Why the Fed Matters Now More Than Ever, with Douglas Diamond

Stuff that's going on right now to proceed faster than it would otherwise. Pretty much everybody I know who's concerned about financial stability is concerned that these new um reductions in capital requirements and uh supervisory uh input into into banking, that pretty much everybody in that crowd is is concerned that we might be about to make a big mistake.

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So right now if you look at the banking sector you'd say this is this is a time uh of relatively low risk. Uh that's the good news. The bad news is the the regulations and things like that uh that that made the banking sector relatively safe have caused a bunch of these activities that they used to do

to move over to uh the the less regulated what's called shadow banking sector. So if you were f looking at the type the type of research that I've done over you want to think about where are potential vulnerabilities of the system, um, it's in a slightly different place than it's it's been for a while. In fact, if you asked me, you know, a few years ago I would say probably the next

crisis is gonna be outside the banking system. Then in twenty twenty two we got the Silicon Valley Bank, which was smackdown in the center of the of the of the financial system. It turns out it was a very special case. So thinking about the vulnerabilities uh th in the in the domain of thinking about where is there lots and lots of short term financing used to finance long term illiquid investments.

Uh that traditionally happened in the banking system. It's happening sort of outside the banking system right now. So with that lens, uh you know, you need to take a broad set of of uh look at a broad set of institutions. And instr intr interestingly enough, they're either regulated by very few people or regulated by a bunch of different people. Like insurance companies are regulated state by state.

Uh the Federal Reserve is on top of this. They're trying they're having a meeting pretty soon to get the state banking regulators together so they can all be thinking about this problem.

One, they're too big to fail, so probably if they got into trouble we would do things to bail them out. And secondly, they rely much more heavily on uninsured deposits, one's over two hundred and fifty thousand dollars. And the ones that run in a crisis are the uninsured ones, because as long as the government is good for it, there's no particular reason to run on insured deposits. So I'm concerned that the proposed reduced capital requirements

the repo proposed reduction in the importance of what are called stress tests which are ways of measuring how b big financial institutions would do in a particular type of systemic crisis that caused trouble in a whole sector, a whole

type of funding, a whole industry, a whole um financial system even, a whole financial system meltdown. The fact that these things that were well thought out are being bac backtracked on means that w even though we're not currently in a case in a situation where the big financial institutions could be troublemat problematic, uh it's the case that we're sort of sowing the seeds for the next one.

The other thing is sort of there's sort of a short memories problem. We haven't had a financial crisis, you know, in the last uh you know since twenty twenty two, which is a long time ago, it seems like. So I I'm uh the short memory thing could be part of it. I think it's probably mainly Just the view that regulation just slows down the economy in a in a in a in a bad way.

So I think it w i it would be better to be nuanced. There's certainly many things, many regulations that are excessive, but some of them I think particularly these capital requirements are ones that are not excessive.

Essentially interest rates had been around zero in the United States and it was clear to pretty much everyone that they had nowhere to go but up. Right. Inflation was above the inflation target the Federal Reserve was trying to get, so it was pretty clear that the Fed was gonna have to increase interest rates soon.

Okay, so that's first point. Second point, uh the way that the Federal Reserve um supervises and regulates the large banks or even the pretty large banks are these things called stress tests, where they look at certain scenarios and see how the bank would do. And all the s stress test scenarios they had been using were about further decreases in interest rates.

Or the worst possible scenario they were looking at for increases in interest rates is if interest rates went up to two percent. So since I thought it was quite possible interest rates would need to go above two percent, that was my point is that Essentially all of the work in supervision and regulation has been thinking about making sure banks were robust to interest rate decreases.

When if you just listen to what the Fed was saying, it was clear interest rate increases were coming. And it struck me that there was sort of a disconnect between the monetary policy part of Fed, the Fed that wanted people to ex to have. To anticipate future interest rate increases, which would pr keep inflation expectations in the future from getting too large. and the supervision and regulation part of the Fed that was really not worrying about interest rate increases.

So there's sort of like what sometimes call a Chinese wall between the two parts of the Fed, the do the part that does supervision and the part that does monetary policy. That's about passing private information back and forth. It was public information that monetary policy was going to increase interest rates.

