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united states

Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications

yellen

Thank you, Claudia, and thanks to the American Economic Association and the American Finance Association for the opportunity to speak to you on a topic of growing interest to our profession and of great importance to understanding the causes and implications of the financial crisis. Everyone here today, I'm sure, is familiar with the tumultuous events that introduced many Americans to the concept of systemic risk. To recap briefly, losses arising from leveraged investments caused a few important, but perhaps not essential, financial institutions to fail. At first, the damage appeared to be contained, but the resulting stresses revealed extensive interconnections among traditional banks, investment houses, and the rapidly growing and less regulated shadow banking sector. Market participants lost confidence in their trading partners, and, as the crisis unfolded, the financial sector struggled to cope with a massive withdrawal of liquidity, the collapse of one of its most prominent institutions, and a 40 percent drop in equity prices. effects of the crisis were felt far beyond the financial sector as credit dried up and a mild recession became something far worse. You are also, no doubt, familiar with the political response to that crisis. After considerable debate, the Congress passed sweeping reform legislation designed to place the nation's financial infrastructure on a more solid foundation. I'm referring, of course, to the banking panic of 1907. The legislation that President Wilson signed in December 1913 created the Federal Reserve, providing the nation with a lender of last resort to respond to such crises. As we approach the centennial of the Federal Reserve System, it is striking how many of the challenges of that era remain with us today. In 1907, the correspondent banking networks that helped concentrate reserves in New York and other money centers also made the banking system highly interconnected. Today, our capability to monitor and model financial outcomes is vastly greater, and the tools available to the Federal Reserve are vastly more powerful, than the private capital and moral suasion that financier J. P. Morgan summoned in 1907 to stabilize the banks and trusts. But as we learned during the recent crisis, the financial system has also grown much larger and more complex, and our efforts to understand and influence it have, at best, only kept pace. Complex links among financial market participants and institutions are a hallmark of the modern global financial system. Across geographic and market boundaries, agents within the financial system engage in a diverse array of transactions and relationships that connect them to other participants. Indeed, much of the financial innovation that preceded the most recent financial crisis increased both the number and types of connections that linked borrowers and lenders in the economy. The rapid growth in securitization and derivatives markets prior to the crisis provides a stark example of this phenomenon. As shown in figure 1, between 2000 and 2007, the notional value of collateralized debt obligations outstanding increased from less than $300 billion to more From 2004, the earliest date for which comprehensive data are available, to 2007, the outstanding notional amount of credit default swap (CDS) contracts increased tenfold, from $6 trillion to $60 trillion. This incredible growth in securitization and derivatives markets reflects a significant increase in the number, types, and complexity of network connections in the financial system. Financial economists have long stressed the benefits of interactions among financial intermediaries, and there is little doubt that some degree of interconnectedness is vital to the functioning of our financial system. Economists take a well-reasoned and dim view of autarky as the path to growth and stability. Banks and other financial intermediaries channel capital from savers, who often have short-term liquidity demands, into productive investments that typically require stable, long-term funding. Financial intermediaries work with one another because no single institution can hope to access the full range of available capital and investment opportunities in our complex economy. Connections among market actors also facilitate risk sharing, which can help minimize (though not eliminate) the uncertainty faced by individual agents. Yet experience--most importantly, our recent financial crisis--as well as a growing body of academic research suggests that interconnections among financial intermediaries are not an unalloyed good. Complex interactions among market actors may serve to amplify existing market frictions, information asymmetries, or other externalities. The difficult task before market participants, policymakers, and regulators with systemic risk responsibilities such as the Federal Reserve is to find ways to preserve the benefits of interconnectedness in financial markets while managing the potentially harmful side effects. Indeed, new Reserve and other financial regulators are intended to do just that. In my remarks, I will discuss a few of the major regulatory and supervisory changes under way to address the potential for excessive systemic risk arising from the complexity and interconnectedness that characterize our financial system. The design of an appropriate regulatory framework entails tradeoffs between costs and benefits, and to illustrate them, I will discuss in some detail proposals currently under consideration to mitigate risk in over-the-counter (OTC) derivatives, which proved to be an important channel for the transmission of risk during the recent crisis. I am quite aware that some reforms in the wake of the financial crisis, including those pertaining to derivatives, have been controversial. In connection with recent rulemakings--and, more broadly, in the arena of public debate--critics have asked whether complexity and interconnectedness should be treated as potential sources of systemic risk. This is a legitimate question that the Federal Reserve welcomes and itself seeks to answer in its roles of researcher, regulator, and supervisor. Let me say at the outset, though, that a lack of complete certainty about potential outcomes is not a justification for inaction, considering the size of the threat encountered in the recent crisis. Responsible policymakers try to make decisions with the best information available but would always like to know more. With that in mind, I'll begin by briefly surveying research that highlights ways in which network structure and interconnectedness can give rise to or exacerbate systemic risk in the financial system. Academic research that explores the relationship between network structure and systemic risk is relatively new. Not surprisingly, interest in this field has increased considerably since the financial crisis. A search of economics research focusing on many as were produced in the previous 25 years. That's not to say that economists were blind to the importance of networks before the financial crisis. In 2000, Franklin Allen and Douglas Gale, for example, developed an important model of financial networks that provides insight into how networks can influence systemic risk. In the model studied by Allen and Gale, systemic risk arises through liquidity shocks that can have a domino effect, causing a problem at one bank to spread to others, potentially leading to failures throughout the system. In their model, interbank deposits are a primary mechanism for the transmission of liquidity shocks from one bank to another. Allen and Gale compare two canonical network structures: a "complete" network, in which all banks lend to and borrow from all other banks, and an "incomplete" network, in which each bank borrows from only one neighbor and lends to only one other neighbor. Figure 2, panel A, presents an example of a complete network, and figure 2, panel B, an example of an incomplete network. In the case of the complete network, banks benefit from diversified funding streams. A liquidity shock at one bank is less likely to cause the bankruptcy of another bank since the shock can be distributed among all banks in the system. In the incomplete network, funding is not diversified. A liquidity shock at one bank is more likely to cause liquidity problems at other connected banks because the same shock is spread over fewer banks and is therefore larger and more destabilizing. The principle behind this result is familiar and basic to economics: Diversification reduces risk and improves stability. While this idea is compelling, both economic research and the events of the financial crisis suggest that it is incomplete. In their classic paper on bank runs, Douglas Diamond and Philip Dybvig showed how rational and prudent actions by individual depositors to limit their own risks may be highly destabilizing to an institution designed to transform short-term liabilities into long- term assets. kind of collective action problem can arise in a network akin to a modern check-clearing system in which credit extensions among banks allow claims on one institution to be fulfilled by another. Such a system is socially useful because it allows depositors to shift funds among banks without forcing banks to sell illiquid assets, thus enabling society as a whole to undertake more productive, long-term investment. But in times of stress or uncertainty, such systems can be subject to coordination failures: A "gridlock" equilibrium can arise in which depositors at each bank withdraw funds early in order to avoid losses arising from credit extensions to other banks whose depositors are also expected to force an early liquidation of assets. In Freixas, Parigi, and Rochet (2000), interbank credit extensions, while useful, can result in institutions that are "too interconnected to fail." These models underscore that the pattern of connections throughout a financial network determines the systemwide implications of liquidity shocks or other financial stresses in one part of the network. This finding is one reason why efforts to collect more and better data on the precise linkages among financial institutions are so important. Without such comprehensive and detailed data, it is simply not possible to understand how stress in one part of the network may spread and affect the entire system. Networks that are more interconnected are inherently more complex than those in which market participants have fewer links to one another, and complexity can exacerbate the kinds of coordination problems highlighted by Diamond and Dybvig and by Freixas, Parigi, and Rochet. Of course, "complexity" is difficult to define in a completely systematic and satisfactory manner, but one way emphasized in recent work by Hyun Song Shin is to consider the number of links required to connect savers to borrowers. Shin's analysis of interconnectedness among financial institutions is based on the idea that the ultimate amount of lending and borrowing that can occur in an economy is determined by economic fundamentals such as income growth, which change only slowly over time, whereas interbank claims can grow or contract far more quickly. Of course, claims within the entire financial system net out to zero, but they do affect the leverage of the institutions involved. In Shin's model, financial institutions seek to take on more leverage during a boom, when banks have strong capital positions and risks are perceived to be low, but can increase leverage, in the aggregate, only by borrowing and lending more intensively to each other. This causes the resulting network of intertwining claims to extend further and further. Conversely, when fundamental conditions or market sentiments change and financial institutions prefer to shed risk, they can deleverage in the short term only by withdrawing credit from one another. Such deleveraging can be particularly destabilizing in longer intermediation chains as debt claims that are called by one financial intermediary to shore up its own assets adversely affect the liability sides of other institutions' balance sheets. As deleveraging accelerates and more and more financial institutions hoard liquidity, other institutions may become concerned that their own funding may dry up and may preemptively withdraw funding from others. Fundamentally strong institutions are forced to liquidate assets at fire sale prices, which results in more deleveraging and instability. More-complex network structures are likely to be more opaque than less complex ones. For example, as the number of intermediaries standing between borrowers and lenders grows, it becomes increasingly difficult to understand how one member of the network fits into the overall system. The well-publicized difficulties that some mortgage borrowers have had in simply figuring out who owns their mortgages illustrates the extent to which lengthening intermediation chains have increased the complexity of the financial system. Moreover, in many cases, market participants may have strong incentives not to disclose their connections to one another. If a bank has a profitable relationship with a borrower, it may be unwilling to disclose it to other banks for fear that competitors will reduce or eliminate the rents that it earns. Ricardo Caballero and Alp Simsek illustrate how a lack of information can create systemic risk in financial networks. In a model that is structurally similar to the incomplete interbank network model of Allen and Gale, Caballero and Simsek examine how banks might respond to news of a liquidity shock when each bank knows the identities of its own counterparties but not the identities of its counterparties' counterparties. The authors posit that banks deal with this uncertainty by appealing to the "maximin principle": Each seeks to maximize profits under the assumption that the network is configured in the worst possible manner from its own perspective. Because each behaves as though the network structure is "stacked against it," when banks learn of an adverse liquidity shock, each tends to sell more of its illiquid assets and withdraw more funding from its counterparties than it would if it had access to complete information about the structure of interbank credit relationships. As in Shin's model, this excessive deleveraging can create a vicious cycle, magnifying the effects of the initial shock. The four models we've discussed thus far are aimed at exploring general features of financial networks. As such, they are necessarily somewhat abstract. With a few narrow exceptions, they treat all market participants as similar in size and in range of activities, and they use relatively simplistic network structures. In the past few years, research on financial networks has moved beyond stylized models of interbank relationships to examine the propagation of shocks in more-realistic settings. Recent research by Gai, Haldane, and Kapadia and by Cont, Moussa, and Santos examines how shocks propagate in network structures in which some banks are larger and more interconnected than others. Using numerical simulations, Gai, Haldane, and Kapadia show that, in concentrated networks, contagion occurs less frequently and is less severe for low degrees of network connectivity. Contagion is significantly more likely at higher levels of connectivity. In a concentrated financial network with a few key players, and when liquidity shocks are targeted at the most connected institutions, distress at highly connected banks spreads widely through the rest of the system. In this sense, the intuition of Allen and Gale--that highly connected networks are resilient to systemic shocks--can be misleading. In an empirical study of 3,000 Brazilian banks, Cont, Moussa, and Santos find that, not surprisingly, institutions with larger interbank exposures tend to be more systemically important. But, critically, they also find that an institution's position within the financial network plays a significant role. A bank that does business with a large number of relatively weak counterparties may have greater systemic importance than an institution with a similar number of counterparties that are better equipped to manage potential losses. The work of Gai, Haldane, and Kapadia and that of Cont, Moussa, and Santos suggest that detailed and comprehensive data on the structure of financial networks is needed to understand the systemic risks facing the financial system and to gauge the contributions to systemic risk by individual institutions. I will describe in a moment how the Federal Reserve is using such data to enhance its understanding of the OTC derivatives market. This line of research suggests that a one-size-fits-all approach to the regulation of financial intermediaries may not be appropriate. So, what have we learned from this brief tour through recent research on interconnectedness and systemic risk? We have seen how interconnectedness can be a source of strength for financial institutions, allowing them to diversify risk while providing liquidity and investment opportunities to savers that would not be available otherwise. But more-numerous and more-complex linkages also appear to make it more difficult for institutions to address certain types of externalities, such as those arising from incomplete information or a lack of coordination among market participants. These externalities may do little harm or may even be irrelevant in normal times, but they can be devastating during a crisis. Governments around the globe have responded to the financial crisis by adopting a strong, multifaceted, and coordinated reform agenda aimed at reducing systemic risk. At a meeting in Pittsburgh in September 2009, governments in the Group of Twenty Supervision to improve capital and the management of liquidity risk in the banking system. I'll briefly review several Basel Committee initiatives that address interconnectedness and systemic risk, but first, let me focus on one in particular: higher capital requirements for global systemically important banks (GSIBs). Enhanced capital standards for GSIBs serve to limit the risks undertaken by the largest, most interconnected institutions whose distress has the greatest potential to impose negative externalities on the broader financial system. A framework of higher minimum regulatory capital standards for these institutions was issued by the Basel Committee in November 2011, and indicators of interconnectedness account for a significant proportion of the overall score used to determine whether a bank will be subject to higher standards. As shown by Gai, Haldane, and Kapadia, among others, highly interconnected firms can transmit shocks widely, impairing the rest of the financial system and the economy. We saw, for example, that when Lehman Brothers failed, the shock was transmitted through money market mutual funds to the short-term funding and interbank markets. While some participants in each of these sectors had direct exposures to Lehman, many more did not. Moreover, even in cases in which direct exposures to Lehman were manageable, the turmoil caused by Lehman's failure added stress to the system at a particularly unwelcome time. In this way, the failure of a highly interconnected institution such as Lehman imposes costs on society well in excess of those borne by the firm's shareholders and direct creditors. Accordingly, tying enhanced capital requirements to interconnectedness improves the resilience of the system. Of course, higher capital requirements are not costless; they may raise financing costs for some borrowers, and they have the potential to induce institutions to engage in regulatory arbitrage. An important ongoing agenda for research and policy is the design and implementation of data-based measures of interconnectedness to ensure that our understanding of financial system interconnections evolves in tandem with financial innovation. While enhanced capital standards for GSIBs are an important tool for managing systemic risk that arises through interconnectedness, they are not the only tool. The Basel Committee's program contains a number of initiatives that will help manage interconnectedness and systemic risk. These measures include countercyclical capital buffers, liquidity requirements, increased capital charges for exposures to large financial institutions, large exposure rules, and deductions from capital for equity investments in banks. These and other initiatives will all play a role in managing the effect of complexity and interconnectedness on financial stability. In fact, the multifaceted nature of the reform program is an important design principle. One of the lessons of the recent financial crisis was that capital alone is not sufficient to prevent or stem a crisis. Multiple channels for reform initiatives will enhance systemic stability. In addition to the banking reforms I just discussed, the G-20 also committed to reduce risk in OTC derivatives markets by enacting reforms to improve transparency and decrease counterparty exposures among market participants. These policies must be considered carefully, as they are apt to increase the cost of financial intermediation and that of hedging risk. To illustrate the tradeoffs policymakers and regulators must manage when crafting such policies, I'll next discuss in some detail a set of initiatives currently being implemented by prudential, market, and systemic risk regulators around the world to address weaknesses in OTC derivatives markets. An OTC derivative is a privately negotiated contract between a pair of counterparties to exchange future cash flows that depend on the performance of an underlying asset or benchmark index. Unlike an immediate purchase or sale of assets, OTC derivatives require one or both sides of the transaction to make payments in the future. Counterparty risk is therefore a key element of OTC derivatives transactions. The scale and significance of counterparty risks in the OTC derivatives markets are large and, as we saw, can have economy-wide implications. The prudent management, regulation, and oversight of these risks are critical to ensuring that derivatives markets serve to diversify, rather than exacerbate, systemic risk. Significant problems with the functioning, regulation, and oversight of derivatives markets became apparent during the financial crisis. These problems are perhaps best exemplified by the widespread effects of large losses by American International Group, Inc. (AIG), on its OTC structured finance and credit derivatives positions. In the absence of government intervention, AIG's failure would have exposed its counterparties to substantial losses at a time of significant financial stress and uncertainty for them and the financial system. Indeed, for a time, the prospect of AIG's failure exacerbated the already impaired functioning in important segments of the OTC market, and, as that happened, it became more costly or even impossible for firms to manage financial risks. Derivatives positions originally undertaken by some firms to hedge risk could not be unwound and instead became sources of risk. AIG's failure revealed, in stark and spectacular fashion, systemic problems inherent in the structure and functioning of OTC derivatives markets that had increased the fragility of the financial system, exposing the rest of the economy to unnecessary systemic risks. Central clearing mandates, minimum margin standards, and data reporting requirements are among the tools that regulators now intend to use to mitigate counterparty risk and improve transparency, thus reducing uncertainty. The September 2009 commitment of the G-20 to require that standardized OTC derivatives be cleared through central counterparties is directly aimed at reducing systemic risk by changing the structure of the network of derivatives counterparty exposures. In the absence of a central counterparty, the network of counterparty exposures associated with a class of OTC contracts might look something like panel A in figure 3. Each market participant has counterparty risk exposures to one or more other market participants. Although each participant knows its own risk exposure, it is unlikely to have complete information on its counterparties' exposures to others. Such opacity can engender the kind of information-related gridlock that we observed in the fall of 2008 and that is explored in the research of Caballero and Simsek. Moreover, because market participants commonly have partially or fully offsetting positions with multiple counterparties, a fully bilateral network is inefficient from a risk-management standpoint: Gains in the value of positions with one counterparty cannot be netted against losses in the value of positions with other counterparties. By taking one side of every trade, a central counterparty serves to transform the mesh network shown in panel A of figure 3 into something that looks more like the hub- and-spoke network illustrated in panel B. This network structure has no effect on the exposure of individual market participants to the assets or indexes underlying the derivatives contracts in question, but it dramatically simplifies and improves the transparency of the network of counterparty risk exposures. Central clearing can yield important advantages over a fully bilateral market structure. The simpler hub-and-spoke network structure is more transparent, and the central counterparty is well positioned to impose common margin requirements on all market participants. Central clearing facilitates the netting of gains and losses across multiple market participants, which has the potential to significantly reduce each participant's aggregate counterparty risk exposure. Rather than managing its counterparty risk exposure to all other trading partners, a market participant needs to manage only its exposure to the central counterparty. The central counterparty acts as a pure intermediary and takes no net position in any of the underlying contracts that it clears, so it can experience losses only when a clearing member defaults and has posted insufficient margin to cover the cost of replacing its open positions. Central counterparties are typically designed to distribute any losses they do incur in a relatively predictable way across all clearing members. In this way, central clearing provides for a transparent mutualization of counterparty risks among participants. Central counterparties are designed to be narrowly focused on intermediation and not the provision of credit and liquidity. This structure improves the chances that, in the event of a significant market stress, market functioning will not be threatened by the failure of market infrastructure itself. Of course, the other side of this coin is that adding a central counterparty introduces a single point of failure for the network, making it critical that the central counterparty itself be well managed and well regulated. To help ensure this result, title VII of the Dodd-Frank Act adopted stronger safeguards than in the past for central counterparties that clear OTC derivatives. Title VIII aimed at strengthening the supervision of financial market utilities, including central counterparties designated as systemically important, by requiring annual examinations as well as ex ante reviews of material rule and operational changes. In April 2012, the international organizations that set standards for financial market infrastructures such as central counterparties published new and stronger standards for these entities. U.S. regulators, including the Federal Reserve, participated actively in this work and are expected to make formal proposals for incorporating the new standards into U.S. regulations as soon as possible. More fundamentally, however, a central counterparty's ability to manage risk is determined by its ability to accurately value the contracts it clears on a frequent and possibly real-time basis and to rapidly replace open positions at or near current prices in the event that a clearing member defaults. Requiring less-liquid and highly customized derivatives to be cleared would likely increase systemic risks, as clearinghouses would not be well positioned to manage the complex risks of such derivatives. The G-20 mandate explicitly recognizes this important limitation on the benefits of central clearing, and it requires only that standardized OTC derivatives be centrally cleared. Accordingly, the G-20 commitment has effectively managed the costs and benefits of central clearing in establishing a global clearing mandate. However, limiting central clearing to standardized derivatives means that a significant proportion of less standardized OTC contracts will continue to be written on a bilateral basis without the benefit of a central counterparty. The International Monetary Fund estimates that one-third of interest rate and credit derivatives and two-thirds of equity, commodity, and foreign exchange derivatives will not be suited to standardization and will remain non-centrally cleared. As more-standardized derivatives migrate to central clearing, it will be important to remain vigilant in managing the risks from non- centrally-cleared derivatives exposures. One important tool for managing the systemic risks of non-centrally-cleared derivatives is margin requirements. Globally, regulators have been working on standards for margin requirements on non-centrally-cleared . derivatives that would provide for harmonized rules and a level playing field, which is crucial given the global nature of derivatives markets. In July, the Basel Committee and the International Organization of Securities Commissions proposed a framework for margin requirements on non-centrally-cleared derivatives. The finalized framework will inform rulemakings of the Federal Reserve and other U.S. regulators. The proposed framework would require financial firms and systemically important nonfinancial firms to collect two types of margin. First, they would be obligated to collect variation margin on a regular basis, so if a derivative loses market value, the party experiencing a loss must realize the loss immediately. This requirement codifies current best market practice, since the largest derivatives dealers already exchange variation margin daily. However, and importantly, the framework extends this prudent risk-management practice to other derivatives counterparties. Requiring timely payment of variation margin will go a long way toward ensuring that an AIG-like event will not happen again, since current exposures will not be allowed to build over time to unmanageable levels. Moreover, variation margin requirements will ensure that market participants will know that counterparties that they deal with will not be carrying large uncollateralized exposures that could impair their ability to perform in the future. Those requirements diminish the likelihood of the kind of information gridlock explored by More controversially, the proposed framework requires the collection of initial margin. While variation margin collateralizes current derivatives losses, initial margin collateralizes future losses that could occur in the event of a counterparty's default. In essence, initial margin is a kind of performance bond. In the event that a counterparty does not perform as required, the initial margin is used to replace the position with a new counterparty. It is here that some of the most significant policy tradeoffs arise, because higher initial margin requirements will make it more costly for market participants to use derivatives to hedge risk. Liquid resources that are set aside as initial margin cannot be deployed for other purposes. Given the sheer size and scope of derivatives markets, requiring initial margin on all derivatives transactions could result in significant opportunity and liquidity costs. In a public comment letter to the Federal Reserve and other regulators, the International Swaps and Derivatives Association estimated that initial margin requirements could lock up as much as $1.7 trillion in liquid assets globally. This number is eye opening, to say the least. In an effort to better gauge the liquidity costs of initial margin requirements, the Federal Reserve, as part of the international group of prudential and market regulators that issued the July proposal, has conducted a detailed impact study to quantify the liquidity costs associated with initial margin requirements. The results of this study, as well as comments received on the proposal, will help ensure that in the final framework, the need to reduce systemic risk is appropriately balanced against the resulting liquidity costs. Even in light of the significant costs of initial margin, it seems clear that some requirements are needed. The current use and application of initial margin is inconsistent, and a more robust and consistent margin regime for non-centrally-cleared derivatives will not only reduce systemic risk, but will also diminish the incentive to tinker with contract language as a way to evade clearing requirements. Robust and consistent initial margin requirements will help prevent the kind of contagion that was sparked by AIG: They would serve, in effect, to limit the effects of interconnectedness within the financial network. The failure of a financial counterparty could be contained in the manner described by Allen and Gale. As I noted in connection with variation margins, initial margin requirements would also improve transparency because derivative market participants will know that their counterparties are at least partially insulated from defaults. Of course, these benefits need to be appropriately balanced against the burdens imposed by initial margin. But it seems highly unlikely that the status quo is consistent with achieving the goals of the G-20 to reduce the potential for systemic risk in the OTC derivatives markets that could threaten the financial system. Finally, let me turn to data requirements. Both the research that I have highlighted today and practical experience demonstrate that market, prudential, and systemic risk authorities need detailed information on derivatives transactions and bilateral positions to assess evolving market risks and to execute their financial stability responsibilities. Indeed, the Federal Reserve has already used preliminary information construct network graphs of the CDS market such as the one illustrated in figure 4. The data enable identification, for example, of firms, such as A and B in figure 4, that are large net sellers of protection. Such information can play a valuable role in supervision. Moreover, the analyses for monitoring and measuring systemic risks suggested and described by Gai, Haldane, and Kapadia and by Cont, Moussa, and Santos require this kind of detailed data to gain a holistic view of systemic risk. Title VII of the Dodd-Frank Act requires that data on U.S. swaps transactions be reported to swaps data repositories regulated by the Commodity Futures Trading Commission or to securities-based swaps data repositories regulated by the Securities and Exchange Commission. Similar European regulations impose trade reporting requirements on swaps transacted in Europe. But there is still no guarantee, due to confidentiality concerns and legal barriers to data sharing, that the data reported into these trade repositories will ultimately be accessible to all of the regulators who require the data to obtain a holistic view of the derivatives market. Given that the derivatives market is global in scope, access to those data is essential for authorities with systemic risk responsibilities, such as the Federal Reserve, to monitor and respond to risks. To make this point concrete, it is unclear whether we will be able, on a regular and comprehensive basis, to produce the sort of analysis illustrated by figure 4. In order to effectively monitor market developments and systemic risks, it is crucial that regulators across jurisdictions and countries share data on a consistent and regular basis. While better data and more transparency are important for monitoring and responding to the buildup of systemic risks, we do, of course, also recognize the confidentiality concerns. Information is a valuable resource to most financial market participants, and unnecessarily burdensome or overly revealing information disclosures could compromise the position of market participants and reduce incentives for trade, thus decreasing liquidity and market efficiency. Dodd-Frank's real-time reporting requirements for swaps transactions recognize this important point by allowing for delayed reporting of large "block trades" where immediate reporting could reveal and undermine a participant's position and ultimately discourage market transactions, depth, and liquidity. In this way, enhanced reporting and transparency requirements are being set to provide the public and regulators with useful information without compromising market integrity. Moreover, while market integrity and appropriate confidentiality are important considerations, the events of the financial crisis have clearly shown that effective systemic risk management demands more, and not less, data disclosure. I began this talk by describing the events surrounding the banking panic of 1907 and the founding of the Federal Reserve. A lesson from that episode, as relevant today as it was then, was that financial stability is essential to sustained economic growth and prosperity. Just as the banking panic of 1907 revealed fundamental weaknesses in our financial system, so, too, did the financial crisis of 2007 and 2008. The recent crisis showed that some financial innovations, over time, increased the system's vulnerability to financial shocks that could be transmitted throughout the entire economy with immediate and sustained consequences that we are still working through today. Some of these vulnerabilities were a consequence of innovations that increased the complexity and interconnectedness of aspects of the financial system. In response to the crisis and the weaknesses it revealed, governments around the globe are acting to improve financial stability and reduce the risks posed by a highly interconnected financial system. These efforts, of course, must account for the costs of new rules and ensure that these costs are clearly outweighed by the benefits. I am confident that the policies I have described today will make the economy more resilient to financial shocks and help reduce the risk of another crisis, while properly balancing these important benefits against the necessary costs. In striking this balance, government has been guided by new research that has added to our understanding of systemic risk. And this work continues. I have no doubt that some of you here today will perform that research and make those discoveries. So, allow me to close by offering my thanks, in advance, for those contributions. I hope my talk today has made it clear that the work of safeguarding our financial system will depend on these efforts and insights, which will empower policymakers to make the right decisions. --------- (2010). --------- (2011). . Basel, Langsam, eds., . Journal of , item 13 under Pickel on the Federal Reserve's proposed rule on margin and capital requirements

r130205a_FOMC

united states

The Future of Community Banking

duke

I would like to thank the Terry College of Business at the University of Georgia for the opportunity to discuss the future of community banking at this annual conference for bank officers and directors. Community banks play an important role in our nation's financial system, and I believe that the future of community banking is bright. But that is not to say that it will be easy. Success, as always, will require energetic and engaged managers and board members who are sensitive to the financial needs of their communities, vigilant to economic conditions, and adaptive to changing regulatory requirements. I hear from a lot of community bankers who are concerned that the community banking model might not survive. Many paint a picture so bleak that they see only personal retirement or sale of the bank as viable strategies. I completely understand how tiring it is to fight a financial crisis and survive a deep recession followed by a weak recovery only to confront what seems to be a tsunami of new regulations. I felt all of those same emotions in 1991. I was a community banker then. We had survived the savings and loan crisis with some bruises, but we were still standing. The Financial regulations stacked on my desk than I had employees in the bank. My bank had just reached the $100 million mark in total assets through the purchase of two branches from a failing thrift. Even more daunting for me personally, was the sudden death of my bank's chief executive officer (CEO), leaving me as the new CEO. Frankly, I didn't know how I was going to tackle all that lay in front of us. But those dark days in 1991 were followed by 15 years of exceptionally strong performance for all banks, including my own. And those experiences--the good and the bad--give me confidence in predicting a bright future for community banking today. Just as the seeds of a crisis are often sown in earlier boom times, strength can be forged during the tough times that follow a crisis. As we did in the early 1990s, bankers and regulators today have learned from the lessons of the crisis and are determined not to repeat the mistakes of the past. Credit metrics are now improving in most banks as problem loans have been addressed and resolved and new credit underwriting has been quite restrictive for a number of years. Deposit growth has outpaced loan demand and reliance on wholesale funding has been reduced. Capital positions are stronger. The interest margin pressure banks face today is partly due to low interest rates and partly due to weak loan demand, both of which are consequences of a sluggish economy. As the economic recovery gains momentum, however, both of these conditions should reverse and give bankers the opportunity to deploy the liquidity and capital they have amassed to the benefit of their shareholders and their local economies. Even as they anticipate economic recovery, however, community bankers worry that the burden of new regulations may inhibit their ability to lend in their communities or prohibitively increase the costs of such lending. We certainly understand this concern. Federal Reserve research over the years has confirmed that the burden of regulations falls disproportionately on smaller banks. Supervisors at the Federal Reserve Bank of Minneapolis have recently tried to quantify this effect. To do so, they used survey data to estimate the relative number of new employees that banks of different sizes might need to hire in response to the same regulatory requirement. Using Call Report data from 2011, they estimated in their preliminary analysis that hiring one additional employee would reduce the return on assets by 23 basis points for the median bank in the group of smallest banks, those with total assets of $50 million or less. To put this estimate in perspective, such a decline could cause about 13 percent of the banks of that size to go from profitable to unprofitable. As a comparison, given the same increase in regulation, they assume banks between $500 million and $1 billion would hire three employees and experience a decline of about 4 basis points in return on assets for the median bank. While this is still a significant effect, very few banks in this group would go from being profitable to unprofitable as a result of the regulatory burden. Regulatory overreaction to a crisis is always a risk. But this time, I think community bankers have been more successful than they realize in making the case against "one-size-fits- all" regulation. I can't remember a time when I have seen more regulatory proposals drafted that differentiate between banks based on size or complexity. I urge you to continue to identify the regulatory requirements that are the most onerous to your business model, and continue to suggest alternatives to achieve those regulatory objectives in a less intrusive way. In fact, most of the regulations required by the Dodd-Frank Wall Street Reform and important banks, and many of the Act's provisions specifically exempt community banks. For example, banks with less than $10 billion in total assets were exempted from a number of the debit interchange restrictions, and early studies indicate that those exemptions are working. In addition, formal stress testing was required only for banks with total assets of $10 billion or more. In implementing these requirements for the larger banks, the bank regulatory agencies specifically indicated that capital stress testing would not be required for community banks. This does not mean that community banks are exempted from prudent risk management, but rather that smaller banks should think about the negative shocks that could affect their business in the future and tailor their risk-management procedures to the risks and complexities of their individual business models. "qualified mortgages" that include safe harbors for mortgages that meet specific loan term and pricing criteria, including certain balloon loans made by community banks in rural or underserved areas. At the same time, they issued a new proposal that contains additional community bank exceptions, as well as a question about the treatment of loans to refinance balloon payments on mortgages that community banks may already have on their books. Noting that smaller institutions have already demonstrated that they generally do a good job of servicing the loans they originate and that the investments necessary to meet the requirements would be unduly onerous for institutions that service a small number of loans, the CFPB also exempted most community banks from many of the provisions of new servicing requirements. think such exceptions are especially important because, as I discussed in a recent speech and will touch upon later in my remarks, Federal Reserve research has shown that (1) community banks are important lenders in the mortgage market, (2) those mortgage loans represent a significant portion of community bank lending, and (3) community banks are quite responsible in their practices. At the Federal Reserve, we have formalized our process for considering the unique characteristics of community banks as we craft regulatory and supervisory policies. A few years ago, we created a subcommittee of the Board, which I chair, that makes recommendations about matters related to community bank supervision and regulation. This subcommittee reviews all regulatory proposals and supervisory guidance with an eye toward the possible effects on community banks. Remembering the days when I had to find time to read all those new regulations stacked up on my desk, I have insisted that all new proposals and rules start with a clear statement of their applicability to community banks so that bankers can spend their time on the rules and guidance that apply to them. This approach was put into practice in a different way last year, when the banking agencies issued proposals for capital regulations that incorporated requirements of the Dodd- Frank Act and the Basel agreement. To help community banks identify the provisions that affected them and submit their comments more easily, the proposal included a short summary of the provisions that were most likely to affect community banks. We received more than 2,000 comments, many from community banks, and we are reviewing them. It's too early in the process to know how we and the other agencies are going to address the issues raised, or when final rules may be released. But what I can promise is that before we issue final capital rules, we will do everything possible to address the concerns that have been expressed by community bankers and still achieve the goal of having strong levels of high-quality capital--built up over a reasonable and realistic transitional period--in banks of all sizes, including community banks. To help us better understand community bank issues, our subcommittee established an informal working group of economists from both the research and supervision functions in the Federal Reserve System. The group is focused on understanding the factors that influence the viability and performance of community banks including, importantly, the effect of regulatory changes and their associated costs and benefits. Members of this working group are exploring a number of interesting topics that I hope will help us to better understand the issues that affect community banks and, where appropriate, have a practical impact on how we supervise these banks. For example, a recent study undertaken by two Federal Reserve Board economists explores the determinants of community bank profitability from 1992 through 2010. findings indicate that a number of bank characteristics are strongly correlated with performance, including relative bank size, portfolio composition, and management quality. Within the group of banks with less than $1 billion in total consolidated assets included in this study, larger bank size is associated with significantly higher profitability. Community banks with higher portfolio shares of real estate loans earn significantly lower profits, while those with higher portfolio shares of construction loans earn higher profits through most of the study period. But, perhaps not surprisingly, the latter relationship does not hold for 2008 through 2010, when greater reliance on construction lending is associated with lower profitability. Managerial quality, as measured by the management component of the banks' regulatory ratings, is strongly related to bank profitability. Moreover, the strength of the relationship increases during and immediately after the financial crisis, confirming that management quality is particularly important during times of economic stress. Factors outside the control of bank management, however, are also importantly related to profitability, particularly over the past several years. For instance, it is not surprising that community banks operating in markets experiencing high unemployment rates have been less profitable since the financial crisis. Perhaps less obvious is that in urban markets, community bank profitability tends to decrease as the size of the market increases. One might suspect that this relationship derives from a more competitive landscape in larger urban areas; however, no relationship between market concentration and profits is evident in urban markets. In contrast, in rural areas, higher market concentration is associated with higher community bank profitability throughout most of the study period. In addition, the study finds that community banks operating in rural markets consistently earn higher average rates of return than do community banks operating in urban markets. In a separate analysis of deposit market competition that may form the basis for a new research paper, one researcher has documented the competitive strength of community banks, especially in rural markets. Although the nationwide share of total deposits held by banks with assets less than $10 billion has declined over the past decade, in rural markets, their deposit market share has increased slightly. Moreover, banks with assets less than $10 billion retained their share of rural market deposits throughout the recent recession and recovery. At a more micro level, banks with assets less than $10 billion gained market share in more than two-thirds of rural banking markets and in nearly half of urban markets between 2003 and 2012. Expansion of deposit insurance during the crisis likely helped all banks retain deposits and may have changed competition somewhat. Deposit insurance has now been permanently increased from $100,000 to $250,000 per depositor, but the unlimited deposit insurance for noninterest-bearing transaction accounts was allowed to expire at the end of 2012. We are watching deposit movement carefully, but so far have seen little evidence of deposits moving out of the banking system or, as some had feared, moving from smaller banks to larger banks perceived as "too big to fail." My own expectation is that, given all of the enhanced regulatory requirements that apply to larger banks, those larger banks will focus their efforts on large urban markets and that community banks will be even more competitive and more vital to the economic well-being of rural, suburban, and small urban markets. Researchers at the Federal Reserve Bank of St. Louis took a different approach to measuring community bank success. Studying banks with total assets less than $10 billion, the researchers attempted to identify the differences between banks that they classified as "thriving" and those that they classified as "surviving." Banks were identified as "thriving" if they maintained the highest supervisory rating, a composite CAMELS "1," continuously from 2006 through the end of 2011. banks in the study that did not qualify as thriving and did not fail or merge out of existence during the period were classified as "surviving." After categorizing the banks, the first phase of analysis looked at the location and size of the thriving banks. Thriving banks were found in 40 of the 50 states but were concentrated in states with larger economic contributions from agriculture and energy, which held up relatively well during the downturn. The fewest thriving banks were found on the West Coast and in the Southeast, where real estate values fell the most. This pattern is consistent with previous Federal Reserve studies, which found that bank performance is heavily affected by the local economy, but I think it is important to note that even in states with high unemployment rates or sharp declines in property values, some community banks were able to thrive. The St. Louis study did not find the thriving banks to be concentrated in any particular size range. Many had total assets less than $50 million as of December 2011, but others had total assets between $1 billion and $10 billion. And thriving banks did more than just rate well with supervisors--the thriving banks outperformed the surviving banks on a wide range of performance indicators, including return on assets, return on equity, loan losses, provision expense, efficiency ratio, asset growth, net interest margin, and net noninterest margin. Looking at balance sheet structure, when the researchers compared the characteristics of thriving banks with surviving banks, they found that the thriving banks had lower levels of loans- to-total-assets and were more reliant on core deposits. Thriving banks also had lower concentrations in commercial real estate (CRE) lending and much lower concentrations in construction and land development loans. Instead, thriving banks were slightly more concentrated in one- to four-family mortgage loans held in portfolio, as well as consumer loans. Despite these overall balance sheet findings, the researchers also noted the wide diversity of business models that they found among the thriving banks. Recognizing that a large part of good performance comes from factors that are more difficult to measure statistically, the researchers examined a sample of comments in examination reports and found that thriving banks benefited from a strong and localized customer service focus with high visibility in the community, conservative underwriting, and products that were profitable and met customer needs. They supplemented their review of examination reports by interviewing management at some of the thriving banks. The bankers they interviewed attributed their success to strong ties to the community, relationship banking, conservative underwriting, and a focus on products and markets they understood. These results were strikingly similar to the results of interviews in separate studies at the Federal Reserve Bank of Kansas City and the These studies confirm what experience has already taught me: Community banks that have deep ties to the community, engaged managers and directors, conservative underwriting, and strong risk management can not only survive, but thrive, even in adverse conditions. While much of our regulatory work recently has involved implementing the requirements of the Dodd-Frank Act, we are also continuing to review the lessons we learned during the crisis and the results of our recent research. In most cases, this work is more likely to result in supervisory guidance than regulation. Supervisory guidance is commonly viewed as a means to restrict activity but, in fact, during the crisis much of the guidance we issued actually directed bankers and bank examiners to take a balanced approach. For example, we issued guidance urging banks to continue to make loans to all qualified borrowers and, in particular, to continue lending to creditworthy small businesses. We also issued detailed guidance about commercial real estate workouts to encourage prudent modifications of real estate loans. Lending is the primary source of income for most community banks and also the greatest source of risk. As you develop your business plans, some of the most important decisions you will make relate to lending. In the planning process, banks should define the portion of the lending portfolio they plan to allocate to different loan categories, the investments they are willing to make to develop expertise and to manage credit and compliance risk, and the levels of credit and interest rate risk they are willing to assume. So I thought it might be helpful to review some recent developments in loan types that are at the core of community bank lending. Residential mortgage lending was at the heart of the financial crisis and has been the target of extensive new regulation and supervisory attention, including the rules issued by the CFPB that I discussed earlier. I think community banks are in an especially difficult position with respect to residential mortgage lending. On the one hand, community banks do not appear to have engaged in many of the more problematic practices that led to the crisis. And their rate of seriously delinquent residential mortgage loans is significantly lower than the overall rate of serious delinquencies on such loans made to prime borrowers, indicating that community banks largely have managed their existing portfolios responsibly. On the other hand, residential mortgage loans made by community banks do frequently share some characteristics, such as higher rates and balloon payments, with the subprime lending that proved to be so disastrous. At the same time, mortgage lending, which averages about one-fourth of community bank loan portfolios, is an important product line for community banks. Further, Federal Reserve research indicates that the residential mortgage loans made by community banks make up a small but vital part of credit availability in the housing market. The challenge for regulators is to design mortgage regulations to address practices that have proved harmful to consumers or financial stability without inhibiting lending to creditworthy borrowers. The challenge for community bankers is to review the full body of new regulations covering mortgage lending and to develop the expertise and control systems necessary to comply with these regulations while remaining active in this important market. I think it is unfortunate when I hear some bankers say that they will stop offering mortgages if they can't make them the same way that they always have. While I certainly understand their frustration, I still believe that community bankers can respond within the new environment by creating products that are profitable and meet the needs of their customers, while still managing their interest rate and funding risks. Even with some regulatory exceptions, compliance with new mortgage regulations likely will require changes to processing systems and extensive staff training. But it is also possible that the systems and expertise necessary to make qualified mortgages for the bank's books could also be used to originate loans for sale. For many community banks, this could represent a new revenue opportunity and a new alternative to offer the bank's customers. For community banks, it was CRE lending--in particular, lending for construction and land development--that caused the most problems during the crisis. As you may know, in 2006 the federal banking agencies issued supervisory guidance that set forth screening criteria based on certain types of CRE concentrations and rapid growth of CRE portfolios. These guidelines contained specific numerical thresholds for the ratios of construction and total CRE lending to an institution's total capital, as well as for identifying rapid growth of such lending. These criteria were never intended to result in hard caps, but were instead meant to trigger conversations between a bank and its supervisors about the bank's ability to manage the risks arising from these concentrations. After our experience in the financial crisis, especially considering the severe problems in commercial real estate markets, we were interested in understanding how community banks were affected by the guidance and whether the screening criteria set forth in the guidance were effective indicators of risk. In that regard, Federal Reserve staff has worked with our counterparts at the Office of the Comptroller of the Currency to analyze how banks' holdings of CRE loans have evolved since the guidance was issued. We have learned a few interesting things based on the findings of this research. For example, the number of institutions that exceed at least one of the two screening criteria has declined substantially from 2006 to the present. While much of this decline seems to have resulted from the contraction of construction portfolios in the wake of the crisis, banks that exceeded the criteria when the guidance was issued appear to have experienced a bigger decline in total CRE loans than can be explained by the adverse economic environment alone. This finding could indicate that the thresholds are indeed being interpreted as hard caps. Moreover, it was apparent that banks that exceeded the criterion for construction and land development were far more likely to have failed over the period from 2007 to 2011 than were those banks that exceeded the criterion for overall CRE exposures and portfolio growth. We now recognize the importance of the rapid growth criterion, which may have received less attention than the criteria for construction and overall CRE lending concentrations. We intend to use the findings of this research to help clarify our communication and training for examiners and bankers around CRE lending concentrations. There is probably no loan category in which community bankers' local knowledge and deep ties to the community are more important than small business lending. The Federal Reserve System has a project under way to try to improve our understanding of small business credit markets, which would of course include community banks. One challenge we have faced is that it is difficult to measure lending to small businesses precisely. For one thing, small business owners frequently tap their personal home equity, credit cards, or loans secured by commercial real estate that they own to finance their business operations, which means such borrowing is not reported as small business lending. But there is also no definition of small business borrowers for the reporting of small business lending as a loan category. However, small loans to businesses--commercial and industrial loans and CRE loans with original principal amounts of less than $1 million--are reported separately and can be used as a proxy for small business lending. Using this measure, we can estimate the importance of small business lending to community banks and the importance of community banks to small businesses. As of September 2012, banks with $10 billion or less in assets accounted for more than 98 percent of all commercial banking institutions, but they held less than 20 percent of banking industry assets. However, they held more than half of outstanding small loans to businesses. For such institutions, these small loans to businesses represent nearly 20 percent of their total domestic lending and slightly more than 40 percent of their total commercial lending. Small business lending is likely even more important to smaller banks than these statistics show because these loans are identified by the size of the loan rather than the size of the borrower. I believe it is probable that many of the larger business loans made by these smaller banks were also made to small business borrowers. At the other end of the spectrum, banking organizations with more than $50 billion in assets accounted for less than one percent of institutions, but held 75 percent of the assets. Holding almost 40 percent of outstanding small loans to businesses, these large banks are important small business lenders, but small loans to businesses were not a significant segment of large bank loan portfolios. They represented less than five percent of these banks' total domestic lending. These statistics demonstrate the importance of community banks to small business and the corresponding importance of small business lending to the community banking business model. In developing policies for small business lending, I think it is critically important for bank boards of directors to insist on appropriate risk management that retains the flexibility to use the bankers' knowledge of their customers' business to their best advantage. And it is equally critical that supervisors develop tools to measure the overall effectiveness of risk management in small business lending without being overly prescriptive for individual loans. I would like to end where I began. I think the future for community banking is bright. I recognize that the regulatory changes underway are not without cost to community banks. But I also know that we at the Federal Reserve are doing our best to avoid adding to regulatory burden wherever possible as we respond to the worst excesses of the financial crisis and make the U.S. financial system more resilient. Research is helpful in this effort but it is also important to maintain an ongoing dialogue with community bankers and to actively solicit comment on regulatory proposals. So I urge you to continue to communicate about the challenges that regulations pose for community banks. More importantly, I know that the natural advantages found in community banks--deep community ties, daily interaction between senior managers of banks and their customers, and the dexterity to customize financial solutions--have not been diminished in any way. Yes, the regulatory environment is challenging and the economy remains weak in many areas. But all our research shows that with creative, engaged bankers and strong risk-management processes, community banks can continue to not only survive but to thrive. Thank you very much for your attention, and I would be interested in hearing your thoughts.

r130207a_FOMC

united states

Overheating in Credit Markets: Origins, Measurement, and Policy Responses

stein

Thank you very much. It's a pleasure to be here. The question I'd like to address today is this: What factors lead to overheating episodes in credit markets? In other words, why do we periodically observe credit booms, times during which lending standards appear to become lax and which tend to be followed by low returns on credit instruments relative to other asset classes? We have seen how such episodes can sometimes have adverse effects on the financial system and the broader economy, and the hope would be that a better understanding of the causes can be helpful both in identifying emerging problems on a timely basis and in thinking about appropriate policy responses. I will start by sketching two views that might be invoked to explain variation in the pricing of credit risk over time: a "primitive preferences and beliefs" view and an "institutions, agency, and incentives" view. While the first view is a natural starting point, I will argue that it must be augmented with the second view if one wants to fully understand the dynamics of overheating episodes in credit markets. According to the primitives view, changes in the pricing of credit over time reflect fluctuations in the preferences and beliefs of end investors such as households, where these beliefs may or may not be entirely rational. Perhaps credit is cheap when household risk tolerance is high--say, because of a recent run-up in wealth. Or maybe credit is cheap when households extrapolate current good times into the future and neglect low-probability risks. The primitives view is helpful for understanding some aspects of the behavior of the aggregate stock market, with the 1990s Internet bubble being one illustration. It seems clear that the sentiment of retail investors played a prominent role in inflating this bubble. More generally, research using survey evidence has shown that when individual investors are most optimistic about future stock market returns, the market tends to be overvalued, in the sense that statistical forecasts of equity returns are abnormally low. This finding is consistent with the importance of primitive investor beliefs. By contrast, I am skeptical that one can say much about time variation in the pricing of credit--as opposed to equities--without focusing on the roles of institutions and incentives. The premise here is that since credit decisions are almost always delegated to agents inside banks, mutual funds, insurance companies, pension funds, hedge funds, and so forth, any effort to analyze the pricing of credit has to take into account not only household preferences and beliefs, but also the incentives facing the agents actually making the decisions. And these incentives are in turn shaped by the rules of the game, which include regulations, accounting standards, and a range of performance- measurement, governance, and compensation structures. At an abstract level, one can think of the agents making credit decisions and the rulemakers who shape their incentives as involved in an ongoing evolutionary process, in which each adapts over time in response to changing conditions. At any point, the agents try to maximize their own compensation, given the rules of the game. Sometimes they discover vulnerabilities in these rules, which they then exploit in a way that is not optimal from the perspective of their own organizations or society. If the damage caused is significant enough, the rules themselves adapt, driven either by internal governance or by political and regulatory forces. Still, it is possible that at different times in this process, the rules do a better or worse job of managing the incentives of the agents. To be more specific, a fundamental challenge in delegated investment management is that many quantitative rules are vulnerable to agents who act to boost measured returns by selling insurance against unlikely events--that is, by writing deep out-of-the-money puts. An example is that if you hire an agent to manage your equity portfolio, and compensate the agent based on performance relative to the S&P 500, the agent can beat the benchmark simply by holding the S&P 500 and stealthily writing puts against it, since this put-writing both raises the mean and lowers the measured variance of the portfolio. Of course, put-writing also introduces low-probability risks that may make you, as the end investor, worse off, but if your measurement system doesn't capture these risks adequately--which is often difficult to do unless one knows what to look for-- then the put-writing strategy will create the appearance of outperformance. Since credit risk by its nature involves an element of put-writing, it is always going to be challenging in an agency context, especially to the extent that the risks associated with the put-writing can be structured to partially evade the relevant measurement scheme. Think of the AAA-rated tranche of a subprime collateralized debt obligation (CDO), where the measurement scheme is the credit risk model used by the rating agency. To the extent that this model is behind the curve and does not fully recognize the additional structural leverage and correlational complexities embedded in a second-generation securitization like the CDO, as opposed to a first-generation one, it will be particularly vulnerable to the introduction of a second-generation product. These agency problems may be exacerbated by competitive pressures among intermediaries and by the associated phenomenon of relative performance evaluation. A leading example here comes from the money market fund sector, where even small increases in a money fund's yield relative to its competitors can attract large inflows of new assets under management. And if these yield differentials reflect not managerial skill but rather additional risk-taking, then competition among funds to attract assets will only make the underlying put-writing problem worse. But it is not all that satisfying--either intellectually or from a policy perspective-- to simply list all of the ways that the delegation of credit decisions to agents inside big, complicated institutions can lead things astray. It must be the case that, on average over long periods of time, these agency problems are contained tolerably well by the rules of the game--by some combination of private governance and public policy--or else our credit markets would not be as large and as well developed as they are. A more interesting set of questions has to do with time-series dynamics: Why is it that sometimes, things get out of balance, and the existing set of rules is less successful in containing risk-taking? In other words, what does the institutions view tell us about why credit markets sometimes overheat? Let me suggest three factors that can contribute to overheating. The first is financial innovation. While financial innovation has provided important benefits to society, the institutions perspective warns of a dark side, which is that innovation can create new ways for agents to write puts that are not captured by existing rules. For this reason, policymakers should be on alert any time there is rapid growth in a new product that is not yet fully understood. Perhaps the best explanation for the existence of second- generation securitizations like subprime CDOs is that they evolved in response to flaws in prevailing models and incentive schemes. Going back further, a similar story can be told about the introduction of payment-in-kind (PIK) interest features in the high-yield bonds used in the leveraged buyouts (LBOs) of the late 1980s. I don't think it was a coincidence that among the buyers of such PIK bonds were savings and loan associations, at a time when many were willing to take risks to boost their accounting incomes. The second closely related factor on my list is changes in regulation. New regulation will tend to spur further innovation, as market participants attempt to minimize the private costs created by new rules. And it may also open up new loopholes, some of which may be exploited by variants on already existing instruments. The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to "reach for yield." An insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk. A similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit-taking franchise. Moreover, these three factors may interact with one another. For example, if low interest rates increase the demand by agents to engage in below-the-radar forms of risk- taking, this demand may prompt innovations that facilitate this sort of risk-taking. To summarize the argument thus far, I have drawn a distinction between two views of risk-taking in credit markets. According to the primitives view, changes over time in effective risk appetite reflect the underlying preferences and beliefs of end investors. According to the institutions view, such changes reflect the imperfectly aligned incentives of the agents in large financial institutions who do the investing on behalf of these end investors. But why should anybody care about this distinction? One reason is that your view of the underlying mechanism shapes how you think about measurement. Consider this question: Is the high-yield bond market currently overheated, in the sense that it might be expected to offer disappointing returns to investors? What variables might one look at to shape such a forecast? In a primitives- driven world, it would be natural to focus on credit spreads, on the premise that more risk tolerance on the part of households would lead them to bid down credit spreads; these lower spreads would then be the leading indicator of low expected returns. On the other hand, in an institutions-driven world, where agents are trying to exploit various incentive schemes, it is less obvious that increased risk appetite is as well summarized by reduced credit spreads. Rather, agents may prefer to accept their lowered returns via various subtler nonprice terms and subordination features that allow them to maintain a higher stated yield. Again, the use of PIK bonds in LBOs is instructive. A long time ago, Steve Kaplan and I did a study of the capital structure of 1980s-era What was most noteworthy about the PIK bonds in those deals was not that they had low credit spreads. Rather, it was that they were subject to an extreme degree of implicit subordination. While these bonds were not due to get cash interest for several years, they stood behind bank loans with very fast principal repayment schedules, which in many cases required the newly leveraged firm to sell a large chunk of its assets just to honor these bank loans. Simply put, much of the action--and much of the explanatory power for the eventual sorry returns on the PIK bonds--was in the nonprice terms. It is interesting to think about recent work by Robin Greenwood and Sam Hanson through this lens. They show that if one is interested in forecasting excess returns on corporate bonds (relative to Treasury securities) over the next few years, credit spreads are indeed helpful, but another powerful predictive variable is a nonprice measure: the high-yield share, defined as issuance by speculative-grade firms divided by total bond issuance. When the high-yield share is elevated, future returns on corporate credit tend to be low, holding fixed the credit spread. Exhibit 1 provides an illustration of their finding. One possible interpretation is that the high-yield share acts as a summary statistic for a variety of nonprice credit terms and structural features. That is, when agents' risk appetite goes up, they agree to fewer covenants, accept more-implicit subordination, and so forth, and high-yield issuance responds accordingly, hence its predictive power. A second implication of the institutions view is what one might call the "tip of the iceberg" caveat. Quantifying risk-taking in credit markets is difficult in real time, precisely because risks are often taken in opaque ways that escape conventional measurement practices. So we should be humble about our ability to see the whole picture, and should interpret those clues that we do see accordingly. For example, I have mentioned the junk bond market several times, but not because this market is necessarily the most important venue for the sort of risk-taking that is likely to raise systemic concerns. Rather, because it offers a relatively long history on price and nonprice terms, it is arguably a useful barometer. Thus, overheating in the junk bond market might not be a major systemic concern in and of itself, but it might indicate that similar overheating forces were at play in other parts of credit markets, out of our range of vision. With these remarks as a prelude, what I'd like to do next is take you on a brief tour of recent developments in a few selected areas of credit markets. This tour draws heavily on work conducted by the Federal Reserve staff as part of our ongoing quantitative surveillance efforts, under the auspices of our Office of Financial Stability The first stop on the tour is the market for leveraged finance, encompassing both the public junk bond market and the syndicated leveraged loan market. As can be seen in exhibit 2, issuance in both of these markets has been very robust of late, with junk bond issuance setting a new record in 2012. In terms of the variables that could be informative about the extent of market overheating, the picture is mixed. On the one hand, credit spreads, though they have tightened in recent months, remain moderate by historical standards. For example, as exhibit 3 shows, the spread on nonfinancial junk bonds, currently at about 400 basis points, is just above the median of the pre-financial-crisis distribution, which would seem to imply that pricing is not particularly aggressive. On the other hand, the high-yield share for 2012 was above its historical average, suggesting--based on the results of Greenwood and Hanson--a somewhat more pessimistic picture of prospective credit returns. This notion is supported by recent trends in the sorts of nonprice terms I discussed earlier (exhibit 4). The annualized rates of PIK bond issuance and of covenant-lite loan issuance in the fourth quarter of 2012 were comparable to highs from 2007. The past year also saw a new record in the use of loan proceeds for dividend recapitalizations, which represents a case in which bondholders move further to the back of the line while stockholders--often private equity firms--cash out. Finally, leverage in large LBOs rose noticeably, though less dramatically, in the third and fourth quarters of 2012. Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern. In this regard, one lesson from the crisis is that it is not just bad credit decisions that create systemic problems, but bad credit decisions combined with excessive maturity transformation. A badly underwritten subprime loan is one thing, and a badly underwritten subprime loan that serves as the collateral for asset-backed commercial paper (ABCP) held by a money market fund is something else--and more dangerous. This observation suggests an idealized measurement construct. In principle, what we'd really like to know, for any given asset class--be it subprime mortgages, junk bonds, or leveraged loans--is this: What fraction of it is ultimately financed by short-term demandable claims held by investors who are likely to pull back quickly when things start to go bad? It is this short-term financing share that creates the potential for systemic spillovers in the form of deleveraging and marketwide fire sales of illiquid assets. This short-term financing share is difficult to measure comprehensively, but exhibit 5 presents one graph that gives some comfort. The graph shows dealer financing of corporate debt securities, much of which is done via short-term repurchase agreements (repos). This financing rose rapidly in the years prior to the crisis, then fell sharply, and remains well below its pre-crisis levels today. So, on this score, there appears to be only modest short-term leverage behind corporate credit, which would seem to imply that even if the underlying securities were aggressively priced, the potential for systemic harm resulting from deleveraging and fire sales would be relatively limited. Nevertheless, I want to urge caution here and, again, stress how hard it is to capture everything we'd like. As I said, ideally we would total all of the ways in which a given asset class is financed with short-term claims. Repos constitute one example, but there are others. And, crucially, these short-term claims need not be debt claims. If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange-traded funds (ETFs), and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt. One is naturally inclined to look at data on short-term debt like repo, given its prominence in the recent crisis. But precisely because it is being more closely monitored, there is the risk that next time around, the short-term claims may take another form. With this caveat in mind, it is worth noting the pattern of inflows into mutual funds and ETFs that hold high-yield bonds, shown in exhibit 6. Interestingly, the picture here is almost the reverse of that seen with dealer financing of corporate bonds. Assets under management in these vehicles were essentially flat in the years leading up to the crisis, but they have increased sharply in the past couple of years. This observation suggests, albeit only loosely, that there may be some substitutability between different forms of demandable finance. And it underscores the importance of not focusing too narrowly on any one category. Continuing on with the theme of maturity transformation, the next brief stop on the tour is the agency mortgage real estate investment trust (REIT) sector. These agency REITs buy agency mortgage-backed securities (MBS), fund them largely in the short- term repo market in what is essentially a levered carry trade, and are required to pass through at least 90 percent of the net interest to their investors as dividends. As shown in exhibit 7, they have grown rapidly in the past few years, from $152 billion at year-end 2010 to $398 billion at the end of the third quarter of 2012. One interesting aspect of this business model is that its economic viability is sensitive to conditions in both the MBS market and the repo market. If MBS yields decline, or the repo rate rises, the ability of mortgage REITs to generate current income based on the spread between the two is correspondingly reduced. Another place where the desire to generate yield can show up is in commercial banks' securities holdings. In recent work, Sam Hanson and I documented that the duration of banks' non-trading-account securities holdings tends to increase significantly when the short rate declines. We hypothesized that this pattern was due to a particular form of agency behavior--namely, that given the conventions of generally accepted accounting principles, a bank can boost its reported income by replacing low-yielding short-duration securities with higher-yielding long-duration securities. Something along these lines seems to be happening today: The maturity of securities in banks' available-for-sale portfolios is near the upper end of its historical range. This finding is noteworthy on two counts. First, the added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully--especially since existing capital regulation does not explicitly address interest rate risk. And, second, in the spirit of tips of icebergs, the possibility that banks may be reaching for yield in this manner suggests that the same pressure to boost income could be affecting behavior in other, less readily observable parts of their businesses. The final stop on the tour is something called collateral transformation. This activity has been around in some form for quite a while and does not currently appear to be of a scale that would raise serious concerns--though the available data on it are sketchy at this point. Nevertheless, it deserves to be highlighted because it is exactly the kind of activity where new regulation could create the potential for rapid growth and where we therefore need to be especially watchful. Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be "pristine"--that is, it has to be in the form of Treasury securities. However, the insurance company doesn't have any unencumbered Treasury securities available--all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade. Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does--say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet. There are two points worth noting about these transactions. First, they reproduce some of the same unwind risks that would exist had the clearinghouse lowered its own collateral standards in the first place. To see this point, observe that if the junk bonds fall in value, the insurance company will face a margin call on its collateral swap with the dealer. It will therefore have to scale back this swap, which in turn will force it to partially unwind its derivatives trade--just as would happen if it had posted the junk bonds directly to the clearinghouse. Second, the transaction creates additional counterparty exposures--the exposures between the insurance company and the dealer, and between the dealer and the pension fund. As I said, we don't have evidence to suggest that the volume of such transactions is currently large. But with a variety of new regulatory and institutional initiatives on the horizon that will likely increase the demand for pristine collateral--from the Basel III Liquidity Coverage Ratio, to centralized clearing, to heightened margin requirements for noncleared swaps--there appears to be the potential for rapid growth in this area. Some evidence suggestive of this growth potential is shown in exhibit 8, which is based on responses by a range of dealer firms to the Federal Reserve's Senior Credit Officer As can be seen, while only a modest fraction of those surveyed reported that they were currently engaged in collateral transformation transactions, a much larger share reported that they had been involved in discussions of prospective transactions with their clients. Let me turn now to policy implications. The question of how policymakers should respond to different manifestations of credit market overheating is a big and difficult one, and I won't attempt to deliver a set of specific prescriptions here. However, I would like to provoke some discussion around one specific aspect of the question-- namely, what are the respective roles of traditional supervisory and regulatory tools, on the one hand, versus monetary policy, on the other, in addressing the sorts of market- overheating phenomena that we have been talking about? To lend a little concreteness and urgency to this issue, imagine that it is 18 months from now, and that with interest rates still very low, each of the trends that I identified earlier has continued to build--to the point where we believe that there could be meaningful systemic implications. What, if any, policy measures should be contemplated? It is sometimes argued that in such circumstances, policymakers should follow what might be called a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability. There are several arguments in favor of this approach. First, monetary policy can be a blunt tool for dealing with financial stability concerns. Even if we stipulate that low interest rates are part of the reason for, say, a worrisome boom in one segment of credit markets, they are unlikely to be the whole story. So, would one really want to raise rates, and risk choking off economic activity, in an effort to rein in that one part of the market? Wouldn't it be better to use a more narrowly focused supervisory or regulatory approach, with less potential for damage to the economy? A related concern is that monetary policy already has its hands full with the dual mandate, and that if it is also made partially responsible for financial stability, it will have more objectives than instruments at its disposal and won't do as well with any of its tasks. These are important points to bear in mind. In some cases, supervisory and regulatory tools are clearly better targeted and more likely to be effective than monetary policy could be. For example, the Federal Reserve's supervisory responsibilities for the banking sector put it in the right position to carefully monitor duration risk in banks' securities portfolios and to take corrective action if necessary. Nevertheless, as we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability. Let me offer three observations in support of this perspective. First, despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns. If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior. This, of course, is not to say that we should not try to do our best with these tools--we absolutely should. But we should also be realistic about their limitations. These limitations arise because of the inherent fallibility of the tools in a world of regulatory arbitrage; because the scope of our regulatory authority does not extend equally to all parts of the financial system; and because risk-taking naturally tends to be structured in a nontransparent way that can make it hard to recognize. In some cases, regulatory tools may also be difficult to adjust on a timely basis--if, for example, doing so requires extended interagency negotiation. Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot. Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument. We can do more than adjust the federal funds rate. By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve. Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front. To see why, recall the central role that maturity transformation--the funding of long-term assets with short-term, run-prone liabilities--can play in propagating systemic instabilities. Moreover, as illustrated by the mortgage REIT sector that I described earlier, the economic appeal of maturity transformation hinges on the shape of the yield curve--in that particular case, on the spread between the yield on agency MBS and the so- called general collateral (GC) repo rate at which these securities can be funded on a short-term basis. And it would appear that our policies have at times put pressure on this spread from both sides. Our purchases of long-term Treasury securities and agency MBS have clearly helped reduce long-term yields, and a number of observers have suggested that an unintended byproduct of our MEP--and the associated sales of short-term Treasury securities--was to exert an upward influence on GC repo rates. This sort of compression of term spreads is the twist in Operation Twist. And you can see the financial stability angle as well as a possible response to concerns over numbers of instruments. Suppose that, at some point in the future, once we are away from the zero lower bound, our dual mandate objectives call for an easing in policy. Also suppose that, at the same time, there is a general concern about excessive maturity transformation in various parts of the financial system, and that we are having a hard time reining in this activity with conventional regulatory tools. It might be that the right combination of policies would be to lower the path of the federal funds rate--thereby effectuating the needed easing--while at the same time engaging in MEP-like asset swaps to flatten the yield curve and reduce the appeal of maturity transformation. I hope you will take this last example in the spirit in which it was intended--not as a currently actionable policy proposal, but as an extended hypothetical meant to give some tangible substance to a broader theme. That broader theme is as follows: One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability. As compared with inflation or unemployment, measurement is much harder, so even recognizing the extent of the problem in real time is a major challenge. Moreover, the supervisory and regulatory tools that we have, while helpful, are far from perfect. These observations suggest two principles. First, decisions will inevitably have to be made in an environment of significant uncertainty, and standards of evidence should be calibrated accordingly. Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension. And, second, we ought to be open- minded in thinking about how to best use the full array of instruments at our disposal. Indeed, in some cases, it may be that the only way to achieve a meaningfully macroprudential approach to financial stability is by allowing for some greater overlap in the goals of monetary policy and regulation. Thank you very much. , , vol. 108 Journal of On the Theory of

r130211a_FOMC

united states

A Painfully Slow Recovery for America's Workers: Causes, Implications, and the Federal Reserve's Response

yellen

For release on delivery Remarks by at Thank you for the opportunity to speak to you today about the Federal Reserve's efforts to strengthen the recovery and pursue a goal that it shares with the labor movement: maximum employment. As an objective of public policy, maximum employment doesn't appear in the U.S. Constitution, in any presidential decree, or even in the mission statement of the Labor Department. A law passed in 1946 made it a general goal for the U.S. government, but so far the Federal Reserve is the only agency assigned the job of pursuing maximum employment. The 1977 law spelling out that responsibility also assigned the goal of stable prices, and we call this combination of objectives the Federal Reserve's dual mandate. With so many people today unable to find work, it might seem odd to highlight such an ambitious and distant goal for employment. I do so because the gulf between maximum employment and the very difficult conditions workers face today helps explain the urgency behind the Federal Reserve's ongoing efforts to strengthen the recovery. My colleagues and I are acutely aware of how much workers have lost in the past five years. In response, we have taken, and are continuing to take, forceful action to increase the pace of economic growth and job creation. In the three years after the Great Recession ended, growth in real gross domestic product (GDP) averaged only 2.2 percent per year. In the same span of time following the previous 10 U.S. recessions, real GDP grew, on average, more than twice as fast--at a 4.6 percent annual rate. So, why has the economy's recovery from the Great Recession been so weak? The slow recovery was preceded, of course, by the deepest recession since the end of the Second World War. The bursting of an unprecedented housing bubble, together with the financial crisis that followed, dealt a huge blow to demand. These developments robbed homeowners of wealth built over a generation, impaired their access to credit, decimated retirement savings, and shattered the confidence of consumers. Businesses slashed capital spending and payrolls, and real GDP contracted by 4.7 percent, more than twice the average for the 10 other recessions since World War II. The Great Recession was also the longest postwar recession--it lasted 18 months, compared with an average of 10 months for the others. The experience of the United States and other advanced economies suggests that deeper recessions are usually followed by stronger-than-average recoveries. While it's also true that longer recessions tend to result in weaker recoveries, even after accounting for this factor, this recovery has been significantly weaker than past experience would have predicted. The dashed line in exhibit 1 shows how real GDP would have been expected to increase in this recovery, based on the experience of the United States and other advanced economies and given the depth and duration of the Great Recession. The gap between the actual and the predicted path of real output gives a sense of how much economic performance has lagged in this recovery. But the implications of this result may seem a little abstract, so let me illustrate the same idea in a way that tries to show the burden that workers continue to bear in this slow recovery. Exhibit 2 shows how employment has declined and recovered following several previous recessions. The employment measure attempts to control for the fact that demographic changes and other factors have altered the trend, or potential, workforce over the years. For example, in the 1970s, the pool of potential workers was expanding as baby boomers and an increasing share of women moved into the labor force, such that employment needed to rise relatively quickly just to absorb these additional workers. More recently, the aging of the population has put downward pressure on labor force participation, so employment hasn't had to grow as quickly to keep pace with the potential workforce. Even after making this adjustment, however, the Great Recession stands out both for the magnitude of the job losses that attended the downturn and for the weak recovery in employment that occurred after the recession ended. In trying to account for why this recovery has been so weak, it is helpful to first consider several important factors that have in the past supported most economic recoveries. By this I don't mean everything that contributes to economic growth, but rather those things that typically play a key role when the U.S. economy is recovering from recession. Think of these as the tailwinds that usually promote a recovery. The first tailwind I'll mention is fiscal policy. History shows that fiscal policy often helps to support an economic recovery. Some of this fiscal stimulus is automatic, and intended to be. The income loss that individuals and businesses suffer in a recession is partly offset when their tax bills fall as well. Government spending on unemployment benefits and other safety-net programs rises in recessions, helping individuals hurt by the downturn and also supporting consumer spending and the broader economy by replacing lost income. These automatic declines in tax collections and increases in government spending are often supplemented with discretionary fiscal action--tax rate cuts, spending on infrastructure and other goods and services, and extended unemployment benefits. These discretionary fiscal policy actions are typically a plus for growth in the years just after a recession. For example, following the severe 1981-82 recession, discretionary fiscal policy contributed an average of about 1 percentage point per year to real GDP growth over the subsequent three years. However, discretionary fiscal policy hasn't been much of a tailwind during this recovery. In the year following the end of the recession, discretionary fiscal policy at the federal, state, and local levels boosted growth at roughly the same pace as in past recoveries, as exhibit 3 indicates. But instead of contributing to growth thereafter, discretionary fiscal policy this time has actually acted to restrain the recovery. State and local governments were cutting spending and, in some cases, raising taxes for much of this period to deal with revenue shortfalls. At the federal level, policymakers have reduced purchases of goods and services, allowed stimulus-related spending to decline, and have put in place further policy actions to reduce deficits. I was relieved that the Congress and the Administration were able to reach agreement on avoiding the full force of the "fiscal cliff" that was due to take effect on January 1. While a long-term plan is needed to reduce deficits and slow the growth of federal debt, the tax increases and spending cuts that would have occurred last month, absent action by the Congress and the President, likely would have been a headwind strong enough to blow the United States back into recession. Negotiations continue over the extent of spending cuts now due to take effect beginning in March, and I expect that discretionary fiscal policy will continue to be a headwind for the recovery for some time, instead of the tailwind it has been in the past. A second tailwind in most recoveries is housing. Residential investment creates jobs in construction and related industries. Before the Great Recession, housing investment added an average of 1/2 percentage point to real GDP growth in the two years after each of the previous four recessions, considerably more than its contribution to growth at other times. During this recovery, in contrast, residential investment, on net, has contributed very little to growth since the recession ended. The reasons are easy to understand, given the central role that housing played in the Great Recession. Following an extended boom in construction driven in large part by overly loose mortgage lending standards and unrealistic expectations for future home price increases, the housing market collapsed-- sales and prices plunged and mortgage credit was sharply curtailed. Tight mortgage credit conditions are continuing to make it difficult for many families to buy homes, despite record-low mortgage interest rates that have helped make housing very affordable. I'm encouraged by recent improvement in the residential sector, but the contribution of housing investment to overall economic activity remains considerably below the average seen in past recoveries, as exhibit 4 shows. Beyond the direct effects on residential investment, the extraordinary collapse in house prices resulted in a huge loss of household wealth--at last count, net home equity is still down 40 percent, or about $5 trillion, from 2005. This loss of wealth has weighed on the finances and spending of many homeowners. Households are less able to tap their home equity to deal with economic shocks, fund their children's education, or start new businesses. For some households, the collapse in house prices has left them underwater on their mortgages, and thus less able to refinance or sell their homes. Another important tailwind in most economic recoveries is one that tends to be taken for granted--the faith most of us have, based on history and personal experience, that recessions are temporary and that the economy will soon get back to normal. Even during recessions, households' expectations for income growth tend to be reasonably stable, which provides support for overall spending. In the most recent recession, however, surveys suggest that consumers sharply revised down their prospects for future income growth and have only partially adjusted up their expectations since then The recovery has also encountered some unusual headwinds. The fiscal and financial crisis in Europe has resulted in a euro-area recession and contributed to slower global growth. Europe's difficulties have blunted what had been strong growth in U.S. exports earlier in the recovery by sapping demand worldwide. Let me say a few words now, and more later, about the role of monetary policy in this recovery. The Federal Reserve typically plays a large role in promoting recoveries by reducing the federal funds rate and keeping it low until the economy is again on a solid footing. Reducing the federal funds rate tends to reduce other interest rates and boost asset prices, thus encouraging spending and investment throughout the economy. reducing the federal funds rate at the first signs of economic weakness and made sharper rate cuts as the recession deepened. As in some past recoveries that were disappointingly slow, the FOMC has kept rates low well after the end of the recession. But unlike the past, by December 2008 the Committee had reduced the federal funds rate effectively to zero. Because that rate, for practical purposes, cannot be cut further, this level is referred to as the effective lower bound. Without the option of using its conventional policy tool, and with the recession getting worse, the FOMC decided to employ unconventional tools to further ease monetary policy, even though the efficacy of these tools was uncertain and it was recognized that their use might carry some potential costs. The better known of these tools is the purchase of large amounts of longer-term government securities, which is commonly referred to as quantitative easing. The other unconventional tool is known as forward guidance--providing information about the future path of short-term interest rates anticipated by the Committee. Both of these approaches are intended to address a gap caused by the effective lower bound. This gap is the shortfall between what the FOMC likely would do in current economic circumstances, were it able to reduce the federal funds rate below zero, and the reality that the rate can't be cut further. I believe that the Federal Reserve's asset purchases and other unconventional policy actions have helped, and are continuing to help, fill this gap and thus shore up aggregate demand. The evidence suggests that the FOMC's actions have lowered short- and longer-term private borrowing rates and boosted asset prices. However, while this contribution has been significant, lower interest rates may be doing less to increase spending than in past recoveries because of some unusual features of the Great Recession and the current recovery. For example, as I noted, the housing crisis left many homeowners with high loan-to-value ratios and damaged credit records, creating barriers to their access to credit, while the financial crisis led many banks to lend only to borrowers with higher credit scores. As a consequence, the proportion of households that have been able to take advantage of declining rates to refinance their mortgages or to borrow to purchase new homes has probably been lower than in past recoveries. In addition, pronounced uncertainty about economic conditions has weighed on capital spending decisions and may have blunted the normal effect of lower interest rates on business investment. These are the major reasons why I believe this recovery has been so slow. After a lengthy recession that imposed great hardships on American workers, the weak recovery has made the past five years the toughest that many of today's workers have ever experienced. The unemployment rate now stands at 7.9 percent. To put this number in perspective, while that's a big improvement from the 10 percent reached in late 2009, it is now higher than unemployment ever got in the 24 years before the Great Recession. Moreover, the government's current estimate of 12 million unemployed doesn't include 800,000 discouraged workers who say they have given up looking for work. And, as exhibit 6 shows, 8 million people, or 5.6 percent of the workforce, say they are working part time even though they would prefer a full-time job. A broader measure of underemployment that includes these and other potential workers stands at 14.4 percent. The effects of the recession and the subsequent slow recovery have been harshest on some of the most vulnerable Americans. The poverty rate has risen sharply since the onset of the recession, after a decade in which it had been relatively stable, and stands at 15 percent of the population, significantly above the average of the past three decades. Even those today who are fortunate enough to hold jobs have seen their hourly compensation barely keep pace with the cost of living over the past three years, while labor's share of income--as measured by the percent of production by nonfinancial corporations accruing to workers as compensation--remains near the postwar low reached in 2011 (exhibit 7). Compared with the 7.9 percent unemployment rate for all workers, the unemployment rate for African Americans is 13.8 percent. The unemployment rate for those without a high school diploma is 12 percent. For young people--workers 16 to 19 years old--the unemployment rate is 23.4 percent, little changed from the end of the recession. Among African Americans in that age group, 38 percent of those in the labor force can't find a job. Another gauge of the effect that this slow recovery has had on workers is how long it is taking to find a job. At its worst point in the 1980s, the median length of unemployment for those looking for a job was 12 weeks, but the median since the Great Recession has averaged 20 weeks and now stands at 16 weeks. Three million Americans have been looking for work for one year or more; that's one-fourth of all unemployed workers, which is down from 2011's peak but far larger than was seen before the Great These are not just statistics to me. We know that long-term unemployment is devastating to workers and their families. Longer spells of unemployment raise the risk of homelessness and have been a factor contributing to the foreclosure crisis. When you're unemployed for six months or a year, it is hard to qualify for a lease, so even the option of relocating to find a job is often off the table. The toll is simply terrible on the mental and physical health of workers, on their marriages, and on their children. Long-term unemployment is also a great concern because it has the potential to itself become a headwind restraining the economy. Individuals out of work for an extended period can become less employable as they lose the specific skills acquired in their previous jobs and also lose the habits needed to hold down any job. Those out of work for a long time also tend to lose touch with former co-workers in their previous industry or occupation--contacts that can often help an unemployed worker find a job. Long-term unemployment can make any worker progressively less employable, even after the economy strengthens. A factor contributing to the high level of long-term unemployment in the current recovery is the relatively large proportion of workers who have permanently lost their previous jobs, as opposed to being laid off temporarily. For example, in past recessions, a considerable share of jobs lost in construction has been temporary, but that isn't the case this time. Construction employment fell from its peak of 7.7 million in 2006 to a low of 5.4 million in 2011. Only about 300,000 of those 2.3 million jobs have returned and most won't, at least for many years. In general, individuals who permanently lose their previous jobs take longer to become reemployed than do those on temporary layoff, are more likely to have to change industries or occupations to find a new job, and earn significantly less when they become reemployed. The greater amount of permanent job loss seen in the recent recession also suggests that there might have been an increase in the degree of mismatch between the skills possessed by the unemployed and those demanded by employers. This possibility and the unprecedented level and persistence of long-term unemployment in this recovery have prompted some to ask whether a significant share of unemployment since the recession is due to structural problems in labor markets and not simply a cyclical shortfall in aggregate demand. This question is important for anyone committed to the goal of maximum employment, because it implicitly asks whether the best we can hope for, even in a healthy economy, is an unemployment rate significantly higher than what has been achieved in the past. For the Federal Reserve, the answer to this question has important implications for monetary policy. If the current, elevated rate of unemployment is largely cyclical, then the straightforward solution is to take action to raise aggregate demand. If unemployment is instead substantially structural, some worry that attempts to raise aggregate demand will have little effect on unemployment and serve only to stoke inflation. This question is frequently discussed by the FOMC. I cannot speak for the Committee or my colleagues, some of whom have publicly related their own conclusions on this topic. However, I see the evidence as consistent with the view that the increase in unemployment since the onset of the Great Recession has been largely cyclical and not structural. For example, the rise in unemployment during the recession was accompanied by a dramatic decline in job vacancies and was widespread across industry and occupation groups. Job losses in the construction and financial services industries were particularly large--hardly surprising given the collapse in these sectors in 2008 and 2009--but manufacturing and other cyclically sensitive industries were hit hard as well, and employment in these industries has likewise recovered slowly. Moreover, if skills mismatch in the labor market has led to an excess supply of workers in some sectors and a shortage of workers in others, then we would expect to see an atypical amount of variation in the balance between job openings and unemployment across sectors. Based on this insight, researchers Ed Lazear and Jim Spletzer constructed quantitative measures of mismatch across industries and occupations. They found that their mismatch indexes were indeed elevated at the end of the Great Recession, as exhibit 8 shows. But these measures have fallen over the course of the recovery to near pre-recession levels. In addition, widespread mismatch between job vacancies and workers across different sectors might be expected to cause wage rates to rise relatively quickly in sectors with many job openings and relatively slowly in sectors with an excess supply of available workers. But work by Jesse Rothstein fails to uncover evidence of such a pattern. This and related research suggests to me, first, that a broad-based cyclical shortage of demand is the main cause of today's elevated unemployment rate, and, second, that whatever problems there may be today with labor market functioning are likely to be substantially resolved as the broader economy improves and bolsters the demand for labor. I don't mean to suggest that there aren't some workers who have been stranded by structural changes in the economy. More can and should be done to help dislocated workers acquire new skills to transition from industries and occupations with fewer opportunities. But making this transition will be much easier in a healthy economy, which is one reason why I am encouraged by the evidence that elevated unemployment is indeed largely cyclical. I will now describe what the Federal Reserve is doing to try to raise demand and create jobs. I have described the two unconventional policy tools that the FOMC has employed since it reduced the target federal funds rate in 2008 to its effective lower bound. The first is large-scale asset purchases, intended to lower long-term interest rates to encourage borrowing for spending and investment. Between 2008 and mid-2011, the FOMC purchased agency-guaranteed mortgage-backed securities (MBS), agency debt, and Treasury securities totaling $2.3 trillion. In 2011, the FOMC began the maturity extension program, under which it reduced its holdings of short-term Treasury securities and used the proceeds to purchase an equivalent amount of longer-term Treasury securities. However, as the scheduled endpoint of that program approached, it became clear that the economy remained weak, and the FOMC took a series of steps to provide further impetus to the recovery. In June 2012, the Committee extended its maturity extension program until the end of the year. Then in September, it made a major new commitment to asset purchases. Unlike its past purchase programs, which were fixed in size, this time the FOMC stated its determination to continue the program, provided that inflation remains well contained, until it judges that there has been a substantial improvement in the outlook for the labor market. The Committee currently intends to purchase MBS and Treasury debt at a pace that will add about $85 billion per month of such securities to the Federal Reserve's balance sheet. In determining the size, pace, and composition of these purchases over time, the Committee will also take into account ongoing assessments of their efficacy and costs. The second unconventional policy tool that the FOMC has used is forward guidance, in the form of more-explicit and more-detailed information about the future path of monetary policy. The longer-term interest rates that most profoundly influence housing demand, capital spending, and asset prices depend on current and expected future levels of short-term interest rates, such as the federal funds rate that has been the Fed's conventional monetary policy tool. Signaling the future path of the federal funds rate can therefore directly affect interest rates today on auto loans, home mortgages, and bonds issued by companies and state and local governments, even when the current level of the federal funds rate cannot be lowered. The FOMC has substantially expanded its forward guidance in recent years. In 2009, the Committee stated that economic conditions "are likely to warrant exceptionally low levels of the federal funds rate for an extended period." this period would likely last "at least through mid-2013," and extended this date guidance several times. A disadvantage of this calendar-based approach was that it might not be clear whether changes in the date reflect changes in the FOMC's outlook for growth, for inflation, or a shift in the desired stance of policy. In December 2012, the FOMC therefore replaced the date with greater detail on the economic conditions that would warrant maintaining the federal funds rate at its present, exceptionally low level. Specifically, it stated that near-zero rates would likely remain appropriate for a considerable time after the asset purchase program ends and "at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well It deserves emphasis that a 6-1/2 percent unemployment rate and inflation one to two years ahead that is 1/2 percentage point above the Committee's 2 percent objective are thresholds for possible action, not triggers that will necessarily prompt an immediate increase in the FOMC's target rate. In practical terms, it means that the Committee does not expect to raise the federal funds rate as long as unemployment remains above and inflation one to two years ahead is projected to be less than 1/2 percentage point above its 2 percent objective. When one of these thresholds is crossed, action is possible but not assured. Moreover, these thresholds for possible action do not reflect any change in the Committee's longer-run goals. With respect to maximum employment, most FOMC participants continue to estimate that the longer-run normal unemployment rate lies in a range of 5.2 to 6 percent, and the Committee continues to believe an inflation rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures) is most consistent with the Federal Reserve's dual mandate. Indeed, the Committee reaffirmed these longer-run goals, first adopted in January 2012, just last month. Of course, our control over the economy is imperfect, and so temporary deviations from the FOMC's specific longer-term goals will sometimes occur. Importantly, these quantitative goals are neither ceilings nor floors for inflation and unemployment, and the Committee will take a balanced approach to returning both measures to their objectives over time. I believe the policy steps we have taken recently are in accord with this balanced approach. With employment so far from its maximum level and with inflation currently running, and expected to continue to run, at or below the Committee's 2 percent longer- term objective, it is entirely appropriate for progress in attaining maximum employment to take center stage in determining the Committee's policy stance. While the Committee's longer-term goals remain unchanged, what has changed is that the FOMC is now providing more information about how it expects to pursue its inflation and employment goals. In particular, we will employ our policy tools, as appropriate, to raise aggregate demand and employment in the context of continued price stability, consistent with our balanced approach. That's good news for workers, because I believe that these steps will increase demand, and more demand means more jobs. It will be a long road back to a healthy job market. It will be years before many workers feel like they have regained the ground lost since 2007. Longer-term trends, such as globalization and technological change, will continue to pose challenges to workers in many industries. Let me close with some words of encouragement. The job market is improving. The progress has been too slow, but there is progress. My colleagues and I at the Federal Reserve are well aware of the difficulties faced by workers in this slow recovery, and we're actively engaged in continuing efforts to promote a stronger economy, more jobs, and better conditions for all workers. Thank you for the opportunity to speak to you today.

r130222b_FOMC

united states

Discussion of "Crunch Time: Fiscal Crises and the Role of Monetary Policy"

powell

The issue of fiscal sustainability and its interaction with monetary policy is certainly timely. Many advanced economies are in an extended period of slow growth and high deficits, and face long-term fiscal pressures from aging populations. I agree with much in this broad-ranging paper. In particular, the authors join others in finding that accommodative monetary policy is often associated with successful fiscal consolidations. They conclude that a "tough love" alternative, which would call for the Federal Reserve to withhold monetary accommodation until fiscal policymakers enact legislation to reduce budget imbalances, is likely to be counterproductive. Indeed, I would argue that the tough love approach also would require the Fed to deviate from the dual mandate that the Congress has assigned it, while assuming a role in influencing fiscal policy that the Congress has not assigned it. I find myself in disagreement, however, with the paper's assessment that the current fiscal policy challenges might interfere in the near-term with the conduct of monetary policy in the United States. Three important propositions underlie the authors' argument on this issue: The federal government's fiscal path is unsustainable under current policies. If the market concludes that a government either cannot or will not service its debt, the central bank may be forced to choose ultimately between monetization leading to inflation or standing by as the government defaults--the threat of "fiscal dominance." The Federal Reserve's balance sheet is currently very large by historical standards and still growing. The process of normalizing the size and composition of the balance sheet poses significant uncertainties and challenges for monetary policymakers. I believe all of these statements to be true. They are also widely, if not universally, accepted. However, based on these points and, importantly, on their empirical findings, the authors set out to show that fiscal difficulties present a near-term threat to the conduct of monetary policy. The paper argues that rising fiscal pressures, exacerbated by Federal Reserve losses on asset sales and low remittances to the Treasury, could lead the Federal Reserve to delay balance sheet normalization and to fail to remove monetary accommodation as needed to keep inflation expectations stable and inflation in check. In that case, the market could perceive the onset of fiscal dominance thus setting off a vicious cycle of rising inflation expectations, increasing interest rates, and ever greater fiscal unsustainability. In my view, this proposition seems highly unlikely. At a minimum, it is premature. The paper led me to look back over the past century of U.S. sovereign debt history. On two prior occasions, federal debt as a percentage of gross domestic product smaller extent, the two decades ending in the mid-1990s. After each of these high-debt periods, fiscal policy responded by running sustained primary surpluses and reducing debt to levels below 40 percent of GDP. In a recent paper, Henning Bohn observed that "the foundation of U.S. debt policy is the promise of safety for bondholders backed by primary surpluses only in response to a high That nicely captures our recent history and suggests a principal reason why the federal debt of the United States still has the market's trust. The Great Recession has generated a third substantial increase in federal debt, from about 35 percent of GDP in 2007 to around 75 percent at the end of this fiscal year, an increase that is consistent with other increases in sovereign debt for advanced economies after severe financial crises during the post-World War II period. and common sense suggest that the federal government should again run primary surpluses sufficient over time to reduce debt to pre-crisis levels of perhaps 35 to 40 percent of GDP. That would leave fiscal space to address the coming wave of health and pension costs, as well as unexpected new shocks. In the past two years, spending cuts and tax increases totaling about $3.5 trillion over the next 10 years have been enacted. Assuming these measures are not rolled back-- in particular, that the spending sequestration either takes effect or is replaced by equivalent deficit-reducing measures--a reasonable "current policy" projection is that the ratio of debt to GDP will be roughly stable at around 75 percent through about 2020. After that, under current policy, health-care costs and, to a much lesser extent, pension costs will produce a sharp, sustained increase in the ratio of debt to GDP. The authors review empirical evidence of sovereign borrowing costs for 20 advanced economies. They join others in finding a statistically significant relationship between sovereign debt levels and borrowing costs. They also find nonlinear increases in borrowing costs beginning at debt-to-GDP ratios of around 80 percent. But the nonlinearities they find are driven to a great extent by the experience of smaller euro- zone nations that, of course, borrow in euros. The United States borrows in its own currency--the world's primary reserve currency. That difference is crucial for investors, along with the fact that the United States economy remains the world's largest and most productive. The United Kingdom and Japan are also high-debt countries that borrow in their own currencies; neither shows any detectable rate increase, let alone a nonlinear one. These countries present a serious problem for the authors' case. Of course, the United States is not exempt from concerns about the potential long- term effects of an unsustainable fiscal path. There is almost certainly a level of debt at which the United States would be at risk of an interest rate spike. However, we should expect that level to be substantially above one identified based on the experience of smaller euro-zone nations. The argument also has a serious timing problem. The Federal Reserve's balance sheet likely will be normalized by late this decade, before the federal debt-to-GDP ratio even increases materially from today's level. Under the reasonable projection mentioned above, the debt-to-GDP ratio will remain roughly stable until 2020 before rising significantly in the next decade. That's not a favorable longer-term forecast, all the more so because it is importantly the result of demographic changes that have been expected for decades. But the forecast doesn't support the authors' claim that fears of fiscal dominance could materialize in the United States within the next five to seven years, during the period when the Fed is normalizing its balance sheet. No current market signal suggests that the United States is near the point of losing the market's confidence. In my view, nothing in the Congressional Budget Office debt forecasts or the authors' empirical findings provides grounds for such an event during this decade. The market has every reason to believe--and apparently still does believe-- that the United States will continue the difficult task of fiscal consolidation until the job is done. Terribly difficult fiscal adjustments lie ahead. Although there is still time to make them, delay will sharply increase the pain of adjustment. The time to act is now. In my view, the problem is not principally one of economics or fiscal policy; it is one of governance. The real threat to the fiscal standing of the United States is that of inaction caused by a long period of political polarization and dysfunction. That would be a self inflicted wound. And that is a problem that can't be derived from the traditional fiscal metrics. We may have more room than other economies around the globe, but I do not intend to project any sense of complacency around this topic. The authors' basic message seems just right to me: We don't know where the tipping point is; wherever it is, we are clearly getting closer to it, and the costs of misestimating its location are enormous and one-sided. The benefits to long-term fiscal consolidation--conducted at the right pace, and without jeopardizing the near-term economic recovery--would be substantial. The authors' work on Federal Reserve income and remittances to the Treasury overlaps with a paper published last month by Federal Reserve Board staff members Seth Both papers provide a basis for public discussion of these matters, which is a highly positive development. Some of the assets acquired through the Federal Reserve's large-scale asset purchases (LSAPs) may be sold at a loss, and it is important to be transparent about this possibility. Thus far, the Federal Reserve's asset purchases have greatly increased our income and remittances to the Treasury. Indeed, remittances have run at an annual level of about $80 billion from 2010 to 2012. Both papers show that remittances are likely to decline substantially from these elevated levels as interest rates rise and the Fed balance sheet normalizes, and there may be a period of zero remittances. If so, the balance sheet would show a deferred asset representing a flow of future income to be retained and not remitted to the Treasury. Nonetheless, we expect that the LSAPs, which began in late 2008, will result in a net increase in remittances over the life of these programs. Moreover, any temporary losses should be weighed against the expected social benefits of the increased economic growth generated by the LSAPs, which would include higher tax revenue from increased output. Greenlaw and his coauthors also note that we have the flexibility to normalize the balance sheet more slowly. For example, a "no asset sale" plan--under which assets would simply run off as they mature--would push out the date of normalization by only a year or so. That approach would also address concerns over potential market disruption from the sale of off-the-run agency mortgage-backed securities. And it would also smooth remittances. Remittances averaged about $25 billion per year, or 0.2 percent of GDP, over the decade before the crisis. After the balance sheet is normalized, these remittances should return to a similar, modest share of GDP. From the standpoint of the sustainability of federal fiscal policy, remittances are not a first-order concern. That said, an extended period of zero remittances could certainly bring the Federal Reserve under criticism from the public and the Congress. The question is whether the Federal Reserve would permit inflation and thereby abandon its post in the face of such criticism. There is no reason to expect that to happen. The Federal Reserve was created as an independent agency, and a broad consensus has emerged among policymakers, academics, and other informed observers around the world that better overall economic performance is achieved when the conduct of monetary policy is free from political control. Of course, we are accountable to the Congress and the American people. The Congress has given us a job to do, and as long as I am a member of the Federal Reserve Board, I will do my utmost to carry out our mandate. The authors note that Federal Reserve asset purchases shorten the duration of debt held by the public, by the issuance of reserves to fund purchases of long-term securities. And shortening the maturity of the public debt does make any government more susceptible, in theory, to fiscal dominance. There is also a general assumption that under fiscal dominance any government has a strong incentive to allow inflation to reduce the real value of the debt. In the case of the United States, there is less to that than one might expect. By shortening the duration of debt held by the public, asset purchases have also reduced any benefit to the government of an unexpected inflation. More fundamentally, the liabilities that matter in the long term for the federal budget are those associated with health care and pension costs. These liabilities are not nominal but real, and cannot be inflated away. I am not suggesting, and I do not expect, that the path ahead for monetary policy will be an easy one. There are legitimate concerns associated with the costs and benefits of continuing asset purchases. We may face challenges related to financial stability, as well as market function and inflation expectations. I do not personally see fiscal dominance as high on the list of near term risks. I thank the authors for their interesting work.

