Americans understandably haven’t yet thought much about anything but themselves and their loved ones, preoccupied as they sadly are with fears of illness and economic privation.  Even so, it seems ineluctably clear to me that, when we again go about our daily lives, the U.S. policy landscape will be irrevocably changed.  Americans will be very, very angry.  Populists such as President Trump and new-born progressives like Joe Biden will make sure that companies that got trillions while many couldn’t pay their bills will take a reckoning.  And so they should.

The fundamental goal of the mountains of post-crisis rules after 2008 was to end the moral hazard which propelled investors to take ever more speculative bets secure in the knowledge that taxpayers would bail them out.  Much in U.S. law and rule after 2008 in fact sharply reduced this risk for the very biggest U.S. banks “called too big to fail” because they were.  Now, they’re not or, if they are, the biggest banks are far less so than all the shadow banks now desperate to survive the illiquidity and leverage that made them Wall Street’s darlings for over a decade. 

We’ve said it as did many others:  asymmetric regulation ensures financial-market transformation into a high-risk configuration in which “fortress banks” serve as a source of supply for the rollicking brigands decimating the financial countryside.  Retribution is sure to follow.

The next round of financial regulation will make the Dodd-Frank Act look like a technical clarification.  No financial agency could have foretold the pandemic, but many of them missed blaring sirens warning that severe stress would unglue core financial markets and the lightly-regulated nonbanks on which they now rely.  As we have noted, the Fed’s surveys of repo-market risk took great comfort in their resilience, but stress was tested under only baseline, benign conditions.  Repo markets failed anyway last September, but by the time the Fed realized its error and rushed in, it was too late.  Funding flows in good times were off-kilter; in severe stress, they ran aground.  Had the Fed stress-tested itself, it would have learned this ahead of time.

To be fair, the Fed did its best to persuade the SEC to rein in investment funds.  Powerful asset managers beat this back, asserting that only their investors take risk when markets turn stressful.  All the OCC and SEC waivers allowing sponsors to buy assets to rescue funds shows not just how right the Fed was, but also how it should have stood firm.  Instead, the Fed was so impressed by all the tough rules it mandated of big banks that it persuaded itself that U.S. and even global financial stability was secure because big U.S. banks were, yes, fortresses.

One of the great ironies of 2008 was that the Federal Reserve – which allowed the biggest banks to merge, binge, and otherwise position themselves to explode – nonetheless ended up the United States’ most powerful financial regulator.  The irony of 2020 is that this could well happen all over again. 

Not only has the Fed now taken over the financial market – its portfolio stands at a record $5 trillion and could soon go over the $10 trillion mark – but proposals abound for it to take over still more.  As we noted earlier this week, Senate Democrats have proposed the new U.S. digital currency espoused by, you guessed it, former Fed officials (among many others). 

We will shortly provide clients with an in-depth analysis of this legislation, but it raises all the questions about central bank digital currency I laid out last October.  If it advances, the Federal Reserve will not only be a giant regulator, likely finally gaining sway over systemic nonbanks and their activities. It could also become the owner, operator, and master of all it surveys not just in the regulatory and payment systems, but also retail deposit-taking.  Since deposits must be put to use, the Fed will soon also allocate credit.  It will do so in the name of national objectives – the “people’s QE” I questioned last year.  However, it will nonetheless do so omnipotently and – inevitably when so much power is housed in so few hands – dangerously.