MNI INTERVIEW: Banks Face Mounting Risks As Fed Hikes -Hoenig

U.S. bank balance sheets could come under rising pressure as the Federal Reserve lifts interest rates and asset values decline because lenders are not as well capitalized as regulators maintain, former Kansas City Fed President Thomas Hoenig told MNI.

Hoenig, also ex-vice chair of the FDIC, said in the latest episode of MNI’s FedSpeak podcast that improvements to bank capital regulation since the last financial crisis were not enough to make him comfortable about the state of the banking system.

“If the Federal Reserve raises rates sufficiently, to or above 4% by the end of the year and they stick to quantitative tightening, then I think you will have downward pressures on asset values of all kinds. I think that’s where the banks will feel the effects,” he said.

“It’s not just in the shadow banks because the largest commercial banks and some of the largest regional banks fund the shadow banking sector and that will come back on their balance sheet.”

QT RISKS

He said financial markets have not yet fully appreciated the effects of the Fed’s quantitative tightening program, which aims to reduce the USD9 trillion balance sheet fairly rapidly. (See MNI: Recession Could Force Fed To End QT Early-Ex Officials)

“I know the regulators say the largest banks are so much better capitalized. When you look at their leverage ratio and you think about liquidity tightness and you think about asset quality, their leverage ratio is 6%. That’s not an overly impressive leverage ratio,” adding that he would prefer to see a ratio around 8% or 9%.

Hoenig acknowledged risk-weighted capital ratios are closer to 13% but added that these could not be relied upon as a long-run measure of financial strength.

“As we learned in the financial crisis, risk-weighted capital becomes secondary in a crisis. Only leverage matters and the leverage ratio matters, and I think 6% is marginal,” he said. “It will I think be tested if the economy runs into confidence issues, if the rates rise sufficiently that it does begin to pressure down asset values, then I think the test of adequate capital would be forthcoming.”

HIGH RISK OF RECESSION

Hoenig said he sees the strong likelihood of a U.S. recession next year if the Fed is serious about bringing down inflation, which slipped to 8.5% in July but remains close to a 40-year high. (See MNI INTERVIEW: Fed's Bullard-Rates Could Be 'Higher For Longer')

“I haven’t really witnessed too many adjustments coming down from 8.5% to 2% without a recession,” he said. “I think the probabilities of a recession are fairly high.” He thinks inflation will end the year around 6% to 6.5%.

Hoenig, who as head of the Kansas City Fed hosted the annual Jackson Hole Symposium for 20 years, said he doubts Fed Chair Powell will commit to a 50bp or 75bp rate hike at the September meeting given that there will still be additional data on inflation and jobs before then.

“I just can’t imagine they’ve made up their mind at this point,” he said.

The easing of financial conditions seen since the softer-than-expected CPI print last week makes policymakers' jobs harder, Hoenig said, adding that’s partly the Fed’s fault because it previously flinched in the face of modest economic weakness and financial distress.

“It’s a statement in the sense of the Fed’s perceived credibility with the market. The Fed is saying inflation is the No. 1 goal and they’re going to bring it back to 2%, and yet there’s this view that they will reverse fairly quickly,” he said.

The minutes also showed some concern about overtightening, which prompts investors to start pricing in the prospect of rate cuts rather quickly after interest rates peak, he said.

“When you give mixed messages the market is going to read it favorably, and that’s because the Fed has changed directions fairly consistently,” he said, citing the repo scare of 2019 and the 2018 pause in hikes.