum
flexibility by selling long-term bonds,
let’s say 30-year bonds. But would this
be the cheapest way for the firm to
borrow? Sensible bondholders will be
concerned that a lot can change in 30
years. The firm’s markets may dry up, or
new managers with a taste for high risk
or costly empire building may replace
current management. The firm may
have to pay quite a high rate of interest
to convince bondholders to accept these
types of risks, or there might not be a
rate high enough to convince them.
One possible alternative for the
firm is to split its borrowings into
short-term debt (commercial paper)
and long-term bonds. In this case,
the firm will have to prove that its
finances are healthy by paying off its
short-term debt on a regular basis. And
if bondholders are no longer convinced
that the firm’s prospects are good,
short-term investors can pull the plug
and the firm will be forced to scramble
for funds. Thus, short-term debt may
serve as a disciplinary device that, in
turn, facilitates borrowing for a longer
term. While this debt structure is feasible for low-risk firms with an impeccable reputation, it poses problems for
riskier firms.17
For very low-risk firms, the disciplinary role of
short-term debt is probably a secondary matter.
For such firms, short-term borrowings are simply
a convenient way to finance working capital.

Let’s take a firm with a significant
chance of default. In fact, let’s consider
a firm that is unable to pay off its shortterm creditors because of financial difficulties. Crucially, a firm facing financial problems is often worth a lot more
alive than dead; simply auctioning off
the firm’s assets inside or outside bankruptcy proceedings would fetch a lower
price than the firm is worth as a going
concern. With the prospect of a looming default, bondholders will have a
powerful incentive to agree if the firm’s
managers propose the following deal:
Accept new claims that pay less than
the original contractual return but
not much more than they would have
received by auctioning off the firm’s assets and sharing the proceeds. As long
as all creditors have the same priority,
that is, each of the firm’s creditors has
a pro rata claim on the firm’s assets in
the event of default, they would unanimously agree to this deal.
While a restructuring to avoid
default is often better for both bondholders and managers, it is not hard
to see that the possibility of renegotiation undermines the threat to impose
default, so short-term debt doesn’t have
as much disciplinary power as it appeared on first sight. Most worrisome,
if managers know that bondholders
will renegotiate, they may take more
risks or build empires, and we are back
where we started: high borrowing
Short-Term Bank Debt Is a
Hard Claim. The threat to impose
default can be made more believable
if the short-term creditor has priority
over other creditors because the creditor with priority captures more than its
pro rata share of the auction value of

Making it very hard to renegotiate would
improve discipline. But the option to renegotiate is also valuable for firms in risky environments. Furthermore, if the firm can choose to
enter Chapter 11 bankruptcy proceedings, the
bondholders get bargaining plus bankruptcy

the firm’s assets. (For these purposes,
having a collateralized claim serves
much the same purpose.) Since it gets
a disproportionately higher payoff in
default, the creditor with priority will
be a hard bargainer; economists would
say that he or she holds a hard claim.
Even if the threat to impose default is
never actually carried out, discipline is
improved because the firm’s managers
know that default will be painful. And
even though the short-term creditor
gains at the expense of other creditors

covenants) held by a creditor that can
monitor the firm closely.21 That is, for
all but the safest firms, bank debt is
part of the debt mix that reduces borrowing costs. For that matter, a firm’s
access to bond markets may depend on
the role played by the bank.
Evidence for the Value of Hard
Claims. Recent research has provided
support for the role of hard claims
in risky firms’ debt structure. Mark
Carey and Michael Gordy examine
a large sample of firms that entered

While holding a hard claim is valuable to
discipline managers, liquidating fundamentally
sound firms or mistakenly relaxing contract
terms for genuinely troubled firms makes
everyone worse off.
in negotiations, the firm’s long-term
creditors benefit from the discipline
imposed by the hard claim.19 Furthermore, negotiations will be more
efficient if the holder of the shortterm claim has the capacity to closely
examine the firm’s financial condition.
While holding a hard claim is valuable
to discipline managers, liquidating
fundamentally sound firms or mistakenly relaxing contract terms for genuinely troubled firms makes everyone
worse off.20
In summary, risky firms with
access to bond markets will borrow
through a mixture of subordinated
long-term debt and higher priority
short-term debt (or debt with stringent

bankruptcy and ask which firms have
a larger recovery value, that is, which
firms ultimately paid creditors the largest amount per dollar invested when
the firm’s assets were liquidated. Carey
and Gordy find that recovery values
are higher for firms with a higher share
of bank debt and that other factors
are of secondary importance. In their
terminology, banks are “grim reapers.” Banks discover financial troubles
early and their interventions prevent
managers from imposing greater losses
on creditors.22
Joshua Rauh and Amir Sufi examine a sample of fallen angels, firms that
experience a dramatic drop in their
credit rating from investment grade


Long-term creditors will also insist on receiving an interest rate that compensates them for
the likelihood that the short-term creditor does
too well at their expense in contract negotiations.


Note that while my account focuses on the
disciplinary role of short-term debt, longer-term
debt with strict covenants and with priority over
other long-term creditors has a similar disciplinary effect.



Subordinated bondholders receive a payoff
only after other debt holders have been paid
in full. Thus, subordinated debt holders have
higher priority than stockholders but lower
priority than other bondholders.
This evidence doesn’t imply that bankruptcy
was an efficient outcome, only that the threat to
impose default was effective and that the decision to liquidate was informed, in the sense that
creditors tended to gain after liquidation.
Business Review Q2 2012 7

to junk status, which means that their
risk of default increases substantially.
They find that these firms were originally funded primarily by unsecured
debt and equity, but after the collapse
in their credit rating, they shifted toward a mix of secured bank debt and
unsecured and subordinated long-term
bonds. Similarly, comparing a sample
of low-risk and high-risk public firms,
Rauh and Sufi found the same pattern;
low-risk firms secure funds mainly using equity and unsecured debt, while
high-risk firms borrow through a mixture of short-term, secured bank loans
and subordinated long-term debt.23
Deposits and Lines of Credit
Are Complements. In their article,
Anil Kashyap and coauthors argue
that because banks are funded by
deposits, they have a cost advantage
in providing lines of credit. As long
as depositors’ and firms’ demands for
funds are not perfectly correlated,
that is, as long as borrowing firms
don’t always borrow under their line of
credit at the same time that depositors withdraw their funds, banks can
meet all commitments while holding a
relatively small amount of (low-yield)
cash balances. Furthermore, if firms’
and depositors’ demands for liquidity
are negatively correlated — meaning
that firms borrow at times when savers
are holding more of their savings in
deposit accounts — the cost complementarity is even stronger.
Evan Gatev and coauthors provide
empirical evidence for this strong type
of cost complementarity. They focus
on periods in which stress in money
markets restricts many firms’ access
to the commercial paper market. At
times of stress, firms borrow on their
lines of credit. In stressful times, funds
on deposit with banks also increase.
I am simplifying their results slightly. The
higher risk firms also include some senior unsecured debt and convertible bonds in their debt
structures. This slightly complicates but doesn’t
contradict my interpretation of their evidence.

8 Q2 2012 Business Review

Funds flow into the banking system,
probably because firms and households
view banks as safe places to put their
savings in a financial storm.
Lines of Credit Are Part of a
Firm’s Optimal Financing Mix. Recently, a number of economists have
modeled firms’ financing decisions as if
they were part of an optimal long-term
contract. The approach in this research

agers without closing down the firm
every time it suffers a setback.
I have argued that bank loans’
mixture of tight control and renegotiation is one solution to these problems,
but it is not the only one. The mix of
securities the firm uses to finance operations is another solution. In DeMarzo and Fishman’s model, the borrowing
firm has an incentive to use cash flows

While depository institutions have a cost
advantage in providing lines of credit, they
have no such advantage in holding long-term
debt in their portfolio.
is to figure out what the best long-term
financing contract would look like —
including the pattern of loan payments
and the conditions under which the
firm is placed in default — and then
to ask whether some mix of securities
could reproduce the terms of this contract. Interestingly, in Peter DeMarzo
and Michael Fishman’s model, the
terms of the optimal long-term contract can be mimicked by a financing
mix of equity, long-term debt, and a
line of credit.
Broadly, the optimal long-term
contract is designed to solve two types
of problems. First, borrowing is rife
with conflicting incentives: Borrowing
firms have incentives to take too much
risk, to cover up problems until it is too
late, or to consume excessive perks.
Uncontrolled, these conflicts would
increase default risk and raise borrowing costs (or even make financing
infeasible altogether), so financial contracts are designed to control incentive
problems. Second, firms operate in an
intrinsically risky business environment. Even when a firm’s managers are
making cautious and thrifty decisions,
the firm’s cash flows are variable and
uncertain. An optimal long-term contract must impose discipline on man-

to consume perks, and the lender can’t
directly observe the firm’s cash flows
or how the firm is using its cash flows.
The authors show that the optimal
financing mix is a combination of
equity, long-term debt, and a line of
credit, a combination that looks a lot
like the mix of contracts used by many
real world firms. The long-term debt
forces the firm to make some payments
to the lender, but because principal
is paid back later, the firm has more
flexibility to pay workers, suppliers, etc.
The line of credit provides even more
flexibility in the event of temporary
setbacks; the firm can draw down the
line of credit to cover long-term debt
payments and to meet operating costs
even when the business environment
is tough. In addition to the long-term
debt payments, discipline is imposed
on the firm in two ways. No payments
can be made to the firm’s stockholders unless the firm stays current on all
debt payments. Furthermore, if the
firm can’t make payments on its credit
line, the lender imposes default.
While depository institutions have
a cost advantage in providing lines of
credit, they have no such advantage in
holding long-term debt in their portfolio. Furthermore, we have already seen

that there are benefits from having
separate investors hold the firm’s shortand long-term debt. Consistent with
both theory and real world practice,
firms with access to public debt markets borrow through a mixture of bank
loans — here, loans borrowed under a
line of credit — and public bonds.
Banks and markets interact in a
number of ways. Firms and households
view banks and markets as substitute
ways to borrow funds and to hold
their savings. Many of the distinctive
features of banking services are based
on cross-subsidies among the bank’s
customers, but these are only feasible
if banks retain market power over borrowers and depositors. Thus, increasing competition in financial markets
— driven primarily by deregulation
in the last quarter of the 20th century
— tends to undermine the profitability of banks and to increase the
share of activities carried out through

financial markets. But there are limits
to how far the banking sector can
shrink because banks and markets are
also complementary. Many firms, not
just those too small to access bond
markets, lower borrowing costs using
a mix of financial contracts, including
bank loans. In particular, banks retain
a comparative advantage in providing
lines of credit because they provide
There is a wealth of evidence
that the mix of bank loans and bonds
has real effects at the firm level — for
example, a heavier reliance on bank
loans increases the recovery rates for
firms that enter bankruptcy — but the
evidence that the mix of banks and
securities markets matters at the macroeconomic level is much weaker. Ross
Levine’s comprehensive review of the
evidence concludes that while financial development has a significant role
in promoting economic growth, there
is not much evidence that the relative scale of the activities carried out

through banks or through markets has
a large effect on a country’s economic
That said, the recent financial crisis and the ensuing deep recession are
likely to force economists to revisit and
rethink the evidence about economic
performance in the last few decades, a
period that witnessed the rapid growth
of financial markets, especially the
growth of securitized assets. Some
analysts view the heavy shift toward
securitized markets in the U.S. as a
major cause of the crisis.24 At the same
time, economies dominated by banks,
for example, Spain and Ireland, also
experienced a lending boom and an attendant bust. It will take some time for
us to absorb the lessons of the financial crisis and to determine whether it
provides any lessons about the mix of
banks and markets going forward. BR

See Ronel Elul’s Business Review article for a
review of the evidence about securitization and
mortgage default.