r130222a_FOMC

united states

International Cooperation in Financial Regulation

tarullo

Next month marks the fifth anniversary of the failure of Bear Stearns--in retrospect, the beginning of the most acute phase of the financial crisis. The cross-border dimensions of the crisis itself and the global effects of the Great Recession that followed provoked a major effort to strengthen international cooperation in financial regulation. While a good deal has already been accomplished, this evening I will suggest the next steps that would be most useful in advancing global financial stability. Of course, the fashioning of an international agenda requires a clear understanding of the overall regulatory aims of participating national authorities. Here is where international regulatory cooperation links to the subject of this conference--if not quite the changing politics of central banks, then at least their changing policy goals in the wake of the financial crisis. Almost by definition, systemic crises reveal failures across the financial system, from breakdowns in risk management at many financial firms to serious deficiencies in government regulation of financial institutions and markets. While the recent crisis was no exception, it has presented particular challenges to the policy foundations of central banks, especially those like the Federal Reserve that carry out regulatory mandates alongside their monetary policy missions. So I begin with some remarks on the nature of those challenges, before turning to a discussion of how changes in approach should inform international cooperation in financial regulation. In surveying the failings of financial authorities, both here and abroad, one can certainly identify some specific characteristics of pre-crisis regulation that look today to have been significantly misguided, rather than the advances they were formerly thought to be. So, for example, regulators became prone to place too much confidence in the capacity of firms to measure and manage their risks. Indeed, the decade or so prior to the crisis had seen an acceleration of the shift from a dominantly regulatory approach to achieving prudential aims-- one that rests on activities and affiliation restrictions, and other reasonably transparent rules--toward greater emphasis on a supervisory approach, which relies on a more opaque, firm- specific process of watching over banks' own risk-management and compliance systems. Yet the breadth and depth of the financial breakdown suggest that it has much deeper roots. In many respects, this crisis was the culmination of fundamental shifts in both the organization and regulation of financial markets that began in the 1970s. The New Deal reforms of financial regulation, themselves spawned by a systemic crisis, had separated commercial banking from investment banking, cured the problem of commercial bank runs by providing federal deposit insurance, and brought transparency and investor protections to trading and other capital markets activities. This regulatory approach fostered a commercial banking system that was, for the better part of 40 years, quite stable and reasonably profitable, though not particularly innovative in meeting the needs of depositors and borrowers. In the 1970s, however, turbulent macroeconomic developments combined with technological and business innovations to produce an increasingly tight squeeze on the traditional commercial banking business model. The squeeze came from both the liability side of banks' balance sheets, in the form of more attractive savings vehicles such as money market funds, and from the asset side, with the growth of public capital markets and international competition. The large commercial banking industry that saw both its funding and its customer bases under attack sought removal or relaxation of the regulations that confined bank activities, affiliations, and geographic reach. While supervisors differed with banks on some important particulars, they were sympathetic to this industry request, in part because of the potential threat to the viability of the traditional commercial banking system. The period of relative legal and industry stability that had followed the New Deal thus gave way in the 1970s to a nearly 30-year period during which many prevailing restrictions on banks were relaxed. A good number were loosened through administrative action by the banking agencies, but important statutory measures headed in the same direction. This legislative trend culminated in the Gramm-Leach-Bliley Act of 1999, which consolidated and extended the administrative changes that had allowed more extensive affiliations of commercial banks with investment banks, broker-dealers, private equity firms, and other financial entities. But in sweeping away the remnants of one key element of the New Deal regulatory system, neither Gramm-Leach-Bliley nor financial regulators substituted new regulatory mechanisms to match the wholesale changes in the structure of the financial services industry and the dramatic growth of novel financial instruments. In fact, I would generalize this last observation to say that the need to address the consequences of the progressive integration of traditional lending, trading activities, and capital markets lies at the heart of three post-crisis challenges to the policy foundations of the Federal Reserve and, to a greater or lesser degree, many other central banks. The first challenge posed by the crisis was to traditional, microprudential regulation, which focuses on the safety and soundness of each prudentially regulated firm. Not all central banks have microprudential regulatory authority, of course, and--as in the United States--those that do sometimes share it with other agencies. But the shortcomings of pre-crisis regulatory regimes have been of concern to all central banks. Most notably, capital requirements for banking organizations, particularly the large ones that might be regarded as too-big-to-fail, simply were not strong enough. Risk-weights were too low for certain traded assets that had proliferated as credit and capital markets integrated more thoroughly. In some cases, the arbitrage opportunities presented by existing capital requirements were an incentive for securitization and other capital markets activities. The exposures created by off-balance-sheet activities such as structured investment vehicles (SIVs) were badly underweighted. Minimum capital ratios were not high enough and, in meeting even those inadequate requirements, firms were allowed to count liabilities that did not really provide the ability to absorb losses and still maintain the firms as viable, functioning intermediaries. There has already been a substantial response to this challenge. With the support of the has strengthened capital requirements by raising risk-weightings for traded assets and improved the quality of loss-absorbing capital through a new minimum common equity ratio. The committee also has created a capital conservation buffer and introduced an international leverage ratio. These Basel 2.5 and Basel III reforms either have been, or soon will be, implemented in the United States and most other countries that are home to internationally active banking firms. step in addressing liquidity problems. In the United States, some important additional steps have been taken. Beginning at the peak of the crisis, the Federal Reserve has conducted stress tests of large banking organizations, making capital requirements more forward-looking by estimating the effect of an adverse economic scenario on firm capital levels in a manner less dependent on firms' internal risk- measurement infrastructure. And the provision of the Dodd-Frank Act popularly known as the Collins Amendment ensures that banking organizations cannot use models-based approaches to reduce their minimum capital below generally applicable, more standardized risk-based ratios. A second challenge for central banks is that the crisis revealed the need for a much more active set of macroprudential monitoring and regulatory policies--that is, a reorientation toward safeguarding financial stability through the containment of systemic risk. The failure to attend to, or even recognize, financial stability risks was perhaps the most glaring public sector deficiency in the pre-crisis period. This was a fault by no means limited to central banks. On the contrary, systemic risk had also come to seem more theoretical than real to many academics and financial market participants. Even most of those inside and outside the official sector who argued for stronger capital or other prudential standards did not appreciate the degree to which the secondary mortgage market had turned into a house of cards. Still, regardless of formal mandates, central banks are better positioned than most other government agencies to see and evaluate the emergence of asset bubbles, excessive leverage, and other signs of potential systemic vulnerability. In some respects this second challenge is an extension of the first, since the safety and soundness of large institutions must take account of the relative correlation of their asset holdings, interconnectedness, common liquidity constraints, and other characteristics of large banking organizations as a group. Similarly, systemic risks and too-big-to-fail problems can increase if large, highly leveraged firms may operate outside the perimeter of statutory microprudential oversight, as was the case prior to 2008 with the large, free-standing investment banks in the United States. And market discipline will be badly compromised if financial market participants believe that an insolvent counterparty cannot be resolved in an orderly fashion and thus is likely to receive government assistance under stress. Here again, domestic and international efforts have already produced significant reform programs, though implementation of some of these programs is less advanced than Basel 2.5 and Basel III. Domestically, the Federal Reserve's annual stress tests examine the effects of unexpected macroeconomic shocks on asset classes held within all major regulated firms. The systemically important firms that are not already bank holding companies within the perimeter of Federal Reserve regulation and supervision. The FSOC is actively considering several firms for Corporation orderly liquidation authority for systemically important financial firms, thereby creating an alternative to the Hobson's choice of bailout or bankruptcy that authorities faced in Internationally, the Basel Committee has agreed to a regime of capital surcharges for large banks based on their systemic importance. There is also an initiative to parallel U.S. efforts to identify non-bank systemically important firms. The Basel Committee and the Financial Stability Board have developed international principles for resolution authority, though most of the rest of the world is behind the United States in actually implementing those principles. But meeting the macroprudential challenge will require measures beyond a more comprehensive, cross-firm approach to microprudential regulation. Much academic and policy work of the past several years has revived and elaborated the previously somewhat heterodox view that financial instability is endogenous to the financial system, or at least the kind of financial system we now have. Consider, for example, how the intertwining of traditional lending and capital markets gave rise to what has become known as the shadow banking system. Shadow banking, which refers to credit intermediation partly or wholly outside the limits of the traditional banking system, involves not only sizeable commercial and investment banks, but many firms of varying sizes across a range of markets. While some of the more notorious pre- crisis components of the shadow banking system are probably gone forever, current examples include money market funds, the triparty repo market, and securities lending. From the perspective of financial stability, the parts of the shadow banking system of most concern are those that create assets thought to be safe, short-term, and liquid--in effect, cash equivalents. For a variety of reasons, demand for such assets has grown steadily in recent years, and is not likely to reverse direction in the foreseeable future. Yet these are the assets whose funding is most likely to run in periods of stress, as investors realize that their resemblance to cash or insured deposits in normal times has disappeared in the face of uncertainty about their underlying value. And, as was graphically illustrated during the crisis, the resulting forced sales of assets whose values are already under pressure can accelerate an adverse feedback loop, in which all firms with similar assets suffer mark-to-market losses, which, in turn, can lead to more fire sales. This kind of contagion lay at the heart of the financial stresses of 2007 and 2008. As already noted, pre-crisis shortcomings at the intersection of microprudential and macroprudential regulation have motivated a variety of reforms, many explicitly directed at the problem of too-big-to-fail institutions. While some of these reforms remain unfinished, and some additional measures are needed, there has been considerable progress. Unfortunately, the same cannot be said with respect to shadow banking and, more generally, the vulnerabilities associated with wholesale short-term funding. These vulnerabilities involve both large, prudentially regulated institutions, and thus too-big-to-fail concerns, and the broader financial system. Except for the liquidity requirements agreed to in the Basel Committee, however, the liability side of the balance sheets of financial firms has barely been addressed in the reform agenda. Yet here is where the systemic problems of interconnectedness and contagion are most apparent. And, as evidenced by the funding stresses experienced by a number of European banks prior to the stabilizing measures taken by the European Central Bank, these problems are still very much with us. Within the United States, reform efforts are underway in some discrete, but important, areas. The provisions of Dodd-Frank requiring more central clearing of derivatives and minimum margins for those that remain uncleared are designed to provide more systemic stability. As to shadow banking itself, the FSOC recently proposed options to address the structural vulnerabilities in money market mutual funds, with an eye toward recommending action by the Securities and Exchange Commission. And the Federal Reserve has begun using its supervisory authority to press for a reduction in intraday credit risk in the triparty repo market. But these measures are incomplete, and do not extend to all forms of short-term funding that can pose run risks, a universe that is likely to expand as prudential constraints begin to apply to large existing shadow banking channels. While the first two policy challenges are shared among regulatory and financial agencies, the third lies solely with central banks. In the wake of the crisis, we need to consider carefully the view that central banks should assess the effect of monetary policy on financial stability and, in some instances, adjust their policy decisions to take account of these effects. The dramatic rise in housing prices, and the associated high amounts of leverage taken on by both households and investors, occurred during an extended period of low inflation. Some have suggested that, by not raising rates because inflation remained subdued, monetary policy in the United States and elsewhere may have contributed to the magnitude of the housing bubble. Whatever the merits of that much-contested point, it seems wise to address this issue as we face what could well be another extended period of low inflation and low interest rates. It is important to note that incorporating financial stability considerations into monetary policy decisions need not imply the creation of an additional mandate for monetary policy. The potentially huge effect on price stability and employment associated with bouts of serious financial instability gives ample justification. Here I want to mention some comments by my colleague Jeremy Stein a couple of weeks ago. After reviewing the traditional arguments against using monetary policy in response to financial stability concerns and relying instead on supervisory policies, Governor Stein offered several reasons for keeping a more open mind on the subject. First, regulation has its own limits, not the least of which is the opportunity for arbitrage outside the regulated sector. Second, whatever its bluntness, monetary policy has the advantage of being able to "get in all the cracks" of the financial system, an attribute that is especially useful if imbalances are building across the financial sector and not just in a particular area. Finally, by altering the composition of its balance sheet, central banks may have a second policy instrument in addition to changing the targeted interest rate. So, for example, it is possible that a central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones. To be clear, I do not think that we are at present confronted with a situation that would warrant these kinds of monetary policy action. But for that very reason, it seems that now is a good time to discuss these issues more actively, so that if and when we do face financial stability concerns associated with asset bubbles backed by excessive leverage, we will have a well- considered view of the role monetary policy might play in mitigating those concerns. Let me turn now to the way in which our shifts in policy approach should inform the agenda for international cooperation in financial regulation. For obvious reasons, the monetary policy issues are not directly related to this agenda, though our understanding of these issues may profit from discussions with our central bank colleagues from around the world. It is equally obvious that the other two sets of policy changes are quite closely related to the international agenda. More than in most other areas, the financial sphere suffers from a basic lack of congruence between the authority to regulate and the object of regulation. Thus we have a significantly internationalized financial system, in which shocks are quickly transmitted across borders, but a nationally-based structure of regulation. Within countries, responsibilities may be divided between prudential regulators and market regulators, among regulators with similar mandates, or both. Central banks may have exclusive prudential authority, share it with other agencies, or have none at all. International arrangements both reflect, and try to compensate for, this web of divided and overlapping domestic authority. Thus there are sectoral standards setters like the Basel International Monetary Fund on the other. In addition, under the umbrella of the international home of central bankers, the Bank for International Settlements, numerous other committees work across fields also covered by one or more of the groups I have just mentioned. There are some obvious weaknesses with such an assortment of international arrangements, notably the difficulty of coordinating initiatives where more than one group is working on an issue. This kind of coordination challenge can be further complicated by the participation in international discussions of various national officials without domestic authority in a particular area. The sheer proliferation of international arrangements, each with its own staff, has at times also led to a proliferation of studies and initiatives that become burdensome to the national regulators and supervisors who have been overtaxed at home since the onset of the crisis and ensuing domestic reform efforts. Yet there are also some strengths derived from the crowded international field of organizations and committees. One such virtue is that issues not falling squarely within the remit of a particular kind of standards setter can nonetheless be dealt with internationally. This, in fact, has been the experience with the ongoing international effort to agree on minimum margin requirements for derivatives that are not centrally cleared. Another is that different perspectives are frequently brought to bear on a single set of problems. At some point, it likely will be beneficial to rationalize somewhat the overlapping, sometimes competing efforts of these various international arrangements. For the near to medium term, though, it is important to have some principles for deciding upon the international agenda that should govern the efforts of these arrangements as a whole. First, initiatives should be prioritized. One point of emphasis should be completing, and ensuring implementation of, the internationally agreed-upon framework for containing the too- big-to-fail risks associated with systemically important firms. Another should be distilling the various ideas relating to short-term funding vulnerabilities into a few that have promise as discrete, relatively near-term initiatives, while continuing study of other, more comprehensive measures. A second, related principle is that initiatives should be focused and manageable, reflecting not only the limited capacity of participating national authorities, but also the desirability of reaching at least a temporary equilibrium at which firms can get on with the business of planning their strategies in a clearer regulatory environment, and regulators can begin to take stock of the cumulative effects and effectiveness of the changes that have taken place in that environment. A third principle is that, in most instances at least, international efforts to develop new regulatory mechanisms or approaches should build on experience derived from national practice in one or more jurisdictions. The challenges encountered during the initial effort to devise an LCR in the Basel Committee, with little or no precedent of national quantitative liquidity requirements from which to learn, should counsel caution in trying to construct new regulatory mechanisms from scratch at the international level. There will doubtless be exceptions to this general principle, such as where the transnational arbitrage incentives of a regulatory measure are so strong as to make national efforts difficult to initiate and sustain without substantial loss of financial activity to other countries. And, in the immediate aftermath of the crisis, there was a need to harness the broad-based demands for reform and move forward on some priority reforms without benefit of learning from national initiatives. On the other hand, there may also be areas where, notwithstanding the importance of a particular regulatory objective for international financial stability, it may be preferable to maintain a variety of approaches to achieving that objective. Bearing in mind both these principles and the key areas for policy change at central banks and other financial regulators, let me now suggest some specific subjects for near-term emphasis. As to the framework for systemically important financial institutions (SIFIs), I would urge that two ongoing initiatives be completed over the next year and two ideas that have been in the discussion stage be developed into concrete proposals. First, the proposal for a capital surcharge for systemically important banking organizations is nearing completion. The Basel Committee continues to refine the methodology to be used in identifying the firms and calibrating the surcharge amount--perhaps a byproduct of the fact that this methodology had to be developed in the Basel Committee without benefit of prior precedent. But I have confidence that this work will be successfully completed. The second ongoing initiative--work on designating non-bank SIFIs--has to date been pursued mostly in the IAIS and thus has concentrated on insurance companies. It is important to take the time to evaluate carefully the actual systemic risk associated with these companies, and to understand the amount of such risk relative to other financial firms, before fixing on a list of firms and surcharges. But this seems to me a realistic goal over the next six months. Third, we should build on the very good analytic work in the Basel Committee, both on simplifying capital requirements for credit risk and on fashioning standardized capital requirements for market risk, to apply standardized credit and market risk capital measures to all internationally active banking firms. As I mentioned earlier, the United States has already adopted such a requirement for capital requirements on credit risk. These standardized measures serve as a floor to guard against the potential for models-based capital measures to understate capital needs under some circumstances. They are also substantially less opaque than, for example, the advanced internal ratings-based approach of Basel II, and thus would provide more comparable measures that are also more amenable to international monitoring. Fourth, I would hope to see a requirement proposed for large internationally active financial institutions to have minimum amounts of long-term unsecured debt, which would be available to absorb losses in the event of insolvency. As I mentioned earlier, work on resolution continues, albeit at different paces in different jurisdictions. Given the complexities arising from the independent, often differing national bankruptcy and insolvency laws, the goal of achieving a fully integrated resolution regime for internationally active financial firms may take a good deal of time. But a minimum long-term debt requirement would at least provide national authorities with sufficient equity and long-term debt in these firms to bear all losses in the event of insolvency, and thereby counteract the moral hazard associated with taxpayer bailouts without risking disorderly failure. This requirement would not break brand new regulatory ground, since it would really be a modification of existing Tier 2 gone-concern capital concepts, and would complement the requirement for minimum equity levels included in Basel III. As implied in my identification of short-term funding vulnerabilities as a priority area, the best way forward here is considerably less easy to specify. Short-term initiatives on money market funds and triparty repo are both possible and desirable. In truth, though, because money market funds are largely American and, to a somewhat lesser extent, European, the United States and the European Union together have the ability to address the global run risks associated with these products. I think we also have the responsibility to do so, but not necessarily in identical ways. Accordingly, I would hope that both the United States and the European Union would each take effective action to counter the run risk, tailored as appropriate to their regulatory environments, and then explain those actions at IOSCO and the FSB, where their efficacy can be reviewed. Similarly, since the settlement process for triparty repo that remains of concern is centered at two institutions, both of which are regulated American banks, the United States can take effective action without need of an international agreement As to broader initiatives, proposals to require minimum haircuts for all securities financing transactions have been tentatively discussed in the FSB. This is certainly a ripe subject for discussion, insofar as securities financing transactions facilitate leverage, enable maturity transformation, and produce the kind of interconnectedness that can spawn runs and contagion. At present, no set of generally applicable prudential standards governs these activities. Even within regulated firms, microprudential risk-weighted capital standards have little effect, since they are calibrated against credit risk and most such transactions are short-term and fully (or over) collateralized. Thus requirements that would attach to instruments and transactions, as opposed to firms that happen to be prudentially regulated for other reasons, have considerable attraction. On the other hand, universal haircut requirements are the type of regulatory innovation that I suggested earlier was best developed internationally following some experience within financially significant countries. One may, for example, have significant concern about some of the unintended consequences that would ensue. My instinct, then, is that the analysis of this idea should continue within the FSB and, one hopes, in other venues both in and out of the official sector. There should also be concerted efforts internationally to gather relevant data, some of which is at present uncollected. But we are not going to be in a position to establish an international securities transaction financing regime in the near term. However, one proposal already on the international agenda might be reconsidered, so as to address more directly the short-term funding problem. Following completion of the LCR earlier this year, the Basel Committee is turning its attention back to the Net Stable Funding Ratio (NSFR), a proposal that was intended to complement the LCR by regulating liquidity levels beyond the 30-day LCR horizon. Like the LCR, the NSFR proposal raised many questions even among those favoring robust measures to deal with the liability side of firm balance sheets. There is some appeal to moving forward with this complementary measure fairly quickly by simply making some incremental changes to the NSFR while keeping its current structure. But I think we may be better advised to take the opportunity of this review to examine whether there are approaches that might address more directly the vulnerabilities for the financial system created by large non-deposit, short-term funding dependence at major financial institutions. I do not mean to prejudge the outcome of such an examination, or the degree to which we might build on measures being considered in various jurisdictions to address these vulnerabilities. But I do think it worth the effort. Responses to what I have described as the three challenges to pre-crisis central bank policies will continue to evolve. So will the reenergized international agenda for cooperation in international financial regulation. My aim tonight has not been to lay out a comprehensive program for either, but to suggest that these changing agendas are neither completely correlated nor completely independent. In suggesting some concrete next steps, I have tried to define some useful and important points of intersection between the two.

r130228a_FOMC

united states

Reflections on Reputation and its Consequences

raskin

Good afternoon. I want to thank the Federal Reserve Bank of Atlanta for inviting me to join you for today's 2013 banking outlook discussion. There are a number of interesting and very relevant topics on your agenda, most of which are rightly focused on the financial and regulatory environment. I would like to share some thoughts this afternoon on a broader topic, however, that may be due for a refreshed look: the relevance of a bank's reputation. Let's start in an elementary way in constructing a concept of reputation: We know that reputation is not entirely a moral trait. We understand that there is a distinction between character and reputation. When we say that someone shows good character, we are usually referring to something at the core of their being or personality. On the other hand, when we refer to a person's reputation, we recognize that reputation is our perception of the person, that it is externally derived and not necessarily intrinsic to that individual. In other words, we understand that a person may not have complete control over the perception that has been created. Reputation, through no fault of one's own, can be tarnished. In the same way, one's reputation can be golden, even though nothing was done to earn it. But like the notion of character, reputation can be earned and it can be a type of stored value for when challenges to one's own reputation come later. Now let's bring this distinction into the context of banks: Many bankers have a sterling character, and they operate financial institutions with sterling reputations that reflect that basic character. At the same time, there are bankers who, regardless of their personal character, manage financial institutions with reputations that have been tarnished. Their banks' reputations could have been tarnished by almost anything, but likely most tarnish is attributable to the subprime mortgage meltdown and the ensuing financial crisis that cost the economy trillions of dollars; left millions of Americans bankrupted, jobless, underemployed, or homeless; triggered massive litigation; and shook the confidence of our nation to the core. Many of the darkest manifestations of the financial crisis have finally begun to diminish: the boarded-up homes with overgrown lawns, the half-built skyscrapers, the "We Buy Houses Cheap" signs planted at exit ramps, the eviction notices nailed to front doors. But even as the economy comes back to life, our memory of these events is still sharp and the reputational damage suffered by U.S. financial institutions during the crisis endures. To be blunt, a lot of people have negative feelings about banks, which they distrust and blame for the huge infusions of taxpayer money into the financial system that were deemed necessary during the crisis. These reputational consequences--whether justified or not--are to be expected. Sociologists and economists have long remarked upon the central role that social trust plays in healthy markets. Market transactions depend on a whole series of assumptions that people must be able to rely on, including the soundness of money, the enforceability of contracts, the good will of their partners, the integrity of the legal system, and the common meanings of language. Social trust is the glue that holds markets and societies together. In the context of banking, social trust and reputation are related concepts. Banks themselves--in crisis or not--are particularly vulnerable to reputational consequences because of their public role. The principal social value of financial institutions is their ability to facilitate the efficient deployment of funds held by investors (and entities that pool these funds) to productive uses. This value is maximized when the cost to the entity putting capital to work is close to the price demanded by the entity that seeks a return on its investment. In traditional banking, this means that financial intermediation occurs most effectively when the interest rate charged for use of funds in lending is close to the interest rate paid for deposits. As the difference between the two grows (which would be attributable to amounts extracted by intermediaries as compensation for essential intermediation), the costs of borrowing for the purposes of creating productive projects become higher than they should be, with arguably negative reputational consequences. Given these particular reputational dimensions associated with financial institutions, might financial regulators have an interest in considering reputational harms analytically? Could there be benefits to understanding the ways that an individual financial institution's reputation-- or that of the financial industry as a whole--might have particular effects on, for example, safety and soundness, financial inclusion, or financial innovation? In my remarks today, I want to consider various aspects of how reputational harm manifests itself in banks and begin a dialogue with you about how we might refresh our thinking about this category of risk. I will start with a description of some factors that can affect a bank's reputation, especially in the wake of the financial crisis. Next, I will talk about ways in which reputation matters, including how supervisors can use their unique ability to see inside the institutions that they examine to uncover some early indicators of reputational problems. I will then turn to other reasons why policymakers may want to think about reputation. One reason involves possible consequences regarding financial inclusion; that is, a customer's ability to have a relationship with his or her bank that puts them in the position to save, access credit in a sustainable way, and understand the nature of the financial transactions in which they participate. Reputation also may help or hinder a bank's ability to innovate, so I will introduce this topic next. Finally, I want to frame a discussion around the recent cybersecurity threats that banks are facing and place them in the context of reputational risk so that they too can be discussed constructively. Of course, I preface these remarks with the admonition that these views are my own and may not be representative of those of the Federal Reserve Board. It has been more than five years since this country began experiencing a financial crisis that reverberated well beyond Wall Street. This crisis was unique, and many of its marks on individuals and communities remain. It was a crisis in which significant numbers of both subprime and prime mortgage defaults quickly spread across whole cities and regions until the impact was felt throughout the country. The devastation was magnified by waves of foreclosures, significant drops in house values, job losses, and, ultimately, significant reductions in household wealth, which have been responsible, in part, for the slow recovery we confront today. The causes of the crisis and the subsequent devastation are myriad, but to large swaths of the American public who have experienced the devastation, the causes rest squarely on the shoulders of financial institutions, especially the largest institutions. Further, many Americans direct their anger at not only banks, but policymakers as well. Because the economy pulled back from the brink of depression only through a massive and unprecedented infusion of public dollars, American taxpayers feel that they were forced into a position of accepting that the government had to put a lot on the line to save the financial system from ruin. And many of those taxpayers are still unhappy about such a massive government intervention that seemed to aid banks that were not held to account, while distressed households were left to pay the price. Unfortunately, in the public's view, little has happened to restore their trust and confidence in financial institutions. Since the crisis, the public's views of banks have been informed--for better or worse--by their experiences and those of their families and neighbors, who may have lost their homes, their jobs, or their household wealth. Many attempted unsuccessfully to modify their underwater mortgages, even when they were current on their payments. Against this backdrop, the public's lack of trust and confidence has been magnified by, among other things, the Occupy Wall Street movement, payday loans, overdraft fees, rate- and bonuses that seem to bear no relationship to performance or risk, failures in the foreclosure process, and a drumbeat of civil litigation. In the Internet age, the impact of consumer distrust is amplified: anyone can easily, cheaply, and anonymously create, organize, and participate in a protest. Participants do not have to gather physically to make their action felt. A recent survey found that 60 percent of American adults use social media, such as Facebook or Twitter, and 66 percent of those social media users (39 percent of all American adults) have used social media to engage on civic and political issues, including by encouraging other people to take action on a political or social issue. Take, for example, the impact of the consumer backlash that erupted in late 2011 when one of the nation's largest banks attempted to charge a $5 monthly fee for its debit card. A California woman, frustrated with the bank's decision to impose the fee, created a Facebook event, dubbed "Bank Transfer Day," and invited her friends to join her in transferring their money from large banks to credit unions on that day. In the five weeks leading up to Bank Transfer Day, this Facebook event received extensive press coverage and resulted in billions of dollars in deposits reportedly shifting out of large banks. The bank targeted by the Facebook protest ultimately reversed itself and declined to assess the monthly fee. Financial institutions of all sizes have shared in the fall-out--fairly or unfairly--from a general decline in their industry's reputation among the public. Moreover, the steady stream of litigation against financial institutions since the crisis has further harmed the reputations of specific firms among their customers. Consider that in today's financial institution sector, a substantial portion of a bank's enterprise value comes from intangible assets such as brand recognition and customer loyalty that may not appear on the balance sheet but are nevertheless critical to the bank's success. Also consider that at the end of 2012, deposits at commercial banks reached a record $10 trillion. At the same time, the share of each deposit dollar that banks lent out hit a post-financial crisis low in the third quarter, which means that banks' net interest margins have fallen sharply. Across the industry, loan-to-deposit ratios are going down. In 2007, banks' aggregate loan-to-deposit ratio was 91 percent. This ratio currently stands at 70 percent. In such a context, achieving higher earnings is a challenge. If bank profitability is going to improve in a context of low interest rates and higher compliance costs, lending income may remain low. Profits will need to come from elsewhere. One source of profits would be products that are not interest-rate dependent, but fee-dependent. In other words, compressed net interest margins mean that many banks may look to new fee-generating products and trading activity to enhance profits. The pressure to generate enhanced profits through high fees is palpable, and banks may choose to move aggressively down these paths. But when a bank already suffers from a poor reputation--either deservedly or as a knock-on effect of broader discontent with the financial industry--it likely will face difficulties in introducing new fee-generating products or activities without inviting further criticism and damage to its reputation. So an evaluation of the effects of the new product or activity on the bank's reputation prior to launch is arguably necessary. The effects of the financial crisis, combined with the power of the Internet to broadly and quickly publicize information--whether factually accurate or not--should alert banks to how they are managing their reputations. And supervisors have a duty to see that all risks are fully understood, even those risks that, like reputational risk, are unquantifiable or have not fully emerged. I believe this is an area where supervision can add value. To the extent possible, supervision can unveil hidden loss exposures that may be building up through the accumulation of reputational risk elements. If we were better able to identify and monitor such free-floating risk, and in so doing, to push bank boards of directors and senior management to pay more attention to reputational risk, we could help reduce the underpricing of these risks. Many have argued, and I think it's a compelling argument, that ineffective supervision and enforcement of existing laws and regulations contributed to the financial crisis. By tolerating reduced transparency of risk in balance sheets and in complex institutional portfolios, as well as arbitrage around capital requirements and other prudential measures, supervision may have encouraged the underpricing of risk. And the sudden correction of this underpricing of risk, in turn, accelerated the crisis. The crisis punished investors who accepted more risk than they thought they had taken on, it punished consumers who overleveraged themselves, it punished Americans who lost their jobs and homes, and it contributed to the decline of once- vibrant neighborhoods and towns. To mitigate the chances of such a crisis occurring again, supervisors need to redouble their efforts toward promoting greater transparency of risks and early confrontation of potential loss exposures. We should view these efforts as a set of responsibilities for both banks and regulators that are aligned to assure the public and markets that risks can be fully understood and accurately estimated and priced. In some ways, this perspective is not new territory for bank regulators. The Federal Reserve, for example, issued supervisory guidance in 1995 that identified the six primary risks that remain the focus of its supervisory program, and reputational risk is among them. said that, it is still a risk that both banks and supervisors should learn how to identify ex ante rather than ex post. So, while reputational risk is not a new concept by any means, it is an area that is ripe for additional work. For example, the enterprise risk management framework of the Committee of not address reputational risk. Likewise, the Basel capital frameworks exclude reputational risks from regulatory capital requirements. Accordingly, the current approach to managing reputational risk is largely reactive rather than proactive. Banks and examiners tend to focus their energies on handling the threats to their reputations that have already surfaced. This is not risk management; it is crisis management--a reactive approach aimed at limiting the damage. Instead, we should think about a supervisory approach that incentivizes bank managers to sufficiently contemplate, quantify if necessary, and control the factors that affect the level of such risks before they fully emerge in an unmitigated form. The way that the Federal Reserve supervises banking organizations may help identify risks sooner. For all banking organizations, the supervisory program here does not simply rely on an annual onsite examination. The Federal Reserve supplements its regular examination activities with a program of continuous monitoring between examinations. One of the key objectives of this program is to identify emerging risks and communicate with other regulators and the banks an updated risk assessment and supervisory strategy based on these risks. When we contemplate a supervisory approach that illuminates reputational risk, we might be able to more fully uncover the interconnection of risks that certain activities could impose on investors, creditors, counterparties, and taxpayers. In this approach, we would first and foremost need to encourage banks to assess the potential riskiness of particular operations, investments, products, and decisions to their reputations and, ultimately, to their enterprise value. As supervisors, one objective as we work with financial institutions to extract such information would be to try to develop ways of measuring the value of the risks that banks shift onto the financial safety net. There is also a relationship between reputation and financial inclusion, by which I mean the extent to which consumers can participate in a financial marketplace that consists of competitive providers of credit, savings vehicles, and sources of enabling financial information. As policymakers, we must address the perceived trustworthiness of those financial institutions that interact with the public and move the millions of Americans lingering in the margins of the financial marketplace into relationships that provide them with sustainable access to banking and credit, an understanding of how mortgages and credit work, and an understanding of how to create savings. Insurance Corporation's survey of the unbanked and underbanked show that the percentage of families earning $15,000 per year or less who reported that they have no bank account has been increasing steadily for the past five years, resulting in more than 28 percent of these families being unbanked as of 2011. Families slightly further up the income distribution scale, earning between $15,000 and $30,000 per year, are also financially marginalized: 12 percent reported being unbanked and almost 26 percent reported being underbanked in 2011. There are several potential reasons for these impediments to inclusion. When we examine barriers that individual consumers face in becoming financially included, we uncover trustworthiness and reputation. A Federal Reserve analysis of the most recent Survey of Consumer Finances suggests that the primary reason individuals do not have a transaction account is a simple dislike of dealing with financial institutions. If that dislike emanates from the reputation of the particular bank, or the reputation of the banking industry as a whole, policymakers and financial institutions will not be able to enhance financial inclusion without addressing the reputational context. I'd like to imagine how the public's sense of well-being might be enhanced by their interactions with financial institutions. If we paid attention to the experiences of consumers as they interact with various segments of the financial marketplace, what could we learn? If we see rigidities or imperfections in that interactive experience, what innovation might we imagine that would not only reduce reputational risk but create something new and potentially advantageous? Technological innovation was the subject of a recent award ceremony in San Francisco. Snapchat, all of which presumably do amazing things, although I don't understand exactly what. But, evidently, the real buzz at the ceremony was over something much more mundane that I for one have no problem understanding. That buzz was around a pedestrian item--a new and improved coffee cup lid. This lid, called FoamAroma, reportedly provides exactly the right set of openings to maximize aroma and recyclability, while minimizing the effects of coffee spurting out too fast. The point here is that the innovator noticed something simple that others had not: many coffee shop employees don't drink their coffee from cups with plastic lids like their customers do, so there was a market need that had not been recognized and then addressed. Here I am not just talking about the mixed miracle of mobile banking and mobile payments or being able to take a picture of a check with a smart phone and it appearing in my checking account. That's a topic that is amazing in its own right and worthy of a separate speech. I am talking about encouraging banks to pay attention to the banking experiences of their customers and finding process improvements or service elements that may lead to something seemingly mundane but valuable nonetheless. Some innovators see reputation itself as not just something to be managed, but as a product in and of itself. With buyers and sellers repeatedly and constantly interacting on the Internet, there are "reputation trails" that are being created that, when compiled, give an alternative set of markers about how trustworthy a particular buyer or seller may be. These reputation trails--gathered when you evaluate a product you've bought online or when you deliver the product that you've promised--create a picture of trust that some have argued has value that can be shaped. Perhaps reputation will one day transform commerce. But in the meantime, I would like to mention one set of reputational issues that the banking industry is confronting as we speak. As is the case for reputation trails, it too involves the Internet, but this use of the Internet is not being done in the spirit of cooperation and enhancement of public trust. This set of reputational issues comes in response to the recent substantial increase in cyberattacks, all of which have the potential to undermine the fundamental trust that the public puts into financial institutions. Cyberattacks on banks are occurring with increasing frequency, and concerted cooperative work between government and financial institutions is underway. Customers are increasingly being affected by the cybersecurity threats that banks face. Recently, distributed denial-of-service attacks have caused temporary disruptions of some web services. In September, the websites of several large banks were rendered inaccessible for several hours from attacks now attributed to possible foreign state-sponsored hackers. One of the greatest threats facing not just banks but many businesses and government agencies is hacking--and the possible theft of proprietary data and personal information about customers. This cybersecurity threat is increasing at a time when more and more bank customers depend on electronic and mobile banking. Workers are using their own laptops and smart phones or working remotely from home computers, and this increases the entry points to the systems that need to be protected. In addition, customers and vendors are linking their systems, enhancing efficiency, but also creating more opportunities for potential intrusions. But even beyond the potential theft of data and disruption of service, cyberattacks can represent significant reputational risk because they have the potential to create dissatisfaction among many customers or, even more chilling, total loss of consumer confidence. Cooperative work between government and industry is underway. Through the Department of the Treasury, many of the affected institutions have requested and received technical assistance from the Department of Homeland Security, which has been helpful in mitigating the attacks. Some institutions are researching new technologies for defense against cyberattacks through their Internet service providers or security vendors, and others are reviewing their incident response processes to better manage recovery time and communications among information technology, employees, vendors, media, and customers. Council are serving as the forum through which the financial services sector shares important information and develops critical infrastructure protection policies. Through their coordination, affected institutions and law enforcement agencies can share threat information and mitigation techniques. In addition, a recent Executive Order issued by the President represents a continued commitment to enhancing the security and resiliency of the nation's critical infrastructure to meet future threats. In closing, these have been some of my reflections on reputation as it applies to the business of banks. The concept of trust is relevant to how bankers engage in a business that is of benefit to the public and provides meaningful innovation to the core function of financial intermediation, as well as to how we as supervisors can engage in a process of observation that is forward-looking and of benefit to both the public and the institutions that we regulate. Thank you for your attention today. I look forward to taking your questions.

r130301a_FOMC

united states

Long-Term Interest Rates

bernanke

I will begin my remarks by posing a question: Why are long-term interest rates so low in the United States and in other major industrial countries? At first blush, the answer seems obvious: Central banks in those countries are pursuing accommodative monetary policies to boost growth and reduce slack in their economies. However, while central banks certainly play a key role in determining the behavior of long-term interest rates, theirs is only a proximate influence. A more complete explanation of the current low level of rates must take account of the broader economic environment in which central banks are currently operating and of the constraints that that environment places on their policy choices. Let me start with a brief overview of the recent history of long-term interest rates in some key economies. Chart 1 shows the 10-year government bond yields for five United States. Note that the movements in these yields are quite correlated despite some differences in the economic circumstances and central bank mandates in those countries. Further, with the notable exception of Japan, the levels of the yields have been very similar--indeed, strikingly so, with long-term yields declining over time and currently close to 2 percent in each case. The similar behavior of these yields attests to the global nature of the economic and financial developments of recent years, as well as to the broad similarity in how the monetary policymakers in the advanced economies have responded to these developments. Of course, Japanese yields are clearly a case apart, as Japan has endured an extended period of deflation, while inflation in the other four countries has been positive and generally close to the stated objectives of the monetary authorities. But even Japanese yields have shown some tendency to fluctuate along with other benchmark yields, and they have also declined over the period shown. In my comments, I will delve more deeply into the reasons why these long-term interest rates have fallen so low. This examination may be useful both for understanding the current stance of policy and also for thinking about how rates may evolve. In short, we expect that as the economy recovers, long-term rates will rise over time to more normal levels. A return to more normal conditions in financial markets would, of course, be most welcome. Many commentators have noted, however, that both an extended period of low rates and the transition back toward normal levels may pose risks to financial stability. In the final portion of my remarks, I will discuss some aspects of how the Federal Reserve is approaching these risks. So, why are long-term interest rates currently so low? To help answer this question, it is useful to decompose longer-term yields into three components: one reflecting expected inflation over the term of the security; another capturing the expected path of short-term real, or inflation-adjusted, interest rates; and a residual component known as the term premium. Of course, none of these three components is observed directly, but there are standard ways of estimating them. Chart 2 displays one version of this decomposition of the 10-year U.S. Treasury yield based on a term structure model developed by Federal Reserve staff. The broad features I will emphasize are similar to those found by other authors using a variety of methods. All three components of the 10-year yield have declined since 2007. The decomposition attributes much of the decline in the yield since 2010 to a sharp fall in the term premium, but the expected short-term real rate component also moved down significantly. Let's consider each component more closely. The expected inflation component has drifted gradually downward for many years and has become quite stable. In large part, the downward trend and stabilization of expected inflation in the United States are products of the increasing credibility of the Market Committee (FOMC) underscored this commitment by issuing a statement--since reaffirmed at its January 2013 meeting--on its longer-run goals and policy strategy, which included a longer-run inflation target of 2 percent. The anchoring of long-term inflation expectations near 2 percent has been a key factor influencing long-term interest rates over recent years. It almost certainly helped mitigate the strong disinflationary pressures immediately following the crisis. While I have not shown expected inflation for other advanced economies, the pictures would be very similar--again, except for Japan. With the expected inflation component of the 10-year rate near 2 percent and the rate itself a bit below 2 percent recently, it is clear that the combination of the other two components--the expected path of short-term real interest rates and the term premium-- must make a small net negative contribution. The expected path of short-term real interest rates is, of course, influenced by monetary policy, both the current stance of policy and market participants' expectations of how policy will evolve. The stance of monetary policy at any given time, in turn, is driven largely by the economic outlook, the risks surrounding that outlook, and at times other factors, such as whether the zero lower bound on nominal interest rates is binding. In the current environment, both policymakers and market participants widely agree that supporting the U.S. economic recovery while keeping inflation close to 2 percent will likely require real short-term rates, currently negative, to remain low for some time. As shown in chart 2, the expected average of the short-term real rate over the next 10 years has gradually declined to near zero over the past few years, in part reflecting downward revisions in expectations about the pace of the ongoing recovery and, hence, a pushing out of expectations regarding how long nominal short-term rates will remain low. As the persistence of the effects of the crisis have become clearer, the Federal Reserve's communications have reinforced the expectation that conditions are likely to warrant highly accommodative policy for some time: Most recently, the FOMC indicated that it expects to maintain an exceptionally low level of the federal funds rate at least as long as the unemployment rate is above 6.5 percent, projected inflation between one and two years ahead is no more than a half percentage point above the Committee's 2 percent target, and long-term inflation expectations remain stable. In discussing the role of monetary policy in determining the expected future path of real short-term rates, I have cheated a little: What monetary policy actually controls is nominal short-term rates. However, because inflation adjusts slowly, control of nominal short-term rates usually translates into control of real short-term rates over the short and medium term. In the longer term, real interest rates are determined primarily by nonmonetary factors, such as the expected return to capital investments, which in turn is closely related to the underlying strength of the economy. The fact that market yields currently incorporate an expectation of very low short-term real interest rates over the next 10 years suggests that market participants anticipate persistently slow growth and, consequently, low real returns to investment. In other words, the low level of expected real short rates may reflect not only investor expectations for a slow cyclical recovery but also some downgrading of longer-term growth prospects. Chart 3, which displays yields on inflation-indexed, long-term government bonds for the same five countries represented in chart 1, shows that expected real yields over the longer term are low in other advanced industrial economies as well. Note again the strong similarity in returns across these economies, suggesting once again the importance of common global factors. While indexed yields spiked up around the end of 2008, reflecting market stresses at the height of the crisis that undercut the demand for these bonds, these effects dissipated in 2009. Since that time, inflation-indexed yields have declined steadily and now stand below zero in each country. Apparently, low longer- term real rate expectations are playing an important role in accounting for low 10-year nominal rates in other industrial countries, as well as in the United States. The third and final component of the long-term interest rate is the term premium, defined as the residual component not captured by expected real short-term rates or expected inflation. As I noted, the largest portion of the downward move in long-term rates since 2010 appears to be due to a fall in the term premium, so it deserves some special discussion. In general, the term premium is the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities over the same period. In part, the term premium compensates bondholders for interest rate risk--the risk of capital gains and losses that interest rate changes imply for the value of longer-term bonds. Two changes in the nature of this interest rate risk have probably contributed to a general downward movement of the term premium in recent years. First, the volatility of Treasury yields has declined, in part because short-term rates are pressed up against the zero lower bound and are expected to remain there for some time to come. Second, the correlation of bond prices and stock prices has become increasingly negative over time, implying that bonds have become more valuable as a hedge against risks from holding other assets. Beyond interest rate risk, a number of other factors also affect the term premium in practice. For example, during periods of financial turmoil, the prices of longer-term Treasury securities are often driven up by so-called safe-haven demands of investors who place special value on the safety and liquidity of Treasury securities. Indeed, even during more placid periods, global demands for safe assets increase the value of Treasury securities. Many foreign governments and central banks, particularly those with sustained current account surpluses, hold substantial international reserves in the form of Treasuries. Foreign holdings of U.S. Treasury securities currently amount to about $5-1/2 trillion, roughly half of the total amount of marketable Treasury debt outstanding. The global economic and financial stresses of recent years--triggered first by the financial crisis, and then by the problems in the euro area--appear to have significantly elevated the safe-haven demand for Treasury securities at times, pushing down Treasury yields and implying a lower, or even a negative, term premium. Federal Reserve actions have also affected term premiums in recent years, most programs consist of open market purchases of agency debt, agency mortgage-backed securities, and longer-term Treasury securities. To the extent that Treasury securities and agency-guaranteed securities are not perfect substitutes for other assets, Federal Reserve purchases of these assets should lower their term premiums, putting downward pressure on longer-term interest rates and easing financial conditions more broadly. Although estimated effects vary, a growing body of research supports the view that LSAPs are effective at bringing down term premiums and thus reducing longer-term rates. course, the Federal Reserve has used this unconventional approach to lowering longer- term rates because, with short-term rates near zero, it can no longer use its conventional approach of cutting the target for the federal funds rate. Accordingly, this portion of the decline in the term premium might ultimately be attributed to the sluggish economic recovery, which prompted additional policy action from the Federal Reserve. Let's recap. Long-term interest rates are the sum of expected inflation, expected real short-term interest rates, and a term premium. Expected inflation has been low and stable, reflecting central bank mandates and credibility as well as considerable resource slack in the major industrial economies. Real interest rates are expected to remain low, reflecting the weakness of the recovery in advanced economies (and possibly some downgrading of longer-term growth prospects as well). This weakness, all else being equal, dictates that monetary policy must remain accommodative if it is to support the recovery and reduce disinflationary risks. Put another way, at the present time the major industrial economies apparently cannot sustain significantly higher real rates of return; in that respect, central banks--so long as they are meeting their price stability mandates-- have little choice but to take actions that keep nominal long-term rates relatively low, as suggested by the similarity in the levels of the rates shown in chart 1. Finally, term premiums are low or negative, reflecting a host of factors, including central bank actions in support of economic recovery. Thus, while the current constellation of long-term rates across many advanced countries has few precedents, it is not puzzling: It follows naturally from the economic circumstances of these countries and the implications of these circumstances for the policies of their central banks. So, how are long-term rates likely to evolve over coming years? It is worth pausing to note that, not that long ago, central bankers would have carefully avoided this topic. However, it is now a bedrock principle of central banking that transparency about the likely path of policy, in general, and interest rates, in particular, can increase the effectiveness of policy. In the present context, I would add that transparency may mitigate risks emanating from unexpected rate movements. Thus, let me turn to prospects for long-term rates, starting with the expected path of rates and then turning to deviations from the expected path that may arise. If, as the FOMC anticipates, the economic recovery continues at a moderate pace, with unemployment slowly declining and inflation expectations remaining near 2 percent, then long-term interest rates would be expected to rise gradually toward more normal levels over the next several years. This rise would occur as the market's view of the expected date at which the Federal Reserve will begin the removal of policy accommodation draws nearer and then as accommodation is removed. Some normalization of the term premium might also contribute to a rise in long-term rates. To illustrate possible paths, chart 4 displays four different forecasts of the evolution of the 10-year Treasury yield over coming years. The black line is the forecast gives the Congressional Budget Office forecast published in February, and the blue line presents the median from the Survey of Professional Forecasters, as reported in the first quarter of this year. Finally, the purple line shows a forecast based on the term structure model used for the decomposition of the 10-year yield in chart 2. While these forecasts embody a wide range of underlying models and assumptions, the basic message is clear-- long-term interest rates are expected to rise gradually over the next few years, rising (at least according to these forecasts) to around 3 percent at the end of 2014. The forecasts in chart 4 imply a total increase of between 200 and 300 basis points in long-term yields between now and 2017. Of course, the forecasts in chart 4 are just forecasts, and reality might well turn out to be different. Chart 5 provides three complementary approaches to summarizing the uncertainty surrounding forecasts of long-term rates. The dark gray bars in the chart are based on the range of forecasts reported in the Blue Chip Financial Forecasts, the blue bars are based on the historical uncertainty regarding long-term interest rates as reflected in the Board staff's FRB/US model of the U.S. economy, and the orange bars give a market-based measure of uncertainty derived from swaptions. These three different measures give a broadly similar picture about the upside and downside risks to the forecasts of long-term rates. Rates 100 basis points higher than the expected paths in chart 4 by 2014 are certainly plausible outcomes as judged by each of the three measures, and this uncertainty grows to as much as 175 basis points by 2017. Note, though, that while the risk of an unexpected rise in interest rates has drawn much attention, the level of long-term interest rates also could prove to be lower than forecast. Indeed, by the measures shown in chart 5, the upside and downside risks to the level of rates are roughly symmetric as of 2017. We also have some historical experience with increases in rates during tightening cycles to consider. For example, in 1994, 10-year Treasury yields rose about 220 basis points over the course of a year, reflecting an unexpected quickening in the pace of economic growth and signs of building inflation pressures. This increase in long-term rates appears to have reflected a mix of a pronounced rise in the expected path of the policy interest rate and some increase in the term premium. A rise of more than 200 basis points in a year is at the upper end of what is implied by the mean paths and uncertainty measures shown in charts 4 and 5, but these measures still admit a substantial probability of higher--and lower--paths. Overall, then, we anticipate that long-term rates will rise as the recovery progresses and expected short-term real rates and term premiums return to more normal levels. The precise timing and pace of the increase will depend importantly on how economic conditions develop, however, and is subject to considerable two-sided uncertainty. As I noted when I began my remarks, one reason to focus on the timing and pace of a possible increase in long-term rates is that these outcomes may have implications for financial stability. Commentators have raised two broad concerns surrounding the outlook for long-term rates. To oversimplify, the first risk is that rates will remain low, and the second is that they will not. In particular, in an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe "reach for yield" either through excessive use of leverage or through other forms of risk-taking. My Board colleague Jeremy Stein recently discussed how this behavior may arise in some financial markets, including credit markets. Alternatively, we face a risk that longer-term rates will rise sharply at some point, imposing capital losses on holders of fixed-income instruments, including financial institutions. Of course, the two risks may very well be mutually reinforcing: Taking on duration risk is one way investors may reach for yield, and the losses resulting from a sharp rise in longer-term rates will be greater if investors have done so. One might argue that the right response to these risks is to tighten monetary policy, raising long-term interest rates with the aim of forestalling any undesirable buildup of risk. I hope my discussion this evening has convinced you that, at least in economic circumstances of the sort that prevail today, such an approach could be quite costly and might well be counterproductive from the standpoint of promoting financial stability. Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low. Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading--ironically enough--to an even longer period of low long- term rates. Only a strong economy can deliver persistently high real returns to savers and investors, and the economies of the major industrial countries are still in the recovery phase. So how can financial stability concerns--which the Federal Reserve takes very seriously--be addressed? Our strategy, undertaken in cooperation with other regulators and central banks, has a number of elements. First, we have greatly increased our macroprudential oversight, with a particular focus on potential systemic vulnerabilities, including buildups of leverage and unstable funding patterns as well as interest rate risk. Under the umbrella of our attention to developments at the largest, most complex financial firms, making use of information gathered in our supervision of the institutions and drawn from financial market indicators of their health and systemic vulnerability. We also monitor the shadow banking sector, especially its interaction with regulated institutions; in this work, we look for factors that may leave the system vulnerable to an adverse "fire sale" dynamic, in which declining asset values could force leveraged investors to sell assets, depressing prices further. We exchange information regularly with other regulatory agencies, both directly and under the auspices of the Financial Stability Oversight Council. Throughout the Federal Reserve System, work in these areas is conducted by experts in banking, financial markets, monetary policy, and other disciplines, and at the Federal Reserve Board we have established our Office for Financial Stability Policy and Research to help coordinate this work. Findings are presented regularly to the Board and to the FOMC for use in its monetary policy deliberations. Second, recognizing that our monitoring of the financial sector will always be imperfect, we are using regulatory and supervisory tools to help ensure that financial institutions are sufficiently resilient to weather losses and periods of market turmoil arising from any source. Indeed, reflecting expectations embodied in the new Basel III and Dodd-Frank standards, the largest and most complex financial firms have substantially increased both their capital and their liquidity in recent years. Our current round of stress testing of the largest bank holding companies, to be completed early this month, examines whether the largest banking firms have sufficient capital to come through a seriously adverse economic downturn and still have the capacity to perform their roles as providers of credit. In a related exercise, we are also asking banks to stress- test the adequacy of their capital in the face of a hypothetical sharp upward shift in the term structure of interest rates. Third, our approach to communicating and implementing monetary policy provides the Federal Reserve with new tools that could potentially be used to mitigate the risk of sharp increases in interest rates. In 1994--the period discussed earlier in which sharp increases in interest rates strained financial markets--the FOMC's communication tools were very limited; indeed, it had just begun issuing public statements following policy moves. By contrast, in recent years, the Federal Reserve has provided a great deal of additional information about its expectations for the path of the economy and the stance of monetary policy. Most recently, as I mentioned, the FOMC announced unemployment and inflation thresholds characterizing conditions that will guide the timing of the first increase in the target for the federal funds rate. Further, the FOMC stated that a highly accommodative stance of monetary policy is likely to remain appropriate for a considerable time after our current asset purchase program ends. By providing greater clarity concerning the likely course of the federal funds rate, FOMC communication should both make policy more effective and reduce the risk that market misperceptions of the Committee's intentions would lead to unnecessary interest rate volatility. In addition, the Federal Reserve could, if necessary, use its balance sheet tools to mitigate the risk of a sharp rise in rates. For example, the Committee has indicated its intention to sell its agency securities gradually once conditions warrant. The Committee also noted, however, that the pace of sales could be adjusted up or down in response to material changes in either the economic outlook or financial conditions. In particular, adjustments to the pace or timing of asset sales could be used, under some circumstances, to dampen excessively sharp adjustments in longer-term interest rates. Let me finish with some thoughts on balancing the risks we face in the current challenging economic environment, at a time when our main policy tool, the federal funds rate, is near its effective lower bound. On the one hand, the Fed's dual mandate has led us to provide strong support for the recovery, both to promote maximum employment and to keep inflation from falling below our price stability objective. One purpose of this support is to prompt a return to the productive risk-taking that is essential to robust growth and to getting the unemployed back to work. On the other hand, we must be mindful of the possibility that sustained periods of low interest rates and highly accommodative policy could lead to excessive risk-taking in some financial markets. The balance here is not an easy one to strike. While the recent crisis is vivid testament to the costs of ill-judged risk-taking, we must also be aware of constraints posed by the present state of the economy. In light of the moderate pace of the recovery and the continued high level of economic slack, dialing back accommodation with the goal of deterring excessive risk-taking in some areas poses its own risks to growth, price stability, and, ultimately, financial stability. Indeed, as I noted, a premature removal of accommodation could, by slowing the economy, perversely serve to extend the period of low long-term rates. For these reasons, we are responding to financial stability concerns with the multipronged approach I summarized a moment ago, which relies primarily on monitoring, supervision and regulation, and communication. We will, however, be evaluating these issues carefully and on an ongoing basis; we will be alert for any developments that pose risks to the achievement of the Federal Reserve's mandated objectives of price stability and maximum employment; and we will, of course, remain prepared to use all of our tools as needed to address any such developments. and Banking

r130304a_FOMC

united states

Ending "Too Big to Fail"

powell

Today I will discuss "too big to fail" and the ongoing work since the financial crisis to end it. More than three years into this effort, there have been sweeping reforms to the regulation of large financial organizations in the United States and around the world. Substantial proportions of the new rules are designed to end the practice of bailing out such firms with taxpayer money. The too-big-to-fail reform project is massive in scope. In my view, it holds real promise. But the project will take years to complete. Success is not assured. In the meantime, some urge the adoption of more intrusive reforms, such as a return to Glass-Steagall-style activity limits, more stringent limits on size or systemic footprint, or a requirement that the largest institutions break up into much smaller pieces. I believe that public discussion and evaluation of these ideas is important. At a minimum, we need to thoroughly understand these alternatives in case the existing reform project falters. It is worth noting that too big to fail is not simply about size. A big institution is "too big" when there is an expectation that government will do whatever it takes to rescue that institution from failure, thus bestowing an effective risk premium subsidy. Reforms to end too big to fail must address the causes of this expectation. In broad terms, these reforms seek to eliminate the expectation of bailouts in two ways-- by significantly reducing the likelihood of systemic firm failures, and by greatly limiting the costs to society of such failures. When failures are unusual and the costs of such a failure are modest, the expectation at the heart of too big to fail will be substantially eliminated. My focus today is principally on the second of these two aspects of reform--containing the costs and systemic risks from failures, a goal being advanced by work to create a credible resolution authority. I hope you won't mind if I draw today on some of my own experiences over the years with too big to fail, beginning with my service at the Treasury Department during the after the rescue of Continental Illinois, which is sometimes said to have codified the practice of too big to fail. In my years at Treasury, we faced a wave of well over 1,000 savings and loan and bank failures. That included the failure of the Bank of New England Corp., then the third largest bank failure in U.S. history. It happened in January 1991, at a time of great stress in the financial system and the broader economy, and only days after 45 depository institutions in the region had been closed and 300,000 deposit accounts frozen. My Treasury colleagues and I joined Board in a conference room on a Sunday morning. We came to understand that either the FDIC would protect all of the bank's depositors, without regard to deposit insurance limits, or there would likely be a run on all the money center banks the next morning--the first such run since 1933. We chose the first option, without dissent. In the summer of 1991, we faced the Salomon Brothers crisis. Salomon, a global investment bank, was one of the largest financial institutions in the United States, and the largest dealer in U.S. government securities. The firm came under severe market pressure after some of its traders were caught submitting phony bids in Treasury bond auctions. As recounted in harrowing detail in the book "The Snowball," Salomon came within hours of failure over a weekend in late August. Salomon was clearly understood to be outside the safety net, and I recall no discussion of a government rescue. But the firm's failure would almost certainly have caused massive disruption in the markets. To this day, I am grateful that we resolved that crisis with neither a bailout nor a failure. Over 20 years later, both these events still frame the too big to fail reform agenda. Faced with the failure of a large commercial bank, we chose to extend the safety net rather than run the very real risk of a systemic depositor run. Our "near miss" with Salomon in 1991 presaged the enormous damage that would result from the failure of Lehman Brothers, another investment bank, in 2008. In fact, the dimension of the problem grew substantially over the years. Since 1991, the ratio of U.S. banking assets to annual gross domestic product in the United States has more than doubled, from 55 percent to 126 percent. Meanwhile, the percentage of those assets held by the largest three institutions has increased from 14 to 32 percent. Bailouts may have been more tolerable in the early 1990s when they were rare and their use for a failing bank was uncertain. That is no longer the case. Recent years have seen large and numerous bailouts as a result of the financial crisis. The public, the regulatory community, and large financial institutions themselves all agree now that too big to fail must end. As I said earlier, reforms to end too big to fail must wage the fight on two fronts. First, we need enhanced regulation to make large financial institution failures much less likely. Second, we need a credible mechanism to manage the failure of even the largest firms, without causing or amplifying a systemic crisis. Let's survey what has been proposed and implemented thus far in that two-front war on too big to fail. Much has been done since the crisis to strengthen the regulation of large banking organizations. The highlights would begin with the Basel III capital and liquidity reforms, including the graduated risk-based capital surcharges for globally systemic financial firms. These reforms are in the process of implementation in the United States and elsewhere. In imposes on the largest financial institutions enhanced prudential standards and also requires central clearing of derivatives. And banking regulators have implemented enhanced supervisory measures such as stress testing and recovery planning. While these measures are not the primary focus of my remarks today, I believe that they collectively constitute a broad and well-structured agenda to strengthen the resilience of the financial system. The Federal Reserve and the rest of the regulatory community are working diligently to implement that agenda. Today, risk-based capital and leverage ratios for banks of all sizes have improved materially since 2009 and are significantly above their levels in the years preceding the crisis. The banking sector overall also has substantially improved its liquidity position over the past few years. The system is undeniably stronger than before the crisis. It is neither possible nor desirable to regulate large financial institutions so that they literally cannot fail. But regulation can limit the systemwide impact of such a failure. Let's review what has been done since the crisis to reduce the damage to the system from the failure of one of the very largest firms. Under Dodd-Frank, nearly all financial institution failures, including those of large, complex institutions, will continue to be addressed as they were before passage of the new law. The holding company will be resolved in bankruptcy. Operating subsidiary failures will continue to be treated either under bankruptcy or, where applicable, under specialized resolution schemes, including the Federal Deposit Insurance Act for banks and the Securities Investor Protection Act for securities firms. Dodd-Frank eliminated the authority used by the Federal Reserve and other regulators to bail out individual institutions during the crisis, including Bear Stearns, Citicorp, Bank of America and AIG. But Congress also recognized that there may be rare instances in which the failure of a large financial firm could threaten the financial stability of the United States. To empower regulators to handle such a failure without destabilizing the financial system or exposing taxpayers to loss, Dodd-Frank created two important new regulatory tools. First, the Act requires large bank holding companies and nonbank financial firms designated by the Financial Stability Oversight Council to submit a resolution plan or "living will" for their rapid and orderly resolution under the Bankruptcy Code. Second, the Act created a new Orderly Liquidation Authority (OLA) as a backup to resolution in an ordinary bankruptcy. The largest bank holding companies submitted their first annual "living wills" to the Federal Reserve and the FDIC last summer. The initial round has yielded valuable information that is being used to identify and assess key challenges to resolvability under the Bankruptcy Code (Title I plans). The Title I plans will help to focus firm efforts to mitigate those challenges so that bankruptcy may be a viable resolution strategy for large institutions. These plans will also support development of the FDIC's backup resolution plans under OLA (Title II plans). The resolution plan process is iterative by design. There is still much work to be done by firms, domestic and foreign regulators, and national governments. We remain committed to ensuring that this work is done quickly but responsibly in the coming years. That brings us to the question of special resolution regimes. In October 2011, immediately before I was nominated to the Federal Reserve Board, I helped design a public simulation of the failure of a large financial institution under OLA. The cast included former senior government officials as well as leading experts from the private sector. The FDIC, the Federal Reserve, and the industry offered their assistance as we developed the simulation. From the outset, my earlier experience had led me to be skeptical about the possibility of resolving one of the largest financial companies without destabilizing the financial system. Today's global financial institutions are of staggering size and complexity. I believed that an attempt to resolve one of these firms--a firm with multiple business lines carried out through countless legal entities, across many jurisdictions and different legal systems--could easily spin out of control. The result could be greatly increased uncertainty for creditors and counterparties, which could trigger or accelerate a run on the failed institution that could quickly spread and destabilize the whole system. As we developed the simulation, however, I came around to the view that it is possible to resolve a large, global financial institution. What changed my mind was the FDIC's innovative "single-point-of-entry" approach, which was just coming into focus in 2011. This approach is a classic simplifier, making theoretically possible something that seemed impossibly complex. Under single point of entry, the FDIC will be appointed receiver of only the top-tier parent holding company of the failed financial group. Promptly after the parent holding company is placed into receivership, the FDIC will transfer the assets of the parent company (primarily its investments in subsidiaries) to a bridge holding company. Equity claims of the failed parent company's shareholders will be wiped out, and claims of its unsecured debt holders will be written down as necessary to reflect any losses in the receivership that the shareholders cannot cover. To capitalize the bridge holding company and the operating subsidiaries, and to permit transfer of ownership and control of the bridge company back to private hands, the FDIC will exchange the remaining claims of unsecured creditors of the parent for equity and/or debt claims of the bridge company. If necessary, the FDIC would provide temporary liquidity to the bridge company until the "bail-in" of the failed parent company's creditors can be accomplished. It is crucial to recognize how this approach addresses the problem of runs. Single point of entry is designed to focus losses on the shareholders and long-term debt holders of the failed parent and to produce a well-capitalized bridge holding company in place of the failed parent. The critical operating subsidiaries would be well capitalized, and would remain open for business. There would be much reduced incentives for creditors or customers of the operating subsidiaries to pull away, or for regulators to ring-fence or take other extraordinary measures. If the process can be fully worked out and understood by market participants, regulators, and the general public, it should work to resolve even the biggest institution without starting or accelerating a run, and without exposing taxpayers to loss. Single point of entry has important features in common with Chapter 11 bankruptcy reorganization. The principal differences in favor of OLA are the greater speed at which a firm can be placed into a resolution process and stabilized, the ability to avoid disruptive creditor actions, and the availability of temporary backup liquidity support to continue critical operations. Some have proposed changes to adapt the Bankruptcy Code to the purpose of handling the failure of a large financial institution--for example, to allow the government to provide debtor in possession (DIP) financing, or to allow a firm's primary regulator to initiate a bankruptcy filing. At a minimum, these proposals would further limit the need for OLA to the rarest of cases. As the development of the single-point-of-entry approach continues, it is important to continue to reduce the uncertainties that creditors and other market participants would face in connection with their potential treatment in OLA. Questions remain about how the FDIC will apply its broad statutory discretion. For example: How will the FDIC exercise its discretion to dissimilarly treat creditors of the same class? How will a creditor's "minimum right of recovery" be determined? And how will the FDIC value the failed firm? Stability demands that market participants have a reasonable degree of certainty about their treatment in OLA ex ante . This is an important concern. To reduce uncertainty, the FDIC is working to provide market participants as much clarity as is feasible regarding its contemplated approach to the failure of a systemic U.S. firm. Regulators will always need to maintain some degree of flexibility to manage the evolving failure of a systemic financial firm. But greater clarity would increase the predictability of this new process, and thus reduce the likelihood that creditors, counterparties, and customers would pull away from even a well-capitalized institution in OLA. I strongly support these efforts to provide more clarity to market participants. Two remaining challenges loom large: ensuring that all systemic financial firms have sufficient unsecured long-term debt at the parent level to recapitalize a bridge holding company in OLA; and mitigating cross-border impediments to resolution of a multinational financial firm. In consultation with the FDIC, the Federal Reserve is considering the pros and cons of a regulatory requirement that systemic U.S. financial firms maintain a minimum amount of long- term unsecured debt. Such a requirement would help ensure that equity and long-term debt holders of a systemic firm can bear potential future losses at the firm and sufficiently capitalize a bridge holding company. The cross-border activities of large institutions present another set of challenges to an orderly resolution. OLA is limited in its applicability to U.S.-chartered entities. Subsidiaries and bank branches of a U.S.-based systemic firm chartered in other countries could be ring-fenced or wound down separately under the insolvency laws of those countries, if foreign authorities did not have full confidence that local interests would be protected. Certain OLA stabilization mechanisms, including the one-day stay provision with respect to over-the-counter derivatives and other qualified financial contracts, may not apply outside the United States. Accordingly, counterparties to qualified financial contracts with the foreign subsidiaries and branches of a U.S. firm may have contractual rights and substantial economic incentives to terminate their transactions as soon as the U.S. parent enters an OLA resolution. Today, regulators and the industry are focused on the potential for addressing this concern through modifications to contractual cross-default practices and other means. Further progress on these cross-border challenges will require significant coordination among U.S. regulators and the key foreign central banks and supervisors for the largest financial firms. For example, the FDIC and the Bank of England are deeply engaged in this important work, as recently described in their joint paper applying the single-point-of-entry framework to the resolution of a globally active, U.S. - or U.K.-headquartered banking firm. has an active dialogue with the European Commission. These challenges will also require foreign jurisdictions to have national resolution regimes consistent with the Financial Stability It seems to me that efforts by U.S. and global regulators to fight too big to fail are generally on the right track. The Basel III and Dodd-Frank reforms designed to reduce the probability of failure of large banking firms are sensible and, for the most part, targeted at the causes of the crisis. They are being implemented thoughtfully and effectively. And I believe that those Financial Stability Board and Dodd-Frank reforms designed to permit the resolution of systemic firms without taxpayer exposure or undue disruption are very promising. That said, much of the work lies ahead. The critics also deserve a fair hearing. Criticism of the current U.S. and global anti-too-big-to-fail policies generally takes one of two tacks. Some of the criticism argues that Dodd-Frank--particularly the OLA mechanism-- enshrines taxpayer bailouts. I do not believe that it does. OLA requires by its terms that the losses of any financial company placed into FDIC receivership be borne by the private sector stockholders and creditors of the firm. Single point of entry can work without exposing taxpayers to loss. Although the FDIC has authority to provide temporary liquidity to a failed firm, any costs incurred by the FDIC in resolving the firm must be recovered completely from either the assets of the firm or assessments on the financial industry. The failed firm's investors, and, if necessary, other large financial firms, will bear any costs. That is "bail-in," not "bailout." Another strand of criticism argues that reforms do not go far enough and calls for more activity limits on banking firms, for limiting their size or systemic footprint, or for simply breaking them up. Some have urged the resurrection of the 1930s-era Glass-Steagall prohibitions--that is, preventing the affiliation of commercial banks with investment banks. This proposal seems neither directly related to the causes of the financial crisis, nor likely to help end too big to fail. The systemic run that led to the financial crisis began with traditional investment banks, such as Bear Stearns and Lehman Brothers. The activities of these firms were, of course, not affected by the repeal of Glass-Steagall. Commercial banking firms now engage in activities traditionally associated with investment banking, such as securities underwriting. The combination of these activities under a single corporate umbrella did not contribute meaningfully to the financial crisis. In my view, losses at the commercial banks were more importantly a consequence of bad credit underwriting and the failure of risk management systems to keep up with innovation and the explosive growth in securitization--developments that were not fundamentally driven by the There are also calls to further limit the size or systemic footprint of financial firms. Limits of this nature require, and deserve, careful analysis. Two provisions of existing law already impose size caps on U.S. banking firms. One limits acquisitions of banks by any bank holding company that controls more than 10 percent of the total insured deposits in the United States, and a second, added by Dodd-Frank, forbids acquisitions by any financial firm that controls more than 10 percent of the total liabilities of financial firms in the United States. In addition, Dodd-Frank added a new requirement that banking regulators consider "risk to the stability of the U.S. banking or financial system" in evaluating any proposed merger or acquisition by a bank or bank holding company. Critics argue that these restrictions are inadequate and subject to exceptions that continue to allow even the largest firms to grow, both organically and through acquisitions. The simplest forms of this idea would put a further absolute limit on the amount of balance sheet assets or liabilities, or on the risk-weighted assets of a financial firm. Capping the size or systemic footprint of each financial firm would limit the adverse systemic effects of the failure of any single firm. Smaller, simpler financial firms should be easier to manage and supervise in life, and easier to resolve in death. One option would be to impose a cap on a large U.S. banking firm's short-term non-deposit liabilities as a fraction of U.S. GDP. This form of proposal would allow such a firm to continue to increase assets and diversify its activities to achieve potentially available economies of scale and scope, so long as the firm finances expansion through more stable forms of funding. Any new size limits should be designed to limit systemic footprint while minimizing costs to efficiency. This will be a challenging task. The question of whether the benefits of further size limits would exceed any losses in scale economies and other efficiencies is the subject of ongoing research and debate. Some critics want to get right to the business of breaking up the big banks into smaller, more manageable, more easily resolvable pieces. At the heart of this proposal is the thought that no financial institution should be so large or complex that it cannot be allowed to fail, like any other private business, with losses to its equity holders and creditors, and consequences for senior management. If the largest institutions were too big to fail during the financial crisis, why not make them smaller? Today, the market still appears to provide a subsidy, of changing and uncertain amount, to very large banks to account for the possibility of a government bailout in the event of failure. This subsidy, in the form of lower funding costs, may encourage "too-bigness." There would be substantial externalities to a large bank failure as well. The market needs to believe--and it needs to be the case--that every private financial institution can fail and be resolved under our laws without imposing undue costs on society. The current reform agenda is designed to accomplish just that, through two channels. it is intended to substantially reduce the likelihood of failure through a broad range of stronger regulation, including higher capital and liquidity standards, stress tests and recovery planning among other reforms. S econd, it is intended to minimize the externalities from failure by making it possible to resolve a large financial institution without taxpayer exposure and without uncontainable disruption. If these reforms achieve their purpose, in my view they would be preferable to a government-imposed break-up, which would likely involve arbitrary judgments, efficiency losses, and a difficult transition. Today, few ideas can be less controversial than ending too big to fail. The question is given the regulators a game plan for ending too big to fail. The regulators, including the Federal Reserve, are forcefully implementing the plan we have been given. My own view is that the framework of current reforms is promising, and should be given time to work. In any case, too big to fail must end, even if more intrusive measures prove necessary in the end. Thank you very much.

r130304b_FOMC

united states

Challenges Confronting Monetary Policy

yellen

Thank you. I'm delighted to address the National Association for Business Economics (NABE), a group that has done so much to promote understanding of the economy and the appropriate role of policy. My topic today is the challenges confronting monetary policy in what has been an unusually weak recovery from a severe recession. I will discuss the Federal Reserve's ongoing efforts in these circumstances to speed the U.S. economy's return to maximum employment in a context of price stability. new steps to achieve this objective. In September, the Committee approved a new program of agency-guaranteed mortgage-backed securities (MBS) purchases, pledging to continue the program--contingent on favorable ongoing evaluations of its efficacy and costs--until there has been a substantial improvement in the outlook for the labor market. Most recently, in December the Committee announced that it would purchase longer-term Treasury securities after completion of the maturity extension program. At the same time, it revamped its forward guidance for the federal funds rate, explicitly linking the path of that rate to quantitative measures of economic performance. My goal today is to explain these policies and why I consider them appropriate under current conditions. With respect to the asset purchase program, I will discuss several economic indicators that I plan to consider in evaluating the outlook for the labor market and then offer my perspective at present on the program's efficacy and costs, an assessment I will continue updating in light of experience. The Committee's recent actions are shaped by the fact that the labor market is still far from healed from the trauma of the Great Recession. Despite some welcome improvement, employment remains well below its pre-recession peak, reflecting an economy that is still operating far short of its potential. At 7.9 percent in January, the unemployment rate has declined from its recent peak of 10 percent in October 2009. But that's still higher than unemployment ever reached in the 24 years prior to the recent recession and well above the 5.2 to 6 percent that is the central tendency of FOMC participants' estimates of the longer-run normal rate of unemployment. With economic activity constrained by fiscal consolidation, the lingering effects from the financial crisis, and the added headwinds of Europe's recession and debt problems, most FOMC participants reported in December that they expected only a gradual decline in unemployment over the next two years, to about 7 percent by the end of 2014. The official estimate of 12 million currently unemployed does not include 800,000 more discouraged workers who say they have given up looking for work. addition, nearly 8 million people, or 5.6 percent of the workforce, say they are working part time even though they would prefer full-time jobs. A broader measure of underemployment that includes these and others who want a job stands at 14.4 percent, nearly double the 7.9 percent "headline" rate that is most commonly reported in the media. The large shortfall of employment relative to its maximum level has imposed huge burdens on all too many American households and represents a substantial social cost. In addition, prolonged economic weakness could harm the economy's productive potential for years to come. The long-term unemployed can see their skills erode, making these workers less attractive to employers. If these jobless workers were to become less employable, the natural rate of unemployment might rise or, to the extent that they leave the labor force, we could see a persistently lower rate of labor force participation. In addition, the slow recovery has depressed the pace of capital accumulation, and it may also have hindered new business formation and innovation, developments that would have an adverse effect on structural productivity. In contrast to the large gap between actual and maximum employment, inflation, apart from fluctuations due to energy and other commodity prices, has been running for some time now a little below the rate of 2 percent per year that the Committee judges to be consistent with the Federal Reserve's dual mandate. The Committee anticipates that inflation will continue to run at or below 2 percent over the medium term. Moreover, expectations for inflation over the next 5 to 10 years remain well anchored, according to surveys of households and professional forecasters. With employment so far from its maximum level and with inflation running below the Committee's 2 percent objective, I believe it's appropriate for progress in the labor market to take center stage in the conduct of monetary policy. Let me therefore turn to the FOMC's recent actions and describe how I see them promoting this important goal. I'll begin with the Committee's forward guidance for the federal funds rate. The FOMC has employed such forward guidance since 2003 but has relied more heavily on it since December 2008, when the target for the federal funds rate was reduced to its effective lower bound. In current circumstances, forward guidance can lower private- sector expectations regarding the future path of short-term rates, thereby reducing longer- term interest rates on a wide range of debt instruments and also raising asset prices, leading to more accommodative financial conditions. In addition, given the FOMC's stated intention to sell assets only after the federal funds rate target is increased, any outward shift in the expected date of liftoff for the federal funds rate suggests that the Federal Reserve will be holding a large stock of assets on its balance sheet longer, which should work to further increase accommodation. Starting in March 2009, the FOMC's postmeeting statements noted that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period," and in November of the same year added "low rates of resource utilization, subdued inflation trends, and stable inflation expectations" as justification for this stance." through mid-2013" for the words "for an extended period." This date was moved further into the future several times, most recently last September, when it was shifted to mid- Also in September, the Committee changed the language related to that commitment, dropping the reference to "low rates of resource utilization and a subdued outlook for inflation." Instead, it emphasized that "a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens," clarifying the Committee's intention to continue to provide support well into the recovery. Finally, last December, the Committee recast its forward guidance for the federal funds rate by specifying a set of quantitative economic conditions that would warrant holding the federal funds rate at the effective lower bound. Specifically, the Committee anticipates that exceptionally low levels for the federal funds rate will be appropriate "at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." An important objective of these changes in forward guidance is to enhance the public's understanding of the Committee's policy strategy and its "reaction function"-- namely, how the FOMC anticipates varying its federal funds rate target in response to evolving economic developments. For example, the Committee's initial, calendar-based guidance did not clearly convey the rationale for the specified date. In particular, when the Committee extended the calendar date, the public was left to infer whether the change reflected a deterioration in the Committee's economic outlook or, instead, a decision to increase policy accommodation. In my view, the language now incorporated into the statement affirmatively conveys the Committee's determination to keep monetary policy highly accommodative until well into the recovery. And the specific numbers that were selected as thresholds for a possible change in the federal funds rate target should confirm that the FOMC expects to hold that target lower for longer than would be typical during a normal economic recovery. This improved guidance should help the public to accurately adjust their expectations for the federal funds rate in response to new financial and economic information, which should make policy more effective. In addition, I hope that improved guidance will help to boost confidence in the outlook and bolster households' unusually depressed expectations for income gains, which in turn will spur a faster recovery. A considerable body of research suggests that, in normal times, the evolution of the federal funds rate target can be reasonably well described by some variant of the widely known Taylor rule. Rules of this type have been shown to work quite well as guidelines for policy under normal conditions, and they are familiar to market participants, helping them judge how short-term rates are likely to respond to changing economic conditions. The current situation, however, is abnormal in two important and related ways. First, in the aftermath of the financial crisis, there has been an unusually large and persistent shortfall in aggregate demand. Second, use of the federal funds rate has been constrained by the effective lower bound so that monetary policy has been unable to provide as much accommodation as conventional policy rules suggest would be appropriate, given the weakness in aggregate demand. I've previously argued that, in such circumstances, optimal policy prescriptions for the federal funds rate's path diverge notably from those of standard rules. Williams have shown that when policy is constrained by the effective lower bound, policymakers can achieve superior economic outcomes by committing to keep the federal funds rate lower for longer than would be called for by the interest rate rules that serve as reasonably reliable guides for monetary policy in more normal times. Committing to keep the federal funds rate lower for longer helps bring down longer-term interest rates immediately and thereby helps compensate for the inability of policymakers to lower short-term rates as much as simple rules would call for. I view the Committee's current rate guidance as embodying exactly such a "lower for longer" commitment. In normal times, the FOMC would be expected to tighten monetary policy before unemployment fell as low as 6-1/2 percent. Under the new thresholds guidance, the public is informed that tightening is unlikely as long as unemployment remains above 6-1/2 percent and inflation one to two years out is projected to be no more than a half percentage point above the FOMC's 2 percent longer- run goal. The evidence suggests that the evolution I've described in the Committee's forward guidance, particularly the new thresholds, has shifted the market's view of how forceful the FOMC intends to be in supporting the recovery. In the Federal Reserve Bank of New York's Survey of Primary Dealers, for example, participants have repeatedly revised downward the unemployment rate at which they anticipate that tightening will first occur. I mentioned that the FOMC's new forward guidance offers considerable insight into the Committee's likely reaction function, but I should note that the guidance it provides is not complete. For example, the Committee has not specified exactly how it intends to vary the federal funds rate after liftoff from the effective lower bound, although it has stated that "when the Committee decides to begin to remove policy accommodation, it will take a balanced approach." This language is consistent with optimal policy prescriptions that call for lower-for-longer considerations to pertain to the path of the federal funds rate both before and after liftoff. In addition, the guidance specifies thresholds for possible action, not triggers that will necessarily prompt an increase in the federal funds rate. The FOMC statement therefore notes that "in determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments." For example, the Committee could decide to defer action even after the unemployment rate has declined below 6-1/2 percent if inflation is running and expected to continue at a rate significantly below the Committee's 2 percent objective. Alternatively, the Committee might judge that the unemployment rate significantly understates the actual degree of labor market slack. A decline in the unemployment rate could, for example, primarily reflect the exit from the labor force of discouraged job seekers. That is an important reason why the Committee will consider a broad range of labor market indicators. I will discuss some of the additional indicators I plan to consider in judging the strength of the labor market in connection with the Committee's current asset purchase program. Turning next to that program, the Federal Reserve initiated a new asset purchase program last September, extending it in December, under which the Federal Reserve is currently buying agency-guaranteed MBS at a pace of $40 billion per month and longer- term Treasury securities at a pace of $45 billion per month. As with the guidance for the federal funds rate, the Committee tied the new program to labor market conditions, stating that purchases would continue until there is a substantial improvement in the outlook for the labor market in a context of price stability. The FOMC's earlier large- scale asset purchase programs, in contrast, were fixed in size and carried out on a specified schedule. The Committee has also noted that, in determining the size, pace, and composition of its asset purchases, it would take appropriate account of the likely efficacy and costs of such purchases. The purpose of the new asset purchase program is to foster a stronger economic recovery, or, put differently, to help the economy attain "escape velocity." By lowering longer-term interest rates, these asset purchases are expected to spur spending, particularly on interest-sensitive purchases such as homes, cars, and other consumer durables. Research on the effects of such asset purchases suggests that what matters for the reaction of longer-term interest rates to a purchase program is the extent to which the program leads market participants to change their expectations concerning the entire path of the Federal Reserve's holdings of longer-term securities. Other things being equal, the greater the effect that a purchase program has on the expected path of the Federal Reserve's securities holdings, the more substantial should be the downward pressure on the term premium in longer-term interest rates. By linking the pace of purchases and how long that pace will be maintained to the outlook for the labor market, the program acts as a sort of automatic stabilizer: As market perceptions of the prospects for the economy vary, so too should expectations of the pace and duration of asset purchases. In stating that asset purchases will continue, subject to caveats pertaining to efficacy and costs, until there has been a substantial improvement in the outlook for the labor market, the FOMC established a criterion that differs in three important respects from the forward guidance for the federal funds rate: (1) It is qualitative, not quantitative; (2) it refers to an improvement in the outlook for the labor market rather than an improvement in actual labor market conditions; and (3) it requires the Committee not only to consider progress toward its employment goal, but also to evaluate the efficacy and costs of asset purchases on an ongoing basis. The public is, naturally, eager to understand how the FOMC will approach such complex judgments. I cannot, of course, speak for the Committee on this issue, but I can spell out some of the key factors that will guide my conclusions. The first imperative will be to judge what constitutes a substantial improvement in the outlook for the labor market. Federal Reserve research concludes that the unemployment rate is probably the best single indicator of current labor market conditions. In addition, it is a good predictor of future labor market developments. Since 1978, periods during which the unemployment rate declined 1/2 percentage point or more over two quarters were followed by further declines over the subsequent two quarters about 75 percent of the time. That said, the unemployment rate also has its limitations. As I noted before, the unemployment rate may decline for reasons other than improved labor demand, such as when workers become discouraged and drop out of the labor force. In addition, while movements in the rate tend to be fairly persistent, recent history provides several cases in which the unemployment rate fell substantially and then stabilized at still-elevated levels. For example, between the fourth quarter of 2010 and the first quarter of 2011, the unemployment rate fell 1/2 percentage point but was then little changed over the next two quarters. Similarly, the unemployment rate fell 3/4 percentage point between the third quarter of 2011 and the first quarter of 2012, only to level off over the subsequent spring and summer. To judge whether there has been a substantial improvement in the outlook for the labor market, I therefore expect to consider additional labor market indicators along with the overall outlook for economic growth. For example, the pace of payroll employment growth is highly correlated with a diverse set of labor market indicators, and a decline in unemployment is more likely to signal genuine improvement in the labor market when it is combined with a healthy pace of job gains. The payroll employment data, however, also have shortcomings. In particular, they are subject to substantial revision. When the Labor Department released its annual benchmarking of the establishment survey data last month, it revised up its estimate of In addition, I am likely to supplement the data on employment and unemployment with measures of gross job flows, such as job loss and hiring, which describe the underlying dynamics of the labor market. For instance, layoffs and discharges as a share of total employment have already returned to their pre-recession level, while the hiring rate remains depressed. Therefore, going forward, I would look for an increase in the rate of hiring. Similarly, a pickup in the quit rate, which also remains at a low level, would signal that workers perceive that their chances to be rehired are good--in other words, that labor demand has strengthened. I also intend to consider my forecast of the overall pace of spending and growth in the economy. A decline in unemployment, when it is not accompanied by sufficiently strong growth, may not indicate a substantial improvement in the labor market outlook. Similarly, a convincing pickup in growth that is expected to be sustained could prompt a determination that the outlook for the labor market had substantially improved even absent any substantial decline at that point in the unemployment rate. Let me turn next to the efficacy and potential costs of asset purchases, a topic discussed at recent FOMC meetings and that I suspect will be discussed at succeeding meetings as well. I see the currently available evidence as suggesting that our asset purchases have been reasonably efficacious in stimulating spending. There is considerable evidence that these purchases have eased financial conditions, and so have presumably increased interest-sensitive spending. Research suggests that our purchases of mortgage-backed securities pushed down MBS yields and that MBS yields pass through, with a lag, to mortgage rates. Indeed, I see the recent strength in housing and consumer durables, such as motor vehicle purchases, as partly reflecting the effect of reduced borrowing costs. Plausible, albeit uncertain, estimates of the ultimate economic effect of asset purchases can be obtained from simulations of the Board's FRB/US model. Such simulations suggest that a hypothetical program involving $500 billion in longer- term asset purchases would serve to lower the unemployment rate by close to 1/4 percentage point within three years while keeping inflation close to the Committee's 2 percent objective. One issue on which there has been considerable debate is whether low interest rates are doing as much to promote economic growth since the financial crisis as they would have before the financial crisis--whether the interest rate channel of transmission for monetary policy has been attenuated. I agree with those who think this channel has been partially blocked. Individuals who have impaired credit histories, have been unemployed, or hold underwater mortgages are experiencing great difficulty gaining access to credit, whether to buy or refinance a home, finance a small business, or support spending for other needs. Even those with good, but not stellar, credit histories and sufficient income are facing capacity constraints in the mortgage market. However, even if the interest rate channel is less powerful right now than it was before the crisis, asset purchases still work to support economic growth through other channels, including by boosting stock prices and house values. The resulting improvement in household wealth supports greater consumption spending. Turning to the potential costs of the Federal Reserve's asset purchases, there are some that definitely need to be monitored over time. At this stage, I do not see any that would cause me to advocate a curtailment of our purchase program. To address one concern that I have heard, there is no evidence that the Federal Reserve's purchases have impaired the functioning of financial markets, and, while we continue to monitor market function carefully, so long as we pursue our purchases sensibly, I do not expect market functioning to become a problem in the future. Further, I've argued previously, and still judge, that the FOMC has the tools it needs to withdraw accommodation, even if the balance sheet at that time is large. These tools include a new one, approved by the Congress during the financial crisis, which allows the Federal Reserve to pay banks interest on their reserves. A suite of supporting tools, such as reverse repurchase agreements with a wide range of counterparties and the Term Deposit Facility, are routinely tested to make sure that the Federal Reserve is prepared to use them and that they will work as planned. Two additional costs have been discussed at recent meetings of the FOMC. First, the expansion of the balance sheet has implications for the Federal Reserve's earnings from its asset holdings and, hence, for its remittances to the Treasury. Second, some have raised the possibility that the Committee's policies could have negative consequences for financial stability. With respect to the Federal Reserve's remittances, balance sheet operations are intended to support economic growth and job creation in a context of price stability and not to maximize Federal Reserve income. There is a possibility that the Federal Reserve's earnings from its assets and the remittances of those earnings to the Treasury will decline later in the decade, perhaps even ceasing entirely for some period. It is important to note, however, that any losses that could conceivably occur would not impair the Federal Reserve's conduct of monetary policy. Further, even if remittances to the Treasury ceased for a time, it is highly likely that average annual remittances over the period affected by our asset purchases will be higher than the pre-crisis norms. Though our expanded portfolio of longer-term securities has in recent years translated into substantial earnings and remittances to the Treasury, the Federal Reserve has, to be sure, increased its exposure to interest rate risk by lengthening the average maturity of its securities holdings. As the economic recovery strengthens and monetary policy normalizes, the Federal Reserve's net interest income will likely decline. In particular, the Federal Reserve's interest expenses will increase as short-term interest rates rise, while reserve balances initially remain sizable. In addition, policy normalization may well involve significant sales of the Federal Reserve's agency securities holdings, and losses could be incurred in these sales. A recent study by the Board staff considered the effect of a number of scenarios on Federal Reserve income, based on assumptions about the course of balance sheet normalization that are consistent with the exit strategy principles adopted at the June 2011 FOMC meeting. The projections resulting from this exercise imply that Federal Reserve remittances to the Treasury will likely decline for a time. In some scenarios, they decline to zero. Once the Federal Reserve's portfolio is normalized, however, earnings are projected to return to their long run trend. The study supports the conclusion that the Federal Reserve's purchase programs will very likely prove to have been a net plus for cumulative income and remittances to the Treasury over the period from 2008 through 2025, by which time it is assumed that the balance sheet has been normalized. Focusing only on the ebb and flow of the Federal Reserve's remittances to the Treasury, however, is not, in my view, the appropriate way to evaluate the effect of these purchases on the government's finances. More germane is the overall effect of the program on federal finances. If the purchases provide even a modest boost to economic activity, increased tax payments would swamp any reduction in remittances. By depressing longer-term interest rates, the purchases also hold down the Treasury's debt service costs. These effects can be quantified through simulations of the Board's FRB/US model. In the simulation I described earlier, a hypothetical program involving $500 billion of asset purchases would reduce the ratio of federal debt to gross domestic mainly reflects stronger tax revenue as a result of more-robust economic activity. Finally, let me comment on the possibility that our asset purchase program could threaten financial stability by promoting excessive risk-taking, a significant concern that I and my colleagues take very seriously. To put this concern in context, though, remember that during the most intense phase of the financial crisis, risk aversion surged. Even in the aftermath of the crisis, businesses, banks, and investors have been exceptionally cautious, presumably reflecting their concern about future business conditions, uncertainty about economic policy, and the perception of pronounced tail risks relating, for example, to stresses in global financial markets. I see one purpose of the Committee's accommodative policies as promoting a return to prudent risk-taking. Indeed, the return to more normal levels of risk-taking and the associated normalization of credit markets have been vital to recovery from the Great Recession. Of course, risk-taking can go too far, thereby threatening future economic performance, and a low interest rate environment has the potential to induce investors to take on too much leverage and reach too aggressively for yield. At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability. That said, such trends need to be carefully monitored and addressed, and the Federal Reserve has invested considerable resources to establish new surveillance programs to assess risks in the financial system. In the aftermath of the crisis, regulators here and around the world are also implementing a broad range of reforms to mitigate systemic risk. With respect to the large financial institutions that it supervises, the Federal Reserve is using a variety of supervisory tools to assess their exposure to, and proper management of, interest rate risk. To the extent that investors are reaching for yield, I see the low interest rate environment and not the FOMC's asset purchases, per se, as a contributing factor. It is true that asset purchases put downward pressure on the term premium component of longer-term rates, and that discontinuing purchases would likely cause term premiums to rise. But ending asset purchases before observing a substantial improvement in the labor market might also create expectations that the amount of accommodation provided would not be sufficient to sustain the improvement in the economy. This weakening in the economic outlook might bring down the expected path of the federal funds rate, with the result that longer-term interest rates might not rise appreciably, on net. Moreover, a weakening of the economic environment could also create significant financial stability risks. That said, financial stability concerns, to my mind, are the most important potential cost associated with the current stance of monetary policy. In these remarks, I have reviewed recent FOMC policy actions--actions I have supported because I believe they will help foster a stronger recovery and keep inflation close to the Committee's longer-run target. I recognize that the Federal Reserve's highly accommodative policy entails some costs and risks. It will be important both to monitor them and to continue strengthening our financial system. However, insufficiently forceful action to achieve our dual mandate also entails costs and risks. There is the high cost that unemployed workers and their families are paying in this disappointingly slow recovery. There is the risk of longer-term damage to the labor market and the economy's productive capacity. At present, I view the balance of risks as still calling for a highly accommodative monetary policy to support a stronger recovery and more-rapid growth in employment. Thank you for inviting me to speak to you today at NABE's spring conference. press release, July 12, press release, January 3, . , vol. 32 symposium sponsored by the Federal Reserve Bank of Kansas City, held in

