Fed at Odds With Itself as It Eases Bank Rules and Raises Rates

(Bloomberg) -- Federal Reserve policy makers seem to be working at cross purposes.

In laying out plans to ease some constraints imposed on banks after the financial crisis, the Fed is moving to free up tens of billions of dollars for financial institutions to lend to promote faster economic growth.

At the same time it is reducing its balance sheet and gradually raising interest rates to restrain credit creation and keep the economy in check.

“The timing is not the most opportune” for relaxing the banking rules, said Mark Zandi, chief economist at Moody's Analytics Inc. in West Chester, Pennsylvania.

Those steps will complicate the Fed's effort to engineer the soft landing of an economy that is already being juiced by tax cuts and government spending increases. To help bring that about, officials plan to keep raising interest rates over the next few years, though they're expected to hold policy steady at their meeting next week.

“By itself this would risk putting regulatory policy on the same pro-cyclical trajectory as fiscal policy,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, though he added that the economic impetus from the former is dwarfed by that from the latter.

In unveiling a proposal on April 11 to ease leverage limits on Wall Street banks, the Fed and the Office of the Comptroller of the Currency said the step might lower the amount of capital lenders are required to hold in their main subsidiaries by $121 billion. The move would give banks added flexibility to extend credit.

Deposit-Shunning Banks Get Big Break as U.S. Eases Leverage Rule

It came on the heels on an announcement by the Fed of plans to revise its bank stress tests and risk-based capital rules. The agency estimated that the action would cut the total cushion that the banking industry has to maintain by $30 billion, though some Wall Street analysts reckon it could free up more than $50 billion in capital.

More important than the amounts involved is the message it sends to the financial industry to boost lending, Zandi said.

“I suspect we will see credit growth start to rev up here,” he said.

Financial industry analyst Fred Cannon disagreed.

“The spigots aren't going to be opened,” said Cannon, global director of research for Keefe Bruyette & Woods Inc. in New York. “Most of the banks would prefer to return capital to shareholders or use it to invest in technology initiatives” than resort to riskier lending.

Fed Vice Chairman for Supervision Randal Quarles said the central bank's regulatory and monetary policies are “mutually supportive.”

Win-Win

A more efficient financial system enhances the Fed's ability to affect the economy via changes in interest rates, while the normalization of monetary policy helps smaller banks by allowing them to earn more profits on their loans, Quarles told an economic conference in Washington on April 18.

Some of his colleagues are not so sure and question whether the Fed's regulatory actions are appropriate at a time when stock and other asset prices are showing signs of froth.

“While we should carefully consider how to make our regulations more effective and better tailored, we must take great care to ensure that we do not inadvertently contribute to pro-cyclicality that would exacerbate financial conditions that are, on some dimensions, somewhat stretched,” Fed Governor Lael Brainard said in an April 19 Washington speech.

Brainard, a Democrat, voted against the plan to ease leverage limits for Wall Street banks. Quarles and Fed Chair Jerome Powell, both of whom are Republicans, voted in favor.

The proposal was also opposed by the Federal Deposit Insurance Corp., which is still headed by Democrat Martin Gruenberg.

Boston Fed President Eric Rosengren said he saw some benefits to the Fed's regulatory actions, while noting they were decided by the central bank's board in Washington and not by the Federal Open Market Committee that includes the regional reserve banks.

The steps “have the potential to, on the margin, lower the capital requirement for some of our largest institutions,” he said in an April 13 interview, adding he wouldn't like to see such obligations reduced significantly.

Looser Reins

In fact, Rosengren wants the banks to hold more capital. He's urged the Fed board to compel banks to build a counter-cyclical capital buffer now, when asset prices are high. That money would then be freed up for lending later, during times of financial stress.

Brainard has also highlighted the buffer as a potential policy tool, saying it could be implemented “if cyclical pressures continue to build and financial vulnerabilities broaden.”

The Fed board is currently required to vote at least once a year on the appropriate level for the buffer. Last year it left it at zero.

Former FDIC Chair Sheila Bair called the actions being taken by the regulators to reduce bank capital a “misguided effort” to boost lending when unemployment is low and taxes are being cut.

There's “no evidence that I've seen that there's a credit shortage in the U.S. economy,” she told the Peterson Institute for International Economics on April 20. “If anything, I think there are certain pockets where we may have too much of a debt overhang.”

--With assistance from Christopher Condon and Jesse Hamilton

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net.

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Alister Bull, Sarah McGregor

©2018 Bloomberg L.P.