Minneapolis Fed President Neel Kashari recently stated that he believes that the US banking system is far safer today than it was during the 2007-2009 financial crisis. Is that true? Perhaps. Is it relevant? Not really.
Given the nature of fractional reserve banking and the fragility of the American banking system in particular, even a banking system twice as safe as a decade ago isn’t safe enough. If a bank boosts its reserve ratio from 5% to 10%, it still is attempting to operate with a mere fraction of its deposits. Yes, it can protect itself a little better in the event of a financial crisis, but it’s still fundamentally unsound.
One positive aspect of the financial sector today is that it has less outstanding debt than it did a decade ago.
But non-financial business debt has exploded in recent years, spurred by a decade of low interest rates. How much exposure do financial institutions have to that debt?
Much of the corporate debt that has been issued in recent years is of unknown quality. The amount of corporate debt that is one rung above junk status has grown faster than the overall debt market, and significant amounts of debt could be downgraded to junk status in the event of an economic downturn.
Just look at the current example of PG&E in California, whose debt is trading at a significant discount today despite having been rated investment grade within the past year. With interest rates rising, the bond bull market coming to a close, and unknown shocks potentially affecting bond markets, how badly will banks fare in the event of systemic downgrades?
Kashkari went on to state that the Federal Reserve has just as much ability to safeguard the financial system as it did before the financial crisis. While he understands that the Fed has less room to cut interest rates, he seems to believe that the Fed’s experience with quantitative easing (QE) will stand it in good stead.
But how can the Fed really engage in further QE? The Fed’s balance sheet remains at $4 trillion, way beyond what it would be during a period of normal monetary policy.
How can the Fed continue to engage in QE in the future? Can we really afford to have the central bank buy another $4 trillion in assets? Do we really want to become like Japan, whose central bank’s assets now exceed 100% of GDP with no economic growth to show for it?
The likelihood of there being sufficient amounts of investment-grade securities available for the Fed to purchase in the event of another systemic crisis is very low. So if the Fed does engage in future QE, expect full monetization of federal budget deficits. And while Kashkari isn’t on the FOMC this year, he will become a voting member next year, when the economy may very well be in the middle of a tailspin. Are you getting scared yet?
Image: Mike Mozart
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