Business Review Q2 2012 9

Berglof, Eric, and Ernst Ludwig von
Thadden. “Short-Term Versus Long-Term
Interests: Capital Structure with Multiple
Investors,” Quarterly Journal of Economics,
109 (1994), pp. 1055-84.
Berlin, Mitchell, and Loretta Mester. “Debt
Covenants and Renegotiation,” Journal
of Financial Intermediation, 2 (1992), pp.
Boot, Arnoud, and Anjan Thakor. “Financial System Architecture,” Review of Financial Studies, 10 (Fall 1997), pp. 693-733.
Brav, Alon, Wei Jiang, Randall Thomas,
and Frank Partnoy. “Hedge Fund Activism, Corporate Governance, and Firm
Performance,” Journal of Finance, 63, 2008,
pp. 1729-75.
Carey, Mark, and Michael Gordy. “The
Bank as Grim Reaper: Debt Composition
and Bankruptcy Thresholds,” Board of
Governors of the Federal Reserve System
Working Paper (May 4, 2009).
Chava, Sudheer, and Michael Roberts.
“How Does Financing Impact Investment?
The Role of Debt Covenants,” Journal of
Finance, 63 (2008), pp. 2095-2121.
Degryse, Hans, Moshe Kim, and Steven
Ongena. Microeconometrics of Banking:
Methods, Applications and Results. Oxford
University Press, 2009.
DeMarzo, Peter, and Michael Fishman.
“Optimal Long-Term Financial Contracting,” Review of Financial Studies, 20 (2007),
pp. 2079-2128.
Diamond, Douglas. “Liquidity, Banks and
Markets,” Journal of Political Economy, 105
(1997), pp. 928-56.
Diamond, Douglas, and Philip Dybvig.
“Bank Runs, Deposit Insurance, and
Liquidity,” Journal of Political Economy, 91
(1983), pp. 401-19.

10 Q2 2012 Business Review

Dichev, Ilia, and Douglas Skinner. “LargeSample Evidence on the Debt Covenant
Hypothesis,” Journal of Accounting Research
(September 2002), pp. 1091-1123.
Edmans, Alex, Itay Goldstein, and Wei
Jiang. “The Real Effects of Financial Markets: The Impact of Prices on Takeovers,”
Journal of Finance, forthcoming.
Elul, Ronel. “What Have We Learned
About Mortgage Default?,” Federal Reserve Bank of Philadelphia Business Review
(Fourth Quarter 2010), pp. 12-19.
Fink, Jason, Kristin Fink, Gustavo Grullon, and James Weston. “What Drove the
Increase in Idiosyncratic Volatility During
the Internet Boom?,” Journal of Financial
and Quantitative Analysis, 45 (2010), pp.
Gatev, Evan, Til Schuermann, and Philip
Strahan. “Managing Bank Liquidity Risk:
How Deposit-Loan Synergies Vary with
Market Conditions,” Review of Financial
Studies, 22 (2009), pp. 995-1020.
Glode, Vincent, Richard Green, and
Richard Lowery. “Financial Expertise as an
Arms Race,” Journal of Finance, forthcoming.
Gorton, Gary, and Andrew Metrick. “Securitization,” in George Constantinides,
Milton Harris, and Rene Stulz, eds., Handbook of the Economics of Finance, forthcoming.
Kashyap, Anil, Raghuram Rajan, and
Jeremy Stein. “Banks as Liquidity Providers: An Explanation for the Coexistence
of Lending and Deposit Taking,” Journal of
Finance, 58 (2002), pp. 33-73.
Leitner, Yaron. “Stock Prices and Business Investment,” Federal Reserve Bank
of Philadelphia Business Review (Fourth
Quarter 2007), pp. 12-18.

Levine, Ross. “Finance and Growth:
Theory and Evidence,” in Philippe Aghion
and Steven Durlauf, eds., Handbook of Economic Growth. The Netherlands: Elsevier
Science, 2005.
Mester, Loretta, Leonard Nakamura, and
Marie Renault. “Transactions Accounts
and Loan Monitoring,” Review of Financial
Studies, 20 (2007), pp. 529-56.
Park, Cheol. “Monitoring and the Structure of Debt Contracts,” Journal of Finance,
55 (2000), pp. 2157-95.
Parlour, Christine, and Guillaume Plantin.
“Loan Sales and Relationship Banking,”
Journal of Finance, 63 (2008), pp. 12911314.
Rauh, Joshua, and Amir Sufi. “Capital
Structure and Debt Structure,” Review of
Financial Studies, 12 (2010), pp. 4242-80.
Roberts, Michael. “The Role of Dynamic
Renegotiation and Asymmetric Information in Financial Contracting,” University
of Pennsylvania Working Paper (December
29, 2010).
Roberts, Michael, and Amir Sufi. “Renegotiation of Financial Contracts: Evidence
from Private Credit Agreements,” Journal
of Financial Economics, 93 (2009), pp. 15984.
Schenone, Carola. “Lending Relationships and Informational Rents: Do Banks
Exploit their Information Advantages?,”
Review of Financial Studies, 23 (2010), pp.
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Journal, 120 (2010), pp. 1021-55.
Sufi, Amir. “Bank Lines of Credit in Corporate Finance: An Empirical Analysis,”
Review of Financial Studies, 22 (2009), pp.

Contingent Capital*


overnment bailouts during the recent
financial crisis were controversial because of
the burden on taxpayers and because even
if taxpayers eventually get their money back,
such bailouts can undermine banks’ incentives not to
take excessive risk in the future. New regulatory reforms
aim to avoid such crises in the future. One proposal
is to require banks to hold “contingent capital.” In this
article, Yaron Leitner explains what contingent capital
is and discusses some of the arguments in favor of it. He
also discusses potential implementation problems and
looks at some of the alternatives.

The recent financial crisis has
illustrated the problems that can be
caused by a failure of a large financial
institution and the government’s reluctance to let it fail. These government
interventions, or bailouts, have been
controversial because of the burden
they impose on taxpayers and because
even if taxpayers eventually get their
money back, such bailouts can undermine banks’ incentives not to take excessive risk in the future. New regulatory reforms aim to avoid such crises in
the future. One proposal is to require
Yaron Leitner
is a senior
economist in
the Research
Department of
the Philadelphia
Fed. This article
is available
free of charge
at www.

banks to hold “contingent capital.”
Indeed, the Dodd-Frank Wall
Street Reform and Consumer Protection Act, passed by Congress on July
21, 2010, allows the Federal Reserve to
require large banks and other financial
firms supervised by the Fed to “maintain a minimum amount of contingent
capital that is convertible to equity in
times of financial stress.” However, this
can be mandated only after a study
by the Financial Stability Oversight
Council to be completed by June 2012.1
Regulators in several other countries
The Financial Stability Oversight Council was
established by the Dodd-Frank Act to identify
threats to the financial stability of the United
States, promote market discipline, and respond
to emerging risks to the stability of the U.S.
financial system. The act contains details about
the council’s organizational design (members,
meetings), duties, and authority.

*The views expressed here are those of the
author and do not necessarily represent
the views of the Federal Reserve Bank of
Philadelphia or the Federal Reserve System.

have also shown interest in adding
contingent capital to their supervisory
toolkit to improve crisis management.2
Before explaining what contingent capital is, it is useful to say what
we mean by capital. Bank capital is the
value of the bank’s assets minus the
value of its liabilities (its debt). Alternatively, this is what the bank’s shareholders own, or their equity.3 Examples
of banks’ assets are loans that banks
make to households and firms and
financial securities that banks hold,
such as government bonds. Examples
of banks’ liabilities are the amounts of
money that banks obtain by borrowing
or by taking deposits from households
and firms. Essentially, banks earn
interest on their assets and pay interest
on their debt.4, 5

See, for example, the recent regulatory proposal (July 20, 2011) by the European Commission.
More details are available at

Regulators may define capital a bit differently
to account for the fact that, in practice, banks
hold complex securities other than simple debt
and equity (see Bank Capital Regulation in the
Business Review article by Mitchell Berlin). But,
to simplify, we will use the simple definition in
the text.

