Saft Commentary: The Fed Discovers Chicanery

By | February 14, 2013

Acknowledging that sometimes banks chisel clients and bank employees chisel banks may sound obvious to you, but for the Federal Reserve this is a pretty big step forward.

Jeremy Stein, a member of the Board of Governors of the Fed, gave a speech last week in which he said that sometimes it may be necessary for the fed to raise interest rates to control overheating in credit markets.

While a lot was made about him being Wall Street’s new bubble cop, I’d argue that actually the big step here was that he specifically and convincingly argued that you can’t understand markets without understanding the way participants game the system to their own advantage.

This is a huge change from the old Greenspan – and Bernanke – assumption, which was that the market was self-policing; that fear of the commercial consequences of bad actions would serve as an effective brake on fraud and abuse.

That naïve view allowed the Fed to assume that markets would behave predictably and rationally. It helped to set the intellectual underpinnings that led to too-easy rates, further easings when things went bad and the rolling series of bubbles and panics we’ve seen over the last decade and a half.

The truth, as we’ve seen, is that you can’t understand financial markets without taking into account the fact that agents, like banks and fund managers, often put clients in bad but profitable products and that those same bankers and managers often do the same thing to their own institutions.

“The premise here is that since credit decisions are almost always delegated to agents inside banks, mutual funds, insurance companies, pension funds, hedge funds, and so forth, any effort to analyze the pricing of credit has to take into account not only household preferences and beliefs, but also the incentives facing the agents actually making the decisions,” Stein said in a speech at a symposium sponsored by the St. Louis Fed.

“And these incentives are in turn shaped by the rules of the game, which include regulations, accounting standards, and a range of performance measurement, governance, and compensation structures.”

This, if accepted, could be a kind of Copernican revolution in Federal Reserve thinking, except that, rather than accepting that the earth revolves around the sun, the Fed would at last be acknowledging that banks do the dirty to their clients and bank employees do the same to their banks.


Accepting that human beings act in their own best interests, not those of their clients, is a crucial ingredient not only to running regulatory enforcement and policy but also to managing monetary policy.

My guess is that Federal Reserve officials and other economists tended to ignore these issues because they make analysis so messy and difficult. For academic purposes it is far easier, when trying to prove a theorem, to assume that markets are efficient and that people within them act in what they see as their own best interests. It is also true that this reflects a kind of market fundamentalism born out of a suspicion of the effectiveness of regulation and government intervention.

Stein argues that generally these problems of the gap between banks, or agents, and the principals to whom the money belongs are well controlled, reasoning that if they were not we would not have such well developed and large credit markets.

That’s true but only up to a point. Credit markets are in receipt of huge subsidies; in the form both of the tax detectability of interest payments and in the general backstopping of the banking system by the government.

Stein argues instead that overheating in credit markets often goes hand in hand with innovation, new regulations or changes in the economic environment like, say, a long period of very low rates. Innovation often allows agents to sell their clients, or their employers, riskier investments in which the risks are hidden but the higher rewards are promised. Likewise new regulations bring with them new ways to game them, a notable example being the growth of the debt conduit as a means of moving bank risk off of balance sheet but sadly not off of bank responsibility.

Stein argues that there are some signs indicating a “fairly significant pattern of reaching for yield” in credit markets but not the kind of use of leverage that makes that so much more dangerous. He does see a possibility of it being appropriate in 18 months to raise rates in order to control credit market excesses.

I’d go one step further and argue that it makes good sense to make regulation as simple as possible, which in turn would lead to simplicity in financial products and minimize the potential for the abuse of clients by their advisers. Glass-Steagall did a very good job of that for many decades, making the job of the Federal Reserve easier at the same time.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at and find more columns at

(Editing by James Dalgleish)

Topics Agencies Legislation

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