Karen Shaw Petrou memorandum to the Federal Financial Analytics clients On the Fed’s empty toolbox.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: October 9, 2015

What does it mean when the FRB says it isn’t at all sure that it can preserve financial stability under stress? Nothing good, especially since Dodd-Frank took away the FRB’s secret weapons. The post-crisis regulatory framework is premised on systemic regulations spotted by the FSOC and implemented by the FRB, but in practice the FSOC has spotted little, designated few, and demanded only a bit from the FRB that is largely yet to be done. Former Vice Chairman Don Kohn devastatingly scoped this out earlier this week when he said that the FSOC has muzzled itself and the FRB is politically incapable of macroprudential action. A conference at the same time at the Federal Reserve Bank of Boston was more diplomatic, but no less devastating. If, then, the FRB cannot regulate, could it ensure financial stability via monetary policy? Some hope so, but last week’s verdict was a definite “probably not.” Do we now just abandon hope and trust the next systemic threat will evaporate by miraculous intervention? Seven years on, that’s a very thin reed.

Banks – especially big banks – are carrying the load for the rest of the financial system because of all the post-crisis rules so far levelled almost exclusively on them. The theory at the start of the regulatory build-out was that regulating banks would by proxy govern everyone else. However, the Fed has finally wised up to the fact that the U.S. financial system is the least dependent on banks of any in the world. As Vice Chairman Stanley Fischer said last week, two-thirds of U.S. credit comes from non-banking. And, of course, deposit products long ago turned into liability ones now shared with mutual funds, securities-financing transactions, repos, and other products. A recent academic study properly dubbed these “shadow liabilities.” Critical infrastructure tasks – think central clearing – are also shifting quickly beyond the reach of banks and, thus, the FRB.

As a result, rules on banks don’t mean compliance by anyone else. In fact, they mean not only asymmetric regulation for like-kind products, but also strong incentives for what was once banking quickly to head to non-banks and, as a result, put itself outside the FRB’s reach. Several FRB officials along with a new study presented last week bemoaned the jurisdiction the central bank is forced to share and the indifference other regulators often have to its pleas, but other regulators remain singularly unmoved.
What then of monetary policy as a financial-market stabilizing force? The President of the Federal Reserve Bank of Boston, Eric Rosengren, last week argued that this is de facto what the FOMC does and should become the central bank’s go-to mandate. All well and good, but the FRB’s ability to transmit monetary policy is as uncertain as its ability to issue macroprudential edicts because, yet again, so much of the financial system has moved outside banking. Monetary policy is constructed on transmission channels that depend on banks subject to the FRB’s will. However, as Mr. Rosengren also pointed out in a paper earlier this year, this is getting harder and harder to do. Shadow liabilities don’t dance to the Fed’s tune and, as a result, asset pricing doesn’t go up or down when the FRB sets rates.
What then to do? As Mr. Fischer suggested last week, unconventional monetary policy may be needed because nothing but an act of law – or, more likely, God – could prompt other regulatory agencies to join the macropru club. The Board is in fact already experimenting with a most unconventional tool: reverse repurchase agreements. These rely not on banks, but rather on MMFs. The hope has been to keep reverse repos small to prevent so much central-bank reliance on MMFs as to turn the tables and make the FRB liable to counterparties about which it has no supervisory clue. But, even if the reverse-repo program remains modest – a bit if given other normalization challenges – the FRB could quickly find itself the market-maker of last resort for those to whom it’s entrusted its funds.

What else could the FRB unconventionally muster to maintain financial stability without macroprudential regulation? Mr. Fischer posited a couple of options – altering the way reserves are structured, for example – but all of these are hypothetical and none is even close to battle-hardened. The only macrpru tool the FRB has confidence in is its stress tests, but these apply only to banks and all are very models-driven. That the model is the Fed’s doesn’t make it necessarily any better than those crafted by big banks. While it’s at least not self-interested like a bank’s model, the FRB’s does serve to correlate risk across the banking industry, making it more susceptible to shocks unforeseen. Big asset managers are happily now starting to stress test, but they’ve hit a hard wall because custody banks can’t hold their cash reserves.

Stress tests may well protect markets under acute stress, but they can’t forestall it. Other macrpu tools are clearly difficult, if not impossible to mandate, let alone to put in place quickly enough to reverse fast-rising asset tides. With monetary policy also not fit for macropru purpose, the FRB really has just one way to stop a crisis: open the spigot. Sad, indeed very sad, but true.