And then it seemed like the Fed had also been trying to convince the market That interest rates were not going to go up before this period. Some people interpreted that as a way to signal or commit that they weren't about to raise the short-term rate. So if everybody thought short term rates were going to stay low for sure, then you could lend long term and not have to worry too much about those.

long-term interest rates going up, and if the long-term interest rates aren't gonna go up, then the market value of the long-term bonds isn't gonna go down, because bond prices go the opposite way from interest rates. So that it stran seemed like the Fed had this what you might call excess credibility to commit not to to promise they didn't commit, to sorta cross your fingers and promise not to to raise interest rates.

But then they were at a point where they needed to raise interest rates, and it wasn't clear which way that was going to work. If they were going to keep their fingers crossed promise, then they couldn't raise the interest rates. That probably would have been the thing to do is say, look, we're not going to raise interest rates now'cause we sorta promised not to, and we're going to raise them gradually so people can unwind these positions.

So what I was worried that they would raise interest rates rapidly, which they did, and then I wasn't anticipating something like Silicon Valley, so then Silicon Valley was an unusual case. They had a huge fraction of their uh assets

in medium term um US government agency securities. Think of like Fannie Mae or Freddie Mac and things like that. And those medium term securities dropped in value quite a bit when the interest rates went up. And as a r and uh and if you the head of Silicon Valley said, Oh we were sort of told interest rates were weren't going up. So they made this bet on interest rates not going up.

So that hurt their so that at mark to market they were insolvent. Now the accounting that they had to use for their regulators was not marked to market. They could what use what's called hold maturity accounting, which basically says if the market value goes down, you know, why should you mark it down if you don't have to sell?

But you know, they didn't have to sell it, but they eventually then had a run on them where all of their depositors, or most of their depositors, were pulling their money out super fast. And

That was partly the main reason that they had that such a rapid run is that unlike any other bank I was aware of, they had 94% of their deposits in uninsured deposits. They had an over one billion dollar deposit from Circle, the stablecoin company. So, you know, just if that was pulled out in one day, that would cause trouble for the for the for the bank.

And not only do they have uninsured deposits with one of them being over a billion, they had uninsured deposits from a set of well connected to each other firms that had uh w venture capital funding. So when their venture capitalists told them maybe you should get your money out because things don't look good. That was basically a self fulfilling prophecy right there because that was a huge fraction of their deposit.

So so basically my point I I I didn't know all I didn't know all the Silicon Valley stuff. I didn't know about the ninety-four percent. Silicon Valley wasn't on my radar screen, but I knew that there was some institutions out there that thought interest rates weren't going up and they found found it profitable to borrow at around zero and then they could lend at around one and a half or two and a half percent and pick up a spread.

But that was a pretty small spread to pick up, interest rate spread between the short rate you're borrowing at and longer rate you're lending at. To risk the institution. I was guessing it would be a shadow bank that did it, but it was a commercial bank that was financed like a shadow bank.

The it turned out an elastic currency was the wrong way to think about what the Fed should be doing. It was the banks should issue more currency, and when it shrinks, they should issue less currency. So it's like saying you want the amount of currency created to equal the demand for currency and a demand from this particular source, real bills of exchange, which means basically means financing of inventory.

Or financing of of of of sales where you're gonna sell something to somebody in California, it's gonna take a month to get there from New York. So for that one month, you know, you need the financing, and then they will pay you and they'll bring the bill back. The Fed is the fast moving part of the government regulatory, the government intervention system.

So when there's a crisis, when bad things happen It might take a long time for the Congress to pass a bill to deal with the problem. The Fed can do this instantly. We saw this in two thousand eight.

And that's about inflation largely, although it has I mentioned, if you change the monetary policy too quickly and move interest rates too much, it could have financial stability implications like it did at Silicon Valley. So there's lots of uncertainty. And everybody knows that the the Fed's inflate inf the inflation is still a little bit above the Fed's target. Right. So warm.

So the reason it's so unusual right now is we know we're gonna have this big change. We have the President of the United States encouraging the Fed to cut interest rates to zero, which would be like a negative after inflation real interest rate.

