We Wanted Safer Banks. We Got More Inequality.

[Hydrogen]

How regulations after the financial crisis, along with a heavy-handed Fed, have hurt the middle class.

A few years ago, one of Karen Petrou’s banking clients gave her an unusual assignment: It wanted her to write a paper laying out “the unintended consequences of the post-financial-crisis capital framework.” Petrou is the co-founder of Federal Financial Analytics Inc., a financial services consulting firm in Washington that focuses on public policy and regulatory issues. She is also, as the American Banker once described her, “the sharpest mind analyzing banking policy today — maybe ever.” Whenever I’m writing about banking issues, she’s the first person I call.

Writing that paper caused Petrou to ask a question she’d never really considered before: Did the bank regulations enacted after the 2008 crisis — along with the Federal Reserve’s post-crisis monetary policy — exacerbate income inequality? Her answer, which she laid out in a series of blog posts, as well as a lecture at the New York Federal Reserve in March, was yes. “Post-crisis monetary and regulatory policy had an unintended but nonetheless dramatic impact on the income and wealth divides,” she wrote recently.

That particular sentence was in a blog post devoted to a recent study by the Federal Reserve Bank of Minneapolis that evaluated income and wealth inequality from 1949 to 2016. The study certainly seems to validate her thesis. It shows that between 1989 and 2007, the top 10 percent increased their share of the nation’s wealth by just 5.8 percent. But in just the next nine years, between 2007 and 2016, the richest Americans captured an additional 8.3 percent of the country’s wealth. Meanwhile, those in the 50 percent to 90 percent wealth bracket saw their share of the nation’s wealth drop by 17 percent, and those in the bottom 50 percent saw a 52 percent drop. The single biggest variable that changed after 2007 was the way banking was conducted and regulated.

Petrou has written a book outlining her analysis of the problem — and her proposed solutions — which will be published next spring by Yale University Press. Not wanting to wait that long, I visited her recently to get a sneak preview.

JN: Let’s cut to the chase. How does banking accelerate income inequality?

KP: First, as the country becomes more unequal, there are fewer middle class customers. That means middle class bank products become unprofitable, and banks follow the money. And banking regulations make it worse because the capital requirements imposed after the banking crisis make it a lot more expensive for banks to do a startup small-business loan than go into wealth management. Startup loans are riskier than wealth management, of course, but the capital costs have become prohibitive, and banks don’t lose money on purpose.

JN: Can you really blame the banks for behaving in this fashion?

KP: I’m not blaming the banks. I’m blaming the unintended consequences of the rules. I think the rules unduly penalize equality-enhancing financial services.

JN: Can you give me an example?

KP: Thanks to the new capital requirements, it’s basically impossible for banks to make mortgage loans to anyone but wealthy customers, unless they can send the loan to the GSEs (Fannie Mae and Freddie Mac) or taxpayer-backed Ginnie Mae. And the new capital requirements also discourage banks even from sending loans to the GSEs or Ginnie — if the loan to a low, moderate-, or middle-income borrower is kept on the bank’s books, there’s a very large capital charge at the front end; if it’s sold, the bank still has to hold back-end capital in case the loan defaults and comes back to the bank. Nonbank mortgage originators — which have eclipsed bank lending in the last few years — face none of these capital charges, but they also can make no loans they don’t sell on to investors. Their entire focus is on booking loans for an upfront fee and sending them on to these taxpayer-backed entities. Without capital at risk, these nonbanks (companies such as Quicken Loans Inc.) also have a lot less at risk if loans eventually default. As a result, high-risk mortgage lending is making a comeback. Let me be clear — I’m not against post-crisis capital standards designed to prevent lenders from making high-risk loans that put only the borrower or taxpayer at risk. There’s no quicker way to make Americans even less equal than to expose vulnerable homeowners to foreclosure. What I am saying is that now some lenders — banks — are under rules so tough they can’t support equality-enhancing mortgages and other lenders are totally outside the post-crisis “skin in the game” rules designed to end high-risk, predatory lending. This asymmetry redefines the market in ways risky all over again, to both vulnerable borrowers and the taxpayer.

JN: Would you have said that this was a problem prior to the financial crisis?

KP: If I had known to look for it, I would probably have said it was a problem. It’s common knowledge that income inequality in the U.S. has been getting increasingly worse since 1980. But what I’ve been pointing out in some of my blog posts is that it became hugely worse after the financial crisis. Were there underlying issues pre-2008? Absolutely. But we had more of a middle class even in 2006 than we do now. By a lot.

JN: How does the Minneapolis Fed study add to our understanding of the causes of income inequality?

