How Too big to fail creates problems for monetary and financial regulatory policies?

Dallas Fed economists Harvey Rosenblum, Jessica Renier and Richard Alm have written an insightful paper on nthe subject. We all know TBTF is a serious concern but how does it hinder policies?

In monetary policy there are 4 transmission channels – securities market channel, asset prices, wealth channel and exchange rate channel.

securities market channel operates through money and capital markets, where interest rates generally move in the same direction as the federal funds rate. Changes in the price and availability of nonbank financing influence the borrowing decisions that determine larger businesses’ employment and output decisions. Smaller companies and individuals usually borrow from banks and other financial intermediaries.

An asset prices and wealth channel works through interest rate changes’ effect on market prices for a range of assets—such as bonds, equities, and homes and other real estate. Consumers and businesses carry these assets on their balance sheets and use them as collateral for loans. Changes in borrowing capacity directly affect credit use. The perceived value of the assets also factors into households’ decisions to spend, borrow and save out of current income.

Finally, interest rate changes impact the relative attractiveness of U.S. investments, creating an exchange rate channel. When rates rise or fall faster in the U.S. than in other countries, foreign investors respond by acquiring or divesting dollar-denominated assets. These transactions alter currency values, which in turn affect the relative prices of imports and exports. The price changes filter through to demand for goods and services, affecting overall economic activity.

Enter banks in monetary policy. All these channels work properly if banks are working well.

However, monetary policy’s channels function smoothly only when banks hold enough capital to safeguard against bad loans and other risks. Well-capitalized banks can expand credit to the private sector in concert with monetary policy easing. Undercapitalized banks are in no position to lend money to the private sector, sapping the effectiveness of monetary policy.

The bank capital linkage completes the financial market architecture of effective monetary policy (Figure 1). However, it’s regulatory policy—not monetary policy—that focuses on ensuring banks maintain healthy capital ratios

The authors then discuss US Financial regulatory system. They point to a system called prompt corrective action (PCA) which is designed to work on banks under trouble:

The savings and loan crisis of the 1980s prompted regulatory reform designed to preserve the solvency of federal deposit insurance and to restore confidence in the banking system. The resulting legislation mandated an approach, dubbed prompt corrective action (PCA), designed to remedy banks’ potential balance-sheet problems before they could fester.[4] It requires undercapitalized banks to take immediate steps to restore their financial integrity.

To be considered well-capitalized, banks are required to maintain capital-to-risk-weighted asset ratios of at least 10 percent. In hard times, higher-than-anticipated loan losses can force banks to take writedowns that erode their capital bases. When the key capital ratio slips below 8 percent, regulators begin to invoke a series of PCA procedures that include restraining asset growth. Once the ratio falls below 6 percent, banks face further requirements that include raising equity capital and restricting dividends and bonuses. Taking these actions forces banks to replenish their capital bases, restoring their capacity to lend.

PCA breaks down if troubled banks are overlooked or undiscovered by regulators…..

What interferes with PCA? For starters, it could be a lot of banks getting into trouble at the same time—victims of the same shock. Regulators can’t carry out PCA at that many banks quickly enough, and at least some troubled banks will be left to deteriorate further.[5] Instead of getting well, the sick banks get sicker, tighten credit standards and rein in lending. The cumulative impact is slower growth in the overall economy, causing additional loan losses and feeding the downward spiral of credit and economic activity.

Too-big-to-fail (TBTF) banks are an even greater potential drag on PCA. Our financial system has changed a great deal since the introduction of PCA. The past two decades’ financial-market innovations and legislative changes have allowed banks to operate nationwide, offer a wider range of services and invest in riskier and ever more complex financial instruments.[6]

TBTF led to failure of  PCA which led to breaking of all four monetary policy channels.

Troubled banks left in place clog up monetary policy mechanisms. The bank loan channel behaved perversely. The FOMC aggressively lowered the federal funds rate, anticipating that interest rates on bank credit would go down, too. In their efforts to ration the limited capital remaining on their balance sheets, however, banks facing loan losses tightened credit standards and retrenched, and the rates that matter most—those paid by businesses and households—rose rather than fell, thwarting the Fed’s goal of reducing rates to stimulate the economy.

The securities market channel constricted because investors hunkered down as the rapidly deteriorating conditions of many TBTF banks slowed the economy and shattered overall confidence. Toxic assets’ deadweight impeded the flows of debt and equity capital to businesses and consumers. In past crises, large companies had the alternative of issuing bonds when troubled banks raised rates or curtailed lending. This time, capital markets offered little relief.[10]

When the crisis sent private-sector interest rates up rather than down, the value of homes, stocks, bonds and other assets fell, impeding the asset prices and wealth channel. In a flight to cash, households and businesses turned to balance sheet deleveraging—that is, asset sales, even at unattractive prices. Debt and new borrowing tumbled at the worst possible time.

The exchange rate channel failed for several reasons. First, official policy rates fell, but rising interest rates for private-sector borrowers made U.S. assets more attractive. Second, the simultaneous drop in official policy rates in other countries experiencing similar financial problems reduced the incentive for foreigners to purchase U.S. assets, goods and services. Third, investors fled to the safety of the U.S. dollar, pushing its value up.[11]

Because of the blockages in these channels, PCA was ineffective in an era of TBTF banks. Figure 2). The problems originated with several very large, systemically important financial institutions that were experiencing similar shocks and hemorrhaging losses. Because PCA loses its “prompt” in the case of TBTF banks, problems festered, causing negative spillovers in the rest of the economy.

This led Fed to come out with alphabet soup of unconventional monetary policy tools.

What next? The authors say unless we solve the TBTF problem monetary policy breakdown will always be a concern. There have been many suggestions and it would be a combination to solve TBTF issue. Even if we solve TBTF, it is important that Fed keeps its supervisory role:

Even if we reduce the TBTF threat, monetary policy will still depend heavily on effective regulatory policy. Transmitting the Fed’s actions to the real economy requires sound financial institutions that are well-capitalized and willing to lend. It’s the job of regulation and supervision to weed out the weak banks so their inability to lend doesn’t block monetary policy channels.

This reliance on well-functioning banks gives central bankers a vital need for precisely targeted, real-time data on the health of the financial system and the institutions within it. These data can affect central bank decisions such as the timing, strength and tactics of monetary policy actions, including lender-of-last-resort policies and decisions. Incomplete or dated information increases the chances for errors.

Monetary and regulatory policies are inseparable. The Fed’s supervisory role puts the central bank’s finger directly on the pulse of the financial system, providing a tool that serves the goal of effective monetary policymaking. While the Fed has accepted criticism for failing to detect potential problems prior to the crisis, the failure only highlights the need for better integration of monetary and regulatory policies. Stripping the Fed of regulatory functions would compromise the conduct of monetary policy.

Very interesting paper. Explains clearly how TBTF leads to problems for monetary policy. The linkage between mon pol. bank regulation and TBTF is very well explained. It also suggests why Fed needs to keep its supervisory role of banks.

3 Responses to “How Too big to fail creates problems for monetary and financial regulatory policies?”

  1. Some interesting speeches etc to read « Mostly Economics Says:

    […] outlined his list of Financial Reform. He says biggest challenge is to address the TBTF problem (we know now the basics). To end TBTF we need a bankruptcy court which extends to non bank firms as well. Let us not leave […]

  2. unicon india Says:

    securities market channel operates through money and capital markets, where interest rates generally move in the same direction as the federal funds rate.

  3. select your broker Says:

    The exchange rate channel failed for several reasons. First, official policy rates fell, but rising interest rates for private-sector borrowers made U.S. assets more attractive.

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