Why Federal Reserve Policy Is Failing

The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years.

This parallel banking system financed vast amounts of real estate lending and consumer borrowing. The system (which included the likes of Thornburg Mortgage, Bear Stearns and Lehman Brothers) made loans but had no deposit base. Instead, it relied on roll-over funding obtained through money markets. Additionally, it operated with little capital and extremely high leverage ratios, which was critical to its tremendous profitability. Finally, loans were often securitized and traded among financial firms.

This business model has now proven extremely fragile. First, the model created a fundamental maturity mismatch, whereby loans were of a long term nature but funding was short-term. That left firms vulnerable to disruptions of money market funding, as has now occurred.

Second, securitization converted loans into financial instruments that could be priced according to market conditions. That was fine when prices were rising, but when they started falling firms had to take large mark-to-market losses. Given their low capital ratios, those losses quickly wiped out firms’ capital bases, thereby freezing roll-over funding.

In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.

Though the parallel banking system engaged in riskier lending than the traditional banking system, those differences were a matter of degree. Traditional banks like Washington Mutual, Wachovia, and Citigroup have also all lost huge sums. However, the traditional banking system is more protected for two reasons.

First, traditional banks are significantly funded by customer deposits. Ironically, such deposits can be withdrawn on demand and are in principle even more insecure than short term roll-over funding. However, they stay in place because of federally provided deposit insurance.

Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans. These loans are therefore priced by auditors on a mark-to-realization basis. However, if they were securitized their market value would be significantly lower owing to current disruptive market conditions.

The bottom line is that the banking system is in better shape not because of its virtues, but because of policy. Deposit funding is safe because of deposit insurance. Banks are spared mark-to market losses because of different accounting rules. And the Federal Reserve is providing banks with massive liquidity infusions through its discount window and its various emergency auction facilities.

Policy has therefore ring-fenced traditional banks. But in the meantime it has left the parallel system in the cold, leaving a gaping hole in the policy dyke.

This policy stance reflects the Fed’s continuing attachment to an antiquated view of the system whereby it takes responsibility for traditional banks and nothing else. Such a policy makes no sense and will fail. The Fed encouraged development of the parallel system, and that system undertakes many of the same activities as traditional banks. Meanwhile, failure of the parallel banking system will continue putting downward pressure on asset prices and lender confidence.

The Treasury’s proposed seven hundred billion dollar asset purchase program will help put a needed floor under asset prices. However, it does nothing to tackle the parallel banking system’s roll-over funding crisis that is crimping lending and pushing firms into bankruptcy. That is causing distress to spread far beyond the mortgage market, undermining the ability of any asset purchase program to put a floor under asset prices.

The urgent implication is the Fed (and other central banks) must extend its safety network to include the parallel banking system. Just as the traditional banking system needs liquidity assistance, so too does the parallel system. That assistance can be provided through such vehicles as the discount window and Federal Reserve auction facilities, and it should be allocated to qualified firms able to post appropriate collateral.

A credit based system is a chain, and a chain is only as strong as its weakest link. The Federal Reserve’s antiquated view has it protecting links connected to the traditional banking system while neglecting everything else. That is a recipe for failure.

Copyright Thomas I. Palley

6 Responses to “Why Federal Reserve Policy Is Failing”

  1. Jose Tapia Says:

    How many more billions are needed to fix the chain? Is it worth to throw another pebble into a churning sea? How much taxpayer money will be left for income support for poor people, health care, education, and so on and so forth? Everything indicates the real economy is going down, and money will be needed to help needy people.

  2. TheTraderBlog.com » One Record Left To Break …. Says:

    [...] Why Federal Reserve Policy Is Failing ”The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years…” [...]

  3. flow5 Says:

    In the 1966 housing crisis, Congress gave the non-banks permission to borrow via the member banks, funds at the FED’s discount window. This provision was fortunately, never used.

    Your speaking of the biggest error in economics. Commercial banks enlarge the money supply when they make loans & buy investments from the non-bank public. Never are they intermediaries in the lending process. However the non-banks lend existing money. The commercial banks could continue to lend even if the public ceased to save altogether.

    How does the FED follow a “tight” money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business — gradually (REG Q in reverse-but leave the non-banks unrestricted).

    What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits within the commercial banking system, are demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.

    The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the commercial banks pay for something they already have? I.e., interest on time deposits.

    There would be an immediate increase in the supply of loan-funds, a decrease in long-term mortgage rates, which would feed back to the short-term rates, and all of which would contribute to much higher employment and production.

  4. Tim C Says:

    It has taken them some time but I believe the Fed is trying to address the shadow banking system. They are addressing the shadow banking systems’ liabilities through various programs to buy commercial paper and asset-backed commercial paper (eg, CPFF, AMLF) as well as guaranteeing money market funds. They will attack the assets by buying securitized assets (RMBS, CMBS, and CDOs) with $700B TARP.

  5. justin Says:

    so the establishment of the SPV to buy investment grade commercial paper directly from eligible companies is a step in the right direction. yes? what else would be important links to address?

    the amount of money fed/treasury is using for all their “fixes” is staggering. are their any serious implications when these measures are reconciled back?

    what is holding the government back from coming to people such as yourself for help? its really disheartening when i learn of the negative/unwanted consequences of recent actions. they obviously need help to construct a better plan. is it denial, corruption, pride?

  6. Esteban M. Says:

    Perdón que hablo en castellano pero es muy tarde y no tengo ganas de ponerme a traducir. Ante todo soy de Buenos Aires, Argentina.
    Concuerdo con lo que usted dice, del mercado financiero paralelo, por supuesto que hay que trabajar sobre ese mercado, es vital ponerle un piso a los activos, sino se seguiran desplomando los precios. Pero yo tengo una teoría, que la burbuja financiera se pincho porque su crecimiento no estuvo correlacionado con el crecimiento de esta burbuja. Era una cuestión de tiempo que que caiga, no pensaba que iba a ser de manera tan estrepitosa, pero asi lo fue.
    La otra cuestión es si el Bailout, servirá de mucho, creo que es necesario Politicas Fiscales expansivas, porque da la impresión que se esta cerca de una trampa de liquidez, es vital que El Gobierno implemente un plan de demanda efectiva importante. Porque si se está en trampa de liquidez, se puede caer en estancamiento económico prolongado (le llamo a estancamiento a crecer 1%), por mas que se restituya el crédito puede ser que la demanda haya caido mucho y no pueda levantarse o tarde mucho tiempo. Aunque la economia de USA es la mas dinámica del mundo.
    Por supuesto que un salto adelante que se me ocurre es que China e India incrementen mucho su Consumo.