Neel Kashkari and the Minneapolis Plan to End Too Big to Fail
Neel Kashkari has been President of the Federal Reserve Bank of Minneapolis since January 1, 2016. Prior to that, he was brought over from Goldman Sachs to be Assistant Secretary of the Treasury for Stability from October 2008 to May 2009. His job was to hand out money to the banks as bailout.
I believe the first time first time he was mentioned at this blog was right after he was appointed to give away our money:
The bail-out will succeed only, repeat, only in the sense that the US succeeded in Iraq in 2003 and 2004 when Simone Ledeen and the rest of the Heritage interns were running around the country handing out trash bags full of money and giving Halliburton money for services it would never begin to render. There will be less yabbering of silly catchphrases like “but what about all the schools that were painted?” this time around, though, because the schools will be exploding when GW is no longer in office. To be extremely precise, this is what I think the success will look like: shady, undeserving characters will be enriched, young versions of the idiots who got us into the mess will launch successful careers (can you say “Kashkari”?), and the promised benefits to the American public, the schmucks footing the bill, will never materialize.
From memory, not only is that the first time I mentioned Mr. Kashkari, it is also the most complementary I have been toward him yet. But now, Mr. Kashkari is back with a new scheme to reduce the likelihood of a meltdown.
Kashkari provides this slide as a summary of his plan:
Figure 1 (click on the slide to embiggen)
Accompanying the slide is this platitude which also functions as a fly in the ointment:
We cannot make the risk zero, and safety isn’t free. Regulations can make the financial system safer, but they come with costs of potentially slower economic growth. Ultimately, the public has to decide how much safety they want in order to protect society from future financial crises and what price they are willing to pay for that safety.
Because Kashkari is a political creature who won’t speak clearly, to get an understanding of what the vegetables he wants us to eat taste like we go to the full plan:
We measure the cost of higher capital requirements in terms of lost GDP due to tighter lending conditions. This calculation requires a number of steps. We trace the impact of higher capital requirements to lower bank return on equity (ROE) and then to higher loan rates. Higher loan rates slow economic growth by restricting borrowing. As noted above, this approach closely follows the BIS.
And the banks agree:
The Financial Services Forum that represents U.S. financial services companies cautioned that implementing the recommendations would stymie the economy. “For those looking to accelerate economic growth and job creation, tripling bank capital levels — already double from pre-crisis levels — will make it much harder to meet those goals,” the forum’s spokeswoman, Laena Fallon, said by e-mail.
So, to summarize the negative side of this proposal: more stringent regulatory requirements –> higher interest rates –> less borrowing –> slower growth in GDP.
I recognize that this is gospel in the banking and regulatory community, and its been many moons since I thought of myself as an economist, but this seems pretty daft to me. Or rather, it seems like regulatory capture speaking. Consider for a moment this seemingly unrelated graph:
Figure 2.
Note that the bank prime rate (orange line on the graph) is almost perfectly correlated with the fed funds rate (blue line on the graph) which is set by the Federal Reserve Bank. The difference between the two lines is shown in the gray bars. Do you see the large, sustained increase in that difference between the pre-Crisis period and the present that is due to the large increase in capital requirements we’ve already seen? No? Well, that’s because it didn’t happen. This notion that increased capital requirements raises the interest rates that banks charge their customers makes perfect sense in theory, but it stubbornly refuses to actually be true in the real world.
However, let’s assume this time things will be different. Let’s assume that unlike what we’ve seen so far, this time increased capital requirements do lead to a big sustained increase in the bank prime rate. Say for the sake of this post that the requirements effectively doubles the difference between the fed funds rate and the bank prime rate, permanently. What changes?
Well, if the Fed decided, at that point, that it wanted to raise or lower the interest rates charged by banks, it would do what it currently does in the same situation, namely change the federal funds rate. If anything changes at all, maybe, just maybe it will do so at the lower bound. And if there were some evidence that the Fed knows what its doing when the Fed Funds rate is near the lower bound, I admit that would be a concern.
So there’s no downside to this plan, at least as far as I can see. Of course, the plan is just the tame one we’ve already enacted, but with a bit more in the way of a bite and, courtesy of Mr. Kashkari, a more extravagant soundtrack. The Federal Reserve Bank of Minneapolis has a good sized research team. Kashkari could have asked any of them of to explain how the Fed Funds rate works, or about the relationship between the Fed Funds rate and the rates charged by banks. But failing upwards requires ignorance. The higher up you are, the more ignorance is required. It is clear Mr. Kashkari has further to rise.
First, I think we can skip right past the Higher Interest Rate part. If capital requirements go up, banks have less money to lend no matter what the interest rate.
Second, most of us don’t get to borrow at prime. So, how do mortgage rates and auto loan rates and credit card rates correlate to prime?
Warren,
It isn’t for me to be defending Kashkari and his partly-right partly stupid argument but let me try anyway. I suspect you’d have the same problem Kashkari does, which is that the answer is great in theory but it hasn’t actually worked in practice in the last couple of decades in the US. If there were some sort of a shortage of funding as a result of the big increase in capital levels which occurred in response to the 2007 meltdown, the law of supply and demand would have resulted in a rise in interest rates unless demand for money also tanked.
