Costs of Quantitative Easing

The law of unintended consequences haunts economic policy.  The Federal Reserve's quantitative easing program, now in its third phase, is meant to provide economic stimulus.  However, it also drags on the economy.  Let us count the ways.

Reduced Interest Income.  Hundreds of billions of dollars of interest income have been lost because of the Fed's longstanding campaign to drive down borrowing costs.  Losses of this magnitude undoubtedly have dampened consumer demand.  Even though QE likely sprung loose some personal income by providing lower mortgage rates for homeowners to refinance, tight standards applied by banks making mortgage loans have limited the refi impact of lower rates.

Reduced Retirement Savings.  As bond yields shrivel up like corn in today's drought-ridden Midwest, many retirements look bleaker.  Even though the stock market has boomed, large numbers of shell-shocked savers abandoned stocks after the 2008-09 market crash and haven't participated in the gains.  Instead, they ducked into bonds.  Although the improbable bond rally of the past few years generated capital gains for many bond holders, the basic return sought by bond investors comes from interest paid.  That has been paltry.  As retirements look bleaker, many workers cut back on current consumption in order to save more.

Pension Pain.  Despite appearances from some recent press coverage, pension funds cannot take large risks, overall, with their portfolios.  However much publicity pensions' alternative investments may generate, a large part of pension assets must be invested in high quality bonds.  As returns on these puppies shrink, employers corporate and municipal confront the necessity for greater contributions.  Workers may be laid off, citizens may receive fewer public services, state and local taxes may be raised, shareholders may endure lower returns, and those workers still employed may have to make greater pension contributions.  All of which would further discourage current consumption.

Insurers Backpedal.  Insurance companies' returns on their investments are falling.  This means policies that depend on long term returns, such as annuities and long term care policies, become more expensive or even impossible to buy.  Or else, they offer fewer benefits.  Policy holders suffer.  Those people who want to provide for themselves, through long term care policies, annuities, whole life and similar products, have a harder time.  More people end up having to rely on government programs like Social Security, Medicaid and so on.  That's not good in an age of serious federal deficits.

Yield Curve Flattens Bank Incentive to Lend.  Back in the days when they made loans, banks would borrow short term (usually through demand deposits, interbank loans via the fed funds market, and savings accounts) and lend longer term.  The difference between short term interest rates (historically lower) and longer term interest rates (historically higher) provided profits for the banks.  But the yield curve (the graph of interest rates from short to long) has been flattened by the Fed's monetary policies.  There isn't that much difference any more between short and long term rates.  Potential profitability for banks has been squeezed.  Banks have less incentive to lend, and fewer loans means less potential for economic growth.

The Fed has sworn on a stack of printed money to keep short term rates darn near invisible until at least mid-2015.  It may achieve some of its objectives.  But it will also create unintended consequences.  The impact of these opposite reactions to the Fed's actions may be greater than the central bank foresees.  There are few real life experiments in economics.  But if we look at the most obvious example of the impact of a central bank squashing interest rates for years at a time, we can see that Japan has remained moribund for two decades since its financial and real estate crashes in the early 1990s.  The Bank of Japan has ruthlessly stamped out any positive upswings of interest rates in that nation.  But that hasn't produced the spark needed to revive Japan's economy.

It now looks like the Fed will keep rates unnaturally low for the better part of a decade.  Given Japan's experience, one wonders what is in the Fed's playbook.  If it's a sensible fiscal program from Congress and the White House, the next question would be what is the Fed smoking?  But if the Fed is acting on the reasonable assumption that we will have fiscal dysfunction for the foreseeable future, only the arrival of Godot, it would seem, would offer reason for optimism.

Will Customer Fee Increases Hurt the Big Banks?

Recent bank fee increases are pushing consumer funds to credit unions and other financial firms. (See http://www.cnbc.com/id/44930883.) This is understandable from the consumers' standpoint. Why enrich banks when you're barely making ends meet? A less obvious question is whether these fee increases are bad for banks.

Banks play a potentially dangerous game. They make medium and long term loans and investments, using short term money (i.e., money that can be withdrawn quickly). Because short term deposits and other borrowings tend to cost banks less in interest expense than medium and long term loans generate in interest income, banks make profits on the difference. This game works fine as long as the short term depositors and other creditors of banks don't bolt. But, as we all know from recent financial upheavals, a run on the bank results muy pronto in its collapse--unless it's so big that the government steps in and gives the bank a blank check drawn on taxpayers.

