The Fed’s Plan for “Countercyclical Capital Buffers” Is Just More of the Same

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If you follow financial news related to Fed policy, you would have noticed a recent push for the use of “a new monetary tool,” called countercyclical capital buffers. Some prominent Fed officials and Fed watchers — the monetary version of all the king’s horses and all the king’s men — have decided the time is now to start raising such requirements, notwithstanding resistance to their implementation.

A countercyclical capital buffer, often abbreviated CCyB, is a capital requirement enforced on the US’s largest banks to promote bank stability when the inevitable recession hits. Restated in FedSpeak, CCyB

…is a macroprudential tool that can be used to increase the resilience of the financial system by raising capital requirements on internationally active banking organizations when the risk of above-normal losses is elevated. The CCyB would then be available to help banking organizations absorb shocks associated with declining credit conditions. Implementation of the buffer could also help moderate fluctuations in the supply of credit.

Some within the Fed believe that we are at the stage of the business cycle in which such a tool needs to be implemented, with the most prominent among them being Governor Lael Brainard. To her, CCyB provides an additional level of security going into the next recession (will it be in 2020?) just in case other post-crash monetary interventions — think of Dodd-Frank, heightened stress tests, and interest payments on excess reserves — prove insufficient to mask financial system failures.

Other supporters, including the regional Fed bank presidents from Boston, Chicago, Cleveland, and Kansas City, argue that as financial risks grow toward the end of economic expansions, measures such as CCyB should be invoked. However, CCyB opponents note that such buffers are not necessary in the banking world of today in which capital reserves and household net worth are already at historically high levels, making additional capital reserve requirements meaningless.

Scratching beneath the surface of the debate, we find the normal level of duplicity that characterizes most debates about monetary policy. For instance:

First, there is nothing new about this policy tool, which is common in the UK Ireland, and Hong Kong. The US approved CCyB as a policy tool over two years ago and the Federal Reserve Board has since voted on its current level (0 percent). Its appeal is in providing some relief to pressures for lower interest rate targets in a recession, especially to help avoid the appearance of monetary policy impotence when interest rates approach the zero bound.

This was a serious problem for the Bernanke Fed, which had to develop — on the fly — new ways to inject money into the economy after the federal funds target went as low as it could go. The appeal of countercyclical capital buffers is to help the Fed avoid appearing so desperate, again, in the event of a Great Recession II.

But there are more serious problems with CCyB than such ulterior motives of its supporters. In terms of its being a strategic reserve for capital, it poses many of the same problems for financial markets that the strategic oil reserve provides for oil markets. By reducing the supply of available capital, it raises its cost, even to borrowers of small and midsize banks not subject to the capital requirement but that still must charge market rates.

Like the strategic oil reserve, a strategic capital reserve would weaken price signals in financial markets, the free-flow of which are essential to a quick and efficient market correction process. Rising interest rates in recessions attract the real saving necessary for stable long-term economic growth. What’s more, they are normal in recessions due to the reduced demand for money and the change in time preferences toward more future orientations. Unfortunately, incentives would be hindered if the Fed released these reserves into the economy, thus delaying the recovery process.

Furthermore, there is no assurance that by injecting these reserves into the economy they will be used to promote economic growth. Bank excess reserves since 2008 suggest that if there is underlying fiscal and monetary regime uncertainty, there is no reason to assume CCyB will have any effect but to add to existing excess reserves.

Worse than that, it would add to moral hazard too. Banks that make poor lending decisions or that maintain incorrect mixes of loans based on term or risk, should pay a market penalty. Savers and investors are right to direct their business elsewhere. Banks protected from market penalties have little incentive to reform their practices and policies.

The irony is that well-run banks responding to market forces already have incentives to maintain capital reserves. By forcing all banks to create these reserves, the Fed would remove a signal that might allow consumers to differentiate well-run institutions from poor-run ones. To the extent that CCyB increases costs to traditional banks, it creates incentives for consumers to avoid these banks and, possibly, hasten their demise.

As Mises noted in Liberalism, governments often grow because an initial intervention in the market to bring about a favored outcome often causes unintended secondary effects that eventually justify further intervention. These secondary interventions then result in a new round of unintended consequences. And so it goes, leading to the countercyclical capital buffer debate of today.

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