In 2015, FedFin issued a paper showing the unintended, damaging consequences of imposing the leverage ratio (LR) on custody banks. Almost two years to the day later, lo it may be so with the LR. Some central banks take a lot of persuading to alter a relatively modest rule with big, observable perverse prudential consequences. Indeed, unanticipated risk is not the only problem with the LR – it also exacerbates U.S. economic inequality. Too accustomed to looking too narrowly only at its own concerns, the FRB talks about the ill effects of income inequality but does little within its reach to fix what it can. As a forthcoming FedFin paper on housing-finance inequality will demonstrate, the LR requires rapid attention not just for custody banks, but also across the industry to end an unnecessary impediment to economic development.
To be sure, the LR isn’t the only Fed action with adverse equality impact. We took a hard look most recently at this question in a paper presented last April at the IMF spring meeting. In it, I describe the strands in both monetary and regulatory policy since 2008 that weave together to form a heavy blanket over opportunity for low- and moderate-income households. Our forthcoming paper will go into detail on housing finance to urge equality-boosting action as Congress turns to GSE reform, but the problem goes deeper and is still more damaging across the spectrum of income and wealth distributional drivers.
Thomas Piketty’s masterful book on income inequality is a daunting read with one critical, fundamental point: economic equality gets worse when macroeconomic growth is slow and return on capital is high. That is, those who are able to hold financial assets get wealthier as returns rise even as those trying to make ends meet fall farther and farther behind.
How does this work out in the U.S., and what does the LR have to do with growth and return on capital? Since the financial crisis, U.S. GDP has grown fitfully and sluggishly, as the Fed readily acknowledges. Unemployment has dropped by some measures, but economic discontent remains deeply embedded for every American without a college education as the Fed’s own research makes distressingly clear. And, if one wants to go beyond arcane data debates to see just how economically unhappy many Americans are, there’s always last year’s election to show what angry, populist-minded voters left out of the recovery think about their economic equality.
At the same time lower-income Americans are falling farther behind, the rich have gotten richer. Federal Reserve accommodative monetary policy has played a demonstrable role increasing the valuation of the assets capitalists enjoy – stocks, bonds, and the like – versus the homes that serve as the principal asset of lower-income Americans. Some have countered this argument in our prior work by claiming that house prices have risen enough to give home owners a meaningful boost, attributing rising house prices in part to Fed policy and then suggesting that the proverbial rising tide lifts all boats.
In fact, house-price appreciation is anything but equal. As our forthcoming paper will show, richer home owners have seen sharp house-price hikes since 2012 but lower-cost housing remains well below pre-crisis values even where they have finally crept above water. As Sen. Brown pointed out yesterday, twenty percent of borrowers in Ohio still have houses worth less than their mortgages and nationwide numbers aren’t all that different.
Where does the LR fit into this grim picture? Importantly and apparently unintentionally (at least as far as the Fed is concerned), the LR is now the binding constraint for many big banks, not just the custody banks set for LR relief. This is largely because the liquidity coverage ratio (LCR) forces larger banks to hold on average 24 percent of their assets in no- or low-risk obligations that are pummeled by the LR. To make complying with the LR and the LCR comport with making more than a pittance for investors, larger banks have realign the asset/liability mix to hold short-term assets favored by the LCR with no credit risk to arbitrage the cost of the LR. No wonder larger banks are turning to wealth management and away from traditional intermediation services. The combined effect of monetary and regulatory policy has driven up stock-market values, diverted trillions into yield-chasing assets, bumped up McMansion prices, and realigned the bank asset/liability mix away from the basic business of banking.
Critics will be quick to note that the discussion above does not address the extent to which the LR makes banks safer and sounder. At a time when Congress could well plunge the U.S. into a technical Treasury default, it would be foolish to argue that any asset is riskless (although central-bank reserves come close to immortal). An LR backstop to any risk-based capital standards that would give sovereign obligations a zero weighting does make a lot of sense. The income-inequality effect I have described above comes not from the fact of a leverage ratio, but from how high the U.S. has set it for the largest U.S. banks and how the LR fits into the LCR and all the other new rules.
Regardless of prudential benefit, a very costly capital requirement not applicable to key competitors with no underlying economic rationale makes banks change what they do. What they then do makes sense for shareholders even as what regulators do may well make sense from a regulatory perspective. However, the sum total of what banks do because regulators tell them to hold the LR is to change their business model. No one wants this new model to make Americans less equal. It just does.