The Cumulative Impact Of New Rules On U.S. Monetary Policy, Macroprudential Regulation by Federal Financial Analytics
This paper assesses the assumptions on which U.S. monetary policy and macroprudential regulation are premised to determine the extent to which their goals can be achieved given the structural changes in the U.S. financial system. The post-crisis financial framework is built on what was to be a firm foundation of effective micro- and macro-prudential policy based on sound monetary policy and informed by an understanding of the catastrophic financial-stability costs of unduly-lenient supervision and misguided central-bank actions. None of these bulwarks is performing as hoped.
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Positive feedback loops between regulatory and monetary policy are shown in this paper to be short-circuited because improvements in bank resilience have been countered by regulatory arbitrage that shifts key financial-intermediation activities outside of banks, blunting the ability of the Federal Reserve to implement monetary policy. A negative feedback loop then results that can be interrupted only by effective macroprudential regulation. However, limits on the ability of U.S. regulators to reach beyond banks undermines macroprudential regulation and thus exacerbates negative feedback – macroprudential standards compound microprudential regulatory costs and spur still more finance outside regulated banks to entities that are unresponsive to monetary policy.
This poses significant financial-stability, macroeconomic, and even social-policy challenges. To the extent that banks lose their ability to provide financial-intermediation services that are either not replaced by non-banks or replaced in ways that raise costs or undermine market liquidity, under-served populations will lack access to sustainable credit and macroeconomic growth could become acutely procyclical at cost to national income inequality. The role of central banks becomes still more crucial because the choices made by the Federal Reserve to balance its goals become so critical that the central bank is essentially picking winners and losers across the economy and among specific asset classes.
It is thus critical to balance the policy framework regulators can affect – the rules that govern financial-market structure, monetary policy, and macroprudential regulation – to ensure that conflicts are quickly resolved and new mechanisms to protect financial stability and macroeconomic policy are put rapidly into place. It is suggested that policy-makers assess the cumulative impact of the new policy framework to identify unanticipated implications for monetary policy and financial stability. With an initial, market-focused assessment of cumulative effects, U.S. regulators can determine the best way to rebalance the prudential framework without watering it down, revising monetary-policy transmission channels and enhancing macroprudential regulation as needed.
Macroprudential Regulation – The Changing Nature of U.S. Financial Intermediation
Financial intermediation is the critical function in which deposits acquired from individuals and businesses are converted into the loans that power economic growth and meet consumer needs. Effective financial intermediation requires not only safe and stable transformation of deposits into loans, but also an effective financial market in which payments are quickly and accurately transferred, equity and other trades are executed without risk, and assets housed for custody or long-term use are appropriately safeguarded. All of these financial-market functions were sorely tested in the financial crisis and have since changed dramatically due not only to the post-crisis regulatory framework, but also to technological changes and geopolitical factors.
It is not within the scope of this paper to provide a detailed discussion of how financial intermediation and related functions have been transformed – that would require a book-length paper on its own. However, because the changing nature of financial intermediation directly affects both monetary-policy implementation and the prospects for macroprudential regulation, it is important to assess how actions within the scope of federal policy have altered the functioning of U.S. financial intermediation and how this in turn affects the ability and willingness of banks to participate in monetary-policy operations, the ability of the FRB to implement monetary policy, and the benefits of macroprudential regulation as a roadblock to potential procyclicality or other systemic risks.
Throughout this paper, we address not only what are often called “microprudential” regulations, but also macroprudential actions. Microprudential rules are those that govern individual banks to ensure capital adequacy, ample liquidity, and overall safe and sound operations. Although banking-system resilience is achieved to the degree each bank on its own becomes more resilient, financial-system stability may not be achieved or could even be undermined if microprudential rules in aggregate make banks less responsive to monetary-policy signals or if they restructure financial intermediation in new, risky ways. Macroprudential regulation is designed to ensure financial stability by changing the structure of financial markets and/or creating counter-cyclical push-backs against boom/bust trends. However, as we shall show, the intersection between microprudential and macroprudential rules is blurred by regulatory efforts to use each for different purposes and varying views on what macroprudential standards should accomplish.