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Comments on Housing and Mortgage Markets

duke

Since joining the Board in 2008 amid a crisis centered on mortgage lending, I have focused much of my attention on housing and mortgage markets, issues surrounding foreclosures, and neighborhood stabilization. Today I am pleased to provide some comments about the outlook for housing and mortgages. Before I proceed, I should note that the views I express are my own and not necessarily those of my colleagues on the I think the evidence is pretty clear that a recovery in the housing market is finally under way. National house prices have increased for 13 consecutive months and are now 10 percent higher than at their trough in December 2011. Construction activity has also picked up. Housing starts and permits are still far below their peaks but have risen by about one-third over the past year, and homebuilder sentiment has improved notably. New and existing home sales have increased. In national surveys, households report that low interest rates and house prices make it a good time to buy a home; they also appear more certain that house price gains will continue. And real estate agents report stronger traffic of people shopping for homes. The open question is whether this positive trend is sustainable. When I look at the factors driving recent improvement and those that have inhibited housing recovery through the downturn, I conclude that recent gains in the housing market will continue and perhaps even strengthen. My main hesitation with this forecast is that mortgage credit conditions remain quite tight for many would-be borrowers, and I suspect that the easing of these conditions will be a slow and gradual process. In particular, I expect demand to come from a pickup in new household formation, but I also recognize that these households may be the very population that faces especially tight credit conditions. I will return to the subject of mortgage credit later in my talk. Last year's house price gains were achieved in an environment largely defined by historically unusual factors: a large number of underwater homeowners, which have effectively reduced the supply of properties for sale; the fact that foreclosed properties continue to represent an outsized, although gradually decreasing, share of sales transactions; and strong demand on the part of investors. Turning first to underwater homeowners, although the actual number of these homeowners is unknown--plausible estimates range fairly broadly from 7 million to 14 million--it seems clear that some are unable or unwilling to sell their homes because they lack the funds to carry out the transactions or are reluctant to realize losses. As a result, some potential sellers have not responded to the signs of housing market recovery by putting their properties on the market. The number of single-family homes for sale has fallen to its lowest level in a decade, which has likely contributed to the recent house price gains. Indeed, cities that started 2012 with an outsized share of underwater homeowners have seen some of the largest price increases. Next, sales of properties from lenders' real estate owned (REO) inventories represented 14 percent of sales transactions in 2012, down from 21 percent in 2010. These sales have damped house prices by increasing the supply of homes for sale and, in some areas, by reducing the desirability of a neighborhood as a place to live. This effect may be diminishing, as the foreclosure inventory has gradually started to decline. The decline in REO sales has been partly offset by an increase in short sales, but these properties tend to transact at smaller discounts than REO properties. Finally, investors have been attracted to the housing market because of the low prices on REO properties. The properties tend to sell at lower prices because some are damaged and because lenders may be more motivated sellers than the typical homeowner. The combination of a low purchase price, a possible steady stream of rental income, and the potential for significant capital gains has attracted considerable interest from large institutional investors as well as from the mom-and-pop investors who have historically dominated this market. This increase in investor demand has supported house prices so far and may continue to provide a floor for them. What role will these forces play going forward? I think house prices will continue to rise, as the supply of existing homes on the market will remain quite tight. I do not believe that a flood of houses on the market from households that are currently underwater or from bank REO is likely to materialize or to be sufficient to outpace growing demand. As house price gains continue, more underwater homeowners will regain a position of positive equity in their homes. House price increases of 10 percent or less would be sufficient for about 40 percent of underwater homeowners to regain positive equity; presumably, some subset of those homeowners will be interested in selling their homes. If the majority of newly above-water sellers exit homeownership, they could create a substantial increase in overall supply and change the trajectory of house prices. But I think it is much more likely that many of them will also purchase a home in the same market, perhaps moving up to a larger home or downsizing to a smaller one. In that case, they would create additional demand as well as supply. And, in any event, the sales would provide more clarity about the level of house prices and increase liquidity in these markets. The weight of the shadow inventory--homes in the process of foreclosure or loans 90 days or more past due--on home prices is likely to wane as the number of loans entering the foreclosure pipeline declines and those already in the pipeline resolve. I think the nature and duration of the effect on prices will vary across the country, depending on the location of the shadow inventory and the speed of its resolution. Some evidence of this relationship can be found by comparing the relative performance of house prices in states where foreclosures are processed through the court system (judicial states) with performance in states where foreclosures do not go through the courts Through mid-2012, house prices fell further in nonjudicial states than in judicial states, likely in part because the faster nonjudicial foreclosure process boosted the for- sale inventory in those states. Since that time, though, prices have moved back up in nonjudicial states, as the inventory was worked down while prices drifted lower in judicial states as inventory accumulated. Over time, the shadow inventory is becoming more concentrated in states with the slower judicial foreclosure processes and will likely continue to damp house prices in those states. Nonetheless, the specific dynamics going forward will depend on the pace at which these properties are put on the market for sale. Investor activity is difficult to predict. As house prices rise, some investors may no longer find purchasing homes to be a profitable enterprise. Other investors may want to lock in their gains and sell properties. The prospect of steady rental income and possible further capital gains, though, will likely continue to be attractive to many investors. In addition, I suspect that the development of large-scale rental of single- family homes as an asset class has gained enough traction with investors to continue in some form. For the housing recovery to gain true momentum, however, demand for housing among owner-occupiers must increase. As I noted earlier, household sentiment toward homebuying, as measured by households' assessments of purchasing conditions and by homebuyer traffic, appears to be on an upswing and should gradually strengthen demand. But I expect the strongest impetus to recovery to come from pent-up demand for housing in the form of household formation. Between 2006 and 2011, roughly 550,000 new households formed per year, on net, significantly fewer than the 1.35 million per year over the previous five years. Indeed, household formation from 2006 to 2011 appears to have been far lower than in any other five-year period since at least the mid-1960s. Federal Reserve staff research indicates that this decline in household formation largely reflects the weak labor market, especially among younger adults. If you have an adult son or daughter still living at home because he or she can't find a job, it might not surprise you to know that the number of individuals aged 18 to 30 living with older family members increased between 2006 and 2010 by over 1 million more than would be expected by the demographic trend. In this downturn, the unemployment rate among younger adults rose by more than among the population as a whole. And when they are unemployed or have low incomes, younger individuals are particularly likely to live with their parents or older family members rather than moving out on their own. As the unemployment rate continues to decline--albeit likely at a slower pace than any of us would like--household formation and housing demand should increase. One model suggests that household formation could increase to 1-1/2 million or more per year. If, as seems likely, however, many of these new households rent rather than buy their homes, the effect on rental housing could be stronger than for owner-occupied homes, and applications for mortgages to purchase homes might recover only slowly. Evidence to date of an increase in home purchases by owner-occupiers--as opposed to investors--is scarce. The most discouraging evidence comes from purchase mortgage originations. Data collected under the Home Mortgage Disclosure Act (HMDA) indicate that in 2011, purchase mortgage originations hit their lowest level since the early 1990s. According to Federal Reserve staff estimates, purchase originations remained near these subdued levels in 2012 even as mortgage rates hit historic lows. The drop in purchase mortgage originations, although widespread, has been most pronounced among borrowers with low credit scores. For example, between 2007 and 2012, purchase originations fell by about 30 percent for borrowers with credit scores above 780, compared with a fall of about 90 percent for borrowers with credit scores between 620 and 680. Originations are virtually nonexistent for borrowers with credit scores below 620. Whether this pattern stems from tight supply or from weak demand among borrowers with lower credit scores, it has disturbing implications for potential new households. Younger individuals--who have seen the greatest drop in household formation--have, on average, credit scores that are more than 50 points lower than those of older individuals, a difference that existed even before the recession. Staff analysis comparing first-time homebuying in recent years with historical levels underscores the contraction in credit supply. From late 2009 to late 2011, the fraction of individuals under 40 years of age getting a mortgage for the first time was about half of what it was in the early 2000s. The drop was especially pronounced for individuals with low credit scores and remained large even after controlling for local unemployment rates and for measures of the individual's demand for credit--a result indicating that tight credit supply is an important factor. As I noted earlier, household formation has been particularly weak among young individuals, who are also a large part of the potential first-time homebuyer population. Many of these young individuals have relatively weak credit records and are more likely to have had a recent spell of unemployment. Our staff analysis highlights how tight credit conditions are for such individuals in the current environment. In the early 2000s, about one-third of first-time homebuyers under the age of 40 had credit scores below 620, and another one-fourth had scores between 620 and 680. Today, many of these individuals would have a difficult time obtaining mortgage credit. Why are conditions still so tight for these potential first-time homebuyers, and when might they return to normal? As I'll discuss next, the mortgage market is reacting to a variety of economic, market, and regulatory issues that may not be present in other lending markets. So it's difficult to predict what a "normal" mortgage market will look like when things settle down. After the crisis we have just experienced, I am pretty sure that we don't want the market to return to the lending environment of the pre-crisis boom times. But I also don't think it would be a good idea to go back to the quite restrictive credit conditions of the early 1980s. Part of the tightening in mortgage credit standards is the result of lender fears about the economy and the trajectory of house prices. Of respondents who reported tightening mortgage lending standards in the April 2012 Senior Loan Officer Opinion Survey on Bank Lending Practices, more than 80 percent identified concerns about the economy or house prices as a factor in their decision. As the economic recovery continues, lenders should gain confidence that mortgage loans will perform well, and they should expand their lending accordingly. Credit for potential home purchasers with lower credit scores--in particular, the first-time homebuyers I discussed earlier--has likely also been affected by capacity constraints of mortgage lenders. As most of you know very well, the mortgage industry has been operating near its capacity. Although purchase originations have been subdued, refinancing originations, according to staff estimates, have responded to record-low interest rates by more than doubling from mid-2011 to the end of 2012. The ratio of refinance applications to the number of real estate credit employees-- a measure of capacity constraints--has been at levels near those seen during the record 2003 refinancing boom. And, at the same time, each loan takes longer to process, as all elements of an application are now fully documented. Capacity may be slow to expand, as hiring and training additional staff takes time and some lenders may judge the boom as likely to be too short lived to justify the cost. Indeed, the number of real estate credit employees, as measured by the Bureau of Labor and Statistics, has only edged up over the past year. When capacity constraints are binding, lenders may manage the surge in refinancing demand by holding mortgage rates high relative to lenders' funding costs. That would explain the pattern observed during refinance booms, such as the one in 2003, when mortgage rates fell more slowly than yields on mortgage-backed securities (MBS). Also, when MBS yields drop sharply, as occurred in September 2012 when the Federal Reserve announced its most recent MBS purchase program, the mortgage rate may take time to adjust as a result of both capacity issues and the need to process loans with rate locks in place. Furthermore, when refinancing demand is high, lenders have less incentive to pursue harder-to-complete or less profitable loan applications. In the current environment, refinance applications by high-credit-quality borrowers--many of whom may have refinanced repeatedly as rates have fallen over the past couple of years--are likely the easiest to complete. And refinances under the revised Home Affordable Refinance Program, require substantially less documentation than other loans. It is possible that the abundance of these applications may have had the unintended effect of crowding out borrowers with lower credit scores, whose applications may be more time consuming to process. Indeed, staff research suggests that the increase in the refinance workload during the past 18 months appears to be associated with a 50 percent decrease in purchase originations among borrowers with credit scores between 620 and 680 and a 15 percent decrease among borrowers with credit scores between 680 and 720. Purchase originations among borrowers with higher credit scores appear to be affected to only a small degree. Any crowding-out effect that does exist due to capacity constraints should start to unwind if mortgage rates stay at the current levels or rise, in which case the current refinancing boom will begin to run out of steam. Lenders might then ease credit conditions to fill declining refinance pipelines with additional purchase volume. At the same time, as lenders gain more confidence in the strength of the economic recovery and the upswing in house prices, their outlook for home-purchase originations may brighten, making them more confident in easing standards or increasing capacity. Even so, there are still a number of nonmarket forces at work that could make lenders more cautious than normal. For example, lenders remain concerned about the risk that they will be required to repurchase defaulted loans from the government-sponsored enterprises (GSEs)--the so- called putback risk. The ability to hold lenders accountable for poorly underwritten loans is a significant protection for taxpayers. However, if lenders are unsure about the conditions under which they will be required to repurchase loans sold to the GSEs, they may shy away from originating loans to borrowers whose risk profiles indicate a higher likelihood of default. The Federal Housing Finance Agency launched an important initiative last year to clarify the liabilities associated with representations and warranties, but so far, those efforts do not appear to have been sufficient to keep putback risk from weighing on the mortgage market. Mortgage servicing standards, particularly for delinquent loans, are more stringent than in the past due to settlement actions and consent orders. Servicing rules recently standards to all lenders. These standards remedy past abuses and provide important protections to borrowers, but they also increase the cost of servicing nonperforming loans. Under current servicing compensation arrangements, servicers receive the same monthly servicing fee for the routine processing of current loans as they do for the more expensive processing of defaulted loans, a model that assumes that the higher profits on routine processing will offset the cost of servicing delinquent loans. However, this compensation model, coupled with higher default servicing costs, may instead make lenders less willing to extend credit to lower-credit-quality borrowers, who are more likely to default. A change to servicer compensation models, especially for default servicing, could alleviate some of the concern about making these loans, albeit at higher costs to some borrowers. Another key factor contributing to mortgage lender caution is uncertainty about the ultimate regulatory environment. Regulatory decisions will work individually and collectively to shape the cost and availability of mortgage credit in the future. So it is important for policymakers to think carefully about their individual decisions as well as how those decisions will work within the full constellation of mortgage regulation. Regulatory changes are being implemented to ensure that borrowers have more protections and lenders take into account the costs that imprudent mortgage lending can impose on communities, the financial system, and the economy. The accompanying effect, however, may be tighter credit standards, especially for lower-credit-quality borrowers, than prevailed during most of the past decade. It will be up to policymakers to find the right balance between consumer safety and financial stability, on the one hand, and availability and cost of credit, on the other. The CFPB took an important step toward resolving regulatory uncertainty when it released a host of rules in January, including rules on ability-to-repay requirements, the definition of a qualified mortgage (QM), loan officer compensation, and servicing standards. The Federal Reserve and other agencies are in the process of moving forward on proposed rulemakings that would implement revised regulatory capital requirements and the requirements for risk retention mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which include an exemption for mortgages that meet the definition of qualified residential mortgages (QRMs). These and other prudential rules, taken together with the CFPB rules, will further shape the economics of mortgage lending. For example, bank capital rules will specify the amount of capital a bank must hold against certain mortgages. The risk retention rule will specify which loans in the QM universe qualify as QRM loans and therefore are not subject to risk retention when securitized. The risk retention rules will also define how securitizers must meet the risk retention requirement for mortgages that are not QRMs, and the cost associated with this requirement may affect mortgage costs. I won't comment today on the rulemakings that are still under way. However, I believe that, as we layer on additional requirements, it is important to think about the implications of the rules that have already been finalized. So I would like to share my assessment of some potential implications of the QM rule. To provide a little context, the QM rule is part of a larger ability-to-repay rulemaking that requires lenders to make a reasonable and good faith determination that the borrower can repay the loan. Many of the rules' requirements for verification of income, assets, and other payment obligations are probably standard practice for lenders today. But having the rules in place, reinforced with increased legal risk for lenders that do not meet the rules' requirements, helps ensure that these practices continue, even as the economy improves and competition heats up. Borrowers who cannot afford their loans can sue the lender for violations of the ability-to-repay rules and claim monetary damages. If the original lender sells or securitizes the loan, the borrower can claim these damages at any time in a foreclosure action taken by the lender or any assignee. If the mortgage meets the QM standard, however, the lender receives some degree of protection from such potential lawsuits because it is presumed that the borrower had the ability to repay the loan. Loans outside the QM box may become more costly for lenders and borrowers for at least three reasons. The first reason is the possible increase in foreclosure losses and litigation costs. Although the expected losses from this litigation are likely to be small, the full extent of the costs and of lenders' legal liability will become known only after the initial round of ability-to-repay suits are settled by the courts. The second reason is that mortgages that do not meet the QM definition also, by definition, will not meet the future QRM standard, and so lenders will be required to retain some of the risk if these loans are securitized. This requirement may increase costs and limit the size of the market. The third reason is that investors may be wary of investing in securities collateralized by non- QM loans because it is difficult to gauge the risks. A borrower's ability to repay a loan that is not a QM may be based on "soft" information or on idiosyncratic factors that are difficult for the investor to observe or monitor. Investors may respond to this information asymmetry by requiring a higher risk premium or by refusing to purchase these securities altogether. For all of these reasons, the non-QM market could become small and illiquid, which would further increase the cost of these loans. Loans eligible to be purchased, insured, or guaranteed by Fannie Mae, Freddie Affairs, or the U.S. Department of Agriculture are automatically designated as QMs. This provision is slated to end no later than January 2021. As long as such loans remain an outsized share of mortgage originations, the QM rule may have less of an effect on the availability of mortgage credit. As more private capital returns to the mortgage market, though, two aspects of the QM rule will have a more significant effect on access to credit: the debt-to-income (DTI) requirement and the provisions that affect interest rates, points, and fees. Turning first to DTI, under the QM definition, borrower payments on all debts and some recurring obligations--such as mortgages, credit card debt, student loans, auto loans, alimony, and child support--must be 43 percent or less of borrower income. To gauge the possible number of borrowers affected by this requirement, the Board staff looked at households in the Survey of Consumer Finances that purchased a home with mortgage credit in the two years preceding the survey. In the 2001, 2004, and 2010 waves of the survey, about 15 to 20 percent of these households had payments that exceeded 43 percent of income, although the share spiked to 40 percent in the 2007 survey. The households with high DTIs tended to have lower income, fewer financial assets, and higher mortgage loan-to- value ratios than households with lower payment ratios. Of course, some of these households may be able to reduce their DTIs by purchasing a less expensive house or by delaying home purchase for the time it takes to pay off some existing debt. Nonetheless, the borrowers most affected by this aspect of the rule are likely also those who currently face tight access to credit, such as first-time or less-creditworthy borrowers. The QM definition may also affect lenders' ability to charge for the risks of originating loans to borrowers who are more likely to default. For example, lenders might compensate for this risk by charging a higher interest rate on the loan. However, if lenders originate a QM with an annual percentage rate (APR) that is 150 basis points or more above the rate available to the highest-quality borrowers (known as a higher-priced loan), lenders receive less protection against lawsuits claiming violation of the ability-to- repay and QM rules. The extent to which this lower level of legal protection (the "rebuttable presumption of compliance") will affect lenders' willingness to originate such loans is still unclear. Very few of these higher-priced loans are being originated currently, reflecting the weak mortgage demand and tight underwriting standards that I discussed earlier. The HMDA data suggest that only 4 percent of mortgages originated in 2011 carried APRs this high. However, as demand picks up and lending standards ease, the number of potentially higher-priced loans may increase. In 2006--admittedly, not one of the best years for prudent mortgage underwriting in this country--about 25 percent of conventional purchase mortgage originations were considered higher priced. Lenders who prefer to price for risk through points and fees rather than increases in rates also face constraints in originating QMs. Points and fees on a QM loan may not exceed 3 percent of the loan amount, with higher caps available for loans smaller than $100,000. The "points and fees" definition has been expanded from its original definition in the Truth in Lending Act and now includes, for example, compensation paid to the loan originator in the form of a higher interest rate on the loan. Unfortunately, data on points and fees are limited, so it is difficult to determine how many potential borrowers might be affected by this requirement. To be clear, many borrowers were overcharged or defrauded by lenders in the past decade, and these abuses were concentrated among the more vulnerable parts of the population. It is a positive development if new regulations make such abuses more difficult. Still, the costs associated with mortgage lending, especially to borrowers more likely to default, have increased, and if lenders cannot charge enough to recoup these costs, they may not be willing to make the loans at all. As a result, the QM-related incentives against charging higher interest rates, points, or fees will likely affect more loans than in the past and may, in turn, have a greater effect on credit availability for higher-risk borrowers. To bring this discussion back to the effect on the housing market, I think the ability of newly formed households, which are more likely to have lower incomes or weaker credit scores, to access the mortgage market will make a big difference in the shape of the recovery. Economic improvement will cause household formation to increase, but if credit is hard to get, these will be rental rather than owner-occupied households. And without first-time homebuyers, the move-up market will be sluggish, new and existing home sales will be more subdued, and purchase mortgage volumes will return only slowly. As I've noted, credit availability to newly formed households is being affected by a variety of economic, market, and regulatory factors. Some of these factors are likely to ease, whereas others will be more permanent. As a result, this housing recovery may look different than previous ones. In particular, tighter mortgage credit and sustained investor interest in single-family rental properties may result in a lower homeownership rate than in the past. However, the same regulations that could contribute to tighter mortgage credit should also ensure that more of those homeownership experiences succeed. I would like to conclude with a brief discussion of the role of monetary policy in the housing recovery. The fact that mortgage purchase originations have remained nearly flat at a time when interest rates have hit historic lows naturally raises the question of whether monetary policy is effective in stimulating the housing market and thereby the broader economy. As I will explain next, I believe that the answer is yes. Monetary policy has clearly set the stage for a revival of the housing market. Record-low interest rates have sparked interest in homebuying. Monetary policy has contributed significantly to the recent improvement in the labor market and thereby begun to ease one of the main sources of weak housing demand. Monetary policy has likely also supported investor demand for purchasing houses, as the expected return on an investment in housing is more likely to exceed the low yields available on Treasury securities and other debt instruments. Households may be making the same calculus as investors. The interest-rate-sensitive housing market is affected by all of the tools of monetary policy, but purchases of agency MBS have a more direct effect on the mortgage market. So, without delving deeply into monetary policy generally, I would like to make a few observations about the efficacy and costs of MBS purchases specifically. In doing so, I want to reiterate that these are my views and may not be in accord with those of my colleagues on the FOMC. In many ways, purchases of MBS have the same downward effect on the general level of long-term interest rates as purchases of other longer-term securities. But, in addition, purchases of agency MBS reduce the spread between Treasury and MBS yields and thus, compared with purchases of Treasury securities, have somewhat larger effects on mortgage rates. This larger effect was especially true in the first round of purchases in 2009 when investor uncertainty about the degree of government support for agency MBS was quite high. MBS purchases also influence MBS yields by affecting the cost of hedging the risk (known as convexity risk) that mortgages prepay more quickly when rates decline or more slowly when rates increase, because, unlike some mortgage market investors, the Federal Reserve does not hedge such risk. Lower MBS yields result in lower mortgage rates, which can spur the economy through elevated home-purchase and refinancing activity. But this effect is not yet fully transmitted to the economy, as the difference between MBS yields and mortgage rates is still somewhat wide and, as I discussed earlier, tight credit has prevented many households from accessing the low rates. Any improvement in credit conditions would thus act to improve the efficacy of MBS purchases. Similarly, policies that constrain mortgage lending or increase its cost would reduce efficacy. I think the additional impetus to housing from MBS purchases is appropriate for at least three reasons. First, the housing market has suffered extraordinary damage during the past few years. Second, even with the recent positive signs, housing investment has contributed far less to economic growth than in a typical recovery. And, third, even as terms and standards on other types of credit have eased, standards for mortgage credit remain quite tight. While the purchase of agency MBS has some special efficacy in supporting housing markets, the peculiarities of the MBS market itself present some potential market functioning issues that bear monitoring. The MBS market is not as deep or as liquid as the Treasury market, and the total size of the market is not growing as quickly. As refinancing activity slows, the gross pace of new MBS issuance could slow as well, and Federal Reserve purchases at the current level could leave an even larger footprint in the secondary mortgage market. So it is entirely possible that it might be appropriate at some point to adjust the pace of MBS purchases in response to developments in primary or secondary mortgage markets. Within the context of the Committee's judgment about the appropriate overall level of monetary accommodation, such an adjustment could result in an increase or decrease in the pace of total asset purchases, or it could lead to a change in the composition of purchases. Finally, the statement of exit strategy principles provided in the June 2011 FOMC minutes contemplates the sale of MBS once the Committee has begun to remove policy accommodation in order to return the System Open Market Account to an all-Treasury portfolio. As our holdings of MBS become larger in both absolute terms and in relation to the overall supply of agency MBS outstanding, we could reach a point where market functioning concerns begin to outweigh the efficacy of such purchases. Or we might conclude that sales of MBS in volumes sufficient to meet the parameters of the exit strategy principles might create significant market disruptions. In either case, I think we should consider alternatives, such as holding the securities for longer or allowing them to roll off more gradually. In conclusion, I am optimistic that the housing recovery will continue to take root and expand. While low mortgage rates are helping support the recovery, I believe it will be the pent-up demand of household formation unleashed by improving economic conditions that will provide real momentum. However, the strength of this momentum will be determined by credit availability to these new households, an availability that may be much slower to return as mortgage market participants assess the regulatory, market, and economic environment. I think that if such credit is not readily available, the housing recovery will still continue, but the mix of owner-occupied and rental housing and the level of mortgage originations might be quite different. Thank you very much for your attention this afternoon. I would be happy to take any questions that you might have.

r130322a_FOMC

united states

Focusing on Low- and Moderate-Income Working Americans

raskin

I am delighted to be here at the National Community Reinvestment Coalition (NCRC) Annual Conference today, and to be gathered with so many people who have been working for decades to strengthen communities and the integrity of our nation's economic institutions and financial practices. Those of you involved in community development and community reinvestment know all too well the trauma and hardship experienced by low-income communities over the last several years. You know it in a way that is lost on people whose communities have not been so badly battered by these economic storms. That's why I'm looking forward this morning to sharing with you my perspective on the importance of focusing on the situation and prospects of low- and moderate-income working Americans. In my remarks, I will start by discussing the types of jobs being generated in the current recovery. Certainly, the pace of recovery in employment has improved, but it's important to look at the types of jobs that are being created because those jobs will directly affect the fortunes and challenges of households and neighborhoods as well as the course of the recovery. I will then suggest that we think about how the absence of a substantial number of new high-paying jobs, when combined with changes in the landscape for financial services, affects access generally to affordable, sustainable credit. Finally, I will explore some of the monetary, supervisory, and regulatory touchpoints in which the situation and prospects of low- and moderate-income working Americans can be addressed. The Great Recession stands out for the magnitude of job losses we experienced throughout the downturn. These factors have hit low- and moderate-income Americans the hardest. The poverty rate has risen sharply since the onset of the recession, after a decade of relative stability, and it now stands at 15 percent--significantly higher than the average over the past three decades. And those who are fortunate enough to have held onto their jobs have seen their hourly compensation barely keep pace with the cost of living over the past three years. While today's 7.7 percent unemployment rate is a marked improvement from the 10 percent rate we reached in late 2009, it is still higher than the unemployment rate for the 24 years before the Great Recession, a span of time over which the rate averaged about 6 percent. Moreover, the government's current estimate of 12 million unemployed does not include nearly a million discouraged workers who say they have given up looking for work and 8 million people who say that they are working part time even though they would prefer a full-time job. A broader measure of underemployment that includes these and other potential workers stands at 14.3 percent. About two-thirds of all job losses resulting from the recession were in moderate- wage occupations, such as manufacturing, skilled construction, and office administration jobs. However, these occupations have accounted for less than one-quarter of subsequent job gains. The declines in lower-wage occupations--such as retail sales and food service- -accounted for about one-fifth of job loss, but a bit more than one-half of subsequent job gains. Indeed, recent job gains have been largely concentrated in lower-wage occupations such as retail sales, food preparation, manual labor, home health care, and customer service. Furthermore, wage growth has remained more muted than is typical during an economic recovery. To some extent, the rebound is being driven by the low-paying nature of the jobs that have been created. The slow rebound also reflects the severe nature of the crisis, as the slow wage growth especially affects those workers who have become recently re-employed following long spells of unemployment. In fact, while average wages have continued to increase steadily for persons who have remained employed all along, the average wage for new hires have actually declined since 2010. The faces of low-wage Americans are diverse. They include people of varying employment status, race, gender, immigration status, and other characteristics. Many such Americans are attached to the workforce and are deeply committed to both personal success and to making a contribution to society. For purposes of reference, in 2011, low wage was defined as $23,005 per year or $11.06 per hour. Today, about one-quarter of all workers are considered "low wage." They are sanitation workers, office receptionists, and nursing assistants; they are single mothers of three who worry: How will I be able to send my children to college? What if my landlord raises the rent this year? Tens of millions of Americans are the people who ask themselves these questions every day. This diverse group of workers faces numerous barriers when trying to access the labor market or advance in their current positions. Many of these barriers were identified in an initiative that the Federal Reserve's Community Development function launched in 2011. Over the course of a year, Reserve Banks across the country hosted a series of 32 regional discussions aimed at examining the complex factors creating chronic unemployment conditions and identifying promising workforce development solutions. The kinds of problems faced by low-wage workers are familiar to all of you and have long been part of the structural conditions of poverty and near-poverty in America. We know, for example, that location presents thorny challenges for many low- wage workers. Within metropolitan areas, jobs are not spread out evenly and job creation tends to be depressed in low-income communities. As a result, many low-wage workers face long commutes and serious commuting difficulties due to less reliable transportation and an inadequate transportation infrastructure. Moreover, a number of low-wage employees work non-standard hours, exacerbating both transportation and childcare issues, as well as personal health problems. Traditionally, many workers find jobs through social networks and through personal connections that they have to the labor market. But, because low-income individuals are typically less mobile, more isolated, and less socially connected than other people, they are often left out of the social networks that, in practice, lead to jobs for most Among those responding to these challenges are innovative local practitioners who are implementing programs designed to expand job opportunities for low-wage workers. Consider Impact Services in Philadelphia, an organization that builds relationships with the local business community to better understand their hiring needs and then devises programs that supply those firms with appropriately skilled workers from the community. This organization works with local communities to organize funding collaboratives to support regional industries. So progress is being made, thanks to coalitions like these across the country that are working for practical changes at the community level. But the 21 century labor market is increasingly complex; it continues to generate new challenges. For example, growth in sectors such as green industries and advanced manufacturing is creating jobs, but these jobs may demand different skills. Access to reliable information becomes critical for workers who are considering a new job, and must carefully weigh the skills and credentials required by potential employers with the cost of training and the likelihood of gaining employment. And, more and more, employers are requiring post-secondary credentials. Today, a high school diploma alone is less likely to qualify an individual for a job with a path toward meaningful advancement. And, as demand for more credentials increases, workers who lack those credentials will find it increasingly difficult to gain upward mobility in the job market. Many employers are looking to make the employment relationship more flexible, and so are increasingly relying on part-time work and a variety of arrangements popularly known as "contingent work." This trend toward a more flexible workforce will likely continue. For example, while temporary work accounted for 10 percent of job losses during the recession, these jobs have accounted for more than 25 percent of net employment gains since the recession ended. In fact, temporary help is rapidly approaching a new record, and businesses' use of staffing services continues to increase. Contingent employment is arguably a sensible response to today's competitive marketplace. Contingent arrangements allow firms to maximize workforce flexibility in the face of seasonal and cyclical forces. The flexibility may be beneficial for workers who want or need time to address their family needs. However, workers in these jobs often receive less pay and fewer benefits than traditional full-time or "permanent" workers, are much less likely to benefit from the protections of labor and employment laws, and often have no real pathway to upward mobility in the workplace. Many workers who hold contingent positions do so involuntarily. Department of Labor statistics tell us that 8 million Americans say they are working part-time jobs but would like full-time jobs. These are the people in our communities who are "part time by necessity." As businesses increase their reliance on independent contractors and part- time, temporary, and seasonal positions, workers today bear far more of the responsibility and risk for managing their careers and financial security. Indeed, the expansion of contingent work has contributed to the increasing gap between high- and low-wage workers and to the increasing sense of insecurity among workers. Flexible and part-time arrangements can present great opportunities to some workers, but the substantial increase in part-time workers does raise a number of concerns. Part-time workers are particularly vulnerable to personal shocks due to lower levels of compensation, the absence of meaningful benefits, and even a lack of paid sick or personal days. Not surprisingly, turnover is high in these part-time jobs. The economic marginalization that comes with the growth of part-time and low- paying jobs is exacerbated by inadequate access to credit for many working Americans. Ideally, people chronically short of cash would have access to safe and sound financial institutions that could provide reliable and affordable access to credit as well as good savings plans. Unfortunately, many working Americans have no practical access to reasonably priced financial products with safe features, much less the kind of safe and fair credit that is available to wealthier consumers. Working Americans have several core financial needs. They need a safe, accessible, and affordable method to deposit or cash checks, receive deposits, pay bills, and accrue savings. They may also need access to credit to tide them over until their next cash infusion arrives. They may be coming up short on paying their rent, their mortgage, an emergency medical expense, or an unexpected car repair. They may want access to a savings vehicle that, down the road, will help them pay for these items and for education or further training, or start a business. And many want some form of non-cash payment method to conduct transactions that are difficult or impossible to conduct using cash. Products and services that serve these core financial needs are not consistently available at competitive rates to working Americans. Those with low and moderate incomes may have insufficient income or assets to meet the relatively high requirements needed to establish a credit history. Others may have problems in their credit history that inhibit their ability to borrow on competitive terms. Many workers simply may not have banks in their communities, or may not have access to banks that actually compete with each other in terms of pricing or customer service. There is a growing trend toward greater concentration of financial assets at fewer banks. In my mind, this raises doubts about whether banking services will continue to be provided at competitive rates to all income levels of customers wherever they may live. According to a study of bank branch locations published by NCRC in 2007, there are more persons per branch in low- and moderate-income census tracts than in moderate- and upper-income census tracts. While branch-building has been on the rise, indications are that the increase in the number of bank offices has not occurred evenly across neighborhoods of varying income. In fact, a significant number of low- and moderate-income families have become--or are at risk of becoming--financially marginalized. The percentage of families earning $15,000 per year or less who reported that they have no bank account increased between 2007 and 2009 such that more than one in four families was unbanked. Families slightly further up the income distribution, earning between $25,000 and $30,000 per year, are also financially marginalized: 13 percent report being unbanked and almost 24 percent report being underbanked. This combination of economic insecurity and financial marginalization has incentivized more low- and moderate-income families to seek out alternative financial service providers to meet their financial needs. Some of the providers they find, such as check-cashers and outfits furnishing advance loans on paychecks, can lead unwary workers into very deep financial holes. In light of these challenges, I ask questions that have been asked before: What can economic policy do to reduce unemployment, economic marginalization, and the financial vulnerability of millions of lower-income working Americans? There is no simple cure to these conditions, but government policymakers need to focus seriously on the problems, not simply because of notions of fairness and justice, but because the economy's ability to produce a stable quality of living for millions of people is at stake. Our country cannot achieve prosperity without addressing the powerful undertow created by flat wages and tenuous financial security for so many millions of Americans. So how can the Federal Reserve address these challenges? Let me start with monetary policy. Congress has directed the Federal Reserve to use monetary policy to promote maximum employment and price stability. The Federal Reserve's primary monetary policy tool is its ability to influence the level of interest rates. Federal Reserve policymakers pushed short-term interest rates down nearly to zero as the financial crisis spread and the recession worsened in 2007 and 2008. By late 2008, it was clear that still more policy stimulus was necessary to turn the recession around. The Federal Reserve could not push short-term interest rates down further, but it could--and did--use the unconventional policy tools to bring longer-term interest rates such as mortgage rates down further. Fed policymakers intend to keep interest rates low for a considerable time to promote a stronger economic recovery, a substantial improvement in labor market conditions, and greater progress toward maximum employment in a context of price stability. Both anecdotal evidence and a wide range of economic indicators show that these attempts are working to strengthen the recovery and that the labor market is improving. Nonetheless, and again, the millions of people who would prefer to work full time can find only part-time work. While the Federal Reserve's monetary policy tools can be effective in promoting stronger economic recovery and job gains, they have little effect on the types of jobs that are created, particularly over the longer term. So, while monetary policy can help, it does not address all of the challenges that low- and moderate-income workers are confronting. That said, the existing mandate regarding maximum employment requires policymakers on the Federal Open Market Committee (FOMC) to understand labor market dynamics, which obviously must include an understanding of low- and moderate-income workers. In addition to monetary policy, the Federal Reserve's regulatory and supervisory policies have the potential to address some of the challenges faced by low-income communities and consumers. The Federal Reserve is required by law--by virtue of the Bank Holding Company Act--to approve various applications, such as mergers, acquisitions, and proposals to conduct new activities. This statutory review requires an explicit consideration of public benefits and the effects of the proposed transaction on the convenience and needs of the communities to be served. This assessment is, as many of you know, a critical opportunity for community input and analysis. Indeed, as people with their feet firmly planted on the ground in communities across America, you probably remember James Q. Wilson's theory of "broken windows" in community policing: Move in quickly when vandalism and disorder first start to appear--even if it is only a broken window or graffiti on a stop sign--or else face losing the whole neighborhood as disrespect for the law rapidly spreads. The "broken windows" strategy is every bit as compelling when it comes to addressing the disorder that comes from sloppy practices by financial institutions. If banking practices are undermining the ability of the economically marginalized to become financially included and to access the credit they need in an affordable way, regulators must move in quickly to stop the disorder and repair the broken windows of financial intermediation. Bank supervisors should be prepared to respond to the earliest signs of trouble by requiring operationally challenged banks to address problems quickly and completely. If corrections are made, then the regulators can move on. If not, then the regulators need to escalate enforcement. Swift and decisive corrective action is not always how federal bank regulators have responded to broken windows in the past. In my view, for example, regulators' response to the rampant, long-running problems in loan-servicing practices at large financial institutions was not swift and was not decisive. The point is that federal regulators must listen carefully to community input and analysis in order to keep track of where windows are breaking and how they are being broken. And they must carefully study and take responsibility for analyzing comments provided by organizations such as the NCRC when considering the public benefit of an application. Both the exam process and the application process must be strengthened as key venues for federal regulators to incorporate the voices of affected communities; I'd like to see us revise and strengthen these processes to include the analysis in these voices. Now let's shift back to the private sector. In particular, to the question of whether businesses can be competitive in the current marketplace and still provide a pathway out of poverty for their employees. The Hitachi Foundation recently set out to answer this question by identifying firms that provided upward job mobility for their employees. They found that the identified employers showed noteworthy consistency in how they train and educate workers, develop career ladders, and craft supportive human resources policies and other motivators. They also found some evidence to indicate that the companies benefited from strategic and financial returns while their lower-wage workers also benefited from increased earnings and career advancement. "Anchor institutions," such as hospitals and universities, which are firmly rooted in their locales, can also be powerful engines for job creation in their communities. Anchors may include cultural institutions, health care facilities, community foundations, faith-based institutions, public utilities, and municipal governments. These institutions have the potential to generate local jobs through targeted procurement purchases of food, energy, supplies, and services from local businesses. This can be a substantial, positive development in the local economy. The Evergreen Cooperative in Cleveland, Ohio, is an example of a network of worker-owned businesses, launched in low-income neighborhoods, to support local anchor institutions. The cooperatives were initially established to provide services to local hospitals and universities that had agreed to make their purchases locally. This model is effective because it capitalizes on local production, and because it forges a local business development strategy that effectively meets many of the anchor institutions' own needs. Clearly, the challenges facing low-wage workers are multi-faceted and complex. In addition to the challenges that workforce development and community organizations have addressed for years, structural changes in the economy heighten obstacles, make the stakes higher if we fail to conquer them, and, therefore, require new levels of openness and creativity by policymakers. You are the ideal audience for this message because you know how to link federal policymaking with economic empowerment. NCRC has grown to an association of more than 600 community-based organizations that promote access to basic banking services to create and sustain affordable housing, jobs, and vibrant communities for America's working families. Community-based organizations like many of those represented in this room will need to consider how to work with low-wage workers to bridge information gaps by expanding workers' networks, providing legitimate information, and identifying new job opportunities. But finally, the pressure that community-based organizations exert on financial regulators must continue. Access to credit is an enduring challenge, and the obstacles and problems--all the "broken windows" you see on the block--must be reported and explained. They must be understood by the federal policymakers who are responsible for enforcing our country's laws and regulations in the realm of access to credit; by the federal policymakers who engage in the conduct of monetary policy; and by the federal policymakers whose actions contribute to the shaping of the landscape for financial services in this country. Your voices--whether you are reporting, documenting, monitoring, analyzing, proposing, or even protesting--must be heard. Your voices are crucial to alerting policymakers to the significant developments and emerging trends in the nation's communities that must be confronted--and confronted in a swift and decisive way--if we are to make prosperity a national agenda that touches every American. Thank you.

r130325a_FOMC

united states

Monetary Policy and the Global Economy

bernanke

Mervyn King. As Mervyn noted in a recent speech in New York, we had adjoining offices at MIT as young academics and never imagined that 30 years later we still would be colleagues--as central bankers. Now, as then, I value his advice and insight. The topic of this session is lessons learned from the financial crisis. For me, perhaps the central insight is that the recent crisis, despite its many exotic features, was in fact a classic financial panic--a systemwide run of "hot money" away from assets whose values suddenly became uncertain. In that respect, the crisis was akin to many other financial crises faced by governments and central banks--including that most venerable of central banks, the Bank of England--over the centuries. The response to the crisis likewise followed the classic prescriptions of liquidity provision, liability guarantees, asset evaluation and disposition, and recapitalization where necessary. Although the crisis had classic features, to a significant extent it took place in a novel institutional context, making diagnosis and response more challenging: For example, in the United States, collateralized wholesale funding rather than conventional bank deposits constituted the hot money, and run pressure was experienced not only by banks but by diverse other institutions, such as structured investment vehicles. In addition, the scale and complexity of globalized financial institutions and markets made it difficult to predict how the crisis might spread or to coordinate the response. One of the few positive aspects of this episode was the extraordinary degree of international cooperation achieved among policymakers, including the Bank of England and the Federal Reserve, in responding to the crisis. Because I have developed these themes in some detail elsewhere, I thought today I would tackle a different and more recent issue that has arisen in the aftermath of the crisis--the issue of whether, in the widespread easing of monetary policies, we are seeing a competitive depreciation of exchange rates. Like other aspects of the crisis, the notion of competitive depreciation has strong classical antecedents, particularly in relation to the global Great Depression of the 1930s. So let me start by briefly revisiting the older discussion and its evolution. As my audience knows, on the eve of the Great Depression the exchange rates of most industrial countries were determined by the rules of the international gold standard-- or, more technically, by the gold-exchange standard, as foreign exchange (primarily dollars and pounds sterling) was used along with gold as a form of international reserves. The gold standard, which had been suspended during World War I, was painstakingly rebuilt in the 1920s. Unfortunately, the reconstructed gold standard had a number of serious problems. For one, the exchange rates implied by the gold valuations that countries chose for their currencies following World War I were in some cases far from the levels consistent with balanced flows in trade and payments. Notably, as John Maynard Keynes pointed out in his famous pamphlet, , the British pound was overvalued under the new gold standard, which disadvantaged British exports and contributed to weak economic conditions in the United Kingdom in the late 1920s. One of Mervyn King's predecessors as governor of the Bank of England, Montagu Norman, who presided over both Britain's return to the gold standard and its subsequent exit, said of the ill-fated choice of parity for the pound: "Only God could tell whether it [the value in gold chosen for the pound sterling] was or was not the correct figure"; another commentator added, "But of course the Deity may not be an Economist." Another problem, which became clear as the global economy weakened and financial conditions deteriorated, was that fixed exchange rates under the gold standard were vulnerable to speculative runs. Although runs, or in some cases policy decisions, effectively took a number of countries off the gold standard in the early 1930s, the financial world was shaken to its foundation when the United Kingdom, the unofficial center of the global gold standard, was forced by a speculative attack to leave gold in September 1931. Over the next five years, essentially all of the world's industrial nations left the gold standard, either de facto or de jure. Declines in the value of the departing nation's currency, sometimes very sharp ones, typically followed. The uncoordinated abandonment of the gold standard in the early 1930s gave rise to the idea of "beggar-thy-neighbor" policies. According to this analysis, as put forth by important contemporary economists like Joan Robinson, exchange rate depreciations helped the economy whose currency had weakened by making the country more competitive internationally. Indeed, the decline in the value of the pound after 1931 was associated with a relatively early recovery from the Depression by the United Kingdom, in part because of some rebound in exports. However, according to this view, the gains to the depreciating country were equaled or exceeded by the losses to its trading partners, which became less internationally competitive--hence, "beggar thy neighbor." Over time, so-called competitive depreciations became associated in the minds of historians with the tariff wars that followed the passage of the Smoot-Hawley tariff in the United States. Both types of policies were decried--and in some textbooks, still are--as having prolonged the Depression by disrupting trade patterns while leading to an ultimately fruitless and destructive battle over shrinking international markets. Economists still agree that Smoot-Hawley and the ensuing tariff wars were highly counterproductive and contributed to the depth and length of the global Depression. However, modern research on the Depression, beginning with the seminal 1985 paper by Barry Eichengreen and Jeffrey Sachs, has changed our view of the effects of the abandonment of the gold standard. Although it is true that leaving the gold standard and the resulting currency depreciation conferred a temporary competitive advantage in some cases, modern research shows that the primary benefit of leaving gold was that it freed countries to use appropriately expansionary monetary policies. By 1935 or 1936, when essentially all major countries had left the gold standard and exchange rates were market- determined, the net trade effects of the changes in currency values were certainly small. Yet the global economy as a whole was much stronger than it had been in 1931. The reason was that, in shedding the strait jacket of the gold standard, each country became free to use monetary policy in a way that was more commensurate with achieving full employment at home. Moreover, and critically, countries also benefited from stronger growth in trading partners that purchased their exports. In sharp contrast to the tariff wars, monetary reflation in the 1930s was a positive-sum exercise, whose benefits came mainly from higher domestic demand in all countries, not from trade diversion arising from changes in exchange rates. The lessons for the present are clear. Today most advanced industrial economies remain, to varying extents, in the grip of slow recoveries from the Great Recession. With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth. Do these policies constitute competitive devaluations? To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in the configuration of exchange rates among these countries. The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not "beggar-thy-neighbor" but rather are positive-sum, "enrich-thy-neighbor" actions. Again, the distinction between monetary policies aimed at domestic objectives and trade-diverting exchange rate devaluations or other protectionist measures is critical. The former can be mutually beneficial, the latter are not. Indeed, it was this view that prompted the Group of Seven central bankers and finance ministers to issue a statement in February agreeing to refrain from actions focused on achieving competitive advantage by weakening their currencies and reaffirming that fiscal and monetary policies would remain oriented toward meeting domestic objectives using domestic instruments. Among the advanced economies, the mutual benefits of monetary easing are clear. The case of emerging market economies is more complicated. To a first approximation, industrial countries are most concerned that domestic aggregate demand be set at the level that best fosters price stability and a return to full employment at home. In contrast, many emerging market economies may be concerned not only with the level of domestic demand (as needed to achieve objectives for employment and inflation) but with other considerations as well. First, because in recent decades many of these countries have pursued an export-led strategy for industrialization, they may be leery of expansionary policies in the advanced economies that, all else being equal, tend to cause the currencies of emerging market economies to appreciate, restraining their exports. Second, because many emerging market economies have financial sectors that are small or less developed by global standards but open to foreign investors, they may perceive themselves to be vulnerable to asset bubbles and financial imbalances caused by heavy and volatile capital inflows, including those arising from low interest rates in the advanced economies. I agree these challenges are significant. However, a few points should be made. Regarding the effects of monetary easing on exchange rates and exports, I would note that trade-weighted real exchange rates of emerging market economies, with some exceptions, have not changed much from their values shortly before the intensification of the financial crisis in late 2008. Moreover, even if the expansionary policies of the advanced economies were to lead to significant currency appreciation in emerging markets, the resulting drag on their competitiveness would have to be balanced against the positive effects of stronger advanced-economy demand. Which of these two effects would be greater is an empirical matter. Simulations of the Federal Reserve Board's econometric models of the global economy suggest that the effects are roughly offsetting, so that accommodative monetary policies in the advanced economies do not appear, on net, to have adverse consequences for output and exports in the emerging market economies. A return to solid growth among the advanced economies is ultimately in the interest of advanced and emerging market economies alike. Regarding capital flows: It is true that interest rate differentials associated with differences in national monetary policies can promote cross-border capital flows as investors seek higher returns. But my reading of recent research makes me skeptical that these policy differences are the dominant force behind capital flows to emerging market economies; differences in growth prospects across countries and swings in investor risk sentiment seem to have played a larger role. Moreover, the fact that some emerging market economies have policies that depress the values of their currencies may create an expectation of future appreciation that in and of itself induces speculative inflows. Of course, heavy capital inflows and their volatility pose challenges to emerging market policymakers, whatever their source. Policymakers do have some tools to address these concerns. In recent years, emerging market nations have implemented macroprudential measures aimed at strengthening their financial systems and reducing overheating in specific sectors, such as property markets. Policymakers have also experimented with various forms of capital controls. Such controls raise concerns about effectiveness, cost of implementation, and possible microeconomic distortions. Nevertheless, the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool. In sum, the advanced industrial economies are currently pursuing appropriately expansionary policies to help support recovery and price stability in their own countries. As the modern literature on the Great Depression demonstrates, these policies confer net benefits on the world economy as a whole and should not be confused with zero- or negative-sum policies of trade diversion. In fact, the simultaneous use by several countries of accommodative policy can be mutually reinforcing to the benefit of all. Let me end these remarks as I began, by paying tribute to Mervyn King. He has been a leader in the central banking community during an extraordinarily difficult period. I wish him the very best in the next stage of his career.

r130404b_FOMC

united states

Financial and Economic Education

bernanke

Reserve System. I appreciate this opportunity to speak to the business and finance students and faculty--as well as the practicing financial professionals--attending the pleasure of addressing the 5th annual forum as a member of the Board of Governors in At that time, I spoke about the implementation of monetary policy and how crucial effective communication is to that implementation. Although I cannot join you in person this year, I note from the conference agenda that you are hearing from two Federal Reserve Bank presidents--Charles Evans of Chairman Roger Ferguson. Effective communication in monetary policy is more important than ever, and I have little doubt that my current and former colleagues will provide you with insights about the Federal Reserve's ongoing efforts to achieve the goals that the Congress has given us: maximum employment and price stability. In my brief remarks today, I would like to mention another important mission of the Federal Reserve--promoting economic and financial knowledge among people of all ages and walks of life. The Board in Washington and the 12 Federal Reserve Banks throughout the country are all deeply involved in economic education and supporting the work of teachers, schools, and national organizations. For example, the Federal Reserve provides a financial and economic education website with a variety of resources for teachers as well as for students of various ages and levels of knowledge. The site offers educational games, classroom lesson plans, online publications, and multimedia tools. Federal Reserve Banks offer professional development opportunities for teachers to improve their ability to present lessons on personal finance topics. A number of Reserve Banks also organize personal finance essay, video, and academic competitions for students. And we encourage students and teachers to visit Federal Reserve Bank learning centers and museums, which feature interactive exhibits about many aspects of banking, the financial system, and the economy. Among the lessons of the recent financial crisis is the need for virtually everyone--both young and old--to acquire a basic knowledge of finance and economics. Such knowledge is necessary for anyone who will be faced with managing a household budget, making financial investments, finding reliable information about buying a car or house, and preparing financially for retirement and other life goals. Accordingly, in addition to ensuring that students graduate with the financial literacy skills they need to navigate in the modern financial world, we, as a society, must also make sure that adults have opportunities to gain these skills or to refresh what they have learned. Many of you are, or will be, practitioners in the financial services industry--perhaps serving retail clients--and in that capacity I hope you will make the promotion of financial and economic education a part of your mission as well. These skills not only help people provide a better life for themselves and their families, but, by deepening their understanding of the world economy, having such skills also helps equip them to be engaged citizens and informed voters. Let me close by congratulating the University of Dayton for its leadership in hosting the RISE forum. I hope this innovative program, which I'm told is the world's largest student investment conference, succeeds in its ambitious goal of bringing together the current and future leaders of finance to focus on creating a better economic future.

r130404a_FOMC

united states

Communication in Monetary Policy

yellen

Thank you for inviting me here and for offering me what I consider a perfect opportunity to speak on a topic at the heart of the Federal Reserve's efforts to promote a stronger economy--the vital role and growing use of communication in monetary policy. Some of you cover the Federal Reserve and are familiar with how it sets monetary pays very close attention to what it says in the statements it issues after each meeting. This communication is supplemented by Chairman Bernanke's postmeeting press conferences and by providing detailed minutes of the Committee's meetings. Getting this message out to the public depends a good deal on the work you do in reporting on the FOMC, analyzing its statements and actions, and explaining its role and objectives. So let me begin by thanking you for those contributions. But let me also say why I am particularly pleased to speak to you today. As writers and editors, all of you are prodigious consumers and producers of communication. At first glance, the FOMC's communication may not seem so different from what you've heard other government agencies say about their policies or businesses say about their products. I hope to show how communication plays a distinct and special role in monetary policymaking. Let me offer a comparison that may highlight that difference. Suppose, instead of monetary policy, we were talking about an example of transportation policy--widening a road to ease traffic congestion. Whether this road project is announced at a televised press conference or in a low-key press release--or even if there is no announcement--the project is more or less the same. The benefit to drivers will come after the road is widened and won't be affected by whether drivers knew about the project years in advance. At the heart of everything I'll be explaining today is the fact that monetary policy is different. The effects of monetary policy depend critically on the public getting the message about what policy will do months or years in the future. To develop this idea, I will take you on a tour of past FOMC communication, the present, and what I foresee for the future. Until fairly recently, most central banks actively avoided communicating about monetary policy. Montagu Norman, governor of the Bank of England in the early 20th century, reputedly lived by the motto "never explain, never excuse," and that approach was still firmly in place at the Federal Reserve when I went to work there as a staff economist in 1977. I'll begin by discussing how a growing understanding of the importance of transparency shaped FOMC communication in the years before the financial crisis. Next, I'll relate how the financial crisis brought unprecedented challenges for monetary policy that required the use of unconventional policy tools, including some barely contemplated before the crisis. Communication was a centerpiece of these efforts. Finally, I'll look ahead. I am encouraged by recent signs that the economy is improving and healing from the trauma of the crisis, and I expect that, at some point, the FOMC will return to a more normal approach to monetary policy. At the conclusion of my remarks, I'll discuss the communication challenges the FOMC will face when it comes time to make that transition. FOMC communication has long been a topic of great interest to me, and one I have worked on more directly since 2010, when Chairman Bernanke asked me to lead a new FOMC subcommittee on communications. This is probably a good moment to remind you that, as always, I speak for myself and not the FOMC or my colleagues in the Recently I used the word "revolution" to describe the change from "never explain" to the current embrace of transparency in the FOMC's communication. might sound surprising to an audience that knows very well what it feels like to be in the middle of a communications revolution. The speed and frequency of most communication, it seems, never stops growing, and I will admit that the FOMC's changes to the pace and form of its communication seem rather modest in comparison. I've mentioned the Chairman's quarterly postmeeting press conferences, which were initiated two years ago. While these events are televised and streamed live, the mode for most of the FOMC's communication is decidedly old-school--the printed word. The Committee's most watched piece of communication is the written statement issued after each of its meetings, which are held roughly every six weeks. It may seem quaint that my colleagues and I continue to spend many hours laboring over the few hundred words in this statement, which are then extensively analyzed only minutes after their release. The revolution in the FOMC's communication, however, isn't about technology or speed. It's a revolution in our understanding of how communication can influence the effectiveness of monetary policy. It will help if I start with some basics. The FOMC consists of the 7 members of the Federal Reserve Board in Washington and 5 of the 12 presidents of the regional Federal Reserve Banks. All 12 presidents participate in FOMC meetings but only 5 get a vote, a roster that rotates each year. The FOMC's job, assigned by the Congress, is to use monetary policy to promote maximum employment and stable prices, objectives that together are known as the Federal Reserve's dual mandate. In normal times, the Committee pursues these goals by influencing the level of a short-term interest rate called the federal funds rate, which is what banks charge each other for overnight loans. When the FOMC pushes the federal funds rate up or down, other short-term interest rates normally move in tandem. Medium- and longer-term interest rates, including auto loan rates and mortgage rates, generally adjust also, through a mechanism I will return to in a moment. By pushing the federal funds rate up or down, the FOMC seeks to influence a wide range of interest rates that matter to households and businesses. Typically, the FOMC acts to lower the federal funds rate, with the intention of reducing interest rates generally, when the economy is weakening or inflation is declining below the Committee's longer-run objective. The FOMC raises the federal funds rate when inflation threatens to rise above its objective or when economic activity appears likely to rise above sustainable levels. Raising and lowering the federal funds rate was long the primary means by which the FOMC pursued its economic objectives. It is hard to imagine now, but only two decades ago, the Federal Reserve and other central banks provided the public with very little information about such monetary policy moves--the spirit of "never explain" was very much alive. There were a number of different justifications for this approach. One view was that less disclosure would reduce the risk and tamp down suspicions that some could take advantage of disclosures more readily than others. Some believed that markets would overreact to details about monetary policy decisions. And there was a widespread belief that communicating about how the FOMC might act in the future could limit the Committee's discretion to change policy in response to future developments. In sum, the conventional wisdom among central bankers was that transparency was of little benefit for monetary policy and, in some cases, could cause problems that would make policy less effective. While communication and transparency steadily increased elsewhere in government and society, change came slowly to the FOMC. It wasn't until February 1994 that the Committee issued a postmeeting statement disclosing a change in monetary policy. Even then, it only alerted the public that the Committee had changed its policy stance, with scant explanation. Something big was changing, however, and it would soon be the force driving major enhancements in the FOMC's communication. By the early 1990s, a growing body of research challenged widespread assumptions about the how central banks, such as the Federal Reserve, affected the economy. The reevaluation starts with a question that puzzled many of my students when I was a professor: How is it that the Federal Reserve manages to move a vast economy just by raising or lowering the interest rate on overnight loans by 1/4 of a percentage point? The question arises because significant spending decisions--expanding a business, buying a house, or choosing how much to spend on consumer goods over the year-- depend on expectations of income, employment, and other economic conditions over the longer term, as well as longer-term interest rates. The crucial insight of that research was that what happens to the federal funds rate today or over the six weeks until the next FOMC meeting is relatively unimportant. What is important is the public's expectation of how the FOMC will use the federal funds rate to influence economic conditions over the next few years. For this reason, the Federal Reserve's ability to influence economic conditions today depends critically on its ability to shape expectations of the future, specifically by helping the public understand how it intends to conduct policy over time, and what the likely implications of those actions will be for economic conditions. To return to the example I used earlier, contrast this effect on expectations with that of a road project. Today's commute, alas, will not be improved or changed at all by the news that a road will be widened one day. But the effects of today's monetary policy actions are largely due to the effect they have on expectations about how policy will be set over the medium term. Let me further illustrate this with some history. Starting in the mid-1960s, the Federal Reserve didn't act forcefully in the face of rising inflation, and the public grew less certain of the central bank's commitment to fighting inflation. This uncertainty led expectations of future inflation to become "unanchored" and more likely to react to economic developments. In 1973, an oil price shock led to a large increase in overall inflation. Expectations of higher inflation in the future affected the public's behavior-- workers demanded raises, and businesses set prices and otherwise acted in anticipation of higher costs--and this helped fuel actual inflation. The FOMC's occasional efforts to reduce inflation in the 1970s were ineffective partly due to the expectation that it ultimately wouldn't do enough. By contrast, most of you probably know about the Federal Reserve's successful inflation fighting in the early 1980s. The FOMC raised the federal funds rate very high, causing a deep recession but also convincing the public that it was committed to low and stable inflation. Anchoring inflation expectations at low levels helped ensure that jumps in commodity prices or other supply shocks would not generate persistent inflation problems. This was illustrated by the effect of another escalation in oil prices starting in 2005. Unlike in the 1970s, these price shocks did not result in a broad and lasting increase in overall inflation because the public believed the Federal Reserve would keep inflation in check. The FOMC wasn't forced to raise interest rates--which softened the blow of higher fuel costs on households and businesses--because of the credibility the Federal Reserve had built since the 1980s. If the public's expectations have always been important, you might wonder how monetary policy had any effect prior to the transparency revolution. As it turns out, with the notable exception of the late 1960s and 1970s, the FOMC usually responded in a systematic way to economic conditions. In 1993, economist John Taylor documented that FOMC policy changes since the mid-1980s had fairly reliably followed a simple rule based on inflation and output. Changes in the federal funds rate were usually made in several small steps over a number of months. In practice, the Federal Reserve's approach was "never explain, but behave predictably." A close analysis of the FOMC's past behavior was a good guide to future policy, but it had two shortcomings as a substitute for transparency: First, it gave an advantage to sophisticated players who studied the FOMC's behavior--something that is arguably inappropriate for a government institution. Second, while a policy rule such as the one developed by John Taylor explained the course of the federal funds rate much of the time, there were cases when it didn't and when even the experts failed to correctly anticipate the FOMC's actions. The trend toward greater transparency accelerated during the early 2000s. Starting in 2000, the FOMC issued information after every meeting about its economic outlook. It also provided an assessment of the balance of risks to the economy and whether it was leaning toward increasing or decreasing the federal funds rate in the future. Such information about intentions and expectations for the future, known as forward guidance, became crucial in 2003, when the Committee was faced with a stubbornly weak recovery from the 2001 recession. It had cut the federal funds rate to the very low level of 1 percent, but unemployment remained elevated, and the FOMC sought some further way to stimulate the economy. In this situation, it told the public that it intended to keep the federal funds rate low for longer than might have been expected by adding to its statement that "[i]n these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period." Let's pause here and note what this moment represented. For the first time, the Committee was using communication--mere words--as its primary monetary policy tool. Until then, it was probably common to think of communication about future policy as something that supplemented the setting of the federal funds rate. In this case, communication was an independent and effective tool for influencing the economy. The FOMC had journeyed from "never explain" to a point where sometimes the explanation is the policy. By the eve of the recent financial crisis, it was established that the FOMC could not simply rely on its record of systematic behavior as a substitute for communication-- especially under unusual circumstances, for which history had little to teach. I think we're all fortunate that policymakers had learned this lesson, because the FOMC was about to encounter unprecedented economic conditions and policy challenges. The financial crisis and its aftermath demanded advances in FOMC communication as great as any that had come before. The situation in 2008 and 2009 was like nothing the Federal Reserve had faced since the 1930s. In late 2008, the FOMC cut the federal funds rate nearly to zero-- essentially, as low as it could go--where it has remained. With its traditional tool for expansionary monetary policy--lowering the federal funds rate--off the table, the FOMC turned to unconventional and, in some cases, newly invented policy options to try both to help stabilize the financial system and to arrest the plunge in economic activity. The public had grown accustomed to monetary policy that focused on changes to the federal funds rate target, with occasional, and at this point fairly limited, guidance that a particular policy stance would probably last for a while. Beyond the task of describing the new policies, extensive new communication was needed to justify these unconventional policy actions and convincingly connect them to the Federal Reserve's employment and inflation objectives. The best known of these unconventional policies is large-scale asset purchases, commonly known as quantitative easing. Starting in late 2008 and continuing through today, the Federal Reserve has purchased longer-term government agency debt securities, agency-guaranteed mortgage-backed securities, and longer-term Treasury securities that have added about $2.5 trillion to its assets. These purchases were intended to, and I believe have, succeeded in significantly lowering longer-term interest rates and raising asset prices to help further the Federal Reserve's economic objectives. This is an easing of monetary policy, also known as accommodation, beyond what is provided by maintaining the federal funds rate close to zero. It is important to emphasize that the effects of asset purchases also depend on expectations. If the FOMC buys, say, $10 billion in longer-term securities today but is expected to sell them tomorrow or very shortly, there will be little effect on the economy. Current research suggests that the effects of asset purchases today depend on expectations of the total value of securities the FOMC intends to buy and on expectations of how long the FOMC intends to hold those securities. To make these asset purchases as effective as possible in adding accommodation, the FOMC, therefore, needs to communicate the intended path of Federal Reserve securities holdings years into the future. I will return in a moment to current and possible future ways in which the FOMC does and might communicate this information. The other unconventional policy designed to contribute to monetary easing was almost purely communication--enhanced forward guidance about how long the Committee expects to maintain the federal funds rate near zero. The situation in early 2009 was similar to 2003 but even more challenging, because in that earlier episode, the FOMC at least retained the option of a further reduction in the federal funds rate target. In 2009, communication about the future path of the federal funds rate was the only option. Initially, the forward guidance was simple and familiar: The FOMC statement noted that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." The Committee enhanced its forward guidance in August 2011, when it substituted "at least through mid-2013" for the words This date was moved into the future several times, most recently last September, when it was shifted to mid-2015. This "calendar guidance" was an advance over the indefinite "extended period," but it suffered from an important limitation. The date failed to provide the public with a clear understanding of what conditions the FOMC was trying to achieve or the economic conditions that would warrant a continuation of the policy. As a consequence, it was hard for the public to tell whether a change in the calendar date reflected a shift in policy or a change in the Committee's economic forecast. To help provide greater clarity about the Committee's objectives, in January 2012, the FOMC adopted and released a statement of its longer-run goals and monetary policy strategy. This statement laid out, for the first time, the rates of inflation and unemployment that the FOMC considers consistent with the dual mandate. Specifically, it stated that the longer-run inflation goal most consistent with the FOMC's price stability mandate is 2 percent, and that the central tendency of FOMC participants' estimates of the longer-run normal rate of unemployment ranged from 5.2 to 6 percent. As the statement also made clear, economic developments may cause inflation and unemployment to temporarily move away from the objectives, and the Committee will use a balanced approach to return both, over time, to the longer-run goals. On the one hand, for example, the current rate of unemployment, at 7.7 percent, is far above the 5.2 to 6 percent range in the statement and is expected to decline only gradually. Inflation, on the other hand, has been running at or below 2 percent and is expected to remain at similar levels for several years. In this circumstance, both legs of the dual mandate call for a highly accommodative monetary policy. With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take center stage for the FOMC, even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent. The Committee reaffirmed this statement in January 2013, and I expect it to remain a valuable roadmap for many years to come, indicating how monetary policy will respond to changes in economic conditions. Meanwhile, the FOMC has continued to enhance its communication about how it would use the federal funds rate to return inflation and unemployment to its longer-run objectives. Last December, the Committee replaced its calendar guidance for the federal funds rate with quantitative measures of economic conditions that would warrant continuing that rate at its current very low level. Specifically, the Committee said it anticipates that exceptionally low levels for the federal funds rate will be appropriate "at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." I consider these thresholds for possible action a major improvement in forward guidance. They provide much more information than before about the conditions that are likely to prevail when the FOMC decides to raise the federal funds rate. As for the date at which tightening of monetary policy is likely to occur, market participants, armed with this new information about the Committee's "reaction function," can form their own judgment and alter their expectations on timing as new information accrues over time. These thresholds will, as a consequence, allow private-sector expectations of the federal funds rate to fulfill an important "automatic stabilizer" function for the economy. If the recovery is stronger than expected, the public should anticipate that one or both of the threshold values will be crossed sooner and, hence, that the federal funds rate could be raised earlier. Conversely, if the outlook for the economy unexpectedly worsens, the public should expect a later "liftoff" in rates--an expectation that would reduce longer- term interest rates and thereby provide more-accommodative financial conditions. The threshold guidance for the federal funds rate looks ahead to a time when the economy has healed from the worst effects of the financial crisis. Getting back to more normal economic conditions will allow for a more normal approach to monetary policy. I look forward to the day when we can put away our unconventional tools and return to what now seems like the relatively straightforward challenge of setting the federal funds rate. At some point it will be appropriate to cease adding to accommodation and, later, to begin the process of withdrawing the significant accommodation required by the extraordinary conditions caused by the financial crisis. I believe that, once again, communication will play a central role in managing this transition. Let me start with our current program of asset purchases, which was launched in September 2012 and revised in December. Notably, the FOMC has described this program in terms of a monthly pace of purchases rather than as a total amount of expected purchases. The Committee has indicated that it will continue purchases until the outlook for the labor market has improved substantially in a context of price stability. In its most recent statement, the FOMC also indicated that the pace and composition of the purchases may be adjusted based on the likely efficacy and costs of such purchases, as well as the extent of progress toward the Federal Reserve's economic objectives. my view, adjusting the pace of asset purchases in response to the evolution of the outlook for the labor market will provide the public with information regarding the Committee's intentions and should reduce the risk of misunderstanding and market disruption as the conclusion of the program draws closer. The Federal Reserve's ongoing asset purchases continually add to the accommodation that the Federal Reserve is providing to help strengthen the economy. An end to those purchases means that the FOMC has ceased augmenting that support, not that it is withdrawing accommodation. When and how to begin actually removing the significant accommodation provided by the Federal Reserve's large holdings of longer- term securities is a separate matter. In its March statement, the FOMC reaffirmed its expectation that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the current asset purchase program ends and the economic recovery has strengthened. Accordingly, there will likely be a substantial period after asset purchases conclude but before the FOMC starts removing accommodation by reducing asset holdings or raising the federal funds rate. To guide expectations concerning the process of normalizing the size and composition of the Federal Reserve's balance sheet, at its June 2011 meeting, the FOMC laid out what it called "exit principles." In these principles, the FOMC indicated that asset sales would likely follow liftoff of the federal funds rate. It also noted that, in order to minimize the risk of market disruption, the pace of asset sales during this process could be adjusted up or down in response to changes in either the economic outlook or financial conditions. For example, changes in the pace or timing of asset sales might be warranted by concerns over market functioning or excessive volatility in bond markets. While normalization of the Federal Reserve's portfolio is still well in the future, the FOMC is committed to clear communication about the likely path of the balance sheet. There will come a time when the FOMC begins the process of returning the federal funds rate to a more normal level. In their individual projections submitted for the March FOMC meeting, 13 of the 19 FOMC participants saw the first increase in the target for the federal funds rate as most likely to occur in 2015, and another expected it to occur in 2016. But the course of the economy is uncertain, and the Committee added the thresholds for unemployment and inflation, in part, to help guide the public if economic developments warrant liftoff sooner or later than expected. As the time of the first increase in the federal funds rate moves closer, in my view it will be increasingly important for the Committee to clearly communicate about how the federal funds rate target will be adjusted. I hope I've been able today to convey the vital role that communication plays in the Federal Reserve's efforts to promote maximum employment and stable prices. Communication became even more significant after the onset of the financial crisis when the FOMC turned to unconventional policy tools that relied heavily on communication. Better times and a transition away from unconventional policies may make monetary policy less reliant on communication. But I hope and trust that the days of "never explain, never excuse" are gone for good, and that the Federal Reserve continues to reap the benefits of clearly explaining its actions to the public. I believe further improvements in the FOMC's communication are possible, and I expect they will continue. It has been my privilege to share these thoughts with you. Thank you for inviting me here today.

r130408a_FOMC

united states

Stress Testing Banks: What Have We Learned?

bernanke

Let me begin by thanking President Lockhart and the organizers of the Financial Markets Conference for inviting me to speak here again this year. I have participated regularly in this conference and have always found it stimulating. Four years ago, in remarks at this very conference, I described the 2009 Supervisory Capital Assessment Program, or SCAP, popularly known as the bank stress tests. The SCAP marked the first time the U.S. bank regulatory agencies had conducted a supervisory stress test simultaneously across the largest banking firms. At the time of my 2009 speech, we had just published the results of the SCAP and were still evaluating its effects. In retrospect, the SCAP stands out for me as one of the critical turning points in the financial crisis. It provided anxious investors with something they craved: credible information about prospective losses at banks. Supervisors' public disclosure of the stress test results helped restore confidence in the banking system and enabled its successful recapitalization. The resilience of the U.S. banking system has greatly improved since then, and the more intensive use and greater sophistication of supervisory stress testing, as well as supervisors' increased emphasis on the effectiveness of banks' own capital planning processes, deserve some credit for that improvement. I will begin today with a brief discussion of the state of U.S. banking. I will then turn to the subject of what we have learned about stress testing in the four years since the SCAP, with a focus on the increasingly central role it is playing in bank supervision in the United States. Importantly, as I will elaborate, stress testing adds a macroprudential dimension to our supervision by helping us evaluate the aggregate capital position of the largest banking firms as well as their individual capital levels. The Federal Reserve--like all bureaucracies--has an unfortunate tendency to create acronyms, so, before I proceed further, let me explain our acronyms, in addition to SCAP, for stress tests. With the SCAP now in the past, we currently have two distinct but related supervisory programs that rely on stress testing. The first is the stress testing required by the Dodd-Frank Act, which we have shortened to the acronym DFAST--the Dodd-Frank Act stress tests. The purpose of DFAST is to quantitatively assess how bank capital levels would fare in stressful economic and financial scenarios. The second program, called the Comprehensive Capital Analysis and Review, or CCAR, combines the quantitative results from the stress tests with more-qualitative assessments of the capital planning processes used by banks. For example, under CCAR, supervisors evaluate the ability of banks to model losses for various categories of loans and securities and to estimate earnings and capital requirements in alternative scenarios. We recently completed the first set of DFAST stress tests and disclosed the results, followed a week later by the disclosure of our CCAR findings, which included our qualitative assessments of firms' capital planning. To provide context for the developments in the banking system since the introduction of the SCAP in early 2009, it's worth briefly recalling the economic situation that prevailed at that time. The economy was in deep recession, with the unemployment rate having risen 4 percentage points, from 5 percent to 9 percent, over the preceding 12 months. The prices of real estate and equities had plummeted, interest rate spreads--such as the spread between rates on mortgages and Treasury securities--had widened to unprecedented levels, and securitization markets had frozen. Write-downs and losses continued to deplete banks' capital, unnerving investors and counterparties and exacerbating the severe funding pressures faced by many institutions. In the face of this instability, in 2008 and 2009 policymakers had taken a range of extraordinary measures: The Federal Reserve supplied liquidity to banks and other financial institutions, helping to calm the panic and begin the process of restoring the flow of credit to households and businesses; the Treasury Department guaranteed money market funds and injected capital into banks under the Troubled Asset Relief Program; the Congress expanded deposit guaranteed banks' issuance of long-term debt. And, as I noted, the SCAP helped to increase confidence in the banking system and restore banks' access to private capital markets. Ten of the 19 large bank holding companies that underwent the SCAP were required to raise equity capital--by $75 billion in total. Today the economy is significantly stronger than it was four years ago, although conditions are clearly still far from where we would all like them to be. Because bank credit for households and businesses is critical to continued economic expansion, it is positive for the recovery that banks are also notably stronger than they were a few years ago. For example, premiums on bank credit default swaps have fallen by more than half of their 2009 levels, and other measures of bank risk have also declined substantially. More than 90 percent of the public capital injections that were used to stabilize the banking system have been repaid, and the Federal Reserve's extraordinary liquidity programs and the FDIC's temporary guarantees for uninsured business deposits and bond issues have largely been wound down. The results of the most recent stress tests and capital planning evaluations continue to reflect improvement in banks' condition. For example, projected aggregate loan losses under this year's most stressful scenario (the so-called severely adverse scenario) were 7 percent lower than the comparable figure last year, in part because the riskiness of banks' portfolios continues to decline. The comparison of today's bank capital levels with those at the time of the SCAP is particularly striking. Over the past four years, the aggregate tier 1 common equity ratio of the 18 firms that underwent the recent tests has more than doubled, from 5.6 percent of risk-weighted assets at the end of 2008 to 11.3 percent at the end of 2012--in absolute terms, a net gain of nearly $400 billion in tier 1 common equity, to almost $800 billion at the end of 2012. Indeed, even under the severely adverse scenario of the latest stress test, the estimate of these firms' post-stress tier 1 common capital ratio is more than 2 percentage points higher than actual capital levels at the end of 2008. Higher capital puts these firms in a much better position to absorb future losses while continuing to fulfill their vital role in the economy. In addition, a majority of the 18 CCAR firms already meet new internationally agreed- upon capital standards (the proposed Basel III capital requirements), and the others are on track to meet these requirements as they are phased in over time. Although the stress tests focus on the largest banks, the medium-sized and smaller banks outside of the 18 CCAR firms have also improved their aggregate capital position considerably since the SCAP. For that group of banks, aggregate tier 1 common equity stood at 12.4 percent of risk-weighted assets in the fourth quarter of 2012, more than 4 percentage points higher than at the end of 2008. Another key lesson of the crisis, given the intense funding pressures experienced by many financial institutions during the period, is the importance of maintaining adequate liquidity--that is, a stock of cash and unencumbered high-quality liquid assets that can be converted easily into cash. Here too, the news is mostly positive, as the broader banking system--including both larger and smaller banks--has generally improved its liquidity position relative to pre-crisis levels. For example, banks' holdings of cash and high-quality liquid securities have more than doubled since the end of 2007 and now total more than $2.5 trillion. However, in the area of liquidity and funding, continued improvement is still needed on some dimensions. Notably, supervisors will continue to press banks to reduce further their dependence on wholesale funding, which proved highly unreliable during the crisis. And, in analogy to the need for effective capital planning, banks of all sizes need to further strengthen their ability to identify, quantify, and manage their liquidity risks. Let me turn now to the evolution of stress testing as a supervisory tool. The main benefits of stress tests for supervision have not changed much since the SCAP was conducted in 2009. First, stress tests complement standard capital ratios by adding a more forward-looking perspective and by being more oriented toward protection against so-called tail risks; by design, stress tests help ensure that banks will have enough capital to keep lending even under highly adverse circumstances. Second, as applied by the Federal Reserve, the stress tests look horizontally across banks rather than at a single bank in isolation. This comparative approach promotes more-consistent supervisory standards. It also provides valuable systemic information by revealing how significant economic or financial shocks would affect the largest banks collectively as well as individually. Third, the disclosures of stress test results promote transparency by providing the public consistent and comparable information about banks' financial conditions. The basic methodology of our stress testing has also not changed materially since the SCAP. We continue to take a multidisciplinary approach, drawing on a wide range of staff expertise. To begin the process, our economists create a hypothetical macroeconomic scenario that incorporates an assumed sharp deterioration in economic and financial conditions. Supervisors estimate each bank's expected losses and revenues and we use these estimates to project post-stress capital levels and ratios under that hypothetical scenario. The estimated capital ratios are then compared with regulatory benchmarks. We use a common scenario for all firms; for the firms with the largest trading activities, we supplement the basic scenario with a market-shock scenario that incorporates market turbulence of severity similar to that of the latter half of 2008. Although the basic goals and approach of stress testing have remained largely unchanged since the SCAP, the implementation has evolved and improved from year to year. For example, we have continued to refine the formulation of the hypothetical scenarios that form the basis of the stress tests. As explained in a statement we released in the fall, the severely adverse scenario is designed to reflect, at a minimum, the economic and financial conditions typical of a severe post-World War II U.S. recession. In devising recession scenarios, we draw on many of the same macroeconomic modeling tools used in making monetary policy. Of course, not all significant risks facing banks are tied to the business cycle. Accordingly, our scenarios now generally incorporate not only the typical consequences of a severe recession but also, simultaneously, other adverse developments such as an exceptionally large decline in house prices, sharp drops in the value of stocks and other financial assets, or a worsening of global economic conditions more severe than might normally be expected to accompany a deep recession in the United States. Importantly, in specifying the severely adverse scenario, we seek to avoid adding to the procyclicality of the financial system. In other words, in applying stress tests, we do not want to inadvertently set a standard that is easier to meet in good times (when banks should be preparing for possibly tougher times ahead) than in bad times (when banks need to be able to use accumulated capital to support lending). Accordingly, we will want to ensure that the stress scenario remains severe in an absolute sense even when the economy is strong and the near-term risks to the outlook seem relatively modest. We have also improved our tools for estimating projected bank losses, revenues, and capital under alternative scenarios. The original SCAP was supervisors' first attempt to produce comprehensive and simultaneous estimates of the financial conditions of the nation's largest banking firms, and the required data and analytical methods were developed under great time pressure. Of necessity, when projecting losses and revenues under alternative SCAP scenarios, supervisors relied on the firms' own estimates as a starting point. Although we scrutinized and questioned the firms' estimates and made significant adjustments based on our own analysis, for that inaugural round of stress tests, it was not possible to produce completely independent estimates. However, over the past four years, considerable progress has been made in data collection and in the development of independent supervisory models. For our most recent supervisory stress tests, we collected and analyzed loan- and account-level data on more than two-thirds of the $4.2 trillion in accrual loans and leases projected to be held by the 18 firms we evaluated this year. Those detailed data include borrower, loan, and collateral information on more than 350 million domestic retail loans, including credit cards and mortgages, and more than 200,000 commercial loans. Currently, the Federal Reserve uses more than 40 models to project how categories of bank losses and revenues would likely respond in hypothetical scenarios. The improvements in data and models have increased our ability to distinguish risks within portfolios. Importantly, these supervisory models are evaluated by a special model validation group made up of experts within the Federal Reserve who do not work on the stress tests. We have also created a Model Validation Council made up of external experts to provide independent views and advice. These ongoing efforts are bringing us close to the point at which we will be able to estimate, in a fully independent way, how each firm's loss, revenue, and capital ratio would likely respond in any specified scenario. Another innovation since the SCAP is the increased supervisory focus on banks' internal capital planning practices, which are reviewed as part of CCAR. We see the requirement that banks with assets of $50 billion or more submit annual capital plans to the Federal Reserve as a critical enhancement. While regulatory minimums and supervisory expectations provide floors for acceptable capital levels, the firms and their boards of directors are responsible for assessing their own capital needs over and above the minimums. Our supervisors scrutinize their practices and assess their capacity to fulfill that responsibility. In particular, we require firms to formulate their own scenarios that capture the risks that they face, and to assess potential losses and revenues under both the supervisory scenarios and their internal scenarios over a nine-quarter horizon. In CCAR, our qualitative assessment of a firm's capital planning is integrated with the quantitative results of both the supervisory and company-run stress tests. The Federal Reserve continues to increase the transparency of our stress testing process, the results of the exercises, and our assessments of banks' capital planning. The original SCAP set a new standard of supervisory transparency in disclosing bank-by-bank estimates of stress losses by type of exposure. This departure from the traditionally confidential treatment of supervisory information, as I noted earlier, was intended to restore public confidence by providing much-needed information about banks' potential losses and capital needs. In last month's results, in addition to projected losses and revenues, we disclosed for the first time whether we had objected to each firm's capital plan. Also for the first time, banks were required to disclose their own estimates of stressed losses and revenues. The disclosures by banks give investors and analysts an alternative perspective on the test results; they also help them form judgments about banks' appetites for risk and their risk-management practices, particularly their abilities to measure losses in a severe downturn. Even outside of a period of crisis, the disclosure of stress test results and assessments provides valuable information to market participants and the public, enhances transparency, and promotes market discipline. In the four years since the SCAP, the Federal Reserve's stress testing program has been expanded and strengthened through both statute and regulation. The Dodd-Frank Act widened the scope of stress testing to all bank holding companies with $50 billion or more in total consolidated assets (approximately 11 companies in addition to the original SCAP participants) and to nonbank financial companies designated by the Financial Stability Oversight Council as systemically important, and therefore subject to consolidated supervision by the Federal Reserve. Dodd-Frank also requires these companies to conduct their own stress tests twice a year. In October, the Federal Reserve Board adopted rules implementing these requirements. The 11 additional companies with assets of $50 billion or more will be subject to DFAST and CCAR for the first time next year. While no institutions below $50 billion in assets are subject to supervisory stress testing or the requirements of CCAR, the Dodd-Frank Act does require that institutions with between $10 billion and $50 billion in assets conduct their own stress tests. initial tests by these firms will begin this year and will be completed by March. While we believe that stress testing will help medium-sized institutions better understand the risks they face, we tailored our rule for these institutions to take account of differences in size, complexity, and business models. We specifically exempted community banking organizations with $10 billion or less in total assets from the requirement that they run their own stress tests as those institutions cannot reasonably be expected to have the resources that larger banks devote to stress testing. As already noted, stress testing has a number of important benefits as a supervisory tool. From a microprudential perspective, the CCAR provides a structured means for supervisors to assess not only whether banks hold enough capital, but also whether banks are able to rapidly and accurately determine their risk exposures, an essential element of effective risk management. The cross-firm nature of the stress tests also helps supervisors identify outliers--both in terms of results and practices--that can provide a basis for further, more targeted reviews. From a macroprudential perspective, the use of a common scenario allows us to learn how a particular risk or combination of risks might affect the banking system as a whole--not just individual institutions. This experience with stress testing has indeed been very useful for our efforts to better monitor and evaluate potential systemic risks. For example, in our macroprudential work, as in our stress tests, we tend to rely on horizontal examinations and comparative studies, as opposed to firm-by-firm assessments; we use multidisciplinary, specialized teams to supplement the work of on- site examiners; and we have increased our use of modeling and quantitative methods, using data drawn from different institutions and time periods. All of these features are apparent in the workings of our Large Institution Supervision Coordinating Committee, which provides coordinated oversight of the supervision of systemically important firms. We have also extended the lessons of systemwide stress testing to analysis of factors other than capital: For example, we recently completed a horizontal review of liquidity positions and liquidity risk-management practices at some of the largest CCAR firms. Like the CCAR review of capital planning, this review was a multidisciplinary effort that used quantitative information--in this case, detailed data on firms' liquidity positions--as well as qualitative information on liquidity risk-management practices. Notwithstanding the demonstrated benefits of comprehensive stress testing, this evolving tool also presents challenges. For example, even as we continue to explore ways to enhance the transparency of the models we use to estimate banks' projected revenues and losses, we have chosen not to publish the full specification of these models. As a result, we hear criticism from bankers that our models are a "black box," which frustrates their efforts to anticipate our supervisory findings. We agree that banks should understand in general terms how the supervisory models work, and, even more importantly, they need to be confident that our models are empirically validated and sound. I mentioned our internal efforts at model validation, which have increased the quality and accuracy of our models. We have also begun to host an annual stress test modeling symposium, which provides a venue for regulators, bankers, academics, and others to share their views. Over time, we expect banks to better understand the basic elements of the supervisory models, rendering them at least somewhat less opaque. At the same time, it is reasonable to worry that, with increased disclosure of supervisory models, firms would see a declining benefit to maintaining independent risk- management systems and would just adopt supervisory models instead. Doing so would certainly make it easier to "pass" the stress tests. However, all models have their blind spots, and such an outcome risks a "model monoculture" that would be susceptible to a single, common failure. The differences in stress test results obtained by supervisors' and banks' own models can be informative, and we do not want inadvertently to destroy the healthy diversity or innovation of the models and other risk-management tools used in the banking industry. Another challenge is that our stress scenarios cannot encompass all of the risks that banks might face. For example, although some operational risk losses, such as expenses for mortgage put-backs, are incorporated in our stress test estimates, banks may face operational, legal, and other risks that are specific to their company or are otherwise difficult to estimate. It is important for banking firms to consider the potential for losses from these other classes of risks as systematically as possible, and supervisors also account for these risks as best they can. Of course, unforeseen events are inevitable, which is why maintaining a healthy level of capital is essential. As I have discussed today, the banking system is much stronger since the implementation of the SCAP four years ago, which in turn has contributed to the improvement in the overall economy. The use of supervisory stress tests--a practice now codified in statute--has helped foster these gains. Methodologically, stress tests are forward looking and focus on unlikely but plausible risks, as opposed to "normal" risks. Consequently, they complement more conventional capital and leverage ratios. The disclosure of the results of supervisory stress tests, coupled with firms' disclosures of their own stress test results, provide market participants deeper insight not only into the financial strength of each bank but also into the quality of its risk management and capital planning. Stress testing is also proving highly complementary to supervisors' monitoring and analysis of potential systemic risks. We will continue to make refinements to our implementation of stress testing and our CCAR process as we learn from experience. As I have noted, one of the most important aspects of regular stress testing is that it forces banks (and their supervisors) to develop the capacity to quickly and accurately assess the enterprise-wide exposures of their institutions to diverse risks, and to use that information routinely to help ensure that they maintain adequate capital and liquidity. The development and ongoing refinement of that risk-management capacity is itself critical for protecting individual banks and the banking system, upon which the health of our economy depends.

r130412a_FOMC

united states

Creating Resilient Communities

bernanke

I am pleased to join you for the eighth biennial Federal Reserve System Community Affairs Research Conference. The work you are doing here--sharing research and exchanging ideas on how best to further the development of low-income communities--is vitally important. communities were particularly hard hit by the Great Recession. And, while employment and housing show signs of improving for the nation as a whole, conditions in lower- income neighborhoods remain difficult by many measures. For example, an analysis by Federal Reserve staff reveals that long-vacant housing units tend to be concentrated in a small number of neighborhoods that also tend to have high unemployment rates, low educational levels, and low median incomes. While some of these neighborhoods are in the inner cities, others are in suburbs. This analysis and others like it illustrate the close interconnections of housing conditions, educational levels, and unemployment experience within neighborhoods. Moreover, as this work confirms, poverty is no longer primarily an urban phenomenon but has increasingly spread to suburban areas, many of which lack the social and community development services needed to mitigate poverty and its effects. implications of these trends for community development are profound. Successful strategies to rebuild communities cannot focus narrowly on a single problem, such as the physical deterioration of neighborhoods that suffered high rates of foreclosure. Rather, progress will require multipronged approaches that address housing, education, jobs, and quality-of-life issues in a coherent, mutually consistent way. Moreover, strategies will have to be adapted to meet the special circumstances of urban, suburban, and rural settings. As community development researchers and practitioners, you are confronting the challenge of effectively attending to the needs of both individuals and communities-- of people as well as places. Community development has a long history of innovation and learning from experience. Notably, after decades of large-scale, top-down federal efforts, it became increasingly apparent that a one-size-fits-all approach did not serve local communities well. The urban renewal programs of the 1950s and 1960s were perhaps the most prominent examples of well-meaning but misguided efforts to revitalize decaying inner- city neighborhoods. In practice, these policies often devastated neighborhood cohesion, leading their critics to argue for local, bottom-up solutions. Perhaps the most influential critique of urban renewal and top-down planning was Jane Jacobs's 1961 book, . In that book she celebrated the complexity and organic development of city neighborhoods in which intricate social networks enhance safety, quality of life, and economic opportunity. In Jacobs's view, a police force was not as effective at maintaining order as a neighborhood filled with "public actors" such as storekeepers, doormen, and interested neighbors acting as street watchers at all hours. The development of this sort of community self-monitoring is most likely to emerge, she argued, in neighborhoods with a rich mixture of activities taking place in buildings of varying age, character, and use. For the most part, social science research has vindicated Jacobs's perspective. For example, sociologists studying community resilience in the wake of natural disasters mapped deaths caused by an extreme heat wave in Chicago in 1995. They found, not surprisingly, that death rates were higher in poor areas where air conditioners were scarce. But they also noticed a remarkable difference in the fatality rate in two adjacent neighborhoods were comparable by many measures: Both were 99 percent African American, with similar numbers of elderly residents and comparably high rates of poverty and unemployment. Yet Englewood experienced 33 deaths per 100,000 residents during the heat wave, while Auburn Grisham had among the lowest fatality rates in the city, 3 deaths per 100,000 residents. Researchers found that a key difference between Auburn Grisham and other neighborhoods lay in its physical and social topography--the vitality of its sidewalks, stores, restaurants, and community organizations that brought friends and neighbors together, making it easier for people to look out for each other. This example illustrates a point that many community development practitioners have come to embrace: Resilient communities require more than decent housing, important as that is; they require an array of amenities that support the social fabric of the community and build the capabilities of community residents. The movement toward a holistic approach to community development has been long in the making, but the housing crisis has motivated further progress. To be sure, implementing a holistic approach is easier said than done. Government resources are still largely managed in silos, and coordinating government agencies, philanthropy, and the private sector to meet the needs of local communities requires extraordinary commitment and effective leadership. But persistence and effort pay off. The holistic approach has the power to transform neighborhoods and, as a result, the lives of their lower-income residents. Let me give another example, drawn from the experience of the East Lake neighborhood in Atlanta, a neighborhood that exemplified the effects of concentrated poverty. In the early 1990s, East Lake had a crime rate 18 times higher than the national average. Nearly 60 percent of adults received public assistance, and only 5 percent of fifth grade children were able to meet state academic performance standards. A local philanthropist, Tom Cousins, wanted to improve the quality of life in this neighborhood by de-concentrating its poverty. But he understood that East Lake's problems were interconnected: Replacing substandard housing would do little to attract families to the neighborhood if it lacked good schools, but schools couldn't perform well if students feared for their safety, arrived hungry, and were otherwise unprepared or unable to learn. High dropout rates in turn fueled the neighborhood's high rates of unemployment and crime. To deal with the interconnectedness of the neighborhood's problems, Cousins determined to attack them simultaneously. He created the East Lake Foundation to facilitate transformative change. The foundation partnered with the Atlanta Housing Authority to replace the neighborhood's low-income housing project with mixed-income housing that accommodated former tenants and other very low-income residents as well as attracting new, higher-income families. An independently operated public charter school for grades kindergarten through 12, named the Drew Charter School, and an early learning center serving 135 children were built. A new YMCA health and fitness center began to provide wellness programs and to serve as a neighborhood gathering place. Finally, the foundation worked to attract commercial investments in the neighborhood, including a grocery store, a bank branch, and restaurants. Creating this plan and navigating the complex array of interests and resources of the community, the local government, and the private sector took 10 years of effort. But the character of the neighborhood was fundamentally changed. Today crime in East Lake is down by 73 percent, and violent crime is down by 90 percent. The percentage of low- income adults employed has increased from 13 percent to 70 percent, and Drew Charter School moved from last place in performance among 69 Atlanta public schools after its first year of operation to fourth place. With 74 percent of its students receiving free and reduced-price lunches, Drew performs at the same level as public schools in far more affluent areas. The educational outcomes alone argue for the wisdom of the holistic approach to community development. The success in East Lake raises the question of whether a similar approach can work in other communities. In 2009, Cousins launched a community development organization, Purpose Built Communities, to try to attain the same good outcomes that were achieved in Atlanta in other cities around the country. Experience so far suggests that, while the framework can be replicated, it requires certain neighborhood conditions to succeed. These conditions include (1) housing developments of concentrated poverty, which can feasibly be replaced by good-quality mixed-income housing at sufficient scale to change the housing and income characteristics of the neighborhood; (2) the opportunity to create one or more schools accountable to parents and the community; and (3) civic and business leadership that is prepared to create and support an organization charged with coordinating the necessary partnerships and seeing through the long-term plans. As those involved in this effort note, the Purpose Built strategy is quite different from that of most other bodies whose decisions affect community development. example, city governments rarely organize around neighborhoods. School boards, housing authorities, and transit systems all make decisions critical to the health of neighborhoods, but they generally act independently of city government. Moreover, the goals of such bodies are not typically measured in terms of the health of neighborhoods in any holistic sense. This mindset may be changing, however. For example, Los Angeles recently adopted a community-based approach to strategic planning. Its five-year consolidated plan recognizes that no single program or effort is likely, on its own, to lift families out of poverty or reduce crime in a neighborhood. Rather, the plan calls for a multifaceted approach to "build healthy communities by integrating community, economic, and housing development investments with transit opportunities to increase their positive impact on neighborhoods." It also recognizes the need to build the city's institutional capacity so that it can effectively coordinate these efforts. To that end, the mayor created the Housing and Community Development Cabinet, which is composed of representatives from city departments from housing and transportation to health, family services, and economic development. The cabinet will be responsible for identifying neighborhoods for coordinated investment across sectors. Perhaps one of the most promising new partners in community development is the health-care sector. Factors such as educational attainment, income, access to healthy food, and the safety of a neighborhood tend to correlate with individual health outcomes in that neighborhood. Because these factors are linked to economic health as well as physical health, health-care professionals and community development organizations are seeing new opportunities for cooperation in low-income communities. For example, public health specialists and housing leaders are working together in Seattle to reduce the incidence in low-income homes of allergens that can cause or aggravate asthma. Because asthma results in a significant loss of school days and billions of dollars in treatment costs, it is easy to see that these efforts have the potential to improve not only health, but educational and economic outcomes as well. Beyond complementary interests with community development organizations, health professionals offer an important set of skills and tools, including unique data sets and sophisticated evaluation techniques. For example, using data from 38 children's hospitals, the Children's Hospital of Philadelphia Research Institute found an association between rates of foreclosures and poor health in children, including the incidence of abuse. Health-related philanthropies are also investing in projects in low-income communities, ranging from projects to identify the health ramifications of proposed community improvements to increasing access to fresh food, by creating partnerships to subsidize grocery stores in low-income communities. These examples illustrate the benefits of broad-based collaboration for rejuvenating communities that, in some cases, have been in decline for decades. Research is helping sharpen this approach and give more insight into what works. For example, in 2009, Federal Reserve Bank of Boston researchers evaluated the effects of concentrated poverty in Springfield, Massachusetts, as part of a larger study conducted by the Federal Reserve System. Intrigued by the results, the Boston Fed researchers turned their attention to trying to identify the factors that make it possible for some cities to adjust to changing economic conditions while others languish. To do this, the researchers identified 25 midsize manufacturing cities around the country that were similar to Springfield in 1960, when that city was at the height of its prosperity, and asked what accounted for the differences in the economic trajectories experienced by this group of cities over the past 50 years. Remarkably, their analysis indicated that industry mix, demographic makeup, and geographic location made less difference to success than the presence of a community leader and collaboration around a vision for the future. In some cases, leadership came in the form of an energetic mayor, but not always. In fact, the study found that leadership could come from almost anywhere. The successful leader was simply the person or entity that recognized the importance of preventing further deterioration in the local economy and agreed to take responsibility for the effort to turn things around. The leader helped facilitate local collaboration, which was essential not only because economic development is complicated and multidimensional, but also for the more prosaic reason that outside funders typically require that all interested stakeholders commit to a strategic direction. The specific avenues to recovery varied among the resurgent cities identified in the Boston Fed study. Some built on traditional strengths, while others created new business clusters from scratch. For example, Grand Rapids, Michigan, was once known for its furniture manufacturing. As those jobs disappeared, Grand Rapids worked to become a major medical center in the region, partnering with Michigan State University Similarly, Jersey City has successfully transformed itself from a manufacturing-based economy to a financial center. Its proximity to New York City makes this transformation seem obvious in hindsight, but other similarly situated cities have not made comparable strides. Most of the cities in the study made significant investments in infrastructure and people to aid the transition to a knowledge-based economy. For example, Greensboro, North Carolina, worked with the nearby cities of Winston-Salem and High Point to build a regional airport and to replace its manufacturing economy with one based on high-tech research and production. In a common pattern, Greensboro drew on local resources in post-secondary education, with community colleges providing courses to enhance job skills and universities partnering with businesses to develop innovative products--in Greensboro's case, in nanotechnology and pharmaceuticals. In New Haven, Connecticut, local universities collaborate with private industry and local government to support biotech-related education in public schools by providing teacher training, assistance in curriculum design, and a mobile laboratory. These examples show that a city's path to economic recovery typically depends on its ability to draw on its own particular assets. Leaders that recognize the potential of those assets and foster collaboration in exploiting them can help communities remake themselves. The question then becomes how to develop and encourage local leadership. Technical assistance, networking opportunities, and mentoring programs are just some of the ways that leadership can be fostered locally. Based on its evaluation of Springfield and cities of similar size, the Boston Fed worked with its public, private, and philanthropic partners to come up with an idea to enhance leadership and spur transformative change. The Bank recently announced the Working Cities Challenge, a grant competition for smaller cities in Massachusetts that is designed to foster local collaboration to improve the economic health and well-being of low-income residents. Initiatives winning grants are expected to demonstrate cross- sector collaboration and involve groups that typically do not work together. Prize money is being provided by Living Cities, a national philanthropic collaborative; the among others. The value of the competition goes beyond grant money, though that undoubtedly will help those who receive it. The real value of the competition is that it will encourage conversations among local stakeholders that are necessary to make real and lasting change. Moreover, participants will receive access to technical assistance and planning resources, as well as to a growing network of public, private, nonprofit, and philanthropic leaders in the state who are focused on improving the economies of its smaller cities. For practitioners of community development, as in any field, joining a network of like-minded professionals is important for building skills and becoming aware of opportunities and resources. NeighborWorks America, the leading provider of community development training in the country, has provided management and leadership training for community development professionals for more than 25 years. In the past few years, NeighborWorks has expanded its programs to develop leadership among its network organizations' executive directors and board members. Recognizing that effective board leadership is key to the health and effectiveness of its more than 235 member organizations across the country, NeighborWorks established the Achieving Excellence program in 2002 for its executive directors and others in the organization with significant responsibility. This 18-month program offers professional coaching and an opportunity to work with peers to solve a particular organizational challenge. NeighborWorks also trains community leaders through the Community Leaders Institute. The institute is an annual event that attracts some 800 resident leaders from across the country, making it the largest residential leadership development initiative in the field. Attendees arrive in teams of eight and choose from more than 40 workshops on topics such as public speaking, planning, youth development, and mobilizing senior citizens. After four days, the teams have not only learned new skills, but they have developed action plans addressing particular issues in their neighborhoods. They are given a $2,000 grant as seed money so that they can return to their communities and immediately go to work. More than 13,000 resident leaders have gone through the institute to date, and some cities have replicated the format to provide local training for residents. These and similar programs not only train leaders, but they also create networks, partnerships, and the opportunity to learn from each other. In sum, community development is a complicated enterprise. Neighborhoods and communities are complex organisms that will be resilient only if they are healthy along a number of interrelated dimensions, much as a human body cannot be healthy without adequate air, water, rest, and food. But substantial coordination and dedication are needed to break through silos to simultaneously improve housing, connect residents to jobs, and help ensure access to adequate nutrition, health care, education, and day care. Moreover, each community has its own particular set of needs, which depend on local conditions and resources. Accordingly, local leadership, together with a vision of what each community can be, is essential. With that in mind, I want to thank all of you here today for the role you play in bringing your skills in research and analysis to the important work of rebuilding lower- income communities. Community development leaders have no shortage of commitment to their goals, but with the insights you provide, together with the opportunities to learn from the experiences of other communities, they will be better prepared and thus more successful in meeting the very difficult challenges they face. Thank you for being here.