Throughout the article, we use the word
banks, but the article also applies to other
financial firms that might pose systemic

People sometimes confuse capital requirements
and liquidity requirements. The terms “capital,”
“capital requirements,” and “capital structure”
refer to the way the bank is funded and, in
particular, to the mix between debt and equity.
In contrast, the term “liquidity requirements”
refers to the type of assets and the asset mix the
bank holds. For example, if the bank has a lot
of cash and Treasury securities, it is considered

Business Review Q2 2012 11

Contingent capital refers to debt
that automatically converts into equity
in times of financial stress if certain
prespecified triggers are hit. For example, in November 2009, Lloyds Bank
issued a bond that converts into common stock if the bank’s tier 1 capital
ratio falls below 5 percent. Tier 1 capital is a measure of a bank’s capital used
by regulators.6 The tier 1 capital ratio
is the value of the bank’s tier 1 capital

very liquid. Otherwise, the bank is considered
less liquid because even though the bank may
own a lot of assets, it may not be able to sell
them at short notice, or it may obtain less than
the fair value in a sale.
Tier 1 capital consists mainly of the bank’s
common stock and retained earnings, but it
may also include more complex securities, such
as preferred equity, which is a special type
of equity that is senior to common stock but
subordinate to bonds.

divided by the risk-weighted value of
the bank’s assets.7 It is a measure of the
bank’s financial health and its ability
to absorb losses. When the bank’s capital ratio is high, a significant loss can
be absorbed by the bank’s shareholders
and does not trigger bankruptcy. In
contrast, when the ratio is low, losses
may trigger bankruptcy, since the bank
may not be able to pay off its debt or
make the required interest payments.
Figure 1 illustrates how contingent capital works. The numbers are
for illustration purposes only and are
chosen so that the algebra is simple.
Suppose that initially (Panel A) the
value of the bank’s assets is $10 billion
and its capital ratio (equity divided by
For a definition of risk-weighted assets, see
Bank Capital Regulation in the Business Review
article by Mitchell Berlin.

assets) is 30 percent. The bank also
has $2 billion of contingent capital.
Suppose that the trigger for conversion
is a 15 percent capital ratio; that is,
conversion is automatic whenever the
capital ratio falls below 15 percent. If
this trigger is hit, $1 of the face value
of contingent capital converts to $1
of common stock (i.e., the conversion
ratio is that $1 of contingent capital
converts to $1 of equity). Now suppose
the bank suffers a loss and the value of
its assets drops to $8 billion. The loss
is absorbed by the banks’ equity holders, and the bank’s capital ratio falls
to 12.5 percent, which is below the
trigger (Panel B). Since the trigger is
hit, the $2 billion of contingent capital
converts to $2 billion of equity. The
bank’s capital ratio then rises to 37.5
percent (Panel C) and has returned to
a safe level.

How Contingent Capital Works
Equity (3)
Equity (1)
Capital (2)

Assets (10)

Equity (3)

Capital (2)
Assets (8)

Debt (5)

Assets (8)

Debt (5)

Debt (5)

Panel (A)
Initial Balance Sheet

Panel (B)
Balance Sheet After Loss,
Before Conversion

Panel (C )
Balance Sheet After Loss,
After Conversion

(Capital Ratio = 30%)

(Capital Ratio = 12.5%)

(Capital Ratio = 37.5%)

Panel A shows the balance sheet of a bank that has contingent capital in its capital structure. (Numbers in brackets
represent billions of dollars.) Panel B shows the balance sheet of the same bank after it suffers a loss. As you can see, the
bank’s capital ratio (equity over total assets) falls drastically, and so the trigger for conversion occurs. Panel C shows the
balance sheet of the bank after conversion occurs. Now the bank’s capital ratio is back to a “safe” level.
12 Q2 2012 Business Review

When a large bank fails, its failure
can spread to other banks in a domino
effect, which economists call contagion. Regulators may then be forced
to bail out the bank, using taxpayers’
money, because of the potential damage a single bank’s failure can do to
the banking system and to the whole
economy. Even if taxpayers eventually
get their money back, bailouts have a
social cost because they may induce
banks to take excessive risks, i.e., risks
that benefit the bank’s shareholders but are harmful to society. If the
risky investment succeeds, the bank’s
shareholders gain a lot; if the risky
investment fails, the shareholders are
protected by their limited liability.8
Contingent Capital May Reduce
the Need for Bailouts. The idea behind requiring banks to hold contingent capital, or more generally capital,
is that a bank that suddenly loses
money can absorb losses and does not
need to be bailed out. First, since the
debt is converted to equity, the bank
is relieved from paying interest on its
debt. Second, since the bank obtains
more equity, it is easier for the bank to
absorb additional losses in the future.
In one view, the main role of contingent capital is to prevent failures of
large banks to begin with. Under this
view, the trigger for conversion should
be hit at a relatively early stage, when
there is still a chance to save the bank
by recapitalizing it (i.e., increasing its
level of capital). Conversion would
then be a relatively frequent event
and would not be limited to financial

I talk about contagion in my 2002 Business
Review article and in my paper. I also discuss
private-sector bailouts, in which banks help
each other without using taxpayers’ money and
the regulator acts only as a coordinator.

In another view, the purpose of
contingent capital is not to prevent
single bank failures but instead to create procedures to deal with the failure
of large banks in situations in which
many banks experience problems at
the same time. More generally, the
idea is to have an out-of-court resolu-

When a large bank fails, its failure can spread
to other banks in a domino effect, which
economists call contagion.
tion mechanism so that if large banks
get into financial problems, the regulator does not need to rely on ad hoc
measures or lengthy and costly bankruptcy procedures. In this case, the
trigger should apply at a later stage and
conversion would occur only during a
full-blown financial crisis.10
A Distressed Bank May Not
Take Appropriate Measures on Its
Own. When a bank suffers a loss,
the value of its assets drops, and this
reduces the value of its equity (assuming the value of its liabilities remains
unchanged). Hence, the bank has a
smaller capital cushion to absorb additional losses in the future, and its
chances of going bankrupt increase.
To reduce the likelihood of
bankruptcy, the bank can recapitalize
by issuing more equity. However, the
bank may be reluctant to do so because
of a problem that economists call debt
overhang, one variant of stockholders’
incentive to take excessive risks. A
debt overhang problem refers to a situation in which a bank has a lot of outstanding debt and there is a significant
likelihood of default. Since the money
raised by issuing equity must first go to
satisfy existing debt obligations (debt

See, for example, Mark Flannery’s proposal.

increases the likelihood that existing
debt holders will be repaid but, at the
same time, dilutes the shares of existing shareholders. Moreover, if some
of the bank’s debt is insured, issuing
new equity is not only a transfer from
equity holders to debt holders, but it is
also a transfer from equity holders to
the deposit insurer. Hence, if a bank
is managed in the interests of existing
stockholders, it will not issue equity
unless it is forced to do so.11
The bank can also recapitalize
by selling assets. But again, the bank
may be reluctant to do so because of
the debt overhang problem. Moreover,
selling assets can also impose problems on other banks and on the whole
economy. If other banks, which are the
potential buyers of the assets, also face
financial problems, they may be reluctant to buy the assets. Alternatively,
they may agree to buy, but only at “fire
sale” prices, which are well below the
price they would normally pay. Such a
significant drop in prices further amplifies problems because it reduces the
value of assets that other banks own
and, thus, the banks’ capital ratios.

The problem of debt overhang was first discussed in the seminal paper by Stewart Myers.
More generally, it refers to a situation in which a
firm with a lot of debt forgoes profitable investment opportunities.

See, for example, the Squam Lake Group’s


holders get first priority in payments),
and since new shareholders must at
least break even on their investment
or else they would not provide the
bank with any capital, issuing new
equity is essentially a transfer from
existing shareholders to existing debt
holders. In particular, issuing equity

Business Review Q2 2012 13

Instead of selling existing assets, the
bank can simply stop acquiring new assets, but this means that the bank will
lend less to households and firms. The
regulator may then be forced to step in
to avoid the potential damage to the
Contingent capital may reduce
the need for bailouts because when the
bank gets into trouble and its capital
ratio drops, its debt converts to equity
automatically, and so its capital ratio
increases back to what the regulator
perceives to be a safe level.
One lingering question is whether
contingent capital has an advantage
(to banks or to society as a whole) over
simply requiring banks to hold more
capital. There are views on both sides.
Contingent Capital May Be
“Cheaper” Than Capital. Some
economists argue that contingent capital is cheaper than standard capital.
Underlying this argument is the tradeoff between debt and equity and the
notion that contingent capital captures
the benefits of debt while avoiding
most of its problems. In particular, they
argue that contingent capital captures
the tax benefits and disciplinary role
of debt while avoiding the problems
of debt when the bank is in financial
distress and may not be able to pay off
its debt.12
Under existing tax law, debt has
an advantage over equity (to the issuing bank) because the bank can
deduct interest payments, but it cannot
deduct dividend payments. In addition,
in some economic models, debt has a
disciplinary role. To make sure they get
their money back, debt holders monitor
the bank so that the bank’s managers
don’t waste money or take excessive
risks. Moreover, if the debt is short
term, debt holders may choose not to

Note, however, that it is unclear whether any
form of contingent capital will qualify as debt
for tax purposes. See the discussion of this issue
in the paper by Robert McDonald.

14 Q2 2012 Business Review

renew it after poor performance. The
threat of insolvency if short-term debt
holders refuse to roll over their claims
imposes discipline on bank managers.13
However, as we saw earlier, too

or fully). The automatic conversion of
contingent capital helps to avoid this
Later in this article we discuss
alternative views as to whether contin-

Under existing tax law, debt has an advantage
over equity (to the issuing bank) because the
bank can deduct interest payments, but it
cannot deduct dividend payments.
much debt can create problems both to
the issuing bank (e.g., debt overhang)
and to society as a whole (e.g., contagion and costly bailouts). Assuming
that investors are willing to hold it,
contingent capital can help avoid these
problems because the automatic conversion helps to recapitalize the bank
before the problems spill over to the
rest of the economy.
Contingent capital might also
help banks avoid the costs of lengthy
bankruptcy procedures. Once a bank is
in bankruptcy, it may take a long time
for creditors to get paid (either partially
See, for example, the paper by Douglas
Diamond and Raghuram Rajan.

gent capital is indeed less costly than
equity, but before that, we discuss some
issues with implementation.
Suppose we believe that contingent capital is beneficial. How should
we design it? In particular, what event
should trigger conversion? What
should the conversion ratio be? That
is, how many shares of stocks should $1
of face value of debt convert to?
We start with the event or events
that should trigger conversion. Table
1 provides examples of three different
proposals. We explain the features in
these proposals below.

Examples of Specific Proposals for Contingent

Trigger for Conversion

Book or
Trigger? Market


1.	 Bank’s stock price falls below some



Squam Lake 1.	 The regulator declares a systemic
2.	 The bank’s tier 1 capital ratio falls
below some threshold.