Consumer deposits tend to be stable. This is true even for nominally short term accounts, such as checking accounts that theoretically can be closed on demand. It's a hassle for consumers to change banks, especially now that they often have direct deposits made to their accounts and direct bill paying from their accounts. The banks that have been raising fees are betting that a lot of customers will find it too bothersome to switch accounts, and will cough up $5 a month for a debit card or whatever.

But many customers may leave, particularly after a few months or maybe many months. While the banks will probably profit short term by raising fees, after a while growing numbers of customers may tire of paying for what's free elsewhere. If banks see a shrinkage in their retail deposit base, what will they do? They can either reduce their balance sheets (i.e., reduce the loans and investments they hold) or they can seek alternative funding. Banks, as a rule, don't shrink their balance sheets. If you're a bank CEO, you aren't likely to perceive a lot of benefit to making your organization smaller. The more assets the bank holds, the more profits it will hopefully make and the larger your bonus will hopefully get.

Since banks losing consumer business won't be inclined to shrink their balance sheets, they will seek alternative funding. The choices are likely to be much less stable than consumer deposits. Typical alternatives would include the fed funds market, the commercial paper market and the repo market. Funding from these markets is susceptible to great instability. Money a bank borrows in these markets can evaporate faster than a hedge fund can execute a computerized trade.

Europe's big banks are funded to a large degree in wholesale markets, more so than many of America's big banks, and are consequently less stable. That's one reason why the EU sovereign debt crisis became so acute so fast earlier this year--the money market vigilantes fled the big EU banks, and Europe's governments had to ride to the rescue. (If you have an account with a U.S. money market fund, though, your fund may have been one of these vigilantes and you'd probably consider this a good thing.)

If America's big banks experience a large enough shift in their liabilities, with less retail deposits and more wholesale funding, their risk profiles could change and not in a good way. Are bank executives are concerned? Come on. If a big bank goes way out on a limb and the limb starts to break, the Federal Reserve will climb into its Black Hawks and helicopter to the rescue. But taxpayers should be concerned. If America's big bank risk profiles tilt toward the European model, the potential for bailouts increases.

The risks of reliance on wholesale funding are well-illustrated by Lehman Brothers' collapse in 2008. When the word got around the Lehman was struggling, its funding dried up faster than rich people rushed out of New Orleans as Hurricane Katrina approached. That one time, the Fed and the Treasury Department didn't deliver a bailout by courier. They've been harshly criticized ever since. So you can bet your bippy that no large bank will ever again be allowed to fail. Period. That's why, long term, it might end up being a bad thing if consumer deposits leave big banks. Regulators should require more capital as banks' risk profiles become hinkier. Then again, a lot of things that should be done aren't.

The UBS $2 Billion Loss: This and the Banks Want Easy Capital Standards?

Here we go again. Another big bank, this time UBS AG, reports an elephantine loss attributed to unauthorized trading. In this instance, the big boo boo was allegedly made by a derivatives trader identified in the press as Kweku Adoboli. It seems just like yesterday that Societe Generale 'fessed up to a $6.7 billion loss from its own rogue trader, Jerome Kerviel. Then, there was Nick Leeson at Barings bank, Yasuo Hamanaka at Sumitomo Trust, and John Rusnak at Allied Irish, among others, who have attained notoriety for generating leviathan trading losses. The big banks just don't seem to move up the learning curve when it comes to risk management.

It's no surprise that both the UBS mess and the preceding scandals involved lightly regulated markets. Bad behavior is always more likely when there are few hall monitors. But the banks themselves have the primary obligation to watch over their people and preserve their assets. They keep failing.

One has to wonder if the inevitability of government support makes it easier for bank executives to short sheet the risk management budget. Top management knows that no matter how massive losses get, the government will not allow a major bank to fail. Experience teaches that top management will generally not suffer much from one of these financial tectonic events. Some embarrassment, yes, and perhaps a modest haircut off one's bonus. But loss of employment and legal sanctions seem to be out of the question. So, why invest large sums in risk management systems when that would only reduce the amount of net income used to determine executive bonuses?

In addition, truly effective risk management would likely mean lower levels of risk taken. That would probably reduce income. It would also reduce losses. But management compensation tends not to be diminished as much by losses as it is leveraged by gains. So top executives are incentivized to take risks, and collecting outsized gains if the risks pay off. And if the risks fry the bank's butt? That would be a shame for shareholders.

