Janet Yellen and the Fed will have to choose.

Photographer: Andrew Harrer/Bloomberg

The Fed Is in an Epic Battle With Itself

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Two Federal Reserve announcements less than a week apart, in contrast to the Federal Open Market Committee’s decision earlier this month, are likely to show that the agency's own goals are in conflict.

The committee setting monetary policy remains accommodative, with readily available credit to support a still-recovering economy; the regulatory arm of the Fed has a different agenda and is working to build a more stable system that incidentally makes credit more expensive and less available.

The first of these announcements was the results of the Dodd-Frank Act stress tests, released Thursday. The second is the Comprehensive Capital Analysis and Review for banks, which will come out Wednesday. The purpose of these examinations is to ensure that bank holdings aren't overly risky and that banks hold adequate amounts of capital in the event of a crisis.

The Fed notes that in the stress tests, "this year's severely adverse scenario features a more severe downturn in the U.S. economy as compared to last year's scenario." Try as they might, the banks continue to struggle to exit the Fed's penalty box.

A glance at the Fed's "severely adverse scenario" shows how pessimistic it is. It calls for a stock market drop of 50 percent, a rise in the unemployment rate to 10 percent, a GDP loss of 7.5 percent, and negative interest rates -- essentially a repeat of 2008.

There's a paradox in stress testing for such a scenario, however, as it implies that the structural and regulatory changes in the U.S. economy and banking system since 2008 -- the plunge in the homeownership rate, the extraordinary amount of monetary policy easing, the reduction in bank leverage, banks shedding noncore businesses, new regulations -- haven't reduced systemic risk at all.

There are costs in forcing banks to hold excess levels of capital to withstand a severe downturn. Think of another sector: When oil was at $100 a barrel, if we had forced all energy companies to prove they could withstand a downturn with $30 oil, they would have been forced to slash capital budgets and output. A wave of firms would have consolidated as only the largest, most well-capitalized firms could budget for and withstand such a scenario. Energy prices would have surged.

Similarly, if we forced venture capital firms to prove that they could withstand a tech downturn on par with the dot-com bust, it might mean that Google and Facebook never would have been funded, resulting in lower productivity growth and lost innovation. In any industry, including banking, enforcing regulations that require firms to withstand a once-in-a-generation downturn will mean lost output and a smaller industry comprising fewer but larger participants.

The other problem with reining in banks this way is that credit might not be distributed equally. Banks are in the business of maximizing return on equity and profits for shareholders, not ensuring equal access to credit and financial services to individuals, industries and communities. When banks like Bank of America and Citigroup are being valued below tangible book value, markets are telling them to sell assets and return capital to shareholders, not extend credit or grow.

Market Signal
Price-to-tangible-book ratios under 1 tell banks to return capital to shareholders rather than invest in growth.
 
Source: Bloomberg data

These incentives may impact some individuals and industries more than others. If new regulations and more stringent capital standards have reduced construction activity, that might have a disproportionate impact on Hispanics, because 29 percent of construction workers are Hispanic, well above their 16 percent share of the overall labor market. If lending standards broadly tighten, clamping down on already-restricted lending in mortgages since the 2008 financial crisis, fewer low-income Americans would be able to become homeowners and build wealth in that way. This could disproportionately affect black and Hispanic communities, even without race-conscious "redlining."

While the scars of the financial crisis and anger at its resultant bank bailouts remain fresh on the minds of politicians, it's easy to imagine some future Elizabeth Warren or Bernie Sanders pivoting away from systemic stability and toward racial and geographic inequalities in the banking system.

Regulations and policies involve tradeoffs. The Fed's first mandate was inflation. Over time it added a full employment mandate, and in recent years there's increasingly been an unofficial mandate involving systemic financial stability. But if this last mandate is seen to lead to more inequality, it may be politically untenable.

But ultimately so are huge bailouts, as can happen if the banking sector is unprepared for crises. (Unlike, say, busts in the oil and tech industries, which don’t threaten the financial system of the U.S. No one expects Washington to jump to save companies in those sectors.

Perhaps bank bailouts would be more acceptable to the public if they were structured to force management and investors to suffer more of the consequences, rather than taxpayers and consumers. Perhaps one agenda for lawmakers and for the regulatory division of the Fed should be to shrink the banks so that they’re not systemically important.

But absent huge reforms like those -- changes beyond the power of banks themselves -- it is unreasonable for the U.S. to require the nation's major banks to ensure they can all survive a severe adverse economic shock. Not only unreasonable, but harmful: Elevated capital requirements have presumably been one factor behind the sluggish post-crisis economic expansion. Tight rules may even have fostered increased inequality. And for what upside? It's not at all clear that the benefits outweigh the costs.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Conor Sen at conor@newriverinvestments.com

To contact the editor responsible for this story:
Philip Gray at philipgray@bloomberg.net