1.	 A broad financial stock’s index falls Yes
below some threshold.
2.	 Bank’s stock price falls below some


The Trigger for Conversion.
Some economists have suggested that
conversion should depend only on the
bank’s own condition; that is, conversion should occur whenever the issuing
bank has serious financial problems.
Other economists have suggested using
a dual trigger, meaning that conversion
should occur only if both the issuing
bank and the whole financial system
are in trouble. Clearly, under a dual
trigger, conversion occurs less often,
and any individual bank with financial
problems is less likely to be recapitalized. One advantage of this is that the
disciplinary role of debt is enhanced,
since the threat of bankruptcy is
stronger. One disadvantage is that the
failure of a single large bank can have
negative consequences for the whole
Now suppose we decide on a dual
trigger. How should we determine
whether the financial system is in trouble? Should we rely on the regulator
to declare a systemic crisis, or should
we use a more objective criterion,
such as a broad financial stock index?
Each option has some pros and cons.
One problem with regulatory discretion is that market participants may be
uncertain as to how the regulator will
interpret the data. A second problem
is that regulators may be concerned
about maintaining confidence in the
financial system and, hence, may be
reluctant to declare a financial crisis
until it is too late. An objective rule
may avoid these problems. However,
it is impossible to come up with a rule
that is always accurate, and blindly
following some decision rule may be
misleading. The more likely outcome
is that regulators would choose not
to follow the rule when it looks like it
is mistakenly calling for conversion.
Thus, they are likely to use discretion
in practice. Nonetheless, specifying
some rule for intervention may help
to the extent that regulators may have
difficulty pre-committing to declaring

Examples of Market-Based Triggers


hile most proposals that use market values as triggers rely on
stock prices, it is also possible to use the prices of credit default
swaps. a,b Credit default swaps are a form of insurance against
default on the bank’s debt, and so their prices reflect whether
the bank is in financial trouble. The advantage of using prices
of credit default swaps over stock prices is that prices of credit
default swaps capture only the likelihood of default, whereas stock prices capture
both the expected profits of the bank when it doesn’t default as well as the likelihood of default. One disadvantage is that credit default swaps may also reflect
the likelihood of government bailouts, and at another extreme, they can also
reflect the likelihood that the firm that provides insurance may itself default.


See, for example, the article by Oliver Hart and Luigi Zingales.

A credit default swap is a contract that is written between the seller of the swap and the buyer
of the swap in reference to some credit event, such as a default by Bank ABC on a specific bond
(long-term debt) it issued. The buyer of the swap pays a premium to the seller of the swap, just like
the buyer of car insurance pays a premium to the company that sells insurance. In return, the seller
of the swap promises to make a payment to the buyer of the swap if the credit event occurs.

a crisis. At the minimum, regulators
will have to explain to the public why
they are acting contrary to the rule.
Another issue is whether the triggers for conversion should be based
on book values (meaning accounting numbers) or market values. An
example of a trigger based on book values is regulatory tier 1 capital, which
is derived from the bank’s financial
statements. Examples of triggers based
on market values are the bank’s stock
price or its credit default swap spread
(see Examples of Market-Based Triggers).
One advantage of using market
values is that they are more forward
looking and rapidly adapt to changes
in the bank’s financial condition. In
contrast, financial statements are updated only periodically and reflect the
bank’s financial condition with a lag.
In addition, accounting numbers can
be distorted by the bank. For example,
if a bank is subject to mark-to-market
accounting, meaning that assets are
valued based on the recent market
price of identical or similar assets, the

bank may stop trading in these assets
so that losses are not reflected on its
balance sheet.14
However, relying on market prices
may also create problems because
market prices could trigger conversion based on factors other than the
bank’s true financial condition. One
such problem is that market prices
create opportunities for manipulation.
Second, market prices may create the
possibility of multiple self-fulfilling
Manipulation. An investor who
holds contingent capital may attempt
to drive down the stock price, so that
conversion will occur, and then drive
the price back up to make a profit.15
For example, suppose an investor has
$1000 of face value of debt that converts into 20 shares of stock when the
See, for example, my paper with Philip Bond
and the paper by Konstantin Milbradt.

One way to drive down the price is by short
selling the stock. Short selling is explained in
Ronel Elul’s Business Review article.

Business Review Q2 2012 15

stock price falls below $50. Suppose
the stock price is currently $51 (the
true value of the firm) and the investor
can drive the price down to $49. Then
conversion occurs, and instead of owning $1000 of debt, the investor now
owns 20 shares of stock. When the
price returns to $51, the investor has
a position worth $1020, which is $20
more than what he originally had; that
is, he gained 2 percent.
One way to minimize this problem is to set a low conversion ratio
so that the value of equity that the
holder of contingent capital obtains
after conversion is lower than the
debt’s face value. For example, if the
original $1000 of debt converts into 19
shares of stock, rather than 20 shares,
then after conversion occurs, the
price would need to go up to $52.63
(=1000/19) for the investor to make a
profit. Hence, manipulation becomes
Triggers that are based on the
average stock price over some given
period rather than just one day may
also make it more difficult to manipulate conversion.
Multiple Equilibria. Another possible problem when conversion is based
on market prices has to do with what
economists call “multiple equilibria.”17
We usually think of stock prices as
aggregating investors’ views about the
firm’s true value, given the information
they have. However, stock prices may
also reflect investors’ expectations as
to what other investors will do, which
may affect whether the debt will convert to equity. This may lead to situations in which conversion depends on
self-fulfilling expectations rather than
on whether the bank is truly facing
financial problems. It may also lead to
The numerical examples above are taken from
Robert McDonald’s paper.

situations in which the market “breaks
down,” as it is impossible to come up
with a price that is consistent with
investors’ expectations. The problem in
both cases is that the information role
of the stock price in aggregating investors’ views about the bank’s true value
is reduced.
For example, consider a situation
in which the bank is not in financial trouble, so the stock price should
remain high and conversion should
not occur. Suppose that the conversion ratio is high, so after conversion
the shares of existing equity holders
are diluted and the value of each share
drops. There are two self-fulfilling
outcomes: In the first outcome, stock
holders expect that conversion will
occur (say, tomorrow) and their shares
will be diluted; hence they attempt to
sell their stock today before conversion occurs. But because of these sales,
the stock price falls today, and this
by itself induces conversion.18 Alternatively, what happens if investors do
not expect conversion to occur? In this
case, the stock price remains high, and
conversion indeed does not occur.
Now suppose instead that the
conversion ratio is low so that stockholders’ existing shares are not diluted
and the price of each share rises after
conversion. If investors expect that
conversion will occur tomorrow, the
price will increase today in anticipation, but then conversion will not
occur. In contrast, if investors do not
expect conversion to occur, the price
remains low and conversion occurs
as a result. Hence, in both cases, the
stock price is inconsistent with investors’ expectations. One interpretation
of this is that the market breaks down,
e.g., investors may not trade because
they cannot determine what the price


Such expectations may also cause a “death
spiral,” in which the price drops drastically. This
can happen when the price after conversion is
very low.

In a seminal paper, Douglas Diamond and
Philip Dybvig have illustrated this problem in
the context of bank runs.

16 Q2 2012 Business Review

should be, which economists refer to
as “no equilibrium.” More broadly, the
stock price may be arbitrary and may
not reflect investors’ views about the
bank’s true value.
Note that in the first case, when
the conversion ratio is high, conversion
induces a transfer of wealth from existing equity holders to investors in contingent capital, whereas in the second
case, when the ratio is low, conversion
induces a transfer in the other direction. To avoid the problems above,
Suresh Sundaresan and Zhenyu Wang
have argued that the conversion ratio
must be such that there should never
be any wealth transfers between equity
holders and investors in contingent
capital at the time of conversion. This
means that the conversion ratio should
depend on the market price of the
convertible debt at the time of conversion. However, as for now, it is hard to
tell whether the market for contingent
capital, if introduced, will be liquid
enough so that market prices will be
readily available. In addition, the condition above (no wealth transfer) is inconsistent with the condition of a low
conversion ratio, thereby removing one
of the tools to prevent manipulation.
One may ask why we do not run
into the problems above (multiple
equilibria or no equilibrium) with
the standard, widely used convertible
debt. The reason is that the holder of
convertible debt can choose whether
to convert and so will convert only
if conversion makes him better off. If
conversion induces a wealth transfer
from existing equity holders to holders of convertible debt, the holders of
convertible debt will choose to convert
their debt to equity. If the wealth
transfer is in the other direction, they
will choose not to convert. Hence, in
both cases, we obtain a unique outcome. In contrast, holders of contingent capital cannot choose whether to
convert, since the conversion occurs
automatically whenever the stock price

hits the trigger. As we saw above, this
may lead to multiple outcomes or, alternatively, to a market breakdown.
The technical issues above have
raised concerns about whether contingent capital will satisfy its intended
role. In addition, some economists
have provided compelling arguments as to why we should not take
the notion that “equity is costly” for
granted.19 Under this view, instead of
requiring banks to issue contingent
capital, the regulator should simply
raise capital requirements, i.e., require
banks to have more equity in their
capital structure. Another suggestion is
to increase the liability of equity holders in the event of loss.
Why Bank Equity Should Not
Be Viewed as “Costly.” The wellknown Modigliani-Miller theorem
says that in a frictionless world, it does
not matter to the firm or to society
whether the firm finances itself with
debt or with equity. Although investors
require a higher return to hold equity
than the return they require to hold
debt, equity should not be viewed as
“costly.” The higher return in equity
simply compensates investors for the
extra risk they take.
The importance of the ModiglianiMiller theorem is that it helps us
identify the frictions under which
capital structure does matter. When
designing capital regulations, we should
take these frictions into consideration,
remembering that some of them are
inherent, while others are created by
policy. For example, conflict of interest
between investors and firm managers
is an inherent friction, while the tax
advantage of debt is created by policy.
We should also be aware that the

In particular, see the paper by Anat Admati,
Peter DeMarzo, Martin Hellwig, and Paul

“cost” to the bank and the “cost” to
society are not necessarily the same.
For example, tax deductions make
it cheaper for a bank to issue contingent capital (assuming that contingent capital qualifies for the same tax
benefits as debt). However, instead
of contingent capital, we can require
banks to hold more equity, and we

In particular, when the bank is in
financial distress, the managers may
pass over some profitable investment
opportunities because taking them
hurts existing equity holders. Second,
it is unclear whether debt is the only
(or best) way to discipline the bank’s
managers. For example, the bank can
commit to pay stock holders a prespec-

Some economists have provided compelling
arguments as to why we should not take the
notion that “equity is costly” for granted.
can neutralize the impact of increased
equity requirements on the bank’s tax
liabilities by replacing any tax benefit
lost due to the reduction in leverage
with alternative deductions or tax
More broadly, it is not clear that
the tax advantage of debt over equity
should exist in the first place. After
all, this tax advantage is costly to society because it induces banks to take
too much debt (relative to equity) and
therefore too much risk, which can
create contagion, costly bailouts, and
other spillovers to the whole economy.
The issue is then whether we should
let the tax code, which may be suboptimal to begin with, drive new capital
regulations. An even broader perspective might be to redesign the tax
system, along with redesigning capital
Economists have also questioned
the disciplinary role of debt. First, it
relies on the idea that what disciplines
managers is early liquidation or the
fact that short-term debt may not be
renewed if the bank performs badly.
However, these forms of discipline
increase the fragility of the banking
system as a whole and may cause other
problems to society, such as credit
freezes.20 Using long-term debt may
also create problems, such as the debt
overhang problem discussed earlier.

ified level of dividends, which, if not
maintained, would trigger a shareholder vote to replace the bank’s managers.
Third, since bank deposits are insured
by the government through the Federal Deposit Insurance Fund, banks
may still be induced to take excessive
risk, since the cost is ultimately borne
by taxpayers. The potential for bailouts
also distorts banks’ incentives.21
Increasing Equity Holders’
Liability. Some economists have proposed increasing the liability of equity
holders on the grounds that bank
failures and financial instability have
large social costs. For example, we can
require that equity holders add money
to the firm whenever there is an immediate risk that the firm will default
on its debt. If equity holders don’t add
money, their equity will be wiped out
and they will lose control.22 In particular, Oliver Hart and Luigi Zingales
propose that equity holders should be
See, for example, the paper by Viral Acharya,
Douglas Gale, and Tanju Yorulmazer.