Risk management is not just a problem for trading. One sees weak risk management in recent mortgage-related problems. Alleged poor underwriting standards for mortgage-backed securities may cost some big banks tens of billions each. The robo-signing foreclosure scandal will cost yet billions more.

And then there's Europe's sovereign debt crisis. Europe's major banks were the doofusses that financed the profligacy of Greece, Ireland, Portugal, et al. How the . . . heck . . . did they manage to put the world's financial system and economy at the edge of the abyss? Didn't they have controls that suggested diversification--not exactly a novel concept--might be in order?

For the past half-decade or more now, the world's largest banks have repeatedly imperiled prosperity worldwide. At the same time, they are coddled with bailouts, subsidies, and explicit and implicit government guarantees. Yesterday's announcement by Germany and France of support for Greece, and today's announcement by the Fed and other major central banks offering emergency dollar loans to Europe's commercial banks, are just the latest in a long line of handouts. Europe's banks have been facing growing customer runs, and more government munificence was deemed appropriate. Banks are like kids that never lose a soccer game, no matter how far behind they fall. No wonder they don't act maturely.

The regulators' proposal to end this cycle of wealth transfer from taxpayers to bank executives has been to raise capital standards. The so-called Basel III standards, which are in the process of being implemented, may require major banks to more than double the amounts of capital they hold, compared to the ineffectual Basel II standards. Banks are pushing back as vigorously as they can. Increasing capital means downward pressure on executive compensation, and that can't possibly be, can it? Some regulators may be wavering. The $2 billion loss reported by UBS is a timely reminder that there actually is a purpose to increasing capital standards--and in fact it's a good purpose even though it may likely decrease bank executive compensation.

We must not be lulled into thinking that the $2 billion loss by UBS will motivate banks to clean up their risk management messes. Prior scandals didn't, and this one won't. There surely are more rogue traders who haven't been caught yet. When their losses get big enough, they will be. Bank shareholders will pay the price, and taxpayers may have to pony up another bailout. Even though the Volcker rule will, if ever implemented, make it harder for U.S. banks to self-destruct from unauthorized proprietary trading, international interbank linkages will preclude insulation of the U.S. financial system from the failures of foreign banks.

Truth is we'll never get rid of too big to fail. It's a tax on the citizenry that cannot be repealed, Tea Party or no Tea Party. The next best thing would be to proceed with increasing capital standards. Only when banks are forced to pay, at least in part, for the costs they impose on society, will they begin to stop acting like welfare queens.

The Fragility of the Financial System

Is the stock market crazy with its recent belly flops? In the past 5 weeks, it's dropped over 15%, with the Dow adding another 519 points today (over 4%). We're getting close to a bona fide bear market. While the trading may look like panic selling, maybe it's not. Over half the market is computerized trading. The firms that do this stuff leave it to the algorithms and machines. Many of the non-computerized sellers are institutional investors--mutual funds, pension funds, hedge funds, and so on. The money managers of these institutions presumably have the professional experience to stay focused even when under stress. Are they right to jump ship so quickly?

The heart of the world's economy is the financial system. Banks and other firms that comprise the financial system are unusually fragile. Even the biggest banks have Achilles heels where their commercial counterparts don't. A bank's principal asset is the confidence in which it is held by those that deal with it. Without that confidence, the bank would be overwhelmed by a flash mob of depositors, counterparties and creditors all trying to get their money out immediately. By contrast, the Apples, Googles, Microsofts, and even Fords of the world can't go under in a matter of a day or two or three, no matter how little confidence others have in them. They need months, and even years, to collapse.

Confidence in the big banks has been shaken. The European debt crisis is the biggest reason. Europe's big banks hold large amounts of EU sovereign debt. If the EU's debt crisis keeps metastasizing (and it likely will, by all indications), these banks will have greatly shortened half-lives. While the major U.S. banks hold only modest amounts of EU sovereign debt, they are bound by numerous interconnections to Europe's big banks (through the settlement and clearance process for checks, trade financings and the like, interbank lending, derivatives exposures and so on). If Europe's big banks become insolvent, America's big banks will be living in a world of ships (or something like that). Just a couple of days ago, Spain and Italy were the focus of domino-like rumors as the next shoes to drop in the EU crisis. Now, France is vigorously denying that it has problems. Many in the market are taking this as confirmation that France does have problems (on the theory that if you have to deny it, you're already toast). The EU debt crisis acts like a battering ram on confidence in the world's big banks.

