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

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Investors cheered Federal Reserve Chairman Jerome Powell’s Jackson Hole speech on Friday, with markets interpreting it to mean the central bank would not cut support for the economy too quickly. But not all speakers at the annual gathering gave rise to optimism.

Don Kohn, former Fed vice chairman for financial oversight, instead took the opportunity to warn of looming risks to the stability of the global financial system and called on regulators and lawmakers to take action. quick to respond to these concerns.

“Addressing the risks to financial stability is urgent,” he said during the a speech at the annual Jackson Hole Economic Policy Symposium hosted by the Federal Reserve Bank of Kansas City. “The current situation is replete with… unusually large risks of contingencies, which, if materialized, could result in amplification of shocks by the financial system, putting the economy at risk.”

Kohn pointed out minutes from the last meeting of the Federal Reserve, which indicated that members of the bank’s interest rate setting committee saw that there were “notable” vulnerabilities in the financial system as the value of assets reached historic highs and public and private debt reached near record levels relative to the size of the economy.

Despite these excesses, investors do not seem worried, as evidenced by low interest rates on a wide range of TMUBMUSD10Y government bonds,
2.981%
and corporate debt “even though a disproportionate increase in private debt has occurred among lower-rated commercial borrowers,” he said.

Moreover, Kohn said, the government appears to be in a poor position to react to an economic slowdown that could result from the bursting of an asset bubble or a debt crisis, given that the Federal Reserve is already engaged in aggressive monetary stimulus, while 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 high-profile investors, with GMO co-founder Jeremy Grantham being one of the most prominent advocates of this. point of view. In June, he argued the Fed should “act to deflate all asset prices as carefully as [it can]knowing that an earlier decline, however painful, would be less and less dangerous than waiting.

Unlike bubble watchers such as Grantham, however, Kohn does not blame high debt and asset prices on Fed policy. Rather, he argues that the central bank must prepare now for a possible bursting bubble through prudential regulation.

One strategy to protect the US economy from the bursting of an asset bubble would be to require large banks to XLF,
+0.47%
to finance 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 the amount of debt banks can take on, lowering the level in good times when banks can afford to do so.

“By increasing capital requirements during boom times, it could put a damper on asset price runaways,” said Jeremy Kress, a former attorney in the Federal Reserve’s Banking Policy and Regulation Group and a professor at Michigan’s Ross School of Business. in June. “The Federal Reserve, unlike other countries, has never activated this discretionary buffer. Maybe now might be the time to activate it,” Kress said.

Kohn urged the Fed to increase the countercyclical capital buffer, which Randal Quarles, the Fed’s current vice chairman for financial oversight, has resisted doing, telling an industry audience in June that the cushion increase “unnecessarily reduce the ability of companies to grant credit to their customers.” The disagreement could soon turn political, as President Joe Biden’s progressive allies have called on him to appoint either a Fed chairman or vice chairman more receptive to tougher rules on bank lending.

Kohn also took aim at two creations of the Dodd-Frank Financial Reform Act instituted in the wake of the last financial crisis: the Financial Stability Oversight Council, which includes the heads of all major financial regulators, and the Office of Financial Research, which had subpoena power so that regulators could demand information necessary to maintain financial stability.

“I think most would agree that the performance of these two new entities has been uneven,” Kohn said, arguing that the FSOC proved unable to act quickly while the OFR never used its power to act. subpoena for fear of ruffling the industry’s feathers. He argued that the FSOC should be revamped to give the Secretary of the Treasury more power to act unilaterally and that the OFR should be given a clear new mandate to routinely gather the information 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, systemic risk is not something they are required to consider in carrying out their missions,” he said. “They should be required to broaden their perspective to consider the systemic implications of their actions and the activities and businesses they oversee and be held accountable for doing so.”

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