Condemned to Repeat the History of Bank Failures?

The Federal Reserve is sufficiently concerned about the health of the economy that it has hit the pause button on further interest rate increases, and rightly so. The Fed left its benchmark interest rate unchanged Wednesday, and Fed officials predicted no rate increases during the rest of 2019 — which would be the first year without a rate increase since 2014. But at the same time, the Fed and other agencies keep chipping away at financial regulation — a course of action that threatens to hasten the arrival of the next economic downturn, and to make it more painful.

Barely a decade has passed since the recklessness of major financial institutions helped to catalyze the largest economic crisis since the Great Depression. Many Americans have yet to recover their losses. Yet somehow, the lessons of the crisis already appear to be fading.

The government has loosened a number of the key strictures imposed on banks and other financial firms in the aftermath of the 2008 crisis, and more leniencies are in the pipeline. In particular, the government is allowing large banks to rely more on borrowed money as a source of funding, even as it has reduced scrutiny of their lending decisions.

The government should be taking advantage of this prolonged period of economic tranquillity to strengthen the banking industry’s defenses, as there will be another downturn.

To force large banks to get ready for the bad times during the good times, the Fed created a tool after the 2008 crisis called countercyclical capital buffering. Banks borrow most of the money they lend to customers, but the Fed requires banks to obtain a small portion of their funding from sources that do not need to be repaid — for example, by selling shares to investors or retaining profits. These funds are called capital; the amount of capital is the amount of losses a bank can endure without defaulting on its obligations. Under the new countercyclical policy, the Fed can order banks to increase these capital buffers during periods of economic growth.

This would seem like such a time. But earlier this month, the Fed declined to act. Instead it is moving to let banks shave their capital buffers.

The Trump administration argues that deregulation will spur economic growth, by freeing banks to make more loans. This is wrong in two distinct ways. First, banks say they have plenty of money but not enough customers; the binding constraint on bank lending is not regulation, but instead, weak demand. Second, a number of studies have found that well-capitalized banks are more prolific, consistent and higher-quality lenders during good and bad times.

In October, regulators proposed to ease capital requirements for all but the very largest banks. Leniency for smaller banks enjoyed bipartisan support, and Congress had directed the Fed to act. But the Fed went further than required, extending leniency to banks in the same weight class as Washington Mutual, one of the largest and most consequential bank failures during the 2008 crisis. Lael Brainard, the sole Fed governor to vote against the decision, issued a highly unusual public statement noting that only a few years have passed since the Fed had tightened its capital rules. She said she saw no change in financial conditions to justify weakening the rules. What has changed, of course, is that power passed from the Democrats to the Republicans, who are determined to deregulate.

The Fed also is easing the burden on the largest banks. Basic capital requirements are risk-weighted, meaning banks that make safer investments, such as buying Treasuries, are allowed to rely more heavily on borrowed money. But the rules also impose a minimum ratio limiting how low capital can go. That safety net is called the supplementary leverage ratio. And the government is planning to make it more flexible — letting banks borrow more.

The Fed estimates that the change would let the banking subsidiaries of the eight largest bank holding companies reduce their capital funding by a total of about $121 billion.

Earlier this month, the Fed also said it would narrow the scope of its annual “stress test” regime, which requires large banks to demonstrate they have the resources to endure a severe economic downturn. The Fed still will assess the adequacy of capital, but it will no longer evaluate risk management procedures. The Fed said the stricter standard was no longer necessary “due to the improvements in capital planning made by the largest firms.”

But capital planning improved because banks feared the threat of public censure. In the absence of scrutiny, there is every reason to worry that banks will backslide.

Each change in isolation is relatively modest, but the sum of them is growing. And the trend is particularly worrisome because the Trump administration simultaneously has diminished the role of the Consumer Financial Protection Bureau in policing bank lending. This hurts consumers, of course, but the 2008 crisis also was a striking demonstration of the ways in which an accumulation of individual instances of predatory lending can threaten the health of the financial system. Indeed, capital standards and lending regulations are best seen as mutually reinforcing approaches to preventing excessive risk-taking by banks.

Proponents of these changes take false comfort in the health of financial system. The banks were nursed back to health at public expense, in the context of stronger regulation. Weakening those rules is bad for the banks and the economy.

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