r130416a_FOMC

united states

Panel Discussion on "Monetary Policy: Many Targets, Many Instruments. Where Do We Stand?"

yellen

Thank you to the International Monetary Fund for allowing me to take part in what I expect will be a very lively discussion. Only five or six years ago, there wouldn't have been a panel on the "many instruments" and "many targets" of monetary policy. Before the financial crisis, the focus was on one policy instrument: the short-term policy interest rate. While central banks did not uniformly rely on a single policy target, many had adopted an "inflation targeting" framework that, as the name implies, gives a certain preeminence to that one objective. Of course, the Federal Reserve has long been a bit of an outlier in this regard, with its explicit dual mandate of price stability and maximum employment. Still, the discussion might not have gone much beyond "one instrument and two targets" if not for the financial crisis and its aftermath, which have presented central banks with great challenges and transformed how we look at this topic. Let me start with a few general observations to get the ball rolling. In terms of the targets, or, more generally, the objectives of policy, I see continuity in the abiding importance of a framework of flexible inflation targeting. By one authoritative account, about 27 countries now operate full-fledged inflation-targeting regimes. States is not on this list, but the Federal Reserve has embraced most of the key features of flexible inflation targeting: a commitment to promote low and stable inflation over a longer-term horizon, a predictable monetary policy, and clear and transparent formulate an inflation goal that would not seem to give preference to price stability over inflation goal along with numerical estimates of what the Committee views as the longer- run normal rate of unemployment. The statement also makes clear that the FOMC will take a "balanced approach" in seeking to mitigate deviations of inflation from 2 percent and employment from estimates of its maximum sustainable level. I see this language as entirely consistent with modern descriptions of flexible inflation targeting. For the past four years, a major challenge for the Federal Reserve and many other central banks has been how to address persistently high unemployment when the policy rate is at or near the effective lower bound. This troubling situation has naturally and appropriately given rise to extensive discussion about alternative policy frameworks. I have been very keen, however, to retain what I see as the key ingredient of a flexible inflation-targeting framework: clear communication about goals and how central banks intend to achieve them. With respect to the Federal Reserve's goals, price stability and maximum employment are not only mandated by the Congress, but also easily understandable and widely embraced. Well-anchored inflation expectations have proven to be an immense asset in conducting monetary policy. They've helped keep inflation low and stable while monetary policy has been used to help promote a healthy economy. After the onset of the financial crisis, these stable expectations also helped the United States avoid excessive disinflation or even deflation. Of course, many central banks have, in the wake of the crisis, found it challenging to provide appropriate monetary stimulus after their policy interest rate hit the effective lower bound. This is the point where "many instruments" enters the discussion. The main tools for the FOMC have been forward guidance on the future path of the federal funds rate and large-scale asset purchases. The objective of forward guidance is to affect expectations about how long the highly accommodative stance of the policy interest rate will be maintained as conditions improve. By lowering private-sector expectations of the future path of short-term rates, this guidance can reduce longer-term interest rates and also raise asset prices, in turn, stimulating aggregate demand. Absent such forward guidance, the public might expect the federal funds rate to follow a path suggested by past FOMC behavior in "normal times"--for example, the behavior captured by John Taylor's famous Taylor rule. I am persuaded, however, by the arguments laid out by our panelist Michael Woodford and others suggesting that the policy rate should, under present conditions, be held "lower for longer" than conventional policy rules imply. I see these ideas reflected in the FOMC's recent policy. Since September 2012, the FOMC has stated that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. Since December 2012, the Committee has said it intends to hold the federal funds rate near zero at least until unemployment has declined below 6-1/2 percent, provided that inflation between one and two years ahead is projected to be no more than 1/2 percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. I believe that the clarity of this commitment to accommodation will itself support spending and employment and help to strengthen the recovery. Asset purchases have complemented our forward guidance, and the many dimensions of different purchase programs arguably constitute "many instruments." In designing a purchase program, one must consider which assets to buy: Just Treasury securities or agency mortgage-backed securities as well? Which maturities? The Federal Reserve, the Bank of England, and, more recently, the Bank of Japan have emphasized longer-duration securities. At what pace should the securities be purchased? And how long should they be held once purchases cease? Each of these factors may affect the degree of accommodation delivered. Two innovations in the FOMC's current asset purchase program, for example, are that it is open-ended rather than fixed in size like past programs, and that the overall size of the program is explicitly linked to seeing a substantial improvement in the outlook for the labor market. In these brief remarks, I won't thoroughly review the benefits or costs of our highly accommodative policies, emphasizing only that I believe they have, on net, provided meaningful support to the recovery. But I do want to spend a moment on one potential cost--financial stability--because this topic returns us to the theme of "many targets" for central banks. As Chairman Bernanke has observed, in the years before the crisis, financial stability became a "junior partner" in the monetary policy process, in contrast with its traditionally larger role. The greater focus on financial stability is probably the largest shift in central bank objectives wrought by the crisis. Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let's remember that the Federal Reserve's policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy. Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don't see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation. However, I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense. The Federal Reserve has been working with a number of federal agencies and international bodies since the crisis to implement a broad range of reforms to enhance our monitoring, mitigate systemic risk, and generally improve the resilience of the financial system. Significant work will be needed to implement these reforms, and vulnerabilities still remain. Thus, we are prepared to use any of our many instruments as appropriate to address any stability concerns. Let me conclude by noting that I have touched on only some of the important dimensions of monetary policy targets and instruments that have arisen in recent years. I look forward to a discussion that I expect will explore these issues and perhaps raise others.

r130417a_FOMC

united states

Regulating Large Financial Institutions

stein

Thank you. I'm delighted to be here, and want to thank the International Monetary Fund and the organizers of the conference for including me in a discussion of these important topics. I will focus my remarks today on the ongoing regulatory challenges associated with large, systemically important financial institutions, or SIFIs. In part, this focus amounts to asking a question that seems to be on everyone's mind these days: Where do we stand with respect to fixing the problem of "too big to fail" (TBTF)? Are we making satisfactory progress, or it is time to think about further measures? I should note at the outset that solving the TBTF problem has two distinct aspects. First, and most obviously, one goal is to get to the point where all market participants understand with certainty that if a large SIFI were to fail, the losses would fall on its shareholders and creditors, and taxpayers would have no exposure. However, this is only a necessary condition for success, but not a sufficient one. A second aim is that the failure of a SIFI must not impose significant spillovers on the rest of the financial system, in the form of contagion effects, fire sales, widespread credit crunches, and the like. Clearly, these two goals are closely related. If policy does a better job of mitigating spillovers, it becomes more credible to claim that a SIFI will be allowed to fail without government bailout. So where do we stand? I believe two statements are simultaneously true. We've made considerable progress with respect to SIFIs since the financial crisis. And we're not yet at a point where we should be satisfied. All of you are familiar with the areas of progress. Higher and more robust capital requirements, new liquidity requirements, and stress testing all should help to materially reduce the probability of a SIFI finding itself at the point of failure. And, if, despite these measures, a Reform and Consumer Protection Act now offers a mechanism for recapitalizing and restructuring the institution by imposing losses on shareholders and creditors. In the interests of brevity, I won't go into a lot of detail about OLA. But my Board colleague Jay Powell talked in depth about this topic in a speech last month, and I would just register my broad agreement with "single point of entry" approach to resolution is a promising one. continues to work with the FDIC on the many difficult implementation challenges that remain, but I believe this approach gets the first-order economics right and ultimately has a good chance to be effective. Perhaps more to the point for TBTF, if a SIFI does fail I have little doubt that private investors will in fact bear the losses--even if this leads to an outcome that is messier and more costly to society than we would ideally like. Dodd-Frank is very clear in saying that the Federal Reserve and other regulators cannot use their emergency authorities to bail out an individual failing institution. And as a member of the Board, I am committed to following both the letter and the spirit of the law. Still, we are quite a way from having fully solved the policy problems associated with SIFIs. For one thing, the market still appears to attach some probability to the government bailing out the creditors of a SIFI; this can be seen in the ratings uplift granted to large banks based on the ratings agencies' assessment of the probability of government support. While this uplift seems to have shrunk to some degree since the passage of Dodd-Frank, it is still significant. All else equal, this uplift confers a funding subsidy to the largest financial firms. Moreover, as I noted earlier, even if bailouts were commonly understood to be a zero- probability event, the problem of spillovers remains. It is one thing to believe that a SIFI will be allowed to fail without government support; it is another to believe that such failure will not inflict significant damage on other parts of the financial system. In the presence of such externalities, financial firms may still have excessive private incentives to remain big, complicated, and interconnected, because they reap any benefits--for example, in terms of economies of scale and scope--but don't bear all the social costs. How can we do better? Some have argued that the current policy path is not working, and that we need to take a fundamentally different approach. Such an alternative approach might include, for example, outright caps on the size of individual banks, or a return to Glass- Steagall-type activity limits. My own view is somewhat different. While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd- Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution's systemic footprint. To illustrate my argument, let us take as given the central premise of those who favor size limits: namely, that society would be better off if the distribution of banks were not so skewed toward a handful of very large institutions. (To be clear, I am using the word "size" as shorthand for the broader concept of an institution's systemic footprint, which in addition to size, might reflect complexity, interconnectedness, and global span of operations.) In other words, let's simply posit that a goal of regulation should be to lean against bank size, and ask: What are the best regulatory tools for accomplishing that goal? As in many other regulatory settings, this question can be mapped into the "prices-versus-quantities" framework laid out by Martin Weitzman nearly 40 years ago. Here a size cap is a form of quantity regulation, whereas capital requirements that increase with bank size can be thought of as a kind of price regulation, in the sense that such capital requirements are analogous to a progressive tax on bank size. A key challenge with quantity-based regulation is that one has to decide where to set the cap. Doing so requires a regulator to take a strong stand on the nature of scale and scope economies in large financial firms. Moreover, even if one reads the empirical literature as being quite skeptical about the existence of such economies beyond a certain point in the size distribution--a proposition which itself is debatable--the most that such large-sample studies can do is make on-average statements about scale and scope economies. These studies still leave open the possibility of considerable heterogeneity across firms, and that some firms are able to add considerable value in a given line of business by being very big, even if the average firm in the population is not. And such heterogeneity alone is enough to create significant drawbacks to quantity-based regulation. both have $1 trillion in assets, while C is smaller, with only $400 billion in assets. Bank A actually generates significant economies of scale, so that it is socially optimal for it to remain at its current size. Banks B and C, by contrast, have very modest economies of scale, not enough to outweigh the costs that their size and complexity impose on society. From the perspective of an omniscient social planner, it would be better if both B and C were half their current size. Now let's ask what happens if we impose a size cap of say $500 billion. This size cap does the right thing with respect to Bank B, by shrinking it to a socially optimal size. But it mishandles both Banks A and C, for different reasons. In the case of A, the cap forces it to shrink when it shouldn't, because given the specifics of its business model it actually creates a substantial amount of value by being big. And in the case of C, the cap makes the opposite mistake. It would actually be beneficial to put pressure on C to shrink at the margin--that is, to move it in the direction of being a $200 billion bank instead of a $400 billion one--but since it lies below the cap, it is completely untouched by the regulation. Suppose instead we attack the problem by imposing capital requirements that are an increasing function of bank size. This price-based approach creates some incentive for all three banks to shrink, but lets them balance this incentive against the scale benefits that they realize by staying big. In this case, we would expect A, with its significant scale economies, to absorb the tax hit and choose to remain large, while B and C, with more modest scale economies, would be expected to shrink more radically. In other words, price-based regulation is more flexible, in that it leaves the size decision to bank managers, who can then base their decision on their own understanding of the synergies--or lack thereof--in their respective businesses. This logic can be thought of as supporting the approach taken by the Basel Committee on Banking Supervision in its rule imposing a common equity surcharge on designated global systemically important banks. The exact amount of the surcharge will range from 1 percent to 2.5 percent, and will depend on factors that include a bank's size, complexity, and interconnectedness, as measured by a variety of indicator variables. These progressive surcharges are effectively a type of price-based regulation, and therefore should have the advantages I just noted. However, a proponent of size caps might reasonably reply: "Fine, but how do I know that these surcharges are actually enough to change behavior--that is, to exert a meaningful influence on the size distribution of the banking system?" After all, the analogy between a capital requirement and a tax is somewhat imperfect, since we don't know exactly the implicit tax rate associated with a given level of capital. Some view capital requirements as quite burdensome, which would mean that even a 2 percent surcharge amounts to a significant tax and, hence, a strong incentive for a bank to shrink, while others have argued that capital requirements impose only modest costs, which would imply little incentive to shrink. This uncertainty about the ultimate effect of a given capital-surcharge regime on the size distribution of banks could potentially tip the balance back in favor of quantity-based regulation, like size caps. And indeed, if we were faced with a static, once-and-for-all decision, I don't think economic reasoning alone could give us a definitive answer as to whether caps should be preferred to capital surcharges. This ambiguity is in some sense the central message of Weitzman's original analysis. One way to resolve this tension is to refrain from putting ourselves in the position of having to make a once-and-for-all decision in a setting of substantial uncertainty. Rather, it might be preferable to try to learn from the incoming data and adjust over time, particularly since the recent changes to capital regulation already on the books may represent an informative experiment. In my view, this observation about the potential for learning tips the balance in favor of capital surcharges. For example, the capital-surcharge schedule proposed by the Basel Committee for globally important systemic banks may be a reasonable starting point. However, if after some time it has not delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up. In principle, this turning-up-the-dials approach feels to me like the right way to go: It retains the flexibility that makes price-based regulation attractive, while mitigating the risk that the implicit tax rate will be set too low. Of course, I recognize that its gradualist nature presents practical challenges, not least of which is sustaining a level of regulatory commitment and resolve sufficient to keep the dials turning so long as this is the right thing to do. Before wrapping up, let me briefly mention another piece of the puzzle that I think is sometimes overlooked, but strikes me as having the potential to play an important complementary role in efforts to address the TBTF problem--namely, corporate governance. Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets. But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board. As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy. banks: assessment methodology and the additional loss absorbency requirement," rules text , vol. 41

r130418a_FOMC

united states

Aspects of Inequality in the Recent Business Cycle

raskin

Thank you for asking me to join you today at this conference and to be a part of your continuing inquiry into how the ideas and legacy of Hyman Minsky can inform and shape our understanding of financial markets and the economy. This speech expands on remarks I made in March to the National Community Reinvestment Coalition, in which I explored the roles that monetary and bank regulatory policy play in reducing the unemployment, economic marginalization, and financial vulnerability of millions of moderate- and low-income working Americans. Today I am interested in continuing this exploration by examining an issue of growing saliency that macroeconomic models used at central banks and by academics have not traditionally emphasized--specifically, how such economic marginalization and financial vulnerability, associated with stagnant wages and rising inequality, contributed to the run-up to the financial crisis and how such marginalization and vulnerability could be relevant in the current recovery. To isolate my proper subject here, I want to be clear that I am not engaging this afternoon with the concern that many Americans have that excessive inequality undermines American ideals and values. Nor will I be investigating the social costs associated with wide distributions of income and wealth. Rather, I want to zero in on the question of whether inequality itself is undermining our country's economic strength according to available macroeconomic indicators. Economists have documented that widening income and wealth inequality has been one of the most notable structural changes to the U.S. economy since the late 1970s. This change represents a dramatic departure from the three decades prior to that time, when Americans enjoyed broadly rising incomes and shared prosperity. Indeed, many of you in the room have shed important light on the recent trends in inequality and on the potential role of fiscal policy in addressing them. You have also explored how these trends are relevant to issues of financial stability. I won't attempt to repeat this strong line of research and analysis. Instead, my remarks today are specifically focused on adding to the conversation about how such disparities in income and wealth could be relevant for a macro understanding of the financial crisis and the recovery and the appropriate course of monetary policy today. I will argue that at the start of this recession, an unusually large number of low- and middle-income households were vulnerable to exactly the types of shocks that sparked the financial crisis. These households, which had endured 30 years of very sluggish real-wage growth, held an unusually large share of their wealth in housing, much of it financed with debt. As a result, over time, their exposure to house prices had increased dramatically. Thus, as in past recessions, suffering in the Great Recession-- though widespread--was most painful and most perilous for low- and middle-income households, which were also more likely to be affected by job loss and had little wealth to fall back on. Moreover, I am persuaded that because of how hard these lower- and middle- income households were hit, the recession was worse and the recovery has been weaker. The recovery has also been hampered by a continuation of longer-term trends that have reduced employment prospects for those at the lower end of the income distribution and produced weak wage growth. Of course, it is not part of the Federal Reserve's mandate to address inequality directly, but I want to explore these issues today because the answers may have implications for the Federal Reserve's efforts to understand the recession and conduct policy in a way that contributes to a stronger pace of recovery. Traditionally, the distribution of wealth and income has not been a primary consideration in the way most macroeconomists think about business cycles. But if inequality played a role in the financial crisis, if it contributed to the severity of the recession, and if its effects create a lingering economic headwind today, then perhaps our thinking, and our macroeconomic models, should be adjusted. Despite the tentative nature of these conclusions, I do think it is vital to explore these issues, and, in the spirit of Minsky, I hope my remarks spur more inquiry and discussion. I should also note that the views I express are my own and not necessarily those of my colleagues on the Board of Governors or the Federal Open Market In order to "level set" our understanding, let me begin by reviewing some of the changes to the structure of income, wealth, and debt in the years leading up to the Great Recession--changes that have had significant implications for the well-being of most American households. Long before the recession--decades before, in fact--income data show only sluggish increases in real incomes for low- and middle-income American households, and more-rapid increases for high-income households, resulting in a much greater concentration of income among those at the very top of the income distribution. As just one example of the broader trend, according to the Congressional Budget Office, between 1979 and 2007, inflation-adjusted, pretax income for a household in the top 1 percent more than doubled, while, in contrast, income for a household in the middle of the income distribution increased less than 20 percent. Over these years, the share of pretax income accruing to the top 1 percent of households also doubled, from 10 percent to 20 percent, while the share accruing to the bottom 40 percent fell from 13 percent to 10 percent. These growing disparities of total income are largely due to the increasing concentration of labor income, which, on average, accounted for more than 70 percent of all income over this period. In addition, the distribution of other sources of total income--such as profits from small businesses, capital gains and dividend income, rental income, and the like--also became more concentrated over this period. Many have argued that these disparities in income are hindering economic growth through their effects on consumption. Intuitively, one might assume that the growing concentration of income at the top could lead to less consumer spending and aggregate demand, as wealthier households tend to save more of their additional income than others. However, there is no definitive research indicating that these income disparities show mixed results on the question of whether there are stable differences in the marginal propensity to consume across households with different incomes. More generally, the evidence is equivocal as to whether there is an empirical relationship between higher income inequality and reduced aggregate demand. In my view, understanding the links between greater concentrations of income, variation in spending patterns throughout the income distribution, and the effect of that variation on aggregate consumption--and, ultimately, growth--requires more exploration. But since household behavior is surely driven by more than the size of the paycheck coming in the proverbial front door, the distribution of wealth--as distinct from the distribution of income--could have clearer implications for the macroeconomy. Indeed, wealth inequality is greater than income inequality in the United States, although it has widened little in recent decades. For example, according to the Survey of Board, the top one-fifth of families ranked by income owned 72 percent of the total wealth in the economy in 2010, whereas families in the bottom one-fifth of the income distribution together owned only 3 percent of total wealth in 2010. Hence, families with more-modest incomes have much less wealth to cushion themselves against income shocks, such as unemployment. For example, in 2010, the median value of financial assets was less than $1,000 for families in the lowest income quintile. Moreover, what wealth low- and middle-income families do have is typically concentrated in housing. For families in the top quintile of income, the value of residential properties accounted for about 15 percent of total wealth in 2010. For families in the middle and lower half of the income distribution, the ratio of their home values to total net worth was near 70 percent. In contrast, stock market wealth (and the value of other securities) constitutes a very small share of wealth for low- and middle-income families. Because the wealth of people at the lower end of the distribution is concentrated in housing, these households are disproportionately exposed to swings in house prices. This compositional effect was intensified during the housing boom, as the share of wealth accounted for by housing grew even faster for low- and middle-income families than for high-income families. That said, the increases in homeownership and house values during the boom were largely financed by rising mortgage debt. Thus, the direct positive effect of rising house prices on most households' net worth was largely offset by the negative effect of increased debt that households took on. On net, mortgage debt and home values moved up together. But when house prices began falling , the mortgage debt and repayment obligations remained. To be sure, the increase in mortgage debt prior to the recession occurred across all types of households. But it was families with modest incomes and wealth largely in their homes that were the most vulnerable to subsequent drops in home values. The question then arises as to why households with poor income prospects sought out levels of mortgage debt that would ultimately prove so problematic. Putting aside the practice, in the run-up to the crisis, of lenders steering households to mortgage debt products that were more costly than what such households may have otherwise qualified for, one reason may have been that many households in the middle and lower end of the income distribution, whose wage earnings were stagnant, did not recognize the long-run and persistent trends underlying their lack of income growth. If households thought they were merely going through a rough patch, it would have been quite reasonable for them to borrow money to smooth through it--to make home improvements, for example, or to send a child to college. At the same time, many people believed that the sharp increases in their home values had made them permanently richer and that house prices would never turn down, a belief that appears to have been shared by many households in the upper part of the income distribution as well. In fact, purchasing a house using debt was a profitable investment in the early 2000s. While it is hard to know with any certainty what these individual households believed at the time, it seems quite plausible to me, as others have argued, that stagnant wages and rising inequality, in combination with the relaxation of underwriting standards, led to an increase in the use of credit unsupported by greater income. Given these developments, when house prices fell, household finances were struck a devastating blow. The resulting fallout magnified this initial shock, ushering in the Great Recession. Let me lay out this argument in more detail. As I mentioned earlier, low- to middle-income families held a disproportionate share of their assets in housing prior to the financial crisis and hence were very exposed to what was a historic decline in house prices. And so, while total household net worth fell 15 percent in real terms between 2007 and 2010, median net worth fell almost 40 percent. This difference reflects the amplified effect that housing had on wealth changes in the middle of the wealth distribution. The unexpected drop in house prices on its own reduced both households' wealth and their access to credit, likely leading them to pull back their spending. In particular, underwater borrowers and heavily indebted households were left with little collateral, which limited their access to additional credit and their ability to refinance at lower interest rates. Indeed, some studies have shown that spending has declined more for indebted households. Compounding the effect of falling house prices on household wealth and credit was the fact that these low- to middle-income households are also composed of some of the groups that have historically borne the brunt of downturns in the labor market. During recessions, the young, the less educated, and minorities are more likely to experience flat or declining wages, reduced hours, and unemployment. While this disparity is not a new phenomenon, dealing with a loss in labor income during the most recent recession was a heightened challenge to households that had mortgage obligations and no other forms of wealth to cushion the blow. The adverse developments in the labor market added to the difficulty most households were having in repaying their existing debts and in accessing credit in the recession. These low- to middle-income households that bore the strains in both housing and labor markets, and had little wealth cushion, had more difficulty making payments on their mortgages and other consumer credit debt. For example, among the mortgages originated from 2004 to 2008, almost 25 percent of those in low-income neighborhoods were foreclosed on or in serious delinquency as of 2011, more than twice the rate of mortgages originated in higher-income neighborhoods. Higher-income households had also taken on debt and were affected by declines in asset prices. But these households entered the recession with a larger wealth buffer and higher incomes, so they generally were still able to service their debts. The sharp rise in defaults and delinquencies put extraordinary stress on most households' finances, intensified the financial crisis, and exacerbated the effect of the initial economic shocks. Indeed, a rapid downward spiral of tighter credit, declines in asset prices, rising unemployment, and falling demand caused severe distress and a pullback in spending that was ultimately widespread across households. Inequality and the Recovery I have argued that rising inequality and stagnating wages may have led households to borrow more and to pin their hopes for economic advancement on rising home values, developments that exacerbated the severity of the financial crisis and recession. Now we are nearly four years into the recovery, which has been weak. In my view, this same confluence of factors has also contributed to the tepid recovery. If my theory about why households overextended themselves before the financial crisis is correct, then it is likely also true that households have had a rude awakening in the years since. Not only did they receive an unwelcome shock to their net current wealth, but they also undoubtedly have come to realize that house prices will not rise indefinitely and that their labor income prospects are less rosy than they had believed. As a result, they are curtailing their spending in an effort to rebuild their nest eggs and may also be trimming their budgets in order to bring their debt levels into alignment with their new economic realities. In this case, the effects of the plunge in net wealth and the jump in unemployment on subsequent spending have been long lasting and lingering. Overall debt levels remain higher than before the house price boom, and many families continue to struggle to keep up with their monthly payments. Although many households have significantly reduced their debt levels, many others probably have far to go. It is hard to know just what the optimal debt-to-income ratio is, but, in my view, households will likely aim for something lower than before the financial crisis: Households are probably working toward lower, more-manageable debt service obligations; the heightened uncertainty in the recession may have raised the desired level of financial buffers; and, to the extent that households saw the negative shocks to house prices and income as permanent, they are reducing their spending and thus their demand for new borrowing. While the process of household deleveraging has affected the spending and borrowing of many households, there is no doubt that the process has been more acute for those that have experienced unemployment, underemployment, or slower wage gains. To make matters worse, there is also some evidence to suggest that the factors that contributed to the rise in inequality and the stagnation of wages in the bottom half of the income distribution, such as technological change that favors those with a college education and globalization, are still at play in the recovery--and perhaps may have accelerated. About two-thirds of all job losses in the recession were in middle-wage occupations--such as manufacturing, skilled construction, and office administration jobs-- but these occupations have accounted for less than one-fourth of subsequent job growth. In contrast, the decline in lower-wage occupations--such as retail sales, food service, and other lower-paying service jobs--accounted for only one-fifth of job loss and more than one-half of total job gains in the recovery. It is not only the occupational and industrial distribution of the new jobs that poses challenges for workers and their families struggling to make ends meet, but also the fact that many of the jobs that have returned are part time or make use of temporary arrangements popularly known as contingent work. The flexibility of these jobs may be beneficial for workers who want or need time to address their family needs. However, workers in these jobs often receive less pay and fewer benefits than traditional full-time or "permanent" workers, are much less likely to benefit from the protections of labor and employment laws, and often have no real pathway to upward mobility in the workplace. Wage gains have remained more muted than is typical during a recovery. While this phenomenon likely partly reflects the trends in job creation that I have already discussed, weak wage growth also reflects the severe nature of the crisis: Typically, those who are laid off during recessions struggle to find reemployment that is of comparable quality to their previous job, and research has shown that, on average, a person's income remains depressed for decades following job loss, and that income losses over one's working life are especially severe when the job loss occurs during a recession. Indeed, while average wages have continued to increase (albeit slowly) on an annual basis for persons who have remained employed, the average wage for new hires has declined since 2010. Although it is too early to state with certainty what the long- term effect of this recession will be on the earnings potential of those who lost their jobs, given the severity of the job loss and sluggishness of the recovery--with nearly 9 million jobs lost and still almost 2 1/2 million jobs below pre-recession employment levels--it is very likely that, for many households, future labor earnings will be well below what they had anticipated in the years before the recession. I have focused most of my remarks on the experiences of households at the lower ends of the income and wealth distributions, those households whose incomes improved the least in the years prior to the financial crisis and that suffered disproportionately as a result of the crisis and ensuing recession. To be clear, my approach of starting with inequality and differences across households is not a feature of most analyses of the macroeconomy, and the channels I have emphasized generally do not play key roles in most macro models. The typical macroeconomic analysis focuses on the general equilibrium behavior of "representative" households and firms, thereby abstracting from the consequences of inequality and other heterogeneity across households and instead focusing on the aggregate measures of spending determinants, including current income, wealth, interest rates, credit supply, and confidence or pessimism. In certain circumstances, this abstraction might be a reasonable simplification. For example, if the changes in the distribution of income or wealth, and the implications of those changes for the overall economy, are regular features of business cycles, then even an aggregate model without an explicit focus on distributional issues would capture those historical regularities. However, the narrative I have emphasized places economic inequality and the differential experiences of American families, particularly the highly adverse experiences of those least well positioned to absorb their "realized shocks," closer to the front and center of the macroeconomic adjustment process. The effects of increasing income and wealth disparities--specifically, the stagnating wages and sharp increase in household debt in the years leading up to the crisis, combined with the rapid decline in house prices and contraction in credit that followed--may have resulted in dynamics that differ from historical experience and which are therefore not well captured by aggregate models. How these factors have interacted and the implications for the aggregate economy are subject to debate, but I have laid out some possible channels through which there could be effects and that I believe represent some particularly fruitful areas for continued research. The arguments that I have laid out suggest that paying attention to the experiences of different types of households may be important for the way we understand and interpret the macroeconomic events of the past several years. As a consequence, these differential experiences may also have implications for the conduct of monetary policy. Arguably, the FOMC's conduct of monetary policy in recent years has in part been designed to address this particular landscape. In response to continuing low levels of resource utilization, the FOMC has kept monetary policy highly accommodative by keeping its primary policy instrument, the federal funds rate, at an exceptionally low level; by supplementing this move with forward guidance about the funds rate; and by initiating unconventional policy actions such as large-scale asset purchases. One channel through which these policies operate is by putting downward pressure on longer-term interest rates, thereby encouraging firms to invest in plants and equipment and helping enable households to purchase cars and other durable goods and also to refinance their mortgages. Lower interest rates also support the prices of homes and other assets, which can lead to additional spending. The resulting boost to demand leads firms to hire and invest further, strengthening the economy as a whole. To be sure, every household is different, and the particular mix of assets, skills, and opportunities that each has will determine how much it is able to share in the recovery. But accommodative monetary policy that lifts economic activity more generally is expected to increase the odds of good outcomes for American families. Of course, it is also relevant to consider whether the unusual circumstances--the outsized role of housing wealth in the portfolios of low- and middle-income households, the increased use of debt during the boom, and the subsequent unprecedented shocks to the housing market--may have attenuated the effectiveness of monetary policy during the depths of the recession. Households that have been through foreclosure or have underwater mortgages or are otherwise credit constrained are less able than other households to take advantage of the lower interest rates, either for homebuying or other purposes. In my view, these effects likely clogged some of the channels through which monetary policy traditionally works. As the housing market recovers, though, I think it is possible that accommodative monetary policy could be increasingly potent. As house prices rise, more and more households have enough home equity to gain renewed access to mortgage credit and the ability to refinance their homes at lower rates. The staff at the Federal Reserve Board has estimated that house price increases of 10 percent or less from current levels would be sufficient for about 40 percent of underwater homeowners to regain positive equity. It is my view that understanding the long-run trends in income and wealth across different households is important in understanding the dynamics of the macroeconomy and thus also may be relevant for setting monetary policy to best reach our goals of maximum employment and price stability. I believe that the accommodative policies of the FOMC and the concerted effort we have made to ease conditions in the mortgage markets will help the economy continue to gain traction. And the resulting expansion in employment will likely improve income levels at the bottom of the distribution. However, given the long-standing trends toward greater income and wealth inequalities, it is unlikely that cyclical improvements in the labor markets will do much to reverse these trends. It strikes me that macroeconomists are far from a comprehensive understanding of how wealth and income inequality may affect business cycle dynamics. My remarks today are given only in the spirit of describing how that relationship might be further explored. I have said nothing about the social costs associated with such trends, nor have I provided much detail on what is occurring at the top end of the income and wealth distribution and the effects of those trends on the recovery. Nonetheless, I believe that, given the wide income and wealth disparities in the United States, this area is ripe for more research. In recent years, the Board has increased its efforts to measure and understand differences in the economic situations faced by different types of families. A particularly strong source of data to improve our understanding of the role for inequality and heterogeneity is the SCF. The triennial SCF marks its 30th anniversary this year, as the fieldwork for the 2013 survey begins this month. The data we collect on U.S. families are a fundamental input for many different types of research projects being undertaken by Board economists, in other government agencies and research centers, and in academia. In addition, the Board, in partnership with other members of the Federal Reserve System, is engaged in a wide range of analysis and research using rich and timely data on households' use of consumer credit. And the Board continues to support direct efforts to understand differences in spending and saving behavior across households, such as studies of stimulus policies in the Thomson Reuters/University of Michigan Surveys of There is much work to be done on understanding the ways in which income and wealth inequality and other forms of household heterogeneity affect aggregate behavior, and the implications for monetary policy. The times demand that we continue to analyze such dynamics and their implications, in partnership with academics, our Federal Reserve System colleagues, and policy analysts representing many different types of government and private-sector institutions. Thank you for your attention and the creative thought you bring to today's economic challenges.

r130419a_FOMC

united states

Liquidity Regulation and Central Banking

stein

Liquidity regulation is a relatively new, post-crisis addition to the financial stability toolkit. Key elements include the Liquidity Supervision, and the Net Stable Funding Ratio, which is still a work in progress. In what follows, I will focus on the LCR. The stated goal of the LCR is straightforward, even if some aspects of its design are less so. In the words of the Basel Committee, "The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario." In other words, each bank is required to model its total outflows over 30 days in a liquidity stress event and then to hold HQLA sufficient to accommodate those outflows. This requirement is implemented with a ratio test, where modeled outflows go in the denominator and the stock of HQLA goes in the numerator; when the ratio equals or exceeds 100 percent, the requirement is satisfied. The Basel Committee issued the first version of the LCR in December 2010. In January of this year, the committee issued a revised final version of the LCR, following an endorsement by its governing body, the Group of Governors and Heads of Supervision (GHOS). The revision expands the range of assets that can count as HQLA and also adjusts some of the assumptions that govern the modeling of net outflows in a stress scenario. In addition, the committee agreed in January to a gradual phase-in of the LCR, so that it only becomes fully effective on an international basis in January 2019. On the domestic front, the Federal Reserve expects that the U.S. banking agencies will issue a proposal later this year to implement the LCR for large U.S. banking firms. While this progress is welcome, a number of questions remain. First, to what extent should access to liquidity from a central bank be allowed to count toward satisfying the LCR? In January, the GHOS noted that the interaction between the LCR and the provision of central bank facilities is critically important. And the group instructed the Basel Committee to continue working on this issue in 2013. Second, what steps should be taken to enhance the usability of the LCR buffer-- that is, to encourage banks to actually draw down their HQLA buffers, as opposed to fire- selling other less liquid assets? The GHOS has also made clear its view that, during periods of stress, it would be appropriate for banks to use their HQLA, thereby falling below the minimum. However, creating a regime in which banks voluntarily choose to do so is not an easy task. A number of observers have expressed the concern that if a bank is held to an LCR standard of 100 percent in normal times, it may be reluctant to allow its ratio to drop below 100 percent when facing large outflows, even if regulators were to permit this temporary deviation, for fear that a decline in the ratio could be interpreted as a sign of weakness. My aim here is to sketch a framework for thinking about these and related issues. Among them, the interplay between the LCR and central bank liquidity provision is perhaps the most fundamental and a natural starting point for discussion. By way of motivation, note that before the financial crisis, we had a highly developed regime of capital regulation for banks--albeit one that looks inadequate in retrospect--but we did not have formal regulatory standards for their liquidity. The introduction of liquidity regulation after the crisis can be thought of as reflecting a desire to reduce dependence on the central bank as a lender of last resort (LOLR), based on the lessons learned over the previous several years. However, to the extent that some role for the LOLR still remains, one now faces the question of how it should coexist with a regime of liquidity regulation. To address this question, it is useful to take a step back and ask another one: What underlying market failure is liquidity regulation intended to address, and why can't this market failure be handled entirely by an LOLR? I will turn to this question first. Next, I will consider different mechanisms that could potentially achieve the goals of liquidity regulation, and how these mechanisms relate to various features of the LCR. In so doing, I hope to illustrate why, even though liquidity regulation is a close cousin of capital regulation, it nevertheless presents a number of novel challenges for policymakers and why, as a result, we are going to have to be open to learning and adapting as we go. One of the primary economic functions of banks and other financial intermediaries, such as broker-dealers, is to provide liquidity--that is, cash on demand--in various forms to their customers. Some of this liquidity provision happens on the liability side of the balance sheet, with bank demand deposits being a leading example. But, importantly, banks also provide liquidity via committed lines of credit. Indeed, it is probably not a coincidence that these two products--demand deposits and credit lines--are offered under the roof of the same institution; the underlying commonality is that both require an ability to accommodate unpredictable requests for cash on short notice. number of other financial intermediary services, such as prime brokerage, also embody a significant element of liquidity provision. Without question, these liquidity-provision services are socially valuable. On the liability side, demand deposits and other short-term bank liabilities are safe, easy-to-value claims that are well suited for transaction purposes and hence create a flow of money-like benefits for their holders. And loan commitments are more efficient than an arrangement in which each operating firm hedges its future uncertain needs by "pre- borrowing" and hoarding the proceeds on its own balance sheet; this latter approach does a poor job of economizing on the scarce aggregate supply of liquid assets. At the same time, as the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures--and the accompanying contractions in credit availability--can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy. There are two broad types of policy tools available to deal with this sort of liquidity-based market failure. The first is after-the-fact intervention, either by a deposit insurer guaranteeing some of the bank's liabilities or by a central bank acting as an LOLR; the second type is liquidity regulation. As an example of the former, when the economy is in a bad state, assuming that a particular bank is not insolvent, the central bank can lend against illiquid assets that would otherwise be fire-sold, thereby damping or eliminating the run dynamics and helping reduce the incidence of bank failure. In much of the literature on banking, such interventions are seen as the primary method for dealing with run-like liquidity problems. A classic statement of the central bank's role as an LOLR is Walter Bagehot's 1873 book . More recently, the seminal theoretical treatment of this issue is by Douglas Diamond and Philip Dybvig, who show that under certain circumstances, the use of deposit insurance or an LOLR can eliminate run risk altogether, thereby increasing social welfare at zero cost. To be clear, this work assumes that the bank in question is fundamentally solvent, meaning that while its assets may not be liquid on short notice, the long-run value of these assets is known with certainty to exceed the value of the bank's liabilities. One way to interpret the message of this research is that capital regulation is important to ensure solvency, but once a reliable regime of capital regulation is in place, liquidity problems can be dealt with after the fact, via some combination of deposit insurance and use of the LOLR. It follows that if one is going to make an argument in favor of adding preventative liquidity regulation such as the LCR on top of capital regulation, a central premise must be that the use of LOLR capacity in a crisis scenario is socially costly, so that it is an explicit objective of policy to economize on its use in such circumstances. I think this premise is a sensible one. A key point in this regard--and one that has been reinforced by the experience of the past several years--is that the line between illiquidity and insolvency is far blurrier in real life than it is sometimes assumed to be in theory. Indeed, one might argue that a bank or broker-dealer that experiences a liquidity crunch must have some probability of having solvency problems as well; otherwise, it is hard to see why it could not attract short-term funding from the private market. This reasoning implies that when the central bank acts as an LOLR in a crisis, it necessarily takes on some amount of credit risk. And if it experiences losses, these losses ultimately fall on the shoulders of taxpayers. Moreover, the use of an LOLR to support banks when they get into trouble can lead to moral hazard problems, in the sense that banks may be less prudent ex ante. If it were not for these costs of using LOLR capacity, the problem would be trivial, and there would be no need for liquidity regulation: Assuming a well-functioning capital-regulation regime, the central bank could always avert all fire sales and bank failures ex post, simply by acting as an LOLR. This observation carries an immediate implication: It makes no sense to allow unpriced access to the central bank's LOLR capacity to count toward an LCR requirement. Again, the whole point of liquidity regulation must be either to conserve on the use of the LOLR or in the limit, to address situations where the LOLR is not available at all--as, for example, in the case of broker-dealers in the United States. At the same time, it is important to draw a distinction between priced and unpriced access to the LOLR. For example, take the case of Australia, where prudent fiscal policy has led to a relatively small stock of government debt outstanding and hence to a potential shortage of HQLA. The Basel Committee has agreed to the use by the Reserve Bank of Australia an up-front fee for what is effectively a loan commitment, and this loan commitment can then be counted toward its HQLA. In contrast to free access to the LOLR, this approach is not at odds with the goals of liquidity regulation because the up-front fee is effectively a tax that serves to deter reliance on the LOLR-- which, again, is precisely the ultimate goal. I will return to the idea of a CLF shortly. Once it has been decided that liquidity regulation is desirable, the next question is how best to implement it. In this context, note that the LCR has two logically distinct aspects as a regulatory tool: It is a mitigator, in the sense that holding liquid assets leads to a better outcome if there is a bad shock; it is also an implicit tax on liquidity provision by banks, to the extent that holding liquid assets is costly. Of course, one can say something broadly similar about capital requirements. But the implicit tax associated with the LCR is subtler and less well understood, so I will go into some detail here. An analogy may help to explain. Suppose we have a power plant that produces energy and, as a byproduct, some pollution. Suppose further that regulators want to reduce the pollution and have two tools at their disposal: They can mandate the use of a pollution-mitigating technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the plant. In an ideal world, regulation would accomplish two objectives. First, it would lead to an optimal level of mitigation--that is, it would induce the plant to install scrubbers up to the point where the cost of an additional scrubber is equal to the marginal social benefit, in terms of reduced pollution. And, second, it would also promote conservation: Given that the scrubbers don't get rid of pollution entirely, one also wants to reduce overall energy consumption by making it more expensive. A simple case is one in which the costs of installing scrubbers, as well as the social benefits of reduced pollution, are known in advance by the regulator and the manager of the power plant. In this case, the regulator can figure out what the right number of scrubbers is and require that the plant install these scrubbers. The mandate can therefore precisely target the optimal amount of mitigation per unit of energy produced. And, to the extent that the scrubbers are costly, the mandate will also lead to higher energy prices, which will encourage some conservation, though perhaps not the socially optimal level. This latter effect is the implicit tax aspect of the mandate. A more complicated case is when the regulator does not know ahead of time what the costs of building and installing scrubbers will be. Here, mandating the use of a fixed number of scrubbers is potentially problematic: If the scrubbers turn out to be very expensive, the regulation will end up being more aggressive than socially desirable, leading to overinvestment in scrubbers and large cost increases for consumers; however, if the scrubbers turn out to be cheaper than expected, the regulation will have been too soft. In other words, when the cost of the mitigation technology is significantly uncertain, a regulatory approach that fixes the quantity of mitigation is equivalent to one where the implicit tax rate bounces around a lot. By contrast, a regulatory approach that fixes the price of pollution instead of the quantity--say, by imposing a predetermined proportional tax rate directly on the amount of pollution emitted by the plant--is more forgiving in the face of this kind of uncertainty. This approach leaves the scrubber-installation decision to the manager of the plant, who can figure out what the scrubbers cost before deciding how to proceed. For example, if the scrubbers turn out to be unexpectedly expensive, the plant manager can install fewer of them. This flexibility translates into less variability in the effective regulatory burden and hence less variability in the price of energy to consumers. What does all this imply for the design of the LCR? Let's work through the analogy in detail. The analog to the power plant's energy output is the gross amount of liquidity services created by a bank--via its deposits, the credit lines it provides to its customers, the prime brokerage services it offers, and so forth. The analog to the mitigation technology--the scrubbers--is the stock of HQLA that the bank holds. And the analog to pollution is the net liquidity risk associated with the difference between these two quantities, something akin to the LCR shortfall. That is, when the bank offers a lot of liquidity on demand to its customers but fails to hold an adequate buffer of HQLA, this is when it imposes spillover costs on the rest of the financial system. In the case of the power plant, I argued that a regulation that calls for a fixed quantity of mitigation--that is, for a fixed number of scrubbers--is more attractive when there is little uncertainty about the cost of these scrubbers. In the context of the LCR, the cost of mitigation is the premium that the bank must pay--in the form of reduced interest income--for its stock of HQLA. And, crucially, this HQLA premium is determined in market equilibrium and depends on the total supply of safe assets in the system, relative to the demand for those assets. On the one hand, if safe HQLA-eligible assets are in ample supply, the premium is likely to be low and stable. On the other hand, if HQLA- eligible assets are scarce, the premium will be both higher and more volatile over time. This latter situation is the one facing countries like Australia, where, as I noted earlier, the stock of outstanding government securities is relatively small. And it explains why, for such countries, having a price-based mechanism as part of their implementation of the LCR can be more appealing than pure reliance on a quantity mandate. When one sets an up-front fee for a CLF, one effectively caps the implicit tax associated with liquidity regulation at the level of the commitment fee and tamps down the undesirable volatility that would otherwise arise from an entirely quantity-based regime. Moreover, it bears reemphasizing that having a CLF with an up-front fee is very different from simply allowing banks to count central-bank-eligible collateral as HQLA at no charge. Rather, the CLF is like the pollution tax. For every dollar of pre-CLF shortfall--that is, for every dollar of required liquidity that a bank can't obtain on the private market--the bank has to pay the commitment fee. So even if there is not as much mitigation, there is still an incentive for conservation, in the sense that banks are encouraged to do less liquidity provision, all else being equal. This would not be the case if the CLF were available at a zero price. What about the situation in countries where safe assets are more plentiful? The analysis here has a number of moving parts because in addition to the implementation of the LCR, substantial increases in demand for safe assets will arise from new margin requirements for both cleared and noncleared derivatives. Nevertheless, given the large and growing global supply of sovereign debt securities, as well as other HQLA-eligible assets, most estimates suggest that the scarcity problem should be manageable, at least for the foreseeable future. In particular, quantitative impact studies released by the Basel Committee estimate that the worldwide incremental demand for HQLA coming from both the implementation of the LCR and swap margin requirements might be on the order of $3 trillion. This is a large number, but it compares with a global supply of HQLA-eligible assets of more than $40 trillion. Moreover, the eligible collateral for swap margin is proposed to be broader than the LCR's definition of HQLA--including, for example, certain equities and corporate bonds without any cap. If one focuses just on U.S. institutions, the incremental demand number is on the order of $1 trillion, while the sum of Treasury, agency, and agency mortgage-backed securities is more than $19 trillion. While this sort of analysis is superficially reassuring, the fact remains that the HQLA premium will depend on market-equilibrium considerations that are hard to fully fathom in advance, and that are likely to vary over time. This uncertainty needs to be understood, and respected. Indeed, the market-equilibrium aspect of the problem represents a crucial distinction between capital regulation and liquidity regulation, and it is one reason why the latter is particularly challenging to implement. Although capital regulation also imposes a tax on banks--to the extent that equity is a more expensive form of finance than debt--this tax wedge is, to a first approximation, a fixed constant for a given bank, independent of the scale of overall financial intermediation activity. If Bank A decides to issue more equity so it can expand its lending business, this need not make it more expensive for Bank B to satisfy its capital requirement. In other words, there is no scarcity problem with respect to bank equity--both A and B can always make more. By contrast, the total supply of HQLA is closer to being fixed at any point in time. What does all of this imply for policy design? First, at a broad philosophical level, the recognition that liquidity regulation involves more uncertainty about costs than capital regulation suggests that even a policymaker with a very strict attitude toward capital might find it sensible to be somewhat more moderate and flexible with respect to liquidity. This point is reinforced by the observation that when an institution is short of capital and can't get more on the private market, there is really no backup plan, short of resolution. By contrast, as I mentioned earlier, when an institution is short of liquidity, policymakers do have a backup plan in the form of the LOLR facility. One does not want to rely too much on that backup plan, but its presence should nevertheless factor into the design of liquidity regulation. Second, in the spirit of flexibility, while a price-based mechanism such as the CLF may not be immediately necessary in countries outside of Australia and a few others, it is worth keeping an open mind about the more widespread use of CLF-like mechanisms. If a scarcity of HQLA-eligible assets turns out to be more of a problem than we expect, something along those lines has the potential to be a useful safety valve, as it puts a cap on the cost of liquidity regulation. Such a safety valve would have a direct economic benefit, in the sense of preventing the burden of regulation from getting unduly heavy in any one country. Perhaps just as important, a safety valve might also help to protect the integrity of the regulation itself, by harmonizing costs across countries and thereby reducing the temptation of those most hard-hit by the rules to try to chip away at them. Without such a safety valve, it is possible that some countries--those with relatively small supplies of domestic HQLA--will find the regulation considerably more costly than others. If so, it would be natural for them to lobby to dilute the rules--for example, by arguing for an expansion in the type of assets that can count as HQLA. Taken too far, this sort of dilution would undermine the efficacy of the regulation as both a mitigator and a tax. In this scenario, holding the line with what amounts to a proportional tax on liquidity provision would be a better outcome. One situation where liquid assets can become unusually scarce is during a financial crisis. Consequently, even if CLFs were not counted toward the LCR in normal times, it might be appropriate to count them during a crisis. Indeed, while the LCR requires banks to hold sufficient liquid assets in good times to meet their outflows in a given stress scenario, it implicitly recognizes that if things turn out even worse than that scenario, central bank liquidity support will be needed. Allowing CLFs to count toward the LCR in such circumstances would acknowledge the importance of access to the central bank, and this access could be priced accordingly. Finally, a price-based mechanism might also help promote a willingness of banks to draw down their supply of HQLA in a stress scenario. As I noted at the outset, one important concern about a pure quantity-based system of regulation is that if a bank is held to an LCR standard of 100 percent in normal times, it may be reluctant to allow its ratio to fall below 100 percent when facing large outflows for fear that doing so might be seen by market participants as a sign of weakness. By contrast, in a system with something like a CLF, a bank might in normal times meet 95 percent of its requirement by holding private-market HQLA and the remaining 5 percent with committed credit lines from the central bank, so it would have an LCR of exactly 100 percent. Then, when hit with large outflows, it could maintain its LCR at 100 percent, but do so by increasing its use of central bank credit lines to 25 percent and selling 20 percent of its other liquid assets. This scenario would be the sort of liquid- asset drawdown that one would ideally like to see in a stress situation. Moreover, the central bank could encourage this drawdown by varying the pricing of its credit lines-- specifically, by reducing the price of the lines in the midst of a liquidity crisis. Such an approach would amount to taxing liquidity provision more in good times than in bad, which has a stabilizing macroprudential effect. This example also suggests a design that may have appeal in jurisdictions where there is a relatively abundant supply of HQLA-eligible assets. One can imagine calibrating the pricing of the CLF so as to ensure that lines provided by central banks make up only a minimal fraction of banks' required HQLA in normal times--apart, perhaps, from the occasional adjustment period after an individual bank is hit with an idiosyncratic liquidity shortfall. At the same time, in a stress scenario, when liquidity is scarce and there is upward pressure on the HQLA premium, the pricing of the CLF could be adjusted so as to relieve this pressure and promote usability of the HQLA buffer. Such an approach would respect the policy objective of reducing expected reliance on the LOLR while at the same time allowing for a safety valve in a period of stress. The limit case of this approach is one where the CLF counts toward the LCR only in a crisis. By way of conclusion, let me just restate that liquidity regulation has a key role to play in improving financial stability. However, we should avoid thinking about it in isolation; rather, we can best understand it as part of a larger toolkit that also includes capital regulation and, importantly, the central bank's LOLR function. Therefore, proper design and implementation of liquidity regulations such as the LCR should take account of these interdependencies. In particular, policymakers should aim to strike a balance between reducing reliance on the LOLR on the one hand and moderating the costs created by liquidity shortages on the other hand--especially those shortages that crop up in times of severe market strain. And, as always, we should be prepared to learn from experience as we go.

r130503a_FOMC

united states

Evaluating Progress in Regulatory Reforms to Promote Financial Stability

tarullo

More than five years after the failure of Bear Stearns marked an escalation of the financial crisis, and nearly three years since the passage of the Dodd-Frank Act, debate continues over the appropriate set of policy responses to protect against financial instability. In recent months, there has been, in particular, a renewal of interest in additional measures to address the too-big-to-fail problem. In some respects, the persistence of debate is unsurprising. After all, the severity of the crisis and ensuing recession, and the frustratingly slow pace of economic recovery, have properly occasioned much thought about the structure of the financial system and the fundamentals of financial regulation. Continuing discussion of these issues is part of a protracted policy debate over financial regulatory reform. Some argue that little has changed and that the needed reform is a single, dramatic policy change (though that single policy differs considerably among those taking this view). Others argue that reforms already enacted are sufficient to ensure financial stability. Still others contend that there has already been too much of a regulatory response, which is suppressing credit extension and faster economic recovery. I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by short-term wholesale funding markets. This afternoon I would like both to highlight the importance of what has already been accomplished and, at somewhat greater length, to identify what I believe to be the key steps that remain. Before turning to these subjects, though, I begin with a brief reprise of the origins of the financial crisis, to remind ourselves of the vulnerabilities that led to the crisis and that remain of concern today. It should, but does not always, go without saying that proposed solutions should actually help solve the problems at hand, and do so in a manner that minimizes the costs to otherwise productive activities. Beginning in the 1970s, the separation of traditional lending and capital markets activities established by New Deal financial regulation began to break down under the weight of macroeconomic turbulence, technological and business innovation, and competition. During the succeeding three decades these activities became progressively more integrated, fueling the expansion of what has become known as the shadow banking system, including the explosive growth of securitization and derivative instruments in the first decade of this century. This trend entailed two major changes. First, it diminished the importance of deposits as a source of funding for credit intermediation, in favor of capital market instruments sold to institutional investors. Over time, these markets began to serve some of the same maturity transformation functions as the traditional banking systems, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid. Second, this trend altered the structure of the industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates. There was, in fact, a symbiotic relationship between the growth of large financial conglomerates and the shadow banking system. Large banks sponsored shadow banking backed commercial paper conduits, and auction rate securities. These firms also dominated the underwriting of assets purchased by entities within the shadow banking system. Though motivated in part by regulatory arbitrage, these developments were driven by more than regulatory evasion. The growth and deepening of capital markets lowered financing costs for many companies and, through innovations such as securitization, helped expand the availability of capital for mortgage lending. Similarly, the rise of institutional investors as guardians of household savings made a wide array of investment and savings products available to a much greater portion of the American public. But these changes also helped accelerate the fracturing of the system established in the 1930s. While the increasingly outmoded regulation of earlier decades was eroded, no new regulatory mechanisms were put in place to control new risks. When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based--notably, those tied to poorly underwritten subprime mortgages--a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets, notably including the structured products that had become central to the shadow banking system. Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop. Severe repercussions were felt throughout the financial system, as short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower. Moreover, as demonstrated by the intervention of the government when Bear Stearns and AIG were failing, and by the aftermath of Lehman Brothers' failure, the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation. In short, the financial industry in the years preceding the crisis had been transformed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system's reliance on wholesale funding. The relationship between large firms and shadow banking meant that strains on wholesale funding markets could both reflect and magnify the too-big-to-fail problem. These were not the relatively slow-developing problems of the Latin American debt crisis, or even the savings and loan crisis, but fast-moving episodes that risked turning liquidity problems into insolvency problems almost literally overnight. However, note that while the presence of too-big-to-fail institutions substantially exacerbates the vulnerability created by the new system, they do not define its limits. Even in the absence of any firm that may individually seem too big or too interconnected to be allowed to fail, the financial system can be vulnerable to contagion. An external shock to important asset classes can lead to substantial uncertainty as to underlying values, a consequent reluctance by investors to provide short-term funding to firms holding those assets, a subsequent spate of fire sales and mark-to-market losses, and the potential for an adverse feedback loop. An effective set of financial reforms must address both these related problems of too-big-to-fail and systemic vulnerability. As is obvious from the scope of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the amount of activity at the regulatory agencies, reform efforts to date have been extensive. They have also been significant. Without trying to give a full review, let me draw your attention to some of the more notable accomplishments, which can be categorized in three groups. First, the basic prudential framework for banking organizations is being considerably strengthened, both internationally and domestically. Central to this effort are the Basel III changes to capital standards, which create a new requirement for a minimum common equity capital ratio. This new standard requires substantial increases in both the quality and quantity of the loss-absorbing capital that allows a firm to remain a viable financial intermediary. Basel III also established for the first time an international minimum leverage ratio which, unlike the traditional U.S. leverage requirement, takes account of off-balance-sheet items. Second, a series of reforms have been targeted at the larger financial firms that are more likely to be of systemic importance. When fully implemented, these measures will have formed a distinct regulatory and supervisory structure on top of generally applicable prudential regulations and supervisory requirements. The governing principle for this new set of rules is that larger institutions should be subject to more exacting regulatory and supervisory requirements, which should become progressively stricter as the systemic importance of a firm increases. This principle has been codified in Section 165 of the Dodd-Frank Act, which requires special regulations applicable with increasing stringency to large banking organizations. Under this authority, the Federal Reserve will impose capital surcharges on the eight large U.S. banking organizations identified in the Basel Committee agreement for additional capital requirements on banking organizations of global systemic importance. The size of a surcharge will vary depending on the relative systemic importance of the bank. Other rules to be applied under Section 165--including counterparty credit risk limits, stress testing, and the quantitative short-term liquidity requirements included in the internationally-negotiated Liquidity Coverage Ratio (LCR)--will apply only to large institutions, in some cases with stricter standards for firms of greatest systemic importance. An important, related reform in Dodd-Frank was the creation of orderly liquidation authority, under which the Federal Deposit Insurance Corporation can impose losses on a failed systemic institution's shareholders and creditors and replace its management, while avoiding runs and preserving the operations of the sound, functioning parts of the firm. This authority gives the government a real alternative to the Hobson's choice of bailout or disorderly bankruptcy that authorities faced in 2008. Similar resolution mechanisms are under development in other countries, and international consultations are underway to plan for cooperative efforts to resolve multinational financial firms. A third set of reforms has been aimed at strengthening financial markets generally, without regard to the status of relevant market actors as regulated or systemically important. The greatest focus, as mandated under Titles VII and VIII of Dodd-Frank, has been on making derivatives markets safer through requiring central clearing for derivatives that can be standardized and creating margin requirements for derivatives that continue to be written and traded outside of central clearing facilities. The relevant U.S. agencies are working with their international counterparts to produce an international arrangement that will harmonize these requirements so as to promote both global financial stability and competitive parity. In addition, eight financial market utilities engaged in important payment, clearing, and settlement activities have been designated by the Financial Stability Oversight Council as systemically important and, thus, will now be subject to enhanced supervision. As you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace--occasioned as it is by the rather complicated domestic and international decisionmaking processes--may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets. Indeed, even without full implementation of all the new regulations, the Federal Reserve has already used its stress-test and capital-planning exercises to prompt a doubling in the last four years of the common equity capital of the nation's 18 largest bank holding companies, which hold more than 70 percent of the total assets of all U.S. bank holding companies. The weighted tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, of these 18 firms rose from 5.6 percent at the end of 2008 to 11.3 percent in the fourth quarter of 2012, reflecting an increase in tier 1 common equity from $393 billion to $792 billion during the same period. Despite this considerable progress, we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs. It is true that some of the clearly risky forms of wholesale funding that existed before the crisis, such as the infamous SIVs, have disappeared or substantially contracted. But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions (SFTs). Repo, reverse repo, securities lending and borrowing, and securities margin lending are part of the healthy functioning of the securities market. But, in the absence of sensible regulation, they are also potentially associated with the dynamic I described earlier of exogenous shocks to asset values leading to an adverse feedback loop of mark- to-market losses, margin calls, and fire sales. Indeed, some have argued that this dynamic is exacerbated by a "maturity rat race," in which each creditor acts to shorten the maturity of its lending so as to facilitate quick and easy flight, and in which creditors pay relatively little attention to the recovery value of the underlying assets. With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way. The regularization and refinement of rigorous stress testing may be the single most important supervisory improvement to strengthen the resilience of large institutions. The creation of orderly liquidation authority and the process of resolution planning advance prospects for increasing market discipline. But questions remain as to whether all this is enough to contain the problem. The enduring potential fragility of a financial system substantially dependent on short-term wholesale funding is especially relevant in considering the impact of severe stress or failure at the very large institutions with very large amounts of such funding. Concern about the adequacy of policy responses to date is supported by some recent research that attempts to quantify the implicit funding subsidy enjoyed by certain institutions by looking to such factors as credit ratings uplifts, differentials in interest rates paid on deposits or in risk compensation for bank debt and equity, and premia paid for mergers that would arguably place the merged firm in the too-big-to-fail category. The calculation of a precise subsidy is difficult, and each such effort will likely occasion substantial disagreement. But several measures provide at least directionally consistent results. In sketching out the kinds of steps needed to address these remaining vulnerabilities, let me begin with wholesale funding generally, and then circle back to too-big-to-fail. At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less comprehensively to all uses of short-term wholesale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution. The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short- dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A regulatory measure should force some internalization by market actors of the systemic costs of this intermediation. Second, to the degree that regulatory measures apply only to some types of wholesale funding, or only to that used by prudentially regulated entities, there will be a growing risk of regulatory arbitrage. Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust Stating the goal is easy, but executing it is not, precisely because short-term wholesale funding is used in a variety of forms by a variety of market actors. Determining appropriately equivalent controls is a challenging task and, with respect to institutions not subject to prudential regulation, there may be questions as to where--if at all--current regulatory authority resides. And, of course, there is the overarching problem of calibrating the regulation so as to mitigate the systemic risks associated with these funding markets, while not suppressing the mechanisms that have become important parts of the modern financial system in providing liquidity and lowering borrowing costs for both financial and non-financial firms. For all these reasons, it may well be that the abstract desirability of a single, comprehensive regulatory measure may not be achievable in the near term. Still, at least as a starting point, we would do well to consider measures that apply broadly. One option is to change minimum requirements for capital, liquidity, or both at all regulated firms so as to realize a macroprudential, as well as microprudential, purpose. In their current form, existing and planned liquidity requirements produced by the Basel Committee aim mostly to encourage maturity-matched books. While maturity mismatch by core intermediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary's book of securities financing transactions is perfectly matched, a reduction in its access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. The intermediary's customers are likely to be highly leveraged and maturity transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high. Thus, the long-term and short-term liquidity ratios might be refashioned so as to address directly the risks of large SFT books. Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the financial stability risks associated with SFTs. Accordingly, higher, generally applicable capital charge applied to SFTs might be a useful piece of a complementary set of macroprudential measures, though an indirect measure like a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding. By definition, both liquidity and capital requirements would be limited to banking entities already within the perimeter of prudential regulation. The obvious questions are whether these firms at present occupy enough of the wholesale funding markets that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle. In part for these reasons, a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs. The Financial Stability Board has already issued a consultative paper, and received public comment, on the idea. Under such a regime, all repo lenders, for example, could be required to take a minimum amount of over-collateralization as determined by regulators (the amount varying with the nature of the securities collateral), regardless of whether the repo lender or repo borrower were otherwise prudentially regulated. This kind of requirement could be an effective tool to limit procyclicality in securities financing and, thereby, to contain the risks of runs and contagion. Of course, it also raises many of the issues that make settling on a single policy instrument so hard to achieve, and the decision on calibration would be particularly consequential. Still, the concept has much to be said for it and seems the most promising avenue toward satisfying the principle of comprehensiveness. It is definitely worth pursuing. As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the present, we can continue to work on discrete aspects of these markets, such as through the diminution of reliance on intraday credit in triparty repo markets that is being achieved by Federal Reserve supervision of clearing banks and through the money market fund reforms that I expect will be pursued by the Securities and Exchange Commission. We might also think about less comprehensive measures affecting SFTs, such as limits on rehypothecation, when an institution uses assets that have been posted as collateral by its clients for its own purposes. But I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place. Before discussing policies specifically directed at too-big-to- fail, let me say a word about the capital regime that should be applicable to all banks, on top of which any additional requirements for systemically important institutions would be built. The first order of business is to complete the Basel III rulemaking as soon as possible. The required increases in the quality and quantity of minimum capital, and the introduction of an international leverage ratio, represent important steps forward for banking regulation around the world. U.S. banks have increased their capital substantially since the financial crisis began, and the vast majority already have Tier 1 common risk-based ratios greater than the Basel III 7 percent requirements The new requirements, while big improvements, are not as high as I would have liked, and the agreement contains some provisions I would have omitted or simplified. In coming years we may well seek changes. Indeed, I continue to be a strong advocate of establishing simpler, standardized risk-based capital requirements and am encouraged at the initial work being done on the topic of simplification in the Basel Committee. And we will certainly simplify the final capital rules here in the United States so as to respond to the concerns expressed by smaller banks. But opposing, or seeking delay in, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favor higher or simpler capital requirements were unintentionally to lend assistance to banks that want to avoid strengthening their capital positions. Turning to specific policies to address too-big-to-fail, the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks--whatever their merits and demerits--embody basic policy decisions that are properly the province of Congress. However, that does not mean there is no role for regulators. On the contrary, Section 165 of the Dodd-Frank Act gives the Federal Reserve the authority, and the obligation, to apply regulations of increasing stringency to large banking organizations in order to mitigate risks to financial stability. In any event, it is unlikely that the problems associated with too-big-to-fail institutions can be efficiently ameliorated using a single regulatory tool. The explicit expectation in Section 165 that there will be a variety of enhanced standards seems well-advised. We should be considering ways to use this authority in pursuit of three complementary ends: (1) ensuring the loss absorbency needed for a credible and effective resolution process, (2) augmenting the going-concern capital of the largest firms, and (3) addressing the systemic risks associated with the use of wholesale funding. There is clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency. Although the details will, as always, be important, there appears to be an emerging consensus among regulators, both here and abroad, in support of the general idea. Debt subject to this kind of bail-in would supplement the increased regulatory capital in order to provide greater assurance that, should the firm become insolvent, all losses could be borne using resources within the firm. This requirement for additional "gone concern" capital would increase the prospects for orderly resolution and, thereby, counteract the moral hazard associated with expectations of taxpayer bailouts. Switzerland has already adopted a requirement of this sort, and similar proposals are being actively debated in the European would both strengthen our domestic resolution mechanisms and be consistent with emerging international practice. With respect to "going concern" capital requirements, there is a good case for additional measures to increase the chances that large financial institutions remain viable financial intermediaries even under stress. To me, at least, the important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them so and with what specific risks in mind. In this regard, I would observe that our stress tests and capital-planning requirements have already strengthened capital standards by making them more forward-looking and more responsive to economic developments. As we gain experience, and as the annual process becomes smoother for both the banks and the Federal Reserve, we have the opportunity to enhance the stress tests by, for example, varying the scenario for stressing the trading books of the largest firms, so as to reflect changes in the composition of those books. As to regulatory measures of capital outside the customized context of stress testing, one approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms. The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms' failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later. The area in which the most work is needed is in addressing the risks arising from the use of short-term wholesale funding by systemically important firms. The systemic risks associated with runs on wholesale funding would, almost by definition, be exacerbated if a very large user of that funding were to come under serious stress. There could also be greater negative externalities from a disruption of large, matched SFT positions on the books of a major financial firm than if the same total activity were spread among a greater number of dealers. Thus, in keeping with the principle of differential and increasingly stringent regulation for large firms, there is a strong case to be made for taking steps beyond any generally applicable measures that are eventually applied to SFTs or short-term wholesale funding more generally. One possibility would be to have progressively greater minimum liquidity requirements for larger institutions under the LCR and the still-under-construction Net There is certainly some appeal to following this route, since it would build on all the work done in fashioning these liquidity requirements. The only significant additional task would be calibrating the progressivity structure. However, there are at least two disadvantages to this approach. First, the LCR and, at least at this stage of its development, the NSFR, both rest on the implicit presumption that a firm with a perfectly matched book is in a fundamentally stable position. As a microprudential matter, this is probably a reasonable assumption. But under some conditions, the disorderly unwind of a single, large SFT book, even one that was quite well maturity matched, could set off the kind of unfavorable dynamic described earlier. Second, creating liquidity levels substantially higher than those contemplated in the LCR and eventual NSFR may not be the most efficient way for some firms to become better insulated from the run risk that can lead to the adverse feedback loop and contagion possibilities discussed earlier. A more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements. This approach would reflect the fact that the market perception of a given firm's position as counterparty depends upon the combination of its funding position and capital levels. It would also supplement the Basel capital surcharge system, which does not include use of short-term wholesale funding among the factors used to calculate the systemic "footprint" of each firm, and thus determine its relative surcharge. While there is decidedly a need for solid minimum requirements for both capital and liquidity, the relationship between the two also matters. Where a firm has little need of short-term funding to maintain its ongoing business, it is less susceptible to runs. Where, on the other hand, a firm is significantly dependent on such funding, it may need considerable common equity capital to convince market actors that it is indeed solvent. Similarly, the greater or lesser use of short-term funding helps define a firm's relative contribution to the systemic risk latent in these markets. If realized, this approach would allow a firm of systemic importance to choose between holding capital in greater amounts than would otherwise be required, or changing the amount and composition of its liabilities in order to reduce the contribution it could make to systemic risk in the event of a shock to short-term funding channels. The additional capital requirements might be tied, for example, to specified scores under an NSFR that had been reworked significantly so as to take account of the macroprudential implications of wholesale funding discussed earlier. If one wished to maintain the practice of grounding capital requirements in measures of assets, another possibility would be to add as a capital surcharge a specified percentage of assets measured so as to weight most heavily those associated with short-term funding. To provide a meaningful counterweight to the risks associated with wholesale funding runs, the additional capital requirement would have to be material. The highest requirement would be at just the point where a firm had the minimum required level of liquidity. The requirement then would diminish as the liquidity score of the firm rose sufficiently above minimum required levels. If the requirement were significant enough and likely to apply to any large institution with substantial capital market activities, it might also be a substitute for increasing the capital surcharge schedule already agreed to in Basel. I readily acknowledge that calibrating the relationship would not be easy, and that the stakes for both financial stability and financial efficiency in getting it right would be significant. But I think this approach is worth exploring, precisely because it rests upon the link between too-big-to-fail concerns and the runs and contagion that we experienced five years ago, and to which we remain vulnerable today. Whether it proves feasible, or whether we would have to fall back on the more straightforward approach of strengthening liquidity requirements for systemically important firms, the key point is that the principle of increasing stringency be applied. Of late I find myself of two minds on the question of bringing to a close the major elements of regulatory change following the financial crisis. On the one hand, I strongly believe that all the regulatory agencies should complete as soon as possible the remaining rulemakings generated by Dodd-Frank and Basel III. It is important that banks and other financial market actors know the rules that will govern capital standards, proprietary trading, mortgage lending, and other activities. In fact, we should monitor whether these rules end up having significant unintended effects on credit availability and, if so, modify them in a manner consistent with basic aims of safety and soundness and consumer protection. On the other hand, I equally strongly believe that we would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem. This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it.

r130509a_FOMC

united states

A View from the Federal Reserve Board: The Mortgage Market and Housing Conditions

duke

For release on delivery Remarks by at the Since joining the Board in 2008 amid a crisis centered on mortgage lending, I have focused much of my attention on housing and mortgage markets, issues surrounding foreclosures, and neighborhood stabilization. In March of this year, I laid out my thoughts on current conditions in the housing and mortgage markets in a speech to the Today I will summarize and update that information with a focus on mortgage credit conditions. Before I proceed, I should note that the views I express are my own and not necessarily those of my colleagues on the Board of A sustained recovery in the housing market appears to be under way. House prices, as measured by a variety of national indexes, have risen 6 to 11 percent since the The recovery of house prices has been broad based geographically, with 90 percent of local markets having experienced price gains over the year ending in February. Also since the beginning of 2012, housing starts and permits have risen by nearly 30 percent (figure 2), while new and existing home sales have also seen double-digit growth rates. Homebuilder sentiment has improved notably, and real estate agents report stronger traffic of people shopping for homes (figure 3). In national surveys, households report that low interest rates and house prices make it a good time to buy a home; they also appear more certain that house price gains will continue (figure Despite the recent gains, the level of housing market activity remains low. Existing home sales are currently at levels in line with those seen in the late 1990s, while single-family starts and permits are at levels commensurate with the early 1990s. And applications for home-purchase mortgages, as measured by the Mortgage Bankers Association index, were at a level in line with that of the mid-1990s (figure 5). The subdued level of mortgage purchase originations is particularly striking given the record low mortgage rates that have prevailed in recent years. The drop in originations has been most pronounced among borrowers with lower credit scores. For example, between 2007 and 2012, originations of prime purchase mortgages fell about 30 percent for borrowers with credit scores greater than 780, compared with a drop of about 90 percent for borrowers with credit scores between Originations are virtually nonexistent for borrowers with credit scores below 620. The distribution of credit scores in these purchase origination data tells the same story in a different way: The median credit score on these originations rose from 730 in 2007 to 770 in 2013, whereas scores for mortgages at the 10th percentile rose Many borrowers who have faced difficulty in obtaining prime mortgages have turned to mortgages insured or guaranteed by the Federal Housing Administration (FHA), Data collected under the Home Mortgage Disclosure Act indicate that the share of purchase mortgages guaranteed or insured by the FHA, the VA, or the RHS rose from 5 percent in 2006 to more than 40 percent in 2011 (figure 8). But here, too, loan originations appear to have contracted for borrowers with low credit scores. The median credit score on FHA purchase originations increased from 625 in 2007 to 690 in 2013, while the 10th percentile has increased from 550 to 650 (figure 9). Part of the contraction in loan originations to households with lower credit scores may reflect weak demand among these potential homebuyers. Although we have little data on this point, it may be the case that such households suffered disproportionately from the sharp rise in unemployment during the recession and thus have not been in a financial position to purchase a home. There is evidence that tight mortgage lending conditions may also be a factor in the contraction in originations. Data from lender rate quotes suggest that almost all lenders have been offering quotes (through the daily "rate sheets" provided to mortgage brokers) on mortgages eligible for sale to the government-sponsored enterprises (GSEs) to borrowers with credit scores of 750 over the past two years. Most lenders have been willing to offer quotes to borrowers with credit scores of 680 as well. Fewer than two- thirds of lenders, though, are willing to extend mortgage offers to consumers with credit And this statistic may overstate the availability of credit to borrowers with lower credit scores: The rates on many of these offers might be unattractive, and borrowers whose credit scores indicate eligibility may not meet other aspects of the underwriting criteria. Tight credit conditions also appear to be part of the story for FHA-insured loans. Lending Practices (SLOOS), one-half to two-thirds of respondents indicated that they were less likely than in 2006 to originate an FHA loan to a borrower with a credit score SLOOS, about 30 percent of lenders reported that they were less likely than a year ago to originate FHA mortgages to borrowers with a credit score of 580 or 620 (figure 12). The April SLOOS offers some clues about why mortgage credit is so tight for borrowers with lower credit scores. Banks participating in the survey identified a familiar assortment of factors as damping their willingness to extend any type of loan to these borrowers: the risk that lenders will be required to repurchase defaulted loans from the GSEs ("putback" risk), the outlook for house prices and economic activity, capacity constraints, the risk-adjusted opportunity cost of such loans, servicing costs, balance sheet or warehousing capacity, guarantee fees charged by the GSEs, borrowers' ability to obtain private mortgage insurance or second liens, and investor appetite for private-label mortgage securitizations. Respondents appeared to put particular weight on GSE putbacks, the economic outlook, and the risk-adjusted opportunity cost. In addition, several large banks cited capacity constraints and borrowers' difficulties in obtaining private mortgage insurance or second liens as at least somewhat important factors in restraining their willingness to approve such loans. Over time, some of these factors should exert less of a drag on mortgage credit availability. For example, as the economic and housing market recovery continues, lenders should gain confidence that mortgage loans will perform well, and they should expand their lending accordingly. Capacity constraints will likely also ease. Refinancing applications have expanded much more over the past year and a half than lenders' ability to process these loans. For example, one measure of capacity constraints--the number of real estate credit employees--has only edged up over this period (figure 13). When capacity constraints are binding, lenders may prioritize the processing of easier-to-complete or more profitable loan applications. Indeed, preliminary research by the Board's staff suggests that the increase in the refinance workload during the past 18 months appears to have been associated with a 25 to 35 percent decrease in purchase originations among borrowers with credit scores between 620 and 680 and a 10 to 15 percent decrease among borrowers with credit scores between 680 and 710. Any such crowding-out effect should start to unwind as the current refinancing boom decelerates. Other factors holding back mortgage credit, however, may be slower to unwind. As the SLOOS results indicate, lenders remain concerned about putback risk. The ability to hold lenders accountable for poorly underwritten loans is a significant protection for taxpayers. However, if lenders are unsure about the conditions under which they will be required to repurchase loans sold to the GSEs, they may shy away from originating loans to borrowers whose risk profiles indicate a higher likelihood of default. The Federal Housing Finance Agency launched an important initiative last year to clarify the liabilities associated with representations and warranties, but, so far, putback risk appears to still weigh on the mortgage market. Mortgage servicing standards, particularly for delinquent loans, are more stringent than in the past due to settlement actions and consent orders. Servicing rules recently standards to all lenders. These standards remedy past abuses and provide important protections to borrowers, but also increase the cost of servicing nonperforming loans. This issue is compounded by current servicing compensation arrangements under which servicers receive the same fee for the routine processing of current loans as they do for the more expensive processing of delinquent loans. This model--especially in conjunction with higher default-servicing costs--gives lenders an incentive to avoid originating loans to borrowers who are more likely to default. A change to servicer compensation models for delinquent loans could alleviate some of these concerns. Government regulations will also affect the cost of mortgage credit. In January, the CFPB released rules, in addition to those for servicing standards, on ability-to-repay requirements, the definition of a qualified mortgage (QM), and loan originator compensation. The Federal Reserve and other agencies are in the process of moving forward on proposed rulemakings that would implement revised regulatory capital requirements and the requirements for risk retention mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which include an exemption for mortgages that meet the definition of qualified residential mortgages (QRM). As the regulatory capital and risk retention requirements are still under deliberation, I won't comment on these regulations today. However, I will share a few thoughts on the possible effects of the QM rulemaking on access to credit. As background, the QM rule is part of a larger ability-to-repay rulemaking that requires lenders to make a reasonable and good faith determination that the borrower can repay the loan. The rulemaking addresses the lax underwriting practices that flourished during the housing boom by setting minimum underwriting standards and by providing borrowers with protections against lending abuses. In particular, borrowers can sue the lender for violations of the ability-to-repay rules and claim monetary damages. If the original lender sells or securitizes the loan, the borrower can claim these damages at any time in a foreclosure action taken by the lender or any assignee. If the mortgage meets the QM standard, however, the lender receives greater protection from such potential lawsuits because it is presumed that the borrower had the ability to repay the loan. Loans that fall outside the QM standard may be more costly to originate than loans that meet the standard for at least four reasons, all else being equal. The first reason is the possible increase in foreclosure losses and litigation costs. Although these costs, in the aggregate, are expected to be small, their full extent will not be known until the courts settle any ability-to-repay suits that may be brought forward. The second reason is that mortgages that do not meet the QM definition will also not qualify as QRMs, so lenders will be required to hold some of the risk if these loans are securitized. The third reason is that loan originators will have better information than investors on the quality of the underwriting decision. Investors may demand a premium to compensate them for the concern that originators might sell them the loans most vulnerable to ability- to-repay lawsuits. The fourth reason is that the non-QM market, at least initially, may be small and illiquid, which would increase the cost of these loans. The higher costs associated with non-QM loans should have very little effect on access to credit in the near term because almost all current mortgage originations meet the QM standard. The vast majority of current originations are eligible to be purchased, insured, or guaranteed by Fannie Mae, Freddie Mac, the FHA, the VA, or the RHS. These loans are classified as QMs under the rule. The small proportion of mortgages originated at present outside of these programs, for the most part, are being underwritten to tight standards consistent with the QM definition. As lender risk appetite increases and private capital returns to the mortgage market, a larger non-QM market should start to develop. Two aspects of the QM rule, though, may make this market slow to develop for borrowers with lower credit scores. First, the QM requirement that borrower payments on all debts and some recurring obligations must be 43 percent or less of borrower income may disproportionately affect less-advantaged borrowers. Board staff tabulations based on the Survey of Consumer Finances indicate that such households tend to have lower incomes, fewer financial assets, and higher mortgage loan-to-value ratios than households with lower payment Second, the QM definition affects lenders' ability to charge for the risks of originating loans to borrowers who are more likely to default. For example, lenders may in general compensate for this risk by charging a higher interest rate on the loan. However, if lenders originate a first-lien QM with an annual percentage rate that is 150 basis points or more above the rate available to the highest-quality borrowers, lenders receive less protection against lawsuits claiming violation of the ability-to-repay and QM rules. Lenders who prefer to price for risk through points and fees face the constraint that points and fees on a QM loan may not exceed 3 percent of the loan amount, with higher caps available for loans smaller than $100,000. The extent to which these rules regarding rates, points, and fees will damp lender willingness to originate mortgages to borrowers with lower credit scores is still unclear. To summarize, the housing market is improving, but mortgage credit conditions remain quite tight for borrowers with lower credit scores. And the path to easier credit conditions is somewhat murky. Some of the forces damping mortgage credit availability, such as capacity constraints and concerns about economic conditions or house prices, are likely to unwind through normal cyclical forces. However, resolution of lender concerns about putback risk or servicing cost seems less clear. These concerns could be reduced by policy changes. For example, the structure of liability for representations and warrantees could be modified. Or servicing compensation could be changed to provide higher compensation for the servicing of delinquent loans. Or lenders might find ways to reduce their exposure to putback risk or servicing cost by strengthening origination and servicing platforms. New mortgage regulations will provide important protections to borrowers but may also lead to a permanent increase in the cost of originating loans to borrowers with lower credit scores. It will be difficult to determine the ultimate effect of the regulatory changes until they have all been finally defined and lenders gain familiarity with them. The implications for the housing market are also murky. Borrowers with lower credit scores have typically represented a significant segment of first-time homebuyers. For example, in 1999, more than 25 percent of first-time homebuyers had credit scores below 620 compared with fewer than 10 percent in 2012 (figure 15). housing demand to expand along with the economic recovery, if credit is hard to get, much of that demand may be channeled into rental, rather than owner-occupied, housing. At the Federal Reserve, we continue to foster more-accommodative financial conditions and, in particular, lower mortgage rates through our monetary policy actions. We also continue to monitor mortgage credit conditions and consider the implications of our rulemakings for credit availability. For your part, I urge you to continue to develop new and more sustainable business models for lending to lower-credit-score borrowers that lead to better outcomes for borrowers, communities, and the financial system than we have experienced over the past few years.

r130510a_FOMC

united states

Monitoring the Financial System

bernanke

We are now more than four years beyond the most intense phase of the financial crisis, but its legacy remains. Our economy has not yet fully regained the jobs lost in the recession that accompanied the financial near collapse. And our financial system-- despite significant healing over the past four years--continues to struggle with the economic, legal, and reputational consequences of the events of 2007 to 2009. The crisis also engendered major shifts in financial regulatory policy and practice. Not since the Great Depression have we seen such extensive changes in financial regulation as those codified in the Dodd-Frank Wall Street Reform and Consumer Accord and a range of other initiatives. This new regulatory framework is still under construction, but the Federal Reserve has already made significant changes to how it conceptualizes and carries out both its regulatory and supervisory role and its responsibility to foster financial stability. In my remarks today I will discuss the Federal Reserve's efforts in an area that typically gets less attention than the writing and implementation of new rules--namely, our ongoing monitoring of the financial system. Of course, the Fed has always paid close attention to financial markets, for both regulatory and monetary policy purposes. However, in recent years, we have both greatly increased the resources we devote to monitoring and taken a more systematic and intensive approach, led by our Office of Financial Stability Policy and Research and drawing on substantial resources from across the Federal Reserve System. This monitoring informs the policy decisions of both the Federal Reserve Board and the Federal Open Market Committee as well as our work with other agencies. The step-up in our monitoring is motivated importantly by a shift in financial regulation and supervision toward a more macroprudential, or systemic, approach, supplementing our traditional microprudential perspective focused primarily on the health of individual institutions and markets. In the spirit of this more systemic approach (FSOC), which is comprised of the heads of a number of federal and state regulatory agencies. The FSOC has fostered greater interaction among financial regulatory agencies as well as a sense of common responsibility for overall financial stability. Council members regularly discuss risks to financial stability and produce an annual report, which reviews potential risks and recommends ways to mitigate them. broad-based monitoring efforts have been essential for promoting a close and well- informed collaboration with other FSOC members. Ongoing monitoring of the financial system is vital to the macroprudential approach to regulation. Systemic risks can only be defused if they are first identified. That said, it is reasonable to ask whether systemic risks can in fact be reliably identified in advance; after all, neither the Federal Reserve nor economists in general predicted the past crisis. To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities. triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises; the collapse of the relatively small market for subprime mortgages, for example, would not have been nearly as consequential without preexisting fragilities in securitization practices and short-term funding markets which greatly increased its impact. Of course, monitoring can and does attempt to identify potential triggers--indications of an asset bubble, for example--but shocks of one kind or another are inevitable, so identifying and addressing vulnerabilities is key to ensuring that the financial system overall is robust. Moreover, attempts to address specific vulnerabilities can be supplemented by broader measures--such as requiring banks to hold more capital and liquidity--that make the system more resilient to a range of shocks. Two other related points motivate our increased monitoring. The first is that the financial system is dynamic and evolving not only because of innovation and the changing needs of the economy, but also because financial activities tend to migrate from more-regulated to less-regulated sectors. An innovative feature of the Dodd-Frank Act is that it includes mechanisms to permit the regulatory system, at least in some circumstances, to adapt to such changes. For example, the act gives the FSOC powers to designate systemically important institutions, market utilities, and activities for additional oversight. Such designation is essentially a determination that an institution or activity creates or exacerbates a vulnerability of the financial system, a determination that can only be made with comprehensive monitoring and analysis. The second motivation for more intensive monitoring is the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword. To be sure, a favorable overall environment reduces credit risk and strengthens balance sheets, all else being equal, but it could also reduce the incentives for market participants to take reasonable precautions, which may lead in turn to a buildup of financial vulnerabilities. Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential and other policy tools that can be used to address them. So, what specifically does the Federal Reserve monitor? In the remainder of my remarks, I'll highlight and discuss four components of the financial system that are among those we follow most closely: systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector. SIFIs are financial firms whose distress or failure has the potential to create broader financial instability sufficient to inflict meaningful damage on the real economy. SIFIs tend to be large, but size is not the only factor used to determine whether a firm is systemically important; other factors include the firm's interconnectedness with the rest of the financial system, the complexity and opacity of its operations, the nature and extent of its risk-taking, its use of leverage, its reliance on short-term wholesale funding, and the extent of its cross-border operations. Under the Dodd-Frank Act, the largest bank holding companies are treated as SIFIs; in addition, as I mentioned, the act gives the FSOC the power to designate individual nonbank financial companies as systemically important. This designation process is under way. Dodd-Frank also establishes a framework for subjecting SIFIs to comprehensive supervisory oversight and enhanced prudential standards. For all such companies, the Federal Reserve will have access to confidential supervisory information and will monitor standard indicators such as regulatory capital, leverage, and funding mix. However, some of these measures, such as regulatory capital ratios, tend to be backward looking and thus may be slow to flag unexpected, rapid changes in the condition of a firm. Accordingly, we supplement the more standard measures with other types of information. One valuable source of supplementary information is stress testing. Regular, comprehensive stress tests are an increasingly important component of the Federal Reserve's supervisory toolkit, having been used in our assessment of large bank holding companies since 2009. To administer a stress test, supervisors first construct a hypothetical scenario that assumes a set of highly adverse economic and financial developments--for example, a deep recession combined with sharp declines in the prices of houses and other assets. The tested firms and their supervisors then independently estimate firms' projected losses, revenues, and capital under the hypothetical scenario, and the results are publicly disclosed. Firms are evaluated both on their post-stress capital levels and on their ability to analyze their exposures and capital needs. Stress testing provides a number of advantages over more-standard approaches to assessing capital adequacy. First, measures of capital based on stress tests are both more forward looking and more robust to "tail risk"--that is, to extremely adverse developments of the sort most likely to foster broad-based financial instability. Second, because the Federal Reserve conducts stress tests simultaneously on the major institutions it supervises, the results can be used both for comparative analyses across firms and to judge the collective susceptibility of major financial institutions to certain types of shocks. Indeed, comparative reviews of large financial institutions have become an increasingly important part of the Federal Reserve's supervisory toolkit more generally. Third, the disclosure of stress-test results, which increased investor confidence during the crisis, can also strengthen market discipline in normal times. The stress tests thus provide critical information about key financial institutions while also forcing the firms to improve their ability to measure and manage their risk exposures. Stress-testing techniques can also be used in more-focused assessments of the banking sector's vulnerability to specific risks not captured in the main scenario, such as liquidity risk or interest rate risk. Like comprehensive stress tests, such focused exercises are an important element of our supervision of SIFIs. For example, supervisors are collecting detailed data on liquidity that help them compare firms' susceptibilities to various types of funding stresses and to evaluate firms' strategies for managing their liquidity. Supervisors also are working with firms to assess how profitability and capital would fare under various stressful interest rate scenarios. Federal Reserve staff members supplement supervisory and stress-test information with other measures. For example, though supervisors have long appreciated the value of market-based indicators in evaluating the conditions of systemically important firms (or, indeed, any publicly traded firm), our monitoring program uses market information to a much greater degree than in the past. Thus, in addition to standard indicators--such as stock prices and the prices of credit default swaps, which capture market views about individual firms--we use market-based measures of systemic stability derived from recent research. These measures use correlations of asset prices to capture the market's perception of a given firm's potential to destabilize the financial system at a time when the broader financial markets are stressed; other measures estimate the vulnerability of a given firm to disturbances emanating from elsewhere in the system. The further development of market-based measures of systemic vulnerabilities and systemic risk is a lively area of research. Network analysis, yet another promising tool under active development, has the potential to help us better monitor the interconnectedness of financial institutions and markets. Interconnectedness can arise from common holdings of assets or through the exposures of firms to their counterparties. Network measures rely on concepts used in engineering, communications, and neuroscience to map linkages among financial firms and market activities. The goals are to identify key nodes or clusters that could destabilize the system and to simulate how a shock, such as the sudden distress of a firm, could be transmitted and amplified through the network. These tools can also be used to analyze the systemic stability effects of a change in the structure of a network. For example, margin rules affect the sensitivity of firms to the conditions of their counterparties; thus, margin rules affect the likelihood of financial contagion through various firms and markets. Shadow banking, a second area we closely monitor, was an important source of instability during the crisis. Shadow banking comprises various markets and institutions that provide financial intermediation outside the traditional, regulated banking system. Shadow banking includes vehicles for credit intermediation, maturity transformation, liquidity provision, and risk sharing. Such vehicles are typically funded on a largely short-term basis from wholesale sources. In the run-up to the crisis, the shadow banking sector involved a high degree of maturity transformation and leverage. Illiquid loans to households and businesses were securitized, and the tranches of the securitizations with the highest credit ratings were funded by very short-term debt, such as asset-backed commercial paper and repurchase agreements (repos). The short-term funding was in turn provided by institutions, such as money market funds, whose investors expected payment in full on demand and had little tolerance for risk to principal. As it turned out, the ultimate investors did not fully understand the quality of the assets they were financing. Investors were lulled by triple-A credit ratings and by expected support from sponsoring institutions--support that was, in fact, discretionary and not always provided. When investors lost confidence in the quality of the assets or in the institutions expected to provide support, they ran. Their flight created serious funding pressures throughout the financial system, threatened the solvency of many firms, and inflicted serious damage on the broader economy. Securities broker-dealers play a central role in many aspects of shadow banking as facilitators of market-based intermediation. To finance their own and their clients' securities holdings, broker-dealers tend to rely on short-term collateralized funding, often in the form of repo agreements with highly risk-averse lenders. The crisis revealed that this funding is potentially quite fragile if lenders have limited capacity to analyze the collateral or counterparty risks associated with short-term secured lending, but rather look at these transactions as nearly risk free. As questions emerged about the nature and value of collateral, worried lenders either greatly increased margin requirements or, more commonly, pulled back entirely. Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation. To monitor intermediation by broker-dealers, the Federal Reserve in 2010 created dealers about the credit they provide. Modeled on the long-established Senior Loan Officer Opinion Survey on Bank Lending Practices sent to commercial banks, the survey of senior credit officers at dealers tracks conditions in markets such as those for securities financing, prime brokerage, and derivatives trading. The credit officer survey is designed to monitor potential vulnerabilities stemming from the greater use of leverage by investors (particularly through lending backed by less-liquid collateral) or increased volumes of maturity transformation. Before the financial crisis, we had only very limited information regarding such trends. We have other potential sources of information about shadow banking. The collaborating to construct data sets on triparty and bilateral repo transactions, which should facilitate the development of better monitoring metrics for repo activity and improve transparency in these markets. We also talk regularly to market participants about developments, paying particular attention to the creation of new financial vehicles that foster greater maturity transformation outside the regulated sector, provide funding for less-liquid assets, or transform risks from forms that are more easily measured to forms that are more opaque. A fair summary is that, while the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities. For example, although money market funds were strengthened by reforms undertaken by the Securities and Exchange Commission (SEC) in 2010, the possibility of a run on these funds remains--for instance, if a fund should "break the buck," or report a net asset value below 99.5 cents, as the Reserve Primary Fund did in 2008. The risk is increased by the fact that the Treasury no longer has the power to guarantee investors' holdings in money funds, an authority that was critical for stopping the 2008 run. In November 2012, the FSOC proposed for public comment some alternative approaches for the reform of money funds. The SEC is currently considering these and other possible steps. With respect to the triparty repo platform, progress has been made in reducing the amount of intraday credit extended by the clearing banks in the course of the daily settlement process, and, as additional enhancements are made, the extension of such credit should be largely eliminated by the end of 2014. However, important risks remain in the short-term wholesale funding markets. One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower. The Dodd- Frank Act has provided important additional tools to deal with this vulnerability, notably the provisions that facilitate an orderly resolution of a broker-dealer or a broker-dealer holding company whose imminent failure poses a systemic risk. But, as highlighted in the FSOC's most recent annual report, more work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market. Asset markets are a third area that we closely monitor. We follow developments in markets for a wide range of assets, including public and private fixed-income instruments, corporate equities, real estate, commodities, and structured credit products, among others. Foreign as well as domestic markets receive close attention, as do global linkages, such as the effects of the ongoing European fiscal and banking problems on Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts. In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves. From a financial stability perspective, however, the assessment of asset valuations is only the first step of the analysis. Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset's value to changes in broad financial conditions. Differences in these factors help explain why the correction in equity markets in 2000 and 2001 did not induce widespread systemic disruptions, while the collapse in house prices and in the quality of mortgage credit during the 2007-09 crisis had much more far-reaching effects: The losses from the stock market declines in 2000 and 2001 were widely diffused, while mortgage losses were concentrated--and, through various financial instruments, amplified--in critical parts of the financial system, resulting ultimately in panic, asset fire sales, and the collapse of credit markets. Our financial stability monitoring extends to the nonfinancial sector, including households and businesses. Research has identified excessive growth in credit and leverage in the private nonfinancial sector as potential indicators of systemic risk. Highly leveraged or financially fragile households and businesses are less able to withstand adverse changes in income or wealth, including those brought about by deteriorating conditions in financial and credit markets. A highly leveraged economy is also more prone to so-called financial accelerator effects, as when financially stressed firms are forced to lay off workers who, in turn, lacking financial reserves, sharply cut their own spending. Financial stress in the nonfinancial sector--for example, higher default rates on mortgages or corporate debt--can also damage financial institutions, creating a potential adverse feedback loop as they reduce the availability of credit and shed assets to conserve capital, thereby further weakening the financial positions of households and firms. The vulnerabilities of the nonfinancial sector can potentially be captured by both stock measures (such as wealth and leverage) and flow measures (such as the ratio of debt service to income). Sector-wide data are available from a number of sources, importantly the Federal Reserve's flow of funds accounts, which is a set of aggregate integrated financial accounts that measures sources and uses of funds for major sectors as well as for the economy as a whole. These accounts allow us to trace the flow of credit from its sources, such as banks or wholesale funding markets, to the household and business sectors that receive it. The Federal Reserve also now monitors detailed consumer- and business-level data suited for picking up changes in the nature of borrowing and lending, as well as for tracking financial conditions of those most exposed to a cyclical downturn or a reversal of fortunes. For example, during the housing boom, the aggregate data accurately showed the outsized pace of home mortgage borrowing, but it could not reveal the pervasive deterioration in underwriting that implied a substantial increase in the underlying credit risk from that activity. More recently, gains in household net worth have been concentrated among wealthier households, while many households in the middle or lower parts of the distribution have experienced declines in wealth since the crisis. Moreover, many homeowners remain "underwater," with their homes worth less than the principal balances on their mortgages. Thus, more detailed information clarifies that many households remain more financially fragile than might be inferred from the aggregate statistics alone. In closing, let me reiterate that while the effective regulation and supervision of individual financial institutions will always be crucial to ensuring a well-functioning financial system, the Federal Reserve is moving toward a more systemic approach that also pays close attention to the vulnerabilities of the financial system as a whole. Toward that end, we are pursuing an active program of financial monitoring, supported by expanded research and data collection, often undertaken in conjunction with other U.S. financial regulatory agencies. Our stepped-up monitoring and analysis is already providing important information for the Board and the Federal Open Market Committee as well as for the broader regulatory community. We will continue to work toward improving our ability to detect and address vulnerabilities in our financial system.