A potential solution, suggested by Viral
Acharya, Lasse Pedersen, Thomas Philippon,
and Matthew Richardson, is to tax each bank
during good times based on its expected loss
conditional on the occurrence of a systemic

This is analogous to margin accounts and
margin calls that are in place to guarantee payments on future obligations.

Business Review Q2 2012 17

forced to add money whenever the
price of a credit default swap moves
above some prespecified threshold,
meaning that the price of insurance
against default on the bank’s debt is
too high.23 Anat Admati and Paul
Pfleiderer also propose to increase the
liability of equity holders, but in their
proposal, equity holders must set aside
some cushion of safe assets upfront to
back up their guarantees. One way

to think of these equity injections is
as a more general form of contingent
Viral Acharya, Hamid Mehran,
and Anjan Thakor take the idea above
even further by proposing that if a
bank gets into financial trouble, a part
of the safe asset buffer will belong to
the regulator, rather than to the bank’s
creditors. Their idea is to provide
both debt holders and equity holders
with incentives to monitor. Since the
regulator takes over part of the bank’s
equity cushion when the bank is troubled, debt is risky from the perspective
of creditors and they are induced to
monitor the bank managers. (If debt is
completely safe, debt holders will have
no incentive to monitor.) At the same
time, since equity holders have a lot of

equity at stake (if the bank fails, they
lose the buffer of safe assets), they will
make sure that bank managers are not
tempted to take excessive risk.

Acharya, Viral V., Douglas Gale, and Tanju Yorulmazer. “Rollover Risk and Market
Freezes,” Journal of Finance 66:4 (August
2011), p. 1177-1209.

Berlin, Mitchell. “Can We Explain Banks’
Capital Structures?,” Federal Reserve Bank
of Philadelphia Business Review (Second
Quarter 2011).

Leitner, Yaron. “Financial Networks: Contagion, Commitment, and Private-Sector
Bailout,” Journal of Finance, 60 (2005), pp.

Acharya, Viral V., Hamid Mehran, and
Anjan Thakor. “Caught Between Scylla
and Charybdis? Regulating Bank Leverage When There Is Rent Seeking and Risk
Shifting,” Federal Reserve Bank of New
York Staff Report 469 (revised November

Bond, Philip, and Yaron Leitner. “Market
Run-Ups, Market Freezes, Inventories,
and Leverage,” Federal Reserve Bank of
Philadelphia Working Paper 12-8 (February 2012).

Leitner, Yaron. “A Lifeline for the Weakest
Link? Financial Contagion and Network
Design,” Federal Reserve Bank of Philadelphia Business Review (Fourth Quarter

Diamond, W. Douglas, and Philip H. Dybvig. “Bank Runs, Deposit Insurance and
Liquidity,” Journal of Political Economy 9
(1983), pp. 401-19.

McDonald, Robert L. “Contingent Capital
with a Dual Price Trigger,” Northwestern
University Working Paper (February 2010).

They also propose that equity capital protect
only against “systemically relevant” obligations
(such as bank deposits, short-term debt, interbank borrowing, and derivative contracts) but
not against long-term debt obligations. Hence,
long-term debt will sometimes need to absorb
losses. This provides an extra protection, and
it also provides an underlying asset on which
credit default swaps can be traded

Contingent capital may be a
step toward reducing failures of large
banks, but it is unclear whether it can
fulfill its intended role. In particular,
problems such as price manipulation,
multiplicity of equilibria, and incentive
issues must be addressed.
Some alternatives to contingent
capital, such as increasing capital
requirements and increasing shareholders’ liability, also exist. Contingent
capital must be evaluated against these
as well as other alternatives. BR


Acharya Viral V., Lasse H. Pedersen,
Thomas Philippon and Matthew Richardson. “A Tax on Systemic Risk,” New York
University Working Paper (2010).
Admati, Anat R., and Paul Pfleiderer.
“Increased-Liability Equity: A Proposal
to Improve Capital Regulation of Large
Financial Institutions,” Stanford Graduate
School of Business Working Paper (June
Admati, Anat R., Peter M. DeMarzo,
Martin F. Hellwig, and Paul Pfleiderer.
“Fallacies, Irrelevant Facts, and Myths in
the Discussion of Capital Regulation: Why
Bank Equity Is Not Expensive,” Stanford
Graduate School of Business Research
Paper 2065(R) (October 2010).

18 Q2 2012 Business Review

Diamond, W. Douglas, and Raghuram G.
Rajan. “A Theory of Bank Capital,” Journal
of Finance 55 (2000), pp. 2431-65.

Milbradt, Konstantin. “Level 3 Assets:
Booking Profits and Concealing Losses,”
Review of Financial Studies, 25 (2012), pp.

Elul, Ronel. “Regulating Short-Sales,” Federal Reserve Bank of Philadelphia Business
Review (Second Quarter 2009).

Myers, Stewart. “Determinants of Corporate Borrowing,” Journal of Financial
Economics, 5 (1977), pp. 147-75.

Flannery, Mark. “Stabilizing Large Financial Institutions with Contingent Capital
Certificates,” Working Paper, University of
Florida (October 2009).

Squam Lake Group. The Squam Lake Report: Fixing the Financial System. Princeton:
Princeton University Press, 2010.

Hart, Oliver, and Luigi Zingales. “A New
Capital Regulation for Large Financial
Institutions,” American Law and Economics
Review, 13:2 (Fall 2011), pp. 453-90.

Sundaresan, Suresh, and Zhenyu Wang.
“Design of Contingent Capital with a
Stock Price Trigger for Mandatory Conversion,” Federal Reserve Bank of New York
Staff Report 448 (May 2010).

Time-Consistency and Credible Monetary
Policy After the Crisis*



he economic crisis and its aftermath have
posed significant challenges to policymakers.
To help meet those challenges, the Federal
Reserve deployed several innovative policy
tools to help relieve the stress in financial markets
during the crisis. These tools have created their own
significant challenges for the conduct of monetary policy
in the post-crisis era. The wider range of policy options
now available to policymakers makes it more difficult to
credibly commit to a particular policy course, and this
discretion poses a problem. This is because monetary
policy is subject to a time-inconsistency problem. The
new monetary policy tools introduced during the crisis
can make such time-inconsistency problems worse by
reinforcing the incentives for financial institutions or
other sectors of the economy to take on excessive risk. In
this article, Jim Nason and Charles Plosser discuss why it
is important for central banks to consider ways in which
they can limit discretion and use these new tools in a
systematic way.

The economic crisis and its aftermath have posed significant challenges
to policymakers around the world. To
help meet those challenges, the FedJim Nason is a
vice president
and economist
in the Research
Department of
the Philadelphia
Fed and the
head of the
section. This
article is available free of charge at www.

eral Reserve developed and deployed
some innovative policy tools, including liquidity programs, to help stressed
markets and large-scale purchases of
mortgage-backed securities and longer
maturity Treasury securities, which
altered the size and composition of the
Fed’s balance sheet. These tools have
created their own significant challenges for the conduct of monetary
policy in the post-crisis era. We do
*The views expressed here are those of the
authors and do not necessarily represent
the views of the Federal Reserve Bank of
Philadelphia or the Federal Reserve System.

not yet have well-developed theories
about how such tools can be optimally
deployed, but we can draw on earlier economic research to reach some
conclusions. In particular, we know
that the wider range of policy options
now available to policymakers and the
lack of fully articulated models make
it more difficult for policymakers to
credibly commit to a particular policy
course and that this discretion poses a
problem. Research since the late 1970s,
including important contributions
by Henry Simons, Guillermo Calvo,
Finn Kydland, and Edward Prescott,
indicates, perhaps paradoxically, that
when policymakers take a more systematic approach to policy and use less
discretion, their policies yield better
This is because monetary policy
is subject to what economists call a
time-inconsistency problem — what
might seem like the best policy when
first announced may not be viewed
as best when the time comes to act.
But if policymakers yield to temptation and renege on that announced
policy, this can lead to worse outcomes
than if they were able to stick with the
original plan. This is a well-known
aspect of many forms of policymaking
and one reason monetary policymakCharles Plosser
is the president
and chief
executive officer
of the Federal
Reserve Bank
of Philadelphia.
This article is
available free of
charge at www.

