FDIC Vice Chairman Hoenig Addresses Cato Institute Monetary Conference
"As central banks have come to dominate financial markets, the debate over their ability to deliver strong, long-run economic growth has become increasingly intense. "Central Banks and Financial Turmoil" is the theme of this conference, and given the dramatic expansion of central bank balance sheets and their influence over economies, it is a topic well worth our attention. I congratulate the conference organizers for their foresight in selecting it.
"I will focus my remarks this morning on two areas on which central bank performance is judged: monetary policy and macro-prudential supervision. While a host of factors determine an economy's strength, these two policy instruments have come to play a dominant role in our economy, and their role going forward is a major subject of attention. I will suggest that monetary and regulatory policies have for some time been overly focused on short-run effects at the expense of long-run goals, which has unintentionally served to increase uncertainty and economic fragility. Future success requires that policy move deliberately toward a more balanced long-run objective.
"Monetary Policy
"The dual mandate for
"In a world of discretionary policy, when the moment comes to choose between long-run goals and short-term effects, policymakers experience enormous pressure to choose the more expedient short-run solution, deferring to another time concern with long-run implications.
"This tendency can be seen in the long-run trends of short-term interest rates. Chart 1, for example, shows the real fed funds rate from 1960 to
"Regulatory Policy and Macro-Prudential Supervision
"Turning to macro-prudential supervision, its objective might best be described as that of assuring the integrity of financial institutions, sound markets, and a reliable payments and intermediation framework. Carrying out this mandate involves an extensive program of rules and supervisory oversight designed to achieve long-run financial stability, credit availability, and stable economic growth.
"As with monetary policy, authorities have discretion as to how they carry out the supervision mandate, which has led to different degrees of oversight over time. For much of the quarter century prior to 2008, for example, there was a systematic easing of constraints on bank activity and, most notably, an extension of the public safety net to an increasing number of non-bank financial activities conducted by both banks and shadow banks. Commercial banks were given authority to engage in investment banking, trading, and broker-dealer activities, while investment banks and other financial firms were permitted to engage in a host of bank-like activities.2
"While the safety net was broadened over this period, capital requirements were allowed to weaken, exacerbating the downward effects on stability.3 Chart 2 shows that from 2001 through 2008, equity capital supporting the industry's balance sheet - defined as the ratio of tangible equity-to-tangible assets - declined to less than 4 percent. This trend of lower capital continued a century-long shift in which market and public confidence in banks relied less on bank capital levels and more on the growing presence of government safety nets.4
"Leveraging the Economic System
"Chart 3 shows the longer-run effects of accommodative monetary and supervisory policies. Total
"These trends in debt have been described by some as a consequence of a global savings glut. However, it is no coincidence that the trends followed nearly a decade of systematic and sometimes dramatic accommodative
"Finally, Chart 4 shows that despite these ever-more accommodative monetary and regulatory policies, and despite the increase in financial and economic leverage, the growth rate of the
"Financial Crisis
"These trends suggest that the financial and economic shock experienced in 2008 did not just happen randomly. It followed an extended period of accommodative policies in which long-run considerations were most often discounted against the perception of immediate needs. Extended periods in which monetary policy catered to short-term growth objectives and regulatory policies encouraging ever-declining capital levels among financial firms made the system increasingly vulnerable to shocks.
"As 2007 and 2008 unfolded, the effects of these policies erupted and losses quickly overwhelmed the financial industry. Chart 5 shows that cumulative losses and TARP capital injections in 2008 approached nearly 6 percent of total industry assets. Several of the largest financial firms failed, requiring unprecedented government support to prevent collapse, while many others appeared ripe for failure. The public and the market did the rational thing; they ran for the exits. The crisis was on.
"Central banks, using unprecedented facilities, injected enormous amounts of liquidity into the economy. In an important sense, their actions represented a decisive execution of the lender and liquidity provider of last resort, which calmed fears and staunched the crisis. While it was the appropriate short-run response, its extended duration comes with a substantial public cost.
"Post Crisis: Monetary Policy and Discretion
"By the third quarter of 2009, an economic recovery was underway. Then, as now, the month-to-month data were mixed5 but the overall trend suggesting a sustained recovery was compelling. For example, average GDP growth during the first year of recovery was 2.7 percent, which compares favorably to the 2.9 percent growth rate in the first year following the 1991 recession and 2.3 percent growth following the 2001 recession.
