The Fed's Unhealthy Influence

The market would discipline banks far better than the Federal Reserve.

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Federal Reserve Chairman Ben Bernanke signaled that the Fed moving closer to slowing its bond-buying program, intended to keep long-term interest rates low.

A few weeks ago, markets reacted very badly to the Federal Reserve's announcement that it would have to stop its bond buying spree at some point, and indeed might, in Chairman Ben Bernanke's words, "moderate the monthly pace of purchases later this year." The market's response prompted Fed officials to tell market players to collect themselves and stop behaving like "feral hogs," which apparently are pretty dogged in pursuing something once they get a whiff of it.

But hypersensitivity to Fed pronouncements is natural when the Fed, through its monetary (and arguably fiscal) policy, is such a huge player in the marketplace. The Fed also plays a huge role in shaping the marketplace through its regulatory policy.

Last week, for instance, it announced the new Basel III capital rules for banks. These rules are supposed to make banks stronger and less vulnerable to severe market downturns. They are known as "Basel" rules, because they are based on a framework agreed to by central bankers in meetings that take place in Basel, Switzerland. The III in "Basel III" means that they replace prior iterations of bank capital standards, which, as the last financial crisis illustrated, have not worked terribly well.

The thousand-page rulemaking includes updated risk-based capital rules. To finance its business, a bank needs money, which it can get by retaining the money it earns, raising money by selling shares or borrowing money. When you deposit money with a bank, the bank is borrowing from you, but banks can also borrow from other financial institutions. If the bank does well, depositors and other creditors get paid back, and the shareholders get to keep the profits. If the bank runs into trouble, depositors and other creditors are supposed to get paid back before shareholders get a dime. 

[See a collection of political cartoons on the European debt crisis.]

The less a bank borrows, the better it is able to survive a bad event, such as a massive drop in housing prices that erodes the value of its portfolio of mortgages and construction loans. That's why it matters how banks finance their operations. In order to determine how much capital (which means financing that isn't borrowed) a bank has to have, the Basel III regulations take into account how many and what kind of assets it has. The riskier the assets, the greater amount of capital the bank is required to have.

Risk is in the eye of the beholder, however. The Fed, with input from other regulators and complicated risk models, has appointed itself the official beholder. The Fed decides the relative risks of different types of assets and assigns a "risk weight" to each asset class. Under the new rules, for example, U.S. and some foreign government debt securities have a zero risk weight, U.S. bank debt has a 20 percent risk weight, corporate bonds have a 100 percent risk weight and certain commercial real estate loans have a 150 percent risk weight.

Assets that have a zero risk weight require less capital backing than assets that have a 150 percent risk weight. As a result, banks have an incentive to hold assets to which the Fed has assigned a low risk weight. The Fed's assessment of risk becomes the standard for the entire financial industry and all banks will likely end up with a similar set of assets. If the Fed turns out to be wrong in its risk assessments, which recent history suggests is not impossible, banks will all go down together. Abandoning risk weighting in favor of a straight capital ratio could avoid this problem and, as a recent Mercatus Center paper explained, could also do a better job at identifying risky banks.

[See a collection of political cartoons on the economy.]

Just as it is sad to see the markets paying such careful attention to the Fed's bond purchase plans, it is also disheartening to see financial firms' internal risk assessments displaced by the Fed's. A better, simpler, and safer system would ensure that banks get a good chunk of their financing from shareholders and would make banks responsible for assessing the risk of their assets.

The market would help to discipline banks in making these determinations. Investors who would have a lot of money at stake would be drawn to enterprises that distinguish themselves not only by generating solid returns, but also managing the attendant risk prudently. The Fed can tame the "feral hogs" by moving out of the way so that the markets can start paying attention to something other than the Fed's latest pronouncements.

Hester Peirce is a senior research fellow at the Mercatus Center at George Mason University. Prior to that, she served as counsel for the Securities and Exchange Commission and the Senate Banking Committee.

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