Business Review Q2 2012 19

ers often talk about the importance of
commitment, credibility of previous
policy promises, and reputation, and
they look for ways to limit the use of
discretion in their policymaking.
But the new monetary policy tools
introduced during the crisis can make
such time-inconsistency problems
worse by reinforcing the incentives for
financial institutions or other sectors
of the economy to take on excessive
risk — so-called moral hazard. These
firms know that in the midst of severe
problems in financial markets, policymakers might find it extremely difficult
to refrain from acting as lender of last
resort to rescue them, even if doing so
would lead to better risk-taking incentives in the future. Such a policy of
refraining from bailouts would not be
credible or time-consistent. But knowing this, firms have less incentive to refrain from excessive risk-taking in the
first place, making the likelihood that
policymakers might face a situation in
which a firm will need to be rescued
even greater. Thus, with new tools now
at policymakers’ disposal, it is important that they understand the interplay
between time inconsistency and moral
hazard. As we’ll discuss below, we
think it is important for central banks
to consider ways in which they can
limit discretion and use these tools in a
systematic, or rule-like, way.
Although “time-inconsistency” is
an economic concept, it affects almost
everyone at some time or another.
Consider Jane and her parents, who
have given Jane a bedtime rule. On a
school night, Jane must turn off the
TV, laptop, and smartphone, as well as
unplug the electric guitar and amplifier
at 9 p.m. and go to bed. The parents’
goal of setting the rule is for Jane to
be well rested for school. They also
anticipate that without a rule, it will be
very costly negotiating bedtime every
20 Q2 2012 Business Review

school night with Jane, whose goal is
to watch TV, IM her friends, and play
guitar (all at the same time!).
How the rule works in practice,
however, is different than intended.
One school night at 9 p.m., Jane complains loudly and persistently to her
parents that there is a TV show that
she must watch. Her complaints impose high enough costs on her parents
that they relent and give Jane more
time before going to bed.
What do you think will happen
on future school nights? Jane reasons
that because her parents have deviated
from their bedtime rule once, they are
likely to do so again. In other words,
the bedtime rule has lost its credibility.
The loss of credibility gives Jane the
incentive to test her parents’ willing-

The key elements are: (a) the central
bank engages in discretionary policy
because it is next to impossible to credibly commit today to follow rules in the
future; (b) the central bank and the
private sector can have different goals;
(c) the monetary policy “game” is repeated over and over; and (d) the central bank and the private sector each
believe the other will act in its own best
interest, given previous actions and
outcomes. When the central bank engages in discretionary monetary policy,
say, by cutting interest rates in an attempt to boost employment in the short
to medium run, the private sector has
incentives to challenge the credibility
of the central bank’s commitment to
price stability over the medium to longer run, as Jane did with her parents’

The new monetary policy tools introduced
during the crisis can make such timeinconsistency problems worse by reinforcing
the incentives for financial institutions or other
sectors of the economy to take on excessive
risk — so-called moral hazard.
ness to stand by their bedtime rule on
future school nights. She doubts that
her parents are prepared to bear the
costs necessary to enforce the bedtime
rule in the future. Jane’s parents have
lost their reputation for following their
bedtime rule.
This bedtime story shares much in
common with the canonical monetary
policy “game” facing central banks.1

Our interest is in the class of monetary policy
“games” that focus on the economic costs the
private sector can impose on a central bank
engaged in discretionary monetary policy. Economic costs are generated by, for example, disagreements over the (specific) goals of monetary
policy. There are monetary policy “games” that
include political costs. Political costs can arise
because pre-election promises and post-election
outcomes are not time-consistent.

bedtime rule. Over time, the public will
learn by experience whether the central bank’s commitment is sustained,
and the central bank will develop a
reputation for either making credible
commitments or not.
While time-inconsistency problems will arise when a central bank
changes its goals for inflation and
output growth over time,2 this is not
the only, or even main way, it arises
in monetary policymaking. Similar to
Jane’s parents’ experience with their

The seminal reference is the paper by Robert

bedtime rule, time-inconsistency is
driven by incentives that encourage
a central bank to deviate today from
a previously announced policy.3 Even
though there are well-known benefits
to having policymakers commit to engage in systematic or rule-like behavior
over time and limit their use of discretion, full commitment by a central
bank is not possible.4 That is, there
is no credible way for a policymaker,
before the fact, to promise always and
everywhere not to take discretionary
actions and follow rules announced
earlier. However, while full commitment is not feasible for real world
central banks, economics can provide
alternative ways to limit discretion and
tie the hands of policymakers, thereby
yielding better economic outcomes.
One such method is reputation; another is central bank independence.
Reputation. The current U.S.
monetary policy regime has been associated with great diversity on the
FOMC led by Chairmen as different as
William McChesney Martin, Arthur
Burns, Paul Volcker, Alan Greenspan,
and Ben Bernanke.5 Under Chairman Martin, the FOMC established
its reputation with a long period of low
inflation, which is often credited with
the sustained real growth experienced

These incentives are part of an economic
environment in which market participants and
policymakers act rationally.

See the 2008 and 2010(a) speeches by Charles
Plosser and the paper by John Taylor. Although
rule-like behavior generally yields better outcomes than discretion, it may not be desirable
to entirely rule out discretion by policymakers in
all cases, especially in a democracy. In the U.S.
democratic system, the make-up of the legislative, executive, and judicial branches changes
over time by design. Future Congresses, Presidents, and federal judges can repudiate current
law constrained only by the U.S. Constitution
and its legal interpretation.

during his tenure. Responsibility for
the disinflation of the 1980s is often
attributed to the FOMC because it rebuilt its anti-inflation reputation under
Chairman Volcker after having lost it
in the 1970s.6
These examples suggest that timeconsistency problems can be solved by

While full commitment is not feasible for real
world central banks, economics can provide
alternative ways to limit discretion and tie the
hands of policymakers, thereby yielding better
economic outcomes.
reputation when it fills in gaps created
by a lack of commitment.7 A central
bank can use a reputation for being
intolerant of high inflation to commit
to low inflation.8 Although reputation can surmount time-consistency
problems, a study by Kenneth Rogoff
shows that reputation alone cannot
determine the inflation rate for an
economy.9 Instead, private-sector market participants must agree about the
inflation rate on which to focus, given
that many inflation rates are possible.
But this creates a problem for central
banks. Because the way in which
market participants determine which
inflation rate they believe will prevail
is beyond the control of policymakers,
a central bank depending only on its


Martin served as Federal Reserve Chairman
from 1951 to 1970; Burns served 1970-1978;
Volcker from 1979-1987; Greenspan from 19872006; and Bernanke from 2006 to the present.

reputation of being tough on inflation
will eventually lose control of inflation
in the long run.
There is at least one partial solution to this public-private coordination problem. The solution is to have
the government and the central bank
strike a contract that creates incen-


tives for the central bank to adopt
low-inflation policies. In a 1995 study,
Carl Walsh provides the first example
in which a contract between the
government and its central bank is a
means to coordinate market participants’ beliefs about policies that yield
low inflation.10 Since the 1980s, several
countries have altered the design of
their central banks by offering monetary policymakers a contract with
inducements to achieve, say, a low
inflation rate averaged over three to
five years. While such contracts can
help, experience with these contracts
teaches us that central bank reputations are fragile unless supported by
actual achievements.
Central Bank Independence.
Designing a central bank so that its
monetary policy decisions are inde-

See the 2007 speech by Charles Plosser.

For a nontechnical exposition of how reputation can support a central bank in attaining low
inflation, see the article by Herb Taylor.

The 1985 paper by Kenneth Rogoff provides
an example of the importance of the central
bank’s reputation for supporting a low inflation
policy that has been interpreted as explaining
the Volcker deflation of the early 1980s. For a
nontechnical discussion of these issues, see the
article by Herb Taylor.


See the 1989 study by Rogoff.

Walsh studies a wage contract between the
government and the central banker. The contract specifies an inflation goal and a wage for
the central banker. The more negative actual
inflation is net of the inflation goal, the higher
is the central banker’s wage. Walsh argues that
his interpretation of the contract between the
central bank and the government can be generalized. The contract can include rewards and
punishments based on things other than wages
to encourage the central bank to achieve the
outcomes desired by the government.

Business Review Q2 2012 21

pendent of the political process can
also help moderate time-consistency
problems.11 In the U.S., several Congresses and Presidents have delegated
monetary policy to the Federal Reserve
and Federal Open Market Committee
(FOMC). This sort of independence
seems to be necessary for a central
bank to wield its reputation as a pledge
to keep inflation low. Nonetheless,
central bank independence is no guarantee that similar pledges will always
lead to low inflation as the Fed and
the country learned during the Great
Inflation of the 1970s.
The Fed responded to the crisis
with some innovative policy tools,
including paying interest on the excess
reserves that banks hold in their accounts at the Fed, setting up special
lending facilities, and engaging in
large-scale purchases of assets that
increased the size of the Fed’s balance
sheet. These tools have expanded the
scope of discretion available to the
Fed. But as the time-inconsistency
literature indicates, regardless of how
necessary the exercise of discretion
during the crisis may have been, it
presents the Fed with the possible loss
of credibility and independence.
Interest on Excess Reserves:
Fed Independence and the Balance
Sheet. In October 2008, Congress and
the President gave authority to the
Board of Governors to pay interest on
excess reserves (IOER). This authority
means the Fed compensates private
banks on reserves they hold at the
Fed that are in excess of the reserves
required by Fed regulation. The return on the reserves in excess of the
required reserves is the IOER. The
Board of Governors has discretion to


See the speech by Charles Plosser (2010b).

22 Q2 2012 Business Review

set the IOER, which it does in consultation with the FOMC.
The economist and Nobel laureate
Milton Friedman argued that a central
bank should pay interest on reserves to
improve financial market efficiency.12
When a central bank pays IOER, the
difference between the rate of return

Designing a central
bank so that its
monetary policy
decisions are
independent of the
political process can
also help moderate
a bank earns on reserves it holds at
the Fed and what it would earn by
investing in short-term assets (e.g., in
the money markets) is reduced, if not
eliminated. Thus, banks no longer
have a reason to look for ways to avoid
an implicit tax on their reserve holdings, thereby increasing efficiency in
the intermediation process. However,
Friedman also noted that inherent in
IOER is a trade-off. Greater financial
market efficiency resulting from paying
IOER may align the interests of the
fiscal authority too closely with those
of the central bank. Friedman’s argument is that when taxes fund IOER
payments to private banks, the balance
sheet of the central bank becomes
entwined with the fiscal authority.13

See the study by Milton Friedman and the
paper by Thomas Sargent.

When IOER are financed by taxes, the budget constraints of the central bank and the rest
of the government are explicitly tied together.
Thomas Sargent discusses IOER and central
bank independence in the context of Friedman’s monetary policy proposals.