"Nevertheless, most policymakers were uncertain of the recovery's durability and were loath to normalize monetary policy regardless of the emerging favorable evidence. Long-run considerations took a back seat to short-run concerns.6 In November of 2010, under the title QE2, the
"As a result, a fragile equilibrium dependent on low interest rates has settled so deeply into the economy and financial markets that the difficulty of moving rates higher represents an unsettling force within
"Post Crisis: Macro-Prudential Supervision
"As monetary policy was steadily eased, concern arose regarding its negative long-term effects on financial firms and the broader economy. To offset these concerns, macro-prudential supervision was touted in financial policy circles as a powerful force to balance any negative effects of monetary policy.
"Enhanced macro-prudential financial rules and standards are tools that serve the goal of greater financial stability, but as a complement to monetary policy they raise their own set of issues. If monetary policy is set to stimulate credit expansion and wealth effects, it is highly unlikely that bank supervisors would take actions that impede those policies.
"Chart 6 shows the trend line for tangible capital-to-tangible assets for the largest
"While strengthening bank capital would serve the industry and the economy well, an effort is underway to back away from this macro-prudential policy goal.9 The argument continues now, as it did pre-crisis, that increasing capital from current levels will hurt economic growth. To the extent that these arguments are successful, the industry and economy will be very poorly served. Macro-prudential supervision and monetary policy are not tools for fine-tuning the economy, but are blunt instruments generally managed toward the same policy goals. The mandate for these policies is long-term stability, but too often the immediacy of the short term has taken precedence. And the cost has been great.
"Changing the Approach
"After nearly a decade of highly accommodative monetary policy and uneven supervision, the
"This accommodative policy loop must change. To normalize monetary policy, interest rates must increase, which will temporarily put downward pressure on financial industry asset values and earnings. It is also understood, but less acknowledged, that if capital levels of the world's largest banks remain at current levels, these firms will continue to be vulnerable to losses that flow from higher rates and macro-economic adjustments. Such consequences could weaken bank balance sheets significantly and undermine their ability to support the economy through the adjustment period.
"The challenge is to find a path that enables central banks to rebalance monetary policy without shock overwhelming the financial system and undermining long-run economic growth. One such path to consider is for interest rates to be increased in a clear, deliberate manner toward an announced long-run target rate or range. The time line, adjustment path, and target range would be influenced by a host of factors, including, for example, fiscal policy, demographics, and international events. However, once chosen and announced, the policy must not be abandoned at the first - or even second - sign of stress. It took a decade to get to this point, and it will take time to return to "normal".
"Importantly, there should be no backing away from insisting on strong equity capital standards. Capital should be set to levels that ensure the industry can absorb future losses and reduce concerns about its resilience. This requires building tangible equity capital beyond current levels.
"While challenging, there is clearly room to strengthen capital through retained earnings. For example, since 2009, the largest eight US banks have paid out
"Importantly also, retained earnings would not be stale reserves, as is sometimes suggested. Retained earnings are working capital that facilitates bank lending, enhances bank earnings, promotes financial stability, and supports long-term economic growth. While concern has been expressed in some quarters that requiring increased equity would lower returns to investors and raise the cost of capital, there is ample evidence that well-capitalized banks trade at higher premiums than less well-capitalized banks and have a lower cost of capital over time. History also shows that without the government safety net, the market would insist on banks having tangible capital levels - in other words, owner equity -- higher than currently maintained. And, as a matter of public policy, we should not allow the benefits of the government safety net, which are meant to protect the public, to flow as a subsidy to private investors.
"In summary, I am suggesting that both monetary and macro-prudential policies need to focus independently on the long run. Interest rates need to normalize, and bank capital needs to be strengthened. Policy cannot stay on its current path of low-for-long rates and return-to-lower capital without undermining the resilience of the financial system and the economy, and without inviting harsher future adjustments, as occurred in past episodes when policy was highly accommodative. We have an opportunity to strengthen banks, the financial system, and the economy to achieve real long-run growth goals, if the view of policymakers shifts from short-run effect to long-term sustainability."
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