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.