The New Unwritten Mandate for the Fed

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.