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Investments

This will probably cause the next Great Recession

Federal Reserve: We told you so

March 27, 2014
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The Federal Reserve Bank of New York is on a blog-publishing tear at the moment.

The latest post is the fifth in a series of twelve Liberty Street Economics. The subjects are all on large and complex banks and nonbanks. The daily posts are short, concise and fascinating reads, especially today.

Today, the post by Samuel Antill, David Hou, and Asani Sarkar offers some thoughts on the shadow bank sector. The title is foreboding enough to get the attention: The Growth of Murky Finance.

And the point is basically this: shadow banks are growing, we can't regulate them without tons more dough and manpower and if and when they blow up just remember, "We told you so."

Wait, isn't there a whole new slate of regulation in Dodd-Frank meant to stop this?

Isn't there a Consumer Financial Protection Bureau to prevent these greedy, unregulated fat cats from growing out of control?

Yes, but it isn't enough apparently, and it never will be, the blog suggests.

"While new regulations such as the Dodd-Frank Act impose restrictions on financial activities and increase their costs, especially those of large firms," the researchers say, "our paper suggests that there may be limits to what regulation can achieve."

Well, that's a real confidence builder.

And it continues.

"On average, the financial sector has accounted for about 50% of the asset values of publicly listed firms, but roughly 70% of total business sector liabilities. Hence, one reason to worry about the size of this sector is its high representation among private firms that have virtually no transparency."

The only reasonable way to read that is to infer an excessive amount of risk in the sector; especially when factoring such an excessive share of business liabilities.

Words such as "Murky," "Worry," and "no transparency," all hint at the potential for the same blinding crash the pro-cyclical credit crisis brought.

However, there is some relief, but you have to wait for it.

In the conclusion the authors pull up:

"Although the policy response to the growth and vulnerabilities of the financial sector has been to enhance supervision and regulation of large firms and visible financial sectors, our paper documents that, historically, growth has occurred mainly in areas outside the current regulatory ambit. If financial transactions migrate out of regulated sectors, as expected by some, then this trend is likely to persist. We need to improve our knowledge of these opaque financial sectors in order to understand what risks (if any) they pose to the economy."

Oh, so these firms may not pose a risk after all?

The Federal Reserve is basically saying that they don't know the risk — fair enough.

And if another Great Recession is coming, this will be it.

And when it does, remember the Federal Reserve told you so.

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