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Federal Reserve Considers a New Tool to Avert Crises

Some officials favor demanding banks stock up on capital while the economy is strong. IT’S THE ECONOMY STUPID: EPISODE#24

A decade after a financial crisis that paralyzed the global economy, Federal Reserve officials are debating how to apply one of the central lessons they drew from that dark episode.

It involves preventing the next crisis from happening on their watch.

The Fed has two tools for stamping out financial bubbles. It can use either regulation or interest-rate increases to prevent banks and other financial institutions from getting carried away during an economic boom.

Many Fed officials concluded after the last crisis that it’s best to use regulation. They can apply that tool surgically, while aggressive interest-rate increases—like taking a sledgehammer to a nail—might damage the broader economy in the name of financial stability.

Some Fed officials want to use one of the regulatory tools the central bank developed after the crisis, called a countercyclical capital buffer. It can require the U.S.’s largest banks to sock away additional capital during good times so they have more to fall back on when loans go bad during bad times, like socking oil away in the nation’s strategic petroleum reserve.

But other officials, as well as the banking industry, have questioned why the tool is needed now, when bank capital levels are high and financial-stability risks appear in check.

One reason for the concern is that asset prices are booming. U.S. household net worth—a function of rising stock and real-estate values—was nearly seven times household after-tax incomes in the first quarter, according to the Fed.

That’s higher than during the tech-stock boom of the late 1990s or real-estate boom of the 2000s, both of which ended badly.

Capital is long-term money a bank draws on to make loans, coming largely from shareholders and retained profits. It represents funds the bank isn’t on the hook to pay back right away, like a bank deposit, when a loan portfolio goes sour. That creates an important cushion in a shock, when depositors and others demand their money back quickly from their banks.

Forcing banks to hold additional capital might take some pressure off the Fed to raise interest rates very aggressively to cool the economy if it overheats. Some officials also like the tool because the buffer can be reduced when an actual downturn hits, providing relief to banks when they really need it.

Officials in other places like the U.K., Ireland, France and Hong Kong have raised their capital buffers, while the Fed’s is set at zero.

“This would be a good time to be raising that capital buffer,” said Cleveland Fed President Loretta Mester in a July interview. “In good times, you raise it.” Not using it now “puts you more into the camp of” using interest rates to guard against financial instability, she added.

It was a subject of discussion at a Boston Fed conference Friday and Saturday. Ms. Mester is among five regional Fed bank presidents pushing for a move, but the authority isn’t in their hands. Instead, Fed governors in Washington, overseen by board Chairman Jerome Powell, make the decision, voting at least once a year on its level.

One Fed governor, Lael Brainard, has publicly backed increasing the buffer. Mr. Powell hasn’t weighed in publicly, except to say in June he didn’t think financial-stability risks were meaningfully above normal.

Banks and some Fed officials argue against the move. One reason is that big banks have already built up substantial levels of capital: Among banks with assets greater than $50 billion, so-called “tier one” capital was 12.7% of assets in the first quarter, compared with 8.5% in 2008.

Another limitation of the rule is that it only applies to big banks. Those with assets of less than $50 billion have seen their capital shrink to 14.2% of assets in the first quarter from 15.7% in 2012.

Moreover, some Fed officials have said annual stress tests have already accomplished the goal of raising capital levels for big banks during good times.

“We’ve just gone through a lot of changes in terms of how financial institutions are going to be regulated,” Atlanta Fed President Raphael Bostic said in an interview last month. He said it made sense to see how banks manage the new rules before placing a new demand on them.

Under one possible compromise, the Fed might stop ramping up the difficulty of the stress tests, while activating the new capital buffer. The stress tests are important to banks because they dictate how much they can pay in dividends and deploy toward share buybacks.

The banking industry has bristled at the idea of deploying a regulatory tool simply because the economy is strong. Officials also say the Fed couldn’t currently meet the criteria it laid out two years ago for activating the buffer.

In 2016, the Fed said the buffer should be activated “when systemic vulnerabilities are meaningfully above normal.” Fed staff, tasked with monitoring the financial system, have characterized such vulnerabilities for now as moderate.

States Face Crunch If Fed’s Tool Kit Is Limited In Next Recession

Simulation by the Boston Fed shows the central bank’s inability to cut rates by the usual 5 percentage points would disproportionately hit certain states.

BOSTON—When the next recession comes, some states are likely to suffer much more than others if the Federal Reserve lacks ammunition to make economic downturns less severe, new research shows.

In recent downturns, the Fed has cut its short-term benchmark interest rate by about 5 percentage points to stimulate growth. But in the future, that might be impossible because rates are still historically low. The Fed’s benchmark rate is currently in a range between 1.75% and 2%.

“Monetary buffers have been depleted,” said Eric Rosengren, president of the Federal Reserve Bank of Boston, which sponsored the conference this weekend where the research was released. A decline in rates over the past decade means the Fed’s recent experience of running out of room to cut them after lowering them to zero will not be “a one-time event,” he said.

Mr. Rosengren and his co-authors, Boston Fed economists Joe Peek and Geoffrey Tootell, ran an experiment that shows how a recession might affect states assuming a traditional monetary-policy response, in which the Fed could cut its short-term benchmark rate by 5 percentage points.

Then they looked at two other alternatives. In both scenarios, monetary policy couldn’t fully respond because the Fed had raised rates to only 2% before the hypothetical downturn. But in the last scenario, regulatory, state and local, and federal fiscal buffers were also depleted because they weren’t built up before the recession.

The results show, unsurprisingly, that the last scenario is the grimmest. But they also show that the effects are distributed unevenly across states—some fare much worse than others when the Fed can’t cut rates as it traditionally has.

States with industries that are sensitive to both the economic cycle and interest rates—think of Michigan, with its heavy dependence on the auto industry—could face a much worse downturn than Midwestern states that are heavy in agriculture, which is less exposed to a cyclical downturn.

State of Policy

New research suggests changes in per capita personal income growth would hit some states much harder depending on how aggressively monetary policy can respond to a recession.

Take the first example, in which monetary policy is able to respond as it traditionally does. Here, 16 states avoid declines in inflation-adjusted-per-capita income, including many Southern states.

In the second scenario, where monetary policy is limited but the other policy buffers are available, all states experience declines in personal income. Midwestern states that depend on agriculture avoid some of the sharpest declines.

The Southern states that manage through the recession in the first simulation fare worse in the second example. In Alabama, for example, per-capita income falls 1.9%, versus nearly no change in the first simulation.

In the final scenario, the Southern states that didn’t see any income loss in the first simulation are “now among the states most severely adversely impacted when all policy buffers are insufficient.” Personal income falls even further, by 2.7%, in Alabama.

Mr. Rosengren highlighted three areas where policy tools, if deployed now, could help compensate for the potential dearth of monetary stimulus.

First, regulators could require banks to raise more capital in good times to prevent tighter lending from exacerbating an inevitable recession.

Second, the federal government could implement fiscal policies that automatically boost safety-net spending, such as unemployment insurance, during downturns.

Third, state and local governments can build up “rainy day” funds to cushion downturns. Unlike the federal government, states generally can’t run budget deficits, which typically leads to spending cuts and layoffs during a recession—a double whammy because private-sector employment and investment is often also shrinking.

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