NEW YORK: The massive $16-billion mortgage fraud settlement agreement reached by Bank of America and federal authorities — only the latest in a string of such settlements — makes it easy to lose sight of what good shape banks are in.

Banks are now far better capitalised, with tighter credit processes and better risk accounting. The bigger Wall Street houses have also jettisoned many of their most volatile trading operations. Yet most have still managed to turn in decent earnings. That is a tribute to the steady and generally thoughtful imposition of the new Dodd-Frank and Basel III regulations, the rules on “stress-testing” balance sheets and the controversial Volcker Rule that limits speculative proprietary trading operations.

And the feds are keeping on the pressure, as demonstrated by their rejection of almost all the “living will” plans submitted by the major banks, which are supposed to prevent the kind of disorderly collapse that Lehman Brothers went through in 2008. These living will impositions are designed either to reduce the riskiness of bank holdings or to make the financial institutions post more capital and reserves to cushion against reverses.

While these reforms were badly needed after the virtual wholesale deregulation of the 1990s, they almost all raise costs and limit flexibility. But that is far from the worst problem facing the banks. The regulatory impact on revenues and profits is likely to be dwarfed by the pain banks will experience after the inevitable removal of their current federal life-support systems.

The Federal Reserve has taken extraordinary measures to entice banks to lend money. It has used two main tools. The first, called quantitative easing or “QE,” has entailed the Fed buying massive quantities of securities normally held by private financial institutions. The second has been to keep the fed funds rate, or the rate at which major banks lend their short-term funds to each other, at unusually low levels.

The Fed’s use of these tools has been extremely aggressive. Take quantitative easing. The Fed is a bank and has a balance sheet. At the end of 2007, or just before the financial crash, the value of its securities portfolio totaled about $925bn; because of QE, the Fed’s balance sheet has ballooned to $4.4 trillion.

Published in Dawn, August 12th, 2014