This Simple Tool Could Help Prevent the Next Financial Crisis, Yet The Fed Refuses To Use It

Lael Brainard, governor of the U.S. Federal Reserve, arrives to a Federal Reserve Board meeting in Washington, D.C., U.S., on Wednesday, Oct. 31, 2018. Photographer: Andrew Harrer/Bloomberg© 2018 Bloomberg Finance LP

Federal Reserve Lael Brainard has a fairly simple suggestion for her fellow bank regulators: Maybe they should require banks to raise more equity capital now that profits are booming and the economy is relatively stable.

Most financial experts agree that, regardless of the causes of the last financial crisis, high leverage ratios, which reflect banks’ unusually heavy reliance on debt to fund their operations, played a key role in spreading the troubles that began in housing to the rest of the financial system.

The result was a historic meltdown not seen since the Great Depression, and one with deep and long-ranging repercussions for the economy’s health.

So it makes sense for Brainard to be asking banks to strengthen their defenses now that the going is good.

“At a time when cyclical pressures have been building and bank profitability has been strong, it might be prudent to ask large banking organizations to fortify their capital buffers, which could subsequently be released if conditions warrant,” Brainard said in a speech last week.

Yet for now, there is little sign that her colleagues will take her cue and raise the so-called “countercyclical capital buffer” from its current level: zero.

“I’d much prefer a significant increase in capital requirements,” tweeted Gregg Gelzinis, a research associate at the Center for Economic Progress who focuses on financial institutions and markets, following Brainard’s speech.

“But it seems to me that activating this buffer sets a good precedent on countercyclical policy – and it might be the only avenue to get any increase in capital from these regulators,” he added.

“My guess is they won’t activate it anyway. Other Fed governors have remained skeptical that any increase in capital is warranted.”

He’s right, and that’s an especially curious propensity for a central bank that has just issued a report on financial stability highlighting increasing risks in the corporate bond and leverage lending markets. Fed Chairman Jerome Powell said last year bank capital levels are “about right.”

Yet Brainard warned that, “in an economic downturn, widespread downgrades of these low-rated investment-grade bonds to speculative-grade ratings could induce some investors to sell them rapidly.

“This concern may be higher now than in the past, since total assets under management in bond mutual funds have more than doubled in the past decade to about $2.3 trillion this year. These funds now hold about one-tenth of the corporate bond market, and the redemption behavior of investors in these funds during a market correction is unclear.”

What exactly is a countercylical capital buffer? The Fed defines it as a “macroprudential tool that can be used to increase the resilience of the financial system by raising capital requirements on internationally active banking organizations when there is an elevated risk of above-normal future losses.”

Memories can be awfully short on Wall Street, especially when top bankers are rewarded rather than punished for bad behavior.

Americans should hope Brainard can convince other bank supervisors that the time to make sure those balance sheets are in tip top shape is now – not once markets start to crater, which last week suggests they have already started doing.

source: forbes.com