With Tarullo going, 2008 more likely to recur

I do not know much about Daniel Tarullo, the recently resigned board member of the Federal Reserve. He is a lawyer who spent a lot of time inside the Clinton administration working on international law, international financial regulation and banking law – and must have watched the implementation of Basel I very closely. After Clinton left the White House, he became a law professor at Georgetown but stayed close to the development of global banking regulation that gave rise to Basel II.

He had an inkling that monetary policy might cause problems

In his exhaustive description of the creation and critique of that international bank regulatory regime, Tarullo did make one nod to the interaction of banking crises and poor monetary policy but only in relation to Japan:

As has already been suggested, many causes of the Japanese banking crisis substantially predate the implementation of Basel I. Once the equity and real estate bubbles burst, Japanese banks suffered both from the greatly reduced value of their assets and from unfavorable market conditions within which to attempt raising additional tier 1 capital. Moreover, the ensuing travails of the Japanese economy, and thus the condition of the banks, were exacerbated by an ill-advised monetary policy. Nonetheless, the Japanese banking crisis and its aftermath do not reflect well on Basel I.

Banking on Basel, 2008 (p.74)

The book quoted above shows just how well qualified he was when put in unofficial charge of the Federal Reserve’s bank regulatory regime by Obama in 2009 in the wake of the financial crisis. He was the point man at the Fed for their role in the application of Dodd-Frank and other banking rules.

Primary focus was on financial risk

He understood well the dangers not only of banking risk but also of the explosion in non-banking financial risk. The battle against the creation of excessive risk is endless:

As evidenced by a continuing stream of scholarship, many factors contributed to the unsustainability and fragility of the pre-crisis financial system. But the inadequacy of regulation and supervision was clearly among them. Large banking firms had insufficient levels of high quality capital; excessive amounts of short-term, wholesale funding; too few high quality, liquid assets; and inadequate risk measurement and management systems.

Systemically important nonbank financial firms whose failure could threaten the stability of the financial system were effectively outside the regulatory perimeter. Governments did not have resolution regimes that could provide for an orderly resolution of a systemically important financial firm. Shadow banking–which was funding long-term assets with short-term wholesale liabilities-exposed the financial system to a system wide liquidity run.

Financial Regulation Since the Crisis, 2016

The day job was tough

The financial system is incredibly complex, both within the banking system itself and in the shadow banking system. This annual monitoring report by the Financial Stability Board into shadow banking illustrates just how hard it is to even understand let alone regulate.

Banks balance sheets are incredibly complex, and extremely hard to compare one with another, let alone from one banking system to another – particularly the US vs the Rest of the World. Just something as simple as bank credit varies enormously in the US vs the RoW. In the US, credit is mostly off the balance sheets of banks and securitized instead. In the RoW, it remains on bank balance sheets. The US banks do implicitly guarantee the quality of the loans they securitize but there is no capital allocated to those guarantees. All bank assets, from loans to bonds, to derivatives, to explicit guarantees, to implicit guarantees, need to be weighted according to their riskiness; but this is a very difficult assessment process indeed. All this complexity can only be regulated with more complexity. There Is No Alternative.

Yet bank regulators are under constant attack from banks, their lobbyist friends and those politicians in their pay, for crimping entrepreneurialism, credit creation, and profitability (measured by profits as a percent of capital). The more capital required the lower the profitability and the lower the returns available to the bankers.

It is soul-destroying being a financial regulator. The opposition continually picks off your best people, leaving you mostly staffed with second-rafters whom all the financial types hold in contempt. If you are good and experienced, you will only be doing it out of a profound sense of public duty. Then you find the new President appoints half a dozen top ex-Goldman Sachs multi-millionaires to be your boss. It is no wonder Tarullo has had enough.

In public, he kept out of monetary policy discussions

In looking for some more comments on monetary policy, all I could find was this on Monetary Policy and Financial Stability from 2014. Disappointingly it only discussed how easy monetary policy might cause risk build-ups rather than how tight monetary policy might cause problems.

He consistently leaned against the use of monetary policy to counter excessive financial risks, preferring better and more targeted regulation instead.

Tarullo seems to have mostly kept his comments on monetary policy private. The interview he gave in July 2016 on his thoughts on rate rises indicated a sound framework that incorporated market views on policy that were reminiscent of Greenspan. It would be great to ask him if he thought bad monetary policy in 2008 also contributed to the crisis, and indeed was the major cause – even if exacerbated by large non-bank financial leverage.

2008 more likely to be repeated now that Tarullo is leaving

With the banks now seemingly back in charge of banking regulation in the US, there will likely be an explosion of risk-taking in shadow banking, helping banks to huge, apparently risk-free, profits. It will be an interesting time. Eventually, the consequences might have to be dealt with by more regulation, or haphazardly and with terrible consequences by an inappropriately tight monetary policy, and we might be unlucky enough to relive 2008 all over again.

I hope Tarullo can be encouraged to read some more about monetary policy and the catastrophic mistakes of 2008, not just in banking regulation but more importantly in monetary policy.


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