Federal Reserve: Conflicts
Between Monetary Policy andBank Regulation in Tackling
Inflation

Aaron Klein
Miriam K. Carliner Chair and Senior Fellow,
Economic Studies at the Brookings Institution

Why Did America’s Banking System Wobble inSpring 2023?
• Covid recession, response, and inflation were global.
• America’s financial system was not resilient• Thesis: America’s large fiscal and monetary response created adeposit bubble that banks invested in low yielding securities, losing
value when rates rose sharply.
• Federal Reserve in the middle of it all:• Monetary policy and stimulus provider• Bank regulator• Emergency lender• Solution: Narrow the Fed’s growing mandate
1

Setting the Stage: Covid Recession and Recovery• US has surprisingly large fiscalstimulus• Banks are used as payment
mechanism• Federal Reserve given substantial
role in stimulus, blending ofmonetary and fiscal policy

Figure 1 Discretionary fiscal response, 2020: Q1-2021: Q3• Bails out debt holders• Juices mortgage market• Delivers massive cut infunding costs to large
businesses
Source: (CEA 2022, 102)
Original Data Source:(International Monetary Fund 2021)
2

Go Big Goes Well? At First• US features fastest
recovery post-Covid,
seemingly justifying large
fiscal/monetary stimulus.
• Did inflating the balloonwork?

Figure 3 Real GDP shortfall relative to pre-pandemic
trends.

Note: Pre-pandemic trend is estimated over 2015-2019. Source: (Harris and Sinclair 2023)
3

Where did the Covid money go?
• Stimulus piles up in bankdeposits• Too much money or too
poorly targeted?
• Banks hesitant to lend:Figure 5 Deposits, all commercial banks.

• Low interest rateenvironment• economic uncertainty• regulation
Adapted from: (FRB 2023a).

4

Example of Deposit Increase from Covid
Stimulus: State and Local Governments• Covid pumped billions tostate and local
governments who wereunable to spend it.
• Stock-piled in rainy day
funds back at banks.

Figure 6 Total state rainy day fund balance

Source: (Boddupalli 2023).
Original Data Sources: National Association of State Budget Officers. State Rainy Day Fund
Balances Historical Data Set, 1988-2024. June 2023; Bureau of Labor Statistics. Consumer Price 5Index. “R-CPI-U-RS Homepage: Updated R-CPI-URS, All items, 1977-2022.” 2023.

America’s Financial Instability• Large number of smallbanks historical artifact• Part of a fragmented
regulatory system:

Figure 4 Commercial banks U.S• OCC – Federal Banks• FDIC – State non-member• FED – State member + allbank holding companies

Adapted from: (Federal Financial Institutions Examination Council (US) and Federal
Reserve Bank of St. Louis 2023).
6

Bank balance sheets during Covid:• Banks prepared for aworse recession / slower
recovery than realized• Is being prudent good orbad for “financialstability?”

Figure 7 Provisions for loan and lease losses as a share ofaverage loan and leases

Source: (FRB 2022).
Original Data Source: Call Report and FR-Y-9C.

7

Personal Lending: Retrenchment
Figure 8 Changes in Lending Standard for Households

Note: The sample range is the interquartile range of lending standards for France, Germany, Italy, Japan,Netherlands, Poland, South Korea, Spain, United States, and United Kingdom. The shaded area denotes the GFC.
Source: (Bodovski et al. 2021)
Original Data Sources: Bank of England, Bank of Japan, Bank of Korea, European Central Bank, Federal ReserveBoard, and National Bank of Poland.

8Corporate Lending Retrenchment
Figure 9 Changes in Lending Standards for Firms

Source: Ibid9US global outlier• US banks
tightened morethan the rest ofthe world while
also seeing lessdemand for
lending, due tolarger stimulus

Figure 10 Changes in Commercial and Industrial Loans, Credit Standards, andLoan Demand.

Notes: Tightening Credit Standards refers to the net percentage of banks reporting a tightening of credit standards. Increasein Loan Demand refers to the net percentage of banks reporting an increase in the demand for loans over 2020:Q2-Q3. C&Iloans.
10Source: Ibid.

Fed’s Monetary Policy U-Turn• Fed’s 500+ bp increase
historically sharp• Catches banks off-guard

Figure 11 Federal funds effective rate

Adapted from: (FRB 2023b).
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Banks over invested in low yielding debt
Figure 12 Unrealized Gains (Losses) on Investment Securities.

Note: Insured Call Report filers only. Unrealized losses on securities reflects the difference between the market value as of quarter end and the book value of nonequity securities. This calculation does not account for any unrealized gains or losses in "accumulated other comprehensive income" because they cannot be derived
from Call Reports for the industry.
Source: (Federal Deposit Insurance Corporation 2023b).

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SVB: Right Under the Fed’s Nose
• Fed regulated SVB head totoe• Supervision at SF Fed poorand conflicted• SVB piled up excess,uninsured deposits andinvested in MBS (less soTreasuries)

Figure 13 Selected balance sheet items of Silicon Valley Bank asreported to regulators in 2019

Source: (Silicon Valley Bank 2019)13

Over 2 years SVB adds over $77B in low ratesecurities it can not liquify
Figure 14. Selected balance sheet items of Silicon Valley Bank as reported to regulators in 2022

Source: (Silicon Valley Bank 2022)
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Fed Stress Tests: Asleep at Switch• Fed stops stress testing forrising rate environment in2015• If the central bank is not
testing for interest raterisk then what is its corecompetence as a bankregulator?

Figure 16 Change in 10-Yr Treasury yield over CCAR
scenarios.

Source: (Nelson and Covas 2018)15

Debunking False Narrative: Money moved faster• Bank deposits become electronic in early 1980s.
• Fed ironically among last central banks to enact real time retailpayments (FedNow launched in July 2023).
• Reliance on uninsured deposits (large corporate/tech) explains SVB
Figures 18 and 19 Selected Deposit Runs and SVB deposit baseNote: *Figures with asterisks are the expected amount of outflows that were scheduled to go out the next business day, but did not actuallyoccur because the banks were closed.
Source: (Rose 2023)

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Conclusion: SVB highlights Federal Reserve
failure as bank regulator• Fed gained regulatory authority in response to GFC (Dodd-Frank Act)• Covid recession first test of Fed’s enhanced bank regulatory competence• Fed fails• Failure particularly poor given the proximate cause was Fed’s monetary policy,
poor supervision of SVB, and failure of new ‘macroprudential’ stress test tool

• Attempts to blame social media, faster money are false• Solution: improve the Fed as a regulator or replace it17