Federal Reserve & Interest Rates

During an economic conference at the Federal Reserve Bank of Boston, Chairman Bernanke called for legislative action from Congress to close regulatory gaps,  as well as give regulators the power to unwind failing non-banking firms.  Only the FDIC currently holds such power over financial institutions with bank holding companies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers.

On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firmwide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or systemwide, approach that should help us better anticipate and mitigate broader threats to financial stability.

States which regulates insurance companies and the SEC which had regulated the now defunct investment banking sector had little such power, which led to little choice last year but to let Lehman Brothers collapse and AIG receiving a massive federal bailout.  While both Citigroup and Bank of America also required substantial federal aid subsequently, much of that was due to the global liquidity crisis which ensued following the problems of the two above mentioned institutions.

While Congress has been expected to act for some time and many changes are expected in the financial regulatory structure, little has been done thus far with it’s main focus on healthcare reform at the moment.  A plan which has gained steam recently is the creation of a regulatory council made up from a number of federal agencies with the power to supervise firms deemed systemic risks to the greater economy.

There have also been many calls to break up so called firms that are “too big” to fail in order to avoid a repeat of last year where substantial taxpayer dollars were put at risk in order to rescue the economy from financial collapse.

The Federal Reserve has kept interest rates at nearly 0% for some time now and by all accounts it will remain at that level through next year.  Now over a year removed from the beginning of the financial panic, credit markets have yet to recover.

Consumers and businesses are reluctant to borrow and financial institutions are reluctant to lend, even with interest rate at historical lows.  Consumer spending has been stagnant and with demand still low, businesses are loathe to make capital investments.

Throughout the recession, the savings rate of American households continues to climb despite repeated efforts by the government to stimulate consumer spending through stimulus payments and incentive programs.  Although the economy is expected to return to positive growth this quarter, it’s been mainly driven though the government’s fiscal and monetary policy initiatives.

With it’s normal monetary policy tool exhausted, the Federal Reserve has had to use balance sheet growth to expand the money supply.  The federal government has also had to undertake massive budget deficits in order to rescue the financial system.

With the current state of the credit system, talks of exit strategies might be premature at this juncture.  Short term inflation expectations remains low but it is something the government will have to worry about in the long run.

Financial institutions are still trying to de-leverage themselves and hundreds of banks are likely to fail in the next three to four years.  Consumer confidence will also likely remain muted for some time with the labor market expected to take years to recover.

Despite the record growth of the national debt, a number of individuals have cautioned against the government reducing it’s fiscal spending anytime soon or the economy could see a series of fits and starts as it tries to recover.

Nearly a hundred banks have already failed this year and the FDIC’s bad bank list contains hundreds more that are in danger of failing in the next few years.  With it’s insurance fund running dangerously low, the FDIC put forward a plan earlier this month, in which banks would prepay three years worth of fees to replenish the fund.

It’s the worst stretch of bank failures since the Savings and Loan crisis of the 1990’s when nearly two hundred banks and thrifts failed, costing taxpayers over $100 billion.  The insurance fund has shrunk by nearly $35 billion since the recession began and has a little over $10 billion remaining.

While banking system has stabilized somewhat, it’s still in a fragile state and the continued weakness in the residential and commercial real estate markets will lead to more failures in the next few years.  At this point, the FDIC estimates that bank failures will cost the insurance fund $100 billion by 2013.

The proposed prepayment plan is expected to raise somewhere in the neighborhood $50 billion and while the banking industry isn’t happy about it, they prefer this option to a special fee assessment which was also a possibility. In May, Congress increased the FDIC’s line of credit with the Treasury to $100 billion, but it been reluctant thus far to borrow from the Treasury and putting more of the onus of bank failures on taxpayers.