Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients on, “Why The Fed Can’t Hide From Financial-Stability Risk.”
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: May 20, 2016
Why The Fed Can’t Hide From Financial-Stability Risk
The FOMC minutes released on Wednesday focused on the top-billing question of a forthcoming interest-rate hike but also included a little-noticed discussion of the condition of U.S. financial regulation. The FOMC concluded not only that post-crisis financial regulation makes the system a lot safer, but also that the FRB may well need to use macroprudential tools that might not work. It might thus need to deploy monetary policy, but this too might not work or prove still more problematic if financial-stability objectives conflict with the central bank’s dual mandate. So, what to do? A new FedFin study concludes that the FRB cannot rest on its microprudential laurels – the macroprudential and monetary-policy problems acknowledged by the FOMC are signs of a larger disconnect in the post-crisis framework. Big banks may well have fortress balance sheets, but the recovery is tepid, markets are volatile, alternative credit providers are in paroxysms, and the Board’s balance sheet is so big that Congress is increasingly contemplating it with hungry eyes.
I knew when we headed into this project that it would face a barrage of skepticism, not least because of funding from The Clearing House. We gratefully acknowledge this not only because it let us take on a project I wanted to do since FedFin in 2011 first spotted potentially perverse consequences of the increasingly complex regulatory framework. The Clearing House also gave FedFin complete editorial and methodological control over the project, ensuring that any of its faults are only our own.
Skepticism of work like this goes deeper, though, than cynicism about who pays for it. In the wake of the cataclysmic financial crisis, it’s no surprise that anything that smacks of regulatory change is characterized as “watering down.” Banks have also done themselves no favors by intra-industry warfare and occasional hyperbole.
But, step back from the rhetoric and the picture isn’t pretty. Yes, the U.S. financial system is on sounder footing than most others, in part because the largest banks here started to clean up their act in concert with their regulators as early as 2009. But, not only is GDP growth lackluster and real unemployment deeply troubling, but we are also in the midst of a profound populist revolt evident most clearly in an election that could throw the U.S. into a political-risk crisis reminiscent of erratic developing countries. If the financial system is as safe as all that, why is growth so mediocre and the nation still so flat-out angry?
I think it’s because reforms to date are choking off what would be, if properly regulated, the traditional engine of sustained, stable recovery through straightforward financial intermediation. Monetary policy cannot work without banks because the FRB simply doesn’t know how to stimulate solid recovery without them. It’s been improvising in often-brilliant fashion since 2008, but the weak link in its policy chain remains the fact that the FRB depends on banks and the Fed’s rules make it very hard for the largest banks – let alone the rest of them – to do the FRB’s bidding.
This isn’t just what I think. Our study relies on 112 studies and speeches from the FRB, BIS, OFR, and other governmental bodies along with major academics. We structured it this way to ensure that conclusions are founded not on our best guess, but rather on what data derived from public sources tells us and should also tell the policy-makers.
Many of the studies we cite show deep unease in U.S. and global quarters about growing signs of profound financial-market imbalances that the new rules may not correct. This is a vital early warning sign. Politics may not let top regulators speak their fears because populist critics will lambaste them for being big-bank puppets, but the fears are there as evidenced by a growing body of empirical research. If we avert our gaze to avoid awkward questions, we run real risks with damaging consequences that will only further undermine the basic framework of prudent regulation needed for long-term growth and income equality.
The solution is not to water down the rules even though they may well be exacerbating these imbalances or to pretend the imbalances aren’t there despite what the data demonstrate. I don’t yet know what the solution is, although I have some suggestions. I do know, though, that we can’t solve these problems if we pretend they aren’t there. And I know that the risks are too urgent to assess the cumulative impact after all the new rules are written, the course of action the FRB indicated to Congress that it planned to follow.
Given that even the FRB knows its macroprudential solution won’t work and its monetary-policy failsafe for financial stability is dubious, it needs quickly to come up with a new way to ensure a smooth, continuing, and stable flow of deposits and investments into loans and production at reasonable return not just to depositors and borrowers and investors, but also to bankers.