The Blob That Ate Monetary Policy

Banks that are 'too big to fail' have prevented low interest rates from doing their job.

RICHARD W. FISHER HARVEY ROSENBLUM

Fans of campy science fiction films know all too well that outsized monsters can wreak havoc on an otherwise peaceful and orderly society.

But what B-movie writer could have conjured up this scary scenario—Too Big To Fail (TBTF) banks as the Blob that ate monetary policy and crippled the global economy? That's just about what we've seen in the financial crisis that began in 2007.

While the list of competitive advantages TBTF institutions have over their smaller rivals is long, it is also well-known. We focus instead on an unrecognized macroeconomic threat: The very existence of these banks has blocked, or seriously undermined, the mechanisms through which monetary policy influences the economy.

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Martin Kozlowski

Economics textbooks tell us that when the Federal Reserve encounters rising unemployment and slowing growth, it purchases short-term Treasury bonds, thus lowering interest rates and inducing banks to lend more and borrowers to spend more. The banking system, and the capital markets that respond to these same signals, are critical to transmitting Fed policy actions into changes in economic activity.

These links normally function smoothly. Numerous academic studies have concluded that monetary policy before the financial crisis was working better, faster and more predictably than it did a few decades ago. Monetary policy's increased effectiveness helped usher in a quarter century of unprecedented macroeconomic stability often called The Great Moderation—infrequent and mild recessions accompanied by low inflation.

Then the Blob struck. With financial markets in trouble and the economy wobbling, the Fed began lowering its target interest rate two years ago, bringing it close to zero by December 2008. Other central banks followed suit. Based on recent experience, such aggressive policies should have fairly quickly restored stability and growth. Unfortunately, the Blob was already blocking the channels monetary policy uses to influence the real economy.

Many TBTF banks grew lax about risk as they chased higher returns through complex, exotic investments—the ones now classified as "toxic assets." As the financial crisis erupted, these banks saw their capital bases erode and wary financial markets made them pay dearly for new capital to shore up their balance sheets.

In this environment, monetary policy's interest-rate channel operated perversely. The rates that matter most for the economy's recovery—those paid by businesses and households—rose rather than fell. Those banks with the greatest toxic asset losses were the quickest to freeze or reduce their lending activity. Their borrowers faced higher interest rates and restricted access to funding when these banks raised their margins to ration the limited loans available or to reflect their own higher cost of funds as markets began to recognize the higher risk that TBTF banks represented.

The credit channel also narrowed because undercapitalized banks, especially those writing off or recognizing massive losses, must shrink, not grow, their private-sector loans. TBTF institutions account for more than half of the U.S. banking sector, and the industry is even more highly concentrated in the European Union. Small banks, most of them well capitalized, simply don't have the capacity to offset the TBTF banks' shrinking lending activity.

The balance-sheet channel depends on falling interest rates to push up the value of homes, stocks, bonds and other assets, creating a positive wealth effect that stimulates spending. When the financial crisis pushed interest rates perversely high, balance-sheet deleveraging took place instead, with households and businesses cutting their debt at the worst possible time.

Falling interest rates usually drive down the dollar's value against other currencies, opening an exchange-rate channel for monetary policy that boosts exports. In the financial crisis, the dollar rose for about a year relative to the euro and pound (but not the yen). This unusual behavior partly reflected higher interest rates, but probably had more to do with the perception that financial conditions at TBTF banks were worse in the EU than in the U.S.

Finally, the troubles of TBTF institutions gummed up the capital-market channel. In past crises, large companies had the alternative of issuing bonds when troubled banks raised rates or curtailed lending. In the past decade, however, deregulation allowed TBTF banks to become major players in capital markets. The dead weight of their toxic assets diminished the capacity of markets to keep debt and equity capital flowing to businesses and scared investors away.

Obstructions in the monetary-policy channels worsened a recession that has proven to be longer and, by many measures, more painful than any post-World War II slump. With its conventional policy tools blocked, the Fed has resorted to unprecedented measures over the past two years, opening new channels to bypass the blocked ones and restore the economy's credit flows.

Guarding against a resurgence of the omnivorous TBTF Blob will be among the goals of financial reform. Our analysis underscores the urgency of quickly implementing reforms in order to restore the ability of central banks to manage an effective monetary policy. Most observers agree on the need to implement and enforce rules that require more capital and less leverage for TBTF financial institutions. Think of it like lower speed limits for the heavy trucks, the ones whose accidents cause the most damage.

Japan paid dearly for propping up its troubled banks in the 1990s. We need to develop supervision and resolution mechanisms that make it possible for even the biggest boys to fail—in an orderly way, of course. We want creative destruction to work its wonders in the financial sector, just as it does elsewhere in the economy, so we never again have a system held hostage to poor risk management.

Other useful ideas center on creating early warning systems and acting more quickly to resolve problems at large financial enterprises with overwhelming problems. For example, we might require the largest institutions to issue debt with mandatory conversion to equity when certain triggers are reached. The existence of this contingency capital would induce debt holders to exert more market discipline on management and encourage increased transparency and reduced complexity, not to mention speed up the bankruptcy process.

Fueling the rapid growth of TBTF banks in this decade were convoluted arrangements now widely reduced to three-letter shorthand—CDSs, CDOs, SIVs and the rest, all brought to you by the same people who gave you TBTF.

Widespread use of these three-letter monsters had a lot to do with making financial institutions too complex to manage. How else can top management explain being blindsided by the wave of writedowns that began in February 2007? If a bank's true financial condition isn't understood by its highly paid leaders, how can bank supervisors, who rely on a bank's internal measurements as basic input, do their jobs?

Instead of attacking bigness per se, public policy should focus on encouraging transparency and simplicity. This is what markets are supposed to do but, for a variety of reasons, have failed to do.

The problem isn't just the riskiness of a big bank's assets, nor even the bank's size relative to the overall system. It's important to know whether the bank's asset holdings are highly correlated with those of other banks. Did they all make the same bad bets at the same time? Did they all bet that real-estate prices would rise forever? As we all know, the answer, in this decade, unfortunately, is "yes."

We hope that putting these basic principles into practice will encourage market forces to move in the direction of opportunistic deconsolidation—that is, the spinning off of parts of banking empires that have little or no economic basis for existing in the new environment.

Since the TBTF Blob reduces the effectiveness of monetary policy's transmission mechanisms, unorthodox policies become the only recourse. These measures carry great risks. Don't do enough and the economy may descend into a deflationary spiral. Doing too much for too long may ignite an inflationary burst.

Holding the TBTF Blob at bay will help keep the conventional channels operational. Monetary policy will stay in the ideal middle ground, navigating small changes in inflation rates running in the low one-to-two percent range, where central bankers are most comfortable and economies perform at maximum efficiency.

Mr. Fisher is president and chief executive officer of the Federal Reserve Bank of Dallas. Mr. Rosenblum is the bank's executive vice president and director of research.