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Why Janet Yellen is very wrong about the banks

Federal Reserve Chairperson Janet Yellen spoke in London on Tuesday and indicated that the financial system was not likely to experience another significant financial crisis in our lifetime. Ms. Yellen is convinced that the actions taken by the Congress and the banking regulators have created a financial system in this country that can withstand significant stress without breaking. If one looks at the banking ratios, Ms. Yellen is making a good case.

However, if one assesses the impact of the new rules and regulations on this country, it is clear that the Fed has placed the United States at greater risk of a major collapse than at any time in the past 110 years – going back to the Panic of 1907.

The Ratios

Thirty years ago, in the first quarter of 1987, the FDIC indicates that U.S. banks had equity equal to 4.5 percent of assets. In the first quarter of 2017, this ratio was 5.9 percent. Bank liquidity has also improved. Cash and securities were 28.8 percent of assets in the earlier period and 32.7 percent recently. Plus, banks have more money to lend. Thirty years ago the loan to deposit ratio was 78.8 percent (it was 92.2 percent ten years ago). Today it is 71.1 percent.

These numbers indicate that the banking system is well capitalized; it has more than adequate liquidity; and it has excess deposits that can be loaned. It will take a long, long time for these ratios to erode. In this regard Ms. Yellen is right.

Protections Gone

The first place where Ms. Yellen may be wrong is that the new regulatory environment demands that banks fail in the event of a crisis. It prevents any and all bank regulatory agencies from aiding a weakening bank. It is actually against the law for the government to bail out a bank now due to new regulations. The new system relies on bank capital and liquidity to protect the system when an economic and/or financial set of problems occur.

This approach has been tried before. In the 19th century, and in 1929, the only protections that banks had against failures were their own balance sheets and what they could borrow from other bank balance sheets. It did not work. There were mammoth depressions prior to the Civil War – 1837 was a lollapalooza. There were depressions in 1873, 1883, 1893 and a panic in 1907.

In 1929 the regulators had the tools to prevent a massive setback but they did not use them and the system failed. In 2008, they had the tools but did not use them until Lehman failed and almost crashed the system or until the protections were utilized.

There are no more tools. The protections put in place going back to the establishment of the Fed are gone. The financial system is now at massive risk. The next downturn will be far more devastating than what happened in this country a decade ago.

Economic Activity

A series of new regulations have effectively nationalized the banks. They give government agencies the power to control every key aspect of banking. The government penalizes banks that get too big. It tells banks how they should allocate their assets. It demands that a large percent of those assets be loaned to the government. It penalizes banks that lend money to industries or in types of loans that the government does not like. It tells banks where they must acquire their liabilities. It tells them what types of liabilities are acceptable and what are not. It tells the banks that they must borrow money at relatively high rates in long-term markets and lend that money at relatively low rates to the government.

Under its new system it forces banks away from international activity liberally using the Bank Secrecy Act and the Anti Money Laundering laws. Its activities have forced two of the nation's largest banks to close what could be millions of overseas accounts and ruin thousands of relationships. It is weakening the country's ability to offer the liquidity in global financial markets that was once available.

If one believes that a small group of people operating behind closed doors, in private, a group that totally failed to protect the system from the last collapse, knows best about the direction of funds in the United States economy, Ms. Yellen is right. If you believe that this is the worst possible structure because it assumes that regulators know more about the economy than the economy knows about itself, this new system is a disaster.

Ms. Yellen is not right. She is blind to what she and her political cohorts have done.

Commentary by Richard X. Bove, vice president of equity research and financial sector analyst at Rafferty Capital,

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