KP: There are a lot of things that helped bring about income inequality in the US – crummy education, the decline of middle-class manufacturing jobs, technological innovation and so on. But if you look at the Minneapolis Fed data, as well as many other analyses, it happens gradually prior to 2008. Then it actually flattens out in 2008 because rich people lost money in the crash, which narrowed the inequality gap. But starting in 2010, the gap widens dramatically. The one really big change are the post-crisis rules. And, very importantly, the Fed also changed the way money moved.

JN: What do you mean by that?

KP: The Fed did two things with huge inequality implications. First, with its massive quantitative easing, it sucked $4.5 trillion of assets out of the banking system. The idea was that it would empty out the bank balance sheets so that they would start to make loans. And that didn’t happen —initially the banks were too weak, and as they recovered, the rules created significant impediments. If you look at who is getting loans it is large corporations, not small businesses. Second, the Fed’s low-interest policy gave rise to yield-chasing. And what has the stock market done since 2010? Everybody who has money has seen their financial assets appreciate dramatically. Everybody who doesn’t have money, which is the bottom 90 percent, what is their principal source of wealth? Houses? House-price appreciation for expensive houses is way up since 2012. But overall, real U.S. house prices are down 10 percent.

JN: Isn’t the role of Fannie Mae and Freddie Mac to take up the slack and make it possible for people to buy homes?

KP: Yes. But they’re not. If you look at the credit scores of mortgages that Fannie and Freddie are buying, they are way up — the average is something like 740, of a possible 850.

JN: What does the Federal Reserve say about your criticism?

KP: I should stress, first of all, that the Fed certainly didn’t set about to make income inequality worse. It is an unintended consequence of its efforts to stimulate the economy while tightening bank regulations — two goals that are fundamentally incompatible. Essentially, though, the Fed denies that it played a role in income inequality. The Fed is always saying, “Look what we did — record low unemployment!” But that is partly because it takes two or three wage earners in a household to make ends meet now. So, yes, you see more employment, but people are really struggling. The whole Fed view of monetary policy is based on the view that if you stimulate the economy, wealthier people will buy a lot of stuff, and companies will have more money to invest in plants and hire more people. And that is totally not happening.

JN: If you were in charge, how would you solve this?

KP: I have two ideas, and they are both hard. On monetary policy, I really think the Fed needs to step back. It has been essentially running the market, and allocating credit, since 2008. And they don’t mean to be. They really don’t. But they are.

JN: What does it mean to step back?

KP: I think it would mean to taper their portfolio far more quickly than they are. If the economy is in a real recovery, why does the Fed still need to hold $4.5 trillion of the funds that should be out working in the economy and keep interest rates below zero in real terms?

JN: How would it help income inequality?

KP: It would normalize markets. People would hold a lot more money in lower-risk assets as opposed to stock equities, which would start to generate more productive economic activity over time instead of just fueling more speculative betting.

JN: And your second idea?

KP: The Fed needs to let interest rates normalize. Right now, what the Fed calls the neutral rate — the rate that drives their thinking  — is about 2 percent. The previous neutral rate had been 5 percent. Think about that on an inflation-adjusted return. Back in the day when Treasury bills were 5 percent or higher, if I had my savings in that, I could make money in low-risk assets. If you have monetary policy where the rate is 2, that combined with the 2 percent inflation, and you will have a permanently impoverished middle class. My main call in my book is that the Fed needs to think about that.

JN: Anything else?

KP: There is one other thing. When the Fed looks at their data, they think everything is great. Unemployment is low, profits are up, and so on. But the median net worth today is $97,000. In 2004, it was $102,000 — which is actually $140,000 in purchasing power today. Look at the difference! I would argue for an inclusive monetary policy that factors in the real world of higher income people not buying stuff, lower income people with huge debt burden, no middle class, and so on. And with 60 percent of American financial assets outside the banking system, a monetary policy system predicated on banks being the means through which the economy is stimulated, well, it just doesn’t work anymore. So that is what I think.

https://www.bloomberg.com/view/articles/2018-08-06/inequality-why-bank-rules-and-fed-rates-hurt-middle-class

....

Here we have a different perspective on things. Some say Karen Petrou is one of the best banking industry analysts in the entire world.

I tried to bold the best parts but tbh the whole thing is well worth reading for anyone interested in these topics.

Wealth inequality and its implications are the leading theme here. It would seem that there are many unintended side effects ranging from real estate to small business loans which are negatively affected by rises in wealth/wage inequality. Some of the things she said about GSEs are over my head. Have to do research sometime to try to decipher that part.

This could provide a stark contrast to the "fractional reserve banking is 100% benevolent and benefits society/civilization" theme commonly taught in school courses although I suspect it will be a long time before anything this woman says is proven true. If indeed that day ever comes.

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[d57heinz]

Thank you for sharing this article.  It’s right on the money!!  And yes your right it will be a long time if ever.  America doesn’t like the truth one iota!

