Lower Leverage Ratios Will Help, Not Hurt, Monetary Policy

March 20th, 2014 at 8:43 am

The NYT has a somewhat incomplete piece out this AM about how Bill Dudley, a former Goldman Sachs exec and now the president of the New York Fed (the Fed bank that interacts most closely with Wall St./financial markets), is allegedly raising concerns that lower leverage ratios–i.e., requiring banks to hold more capital against losses–will hinder Fed monetary policy.

As I said, the piece doesn’t get into precisely what his concerns are based on, but the thrust of it is here’s this former banker who’s willing to buck regulators and engender more risk in the financial sector.  From what little I know of Dudley, I’m not sure that’s right, so let me just speak to the issue of leverage ratios at banks and monetary policy and why if that is, in fact, Dudley’s concern, it’s misguided.

Banks face a tension between leverage, which significantly amplifies profitability, and the ability to absorb losses without facing insolvency (and bailouts, systemic risk, taxpayer exposure through the FDIC, and other bad stuff).  Part of financial market reform is to require higher capital ratios to balance this risk more towards avoiding the bad stuff.  As this rule making has proceeded, the finance lobby has predictably been pushing for lower ratios (less capital holdings against liabilities).

Now, let’s bring in the Fed.  In order to implement monetary policy in the interest of macro-management in weak economies, the Fed must lower rates, and when rates hit zero, use whatever else they have in the tool shed to try to bring the real rate down to where it needs to be to meet their full employment mandate.

However, critics argue that these monetary interventions simply inflate bubbles, as low rates force investors to seek more risk in all the wrong places.  This is somewhat theoretical—the Fed funds rate has been at about zero for years and one doesn’t see obvious asset bubbles forming.  But it’s not a crazy concern.

Ergo, to avoid bubbles when the Fed is applying monetary stimulus, and since stimulative monetary policy is absolutely essential in weak economies, a solid regulatory regime, including ample capital ratios, is also an absolutely essential complement to the critical role of the Fed.  Otherwise, the Fed is in an untenable position wherein it must eschew its macro-management role in order to avoid roiling financial markets.  QED!

The article presents some inchoate nervousness about how higher ratios will dampen the repo (short-term commercial paper) market, but this is second, third, or fourth order relative to the logic above, IMHO.  We mustn’t allow weak financial market regulation to a) cripple the Fed’s ability to act, or b) blow up the economy again anytime soon.

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5 comments in reply to "Lower Leverage Ratios Will Help, Not Hurt, Monetary Policy"

  1. Larry Signor says:

    Higher leverage ratios should dampen the repo market, thus removing some risk from the financial markets.

    “…to avoid roiling financial markets.”. “Yellen earns mixed grades from Wall St.”. http://www.usatoday.com/story/money/markets/2014/03/20/wall-street-gives-yellen-mixed-grades/6643565/

    I am so proud of Janet Yellen for this reaction. The Lady hath confounded the financial geniuses of the Street. Let their forward guidance be a little fuzzy. It will be entertaining, and perhaps re-distributive.

  2. Procopius says:

    It’s been almost sixty years since I took Econ 101, but I do read the blogs, and this post gave me a strong sense of disorientation. I’ve always thought “leverage ration” compared liabilities to capital, not the other way around. For example, I recall reading that economists were horrified to discover that Greenspan’s Fed had given approval to the banks to have leverage ratios of 33:1. That is, they were permitted to use 33 borrowed dollars for trading for every dollar of their own capital they put up. Now, when I see “higher leverage ratios,” I immediately think of using even more borrowed money and incurring even greater risk of insolvency.

    • Jared Bernstein says:

      No, you’re right–my bad–just flipped the damn polarity. Will fix.

      • Larry Signor says:

        capital/liabilities seems to be more informative. This indicates the true risk associated with different amounts of leverage by producing a fraction that specifies net ownership. When buying a house it is the industry standard to use capital/liabilities to indicate risk and ownership. liabilities/capital returns a number which takes much more explanation and offers very little information as a raw number.

  3. Perplexed says:

    “Ergo, to avoid bubbles when the Fed is applying monetary stimulus, and since stimulative monetary policy is absolutely essential in weak economies, a solid regulatory regime, including ample capital ratios, is also an absolutely essential complement to the critical role of the Fed.”

    So how is it again that we get to this foregone conclusion that the Fed’s mandate now includes the “accurately anticipate, predict, and prevent bubbles” function? Why is there no discussion of why the Fed is forced into this role as a result of the provision of public insurance provided for free to these TBTF institutions? Are the interests of the public and bank stockholders, bondholders, and employees now just one in the same and therefore there is just no longer any need to separate them? Who is a risk from a collapse of these “bubbles” and why are these institutions allowed to exist without providing insurance for the damage they do to the “public interest” with their mismanagement and taking every possible advantage the “moral hazard” the government provides them? Are Elizabeth Warren and Bernie Sanders alone in their opposition to this scam? Will no others even separate out the public interest from that of bank stockholders, employees, and plutocrats anymore and speak for protection of the public interest from exploitation by these institutions? The public is supposed to provide free insurance AND worry about what bank lobbyists think the regulations should be? What isn’t wrong with this picture?