The Office of Financial Research (OFR) in the U.S. Treasury has observed that credit risk is rising, macroeconomic fundamentals have “deteriorated,” incentives to financial risk-taking are heightened, and improvements in U.S. financial-market resilience are “uneven.” From this and ongoing developments, one can conclude that, at least to date, the sum total of all the new microprudential rules is not having the desired impact on financial-market stability. We here assess why this is the case, guided in part by a recent report by the Committee on the Global Financial System (CGFS) of the Bank for International Settlements (BIS), the central bank of central banks.
A BIS official, Claudio Borio, has looked at the problem of microprudential regulation with specific regard to macroprudential rules, noting that macroprudential rules must be effective because microprudential regulations have two drawbacks:
First, they set the same standards regardless of the impact of an institution’s failure on the financial system. It is as if the same speed limit applied to both trucks and cars. Second, they set the same standards regardless of the financial system’s condition. It is as if the same speed limit applied irrespective of traffic conditions.
The analysis below highlights the rules the CGFS identified as most significant in terms of monetary-policy impact and expands on them also to assess macroprudential implications. We shall inform this discussion by going beyond the current rulebook also to consider the financial-intermediation implications of major pending initiatives so that forward-looking considerations are identified to guide future policy deliberations.
U.S. Financial Intermediation
As noted, it is not within the scope of this paper to provide a detailed discussion of how the financial market has changed in recent years. However, it is critical to recognize that the scope of these changes is profound when considering the regulatory issues applicable only to banks and their monetary-policy and macroprudential implications. Financial intermediation begins with the deposits banks gather that are then used to make loans. Recent research has highlighted the growing importance of what are often called “shadow liabilities.” Key to this sector are money-market funds (MMFs) that, despite the lack of deposit insurance, are able to bid away non-operational deposits (those most penalized under the liquidity regulations discussed below) by paying higher rates. The leverage-capital requirements (see below) also constrain the ability of banks to place these non-operational deposits in excess reserves or other cash-equivalent assets. However, MMFs can now put these deposits to considerable use in the FRB’s alternative monetary-policy instrument: the reverse repurchase program (RRP) facility discussed below. Interestingly, recent data suggest that the RRP is serving increasingly as a backstop for MMFs that may be swamped with quarter-end redemption demands as non-U.S. banks subject only to quarter-end (not quarter-average) leverage rules adjust market-making activities to enhance reported results.
Mutual funds that take investments once housed largely at banks and deploy them for asset holdings (including loan products) have also become a major presence since the crisis, growing from approximately $13 trillion in 2007 to $18 trillion at year-end 2014. The role of banks in the repurchase-agreement arena – another critical source of market funding – has declined by approximately 28 percent in the past four years, with this often attributed not only to large FRB holdings of the bonds typically used in these transactions, but also to the cost of regulations described below.
The credit and market-making capacity of banks shows changes of similar magnitude to that of deposits, with credit increasingly reliant on non-banking institutions and government-sponsored enterprises (GSEs). The chart below presented by FRB Vice Chairman Fischer demonstrates that banks now supply only about one-third of the credit in the U.S. system:
(Source: Board of Governors of the Federal Reserve.17 Note: Credit outstanding consists of domestic private nonfinancial sector debt (43 percent), domestic government debt (27 percent), domestic financial-sector debt (24 percent), and foreign bonds held in the U.S. financial system (5 percent). IC.PF.MF.ETF denotes insurance companies, pension funds, mutual funds, and exchange-traded funds. GSEs are government-sponsored enterprises. Other nonbanks are issuers of asset-backed securities, finance companies, mortgage real estate investment trusts, broker-dealers, funding corporations, and holding companies.)
Mr. Fischer concluded from these and other data that the FRB will face considerable obstacles to effective macroprudential regulation. Many analysts have also relied on these data to suggest that FRB monetary policy is increasingly “pushing on a string” because central-bank policy does not translate into meaningful adjustments in available credit.
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