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Prof. Gerald Epstein is skeptical about new Fed rules and the appointment of Federal Reserve vice chairman Stanley Fischer to head the Financial Stability Committee

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SHARMINI PERIES, EXEC. PRODUCER, TRNN: Welcome to The Real News Network. I’m Sharmini Peries, coming to you from Baltimore. This is an edition of the Gerry Epstein report.

Federal Reserve is proposing a new rule to rein in big banks that are too big to fail. The Senate Banking Committee heard last week that the central bank was hoping to regulate the banks still thought to be too big, in an effort to favor small banks, less complex banks.

Now joining us to discuss the rule is Gerry Epstein. Gerry Epstein is codirector of the Political Economy Research Institute at UMass Amherst. He has published widely on a variety of progressive economic policies, issues, especially in the area of central banking and international finance.

Thanks for joining us, Gerry.

EPSTEIN: Thanks, Sharmini, for having me. It’s good to be here.

PERIES: Gerry, let’s start with what’s the rule. I understand there’s many components to it, so let’s talk about the rule first.

EPSTEIN: Okay. So, ever since the financial crisis hit, people have recognized that there were several components related to it. One was the excessive leverage or debt that banks and other financial institutions took on. They invested in very risky assets and used borrowed money to do that. So that’s a leverage debt problem. A second aspect is the kind of money they borrowed in order to invest in these risky assets was very short-term borrowing, overnight borrowing, borrowing that they could just disappear at the drop of a hat. And that’s what happened when the crisis hit. So this was a short-term borrowing or liquidity problem. And the third is the fact that these banks invested a lot of their own assets in these very risky deals, and so that when the crisis hit, the banks, many of the banks themselves, the biggest ones, were insolvent and the government chose to bail them out. So the risky deals, or proprietary trading, the liquidity problems, and the leverage problems were all at the core of the crisis. And what really encapsulates all of this is that these were very large banks that were too complex and too big to fail.

So the government could have addressed these problems directly by breaking up these banks that were too big to fail and too complex to fail. But instead [inaud.] them separately. The Volcker Rule, which we’ve talked about, dealt with proprietary trading. It took a long time to implement. It has a lot of holes in it.

So what happened just last week is Daniel Tarullo, who is on the Federal Reserve Board of Governors, who’s been spearheading these issues from the point of view of the Federal Reserve–and he’s actually a pretty decent person. He’s a good guy. He’s dealt with Americans for Financial Reform, and he’s open to try to deal with these problems. Well, he gave testimony before the Senate and talked about two aspects of this. One is dealing with the liquidity problem by enforcing a liquidity rule. I’ll explain what that is in the second. And the second is dealing with the leverage problem, with the banks taking on too much debt.

The bottom line is that while these initiatives are important if you’re going to adopt this approach of trying to chip away piece by piece, once again they’ve been gamed by the banks. There are a lot of holes in these. I’m afraid this kind of piecemeal approach isn’t really going to solve the problem.

PERIES: Even if it’s not effective, what is the process for the implementation of this kind of rule? Will it take a long time? Will it be done quickly?

EPSTEIN: So the implementation is that it’s already taken quite a long time. Dodd-Frank was passed five years ago. It’s taking a very long time to write these rules. These rules are still going to be implemented quite slowly, maybe not be fully effective till 2018 or so.

Let me explain a little bit about what the rules are. So the liquidity rule. When the crisis hit in 2008 and all of these banks and pension funds and hedge funds had lent money overnight to the big banks, they started pulling their money out. There was a big run on the bank, all the big banks. And the banks were just holding these very complex assets that they’d financed with this overnight money, and these assets had lost their value because the crisis hit. So they couldn’t sell these assets and recover this money to pay back the people who were taking the money out. So what the liquidity rule says is that these banks have to hold on to very safe assets, so that if a run occurs again, they’ll be able to sell these assets, like government bonds, for example, or cash at the Federal Reserve.

So the banks don’t like to hold a lot of these assets, because they don’t earn much interest. So what the banks did is they fought and they fought and they fought, and they got the Federal Reserve to allow them to hold riskier assets, which defeats the purpose, because if they’re holding risky assets, you’re back to square one, the problem you started with. It’s a step in the right direction, because they will have to hold some more of these very highly liquid assets, but it’s definitely not going far enough. You said that they’re going to exempt some of the smaller banks from some of these rules, and that’s probably good, because this will penalize the larger banks, I mean, this kind of piecemeal way of trying to deal with the too-big-to-fail problem.

The second rule, this leverage ratio rule, is also a good idea. It puts a limit on how much banks can borrow to finance assets. The problem is there’s major loopholes because it doesn’t clearly cover a lot of foreign banks or foreign bank subsidiaries, so that a big bank like JPMorgan or Goldman Sachs could set up kind of a network of foreign bank subsidiaries, they could book all of their complex assets and borrowing overseas, and the rule might not apply to them. So once again this shows that there are so many different ways that the banks can get around these complex rules that a better approach would be to adopt some of the rules that have been suggested to have a clear size limit on how big banks can get, a clear limits on what banks can do, and stop this process of trying to implement piecemeal these rules that the banks can constantly game and poke holes in.

PERIES: Gerry, it was recently announced that the vice Fed, Stanley Fischer, would head up a financial stability committee. What do you think of that decision?

EPSTEIN: Well, I’m very skeptical. As I’ve talked on this program earlier, last year, I’m very skeptical about the role of Stanley Fischer. He was one of the–he’s a very smart guy, clearly. He’s very well trained, clearly. But he was one of the architects of the so-called Washington Consensus, the kind of neoliberal globalization, which ultimately led to a lot of financial liberalization. He was chief economist at the IMF when a lot of this was going on. So I think all of his instincts are to let the market rule and to minimize government interference with the banks and in the market. Now, maybe he’s changed his stripes. You know, maybe he’s found the new religion, that we have to do things differently. But I’m quite skeptical that he’s the right person to lead this. I would have rather have had Tarullo lead this group.

PERIES: And, Gerry, the quantitative easing policy, you had mentioned that. Do you want to elaborate what you mean by that and what Janet Yellen should do in terms of this problem?

EPSTEIN: Yeah. So as your viewers probably know, Janet Yellen, the head of the Federal Reserve, has agreed to taper this expansionary monetary policy that the Fed has been doing for the last couple of years, the quantitative easing. It’s going to end next month. And they’re essentially giving up on trying to mobilize the economy, generate more employment. They say they’re going to keep interest rates low, but that clearly has not been sufficient to get the economy back towards full employment. And I don’t think it’s that Janet Yellen doesn’t want to do that; I just think that the realities are that they’re not going to be able to do that, play a positive role, unless they develop really new kinds of tools. They’re not doing that. They’re going to abandon quantitative easing and just stick to a low interest rate policy. And what the Federal Reserve needs to do is develop new techniques to start supporting the allocation of credit to socially useful activities–small businesses, making the green transition that we need to make and that my colleague Bob Pollin is going to be talking about with you a lot in the coming weeks. They have to really tear up the rulebook and start doing new kinds of directed lending in order to get our economy going. And we should probably talk more about that in the future, about more precisely what they should be doing.

PERIES: We’d be glad to do that. Thank you so much for joining us, Gerry.

EPSTEIN: Thank you very much.

PERIES: And thank you for joining us on The Real News Network.


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Gerald Epstein is co-director of the Political Economy Research Institute and Professor of Economics at UMass Amherst.