Darrell Duffie is a star in the world of finance. He is a Stanford theoretician well known and admired in policy making, academic, and investment circles for his work on financial risk and what needs to be done to at how to fix the pipes and valves" of modern finance.
His “genius,” if you will, for me is also his ability and desire to communicate clearly and simply enough for those of us who have not worked in this field to understand what is is happening, what is wrong with the system, what needs to be fixed, and what is driving future risks. Bottom line: he’s patient.
We sat down at the Hoover Institution at Stanford University where the Shadow Open Market Committee celebrated its 50th Anniversary this week and where he presented his paper on ”The Conduct of Monetary Policy: Evolution from Free Reserves to the Corridor and Floor Systems.”
Here are some of the highlights.
Duffie warns...."the US government is running enormous fiscal deficits, so the amount of Treasury bonds and agency securities in the market is ginormous. It's gotten huge. There's now 28 trillion of treasuries. On the eve of the financial crisis, there was only 7 trillion. And the Congressional Budget Office projects 51 trillion in ten years."
So now its the repo mar\ket that matters more than the Fed funds market
"And so that repo market has become huge. It's now in excess of 4 trillion a day in volumes, whereas the Fed funds market is on the order of 100 billion. But of that, only about 5 billion is really relevant because that's the US bank portion of it"
…and the Fed funds market has not grown.
"...the Fed has a very large balance sheet which is funded by a whole lot of reserves, and the banks are flush with reserves. They don't really need to borrow that much from each other anymore <<that borrowing is the Fed funds market>> , but they do need to finance their bonds in the repo market. And as I mentioned yesterday, the repo market is now the engine room of money markets."
Where the action is and where the risks are...
"That's where the action is and that's where it's difficult to control interest rates. In September 2019, rates blew out hundreds of basis points when it was discovered that key banks didn't have enough reserves. And in the end of the third quarter this year, rates blew out not quite as much, but still triggered some alarm bells when banks were found not to have enough capital to meet their balance sheet requirements, regulatory capital balance sheet requirements."
As for the he corridor system
"...once we ditched the old system of scarcity of money to drive rates, we now have a system by which, as I mentioned, rates are set mainly by a decision of the Fed of the interest rate that it will pay to banks on their deposits at the Fed, which are called reserves. And so that sets, in a way, the floor of this corridor. So you think of a corridor, it's a long, narrow channel, but turn it on its side. The bottom of this or the floor of this corridor is supposed to be the interest rate that the banks get from the Fed on their deposits. And the ceiling would be the interest rate that they would have to pay if they were to borrow from the Fed, which they almost never do."
Explaining the system - warts and all…
"It's not a perfect floor. It's a bit leaky. I can tell you about that if you want. Yeah, I do worry about leaks in the floor. Okay. So it turns out that again, because of bank capital requirements, they don't want to have too many deposits at the Fed because that counts against their capital requirements, surprisingly. And so once they get a lot of reserves there, they're market interest rates can actually go below the deposit rate that the Fed is offering to banks, because the Fed because the banks are not that anxious to have the money, they're happy to lend it out sometimes at even lower rates."
Duffie says the essential problem is not the Fed's to solve but it's up to Congress.
"The central banks were designed from their inception to cure or at least mitigate financial crises by stepping in and providing liquidity. But I would look more to Congress than to the Fed with respect to this issue of the bond markets getting too big relative to the ability of banks to intermediate the market. So as I mentioned, we're looking at a situation in which in ten years there's going to be 50 trillion of Treasury securities out there."
That's just a taste of what is in this interview. Darryl point out flaws in the system, and where they come from. He offers suggestions for making the system work better. There is no 'free-lunch.' Fixes will have costs as well but there are things that can be done. If you are interested in understanding what drives the bank funding market and what causes certain stresses to foam up and overload the system this is the place to do it.”
I highly recommend that you listen to every word he has to say. It’s not only about his brain it’s about his clarity, warmth and even some financial risk humor.
Darrell Duffie is the Adams Distinguished Professor of Managment and Professor of Finance and Senior Fellow at Stanford Institute for Economic Policy Research, Professor of Economics (by courtesy), School of Humanities and SciencesSenior Fellow (by courtesy), Hoover InstitutionResearch Statement
Darrell Duffie’s research interests include over-the-counter markets, banking, financial stability, credit risk, valuation and hedging of derivative securities, financial market infrastructure, the term structure of interest rates, financial innovation, security design, market design, and fintech payments.
Darrell Duffie is The Adams Distinguished Professor of Management and Professor of Finance at Stanford University’s Graduate School of Business. He is a Research Fellow of the National Bureau of Economic Research and a Fellow of the American Academy of Arts and Sciences. Duffie is a past president of the American Finance Association and chaired the Financial Stability Board’s Market Participants Group on Reference Rate Reform. He is an independent director of the Dimensional Funds and a member of the leadership teams of the G30 Working Groups chaired by Tim Geithner on Treasury Market Liquidity and chaired by Bill Dudley on Bank Failures and Contagion: Lender of Last Resort, Liquidity, and Risk Management. Duffie’s most recent book is Fragmenting Markets: Post-Crisis Bank Regulations and Financial Market Liquidity, DeGruyter, 2022. In 2024, Duffie is teaching a new course at Stanford, “The Future of Money and Payments.”
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