This raises questions about the central
bank’s independence.
The trade-off becomes starker
when we consider the impact the
IOER operating mechanism can have
on the Fed’s balance sheet. Two different kinds of IOER operating mechanisms have been proposed for the Fed
once monetary policy returns to more
normal operating conditions.14 Under
the corridor system, the Fed’s policy
rate would lie within a range bounded
below by the IOER rate and above by
the Fed’s discount rate. The discount
rate is the rate the Fed charges on
short-term loans it makes to banks
facing temporary liquidity needs that
come to borrow at the Fed’s discount
window. The corridor system is consistent with the monetary policy procedures the Fed employed for 25 years
or more prior to the financial crisis.
Since the Fed did not pay interest on
excess reserves during this period, the
IOER rate was implicitly zero, and the
Fed’s policy rate, the fed funds rate, lay
below the discount rate.
Whether the IOER rate is zero or
not, the corridor system only requires
that the IOER rate be less than the
policy rate for private banks to want to
minimize the opportunity cost of holding excess reserves. This cost reflects
the best alternative use of these funds
for banks (i.e., the return banks can
earn by investing in other assets). An
implication is that banks’ demand for
excess reserves will fall as the policy
rate rises and the opportunity cost
increases. This demand does not go all
the way down to zero because the rate
charged at the discount window, which
is greater than the policy rate, is an incentive for a bank to hold at least some
excess reserves as insurance against
unexpected liquidity needs. Converse-


The study by Marvin Goodfriend and the
one by Todd Keister, Antoine Martin, and
James McAndrews analyze the IOER operating
mechanisms in full.

ly, a fall in the policy rate encourages
banks to hold more reserves, since the
opportunity cost of holding those reserves has fallen. When the IOER rate
is non-zero and less than the policy
rate, the opportunity cost of holding
excess reserves limits the amount that
banks are willing to hold. Reserves are
a liability on the Fed’s balance sheet,
which are offset by the assets the Fed
holds, mainly marketable securities.
By limiting the amount of reserves, the
corridor system puts a constraint on
discretionary use of the Fed’s balance
sheet by placing an upper bound on
its size — it gives the balance sheet a
“small footprint.”
The other IOER operating
mechanism is called the floor system.
Under the floor system, the central
bank’s policy rate is set equal to the
IOER rate. This equality implies that
private banks face no opportunity cost
when holding excess reserves. Under
this system, the demand for excess
reserves does not respond to the IOER
policy rate, and the central bank always supplies the amount of reserves
that meets the demand for reserves of
private banks.
Essentially, the Fed has been operating under the floor system for the
past two years since the depths of the
crisis. Notice that the independence of
the IOER policy rate from the supply
of excess reserves in the floor system
gives the Fed two policy tools: the
IOER rate and the size (and composition) of the Fed’s balance sheet.15
Under the floor system, the Fed has
been able to saturate banks with excess
reserves to satisfy liquidity needs in
financial markets without having to
change the IOER policy rate, that is,

Under the floor system, the demand for
reserves is not determined by the price — the
IOER policy rate — in the sense that the supply
of reserves is any amount that is consistent
with the IOER policy rate; see the article by
Goodfriend and the one by Keister, Martin, and

without having to alter the stance of
monetary policy.
This benefit that the floor system
can bestow during a financial crisis
needs to be weighed against the potential costs of such a system. A central
bank using the floor system faces the
potential of a very large balance sheet,
that is, one with a “big footprint.” In
fact, reserves are potentially in unlimited supply at the IOER policy rate, so
the floor system calls into question the
credibility of commitments to limit the
size of the Fed’s balance sheet. As long
as the Fed’s balance sheet is seen as a
policy tool with little or no costs, there
likely will be those who want to employ it to solve problems even if the expected benefits are small or to achieve

some limits on the Board’s discretionary authority under 13(3). In particular, the Board must now act in concert
with the Treasury to broadly supply
liquidity to the financial system rather
than to assist a financial firm that is
in trouble. Nonetheless, the Board
retains substantial discretion to employ
section 13(3) because the Dodd-Frank
Act imposes few other restrictions on
the uses to which the Fed can put its
balance sheet.
The Fed Balance Sheet: Large
Scale Asset Purchases. Large scale asset purchases refer to policies in which
the Fed buys long-term non-Treasury
and Treasury securities. Purchases of
mortgage-backed securities (MBS) and
government agency (i.e., Freddie Mac,

A central bank using the floor system faces the
potential of a very large balance sheet, that is,
one with a “big footprint.”
goals outside the realm of monetary
policy, such as supporting particular
industrial sectors of the economy. Such
policy actions risk not only the Fed’s
credibility but its independence as well.
The Fed Balance Sheet: Section 13(3). During the financial crisis,
for the first time since the 1930s, the
Board of Governors invoked section 13(3) of the Federal Reserve
Act to offer liquidity to particular
financial market participants. Prior
to being amended by passage of the
Dodd-Frank Wall Street Reform and
Consumer Protection Act in July 2010,
section 13(3) granted the Board the
authority to discount securities of
“corporations, partnerships, and individuals” when it deemed there were
“unusual and exigent circumstances.”
The Board used this authority to set
up several term lending facilities and
create entities that discounted private
securities.16 The Dodd-Frank Act put

Fannie Mae, and Federal Home Loan
Banks) debt helped to support housing finance. Buying MBS and agency
debt broke a self-imposed Fed rule of
a “Treasuries-only balance sheet” that
dated at least to the Treasury-Fed Accord of March 1951.17 However, these
purchases were motivated by a desire
to shore up distressed financial markets and were justified by the Fed’s responsibilities as the U.S.’s lender of last

Examples are the Asset-Backed Commercial
Paper Facility, Money Market Fund Liquidity
Facility, the Term Asset-Backed Securities Loan
Facility, Term Asset Lending Facility, and Maiden Lane, Maiden Lane II, and Maiden Lane
III. For more details, see the 2010(b) speech by
Charles Plosser.

From 1971 to 2003, the Fed’s balance sheet
held agency debt. These holdings of nonTreasury securities were tiny compared with
the stock of Treasury securities on the balance
sheet. The Fed’s balance sheet consisted only
of Treasury securities from January 2004 to
September 2008.

Business Review Q2 2012 23

resort.18 The FOMC has also scaled up
its purchases of longer-dated Treasury
securities for the Fed’s balance sheet
— the so-called quantitative easing
program. Having already reduced its
policy rate, the fed funds rate, to essentially zero, the Fed began purchasing longer maturity Treasuries with
the goal of lowering long-term interest
rates. The large scale asset purchases
programs enlarged the Fed’s balance
sheet as well as altered its composition
and maturity structure.19
A concern of holding MBS on
the Fed’s balance sheet is that moral
hazard becomes incorporated into the
time-consistency problem.20 Having
seen the Fed purchase non-Treasury
assets, market participants may come
to expect that the Fed will adopt a
policy to purchase other assets with
credit risk greater than Treasuries or
even than MBS.21 This might induce
these participants to take on excessive risk. The expense of such policies
could fall on taxpayers.22

David Small and James Clouse discuss the
legal restrictions on monetary policy and the
Fed’s balance sheet prior to IOER and the
Dodd-Frank Act. James Clouse, Dale Henderson, Athanasios Orphanides, David Small, and
Peter Tinsley extend this analysis to environments in which the zero bound on the federal
funds rate binds.

Prior to the crisis, the Fed aimed its Treasuries-only balance sheet at replicating approximately the maturity structure of outstanding
Treasury securities.


See the 2009 speech by Charles Plosser.

Current policy for the Fed’s MBS and agency
debt holdings is contained in the FOMC statement of August 10, 2010 in which the FOMC
announced that the Fed’s balance sheet will not
be allowed to shrink and that it would reinvest
principal payments from agency debt and
agency mortgage-backed securities in longerterm Treasury securities.

For example, the U.S. Treasury has committed to absorbing the Maiden Lane facilities
on the Fed’s balance sheet, according to the
Treasury-Fed joint statement, “The Role of the
Federal Reserve in Preserving Financial and
Monetary Stability,” of March 23, 2009. However, this commitment has yet to be fulfilled

24 Q2 2012 Business Review

Without constraints on the composition of the Fed’s balance sheet,
discretion may also encourage time-inconsistent policies independent of the
amount of credit risk or interest-rate
risk the Fed might take on its balance
sheet.23 Instead, MBS holdings can
prompt expectations that the Fed’s balance sheet is a tool that could be put

ers of section 13(3), say, to a 120-day
window during which the Fed would
seek public support from the Treasury
and congressional leadership to continue the emergency lending in a crisis for
an additional 60-day period. Assuming
the extra 60-day period is granted, the
Fed would have six months to manage
the crisis during which time Congress

Without constraints on the composition of
the Fed’s balance sheet, discretion may
also encourage time-inconsistent policies
independent of the amount of credit risk or
interest-rate risk the Fed might take on its
balance sheet.
to uses outside the realm of monetary
policy. When market participants
come to embrace these expectations,
the Fed’s credibility and reputation
suffer, and this makes it more costly for
the Fed to achieve its monetary policy
Proposals to Sustain Fed Independence and Constrain the Balance
Sheet. Without systematic policy or
rule-like behavior to constrain discretion, are there other actions that could
raise the hurdle for the Fed to deviate from widely agreed-to policy rules?
Let’s discuss a few possibilities.
A good initial step is the restrictions imposed by the Dodd-Frank Act
on the Board’s use of section 13(3).
Another step could be for the Board to
announce that, in the future, it would
limit the use of the discretionary pow-

and, at the moment, appears to have fallen by
the wayside.
Holding MBS on the Fed’s balance sheet
most likely does not generate much credit risk
given that market participants believe that
at least some of these securities have implicit
U.S. government guarantees. The potential for
interest-rate risk from holding MBS is greater
because the maturity duration of the Fed’s balance sheet is longer.

and the President could enact legislation aimed at resolving the crisis.
By adopting this proposal, the
Board of Governors would impose
constraints on a future Board. This
is a theme that runs through the academic literature on time-inconsistency:
designing constraints to minimize the
discretion available to future policymakers. It is always possible for a future
Board to decide to deviate from this
constraint, but such an action could
entail its own costs in the form of
stronger congressional prohibitions on
Fed discretion. For example, the Fed
could find itself restricted to lending
under section 13(3) only when there
is a request from the Treasury and
Another possibility for limiting
Fed discretion is to have the Treasury
and Congress become increasingly
responsible for taking discretionary
actions about lending during the “unusual and exigent circumstances” of a
financial crisis, which seems reasonable given that this type of lending is
part of fiscal policy. For example, the
Treasury and Fed could negotiate and
commit to an accord under which the
Treasury could agree that during a

financial crisis it would exchange its
own securities for non-Treasury securities purchased and held by the Fed,
say, after 120 days.24 With such an accord, fiscal policy remains outside the
province of the Fed, but policy has the
flexibility to respond to a crisis in the
short run. Once again, this would give
Congress and the Treasury time to prepare a legislative response to a crisis.
Committing to a corridor system, with
a positive IOER rate, would dovetail
with these proposals.
Congress delegated authority for
monetary policy to the Federal Reserve
System beginning with its founding in
1913. Inherent in monetary policy are
time-inconsistency problems that are
not eliminated by making the central
bank independent. Time-consistent

See the 2010(b) speech by Plosser.