r130516a_FOMC

united states

Prospects for a Stronger Recovery

raskin

Thank you. I am very pleased to be here among an audience of professional economists, which is certainly preferable to appearing before an audience of unprofessional economists. I like your kind! Your talents are needed now more than ever as we try to put the tools of the economic profession to work for the common good. It's easy to be an economist who looks back on crises and crashes and tries to explain why they happened, but much harder to be an economist whose efforts manage to help stop them from happening in the first place. Economic policymaking, at its best, reflects a continuous struggle to make sure that data and explanations of such data are consistent with real experience. If we're to engage in this struggle honestly, it's no easy task. It involves understanding not just the reliability and signal in various data, but also questioning whether the data accords with our understanding of actual experience. So, to get this right requires many different perspectives, not just on the data but on the underlying realities the data are trying to capture. Government economists understand that non-economists bring something valuable to the table in policymaking--a grounded perspective in what is happening in the economy. With that said, what is really happening now in the American economy? What do the economic data we see at the Federal Reserve currently show, and how do we think these data line up with the economic realities of most American households and businesses? In my remarks today I will offer my assessment of recent economic developments and the economic outlook, and I will discuss the actions that the Federal Reserve has been taking, in light of its view of developments and the outlook, to support the economic recovery. Before I begin, I should note that the views that I will be presenting are my own and not necessarily those of my colleagues on the Federal Open For the past three and a half years the U.S. economy has been in a recovery-- albeit a very weak one--from a severe financial crisis and the deepest recession of the post-World War II period. The unemployment rate, which reached a high of 10 percent in the fall of 2009, has since come down 2-1/2 percentage points, to 7.5 percent in April. The increase in economic activity and the decline in the unemployment rate are, of course, welcome, but we still have a long way to go to reach what feels like a healthy economy. In fact, the pace of recovery has been slower than most had expected. The gap between actual output and the economy's potential remains quite large, according to estimates from the Congressional Budget Office, and the unemployment rate today remains well above levels seen prior to the recession, and well above the level that the Committee thinks can be sustained once a full recovery has been achieved. In addition, the number of long-term unemployed--people who have been unemployed for 27 weeks or more--remains historically high. My interpretation of the economic data that we have received over the past few quarters is that the recovery has continued to gain traction. The Bureau of Economic Analysis reported last month that real gross domestic product (GDP) rose at an annual rate of 2-1/2 percent in the first quarter of this year after barely expanding at all in the fourth quarter of 2012. The step-up in growth in the first quarter partly reflected a rebound from last year's drought and Hurricane Sandy. Smoothing through these factors, real GDP was about 1-3/4 percent above its year-earlier level in the first quarter, a modest gain that is about in line with the pace of growth during much of the recovery. The strength of the recovery among the components of GDP has been mixed recently. In terms of the housing sector, there is no question that many communities and neighborhoods were devastated by the effects of the financial crisis. Recently, we see that overall demand has been strengthening, with both home sales and prices rising markedly in many areas. Both new and existing home sales have moved up, on net, since late 2011, and housing starts averaged an annual rate of nearly 1 million units in the first quarter of this year, up considerably from the extremely low levels that prevailed through 2011. Inventories of new homes for sale have become quite lean in most markets over the past year, a notable change from earlier in the recovery. The increase in activity in the housing sector has been driven by historically low mortgage rates, growing optimism about future house prices, continued gains in the job market, and sizable purchases of homes by investors. Elsewhere in the household sector, consumer spending--about two-thirds of overall final demand--has continued growing at a moderate pace. On the whole, families have benefited from the modest improvement in the labor market, and rising stock prices and rebounding home values have helped some households recoup part of the wealth they lost during the recession. However, overall wage growth has been anemic, and many households have not seen their circumstances improve materially. As I described in a speech last month, globalization and technological change have continued to shift the occupations and industrial distribution of new jobs available. These currents of globalization and technological change continue on their path, making it more likely that workers who were laid off during the recession would be unable to find reemployment that is of comparable quality to their previous jobs. About two-thirds of all job losses in the recession were in middle-wage occupations--such as manufacturing, skilled construction, and office administration jobs--but these occupations have accounted for less than one-fourth of the job growth during the recovery. By contrast, lower-wage occupations, such as retail sales, food service, and other lower-paying service jobs, accounted for only one-fifth of job losses during the recession but more than one-half of total job gains during the recovery. As a result of these trends in job creation, which could well have been exacerbated by the severe nature of the crisis, the earnings potential for many households likely remains below what they had anticipated in the years before the recession. Moreover, as you all know, the temporary payroll tax cut has now expired, and many households have seen their disposable incomes reduced for this reason as well. Spending in the business sector recently has increased only modestly, perhaps due in part to the effect of these recent tax changes on consumers. Real spending on equipment and software rose about 4 percent over the past 12 months, according to the most recent GDP report, a modest gain for this category of spending. Indicators for capital investment in the months ahead, including new orders for durable capital goods and survey measures of business sentiment, suggest that growth in business spending on new equipment and software is likely to remain modest in the coming quarters. Turning to the government sector, the legislated reduction in spending by the federal government is exerting a clear and continuing drag on economic activity. Even prior to the bulk of the spending cuts associated with sequestration, real purchases by the federal government were reported to have dropped at an annual rate of more than 8 percent in the first quarter of this year, following an even larger drop in the fourth quarter of last year. These cuts in federal spending are likely to be an important influence on the near-term prospects for economic growth, and I will say more about this issue in a moment. In contrast to the federal government, the budget outlook for state and local government continues to improve, and the drag on economic activity from this sector's cutbacks in spending has diminished considerably. Reflecting some of these mixed influences, as I already noted, real GDP has been rising at a very modest rate, and the labor market has shown similarly modest gains over the past year, with the unemployment rate coming down about 1/2 percentage point. To more fully understand the experience of the 11.7 million Americans who can't find work, we look to broader measures of labor underutilization, which take into account job seekers who have stopped looking for work because they have become discouraged, and people working part time but who would prefer to work full time. Recently, these numbers seem to be coming down. The gains in payroll employment over this period have been about in line with the decline in the unemployment rate, although, as is typical, the pace of job gains has been somewhat erratic in recent months. Since the beginning of the year, the increases in payroll employment have averaged 196,000 per month, a little above the 183,000 average monthly gains observed during 2012. Other indicators from the labor market have also shown some improvement recently. Initial claims for unemployment insurance have declined since last summer, and the number of job openings appears to be increasing. I hope these indicators mean we are turning the corner on some of the painful costs associated with being unemployed or underemployed in America. Turning to inflation, recent data show that price pressures have remained subdued. Both total and core inflation were only about 1 percent over the 12 months ending in March, below the FOMC's long-run objective of 2 percent. Inflation is being restrained by the continued slack in labor and product markets, while stable inflation expectations have offset disinflationary pressures to some extent. Moreover, the increase in gasoline prices that we saw earlier in the year appears to have fully reversed, and the path of oil futures prices is downward-sloping, suggesting that energy prices are likely to hold down headline inflation rates in the years ahead. Let me now turn to the outlook. As my Federal Reserve colleagues and I have noted in the past, the pace of the economic recovery has been restrained by lingering effects of the financial crisis. Assessing the current strength of the headwinds related to these lingering effects is an important determinant of the economic outlook for the coming years. Unfortunately, current federal fiscal policy is one headwind to the recovery that has intensified this year. In fact, federal fiscal policy has been tightening since 2011, after having been quite expansionary during the recession and early in the recovery. More recently, actions by the Administration and the Congress to reduce the budget deficit have led to further tightening of federal fiscal policy. As I already mentioned, both the tax legislation signed into law in January and the sharp spending cuts associated with sequestration will likely significantly hinder GDP growth this year. Indeed, the Congressional Budget Office has estimated that these changes in fiscal policy would reduce GDP growth by 1-1/2 percentage points this year relative to what we otherwise would have achieved. Looking further ahead, fiscal policy seems likely to remain restrictive at the federal level. The headwinds from the housing sector have eased, and housing market activity is likely to continue to contribute to GDP growth over the next few years. These headwinds had been substantial, as the aftermath of the financial crisis and housing bubble left many homeowners underwater on their mortgages, a large overhang of vacant homes, and mortgage credit very hard to obtain for anyone without an excellent credit record and a sizable down payment. The rise in house prices over the past year or so has lifted household net worth and pushed some homeowners above water on their mortgages. These developments may help to ease credit for many households as well, although mortgage credit remains very tight. In a speech last month, I described how the net decline in housing wealth since the recession has had particularly acute effects on the balance sheets of lower- and middle-income households, which tend to hold a relatively high share of their total wealth in their homes. Households at the bottom of the income distribution have also had a harder time than others finding jobs during the recovery and their wages have continued to stagnate. In my view, the large and increasing amount of inequality in income and wealth, which has been an ongoing development for decades, may have exacerbated the crisis and I think more research is required to determine whether it may also pose a significant headwind to the recovery from the crisis for years to come. So, while I am hopeful that pressures will ease further as home prices continue to rebound, I also believe that some of the restraints on the recovery may be quite long-lasting. The headwind from the financial sector also has diminished somewhat over the past year and should present less of a restraint on economic growth than has been the case in the recent past. U.S. equity prices are up more than 10 percent so far this year following last year's 13 percent increase. Risk spreads embedded in the interest rates paid by many American businesses, although still above their pre-crisis levels, have also moved down substantially over the past year to levels that are moderate, given the state of the broader economy. The situation in Europe, although still uncertain, appears to have improved since last summer--aided importantly by the policies of the European Central Bank (ECB)--and these developments have led to an improvement in financial conditions globally. Policy actions and promises, including the ECB's program to purchase the sovereign debt of vulnerable euro-area countries and discussions about creating a banking union, appear to have helped market participants negotiate past some recent hurdles, including the challenges in forming a governing coalition in Italy and the severe banking difficulties in Cyprus. If policymakers in Europe can follow through on their commitments to financial integration and structural reforms, among other things, financial stress in Europe should continue to lessen, and European economies should gradually recover from their current slump. If the economy in Europe were to begin to grow again, it could support global economic growth more broadly. The financial condition of the U.S. banking sector has also continued to improve from the perspective of regulatory capital. While much work remains for regulators and banks implementing pending capital requirements, most large, medium-sized, and community banks are in stronger capital positions today than they were prior to the financial crisis. Although not all, some consumers at least, are seeing the benefits of improvements in financial markets. In combination with low interest rates, the easing of financial stress has allowed some homeowners to refinance their mortgages to lower their monthly payments, and some types of loans, such as those for purchasing a new or used car, have become available to more people. That said, we clearly still have a long way to go in assuring that Americans have access to affordable credit. As I noted, an especially large number of people are unable to obtain mortgage credit, and credit card borrowing is also tight. Taken together, the incoming data and my own analysis of recent developments in fiscal policy suggest that the recovery will continue at a moderate pace, and the unemployment rate will fall gradually. According to the Summary of Economic Projections that was released by Federal Reserve Board members and Reserve Bank presidents after the March FOMC meeting, my colleagues and I expected real GDP growth to step up moderately this year, rising roughly 2-1/2 percent after having risen 1-3/4 percent in 2012. In the projection, participants also expected the unemployment rate to be in the range of 7.3 to 7.5 percent by the end of the year. Looking a bit further ahead, FOMC participants largely expected the unemployment rate to continue receding, but it was expected to remain above its long-run sustainable level for several years. Meanwhile, inflation was expected to remain close to or a little below the Committee's objective of 2 percent, consistent with ongoing slack in the labor and product markets and well-anchored inflation expectations. In light of this outlook and the risks around the outlook, it has been appropriate for the Federal Reserve to continue to pursue a highly accommodative monetary policy. As you all know, during the financial crisis and at the onset of the recession, the Federal Reserve took strong easing measures, cutting the target for the federal funds rate--the traditional tool of monetary policy--to nearly zero by the end of 2008. During the recovery, we have provided additional accommodation through two nontraditional policy tools aimed at putting downward pressure on longer-term interest rates even with short- term rates stuck at zero: (1) purchases of Treasury securities and mortgage backed securities and (2) communication about the future path of the federal funds rate. Our most recent policy actions have sought to strengthen the recovery in the face of only slow improvements in labor market conditions and subdued inflationary pressures. After last September's policy meeting, the FOMC announced that the Federal Reserve would continue asset purchases until the outlook for the labor market has improved substantially in the context of price stability. Then, at the meeting in December, the FOMC voted to continue purchasing longer-term Treasury securities at a pace of $45 billion each month and agency mortgage-backed securities at a pace of $40 billion each month, and we have maintained that pace of asset purchases so far this year. In considering changes to the pace of asset purchases in the future, we take into account judgments about both the efficacy and potential costs of these purchases, including potential risks to inflation and financial stability, as well as the extent of progress toward our economic objectives. At its December meeting, the FOMC also recast its forward guidance to clarify how the target for the federal funds rate is expected to depend on future economic developments. Specifically, we said that we anticipate that an exceptionally low funds rate is likely to be warranted at least as long as the unemployment rate remains above 6-1/2 percent, inflation over the period between one and two years ahead is projected to be no more than 1/2 percentage point above 2 percent, and longer-term inflation expectations remain well anchored. These thresholds are intended to make monetary policy more transparent and predictable to the public by making more explicit our intention to maintain policy accommodation as long as needed to promote a stronger recovery in the context of price stability. Although it is still too early to assess the full effects of the most recent policy actions, available research suggests that our previous asset purchases have eased financial conditions and provided meaningful support to the economic recovery. Given its statutory mandate, the FOMC's policy actions and communications have naturally sought to lower interest rates as a means of strengthening aggregate demand, promoting the pace of recovery in the labor market, and keeping inflation from falling further below the rate preferred by the Committee over the longer run. We will continue to calibrate monetary policy--including both the ongoing pace of asset purchases and communications about the likely path of the federal funds rate--in light of our interpretations of the latest data and the implications of those interpretations for the outlook for economic activity, labor market conditions, and inflation. In summary, the U.S. economy has continued to recover from the effects of the financial crisis and deep recession, though at a pace that has been disappointingly slow. The recovery does appear to have picked up steam in some sectors, most notably in housing, likely reflecting the easing of some of the headwinds that had been holding back the pace of the recovery in earlier years. However, federal fiscal policy remains an important source of restraint. In light of these factors, most members of the FOMC project a modest improvement in the pace of the recovery this year and next, and, accordingly, a modest decline in the unemployment rate. The Federal Reserve will continue to conduct monetary policy so as to promote a stronger economic recovery in the context of price stability.

r130518a_FOMC

united states

Economic Prospects for the Long Run

bernanke

Let me start by congratulating the graduates and their parents. The word "graduate" comes from the Latin word for "step." Graduation from college is only one step on a journey, but it is an important one and well worth celebrating. I think everyone here appreciates what a special privilege each of you has enjoyed in attending a unique institution like Simon's Rock. It is, to my knowledge, the only "early college" in the United States; many of you came here after the 10th or 11th grade in search of a different educational experience. And with only about 400 students on campus, I am sure each of you has felt yourself to be part of a close-knit community. Most important, though, you have completed a curriculum that emphasizes creativity and independent critical thinking, habits of mind that I am sure will stay with you. What's so important about creativity and critical thinking? There are many answers. I am an economist, so I will answer by talking first about our economic future-- or your economic future, I should say, because each of you will have many years, I hope, to contribute to and benefit from an increasingly sophisticated, complex, and globalized economy. My emphasis today will be on prospects for the long run. In particular, I will be looking beyond the very real challenges of economic recovery that we face today-- challenges that I have every confidence we will overcome--to speak, for a change, about economic growth as measured in decades, not months or quarters. Many factors affect the development of the economy, notably among them a nation's economic and political institutions, but over long periods probably the most important factor is the pace of scientific and technological progress. Between the days of the Roman Empire and when the Industrial Revolution took hold in Europe, the standard of living of the average person throughout most of the world changed little from generation to generation. For centuries, many, if not most, people produced much of what they and their families consumed and never traveled far from where they were born. By the mid-1700s, however, growing scientific and technical knowledge was beginning to find commercial uses. Since then, according to standard accounts, the world has experienced at least three major waves of technological innovation and its application. The first wave drove the growth of the early industrial era, which lasted from the mid- 1700s to the mid-1800s. This period saw the invention of steam engines, cotton-spinning machines, and railroads. These innovations, by introducing mechanization, specialization, and mass production, fundamentally changed how and where goods were produced and, in the process, greatly increased the productivity of workers and reduced the cost of basic consumer goods. The second extended wave of invention coincided with the modern industrial era, which lasted from the mid-1800s well into the years after World War II. This era featured multiple innovations that radically changed everyday life, such as indoor plumbing, the harnessing of electricity for use in homes and factories, the internal combustion engine, antibiotics, powered flight, telephones, radio, television, and many more. The third era, whose roots go back at least to the 1940s but which began to enter the popular consciousness in the 1970s and 1980s, is defined by the information technology (IT) revolution, as well as fields like biotechnology that improvements in computing helped make possible. Of course, the IT revolution is still going on and shaping our world today. Now here's a question--in fact, a key question, I imagine, from your perspective. What does the future hold for the working lives of today's graduates? The economic implications of the first two waves of innovation, from the steam engine to the Boeing 747, were enormous. These waves vastly expanded the range of available products and the efficiency with which they could be produced. Indeed, according to the best available data, output per person in the United States increased by approximately 30 times between 1700 and 1970 or so, growth that has resulted in multiple transformations of our economy and society. History suggests that economic prospects during the coming decades depend on whether the most recent revolution, the IT revolution, has economic effects of similar scale and scope as the previous two. But will it? I must report that not everyone thinks so. Indeed, some knowledgeable observers have recently made the case that the IT revolution, as important as it surely is, likely will not generate the transformative economic effects that flowed from the earlier technological revolutions. As a result, these observers argue, economic growth and change in coming decades likely will be noticeably slower than the pace to which Americans have become accustomed. Such an outcome would have important social and political--as well as economic--consequences for our country and the world. This provocative assessment of our economic future has attracted plenty of attention among economists and others as well. Does it make sense? Here's one way to think more concretely about the argument that the pessimists are making: Fifty years ago, in 1963, I was a nine-year-old growing up in a middle-class home in a small town in South Carolina. As a way of getting a handle on the recent pace of economic change, it's interesting to ask how my family's everyday life back then differed from that of a typical family today. Well, if I think about it, I could quickly come up with the Internet, cellphones, and microwave ovens as important conveniences that most of your families have today that my family lacked 50 years ago. Health care has improved some since I was young; indeed, life expectancy at birth in the United States has risen from 70 years in 1963 to 78 years today, although some of this improvement is probably due to better nutrition and generally higher levels of income rather than advances in medicine alone. Nevertheless, though my memory may be selective, it doesn't seem to me that the differences in daily life between then and now are all that large. Heating, air conditioning, cooking, and sanitation in my childhood were not all that different from today. We had a dishwasher, a washing machine, and a dryer. My family owned a comfortable car with air conditioning and a radio, and the experience of commercial flight was much like today but without the long security lines. For entertainment, we did not have the Internet or video games, as I mentioned, but we had plenty of books, radio, musical recordings, and a color TV (although, I must acknowledge, the colors were garish and there were many fewer channels to choose from). The comparison of the world of 1963 with that of today suggests quite substantial but perhaps not transformative economic change since then. But now let's run this thought experiment back another 50 years, to 1913 (the year the Federal Reserve was created by the Congress, by the way), and compare how my grandparents and your great- grandparents lived with how my family lived in 1963. Life in 1913 was simply much harder for most Americans than it would be later in the century. Many people worked long hours at dangerous, dirty, and exhausting jobs--up to 60 hours per week in manufacturing, for example, and even more in agriculture. Housework involved a great deal of drudgery; refrigerators, freezers, vacuum cleaners, electric stoves, and washing machines were not in general use, which should not be terribly surprising since most urban households, and virtually all rural households, were not yet wired for electricity. In the entertainment sphere, Americans did not yet have access to commercial radio broadcasts and movies would be silent for another decade and a half. Some people had telephones, but no long-distance service was available. In transportation, in 1913 Henry Ford was just beginning the mass production of the Model T automobile, railroads were powered by steam, and regular commercial air travel was quite a few years away. Importantly, life expectancy at birth in 1913 was only 53 years, reflecting not only the state of medical science at the time--infection-fighting antibiotics and vaccines for many deadly diseases would not be developed for several more decades--but also deficiencies in sanitation and nutrition. This was quite a different world than the one in which I grew up in 1963 or in which we live today. The purpose of these comparisons is to make concrete the argument made by some economists, that the economic and technological transformation of the past 50 years, while significant, does not match the changes of the 50 years--or, for that matter, the 100 years--before that. Extrapolating to the future, the conclusion some have drawn is that the sustainable pace of economic growth and change and the associated improvement in living standards will likely slow further, as our most recent technological revolution, in computers and IT, will not transform our lives as dramatically as previous revolutions have. Well, that's sort of depressing. Is it true, then, as baseball player Yogi Berra said, that the future ain't what it used to be? Nobody really knows; as Berra also astutely observed, it's tough to make predictions, especially about the future. But there are some good arguments on the other side of this debate. First, innovation, almost by definition, involves ideas that no one has yet had, which means that forecasts of future technological change can be, and often are, wildly wrong. A safe prediction, I think, is that human innovation and creativity will continue; it is part of our very nature. Another prediction, just as safe, is that people will nevertheless continue to forecast the end of innovation. The famous British economist John Maynard Keynes observed as much in the midst of the Great Depression more than 80 years ago. He wrote then, "We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the 19th century is over; that the rapid improvement in the standard of life is now going to slow down." argued at that time that such a view was shortsighted and, in characterizing what he called "the economic possibilities for our grandchildren," he predicted that income per person, adjusted for inflation, could rise as much as four to eight times by 2030. His guess looks pretty good; income per person in the United States today is roughly six times what it was in 1930. Second, not only are scientific and technical innovation themselves inherently hard to predict, so are the long-run practical consequences of innovation for our economy and our daily lives. Indeed, some would say that we are still in the early days of the IT revolution; after all, computing speeds and memory have increased many times over in the 30-plus years since the first personal computers came on the market, and fields like biotechnology are also advancing rapidly. Moreover, even as the basic technologies improve, the commercial applications of these technologies have arguably thus far only scratched the surface. Consider, for example, the potential for IT and biotechnology to improve health care, one of the largest and most important sectors of our economy. A strong case can be made that the modernization of health-care IT systems would lead to better-coordinated, more effective, and less costly patient care than we have today, including greater responsiveness of medical practice to the latest research findings. Robots, lasers, and other advanced technologies are improving surgical outcomes, and artificial intelligence systems are being used to improve diagnoses and chart courses of treatment. Perhaps even more revolutionary is the trend toward so-called personalized medicine, which would tailor medical treatments for each patient based on information drawn from that individual's genetic code. Taken together, such advances could lead to another jump in life expectancy and improved health at older ages. Other promising areas for the application of new technologies include the development of cleaner energy--for example, the harnessing of wind, wave, and solar power and the development of electric and hybrid vehicles--as well as potential further advances in communications and robotics. I'm sure that I can't imagine all of the possibilities, but historians of science have commented on our collective tendency to overestimate the short-term effects of new technologies while underestimating their longer-term potential. Finally, pessimists may be paying too little attention to the strength of the underlying economic and social forces that generate innovation in the modern world. Invention was once the province of the isolated scientist or tinkerer. The transmission of new ideas and the adaptation of the best new insights to commercial uses were slow and erratic. But all of that is changing radically. We live on a planet that is becoming richer and more populous, and in which not only the most advanced economies but also large emerging market nations like China and India increasingly see their economic futures as tied to technological innovation. In that context, the number of trained scientists and engineers is increasing rapidly, as are the resources for research being provided by universities, governments, and the private sector. Moreover, because of the Internet and other advances in communications, collaboration and the exchange of ideas take place at high speed and with little regard for geographic distance. For example, research papers are now disseminated and critiqued almost instantaneously rather than after publication in a journal several years after they are written. And, importantly, as trade and globalization increase the size of the potential market for new products, the possible economic rewards for being first with an innovative product or process are growing rapidly. In short, both humanity's capacity to innovate and the incentives to innovate are greater today than at any other time in history. Well, what does all this have to do with creativity and critical thinking, which is where I started? The history of technological innovation and economic development teaches us that change is the only constant. During your working lives, you will have to reinvent yourselves many times. Success and satisfaction will not come from mastering a fixed body of knowledge but from constant adaptation and creativity in a rapidly changing world. Engaging with and applying new technologies will be a crucial part of that adaptation. Your work here at Simon's Rock, and the intellectual skills, creativity, and imagination that that work has fostered, are the best possible preparation for these challenges. And while I have emphasized technological and scientific advances today, it is important to remember that the arts and humanities facilitate new and creative thinking as well, while helping us to draw meaning that goes beyond the purely material aspects of our lives. I wish you the best in facing the difficult but exciting challenges that lie ahead.

r130602b_FOMC

united states

The Ten Suggestions

bernanke

It's nice to be back at Princeton. I find it difficult to believe that it's been almost 11 years since I departed these halls for Washington. I wrote recently to inquire about the status of my leave from the university, and the letter I got back began, "Regrettably, Princeton receives many more qualified applicants for faculty positions than we can I'll extend my best wishes to the seniors later, but first I want to congratulate the parents and families here. As a parent myself, I know that putting your kid through college these days is no walk in the park. Some years ago I had a colleague who sent three kids through Princeton even though neither he nor his wife attended this university. He and his spouse were very proud of that accomplishment, as they should have been. But my colleague also used to say that, from a financial perspective, the experience was like buying a new Cadillac every year and then driving it off a cliff. I should say that he always added that he would do it all over again in a minute. So, well done, moms, dads, and families. This is indeed an impressive and appropriate setting for a commencement. I am sure that, from this lectern, any number of distinguished spiritual leaders have ruminated on the lessons of the Ten Commandments. I don't have that kind of confidence, and, anyway, coveting your neighbor's ox or donkey is not the problem it used to be, so I thought I would use my few minutes today to make Ten Suggestions, or maybe just Ten Observations, about the world and your lives after Princeton. Please note, these points have nothing whatsoever to do with interest rates. My qualification for making such suggestions, or observations, besides having kindly been invited to speak today by President Tilghman, is the same as the reason that your obnoxious brother or sister got to go to bed later--I am older than you. All of what follows has been road-tested in real-life situations, but past performance is no guarantee of future results. The poet Robert Burns once said something about the best-laid plans of mice and men ganging aft agley, whatever "agley" means. A more contemporary philosopher, Forrest Gump, said something similar about life and boxes of chocolates and not knowing what you are going to get. They were both right. Life is amazingly unpredictable; any 22-year-old who thinks he or she knows where they will be in 10 years, much less in 30, is simply lacking imagination. Look what happened to me: A dozen years ago I was minding my own business teaching Economics 101 in Alexander Hall and trying to think of good excuses for avoiding faculty meetings. Then I got a phone call . . . In case you are skeptical of Forrest Gump's insight, here's a concrete suggestion for each of the graduating seniors. Take a few minutes the first chance you get and talk to an alum participating in his or her 25th, or 30th, or 40th reunion--you know, somebody who was near the front of the P-rade. Ask them, back when they were graduating 25, 30, or 40 years ago, where they expected to be today. If you can get them to open up, they will tell you that today they are happy and satisfied in various measures, or not, and their personal stories will be filled with highs and lows and in-betweens. But, I am willing to bet, those life stories will in almost all cases be quite different, in large and small ways, from what they expected when they started out. This is a good thing, not a bad thing; who wants to know the end of a story that's only in its early chapters? Don't be afraid to let the drama play out. Does the fact that our lives are so influenced by chance and seemingly small decisions and actions mean that there is no point to planning, to striving? Not at all. Whatever life may have in store for you, each of you has a grand, lifelong project, and that is the development of yourself as a human being. Your family and friends and your time at Princeton have given you a good start. What will you do with it? Will you keep learning and thinking hard and critically about the most important questions? Will you become an emotionally stronger person, more generous, more loving, more ethical? Will you involve yourself actively and constructively in the world? Many things will happen in your lives, pleasant and not so pleasant, but, paraphrasing a Woodrow Wilson School adage from the time I was here, "Wherever you go, there you are." If you are not happy with yourself, even the loftiest achievements won't bring you much satisfaction. The concept of success leads me to consider so-called meritocracies and their implications. We have been taught that meritocratic institutions and societies are fair. Putting aside the reality that no system, including our own, is really entirely meritocratic, meritocracies may be fairer and more efficient than some alternatives. But fair in an absolute sense? Think about it. A meritocracy is a system in which the people who are the luckiest in their health and genetic endowment; luckiest in terms of family support, encouragement, and, probably, income; luckiest in their educational and career opportunities; and luckiest in so many other ways difficult to enumerate--these are the folks who reap the largest rewards. The only way for even a putative meritocracy to hope to pass ethical muster, to be considered fair, is if those who are the luckiest in all of those respects also have the greatest responsibility to work hard, to contribute to the betterment of the world, and to share their luck with others. As the Gospel of Luke says (and I am sure my rabbi will forgive me for quoting the New Testament in a good cause): "From everyone to whom much has been given, much will be required; and from the one to whom much has been entrusted, even more will grading on the curve, you might say. Who is worthy of admiration? Luke's admonition--which is shared by most ethical and philosophical traditions, by the way--helps with this question as well. Those most worthy of admiration are those who have made the best use of their advantages or, alternatively, coped most courageously with their adversities. I think most of us would agree that people who have, say, little formal schooling but labor honestly and diligently to help feed, clothe, and educate their families are deserving of greater respect--and help, if necessary-- than many people who are superficially more successful. They're more fun to have a beer with, too. That is all you need to know about sociology. Since I have covered sociology, I might as well cover political science as well. In regard to politics, I have always liked Lily Tomlin's line, in paraphrase: "I try to be cynical, but I just can't keep up." We all feel that way some time. Actually, having been in Washington now for almost 11 years, as I mentioned, I feel that way quite a bit. Ultimately, though, cynicism is a poor substitute for critical thought and constructive action. Sure, interests and money and ideology all matter, as you learned in political science. But my experience is that most of our politicians and policymakers are trying to do the right thing, according to their own consciences, most of the time. If you think that the bad or indifferent results that too often come out of Washington are due to base motives and bad intentions, you are giving politicians and policymakers way too much credit for being effective. Honest error in the face of complex and possibly intractable problems is a far more important source of bad results than are bad motives. For these reasons, the greatest forces in Washington are ideas, and people prepared to act on those ideas. Public service isn't easy. But, in the end, if you are inclined in that direction, it is a worthy and challenging pursuit. Having given you the essence of sociology and political science, let me wrap up economics while I'm at it. Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much. However, careful economic analysis does have one important benefit, which is that it can help kill ideas that are completely logically inconsistent or wildly at variance with the data. This insight covers at least 90 percent of proposed economic policies. I'm not going to tell you that money doesn't matter, because you wouldn't believe me anyway. In fact, for too many people around the world, money is literally a life-or-death proposition. But if you are part of the lucky minority with the ability to choose, remember that money is a means, not an end. A career decision based only on money and not on love of the work or a desire to make a difference is a recipe for unhappiness. Nobody likes to fail but failure is an essential part of life and of learning. If your uniform isn't dirty, you haven't been in the game. I spoke earlier about definitions of personal success in an unpredictable world. I hope that as you develop your own definition of success, you will be able to do so, if you wish, with a close companion on your journey. In making that choice, remember that physical beauty is evolution's way of assuring us that the other person doesn't have too many intestinal parasites. Don't get me wrong, I am all for beauty, romance, and sexual attraction--where would Hollywood and Madison Avenue be without them? But while important, those are not the only things to look for in a partner. The two of you will have a long trip together, I hope, and you will need each other's support and sympathy more times than you can count. Speaking as somebody who has been happily married for 35 years, I can't imagine any choice more consequential for a lifelong journey than the choice of a traveling companion. Call your mom and dad once in a while. A time will come when you will want your own grown-up, busy, hyper-successful children to call you. Also, remember who paid your tuition to Princeton. Those are my suggestions. They're probably worth exactly what you paid for them. But they come from someone who shares your affection for this great institution and who wishes you the best for the future. Congratulations, graduates. Give 'em hell.

r130602a_FOMC

united states

Regulatory Landscapes: A U.S. Perspective

yellen

Thank you. I don't want to delay what I expect to be a lively discussion, so my opening remarks will be brief. I'll summarize the considerable progress since 2008 to make the global financial system more resilient, and then offer my views on what more should be done. It's useful to divide the regulatory reform work of the past few years into three categories: strengthening the basic bank regulatory framework, reducing the threat to financial stability posed by systemically important financial institutions (SIFIs), and strengthening core financial markets and infrastructure. The financial crisis revealed that banking firms around the world did not have enough high-quality capital to absorb losses during periods of severe stress. The Basel III reforms promulgated in 2010 by the Basel Committee on Banking Supervision will increase the amount of regulatory capital required to be held by global banking firms and improve the loss-absorbing quality of that capital. U.S. banking agencies issued proposals last summer to implement Basel III's capital reforms, have reviewed comments, and are preparing the final regulation. We also were reminded during the crisis that a banking firm--particularly one with significant amounts of short-term wholesale funding--can become illiquid before it becomes insolvent, as creditors run in the face of uncertainty about the firm's viability. The Basel Committee generated two liquidity standards to mitigate these risks: a Liquidity Coverage Ratio with a 30-day time horizon and a Net Stable Funding Ratio (NSFR) with a one-year time horizon. The U.S. banking agencies expect to issue a proposal to implement the Liquidity Coverage Ratio later this year, and we are working with the Basel Committee now to review the structure and parameters of the NSFR. The financial crisis also made clear that international bank rules should focus more on the potential threat to financial stability posed by SIFIs. In this arena, the efforts of the Federal Reserve and the global regulatory community have focused principally on (1) producing stronger regulations to reduce the probability of default of such firms to levels that are meaningfully below those for less systemically important financial firms, and (2) creating a resolution regime to reduce the losses to the broader financial system and economy upon the failure of a SIFI. The goal has been to compel SIFIs to internalize the costs their failure would impose on society and to offset any implicit subsidy that such firms may enjoy due to market perceptions that they are too-big-to-fail. The effort to reduce the likelihood of SIFI failure has worked through several channels. The Basel Committee in 2011 agreed on a framework of graduated common equity risk-based capital surcharges for systemic firms, and we are working toward proposing rules to implement Reform and Consumer Protection Act, the Federal Reserve proposed a broad set of enhanced prudential standards for large U.S. bank holding companies in December 2011. The Federal Reserve also now performs rigorous annual supervisory stress tests and capital plan reviews of the largest banking firms to ensure that these firms can continue to operate and lend through times of severe economic and financial stress. In addition, in December the Federal Reserve proposed enhanced prudential standards for foreign banks under the Dodd-Frank Act. The proposal generally would require foreign banks with a large U.S. presence to organize their U.S. subsidiaries under a single intermediate holding company that would be subject to the same capital and liquidity requirements as U.S. bank holding companies. The proposal is designed to increase the resiliency and resolvability of the U.S. operations of foreign banks, help protect U.S. and global financial stability, and promote competitive equity for all large banking firms operating in the United States. In addition to reducing the probability of SIFI failure, global regulators also have striven to reduce the potential damage to the financial system and the economy if a failure of a major financial firm were to occur. The Financial Stability Board (FSB) has proposed new standards for statutory resolution frameworks, firm-specific resolution planning, and cross-border required all large bank holding companies to develop resolution plans. Other countries that are home to large global banking firms are working along similar lines. Reducing the likelihood of a severe financial crisis also requires strengthening the capacity of our financial markets and infrastructure to absorb shocks. Toward that end, U.S. and global regulators have worked to improve the transparency and stability of the over-the-counter derivatives markets and to strengthen the oversight of financial market utilities and other critical financial infrastructure. In particular, U.S. agencies are working together to address structural weaknesses in the triparty repo market and in money market mutual funds. Let me now look forward. Although we have made the financial system safer, important work remains in each of the three areas I have highlighted: the basic bank regulatory apparatus, addressing the problems posed by SIFIs, and limiting risks in shadow banking and financial markets. Let me outline what I consider the principal pieces of unfinished business in global financial regulatory reform. First, we must actively support the continuing efforts of the Basel Committee to strengthen the foundations of global bank regulation. Key Basel Committee work in the years ahead will include finalizing the Basel III leverage ratio and NSFR, completing the comprehensive review of trading book capital requirements, adopting a global large-exposure regime, and increasing the comparability of risk-based capital requirements across banks and across countries. I want to highlight the importance of the committee's work to explore ways to increase the standardization and comparability of the risk-based capital rules for global banks. The stability of the global financial system depends critically on the capital adequacy of global banks, the capital adequacy of global banks depends critically on the Basel III reforms, and much of the good progress in the Basel III reforms rests on the integrity and strength of the risk weights. As this brief history has highlighted, tougher prudential regulation and supervision have substantially reduced the probability of a SIFI failure. Ending too-big-to-fail will require steadfast implementation by global regulators over the next few years of the work already in train. Some have proposed ideas for more sweeping restructuring of the banking system to solve too-big-to-fail. These ideas include resurrection of Glass-Steagall-style separation of commercial banking from investment banking and imposition of bank size limits. I am not persuaded that such blunt approaches would be the most efficient ways to address the too-big-to- fail problem. But at the same time I'm not convinced that the existing SIFI regulatory work plan, which moves in the right direction, goes far enough. As my colleagues Governors Tarullo and Stein have noted in recent speeches, it may be appropriate to go beyond the capital surcharges put forward by the Basel Committee. As they suggest, fully offsetting any remaining too-big-to-fail subsidies and forcing full internalization of the social costs of a SIFI failure may require either a steeper capital surcharge curve or some other mechanism for requiring that additional capital be held by firms that potentially pose the greatest risks to financial stability. There are at least three key obstacles that policymakers must overcome to maximize the prospects for an orderly resolution of a global financial firm. First, each major jurisdiction must adopt a statutory resolution regime for financial firms consistent with the FSB's Key Attributes. The United States has been a leader in this regard, and I hope that other countries that have not yet adopted a compliant resolution regime will do so promptly. Second, policymakers need to ensure that all SIFIs maintain a sufficient amount of total pre-failure and post-failure loss absorption capacity. In consultation with the Federal Deposit Insurance Corporation, the Federal Reserve is considering the merits of a regulatory requirement that the largest, most complex U.S. banking firms maintain a minimum amount of long-term unsecured debt outstanding. Such a requirement could enhance the prospects for an orderly SIFI resolution. Switzerland, the United Kingdom, and the European Union are moving forward on similar requirements, and it may be useful to work toward an international agreement on minimum total loss absorbency requirements for global SIFIs. Third, it is time for policymakers to find concrete and credible solutions to the thorny cross-border obstacles that impede the orderly resolution of a globally systemic financial firm. Important as banking reforms may be, it is worth recalling that the trigger for the acute phase of the financial crisis was the rapid unwinding of large amounts of short-term wholesale funding that had been made available to highly leveraged and/or maturity-transforming financial firms that were not subject to consolidated prudential supervision. Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally. But I believe the path forward is reasonably clear. We need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks. We also need to take further steps to reduce the risk of runs on money market mutual funds. In addition, we need to further ameliorate risks in the settlement process for triparty repo agreements, including through continued reductions in the amount of intraday credit provided by the clearing banks. But even when we accomplish these reforms, more work will remain to reduce systemic risk in the short-term wholesale funding markets that shadow banking relies on. A major source of unaddressed risk emanates from the large volume of short-term securities financing transactions (SFTs)--repos, reverse repos, securities borrowing and lending transactions, and margin loans--engaged in by broker-dealers, money market funds, hedge funds, and other shadow banks. Regulatory reform mostly passed over these transactions, I suspect, because SFTs appear safe from a microprudential perspective. But SFTs, particularly large matched books of SFTs, create sizable macroprudential risks, including large negative externalities from dealer defaults and from asset fire sales. The existing bank and broker-dealer regulatory regimes have not been designed to materially mitigate these systemic risks. The global regulatory community should focus significant amounts of energy, now, to attack this problem. The perfect solution may not yet be clear but possible options are evident: raising bank and broker-dealer capital or liquidity requirements on SFTs, or imposing minimum margin requirements on some or all SFTs. I'll stop there, and I look forward to the discussion.

r130606a_FOMC

united states

Let's Move Forward: The Case for Timely Implementation of Revised Capital Rules

raskin

Good morning and thank you to the Ohio Department of Commerce Division of Financial Institutions (DFI) for the invitation to come to Columbus to share some thoughts with you on In my remarks this morning, I want to describe some features of an appropriate regulatory capital framework for banks--focusing on community banks--and I'll cut to the chase by setting out what I believe to be two imperatives in finalizing this framework. Each of these imperatives has, at its core, the inherent goals of minimizing uncertainty and promoting safety and soundness. These imperatives are timeliness and simplicity. To explain why timeliness--by which I mean timely implementation of final capital rules in the United States--and simplicity are imperative, it helps to set the stage. And to do that, I have to go back in time. Way back, in fact, to when I was a child growing up in a small town in Illinois, just minutes away from the Indiana border. There was no bank in our town, but there was one in the next town over, which was where my family and our neighbors would do their banking. The bank probably had no more than $30 million in assets. On Saturday mornings, my mother (who essentially was the CFO of the family financial unit) would toss me in the back seat of the car and drive over to deposit my parents' paychecks, which, in those days before ATMs, meant visiting a teller. If there were no checks to deposit, Saturday morning would be when my mother would go to withdraw cash for the week. "Get in this line," my mother would order. Sometimes, we would end with a visit to the vault. To my seven-year-old self, going to the vault was deadly serious, a ritual that began by signing in with a stern-looking man who held the keys. It felt like entering a cave and looking at gold, although in retrospect I suspect my mother was only checking on insurance policies or her passbook savings. After the vault, back in the lobby there were donuts with sprinkles and coffee, and the donuts came from the bakery next to the bank, which meant they were exceedingly special. Years later, I learned that this bank was swallowed up by a larger competitor. But what was important about this bank, and why it remains so vivid in my memory, is that it was part of the fabric of our community. Our bank not only bought the local donuts, it sponsored the local Little League team, had a table at the summer sidewalk sale, made the hand fans for the Fourth of July parade, gave money to the local hospital's candy stripers, and surely did hundreds of other things invisible to me but nonetheless sewn into the tapestry of the lives of our community. Lest this sound only like nostalgia for small-town America, let's remember that the vast majority of American banks today are still very much like this one in scale, and have deep roots in their communities. For the most part, these banks did not engage in subprime lending, nor did they otherwise contribute to the financial crisis. These banks provide their towns with sustainable and affordable credit, and have employees on hand to provide families with good advice about how to save for cars, houses, new businesses, and education. This large segment of financial institutions is a necessary and critical part of our country's financial landscape. And it is returning to strength. While revenue is not fully back to pre-crisis levels, the community banking sector is solidly profitable. Asset quality has improved and appears to have stabilized and capital ratios have been strengthened and remain, on average, higher than those of larger banks. I do not need to trumpet the benefits that community banks provide right now. But I will highlight that post-crisis research regarding these banks is moving front and center and shows that these banks provided public benefits in the crisis and in the recovery stage after the crisis. For example, data show that community banks played an important cushioning role in the aftermath of the collapse of the market for jumbo mortgages. When the market for private-label, mortgage-backed securities collapsed in 2007, so too did jumbo mortgage lending as liquidity dried up. In the immediate aftermath, despite a substantial reduction in jumbo lending as a share of the overall mortgage market, the data indicate that the share of community bank jumbo mortgage lending held steady. Such lending actually increased at community banks that were not dependent on correspondent banking and at those that were sufficiently well capitalized and more profitable. And, by their sheer numbers and their central role in local communities, these banks are vital and competitive players in a highly diverse landscape for financial services. They often provide competitive options where none would otherwise exist, thereby lower borrowing costs for businesses and consumers. Whether we single them out for special advantage is a question for legitimate debate. What I do know is that what we most certainly should not do is hinder them from engaging in a fair fight. This brings me to regulatory policy. One of the questions I am most frequently asked when I speak to audiences like this one is, "What on earth is going on in Washington these Well, there certainly is a lot going on. Right now, among some other things, federal regulators are working to build out hundreds of requirements laid out by Congress in the Dodd- rule-writing effort, there is a renewed debate over whether these requirements are sufficient to end too-big-to-fail. Regulators are also continuing to oversee improvements to the operational problems in the massive numbers of foreclosures in the wake of the financial crisis and exploring the risks to financial stability that may persist in the differentially regulated parts of our financial system. This is all necessary work, and it is appropriately getting significant attention from officials at the highest levels in multiple agencies. But just as important is what, unfortunately, is not yet getting as much attention in Washington. What is not happening--what in fact may be difficult to achieve until this post- crisis work is near completion and the overarching goal of financial stability has been addressed--is a more proactive inquiry and articulation of a positive vision of what kind of financial system we want to foster or preserve. While we focus on the difficult task of implementing a wide range of rules, a number of questions about the industry remain, questions that we must shift our full focus to once the post-crisis work is near completion. For example, is diversity in both the size and type of financial institutions critical to the goals of stability and access to credit? Should new technologies that permit mobile payments and mobile banking be fostered through federal policy? To what extent should we be concerned about cyber threats, and are there features of a financial system that can mitigate or thwart such threats? After a crisis caused in part by opaque financial engineering, how do we prevent such excesses without stifling innovation that might benefit customers and the public and foster economic growth? Should financial inclusion and financial literacy be regulatory goals, as some have suggested, and what responsibility should banks bear in achieving such ends? What do we do to re-calibrate a multi-layered regulatory response that was partly dictated by the exigencies of a crisis rather than by calculated principles of best design? We have to address these and other questions if we hope to envision a post-crisis financial regulatory system that supports a strong, dynamic, and diverse financial system. This, to me, is the strongest motivation for moving ahead as expeditiously as possible on implementing statutory requirements and international agreements to raise capital standards so that we can begin lifting our vision beyond a crisis response. Moreover, as we implement these requirements and agreements, one of the things that the agencies have been considering is how we can do so in a way that does not differentially harm those financial institutions whose actions were not, by and large, responsible for the need to develop a policy response to the crisis. Let's talk about the importance of timely implementation of rules based on one set of international agreements--the Basel III framework. The proposed rule, together with the capital- related provisions in the Dodd-Frank Act, is intended to raise both the quality and quantity of capital at banking organizations in the United States. I fully support this goal, because the financial crisis demonstrated, among other things, the need for robust capital at banks of all sizes. The issue, of course, is that the framework has not been finalized, and I am concerned that significant, further delays could add to uncertainty and could detract from the maintenance of strong capital levels. There are some good reasons why the capital rules have not yet been finalized--in particular, the need to carefully consider the thousands of comment letters on the proposed rules, many of which came from community banks. Meanwhile, since Basel III sets a final deadline for implementation of 2019, one might ask why it is so imperative to act sooner. First, while it is important to get it right, this goal must be balanced with the costs imposed by delay. Lending decisions and funding plans today are shaped by perceptions of business conditions in the future, and those conditions include the details of the final regulatory capital framework. It seems obvious to me that uncertainty over that framework is weighing on the balance sheets of banks that will be affected by the rules. Second, while Basel III calls for full implementation by 2019, it also envisions a transition that must start years earlier. Since the transition to the new rules will be gradual, with some elements of the rules proposed to come into effect earlier, the sooner that regulators finalize the rules, the sooner banks will be able to incorporate those rules into their capital planning efforts. Now that banking agencies, including the Federal Reserve, have completed much of the analytical work in response to public comments on the proposed rules on Basel III, we must continue to work together to get on with the finalization of a regulatory capital framework. So let me add my voice to those who believe that this work must be completed soon. At a moment when the economy finally seems to be gaining some traction, I believe that finalizing a capital rule will minimize uncertainty related to capital requirements as well as promote safer and sounder banks. There is significant justification for both higher levels, and higher quality, of capital. In particular, we have seen that highly capitalized banks are more likely to maintain their lending activity through good times and bad, as evidenced during the recent crisis, a trend that helps their customers and the overall economy. A framework requiring higher quality and quantity of capital should be established post-haste. At the same time, however, for community banks in particular, more and better capital should be achieved without significantly increasing the complexity of capital calculations. It is not only possible and desirable, but also necessary, to ensure that our capital requirements for community banks remain relatively simple and effective. Otherwise, we risk drowning banks in a capital adequacy system that is so complex that it both misses the mark of addressing meaningful emerging risks and piles regulatory costs on banks with no public benefit. I should note here that the proposed Basel III rules include complex models-based approaches for internationally-active banks and for banks with significant trading activities. These models-based approaches are clearly inappropriate for, and will not apply to, community banks. To step back, the first framework for risk-based capital was implemented in the United States in 1989 and entailed assigning assets to one of four defined risk-weighting categories: zero percent, 20 percent, 50 percent, and 100 percent, with a higher percentage signifying higher inherent risk. This had the advantage of making the framework more risk-sensitive than the simpler, one-size-fits-all, leverage-based approach that I will discuss later. As a result, a Treasury security and an unsecured loan to a start-up business were no longer treated identically for purposes of regulatory capital. This not only made intuitive sense, but was also more consistent with how banks managed their own balance sheets and measured their risk-based performance. But the approach of risk-weighting assets by placing them in defined buckets is not precise. While it might have the virtue of providing some capital sensitivity to the quality of different asset classes, a granular system of risk-weighting raises issues of its own. For example, the riskiness associated with each asset class can be flat-out wrong. Errors are going to occur in part because risks can change over time and in part because no one has perfect knowledge about the nature of risks associated with every single asset class. To note one prominent example, risk exposures to the sovereign debt of countries that are members of the Organisation for Economic Co-operation and Development currently receive a zero percent risk weight. That is, for regulatory capital purposes, their debt is considered to be risk-free. But if there is one thing we have learned in recent years, sovereign debt can indeed be risky even if, in good times, it appears to be perfectly safe. In addition, I believe you can make a case that risk weights for securitization exposures understated the risks and losses that were actually incurred in these exposures. In fairness, losses during the financial crisis far exceeded prior historical losses on securitization exposures. But that's just the point: The risk profile of a particular financial instrument can change significantly over time, which can be very difficult to capture in a regulatory capital regime based on crude risk buckets that do not evolve over time. Accordingly, the amount of capital held can be inappropriate relative to the actual risk. One problem this can lead to is that it can create incentives that skew lending decisions and credit allocation more broadly. To be clear, I don't want to give the impression that banks' lending decisions are driven solely, or even primarily, by regulatory capital requirements. Bank lending is influenced by a variety of factors--capital requirements are just one. But at the margin, we shouldn't be surprised to see banks in aggregate making lending and investment decisions that have favorable risk-based capital treatment or that generate higher returns on a given amount of regulatory capital. So, for example, in Europe a number of banks had significant sovereign holdings going into the financial crisis, not only because capital requirements were so low, but also because high credit spreads made these particularly attractive investments. Likewise, here in the United States, banks piled into mortgage lending in the early- to mid-2000s not only because it offered generous returns, but also because regulatory capital requirements did not adequately capture the risks in this lending, particularly for subprime exposures. One of the ways that supervisors, particularly here in the United States, have addressed shortcomings in the risk-based capital regime has been to also impose a simple capital-to-assets requirement, or leverage ratio, to supplement the risk-based measures. A leverage ratio has a number of things that make it intuitively appealing, if it can be set correctly. First and foremost, it has the virtue of simplicity. Not only is it easy to calculate and easy for market participants and the public to understand, it also provides a single benchmark by which to easily compare and calibrate institutions' capital positions. In addition, a leverage ratio provides a relatively straightforward gauge of how close an institution is to insolvency. In simple terms--and I should caution that reality is seldom this simple--if an institution has a leverage ratio of 3 percent, a decline in value of assets on the balance sheet of greater than 3 percent is likely to render the institution insolvent. Moreover, we know not only from the fundamentals of finance theory but also from hard experience, that while leverage can boost earnings when times are good, leverage can also amplify losses. There is a reason why, despite the evolution of risk-based capital frameworks over the years, the leverage ratio has remained a key part of the banking supervision toolbox. This was recognized by the U.S. Congress when it passed the Federal Deposit Insurance key elements of the prompt corrective action framework for assigning capital categories to banks and taking supervisory action as appropriate and required by law. As a matter of fact, U.S. supervisors felt that a leverage ratio was such an important factor in assessing capital adequacy that U.S. negotiators worked to make sure a leverage ratio was included in the Basel III framework for global banks, many of which were not subject to explicit leverage requirements. For all its strengths, however, a leverage ratio also has significant shortcomings if not set appropriately. While its simplicity may be one of its greatest virtues, simplicity is also one of its biggest drawbacks. Notably, leverage ratios typically only apply to assets held on the balance sheet. This may be fine for institutions that primarily engage in on-balance-sheet deposit-taking and lending--like most community banks--but it can fail to capture the risks of banks' off- balance-sheet activities, which have grown exponentially over the past several decades. I mentioned previously that leverage tends to amplify losses, and I would suggest that many of the losses during the recent financial crisis, particularly at the largest firms, were a result of off- balance-sheet leverage. So, given the various features of a simple leverage-based approach and a more complex and imperfect system of risk weighting, what is the right approach for community banks? The right approach should not significantly increase the complexity of capital. The risk-based capital ratios should provide a rough baseline benchmark for ensuring that sufficient capital is held relative to a bank's risk profile, and the leverage ratio--which has certainly stood the test of time- -serves as an effective backstop to reduce the risk that a bank would allow its balance sheet to become overleveraged. Indeed, there is another side to appropriate regulation. And that is supervision and the supervisory process. At least as, if not more important as the regulatory ratios for banks is an effective supervisory assessment of capital adequacy. Regulatory capital ratios certainly provide valuable input into a bank's capital adequacy, but it is important to understand that these ratios are rough and imperfect estimates. As supervisors, we expect banks to hold capital that captures the full range of risks associated with the bank's activities, which, based on a bank's expertise in managing the risks, may very well dictate capital levels that differ from these minimum ratios. I'm not talking about anything new here: If you look at the criteria for rating capital adequacy under the banking agencies' CAMELS rating system for banks , and under the Federal Reserve's RFI rating system for bank holding companies, you will actually see very few references to minimum regulatory capital. Instead, the focus is on maintaining capital that is commensurate with the overall risk profile of the bank, not just credit risk. This requires both management and the supervisor to have an effective understanding of the banking organization's risk profile, which is central to our supervisory program. This supervisory feature sometimes gets lost in the public debate about the value of well-constructed regulatory capital ratios, but I believe that effective supervisory assessments of risk and capital adequacy as part of the community bank examination process are absolutely critical. In sum, let me conclude by saying that time is of the essence here in moving forward with the Basel III final rules. The proposed rules were not perfect and I expect there to be meaningful modifications. At the same time, while we attempt to craft a risk-based system that makes sense from the perspective of safety and soundness, we have to resist the temptation to believe we can create a perfectly sensitive risk-based regime that gives the illusion of safety. Such a regime would not be a meaningful surrogate for effective on-site supervision, and the effort to try to create an ever-more refined system would distract us from some of the important policy questions that lie ahead for our financial system. Finally, there are costs to complexity that should not be ignored. We shouldn't be lulled into thinking that these unnecessary costs should be allocated to community banks, which are a segment of our financial system that provides meaningful benefits to many Americans. Thank you very much for your time this morning.

r130627a_FOMC

united states

Thoughts on Unconventional Monetary Policy

powell

It is great to be back at the Bipartisan Policy Center. I will comment briefly on the outlook for the economy and then turn to monetary policy. Our economy has grown at an average annual rate of only about 2 percent since the recovery began exactly four years ago. That modest pace is notably weaker than the experience of past recoveries would have predicted, even accounting for the depth and duration of the Great Recession. Since 2009, the question has been when the recovery will decisively take hold and begin to deliver the higher levels of growth that are needed to put people back to work more quickly. week, and, among other tasks, each of the 19 members of the Committee submitted individual economic projections for growth, unemployment, and inflation for 2013 through 2015. These forecasts are combined into the Summary of Economic Projections (SEP), a high-level outline of which was released at the Chairman's press conference last week. FOMC participants generally expect an acceleration of the recovery through 2013 and 2014 and continued strong growth in 2015. While I make no claim to special forecasting skills, my individual projections are within the so-called central tendency of the projections. Of course, the economy has looked to be poised for a breakout several times since 2009, only to disappoint. Will this time be different? There are, in my view, good reasons to believe that the economy will continue to gain strength. I would point in particular to the housing sector, which in prior recoveries has been an important engine of growth. For the first two years of the current recovery, housing contributed nothing to growth, as housing investment hovered at extremely low levels. House prices declined sharply through most of 2011, wiping out about half of home equity and restraining consumer spending. But the housing market finally began to recover in early 2012, and that recovery seems to be proceeding strongly. Single-family housing starts have risen by more than 40 percent over the past two years, albeit from a low base. House prices are up more than 10 percent over the past 12 months. A better housing market has helped boost consumer attitudes from very low levels and supported consumer spending. The housing sector is still being held back by limited credit availability for less-creditworthy homebuyers and tight conditions for homebuilders. But overall trends suggest to me that the housing recovery can continue for many years and become an important contributor to growth. The labor market has also made real progress, as I will discuss in a moment. Auto sales have nearly returned to pre-recession levels. Our financial system is far healthier and better capitalized than it was before the crisis. And after losing one-half of its value during the financial crisis, the stock market now exceeds its pre-recession peak in nominal terms. Growth would be higher this year but for U.S. fiscal policy. The Congressional Budget Office (CBO) estimates that federal tax increases and spending cuts will slow the pace of real gross domestic product (GDP) growth about 1-1/2 percentage points this year. Tight fiscal policy may also be preventing faster reductions in unemployment. I have been surprised by how well consumer spending--and private domestic final demand more generally--have held up in the face of this pronounced fiscal drag. In the first quarter of this year, consumer spending and private domestic final demand rose at an annual rate of just above 2-1/2 percent. More-recent indicators of household and business spending suggest that private demand is continuing to advance at a reasonable clip despite the fiscal tightening. This strength is a reason for optimism. Indeed, even if real GDP rises only 2 percent or so this year--which is at the bottom end of the range of projections from the June SEP--it would still represent a solid performance in the face of these fiscal headwinds. There is still a long way to go before we achieve a full recovery. The healing process will take time, but we continue to make real progress. Let's turn to monetary policy, starting with the dual mandate, pursuant to which the Congress directs the Federal Reserve to conduct monetary policy so as to foster stable prices and full employment. Inflation is currently running below the FOMC's 2 percent long-term objective for personal consumption expenditure (PCE) price inflation, and these readings have our attention. But inflation often fluctuates for transitory reasons. We generally try to look through such transitory movements, whether above or below our objective. There is some reason to think that the recent low readings partly reflect transitory factors. Other factors point to a gradual increase in inflation. While some measures of longer-term inflation expectations have moved down, others remain more stable. Most FOMC participants anticipate that inflation will gradually move up to the FOMC's 2 percent target over coming years. Continued low or falling inflation could, however, raise real concerns. Inflation can be too low as well as too high. I have no doubt that the Committee will monitor this carefully and defend the inflation goal "from below," if necessary. The employment side of the dual mandate is a different story. From payroll employment's peak in January 2008 to its trough in February 2010, the U.S. economy lost nearly 9 million jobs, while the unemployment rate rose from an average of about 4-1/2 percent in 2007 to a high of 10 percent in October of 2009. As the economy has recovered, we have regained only about three-fourths of those lost jobs. Unemployment was 7.6 percent in May and so has come down about 2-1/2 percentage points from its peak. A broader measure that includes those who can only find part-time work, as well as those who want a job but have stopped looking, was 13.8 percent last month; in 2007, In addition, long-term unemployment remains very high--4.4 million Americans or about 37 percent of the unemployed have been out of work for six months or more. These numbers represent tragedy and hardship for these workers and their families, of course, but they also represent a crucial economic challenge. The longer workers are unemployed, the greater the likelihood that their skills will erode and workers will lose attachment to the labor force, permanently damaging the economy's dynamism and potential output. To summarize, although inflation is below target, it is expected by most observers to return over time to the Committee's 2 percent objective. The Committee will continue to carefully monitor inflation developments. But we are still far from full employment. The case for continued support for the economy from monetary policy is strong. The federal funds rate has been near zero since late 2008, and since then the FOMC has been providing accommodation through two relatively new policy tools. These tools are "forward guidance" about the future level of the federal funds rate, which is the interest rate charged on overnight loans between banks, and large-scale asset In part, the forward-guidance tool is embodied in the thresholds the FOMC adopted last December. The Committee indicated its intention to hold short-term rates near zero at least as long as unemployment remains above 6.5 percent, provided inflation one- to two-years ahead is projected to be no higher than 2.5 percent. And under the current flow-based LSAP program, adopted last year, we are purchasing $85 billion a month in long-term Treasury securities and agency mortgage-backed securities (MBS). Although the level of purchases may vary depending on economic conditions, the program will continue until there is a substantial improvement in the outlook for the labor market, in a context of price stability. I see the first tool, forward guidance about rates, as really an extension of traditional central bank rate-setting policy. By stating an intention to hold rates low and linking that intention to the path of the economy, forward guidance affects the path of longer-term rates and allows the market to make adjustments to these rates as economic conditions evolve. The second tool is large-scale asset purchases. By purchasing and holding large amounts of Treasury securities and MBS, we put additional downward pressure on term premiums and so on long-term rates. Asset purchases are an innovative, unconventional policy. Their likely benefits may be accompanied by costs and risks, the nature and size of which remain uncertain. These two policies are complementary but play somewhat different roles. Asset purchases are being deployed to add near-term momentum to the economy. After those purchases are eventually completed, the purchased assets will remain on the Fed's balance sheet for some time and continue to put downward pressure on rates. The Committee will continue to use interest rate policy, including forward guidance about short-term rates, as we return to full employment. Provided inflation remains in check, the Committee will begin to assess whether to increase short-term rates when unemployment reaches 6.5 percent. Two important considerations are likely to arise at that time. First, if inflation remains low, as expected, that would be a signal that there is still significant slack in the economy. Second, a variety of other information will shed further light on the health of the labor market, including the labor force participation rate, flows into and out of employment, and other measures of labor slack. After the Committee first raises short-term rates, it will take a balanced, and in all likelihood gradual, approach consistent with its longer-run goals of full employment and inflation of 2 percent. Both forward guidance and asset purchases work by lowering longer-term interest rates and contributing to an easing of overall financial market conditions. Lower rates increase economic activity through a variety of channels. Businesses and households react to lower rates by investing and spending more. Lower rates also support the prices of housing and financial assets such as stocks and bonds. Higher asset prices increase wealth and, with a lag, induce higher spending. In all likelihood, the current LSAP program will continue for some time. It is therefore appropriate to ask how well asset purchases have worked, and whether they are still working today. Most research has found, and I agree, that the first round of purchases of longer- term securities, which began in November 2008, contributed significantly to ending the financial crisis and preventing a much more severe economic contraction. The second round of purchases that began in November 2010 also appears to have been successful in countering disinflationary pressures. Now that the financial crisis has receded and the economy is recovering at a moderate pace, are asset purchases still effective? In my view, the evidence across the channels is mixed, but positive on balance. Economic models are used to provide a necessarily uncertain estimate of the effect on the economy of the FOMC's asset purchases. The Fed's workhorse macro model is FRB/US, which estimates a reduction of about 20 basis points in the unemployment rate after three years in the wake of $500 billion in purchases of longer- term securities. There are reasons to think that this estimate may be too low; for example, FRB/US does not include any direct channel for LSAPs to boost house prices. There are also reasons to think that the estimate might be too high, since some of the channels by which lower rates spur economic activity could be attenuated in current circumstances, for example, by lower credit availability for small businesses and less creditworthy households, or corporate and household risk aversion. My view is that the LSAPs continue to provide meaningful support for economic activity but perhaps less than what the FRB/US estimates suggest. Although the channels may not be working perfectly, it is unlikely that they are not working at all. Beyond these model-predicted effects, it also seems likely that the economy continues to benefit from the knowledge that the Federal Reserve is committed to supporting growth as long as necessary. What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing. A related worry is that the eventual process of reducing purchases and normalizing the balance sheet may itself be destabilizing or disruptive to the economy. Indeed, recent volatility in markets is in part related to concerns about the possibility of a reduction in asset purchases. I'll address both of these broad concerns, starting with incentives for risk-taking. Monetary policy has helped to keep real interest rates low. While longer-term real rates have turned positive in recent weeks, they remain at historically low levels. Experience suggests that low real rates, if maintained for a long time, can lead to asset price bubbles and eventually to financial instability. But low rates are not solely or even primarily a result of the Federal Reserve's accommodative monetary policies; they are rooted in the market's expectations of low inflation and the weakness of the economic recovery, factors weighing on rates not just in the United States but throughout the advanced economies. Given low real rates and low inflation, expected nominal returns should be low across all asset classes. The concern would be that these conditions, and our policies, could be encouraging irrational expectations of high returns. Is there any sign of that now? By most measures, equity valuations seem to be within a normal range. Whether one looks at trailing or forward price-to-earnings ratios, equity risk premiums, or option prices, there is little basis for arguing that markets show excessive optimism about future returns. Of course, in the equity markets there is always downside risk. But, as my Board colleague Jeremy Stein has observed, there have been signs of a "reach for yield" in the fixed-income markets for some time. Demand for higher- yielding fixed-income securities has outstripped new supply. The result has been very low rates, declining spreads, increasing leverage, and pressure on non-price terms such as covenants. These concerns have diminished somewhat as rates have risen since mid- May. Nonetheless, since it is likely that asset purchases will continue for some time, markets will need careful monitoring. What about house prices? At the peak of the bubble, house prices were more than 40 percent above their usual relationship to rents, according to one model that the Fed staff follows. At their trough, house prices had fallen about 10 percent below fair valuation. Given the price increases over the past year, they are--by the lights of this one model--moving back into the approximate neighborhood of fair valuation. The second concern is that the process of normalizing monetary policy and the balance sheet could itself be destabilizing or disruptive to the economy. Many cite the experiences of 1994 and 2003, when long-term rates increased quite sharply on changing views about the likely near-term path of policy. In those instances, there were both changes in views about the economy and changes in the public's understanding of the Federal Reserve's policy intentions. These same two factors have affected markets in recent weeks. Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy. In particular, the reaction of the forward and futures markets for short-term rates appears out of keeping with my assessment of the Committee's intentions, given its forecasts. The June SEP shows that 15 of 19 participants see the first rate increase happening in 2015 or 2016. The path of rates will ultimately depend on the path of the economy, and the Committee has said that the first rate increase will not happen until a considerable time has elapsed after asset purchases have been concluded. Thus, to the extent the market is pricing in an increase in the federal funds rate in 2014, that implies a stronger economic performance than is forecast either by most FOMC participants or by private forecasters. We have made significant strides in communication in recent years. The unemployment and inflation thresholds I discussed earlier, as well as the communication around asset purchases, are all designed to improve public understanding of the Committee's intentions. But communications are bound to be imperfect, and changes in the outlook can still lead to adjustments in asset prices. Thus, some volatility is unavoidable, and indeed is a necessary part of the process by which markets and the economy adjust to incoming information. Last week, the Chairman provided greater clarity about the path of asset purchases. Specifically, the Chairman noted that, if incoming data are broadly consistent with the Committee's sense of the economic outlook, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. If the subsequent data remain broadly aligned with the Committee's current expectations for the economy, the Committee could continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year. At that time, the unemployment rate would likely be in the vicinity of 7 percent, with growth consistent with further improvements and inflation heading back toward our objective. If unemployment reaches the 7 percent range, that would constitute a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced the current program of asset purchases. I want to emphasize the importance of data over date. economic outlook is broadly realized, there will likely be a moderation in the pace of purchases later this year. If the performance of the economy is weaker, the Committee may delay before moderating purchases or even increase them. If the economy strengthens faster than the Committee anticipates, the pace of purchases may be moderated somewhat more quickly. The path of purchases is in no way predetermined; we will monitor economic data and adjust our purchases as appropriate. In my view, there has been real progress in the labor market. The Committee first adopted the "substantial improvement" test at the September 2012 meeting, so it is appropriate to measure the economy's progress against economic conditions at that time. When the Committee met in September, the unemployment rate stood at 8.1 percent. Today, just nine months later, the unemployment rate is 7.6 percent--a larger decline than most FOMC participants expected in September. At the time of the September meeting, nonfarm payrolls were reported to have increased at a monthly rate of 97,000 over the prior six months. Today the trailing six-month average payroll growth is 194,000. Other labor market indicators also show moderate progress, including aggregate hours worked, initial unemployment insurance claims, the duration of unemployment, and the share of long-term unemployment. There are many signs that the economy is healing. If the Committee's economic outlook is broadly realized, and we do see the first moderation in the pace of purchases later this year, that would be good news. The first reduction in purchases, when it comes, will be an acknowledgement of the economy's progress and a sign of the Committee's confidence in the path to full recovery. In all cases, the path of policy will remain fully data-dependent. If economic growth, unemployment, or inflation do not meet the Committee's expectations, or if financial conditions evolve in a way that is inconsistent with continued recovery, the Committee will respond. Thanks, and I am happy to take your questions.

r130628a_FOMC

united states

Comments on Monetary Policy

stein

Thank you very much. It's a pleasure for me to be here at the Council on Foreign Relations, and I look forward to our conversation. To get things going, I thought I would start with some brief remarks on the current state of play in monetary policy. As you know, at the Federal Open Market Committee (FOMC) meeting last week, we opted to keep our asset purchase program running at the rate of $85 billion per month. But there has been much discussion about recent changes in our communication, both in the formal FOMC statement, as well as in Chairman Bernanke's post-meeting press conference. I'd like to offer my take on these changes, as well as my thoughts on where we might go from here. But before doing so, let me note that I am speaking for myself, and that my views are not necessarily shared by my colleagues on the FOMC. It's useful to start by discussing the initial design and conception of this round of asset purchases. Two features of the program are noteworthy. The first is its flow-based, state-contingent nature--the notion that we intend to continue with purchases until the outlook for the labor market has improved substantially in a context of price stability. The second is the fact that--in contrast to our forward guidance for the federal funds rate--we chose at the outset of the program not to articulate what "substantial improvement" means with a specific numerical threshold. So while the program is meant to be data-dependent, we did not spell out the nature of this data-dependence in a formulaic way. To be clear, I think that this choice made a lot of sense, particularly at the outset of the program. Back in September it would have been hard to predict how long it might take to reach any fixed labor market milestone, and hence how large a balance sheet we would have accumulated along the way to that milestone. Given the uncertainty regarding the costs of an expanding balance sheet, it seemed prudent to preserve some flexibility. Of course, the flip side of this flexibility is that it entailed providing less- concrete information to market participants about our reaction function for asset purchases. Where do we stand now, nine months into the program? With respect to the economic fundamentals, both the current state of the labor market, as well as the outlook, have improved since September 2012. Back then, the unemployment rate was 8.1 percent and nonfarm payrolls were reported to have increased at a monthly rate of 97,000 over the prior six months; today, those figures are 7.6 percent and 194,000, respectively. Back then, FOMC participants were forecasting unemployment rates around 7-3/4 percent and 7 percent for year-end 2013 and 2014, respectively, in our Summary of Economic Projections; as of the June 2013 round, these forecasts have been revised down roughly 1/2 percentage point each. While it is difficult to determine precisely, I believe that our asset purchases since September have supported this improvement. For example, some of the brightest spots in recent months have been sectors that traditionally respond to monetary accommodation, such as housing and autos. Although asset purchases also bring with them various costs and risks--and I have been particularly concerned about risks relating to financial stability--thus far I would judge that they have passed the cost-benefit test. However, this very progress has brought communications challenges to the fore, since the further down the road we get, the more information the market demands about the conditions that would lead us to reduce and eventually end our purchases. This imperative for clarity provides the backdrop against which our current messaging should be interpreted. In particular, I view Chairman Bernanke's remarks at his press conference--in which he suggested that if the economy progresses generally as we anticipate then the asset purchase program might be expected to wrap up when unemployment falls to the 7 percent range--as an effort to put more specificity around the heretofore less well-defined notion of "substantial progress." It is important to stress that this added clarity is not a statement of unconditional optimism, nor does it represent a departure from the basic data-dependent philosophy of the asset purchase program. Rather, it involves a subtler change in how data-dependence is implemented--a greater willingness to spell out what the Committee is looking for, as opposed to a "we'll know it when we see it" approach. As time passes and we make progress toward our objectives, the balance of the tradeoff between flexibility and specificity in articulating these objectives shifts. It would have been difficult for the Committee to put forward a 7 percent unemployment goal when the current program started and unemployment was 8.1 percent; this would have involved a lot of uncertainty about the magnitude of asset purchases required to reach this goal. However, as we get closer to our goals, the balance sheet uncertainty becomes more manageable--at the same time that the market's demand for specificity goes up. In addition to guidance about the ultimate completion of the program, market participants are also eager to know about the conditions that will govern interim adjustments to the pace of purchases. Here too, it makes sense for decisions to be data- dependent. However, a key point is that as we approach an FOMC meeting where an adjustment decision looms, it is appropriate to give relatively heavy weight to the accumulated stock of progress toward our labor market objective and to not be excessively sensitive to the sort of near-term momentum captured by, for example, the last payroll number that comes in just before the meeting. In part, this principle just reflects sound statistical inference--one doesn't want to put too much weight on one or two noisy observations. But there is more to it than that. Not only do FOMC actions shape market expectations, but the converse is true as well: Market expectations influence FOMC actions. It is difficult for the Committee to take an action at any meeting that is wholly unanticipated because we don't want to create undue market volatility. However, when there is a two-way feedback between financial conditions and FOMC actions, an initial perception that noisy recent data play a central role in the policy process can become somewhat self-fulfilling and can itself be the cause of extraneous volatility in asset prices. Thus both in an effort to make reliable judgments about the state of the economy, as well as to reduce the possibility of an undesirable feedback loop, the best approach is for the Committee to be clear that in making a decision in, say, September, it will give primary weight to the large stock of news that has accumulated since the inception of the program and will not be unduly influenced by whatever data releases arrive in the few weeks before the meeting--as salient as these releases may appear to be to market participants. I should emphasize that this would not mean abandoning the premise that the program as a whole should be both data-dependent and forward looking. Even if a data release from early September does not exert a strong influence on the decision to make an adjustment at the September meeting, that release will remain relevant for future decisions. If the news is bad, and it is confirmed by further bad news in October and November, this would suggest that the 7 percent unemployment goal is likely to be further away, and the remainder of the program would be extended accordingly. In sum, I believe that effective communication for us at this stage involves the following key principles: (1) reaffirming the data-dependence of the asset purchase program, (2) giving more clarity on the type of data that will determine the endpoint of the program, as the Chairman did in his discussion of the unemployment goal, and (3) basing interim adjustments to the pace of purchases at any meeting primarily on the accumulated progress toward our goals and not overemphasizing the most recent momentum in the data. I have been focusing thus far on our efforts to enhance communications about asset purchases. With respect to our guidance on the path of the federal funds rate, we have had explicit links to economic outcomes since last December, and we reaffirmed this guidance at our most recent meeting. Specifically, we continue to have a 6.5 percent unemployment threshold for beginning to consider a first increase in the federal funds rate. As we have emphasized, the threshold nature of this forward guidance embodies further flexibility to react to incoming data. If, for example, inflation readings continue to be on the soft side, we will have greater scope for keeping the funds rate at its effective lower bound even beyond the point when unemployment drops below 6.5 percent. Of course, there are limits to how much even good communication can do to limit market volatility, especially at times like these. At best, we can help market participants to understand how we will make decisions about the policy fundamentals that the FOMC controls--the path of future short-term policy rates and the total stock of long-term securities that we ultimately plan to accumulate via our asset purchases. Yet as research has repeatedly demonstrated, these sorts of fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call "changes in discount rates," which is a fancy way of saying the non-fundamental stuff that we don't understand very well--and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics. This observation reminds us that it often doesn't make sense to try to explain a large movement in asset prices by looking for a correspondingly large change in expectations about economic fundamentals. So while we have seen very significant increases in long-term Treasury yields since the FOMC meeting, I think it is a mistake to infer from these movements that there must have been an equivalently big change in monetary policy fundamentals. Nothing we have said suggests a change in our reaction function for the path of the short-term policy rate, and my sense is that our sharpened guidance on the duration of the asset purchase program also leaves us close to where market expectations--as expressed, for example, in various surveys that we monitor--were beforehand. I don't in any way mean to say that the large market movements that we have seen in the past couple of weeks are inconsequential or can be dismissed as mere noise. To the contrary, they potentially have much to teach us about the dynamics of financial markets and how these dynamics are influenced by changes in our communications strategy. My only point is that consumers and businesses who look to asset prices for clues about the future stance of monetary policy should take care not to over-interpret these movements. We have attempted in recent weeks to provide more clarity about the nature of our policy reaction function, but I view the fundamentals of our underlying policy stance as broadly unchanged. Thank you. I look forward to your questions .

r130702a_FOMC

united states

International Financial Regulatory Reform

powell

Thank you so much for inviting me to speak today. I join others in thanking Mr. Stephan for his service, and in welcoming Ms. Stirbock to her new role as Chief Representative of the Deutsche Bundesbank in the United States. I look forward to working with both of you, and with your colleagues, in the coming years. The Federal Reserve places great importance on our relations with the Bundesbank. Few such relationships have been as important, over the decades, in promoting financial stability and prosperity around the world. Governments, central bankers, and financial regulators labor today in the long shadow cast by the global financial crisis, and that likely will remain the case for many years. Against that background, I will touch briefly on fiscal and monetary policy here in the United States, before turning to financial regulatory issues. It has long been clear that, starting in this decade, the United States would begin to face longer-term fiscal challenges due to the aging of our population and our high and fast-rising per capita health-care costs. Over the next 20 years, it is projected that the ratio of our retired elderly to our working-age population will increase sharply from about 23 percent to about 36 percent. And, as you surely know, our per capita health care costs are far higher than those of other advanced economies, and have risen over time at a faster pace than per capita income. The combination of these two factors will put the U.S. federal budget on an unsustainable path if appropriate measures are not taken. At the end of 2007, just prior to the onset of the last recession, the United States had federal government debt equal to about 36 percent of the size of our annual gross domestic product (GDP)--a moderate level. Since 2007, and largely as a consequence of the recession and policy actions to help alleviate its effects, the U.S. federal government's debt-to-GDP ratio has increased to around 75 percent. It is projected to remain near this level for the remainder of the decade under current federal budget policies. This high level of federal government debt leaves U.S. policymakers with less "fiscal space" than may be required to deal with expected increases in retirement and health-care costs, or with unanticipated economic shocks. Over the last few years, the fiscal authorities have cut federal spending and raised taxes, and our Congressional Budget Office estimates that these fiscal headwinds will reduce real GDP growth by about 1.5 percentage points this year from what it otherwise would have been. Nevertheless, as a nation, we have not yet addressed in a fundamental way our longer-term budget challenges, particularly those associated with federal health- care programs. So I have no doubt that fiscal policy issues will retain an important and highly contentious place on the political agenda for many years here in the United States, as in Europe. I will turn for a moment to monetary policy. The Congress has tasked the Federal Reserve with conducting monetary policy to foster stable prices and full employment. Today, inflation is well below our 2 percent longer-term objective, as measured by prices for personal consumption expenditures. And although the unemployment rate has declined notably since its peak in 2010, it remains well above our estimate of a longer- run, more normal level. I expect that inflation will return gradually to our 2 percent objective, and that we will continue to make progress in reducing unemployment. In the meantime, the case for continued support for our economy from monetary policy remains strong. With these fiscal headwinds and the lingering effects of the recession, growth has remained in the range of 2 percent since 2009. But today, our private sector shows real signs of underlying improvement. Auto sales are strong, as is activity in our energy sector. Our housing market, which was at the heart of the crisis, is now recovering strongly. House prices are rising, and that is supporting improvement in household net worth and consumer attitudes. Homebuilders are responding to this price signal with rising housing starts, which will support job growth. Together, these and other factors give grounds to hope for the kind of self-reinforcing cycle of economic growth that we have been waiting to see. And as our economy has gradually improved, it has become possible, and appropriate, for the Federal Reserve to provide clearer guidance on the path of monetary policy. In all likelihood, this path will involve continued support from accommodative monetary policy for quite some time. Meanwhile, financial regulators around the world are engaged in a historic and sweeping renovation of the global financial architecture. The scope of this global regulatory project is enormous, and I will touch on only a few of its elements. One of the most important goals is to ensure that banks have adequate capital to withstand severe financial stress. I am pleased that, just this morning, the Federal Reserve Board finalized the Basel III capital requirements for bank holding companies and Federal Reserve state- chartered member banks. The other U.S. bank regulatory agencies are on track to adopt the same set of rules for the institutions they regulate over the next week or so. The Basel III capital reforms will substantially improve the resiliency of global banks and will serve as the cornerstone of the global regulatory effort to safeguard the stability of the world's financial system. Both in the United States and in Europe, some parts of the reform agenda will take longer to complete. For example, I note the ongoing progress toward achieving one of the most ambitious and important regulatory goals: the creation of a European banking union. It is clear that this challenging project will be the work of many years; indeed, it is not for an American to educate Europeans on the challenges of international cooperation. But the importance of this project for Europe's future is equally clear. The recent agreement on harmonizing national resolution regimes is an important achievement, and a milestone on the road to longer-term goals such as a single, centralized resolution authority. Another reform that will take time to complete is the establishment of a global framework for resolving large, systemically important banks. Work to enable resolution of such institutions with diverse cross-border operations is especially important, and especially daunting. The challenge is not so much to allow such institutions to fail, but rather to contain their failure so that it does not inflict enormous collateral damage on innocent bystanders and the broader economy. As many of you know, in the United States, the Federal Deposit Insurance Corporation is developing a preferred approach to resolution for such rare cases: the single-point-of-entry (SPOE) approach. This approach may be gaining some traction internationally. In my view, SPOE can be a classic "simplifier," making theoretically possible something that seemed impossibly complex. Under the SPOE approach, the home country resolution authority for a failing banking firm would effect a creditor-funded parent company recapitalization of the failed firm. To do so, the resolution authority would first use available parent company assets to recapitalize the firm's critical operating subsidiaries, and then would convert liabilities of the parent company into equity of a surviving entity. This approach would have the effect of concentrating the firm-wide losses on the parent company's private sector equity holders and creditors. The SPOE approach places a high priority on what your own President Weidmann recently described as "the principle of liability," meaning that those who benefit should also bear the costs. Perhaps the greatest challenge for the resolution of a systemic global bank is the possibility that public or private actors in different countries might take local actions that would cause the overall resolution to spin out of control. Creditors and counterparties of solvent operating subsidiaries might rush for the exit if they are unsure of their status. As a subsidiary comes under increasing stress, authorities might preemptively ring-fence local assets. The process of resolution will need to be fully worked out and understood beforehand by market participants, regulatory authorities, and the general public. It will be absolutely essential to build trust among all parties, and especially between regulatory authorities. Much remains to be done in eliminating "too-big-to-fail." The Federal Reserve is considering a requirement that systemic institutions maintain sufficient long-term debt at the parent company level to absorb losses and recapitalize operating subsidiaries in the event of failure. We expect to propose such a requirement later this year. I share the view expressed recently by several of my Board colleagues that the work of large bank resolution is not complete, and that further measures may be necessary. No one should doubt that the Federal Reserve is committed to completing this project. Reaching agreement on a cross-border resolution process will be challenging. Our financial services industries and our economies differ in many ways. But we have a shared interest in financial stability, in reducing moral hazard, and in protecting taxpayers. On that note, I will briefly discuss the Fed's proposal for oversight of foreign banks operating in the United States, which carries out a mandate from the Congress Our proposal represents a targeted set of adjustments aimed at reducing the risks posed by the U.S. operations of large foreign banks to U.S. financial stability that were revealed during, and in the aftermath of, the recent financial crisis. The proposal is not intended to create a disadvantage for foreign banks in the U.S. market. Rather, the proposal is part of a larger set of regulatory reforms that substantially raises standards for all banking organizations operating in the United States and aims to achieve the goals we share with Germany: vigorous and fair competition and a stable financial system. Indeed, in some sense it follows the lead of the European Union and its member states in ensuring that all large subsidiaries of globally active banks meet Basel capital rules. We believe that our foreign bank proposal, which would increase the strength and resiliency of the U.S. operations of these firms, would meaningfully reduce the likelihood of disruptive ring- fencing at the moment of crisis that could undermine an SPOE resolution of a large foreign bank. We are fully committed to the international efforts to address cross-border resolution issues and to maintaining strong cooperation between home and host supervisors during normal and crisis periods. I will close by observing that the international effort to strengthen financial regulation cannot succeed unless each nation understands the goals and challenges faced by its partners. The Federal Reserve and the Bundesbank have a long history. I believe there is a trust between us that is the basis for collaboration. I look forward to working with you to make the financial system safer and stronger. Thank you.

