Former Fed official warns of ‘urgent’ threat of new financial crisis

Investors applauded Fed Chair Jerome Powell’s Jackson Hole speech on Friday, with markets interpreting it as meaning the central bank was not going to cut its support for the economy too soon. But not every speaker at the annual meeting gave cause for optimism.

Don Kohn, the former Fed Vice-Chairman for Financial Supervision, instead took the opportunity to warn of impending risks to the stability of the global financial system, and called on regulators and lawmakers to act quickly to address these concerns. to dispel.

“Managing risks to financial stability is urgent,” he said during a speech at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Economic Policy Symposium. “The current situation is fraught with…unusually high risks of the unexpected, which, if they materialize, could cause the financial system to amplify shocks, putting the economy at risk.”

Kohn pointed to the minutes of the most recent meeting of the Federal Reserve, which noted that members of the bank’s interest rate committee saw “notable” vulnerabilities in the financial system as asset values ​​soared to historic highs and public and private debt near record levels have achieved relative to the size of the economy.

Despite these excesses, investors seem unconcerned, as evidenced by low interest rates on a wide range of government bonds TMUBMUSD10Y,
1.285%
and corporate debt “although a disproportionate increase in private debt has occurred among lower-rated corporate borrowers,” he said.

In addition, Kohn said, the government appears to be in a bad position to respond to an economic downturn that could result from the bursting of an asset bubble or a debt crisis, as the Federal Reserve is already engaging in aggressive monetary stimulus as the federal government maintains a historically high budget deficit.

Kohn’s distrust of the state of the economy and financial markets is shared by many leading investors, with GMO co-founder Jeremy Grantham being one of the most prominent proponents of this view. In June, he argued the Fed should “act so carefully to bring all asset prices down” [it can], knowing that an earlier decline, however painful, would be smaller and less dangerous than waiting.”

Unlike bubble watchers like Grantham, however, Kohn doesn’t blame the high debt and asset prices at the feet of the Fed’s policies. Instead, he argues that the central bank must now prepare for a potential bubble burst due to prudential regulation.

One strategy to protect the US economy from the bursting of an asset bubble would be to demand XLF from major banks,
-1.09%
to fund itself with less debt and more equity, in the form of retained earnings or money raised from shareholders.

The Fed’s so-called countercyclical capital buffer allows the regulator to change how much debt banks can take on, lowering the level in good times when banks can afford it.

“Raising capital requirements during boom times could signal a breakthrough for runaway asset prices,” said Jeremy Kress, a former lawyer in the banking regulation and policy group at the Federal Reserve and a professor at the Ross School of Business in Michigan, at MarketWatch. in June. “The Federal Reserve, unlike other countries, has never engaged this discretionary buffer. Now might be a good time to activate it,” Kress says.

Kohn urged the Fed to increase the countercyclical capital buffer, something Randal Quarles, the current Fed’s vice chairman for financial supervision, has opposed. “Unnecessarily reducing the ability of companies to extend credit to their customers.” The disagreement could quickly turn political as President Joe Biden’s progressive allies have called on him to appoint either a Fed chairman or vice-chairman who is more susceptible to tougher bank lending rules.

Kohn also focused on two creations of the Dodd-Frank financial reform bill enacted in the wake of the latest financial crisis: the Financial Stability Oversight Council, which is made up of the heads of all major financial regulators, and the Office of Financial Research. , which was equipped with subpoena powers so that regulators could request information necessary to maintain financial stability.

“I think most would agree that the performance of these two new entities has been spotty,” Kohn said, arguing that FSOC is incapable of acting quickly, while OFR has never used its subpoena power for fear of disrupt the industry’s springs. He argued that the FSOC should be reorganized to give the finance minister more power to act unilaterally and that the OFR should be given a new, clear mandate to regularly collect information that policymakers need.

Kohn also called on Congress to pass a new mandate for all federal financial regulators to make financial stability a priority.

“Right now, they don’t have to factor in systemic risks when conducting their missions,” he said. “They should be required to broaden their perspective to consider and be held accountable for the systemic implications of their actions and of the activities and companies they oversee.”

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