Update 316 — Fed Stability Report: Incomplete
Missing: Systemic Risk and TBTF Analysis
Yesterday, the Dow lost over 800 points, its third worst point decline in history; the S&P 500 saw its steepest fall since February. Waves of selling are hitting Wall Street amid fear of slowing economic growth and trade tensions between the U.S. and China. The VIX — Wall Street’s fear gauge — is on the rise again and hasn’t fallen below the 15 point benchmark for market stability since September.
Not the picture of financial stability. This of course was not reflected in the Federal Reserve’s Report on Financial Stability yesterday. But neither was analysis conducted or even reference made to TBTF and systemic risk in the financial sector, oddly. There’s a curious Nothingburger here. Details below…
Last week, the Federal Reserve released its first Financial Stability Report, a new semi-annual publication that will provide an overview of the health of the financial system. Missing from this overview is a thorough discussion of regulatory rules and their impact on systemic risk — a curious oversight given that the Fed announced its plans to reduce capital and liquidity standards for banks between $100 and $700 billion in assets just last month. These changes will increase systemic risk and instability in the financial system. The Fed’s report concludes that big bank capital and liquidity is adequate, but ignores the systemic risk implications of its current rulemaking proposals and market forces, such as debt levels and increasing consolidation in the sector.
The Fed’s First Financial Stability Report
The Fed’s new semi-annual report complements the existing annual report by the Financial Stability Oversight Council (FSOC) and is similar to others produced by central banks around the world. The Fed has lagged behind other countries in terms of transparency, so this report is a welcome step in aligning to global norms. Fed Governor Lael Brainard calls it “an important step in providing the public with more information about the board’s assessment of financial stability.”
The report was generally positive; the labor market is strong, inflation appears to be controlled, and wages are growing moderately. The report did, however, identify four broad categories of vulnerability in the financial system:
- Elevated valuation pressures: Echoing Brainard’s warning in a speech earlier this year, the Fed is concerned that elevated asset prices are signalling an increased willingness of investors to take on risk. Greater appetite for risk implies a greater possibility of outsize drops in asset prices, or losses, that could shock the financial system. This risk has been made clear by the recent volatility in the U.S. stock market.
- Excessive borrowing by businesses and households: Historically, heightened borrowing by businesses and households has resulted in major stress on consumers, as well as the financial system. After a steady rise at pace with nominal GDP, business and household borrowing is starting to grow at a faster rate. Business debt levels in particular are high, with signs of increased risky debt issuance and deteriorating credit standards. Although household debt is concentrated among low-credit-risk borrowers, households are still struggling with student, auto, and credit card loans.
- Excessive leverage within the business sector: The leveraged loans market is worth just over $1 trillion, and in its report, the Fed highlighted this market as another cause for concern. Current regulators have rolled back the leveraged loan safeguards put in place by Obama-era regulators. Investors have flocked to this market, and leveraged loan prices will likely deteriorate rapidly in the event of a crisis. Leveraged loan funds have already seen heavy outflows in recent months.
- Funding risk: Many firms have taken advantage of the period of record-low interest rates after the financial crisis by taking on mountains of debt. Both the Fed and the Office of the Comptroller of the Currency (OCC) have expressed concern about the high level of corporate debt. Per the report, corporate borrowing levels are “historically high” and debt at US nonfinancial companies is up nearly 70 percent since 2008. Ominously, debt levels at nonfinancial companies have typically risen sharply just before the past three downturns.
If It Ain’t Broke, Don’t Unfix It
The report concluded that “the nation’s largest banks are strongly capitalized” and “hold more liquid assets” than in the period leading up to the crisis, making them more resilient in case of another downturn. Despite the relatively rosy tone taken by the Fed on the state of the financial sector, it continues to plug away with the deregulatory agenda meant to roll back “burdensome” Dodd Frank-era rules.
Last week, the Fed released an official rule report outlining a number of changes that were first presented by Vice Chair Quarles about a month ago. The rule report is a detailed overview of how the Fed plans to implement S. 2155 and “tailor” regulatory processes. These proposed changes include:
- raising the asset thresholds for banks to be subject to enhanced prudential standards
- overhauling the Dodd-Frank stress testing framework
These changes are likely to increase systemic risk and harm the stability of the financial system. Find a more detailed explanation of our views on the proposed changes here.
Monetarist Approach to Systemic Risk
When it comes to monetary policy, the Fed is on cruise control. The Board has raised the short term interest rate eight times since 2015, the last time in September from 2 to 2.25 percent, as part of the Fed’s dual-mandate to achieve full employment and sustainable inflation rates. Given those narrow objectives, the Fed has done a commendable job, but is it doing the right things to protect those gains in the future?
While mainstream media seems enamoured with last-minute changes to the interest rate, they fail to see what the Fed is doing when it comes to regulation and oversight, which may have more impact on the economy in the long-run. Vice Chair Quarles is pushing rule changes to capital regimes at a time when risk in the economy is low, but continued growth is uncertain.
The current Fed is on a mission, seeking to reduce capital and regulatory standards at precisely the most counter-cyclical time. Coming to the end of a long period of growth and stability, we need the safeguards implemented by Dodd-Frank. Reducing regulatory requirements at this juncture facilities risk-taking by financial institutions as the economy slows, setting up a repeat of 2008 as institutions chase returns that will be increasingly diminished.
In a speech at the Economic Club of New York on Wednesday, November 28, Powell said: “The question for financial stability is whether elevated business bankruptcies and outsized losses would risk undermining the ability of the financial system to perform its critical functions on behalf of households and businesses.” Powell contended, as his predecessors did in the run-up to 2008, that such losses would likely fall on investors rather than posing a threat to the financial institutions that are at the core of the system.
If history has taught us anything, it is that average Americans are always the ones who bear the brunt of financial crises, not wealthy investors. During his speech last week, Fed Chair Powell asserted that monetary policy should not be used as a tool for stabilizing a financial crisis, yet he appears content in allowing the Fed to pursue destabilizing rule changes in financial policy.