Another confidence shaker was the S&P downgrade of U.S. Treasuries. The proximate connection of the downgrade to the big banks is they hold boatloads of U.S. Treasuries. Since the 2008 financial crisis, the big banks have played a sure-win game where they borrow from the Federal Reserve, for virtually nothing, and reinvest the money in U.S. Treasuries. The Treasury securities effectively give the big banks a wash with the federal government, except for a net positive interest payment. In effect, the Fed has been sending income to the big banks for free. There was also no credit risk, that is, until the downgrade. While Treasuries have momentarily risen in market value due to flight to quality buying, the rating downgrade highlights the risks of the concentration of bank assets in Treasury securities.

Taken together, the large holdings of EU sovereign debt by EU banks, and the large positions of U.S. banks in U.S. Treasuries, make the international banking system unusually sensitive to difficulties with sovereign debt. And lately there have been difficulties galore. Hence, the financial system looks shakier and stock values less certain.

To make the situation worse, the Fed's relentless campaign to drive down interest rates along the length and breadth of the yield curve has, perversely, weakened the banks. Banks, in a nutshell, make their money by borrowing on a short term basis, usually at the low rates available at the short end of the curve, and lending longer term at the higher rates usually available for longer maturities. This strategy works when long term interest rates are sufficiently higher than short term rates (i.e., the yield curve is sufficiently upward sloping). The flatter the yield curve gets (i.e., the lower long term rates go, relative to short term rates), the less profitable lending is for banks. The Fed's various policy measures, most recently QE2, have flattened the yield curve quite a bit. Recent flight to quality has flattened it even more. Perhaps one reason why the Fed hasn't yet announced QE3 is because it doesn't want to further stifle the profitability of bank lending by making the yield curve resemble the horizon.

Thus, the Fed's interest rate policies are probably adding to the fragility of the banking system. Folk wisdom on the Street holds that when the yield curve inverts (i.e., the short end rises above the long end), a recession is likely. Today, it's hard to apply this thesis, since the Fed artificially prescribes rates. But if we could extrapolate somehow to what a more normal, less government controlled market would look like, we'd have to be concerned that prospects for the economy are far from rosy.

Last, but certainly not least, the real estate/mortgage crisis still haunts the banking system. Recently, the robo-signing foreclosure debacle has operated like a pipe bomb in bank balance sheets, with escalating costs that the banks have been desperately trying to cap through court settlements. Once the banks are able to foreclose again, they'll have to book losses by writing down a lot of loans currently held in suspension because foreclosures remain in limbo. It will be years and many more losses before the real estate disaster is cleaned up.

So have investors been freaking out and selling in a panic? Or does it make sense that the sudden flaring of the EU sovereign debt crisis over the past few months, coupled with the debt ceiling dance of governmental dysfunction, and the nine lives of the real estate/mortgage crisis, would reveal the ethereal foundations of stock market valuations? This isn't necessarily a situation where the market must be crazy. Maybe the world really is screwed up, and market valuations are adjusting to reflect that reality.

It's the Economy, Stupid, and Republicans and Democrats Are Stupid

Politicians make their livings bashing other people, so it's only right and fair to bash them. There's a lot of grist for this mill.

Republican Congressional leaders were quick to criticize the Obama administration on Friday, June 3, 2011, after bad unemployment numbers were announced. Total job creation in May was 54,000, and the unemployment rate rose from 9.0% in April to 9.1% in May. The weak job creation number wasn't surprising, given other recent data signaling stagnation. The unemployment rate increase naturally flowed from the economy's need for a net increase of over 100,000 jobs every month simply to keep up with population growth (which increases the labor force). In addition, some previously discouraged workers may have jumped back into the labor force to actively look for work. That expands the labor force and raises the unemployment rate when there aren't enough jobs for them.

How did the Republicans shoot themselves in the foot? The private sector increased employment in May by a net of 83,000 jobs. That's not a great number, but it shows hiring exceeded firing. The reason for the lower total of 54,000 new jobs was that governments laid off a net 29,000 workers. This is due to state and municipal governments cutting back to meet austerity demands from primarily Republican governors and legislators. Do we think these government workers who lost their jobs because of Republican policies will blame the Obama administration? (Hint: take a look at recent events in Wisconsin politics.) Government employment levels have fallen for seven months in a row, and that's not because the Obama administration is laying off federal employees. If unemployment trends continue like this, expect the growing numbers of unemployed government workers, and many among their family and friends, to vote Democrat. Republicans hoping to see their party do well in 2012 should be careful what they wish for because the jobless have plenty of time to vote.

