A few years ago, one of Karen Petrou’s banking clients gave her an unusual assignment: It wanted her to write a paper laying out “the unintended consequences of the post-financial-crisis capital framework.” Petrou is the co-founder of Federal Financial Analytics Inc., a financial services consulting firm in Washington that focuses on public policy and regulatory issues. She is also, as the American Banker once described her, “the sharpest mind analyzing banking policy today — maybe ever.” Whenever I’m writing about banking issues, she’s the first person I call.
Writing that paper caused Petrou to ask a question she’d never really considered before: Did the bank regulations enacted after the 2008 crisis — along with the Federal Reserve’s post-crisis monetary policy — exacerbate income inequality? Her answer, which she laid out in a series of blog posts, as well as a lecture at the New York Federal Reserve in March, was yes. “Post-crisis monetary and regulatory policy had an unintended but nonetheless dramatic impact on the income and wealth divides,” she wrote recently.
That particular sentence was in a blog post devoted to a recent study by the Federal Reserve Bank of Minneapolis that evaluated income and wealth inequality from 1949 to 2016. The study certainly seems to validate her thesis. It shows that between 1989 and 2007, the top 10 percent increased their share of the nation’s wealth by just 5.8 percent. But in just the next nine years, between 2007 and 2016, the richest Americans captured an additional 8.3 percent of the country’s wealth. Meanwhile, those in the 50 percent to 90 percent wealth bracket saw their share of the nation’s wealth drop by 17 percent, and those in the bottom 50 percent saw a 52 percent drop. The single biggest variable that changed after 2007 was the way banking was conducted and regulated.
Petrou has written a book outlining her analysis of the problem — and her proposed solutions — which will be published next spring by Yale University Press. Not wanting to wait that long, I visited her recently to get a sneak preview.
JN: Let’s cut to the chase. How does banking accelerate income inequality?
KP: First, as the country becomes more unequal, there are fewer middle class customers. That means middle class bank products become unprofitable, and banks follow the money. And banking regulations make it worse because the capital requirements imposed after the banking crisis make it a lot more expensive for banks to do a startup small-business loan than go into wealth management. Startup loans are riskier than wealth management, of course, but the capital costs have become prohibitive, and banks don’t lose money on purpose.
JN: Can you really blame the banks for behaving in this fashion?
KP: I’m not blaming the banks. I’m blaming the unintended consequences of the rules. I think the rules unduly penalize equality-enhancing financial services.
JN: Can you give me an example?
KP: Thanks to the new capital requirements, it’s basically impossible for banks to make mortgage loans to anyone but wealthy customers, unless they can send the loan to the GSEs (Fannie Mae and Freddie Mac) or taxpayer-backed Ginnie Mae. And the new capital requirements also discourage banks even from sending loans to the GSEs or Ginnie — if the loan to a low, moderate-, or middle-income borrower is kept on the bank’s books, there’s a very large capital charge at the front end; if it’s sold, the bank still has to hold back-end capital in case the loan defaults and comes back to the bank. Nonbank mortgage originators — which have eclipsed bank lending in the last few years — face none of these capital charges, but they also can make no loans they don’t sell on to investors. Their entire focus is on booking loans for an upfront fee and sending them on to these taxpayer-backed entities. Without capital at risk, these nonbanks (companies such as Quicken Loans Inc.) also have a lot less at risk if loans eventually default. As a result, high-risk mortgage lending is making a comeback. Let me be clear — I’m not against post-crisis capital standards designed to prevent lenders from making high-risk loans that put only the borrower or taxpayer at risk. There’s no quicker way to make Americans even less equal than to expose vulnerable homeowners to foreclosure. What I am saying is that now some lenders — banks — are under rules so tough they can’t support equality-enhancing mortgages and other lenders are totally outside the post-crisis “skin in the game” rules designed to end high-risk, predatory lending. This asymmetry redefines the market in ways risky all over again, to both vulnerable borrowers and the taxpayer.
JN: Would you have said that this was a problem prior to the financial crisis?
KP: If I had known to look for it, I would probably have said it was a problem. It’s common knowledge that income inequality in the U.S. has been getting increasingly worse since 1980. But what I’ve been pointing out in some of my blog posts is that it became hugely worse after the financial crisis. Were there underlying issues pre-2008? Absolutely. But we had more of a middle class even in 2006 than we do now. By a lot.