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Rate Hikes Are Designed to Prevent Another Financial Crisis

According to the Fed's recent Financial Stability Report, reforms undertaken since the last financial crisis have made the US financial system more robust and resilient should another crisis occur. With the recovery and resolution plans being particularly applicable to securing businesses and households during good times and bad, risks taken by institutions and investors that could lead to financial failure are largely off the shoulders of US taxpayers.

There are still vulnerabilities that can build over time, however, and business debt remains the greatest concern. While the largest banks are sufficiently capitalized and able to withstand shocks in the market better than before, there is evidence of more aggressive risk-taking, particularly with institutions seeking more profitable investments as well as the increased use of leveraged lending and cov-lite loan structures. Because hedge funds and private equity firms do not play the same pivotal role as banks, while their propensity for high risk-taking may expose their counterparties, the Fed indicates that they will not get bailed out in the event of another financial crisis.

With the measures that the Fed has taken to prevent another financial crisis, should one occur it can be argued that the Fed would largely be responsible. With asset prices progressively being over-inflated, sharp increases in business leverage, and more prevalence of "zombie" firms, it is no wonder that the Fed has used rate increases to temper the risk-taking and flush out inefficient firms. With the next downturn being inevitable, however, it remains to be seen if the Fed's intervention will shorten the downward cycle or prolong it into an even worse recession than before.

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