As for the Democrats, the Obama Administration announced on Saturday, June 4, that it would make a renewed push for principal reductions on defaulting mortgages, in an effort to keep more homeowners in their homes. This is meant to help not only struggling homeowners, but also to keep more houses off the foreclosure and resale markets, where distress sales continue to nudge home prices lower. But principal reduction has been a fools errand. It hasn't worked well in the past and isn't likely to work well now. The people who need principal reduction the most--the jobless--won't qualify because of their lack of income. Banks aren't required to reduce principal, and have little incentive to do so. There may be arguments why banks and mortgage investors lose less from principal reductions than from foreclosure. But the legal latitude banks have to make principal reductions on mortgages they have sold to investors is less clear than proceeding with foreclosure, and banks may be stuck with some or all of the loss to lenders when principal is reduced. In other words, banks may be in a riskier position with principal reduction than they would be with foreclosure (where they can generally pass the loss onto investors because banks mostly sell mortgages they originate). So why would they put themselves at increased risk in order to give a defaulting borrower a break? Never forget that on Wall Street, money talks and bullswaggle walks.

A second, and more important point for political purposes, is that the neighbors are watching. Yes, they want to see if the person next door has a better big screen TV than they, or if the person across the street is having an affair, or if the teenagers two houses away are getting out of control. But keeping up with the Jones would become most urgent if neighbors got a reduced mortgage because they didn't keep up with their monthly payments. Talk about envy. The defaulting Jones would get, perhaps, the equivalent of tens of thousands of dollars over time because they were deadbeats. Principal reductions could have a bandwagon effect--give one to the Jones, and others on their block will start defaulting so they, too, can get a principal reduction. After all, how can you tell your kid to borrow tens of thousands of dollars for college because you wouldn't stiff the bank like the folks next door? If entire neighborhoods start having mortgage default parties, bank earnings will fall and bankers contributions to the Republican Party will soar. Neighbors too proud or too protective of their credit ratings won't default. But they will likely vote Republican to assuage their anger.

So politicians are stupid. That's not news. The scary thing is they don't move up the learning curve. Governance failures are now in vogue. The Japanese government's dysfunction exacerbated its slow reaction to the nuclear crisis that followed the recent earthquake. The Euro bloc's weak governance structure makes bailouts without a true restoration of fiscal discipline the only way to cope with its sovereign debt crisis. This is not a solution, but a deferral of the train wreck to come. California's governance failure has pushed its budget crisis virtually beyond the realm of resolution. And, last but certainly not least, the mud-slinging, gotcha-politics in gridlocked Washington have imperiled the creditworthiness of the U.S. government and the strength of the U.S. dollar. The dumb thing about all this is that Japan, Europe, California and America are all very wealthy. They have the resources to solve their problems. But they can't make their political processes work in a constructive way. Forget all the predictions for the economy and the stock market you're now hearing. Politics has thrown a wild card into the game, and no one knows how things will turn out.

Derivatives Dealers Grumpy Over Deutsche Bank Ruling

Derivatives dealers worldwide are grumpy because of a ruling by the highest civil court in Germany finding that Deutsche Bank AG was responsible for disclosing the risks of a derivatives transaction to a company that bought an interest rate swap. The German court was concerned by the bank's conflict of interest from the risks in the transaction being stacked in its favor, at the customer's expense. The court especially didn't like the bank's failure to disclose that the customer's starting value in the transaction was an unrealized loss of -80,000 Euros, or over -$100,000. The court noted that although Deutsche Bank had warned the client that the risk of loss was theoretically infinite, it also predicted that the transaction would be profitable for the customer. The court thought the bank should have made loud and clear that the customer's losses could really be costly, and not just theoretically so. (See Wall Street Journal, Dec. 23, 2011, P. C3).

From a derivatives dealer's standpoint, disclosure obligations like those required by the German court seriously erode the dealer's informational advantage. In the financial markets, an informational advantage is more valuable than gold. That's why, as illustrated by the U.S. government's investigation into trading by hedge fund manager Galleon Group and others, there is so much apparent insider trading. Having the informational advantage really pays. If derivatives dealers now have to make disclosures as contemplated by the German ruling, bank profits might suffer. And nothing, as we all know, could be more horrifying than that.

