Market Extra: Banking expert from 2008 crisis says low interest rates make banks vulnerable and Americans poorer

Wall Street better be careful what it wishes for.

Karen Shaw Petrou, a prominent voice on financial regulation for decades, wants the Federal Reserve to know it will be making a big mistake if it listens to Wall Street and cuts interest rates later this month.

“I read everyone saying the Fed should drop rates, because that will improve the economy. That it is good for employment. Well, it isn’t,” Petrou told MarketWatch in an interview.

The promise of low central bank rates has helped lift U.S. stocks to all-time-highs, with the Dow Jones Industrial Average DJIA, +0.67%  and S&P 500 SPX, +0.28%  this week reaching new records as investors flee the near $13 trillion pile of global debt currently offering negative yield, including recently even some corporate bonds.

But the Fed’s “lower for longer” interest rate policy also ratchets up risks for banks, warned Petrou, the co-founder of Washington, D.C.-based Federal Financial Analytics Inc., a banking advisory firm to lawmakers, central banks and industry groups since 1985.

“They can’t make money when the most they can charge on a loan is 2.5%, 3% or 4%,” Petrou said of the nation’s lenders. “Banks fail not only in crisis, they fail when investors don’t want to invest in them anymore. Profitability remains a real challenge.”

Check out: Banks should shine among S&P 500 stocks this earnings season

Petrou’s straight-talk on complex banking issues made her a sought-after voice in the wake of the subprime mortgage crisis. American Banker even called Petrou the “sharpest mind analyzing banking policy today — may be ever.”

When you are putting money in the bank and your interest rate is 25 basis points, it will take you until your late middle-age to save enough money for a house

Karen Shaw Petrou, banking analyst

And when U.S. senators were seeking answers as to why J.P. Morgan lost a shocking $6.2 billion from bad derivatives bets place by its “London Whale” trader in 2012, only two years after sweeping banking rules were written, Petrou was taking both the bank’s CEO Jamie Dimon and regulators to task for their part in the debacle.

Check out: The London Whale resurfaces: Bruno Iksil speaks out

Big-picture risks

Yet, the more pressing financial stability issue, in Petrou’s view, is how a decade of artificially low rates have cut off America’s youth and shrinking middle-class.

“When you are putting money in the bank and your interest rate is 25 basis points (0.25%), it will take you until your late middle-age to save enough money for a house,” Petrou said. “The economy is cheating them out of their future.”

Petrou, who is writing a book about income inequality, said part of the problem is outdated models used by the central bank to set policy.

“The U.S. isn’t the middle-class country its models believe it to be,” she said of the Fed, adding that its current models lead to policy catering mostly to the richest 10%.

Read: The richest 10% of households now represent 70% of all U.S. wealth

“Consumption patterns, wealth accumulation patterns and other key assumptions of economic theory have changed out from under the Fed,” Petrou said. “But it isn’t looking to understand that ultra-low rates eviscerate family savings and long-term wealth.”

Petrou worries that young people will be far angrier and more distrustful of a political system that continues leaving them on the sidelines of policy decisions.

“That does keep me up at nights,” she said.

What can the Fed do about it?

“The longer it makes decisions based on old models, that don’t factor economic inequality into the equation, the worse it is going to get,” Petrou said.

Same advice for banks

Petrou said that Deutsche Bank DB, +2.21%  also waited too long to tackle its problems.

The German lender last week announced plans to create a separate “bad-bank” to house some $83 billion of assets, cut 18,000 jobs and pull out of certain lines of business, including global equities sales.

Read: Pressure on Deutsche Bank bonds points to investor skepticism over sweeping overhaul

“The lesson that Deutsche Bank didn’t learn is that you need to do it fast,” she said. “I’ve never seen a case in which the longer you wait, the better it gets.”

To that end, Petrou expects write-downs of asset values to flow from Deutsche’s bad-bank.

“It will take losses. It may take a lot of losses, but that is its point,” Petrou said. “The point is to segregate it from what Deutsche Bank is very much hoping will be a new, good bank.”

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