The Fed Can’t Fix Our Broken Banking System

OThe Federal Reserve declared a plan to shrink its balance sheet on May 4, 2022. $9 trillion large, and ten times bigger than it was before the 2008 financial crisis, the Fed’s accumulation of assets has helped to lower borrowing costs across the economy, lift stock and real estate prices to unprecedented heights, and fuel record profits for financial conglomerates.

Fed says that the Fed can reverse the course of events and unwind emergency measures, which it initiated back in 2008.

The Fed won’t get far because of the current structure and financial system. The last time Fed officials attempted “policy normalization” was in 2017. Faced with much milder macroeconomic circumstances, the Fed reduced their balance sheet by just twenty percent to $3.6 trillion. Then it was hit again by Wall Street turmoil. In 2019, they resumed purchasing financial assets.

A new 2008-style financial panic erupted months later in March 2020. The Fed provided trillions of dollars in loans to foreign central banks and financial institutions, in order to prevent another meltdown. To protect capital markets, and to make trading corporate securities easier, it set up numerous ad-hoc lending facilities. Wall Street didn’t go down without it.

The Fed’s financial sector assistance was so helpful that its leaders expanded their reach. They created programs to direct lend to small and medium-sized enterprises. They also created new mechanisms to support local and state governments. Seeing the Fed’s growing footprint, politicians and policy makers are now suggesting that the Fed use its balance sheet to stabilize commodity markets, make transfer payments directly to households, and more. (Naturally, partisan attention on Fed nominees has also spiked—with recent confirmation fights focused on whether the central bank should play a greater role in combatting climate change.) The Fed has, in fact, remained in an emergency mode for more than a decade and continues to expand its programs as a result of each economic shock.

But the roots of this transformation are deeper than the Fed. Problem is our bank system. Since 2008, Congress has failed to address the dramatic expansion of unregulated money creation by “shadow banks,” firms that operate like banks without complying with bank regulation. Some of the best-known and biggest shadow banks—like Lehman Brothers and Bear Stearns—collapsed or were conglomerated with chartered banks in 2008. Today there are many shadow banks. Some operate independently as broker dealers, or hedge funds. Other branches of conglomerates include banking institutions. Still others have international operations that fall under the control of foreign governments. However, regardless of their origin and location, the economy is dependent on shadow banks’ money instruments. These firms rely on and expect public support from the Fed in times of trouble.

It is important to look at the U.S. financial structure in order to understand how shadow banks are playing a role in today’s economy. Congress created the Fed in order to oversee a network bank-chartered by government agencies. These banks—which range in size from local community banks to conglomerates like Bank of America, JPMorgan Chase, and Wells Fargo—are designed to create most of the money in the economy. The money they create are called deposits. Although the Fed issues the cash we carry around in our wallets, bank deposits (not cash) are what employers generally use to pay salaries (e.g., “direct deposits”) and households use to pay credit card bills. Today, there are approximately $18 trillion in deposits and only $1 trillion cash available for domestic use.

The government doesn’t run these banks. This work is outsourced to selected private investors and managers. However, it imposes strict terms and conditions on banks. This bans them from participating in commercial activities and prohibits them taking on too much risk. The government also has to closely monitor them. It explicitly supports banks by providing deposit insurance and cash access from the Fed. The Fed’s job is to ensure that the banking system operates smoothly, creating enough deposits to keep the economy growing at its full potential.

Shadow banks are nonbank firms that figured out how to copy the lucrative part of the banking business—issuing liabilities that function as a form of money—without complying with the restrictive rules that prevent banks from collapsing during economic downturns. In order to offer large investors, businesses, and individuals financial instruments, shadow banks have been around for decades. These include repurchase arrangements (or repos), eurodollars, money market mutual funds shares and financial and assets-backed commercial papers. These deposit options were more popular than bank deposits by 2007.

These consequences were major collapses, like the huge run on shadow banking in 2007/2008. The run brought down Lehman Brothers, reduced the money supply, frozen credit channels and set off the worst economic recession since the Great Depression.

In 2008, the Fed pumped its balance sheets to keep the shadow banking sector together. Bear Stearns was and AIG were rescued by it. It loaned hundreds of billions to Wall Street broker dealers and other foreign central banks. In 2008 these institutions were considered too crucial to fail. Businesses depended on the money that they issued. Trade and commerce would soon contract if there was no functioning money or credit system.

When the Fed’s lending was not enough, it started to buy up financial assets to bolster shadow bank balance sheets and heal the damage that the crisis inflicted on ordinary households and businesses by reducing borrowing costs across the economy and limiting defaults. However, the economy was still dependent on shadow banking and never recovered its pre-crisis growth. With shadow bank money not under traditional regulatory control the Fed has been alert to support its issuers.

This arrangement is extremely harmful. The Fed’s programs transfer wealth to the financial sector and it’s efforts at stabilization inflate asset prices, enriching those who own financial claims and real estate and further marginalizing the majority of Americans who do not.

The government must first repair America’s monetary system in order to allow the Fed to normalize its monetary policy. Congress needs to reaffirm its control over dollar creation. Either shadow banks will become banks, and comply with bank regulations, or they should cease operating as banks.

If lawmakers don’t act quickly, they will face another crisis of 2008 or worse. The economic, political and social consequences could be devastating if this happens. Let’s make sure it does not come to that.

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