BR

Also some good info in the comments as usual where the hidden gems lie. Spraguer621 has s damn good one.

Another great tidbit. ESP for those here. I was that rube. Never again!

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Ransomexx  Joe Brady
4 days ago
Stocks are trickle-up. At one time, no self-respecting person of wealth bought stocks; stocks were for Rubes. an asset valued by the confidence of a greater fool. There is very little difference between stocks and bitcoin, that is why people feel so confident with bitcoin. .It is doubtful that all the money pouring into the stock market is doing the economy any good. It's simply speculation between Rubes and a few Sharpers that profit consistently. .
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Joe Brady  Ransomexx
4 days ago
Pardon me, but I find that a little ridiculous. Equities over the past 80-90 years, have been essentially free money. There will always be folks that pick exactly the wrong time to get in and out, but if a person invests an identical amount every year for 40 years, is there any given 40-year rolling period that hasn't made money?

From my (limited) research, the results have ranged from doing well to doing really well.

In fact, I'm not sure there are any 10-year rolling periods where people have lost money.
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Ransomexx  Joe Brady
4 days ago
It's not free money or free value creation, it's a value transfer from one Rube to another, in other words, speculation cleverly marketed as "investing". The value that goes into the market was created elsewhere and mal-invested, Stocks were an investment bank gimmick to provide an alternate source of funding to business and a source of income to those who game the market, starting in 1700. Stocks are a derivative with limited rights. There is a whole industry that tells people what stocks are worth, just like in 1700. Nowhere is value created. We use the market as a savings account that provides better yields, much of the time. As more money goes in, up goes the market or down when the money leaves.

[davis196]

The naive people with leftist ideas think that more regulations and more taxation means less inequaliy.
This thesis has been proven wrong so many times in the history of human civilization.
I like what she says "banks follow the money".Dan Lock says that bank will only give you loan when you don't need that loan(you have enough money).If you really need a loan for building a business or something important,a bank will never give you a loan.
 

[LeGaulois]

The naive people with leftist ideas think that more regulations and more taxation means less inequaliy.
This thesis has been proven wrong so many times in the history of human civilization.
I like what she says "banks follow the money".Dan Lock says that bank will only give you loan when you don't need that loan(you have enough money).If you really need a loan for building a business or something important,a bank will never give you a loan.
 

Because banks are much more hesitant when it comes to extending loan to a customer, especially since the 2008 crisis. It is not because there is no more money but just because the banks are more suspicious especially when the markets are not in their best days. If you have money, it's a sign of solvency for them and therefore a sign of confidence.

[First77]

Russia's gold reserves have reached 2000 tonnes and China has some $4 Trillion for Gold buying now that China has 820 billionaires.

[stompix]

Never ending story...

First, they blamed the banks for giving easy loans to people, now they are blaming them for not giving easy loans.
They blame banks for giving low interest but when they give higher interest they accuse them of risking money in investments.

This fight against "inequality" is just stupid.
We tried it once in the eastern block and indeed we all ended equal, dirt poor equal !!!!

Dan Lock says that bank will only give you loan when you don't need that loan(you have enough money).If you really need a loan for building a business or something important,a bank will never give you a loan.

Much like the bitcointalk rules, right?
No collateral no loan!!!  

[KingScorpio]

Russia's gold reserves have reached 2000 tonnes and China has some $4 Trillion for Gold buying now that China has 820 billionaires.

gold can quickly become worthless trash, when certain situations arise.

[mikyadel]

what these banks don't understand or may don't want to is that middle class is the backbone  and the major indication of the country's healthy economy.
same problem is rising in middle east countries.Anyway, american economy is on the edge sine global crisis in 2008 and with the rise of cryptocurrencies and Trump reckless decision , we can witness a similar crisis in near future.

[LeGaulois]

Never ending story...

First, they blamed the banks for giving easy loans to people, now they are blaming them for not giving easy loans.
They blame banks for giving low interest but when they give higher interest they accuse them of risking money in investments.

This fight against "inequality" is just stupid.
We tried it once in the eastern block and indeed we all ended equal, dirty poor equal !!!!

Dan Lock says that bank will only give you loan when you don't need that loan(you have enough money).If you really need a loan for building a business or something important,a bank will never give you a loan.

Much like the bitcointalk rules, right?
No collateral no loan!!! 

Perhaps if the scriptural money and the fractional reserve did not exist there would be fewer problems, at least they would be different. Banks lend money that doesn't exist with a 9:1 ratio. It represents 90% of the money supply, yes 90% of the money is scriptural and exists only virtually

[SplendidHunter]

The naive people with leftist ideas think that more regulations and more taxation means less inequaliy.
This thesis has been proven wrong so many times in the history of human civilization.
I like what she says "banks follow the money".Dan Lock says that bank will only give you loan when you don't need that loan(you have enough money).If you really need a loan for building a business or something important,a bank will never give you a loan.
 

