Institute for Financial Transparency

Shining a light on the opaque corners of finance


Yellen delivers closing argument for breaking up the Fed

During the 2017 Jackson Hole symposium, Fed Chair Janet Yellen explained why breaking up the Fed and sending all of its supervision and regulatory responsibilities to the FDIC is necessary.

She observed:

The effects of capital regulation on credit availability have been investigated extensively. Some studies suggest that higher capital weighs on banks’ lending, while others suggest that higher capital supports lending. Such conflicting results in academic research are not altogether surprising. It is difficult to identify the effects of regulatory capital requirements on lending because material changes to capital requirements are rare and are often precipitated, as in the recent case, by financial crises that also have large effects on lending.

So who did this extensive investigation?  Her footnote to this paragraph tells us:

The related literature is sizable. An early contribution is Ben S. Bernanke and Cara S. Lown (1991), “The Credit Crunch,” Brookings Papers on Economic Activity, no. 2, pp. 205-47. Research finding a sizable negative relationship between capital requirements and lending includes Shekhar Aiyar, Charles W. Calomiris, and Tomasz Wieladek (2014), “Does Macro-Prudential Regulation Leak? Evidence from a UK Policy Experiment,” Journal of Money, Credit and Banking, vol. 46 (s1; February), pp. 181-214. Research finding little relationship between lending and capital ratios (outside financial crises) includes Mark Carlson, Hui Shan, and Missaka Warusawitharana (2013), “Capital Ratios and Bank Lending: A Matched Bank Approach,” Journal of Financial Intermediation, vol. 22 (October), pp. 663-87. Research suggesting that higher capital levels may increase lending includes Leonardo Gambacorta and Hyun Song Shin (2016), “Why Bank Capital Matters for Monetary Policy (PDF),” BIS Working Papers 558 (Basel, Switzerland: Bank for International Settlements, April).

The investigation was lead by several PhD Economists.

After spending considerable amounts of time, these PhD Economists arrived at conflicting results as to the impact on bank lending from raising capital requirements.

Might there be a simple explanation for the conflicting findings?  Yes.

For virtually all banks, the decision to make a loan is independent of the decision of how to fund the loan.  When banks have the opportunity to make a loan that satisfies all of their internal credit tests, they do so.  Lending is opportunity driven.  It isn’t funding driven.

Once the loan is made, the bank then decides how to fund it.  There are two choices for how to fund the loan: hold it on the bank’s balance sheet or sell it.

It is only when banks fund the loan on their balance sheet that higher capital requirements could possibly have any impact.  And even here the impact is minimal.  For example, is the new loan replacing a loan that is maturing?  If yes, then there is zero reason to think higher capital requirements have any impact.

Please note, the independence of the lending and funding decisions is not taught in Econ 101 (or later Economic courses).  The fact it isn’t taught means Fed officials are left blindly implementing supervision and regulation.

There is no reason to assume they get it right.

Naturally, in the very next paragraph of her speech, the Fed Chair provides an example of the Fed not getting supervision and regulation right:

Given the uncertainty regarding the effect of capital regulation on lending, rulemakings of the Federal Reserve and other agencies were informed by analyses that balanced the possible stability gains from greater loss-absorbing capacity against the possible adverse effects on lending and economic growth.

Since lending and funding are independent, does this tradeoff really exist?  No.

Is there any chance the Fed’s capital regulations are appropriate given the regulations reflect a tradeoff that doesn’t exist?  Very little (one can’t rule out blind luck, but the idea of counting on the Fed to get it right by blind luck is very unsettling).

The best the Fed has to offer when it comes to supervision and regulation is blind luck.  This is not a compelling reason to leave the Fed with any supervision and regulation responsibility or authority.  It should all be transferred to the FDIC.