Search for Stability: Regulation, Reform, and the Role of Monetary Policy

Randall S. Kroszner

Randall Kroszner, a professor at the University of Chicago Booth School of Business and a former governor of the U.S. Federal Reserve Bank, discussed the fragility of the banking system and the role of monetary policy during fiscal crises at the 65th CFA Institute Annual Conference in Chicago yesterday. Kroszner joked at the start of his session that the U.S. credit crisis was “his fault” because he served as a Fed governor from 2006 to 2009. Fortunately for the audience, Kroszner’s current occupation allowed him to speak off script — a luxury he did not have during his tenure at the U.S. central bank.

Kroszner opened his discussion by noting that leverage, liquidity, and interconnectedness make the banking system extraordinarily fragile as compared to other industries. The banking model is to borrow short and lend long, which creates a funding mismatch, and banks rely enormously on short-term financing, which can change very quickly. In addition, he pointed out, any nonfinancial institution with a leverage ratio of 10:1 is far too overleveraged. But a bank with the same leverage is extremely well capitalized. The problem was that just ahead of the crisis, many banks only had 3-4% core capital, and that left very little room for asset volatility.

Bank interconnectedness was another factor that made the credit crisis so damaging, Kroszner argued. Banks tend to hedge with each other, and since there was (and still is) no central clearing house, it was impossible to identify counter-party risk concentration. AIG’s participation in the credit default swap market is the prime example.

Kroszner also addressed the response to the crisis. He argued that the best preparation for any economic crisis is knowing history. Understanding previous economic crises and the efficacy of policy responses (or no response) should serve as a guidepost for central banks and regulators. Kroszner said that Fed governors looked to economic history the weekend ahead of JP Morgan’s facilitated acquisition of Bear Stearns. The Fed ultimately dropped interest rates to zero, and Kroszner joked that he left his post at the Federal Reserve because there was nothing left to do.

Randall S. Kroszner, left, and moderator Rodney Sullivan, CFA

Randall S. Kroszner, left, and moderator Rodney Sullivan, CFA

Of course, central banks have other methods of combating crises. The European Central Bank extended sovereign debt maturities through the Long Term Refinancing Operations (LTRO) program. Another policy response is to provide liquidity to banks; however, Kroszner explained that this is the most politically challenging. The Troubled Asset Relief Program (TARP) in the United States was enormously unpopular. In fact, polls indicated that while 65% of the U.S. population opposed torture in the war on terror, 80% opposed the TARP! The European Financial Stability Facility (EFSF) was and still is politically unpopular.

Throughout the credit crisis, the Fed grew its balance sheet from about US$800 billion to close to US$3 trillion. Commercial banks in the United States are holding about US$1.5 trillion of excess reserves. Banks’ risk-averse behavior is keeping those reserves from flooding the market and boosting inflation. Under normal circumstances, growing the money supply as much as the Fed did leads to inflation. Fortunately, the banks are able to earn interest on those reserves, so the opportunity cost of holding excess capital is not as great. This scenario is still playing out, so we have yet to see if the Fed’s actions will ultimately be inflationary. In Europe, banks are bolstering their capital base by holding government debt. This is a sub-optimal solution because the health of government paper is deteriorating. Kroszner emphasized that European banks need to find liquidity from other sources.

The former Fed governor also lamented that banks remain very fragile. The policy response to the financial crisis is still at work. Regulators are in the process of increasing the banking system’s cushion against losses through requiring more equity capital. The consequence of this is that banks will have an incentive to start using off balance sheet vehicles to get around higher capital requirements. These requirements are important, but policy makers need to find more ways to strengthen banks. The Volcker rule  limiting banks’ ability to engage in proprietary trading makes sense in principle, Kroszner noted, but the implementation is challenging. How do you differentiate between proprietary trading and natural hedging? Using the “you know it when you see it” methodology is insufficient. To address interconnectedness, regulators need to make the system more transparent by creating a central clearing house for derivative trades, a move that is important for risk managers and regulators alike.

Kroszner concluded his remarks by saying that, in principle, we are making good decisions to strengthen the banking system. The challenge that remains is implementation.

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