Will the Fed's Capital Rules Interfere with Monetary Policy?

WASHINGTON — The Federal Reserve is cautiously eyeing the impact new capital rules will have on its ability to conduct monetary policy.

It's an unprecedented moment for the central bank. The Fed is moving steadily to toughen capital and liquidity requirements in the hopes of ending "too big to fail," while gradually unwinding its stimulus program and returning the economy to normal rates.

"It's happening at the same time where accommodative policy since 2008 is beginning to be revised with a very complicated exit strategy," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics. "All of these developments are intertwined and the linkages are untested and delicate."

The Fed's banking rule writers in years past paid little, if any, attention to the potential fallout of their efforts on monetary policy or the broader economy, perhaps making a small mention of how a regulatory change could result in fewer loans.

But nowadays Fed officials are repeatedly drawing links between financial stability and monetary policy, including which is better at spotting or reducing asset-price bubbles.

Fed Chairman Ben Bernanke set that line of thinking in motion, and new Chair Janet Yellen has made balancing monetary policy and bank supervision the central bank's No. 3 priority behind the two disciplines themselves.

"Nobody talked about the link between financial stability and monetary policy," Petrou said. "Academics didn't see it, and the Fed didn't understand it, and so nobody thought about it. We learned the hard way how intertwined financial stability and monetary policy can be."

Top Fed officials have becoming increasingly concerned that a low interest rate environment could harm the financial system as banks "reach for yield," while also noting that certain supervisory tools can be limited in their ability to capture all the potential risk.

Alternatively, it's become more recognizable that new rules which call for higher capital and liquidity requirements could affect monetary policy.

The concerns were evident at the Fed board's April 8 meeting to finalize an enhanced leverage ratio for the eight largest U.S. banks, which include JPMorgan Chase (JPM), Citigroup (NYSE:C), Bank of America (BAC) and Wells Fargo (WFC).

The new rule, which the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency also signed off on, is designed to prevent the largest banks from becoming as highly leveraged as they were in the lead up to the financial crisis.

The biggest banks should not be allowed to borrow against more than 5% of their balance sheet, and insured subsidiaries no more than 6%, the three agencies agreed.

The Fed's staff memo noted that the rule would likely have a limited effect on the central bank's ability to implement its monetary policy decisions, and staffers discussed at length their evaluation of the potential impact . That was the first time such a conversation had taken place during any public board meeting on a Dodd-Frank rulemaking.

To some observers, the dialogue sought to correct the perception that the Fed, and other regulators, have taken a narrow view of the impact of higher capital rules.

"There's been a lot of talk the regulators aren't waiting to see what happens to the rules before they impose new ones. No one is thinking about the cumulative effect of the rules, and no one is thinking of the overall economic impact of the rules," said Greg Lyons, a partner at Debevoise & Plimpton. "They're using it as a further occasion to demonstrate they are the not the White Tower, but also trying to be cognizant of the economic implications more broadly."

For others, it raised alarm given that despite some reservations, the Fed agreed to proceed with a final rule.

"Their candid acknowledgement that there may be implications for monetary policy associated with a higher leverage rule is remarkable and of potential concern," said John Dearie, executive vice president for policy at the Financial Services Forum.

At the meeting, staffers named two areas of potential consequences: reserve balances and liquidity in the repo market, both of which are important monetary policy tools for the Fed.

Reserve balances are considered a liability for the Fed that rise and fall based on when the central bank purchases or sells securities. The enhanced leverage ratio would lift the amount of reserve balances, or capital, that the banks would have to hold against their deposits at the Federal Reserve banks.

Currently, the eight largest banks, which will have to meet this new requirement starting in 2018, hold nearly 40% of reserve balances. Presumably their holdings would rise as the Fed's balance sheet shrinks from its current standing of roughly $4 trillion, according to staff from the Fed's meeting.

"The level of reserve balances currently is very high as a result of the large-scale asset purchases and the federal funds rate is at its effective lower bound," said Beth Klee, a Fed economist at the board meeting. "Holding constant the amount of reserve balances and the rate of interest paid on those balances, a shift to a more binding ratio, should tend to reduce short-term money market rates somewhat but would have little implication for monetary policy."

Likewise, the rule would also increase the amount of capital that banks would have to hold against the purchase agreements involving Treasury and agency securities, which could make such firms less inclined to engage in such transactions, she said. That could potentially reduce liquidity in the repo market, a key market for monetary policy.

Some bankers are skeptical about how well each side of the Fed's house is working with the other, especially in light of other rules, like a new liquidity requirement, which has the potential to spark a collateral shortfall just as the central banks begins to unwind its easy-money policies.

"It's not clear to me … that the monetary policy side and the supervisory policy side are in sync on the implications of that," William Demchak, president and CEO of PNC, said of the liquidity rule.

The liquidity proposal would require U.S. banks to hold enough high-quality liquid assets, like excess reserves at the Fed and U.S. government securities, over a 30-day period to prevent a liquidity strain during a crisis. The U.S. central bank would like to prevent a scenario where financial institutions would forcibly rush into the same assets at the same time during a financial crisis.

Thus far, Fed officials have swept away such concerns both for the liquidity plan and the new leverage ratio. Instead, they've argued that there would be no cause for worry when the agency begins to lower the amount of its reserve balances of roughly $2.4 trillion. They've also argued that the leverage ratio would not curtail the central bank's effort to meet its federal funds rate target or harm the repo market.

"Repo intermediation is a vital component of the dealer-client relationship that supports more profitable business activities, like hedging, inventory financing, and prime brokerage services," Klee said. "Thus, dealers have incentives to remain actively engaged in repo markets despite potential of higher regulatory costs."

The Fed plans to use the repo market to eventually drain reserves and guide rates higher. It has also expanded its list of counterparties to include hedge and money market mutual funds.

Ernest Patrikis, a partner at White & Case, says for now it's unclear what the potential impact will be of these new rules.

"What are the consequences that we just don't foresee?" Patrikis said. "I think they should have some visceral concerns about the impact of their actions because we really don't know what the impact is going to be."

Rob Blackwell contributed to this article.