Much of the talk this week as markets plummeted focused – indeed was transfixed – on the U.S. Federal Reserve’s next step. Would it walk rates up a tad in September, stand pat, or even walk back to a QE4 position? I will leave for later what the central bank might do, but one thing is clear: whatever that is, the FRB now must understand that traditional monetary-policy tools are blunt because of the structural transformation of financial markets since 2008. If U.S. monetary policy is the fulcrum of global finance, then U.S. financial-market structure dictates its transmission channels. These are going haywire because the largest U.S. banks – the market’s mainspring – no longer act as efficient market intermediaries. This may well make the financial system safer, but it also makes it very, very different. If the Fed doesn’t get that – and its statements suggest to me it doesn’t – then we’re in for a very rough ride.
The fundamental, bedrock question of what’s going amiss in all the QEs is why huge demand for safe bank deposits is not stoking a like-kind supply of productive lending. Excess reserves held by banks have gone up 1,300 times since 2008, while large-bank lending is flat or even down. Regional banks are doing their bit, but banking assets remain heavily concentrated at the large end of the industry.
For the biggest banks, a lot more than excess-reserve balances has changed since 2008. In my view, their fundamental business proposition is radically different because of the combination of new rules and self-imposed restraint. The FRB can spike its punch bowl with 150-proof liquor, but big banks either can’t or won’t drink from it.
Others, though, are bellying up to the bar. The lower rates go, the more yield-chasing there is and larger grow the balances in shadow liabilities and in higher-risk assets held for longer durations with complete disregard for interest-rate risk. Market structure is thus changing not only because big banks aren’t intermediating, but also because fund flows are largest in assets with little long-term productive value. Current yield-chasing investments are generally not promoting household consumption or long-term business investment. Instead, they’re going into leveraged loans, emerging-market bond funds, and all sorts of other places that we learned all over again this week pose all sorts of investor and systemic risk. Banks and others resisting yield-chasing temptation are housing more and more funds in cash-equivalent assets, but this does nothing for economic growth even as it stokes greater market illiquidity under stress.
The U.S. could have a sound, intermediating financial system with fewer, smaller banks, but fewer, smaller banks without a sound regulatory system for the rest of the financial market is a recipe for boom-bust cycles of cataclysmic proportions. Hopefully, we dodged one this week. If so, the FRB should take heed of the loud warning buzzers and balance monetary-policy actions with financial-stability projections. If it’s too late and markets are already on the black-diamond ski jump, hold on. We’ve never seen this before.