Because banks are much more hesitant when it comes to extending loan to a customer, especially since the 2008 crisis. It is not because there is no more money but just because the banks are more suspicious especially when the markets are not in their best days. If you have money, it's a sign of solvency for them and therefore a sign of confidence.

In my country banks are also not trusted, it even happened few years ago, that we had a crisis in economy and the banks would just crash and get lost without giving off the peoples money.

[Mometaskers]

A bit hard to wrap my head around this but thanks for sharing. Bookmarked the Bloomberg page for rereading.

The naive people with leftist ideas think that more regulations and more taxation means less inequaliy.
This thesis has been proven wrong so many times in the history of human civilization.
I like what she says "banks follow the money".Dan Lock says that bank will only give you loan when you don't need that loan(you have enough money).If you really need a loan for building a business or something important,a bank will never give you a loan.
 

Coz that's what makes perfect sense. The usually Indian/Pakistani "loansharks" in my country (they charge at least 20%) would never lend you money unless you actually have a business. If you already have one then it might provide you a boost if you manage it properly but you'll never be able to build a business by trying to get such loans.

All the leftist idea of taxation manages to do is scare away business owners or outright put them out of business.

This fight against "inequality" is just stupid.
We tried it once in the eastern block and indeed we all ended equal, dirty poor equal !!!!

But hey, being equal is what matters, right? 

[hatshepsut93]

It's unclear what would happen if we replace the current financial system with Bitcoin, because some researches suggest that Bitcoin's wealth distribution is also quite unequal. But I think equality itself is not the goal that society should pursue, instead we should focus on increasing everyone's well-being. If Bitcoin can help people to preserve and increase their wealth, offers better costs than banks for their transactions, offers new business opportunity thanks to being global, then it shouldn't matter if some people have huge amounts of coins.

[aso118]

Russia's gold reserves have reached 2000 tonnes and China has some $4 Trillion for Gold buying now that China has 820 billionaires.

gold can quickly become worthless trash, when certain situations arise.

It is far more likely that the fiat notes which are held by banks become worthless, rather than gold itself becoming worthless. Across the world, loans backed by gold are the easiest to get. That is because gold is a good store of value, and it doesn't look like that fact will change any time soon.

[rickadone]

I’m not a kind of person that likes to read long articles, this is too long you should have tried to compress it and make it easy for those who don’t have time to read long posts, I just got exhausted at the half of the line. By the way, I just saw someone that made a good point here and that is– charging too much tax and more regulation won’t stop the inequality.

Another point is that bank will not give you loan if you need it for building a business, they will only give you when you already have money, means without surety and collateral no banks will be offering any loan. This must be the prime reason why inequalities are rising everywhere.

[cellard]

It's unclear what would happen if we replace the current financial system with Bitcoin, because some researches suggest that Bitcoin's wealth distribution is also quite unequal. But I think equality itself is not the goal that society should pursue, instead we should focus on increasing everyone's well-being. If Bitcoin can help people to preserve and increase their wealth, offers better costs than banks for their transactions, offers new business opportunity thanks to being global, then it shouldn't matter if some people have huge amounts of coins.

I agree with the ones that said leftist politics don't really lead to more equality long term, it just becomes an elite extracting resources via taxes to citizens.

But I also agree with your point: I think it's delusional to present Bitcoin as some sort of cure for equality... it's pretty dumb actually. There are positives tho, I can think of two immediate ones:

1) The elites can no longer play around with the total monetary supply at will, we are all under the same rules of 21 million coins no matter if rich or poor.
2) It can bring economic activity in places were money is simply a massive dysfunctional disaster. Exchanging tokens fast and cheap with low risk for goods and services will be possible if LN is a success (even acknowledging limitations of decentralization with LN.. it's still better than some 3rd world nightmare currency, it can easily allow for an economic to grow under it)
3) For now it allows people to have a decentralized digital gold, but as fees go up it will be increasingly problematic for these that cannot afford it

[1Referee]

3) For now it allows people to have a decentralized digital gold, but as fees go up it will be increasingly problematic for these that cannot afford it

Unfortunately, the only way for these people to avoid being subject to high fees is to have funds in a different coin. I say unfortunately because I don't want to see people be forced to use something other than Bitcoin, but people have no choice other than to do so at this point in time.

Litecoin has taken advantage of Bitcoin's weakness and is now processing more transactions than BCash, and it's truly one of the best on-chain crypto coins to use. 2.5 minute block times and extremely low fees are way better suited for smaller payments than Bitcoin will ever be. Bitcoin's only shot is to have LN become easy to utilize, which should make sure that all past refugees flow back into Bitcoin.