Magazine article American Banker

Will the Fed's Capital Rules Interfere with Monetary Policy?

Magazine article American Banker

Will the Fed's Capital Rules Interfere with Monetary Policy?

Article excerpt

Byline: Donna Borak

WASHINGTON -- The Federal Reserve is cautiously eyeing the impact new capital rules will have on its ability to conduct monetary policy.

It's an unprecedented moment for the central bank. The Fed is moving steadily to toughen capital and liquidity requirements in the hopes of ending "too big to fail," while gradually unwinding its stimulus program and returning the economy to normal rates.

"It's happening at the same time where accommodative policy since 2008 is beginning to be revised with a very complicated exit strategy," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics. "All of these developments are intertwined and the linkages are untested and delicate."

The Fed's banking rule writers in years past paid little, if any, attention to the potential fallout of their efforts on monetary policy or the broader economy, perhaps making a small mention of how a regulatory change could result in fewer loans.

But nowadays Fed officials are repeatedly drawing links between financial stability and monetary policy, including which is better at spotting or reducing asset-price bubbles.

Fed Chairman Ben Bernanke set that line of thinking in motion, and new Chair Janet Yellen has made balancing monetary policy and bank supervision the central bank's No. 3 priority behind the two disciplines themselves.

"Nobody talked about the link between financial stability and monetary policy," Petrou said. "Academics didn't see it, and the Fed didn't understand it, and so nobody thought about it. We learned the hard way how intertwined financial stability and monetary policy can be."

Top Fed officials have becoming increasingly concerned that a low interest rate environment could harm the financial system as banks "reach for yield," while also noting that certain supervisory tools can be limited in their ability to capture all the potential risk.

Alternatively, it's become more recognizable that new rules which call for higher capital and liquidity requirements could affect monetary policy.

The concerns were evident at the Fed board's April 8 meeting to finalize an enhanced leverage ratio for the eight largest U.S. banks, which include JPMorgan Chase (JPM), Citigroup (NYSE:C), Bank of America (BAC) and Wells Fargo (WFC).

The new rule, which the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency also signed off on, is designed to prevent the largest banks from becoming as highly leveraged as they were in the lead up to the financial crisis.

The biggest banks should not be allowed to borrow against more than 5% of their balance sheet, and insured subsidiaries no more than 6%, the three agencies agreed.

The Fed's staff memo noted that the rule would likely have a limited effect on the central bank's ability to implement its monetary policy decisions, and staffers discussed at length their evaluation of the potential impact . That was the first time such a conversation had taken place during any public board meeting on a Dodd-Frank rulemaking.

To some observers, the dialogue sought to correct the perception that the Fed, and other regulators, have taken a narrow view of the impact of higher capital rules.

"There's been a lot of talk the regulators aren't waiting to see what happens to the rules before they impose new ones. No one is thinking about the cumulative effect of the rules, and no one is thinking of the overall economic impact of the rules," said Greg Lyons, a partner at Debevoise & Plimpton. "They're using it as a further occasion to demonstrate they are the not the White Tower, but also trying to be cognizant of the economic implications more broadly."

For others, it raised alarm given that despite some reservations, the Fed agreed to proceed with a final rule.

"Their candid acknowledgement that there may be implications for monetary policy associated with a higher leverage rule is remarkable and of potential concern," said John Dearie, executive vice president for policy at the Financial Services Forum. …

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