The phrase “paradigm-busting” has become a cliché, but the construct in Thomas Kuhn’s landmark 1962 book on scientific revolutions is an illuminating way to understand the pandemic. We know it has broken the global paradigm of health, food, and economic security. But the U.S. has another paradigm: a financial system constructed of private companies that win or lose due not just to managerial success and market opportunity, but also and often principally to adroit arbitrage of the porous boundaries between private finance and government backstops. In 2020, we have not only a macroeconomic crisis unparalleled since 1929, but also a financial-market realignment unseen even in the midst of all the Fed’s 2008 interventions. In its wake, we could well have a new financial system consisting principally of a gigantic central bank, enormous quasi-private utilities, and narrow banks operating on short leashes serving these mighty masters. This may not come by act of law so much as by force of nature – by the time the economy begins a strong recovery, the Fed may have grown so big no one can deconstruct it, banks may have grown so unpopular that no one wants them the way they are but bankers, “shadow” banks will have been dragged into disinfecting sunlight, and bigtech companies grown still more powerful will dominate any financial sector they select.
Let me take each one of these portents in turn. First to the Fed, which will soon have at least $10 trillion on its balance sheet in concert with controlling who gets credit and who doesn’t, who has liquidity and who doesn’t, and even who takes deposits and makes payments or doesn’t. Some of this new “Big Fed” construct is already apparent along with the obvious absence of any idea about when, how, or even if the Fed should go back to being just a punch-bowl wielding central bank.
Other aspects of this construct are being built with lightning speed – see our recent analysis of Democratic plans for a “digital dollar,” along with fast-paced work at the Fed and central banks around the world to craft digital currencies that would make them deposit-takers of first resort. In a weird way, this will make sense – with its huge lending facilities, the Fed now directly or indirectly controls much of U.S. lending. Why not just complete the financial-intermediation chain, formalizing the Fed’s formidable control over lending with a variation on the “people’s QE” progressives favor and populists could come to love.
The Fed’s control over much of the payment system goes without saying and its plan to take over still more is clear in FedNow. Bigtech’s designs on the payment system are evident not just in Libra’s still-pending introduction, but also the calls from bigtech before and even during the pandemic to enter retail payments. The Fed has so far been reluctant to open FedNow to bigtech, but so far isn’t necessarily what’s going to happen going forward.
However, even an enormous Fed cannot control everything. Core infrastructure entities such as custody banks, primary dealers, payment processors, and prime brokers will survive along with a raft of exchanges and wholesale lending and continued capital-markets trading. Retail services such as brokerage and asset management would also need to continue in concert with capital-market vehicles for giant investors such as whatever’s left of American pension funds. Much of this infrastructure has just gotten trillions in Fed support, with much of this support going beyond liquidity to safeguard solvency no matter the monikers on all of the Fed’s facilities. It seems most unlikely that any Administration will be willing to allow another round of near-death experiences across the spectrum of nonbank financial intermediation and investment. Much can and will change by rule and what the Administration can’t touch, a far more progressive/populist Congress will.
The Fed may not, however, be the only large federal presence dominating the new financial paradigm. Fannie and Freddie have already been thrust back into their utility role no matter the Administration’s cherished hope for ending the conservatorship as early as this year. Government guarantees are now also dominating small, medium, and large businesses due not just to urgent needs, but also crisis conditions at many nonbank lenders such as CLOs, P2P, and BDCs. Now, the value proposition of capitalized and liquid lending has been proved but capacity is scarce. Bank lenders will remain and even grow in sectors such as residential and multi-family mortgages and business finance, but not at the scale needed and perhaps not at all if the Fed takes over deposit-taking via CBDC. Government guarantees would thus become de rigueur.
Who is standing financially strong no matter the pandemic? It’s of course Amazon, Facebook, Google, and the other bigtech bastions on which we now all depend for day-to-day work, commerce, education, and even health care. As I have noted, the IMF and others looking at bigtech finance have figured out a solution to all the risks this poses: narrow banks. So far, the U.S. only has one wannabe narrow bank: the TNB charter still waiting for the Fed to stop pretending to think about it. The idea behind narrow banks for bigtech is that these limited-purpose charters provide the reserves necessary to absorb payment-system risk, thus allowing bigtech to access central-bank payment systems and, should it come to pass, digital currency. Bigtech would of course still have all its own resources at its command for lending, likely controlling sectors the Fed would be challenged to usurp even if it wanted to.
In short, the U.S. could quickly evolve into a system in which the Fed controls traditional financial intermediation directly or by fiat across the sector and governs financial infrastructure directly or in concert with other agencies for a far wider array of systemic financial market utilities. Big government utilities such as the GSEs would play an even larger role and new entrants – most importantly, bigtech – could pick up the most desirable pieces not allocated to the Fed, the federal government, and the private financial institutions still able to operate in the new, far more regulated framework.
Much in this paradigm is only sketch out above and none of it is inevitable. But, all of it is already upon us. Caught up as all of us are in day-to-day life and moment-by-moment business decisions, it may be hard to see the structural realignment beneath our feet. However, it’s already well under way.