r130710a_FOMC

united states

A Century of U.S. Central Banking: Goals, Frameworks, Accountability

bernanke

National Bureau of Economic Research for organizing this conference in recognition of the Federal Reserve's centennial, and I'm glad to have the opportunity to participate. In keeping with the spirit of the conference, my remarks today will take a historical perspective. I will leave discussion of current policy to today's question-and-answer session and, of course, to my congressional testimony next week. Today, I'll discuss the evolution over the past 100 years of three key aspects of Federal Reserve policymaking: the goals of policy, the policy framework, and accountability and communication. The changes over time in these three areas provide a useful perspective, I believe, on how the role and functioning of the Federal Reserve have changed since its founding in 1913, as well as some lessons for the present and for the future. I will pay particular attention to several key episodes of the Fed's history, all of which have been referred to in various contexts with the adjective "Great" attached to Great Inflation and subsequent disinflation, the Great Moderation, and the recent Great In the words of one of the authors of the Federal Reserve Act, Robert Latham Owen, the Federal Reserve was established to "provide a means by which periodic panics which shake the American Republic and do it enormous injury shall be stopped." short, the original goal of the Great Experiment that was the founding of the Fed was the preservation of financial stability. At the time, the standard view of panics was that they were triggered when the needs of business and agriculture for liquid funds outstripped the available supply--as when seasonal plantings or shipments of crops had to be financed, for example--and that panics were further exacerbated by the incentives of banks and private individuals to hoard liquidity during such times. The new institution was intended to relieve such strains by providing an "elastic" currency--that is, by providing liquidity as needed to individual member banks through the discount window; commercial banks, in turn, would then be able to accommodate their customers. Interestingly, although congressional advocates hoped the creation of the Fed would help prevent future panics, they did not fully embrace the idea that the Fed should help end ongoing panics by serving as lender of last resort, as had been recommended by the British economist and writer Walter Bagehot. Legislators imposed limits on the Federal Reserve's ability to lend in response to panics, for example, by denying nonmember banks access to the discount window and by restricting the types of collateral that the Fed could accept. The framework that the Federal Reserve employed in its early years to promote financial stability reflected in large measure the influence of the so-called real bills doctrine, as well as the fact that the United States was on the gold standard. In the framework of the real bills doctrine, the Federal Reserve saw its function as meeting the needs of business for liquidity--consistent with the idea of providing an elastic currency-- with the ultimate goal of supporting financial and economic stability. When business activity was increasing, the Federal Reserve helped accommodate the need for credit by supplying liquidity to banks; when business was contracting and less credit was needed, the Fed reduced the liquidity in the system. As I mentioned, the Federal Reserve pursued this approach to policy in the context of the gold standard. Federal Reserve notes were redeemable in gold on demand, and the Fed was required to maintain a gold reserve equal to 40 percent of outstanding notes. However, contrary to the principles of an idealized gold standard, the Federal Reserve often took actions to prevent inflows and outflows of gold from being fully translated into changes in the domestic money supply. This practice, together with the size of the U.S. economy, gave the Federal Reserve considerable autonomy in monetary policy and, in particular, allowed the Fed to conduct policy according to the real bills doctrine without much hindrance. The policy framework of the Fed's early years has been much criticized in retrospect. Although the gold standard did not appear to have greatly constrained U.S. monetary policy in the years after the Fed's founding, subsequent research has highlighted the extent to which the international gold standard served to destabilize the global economy in the late 1920s and early 1930s. Likewise, economic historians have pointed out that, under the real bills doctrine, the Fed increased the money supply precisely at those times at which business activity and upward pressures on prices were strongest; that is, monetary policy was procyclical. Thus, the Fed's actions tended to increase rather than decrease the volatility in economic activity and prices. During this early period, the new central bank did make an important addition to its menu of policy tools. Initially, the Fed's main tools were the quantity of its lending through the discount window and the interest rate at which it lent, the discount rate. Early on, however, to generate earnings to finance its operations, the Federal Reserve began purchasing government securities in the open market--what came to be known as open market operations. In the early 1920s, Fed officials discovered that these operations affected the supply and cost of bank reserves and, consequently, the terms on which banks extended credit to their customers. Subsequently, of course, open market operations became a principal monetary policy tool, one that allowed the Fed to interact with the broader financial markets, not only with banks. I've discussed the original mandate and early policy framework of the Fed. What about its accountability to the public? As this audience knows, when the Federal Reserve was established, the question of whether it should be a private or a public institution was highly contentious. The compromise solution created a hybrid Federal Reserve System. The System was headed by a governmentally appointed Board, which initially included the Secretary of the Treasury and the Comptroller of the Currency. But the 12 regional Reserve Banks were placed under a mixture of public and private oversight, including board members drawn from the private sector, and they were given considerable scope to make policy decisions that applied to their own Districts. For example, Reserve Banks were permitted to set their own discount rates, subject to a minimum set by the Board. While the founders of the Federal Reserve hoped that this new institution would provide financial and hence economic stability, the policy framework and the institutional structure would prove inadequate to the challenges the Fed would soon face. the Fed failed to meet its mandate to maintain financial stability. In particular, although the Fed provided substantial liquidity to the financial system following the 1929 stock market crash, its response to the subsequent banking panics was limited at best; the widespread bank failures and the collapse in money and credit that ensued were major sources of the economic downturn. Bagehot's dictum to lend freely at a penalty rate in the face of panic appeared to have few adherents at the Federal Reserve of that era. Economists have also identified a number of instances from the late 1920s to the early 1930s when Federal Reserve officials, in the face of the sharp economic contraction and financial upheaval, either tightened monetary policy or chose inaction. Some historians trace these policy mistakes to the early death of Benjamin Strong, governor of the Federal Reserve Bank of New York, in 1928, which left the decentralized system without an effective leader. Whether valid or not, this hypothesis raises the interesting question of what intellectual framework an effective leader would have drawn on at the time to develop and justify a more activist monetary policy. The degree to which the gold standard actually constrained U.S. monetary policy during the early 1930s is debated; but the gold standard philosophy clearly did not encourage the sort of highly expansionary policies that were needed. The same can be said for the real bills doctrine, which apparently led policymakers to conclude, on the basis of low nominal interest rates and low borrowings from the Fed, that monetary policy was appropriately supportive and that further actions would be fruitless. Historians have also noted the prevalence at the time of yet another counterproductive doctrine: the so-called liquidationist view, that depressions perform a necessary cleansing function. It may be that the Federal Reserve suffered less from lack of leadership in the 1930s than from the lack of an intellectual framework for understanding what was happening and what needed to be done. The Fed's inadequate policy frameworks ultimately collapsed under the weight of economic failures, new ideas, and political developments. The international gold standard was abandoned during the 1930s. The real bills doctrine likewise lost prestige after the disaster of the 1930s; for example, the Banking Act of 1935 instructed the Federal Reserve to use open market operations with consideration of "the general credit situation of the country," not just to focus narrowly on short-term liquidity needs. Congress also expanded the Fed's ability to provide credit through the discount window, allowing loans to a broader array of counterparties, secured by a broader variety of collateral. The experience of the Great Depression had major ramifications for all three aspects of the Federal Reserve I am discussing here: its goals, its policy framework, and its accountability to the public. With respect to goals, the high unemployment of the Depression--and the fear that high unemployment would return after World War II-- elevated the maintenance of full employment as a goal of macroeconomic policy. The Employment Act of 1946 made the promotion of employment a general objective for the federal government. Although the Fed did not have a formal employment goal until the "stable prices," as part of the Fed's so-called dual mandate, earlier legislation nudged the central bank in that direction. For example, legislators described the intent of the Banking Act of 1935 as follows: "To increase the ability of the banking system to promote stability of employment and business, insofar as this is possible within the scope of monetary action and credit administration." The policy framework to support this new approach reflected the development of macroeconomic theories--including the work of Knut Wicksell, Irving Fisher, Ralph understanding how monetary policy could affect real activity and employment and help reduce cyclical fluctuations. At the same time, the Federal Reserve became less focused on its original mandate of preserving financial stability, perhaps in part because it felt superseded by the creation during the 1930s of the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, along with other reforms intended to make the financial system more stable. In the area of governance and accountability to the public, policymakers also recognized the need for reforms to improve the Federal Reserve's structure and decisionmaking. The Banking Act of 1935 simultaneously bolstered the legal independence of the Federal Reserve and provided for stronger central control by the Federal Reserve Board. In particular, the act created the modern configuration of the Committee, while removing the Secretary of the Treasury and the Comptroller of the Currency from the Board. In practice, however, the Treasury continued to have considerable sway over monetary policy after 1933, with one economic historian describing the Fed as "in the back seat." used its tools to support the war financing efforts. However, even after the war, Federal Reserve policy remained subject to considerable Treasury influence. It was not until the Accord with the Treasury that the Federal Reserve began to recover genuine independence in setting monetary policy. Once the Federal Reserve regained its policy independence, its goals centered on the price stability and employment objectives laid out in the Employment Act of 1946. In the early postwar decades, the Fed used open market operations and the discount rate to influence short-term market interest rates, and the federal funds rate gradually emerged as the preferred operating target. Low and stable inflation was achieved for most of the 1950s and the early 1960s. However, beginning in the mid-1960s, inflation began a long climb upward, partly because policymakers proved to be too optimistic about the economy's ability to sustain rapid growth without inflation. Two mechanisms might have mitigated the damage from that mistaken optimism. First, a stronger policy response to inflation--more like that observed in the 1950s-- certainly would have helped. Second, Fed policymakers could have reacted to continued high readings on inflation by adopting a more realistic assessment of the economy's productive potential. Instead, policymakers chose to emphasize so-called cost-push and structural factors as sources of inflation and saw wage- and price-setting as having become insensitive to economic slack. This perspective, which contrasted sharply with Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon," led to Fed support for measures such as wage and price controls rather than monetary solutions to address inflation. A further obstacle was the view among many economists that the gains from low inflation did not justify the costs of achieving it. The consequence of the monetary framework of the 1970s was two bouts of double-digit inflation. Moreover, by the end of the decade, lack of commitment to controlling inflation had clearly resulted in inflation expectations becoming "unanchored," with high estimates of trend inflation embedded in longer-term interest rates. As you know, under the leadership of Chairman Paul Volcker, the Federal Reserve in 1979 fundamentally changed its approach to the issue of ensuring price stability. This change involved an important rethinking on the part of policymakers. By the end of the 1970s, Federal Reserve officials increasingly accepted the view that inflation is a monetary phenomenon, at least in the medium and longer term; they became more alert to the risks of excessive optimism about the economy's potential output; and they placed renewed emphasis on the distinction between real--that is, inflation- adjusted--and nominal interest rates. The change in policy framework was initially tied to a change in operating procedures that put greater focus on growth in bank reserves, but the critical change--the willingness to respond more vigorously to inflation--endured even after the Federal Reserve resumed its traditional use of the federal funds rate as the policy instrument. The new regime also reflected an improved understanding of the importance of providing a firm anchor, secured by the credibility of the central bank, for the private sector's inflation expectations. Finally, it entailed a changed view about the dual mandate, in which policymakers regarded achievement of price stability as helping to provide the conditions necessary for sustained maximum employment. Volcker's successful battle against inflation set the stage for the so-called Great Moderation of 1984 to 2007, during which the Fed enjoyed considerable success in achieving both objectives of its dual mandate. Financial stability remained a goal, of course. The Federal Reserve monitored threats to financial stability and responded when the financial system was upset by events such as the 1987 stock market crash and the terrorist attacks of 2001. More routinely, it shared supervisory duties with other banking agencies. Nevertheless, for the most part, financial stability did not figure prominently in monetary policy discussions during these years. In retrospect, it is clear that macroeconomists--both inside and outside central banks--relied too heavily during that period on variants of the so-called Modigliani-Miller theorem, an implication of which is that the details of the structure of the financial system can be ignored when analyzing the behavior of the broader economy. An important development of the Great Moderation was the increasing emphasis that central banks around the world put on communication and transparency, as economists and policymakers reached consensus on the value of communication in attaining monetary policy objectives. Federal Reserve officials, like those at other central banks, had traditionally been highly guarded in their public pronouncements. They believed, for example, that the ability to take markets by surprise was important for influencing financial conditions. Thus, although Fed policymakers of the 1980s and early 1990s had become somewhat more explicit about policy objectives and strategy, the same degree of transparency was not forthcoming on monetary policy decisions and operations. The release of a postmeeting statement by the FOMC, a practice that began in 1994, was, therefore, an important watershed. Over time, the statement was expanded to include more detailed information about the reason for the policy decision and an indication of the balance of risks. In addition to improving the effectiveness of monetary policy, these developments in communications also enhanced the public accountability of the Federal Reserve. Accountability is, of course, essential for policy independence in a democracy. During this period, economists found considerable evidence that central banks that are afforded policy independence in the pursuit of their mandated objectives deliver better economic outcomes. One cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms, and financial regulators into paying insufficient attention to building risks must have some truth in it. I don't think we should conclude, though, that we therefore should not strive to achieve economic stability. Rather, the right conclusion is that, even in (or perhaps, especially in) stable and prosperous times, monetary policymakers and financial regulators should regard safeguarding financial stability to be of equal importance as-- indeed, a necessary prerequisite for--maintaining macroeconomic stability. Macroeconomists and historians will continue to debate the sources of the remarkable economic performance during the Great Moderation. My own view is that the improvements in the monetary policy framework and in monetary policy communication, including, of course, the better management of inflation and the anchoring of inflation expectations, were important reasons for that strong performance. However, we have learned in recent years that while well-managed monetary policy may be necessary for economic stability, it is not sufficient. It has been about six years since the first signs of the financial crisis appeared in the United States, and we are still working to achieve a full recovery from its effects. What lessons should we take for the future from this experience, particularly in the context of a century of Federal Reserve history? The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy. The implication is that a central bank must take into account risks to financial stability if it is to help achieve good macroeconomic performance. Today, the Federal Reserve sees its responsibilities for the maintenance of financial stability as coequal with its responsibilities for the management of monetary policy, and we have made substantial institutional changes in recognition of this change in goals. In a sense, we have come full circle, back to the original goal of the Federal Reserve of preventing financial panics. How should a central bank enhance financial stability? One means is by assuming the lender-of-last-resort function that Bagehot understood and described 140 years ago, under which the central bank uses its power to provide liquidity to ease market conditions during periods of panic or incipient panic. The Fed's many liquidity programs played a central role in containing the crisis of 2008 to 2009. However, putting out the fire is not enough; it is also important to foster a financial system that is sufficiently resilient to withstand large financial shocks. Toward that end, the Federal Reserve, together with other regulatory agencies and the Financial Stability Oversight Council, is actively engaged in monitoring financial developments and working to strengthen financial institutions and markets. The reliance on stronger regulation is informed by the success of New Deal regulatory reforms, but current reform efforts go even further by working to identify and defuse risks not only to individual firms but to the financial system as a whole, an approach known as macroprudential regulation. Financial stability is also linked to monetary policy, though these links are not yet fully understood. Here the Fed's evolving strategy is to make monitoring, supervision, and regulation the first line of defense against systemic risks; to the extent that risks remain, however, the FOMC strives to incorporate these risks in the cost-benefit analysis applied to all monetary policy actions. What about the monetary policy framework? In general, the Federal Reserve's policy framework inherits many of the elements put in place during the Great Moderation. These features include the emphasis on preserving the Fed's inflation credibility, which is critical for anchoring inflation expectations, and a balanced approach in pursuing both parts of the Fed's dual mandate in the medium term. We have also continued to increase the transparency of monetary policy. For example, the Committee's communications framework now includes a statement of its longer-run goals and monetary policy strategy. In that statement, the Committee indicated that it judged that inflation at a rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures) is most consistent over the longer run with the FOMC's dual mandate. FOMC participants also regularly provide estimates of the longer-run normal rate of unemployment; those estimates currently have a central tendency of 5.2 to 6.0 percent. By helping to anchor longer-term expectations, this transparency gives the Federal Reserve greater flexibility to respond to short-run developments. This framework, which combines short-run policy flexibility with the discipline provided by the announced targets, has been described as constrained discretion. Other communication innovations include early publication of the minutes of FOMC meetings and quarterly postmeeting press conferences by the Chairman. The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following the ideas of Lars Svensson and others, the FOMC has moved toward a framework that ties policy settings more directly to the economic outlook, a so-called forecast-based approach. In particular, the FOMC has released more detailed statements following its meetings that have related the outlook for policy to prospective economic developments and has introduced regular summaries of the individual economic projections of FOMC participants (including for the target federal funds rate). The provision of additional information about policy plans has helped Fed policymakers deal with the constraint posed by the effective lower bound on short-term interest rates; in particular, by offering guidance about how policy will respond to economic developments, the Committee has been able to increase policy accommodation, even when the short-term interest rate is near zero and cannot be meaningfully reduced further. The Committee has also sought to influence interest rates further out on the yield curve, notably through its securities purchases. Other central banks in advanced economies, also confronted with the effective lower bound on short-term interest rates, have taken similar measures. In short, the recent crisis has underscored the need both to strengthen our monetary policy and financial stability frameworks and to better integrate the two. We have made progress on both counts, but more needs to be done. In particular, the complementarities among regulatory and supervisory policies (including macroprudential policy), lender-of-last-resort policy, and standard monetary policy are increasingly evident. Both research and experience are needed to help the Fed and other central banks develop comprehensive frameworks that incorporate all of these elements. The broader conclusion is what might be described as the overriding lesson of the Federal Reserve's history: that central banking doctrine and practice are never static. We and other central banks around the world will have to continue to work hard to adapt to events, new ideas, and changes in the economic and financial environment. delivered at the New York Chapter of the National Association for Business , " speech delivered at the meetings of the Eastern . and William Roberds, eds., , , proceedings of the Goals, Guidelines, and Constraints , , vol. 66 , , vol. 3, , mc.pdf. , vol. 8 , . . . Year," a review of Journal of . New of Finance , a symposium sponsored by the Federal Reserve Bank of Evidence and Explanations," in proceedings of , a symposium sponsored by the Federal , vol. 17, . Journal of , vol. Journal of Motivation and ed., Proceedings of of , a symposium sponsored by the speech delivered at the Haas School of Business, University of California,

r130717a_FOMC

united states

Beyond Capital: The Case for a Harmonized Response to Asset Bubbles

raskin

Thank you for inviting me to speak to you this afternoon. I'm honored to have the chance to be with so many former colleagues and friends. As I look around this room, I'm reminded of your efforts and the variety of perspectives that you have brought, over the years, to the endeavor of financial regulation. I'm reminded of the contributions you have made to the richness of these debates and tasks. There has been a flurry of pronouncements lately regarding regulations, rules, and guidance, and today's meeting of the Exchequer Club seems like an opportune moment to pause and offer a perspective that lifts us above the many details. Newly adopted capital rules, and those newly proposed, in particular, have received the most attention, and I believe that these rules and proposed rules are a big step forward. There is no question but that a higher quantity and quality of bank capital will strengthen the banking system. Today, I want to discuss regulatory policies in the context of the growth and inevitable collapse of asset bubbles, with a focus on the role of credit. Regulatory policies, when well crafted, can lean against credit excesses that result in asset bubbles. In so doing, they can lean against vulnerabilities in the financial system that encourage the growth of excess credit. Well-crafted regulatory policies can also build resilience for banks after asset bubbles have burst. Many such regulatory policies are already in use, but there are others at the frontiers of regulation that haven't been widely employed. Significantly, both sets of regulatory policies--those that lean against excesses and those that build resilience--need to be understood in the context of a comprehensive system of prudential supervision for all financial institutions. In my remarks, first, I will briefly review how asset bubbles form, and I'll highlight certain features of asset bubbles so we can discern how regulatory policy might respond to them. Second, I'll assert that regulatory tools, including those related to capital, only work if part of a system of prudential supervision for all financial institutions. Third, I'll ask whether capital and other regulatory requirements have meaning without a prescriptive and individualized analysis of risk for individual financial institutions. In this regard, I'll suggest several other considerations that financial institutions and regulators should consider in the regulatory context. In order to think about regulatory policy from the perspective of leaning against excesses and vulnerabilities created by asset bubbles, or from the perspective of strengthening resilience to asset bubbles, we need to understand how financial institutions participate in the creation of bubbles. The story of asset bubbles, for me, is one in which there is usually explicit and purposeful financial institution involvement. It used to be believed that asset bubbles emerged spontaneously, or perhaps came from sunspots or other mysterious causes. Now we know more and we know better, and, while we may not be able to predict bubbles, we understand them to be a product of particular actions and choices by financial institutions and their regulators. Here is one way a bubble might start. And, to approximate current economic conditions, we'll assume an environment of interest rates that have been low, and continue to be low, for a long time. To start, retail investors may become dissatisfied with their low yields and begin to seek higher yields by purchasing some specific higher- yielding asset. If investors have access to credit, they might try to raise the return on their money by funding a greater portion of their purchases with debt. The asset purchased could serve to collateralize their loan. If many investors employ this strategy and they borrow to invest in the same asset, the price of that asset, and perhaps the prices of closely related assets as well, will increase noticeably faster than the historical trend. At the same time, increased demand for credit to finance these asset purchases could lead lenders to increase their reliance on less expensive, unstable short-term funding, such as uninsured deposits, commercial paper, or repo transactions, in order to fund the loans. Besides meeting customers' growing demands for credit, financial intermediaries may themselves decide to "reach for yield" and take on additional risk in a low interest- rate environment. Banks suffering compressed net interest margins because of low long- term interest rates, money market funds facing an earnings squeeze, insurance companies that had promised minimum rates of return on their products, and others may all begin to take on higher interest rate risk, market risk, liquidity risk, or credit risk in search of higher returns. If these conditions seem likely to continue, an initial rise in the asset's price leads to expectations of further increases, which adds to investor demand, spurring further borrowing and credit growth and increased household and financial sector leverage, which, in turn, could drive asset prices still higher. Rising asset prices, in turn, would increase the value of borrowers' collateral, allowing still further borrowing. For loans collateralized by an asset whose price is rising, lenders believe they can rely for repayment more on the appreciation of the asset and collateral and less on the borrower's repayment ability. Lenders relax their underwriting standards, such as minimum requirements for borrower down payments, credit scores and credit history, or required maximum debt-to-income ratios. To compete for loans to buy or to hold the appreciating asset, or financial assets related to it, financial institutions could also decrease the margins and haircuts that usually protect them from asset price declines. Financial institution decisions to relax underwriting and impose less-stringent margins and haircuts will further increase the pool of potential borrowers and their borrowing capacity, further increasing credit growth and supporting still higher asset prices, but, at the same time, will also increase lenders' credit risks and exposure--as secured creditors--to a decline in the asset's price. Ultimately, the asset becomes severely overvalued, with its price untethered from economic fundamentals. We would then have on our hands a full-blown, credit-fueled asset bubble. And, as we experienced in the financial crisis, when a bubble involving a widely- held asset bursts, the consequent plunge in asset prices can seriously impair the balance sheets of households and firms. Indeed, a dramatic decline in the price of a significant asset can reduce household wealth, spending, and aggregate demand. When such effects on wealth, credit availability, and aggregate demand are large enough, the real economy can suffer a significant recession. And, of course, lower employment and incomes further depress asset prices and borrowers' ability to repay loans, with further adverse effects on financial institutions and their ability to extend credit . At this point, some financial institutions may have become nearly insolvent. And this, coupled with their increased reliance on potentially unstable short-term funding, could make them more vulnerable to sudden losses of public confidence. Such a loss of confidence, in turn, makes it impossible for affected institutions to roll over existing debts or extend new credit, and may force deleveraging that requires selling illiquid assets quickly and cheaply in asset fire sales, resulting in further declines in asset prices. Such developments further threaten the solvency of financial institutions and intensify credit contraction, depriving households and businesses of financing. A loss of confidence that is institution-specific could spread, causing other institutions to experience their own heightened solvency risks, liquidity problems, and need to de-lever through asset sales. Something like what I've just described happened during and after the recent housing boom and bust. Home prices rose dramatically for a decade, and then plunged more than 30 percent, throwing the financial system into chaos, severely contracting credit, and triggering the most severe recession in modern memory. We are still living with the consequences. In short, there are common features to asset bubbles. All asset bubbles implicate different segments and participants in financial transactions--lenders, borrowers, and even participants that are connected by virtue of the benefits they derive from the appreciation in the value of the asset in question. The linkages transcend banks. Bubbles are characterized by increased leverage among the various types of lending institutions and by increased maturity transformation on and off the balance sheets of various lenders. Illiquid loans are funded increasingly by unstable short-term funding. At the same time, asset bubbles are accompanied by weakening underwriting standards, and less-stringent margins and smaller haircuts. And asset bubbles are characterized by many investors chasing the same asset, and so there is generally wide-spread participation in the growth and nurturing of the bubble. Perhaps our recent asset bubble was the result of a perfect storm, one that will not recur for decades. But it is my view that asset bubbles are a feature of our financial landscape; that what happened before could happen again; and that the growth and after- effects of asset bubbles reflect particular financial institution decisions and particular regulatory policy choices or lapses. In my view, their emergence is usually neither intentional nor accidental. The good news is that I believe that regulatory policy, when part of a system of effective prudential supervision, has the potential to address asset price bubbles and their consequences. Regulatory policies can lean against emerging asset bubbles and the vulnerabilities that attend them by restraining financial institutions from excessively extending credit. In addition, such policies can build resilience in the financial system, enhancing its ability to absorb and shrug off unexpected losses from any source, including sharp asset price declines. Of course, monetary policy also has the power to lean against the growth of asset bubbles. While there could be situations in which monetary policy might be needed to try to limit the growth of a bubble, in my opinion such use would represent a failure of regulatory policy, which represents a more tailored response than the flattening out of aggregate demand that would likely result from contractionary monetary policy. Some of the significant regulatory tools for addressing asset bubbles--both those in widespread use and those on the frontier of regulatory thought--are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting. Without plumbing the depths of each type of tool, I'll say a few words about each as it relates to the curbing of excess credit growth that fuels asset bubbles and to mitigating the effects of a bubble's collapse. Capital regulation--in particular, the imposition of minimum capital requirements-- increases capital and thereby improves the ability of regulated financial institutions to absorb losses and maintain lending after a bubble has burst. More capital reduces the probability of institutions' failure, with the added benefit of reducing the chance of funding runs due to loss of confidence. But because higher required capital also generally increases the cost of funding assets--by increasing the role of capital in the funding mix--it also raises the possibility of reducing the supply of credit from regulated institutions, making credit more expensive. Thus, higher capital requirements, to some degree, also lean against excessive credit growth that can fuel asset bubbles . Relevant capital regulation tools include a higher amount and quality of capital, such as is required under Basel III; leverage ratios, particularly the supplementary leverage ratio, if regulators increase it; the Basel III countercyclical capital buffer, which is designed to build resilience and lean against credit-fueled asset bubbles in a countercyclical manner; and capital surcharges. Supervisory stress testing and capital planning are related regulatory capital- focused tools. They not only increase resilience, but, by including assumed asset bubbles in their scenarios, they can also focus attention on specific assets, causing banking firms to build capital against unexpected losses in those assets. By focusing management attention on the downside risk posed by certain assets, and by increasing the share of capital in the funding mix, they can also lean against bank lending that supports inflated asset values. In addition, higher "sector-specific" risk weights and capital charges, applied to specific assets such as mortgages, potentially could be a more targeted way of addressing particular asset bubbles; however, these more targeted capital tools require an early understanding of the particular asset class that may be involved in a potential bubble. Whether financial regulators would be capable of spotting such specific asset bubbles early, and then of acting in a timely enough way to address such bubbles is, in my view, unlikely. A second class of policies that addresses asset bubbles and their consequences is liquidity regulation. An example is the new Basel III liquidity coverage ratio. As I discussed earlier, an aspect of credit-driven asset bubbles is financial institutions' increased reliance on unstable short-term wholesale funding, a reliance that makes them vulnerable to heightened rollover risk, sudden losses of confidence, and funding runs. Liquidity regulation increases the stock of cash or easily marketable securities available to institutions in the event of a funding run or margin call. Liquidity regulation also discourages use of unstable short-term wholesale funding of illiquid longer-term assets in the first place. Truly liquid assets, such as cash or Treasury securities, are low-yielding, and being required to hold them means lower earnings. Therefore, minimum liquidity requirements raise the cost, and so reduce the amount of, liquidity risk taking, reducing the chances of a liquidity crisis and asset fire sales. In that sense, minimum liquidity requirements also lean against building vulnerabilities that could accompany the growth of an asset bubble. Indeed, regulators might vary liquidity requirements in a countercyclical way, with greater liquidity required during the development of credit-fueled asset bubbles, in order to regulate the amount of allowable maturity transformation. A third class of policies that could be helpful in addressing credit-fueled asset bubbles is margins and haircuts on securities financing transactions . Such transactions could include, for example, bilateral repurchase transactions in which a broker-dealer, in order to fund its holdings of some security, borrows short-term from a money market mutual fund, while pledging a security of greater value as collateral. The excess of the value of the security over the amount borrowed at the time of the transaction is the "haircut." Haircuts protect the cash lender, since, if the borrower cannot repay, or chooses not to because collateral values have fallen, the lender can take and sell the collateral to satisfy its loan. The larger the haircut is at the time of the transaction, the greater the lender's protection; that is, the greater the likelihood that that the value of the security, when sold, will exceed the amount owed plus interest. Presumably, lenders assess their borrowers' riskiness and calibrate the amount of the appropriate haircut. Regulators should require them to do this consistently and prudently across the credit cycle. Haircuts tend to be cyclical: falling in good times, which adds to the growth of credit, and rising in busts, which contracts credit. A regulator could mitigate the cyclical behavior of haircuts and its consequences by establishing minimum haircuts that apply in both good and bad times. Calibrating minimum haircuts to the risks and volatility expected during bad times would make lenders more secure, increasing their resilience to losses. It could also make it more expensive to fund the purchase of the securities, and so could limit the amount of borrowing that could be supported by an asset of given value; this, in turn, might limit credit-fueled increases in the asset's price. In other words, by requiring increased margin, the growth of credit can be slowed and resiliency can be strengthened. Regulators can also simply require margin requirements to be increased in good times. This would lean against the growth of bubbles even if regulators had not yet discerned the particular type of asset bubble growing. The final class of policies that I'll discuss involves underwriting restrictions that can directly address asset bubbles and their consequences. When assets like houses are largely financed with borrowed money, it is possible to use tighter underwriting requirements to lean against credit extension and growing leverage. This could be done, for example, through regulatory actions that raise lenders' minimum down payment requirements or reduce borrowers' maximum permissible debt- to-income ratios. Such measures can be taken either on a one-time basis or as part of an explicitly countercyclical regime that "switches on" during a building asset bubble. In particular, regulators might impose minimum down payment requirements for property loans or their functional equivalent--maximum loan-to-value ratios. Such policies could both build resilience in the financial system and lean against developing credit excesses. They would build resilience in two ways. First, other things the same, higher minimum down payment requirements reduce the probability of default on loans. And second, higher requirements also imply a lower loss given default. Both effects imply greater resilience for the bank or other entity that made the loan or has an interest in it. Even a structural one-time upward adjustment in minimum down payment requirements--to a prudent level, above industry norms in buoyant times--could have a countercyclical effect in building resilience. Such a requirement could also moderate lender adjustments in minimum down payment requirements over the credit cycle: Minimum requirements would fall less in boom times, implying lower future loan losses than otherwise, and so would increase less in reaction during busts. In addition, by leaning against excessive credit expansion, such a policy could lean against developing asset bubbles and growing financial vulnerabilities. In a dynamic variant of this policy, minimum down payments prescribed by regulators could be implemented and would automatically vary over the credit cycle, tightening in booms and relaxing in busts. Tighter minimum down payment requirements in good times would likely reduce defaults and build lender resilience to later losses due to asset price declines. At the same time, by actively leaning progressively harder against property-related credit expansion, they may restrain excessive credit growth and property price appreciation, and reduce the chances--and magnitude--of a sharp price bust. There has been some experience with this type of tighter down payment rules reduce household leverage and the sensitivity of defaults to changes in property prices, and have been shown to slow property appreciation. I don't mean to suggest that all asset bubbles can be addressed by merely implementing some set of regulatory policies. Indeed, how easy our jobs would then be! In practice, such policies work best if they are part of a system of prudential supervision for all financial institutions. Of course, in the U.S. economy, savers and borrowers are linked not only through intermediaries like banks, but also through nonbanks, such as money market mutual funds and hedge funds, and through the capital markets and securitization. Regulation can only build resilience in, and affect intermediation and lending by, the parts of the system that are, in fact, regulated. Regulatory policies that aim to increase the resilience of regulated institutions, and lean against asset bubbles by restraining the growth of lending by such institutions, can be circumvented when financial activities migrate into less regulated parts of the financial system, parts likely farther from the protections of deposit insurance and the lender of last resort. Consequently, credit extension and associated vulnerabilities can increase outside of the heavily regulated banking system. In our current system of financial regulation-- one that is diffuse and without a single, central regulator --the antidote to such differences in regulatory approach is to put a premium on a high level of cooperation and coordination among relevant financial regulators. Comprehensive financial regulation is required, but comprehensive financial regulation is not the same as unified financial regulation. Looking around this audience today, I see evidence of the fragmented American financial regulatory system. For example, we have representatives of banks regulated by the Office of the Comptroller of in tandem with state bank regulators; we have bank holding companies regulated by the Fed; we have broker-dealers regulated by the Securities and Exchange Commission, we have exchanges regulated by the Commodity Futures Trading Commission; we have consumer financial products regulated by the Consumer Financial Protection Bureau; and we have insurance companies regulated by the state insurance commissioners. I could go on. Needless to say, it's a complicated regulatory system. And such a fragmented structure itself demands unusual and extensive degrees of coordination and cooperation among financial regulators so as to maximize the potential for comprehensive and harmonized regulation. Without such coordination and cooperation, there will be regulatory gaps and overlaps. From this perspective, it made sense to create yet another regulatory body--the Financial Stability Oversight Council--which is dedicated to the goal of coordination. The FSOC calls for agency head and senior-level staff participation of relevant financial regulatory bodies, requires regular meetings and reports on emerging risks to financial stability, and designates systemically important financial institutions. Indeed, the goal of coordination among regulators is to make the regulatory tools work across the entire financial system. This strikes me as an important goal and the ultimate challenge for policymakers. The challenge arises not only from the fact that the regulatory system is fragmented, but also from the fact that, in order to work--indeed, in order to instill trust in the resiliency of the financial system--regulations need to be complied with by financial system participants and enforced by supervisors. The recent attention being paid to capital regulation, in particular, shouldn't distract us from the broader context and importance of compliance with, and enforcement of, the various capital rules. From the perspective of the hammer, everything looks like a nail. Similarly, from the perspective of the financial regulator, everything might look like a problem of insufficient capital. Instead, capital might, in fact, be sufficient but appear insufficient because of circumvention of compliance, or because of absent or delayed enforcement. To make regulation--any financial regulation--work, there must be on-site opportunities for supervisors to look for risk factors that, if not addressed, can lead to failure. There must be strong governance that is practiced by smart management teams and overseen by informed and engaged boards of directors. Loan loss provisioning must be appropriate, and regulators need to enforce such appropriate provisioning, as well as assess the prudence of the institutions' underwriting standards. Examiners of any financial institution must be able to spot early risks and articulate to institutions' management and boards of directors why such risks are, in fact, risks. And the identification of risks should be true risks, and not just new business practices that examiners have never seen before. Addressing risks should not be tomorrow's problem; troubled financial institutions should not be "fixed" by permitting larger firms to buy them without commitments to address the risks presented by the combined firms. Finally, the public needs to have faith that regulation is meaningful. The public has an interest in a strong financial system, and this interest needs to be articulated when regulation is crafted, implemented, and enforced. Even within the regulated sector, crafting appropriate financial regulation to address asset bubbles is challenging. In reality, it is hard to know in real time when asset prices have deviated sharply from fundamentals. Asset price increases often initially reflect improving fundamentals and may only subtly and gradually change into reflections of speculative excess. Prior to the peak of housing prices, interest rates were low, making mortgage payments affordable; real incomes were rising; population was growing; and household formation was high--all "fundamental" determinants of the demand for housing and house prices. At some point, however, house prices were driven less by these fundamentals and more by speculation and weak underwriting. Ultimately, this drove house prices to unsustainably high levels. Regulatory intervention was much too late. The U.S. regulatory system is fragmented, and, hence, it takes time to choose and implement policies and calibrate them appropriately. It takes time to cooperate, coordinate, and harmonize responses. But such is today's imperative. We must complete in a timely fashion the post-Basel III and Dodd-Frank requirements. It is particularly important to increase the amount, and improve the quality, of required minimum capital; to continue stress testing and capital planning; and to reduce overreliance on unstable short-term wholesale funding. These reforms will build resilience to whatever shocks may come, and will reduce the potential for asset bubbles and excessive credit growth, leverage, maturity transformation, reliance on unstable short-term wholesale funding, and, thus, the potential for future financial crises. Still, if regulators become fixated on the tools at the expense of compliance and enforcement, the tools themselves will be meaningless. Only when such tools--be they capital-focused, liquidity-focused, margin--and haircut-focused, or underwriting-focused- -are fully embedded into a comprehensive system of prudential regulation will they reach their potential in mitigating the growth of asset bubbles and providing resiliency against the awful consequences attendant to their destruction. Thank you for your time today. I'm interested in your comments and questions.

r130920a_FOMC

united states

Macroprudential Regulation

tarullo

Real world crises have a way of shaking up the intellectual foundations of policy disciplines. Elements of received wisdom are undermined, while certain heterodox or less mainstream views are seen as more valid or important than had been widely recognized. The financial crisis of 2007-2009 was no exception. Some ideas, such as the efficient markets hypothesis, have taken some hits, as others have risen to prominence. An example of the latter is the view that financial stability must be an explicit economic policy goal. A corollary of this view is that a "macroprudential" perspective--generally characterized as focused on the financial system as a whole as opposed to the well-being of individual firms--should be added to traditional prudential regulation. A single speech cannot hope to touch on, much less do justice to, the many theoretical and policy issues encompassed by the term macroprudential. In my remarks this afternoon I will focus principally on the project of recasting the regulation and supervision of large financial firms so as to realize the macroprudential objective of reducing systemic risk. Specifically, I will offer five propositions that I think should guide this project over the next couple of years. In so doing, I will explain some of the key steps that have already been taken and identify some priorities that remain, though even here I do not pretend to comprehensiveness. Before addressing the macroprudential dimension of regulating large financial firms, however, let me provide some context by briefly reviewing the evolving idea of macroprudential policy. Although the crisis and its aftermath have created a broader consensus for the proposition that financial stability should be a more explicit objective of economic policy, there is considerably less convergence around theories of, metrics for, and policy prescriptions to promote, financial stability. Policy and academic writing generally limits the term "macroprudential" to measures directed specifically at countering risks in the financial system that, if realized, can severely impact real activity. But adoption of consistent terminology does not itself resolve questions of whether, for example, increases in systemic risk are endogenous to the financial system and thus follow a somewhat regular cyclical pattern, or are instead somewhat randomized, albeit repeated, phenomena. Differences in views of the origins of systemic risk obviously affect views of the best ways to measure it and, of course, the best policies to contain it. One example, of particular interest to central bankers, is the ongoing debate about the circumstances under which monetary policy should be adjusted to take account of financial stability concerns. Lying behind the various positions in this debate are differing views on how systemic risk propagates, and thus on the relative efficacy of monetary versus macroprudential policies. Progress in these debates is complicated by the fact that, by definition, financial stability policies are directed toward preventing or mitigating rare events, rather than outcomes such as inflation and unemployment that are continuously observable. This focus on tail risks raises important issues of accountability in the institutional design of macroprudential policies and also complicates the task of testing financial stability theories and proposed policies. Yet even against the backdrop of what is still a comparatively underdeveloped understanding of financial stability, commentators and policymakers have compiled and, in some cases, developed so-called "toolkits" of possible macroprudential measures. These measures are thought available for use against one or both of two frequently identified dimensions of systemic risk: procyclicality and interconnectedness. course, the attractiveness of many of these tools will depend on one's views of a variety of theoretical, institutional, and practical questions. The tools identified can be variously categorized. One useful distinction is between measures designed to prevent systemic risk from building (often termed "lean- against-the-wind" measures) and those designed to increase the resiliency of the financial system should systemic risk nonetheless build sufficiently that broad-based stress ensues. Another distinction is between time-varying and time-invariant measures, with the former based on a response--either discretionary or in accordance with a rule--to some measured increase in risk. It is worth noting that the term "macroprudential regulation" can be found in It appears to have originated in specific contrast to traditional banking regulation, which a 1979 background paper at the BIS characterized as focused on "sound banking practice and the protection of depositors at the level of the individual bank." In fact, much of the New Deal legislation that would define the financial regulatory structure for more than 40 years was in direct response to what we would today call systemic concerns, including banking panics and excessive leverage in equity markets. In the late 1970s, though, there was indeed reason for the development of an explicitly macroprudential perspective. The New Deal regulatory system was beginning to break down in the face of profound changes in financial markets, most importantly the progressive integration of capital market and traditional lending activities. The forms of regulation that were evolving as substitutes--principally, though not only, minimum capital requirements-- were largely based on what various BIS papers characterized as a microprudential approach to regulation. It is, however, equally worth noting that the use of the term macroprudential-- and, it would seem, the influence of the concerns lying behind the term--was somewhat irregular in the three decades after it was coined. Discussion of the concept and its implications for regulation was more likely to be found in the papers of a few academics and intrepid BIS researchers than in the pronouncements of senior regulators or other official sector representatives. One important exception is a speech delivered in September 2000 by the late Andrew Crockett, then the General Manager of the BIS. several reasons, that speech is a good point of reference for us today--as a nod to Sir Andrew's foresight, as an occasion for regret that his words were not more closely heeded by regulators, and as a way of illustrating how the challenge of macroprudential financial regulation has grown in the years since. Sir Andrew's speech contained much that is now familiar and broadly accepted, but was fairly uncommon at the time: He distinguished between the objectives of microprudential regulation--protecting against idiosyncratic risk in a bank--and macroprudential regulation--protecting against systemic risk. He set forth a description of the financial cycle that could be read as a loose paraphrase of Hyman Minsky's theory of financial instability. He identified the procyclical and asset-correlation concerns regarding large bank activities that have commanded so much attention in the past several years. And, again foreshadowing many recent discussions, he suggested macroprudential tools both to increase resiliency (as through capital regulation with a systemic perspective) and to lean against the wind in an effort to slow or limit the growth of unsustainable asset bubbles (as through maximum loan-to-value ratio requirements). The Crockett speech holds up very well today. With the benefit of the experience gained from the intervening financial crisis, an intense period of analysis from a macroprudential perspective, and a variety of regulatory initiatives, I offer these five propositions both to reinforce and to supplement the views Sir Andrew expressed 13 years ago. partnership between the two regulatory dimensions, as he called them. My own sense is that we need to concentrate our post-crisis efforts to reshape the regulation and supervision of large financial institutions on measures reflecting the macroprudential dimension, at least for a time. This view is consistent with the Congressional emphasis on financial stability and systemic risk considerations in the Dodd-Frank Wall Street To be sure, idiosyncratic problems such as certain operational risks may threaten large institutions, and traditional regulation and supervision surely have an important ongoing role to play. But the dynamics observed during the financial crisis of highly correlated asset holdings, shared risks, and contagion among the largest firms suggest that the well-being of any one of these firms cannot be considered in isolation from the well- being of the system as a whole. Severe problems at such institutions are far more likely to arise from vulnerabilities to common stresses, and severe problems at such firms are far more likely to exacerbate systemic weaknesses. Since the health of any one of these large institutions is tied to the health of these firms as a group, good microprudential regulation may itself require a macroprudential dimension. The reorientation of the Federal Reserve's supervision of large, complex financial firms is reflected organizationally in the Large Institution Supervision Coordinating Committee (LISCC). The LISCC was created three years ago to facilitate the execution of horizontal, cross-firm analysis of the largest firms and to centralize supervision of these firms so as to promote an integrated and consistent supervisory approach. The LISCC includes senior staff not only from the supervisory staffs of the Board and Monetary Affairs, Division of Research and Statistics, and other relevant divisions. This "interdisciplinary" approach to large bank supervision not only fosters more rigorous microprudential regulation, it also facilitates and formalizes a broader look at systemic risks by using quantitative methods to evaluate macroeconomic and financial risks, and how they could affect individual firms and the firms collectively. In early 2009 there was widespread doubt about the solvency of the financial system as a whole, particularly at many of the large firms that had directly or indirectly been deeply involved in mortgage markets and associated securitizations. When we created the first supervisory stress test on the fly, as it were, our aim was to stabilize, and restore confidence in, the financial system as a whole by ensuring that the 19 largest bank holding companies were sufficiently capitalized that they could continue serving as viable financial intermediaries. So the focus on resiliency was initially a matter of necessity. But there is also logic to making the resiliency of the largest firms the most important part of our ongoing macroprudential regulatory agenda. Just as a microprudential approach to regulation has come to emphasize building up capital because it makes the individual firm better able to absorb losses from any source, including unpredictable ones, so an appropriately refocused set of macroprudential capital requirements can help make the financial system better able to withstand shocks from unanticipated, as well as familiar, sources. As mentioned by Andrew Crockett, a macroprudential perspective suggests two ways in which resiliency should be strengthened: the first is to treat the financial system as a whole as the "portfolio" of assets subject to safety and soundness oversight; the second is to apply stricter regulations on firms of systemic importance whose failure would carry a good chance of endangering the entire system. In the last four years, we have developed both kinds of measures to increase resiliency. Following our use of stress tests of the nation's 19 largest bank holding companies in the midst of the crisis, Congress included in the Dodd-Frank Act a requirement of annual supervisory stress tests for a larger group of firms: all those with greater than $50 billion in assets. These stress tests, and an associated supervisory review of the capital processes and practices of the covered firms, have in just a few years become a core part of the oversight of these large firms. Our stress testing program is one form of the first type of macroprudential resiliency measure. It also provides a good example of how sound microprudential regulation of the largest banking firms can be difficult to distinguish from regulation with a macroprudential orientation. Conventional capital requirements are by their nature somewhat backward-looking, reflecting loss expectations based on past experience and loss recognition that often occurs well after the likelihood of loss has become clear. Rigorous stress testing helps compensate for these shortcomings through a forward- looking assessment of the losses that would be suffered under stipulated adverse economic scenarios, so that capital can be built and maintained at levels high enough for the firms to withstand such losses and still remain viable financial intermediaries. This forward-looking aspect of stress testing automatically builds capital, and boosts resilience, in the face of weakening loan-underwriting standards because, for any given adverse scenario, weaker underwriting standards will imply higher losses. Also, because the firms are stressed simultaneously, supervisors are able to identify and take account of correlated exposures and other common risks. The firms covered by the Dodd-Frank Act supervisory stress tests account for more than 70 percent of U.S. banking sector assets, thus approaching Sir Andrew's standard of a supervisory perspective that examines the assets of the financial system as a whole. The effectiveness of stress testing as a macroprudential tool depends, of course, on how the tests are constructed. For example, a macroprudential perspective must inform the construction of the scenarios against which the assets and revenues of the banks are stressed. Such a perspective argues for incorporating particular risks to the financial system even when there is some uncertainty regarding the probability of a particular risk being realized. For example, the scenario might include a sharp drop in house prices if analysis suggested--but did not confirm--that there was overheating in the housing market, and if supervisors judged that large banks had correlated exposures to the housing sector. That is, the stress tests provide for resiliency in the event the risk comes to pass, without necessarily requiring other measures to restrict directly the lending or other activity lying behind the risk. A macroprudential perspective also counsels against injecting more procyclicality into the financial system by, for example, simply assuming a standard deterioration in economic conditions from whatever the baseline projections might be. Such an approach would overlook the tendency of systemic risk to build during strong, prolonged expansions, when underwriting standards decline, rising asset prices make secured lending seem safer, and defaults wane. The approach we are instead taking is that, under such conditions, our severely adverse scenario would assume a level of unemployment during the stress period comparable to that observed in past severe recessions, not simply an increase in unemployment comparable to the increase observed during those recessions. Thus, the scenario's unemployment rate would feature a larger and sharper rise in the unemployment rate as economic expansions proceed. Finally, stress tests must be modified so as to avoid incentivizing firms to correlate their asset holdings or adopt correlated hedging strategies. This potential problem can be illustrated by reference to the market shocks we have applied to the trading books of the six largest financial firms in the last two stress tests. The shocks, designed to be severe, consisted of instantaneous, hypothetical jumps in asset prices based on those observed over the entire second half of 2008. The resulting trading losses are--as one would expect--quite large. Even so, had we simply used the same shocks that we used in the 2009 exercise, unchanged from the historical experience, we would have underestimated the potential losses associated with subsequent developments. For that reason, we modified the market shock scenario in 2011 to take account of Eurozone stress and then further modified the hypothesized stress in 2012 to include sharp moves in interest rates. We will continue to modify the market shock regularly to incorporate salient risks that were not necessarily present in 2008 and to ensure that firms cannot artificially improve their performance on the test through holding significant amounts of certain assets that happened to perform well in that period. The second kind of macroprudential resiliency measure reduces the chances of distress or failure for financial companies of systemic importance to a greater degree than for other firms. Key provisions of Dodd-Frank aim at this form of resiliency. One extends the perimeter of regulation by authorizing the Financial Stability Oversight Council (FSOC) to subject nonbank financial companies to supervision and regulation by the Federal Reserve if the council "determines that material financial distress" at such a company, or its nature, size, or other characteristics or activities "could pose a threat to the financial stability of the United States." Another requires the Federal Reserve to establish a broad set of enhanced prudential standards, both for bank holding companies with total consolidated assets of $50 billion or more and for nonbank financial companies designated by the FSOC as systemically important, "[i]n order to prevent or mitigate risks to the financial stability of the United States." The required standards include capital requirements, liquidity requirements, stress testing, single-counterparty credit limits, an early remediation regime, and risk-management and resolution-planning requirements. These requirements are to increase in stringency in accordance with the relative systemic importance of the companies. The capital surcharges that we will apply under this authority provide a clear example of this kind of macroprudentially motivated regulation. A microprudential requirement is informed by asking what level of capital would be necessary to allow the firm to remain a viable financial intermediary even after absorbing losses that, within a fairly high level of confidence, might be encountered over some relevant timeframe. A macroprudential capital requirement should take account of the fact that there would be very large negative externalities associated with the disorderly failure of any systemically important financial institution (SIFI), distinct from the costs incurred by the firm, its stakeholders, and the federal deposit insurance fund. As already suggested, the failure of such a firm, especially in a period of stress, significantly increases the chances that other financial firms will themselves experience great stress, for two reasons. First, direct counterparty impacts can lead to a classic domino effect. Second, because losses in a tail event are much more likely to be correlated for firms deeply engaged in trading, structured products, and other capital market instruments, all such firms are vulnerable to accelerating losses as troubled firms sell their assets into a declining market. Enhanced capital requirements should take into account these costs. Thus, the aim of financial stability capital standards is to reduce further the probability that the firm might fail under stress through a requirement to hold additional capital. These additional capital requirements can also help offset any funding advantage derived from the perceived status of such institutions as too-big-to-fail. In acting on this rationale for capital standards to mitigate risks to financial stability, we first sought to ensure that there would be an international initiative to develop financial stability capital standards for global systemically important financial institutions. The Basel Committee, an international body of supervisors that includes the U. S. banking agencies, took up this agenda and developed a framework covering more than two dozen large financial firms from around the world. Later this year, we will issue under the authority granted by Dodd-Frank a proposed set of capital surcharges congruent with that framework. The task of determining how much additional capital is needed to reduce the probability of a systemically important firm's failure to more acceptable levels is not a straightforward one. In calibrating the surcharge, the Basel Committee, with a good bit of input from the Federal Reserve, began with what has been termed the "expected impact" approach, which calls for additional capital to reduce the probability of the firm's failure sufficiently to equalize the expected impact on the financial system of the failure of a systemically important firm and the failure of a banking firm just outside systemic status. But implementing this concept is complicated by the fact that, despite some very useful metrics that have been developed in the past few years for measuring the systemic risk associated with a particular firm, there is certainly no generally accepted approach. Indeed, differences among reasonable assumptions in applying the expected impact approach led to a fairly broad range of potential surcharges. The 1-2 1/2 percent amounts negotiated within the Basel Committee are at the low end of that range, reflecting a good deal of caution--frankly, more caution than I think would have been desirable, even given the uncertainties. Regardless of one's views on calibration, though, the motivation and methodology for what have become known as "SIFI surcharges" are clearly macroprudential. One last point on macroprudential resiliency measures is that they can have secondary effects that serve the lean-against-the-wind aim of macroprudential policies. For example, a supervisory stress test can assign a higher loss rate to a certain class of assets in a hypothesized adverse scenario because they are particularly vulnerable to potential shocks and thus susceptible to particularly sharp declines in a serious recession. To the extent that firms learn over time that such assets will be treated that way, there is at least a mild disincentive to hold them. As I will discuss in a moment with respect to countercyclical capital requirements, we should not overstate this lean-against-the-wind effect, but perhaps not dismiss it out of hand either. Some discussions of macroprudential policy appear to contemplate a somewhat regular adjustment - up and down - of both resiliency and lean-against-the-wind measures. The idea is to proceed in an intentionally countercyclical fashion by attempting to restrain rapid, unsustainable increases in credit extension or asset prices and to relax those restraints as economic conditions deteriorate. This is a conceptually appealing approach, but, as various commentators on macroprudential policy options have noted, one that raises a fair number of significant issues: the reliability of measures of excess or systemic risk, the appropriate officials to be making macroprudential decisions, the speed with which measures might realistically be implemented and take effect, and the right calibration of measures that will be effective in damping excesses while not unnecessarily reducing well-underwritten credit flows in the economy. If the measures are designed to be targeted, questions of efficacy may be raised by those who believe that suppression of excess credit or asset price increases in one sector will likely result only in the redirection of credit and speculation to other sectors until underlying macroeconomic and financial conditions have ceased enabling such activities. If, on the other hand, the measures are designed to be fairly broad-based, the more basic question of the appropriate role of monetary policy may be raised by those who are focused on reactive policies that "get in all the cracks" of the financial system, not just the heavily regulated portion occupied by large financial firms. Finally, we should probably be skeptical as to how effective a macroprudential relaxation of regulatory requirements can be on the downside of economic cycles. Market discipline, which may have been lax in boom years, tends to become very strict when conditions deteriorate rapidly. Even if supervisors were to announce a relaxation in regulatory requirements, in stressed economic conditions, investors and counterparties may well look unfavorably on reductions in capital levels (even from higher levels) or relaxation of underwriting standards at any one firm, notwithstanding the potential benefits for the economy as a whole were all large firms to follow suit. Anticipating such a reaction, senior management of banks may thus have strong non-regulatory incentives to act as if microprudential regulation continued to dominate. In short, the task of buffering the financial system against a tail event seems more tractable than that of moderating the financial cycle. But these questions of economic knowledge and institutional capacities should be grounds for proceeding cautiously, not for eschewing time-varying measures entirely. It is true that the state of the art of financial stability risk assessment is still in a relatively early stage. But it is reasonable to think that the amount of effort being put into these efforts in governments, central banks, international organizations, and universities will produce some well-conceived and well- tested metrics over time. Some deviations from historical patterns are, even under existing states of knowledge, surely clear enough to justify some action. Moreover, in the absence of time-varying macroprudential tools, the burden of systemic risk containment will rest entirely elsewhere. For time invariant measures to bear this burden, it might be necessary to have through-the-cycle constraints that strengthen financial stability at greater cost to economic activity. If a central bank is reluctant ever to use monetary policy in pursuit of financial stability goals at the expense of more immediate employment and price stability goals, the burden on time invariant measures would be large indeed. Even if financial stability objectives are effectively incorporated into monetary policy, monetary tightening will surely not be the correct response to most instances of increasing leverage or asset prices that raise macroprudential concerns. Well-developed time-varying measures might be effective in slowing the increase in systemic risk to give monetary policymakers more time to evaluate the need for a monetary policy response. There are two obvious places to begin a considered development of time-varying tools. One is in the traditional supervisory oversight of practices at regulated institutions, as enhanced by the increasingly horizontal, interdisciplinary features of large bank supervision. Good supervision is always time-varying, in that it should respond to potential and growing problems in a directed fashion. The coordination engendered by the LISCC and parallel efforts facilitates the identification of potentially risky trends in, for example, underwriting certain forms of lending. The greater use of data, both for the regulated sector as collected by supervisors and for the economy as a whole as analyzed by our Office of Financial Stability, further increases the prospects of timely supervisory responses. I do not want to overstate the significance of this evolution in supervisory practice, however. For one thing, as was shown by the experience with commercial real estate lending guidance issued before the crisis, supervisory guidance is an imperfect tool. In addition to the issues surrounding real-time interventions mentioned earlier, that episode revealed the potential for substantial political resistance to supervisory actions directed at specific sectors. Still, with the institutionalization of financial stability concerns at the Federal Reserve and the FSOC, and with the ongoing improvements in relevant analytic capacities, there is room to develop this tool further. The second place to work on time-varying tools is found in another element of the new capital regime, the countercyclical buffer provision of Basel III. This provision envisions an increase in the applicable risk-weighted capital requirements of financial companies by up to 2 1/2 percentage points when "credit growth is excessive and is leading to the buildup of system-wide risk." While stress testing has a built-in degree of time- variance (since macroeconomic scenarios must be constructed annually), the countercyclical buffer is intended to be purely time variant, in that it is to be activated when, and only when, there is "excess aggregated credit growth," a condition that the Basel Committee anticipates will occur only infrequently. The principal macroprudential rationale of the countercyclical buffer is one of increasing resiliency: that the banking system as a whole will have enough capital to continue effective intermediation, even if a period of stress follows what turned out to be a period of unsustainable, rapid credit growth that leads to unusually high losses as asset prices plummet thereafter. The Basel Committee also noted that there could be a secondary, lean-against-the-wind effect if the higher capital requirements raise the cost of, and thus dampen, credit extension. It is probably not surprising that the regulators represented on the Basel Committee have chosen capital requirements as a time-varying macroprudential tool. Capital regulation is central to prudential regulation and, as already noted, is being used in service of macroprudential objectives. Both regulators and financial institutions are accustomed to capital regimes (although the post-crisis changes have altered that regime quite significantly). Still, it is uncertain just how useful this tool will be. In addition to some of the limitations affecting use of all time-varying instruments, such as judging when leverage or asset prices have become excessive, it is quite blunt. If "turned on," it would apply to all large banks in all parts of the country. So it would not be useful to deploy in response to asset bubbles or leverage in particular sectors, since the additional capital required for lending in those sectors would be no greater than in less frothy parts of the economy. Indeed, it could in some circumstances have the unintended effect of encouraging banks to do more lending in the booming areas of concern, at the expense of lending in more stable areas. The precise impact on bank lending behavior is further muddied by the one- year period given to build the additional capital cushion. These potential shortcomings notwithstanding, the tool is available in the United States to the three federal bank regulatory agencies. It could, in fact, serve as a complement to the more targeted actions available through the supervisory process. The banking agencies included the countercyclical capital provision in the capital regulation to implement Basel III adopted this summer. However, because it will not take effect in the United States until 2016 and because other regulatory and supervisory tasks created by Dodd-Frank and other initiatives need to be completed more quickly, we have not yet built out this tool through policy statements or other institutional steps. Fortunately, when we do turn to the countercyclical capital buffer, we should have the benefit of a good deal of thinking and experience by the Bank of England. The setting of countercyclical capital buffers is now committed to the Financial Policy Committee (FPC) under the reorganization of regulatory functions effected in the United Kingdom on April 1, 2013. The FPC is required to set forth a general statement of its policy and to make quarterly determinations of whether to impose or change a countercyclical buffer. I should note, however, that Parliament extended the countercyclical power beyond the broad measure in Basel III and also granted the FPC authority to direct increases in the risk-weights applicable to specific sectors judged to pose a risk to the financial system. While bank regulators in the United States certainly have similar authority as part of our broad power to set capital requirements, we have not to date considered, much less adopted, any regulation along these lines. . The shared vulnerabilities of large banking organizations as a whole are underscored by something omitted from Sir Andrew's otherwise prescient speech: the potential for damaging fire sales, itself exacerbated by the prevalence of short-term funding. The use of short-term wholesale funding was hardly unknown among major financial firms in the 1990s, but broadened significantly thereafter, both within large firms and in sponsored entities such as the now This trend was a dramatic example of the ways in which traditional lending and capital market activities had become increasingly integrated and another example of how prudential regulation had not quickly enough adjusted to that trend . Earlier this week, as we reached the five-year anniversary of Lehman Brothers' failure, numerous retrospectives on the crisis reminded us of its multiple causes. But the practice of many firms, including all those with sizeable broker-dealers, of funding large amounts of assets with short-term wholesale funding was an accelerant of all the problems that had grown within the financial system. When questions arose about the quality of some of the assets on which short-term funding had been provided, investors who had regarded short-term secured lending as essentially risk-free suddenly became unwilling to lend against a wide range of assets. Then ensued the classic adverse feedback loop, as liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. Although the amounts of short-term wholesale funding have come down from their pre-crisis peaks, this structural vulnerability remains, particularly in funding channels that can be grouped under the heading of securities financing transactions The use of such funding surely has the potential to increase again during periods of rapid asset appreciation and ready access to leverage. While SFTs are an important and useful part of securities markets, without effective regulation they can create a large run risk, and thus can increase systemic problems that may develop in various asset and lending markets. The risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. Capital charges are low because credit Committee and soon to be implemented in the United States through a proposed rulemaking, is an important step forward for financial regulation, since it will be the first broadly applicable quantitative liquidity requirement for banking firms. But it, too, has a principally microprudential focus, since it rests on the implicit premise that maturity- matched books at individual firms present relatively low risks. While maturity mismatch by core intermediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary's book of securities' financing transactions is perfectly matched, a reduction in the intermediary's access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. The intermediary's customers are likely to be highly leveraged and maturity-transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high. The dangers thus arise in the tail and apply to the entire financial market when normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A macroprudential regulatory measure should force some internalization by market actors of the systemic costs of this intermediation. As I have argued elsewhere, one or more such measures should be the highest priority in filling out reform agendas directed both at the largest institutions and at systemic risk more generally. One reason I place a high priority on initiatives to address the vulnerability created by short-term wholesale funding is that the development of these and other structural measures does not depend so heavily on identifying when credit growth or asset prices in one or more sectors of the economy have become unsustainable. Instead, an externality analysis can help identify the points of vulnerability and guide the fashioning of appropriate regulations. Indeed, what I described as structural policies may be better suited to containing certain kinds of risks than would policies requiring regular adjustment. Obviously, judgment will still be needed to determine the degree of constraint to be imposed on relevant activities of large banking organizations. But unlike real-time measures - where time will presumably be of the essence if those measures are to be effective - the adoption of structural constraints can proceed with the full opportunity for debate and public notice-and-comment that attends the rulemaking process. . Whenever increased regulation of similar activities applies only to some firms, incentives increase for the unregulated actors to step up their engagement in those activities. The very considerable strengthening of capital, liquidity, and other regulations in the wake of the financial crisis has presumably created commensurately significant opportunities for just such a shift of activities toward firms not subject to prudential regulation. As more macroprudential regulations applicable to large financial firms come into effect, one can expect that market actors will be exploring possibilities for regulatory arbitrage. In the short term, the potential for migration outside the perimeter of regulated firms may be somewhat limited, precisely because of the dominance of large commercial banks in certain lending markets, of large broker-dealers in intermediation in securities markets, and the absence of ready alternatives to the major clearing and custody banks. But, if the arbitrage gains promise to be high enough, over time, unregulated market actors may find ways to, for example, deal directly with one another in some forms of securities financing. New kinds of firms, perhaps acting solely as agents, might be formed to facilitate these direct transactions between unregulated firms. It is for this reason that the Federal Reserve and our counterparts in other member countries of the Financial Stability Board have been evaluating ideas for market-wide measures even as we move forward with steps directed principally at prudentially regulated firms. Interest in broader, if not universal, regulatory charges on securities financing transactions has developed in recognition of the systemic risks that may develop if, for instance, only certain prudentially regulated firms must incorporate such a charge into their borrowing or lending activities. As we make more progress in reorienting the regulation of large financial firms toward more macroprudential objectives, we will need to watch carefully for such leakage of financial transactions. This concern returns us to the larger project of macroprudential regulation, which implicates a more complicated set of issues around legal authorities and institutional capacities for prudential regulation of markets, as well as firms. But it would be preferable to confront these issues now, before too much of this migration has occurred, than to wait until the problem manifests itself in growing systemic risk. The five propositions I have laid out this afternoon are generally intended to outline the contours of a macroprudential approach to the regulation and supervision of large financial institutions, not to identify or elaborate specific policies. But I will close by saying that specific policies to counteract the structural vulnerabilities created by short-term wholesale funding are a priority, not just for the stability of our large prudentially regulated institutions, but for the financial system as a whole. A macroprudential reorientation of our bank regulatory policies will require a range of continuing work on resiliency, on other structural measures, and on the effective blending of macroprudential with traditional microprudential regulatory and supervisory policies. But, even as we make more progress in these areas, our efforts will not be complete without measures addressing what I have termed an accelerant of systemic problems.

r130926a_FOMC

united states

Yield-Oriented Investors and the Monetary Transmission Mechanism

stein

Let me start by thanking the organizers for including me in this event. It's a great pleasure to be here with other old friends and colleagues to pay tribute to Raghu, and to congratulate him not only on winning the Deutsche Bank prize for Financial Economics, but also on his new job as governor of the Reserve Bank of India. It's an understatement to say that Raghu has a few challenges on his hands in this new role, but having known him for more than 20 years, I can't imagine anybody being better equipped--in terms of intellect, judgment, and strength of character--to handle these challenges. I would like to talk briefly about some recent research of mine, done jointly with Sam Hanson of Harvard Business School, on the monetary transmission mechanism. will become clear, our work is heavily influenced by some of Raghu's earlier writing, and in particular his famous 2005 Jackson Hole paper. After describing what we find, I will try to draw some connections to the current monetary policy environment as well as some lessons about the interplay of monetary policy and financial stability. As always, I am speaking for myself, and my views are not necessarily shared by other members of the In our paper, Sam and I begin by documenting the following fact about the working of conventional monetary policy: Changes in the stance of policy have surprisingly strong effects on very distant forward real interest rates. Concretely, over a sample period from 1999 to 2012, a 100 basis point increase in the 2-year nominal yield on FOMC announcement day--which we take as a proxy for a change in the expected path of the federal funds rate over the following several quarters--is associated with a 42 basis point increase in the 10-year forward overnight real rate, extracted from the On the one hand, this finding is at odds with standard New Keynesian macro models, in which the central bank's ability to influence real variables stems from goods prices that are sticky in nominal terms. In such models, a change in monetary policy should have no effect on forward real rates at a horizon longer than that over which all prices can adjust, and it seems implausible that this horizon could be on the order of 10 years. On the other hand, the result suggests that monetary policy may have more kick than is implied by the standard model, precisely because long-term real rates are the ones that are most likely to matter for a variety of investment decisions. So what is going on? How, in a world of eventually flexible goods prices, is monetary policy able to exert such a powerful influence on long-term real rates? A first clue is that the movements in distant forward real rates that we document appear to reflect changes in term premiums, as opposed to changes in expectations about short-term real rates far into the future. Said differently, if the Fed eases policy today and yields on long-term TIPs go down, this does not mean that the real short rate is expected to be lower 10 years from now--but rather that TIPs have gotten more expensive relative to the expected future path of short rates. These changes in term premiums then appear to reverse themselves over the following 6 to 12 months. This observation then raises the question of why monetary policy might be able to influence real term premiums. Here is where we draw our inspiration from Raghu's work, in particular his hypothesis that low nominal interest rates can create incentives for certain types of investors to take added risk in an effort to "reach for yield." While an emerging body of empirical research investigates this hypothesis in the context of credit risk--documenting that banks tend to make riskier loans when rates are low--our focus is instead on the implications of the reach-for-yield mechanism on the pricing of interest rate risk, also known as duration risk. The theory we sketch involves a set of "yield-oriented" investors. We assume that these investors allocate their portfolios between short- and long-term Treasury bonds and, in doing so, put some weight not just on expected holding-period returns, but also on current income. This preference for current yield could be due to agency or accounting considerations that lead these investors to care about short-term measures of reported performance. A reduction in short-term nominal rates leads them to rebalance their portfolios toward longer-term bonds in an effort to keep their overall yield from declining too much. This, in turn, creates buying pressure that raises the price of the long-term bonds and hence lowers long-term yields and forward rates. Thus, according to this theory, an easing of monetary policy affects long-term real rates not via the usual expectations channel, but rather via what might be termed a "recruitment" channel--by causing an outward shift in the demand curve of yield-oriented investors, thereby inducing these investors to take on more interest rate risk and to push down term premiums. To provide some evidence that bears on the theory, we look at the maturity of securities held by commercial banks. Banks fit with our conception of yield-oriented investors to the extent that they care about their reported earnings--which, given bank accounting rules for available-for-sale securities, are based on current income from securities holdings and not mark-to-market changes in value. And, indeed, we find that when the yield curve steepens, banks increase the maturity of their securities holdings. Moreover, the magnitudes of these portfolio shifts are large in the aggregate, so that if they had to be absorbed by other, less yield-oriented investors, the shifts could plausibly drive changes in marketwide term premiums. We also find that primary dealers in the Treasury market--who, unlike banks, must mark their securities holdings to market--take the other side of the trade, reducing the maturity of their Treasury holdings when the yield curve steepens. Overall, I read this evidence as suggesting--albeit tentatively--that some mechanism involving yield-oriented investors may eventually turn out to be central to our understanding of how monetary policy works, both in ordinary and extraordinary times. When I say "central," I mean that this mechanism may play a role not only in determining how monetary policy influences the pricing of credit risk, but also in how it shapes the real and nominal yield curves for credit-risk-free Treasury securities. Of course, much work remains to be done before statements like these can be made with any degree of confidence. But I think there is a promising research agenda here, and one that owes much to Raghu's insights. With these observations in mind, let me now turn to the events of the past few months in the bond market. A brief summary goes as follows: Long-term real and nominal rates and term premiums in the United States were very low as of early May, with the 10-year Treasury yield bottoming out at 1.63 percent at the beginning of the month, with an associated term premium estimated to be on the order of negative The 10-year TIPS yield reached negative 0.72 percent around the same time. Economic Committee and after our June 18-19 FOMC meeting, yields rose sharply, with the nominal and real 10-year rates reaching 2.61 percent and 0.60 percent, respectively, as of June 25. In the absence of a significant shift in policy fundamentals, a number of observers have highlighted the role of a variety of market dynamics in driving the observed changes in yields. These factors include the unwinding of carry trades, tightening of risk limits in the face of higher volatility, convexity hedging by holders of mortgage-backed securities, and large outflows from bond funds. I believe these factors to have been important collectively, although it is difficult to say how much of an effect is due to any one of them. However, beyond trying to understand the market dynamics that drove changes in rates over the period from May through June, it is also useful to ask a question about the starting levels: What explains why real and nominal rates were as low as they were at the beginning of May? Clearly, our accommodative policies--the combination of forward guidance and asset purchases--played an important role. But I want to draw a key distinction between two views of how our policies might have mattered. One view would be that the configuration of market rates in early May was largely a direct hydraulic outcome of our policies. For example, according to this view, a nominal 10-year yield of 1.63 percent in early May could be explained to a first approximation based on the expected path of the federal funds rate, plus a negative term premium that was itself primarily a function of the cumulative amount of duration that we were expected to remove from the market via our asset purchase program. Let's call this the "direct Fed control" view. An alternative hypothesis is that our policies were indeed responsible for the very low level of long-term rates, but in part through a more indirect channel. According to this view, real and nominal term premiums were low not just because we were buying long-term bonds, but because our policies induced an outward shift in the demand curve of other investors, which led them to do more buying on our behalf--because we both gave them an incentive to reach for yield, and at the same time provided a set of implicit assurances that tamped down volatility and made it feel safer to lever aggressively in pursuit of that extra yield. In the spirit of my earlier comments, let's call this the "Fed recruitment" view. I take the events of the past few months to be evidence in favor of the recruitment view. And, to be clear, I don't mean this as a criticism of the set of policies that we have in place. Quite to the contrary--it can be useful to enlist help when you have a big job to do. Indeed, my whole point in talking about the research I described earlier was to underscore my belief that something like this investor-recruitment mechanism is central to how monetary policy acquires much of its traction over the real economy even in ordinary times. Of course, the magnitude of the effect--the extent of downward pressure that we may have been inducing other investors to apply to the term premium--is likely to have been more noteworthy given the unprecedented scope of our overall monetary accommodation. But in an important sense, this effect is just a powered-up version of what makes garden-variety monetary policy work. Again, the existence of this recruitment channel is helpful; without it, I suspect that our policies would have considerably less potency and, therefore, less ability to provide needed support to the real economy. At the same time, an understanding of this channel highlights the uncertainties that inevitably accompany it. If the Fed's control of long-term rates depends in substantial part on the induced buying and selling behavior of other investors, our grip on the steering wheel is not as tight as it otherwise might be. Even if we make only small changes to the policy parameters that we control directly, long-term rates can be substantially more volatile. And if we push the recruits very hard--as we arguably have over the past year or so--it is probably more likely that we are going to see a change in their behavior and hence a sharp movement in rates at some point. Thus, if it is a goal of policy to push term premiums far down into negative territory, one should be prepared to accept that this approach may bring with it an elevated conditional volatility of rates and spreads. When we talk about the interplay of monetary policy and financial stability, I think that this kind of tradeoff is an important part of what we should be bearing in mind. Indeed, maybe the term "financial stability" is a bit misleading, because the risk scenario that I am describing--and that may be among the most relevant when thinking about the costs and benefits of our current highly accommodative policies--need not be one that is so dramatic as to call into question the viability of any large financial firm or threaten an important part of the market's infrastructure. Rather, one scenario to be worried about may simply be a sharp increase in marketwide rates and spreads at an inopportune time, such that it becomes harder for us to achieve our dual-mandate objectives. Having said all of this, I believe we are currently in a pretty good place with respect to the pricing of interest rate risk. The movement in Treasury rates that we have seen since early May has led to somewhat tighter financial conditions in certain sectors-- most notably the mortgage market--but has also brought term premiums closer into line with historical norms, and thereby has arguably reduced the risk of a more damaging upward spike at some future date. On net, I believe the adjustment has been a healthy one. Finally, let me say a few words about last week's FOMC meeting. I voted with the majority of the Committee to continue our asset purchase program at its current flow rate of $85 billion per month. It was a close call for me, but I did so because I continue to support our efforts to create a highly accommodative monetary environment so as to help the recovery along by using both asset purchases and our threshold-based approach to forward guidance. How should the pace of purchases evolve going forward? The Chairman laid out a framework for winding down purchases in his June press conference. Within that framework, I would have been comfortable with the FOMC's beginning to taper its asset purchases at the September meeting. But whether we start in September or a bit later is not in itself the key issue--the difference in the overall amount of securities we buy will be modest. What is much more important is doing everything we can to ensure that this difficult transition is implemented in as transparent and predictable a manner as possible. On this front, I think it is safe to say that there may be room for improvement. Achieving the desired transparency and predictability doesn't require that the wind-down happen in a way that is independent of incoming data. But I do think that, at this stage of the asset purchase program, there would be a great deal of merit in trying to find a way to make the link to observable data as mechanical as possible. For this reason, my personal preference would be to make future step-downs a completely deterministic function of a labor market indicator, such as the unemployment rate or cumulative payroll growth over some period. For example, one could cut monthly purchases by a set amount for each further 10 basis point decline in the unemployment rate. Obviously the unemployment rate is not a perfect summary statistic for our labor market objectives, but I believe that this approach would help to reduce uncertainty about our reaction function and the attendant market volatility. Moreover, we would still retain the flexibility to respond to other contingencies (such as declines in labor force participation) via our other more conventional policy tool--namely, the path of short-term rates. Thank you very much. I look forward to your questions.

r131002a_FOMC

united states

Brief Welcoming Remarks

bernanke

I would like to welcome everyone to the inaugural Community Banking Research and Policy Conference, co-sponsored by the Federal Reserve System and the Conference CSBS staff members who worked hard to organize this event. By bringing together community bankers, bank regulators, and researchers from academic institutions and government agencies, the conference will help us all to better understand the issues that are most important to the future of community banking. You may have noticed that I referred to this as the "inaugural" conference. Although firm plans have not yet been made, I do hope this will be the first of many joint Federal Reserve System and CSBS conferences that focus on community banking research and policy. The U.S. banking system has undergone significant consolidation over the past two decades or so, with very large banking organizations increasing their market shares. Nevertheless, community banks (which we typically define as banking institutions with assets of $10 billion or less) continue to provide vital financial services to households, small businesses, and small farms in communities across America. Community banking is fundamentally a local, relationship-based business. Community bankers live in the localities they serve; their customers are their neighbors and friends. Their direct, personal knowledge of the local economy enables them to tailor products and services to meet their communities' needs. They can look beyond credit scores and other model-based metrics to make lending decisions in part based on more qualitative information that large regional or national financial institutions are less well suited to consider. Community bankers recognize that their own success depends on the health of the communities they serve, which is why so many community bankers contribute locally as citizens and leaders as well as in their capacities as lenders and providers of financial services. The photos that you see around the conference center do a very nice job of capturing the spirit of community banking and illustrating the contributions of community bankers. Although community banks have some natural advantages, such as local knowledge and relationships, they also face significant challenges. As battle-scarred survivors of a financial crisis and deep recession, community bankers today confront a frustratingly slow recovery, stiff competition from larger banks and other financial institutions, and the responsibility of complying with new and existing regulations. Some observers have worried that these obstacles--particularly complying with regulations--may prove insurmountable. My colleagues at the Federal Reserve and I understand these concerns, and we are committed to crafting supervisory policies and regulations that are appropriately scaled to banks' size and complexity. And we have confidence that the remarkable resilience of America's community bankers will enable them not only to survive, but also to thrive in the years ahead. The best way to understand the challenges that community bankers face is to talk to the bankers themselves, and we at the Federal Reserve do that regularly. For example, to ensure that we remain mindful of the unique characteristics of community banks, the Council. This council is composed of representatives of community banks, thrifts, and credit unions from each of the 12 Federal Reserve Districts. Members of the council meet with the Board twice a year, bringing to us the views and concerns of their colleagues back home. Our meetings with the council have been extremely informative and have improved our ability to understand and respond to community bank concerns. Of course, understanding those concerns is of limited value unless we use what we have learned in the process of rulemaking. To make that connection, we also established a subcommittee of the Board that reviews all regulatory and supervisory proposals for their potential effects on community banks. The subcommittee also has worked toward communicating more effectively with the industry regarding the extent to which new rules and guidance do, or do not, apply to community banks. I hope those efforts are helping community bankers avoid spending time trying to understand rules that do not apply to them. One of the strengths of the Federal Reserve System is the quality of the research done by our economists and other professionals. The research we do on community banking helps guide our thinking on regulatory matters and on broader economic trends. In particular, the Board's subcommittee on community banking is regularly briefed on relevant research being conducted across the System. Thus, research findings inform policy, and policy concerns guide research. In fact, after learning about several research projects, the subcommittee suggested that the staff hold a community banking research conference--a suggestion that brought all of us to St. Louis today. The range of topics that will be covered over the next day and a half is impressive. The first research session this afternoon will focus on the role of community banks in our financial and economic system. Papers in this session examine whether community banks influence new-firm survival, whether equipment finance is a potential growth area for community banks, how community bank failures affect local economic performance, and whether community bank lending relationships in rural areas are fundamentally different from those in urban areas. Two research sessions are scheduled for tomorrow morning. The first will consider community bank performance, with papers looking at the effect of financial derivatives on community bank profitability, the characteristics of community banks that recovered from significant financial distress, the effect of distance between merging banks on postmerger performance, and the determinants of differences in profitability across community banks. The second session will consider issues of bank supervision and regulation, with papers discussing variations in the stringency of bank examination standards over time and their effect on lending, the effects of the Dodd-Frank Act on community banks, the relationship between community bank capital ratios and the likelihood of failure, and an approach for rationalizing bank supervision and regulation. As you can see, the papers at this conference cover a variety of important topics, and I expect they will provoke spirited discussions among the many experts in attendance. I must say that I am encouraged to see so many researchers from a wide range of academic and government institutions working on issues of great interest to both community bankers and their regulators. To close the conference, CSBS Chairman Charles Vice will present a report summarizing information gathered from more than 1,500 community bankers attending town hall sessions across the country over the past several months. In addition, a panel of community bankers will share their own views on the state of community banking and prospects for the future. Thank you for being here. I wish you an enjoyable and productive conference.

r131003a_FOMC

united states

Community Banking: Connecting Research and Policy

powell

Good afternoon. I am delighted to have the opportunity to participate in this inaugural conference on community banking research and policy. By way of introduction, I have spent most of my career in the private sector, including many years as an investor in small and medium-size companies. Although I have never worked in a community bank, I have been a customer, and I know from personal experience the special skills that these institutions bring to their customers. Community banks are a crucial part of our economy and the fabric of our society. My colleagues on the Board of Governors and I understand the value of having a diverse financial system that includes a large and vibrant contingent of community banks. By fostering the economic health and vitality of local communities throughout the country, community banks play a central role in our national economy. One important aspect of that role is to serve as a primary source of credit for the small businesses that are responsible for creating a substantial proportion of all new jobs. A thriving community banking sector is essential to sustaining our ongoing economic recovery. Community banks have faced significant challenges in recent years, as our nation has endured a major financial crisis and recession, followed by a painfully slow recovery. To make matters worse, community bankers, who played no part in causing the financial crisis, have been forced to fight to ensure that they are not swept up in a torrent of costly new regulations that were intended to address problems at those very large banks that did contribute to the crisis. The Federal Reserve will continue to be alert to the possible unintended consequences of regulatory policies, and we welcome input from community bankers as we develop and implement those policies. We have established a number of channels of communication to facilitate such input. For starters, the Reserve Banks have long had programs in place to provide training and guidance to banks in their districts. Recently, some of these programs have been expanded nationwide. For to provide an opportunity for bankers all over the country to hear Federal Reserve staff discuss timely financial or regulatory topics and to ask questions on these topics. Similarly, for consumer compliance issues, the Federal Reserve Bank of San Francisco hosts a national a quarterly publication sponsored by the Federal Reserve Bank of Philadelphia. In addition, the ," a website that serves as a "one-stop shop" for information on issues that affect community banks, as well as providing links to tools and resources that can help them. Another recently established communication channel is the Community Depository The council, which is made up of representatives of smaller banks, credit unions, and savings associations from each of the 12 Federal Reserve Districts, meets with the Board of Governors in Washington twice a year. These meetings allow the Board to gather firsthand information from community bankers about issues that concern them most and about economic conditions in their areas. In addition, the Board of Governors has a community bank subcommittee of our Committee on Bank Supervision that oversees the supervision of community banks and reviews regulatory proposals to ensure they are appropriately tailored for community banks. The subcommittee also meets with Federal Reserve staff to hear about ongoing research in the community banking area. As a new member of this subcommittee, I look forward to helping ensure that community bank concerns receive the attention they deserve in every Federal Reserve policy decision. I also look forward to having the opportunity to help shape the important community banking research that is being conducted by staff across the Federal As Chairman Bernanke mentioned yesterday, this conference was conceived as a result of discussions that took place during a community bank subcommittee meeting. I don't know about you, but I think that, so far, the conference has been a great success. The quality and policy- relevance of papers presented here have been excellent. This work will, no doubt, spur continued research as well as policy discussions about ways in which we can better tailor regulations to meet our legal and prudential goals while reducing burdens on smaller financial institutions. In my view, the research presented at this conference reaffirms the importance of community banks to our economy. In the rest of my talk, I'll try to summarize and tie together what I've learned from the research that has been presented, suggest some areas where further research would be helpful, and discuss what I believe should be the focus for supervision and regulation of community banks going forward. Yesterday afternoon's session on the role of community banks provided ample evidence of their continued viability and importance. The Lee and Williams paper provides evidence of the importance of small businesses to job creation in our economy and the important contribution that community bank lending makes to the survival of small businesses. Focusing on start-ups, Lee and Williams find that proximity to a community bank increases the likelihood that a new small business uses bank credit to finance its operations. Their findings support the importance of local knowledge and "soft information" that emerges from a bank's relationship with its customers in underwriting loans to particularly opaque small businesses. DeYoung and his coauthors look at differences in loan default rates across community banks and find that banks in rural areas make loans that default less often than loans made by community banks in urban areas. They also find that loans made outside of a bank's local area default at higher rates than do local loans. Both results can be interpreted as showing the value of banking relationships, because loans default less often in situations in which soft information is likely to be more available to the lender. If any doubt remains about the importance of community banks to local economies, the Kandrac paper looks at the extreme situation in which a community bank fails, and documents the subsequent harm to local economic growth resulting from that failure. Of particular relevance to regulators, Kandrac points out that the effect of a bank's failure on the local economy differs depending on the resolution method. In particular, he finds that resolutions that include loss-sharing agreements tend to have smaller negative effects on local economic growth than resolutions that do not include such agreements; Kandrac attributes these differences to the greater harm done to banking relationships when there is no loss-sharing agreement. In another result, Kandrac finds that relationship lending appears to be stronger in local markets where banking competition is more intense. This is a contribution to a substantial economic literature that has discussed whether there is a conflict between the desire of antitrust authorities to maintain competitive markets and the desire to foster productive long-term relationships between small businesses and their lenders. Kandrac's finding of no conflict is reassuring for those of us charged with both encouraging economic growth and enforcing antitrust statutes. The Kelly, Khayum, and Price paper notes that there has been more emphasis in recent years on the challenges facing community banks than on the opportunities available to them. Given the success that community banks have enjoyed in lending to small businesses, this paper explores the possibility that these institutions could expand their involvement in business equipment leasing, a potential growth area that community banks might want to investigate. The authors find that community banks that are actively involved in lease financing are more profitable and efficient than other community banks. This morning's first session on community bank performance highlighted the heterogeneity of community banks. The Shen and Hartarska paper notes that while use of financial derivatives by community banks has increased rapidly in recent years, only about one in six community banks were active users of derivatives markets in 2012. Shen and Hartarska estimate that community banks could improve their profitability and reduce their risk of default through increased use of derivatives. They also point out that implementation of the Dodd-Frank Act--in particular the Volcker rule--could prevent the realization of these gains, although I should note that the Volcker rule includes an exception for hedging activities that is intended to allow banking organizations of all sizes to appropriately manage their risks. This is an important point to bear in mind. I believe we are doing so in drafting the regulation and that implementation of the Volcker Rule should not prevent community banks from using derivatives to manage their risks in a safe and sound manner. Gilbert, Meyer, and Fuchs have completed two important studies on the experiences of community banks during the recent recession. Their first paper looked at banks that thrived throughout that period of economic distress while the second paper, presented this morning, looks at community banks that endured some level of financial distress during the downturn but then recovered. This research goes beyond statistical analysis to conduct interviews with a sample of bank presidents and CEOs to gain further insight into banks' unique experiences in recent years. They identify two paths to recovery from financial distress. The first is a return to conservative underwriting practices and sound policies and practices, work that can provide a "road map" for community bankers to follow when confronted with the next--one hopes, less extreme--financial downturn. The second path to recovery is a change of bank ownership or management. Consolidation among community banks has been a constant theme in recent decades, and the Ferrier and Yeager study yields some interesting results on the profitability of community bank acquisitions and reorganizations. Their findings on bank acquisitions echo both the findings of DeYoung and his coauthors and the wisdom of many community bankers, namely that you increase your profits by sticking to what you know. Post-acquisition performance of community banks is better, the closer the target bank is to the acquirer. While more-distant acquisitions might lead to greater diversification benefits, these appear to be outweighed by the greater difficulties in managing the performance of two banks operating far apart from each other. I should note that these findings could conflict to some extent with the antitrust responsibilities of financial regulators and the Department of Justice. While a merger with a crosstown rival might lead to the greatest efficiency gains, the Federal Reserve has a statutory responsibility to make sure that such consolidations leave a sufficient number of local firms to ensure a competitive banking environment. Community bank profitability is affected by both external factors outside of bank control, such as local economic conditions, and factors within bank control, such as the composition and stability of the bank's loan portfolio. The paper by Amel and Prager examines the effects of these two sets of factors on bank profitability over the past 20 years. They find that local economic conditions and demographic changes certainly affect bank profitability, but also that the quality of bank management and the stability of bank portfolio composition consistently have a very substantial impact on a bank's level of profits. They find that any major change in a bank's portfolio composition tends to lower bank profits, indicating yet again that banks tend to be better off when they stick to the markets and products that they know. The papers in this morning's second session on supervision and regulation of community banks are of great interest to me, given my current responsibilities on the community bank subcommittee at the Board. The papers in this session stress the need for flexibility in bank regulation and the need--subject to the constraints imposed by Congress--to tailor regulations to fit banking organizations that cover a huge range, from quite simple to extraordinarily complex. The paper by Bassett, Lee, and Spiller provides reassuring evidence that CAMELS standards have been quite consistent over time, with no indication that CAMELS ratings were unduly stringent during the recovery from the recent recession. However, they do find that there was a slight tendency for exam ratings to become more stringent as we entered both the recession of the early 1990s and the one we just experienced. This finding should be brought to the attention of our examiners, because even a slight tightening of standards can have a significant effect on credit markets, especially if combined with other supervisory actions, and a tightening at the beginning of a recession could cause it to be deeper or longer than might otherwise be the case. Marsh and Norman highlight the need to avoid requiring excessive standardization of bank loans. Such standardization could interfere with effective relationship lending, and as we've seen from the research I've already discussed, that relationship lending is a key aspect that makes community banks such valuable assets to small businesses and so important to a thriving economy. The Marsh and Norman paper stresses that, to the extent the laws allow, we should reduce compliance costs for community banks, such as by simplifying capital rules for smaller banks and relying on market incentives, when feasible. The Moore and Seamans results from their failure-prediction model contribute to this discussion by demonstrating that simple capital ratios do a good job of identifying those community banks with the greatest probability of failure, so that regulators need not unduly impede the actions of the great majority of community banks that are highly unlikely to fail. Meanwhile, the Rosenblum and Organ paper argues for an alternative approach to addressing "too big to fail" that the authors suggest would benefit community banks by creating a more level playing field. Although both the traditional bank regulatory agencies and the Consumer Financial Protection Bureau (CFPB) are constrained, to some extent, by the language in the Dodd-Frank Act, all regulators should aim to ensure that we are not unduly rigid in our actions. Indeed, some steps have already been taken with that goal in mind. For example, the federal banking agencies carefully considered the thousands of comments received from community bankers regarding three notices of proposed rulemaking for revisions to the capital framework. In response to these comments, the agencies reduced and simplified many of the proposed changes to the risk-based capital rules that apply to community banks. And the CFPB has shown an openness to input from the industry and from other regulators in crafting its regulations. In our role as a bank supervisor, the Federal Reserve has been refining our examination programs and recently launched an initiative to review our consumer compliance supervision program for community banks. While Federal Reserve consumer compliance examiners have traditionally applied a risk-driven approach to supervision, we recognized the need to provide more specific guidance to our examiners. Under the updated program, our consumer compliance examiners will base the examination intensity more explicitly on the individual bank's risk profile, including its consumer compliance culture and how effectively it identifies and manages consumer compliance risk. We plan to launch this new consumer compliance supervision program for community banks in 2014. We will begin training for our examiners and outreach to our member community banks later this year. While this conference has presented much valuable research of direct relevance to community bankers, I'd like to recommend a few areas where further work could be of value. First, it would be interesting to explore the effects of risk-retention policies on community banks. To what extent do community banks currently retain a percentage of their loans, and how do small banks compare to money-center banks when it comes to utilizing the secondary markets for loans? Would risk-retention policies be a non-issue for community banks, or would some banks be seriously constrained by such policies? Even if such policies do not constrain community bank activities, would new reporting requirements related to such policies increase the reporting burden faced by small banks? These questions point to a more general area in which more research could be useful, namely a detailed examination of the compliance costs for community banks that can highlight the most beneficial areas for regulatory relief. The Dodd-Frank Act has spawned a variety of new regulatory initiatives that add to the already-substantial regulatory burden faced by community banks. Which regulations--whether new or existing--impose the greatest regulatory burden compared to their benefits? Can regulatory agencies modify or provide exemptions to these regulations so as to make life a bit easier and more profitable for community banks, without adversely affecting bank safety and soundness or financial stability? To give just one example, one area in which new regulations are being developed involves incentive compensation. This area seems to me to be of much more concern when we consider a money-center bank with thousands of shareholders, none of whom has a major stake, than when we consider a community bank in which management has a large or even majority ownership share. Before imposing more regulatory burden on smaller banks in this area, I would like to understand whether there is any evidence that incentive compensation has caused excessive risk taking in such institutions. We are nearing the end of the rulemaking phase of Dodd-Frank and our changes on capital standards, at least those regulations that most directly affect community banks. While we have tried to tailor rules to the size and complexity of institutions, we may not have gotten the balance right in every instance. Thus we will continue to assess the overall effects of the new rules on the safety and soundness of community banks and to consider whether modifications to rules, or the ways in which we implement them, could achieve our safety and soundness aims with a lesser burden on this class of depository institutions. We, of course, would value any observations and suggestions you have along these lines. My fellow governors and I encourage community bankers to use all the available communication channels to share with us their insights and concerns regarding new and existing regulations. And I promise that their voices will be heard in Washington when policy issues that may affect the ability of community banks to thrive are under consideration. While community banks certainly face challenges, I do not see their future as bleak. Community banks continue to do a good job of attracting core deposits, and those stable and relatively inexpensive deposits remain the most sought-after liability on bank balance sheets. However, many of the asset classes that traditionally comprised much of community bank portfolios have faced increasing competition in recent decades from firms that operate at the national level. As auto, mortgage, and credit card loans have become increasingly standardized, community banks have had to focus to a greater extent on small business and commercial real estate lending--products where community banks' advantages in forming relationships with local borrowers are still important. These are not cheap or easy loans to make, and the loss of some traditional product lines has threatened the stability of some community banks. It is incumbent on the Federal Reserve and other regulators to understand the challenges community banks face and to ensure that our regulatory policies do not exacerbate them. I look forward to hearing from the community bankers who will be participating in the conference's final session. Thank you for your attention and for your participation in this inaugural community banking conference. I would be happy to take some questions from the audience.

r131004a_FOMC

united states

The Fire-Sales Problem and Securities Financing Transactions

stein

Thank you. It's a pleasure to be here at this workshop. In an effort to provide some broad framing for the sessions to follow, I thought I would try to do three things in my opening remarks. First, I will briefly discuss the welfare economics of fire sales. That is, I will try to make clear when a forced sale of an asset is not just an event that leads to prices being driven below long-run fundamental values, but also one that involves a market failure, or externality, of the sort that might justify a regulatory response. Second, I will argue that securities financing transactions (SFTs) are a leading example of the kind of arrangement that can give rise to such externalities, and hence are particularly deserving of policy attention. And third, I will survey some of the recently enhanced tools in our regulatory arsenal (e.g., capital, liquidity, and leverage requirements) and ask to what extent they are suited to tackling the specific externalities associated with fire sales and SFTs. To preview, a general theme is that while many of these tools are likely to be helpful in fortifying individual regulated institutions--in reducing the probability that, say, a given bank or broker-dealer will run into solvency or liquidity problems--they fall short as a comprehensive, marketwide approach to the fire-sales problem associated with SFTs. In this regard, some of what I have to say will echo a recent speech by my Board fire sale is essentially a forced sale of an asset at a dislocated price. The asset sale is forced in the sense that the seller cannot pay creditors without selling assets....Assets sold in fire sales can trade at prices far below value in best use, causing severe losses to Shleifer and Vishny go on to discuss the roles of investor specialization and limited arbitrage as factors that drive the magnitude of observed price discounts in fire sales, and there is, by now, a large body of empirical research that supports the importance of these factors. However, by itself, the existence of substantial price discounts in distressed sales speaks only to the positive economics of fire sales, not the normative economics, and hence is not sufficient to make a case for regulatory intervention. To see why, consider the following example: An airline buys a 737, and finances the purchase largely with collateralized borrowing. During an industry downturn, the airline finds itself in distress, and is forced to sell the 737 to avoid defaulting on its debt. Other airlines also are not faring well at this time, and are not interested in expanding their fleets. So the only two bidders for the 737 are a movie star, who plans to reconfigure it for his personal use, and a private-equity firm, which plans to lease out the plane temporarily and wait for the market to recover so the firm can resell it at a profit. In the end, the private-equity firm winds up buying the plane at half its original price. Two years later, it does indeed resell it, having earned a 60 percent return. This is clearly a fire sale in the positive-economics sense, but is there a market failure here that calls for regulation? Intuition suggests not. The airline arguably caused the fire sale by using a lot of leverage in its purchase of the 737, but it also seems to bear most of the cost, by being forced to liquidate at a large loss. The movie star and the private-equity firm are, if anything, made better off by the appearance of a buying opportunity, and there are no other innocent bystanders. So the airline's ex ante capital structure choice would seem to internalize things properly; the fire sale here is just like any other bankruptcy cost that a firm has to weigh in choosing the right mix of debt and equity. For a fire sale to have the sort of welfare effects that create a role for regulation, the reduced price in the fire sale has to hurt somebody other than the original party making the leverage decision, and this adverse impact of price has to run through something like a collateral constraint, whereby a lowered price actually reduces, rather than increases, the third party's demand for the asset. So if hedge fund A buys an asset- backed security and finances it largely with collateralized borrowing, A's fire selling of the security will create an externality in the conventional sense only if the reduced price and impaired collateral value lower the ability of hedge funds B and C to borrow against the same security, and therefore force them to involuntarily liquidate their positions in it as well. The market failure in this case is not simply the fact that this downward spiral causes a large price decline, it is that when hedge fund A makes its initial leverage choice, it does not take into account the potential harm--in the form of tightened financing constraints--that this may cause to hedge funds B and C. Another key point is that the fire-sales problem is not necessarily caused by a lack of appropriate conservatism on the part of whoever lends to hedge fund A in this example--let's call it dealer firm D. By lending on an overnight basis to A, and with an appropriate haircut, D can virtually assure itself of being able to terminate its loan and get out whole by forcing a sale of the underlying collateral. So D's interests may be very well-protected here. But precisely in the pursuit of this protection, A and D have set up a financing arrangement that serves them well, but that creates a negative spillover onto other market participants, like B and C. It follows that even if policies aimed at curbing too-big-to-fail (TBTF) problems are entirely successful in aligning D's interests with those of taxpayers, this is not sufficient to deal with fire-sales externalities. They are a fundamentally different problem, and one that arises even absent any individually systemic institutions or any TBTF issues. The preceding discussion makes clear why SFTs, such as those done via repurchase (repo) agreements, are a natural object of concern for policymakers. This market is one where a large number of borrowers finance the same securities on a short- term collateralized basis, with very high leverage--often in the range of twenty-to-one, fifty-to-one, or even higher. Hence, there is a strong potential for any one borrower's distress--and the associated downward pressure on prices--to cause a tightening of collateral or regulatory constraints on other borrowers. I won't go into much detail about the institutional aspects of SFTs and the repo market. Instead, I will just lay out two stylized examples of SFTs that I can then use to illustrate the properties of various regulatory tools. In this first example, a large broker-dealer firm borrows in the triparty repo market--from, say, a money market fund--in order to finance its own holdings of a particular security. Perhaps the broker-dealer is acting as a market-maker in the corporate bond market, and uses repo borrowing to finance its ongoing inventory of investment-grade and high-yield bonds. In this case, the asset on the dealer's balance sheet is the corporate bond, and the liability is the repo borrowing from the money fund. In this second example, the ultimate demand to own the corporate bond comes not from the dealer firm, but from one of its prime brokerage customers--say, a hedge fund. Moreover, the hedge fund cannot borrow directly from the money market fund sector in the triparty repo market, because the money funds are not sufficiently knowledgeable about the hedge fund to be comfortable taking it on as a counterparty. So instead, the hedge fund borrows on a collateralized basis from the dealer firm in the bilateral repo market, and the dealer then turns around and, as before, uses the same collateral to borrow from a money fund in the triparty market. In this case, the asset on the dealer's balance sheet is the repo loan it makes to the hedge fund. Clearly, there is the potential for fire-sale risk in both of these examples. One source of risk would be an initial shock either to the expected value of the underlying collateral or to its volatility that leads to an increase in required repo-market haircuts (e.g., the default probability of the corporate bond goes up). Another source of risk would be concerns about the creditworthiness of the broker-dealer firm that causes lenders in the triparty market to step away from it. In either case, if the associated externalities are deemed to create significant social costs, the goal of regulatory policy should be to get private actors to internalize these costs. At an abstract level, this means looking for a way to impose an appropriate Pigouvian (i.e., corrective) tax on the transactions. Of course, the tax must balance the social costs against the benefits that accompany SFTs; these benefits include both "money-like" services from the increased stock of near-riskless private assets, as well as enhanced liquidity in the market for the underlying collateral--the corporate bond market, in my examples. So in the absence of further work on calibrating costs and benefits, there is no presumption that the optimal tax should be large, only that it may be non-zero, and that it may make sense for it to differ across asset classes. With this last observation in mind, my next step is to run through a number of our existing regulatory instruments, and in each case ask: to what extent can the instrument at hand be used efficiently to impose a Pigouvian tax on an SFT, either one of the dealer-as- principal type or one of the dealer-as-intermediary type? As will become clear, the answer can depend crucially on both the structure of the transaction as well as the nature of the underlying collateral involved. Also, I should emphasize that nothing in this exercise amounts to a judgment on the overall desirability of any given regulatory tool. Obviously, even if risk-based capital requirements are not particularly helpful in taxing SFTs, they can be very valuable for other reasons. I am asking a different question: to what extent can the existing toolkit be used--or be adapted--to deal with the specific problem of fire-sale externalities in SFTs? 1. Risk-based capital requirements Current risk-based capital requirements are of little relevance for many types of SFTs. In my Example 1, where the dealer firm holds a corporate bond as a principal and finances it with repo borrowing, there would be a capital charge on the corporate bond, but this capital charge is approximately independent of whether the corporate bond is financed with repo or with some other, more stable, form of funding. So there is no tax on the incremental fire-sale risk created by the more fragile funding structure. In Example 2, in which the dealer is an intermediary with a matched book of repo borrowing and lending, there is, in principle, a capital requirement on its asset-side repo loan to the hedge fund. However, the Basel III risk-based capital rules allow banks and bank holding companies to use internal models to compute this capital charge for repo lending, and the resulting numbers are typically very small--for all practical purposes, close to zero--for overcollateralized lending transactions, with repo being the canonical example. I'm not arguing that the very low risk-based charges on repo lending in Basel III are "wrong" in any microprudential sense. After all, they are designed to solve a different problem--that of ensuring bank solvency. And if a bank holding company's broker-dealer sub makes a repo loan of short maturity that is sufficiently well- collateralized, it may be at minimal risk of bearing any losses--precisely because it operates on the premise that it can dump the collateral and get out of town before things get too ugly. The risk-averse lenders in the triparty market--who, in turn, provide financing to the dealer--operate under the same premise. As I noted earlier, these defensive reactions by providers of repo finance mean that the costs of fire sales are likely to be felt elsewhere in the financial system. Liquidity requirements, such as those embodied in the Basel III Liquidity Coverage Ratio (LCR), can impose a meaningful tax on certain SFTs in which the dealer acts as a principal. If the dealer holds a corporate bond and finances it with repo borrowing of less than 30 days' maturity, the LCR kicks in and requires the dealer to hold high-quality liquid assets (HQLA) against the risk that it is unable to roll the repo over. In this particular case, there can be said to be a direct form of regulatory attack on the fire-sales problem. However, this conclusion is sensitive to the details of the example. If, instead of holding a corporate bond, the dealer holds a Treasury security that is deemed to count as Level 1 HQLA, there is no impact of the LCR. Moreover, the LCR plays no role in mitigating fire-sales externalities in the important matched-book case in which the dealer acts as an intermediary. If a dealer borrows on a collateralized basis with repo and then turns around and lends the proceeds to a hedge fund in a similar fashion, the LCR deems the dealer to have no net liquidity exposure--and hence imposes no incremental liquidity requirement--so long as the lending side of the transaction has a maturity of less than 30 days. The implicit logic is that as long as the dealer can generate the necessary cash by not rolling over its loan to the hedge fund, it will always be able to handle any outflows of funding that come from being unable to roll over its own borrowing. This logic is not incorrect per se, but it is very micro-focused in nature, and does not attend to fire-sales externalities. It worries about the ability of the dealer firm to survive a liquidity stress event, but does not take into account that the dealer's survival may come at the cost of forcing its hedge fund client to engage in fire sales. If a broker-dealer firm faces a binding leverage ratio, this constraint can act as a significant tax on two types of SFTs that are largely untouched either by risk-based capital requirements or by liquidity regulations. The first is when the dealer, acting as a principal, uses repo to finance its holdings of Treasury securities or agency mortgage- backed securities, assets that generally have only modest risk weights when held as trading positions. The second is when the dealer acts as an intermediary and has a matched repo book. In both cases, the SFTs blow up the firm's balance sheet and, hence, the denominator of the leverage ratio, even while having little impact on risk-based capital or LCR calculations. The crucial issue here, however, is whether the leverage ratio does, in fact, bind. A traditional view among regulators has been that the leverage ratio should be calibrated so as to serve as a meaningful "backstop" for risk-based capital requirements, but that under ordinary circumstances it should not actually be the binding constraint on firms. For if it were to bind, this would put us in a regime of completely un-risk-weighted capital requirements, where the effective capital charge for holding short-term Treasury securities would be the same as that for holding, say, risky corporate debt securities or loans. Recently, U.S. regulators have issued a proposed rulemaking that seeks to raise the Basel III supplementary leverage ratio requirement to 5 percent for the largest U.S. bank holding companies, and to 6 percent for their affiliated depository institutions. While this increase might be considered a parallel shift that preserves the backstop philosophy in light of the fact that risk-based requirements have also gone up significantly, it does increase the likelihood that the leverage ratio may bind for some of these firms at some times--particularly for those firms with a broker-dealer-intensive business model in which the ratio of total assets to risk-weighted assets tends to be higher. In this event, there would indeed be a significant tax on SFTs undertaken in the affected firms. However, because it is unlikely that the leverage constraint would bind symmetrically across all of the largest firms, my guess is that the effect would be less to deter SFT activity in the aggregate than to cause it to migrate in such a way as to be predominantly located in those firms that--because they have, say, a larger lending business and, hence, more risk-weighted assets--have more headroom under the leverage ratio constraint. To summarize the discussion thus far, the mainstays of our existing regulatory toolkit--risk-based capital, liquidity, and leverage requirements--have a variety of other virtues, but none seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by SFTs. The liquidity coverage ratio affects a subset of SFTs in which a dealer firm acts as a principal to fund its own inventory of securities positions, but does not meaningfully touch those in which it acts as an intermediary. By contrast, an aggressively calibrated leverage ratio could potentially impose a significant tax on a wider range of SFTs, but the tax would by its nature be blunt and highly asymmetric, falling entirely on those firms for whom the leverage ratio constraint was more binding than the risk-based capital constraint. As such, it would be more likely to induce regulatory arbitrage than to rein in overall SFT activity. These observations raise the question of whether there are other tools that might be better suited to dealing with SFT-related fire-sales externalities. I will touch briefly on three of these. Capital surcharges In his May speech, Governor Tarullo alluded to the possibility of liquidity-linked capital surcharges that would effectively augment the existing regime of risk-based capital requirements. Depending on how these surcharges are structured, they could act in part as a tax on both the dealer-as-principal and dealer-as-intermediary types of SFTs. Accomplishing the latter would require a capital surcharge based on something like the aggregate size of the dealer's matched repo book; this comes quite close to the Pigouvian notion of directly taxing this specific activity. As compared to relying on the leverage ratio to implement the tax, this approach has the advantage that it is more likely to treat institutions uniformly: the tax on SFTs would not be a function of the overall business model of a given firm, but rather just the characteristics of its SFT book. This is because the surcharge is embedded into the existing risk-based capital regime, which should in principle be the constraint that binds for most firms. There are a couple of important qualifications, however. First, going this route would involve a significant conceptual departure from the notion of capital as a prudential requirement at the firm level. As noted previously, a large matched repo book may entail relatively little solvency or liquidity risk for the broker-dealer firm that intermediates this market. So, to the extent that one imposes a capital surcharge on the broker-dealer, one would be doing so with the express intention of creating a tax that is passed on to the downstream borrower (i.e., to the hedge fund, in my example). Second, and a direct corollary of the first, imposing the tax at the level of the intermediary naturally raises the question of disintermediation. In other words, might the SFT market respond to the tax by evolving so that large hedge funds are more readily able to borrow via repo directly from money market funds and securities lenders, without having to go through broker-dealers? I can't say that I have a good understanding of the institutional factors that might facilitate or impede such an evolution. But if the market ultimately does evolve in this way, it would be hard to argue that the underlying fire-sales problem has been addressed. Modified liquidity regulation A conceptually similar way to get at matched-book repo would be to modify liquidity regulation so as to introduce an asymmetry between the assumed liquidity properties of repo loans made by a broker-dealer, and its own repo borrowing. For example, in the context of the Net Stable Funding Ratio (NSFR), one could assume that a dealer's repo loans to a hedge fund roll off more slowly than do its own repo borrowings from the triparty market. This assumption would create a net liquidity exposure for a matched repo book, and would thereby force the dealer to hold some long-term debt or other stable funding against it. Although the implementation is different, the end result is quite close to that obtained with the capital-surcharge approach I just described: in one case, there is a broad stable funding requirement for intermediaries against a matched repo book; in the other case, there is an equity requirement. It follows that, whatever its other advantages, going the modified-NSFR route does not eliminate concerns about disintermediation and regulatory arbitrage. Universal margin requirements These sorts of regulatory-arbitrage concerns have motivated some academics and policymakers to think about a system of universal margin requirements for SFTs. In its simplest form, the idea would be to impose a minimum haircut, or down payment requirement, on any party--be it a hedge fund or a broker-dealer--that uses short-term collateralized funding to finance its securities holdings. Because the requirement now lives at the security level, rather than at the level of an intermediary in the SFT market, it cannot be as easily evaded by, say, a hedge fund going outside the broker-dealer sector to obtain its repo funding. This is the strong conceptual appeal of universal margin from the perspective of a fire-sales framework. In this regard, it is worth noting that the Financial Stability Board (FSB) has recently released a proposal to establish minimum haircut requirements for certain However, the FSB proposal stops well short of being a universal margin requirement. Rather, the minimum haircuts envisioned by the FSB would apply only to SFTs in which entities not subject to capital and liquidity regulation (e.g., hedge funds) receive financing from entities that are subject to regulation (i.e., banks and broker- dealers), and only to transactions in which the collateral is something other than government or agency securities. In this sense, there is a close relationship between the FSB minimum-haircut proposal and the specific variant of the capital-surcharge idea that I mentioned a moment ago. Both have the potential to act as a restraint on those SFTs that are intermediated by regulated broker-dealer firms, but both are vulnerable to an evolution of the business away from this intermediated mode. The minimum margin levels in the FSB proposal are also quite small, so it is unclear how much of an effect, if any, they will have on market behavior. For example, the minimums for long-term corporate bonds, securitized products, and equities are 2 percent, 4 percent, and 4 percent, respectively. Let me wrap up. My aim here has been to survey the landscape--to give a sense of the possible tools that can be used to address the fire-sales problem in SFTs--without making any particularly pointed recommendations. I would guess that a sensible path forward might involve drawing on some mix of the latter set of instruments that I discussed: namely, capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements. As we go down this path, conceptual purity may have to be sacrificed in some places to deliver pragmatic and institutionally feasible results. It is unlikely that we will find singular and completely satisfactory fixes. With this observation in mind, I would be remiss if I did not remind you of another, highly complementary area where reform is necessary: the money market fund sector. Money funds are among the most significant repo lenders to broker-dealer firms, and an important source of fire-sale risk comes from the fragility of the current money fund model. This fragility stems in part from their capital structures--the fact that they issue stable-value demandable liabilities with no capital buffer or other explicit loss- absorption capacity--which make them highly vulnerable to runs by their depositors. I welcome the work of the Securities and Exchange Commission on this front, particularly its focus on floating net asset values, and look forward to concrete action. Another source of fragility arises from money funds investing in repo loans collateralized by assets that they are unwilling or unable to hold if things go bad. This feature creates an incentive for them to withdraw repo financing from broker-dealers at the first sign of counterparty risk, even if the underlying collateral is in good shape. I'm sure we will hear much more about this last set of issues over the remainder of the conference today. I look forward to the discussions. Thank you.