Which would be tremendously stimulative, whereas right now the interest rates as they are are sort of what you might call neutral, neither stimulating nor slowing things down. Right. So if we thought that the Fed was gonna keep interest rates at zero, even if inflation got up to four and five percent,

That would cause people to expect inflation in the future, which would cause all kinds of problems today, because expected inflation makes people want to get out of of bonds that are set in US dollars, get either the the Treasury inflation protected securities that are indexed to that t indexed to inflation or get just into foreign currency dominate denominated stuff.

You know, he's been talking about cutting interest rates, but probably my guess is the market isn't super worried because if you once he's the governor, he can't be kicked out by the president. If we got a huge increase in inflation, he would probably raise interest rates.

So that's important to not get these expectations up. So right now we have a lot of uncertainty about what the Fed's going to do in the future. Will it lose its credibility? It spent a long time getting its inflation credibility. Second point. The Fed does other stuff too. It's one of the supervisors and regulators of the banks, and the Fed has been backtracking big time.

Um since Mickey Bowman has become the the governor in charge of of of supervision and regulation at the Fed, um so there's been the Fed joining the other agencies has been sort of de pushing for deregulation and de supervision. So there's a lot of uncertainty about how the Walsh Fed would would would uh would do that. So that's another thing.

It ties in a little bit to fiscal policy, you know, so the money printing that you know or interest rate setting, that's part of what the Fed thing is. But if the government is running huge deficits And the Fed sort of keeps the interest rates from going up, it's sort of indirectly financing the deficit. That's another source of inflationary stuff. But you mentioned things like tariffs and wars and things like that. Right.

Tariffs and wars don't cause, in my view, and I think most economists' view, don't cause increases in long term inflation. They cause prices to go up. So when you w if tariffs go from five percent to ten percent, prices will go up. You will measure that as an increase in inflation between today and a year from today, but between a year from today and two years from today the prices are already up unless they raise the tariffs again.

it won't cause f long term inflation. In fact Milton Friedman was basically making clear to people want made very clear to people many times that to have the market economy work, you have to let prices jump when there's a a g excess demand relative to supply for something. So tariffs do that. You know, wars, you know, tariffs raise the price of of foreign goods. That's gonna raise prices for every everybody in the US. Uh wars reduce supply.

um, you know, strikes and things like that reduce supply, that's gonna make prices go up. But that's not inflation and you gotta let the prices jump And then the Fed basically is gonna say, Well look, I have to realize that my monetary policy has some effect on supply and demand, and I gotta think about my effects on supply and demand, the real effects of monetary policy, but you're supposed to sort of look through these temporary things like tariffs and and wars.

And keep to the path you were already on, keep your inflation targeted two percent, realizing you're gonna get above it, but then hopefully you'll come back below it and you'll come in back to two percent.

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And the Fed didn't have to bail anybody out except Silicon Valley Bank eventually and the First Republic Bank who they gave them a hundred percent deposit insurance on their big deposits. Uh That's pretty recent memory, so I'm guessing the two thousand eight stuff may be fading, but the twenty twenty two stuff is still recent enough that the fading memory thing is headwind that's allowing the general deregulatory um and de supervisory

stuff that's going on right now to proceed faster than it would otherwise. Pretty much everybody I know who's concerned about financial stability is concerned that these new um reductions in capital requirements and uh supervisory uh input into into banking, that pretty much everybody in that crowd is is concerned that we might be about to make a big mistake.

Uh the second thing is that the the way that will work is it will basically mean that the outcome of these stress tests, which is the way of measuring this the the economy wide risks that these uh big banks are subject to w w we would no longer have um the the way the formulas work if you got rid of this surcharge probably almost none of the banks would have the big banks would have an amount of capital they'd have to i uh have in their capital structure, but they'd have to have as a minimum

wouldn't depend on the outcome of the stress test. So if a bank flunked its stress test it wouldn't have to raise any more capital. So the way you prevent crises from happening in advance is by making sure that everybody's damned sure that all of the relevant banks are quite solid.

Okay. So if a bank is thought to have a run and everybody thinks there's going to be a run, if you have lots of uninsured deposits, that's true. It's a self fulfilling prophecy. And one narrative is that we're just letting if we imagine that the bank are potentially insolvent, but we don't know which one's insolvent, or maybe they're all potentially insolvent. If that's a r a relative a a relevant narrative in people's minds, then they can say, oh my God, they're all insolvent.

