Much of the talk this week as markets plummeted focused – indeed was transfixed – on the U.S. Federal Reserve’s next step.  Would it walk rates up a tad in September, stand pat, or even walk back to a QE4 position?  I will leave for later what the central bank might do, but one thing is clear:  whatever that is, the FRB now must understand that traditional monetary-policy tools are blunt because of the structural transformation of financial markets since 2008.  If U.S. monetary policy is the fulcrum of global finance, then U.S. financial-market structure dictates its transmission channels.  These are going haywire because the largest U.S. banks – the market’s mainspring – no longer act as efficient market intermediaries.  This may well make the financial system safer, but it also makes it very, very different.  If the Fed doesn’t get that – and its statements suggest to me it doesn’t – then we’re in for a very rough ride.

The fundamental, bedrock question of what’s going amiss in all the QEs is why huge demand for safe bank deposits is not stoking a like-kind supply of productive lending.  Excess reserves held by banks have gone up 1,300 times since 2008, while large-bank lending is flat or even down.  Regional banks are doing their bit, but banking assets remain heavily concentrated at the large end of the industry. 

For the biggest banks, a lot more than excess-reserve balances has changed since 2008.  In my view, their fundamental business proposition is radically different because of the combination of new rules and self-imposed restraint.  The FRB can spike its punch bowl with 150-proof liquor, but big banks either can’t or won’t drink from it.

Others, though, are bellying up to the bar.  The lower rates go, the more yield-chasing there is and larger grow the balances in shadow liabilities and in higher-risk assets held for longer durations with complete disregard for interest-rate risk.  Market structure is thus changing not only because big banks aren’t intermediating, but also because fund flows are largest in assets with little long-term productive value.  Current yield-chasing investments are generally not promoting household consumption or long-term business investment.  Instead, they’re going into leveraged loans, emerging-market bond funds, and all sorts of other places that we learned all over again this week pose all sorts of investor and systemic risk.  Banks and others resisting yield-chasing temptation are housing more and more funds in cash-equivalent assets, but this does nothing for economic growth even as it stokes greater market illiquidity under stress.

The U.S. could have a sound, intermediating financial system with fewer, smaller banks, but fewer, smaller banks without a sound regulatory system for the rest of the financial market is a recipe for boom-bust cycles of cataclysmic proportions.  Hopefully, we dodged one this week.  If so, the FRB should take heed of the loud warning buzzers and balance monetary-policy actions with financial-stability projections.  If it’s too late and markets are already on the black-diamond ski jump, hold on.  We’ve never seen this before.