r131011a_FOMC

united states

Communications Challenges and Quantitative Easing

powell

It is an honor to be here today with such distinguished panelists to discuss the communications challenges associated with quantitative easing. I should say at the outset that the views I express here today are my own and may not reflect those of other Federal I'll start with the FOMC's commitment, when the current asset purchase program was launched in September 2012, to continue purchases until the Committee sees a substantial improvement in the outlook for the labor market, a term the Committee left undefined. This commitment was powerful precisely because it was open ended. But "open ended" does not mean unending. As time passed and labor market conditions improved, it would be important for the Committee to clarify the meaning of the term substantial improvement. And given the lack of precedent, it was likely that this transition to more-specific guidance would involve some short-run volatility. Economic conditions have improved since the program was launched. Consumer and business confidence moved higher, and sectors such as housing and autos have performed well. Despite strong, ongoing headwinds from fiscal policy, there has been significant progress in the labor market. From September 2012 through August of this year, the private sector created 2.3 million new jobs. The unemployment rate declined from 8.1 percent to 7.3 percent. It's unclear how much of this improvement was due to the program, but I think there is evidence that it played a role, lowering long-term interest rates and raising equity prices and home prices, effects that have supported household and business spending. In March 2013, the Committee began noting in its postmeeting statement that it would consider "the extent of progress toward its economic objectives" in judging "the size, pace, and composition of its asset purchases." In late May, the Chairman stated, in response to a question during a congressional hearing, that the Committee might begin to reduce the pace of asset purchases "over the next few meetings." A few weeks later, at his press conference after the June 2013 FOMC meeting, the Chairman noted that the substantial improvement test might well be met over the coming year, and he therefore set forth a framework designed to clarify the path of purchases. Under the most recent articulation of that framework, in considering when to reduce purchases, the Committee will "assess whether incoming information continues to support [its] expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective." The path of purchases is entirely data dependent, as numerous FOMC participants have emphasized in public remarks. The market reaction to the Chairman's May testimony and the June FOMC press conference was significant, particularly given the modest character of the news: that the Committee might bring purchases to a gradual halt over the course of a full year, but only if the economy performs broadly in line with the Committee's expectations--which is to say, pretty well. Many factors may have contributed to this market reaction. Among them, I would argue that market expectations began to lose touch with Committee intentions in two ways. First, while the Committee sees policy as data dependent, markets seem to fix on dates. The decision to reduce purchases now or to hold off for a meeting or two does not carry great macroeconomic significance. But, to a fixed-income trader, the timing of the decision is everything. It appears that many market participants concluded after the June press conference that the Committee was eager to reduce purchases and committed to doing so at the September meeting, independent of incoming data. Second, the expected path of the federal funds rate, as reflected in various market prices, increased significantly, implying an earlier liftoff from the zero lower bound than suggested by the Committee's forward guidance. Many FOMC members had said publicly that the decision to reduce purchases did not reflect any change in the Committee's plans for holding the federal funds rate at its current level. The September decision not to reduce purchases clearly took some market participants by surprise. For me, the decision was a close call, and I would have been comfortable with a small reduction in purchases. However, as the minutes of the September FOMC meeting reflect, there were legitimate concerns about the strength of incoming economic data, the economic effects of tighter financial conditions and of tighter fiscal policy, and the prospect for disruptive events on the fiscal front. supported the decision as a reasonable exercise in risk management. Events since the September meeting suggest that the concerns regarding fiscal matters were well founded. I would like to push back against the narrative that the decision at the September meeting has damaged the Committee's communications strategy. In its communications, the Committee seeks to influence market conditions over the medium term in a way that is consistent with its policy intentions. As I suggested earlier, as we navigate this unprecedented transition back to more normal policy, there may be volatility in the short run. And we will continually strive to improve our communications and avoid surprises. But, at the end of the day, my own judgment is that market expectations are now better aligned with Committee assessments and intentions. The September decision underscored the Committee's intention to determine the pace of purchases in a data-dependent way based on progress toward our objectives. Moreover, the modest net tightening in financial conditions since the June meeting has likely reduced the prevalence of highly leveraged, speculative positions. I believe that the market is now prepared for a reduction in purchases when the economic outlook and the broader situation support it. Short term rates have fallen back since the September meeting, and are now better aligned with the Committee's forward rate guidance. This is particularly important because, as the Chairman stressed in September, the Committee views rate policy as its stronger and more reliable tool. To wrap up, let me emphasize that what matters is the overall stance of policy, not the pace of asset purchases. In all likelihood, policy will remain highly accommodative for quite a while longer--as long as needed to support an economy that still struggles to shake off the lingering effects of the financial crisis. Thank you.

r131014a_FOMC

united states

Celebrating 20 Years of the Bank of Mexico's Independence

bernanke

It is a pleasure to offer a few remarks at this conference marking the 20th anniversary of the Bank of Mexico's independence. In August 1993, Mexico's congress approved changes to the country's constitution that granted policy autonomy to the Bank of Mexico and made price stability its primary mandate. Over the past two decades, these actions, along with a number of other constructive steps taken by Mexican policymakers, have paid substantial dividends in terms of improved economic performance. At the time that the Mexican congress changed the status and mandate of the central bank, the nation's economy had been suffering periodic bouts of economic instability for many years. The 1970s through the mid-1990s in particular were marked by episodes of high inflation, boom-and-bust cycles, and financial crises. Indeed, shortly after the new Bank of Mexico law went into effect in April 1994, the Mexican economy entered the throes of the so-called peso crisis. However, the changes to the monetary policy framework, along with greater fiscal discipline and the adoption of a more flexible exchange rate, soon bore fruit. Notably, inflation fell to single-digit levels by the early 2000s. And in 2001 the Bank of Mexico formally adopted an inflation-targeting regime, which--outside of some temporary fluctuations--has succeeded in keeping inflation at around 4 percent. Importantly, the improved monetary policy framework, together with other reforms, has thus far helped reduce Mexico's susceptibility to financial crises. When the recent financial crisis in the United States and other advanced economies threatened to spill over to Mexico, the inflation credibility enjoyed by the Bank of Mexico allowed it to counter economic weakness by easing monetary conditions, even though headline inflation was running above its target range at the time. The Bank's rate cuts helped stabilize the economy, and Mexican output returned to its pre-crisis level by late 2010. Strong countercyclical policy actions of this type were unlikely to have been feasible in Mexico a few decades ago; with little in the way of inflation-fighting credibility and an immature financial sector, the monetary authority in earlier years was often forced to respond to a crisis by tightening monetary conditions, rather than loosening them, in an effort to limit capital flight, exchange rate depreciation, and increases in inflation. Of course, we should not be surprised that central bank independence has contributed to Mexico's improved macroeconomic stability over the past two decades. A broad consensus among economists--supported by considerable empirical evidence-- holds that a central bank's credibility and effectiveness are enhanced when it is able to make monetary policy based on its assessment of what is in the economy's long-run interest rather than in response to short-term political pressures. The benefits of a sound monetary framework are further enhanced when combined with good fiscal, regulatory, and trade policies. As you probably know, the Federal Reserve is also celebrating an anniversary this year--the centennial of its founding. Like the Bank of Mexico, the Federal Reserve is an independent central bank, and, as in the case of the Bank of Mexico, that independence has evolved and gradually strengthened over time. For example, in the early years following the Fed's founding in 1913, the Secretary of the Treasury and the Comptroller of the Currency served on the Federal Reserve Board, an arrangement that only changed in the 1930s when the Fed underwent significant structural reforms. The Federal Reserve was also less than fully independent during and just after World War II, when it agreed to keep Treasury yields at low levels to reduce the cost of financing wartime deficits. After the war, as inflation pressures rose, Federal Reserve policymakers wanted to return to independent rate setting, but the Treasury demurred, hoping to keep the cost of servicing the national debt low. The conflict was resolved in 1951 through the Treasury-Fed Accord, an agreement that reestablished the Federal Reserve's ability to set rates as dictated by the needs of the broader economy. During the 1980s, under the leadership of Chairman Paul Volcker, the Fed further established its credibility and independence by taking the necessary steps to bring inflation under control. As in Mexico, the benefits of central bank independence in the United States have included low inflation, well-anchored inflation expectations, and increased policy credibility, which contribute to a more stable overall economic environment. Indeed, during the recent financial crisis and the ensuing recession, the Fed has been able to take aggressive monetary policy actions to help stabilize the economy without dislodging longer-term inflation expectations. We should recognize, though, that in democratic societies, central bank independence must be accompanied by accountability to the public and its representatives. In this regard, transparency is key. To ensure appropriate accountability, while also making monetary policy more effective, central banks in the United States, Mexico, and around the world have worked hard to increase their transparency over the past 20 years or so. For example, in the United States, the Fed's policymaking arm, the Federal Open Market Committee, releases a statement after each meeting explaining its decisions and reporting the vote, publishes detailed minutes three weeks after each meeting, and provides a quarterly summary of Committee participants' economic and policy projections. My colleagues on the Board and I often testify before congressional committees, we speak regularly in public, and I hold news conferences four times a year. The Bank of Mexico has likewise significantly increased its transparency since becoming independent, through steps including the adoption of a target range for inflation, the regular publication of inflation reports and policy statements, and the timely release of minutes following each policy meeting. The economies of the United States and Mexico not only have in common independent central banks, they are also closely tied by geography and history. The United States is by far Mexico's largest trading partner, accounting for about two-thirds of Mexican merchandise trade. In turn, Mexico accounts for about one-eighth of U.S. foreign trade, thereby ranking, along with Canada and China, among our three largest trading partners. In addition, remittances coming from Mexican workers in the United States benefit the Mexican current account and are a welcome source of income for many Mexican families. The strong links between our economies have led to close cooperation between our central banks. An example is the bilateral currency swap arrangement between the Federal Reserve and the Bank of Mexico that was set up during the global financial crisis. This swap line was one of 14 that the Fed established with foreign central banks around the world. These swap arrangements proved their value as they helped alleviate dollar funding pressures, reduce interbank borrowing rates, and calm market fears during some of the worst phases of the crisis. The swap line with Mexico was in addition to a line Reserve and the Bank of Mexico also work closely together--and with other central banks--through international meetings, seminars, and conferences; in the provision of technical assistance; and through other activities in forums such as the Bank for I would be remiss if, before ending, I did not note the strong leadership that Governor Agustin Carstens continues to provide at the Bank of Mexico. His leadership in economic policy, in several key roles, has been instrumental in solidifying the progress that Mexico has made over the past two decades. Agustin has also built an impressive record in the international policy community more broadly. He is currently the chair of the BIS Consultative Council for the Americas, has recently been appointed chair of the key role in Mexico's successful presidency of the G-20 last year. To conclude, I would like to congratulate the Bank of Mexico on the 20th anniversary of its independence. I wish you a productive conference marking this auspicious occasion. And I wish the Bank of Mexico continued success in its work to stabilize and strengthen the Mexican economy.

r131018a_FOMC

united states

Lean, Clean, and In-Between

stein

Thank you. The theme of this conference is, "Lessons from the Financial Crisis for Monetary Policy." Given the opportunity to speak about this topic, my first thought was that I should organize my remarks around the familiar "lean versus clean" debate. The traditional, pre-crisis framing of the question went something like this: Should policymakers rely on ex ante measures to lean against potential financial imbalances as they build up, and thereby lower the probability of a bad event ever happening, or should they do most of their work ex post, focusing on the clean-up? Post-crisis, the emphasis in the debate has shifted. I think it's safe to assume that nobody in this room would now argue that we should be putting all our eggs in the "clean" basket. Discussion these days tends to focus instead on which ex ante measures are best suited to safeguard financial stability. Among these, there seems to be widespread support for unconditional, (i.e., time-invariant) tools that increase the overall resiliency of the financial system to shocks. These tools include more robust capital and liquidity requirements, as well as an enhanced capability to resolve a large financial institution that finds itself on the brink of failure. They might also include universal margin requirements on securities financing transactions, as a way of mitigating fire-sales risks. We might argue about various aspects of calibration and implementation, but I don't think there is too much controversy about the basic proposition that strong, comprehensive regulation aimed at enhancing resiliency is essential. There is considerably less agreement about the desirability and effectiveness of ex ante measures that seek to lean against the wind in an explicitly time-varying fashion-- that is, measures that can be adapted in response to changing economic or financial conditions. At the risk of caricature, one can distinguish three schools of thought. The first school is generally suspicious of any kind of time-varying lean, be it with macroprudential tools such as time-varying, countercyclical capital buffers or margin requirements, or with monetary policy. This school emphasizes the difficulty of identifying emerging financial imbalances in real time. It also points to the political- economy and regulatory-arbitrage impediments that can frustrate the implementation of discretionary time-varying regulation. The second school is more comfortable with the idea of time-varying leans, but invokes what amounts to a separation principle: It takes the view that any financial- stability-motivated leans should come largely, if not entirely, from time-variation in the application of regulatory and supervisory tools, while monetary policy should stick to its traditional dual-mandate objectives of fostering full employment and maintaining price stability. The third school is more heterodox. Like the first, it acknowledges that there are a variety of practical limitations associated with discretionary time-varying regulation, though the severity of these limitations may vary considerably across different countries, markets, and institutional arrangements. In cases where regulation can be effectively adjusted over time, doing so remains the preferred approach. But in other situations, and especially when the imbalances in question are relatively pronounced or widespread across a range of markets, this school of thought is more open to working on multiple fronts and to formulating monetary policy with one eye on its potential implications for these imbalances. The debate between these three schools gets a lot of attention at venues like this one--and with good reason. It touches on issues that are not only of policy interest, but also connect to deeper and strongly held views about how the world works. In other words, this is paradigm-versus-paradigm stuff, which always helps to liven up an academic exchange. But precisely for these reasons, the whole lean-versus-clean debate runs the risk of drawing attention away from other crisis-derived lessons that do not make as good fodder for academic discussion, but that are no less relevant from a practical policy perspective. Let me focus the remainder of my remarks on one of these: the importance of the in-between. The lean-versus-clean framing suggests a simple model in which there are just two dates: (1) an initial ex ante date that is prior to when a shock is realized--and when we may not even have much of a clue as to the form the shock will take--and (2) an ex post date when the shock has hit, its full effects have been felt, and policymakers are dealing with the aftermath. But this before-and-after dichotomy is misleading. Many financial crises unfold over months or even years, and the choices made during this in- between period can be among the most crucial to the eventual outcome. Recall that problems with subprime mortgages were already surfacing in late 2006. The first serious tremors associated with the crisis were felt in August 2007, with BNP Paribas suspending redemptions on its money funds and investor runs on multiple asset-backed commercial paper programs. At this point, there was no longer any real doubt about the nature of the shock confronting us--even if its precise magnitude was yet to be determined. And yet it was more than a full year until the failure of Lehman Brothers in September of 2008, which ignited the most intense part of the crisis. Moreover, during the interval from the start of 2007 through the third quarter of 2008, the largest U.S. financial firms--which, collectively, would go on to charge off $375 billion of loans over the next 12 quarters--paid out almost $125 billion in cash to their shareholders via common dividends and share repurchases, while raising only $41 billion in new common equity. This all happened while there was a clear and growing market awareness of the solvency challenges they were facing. Indeed, the collective market cap of these firms fell by approximately 50 percent from the start of 2007 through the end of There are two points here worth emphasizing. First, it seems indisputable that the severity of the crisis would have been mitigated if policymakers had clamped down on these payouts earlier, and had compelled substantial new equity raises. Second, the conflict between the interests of the firms, acting on behalf of their shareholders, and those of the broader public became particularly acute once the crisis got underway, because of the debt overhang problem. Cutting back on dividends and issuing new shares might have been strong positives for the banks' overall set of stakeholders, as well as for society more broadly, but were clearly negatives for shareholders, given that such actions would have entailed large transfers to underwater creditors. This conflict of interest can make it hard for even the best-intentioned regulators to muster the conviction to take full advantage of either the appropriate legal tools or the resources available under the existing institutional framework. Under what circumstances does one tell a firm that is still well above its regulatory capital requirement that it must do a share issue that will be helpful for the economy as a whole, but highly dilutive to its existing equity holders? This discussion brings us to the role of the now ongoing stress-testing framework for large financial institutions. As you may know, the Federal Reserve has been conducting annual stress tests and capital-planning reviews of the 18 largest banks under adding 12 more firms this year, consistent with requirements of the Dodd-Frank Wall During normal times, when banks are relatively healthy, the CCAR process functions as an important complement to more conventional capital regulation and, like capital regulation, it can be thought of as an ex ante instrument to increase the general resilience of the banking system to as-yet-unknown shocks. I believe that it has been a very valuable addition to our toolkit in this regard, and will continue to be so. However, I also believe that much of the promise of the CCAR framework lies in its potential to help us achieve a better outcome not just in normal times, but also in the important in-between times, in the early stages of a crisis. In other words, when thinking about the design of CCAR, one of the questions I keep coming back to is this: Suppose we were granted a do-over, and it was late 2007. If we had the CCAR process in place, how would things have turned out differently? Would we have seen significantly more equity issuance at this earlier date by the big firms, and hence a better outcome for the real economy? On the one hand, there is some reason for optimism on this score. After all, the 2009--provided the impetus for a significant recapitalization of the banking system. More than $100 billion of new common equity was raised from the private sector in the six months after the SCAP, and in many ways it was a watershed event in the course of the crisis. Moreover, the current CCAR framework gives the Federal Reserve both the authority and the independent analytical basis to require external equity issues in the event that, under the stress scenario, a firm's post-stress, tier 1 common equity ratio is below 5 percent, and the ratio cannot be restored simply by suspending dividends and share repurchases. In my view, these features of the program are among its most crucial. At the same time, having the authority to do something is necessary, but not sufficient--there also needs to be the institutional will. And this will is likely to be especially critical in a time of crisis, again because of the increased prominence of the debt-overhang problem. A firm that is told that it needs to improve its capital position will, given the interests of its shareholders, strongly prefer to do so by reducing assets rather than by engaging in a dilutive share issue, even though the latter is more desirable from the perspective of aggregate credit provision. And it can be expected to make its case forcefully. So if we are serious about taking a macroprudential approach to regulation--one which aims to protect not just the solvency of individual firms, but the health of the financial system as a whole and its ability to continue to perform its intermediation role in times of stress--it is incumbent on us as regulators to do all that we can to develop both the intellectual case, and the institutional resolve, to be able to push back with equal force when the time comes. Thank you. I look forward to the rest of our discussion.

r131018b_FOMC

united states

Toward Building a More Effective Resolution Regime: Progress and Challenges

tarullo

Observing the five-year anniversaries of various key moments in the financial crisis throughout 2013 cannot but prompt us to step back and evaluate the effectiveness of the regulatory reform efforts that followed. This week, which marks five years since the U.S. moment to hold this conference on the resolution of systemically important financial institutions (SIFIs). The TARP's extension of unprecedented capital support to many of the largest U.S. banks reflected the view of government officials that the failure of these firms would have posed a grave threat to the financial system. The turmoil that followed the failure of Lehman and the decision to rescue AIG each, in their way, underscored the absence of a third alternative to the options of bailout or disruptive bankruptcy. The creation of such an alternative, included as the Protection Act, was a key part of the reforms. In fact, the emergence of a growing consensus around the key elements of a credible resolution mechanism, and the work to engraft those elements into appropriate statutory and administrative frameworks, is one of the more unheralded--if still in progress--successes of the post-crisis regulatory response. Here in the United States, the Federal Deposit Insurance Corporation (FDIC) has been doing path-breaking work to build out the statutory provisions of (FSB) has elaborated a set of principles to guide the development of resolution mechanisms globally. And, throughout both processes, there has been fruitful interaction among the official sector, academics, and market participants. In my remarks this afternoon, I will begin by explaining the purpose and critical features of a special mechanism for resolving large financial firms, especially those of systemic importance. Next, I will explain why the efforts of the FDIC have been so important in developing credibility for the Title II resolution mechanism for systemically important firms and identify some of the important work that remains, not just for the FDIC, but for a range of official sector and private actors, here and abroad. Finally, I will end with a few thoughts on the relationship between resolution mechanisms and the broader regulatory reform agenda we have been pursuing over the past several years. The crisis, and the scope of government support for large banks that it precipitated, spawned an ambitious international regulatory reform agenda directed at the financial stability risks posed by SIFIs. It was recognized that, left unaddressed, the necessary but unpalatable government interventions during the crisis would only further entrench the too-big-to-fail status of systemic financial firms--increasing moral hazard, undermining market discipline, and harming competitive equality among financial institutions of different sizes. Stated most pointedly, then, the purpose of a special resolution mechanism for large financial firms is to prevent future situations in which government officials face the unappealing choice they confronted in 2008, to which I alluded a moment ago. Stated more analytically, a special resolution mechanism is needed to take account of the characteristics of financial markets, and of larger firms operating in those markets, that do not fit easily with normal bankruptcy practice. These characteristics all relate to a basic function of financial intermediaries in providing liquidity to firms and households--whether through maturity transformation, by which banks allow depositors to lend out their savings while maintaining complete liquidity; through market-making, by which dealers provide liquidity to investors in various instruments; or through other forms of intermediation. Precisely because financial intermediaries provide these liquidity services, they are subject to funding strains when customers or counterparties become uncertain of the value of the loans, securities, or other assets held by the intermediaries. Where those assets are opaque--as can be the case, for example, with a portfolio of conventional loans or with securities backed by many loans bundled together from various originators--the incentive to withdraw funding increases, particularly in periods of stress when the value of broadly held asset classes may be at risk of precipitous decline. This familiar dynamic is obviously a potential problem for the intermediary. It becomes a problem for society when one or both of two things follow: First, as in the classic case of bank runs, problems at one bank lead depositors or counterparties at other banks to withdraw their own funds, fearing that their own banks may have similar difficulties repaying them because they hold similar assets. Or, second, the liquidity squeeze leads a sizeable financial firm to engage in a fire sale of its assets in order to raise the funds necessary to compensate for the disruption of its normal funding channels. Dumping a sizeable book of assets on the market, in turn, can lead to the adverse feedback loop observed during the crisis: Downward pressure is placed on similar assets held by others, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets, thereby prompting fire sales by others. In either or both of these eventualities, the potential insolvency of the financial firm is a problem not just for shareholders, employees, and creditors, but for the financial system as a whole. A final point is that a financial firm, through the operation of one or both of these dynamics, can shift from viable to non-viable in quite a short period of time. And, once the confidence of counterparties and customers is shaken, and funding withdrawn, the game is essentially over. Of course, matters are made worse if the firm did not maintain adequate capital levels or relied too heavily on short-term funding, as was the case with many of the firms that failed or came under severe pressure in 2008. However, it is important to note that the nature of financial intermediaries means that even firms compliant with more rigorous capital and liquidity requirements could be faced with these dynamics in a tail event. To be credible, then, a resolution mechanism for large financial firms must be capable of dealing with these characteristics of financial markets. This is the premise underlying Title II of Dodd-Frank, and I think it has also been the premise of thoughtful commentators who have proposed amendments to the Bankruptcy Code for application to large financial firms. are three key features of Title II and, modified in certain respects, some of these Bankruptcy Code proposals reflect recognition of the peculiarities of financial markets in a way the current Bankruptcy Code does not. The first key feature of Title II, simply put, is speed. It is vital that a resolving authority be able to move very quickly from non-resolution to resolution status, while maintaining continuity of operations. As many of you will recall, during the financial crisis the makeshift arrangements crafted by governments in an effort to avoid large negative effects on financial markets were usually completed over a weekend. The second key feature is a source of immediate funding to continue essential functions and minimize the kind of fire sales referred to earlier. The Bankruptcy Code allows for so-called debtor-in-possession (DIP) financing to be provided to any firm going through the bankruptcy process. Such DIP financing is often essential to maximize the going-concern value of the firm. For a failed SIFI, such funding may be required quickly and in fairly large sums--needs that may not be fully met by private lenders, at least not in the immediate aftermath of a firm being placed into the Title II process. For these reasons, funding from the FDIC, drawing on a line from Treasury, is available under Title II. It is important to note, though, that the underlying concept has the same roots as DIP financing--lending that will maintain or increase the going-concern value of the firm, not absorb losses. It is not a capital injection and does not put taxpayers at risk. The FDIC has indicated that it will, in order to protect taxpayers more fully, require that the financing be collateralized and if, for any reason, the FDIC cannot recover the full amount of credit extended, the shortfall is to be made up by a tax on other large financial firms. The third necessary feature is a temporary stay of close-out rights of qualified financial contract counterparties. The ability of the FDIC, subject to important creditor safeguards, to nullify the direct- and cross-default rights of counterparties can halt the disruptive, uncertainty- driven race to seize and liquidate a firm's assets immediately upon its entrance into a Title II resolution. The FDIC authority includes the opportunity to decide whether it wants to transfer qualified financial contracts (QFCs) to a bridge financial company or another solvent company during a one-day statutory stay of the contractual rights of counterparties of the firm being resolved. As I will discuss later, this authority is not without limitations, particularly in a cross- border resolution, but it is a critical tool for an effective resolution of a financial firm with complex portfolios of financial contracts. While Title II establishes a special resolution mechanism and grants the FDIC powers responsive to the special challenges posed by the failure of large financial institutions, it provides only a legal framework, not an elaborated description of how these powers would be used to resolve a systemically important financial firm. Moreover, the very large financial firms that are the most likely subjects of a Title II proceeding have extensive cross-border activities, and thus implicate the legal systems of other countries. Thus, for orderly liquidation authority to be effective in containing too-big-to-fail concerns and supporting financial stability, the statutory provisions must be supplemented with administrative planning by the FDIC and with consistent measures in other jurisdictions. It is important to develop and articulate a credible approach to such a resolution proceeding, for at least two reasons. First, unless creditors and counterparties have well- grounded expectations as to how they will be treated in a resolution setting, they may need to charge a premium to compensate for the additional uncertainty associated with the disposition of their claims, which can lead to a mispricing of risks. In some cases, particularly in periods of increasing stress in the financial system, they may be unwilling to deal with certain firms altogether. Parties who have short-term lending to, or contractual arrangements with, these firms may "run" as those loans or contracts lapse, thereby potentially crippling the ongoing business of the firm and creating adverse effects in other parts of the financial system. A second reason is, in some sense, the converse of the first. If creditors and counterparties do not believe the FDIC can successfully resolve the firm, they may not price in the potential for losses that should be incorporated in their dealings with large firms. That is, if investors and other market actors think the prospects for orderly resolution seem low, they may assume the firm will be rescued by the government, and any moral hazard present in these markets will continue. By specifying which financial obligations will be maintained and where the FDIC will look to impose losses, a well-developed approach to resolution can create incentives for private action compatible with the overall aims of systemic firm resolution. The FDIC has made great progress in implementing Title II, in particular by developing the single-point-of-entry approach to resolution of a systemic financial firm. Under the single- point-of-entry approach, the FDIC will be appointed receiver of only the top-tier parent holding company of the failed firm. After the parent holding company is placed into receivership, the FDIC will transfer assets of the parent company to a bridge holding company. The firm's operating subsidiaries (foreign and domestic) will remain open for business as usual. To the extent necessary, the FDIC will then use available parent holding company assets to recapitalize the firm's critical operating subsidiaries. Equity claims of the failed parent company's shareholders will effectively be wiped out, and claims of its unsecured debtholders will be written down as necessary to reflect any losses or other resolution costs in the receivership. The FDIC will ultimately exchange the remaining claims of unsecured creditors of the parent for equity or debt claims of the bridge holding company and return the restructured firm back to private sector control. This conceptual approach to resolution under Title II represents an important step toward ending the market perception that any U.S. financial firm is too big or too complex to be allowed to fail. The aim of the single-point-of-entry approach is to stabilize the failed firm quickly, in order to mitigate the negative impact on the U.S. financial system, and to do so without supporting the firm's equity holders and other capital liabilities holders or exposing U.S. taxpayers to losses. The single-point-of-entry approach offers the best potential for the orderly resolution of a systemic financial firm under Title II, in part because of its potential to mitigate run risks and credibly impose losses on parent holding company creditors and, thereby, to enhance market discipline. In the United States, the top-tier parent company of a large banking firm generally is not an operating company but a holding company, whose primary purpose is to raise capital and direct the operations of its subsidiaries. Its assets largely consist of cash, liquid securities, and equity and debt interests in its subsidiaries. This common organizational feature of U.S. banking firms facilitates the single-point-of-entry approach because the liabilities of the top-tier holding company are structurally subordinated to the customer obligations and other direct liabilities at the firm's operating subsidiaries. Accordingly, under the single-point-of-entry approach, the equity and debt at the holding company level can form a buffer that must first be exhausted before any customer or creditor of a subsidiary suffers losses. The existence of this buffer should help give the customers and creditors of a U.S. banking firm greater clarity regarding their potential loss exposure in failure. The presumption that holding company capital liabilities would be required in the first instance to absorb losses in a systemic financial firm will be critical in maintaining the confidence, and limiting the run potential, of customers, liquidity providers, and other creditors at the operating subsidiary level. The single-point-of-entry approach does not involve a government guarantee that subsidizes systemic financial firms by protecting their investors from downside risk. The resolution would result in a recapitalization of a failed firm by the firm's own investors. Any protection received by the creditors of a failed firm's operating subsidiaries would be provided by the equity and debt holders of the failed firm's parent holding company. And even if any temporary losses were suffered by the government because of its provision of liquidity, Dodd- Frank requires that the government be reimbursed through assessments on large financial firms. The work being done by the FDIC in building out its approach to Title II will continue, and the FDIC has indicated that it will explain this thinking in further detail in a public release later this year. In addition to the FDIC's work, there are other ways that the credibility of Title II can be enhanced. For example, the Federal Reserve and the FDIC can use their joint responsibility for overseeing the resolution plans, which are required by Dodd-Frank, for large, prudentially regulated firms to improve the resolvability of systemically important financial institutions. The largest U.S. bank holding companies and foreign banking organizations submitted their first annual resolution plans to the Federal Reserve and the FDIC in 2012 and have recently submitted a second round of resolution plans. These plans have yielded valuable information that is being used to identify, assess, and mitigate key challenges to resolvability under the U.S. Bankruptcy Code and to support the FDIC's development of backup resolution plans under Title II. We expect the second round of submissions to include improvements that address the initial set of obstacles to resolvability identified during the first round. More broadly, our evaluation of the resolvability of these large firms has been further advanced by the resolution planning process. Let me mention two ways in which the organizational structure of systemic financial firms could be shaped so as to facilitate the single- point-of-entry approach. One would be to ensure that losses at material operating subsidiaries, including in material foreign subsidiaries, could be transferred to the parent holding company in resolution. The other would be to keep the firm's parent holding company non-operational and otherwise "clean" through limits on the issuance of short-term debt and on the conduct of material business operations in the parent holding company. The single-point-of-entry approach concentrates losses on the creditors and counterparties of the SIFI parent, as opposed to the operating subsidiaries. Accordingly, the impending failure of a SIFI would create strong incentives for creditors and counterparties of the parent holding company to run. The single- point-of-entry strategy will be more credible and effective if the only creditors of the parent holding company are holders of capital instruments, and long-term debt holders are fully aware they are subject to bail-in as part of any Title II resolution. Another way to enhance the credibility of the FDIC's approach is to require adequate loss-absorbing capacity within large financial firms. Minimum capital requirements, conceptually, are designed to cover losses up to a certain statistical probability. If an extreme tail event occurs and the equity of the firm is wiped out, successful resolution without taxpayer assistance would be most effectively accomplished if a firm had sufficient long-term, unsecured debt to absorb additional losses and to recapitalize the business transferred to the bridge operating company. The presence of this debt explicitly identified for possible bail-in on a "gone concern" basis should help other creditors clarify their positions in the orderly liquidation process. A requirement for long-term debt could also have the benefit of improving market discipline, since holders of that debt would know they faced the prospect of loss should the firm enter resolution and would presumably demand an appropriate risk premium. The Federal Reserve, in consultation with the FDIC, will be issuing in the next few months a proposal that would require the largest, most complex banking firms to hold minimum amounts of long-term, unsecured debt at the holding company level. This requirement will have the effect of preventing erosion of the current long-term debt holdings of the largest, most complex U.S. firms, which, by historical standards, are currently at fairly high levels. Absent a minimum requirement of this sort, one could expect declines in these levels as the quite flat yield curve of recent years steepens; indeed, we have recently seen some evidence of the beginnings of such declines. At the international level, the FSB has recently announced that it will be issuing proposals for global standards on gone-concern loss absorbency for global systemically important financial institutions. The single-point-of-entry approach will also be facilitated by the presence of a sufficient amount of assets of the right types at the SIFI parent to enable the recapitalization of its material operating subsidiaries when losses have eroded the capital of the subsidiaries. The write-down of equity and the imposition of haircuts on parent holding company debt in Title II does not by itself recapitalize the operating subsidiaries. Moreover, foreign operations of a SIFI are more likely to be ring-fenced or wound down separately under the insolvency laws of their host countries if foreign authorities or directors do not have full confidence that local interests would be protected. A requirement that a SIFI's parent holding company hold minimum amounts of "internal bail-in" debt issued by its material operating subsidiaries could offer a solution to this problem: A failed SIFI parent holding company would be able to inject capital into its material operating subsidiaries by effectively converting that intra-group debt into equity. In many ways, Title II has become a model resolution regime for the international community. In 2011, the FSB adopted the , a new standard for resolution regimes for systemic firms. The core features of this global standard were already embodied in Title II. By acting early, through the passage of the Dodd-Frank Act, the United States led the way in shaping the development of international policy for effective resolution regimes for systemic financial firms. The FDIC's work on the single-point-of-entry approach continues to help frame the terms of international discussions at the FSB. Moreover, as the home-country supervisor of eight of the 28 global responsibility for establishing and routinely convening for each U.S. G-SIB a crisis management group. These firm-specific crisis management groups, which are comprised primarily of the firm's prudential supervisors and resolution authorities in the United States and key foreign jurisdictions, are working to mitigate potential cross-border obstacles to an orderly resolution of the firms. All that said, many other major jurisdictions have not yet enacted legislation that would create a statutory resolution regime with the powers and safeguards necessary to meet the FSB's . Mitigating the obstacles to SIFI resolution will require, at a minimum, that key foreign jurisdictions implement national resolution regimes consistent with the . While compatible host-country resolution regimes are necessary for orderly cross-border resolutions, they may not be sufficient. Most importantly, home-country resolution of a global systemic financial firm may be nearly as difficult if creditors and counterparties of the firm's foreign operations run as will likely happen if domestic creditors and counterparties do so. Possibilities for such runs may be reduced by well-developed and transparent arrangements for cooperation between home- and host-country officials in resolving these firms. The recent joint paper by the FDIC and Bank of England is an important example of such cooperation. standing alone, even the best of cooperative arrangements may not remove all salient obstacles. One key challenge is that certain Title II stabilization mechanisms, including the one-day stay provision with respect to over-the-counter derivatives and certain other financial contracts, may not apply outside the United States. Accordingly, counterparties to financial contracts with the foreign subsidiaries and branches of a U.S. firm may have contractual rights and substantial economic incentives to terminate their transactions as soon as the U.S. parent enters into resolution. Equivalent opportunities and incentives may apply to counterparties of U.S. operations of foreign banking organizations. One approach to addressing this problem would be for domestic legislatures to amend bankruptcy and insolvency laws to recognize stays imposed in home-country resolution procedures consistent with international standards. However, it may be difficult to get such legal changes on roughly comparable terms in all relevant jurisdictions, much less to conclude a binding international agreement along those lines. A second approach, currently under consideration by regulators, would be to seek modifications to standard contractual cross-default, netting, and related practices. This approach would use contractual measures to achieve the same end of having these arrangements effectively governed by resolution decisions in home countries. Of course, even if agreement were reached among regulators, in consultation with relevant industry associations, and effective steps were taken to implement that agreement, it could take some time for the new terms to be widely adopted in relevant markets. But a regulatory timeline could be set to speed up the process. This approach may be the most promising for tackling this vexing problem. The resolution mechanism created by Title II of Dodd-Frank is gaining greater operational credibility as the FDIC builds out its single-point-of-entry approach. With each rule, policy statement, cross-border agreement, and firm-specific resolution plan, that credibility is further increased. Additional measures such as those I have suggested today will continue to enhance this third option of orderly resolution, and relieve government officials of the Hobson's choice of bailout or disruptive bankruptcy for systemically important financial firms. However, as is apparent from the amount of work and planning involved in this effort-- particularly, though not exclusively, on cross-border matters--the construction of a resolution framework remains an ongoing challenge. Moreover, even when a large, complex firm can be resolved at no cost to taxpayers without provoking a systemic crisis, there will very likely still be significant negative externalities in the financial system. That is, even if a firm is not too-big-to- fail, it may still be of sufficient systemic importance to make its failure a costly event. Thus, even as policymakers strive to increase prospects for orderly resolution, we must continue efforts to reduce prospects for the failure of a systemically important firm that would require this special mechanism. Stronger capital and liquidity requirements that improve going- concern resiliency will remain crucial to a reform agenda directed at containing the too-big-to- fail problem. The objectives of preventing failure and of reducing systemic costs in the event failure nonetheless occurs are complementary, rather than alternative, policy aims. The most important systemic vulnerabilities that have not been subject to sufficient regulatory reforms are those created in short-term wholesale funding markets. In the recent financial crisis, severe repercussions were felt throughout the financial system as short-term wholesale lending against all but the very safest collateral froze up. Although short-term wholesale funding levels at major U.S. and foreign banking firms are lower than they were at the outset of the crisis, major global banks remain significant users. High levels of such funding increase the probability of severe funding problems at, and thus the failure of, major financial firms. They also complicate the orderly resolution of major financial firms in the event of failure. Indeed, precisely because an effective orderly resolution mechanism provides for continued funding of certain short-term creditors to staunch potentially calamitous runs, that type of funding will not be subject to the increased market discipline resulting from the creation of a credible resolution process. This fact only strengthens the case for measures to limit the potential of short-term wholesale funding to be an accelerant of systemic problems. As I stated at the outset, I believe that creation of the orderly liquidation authority in Title II of Dodd-Frank, the work of the FDIC in developing that authority, the international consensus on the need for similar authority in relevant jurisdictions, and the continuing dialogue with academic and policy commentators together constitute a relatively unnoticed success in the world of financial regulatory reform. This observation has come with two, probably predictable caveats. First, considerable work remains, so as to continue building and communicating a credible resolution mechanism that will allow investors, creditors, and counterparties of large financial firms to form reasonable expectations as to how a resolution would be conducted. Second, while it is important to have such a mechanism as part of an overall program to confine too-big-to-fail problems, it would not be desirable to have to use it. The more desirable outcome would be for its very credibility to work in concert with capital, liquidity, and other applicable regulations to reduce the chances of its actual utilization. These two thoughts bring me to a final point. As I mentioned, serious work is being done by various commentators on proposals to adapt the Bankruptcy Code to the salient differences between financial and most other industries. As I have watched the back-and-forth between those in the official sector charged with developing orderly resolution mechanisms and those working on bankruptcy amendment proposals, I have noted each side taking account of some points in favor of the other side's model, with attendant modifications in everyone's thinking. Differences remain, to be sure, such as the tradeoff between, on the one hand, a bankruptcy model's reliance on the independence of the judiciary and the accumulated precedent for dealing with creditors' claims and, on the other, the advantages in the Title II model of speed, pre-existing knowledge of financial firms, and a systemic perspective. But there has also been productive convergence. I join those who believe that the best outcome may be an amended Bankruptcy Code co-existing with Title II, with the former the default route in the case of a large financial firm's insolvency, and the latter available for the unusual moment when systemic risks loom large. The adaptation of the Bankruptcy Code to deal with large, but not necessarily systemic, financial firms would itself be an important step forward. And the existence of two options other than bailout or disruptive bankruptcy would be welcome to anyone who remembers the position of policymakers in the fall of 2008.

r131104a_FOMC

united states

Advanced Economy Monetary Policy and Emerging Market Economies

powell

I appreciate this opportunity to offer a few thoughts on the effects of advanced economy monetary policies on emerging market economies (EMEs)--an issue of great importance for Asia and the global economy. Since the global financial crisis, the Federal Reserve has sought to strengthen the U.S. economic recovery through highly accommodative monetary policy. But my colleagues and I are keenly aware that the U.S. economy operates in a global environment. We understand that America's prosperity is bound up with the prosperity of other nations, including emerging market nations. Emerging market economies have long grappled with the challenges posed by large and volatile cross-border capital flows. The past several decades are replete with episodes of strong capital inflows being followed by abrupt reversals, all too often resulting in financial crisis and economic distress. Some of this volatility no doubt reflects the evolution of strengths and vulnerabilities within the EMEs themselves. In recent years, renewed attention has been placed on the role of advanced economies and of common or global factors in driving capital movements. In particular, many observers have singled out monetary policy in the United States and other advanced economies as a key driver. As advanced economies pursued highly accommodative monetary policies and EMEs subsequently received strong capital inflows, reflecting investors' pursuit of higher returns, concerns were expressed that a flood of liquidity would overwhelm emerging markets, drive up asset prices to unsustainable levels, set off credit booms, and thus sow the seeds of future crises. More recently, there have been concerns about potential financial and economic dislocations associated with the advanced economies' eventual exit from highly accommodative policies. In my remarks today, I will discuss the extent to which monetary policy in the advanced economies--and in the United States in particular--has contributed to changes in emerging market capital flows and asset prices, and I will place this discussion in a broader context of economic and financial linkages among economies. I will also address the risks that EMEs may face from the eventual normalization of monetary policy in the advanced economies. The heightened attention to advanced economies' monetary policies and the potential spillovers to EMEs is understandable in light of the unprecedented policy steps taken in the aftermath of the global financial crisis. The severity of the crisis and the challenge of a slow recovery required central banks in the advanced economies and elsewhere to take aggressive action in order to fulfill their mandates. In the United States, the Federal Reserve is bound by its dual mandate to pursue price stability and maximum employment. In following that mandate, the Fed cut the federal funds rate to its effective lower bound in late 2008 and then turned to two less conventional policy tools to provide additional monetary accommodation. The first is forward guidance on the federal funds rate. By lowering private-sector expectations for the future path of short-term rates, forward guidance has reduced longer-term interest rates and raised asset prices, thereby leading to more accommodative financial conditions. The second tool is large scale asset purchases, which likewise increase policy accommodation by reducing longer-term interest rates and raising asset prices. The Federal Reserve has not been alone in implementing unconventional monetary policies. The Bank of England has also engaged in substantial asset purchases and recently introduced explicit forward guidance for its policy rate. The Bank of Japan, a pioneer in the use of unconventional policy, has recently embarked on an ambitious substantially extended its liquidity provision by offering unlimited longer-term refinancing operations. The ECB also purchased some securities in distressed markets, and recently indicated that it expects interest rates to remain low for an extended period. Thus, since the end of the crisis, central banks in the advanced economies have adopted similar policies to promote recovery and price stability. While a great deal of attention has focused on unconventional policy actions, especially asset purchases, these policies appear to affect financial conditions and the real economy in much the same way as conventional interest rate policy. Indeed, recent research suggests that adjustments in policy rates and unconventional policies have similar cross-border effects on asset prices and economic outcomes. If that is so, then the overall stance of policy accommodation matters more here than the particular form of easing. Moreover, neither conventional nor unconventional monetary policy actions are shocks that come out of the blue. Instead, they are the policies undertaken by central banks to offset the adverse shocks that have restrained our economies. Thus, any spillovers from monetary policy actions must be evaluated against the consequences of failing to respond to these adverse shocks. In a world of global trade and integrated capital markets, it is natural for economic and financial shocks and policy actions to be transmitted across borders. Spillovers from advanced-economy monetary policies are to be expected. In theory, when advanced economies ease monetary policy in response to a contractionary shock, their interest rates will decline, prompting investors to rebalance their portfolios toward higher-yielding assets. Some of this rebalancing will occur domestically, but some investment will also move abroad, resulting in capital flows to EMEs. In response, EME currencies should tend to appreciate against those of the advanced economies, and EME asset prices should rise. Conversely, a tightening of advanced economy monetary policy in response to a stronger economy should lead these movements to reverse; that is, tightening should reduce capital flows to EMEs and diminish upward pressure on EME currencies and asset prices. Are these basic relationships apparent in the data? The left side of chart 1 shows an index of EME local-currency sovereign bond yields along with a roughly similar maturity U.S. Treasury yield. The line on the right is the differential between the two, plotted against net inflows of private capital to a selection of EMEs, shown by the bars. If interest rates were the main driver of capital flows, these two series ought to move in a similar fashion. At times, this is indeed the case: From mid-2009 to early 2011, the interest rate differential and EME capital inflows rose together. But the overall relationship is not particularly tight. In early 2007, capital flows to EMEs were quite strong even with a low interest rate differential. And in mid-2011, capital inflows stepped down even as the interest rate differential remained elevated. As I will discuss in a moment, the lack of a tight relationship between capital flows and interest rates suggests that other factors also have been important. Even though interest-rate differentials and capital inflows do not always move in the same direction, numerous empirical studies have shown that interest rates do in fact help explain capital flows once other determinants of these flows are also taken into account. In particular, when U.S. rates decline relative to those in EMEs, private capital flows to EMEs tend to rise, consistent with investors rebalancing toward higher-yielding assets. In a similar vein, event studies have shown that the Federal Reserve's policy announcements, including those related to asset purchases, have been associated with capital flows to EMEs as well as upward movements in EME currencies and asset prices. But the role of monetary policy in driving capital flows and the effects of those flows on EMEs should not be overstated. In this regard, I will offer two considerations. First, many factors affect capital flows to EMEs, not just the stance of advanced economy monetary policy. Differences in growth prospects across countries and the associated differences in expected investment returns are important factors. shows the growth rate of real GDP for EMEs and advanced economies. Given their stage of development and demographic profile, EMEs should grow faster than advanced economies on a trend basis. As shown by the line in the right panel, EME growth has, in fact, consistently outpaced that of the advanced economies. In addition, the bounceback of the EMEs from the global financial crisis widened this differential even more, although the gap has diminished more recently as growth in the EMEs has slowed. Moreover, investing in EMEs has become more attractive as many EMEs have improved their macroeconomic policies and institutional frameworks over recent decades; growth differentials may partly be reflecting these improvements. As is evident in the right-hand chart, the relationship between the growth differential and capital inflows to EMEs seems to be quite strong. In particular, the rise in capital flows following the global financial crisis coincided with stronger relative growth performance in EMEs. And in 2011, capital inflows diminished along with the growth differential. Another key driver of EME capital flows is global attitude toward risk. Swings in sentiment between "risk-on" and "risk-off" have led investors to reposition across asset classes, resulting in corresponding movements in capital flows. Indeed, as shown in chart 3, the most common measure of uncertainty and the market price of volatility--the VIX--is strongly correlated with net inflows into EMEs. Although the causes of movements in global risk sentiment are uncertain, the ebb and flow of potential crises and policy responses, such as we experienced during the European crisis, are clearly important. Of course, movements in risk sentiment may not be fully independent of monetary policy. An interesting line of research has begun to consider how changes in monetary policy itself may affect risk sentiment. For example, some studies indicate that an easing of U.S. monetary policy tends to lower volatility (as measured by the VIX), increase leverage of financial intermediaries, and boost EME capital inflows and currencies. A second point to bear in mind when assessing monetary policy spillovers is that expansionary policies in the advanced economies are not beggar-thy-neighbor; in other words, they do not undermine exports from EMEs. In recent decades, some EMEs have successfully pursued an export-led growth strategy, and policymakers in those economies have sometimes expressed concern that their exports will be unduly restrained as accommodative policies in the advanced economies lead their currencies to appreciate. However, as shown in chart 4, although EME currencies bounced back from their lows during the global financial crisis--when global investors fled from assets they perceived to be risky--for many EMEs real exchange rates have moved sideways or have even declined over the past two years. Some of this weakness may reflect the foreign exchange market intervention and capital controls that policymakers used to staunch the rise in their currencies. But even if advanced economy monetary policies were to put upward pressure on EME currencies, the consequent drag on their exports must be weighed against the positive effects of stronger demand in the advanced economies. According to simulations of the Federal Reserve Board's econometric models of the global economy, these two effects roughly offset each other, suggesting that accommodative monetary policies in the advanced economies have not reduced output and exports in the EMEs. Indeed, this view seems to be supported by recent experience, as the U.S. current account balance has remained fairly stable since the end of the global financial crisis. Over the longer run, advanced economy policy actions that strengthen global growth and global trade will benefit the EMEs as well. A particularly important consideration regarding spillovers from accommodative monetary policies in the advanced economies is the extent to which such policies contribute to financial stability risks in the EMEs. Because many EMEs have financial sectors that are relatively small, large capital inflows may foster asset price bubbles and a too-rapid expansion of credit. These are serious concerns, irrespective of the relative importance of monetary policies in the advanced economies in driving these flows. While the picture is a mixed one and some markets show signs of froth, indicators of financial stability do not seem to show widespread imbalances. For example, EME equity prices, shown in chart 5, plunged during the global financial crisis, rebounded thereafter, but then generally flattened out or even declined. There are exceptions, of course, such as Indonesia, whose stock market soared until earlier this year. But in aggregate, EME stock prices remain below their pre-crisis peak, whereas the S&P 500 is well above its own pre-crisis peak. Chart 6 portrays the rise in credit to the domestic nonfinancial private sector as a share of GDP from its pre-crisis level. For some EMEs, the rise in credit does not seem out of line with historical trends, but some economies have experienced potentially worrisome increases. Credit growth in China is particularly noteworthy, but this does not seem to be the result of accommodative monetary policies in the advanced economies. Much of the rise took place in the aftermath of the crisis, in large part reflecting policy- driven stimulus to support economic recovery. In addition, China's relatively closed capital account limits the extent to which domestic credit conditions are influenced by developments abroad, including changes in advanced economy monetary policy. Increases in credit in some other economies, notably Brazil, have also been driven to a significant degree by policy actions to support aggregate demand. And, of course, EMEs have policy tools to limit the expansion of credit. Another area of potential concern is excessive valuations in property markets. Chart 7 displays inflation-adjusted house prices for several Asian economies. The most striking increases have occurred in Hong Kong, which, through its open capital account and essentially fixed exchange rate, is tied most directly to U.S. financial conditions. Of course, the degree of Hong Kong's exposure to U.S. financial conditions is a policy choice, and other factors have also contributed to the run-up in its property prices. House prices have also resumed their rise in China. But, as with credit growth, this rise seems to reflect domestic developments as opposed to spillovers from global financial conditions. In light of these potential financial stability concerns, it is encouraging that EME policymakers have devoted substantial effort since the Asian financial crisis of the late 1990s to bolster the resilience of their banking systems. Banks in many EMEs have robust earnings and solid capital buffers. Compared with past experience, emerging market banking systems also generally enjoy improved management and a proactive approach by authorities to mitigate risks. Nevertheless, in an environment of volatile global markets, regulators should guard against the buildup of vulnerabilities, such as excessive dependence on wholesale and external funding, declining asset quality, and foreign currency mismatches. To summarize my discussion so far, EMEs clearly face challenges from volatile capital flows and the attendant moves in asset prices. Accommodative monetary policies in the advanced economies have likely contributed to some of these flow and price pressures, and may also have contributed to the buildup of some financial vulnerabilities in certain emerging markets. That said, other factors appear to have been even more important. Moreover, expansionary monetary policies in the advanced economies have supported global growth to the benefit of advanced and emerging economies alike. Turning to the risks and policy challenges going forward, much attention has focused on potential effects in EMEs when recovery prompts the United States and other advanced economies to begin the gradual process of returning policy to a normal stance. As events over the summer demonstrated, even the discussion of such a policy shift may be accompanied by considerable volatility. substantially as market participants reassessed the future course of U.S. monetary policy. In response, EME bond and equity funds experienced very large outflows, as shown by the bars. EME yields rose as well, in some cases by more than those on Treasury securities, and many EME currencies depreciated. The magnitude of these market responses may have been amplified by the carry-trade strategies that many investors had in place; these strategies were designed to take advantage of interest rate differentials and appeared profitable as long as EME interest rate differentials remained wide and EME exchange rates remained stable or were expected to appreciate. When anticipations of Fed tapering led to higher U.S. interest rates and higher market volatility, these trades may have been quickly unwound, engendering particularly sharp declines in EME exchange rates and asset prices. These developments, however, do not appear to have been driven solely by perceptions of U.S. monetary policy. As I noted earlier, GDP growth in many EMEs has fallen from the pace of previous years, which may have led investors to rethink their investment choices. Additionally, it appears that the retreat from emerging markets reflected a change in global risk sentiment, as investors focused on vulnerabilities in EMEs following a period of complacency. Asset prices have fallen considerably more in economies with large current account deficits, high inflation, and fiscal problems than in countries with stronger fundamentals. For example, as shown in chart 9, changes in EME exchange rates and interest rates since April have been correlated with current account deficits. In general, economies with larger current account deficits experienced greater depreciations of their currencies and larger increases in their bond yields. Thus, while a reassessment of U.S. monetary policy may have triggered the recent retrenchment from EMEs, investor concerns about underlying vulnerabilities appear to have amplified the reaction. Whatever their source, large capital outflows from EMEs can pose challenges for EME policymakers by simultaneously producing significant currency depreciation, asset price deflation, and inflationary pressures. In such cases, EME central banks are in the difficult position of judging whether to tighten policy at the same time that demand is weakening. It is notable that some central banks with stronger records on price stability have been able to avoid tightening whereas others have been forced to raise rates to defend price stability in the face of domestic weakness. Monetary policy in the United States is likely to remain highly accommodative for some time, as our economy fights to overcome the remaining headwinds from the global financial crisis. As our economic recovery continues, however, the time will come to gradually reduce the pace of asset purchases and eventually bring those purchases to a stop. The timing of this moderation in the pace of purchases is necessarily uncertain, as it depends on the evolution of the economy. While moderating the pace of purchases and the eventual increase in the federal funds rate may well affect capital flows, interest rates and asset prices in EMEs, the overall macroeconomic effects need not be disruptive. First, tightening will in all likelihood occur in the context of a more firmly established economic recovery in the United States so that any adverse effects on EME financial conditions should be buffered by the beneficial effects of higher external demand. Second, although conditions vary from country to country, on the whole, EMEs exhibit greater resilience than they did in prior decades, reflecting, among other factors, more flexible exchange rates, greater stocks of international reserves, stronger fiscal positions, and better regulated and more conservatively managed banking systems. EMEs have policy tools to help manage any negative externalities that may arise, and recent developments provide additional rationale for them to redouble their efforts to bolster their resiliency. Reducing vulnerabilities, improving policy frameworks, and safeguarding the financial sector will go a long way toward making EMEs more robust to a wide range of shocks, not just those that may arise from changes in monetary policy in the advanced economies. Global investors should also learn from the experience of this summer, when it became clear that unwinding leveraged carry trades can be difficult in an environment of lower liquidity. As for advanced economies, policymakers should move gradually to restore normal policies only as their economic recoveries are more firmly established, consistent with their mandates. In addition, policymakers should communicate as clearly as possible about their policy aims and intentions in order to limit the odds of policy surprises and a consequent sharp adjustment in financial markets in response. Indeed, my colleagues on the FOMC and I are committed to just such an approach. In closing, the Federal Reserve's mandate, like those of other central banks, is focused on the pursuit of domestic policy objectives. This focus is entirely appropriate. Yet, experience has shown that the fortunes of the U.S. economy are deeply intertwined with those of the rest of the world. Economic prospects for the United States are importantly influenced by the course of the world economy, and, by the same token, prosperity around the globe depends to a significant extent on a strong U.S. economy. In order for the Federal Reserve to fulfill its dual mandate of price stability and maximum employment, we must take account of these international linkages. Indeed, the Federal Reserve has a long and varied history of doing so, including our actions during the global financial crisis. There is every reason to expect that to continue. Thank you. I'll be happy to take a few questions or comments. , vol. 60 Journal of Journal of , vol. 88 . . Structure Modeling at the Zero Lower Bound conference held at the Federal

r131107a_FOMC

united states

The Fire-Sales Problem and Securities Financing Transactions

stein

Thank you. I thought I would focus my remarks today on one piece of the shadow banking system, namely the market for securities financing transactions (SFTs). In so doing, I want to call attention to the fire-sales problem associated with SFTs, and consider potential policy remedies. I will do so in three parts. First, I will briefly discuss the welfare economics of fire sales. That is, I will try to make clear when a forced sale of an asset is not just an event that leads to prices being driven below long-run fundamental values, but also one that involves a market failure, or externality, of the sort that might justify a regulatory response. Second, I will argue that securities financing transactions are a leading example of the kind of arrangement that can give rise to such externalities, and hence are particularly deserving of policy attention. And third, I will survey some of the recently enhanced tools in our regulatory arsenal (e.g., capital, liquidity, and leverage requirements) and ask to what extent they are suited to tackling the specific externalities associated with fire sales and SFTs. To preview, a general theme is that while many of these tools are likely to be helpful in fortifying individual regulated institutions--in reducing the probability that, say, a given bank or broker-dealer will run into solvency or liquidity problems--they fall short as a comprehensive, marketwide approach to the fire-sales problem associated with SFTs. In this regard, some of what I have to say will echo a recent speech by my Board fire sale is essentially a forced sale of an asset at a dislocated price. The asset sale is forced in the sense that the seller cannot pay creditors without selling assets....Assets sold in fire sales can trade at prices far below value in best use, causing severe losses to Shleifer and Vishny go on to discuss the roles of investor specialization and limited arbitrage as factors that drive the magnitude of observed price discounts in fire sales, and there is, by now, a large body of empirical research that supports the importance of these factors. However, by itself, the existence of substantial price discounts in distressed sales speaks only to the positive economics of fire sales, not the normative economics, and hence is not sufficient to make a case for regulatory intervention. To see why, consider the following example: An airline buys a 737, and finances the purchase largely with collateralized borrowing. During an industry downturn, the airline finds itself in distress, and is forced to sell the 737 to avoid defaulting on its debt. Other airlines also are not faring well at this time, and are not interested in expanding their fleets. So the only two bidders for the 737 are a movie star, who plans to reconfigure it for his personal use, and a private-equity firm, which plans to lease out the plane temporarily and wait for the market to recover so the firm can resell it at a profit. In the end, the private-equity firm winds up buying the plane at half its original price. Two years later, it does indeed resell it, having earned a 60 percent return. This is clearly a fire sale in the positive-economics sense, but is there a market failure here that calls for regulation? Intuition suggests not. The airline arguably caused the fire sale by using a lot of leverage in its purchase of the 737, but it also seems to bear most of the cost, by being forced to liquidate at a large loss. The movie star and the private-equity firm are, if anything, made better off by the appearance of a buying opportunity, and there are no other innocent bystanders. So the airline's ex ante capital structure choice would seem to internalize things properly; the fire sale here is just like any other bankruptcy cost that a firm has to weigh in choosing the right mix of debt and equity. For a fire sale to have the sort of welfare effects that create a role for regulation, the reduced price in the fire sale has to hurt somebody other than the original party making the leverage decision, and this adverse impact of price has to run through something like a collateral constraint, whereby a lowered price actually reduces, rather than increases, the third party's demand for the asset. So if hedge fund A buys an asset- backed security and finances it largely with collateralized borrowing, A's fire selling of the security will create an externality in the conventional sense only if the reduced price and impaired collateral value lower the ability of hedge funds B and C to borrow against the same security, and therefore force them to involuntarily liquidate their positions in it as well. The market failure in this case is not simply the fact that this downward spiral causes a large price decline, it is that when hedge fund A makes its initial leverage choice, it does not take into account the potential harm--in the form of tightened financing constraints--that this may cause to hedge funds B and C. Another key point is that the fire-sales problem is not necessarily caused by a lack of appropriate conservatism on the part of whoever lends to hedge fund A in this example--let's call it dealer firm D. By lending on an overnight basis to A, and with an appropriate haircut, D can virtually assure itself of being able to terminate its loan and get out whole by forcing a sale of the underlying collateral. So D's interests may be very well-protected here. But precisely in the pursuit of this protection, A and D have set up a financing arrangement that serves them well, but that creates a negative spillover onto other market participants, like B and C. It follows that even if policies aimed at curbing too-big-to-fail (TBTF) problems are entirely successful in aligning D's interests with those of taxpayers, this is not sufficient to deal with fire-sales externalities. They are a fundamentally different problem, and one that arises even absent any individually systemic institutions or any TBTF issues. The preceding discussion makes clear why SFTs, such as those done via repurchase (repo) agreements, are a natural object of concern for policymakers. This market is one where a large number of borrowers finance the same securities on a short- term collateralized basis, with very high leverage--often in the range of twenty-to-one, fifty-to-one, or even higher. Hence, there is a strong potential for any one borrower's distress--and the associated downward pressure on prices--to cause a tightening of collateral or regulatory constraints on other borrowers. I won't go into much detail about the institutional aspects of SFTs and the repo market. Instead, I will just lay out two stylized examples of SFTs that I can then use to illustrate the properties of various regulatory tools. In this first example, a large broker-dealer firm borrows in the triparty repo market-- from, say, a money market fund--in order to finance its own holdings of a particular security. Perhaps the broker-dealer is acting as a market-maker in the corporate bond market, and uses repo borrowing to finance its ongoing inventory of investment-grade and high-yield bonds. In this case, the asset on the dealer's balance sheet is the corporate bond, and the liability is the repo borrowing from the money fund. In this second example, the ultimate demand to own the corporate bond comes not from the dealer firm, but from one of its prime brokerage customers--say, a hedge fund. Moreover, the hedge fund cannot borrow directly from the money market fund sector in the triparty repo market, because the money funds are not sufficiently knowledgeable about the hedge fund to be comfortable taking it on as a counterparty. So instead, the hedge fund borrows on a collateralized basis from the dealer firm in the bilateral repo market, and the dealer then turns around and, as before, uses the same collateral to borrow from a money fund in the triparty market. In this case, the asset on the dealer's balance sheet is the repo loan it makes to the hedge fund. Clearly, there is the potential for fire-sale risk in both of these examples. One source of risk would be an initial shock either to the expected value of the underlying collateral or to its volatility that leads to an increase in required repo-market haircuts (e.g., the default probability of the corporate bond goes up). Another source of risk would be concerns about the creditworthiness of the broker-dealer firm that causes lenders in the triparty market to step away from it. In either case, if the associated externalities are deemed to create significant social costs, the goal of regulatory policy should be to get private actors to internalize these costs. At an abstract level, this means looking for a way to impose an appropriate Pigouvian (i.e., corrective) tax on the transactions. Of course, the tax must balance the social costs against the benefits that accompany SFTs; these benefits include both "money-like" services from the increased stock of near-riskless private assets, as well as enhanced liquidity in the market for the underlying collateral--the corporate bond market, in my examples. So in the absence of further work on calibrating costs and benefits, there is no presumption that the optimal tax should be large, only that it may be non-zero, and that it may make sense for it to differ across asset classes. With this last observation in mind, my next step is to run through a number of our existing regulatory instruments, and in each case ask: to what extent can the instrument at hand be used efficiently to impose a Pigouvian tax on an SFT, either one of the dealer-as- principal type or one of the dealer-as-intermediary type? As will become clear, the answer can depend crucially on both the structure of the transaction as well as the nature of the underlying collateral involved. Also, I should emphasize that nothing in this exercise amounts to a judgment on the overall desirability of any given regulatory tool. Obviously, even if risk-based capital requirements are not particularly helpful in taxing SFTs, they can be very valuable for other reasons. I am asking a different question: to what extent can the existing toolkit be used--or be adapted--to deal with the specific problem of fire-sale externalities in SFTs? 1. Risk-based capital requirements Current risk-based capital requirements are of little relevance for many types of SFTs. In my Example 1, where the dealer firm holds a corporate bond as a principal and finances it with repo borrowing, there would be a capital charge on the corporate bond, but this capital charge is approximately independent of whether the corporate bond is financed with repo or with some other, more stable, form of funding. So there is no tax on the incremental fire-sale risk created by the more fragile funding structure. In Example 2, in which the dealer is an intermediary with a matched book of repo borrowing and lending, there is, in principle, a capital requirement on its asset-side repo loan to the hedge fund. However, the Basel III risk-based capital rules allow banks and bank holding companies to use internal models to compute this capital charge for repo lending, and the resulting numbers are typically very small--for all practical purposes, close to zero--for overcollateralized lending transactions, with repo being the canonical example. I'm not arguing that the very low risk-based charges on repo lending in Basel III are "wrong" in any microprudential sense. After all, they are designed to solve a different problem--that of ensuring bank solvency. And if a bank holding company's broker-dealer sub makes a repo loan of short maturity that is sufficiently well- collateralized, it may be at minimal risk of bearing any losses--precisely because it operates on the premise that it can dump the collateral and get out of town before things get too ugly. The risk-averse lenders in the triparty market--who, in turn, provide financing to the dealer--operate under the same premise. As I noted earlier, these defensive reactions by providers of repo finance mean that the costs of fire sales are likely to be felt elsewhere in the financial system. Liquidity requirements, such as those embodied in the Basel III Liquidity Coverage Ratio (LCR), can impose a meaningful tax on certain SFTs in which the dealer acts as a principal. If the dealer holds a corporate bond and finances it with repo borrowing of less than 30 days' maturity, the LCR kicks in and requires the dealer to hold high-quality liquid assets (HQLA) against the risk that it is unable to roll the repo over. In this particular case, there can be said to be a direct form of regulatory attack on the fire-sales problem. However, this conclusion is sensitive to the details of the example. If, instead of holding a corporate bond, the dealer holds a Treasury security that is deemed to count as Level 1 HQLA, there is no impact of the LCR. Moreover, the LCR plays no role in mitigating fire-sales externalities in the important matched-book case in which the dealer acts as an intermediary. If a dealer borrows on a collateralized basis with repo and then turns around and lends the proceeds to a hedge fund in a similar fashion, the LCR deems the dealer to have no net liquidity exposure--and hence imposes no incremental liquidity requirement--so long as the lending side of the transaction has a maturity of less than 30 days. The implicit logic is that as long as the dealer can generate the necessary cash by not rolling over its loan to the hedge fund, it will always be able to handle any outflows of funding that come from being unable to roll over its own borrowing. This logic is not incorrect per se, but it is very micro-focused in nature, and does not attend to fire-sales externalities. It worries about the ability of the dealer firm to survive a liquidity stress event, but does not take into account that the dealer's survival may come at the cost of forcing its hedge fund client to engage in fire sales. If a broker-dealer firm faces a binding leverage ratio, this constraint can act as a significant tax on two types of SFTs that are largely untouched either by risk-based capital requirements or by liquidity regulations. The first is when the dealer, acting as a principal, uses repo to finance its holdings of Treasury securities or agency mortgage- backed securities, assets that generally have only modest risk weights when held as trading positions. The second is when the dealer acts as an intermediary and has a matched repo book. In both cases, the SFTs blow up the firm's balance sheet and, hence, the denominator of the leverage ratio, even while having little impact on risk-based capital or LCR calculations. The crucial issue here, however, is whether the leverage ratio does, in fact, bind. A traditional view among regulators has been that the leverage ratio should be calibrated so as to serve as a meaningful "backstop" for risk-based capital requirements, but that under ordinary circumstances it should not actually be the binding constraint on firms. For if it were to bind, this would put us in a regime of completely un-risk-weighted capital requirements, where the effective capital charge for holding short-term Treasury securities would be the same as that for holding, say, risky corporate debt securities or loans. Recently, U.S. regulators have issued a proposed rulemaking that seeks to raise the Basel III supplementary leverage ratio requirement to 5 percent for the largest U.S. bank holding companies, and to 6 percent for their affiliated depository institutions. While this increase might be considered a parallel shift that preserves the backstop philosophy in light of the fact that risk-based requirements have also gone up significantly, it does increase the likelihood that the leverage ratio may bind for some of these firms at some times--particularly for those firms with a broker-dealer-intensive business model in which the ratio of total assets to risk-weighted assets tends to be higher. In this event, there would indeed be a significant tax on SFTs undertaken in the affected firms. However, because it is unlikely that the leverage constraint would bind symmetrically across all of the largest firms, my guess is that the effect would be less to deter SFT activity in the aggregate than to cause it to migrate in such a way as to be predominantly located in those firms that--because they have, say, a larger lending business and, hence, more risk-weighted assets--have more headroom under the leverage ratio constraint. To summarize the discussion thus far, the mainstays of our existing regulatory toolkit--risk-based capital, liquidity, and leverage requirements--have a variety of other virtues, but none seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by SFTs. The liquidity coverage ratio affects a subset of SFTs in which a dealer firm acts as a principal to fund its own inventory of securities positions, but does not meaningfully touch those in which it acts as an intermediary. By contrast, an aggressively calibrated leverage ratio could potentially impose a significant tax on a wider range of SFTs, but the tax would by its nature be blunt and highly asymmetric, falling entirely on those firms for whom the leverage ratio constraint was more binding than the risk-based capital constraint. As such, it would be more likely to induce regulatory arbitrage than to rein in overall SFT activity. These observations raise the question of whether there are other tools that might be better suited to dealing with SFT-related fire-sales externalities. I will touch briefly on three of these. Capital surcharges In his May speech, Governor Tarullo alluded to the possibility of liquidity-linked capital surcharges that would effectively augment the existing regime of risk-based capital requirements. Depending on how these surcharges are structured, they could act in part as a tax on both the dealer-as-principal and dealer-as-intermediary types of SFTs. Accomplishing the latter would require a capital surcharge based on something like the aggregate size of the dealer's matched repo book; this comes quite close to the Pigouvian notion of directly taxing this specific activity. As compared to relying on the leverage ratio to implement the tax, this approach has the advantage that it is more likely to treat institutions uniformly: the tax on SFTs would not be a function of the overall business model of a given firm, but rather just the characteristics of its SFT book. This is because the surcharge is embedded into the existing risk-based capital regime, which should in principle be the constraint that binds for most firms. There are a couple of important qualifications, however. First, going this route would involve a significant conceptual departure from the notion of capital as a prudential requirement at the firm level. As noted previously, a large matched repo book may entail relatively little solvency or liquidity risk for the broker-dealer firm that intermediates this market. So, to the extent that one imposes a capital surcharge on the broker-dealer, one would be doing so with the express intention of creating a tax that is passed on to the downstream borrower (i.e., to the hedge fund, in my example). Second, and a direct corollary of the first, imposing the tax at the level of the intermediary naturally raises the question of disintermediation. In other words, might the SFT market respond to the tax by evolving so that large hedge funds are more readily able to borrow via repo directly from money market funds and securities lenders, without having to go through broker-dealers? I can't say that I have a good understanding of the institutional factors that might facilitate or impede such an evolution. But if the market ultimately does evolve in this way, it would be hard to argue that the underlying fire-sales problem has been addressed. Modified liquidity regulation A conceptually similar way to get at matched-book repo would be to modify liquidity regulation so as to introduce an asymmetry between the assumed liquidity properties of repo loans made by a broker-dealer, and its own repo borrowing. For example, in the context of the Net Stable Funding Ratio (NSFR), one could assume that a dealer's repo loans to a hedge fund roll off more slowly than do its own repo borrowings from the triparty market. This assumption would create a net liquidity exposure for a matched repo book, and would thereby force the dealer to hold some long-term debt or other stable funding against it. Although the implementation is different, the end result is quite close to that obtained with the capital-surcharge approach I just described: in one case, there is a broad stable funding requirement for intermediaries against a matched repo book; in the other case, there is an equity requirement. It follows that, whatever its other advantages, going the modified-NSFR route does not eliminate concerns about disintermediation and regulatory arbitrage. Universal margin requirements These sorts of regulatory-arbitrage concerns have motivated some academics and policymakers to think about a system of universal margin requirements for SFTs. In its simplest form, the idea would be to impose a minimum haircut, or down payment requirement, on any party--be it a hedge fund or a broker-dealer--that uses short-term collateralized funding to finance its securities holdings. Because the requirement now lives at the security level, rather than at the level of an intermediary in the SFT market, it cannot be as easily evaded by, say, a hedge fund going outside the broker-dealer sector to obtain its repo funding. This is the strong conceptual appeal of universal margin from the perspective of a fire-sales framework. In this regard, it is worth noting that the Financial Stability Board (FSB) has recently released a proposal to establish minimum haircut requirements for certain However, the FSB proposal stops well short of being a universal margin requirement. Rather, the minimum haircuts envisioned by the FSB would apply only to SFTs in which entities not subject to capital and liquidity regulation (e.g., hedge funds) receive financing from entities that are subject to regulation (i.e., banks and broker- dealers), and only to transactions in which the collateral is something other than government or agency securities. In this sense, there is a close relationship between the FSB minimum-haircut proposal and the specific variant of the capital-surcharge idea that I mentioned a moment ago. Both have the potential to act as a restraint on those SFTs that are intermediated by regulated broker-dealer firms, but both are vulnerable to an evolution of the business away from this intermediated mode. The minimum margin levels in the FSB proposal are also quite small, so it is unclear how much of an effect, if any, they will have on market behavior. For example, the minimums for long-term corporate bonds, securitized products, and equities are 2 percent, 4 percent, and 4 percent, respectively. Let me wrap up. My aim here has been to survey the landscape--to give a sense of the possible tools that can be used to address the fire-sales problem in SFTs--without making any particularly pointed recommendations. I would guess that a sensible path forward might involve drawing on some mix of the latter set of instruments that I discussed: namely, capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements. As we go down this path, conceptual purity may have to be sacrificed in some places to deliver pragmatic and institutionally feasible results. It is unlikely that we will find singular and completely satisfactory fixes. With this observation in mind, I would be remiss if I did not remind you of another, highly complementary area where reform is necessary: the money market fund sector. Money funds are among the most significant repo lenders to broker-dealer firms, and an important source of fire-sale risk comes from the fragility of the current money fund model. This fragility stems in part from their capital structures--the fact that they issue stable-value demandable liabilities with no capital buffer or other explicit loss- absorption capacity--which make them highly vulnerable to runs by their depositors. I welcome the work of the Securities and Exchange Commission on this front, particularly its focus on floating net asset values, and look forward to concrete action. Another source of fragility arises from money funds investing in repo loans collateralized by assets that they are unwilling or unable to hold if things go bad. This feature creates an incentive for them to withdraw repo financing from broker-dealers at the first sign of counterparty risk, even if the underlying collateral is in good shape. In closing, I just want to acknowledge how much my own thinking about these complicated issues has benefited from the work of so many of you on the program at this conference. I look forward to continuing the conversation. Thank you.

r131108a_FOMC

united states

The Crisis as a Classic Financial Panic

bernanke

I am very pleased to participate in this event in honor of Stanley Fischer. Stan was my teacher in graduate school, and he has been both a role model and a frequent adviser ever since. An expert on financial crises, Stan has written prolifically on the subject and has also served on the front lines, so to speak--notably, in his role as the first deputy managing director of the International Monetary Fund during the emerging market crises of the 1990s. Stan also helped to fight hyperinflation in Israel in the 1980s and, as the governor of that nation's central bank, deftly managed monetary policy to mitigate the effects of the recent crisis on the Israeli economy. Subsequently, as Israeli housing prices ran upward, Stan became an advocate and early adopter of macroprudential policies to preserve financial stability. Stan frequently counseled his students to take a historical perspective, which is good advice in general, but particularly helpful for understanding financial crises, which have been around a very long time. Indeed, as I have noted elsewhere, I think the recent global crisis is best understood as a classic financial panic transposed into the novel institutional context of the 21st century financial system. An appreciation of the parallels between recent and historical events greatly influenced how I and many of my colleagues around the world responded to the crisis. Besides being the fifth anniversary of the most intense phase of the recent crisis, this year also marks the centennial of the founding of the Federal Reserve. particularly appropriate to recall, therefore, that the Federal Reserve was itself created in response to a severe financial panic, the Panic of 1907. This panic led to the creation of the National Monetary Commission, whose 1911 report was a major impetus to the 1913. Because the Panic of 1907 fit the archetype of a classic financial panic in many ways, it's worth discussing its similarities and differences with the recent crisis. Like many other financial panics, including the most recent one, the Panic of 1907 took place while the economy was weakening; according to the National Bureau of Economic Research, a recession had begun in May 1907. Also, as was characteristic of pre-Federal Reserve panics, money markets were tight when the panic struck in October, reflecting the strong seasonal demand for credit associated with the harvesting and shipment of crops. The immediate trigger of the panic was a failed effort by a group of speculators to corner the stock of the United Copper Company. The main perpetrators of the failed scheme, F. Augustus Heinze and C.F. Morse, had extensive connections with a number of leading financial institutions in New York City. When the news of the failed speculation broke, depositor fears about the health of those institutions led to a series of runs on banks, including a bank at which Heinze served as president. To try to restore confidence, the New York Clearinghouse, a private consortium of banks, reviewed the books of the banks under pressure, declared them solvent, and offered conditional support--one of the conditions being that Heinze and his board step down. These steps were largely successful in stopping runs on the New York banks. But even as the banks stabilized, concerns intensified about the financial health of a number of so-called trust companies--financial institutions that were less heavily regulated than national or state banks and which were not members of the Clearinghouse. As the runs on the trust companies worsened, the companies needed cash to meet the demand for withdrawals. In the absence of a central bank, New York's leading financiers, led by J.P. Morgan, considered providing liquidity. However, Morgan and his colleagues decided that they did not have sufficient information to judge the solvency of the affected institutions, so they declined to lend. Overwhelmed by a run, the Knickerbocker Trust Company failed on October 22, undermining public confidence in the remaining trust companies. To satisfy their depositors' demands for cash, the trust companies began to sell or liquidate assets, including loans made to finance stock purchases. The selloff of shares and other assets, in what today we would call a fire sale, precipitated a sharp decline in the stock market and widespread disruptions in other financial markets. Increasingly concerned, Morgan and other financiers (including the future governor of the Federal the provision of liquidity through the Clearinghouse and the imposition of temporary limits on depositor withdrawals, including withdrawals by correspondent banks in the interior of the country. These efforts eventually calmed the panic. By then, however, the U.S. financial system had been severely disrupted, and the economy contracted through the middle of 1908. The recent crisis echoed many aspects of the 1907 panic. Like most crises, the recent episode had an identifiable trigger--in this case, the growing realization by market participants that subprime mortgages and certain other credits were seriously deficient in their underwriting and disclosures. As the economy slowed and housing prices declined, diverse financial institutions, including many of the largest and most internationally active firms, suffered credit losses that were clearly large but also hard for outsiders to assess. Pervasive uncertainty about the size and incidence of losses in turn led to sharp withdrawals of short-term funding from a wide range of institutions; these funding pressures precipitated fire sales, which contributed to sharp declines in asset prices and further losses. Institutional changes over the past century were reflected in differences in the types of funding that ran: In 1907, in the absence of deposit insurance, retail deposits were much more prone to run, whereas in 2008, most withdrawals were of uninsured wholesale funding, in the form of commercial paper, repurchase agreements, and securities lending. Interestingly, a steep decline in interbank lending, a form of wholesale funding, was important in both episodes. Also interesting is that the 1907 panic involved institutions--the trust companies--that faced relatively less regulation, which probably contributed to their rapid growth in the years leading up to the panic. In analogous fashion, in the recent crisis, much of the panic occurred outside the perimeter of traditional bank regulation, in the so-called shadow banking sector. The responses to the panics of 1907 and 2008 also provide instructive comparisons. In both cases, the provision of liquidity in the early stages was crucial. In 1907 the United States had no central bank, so the availability of liquidity depended on the discretion of firms and private individuals, like Morgan. In the more recent crisis, the Federal Reserve fulfilled the role of liquidity provider, consistent with the classic prescriptions of Walter Bagehot. The Fed lent not only to banks, but, seeking to stem the panic in wholesale funding markets, it also extended its lender-of-last-resort facilities to support nonbank institutions, such as investment banks and money market funds, and key financial markets, such as those for commercial paper and asset-backed securities. In both episodes, though, liquidity provision was only the first step. Full stabilization requires the restoration of public confidence. Three basic tools for restoring confidence are temporary public or private guarantees, measures to strengthen financial institutions' balance sheets, and public disclosure of the conditions of financial firms. At least to some extent, Morgan and the New York Clearinghouse used these tools in 1907, giving assistance to troubled firms and providing assurances to the public about the conditions of individual banks. All three tools were used extensively in the recent crisis: (FDIC) guarantees of bank debt, the Treasury Department's guarantee of money market funds, and the private guarantees offered by stronger firms that acquired weaker ones. Public and private capital injections strengthened bank balance sheets. Finally, the bank stress tests that the Federal Reserve led in the spring of 2009 and the publication of the stress-test findings helped restore confidence in the U.S. banking system. Collectively, these measures helped end the acute phase of the financial crisis, although, five years later, the economic consequences are still with us. Once the fire is out, public attention turns to the question of how to better fireproof the system. Here, the context and the responses differed between 1907 and the recent crisis. As I mentioned, following the 1907 crisis, reform efforts led to the founding of the Federal Reserve, which was charged both with helping to prevent panics and, by providing an "elastic currency," with smoothing seasonal interest rate fluctuations. In contrast, reforms since 2008 have focused on critical regulatory gaps revealed by the crisis. Notably, oversight of the shadow banking system is being strengthened through the designation, by the new Financial Stability Oversight Council, of nonbank systemically important financial institutions (SIFIs) for consolidated supervision by the Federal Reserve, and measures are being undertaken to address the potential instability of wholesale funding, including reforms to money market funds and the triparty repo market. As we try to make the financial system safer, we must inevitably confront the problem of moral hazard. The actions taken by central banks and other authorities to stabilize a panic in the short run can work against stability in the long run, if investors and firms infer from those actions that they will never bear the full consequences of excessive risk-taking. As Stan Fischer reminded us following the international crises of the late 1990s, the problem of moral hazard has no perfect solution, but steps can be taken to limit it. First, regulatory and supervisory reforms, such as higher capital and liquidity standards or restriction on certain activities, can directly limit risk-taking. Second, through the use of appropriate carrots and sticks, regulators can enlist the private sector in monitoring risk-taking. For example, the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) process, the descendant of the bank stress tests of 2009, requires not only that large financial institutions have sufficient capital to weather extreme shocks, but also that they demonstrate that their internal risk-management systems are effective. In addition, the results of the stress-test portion of CCAR are publicly disclosed, providing investors and analysts information they need to assess banks' financial strength. Of course, market discipline can only limit moral hazard to the extent that debt and equity holders believe that, in the event of distress, they will bear costs. In the crisis, the absence of an adequate resolution process for dealing with a failing SIFI left policymakers with only the terrible choices of a bailout or allowing a potentially destabilizing collapse. The Dodd-Frank Act, under the orderly liquidation authority in Title II, created an alternative resolution mechanism for SIFIs that takes into account both the need, for moral hazard reasons, to impose costs on the creditors of failing firms and the need to protect financial stability; the FDIC, with the cooperation of the Federal Reserve, has been hard at work fleshing out this authority. A credible resolution mechanism for systemically important firms will be important for reducing uncertainty, enhancing market discipline, and reducing moral hazard. Our continuing challenge is to make financial crises far less likely and, if they happen, far less costly. The task is complicated by the reality that every financial panic has its own unique features that depend on a particular historical context and the details of the institutional setting. But, as Stan Fischer has done with unusual skill throughout his career, one can, by stripping away the idiosyncratic aspects of individual crises, hope to reveal the common elements. In 1907, no one had ever heard of an asset-backed security, and a single private individual could command the resources needed to bail out the banking system; and yet, fundamentally, the Panic of 1907 and the Panic of 2008 were instances of the same phenomenon, as I have discussed today. The challenge for policymakers is to identify and isolate the common factors of crises, thereby allowing us to prevent crises when possible and to respond effectively when not.

r131113a_FOMC

united states

Teaching and Learning about the Federal Reserve

bernanke

Thank you for that introduction. Tonight marks the third time in just a little over three years that the Federal Reserve System has hosted a teacher town hall, and I am very pleased to have this opportunity to speak with educators, both those of you here in Washington, D.C., and those watching at Reserve Bank gatherings around the country. I look forward to your questions in a few moments. But let me begin by briefly discussing an important milestone for the Federal Reserve--its centennial--and the opportunity that this occasion affords to teach and learn about the Fed's origins, history, and role, and about how this institution has helped shape the nation's economy and financial system. approaches, we have several reasons to look back at an eventful century. One important reason is to better understand what historical experience can teach us about how best to respond to current challenges. For example, as many of you know, the bold measures the Fed took in response to the recent financial crisis reflected in part its determination to avoid repeating the sorts of mistakes it made before and during the Great Depression of the 1930s. Similarly, our commitment to safeguarding price stability is reinforced by memories of the costs of high inflation during the 1970s and the Federal Reserve's subsequent restoration of price stability under Chairman Volcker during the 1980s. Beyond the insights that the study of the Federal Reserve's first 100 years offer to economists, historians, and policymakers about how the Fed can best meet its objectives today and in the future, a second reason to mark the centennial is the opportunity it affords to educate young people about the Federal Reserve and its important role in promoting a healthy economy and stable financial system. When I was an educator, I quickly came to understand that students are most motivated to learn when they can see the connection of the lesson to their own lives. The Fed and its activities, and economics in general, can seem remote from daily concerns. But as teachers, you can show students how the Federal Reserve's decisions concretely affect them and their families. The Fed's actions influence the overall strength and stability of the economy, as you know, but they also affect the cost of a mortgage, the prices of goods and services, and the health of the job market that your students are part of or will soon be entering. Economics also complements and enriches the study of history. When I took history classes in high school, we spent much of our time memorizing dates and important events--revolutions, wars, elections, the passage of laws, and so on. While I appreciated the need to be familiar with such milestones, I remember feeling that I would like to know more about the lives of ordinary people at those times, not just about kings and queens and presidents. In college and graduate school, I studied economic history and found what I was looking for. For me, economic history added critical context by zooming in on the conditions of ordinary life--how people earned their livings, what their wages would buy, the extent to which they felt economically secure, the pace of economic change that they faced. Appreciating what the lives of ordinary people were like at various times and places helped explain the larger events--the wars, revolutions, and elections--as well. By the same token, understanding history also requires an appreciation of the role of key economic institutions, including central banks like the Federal Reserve. When I was in graduate school, my teacher, Stanley Fischer, introduced me to the work of Milton Friedman and Anna Schwartz, which demonstrated that monetary policy can have enormous effects on how the economy performs, for good or for ill. That realization helped motivate me to specialize, in graduate school and after, in monetary economics and related fields. Similarly, for your students, it's impossible to understand the Great Depression, America's strong economic performance after World War II, or the recent financial crisis without learning about the Federal Reserve and the debates that have surrounded it. Learning about the Federal Reserve and about economics more generally will help students in their daily lives, by helping them make better financial or career decisions, for example, and by helping them become more informed citizens and voters. Learning about the Federal Reserve and its economic context will also give students a deeper understanding of history, as I noted. Yet there is one more reason why we at the Fed hope to use this centennial as an educational opportunity--to maintain and strengthen the democratic accountability and effectiveness of this institution. Traditionally, like other central banks, the Fed was reluctant to explain its policy decisions or otherwise engage with the public, partly based on a belief that this approach increased the effectiveness of monetary policy. However, this lack of openness became increasingly out of step with other institutions in our democratic society; it also reduced the effectiveness of Fed policies by inhibiting public understanding and discussion of policy goals and strategies. This approach began to change in the 1990s, when the Federal Reserve began to regularly provide more information about how it saw the economic situation and how it would respond. Increasing the Fed's transparency, openness, and accountability has been one of my top priorities as Chairman. A more open Fed, in my view, is both a more effective and more democratically legitimate institution. Indeed, the complex challenges we face as a nation are best addressed in an environment of informed public discourse, which is only possible when policy decisions are made in as transparent a way as possible. The centennial may be just an accident of the calendar, but any time is a good time to help more people learn about the Fed and what it does to enhance the economic well-being of Americans. It is often said--alas, accurately--that teaching is a thankless profession, so let me close by thanking you for what you give to your students. Our country and our economy need informed citizens who can think independently and critically. More pertinent to today's meeting, let me also thank you for your interest in teaching your students about the history and role of the Federal Reserve. As many of you have discovered, the Federal Reserve has a variety of classroom tools available through our education portal, staff is introducing today a set of three lesson plans that examine the past 100 years of central banking. I hope they will provide practical help in your classes. Thank you for participating in today's event. I look forward to your questions and to an interesting discussion of the Federal Reserve's past, present, and future.

r131114a_FOMC

united states

40th Anniversary of the Annual Conference of the Union of Arab Banks

bernanke

Good morning. I am pleased to address the Annual Conference of the Union of Arab Banks (UAB) as it celebrates 40 years of success representing the interests of the Arab banking and financial communities. The UAB may justifiably take great pride in its many accomplishments during the past four decades. Among other achievements, the UAB has emerged as a key international and regional participant in developing policies that promote financial stability, economic integration, and sustainable development and prosperity. The UAB has also been a champion of sharing best practices and training among regulators and bankers. The partnership that has developed between the Federal Reserve and the UAB may be counted among these successes. Ten years ago, the Federal Reserve helped establish--with the support of many of the countries represented at this conference--the Yoghourtdjian of the Federal Reserve Board, who is attending with you today, was asked to lead this initiative, whose aim has been to provide technical assistance and bank supervision training to central banks and bank supervisory authorities. Now in its 10th and final year, the Financial Regulators' Initiative has sponsored more than 40 training programs and conferences throughout the MENA region, and it has provided many short- term, on-the-job training opportunities for MENA regulators with U.S. banking agencies. We are grateful to the UAB for its many contributions to the success of this initiative. In addition to celebrating accomplishments, anniversaries also provide a time for reflection and self-assessment. Governments, central bankers, financial regulators, and the banking industry still labor today in the long shadow cast by the global financial crisis. Against that backdrop, financial regulators around the world are engaged in a historic and sweeping renovation of the global financial structure. One of the most important goals is to ensure that banks hold more and higher- quality capital, and have sufficient liquid assets on hand, to be able to survive a market shock or severe economic downturn. In addition, we must push banking organizations of all sizes to ensure their compensation practices link pay to performance and do not encourage excessive risk-taking. Past and current crises underscore an additional lesson. Then as now, international or regional financial crises require a coordinated response to safeguard the stability of the world's financial system. To that end, the UAB can play an important regional role by facilitating efforts to address potential cross-border issues, and by providing a local platform for strong cooperation between home and host supervisors during normal and crisis periods. At your conference this week, I anticipate you will discuss the opportunities and challenges that lay ahead for your members. Among the topics, no doubt, will be the prospects for partnership between the public and private sectors, the importance of establishing institutions capable of managing crises, the effects of new regulatory and supervisory structures on the banking industry, and the role of the banking sector in promoting economic growth. We at the Federal Reserve face similar challenges and opportunities, and we look forward to working with you to find common approaches and solutions. I wish you a successful and productive conference. Warm congratulations on your 40th anniversary, and best wishes for another 40 years of success.

