While the bank stress tests might help the Federal Reserve identify weaknesses in the financial system, the Fed is ill-equipped to adequately address and rectify the problems that might surface.
Much of the concern stems from the risks of non-bank or shadow banking entities that the Fed has no authority to regulate. These institutions control more financial assets than the banks do: their financial assets are housed in money market funds, hedge funds, finance companies, structured-finance vehicles, brokers and dealers, real estate investment trusts, trust companies and other financial firms other than banks, according to the global Financial Stability Board (FSB).
The repeal of Glass-Steagall by President Clinton in 1999 enabled banks to engage in non-bank activities, such as securities and insurance. His deregulation of over-the counter derivatives transactions the following year permitted an excessive increase in global derivatives
or structured-finance vehicles, from less than $100 trillion in 2000 to nearly $700 trillion in 2008, according to the Bank for International Settlements.
Since 2002, global non-bank financial assets grew from nearly $30 trillion to $75 trillion, according to the FSB. The U.S. portion equals a third of the total, at $25 trillion, surpassing the pre-crisis level and greater than the $20 trillion of regulated assets held in the traditional banking system.
, the 2008 Nobel Laureate in Economic Sciences, recently proclaimed the financial crisis caught him by surprise, since he was not aware that roughly half of all financial assets were housed by non-bank entities, which were not adequately regulated and supervised.
Fed Chair Janet Yellen
claims the lessons to be learned from the financial crisis include: 1) lowering debt levels relative to equity, 2) avoiding excessive reliance on unstable short-term financing, 3) enhancing risk measurement and management systems and 4) reducing the level of complex financial vehicles that redistribute risk in opaque forms.
This financial metastasis occurred without a coherent regulatory regime. While some federal agencies do regulate non-bank activities, their coordination with the Fed is one of labyrinth proportions. In the long term, all financial activities that relate to banks and non-banks need to be overseen by one centralized authority.
A key short-term recommendation to help remedy this problem would be an increase in capital requirements against all collateral on all financial transactions. This would go a long way toward alleviating the excess risk-taking endeavors in the shadow banking sector, as well as the traditional banking lines.
Raising interest rates might facilitate this solution to some extent, but it could negatively and unnecessarily impact healthy sectors of the economy and might cultivate creative methods to camouflage risk-taking.
The financial system remains risky and requires more much more healing.
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