As to the relationship between the prime and other rates, here is something I found online.
Warren note that there may be less money to lend. The practice is to m ake contracts with borrowers that has the bank key stroke amounts into a lending account. When demands are made on such accounts the bank may at times need to reach outside their own books to transfer the monies claimed or demanded.
So the real matter is whether they can borrow these sums should they find themselves in this situation. So studies need to look at volume at the Fed discount window and more importantly, at the liquidity markets in the interbank lending world and the shadow world.
I may be wrong but I thought that the non-Fed liquidity serving markets are now huge and offer rates lower than the Fed.
So it looks to me that banks simply use the Fed for signaling on credit pricing, and take advantage to ensure their spreads ratchet upward. Meaning that the Fed’s actions to accommodate an easier money to offset a downturn is not really transmitting to consumer credit channels.
Next downturn the Fed must by rule order the banks to lower their credit prices so as to be accommodating. In the meantime, I suspect that the non-Fed liquidity markets tell you when increasing capital requirement standards are having an influence (at which time the Fed window would me meaningful), so increase them.
I’d prefer that Congress enact a taxation regime to complement the Fed’s tools, taking some of the rent-earned excesses into fuscal budgeting lattitudes, which would help in downturns, and taxing earnings related to real economy lending more favorably than earnings from financial trading. Not the time for this to be considered now, unfortunately.
JF,
I find myself mostly agreeing with you, but you stated the points more clearly than I am able reflecting the fact that you have are closer to the issue and have a better understanding of it than I do. If only people appointed to high level positions like President of the Minneapolis Fed, for instance, had the same understanding. Or failing that, if such people had the presence of mind and decency to resign.
“If there were some sort of a shortage of funding as a result of the big increase in capital levels which occurred in response to the 2007 meltdown, the law of supply and demand would have resulted in a rise in interest rates unless demand for money also tanked.”
Demand HAS tanked. 1.283 million homes were sold at the peak in 2005, and only 501k in 2015.
https://www.statista.com/statistics/219963/number-of-us-house-sales/
And the number of households carrying credit card debt month-to-month declined from 44% in 2009 to 34% in 2014.
http://www.creditcards.com/credit-card-news/credit-card-debt-statistics-1276.php
Warren,
Fewer homes bought and sold is not evidence that fewer people want to buy or sell a home if the banks decide who gets a mortgage and who doesn’t.
But let us assume it is as you say. If (1) it is supply and demand for loans that affects the prime rate and (2) the Fed sets the Fed funds rate based on is attempt to goose the economy in the worse downturn in 80 years then (3) the fact that the spread between the Fed Funds rate and the prime rate seems to have remained the same before and after the crash is one hell of a coincidence. It means that demand and supply for bank loans fell at precisely the same rate, and they moved in lockstep since we don’t see any particular months where there was a big spike or drop. I don;t believe in explanations that requite unlikely coincidences to persist for a long time.
Another mumbling JimH post. Sorry Jim, that is why so many pro-corporate and globalists won election results? Pssst, it is called a evangelical vote, a shitty Democratic Candidate and interference to force in a Republican that said Democratic candidate did not take seriously enough. You are not getting it. When the worms turns and more Clinton style Democrats are elected with some real charisma, what then?
Sorry Jim, people are obviously spending, they do have money, what do you know considering the slow down in debt. Your posts reek of self-masturbation. You deserve a nostril grab then a rip. The pain, hopefully will teach you the lesson Hillary Clinton didn’t learn in 2008.
Eh Warren, those sold homes were 100% above the “norm”. No, demand hasn’t tanked, it has normalized to a smaller demographic. why should we even have 800 homes being sold? Back in the post-war era, getting 500 was a solid month.
Another stupid, lame ignorant post. I mean, do you guys even try to think?
“Demand HAS tanked. 1.283 million homes were sold at the peak in 2005, and only 501k in 2015.
https://www.statista.com/statistics/219963/number-of-us-house-sales/”
Yes but that can’t be attributed to banks.
Almost all of the extra house sales during the bubble
years were financed by the $6 trillion that private investors funneled through private channels into the housing market during the bubble.
http://www.weebly.com/uploads/4/0/4/4/4044041/graph_2.png
Most of those privately funded mortgages are now kaput. In fact, more then half the mortgages funded by private mortgage conduits were already defunct by the time the market crashed. That is because unlike loans funded through bank deposit channels these loans were designed to be short-lived. They were designed to capture the rising house values as quickly as possible and not designed for the long haul like bank funded loans are. The mortgages funded through private mortgage conduits that were already liquidated before the crash were very profitable.
https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=4t8u
The same can be said about credit card and auto lending. The funding channel for much of these loans is not bank deposit money. Therefore all this talk about regulating or not regulating banking is mostly irrelevant and a diversion from the truth.