We better get our money out. Right. And now we got two reasons to get our money out. One, they're insolvent, and two, they're being run, which will make them even more insolvent. So not having stress tests and things like that feeding into something that make the banks raise some more equity. Basically, it is gonna say that it's gonna be more of a of a of a plausible scenario that there is some insolvent big bank.

The big banks are the ones that mainly rely on un uninsured deposits. Silicon Valley to the contrary, that was a highly unusual. They were a middle sized. But the big banks like you know Bank of America or City or JP Morgan, if somebody thought they were potentially insolvent and they relied on all these uninsured deposits, we could have a system wide run.

So I think you need supervision and regulation so that everybody can sleep can go to sleep easily saying, look, the banks are basically solvent.

who understand this will say, Well look, I'm not gonna respond to something today with a very, very short term perspective today because if I do the short term thing today, people expect me to do the short term thing in the future and I'll lose my credibility This is most relevant for inflation. People say, I will not let inflation take off today, because if I let it take off too much today, they think I'll let it take off a lot in the future, and then we'll be in all kinds of bad trouble. So

The Fed needs to think about its commitment to do things in the future that are for the long run and not the short run. How does that relate to independence? Federal Reserve governors are trained in this. They're evaluated in this. Governors around the world, heads of other central banks,

evaluate our governor and our governor evaluates the other ones by their ability to stick with this credibility in the long run. And everybody sort of understands everybody in the central bank community and the financial stability community And even the heads of the big banks understand the Fed wants to be credible.

You can say, Well look, nobody's gonna de this is something that's an existential risk, they should deal with that. Doesn't have much to do with anything else. So you you wanna prevent them from dealing with climate change, but you don't wanna prevent them from dealing with a run on non-banks that happened to be a little bit outside their regulatory domain, but was going to bring down their main domain, the bank.

And the role of the financial system is to create liquidity out of illiquid assets. How do they do that? In practice, it means they create short-term debt. Short-term demand deposits, short-term time deposits. what are called repos, where they have overnight borrowing against Treasury securities. So the f the the good thing the financial one of the many good things the financial system does is produce short-term debt out of long-term assets.

That's the good thing. That works fine as long as there's not a run. But as everybody th if everybody starts to think that system is gonna break down, Either because the long-term assets have gone down in value and the financial system is insolvent, or because everybody thinks th that there's gonna be a run on the financial system that's gonna cause the financial system to have to dump these long term assets and make the financial system insolvent.

Then there'll be a problem. So the thing that I want them to take away is that private financial crises historically have everywhere and always been about the problems caused by short-term debt. And people sometimes think it's too much short-term debt and too many illiquid long-term assets backing that short-term debt.

The short term debt backing backed by long term assets is the feature of the financial system. The runs are the bug. So when you see the f the Fed or the Treasury or other governments, the ECB stepping in to stop runs on short term debt. It's to preserve the good thing, the the liquidity that's created by in the private sector by short term debt.

So short-term debt is the good thing. Preventing runs from bringing down the financial system from runs on short-term debt is the good thing about the financial systems supervisors, regulators, and governments. If you see a run, don't say, Oh my God, something awful has happened. Something awful is about to happen, but we don't want the run to actually bring the financial system down. So financial crises are everywhere and always about the problems of short term debt.

The problems of the Fed and supervisors are about preventing that problem, putting the capital and things like that in advance to pr to minimize the the the probability that that problem actually occurs so we get the good without the evil.

So we like on uh the day that mister Trump announced the big expansion of his tariffs, the stock market went down. I know people that sold out all their security. So basically sit tight. And um choose a level of risk that you're comfortable with for the long run. And don't try to think that you're gonna be able to out guess what's gonna happen in the stock market or in the financial system.

better than the average person. And certainly unless you happen to be, you know, the head of the Fed or something like that, you're not gonna have much information about what's gonna happen that the rest of us don't have. So the way you prevent screwing your family up and yourself up in the future is by choosing a level of risk in your portfolio and then more or less leaving it alone

unless you get a change in your own situation. Changes in the world situation uh probably you shouldn't be reacting to too much. So that that's my best personal advice is that You know, basically try to you can worry about the future but don't take it out on your portfolio.