policy will remain a problem for central banks because current and future
policymakers will not conduct policy in
a systematic manner without credible
commitments to explicit rules. Ample
theory and empirical evidence exist to
support the view that limiting discretionary behavior yields better economic outcomes over the long run.
The Fed reacted to the recent financial crisis by employing its balance
sheet in innovative ways. Much credit
should be given to the Fed for these
actions. However, the Fed may find it
increasingly difficult to reduce the size
of its balance sheet and return it to a
Treasuries-only balance sheet without
a commitment to explicit rules to do
so. In the absence of such rules, the
Fed’s balance sheet remains a discretionary tool carrying the risk of being
used for activities unrelated to the
Fed’s monetary policy mandate. Engaging in these policies would present

the Fed with a loss of credibility and
The Treasury-Fed Accord
of March 1951 helped William
McChesney Martin and his colleagues
on the FOMC to establish a tradition
of Fed independence and an admirable
record of monetary policy. The accord
helped release the Fed from an obligation to support the price of U.S. government debt, which it had done since
World War II. This history indicates
that, at this moment, there is a need
for a new Treasury-Fed accord. A new
accord should contribute to maintaining a credibly independent Fed by
correctly aligning incentives between
it, the Treasury, and Congress. The
proposals suggested here are not the
final words on monetary policy reform,
but such reforms are of profound importance for the future of the Federal
Reserve System and the U.S. economy
in the post-crisis world. BR

Business Review Q2 2012 25

Calvo, Guillermo A. “On the Time Consistency of Optimal Policy in a Monetary
Economy,” Econometrica, 46:6 (1978), pp.
Clouse, James, Dale Henderson, Athanasios Orphanides, David H. Small, and
Peter A. Tinsley. “Monetary Policy When
the Nominal Short-Term Interest Rate Is
Zero,” B.E. Journal of Macroeconomics, 3:1
(2003), Article 12.
Friedman, Milton. A Program for Monetary Stability. New York: Fordham University Press, 1960.
Goodfriend, Marvin. “Interest on Reserves
and Monetary Policy,” Federal Reserve
Bank of New York Economic Policy Review, 8:1 (2002), pp. 13-29.
Keister, Todd, Antoine Martin, and James
McAndrews. “Divorcing Money from
Monetary Policy,” Federal Reserve Bank of
New York Economic Policy Review, 14:2
(2008), pp. 41-56.
Kydland, Finn E., and Edward C. Prescott.
“Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of
Political Economy, 85:1 (1977), pp. 473-91.
Plosser, Charles. “Output Gaps and Robust Policy,” speech to the 2010 European
Banking and Financial Forum at the Czech
National Bank, March 23, 2010a.

26 Q2 2012 Business Review

Plosser, Charles. “The Federal Reserve
System: Balancing Independence and
Accountability,” speech to the World Affairs Council of Philadelphia, February 17,
Plosser, Charles. “Ensuring Sound Monetary Policy in the Aftermath of Crisis,”
speech for the U.S. Monetary Policy Forum, Chicago Booth School of Business,
February 27, 2009.
Plosser, Charles. “The Benefits of Systematic Monetary Policy,” speech to the National Association for Business Economics,
Washington Economic Policy Conference,
March 3, 2008.
Plosser, Charles. “Credibility and Commitment,” speech to the New York Association for Business Economics, March 6,
Rogoff, Kenneth. “The Optimal Degree of
Commitment to an Intermediate Monetary
Target,” Quarterly Journal of Economics,
100:4 (1985), pp. 1169-89.
Rogoff, Kenneth. “Reputation, Coordination, and Monetary Policy,” in Robert J.
Barro, ed., Modern Business Cycle Theory.
Cambridge, MA: Harvard University Press,
1989, pp. 236-64.

Sargent, Thomas J. “Where to Draw Lines:
Stability Versus Efficiency,” New York
University Department of Economics, unpublished paper (2010).
Simons, Henry C. “Rules versus Authorities in Monetary Policy,” Journal of Political Economy, 44:1 (1936), pp. 1-30.
Small, David H., and James Clouse. “The
Limits the Federal Reserve Act Places on
the Monetary Policy Actions of the Federal
Reserve,” Annual Review of Banking Law,
19 (2000), pp. 553-79.
Strotz, Robert. “Myopia and Inconsistency
in Dynamic Utility Maximization,” Review
of Economic Studies, 23:3 (1956), pp. 16580.
Taylor, Herb. “Time Inconsistency: A Potential Problem for Policymakers,” Federal
Reserve Bank of Philadelphia Business
Review (March/April 1985), pp. 3-12.
Taylor, John B. “A Historical Analysis of
Monetary Policy Rules,” in John B. Taylor,
ed., Monetary Policy Rules. Chicago, IL:
University of Chicago Press, 1999, pp. 319340.
Walsh, Carl. “Optimal Contracts for Central Bankers,” American Economic Review,
85:1 (1995), pp. 150–67.

Research Rap

Abstracts of
research papers
produced by the
economists at
the Philadelphia

You can find more Research Rap abstracts on our website at:
publications/research-rap/. Or view our working papers at:

This paper examines how supply-side policies may play a role in fighting a low aggregate demand that traps an economy at the
zero lower bound (ZLB) of nominal interest
rates. Future increases in productivity or
reductions in mark-ups triggered by supplyside policies generate a wealth effect that
pulls current consumption and output up.
Since the economy is at the ZLB, increases
in the interest rates do not undo this wealth
effect, as will be the case outside the ZLB.
The authors illustrate this mechanism with
a simple two-period New Keynesian model.
They discuss possible objections to this set
of policies and the relation of supply-side
policies to more conventional monetary and
fiscal policies.
Working Paper 11-47, “Supply-Side Policies
and the Zero Lower Bound,” Jesús FernándezVillaverde, University of Pennsylvania, and
Visiting Scholar, Federal Reserve Bank of
Philadelphia; Pablo Guerrón-Quintana, Federal Reserve Bank of Philadelphia; and Juan F.
Rubio-Ramírez, Duke University, and Visiting
Scholar, Federal Reserve Bank of Philadelphia
The authors examine the optimal labor
market-policy mix over the business cycle.
In a search and matching model with
risk-averse workers, endogenous hiring and
separation, and unobservable search effort,
they first show how to decentralize the
constrained-efficient allocation. This can
be achieved by a combination of a

tion tax and three labor-market policy instruments, namely, a vacancy subsidy, a layoff
tax, and unemployment benefits. The authors
derive analytical expressions for the optimal
setting of each of these for the steady state
and for the business cycle. Their propositions
suggest that hiring subsidies, layoff taxes, and
the replacement rate of unemployment insurance should all rise in recessions. They find
this confirmed in a calibration targeted to the
U.S. economy.
Working Paper 11-48, “Optimal Labor-Market
Policy in Recessions,” Philip Jung, University of
Mannheim, and Keith Kuester, Federal Reserve
Bank of Philadelphia
The authors document that the U.S. nonfinancial corporate sector became a net lender
in the 2000s, using aggregate and firm-level
data. They develop a structural model with
investment, debt, and equity. Debt is fiscally
advantageous but subject to a no-default
borrowing constraint. Equity allows the firm
to suspend dividends when the cash flow is
negative. Firms accumulate financial assets
for precautionary reasons, yet value equity as
partial insurance against shocks. The calibrated model replicates the prevalence of net
savings in the period 2000-2007 and attributes the rise in corporate savings over the
past 40 years to lower dividend taxes.
Working Paper 12-1, “The Macroeconomics of
Firms’ Savings,” Roc Armenter, Federal Reserve
Bank of Philadelphia, and Viktoria Hnatkovska,
University of British Columbia and the Wharton

Business Review Q2 2012 27

This paper assesses how various approaches to modeling the separation margin affect the ability of the
Mortensen-Pissarides job matching model to explain
key facts about the aggregate labor market. Allowing for
realistic time variation in the separation rate, whether
exogenous or endogenous, greatly increases the unemployment variability generated by the model. Specifications with exogenous separation rates, whether constant
or time-varying, fail to produce realistic volatility and
productivity responsiveness of the separation rate and
worker flows. Specifications with endogenous separation rates, on the other hand, succeed along these
dimensions. In addition, the endogenous separation
model with on-the-job search yields a realistic Beveridge
curve correlation and performs well in accounting for
the productivity responsiveness of market tightness.
While adopting the Hagedorn-Manovskii calibration
approach improves the behavior of the job finding rate,
the volume of job-to-job transitions in the on-the-job
search specification becomes essentially zero.
Working Paper 12-2, “Exogenous vs. Endogenous Separation,” Shigeru Fujita, Federal Reserve Bank of Philadelphia,
and Garey Ramey, University of California, San Diego
Using an estimated dynamic stochastic general equilibrium model, the author shows that shocks to a common international stochastic trend explain, on average,
about 10 percent of the variability of output in several
small developed economies. These shocks explain
roughly twice as much of the volatility of consumption
growth as the volatility of output growth. Country-specific disturbances account for the bulk of the volatility
in the data. Substantial heterogeneity in the estimated
parameters and stochastic processes translates into a
rich array of impulse responses across countries.
Working Paper 12-3, “Common and Idiosyncratic Disturbances in Developed Small Open Economies,” Pablo
Guerrón-Quintana, Federal Reserve Bank of Philadelphia

28 Q2 2012 Business Review

The authors survey Bayesian methods for estimating
dynamic stochastic general equilibrium (DSGE) models
in this article. They focus on New Keynesian (NK)
DSGE models because of the interest shown in this
class of models by economists in academic and policymaking institutions. This interest stems from the ability
of this class of DSGE model to transmit real, nominal,
and fiscal and monetary policy shocks into endogenous
fluctuations at business cycle frequencies. Intuition
about these propagation mechanisms is developed by
reviewing the structure of a canonical NKDSGE model.
Estimation and evaluation of the NKDSGE model rests
on being able to detrend its optimality and equilibrium
conditions, to construct a linear approximation of the
model, to solve for its linear approximate decision rules,
and to map from this solution into a state space model
to generate Kalman filter projections. The likelihood
of the linear approximate NKDSGE model is based
on these projections. The projections and likelihood
are useful inputs into the Metropolis-Hastings Markov
chain Monte Carlo simulator that the authors employ
to produce Bayesian estimates of the NKDSGE model.
The authors discuss an algorithm that implements this
simulator. This algorithm involves choosing priors of
the NKDSGE model parameters and fixing initial conditions to start the simulator. The output of the simulator is posterior estimates of two NKDSGE models,
which are summarized and compared to results in the
existing literature. Given the posterior distributions, the
NKDSGE models are evaluated with tools that determine which is most favored by the data. The authors
also give a short history of DSGE model estimation as
well as point to issues that are at the frontier of this
Working Paper 12-4, “Bayesian Estimation of DSGE
Models,” Pablo Guerrón-Quintana, Federal Reserve Bank
of Philadelphia, and James Nason, Federal Reserve Bank of

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102