Roy C. Smith and Ingo Walter
In recent testimony before Congress, Janet Yellen noted that
“protecting the US from systemic risk is an unwritten third mandate of the
Federal Reserve,” the other two being keeping inflation under control and
promoting full employment.
Received wisdom says that managing two conflicting goals
requires at least two policy tools. The classic duo of monetary and fiscal
policy to manage inflation and unemployment has encountered plenty of problems
over the years, with atrophied fiscal policy (heavily weighed-down by
entitlement and other non-discretionary spending, and equally heavily
politicized) placing a heavy burden on the Fed – one that is unlikely to go
away anytime soon.
Now comes another policy target: safety and soundness of the
financial system, using the same toolkit (with some unconventional tweaks) that
is already stretched.
The three mandates get in each other’s way, making things
worse rather than better.
Zero interest rate monetary policy and Quantitative Easing were
intended to stimulate consumption and investment spending, boost the trade balance
through a weaker dollar, and cut unemployment. But, in keeping both short and
long term rates well below market levels that would otherwise properly reflect
a debt risk premium and inflation, both policies involve significant
distortions of markets.
Neither policy, however, seems to have been particularly
effective: Economic activity expansion since 2008 has averaged less than 2%,
well below the US historical average of 3.5%.
Though the unemployment rate has fallen from a peak of 10% to just over
6% in the past six years, in June of 2014 only 59% of the civilian labor force
was engaged in full time employment, still less than the 63% employed seven
years earlier. Now comes Obamacare,
encouraging companies to substitute part-time for full-time and duck under
company employment minimums. Around 17% of the labor force today is unemployed,
stuck in part-time work or has given up looking for jobs.
The overall recovery of the US economy from the financial
crisis of 2008 is one of the slowest on record.
It is certainly miserable compared to recoveries from the five previous
US recessions, although defenders can always argue that things would have been
immeasurably worse without the Fed’s unconventional policies. Who knows? We
can’t run the world twice.
The stock market’s sharp recovery is an offset to the gloomy
picture, but even that only reflects a modest 4.2% annualized growth in the
S&P 500 index from its 2007 peak level.
We believe, along with many others, that the ongoing slow
recovery has a lot to do with the curtailment of credit from the banking system
to the real estate, commercial and entrepreneurial sectors of the economy due
to efforts to “control” systemic risk by the Federal Reserve and other
financial regulators.
From 2008 to 2012, US bank loans shrank at a rate of 4% annually – due in large part to de-risking
household, corporate and bank balance sheets in the first couple of years of
the recovery. Since 2012, loans have increased by 3% annually, a significant
relative change but still a very low rate of growth in lending. Recently the
Fed reported that much of the new lending was in the riskiest credit categories
– borrowers that banks have been driven to for profits in an ultra-low interest
rate environment. Heavily affected are small and medium-size businesses that
are both reliant on bank finance and generators of a large proportion of new
jobs in the economy.
For their part, banks have been under severe pressure to
adapt to new regulatory regimes that have crushed several of their pre-crisis profit
centers and added many billions to the cost of complying with the new rules.
These rules are numerous (the Dodd Frank Act spawned about 400 of them) and
have been slow in coming (only about half are finalized even today), which adds
to the uncertainty as to what banks will or will not be permitted to do in the
future.
The biggest banks – those involved with substantial
investment banking activities, and still defending themselves from a torrent of
litigation stemming from industry practices leading up to the financial crisis
– have not earned their cost of equity capital since 2009. This is an important sector of the financial
industry that is struggling to remain viable.
So, is the cost of under-performance in the economy worth
the protection Americans have received by reducing systemic risk in the
financial system? Last time solid economic expansion in the mid-2000s gave way
to a collapse estimated by the Congressional Budget Office to have cost some
$10 trillion in lost GDP, plus vast damage to particularly vulnerable parts of
the population like pension beneficiaries.
The government has not defined systemic risk in the US
financial architecture, other than to set a trigger of $50 billion in assets
for imposing special risk-reducing regulations on the largest banks – a pretty
arbitrary number.
At NYU Stern, the Volatility Lab headed by Nobel Laureate
Robert Engle defines systemic risk as the gross amount of capital a bank would
have to raise to replace capital lost to mark-downs of assets after a stock
market decline of 40% over a six-month period. This approach recognizes that
systemic risk is mainly a function of market risk at a time when markets
undergo sudden, panic-driven changes - as occurred in 2008.
Using this definition, US exposure to systemic risk has
declined by approximately 30% from its peak in 2008. The risk reduction comes mainly from a
shrinking in the size of the larger banks and a lowering of the volatility of
their stock prices. But it suggests as well that there is a trade-off between
squeezing the banks to reduce systemic risk and allowing them to make a living
as providers of risk finance to the global economy.
The most useful thing the Federal Reserve can do now is to
reduce the unsustainable cost of this trade off. It would help if the Fed would
challenge the conventional wisdom that the banks are perpetually powerful,
insatiable, manipulative and almost solely responsible for the crisis and its
resulting economic hardships. This greatly overstates the problems that banks
represent. Indeed, the Fed could say the time has come to return the banks to a
normal, competitive and economically viable state. This can be greatly aided by
saying that Dodd Frank Act has given it (and the Financial System Oversight
Committee, to which it reports) sufficient powers to regulate the US banking
system without having to rely on the voluminous, costly and often unnecessary
stream of new rules incorporated in the Dodd Frank Act.
These new regulations are also costly to regional and
smaller banks. New research shows that local and regional banks fared
substantially better – and with far less reliance on government bailouts – than
the big banks. So a financial system dominated by the need to control six or
eight financial goliaths – controls that affect all the rest of the banks as
well - may not be in the national interest.
Indeed, the Fed has shown that its combination of stress
testing and appraisal of governance and management efforts can force banks to
meet qualitative and well as quantitative standards for “fitness and
properness” in order to be able to return capital to shareholders through
dividends and stock buyback programs. There are only a dozen or so financial
institutions in the country that pose real systemic issues, so the Fed, with supervisory
staff imbedded in these banks, ought to be able to monitor what goes on
sufficiently to meet the key safety and soundness standards.
These standards are based on the idea of reducing leverage
and increasing capital to keep banks safe, but they also need to recognize that
banks have to be sound as well. That means being healthy, sustainable
businesses that attract investors.
Furthermore, the Fed needs to acknowledge that banks require
healthy capital markets in which to raise funding sell loans through securitizations
other avenues. It needs to weigh in on
what to do with Fannie Mae and Freddie Mac, to revive and deepen the
mortgage-backed securities market - an enormous component of the US capital
market that has not recovered much since the crisis, leaving inadequate
availability of mortgage credit to support recovery of the housing sector.
The Fed remains the only institution with the political
independence, credibility and institutional knowledge to do this. Its power to intervene in problematic banks
and nonbanks are considerable. It has to
be the main advocate in government circles for a healthy financial system, one
that does not depend on market-distorting subsidies or intervention, or on
politically inspired but growth-killing regulatory constraints to manage the
delicate task of keeping major banks in line while enjoying the market freedoms
to meet their shareholders’ objectives.
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