Has policy schizophrenia gripped the Federal Reserve? Some people think so.

Over the last 24 months, the U.S. central bank has been gradually raising its interest rate target as labor markets tightened, putting upward pressure on prices and wages. At the same time, the Fed has announced proposals to tailor capital buffers to the prudential needs of each bank, in a bid to ease lending.

Interest rate increases tighten financial conditions. Regulatory relief loosens them. This leaves many people wondering whether the Fed is working at cross-purposes: reducing credit supply via the monetary channel, while boosting it through regulatory relief. Some even worry that the two actions combined could increase financial fragility, spelling disaster akin to 2008.

Despite concerns from some, the Fed's monetary and regulatory policies are not spurring another crisis. Bloomberg News

While it’s true that monetary tightening and deregulation — however modest — counteract each other, fears that the Fed’s actions will compromise the safety of the financial system are overblown.

Start with monetary policy. The mission of the Fed is to promote full employment and maintain stable prices. With joblessness at a post-9/11 low, recent inflation set to exceed the 2 percent target and further upward pressure on consumer prices expected as a result of tax cuts, moves to raise the federal funds rate target appear perfectly justified.

Raising the cost of credit will, in general, reduce credit demand. Higher interest rates will therefore reduce loan volumes. In this way, consumer demand and therefore inflationary pressures will be tamed.

But that doesn’t mean that banks will suffer. They lend funds at a higher interest rate than the one paid to depositors. The difference between the two, the net interest margin, is a measure of bank profitability. Lower interest rates have historically been associated with squeezed net interest margins and profits.

Indeed, Fed researchers have argued that low interest rates explain the paucity of new bank charters since 2008, which in turn is partly responsible for the accelerated decline in the number of banks in America.

So, while overall loan volumes may decline as interest rates rise, bank profits from each loan could actually increase.

Moreover, bank profitability shouldn’t in and of itself concern policymakers. However, the ability of financial institutions to yield an adequate rate of return makes failure less likely and, to the extent that interest rates affect all banks, it also makes the financial system less fragile. Higher interest rates, in the present context, do not herald financial catastrophe but rather a return to the historical norm.

Critics of deregulation claim that the Fed’s moves in that direction might restore another, less auspicious, historical norm — namely, the pre-crisis environment of undercapitalized financial institutions. They say proposals to adjust bank leverage ratios in line with the individual characteristics of each bank amount to a giveaway to the biggest institutions, for which taxpayers might ultimately be liable.

The criticism is disproportionate. The Fed estimates that tailoring will, in aggregate, reduce the capital that the largest banks must hold by $400 million, or 0.04%. This is not a radical U-turn from the post-crisis practice of higher capital requirements. Rather, it is a redistribution of the regulatory burden from some large banks to other large banks. It aims to address the concern that leverage requirements are at present discouraging banks from performing certain low-risk functions that are nonetheless important and beneficial, such as providing short-term financing to market participants.

One may quibble with the specific changes proposed, but to posit that this amounts to a wholesale gutting of the post-crisis regulatory regime is simply misleading.

That said, the status quo is hardly optimal, either. As mentioned, new bank creation has ground to a halt since 2008. Banks, especially those with assets under $1 billion, report a ballooning compliance burden from Dodd-Frank and other regulation. And yet, up to 29% of the U.S. population remains excluded from basic financial services. In other words, the post-crisis response leaves much to be desired.

The modest moves at regulatory relief over the last year and a half should be viewed in this context. Policymakers on both sides of the aisle have been increasingly concerned with the impact of Dodd-Frank on small and medium-sized banks, whose operations pose little threat to the financial system but must nonetheless comply with reams of new rules.

Regulatory relief can facilitate lending and lower barriers to competition, both eminently desirable goals so long as the costs of lending decisions are borne by the banks and their customers, not taxpayers. Furthermore, it would be a mistake to infer from the sheer scale and complexity of Dodd-Frank that it is in fact effective at achieving its goals of safety and soundness. If anything, complexity of regulation has historically been a driver of financial instability.

While there is much good to be had from simpler, less burdensome financial regulation, the Fed’s proposed reforms make precious little headway in that direction. But neither do they compromise the integrity of the financial system. To suggest otherwise is to make a beneficial policy change more difficult and to divert policymakers’ attention from genuine sources of systemic risk.

Diego Zuluaga

Diego Zuluaga

Diego Zuluaga is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives.

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