The Federal Reserve considers a new tool to prevent crises

The Fed has two tools to eliminate financial bubbles. It can use either regulation or interest rate increases to prevent banks and other financial institutions from racing in an economic boom.

After the last crisis, many Fed officials concluded that it was better to use the regulation. They can apply this tool surgically, while aggressive increases in interest rates, such as mass pounding, can hurt the wider economy in the name of financial stability.

Some Fed officials want to use one of the regulatory tools developed by the central bank after the crisis, called the "countercyclical buffer of capital." It can demand that the largest US banks release additional capital during boom times, so that they have even more to fall back when loans deteriorate during difficult times, such as the elimination of oil in oil reserves strategic aspects of the country.

But other officials, as well as the banking sector, wondered why the tool was needed now, when banks' capital levels were high and the risks of financial stability seemed to be under control.

One of the reasons for concern is that asset prices are booming. According to the Fed, the net worth of US households – based on rising inventories and property values ​​- was nearly seven times higher than after-tax household income. This is more than the tech boom of the late 90s or the real estate boom of the 2000s, both of which ended badly.

Capital is the long-term money a bank draws on to make loans, largely from shareholders and retained earnings. This represents funds that the bank is not able to repay immediately, such as a bank deposit, when a loan portfolio is deteriorating. This creates a large cushion in case of shock, when depositors and others quickly deposit their money with their banks.

Forcing banks to hold additional capital could prompt the Fed to aggressively push for interest rates if it overheated. Some officials also like the tool because the buffer can be reduced in the event of a real slowdown, which relieves the banks when they really need it.

Officials from other countries such as the United Kingdom, Ireland, France and Hong Kong have increased their capital reserves, while the Fed is at zero.

"It would be a good time to lift this capital reserve," said Cleveland Fed President Loretta Mester during an interview in July. "In good times, you lift it up." Do not use it now "puts you more in the camp of" using interest rates to protect against financial instability, she added.

This was a topic of discussion at a Boston Fed conference on Friday and Saturday. Mester is one of the five presidents of the Fed's regional banks who advocate for change, but the authority is not in their hands. Instead, Fed governors in Washington, overseen by chairman Jerome Powell, make the decision, voting at least once a year at his level.

A Fed governor, Lael Brainard, has publicly supported the increase of the buffer. Mr. Powell did not take public account except to say in June that he did not think the risks of financial stability were significantly higher than normal.

Banks and some Fed officials are opposed to this initiative. One of the reasons is that the big banks have already accumulated substantial levels of capital: among the banks with assets of more than $ 50 billion, the tier one capital was 12.7%. % of assets against 8.5% in 2008.

Another limitation of the rule is that it only applies to large banks. Those with assets of less than $ 50 billion saw their capital decrease to 14.2% of assets in the first quarter, compared to 15.7% in 2012.

In addition, some Fed officials said the annual stress tests had already achieved the goal of raising capital levels for the big banks in good times.

"We have seen many changes in the regulation of financial institutions," Atlanta Fed President Raphael Bostic said in an interview last month. He said it made sense to see how the banks handle the new rules before they reapply.

In a possible compromise, the Fed could stop accelerating the difficulty of stress tests, while activating the new capital buffer. Stress tests are important for banks as they determine the amount of dividends to be paid and their deployment for share buybacks.

The banking sector has been confronted with the idea of ​​deploying a regulatory tool simply because the economy is strong. Officials also said the Fed could not currently meet the criteria it had set two years ago to activate the buffer.

In 2016, the Fed said the buffer should be activated "when systemic vulnerabilities are significantly higher than normal". Fed staff monitoring the financial system has described these vulnerabilities as moderate.

Write to Kate Davidson at [email protected] and Nick Timiraos at [email protected]