The U.S. SEC's 2010 case against Goldman Sachs for its role in a mortgage-related derivatives transaction called Abacus 2007-AC1 crimped the style of banks acting as underwriters. The German court's ruling may have a bigger day-to-day impact, since it concerns a bank acting as a dealer in the interest rate swaps market. Trillions of dollars of transactions per month take place in this market. Banks are dealers--i.e., they act as principal on one side or the other of the swap--because customers don't want the credit risk of any counterparty other than a very large (and de facto government guaranteed bank). Too-large-to-fail banks of commercially powerful nations like Germany and the U.S. have an advantage in this market, since their governments' implicit guarantees are worth much more than, say, the Greek or Dubai government's guarantee. If the laws of commercially powerful nations like Germany and the U.S. begin to tilt the derivatives playing field toward anything approaching level, the banks may seek more accommodating nations in which to ply their derivatives trade. But, as financial markets globalize, there will be fewer and fewer places for big banks to go. And increasingly savvy corporate clients may abjure from doing transactions routed through a Caribbean island or Equatorial African nation.

Progress on the regulatory reforms in the Dodd-Frank financial legislation enacted last year has, on the best of days, been confined to the slow lane. Big banks have lobbied combatively to limit and water down the changes. The SEC has long known of the informational disparity in the derivatives market, having brought an enforcement case in 1994 that illustrated the problem. See http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html. Perhaps the German court's decision will help to encourage U.S. regulators to push through the headwinds of the big bank lobbying juggernaut. Some of the big banks' corporate customers have been convinced to lobby against change. But the German case, and the SEC's 2010 and 1994 cases, reveal that corporate customers sometimes don't even know what they don't know. It's one thing to let people knowingly take risks. It's another thing to leave them unknowing and saddled with risk.

The Federal Reserve's Failure to Supervise

Sometimes, the way to solve a problem is to question your assumptions. That's a lesson the Federal Reserve should take from the Financial Crisis Inquiry Commission's Final Report. There's an interesting tidbit on p. 54, which quotes a former senior Fed staff member as writing, "Supervisors understood that forceful and proactive supervision, especially early intervention before management weaknesses were reflected in poor financial performance, might be viewed as i) overly-intrusive, burdensome, and heavy-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with the Fed's public posture." In other words, when a bank was making profits, especially lots of profits, regulatory staff were supposed to hold back.

This is exactly wrong. Undergraduate level economics teaches that any high degree of profitability should be ironed out by competitive forces in the market. Thus, the existence of high profitability may be a sign that something less than entirely desirable may be happening. The bank might be taking a lot of risk (remember that risk comes with reward), such as by underwriting mortgage loans to people whose documented ability to repay is skimpy or nonexistent. Or the bank may be doing something illegal. Fraud, manipulation and other illegal conduct can be immensely profitable. That's why there are so many financial shenanigans. High profitability is a yellow flag, indicating that increased regulatory scrutiny is warranted.

Requiring staff members to hold back until a bank's financial performance has nosedived, as the Fed apparently did, is tantamount to fiddling until disasters burst forth and wreak a full measure of havoc and collateral damage. No glory is attained when the cavalry charges over the hill after the wagon train has been massacred.

The FCIC final report also notes, on p. xvii, that in 1980, the financial sector earned 15% of total corporate profits in America. This figure grew to 27% by 2006. This sustained rise in profitability is another yellow flag. It could indicate a sustained increase in risk levels (uh, duh). Or it could be a sign of illegal behavior. Either way, a sustained rise in profitability should have been seen as a reason for greater regulatory alertness.

Sustained elevated profitability might also indicate cartelization, with large, powerful banks extracting outsized profits by dominating markets. This is also undesirable, as greater oligopoly power would reduce the benefits of competition. Regulators should be vigilant against a shift toward concentration in market power.

The Fed appears to have viewed bank profitability as desirable. Better financial performers would presumably be more stable and less likely to collapse, which would reduce the Fed's worries. But we now know that the sustained increase in bank profitability resulted from high risk and sometimes illegal conduct that exacerbated the instability of the financial sector, ultimately leading to the crisis of 2007-08.

It may be counter-intuitive for regulators to scrutinize their regulatees more closely when the latter are reporting rosier financial performance. But greater profitability is a yellow flag, and perhaps a red flag, for serious problems. Regulators are not supposed to be cheerleaders for management, nor are they supposed to relax when the regulated industry is prosperous. They must apply unrelenting skepticism, 24/7. The history of financial crises preceding the creation of the Federal Reserve well-document that markets are not invariably self-correcting or self-regulating. That's why the Fed was created. One of the root causes of financial bubbles is too much credulity. The civil servants charged with preventing these disasters should never add to the credulity.