r131119a_FOMC

united states

Communication and Monetary Policy

bernanke

Nearly eight years ago, when I began my time as Chairman, one of my priorities was to make the Federal Reserve more transparent--and, in particular, to make monetary policy as transparent and open as reasonably possible. I believed then, as I do today, that transparency in monetary policy enhances public understanding and confidence, promotes informed discussion of policy options, increases the accountability of monetary policymakers for reaching their mandated objectives, and ultimately makes policy more effective by tightening the linkage between monetary policy, financial conditions, and the real economy. Of course, responding to the financial crisis and its aftermath soon became the Federal Reserve's main focus. As it has turned out, however, following the stabilization of the financial system, supporting our economy's recovery from the deepest recession since the Great Depression has required a more prominent role for communication and transparency in monetary policy than ever before. In my remarks, I will discuss how the Federal Reserve's communications have evolved in recent years and how enhanced transparency is increasing the effectiveness of monetary policy. Despite the challenges inherent in communicating in an unprecedented economic and policy environment about a future that can be only imperfectly foreseen, I will explain why I believe that policy transparency remains an essential element of the Federal Reserve's strategy for meeting its economic objectives. To understand the critical role that the Federal Reserve's communications about monetary policy has played in recent years, it is useful to start by discussing the role of monetary policy communication more generally, including the relationship between policy communication and the broader policy framework. Making monetary policy is sometimes compared to driving a car, with policymakers pressing on the accelerator or the brakes, depending on whether the economy needs to be sped up or slowed down at that moment. That analogy is imperfect, however, for at least two reasons. First, the main effects of monetary policy actions on the economy are not felt immediately but instead play out over quarters or even years. Hence, unlike the driver of a car, monetary policymakers cannot simply respond to what lies immediately in front of them but must try to look well ahead--admittedly, a difficult task. Second, the effects of monetary policy on the economy today depend importantly not only on current policy actions, but also on the public's expectations of how policy will evolve. The automotive analogy clearly breaks down here, for it is as if the current speed of the car depended on what the car itself expects the driver to do in the future. The public's expectations about future monetary policy actions matter today because those expectations have important effects on current financial conditions, which in turn affect output, employment, and inflation over time. For example, because investors can choose freely between holding a longer-term security or rolling over a sequence of short-term securities, longer-term interest rates today are closely linked to market participants' expectations of how short-term rates will evolve. If monetary policymakers are expected to keep short-term interest rates low, then current longer-term interest rates are likely to be low as well, all else being equal. In short, for monetary policy, expectations matter. Indeed, expectations matter so much that a central bank may be able to help make policy more effective by working to shape those expectations. Experience demonstrates that a useful approach to managing expectations--one that dovetails well with basic principles of transparency--involves policymakers stating clear objectives as well as their plans for attaining those objectives. For example, over the past two decades, many central banks have introduced explicit numerical targets for inflation. Supplemented by regular publication of the central bank's economic forecasts and provisional plans for achieving its objective in the medium term, numerical inflation goals have helped increase the transparency and predictability of policy in a number of economies. Federal Reserve's objectives and policy strategy. Because of its dual mandate from the Congress, which specifies both maximum employment and price stability as policy objectives, the Federal Reserve could not adopt a numerical inflation target as its exclusive goal. Nor would it have been appropriate for the FOMC simply to provide a fixed objective for some measure of employment or unemployment, in parallel with an inflation objective. In contrast to inflation, which is determined by monetary policy in the longer run, the maximum level of employment that can be sustained over the longer run is determined primarily by nonmonetary factors, such as demographics, the mix of workforce skills, labor market institutions, and advances in technology. Moreover, as these factors evolve, the maximum employment level may change over time. Consequently, it is beyond the power of the central bank to set a longer-run target for employment that is immutable or independent of the underlying structure of the economy. The approach on which the FOMC agreed is described in its statement of longer- run goals and policy strategy, issued in January 2012 and reaffirmed in January of this year. The statement begins by affirming the FOMC's commitment to meeting both of its statutory objectives. It then indicates that, in the context of the FOMC's dual mandate, the Committee sees price stability as corresponding to a 2 percent longer-term inflation goal. On the employment side of the mandate, the Committee makes its best assessment of the maximum level of employment at any given time, recognizing that such assessments are necessarily uncertain and subject to revision. In practice, the Committee often expresses its employment objective in terms of the longer-run normal rate of unemployment. Currently, FOMC participants' estimates of the longer-run normal unemployment rate, as publicly reported in the quarterly Summary of Economic As I noted, explicit objectives are most useful when accompanied by provisional plans for achieving them. Many central banks supplement their announced objectives with published forecasts that, implicitly or explicitly, lay out plans for achieving their goals. Although the size and diversity of the Federal Reserve's policymaking committee has made achieving a single consensus forecast difficult, the quarterly Summary of Economic Projections reports each FOMC participant's view of the most likely future paths of inflation, unemployment, and output growth, conditional on that individual's view of appropriate monetary policy. In recent years, this survey has also included participants' projections of the path of future short-term interest rates they see as most likely to achieve the Committee's goals. In general, the Committee's two objectives of maximum employment and price stability are complementary. When they are not, the FOMC has stated that it will pursue a balanced approach in the pursuit of its dual mandate, working to ensure that both inflation and employment are close to their desired values in the longer term. In short, the Federal Reserve, like many central banks around the world, has made significant progress in recent years in clarifying its goals and policy approach, and in providing regular information about the future path of policy that it views as most likely to attain its objectives. This increased transparency about the framework of policy has aided the public in forming policy expectations, reduced uncertainty, and made policy more effective. The financial crisis and its aftermath, however, have raised even greater challenges for, and demands on, the Federal Reserve's communication. We have had to contend with the persistent effects of the seizing-up of the financial system, the collapse of housing prices and construction, new financial shocks in Europe and elsewhere, restrictive fiscal policies at all levels of government, and, of course, the enormous blows to output and employment associated with the worst U.S. recession since the Great Depression. Moreover, for the first time since the FOMC began using the federal funds rate as its policy interest rate, that rate is effectively at zero and thus cannot be lowered meaningfully further. Consequently, to provide needed support to the economic recovery and minimize the risk of deflation, the Federal Reserve has had to adopt new policy tools, which bring their own communication challenges. In the remainder of my talk, I will discuss how the Federal Reserve has used communication to try to further inform the public's expectations about how the FOMC will employ what are currently its two principal policy tools: its plans regarding its short-term policy interest rate and its large- scale purchases of securities. As the economy weakened over 2008, the FOMC repeatedly cut its target for the federal funds rate, its short-term policy rate. In December of that year, the target for the funds rate was reduced to a range of zero to 1/4 percent, and money market rates declined nearly to zero. Thus, using the standard means of further easing monetary policy--cutting the target interest rate--was no longer possible. The so-called zero lower bound on the FOMC's policy interest rate was not the only challenge the Committee faced. First, the depth of the recession, combined with ongoing concerns about the functioning of the financial system, raised significant uncertainties about both the likely pace of recovery and the effectiveness of monetary policy in supporting growth. The recoveries from most post-World War II U.S. recessions had been relatively rapid, with production, unemployment, and other key variables returning to close to normal levels within six to eight quarters. In such cases, the policy horizon most relevant to financial markets might be the next several quarters. In the aftermath of the recent crisis, however, the Committee had to consider the possibility that a highly accommodative policy might be required for a number of years. Second, a federal funds rate effectively at zero created an important asymmetry for policy planning. On the one hand, if the economy were to recover rapidly and inflation were to increase, monetary policymakers would be able to respond in the normal way, by raising the federal funds rate. But, on the other hand, if the economy were to remain weak or recover only gradually--the case we actually faced--the FOMC would not be able to cut the funds rate further. Moreover, in the latter case, the economy could face an increased risk of deflation--falling prices. As the case of Japan illustrates, deflation may impede economic growth while being very difficult to escape. To try to preempt such outcomes, a strong case existed for monetary policy to be more accommodative than suggested by standard policy rules calibrated to normal times. So the Committee faced a situation in which more monetary policy accommodation was needed, and possibly for quite a long time--yet its basic policy tool, the federal funds rate target, had been pushed to its limit. To put the Committee's problem another way, standard policy rules and a range of other analyses implied that, to achieve the FOMC's objectives, the target for the federal funds rate should be set well below zero, which, of course, was not feasible. Fortunately, as I discussed earlier, the degree of accommodation provided by monetary policy depends not just on the current value of the policy rate, but on public expectations of future settings of that rate. The Committee accordingly realized that it could ease policy further--and reduce uncertainty about future policy--by assuring the public and markets that it intended to keep the policy rate low for some time, and for a longer period than the public initially expected. At first, the Committee employed purely qualitative language to send this message: After the FOMC stated in December 2008 that it would likely be appropriate for the federal funds rate to remain near zero for "some time," it changed the formulation However, such language did not convey very precisely the Committee's intentions. In August 2011, the Committee introduced a specific date into its guidance, stating that conditions would likely warrant keeping the federal funds rate target near zero at least through mid-2013. This date-based guidance was more precise than the qualitative language the Committee had been using, and it appears to have been effective in communicating the FOMC's commitment to a highly accommodative policy. In particular, following the introduction of dates into the FOMC statement, interest rates and survey measures of policy expectations moved in ways broadly consistent with the guidance. Although the date-based forward guidance appears to have affected the public's expectations as desired, it did not explain how future policy would be affected by changes in the economic outlook--an important limitation. Indeed, the date in the guidance was pushed out twice in 2012--first to late 2014 and then to mid-2015--leaving the public unsure about whether and under what circumstances further changes to the guidance might occur. In December of last year, the FOMC addressed this issue by tying its forward guidance about its policy rate more directly to its economic objectives. Introducing so-called state-contingent guidance, the Committee announced for the first time that no increase in the federal funds rate target should be anticipated so long as unemployment remained above 6-1/2 percent and inflation and inflation expectations remained stable and near target. This formulation provided greater clarity about the factors influencing the Committee's thinking about future policy and how that thinking might change as the outlook changed. As my colleagues and I have frequently emphasized, the conditions stated in this guidance are thresholds, not triggers. Crossing one of the thresholds will not automatically give rise to an increase in the federal funds rate target; instead, it will signal only that it is appropriate for the Committee to begin considering whether an increase in the target is warranted. This threshold formulation helps explain why the Committee was willing to express the guidance bearing on the labor market in terms of the unemployment rate alone, instead of following its usual practice of considering a broad range of labor market indicators. In the judgment of the Committee, the unemployment rate--which, despite some drawbacks in this regard, is probably the best single summary indicator of the state of the labor market--is sufficient for defining the threshold given by the guidance. However, after the unemployment threshold is crossed, many other indicators become relevant to a comprehensive judgment of the health of the labor market, including such measures as payroll employment, labor force participation, and the rates of hiring and separation. In particular, even after unemployment drops below 6- 1/2 percent, and so long as inflation remains well behaved, the Committee can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate. Because of the severity of the recession and the disruptions in financial markets, and because short-term interest rates were near the zero lower bound, it became clear early on that more monetary accommodation would be needed than could be provided through the management of short-term rates alone, even with guidance that those rates would be kept low well into the future. Accordingly, at about the same time that the FOMC reduced its target for the federal funds rate close to zero, it began supplementing its rate policies and forward rate guidance with large-scale asset purchases (LSAPs)-- specifically, open market purchases of longer-term U.S. Treasury securities and securities issued by the government-sponsored enterprises, primarily mortgage-backed securities Both LSAPs and forward guidance for the federal funds rate support the economy by putting downward pressure on longer-term interest rates, but they affect longer-term rates through somewhat different channels. To understand the difference, it is useful to decompose longer-term interest rates into two components: One reflects the expected path of short-term interest rates, and the other is called a term premium. The term premium is the extra return that investors require to be willing to hold a longer-term security to maturity compared with the expected yield from rolling over short-term securities for the same period. As I have noted, forward rate guidance affects longer-term interest rates primarily by influencing investors' expectations of future short-term interest rates. LSAPs, in contrast, most directly affect term premiums. As the Federal Reserve buys a larger share of the outstanding stock of longer-term securities, the quantity of these securities available for private-sector portfolios declines. As the securities purchased by the Fed become scarcer, they should become more valuable. Consequently, their yields should fall as investors demand a smaller term premium for holding them. This argument depends importantly on the assumption that the longer-term Treasury and MBS securities that the Fed buys are not perfectly substitutable with other types of assets, an assumption that seems well supported in practice. As both forward rate guidance and LSAPs affect longer-term interest rates, the use of these tools allows monetary policy to be effective even when short-term interest rates are close to zero. However, the Committee does not view these two tools as entirely equivalent. One reason is that we have much less experience with policies designed to operate on term premiums, as LSAPs do. As a result, though a strong majority of FOMC members believes that both the forward rate guidance and the LSAPs are helping to support the recovery, we are somewhat less certain about the magnitudes of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed's balance sheet. Moreover, economists do not have as good an understanding as we would like of the factors determining term premiums; indeed, as we saw earlier this year, hard-to-predict shifts in term premiums can be a source of significant volatility in interest rates and financial conditions. LSAPs have other drawbacks not associated with forward rate guidance, including the risk of impairing the functioning of securities markets and the extra complexities for the Fed of operating with a much larger balance sheet, although I see both of these issues as manageable. In deciding to employ LSAPs, the FOMC has accordingly remained attentive to the possible costs and risks as well as to the efficacy of this less familiar tool, a point the Committee has regularly noted in its post-meeting statements. Of course, elevated unemployment, below-target inflation, lingering economic fragility, and the harmful effects of long-term unemployment on our society and economic potential also pose significant costs and risks, and the Committee has, thus far, judged that the balance favors the use of LSAPs. Between November 2008 and June 2012, the FOMC announced or extended a series of asset purchase programs, in each case specifying the expected quantities of assets to be acquired under the program. Like the use of date-based forward guidance, announcing a program of predetermined size and duration has advantages and disadvantages. On the one hand, a fixed program size is straightforward to communicate; on the other hand, a program of fixed size cannot so easily adapt to changes in the economic outlook and the consequent changes in the need for policy accommodation. In announcing its fixed-size programs, the FOMC did state a general willingness to do more if needed--and, indeed, it has followed through on that promise--but such statements left considerable uncertainty regarding the conditions that might warrant changes in an existing program or the introduction of a new one. In a step roughly analogous to the shift from date-based guidance to the contingent, thresholds-based guidance now in use for the federal funds rate target, in September 2012 the FOMC announced a program of asset purchases in which the total size of the purchase program would not be fixed in advance but instead would be linked to the Committee's economic objectives. In particular, the Committee initiated purchases of agency MBS at the rate of $40 billion per month and stated its intention to continue purchases until the outlook for the labor market improved substantially in a context of price stability. In December 2012, when a program to extend the maturity of the Fed's portfolio of Treasury securities came to an end, the FOMC added purchases of $45 billion per month in longer-term Treasury securities to the new program, bringing the monthly purchase rate to $85 billion, where it remains today. As I noted, the Committee set a criterion of substantial improvement in the outlook for the labor market as the condition for ending the new purchase program. The Committee also signaled its expectation that it would end the purchases and return to an emphasis on rates policy and forward guidance before it had fully attained its dual mandate objectives, stating that "the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." The reason for this sequencing choice, again, was the greater uncertainty about the costs and efficacy of LSAPs, relative to the more familiar tool of managing the current short-term interest rate and, through forward guidance, expectations of future short-term interest rates. Moreover, to the extent that the use of LSAPs engenders additional costs and risks, one might expect the tradeoff between the efficacy and costs of this tool to become less favorable as the Federal Reserve's balance sheet expands. Having seen progress in the labor market since the beginning of the latest asset purchase program in September 2012, the Committee agreed in June of this year to provide more-comprehensive guidance about the criteria that would inform future decisions about the program. Consequently, in my press conference following the June FOMC meeting, I presented a framework linking the program more explicitly to the evolution of the FOMC's economic outlook. In particular, I noted the Committee's expectation at the time that improvements in the job market would continue, supported by a moderate pickup in growth that would support those gains. The Committee additionally expected that inflation would be moving back toward its 2 percent objective over time. If the incoming data were broadly consistent with that outlook, the Committee would likely begin measured reductions in the pace of asset purchases later in 2013. If the economy evolved as anticipated, the end of purchases would occur around midyear 2014. I also emphasized that the path of purchases would depend on incoming data and could be slower or faster than envisioned in the modal scenario--indeed, I noted that the pace of purchases could be increased for a time, if warranted. The framework I discussed in June implied that substantial additional asset purchases over the subsequent quarters were likely, with even more purchases possible if economic developments proved disappointing. However, following the June meeting and press conference, market yields moved sharply higher. For example, between the FOMC meetings of June and September, the 10-year Treasury yield rose about 3/4 percentage point and rates on MBS increased by a similar amount. Financial market movements are often difficult to account for, even after the fact, but three main reasons seem to explain the rise in interest rates over the summer. First, improvements in the economic outlook warranted somewhat higher yields--a natural and healthy development. Second, some of the rise in rates reportedly reflected an unwinding of levered positions--positions that appear to have been premised on an essentially indefinite continuation of asset purchases--together with some knock-on liquidations of other positions in response to investor losses and the rise in volatility. Although it brought with it some tightening of financial conditions, this unwinding and the associated rise in term premiums may have had the benefit of reducing future risks to financial stability and, in particular, of lowering the probability of an even sharper market correction at some later point. Third, market participants may have taken the communication in June as indicating a general lessening of the Committee's commitment to maintain a highly accommodative stance of policy in pursuit of its objectives. In particular, it appeared that the FOMC's forward guidance for the federal funds rate had become less effective after June, with market participants pulling forward the time at which they expected the Committee to start raising rates, in a manner inconsistent with the guidance. To the extent that this third factor--a perceived reduction in the Fed's commitment to meeting its objectives--contributed to the increase in yields, it was neither welcome nor warranted, in the judgment of the FOMC. This change in expectations did not correspond to any actual lessening in the FOMC's commitment or intention to provide the high degree of monetary accommodation needed to meet its objectives, as Committee participants emphasized in subsequent communications. At its September 2013 meeting, the FOMC applied the framework communicated in June. The Committee's decision at that meeting to maintain the pace of asset purchases was appropriate and fully consistent with the earlier guidance. The Committee was looking for evidence that job market gains would continue, supported by a pickup in growth. As it happened, the implications for the outlook of the evidence reviewed at the September meeting were mixed at best, while the ongoing fiscal debates posed additional risks. The Committee accordingly elected to await further evidence supporting its expectation of continued improvement in the labor market. decision came as a surprise to some market participants, it appears to have strengthened the credibility of the Committee's forward rate guidance; in particular, following the decision, longer-term rates fell and expectations of short-term rates derived from financial market prices showed, and continue to show, a pattern more consistent with the guidance. In coming meetings, in evaluating the outlook for the labor market, we will continue to consider both the cumulative progress since September 2012 and the prospect for continued gains. We have seen meaningful improvement in the labor market since the latest asset purchase program was announced in September 2012. At the time, the latest reading on the unemployment rate was 8.1 percent, and both we and most private- sector economists were projecting only slow reductions in unemployment in the coming quarters. Recent reports on payroll employment had also been somewhat disappointing. However, since the program was announced, the unemployment rate has fallen 0.8 percentage point, and about 2.6 million payroll jobs have been added. Looking forward, we will of course continue to monitor the incoming data. As reflected in the latest Summary of Economic Projections and the October FOMC statement, the FOMC still expects that labor market conditions will continue to improve and that inflation will move toward the 2 percent objective over the medium term. If these views are supported by incoming information, the FOMC will likely begin to moderate the pace of purchases. However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook. As before, the Committee will also continue to take into account its assessment of the likely efficacy and costs of the program. When, ultimately, asset purchases do slow, it will likely be because the economy has progressed sufficiently for the Committee to rely more heavily on its rate policies, the associated forward guidance, and its substantial continued holdings of securities to maintain progress toward maximum employment and to achieve price stability. particular, the target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end, perhaps well after the unemployment threshold is crossed and at least until the preponderance of the data supports the beginning of the removal of policy accommodation. I began my time as Chairman with the goal of increasing the transparency of the Federal Reserve, and of monetary policy in particular. In response to a financial crisis and a deep recession, the Fed's monetary policy communications have proved far more important and have evolved in different ways than I would have envisioned eight years ago. The economy has made significant progress since the depths of the recession. However, we are still far from where we would like to be, and, consequently, it may be some time before monetary policy returns to more normal settings. I agree with the sentiment, expressed by my colleague Janet Yellen at her testimony last week, that the surest path to a more normal approach to monetary policy is to do all we can today to promote a more robust recovery. The FOMC remains committed to maintaining highly accommodative policies for as long as they are needed. Communication about policy is likely to remain a central element of the Federal Reserve's efforts to achieve its policy goals. , transcript, June 19, , no. 1, , vol. 32

r131121a_FOMC

united states

OTC Market Infrastructure Reform: Opportunities and Challenges

powell

The financial crisis revealed important weaknesses in many areas of our financial system. In response, governments around the world have undertaken a variety of far- reaching regulatory reforms that, I would argue, can be grouped into three categories: those intended to strengthen institutions; those aimed at strengthening financial markets; and those that take steps to reinforce and, in some cases, build new market infrastructures. The reform effort seeks to address each of these areas in a comprehensive manner that recognizes the interplay among them. For instance, enhanced capital and liquidity regulations will strengthen the ability of financial institutions to withstand both credit losses and liquidity shocks. Stronger financial institutions, along with enhanced risk management and supervision, will strengthen market infrastructures. And new rules to improve the functioning of markets, such as those that require greater transparency of over-the-counter (OTC) derivatives markets through trade repositories and swap execution facilities, will strengthen financial institutions and infrastructures alike. Moreover, greater post-trade transparency will improve competition and make it easier for market participants to make informed choices about which OTC derivatives are best suited to their needs. Today I will focus on the third aspect of this effort--reforms intended to strengthen financial market infrastructures. Specifically, I will look at measures to improve the clearing of OTC derivatives through the expanded use of central counterparties (CCPs) and the introduction of margin requirements for those OTC derivatives that remain bilateral. In the United States, several agencies are working together to implement these reforms. The Commodity Futures Trading Commission establishing the regulatory regime for and supervising CCPs as well as determining which swaps must be centrally cleared. The Federal Reserve and six other agencies are responsible for establishing margin requirements for derivatives that are not cleared through a CCP. The Federal Reserve shares with the other members of the Financial from a broader financial stability perspective. The Fed also plays a role in supervising financial market utilities that are designated as systemically important under Title VIII of The financial crisis involved significant failures in the functioning, regulation, and supervision of OTC derivatives markets. These failures were well illustrated by the widespread and destabilizing effects of large losses by American International Group (AIG) on its OTC structured finance and credit derivative positions. In the absence of government intervention, AIG's failure would have exposed its counterparties to significant losses at a time of widespread financial stress. Further, the lack of transparency in OTC derivatives markets at that time led to a wave of uncertainty about who was exposed to AIG and the extent of that exposure. This fundamental lack of information fueled concerns about potential losses and drove a cycle of escalating pressure on large financial institutions around the globe. Government intervention was deemed necessary to stop this cycle and contain the threat to the financial system. AIG's failure revealed systemic problems in the OTC derivatives market that went well beyond the failure of a single market participant. The Group of Twenty governments responded by committing that all standardized derivatives would be moved to central clearing and that derivatives that are not centrally cleared would be subject to margin requirements. Progress has been made on both of these fronts. Since credit default swaps clearing was introduced in 2009, the notional value of cleared credit derivatives has grown to more than $6 trillion. The notional value of interest rate swaps that are centrally cleared has more than doubled since 2009 and now stands at more than $400 trillion. These amounts will surely increase further in the coming years. And international standards on margin requirements for derivatives that are not centrally cleared have recently been finalized. I would like to briefly discuss how these reform efforts are intended to reduce systemic risks and offer my views on how to ensure that they are effectively implemented. By design, central clearing offers important advantages over a bilateral market structure in which no participant can know the full extent of its counterparties' risk exposures. The hub-and-spoke structure of central clearing enables the netting of gains and losses across multiple market participants, which has the potential to significantly reduce each participant's aggregate counterparty risk exposure. Central clearing can also improve transparency, which is important in reducing incentives for market participants to pull away from other institutions in times of stress. Rather than trying to assess its exposure to all of its trading partners, a market participant would need to manage only its exposure to the central counterparty. And CCPs can also reduce risk by imposing more effective risk controls on clearing members. Since their origins in the 19th century, CCPs have evolved significantly, and that evolution has allowed them to survive and continue functioning through many crises, including the most recent one. Of course, the other side of this coin is that concentrating risk in a central counterparty could create a single point of failure for the entire system. Given their heightened prominence in the financial infrastructure, if CCPs are to mitigate systemic risks they must hold themselves to--and be held to--the highest standards of risk management. In many respects, CCPs are the collective reflection of the financial institutions that are their members and the markets that they support. The credit and liquidity risks borne by a CCP arise from the clearing activities of its members. Those risks materialize when a clearing member defaults. Most of the financial resources to cover risk exposures will come from a CCP's members. And a member's default will require the CCP to work with surviving members in the context of prevailing market conditions. CCPs play a critical role in ensuring a robust risk management regime that fully takes account of this interplay among markets, institutions, and infrastructure. Regulators, clearing members, and their clients also must be engaged in making sure CCPs are safe and effective at managing the risks, interactions, and interdependencies inherent in the clearing process. I will now turn to some key aspects of the regulatory framework for CCPs that will strengthen the financial system and help reduce systemic risk. There are three key dimensions to making the reform program work in practice: enhancing supervision and regulation of CCPs, strengthening CCP risk management and governance, and promoting the stability of clearing members. The decision to require central clearing of standardized derivatives as a foundation for reform has raised the stakes for CCPs, clearing members, regulators, and the general public. At the international level, financial regulatory authorities addressed this challenge by updating, harmonizing, and strengthening the minimum risk management standards applied to financial market infrastructures, including CCPs. The new Principles for Financial Market Infrastructures, commonly referred to as the PFMIs, set a higher bar for risk management to strengthen these core market infrastructures and promote financial stability. Just last week, the CFTC finalized its adoption of the PFMIs for the derivatives clearing organizations it regulates and supervises. The PFMIs require that a CCP develop strategies to cover its losses and continue operating in a time of widespread financial stress. In particular, the PFMIs require that a CCP maintain financial resources sufficient to cover its current and potential future exposures to each participant fully with a high degree of confidence. CCPs must maintain additional resources to cover the failure of the clearing member with the largest exposure under extreme but plausible market conditions. In the case of CCPs with more complex risk profiles or those that are systemically important in multiple jurisdictions, the CCP must have adequate resources to handle the failure of the two clearing members with the largest exposures. Finally, the PFMIs require a CCP to identify scenarios that may potentially prevent it from being able to continue operations, including so-called end-of-default waterfall issues, and develop detailed plans for recovery or orderly wind- down. Regulators and industry groups are working to establish minimum expectations for CCP transparency of both qualitative and quantitative information that will allow key stakeholders to assess a CCP's risk management. This international strategy for strengthening CCPs has been complemented by several domestic initiatives to introduce regulatory frameworks for OTC derivatives and to enhance supervision of systemically important CCPs. The two most notable developments are the passage of the European Market Infrastructure Regulation and Dodd-Frank, notably titles VII and VIII. Both laws establish a framework for reporting, regulating, and clearing OTC derivatives transactions; call for international coordination; and emphasize enhanced risk management standards for CCPs. Differences of implementation have emerged, however, and it will be important to engage with other governments to ensure that such differences do not lead to regulatory arbitrage or weakened standards. The two primary risks facing a CCP are credit risk (the potential for the CCP to incur losses after it closes out a defaulter's positions) and liquidity risk (the possibility that a CCP will not have sufficient cash on hand to meet its payment obligations in a timely manner). While credit risk and liquidity risk are interrelated, they are also distinct and need to be measured and managed separately. To promote sound credit risk management, the PFMIs require that a CCP collect variation margin from its members to limit the buildup of current exposures. In addition, CCPs must also calculate and collect initial margin sufficient to cover potential changes in the value of each participant's position between the last collection of variation margin and the final closeout of a participant's position should it default to the CCP. This process involves modeling potential price movements with an appropriate confidence threshold, determining the closeout period in the event the participant defaults, and numerous other factors. Given the complexity of this modeling, it is important that CCPs rigorously back-test and stress-test the adequacy of their margin models under a wide range of extreme yet plausible scenarios. More broadly, a CCP should test the sufficiency of its total financial resources--initial margin, default funds and capital--to cover potential credit losses, taking into account evolving market volatility and liquidity conditions. An important lesson from the financial crisis is that liquidity is extremely important in ensuring ongoing viability and resilience during a period of financial stress. No amount of resources can guarantee that a CCP will be able to meet its payment and settlement obligations, unless those resources can be converted to cash with certainty and within a very short time frame. CCP liquidity is especially important, since a failure to meet required payment obligations could undermine market confidence at precisely the moment when it is most fragile and trigger run-like behavior as financial institutions seek to reduce their exposure to the CCP and its members. To measure and manage its liquidity risks, the PFMIs require a CCP to have effective methodologies to estimate its funding exposures under a variety of stressed conditions, to identify available cash resources, and to establish mechanisms for converting its noncash collateral to cash. The need to assure adequate liquidity presents a number of challenges. CCPs will need to mobilize cash within a matter of hours on the day of a large clearing member's default. Cash balances on deposit at a bank can be quickly accessed, but CCPs often put their cash resources in overnight investments to earn a return. The nature and mechanics of such investments, as well as prevailing market conditions, can critically affect the ability of a CCP to unwind those investments quickly enough to meet its cash needs. A similar challenge will arise with the need to convert noncash collateral, such as initial margin collateral, to cash. The PFMIs require CCPs to have in place prearranged and highly reliable funding sources to address this need. Managing credit and liquidity risks requires effective governance. One important aspect of CCP governance is a commitment to transparency. Clearing members bear primary responsibility for understanding the risks associated with participating in a CCP, including their potential exposures in the event of a default. This will require the CCP to provide relevant and even firm-specific information to facilitate the members' analysis. Clearing members and their clients, regulators, and the broader public require transparency so that they can assess the adequacy of a CCP's risk management and its overall risk profile. So far, I have focused on CCPs. Now I would like to turn to the critical role played by clearing members of those CCPs. A CCP ultimately draws its strength and resilience from that of its members. And it is not a one-way street, since strong CCPs enable clearing members and their clients to significantly reduce their exposure to counterparty credit risk. Effective risk management by both a CCP and its clearing members need to work in concert. As a general matter, enhanced capital and liquidity requirements have substantially improved the overall risk position of the banks that constitute many of the major clearing members. For example, Tier 1 common equity capital ratios at the largest U.S. banks have nearly doubled since 2007. In addition, new requirements address the specific interactions that banks have with CCPs and derivatives markets in order to promote both the use of central clearing and strong CCP risk management. Under Basel III, capital requirements for bank exposures to a CCP are sensitive to the risk management standards applied by the CCP. These requirements acknowledge that CCPs that adhere to the PFMIs present lower risks to their members. Exposures to such qualifying CCPs require less capital. The capital rules also recognize that a CCP requiring more initial margin from its members exposes those members to less default risk, and therefore require less capital. On the liquidity front, the recently proposed liquidity coverage ratio (LCR) recognizes the liquidity-intensive nature of derivatives transactions. Under the LCR, a bank is required to maintain high-quality liquid assets that are sufficient to withstand an extreme yet plausible margin call from its derivatives counterparties. Importantly, the liquidity requirement depends on the member's net derivatives position with the CCP--if the position is hedged, the liquidity requirement will be appropriately attenuated. While central clearing is important and is expected to increase substantially over time, a significant portion of nonstandardized, bespoke derivatives will never be suitable for central clearing. This bilaterally cleared part of the market was a principal source of systemic risk during the crisis. For noncentrally cleared derivatives, margin requirements will serve as the main tool to mitigate systemic risks. The Basel Committee on Banking Commissions (IOSCO) have recently finalized a framework for margin requirements on noncentrally cleared derivatives that provides for harmonized rules and a level playing field, which is important given the global nature of derivatives markets. Regulatory authorities in participating countries are now in the process of developing margin rules for noncleared derivatives in light of the international framework. The framework requires both financial firms and systemically important nonfinancial firms that trade derivatives to collect both variation margin and initial margin, as is the case for centrally cleared derivatives. The initial margin requirements represent a significant change to existing market practice and will undoubtedly impose some costs on market participants. As originally proposed, the new framework would have required most market participants to collect initial margin from the first dollar of exposure. The International Swap Dealers Association estimated that roughly an additional $1.7 trillion in initial margin would have been required globally. In light of this concern, the framework was released for public consultation on two separate occasions and the Basel Committee and IOSCO conducted a detailed impact study to determine the potential liquidity costs of the new requirements. The final version of the framework addressed these concerns by allowing firms to begin collecting initial margin only as potential future credit exposures rise above $65 million for a particular counterparty. According to the impact study, this revision reduced the estimated global liquidity requirement from roughly $2.3 trillion to $900 billion. The result is a margin regime that will protect the financial system from the largest and most systemic exposures while also reducing overall liquidity costs and providing relief to smaller derivatives market participants. It should also be noted that these margin requirements are new to the market and their effects cannot be fully understood before they become effective. There is simply no substitute for experience. Accordingly, the Basel Committee and IOSCO have established a monitoring group that will evaluate the effects of the margin requirements. The evaluation will focus on the consistency of the margin standards with related regulatory initiatives such as the implementation of the LCR and potential minimum haircuts on repurchase transactions. Based on the findings of this monitoring group, the Basel Committee and IOSCO will jointly determine whether any modifications to the margin requirements are necessary or appropriate. In this way, regulators are taking an experience-based approach to managing systemic risk that looks across the combined effect of a number of related regulatory initiatives. The financial crisis revealed significant flaws in the structure of the OTC derivatives markets that are now being addressed as part of a worldwide reform effort. Increased central clearing and margins for noncleared derivatives are foundational elements of the program. Together, these reforms can help create a system in which the OTC derivatives market infrastructure acts as a pillar of strength in the next crisis. To achieve this goal, it is imperative that international standards such as the PFMIs and the margining framework for noncentrally cleared derivatives be forcefully and consistently implemented across the globe. Implementation of the new framework will present some real-world challenges. National rules still need to be written, including rules for margin requirements on noncentrally cleared derivatives. These national rules will need to deal with local legal regimes and markets, yet also be internationally consistent to ensure a level playing field. More broadly, international cooperation will be needed to ensure that the new framework works in practice.

r131122a_FOMC

united states

Shadow Banking and Systemic Risk Regulation

tarullo

As illustrated, quite literally, by a chart that New York Fed staff produced a few years ago, the term "shadow banking system" encompasses a wide variety of institutions that engage in credit intermediation and maturity transformation outside the insured depository system. In my remarks today, I want to concentrate on short-term wholesale funding and, especially, the pre- crisis explosion in the creation of assets that were thought to be "cash equivalents." Such assets were held by a range of highly risk-averse investors, who were in many cases not fully cognizant that the "cash equivalents" in their portfolios were liabilities of shadow banks--the institutions depicted in the memorable graphic. In some cases, the perception of claims on shadow banks as cash equivalents was based on explicit or implicit promises by regulated institutions to provide liquidity and credit support to such entities. In other cases, the perception came about because market participants viewed the instruments held on the balance sheets of shadow banking entities--notably highly rated, asset- backed securities--as liquid and safe. While reliance on private mechanisms to create seemingly riskless assets was sustainable in relatively calm years, the stress that marked the onset of the financial crisis reminded investors that claims on the shadow banking system could pose far reminded of their potential exposure, investors engaged in broad-based and sometimes disorderly flight from the shadow banking system. This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century. As I will describe in a few moments, the Federal Reserve has taken some steps toward this end over the past few years. However, as I will also contend, completion of this task will require a more comprehensive set of measures, at least some of which must cover financial actors not subject to prudential regulatory oversight. Before turning to these points, I want to develop briefly the comparison between deposit runs of the pre-FDIC period and contemporary short-term wholesale funding runs in order better to explain the nature of the regulatory challenge. There are notable similarities between the bank runs that periodically afflicted the U.S. banking system before the creation of federal deposit insurance and the dramatic short-term wholesale funding runs that began in 2007. Each had a cascading, self-reinforcing quality, fueled by questions concerning the solvency of borrowing entities--whether deposit-taking banks or dealers seeking credit in repo markets. And, in each case, the opaqueness of the balance sheets of the borrowing entities led lenders to fear that an institution holding assets similar to, or interconnected through counterparty relationships with, another, troubled institution might itself be in trouble. Significantly, though, in each case, at least some of the lending actors were interested not just in eventually recovering the full amount of the funds they had extended, but in having access to those funds more or less immediately. Some depositors in 1932 needed their money in order to meet the requirements of daily life, while many repo counterparties in 2008 needed their money to meet other short-term obligations. Thus the issue was not just a matter of solvency--whether the firm would ultimately be able to pay all the claims even after the run--but also a matter of the short-term liquidity of the bank or broker. The dynamic unleashed by short-term wholesale funding runs in 2007 and 2008 directly exacerbated financial stress. Many assets funded through the shadow banking system were traded assets, which could be liquidated rapidly, though often at distressed prices, to reduce the funding needs of the borrowing firms. The resulting fire sales recalled the asset liquidations by some trust companies during the Panic of 1907 and by some securities firms in the 1930s. In 2008, these fire sales created adverse feedback loops of mark-to-market losses, margin calls, and further liquidations. The unwinding of the risk illusion--that is, the assumption that lending to shadow banks was essentially risk-free--helped transform a dramatic correction in real estate valuations into a crisis that engulfed the entire economy. But for a few idiosyncratic instances since the introduction of deposit insurance in 1933, bank runs have been rendered a thing of the past. Deposits below the amount of the federal insurance cap are fully and explicitly guaranteed. Access to the Federal Reserve's discount window for depository institutions complements the deposit insurance system by helping to relieve liquidity pressures in solvent banks. In practice, failing banks usually merge into healthier ones, so that depositors do not lose access to their funds and deposits exceeding the amount of the federal insurance cap are effectively protected. In the relatively few instances of depositor payouts, the FDIC has reimbursed depositors expeditiously. Of course, the explicit and de facto extension of federal guarantees created moral hazard problems, which the safety-and- soundness regulation of insured depository institutions was strengthened to address. The similarities between deposit runs and short-term wholesale funding runs have suggested to some that the policy responses should also be similar. Those taking this position argue for providing discount window access to broker-dealers, guaranteeing certain kinds of wholesale funding, or both. Others, myself included, are wary of any such extension of the government safety net and would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding. Unlike deposit insurance, the savings of most U.S. households are generally not directly at risk in short-term wholesale funding arrangements. And, also unlike insured deposits, there is an argument in the short-term wholesale funding context that counterparties should be capable of providing some market discipline in at least some of the contexts in which such funding is provided. In thinking about how to regulate shadow banking, we must be mindful that it is not really a single system. It is immeasurably more complicated than the bank deposit system of either the 1930s or today. Even with the reduction in activity following the crisis, the scale of shadow banking activity remains very large. Banks and broker-dealers currently borrow about $1.6 trillion, much of this from money market funds and securities lenders, through tri-party repos, leaving aside additional funds sourced from asset managers and other investors through other channels. The banks and broker dealers, in turn, use reverse repo to provide more than $1 trillion in financing to prime brokerage and other clients. While the volume of this activity has fallen considerably since the crisis and the haircuts and other conditions associated with current securities financing transactions are considerably more conservative than during the pre-crisis period, there is every reason to believe that the amount of this activity could increase, and the conservatism of the terms of the lending could be eroded, as economic conditions improve. Let me turn now to some of the specific vulnerabilities, steps that have been taken thus far to address these vulnerabilities, and the work that remains. While the term "shadow banking" implies activity outside the purview of regulatory oversight, regulated institutions are in fact heavily involved in these activities, both in funding their own operations and in extending credit and liquidity support to shadow banks beyond the regulatory perimeter. Support provided for shadow banking activities may be either explicit or implicit. In some cases, there are explicit contractual provisions for credit enhancements and liquidity support. In other cases, the support is implicit, based on a bank's historical pattern of providing support or a belief among investors that a bank will provide support to maintain the value of its franchise. In the lead-up to the crisis, explicit and implicit commitments by regulated banking firms to shadow banks often combined to create the assumption that the liabilities of such entities were risk-free. This perception led to an underpricing of the risks embedded in these money-like instruments, making them an artificially cheap source of funding and creating an oversupply of these instruments that contributed to systemic risk. Contractually committed credit and liquidity support lends itself more readily to regulation than does implicit support. Basel III reforms have strengthened the regulatory requirements for situations in which there is contractual support for shadow banking activities. For example, the Basel III capital requirements increase from 0 percent to 20 percent the credit conversion factor for commitments with an original maturity of one year or less that are not 100 percent drawdown rate to undrawn amounts of credit and liquidity facilities extended by banks to a special purpose entity (SPE), effectively requiring a bank to hold $100 in high-quality liquid assets (HQLA) for every $100 it commits to a SPE. Implicit support presents more of a regulatory challenge. Identifying implicit forms of support requires a supervisory judgment that, despite sometimes stern warnings in offering documents, a banking organization bears some of the risk associated with that investment. Regulators must decide how much of the risk the banking organization retains and make context- sensitive judgments about the financial stability implications of various remedies. These challenges notwithstanding, regulators have made some progress in addressing instances of implicit support that played a major role in the last crisis. Let me mention two examples. The first involves the implicit support associated with the provision of intraday credit by clearing banks in the tri-party repo market. In a repurchase agreement or "repo," the cash borrower agrees to sell a security to a cash lender, and to repurchase the security from the cash lender at a later date. In a tri-party repo transaction, a clearing bank handles settlements through accounts held at that financial institution by the parties to the transaction. To allow broker- dealers who borrow in the tri-party repo market to have access to their securities for routine trading purposes, the market developed an operational feature known as the "daily unwind." Before the crisis and for some time afterwards, the clearing banks unwound all tri-party repo trades each day--even those with a significant term, which in theory represented longer-term financing commitments--returning securities to borrowers and cash to lenders. However, because the securities still required financing during the day, cash borrowers relied on uncommitted secured credit, backed by their overall portfolio of securities and provided by the clearing bank. Transactions were re-wound at the end of the day, with specific securities allocated as collateral to each lender at that time. Cash lenders in the tri-party repo market thus came to expect that the two clearing banks would always unwind their maturing trades in the morning, returning cash to their account, despite the absence of a contractual provision requiring them to do so. As a result, they grew comfortable in the belief that they held a cash-equivalent asset that was perfectly safe and liquid. But as the crisis deepened, cash lenders became aware of the fact that the clearing banks were not contractually obligated to unwind repo trades and that the dealers that were the primary borrowers in the tri-party repo market could fail, leaving lenders with collateral that they had little or no capacity to manage at a juncture when its value and liquidity was open to doubt. This resulted in several distinct episodes during the crisis when cash lenders, despite holding collateral, quickly withdrew financing from dealers perceived to be facing potential financial distress. The tri-party repo market might have suffered a full-scale run in the absence of public- sector intervention. Since the crisis, the Federal Reserve has led an effort to reduce reliance on intraday credit in the tri-party repo market. Work to date has reduced the amount of intraday credit provided by the clearing banks from 100 percent of the tri-party repo market to approximately 30 percent, and commitments by market participants suggest that this amount will fall to 10 percent by the end of next year. This operational change, in addition to enhancing the resiliency of the settlement process, should help limit the likelihood that tri-party repo lenders return to believing that lending in the tri-party repo market is a risk-free proposition. As a result, tri-party repo lenders are likely to conduct more thorough due diligence on their counterparties and exercise more care in considering the types of collateral that they will lend against than was the case before the crisis. The second example involves the implicit support provided by bank sponsors of certain securitization SPEs. Before the crisis, the interplay between bank capital requirements and accounting rules created a significant incentive for banks to shift assets off-balance sheet through the use of various SPEs. Under the capital requirements that applied at the time, a bank that sold assets to a conduit or other SPE it sponsored was required to hold capital only against its contractual exposure to the SPE. Yet because a bank that failed to support SPEs it sponsored might irreparably damage the value of its franchise, banks often provided credit and liquidity support in excess of contractually obligated amounts to asset-backed commercial paper (ABCP) programs, credit card securitizations, and other structured finance vehicles. Recognizing this incentive, pre-crisis lenders were willing to hold commercial paper and other liabilities issued by bank-sponsored SPEs at yields only slightly higher than those on liabilities issued directly by the bank. In effect, the bank was able to hold less capital and reduce its funding costs without decreasing its economic exposure. Post-crisis reforms have reduced the opportunity for banks to exploit this regulatory to modify the accounting treatment of structured finance transactions involving certain SPEs. Under the new accounting guidance, a company is required to consolidate those SPEs for which the company has the power to direct matters that most significantly impact the entity as well as the obligation to absorb losses or the right to receive benefits. Securitization sponsors have generally interpreted the new guidance as requiring a sponsor to consolidate a SPE under circumstances in which the sponsor retains loan-servicing obligations and exposure to the equity tranche of the securitization. Following the publication of FAS 166 and 167, the federal banking agencies adopted new rules requiring banking organizations to hold risk-based and leverage capital against assets of the newly consolidated SPEs. These rules eliminated a provision in the bank capital requirements that permitted a banking organization to exclude from the calculation of its risk-weighted assets the assets of an ABCP program that the banking organization sponsored and was required to consolidate. As a result, bank sponsors of ABCP conduits and certain other securitizations must now hold levels of regulatory capital commensurate with the exposure arising from the implicit support they provide. Turning now to financial stability concerns raised by short-term wholesale funding more generally, I want to focus on collateralized borrowing arrangements. These collateralized borrowing arrangements consist largely of securities financing transactions (SFTs), a term that generally refers to repo and reverse repo, securities lending and borrowing, and securities margin lending. Lenders are willing to extend credit on a secured basis because these transactions are usually short-term, over-collateralized, backed by reasonably liquid securities, subject to daily mark-to-market and re-margining requirements, and exempt from the automatic stay in insolvency proceedings. In the most common practice, a broker-dealer uses SFTs to finance either securities inventory or a back-to-back SFT loan to another financial firm (SFT matched The financial stability risks associated with a dealer's use of short-term SFT funding to finance its inventory are relatively straightforward. If a broker-dealer loses access to financing and is forced to sell securities at a depressed price, fire sale externalities may result because other market participants may be less able to borrow against the same securities. And if the broker- dealer fails due to runs by short-term SFT lenders, post-default fire sales by the firm's creditors or contagious runs on other financial intermediaries may ensue. Because broker-dealers generally do not internalize the externalities that arise in these cases, they may use more than the economically efficient level of short-term funding. The financial stability risks associated with SFT matched books are somewhat less obvious. Even if the outflows and inflows associated with a dealer's SFT positions are perfectly maturity-matched, reputational considerations may inhibit a dealer from reducing the amount of SFT credit that it provides its customers, exposing the dealer to considerable liquidity stress. If the dealer does reduce the amount of credit that it provides to its customers, those customers may be forced to engage in asset fire sales of their own. Particularly in situations in which the customers are highly leveraged, maturity-transforming entities that lack access to a liquidity provider of last resort may pose a significant risk of contagion. Post-crisis financial regulatory reform has taken some steps to address the financial stability risks associated with a dealer's use of short-term SFT funding to finance inventory. For example, the liquidity coverage ratio requires firms to hold a buffer of high-quality liquid assets when they use SFT liabilities that mature in less than 30 days to fund many types of securities. New risk-based capital rules have substantially increased the amount of capital that dealers are required to hold against assets in the trading book. But these reforms are limited: The LCR does not require firms to hold any liquidity buffer against SFT liabilities that mature in more than 30 days or that are backed by very liquid assets. There continues to be a need for standardized capital requirements for market risk to back up model-derived risk weights. Moreover, the current regulatory framework does not impose any meaningful regulatory charge on the financial stability risks associated with SFT matched books. The Basel III risk- based capital rules require banking organizations to hold relatively little capital against SFT assets, which are assumed to pose little microprudential risk. Because leverage requirements do not take into account the fact that SFTs are collateralized transactions, leverage requirements have the potential to impose higher charges on SFT assets. But leverage requirements have traditionally been calibrated at non-binding levels and, to the extent they do bind in the future, are unlikely to bind evenly across firms. As a result, the leverage ratio may simply cause SFT assets and liabilities to migrate to those firms with stronger leverage ratios. Similarly, the LCR and, at least at this stage of its development, the Net Stable Funding Ratio (NSFR), both assume that a firm with a perfectly matched book is in a stable position. The LCR assumes a bank can call in reverse repos and other SFT assets that mature in less than 30 days or reuse the collateral that secures those assets for purposes of its own borrowing. Thus, reverse repos and other SFT assets generally are treated as completely liquid instruments. Under the initial version of the NSFR, firms would not need to hold any stable funding against reverse repos, securities borrowing receivables, or other loans to financial entities that mature in less than one year. Again, this may be a reasonable position from a microprudential perspective, geared toward more or less normal times. But here is where we need an explicitly macroprudential perspective that forces firms to internalize the tail-event financial stability risks associated with SFT matched books. There are two kinds of policy options that can be considered, individually or together, in responding to the financial stability vulnerabilities inherent in firms with large amounts of short- term wholesale funding--whether loaned, borrowed, or both. The first would impose a regulatory charge calculated by reference to reliance on SFTs and other forms of short-term wholesale funding, whether the firm uses that funding to finance inventory or an SFT matched book. The second would directly increase the very low charges under current and pending regulatory standards attracted by SFT matched books. Among the first set of options, the idea that seems most promising is to tie capital and liquidity standards together by requiring higher levels of capital for large firms that substantially rely on short-term wholesale funding. The additional capital requirement would be calculated by reference to a definition of short-term wholesale funding, such as total liabilities minus regulatory capital, insured deposits, and obligations with a remaining maturity of greater than a specified term. There might be a kind of weighting system to take account of the specific risk characteristics of different forms of funding. The capital requirement would then be added to the Tier 1 common equity requirement already mandated by the minimum capital, capital conservation buffer, and globally systemic bank surcharge standards. However, this component of the Tier 1 common equity requirement would be calculated by reference to the liability side, rather than the asset side, of the firm's balance sheet. The rationale behind this policy option is that, while solid requirements are needed for both capital and liquidity, the relationship between the two also matters. For example, a firm with little reliance on short-term funding is less susceptible to runs and, thus, to the need for engaging in fire sales that can depress capital levels. A capital surcharge based on short-term wholesale funding usage would add an incentive to use more stable funding and, where a firm concluded that higher levels of such funding were nonetheless economically sensible, the surcharge would increase the loss absorbency of the firm. Such a requirement would be consistent with, though distinct from, the long-term debt requirement that the Federal Reserve Board will be proposing to enhance prospects for resolving large firms without taxpayer assistance. The second kind of policy option is to address head-on the macroprudential concerns arising from large matched books of securities financing transactions. A capital surcharge is in some respects an indirect response to the problem of short-term wholesale funding runs and, as earlier noted, current versions of capital and liquidity standards do not deal with matched book issues. One might choose either to increase capital charges applicable to SFT assets or to modify liquidity standards so as to require firms with large amounts of these assets to hold larger liquidity buffers or to maintain more stable funding structures. It is not clear how much appetite there may be internationally for revisiting agreements that have been completed, such as the LCR and the Basel III capital rules. However, with the NSFR still under discussion, and with the Basel Committee in the process of reconsidering the standardized banking book risk weights and capital regulations associated with traded assets, there are opportunities to pursue these options. Requirements building on any of the foregoing options would by definition be directly applicable only to firms already within the perimeter of prudential regulation. The obvious questions are whether these firms at present occupy enough of the market that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would lead to a significant arbitrage through increased participation by those outside the regulatory perimeter. It does not seem far-fetched to think that, with time and sufficient economic incentive, the financial, technological, and regulatory barriers to the disintermediation of prudentially regulated dealers could be overcome. Indeed, there have already been reports of some hedge funds exploring the possibility of disintermediating dealers by lending cash against securities collateral to other market participants. For this reason, there is a need to supplement prudential bank regulation with a third set of policy options in the form of regulatory tools that can be applied on a market-wide basis. That is, regulation would focus on particular kinds of transactions, rather than just the nature of the firm engaging in the transactions. To date, over-the-counter derivatives reform is the primary example of a post-crisis effort at market-wide regulation. crisis was driven more by disruptions in the SFT markets than by disruptions in the over-the- counter derivative markets, comparable attention to SFT markets is surely needed. Over the past two years, the Financial Stability Board (FSB) has been evaluating proposals for a system of haircuts and margin requirements for SFTs. In its broadest form, a system of numerical floors for SFT haircuts would require any entity that wants to borrow against any security to post a minimum amount of excess margin that would vary depending on the asset class of the collateral. Like minimum margin requirements for derivatives, numerical floors for SFT haircuts would be intended to serve as a mechanism for limiting the build up of leverage at the security level, and could mitigate the risk of procyclical margin calls. In August, the FSB released a proposal that would represent a first step in the direction of such a framework. However the FSB's proposal has some significant limitations. First, with respect to counterparty scope, the FSB's proposal would apply only to SFTs in which regulated entities provide financing to unregulated entities; the proposal would not cover SFTs between a regulated lender and a regulated borrower, between an unregulated lender and a regulated borrower, or between an unregulated lender and an unregulated borrower. Second, the proposal would apply only to lending against collateral other than sovereign obligations. And finally, with respect to calibration, the FSB's proposed numerical floors are set at relatively low levels-- levels that are, for example, significantly below the haircuts that currently prevail in the tri-party repo market. An alternative to the FSB's proposal would be to apply a system of numerical floors to SFTs regardless of the identity of the parties to the transaction. Such an approach would at least partially offset the incentive that will otherwise exist to move more securities financing activity completely into the shadows. Regarding calibration, there are at least three conceptually plausible bases for setting the level of the numerical floors above the low backstop levels contemplated in the current FSB proposal. One approach would be to base the calibration of the numerical floors on current repo market haircuts. These haircuts have increased significantly compared to pre-crisis levels. Establishing numerical floors at around current levels could prevent the return of a less prudent set of practices as memories of the crisis fade. A second approach would be to set haircuts for a given asset class based on asset price volatility or haircut levels observed during times of stress or long-term periods that include times of stress. While minimum haircut levels should not be set as high as the haircuts lenders demanded at the depths of the crisis, setting numerical floors in proportion to those levels might be reasonable. A third alternative would be to set numerical floors for SFT haircuts at levels that are commensurate with the amount of capital a banking organization would need to hold against the security if it held the security in inventory. Such an approach could be viewed as an indirect way of extending bank capital requirements to the shadow banking system, and would reduce the current bank regulatory incentive to lend against a security rather than hold it directly. Finally, it is worth noting that, while a framework of universal margin requirements for SFTs could not be evaded through the disintermediation of regulated entities, it might be evaded through the use of alternative transactional structures. If margin requirements for cash SFT transactions are significantly higher than margin requirements for creating the same economic exposures using synthetic SFT transactions, a framework of minimum margins for SFTs could push market participants to rely more heavily on derivatives that are the functional equivalent of cash SFTs. Moreover, market participants might attempt to arbitrage margin floors through arrangements whereby the lender effectively lends the SFT borrower the minimum excess margin amount. These and similar issues will need to be addressed as options for minimum margins are further developed. If we think back to the rapid growth of the shadow banking system in the pre-crisis period, we are reminded of some glaring vulnerabilities: Large firms that could themselves be considered shadow banks and that relied on the shadow banking system for a significant proportion of their funding--a group that included the "free-standing" investment banks--were outside the perimeter of prudential regulation. The breaking of the buck by the Reserve Primary Fund following Lehman's collapse triggered a run on the shadow banking system that required unprecedented support by the Treasury Department and the Federal Reserve. Act for designation of systemically important non-bank firms has provided a means for ensuring that the perimeter of prudential regulation can be extended as appropriate to cover large shadow banking institutions. The proposals of the Securities and Exchange Commission on money market fund regulation are a response to continuing vulnerabilities as well as to the run in the fall of 2008. These are important initiatives that will contribute to a safer system of funding throughout the financial system. Yet the risk of contagious runs would persist even in the absence of individually systemic institutions. And with less vulnerable money market funds, other cash-rich entities could emerge as a source of inexpensive funding for the shadow banking system. Finally, as I have noted, the systemic risks associated with short-term wholesale funding in prudentially regulated institutions have not fully been countered by the important capital and liquidity standards adopted since the crisis. My purpose today has been to reinforce the point that a sounder, more stable financial system requires a more comprehensive reform agenda.

r131216a_FOMC

united states

Concluding Remarks

bernanke

I have been asked to close this ceremony marking the 100th anniversary of the signing of the Federal Reserve Act--the law that created the Federal Reserve--by looking ahead to the next century. Given the well-known difficulties that economists have in forecasting even the next few quarters, I will happily point out one important advantage in making a 100-year forecast, which is that I won't be around to explain why the forecast went wrong. Our ability to make accurate long-term forecasts is limited, to say the least. Nevertheless, I will venture one prediction that I don't think is too bold, which is this: The values that have sustained and served the Federal Reserve at its best, and have permitted it to make critical contributions to the economic health of our nation during the past century, will continue to serve it and the nation well in the century ahead. Among the Fed's most important values is the belief that policymaking should be based on dispassionate, objective, and fact-based analysis. The ideal we seek is a combination of the researcher's intellectual rigor and the ability of the effective policymaker to navigate the messiness of the real world, a world that includes complex institutions and markets, imperfect and incomplete data, and often-unpredictable human behavior. Of course, policy analysis and implementation of the highest quality do not just happen. They require professionalism and a commitment to public service as exemplified by the generations of staff members who have served this institution so well. Without the expertise and creativity embodied in the staff, it would have been impossible to develop the innovative policies required to meet, in the words of the Federal Reserve Act, the "unusual and exigent circumstances" we confronted during the recent financial crisis. If there is one thing on which I believe all of us here can agree, it is that the quality of the staff has been a great strength throughout our institution's history. Maintaining that quality and commitment to public service will be essential if the Fed is to have a successful second century. Dispassionate analysis, expertise, and commitment to public service--all are values that have served us well. But one value that strikes me as having been at least as important as any other has been the Federal Reserve's willingness, during its finest hours, to stand up to political pressure and make tough but necessary decisions. The fight against inflation during Paul and Alan's times in office was critical for the nation's longer-term prosperity, and it required perseverance in the face of heavy criticism. I keep in my office one of the 2-by-4s mailed to the Fed during Paul's tenure, which communicates some distinctly unfavorable views of high interest rates and their effects. More recently, of course, the Federal Reserve took controversial but necessary measures to arrest what was arguably the worst financial crisis in American history, helping to avert what likely would have been a much more severe economic downturn than the Great Recession we did experience. We have been able to respond nimbly to economic emergencies and make difficult choices in part because of our institutional structure--including long terms for members of the Board of Governors and diverse regional representation in our policymaking Committee--and because of the willingness of policymakers, past and present, to do whatever was needed in the longer-run interest of the economy. As an institution, the Federal Reserve must continue to be willing to make tough decisions, based on objective, empirical analysis and without regard to political pressure. But, finally, we must also recognize that the Fed's ability to make and implement such decisions ultimately depends on the public's understanding and acceptance of our actions. For this reason, we must continue to emphasize two other essential values-- transparency and accountability. We must do all that we can to explain our actions and to show how they serve the public interest. That's why we must welcome communication, broadly defined. Of course, we will continue to talk to economists and market participants, but that is not enough. Ultimately, the legitimacy of our policies rests on the understanding and support of the broader American public, whose interests we are working to serve. The ability of this institution to support a healthy economy--an economy with high levels of employment, low inflation, and a stable financial system-- will require our continued efforts to engage in two-way communication--explaining our actions and, importantly, listening to what our fellow citizens have to say. Let me end by thanking the organizers of this event and, in particular, all of the past and present policymakers in attendance for helping us mark this centennial milestone in such a memorable fashion.

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united states

The Federal Reserve: Looking Back, Looking Forward

bernanke

In less than a month my term as Fed Chairman will end. Needless to say, my tenure has been eventful--for the Federal Reserve, for the country, and for me personally. I thought it appropriate today to reflect on some accomplishments of the past eight years, as well as some uncompleted tasks. I will briefly cover three areas in my remarks: (1) the Federal Reserve's commitment to transparency and accountability, (2) financial stability and financial reform, and (3) monetary policy. I will close by discussing the prospects for the U.S. and global economies. Fostering transparency and accountability at the Federal Reserve was one of my principal objectives when I became Chairman in February 2006. I had long advocated increased transparency and, in particular, a more explicit policy framework as ways to make monetary policy more predictable and more effective. Our efforts to enhance transparency and communication have indeed made monetary policy more effective, but, as I'll discuss, these steps have proved important in other spheres as well. When I began my term I expected to build on the monetary policy framework I had inherited from Paul Volcker and Alan Greenspan. My predecessors had solidified the Fed's commitment to low and stable inflation as a foundation of broader economic stability, and they gradually increased the transparency of monetary policy deliberations and plans. For example, Chairman Volcker introduced a money-targeting framework to help guide the Fed's attack on high inflation in the early 1980s, and the practice of began under Chairman Greenspan. I believed that a still more transparent approach would make monetary policy even more effective and further strengthen the Fed's institutional credibility. In particular, as an academic I had written favorably about the flexible inflation-targeting approach used by the Bank of England and a number of other central banks. By making public considerable information about policy goals and strategies, together with their economic forecasts, these central banks provided a clear framework to help the public and market participants understand and anticipate policy actions. The provision of numerical goals and policy plans also helped make these central banks more accountable for achieving their stated objectives. I was confident that we could adapt this type of framework to the Federal Reserve's dual mandate to promote both maximum employment and price stability. Indeed, central banks using this framework were already, in practice, often pursuing economic objectives in addition to low and stable inflation--hence the term, "flexible" inflation targeting. Because the financial crisis and its aftermath naturally occupied so much of policymakers' attention, progress toward a more explicit policy framework at the Federal Reserve was slower than I had hoped. Nevertheless, progress was made. In the minutes of its October 2007 meeting, the FOMC introduced its quarterly Summary of Economic macroeconomic variables such as inflation, gross domestic product (GDP) growth, and the unemployment rate. Over time, we added long-run projections of inflation, growth, and unemployment, as well as projections of the path of the target federal funds rate consistent with each individual's views of appropriate monetary policy. These additions have better informed the public about participants' views on both the long-run objectives of policy and the path of interest rates most consistent with achieving those objectives. We took another important step in January 2012, when the FOMC issued a statement laying out its longer-run goals and policy strategy. The statement established, for the first time, an explicit longer-run goal for inflation of 2 percent, and it pointed to the SEP to provide information about Committee participants' assessments of the longer- run normal unemployment rate, currently between 5.2 and 6 percent. The statement also indicated that the Committee would take a balanced approach to its price stability and employment objectives. We adopted additional measures aimed at clarifying the rationales for our decisions, including my quarterly postmeeting press conference. The increases in policy transparency that were achieved proved valuable during a very difficult period for monetary policy. As it happened, during the crisis and its aftermath the Federal Reserve's transparency and accountability proved critical in a quite different sphere--namely, in supporting the institution's democratic legitimacy. The Federal Reserve, like other central banks, wields powerful tools; democratic accountability requires that the public be able to see how and for what purposes those tools are being used. Transparency is particularly important in a period like the recent one in which the Federal Reserve has been compelled to take unusual and dramatic actions--including the provision of liquidity to a wide range of financial institutions and markets that did not normally have access to the Fed's discount window--to help stabilize the financial system and the economy. What types of transparency are needed to preserve public confidence? At the most basic level, a central bank must be clear and open about its actions and operations, particularly when they involve the deployment of public funds. The Federal Reserve routinely makes public extensive information on all aspects of its activities, and since the crisis it has greatly increased the quantity and detail of its regular reports to the Congress and the public. Importantly, contrary to what is sometimes asserted, all of the Fed's financial transactions and operations are subject to regular, intensive audits--by the Government Accountability Office, an independent Inspector General, and a private accounting firm, as well as by our own internal auditors. It is a testament to the dedication of the Federal Reserve's management team that these thorough audits have consistently produced assessments of the Fed's accounting and financial controls that most public companies would envy. Transparency and accountability are about more than just opening up the books, however; they also require thoughtful explanations of what we are doing and why. In this regard, our first responsibility is to the Congress, which established the Federal Reserve almost exactly a century ago and determined its structure, objectives, and powers. Federal Reserve Board members, including the Chairman, of course, as well as senior staff, testify frequently before congressional committees on a wide range of topics. When I became Chairman, I anticipated the obligation to appear regularly before the Congress. I had not entirely anticipated, though, that I would spend so much time meeting with legislators outside of hearings--individually and in groups. But I quickly came to realize the importance of these relationships with legislators in keeping open the channels of communication. As part of the Fed's interaction with the Congress, we have also routinely provided staff briefings on request and conducted programs at the Board for the benefit of congressional staff interested in Federal Reserve issues. I likewise maintained regular contact with both the Bush and Obama Administrations, principally through meetings with the Secretary of the Treasury and other economic officials. The crisis and its aftermath, however, raised the need for communication and explanation by the Federal Reserve to a new level. We took extraordinary measures to meet extraordinary economic challenges, and we had to explain those measures to earn the public's support and confidence. Talking only to the Congress and to market participants would not have been enough. The effort to inform the public engaged the whole institution, including both Board members and the staff. As Chairman, I did my part, by appearing on television programs, holding town halls, taking student questions at universities, and visiting a military base to talk to soldiers and their families. The Federal Reserve Banks also played key roles in providing public information in their Districts, through programs, publications, speeches, and other media. The crisis has passed, but I think the Fed's need to educate and explain will only grow. When Paul Volcker first sat in the Chairman's office in 1979, there were no financial news channels on cable TV, no Bloomberg screens, no blogs, no Twitter. Today, news, ideas, and rumors circulate almost instantaneously. The Fed must continue to find ways to navigate this changing environment while providing clear, objective, and reliable information to the public. For the U.S. and global economies, the most important event of the past eight years was, of course, the global financial crisis and the deep recession that it triggered. As I have observed on other occasions, the crisis bore a strong family resemblance to a classic financial panic, except that it took place in the complex environment of the 21st century global financial system. Likewise, the tools used to fight the panic, though adapted to the modern context, were analogous to those that would have been used a century ago, including liquidity provision by the central bank, liability guarantees, recapitalization, and the provision of assurances and information to the public. The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices. Policymakers at the time, including myself, certainly appreciated that house prices might decline, although we disagreed about how much decline was likely; indeed, prices were already moving down when I took office in 2006. However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short- term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole. The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions. However, the institutional context had changed substantially since Bagehot wrote. The panics of the 19th and early 20th centuries typically involved runs on commercial banks and other depository institutions. Prior to the recent crisis, in contrast, credit extension had progressively migrated outside of traditional banking to so-called shadow banking entities, which relied heavily on short-term wholesale funding that proved vulnerable to runs. Accordingly, to help calm the panic, the Federal Reserve provided liquidity not only to commercial banks, but also to other types of financial institutions such as investment banks and money market funds, as well as to key financial markets such as those for commercial paper and asset-backed securities. Because funding markets are global in scope and U.S. borrowers depend importantly on foreign lenders, the Federal Reserve also approved currency swap agreements with 14 foreign central banks. Providing liquidity represented only the first step in stabilizing the financial system. Subsequent efforts focused on rebuilding the public's confidence, notably including public guarantees of bank debt by the Federal Deposit Insurance Corporation and of money market funds by the Treasury Department, as well as the injection of public capital into banking institutions. The bank stress test that the Federal Reserve led in the spring of 2009, which included detailed public disclosure of information regarding the solvency of our largest banks, further buttressed confidence in the banking system. The success of the stress-test disclosures, by the way, was yet another example of the benefits of transparency. The subsequent efforts to reform our regulatory framework have been focused on limiting the reemergence of the vulnerabilities that precipitated and exacerbated the crisis. Changes in bank capital regulation under Basel III have significantly increased requirements for loss-absorbing capital at global banking firms--including a surcharge for systemically important institutions and a ceiling on leverage. The Federal Reserve's Comprehensive Capital Analysis and Review, or CCAR, process, a descendant of the 2009 stress test, requires that large financial institutions maintain sufficient capital to weather extreme shocks, and that they demonstrate that their internal planning processes are effective; in addition, public disclosure of the results facilitates market discipline. The Basel III framework also includes liquidity requirements designed to mitigate excessive reliance by global banks on short-term wholesale funding and to otherwise constrain risks at those banks. Further steps are under way to toughen the oversight of large institutions and to strengthen the financial infrastructure, for example, by requiring central clearing with greater transparency for the trading of most standardized derivatives. Oversight of the shadow banking system also has been strengthened. For example, the new Financial Stability Oversight Council has designated some nonbank firms as systemically important financial institutions, or SIFIs, subject to consolidated supervision by the Federal Reserve. In addition, measures are being undertaken to address the potential instability of short-term wholesale funding markets, including reforms to money market funds and the triparty repo market. Of course, in a highly integrated global financial system, no country can effectively implement the financial reforms I have described in isolation. The good news is that similar reforms are being pursued throughout the world, with the full support of the United States and with international bodies such as the Basel Committee and the More broadly, the approach to regulation and supervision at the Federal Reserve has evolved to include a substantial macroprudential, or systemic, orientation in addition to the traditional focus on individual institutions. For example, the Federal Reserve created the Office of Financial Stability Policy and Research, which coordinates System efforts to monitor the interaction of financial institutions, financial markets, and economic developments to identify emerging vulnerabilities and systemic risks. Enhanced monitoring of this type is especially important as the changes in regulatory structure and financial innovation may lead risks to manifest in new ways or to migrate outside the perimeter of the current regulatory structure. Much progress has been made, but more remains to be done. In addition to completing the efforts I have already mentioned, including the full implementation of new rules and supervisory responsibilities, the agenda still includes further domestic and international cooperation to ensure the effectiveness of mechanisms to allow the orderly resolution of insolvent institutions and thereby increase market discipline on large institutions. The evaluation of potential macroprudential tools that might be used to address emerging financial imbalances is another high priority. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional resilience within the financial sector during periods of buoyant credit creation. Staff members are investigating the potential of this and other regulatory tools, such as cyclically sensitive loan-to-value requirements for mortgages, to improve financial stability. A number of countries, including both advanced and emerging-market economies, have already deployed such measures, and their experiences should be instructive. Although, in principle, monetary policy can be used to address financial imbalances, the presumption remains that macroprudential tools, together with well- focused traditional regulation and supervision, should serve as the first line of defense against emerging threats to financial stability. However, more remains to be done to better understand how to design and implement more effective macroprudential tools and how these tools interact with monetary policy. While liquidity provision and other emergency steps were critical to stemming the financial panic, a rapid shift in the stance of monetary policy was necessary to counteract the massive economic blow delivered by the crisis. The FOMC reduced the target federal funds rate from 5-1/4 percent in the summer of 2007 to a range of 0 to 1/4 percent by the end of 2008, a very rapid easing. The federal funds rate has been at its effective lower bound since then. To provide additional monetary policy accommodation despite the constraint imposed by the effective lower bound on interest rates, the Federal Reserve turned to two alternative tools: enhanced forward guidance regarding the likely path of the federal funds rate and large-scale purchases of longer-term securities for the Federal Reserve's portfolio. Other major central banks have responded to developments since 2008 in roughly similar ways. For example, the Bank of England and the Bank of Japan have employed detailed forward guidance and conducted large-scale asset purchases, while the European Central Bank has moved to reduce the perceived risk of sovereign debt, provided banks with substantial liquidity, and offered qualitative guidance regarding the future path of interest rates. With short-term rates near zero, expanded guidance about intentions for future policy has helped to shape market expectations, which in turn has eased financial conditions by putting downward pressure on longer-term interest rates and helped support economic activity. Forward guidance about the short-term interest rate supplements the broader policy framework I described earlier, by providing information about how the Committee expects to achieve its stated policy objectives despite the complications created by the zero lower bound on the policy interest rate and uncertainties about the costs and efficacy of the available policy tools. Beginning with qualitative guidance, the Committee's communication about its anticipated future policy has evolved through several stages. In December 2012, the Committee introduced state-contingent guidance, announcing for the first time that no increase in the federal funds rate target should be anticipated so long as unemployment remained above 6-1/2 percent, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continued to be well anchored. My colleagues and I emphasized that the conditions stated in that guidance were thresholds, not triggers. That is, crossing one of the thresholds would not automatically give rise to an increase in the federal funds rate target; instead, it would signal only that it would be appropriate for the Committee to begin considering, based on a wider range of indicators, whether and when an increase in the target might be warranted. Large-scale asset purchases also provide monetary accommodation by lowering long-term interest rates. Working through the portfolio-balance channel, asset purchases reduce the supply of long-duration assets in the hands of the public, depressing term premiums and thus reducing longer-term yields. At times, the decision to begin or extend an asset-purchase program may also have a signaling effect, to the extent that market participants see that decision as indicative of policymakers' commitment to an accommodative policy stance. However, it is important to recognize that the potential signaling aspect of asset purchases depends on the broader economic and policy context. In particular, the FOMC's decision to modestly reduce the pace of asset purchases at its December meeting did not indicate any diminution of its commitment to maintain a highly accommodative monetary policy for as long as needed; rather, it reflected the progress we have made toward our goal of substantial improvement in the labor market outlook that we set out when we began the current purchase program in September 2012. At its most recent meeting, the Committee reaffirmed and clarified its guidance on rates, stating that it expects to maintain the current target range for the federal funds rate well past the time that the unemployment threshold of 6-1/2 percent is crossed, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. Have these unconventional tools been effective? Skeptics have pointed out that the pace of recovery has been disappointingly slow, with inflation-adjusted GDP growth averaging only slightly higher than a 2 percent annual rate over the past few years and inflation below the Committee's 2 percent longer-term target. However, as I will discuss, the recovery has faced powerful headwinds, suggesting that economic growth might well have been considerably weaker, or even negative, without substantial monetary policy support. For the most part, research supports the conclusion that the combination of forward guidance and large-scale asset purchases has helped promote the recovery. For example, changes in guidance appear to shift interest rate expectations, and the preponderance of studies show that asset purchases push down longer-term interest rates and boost asset prices. These changes in financial conditions in turn appear to have provided material support to the economy. Once the economy improves sufficiently so that unconventional tools are no longer needed, the Committee will face issues of policy implementation and, ultimately, the design of the policy framework. Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC's ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate. It is possible, however, that some specific aspects of the Federal Reserve's operating framework will change; the Committee will be considering this question in the future, taking into account what it learned from its experience with an expanded balance sheet and new tools for managing interest rates. In the remainder of my remarks, I will reflect on the state of the U.S. economic recovery and its prospects. The economy has made considerable progress since the recovery officially began some four and a half years ago. Payroll employment has risen by 7-1/2 million jobs from its trough. Real GDP has grown in 16 of 17 quarters, and the level of real GDP in the third quarter of 2013 was 5-1/2 percent above its pre-recession peak. The unemployment rate has fallen from 10 percent in the fall of 2009 to 7 percent recently. Industrial production and equipment investment have matched or exceeded pre-recession peaks. The banking system has been recapitalized, and the financial system is safer. When the economy was in free fall in late 2008 and early 2009, such improvement was far from certain, as indicated at the time by stock prices that were nearly 60 percent below current levels and very wide credit spreads. Despite this progress, the recovery clearly remains incomplete. At 7 percent, the unemployment rate still is elevated. The number of long-term unemployed remains unusually high, and other measures of labor underutilization, such as the number of people who are working part time for economic reasons, have improved less than the unemployment rate. Labor force participation has continued to decline, and, although some of this decline reflects longer-term trends that were in place prior to the crisis, some of it likely reflects potential workers' discouragement about job prospects. In retrospect, at least, many of the factors that held back the recovery can be identified. Some of these factors were difficult or impossible to anticipate, such as the resurgence in financial volatility associated with the European sovereign debt and banking crisis and the economic effects of natural disasters in Japan and elsewhere. Other factors were more predictable; in particular, we appreciated early on, though perhaps to a lesser extent than we might have, that the boom and bust left severe imbalances that would take time to work off. As Carmen Reinhart and Ken Rogoff noted in their prescient research, economic activity following financial crises tends to be anemic, especially when the preceding economic expansion was accompanied by rapid growth in credit and real estate prices. Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries. Although the Federal Reserve, like other forecasters, has tended to be overoptimistic in its forecasts of real GDP during this recovery, we have also, at times, been too pessimistic in our forecasts of the unemployment rate. For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped. (Incidentally, the slow pace of productivity gains early in the recovery was not evident until well after the fact because of large data revisions--an illustration of the frustrations of real-time policymaking.) The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth. To this list of reasons for the slow recovery--the effects of the financial crisis, problems in the housing and mortgage markets, weaker-than-expected productivity growth, and events in Europe and elsewhere--I would add one more significant factor-- namely, fiscal policy. Federal fiscal policy was expansionary in 2009 and 2010. that time, however, federal fiscal policy has turned quite restrictive; according to the Congressional Budget Office, tax increases and spending cuts likely lowered output growth in 2013 by as much as 1-1/2 percentage points. In addition, throughout much of the recovery, state and local government budgets have been highly contractionary, reflecting their adjustment to sharply declining tax revenues. To illustrate the extent of fiscal tightness, at the current point in the recovery from the 2001 recession, employment at all levels of government had increased by nearly 600,000 workers; in contrast, in the current recovery, government employment has declined by more than 700,000 jobs, a net difference of more than 1.3 million jobs. There have been corresponding cuts in government investment, in infrastructure for example, as well as increases in taxes and reductions in transfers. Although long-term fiscal sustainability is a critical objective, excessively tight near-term fiscal policies have likely been counterproductive. Most importantly, with fiscal and monetary policy working in opposite directions, the recovery is weaker than it otherwise would be. But the current policy mix is particularly problematic when interest rates are very low, as is the case today. Monetary policy has less room to maneuver when interest rates are close to zero, while expansionary fiscal policy is likely both more effective and less costly in terms of increased debt burden when interest rates are pinned at low levels. A more balanced policy mix might also avoid some of the costs of very low interest rates, such as potential risks to financial stability, without sacrificing jobs and growth. I have discussed the factors that have held back the recovery, not only to better understand the recent past but also to think about the economy's prospects. The encouraging news is that the headwinds I have mentioned may now be abating. Near- term fiscal policy at the federal level remains restrictive, but the degree of restraint on economic growth seems likely to lessen somewhat in 2014 and even more so in 2015; meanwhile, the budgetary situations of state and local governments have improved, reducing the need for further sharp cuts. The aftereffects of the housing bust also appear to have waned. For example, notwithstanding the effects of somewhat higher mortgage rates, house prices have rebounded, with one consequence being that the number of homeowners with "underwater" mortgages has dropped significantly, as have foreclosures and mortgage delinquencies. Household balance sheets have strengthened considerably, with wealth and income rising and the household debt-service burden at its lowest level in decades. Partly as a result of households' improved finances, lending standards to households are showing signs of easing, though potential mortgage borrowers still face impediments. Businesses, especially larger ones, are also in good financial shape. The combination of financial healing, greater balance in the housing market, less fiscal restraint, and, of course, continued monetary policy accommodation bodes well for U.S. economic growth in coming quarters. But, of course, if the experience of the past few years teaches us anything, it is that we should be cautious in our forecasts. What about the rest of the world? The U.S. recovery appears to be somewhat ahead of those of most other advanced industrial economies; for example, real GDP is still slightly below its pre-recession peak in Japan and remains 2 percent and 3 percent below pre-recession peaks in the United Kingdom and the euro area, respectively. Nevertheless, I see some grounds for cautious optimism abroad as well. As in the United States, central banks in other advanced economies have taken significant steps to strengthen financial systems and to provide policy accommodation. Financial-sector reform is proceeding, and the contractionary effects of tight fiscal policies are waning. Although difficult reforms--such as banking and fiscal reform in Europe and structural reform in Japan--are still in early stages, we have also seen indications of better growth in the advanced economies, which should have positive implications for the United States. Emerging market economies have also grown somewhat more quickly lately after a slowing in the first half of 2013. Although growth prospects for the emerging markets continue to be good, here too the extent and effectiveness of structural reforms, like those currently under way in China and Mexico, will be critical factors. Last month we had a ceremony at the Board to commemorate the centennial of 100 years of existence, the Fed has faced numerous economic and financial challenges. Certainly the past few years will rank among some of the more difficult for the U.S. economy and for the Fed. The experience has led to important changes at our institution, including new monetary policy tools, enhanced policy communication, a substantial increase in the institutional focus on financial stability and macroprudential policy, and increased transparency. We often speak of the Federal Reserve or other institutions as if they were autonomous actors. Of course, they are not. The Fed is made up of people, working within an organizational structure and with an institutional culture and set of values. I am very proud of my colleagues at the Fed for the hard work and creativity they have brought to bear in addressing the financial and economic crisis, and I think we and they have been well served by a culture that emphasizes objective, expert analysis; professionalism; dedication; and independence from political influence. Whatever the Fed may have achieved in recent years reflects the efforts of many people who are committed, individually and collectively, to pursuing the public interest. Although the Fed undoubtedly will face some difficult challenges in the years ahead, our people and our values make me confident that our institution will meet those challenges successfully. press release, November 20, Fall, available at

r140103b_FOMC

united states

Banks as Patient Debt Investors

stein

Given the audience--and because I may never again have so many economists in front of me at one time--I thought that rather than giving a policy-oriented speech, I would test-drive a new research project. The project is ongoing joint work with Samuel Hanson and Andrei Shleifer of Harvard and with Robert Vishny of the University of Chicago. We haven't quite finished writing up the paper, but we have most of the raw material and a pretty good idea of where we are trying to go, so I figured I would give it a shot. Our aim is primarily positive, as opposed to normative: We're interested in better understanding the economic role played by commercial banks, as well as the interplay between the traditional commercial banking sector and the so-called shadow-banking sector, which includes various non-bank intermediaries such as broker-dealers, money- market funds, and hedge funds. It would be an understatement to say that the literature on the role of banks is vast. Without attempting to do it justice, let me just note three prominent classes of theories. The first focuses on the liability side of banks' balance sheets--that is, their deposit-taking role. In this view, what is most important about banks is that they create safe claims which, precisely because of their safety and immunity from adverse-selection problems, are useful as a transactions medium. In other words, banks are special because they are the institutions that create private, or "inside," money. Although it does not necessarily follow as a logical matter, this view has led some observers to advocate narrow-banking proposals, whereby bank-created money is backed by very safe liquid assets, such as Treasury bills. A second class of theories emphasizes the asset side of banks' balance sheets and their role as delegated monitors in the lending process. Here banks are seen as a mechanism for dealing with the information and incentive problems that would otherwise make it difficult for credit to be extended to opaque borrowers such as small businesses. Because this work is silent on the precise structure of the liability side, it does not draw much of a distinction between banks and other, nonbank lending intermediaries, such as finance companies. Finally, a third class of theories explicitly addresses the question of what ties together the asset and liability sides of banks' balance sheets--that is, why do the same institutions that create private money choose to back their safe claims by investing in loans and other relatively illiquid assets? What is the nature of the synergy between the two activities? Our work fits into this third category, with two twists relative to previous research. First, we stress the fact that on the asset side, banks hold not only loans, but like their shadow-banking counterparts, they also hold securities, often in very substantial amounts. Moreover, these securities holdings have a particular pattern. Banks tend to stay away from the safest and most liquid securities, such as Treasury securities, and instead concentrate their holdings in securities that are less liquid and whose market prices are more volatile, including agency mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs), asset-backed securities and corporate bonds. We argue that this pattern is an important clue to the business of banking more generally. Second, while we follow previous work in assuming that the safety of bank liabilities is an important part of what makes them special, we depart from much of the rest of the literature by downplaying the vulnerability of bank deposits to runs. Indeed, we emphasize precisely the opposite aspect of deposit finance: Relative to other forms of private-money creation that occur in the shadow-banking sector--notably, short-term collateralized claims such as broker-dealer repurchase agreements (repos)--bank deposits are noteworthy because, in the modern institutional environment, they are highly sticky and not prone to run at the first sign of trouble. In its simplest terms, our story is as follows: There are different private technologies for creating safe money-like claims. The "banking" technology involves meaningful amounts of capital as well as deposit insurance and thus leads to deposits that are both safe and relatively stable. The "shadow banking" technology uses less capital and manufactures safety by, instead, giving repo investors collateral and the right to seize the collateral on a moment's notice. So shadow banking money is much more run prone than bank money. Given its relatively stable nature, the banking model is better suited to investing in assets that are illiquid and subject to interim price volatility--that is, to fire- sale risk. These assets can be loans that involve significant amounts of monitoring, or they can be securities that require less monitoring. What is essential is the synergy between issuing stable types of money claims and investing in assets that have some degree of exposure to fire-sale risk. That synergy, in our view, is at the heart of the business of traditional banking. We have developed a simple theoretical model that captures the main ingredients of this story and makes some further testable predictions. It's probably ill-advised over lunch, but I will take a crack at sketching this model for you here. However, let me start with three stylized facts to motivate the theory. The first fact, and the one that I suspect will surprise you the least, is the strong homogeneity of the liability side of banks' balance sheets: Banks are almost always and everywhere largely deposit financed. For example, in the cross section, and using year- end 2012 data, a bank at the 10th percentile of the distribution had a ratio of deposits to assets of 73.6 percent, while a bank at the 90th percentile had a ratio of 88.9 percent. similar homogeneity is apparent in the time series: Over the past 115 years, deposits have averaged 80 percent of bank assets, with a standard deviation of only 8 percent. These patterns are in sharp contrast to those for nonfinancial firms, for which capital structure tends to be much less determinate, both within an industry and over time. They suggest that for banks--unlike non-financials, and counter to the spirit of Modigliani and Miller (1958)--an important part of their economic value creation happens on the liability side of the balance sheet, via deposit-taking. The second fact, which is perhaps just a bit more surprising, is that the asset side of banks' balance sheets--and, in particular, their mix of loans versus securities--is considerably more heterogeneous. In the 2012 cross section, a bank at the 10th percentile of the distribution had a ratio of securities to assets of 6.9 percent, while, for a bank at the 90th percentile, the ratio was almost six times higher, at 40.7 percent. One interpretation of this heterogeneity is as follows: While lending is obviously very important for a majority of banks, it need not be the case that a bank's scale is pinned down by the nature of its lending opportunities. Rather, at least in some cases, it seems that a bank's size is determined by its deposit franchise, and that, taking these deposits as given, its problem then becomes one of how best to invest them. Again, this liability-centric perspective is very different from how we are used to thinking about nonfinancial firms, whose scale is almost always presumed to be driven by its opportunities on the asset side of the balance sheet. The third stylized fact, illustrated in figure 1, is the one that I found most eye- opening: While banks might be quite heterogeneous in their mix of loans and securities, within the category of securities, they appear to have well-defined preferences. As can be seen in the figure, banks hold very little in the way of Treasury securities and securities issued directly by the government-sponsored agencies: These two categories accounted for just 7.7 percent and 5.8 percent of total securities holdings, respectively, on a value- weighted basis in 2012. The large bulk of their holdings is in MBS guaranteed by the agencies and other types of mortgage-linked securities--such as CMOs and commercial securities holdings in 2012. Also important is the "Other" category, which includes corporate and municipal bonds, as well as asset-backed securities, and which accounted for 29.3 percent of holdings in 2012. This composition of banks' securities portfolio is not what you would expect if they were simply holding securities as a highly liquid buffer against, say, unexpected deposit outflows or commitment drawdowns. It also appears--superficially, at least--at odds with the narrow-banking premise that one can profitably exploit a deposit franchise simply by taking deposits and parking them in Treasury bills. Rather, it looks as if banks are purposefully taking on some mix of duration, credit, and prepayment exposure in order to earn a spread relative to Treasury bills. And indeed, over the period from 1984 to 2012, the average spread on banks' securities portfolio relative to bills was 1.73 percent. By contrast, over this same period, we estimate that if banks had raised deposits and invested them exclusively in three-month Treasury bills, they would have earned an average net return of only 0.06 percent of deposits. This figure is based on three components. First, the spread between the rate earned on bills and that paid on deposits averaged 0.87 percent over the sample period. Second, there was additional noninterest income on deposits (for example, overdraft fees) of 0.49 percent of deposits. Third, however, deposit-taking involves considerable bricks-and-mortar costs. Using Call Report data on banks' total costs, and a hedonic regression approach to infer the portion of cost that is due to deposit-taking, we estimate this piece to have averaged 1.30 percent of deposits over the sample period. Thus, the net profitability of narrow banking is given Overall, our synthesis of these stylized facts is that banks are in the business of taking deposits and investing these deposits in fixed-income assets that have certain well- defined risk and liquidity attributes but which can be either loans or securities. The information-intensive nature of traditional lending--in the delegated monitoring sense--while clearly important in many cases, may not be the defining feature of banking. Rather, the defining feature may be that, whether banks invest in information-intensive loans or relatively transparent securities, they invest in fixed-income assets that have some degree of price volatility and illiquidity and so offer a higher return than very liquid and safe Treasury securities. In this sense, small business loans and CMOs are on one side of the fence, and Treasury securities are on the other. Before proceeding, I should note a natural first reaction to these observations. You might say, "Of course banks prefer holding riskier securities to riskless ones, even if they create no monitoring value in either case. They are just taking advantage of the put option created by deposit insurance. In other words, the evidence on the patterns of banks' securities holdings just reflects a moral hazard problem and nothing more." Without intending to dismiss the importance of moral hazard generally, I don't think it can fully account for the data in figure 1. One way to make this point is to redraw the figure, restricting the sample only to those banks with the highest levels of capital at any point in time--those above the median of the distribution by the ratio of equity to assets--as is done in figure 2. As can be seen, the basic patterns are very similar to those in figure 1. Given that these highly capitalized banks are less likely to impose losses on the Deposit Insurance Fund, I think there is something deeper here than can be explained by a simple appeal to deposit-insurance-induced moral hazard. So what, then, is the story? As I alluded to earlier, it begins with the observation that a deposit franchise has two important dimensions. First, it offers a bank a low-cost source of financing, given the premium that investors are willing to pay (that is, the lower yield they are willing to accept) for safe money-like claims. And, second, it offers funding stability, since with an adequate capital buffer and deposit insurance, it is rational for depositors to be "sleepy" and disregard moderate changes in the mark-to-market value of long-term fixed-income assets. Thus, a stable deposit franchise gives a bank the ability to ride out transitory valuation changes of the sort that might come from noise- trader shocks or fire sales, without being forced to liquidate assets at temporarily depressed prices. As a result, traditional banks with stable funding have an advantage relative to their shadow banking counterparts in holding those assets where transitory repricing risk is high for a given level of underlying fundamental cash flow risk. Here's one way to put the broad theme of our work: We have learned from this year's Nobel laureates, Eugene Fama and Robert Shiller, that discount rate variation--that is, transitory movements in asset prices not driven by changes in future expected cash flows--is central to understanding asset pricing. Our basic message is that this same discount rate variation may also be central to thinking about financial intermediation and, in particular, the connection between the asset and liability sides of intermediary balance sheets. In a world with transitory pricing shocks, a stable funding structure can be an important source of comparative advantage for holding certain types of assets. We have developed a simple model to try to make these ideas precise and to flesh out further empirical implications. I won't try to walk you through it in all of its detail, but I will try to give you a flavor for the basic structure and the main results. The model has three dates--0, 1, and 2--with a timeline illustrated in figure 3. There is a collection of different long-lived fixed-income assets indexed by i . The payoffs on these assets are all perfectly correlated. In particular, each asset i pays off at time 2 if the aggregate state of the world is such that there has been no default, and it pays off a lower amount, z , if there has been a default. At time 1, there is an interim news event. With probability p , the news is good, which means that all assets will definitely not default at time 2. And with probability (1 - p ), the news is bad, which means that there is a subsequent probability of default on all assets of (1 - q ) at time 2. Thus, in the bad-news state at time 1, the fundamental value of asset i is (1 - q z . However, if there is bad news at time 1, the market value of asset i will be depressed by a temporary fire-sale effect and will be given by k . The value of k is endogenous and asset specific in our model and depends on the equilibrium quantity of asset i that is liquidated at time 1; I will return to this feature momentarily. Household preferences are as follows: Households are risk neutral over fluctuations in their consumption. However, they derive additional utility--which can be thought of as transactions services--from holding completely safe claims, since these claims can be used in a money-like fashion. The upshot of these assumptions is that households require a fixed rate of return on any risky claims, no matter how risky, but a lower rate of return on claims that can be made completely safe. These latter safe claims can be interpreted as privately created money. Given these household preferences, the name of the game for financial intermediaries is to create as much in the way of safe money-like claims from each asset category i as possible. And given the structure of the model, there are two distinct technologies for creating safe claims. The first technology we label "traditional banking." A traditional bank is relatively conservative in issuing safe claims. In particular, for each dollar it holds of asset i , it issues z of deposits and finances the rest with equity. Since asset i always pays off at least z , even in the worst-case scenario, a depositor in a traditional bank can sleep through whatever news comes in at time 1 and still be assured of having a safe claim. In other words, a bank backs its deposits with enough capital so as to make these deposits safe over a two-period horizon and hence endogenously sticky; there is no reason for bank depositors ever to run at time 1. Alternatively, one can think of the bank as having acquired deposit insurance--which allows depositors to sleep through time 1--and the deposit insurer as having imposed a capital requirement of (1- z ) on the bank so as to reduce its expected losses to zero. The second technology for creating safe claims we label "shadow banking." Shadow banks are more aggressive: They rely less on capital, and more on the exit option at time 1, to create safety for their investors. Specifically, a shadow bank issues k of short-term collateralized claims for each dollar of asset i it holds, where k z . The way these claims are kept safe is that if there is bad news at time 1, the investors seize the collateral and dump it at the fire-sale price, realizing k . In other words, unlike bank investors, shadow bank investors cannot afford to sleep through time 1; their ability to pull the plug at this interim date is essential to keeping their claim safe. For any given asset i , the key question is, which type of intermediary--traditional bank or shadow bank--will end up holding the asset in equilibrium, and in what relative proportions? The answer to this question turns on the following tradeoff. On the one hand, since banks finance themselves with more equity and less cheap "money" than shadow banks, their overall cost of financing is higher, which puts them at a disadvantage. On the other hand, their more conservative capital structure means that banks' deposits never run on them. Hence, unlike shadow banks, they are never forced to liquidate assets at temporarily low prices when there is bad news at time 1; they can simply ride out this bad news and hold on to their investments until prices recover at time 2. In other words, as compared with shadow banks, traditional banks pay more to have a stabler funding structure, which is especially helpful for investing in those assets for which fire-sale discounts are high. To close the model, we need to endogenize the fire-sale discount factor, k . We assume that this fire-sale discount depends in part on the amount of liquidations at time 1, which is in turn related to the extent of ownership of asset i by the shadow banking sector--the more the shadow banking sector owns, the more gets dumped at time 1, and hence the lower is the fire-sale price. This assumption implies that the fire-sale discount plays an important equilibrating role in the model, and that we can have interior equilibria in which the ownership of a given asset i is divided across the traditional banking and shadow banking sectors; as ownership migrates to shadow banks, the fire- sale discount widens, which tends to reduce the relative advantage of shadow banks. Specifically, we adopt the following reduced form: k k m , ph ), where m is the fraction of asset i held by the shadow banking sector and ph is an index of asset illiquidity, with higher values of ph corresponding to less-liquid assets. We assume that d k m < 0, meaning that a greater shadow banking share results in a lower fire-sale price, and that d k m d ph < 0, meaning that this adverse price-pressure effect is amplified in more-illiquid assets. With all of this machinery in place, I can now state our main results, which characterize how banks' equilibrium market shares depend on the two primitive asset- level parameters, ph and z . First, we have that dm d < 0, which means that banks have a bigger share relative to shadow banks in more-illiquid assets, all else being equal. Second, we have that dm dz < 0, which means that banks have a bigger share in assets that have less long-run solvency risk, all else being equal. Taken together, these two results suggest that banks have a comparative advantage in holding assets that can experience significant temporary price dislocations but, at the same time, have only modest fundamental risk. Agency MBS might be a leading example of such an asset, since they are insured against default risk but are less liquid than Treasury securities and, for a given duration, have more price volatility, as the MBS-Treasury spread varies significantly. The model also explains why, even absent any institutional or regulatory constraints, banks would endogenously choose to avoid equities--they simply have too much fundamental risk. Because their value can fall very far over an extended period of time--that is, because their z is close to zero--equities cannot be efficiently used as backing to create safe two-period claims. So they are not good collateral for bank money. By contrast, to the extent that they are highly liquid, they do make suitable collateral for very short-term repo financing. In other words, equities can be used to back some amount of shadow bank money. It should be noted that the model admits either interior outcomes or corner solutions, depending on the asset-specific values of z and ph . So it is consistent with the possibility that some assets (say, highly illiquid loans) will be held only by banks, some (say, Treasury securities) will be owned predominantly but not exclusively by shadow banks, and some (say, agency MBS, CMBS, and CMOs) will be owned in significant quantities by each type of intermediary, with an equilibrium fire-sale discount that just balances the tradeoff between the two organizational forms. In this view of the world, loans are seen as being on a continuum with less-liquid securities, and they are held by banks because of their relative illiquidity and susceptibility to fire-sale discounts, not solely because of a need for monitoring. One way to draw out some further implications of the model is to focus on the key comparative static, dm d < 0--namely, that banks have a bigger market share in more-illiquid assets. Now, of course in the real world, there are many different kinds of financial intermediaries, not just two as in our simple model. But a rough generalization of our theory would be to say that across intermediary types, we should expect those with relatively more-stable liabilities to hold more-illiquid assets. To implement a test of this proposition, we use flow of funds data on eight classes of financial intermediaries: banks, broker-dealers, money market funds, real estate investment trusts, government-sponsored enterprises, property and casualty insurers, life insurers, and finance companies. The flow of funds data include breakdowns of the different assets and liabilities of each of these intermediaries. Our test then requires us to measure the "illiquidity" of each category of asset and the "stickiness" of each category of liability, which we do using homemade indexes that vary from 0 to 1. Although there is inevitably some subjectivity involved in constructing these indexes, we try to minimize this subjectivity by relying as heavily as possible on the parameters in Basel III's Net With these indexes in hand, we can then aggregate up to create values for the asset illiquidity and liability stickiness of an entire intermediary sector. Figure 4 plots the results of this exercise using data as of year-end 2012. As can be seen, there is a very tight cross-intermediary correlation between liability stickiness and asset illiquidity. At one end of the spectrum are money market funds and broker- dealers--prototypical shadow-bank-type institutions--with very low values of both, and at the other end are banks and life insurance companies. While there are only eight data points, the close fit of the regression line is consistent with the broad thrust of our story. To further highlight the importance of stable bank liabilities, figure 5 takes an approach similar to that of figure 4 but plots asset illiquidity versus the contractual maturity of liabilities, rather than their effective stickiness. Now the banking sector appears as a huge outlier, since the contractual maturity of banks' liabilities is extremely short--indeed, shorter than that of broker-dealers--even while they hold highly illiquid assets. This observation underscores a key point: If one wants to understand the divergent asset-side behavior of banks and shadow banks, one has to look not to the literal contractual maturity of their liabilities, but rather to the differing incentives that their overall financial and institutional arrangements create for short-term claims to be stable in the face of bad news. Our framework may also be helpful in understanding a couple of other aspects of the business of banking. The first is banks' accounting treatment of their "available for sale" securities, according to which ongoing mark-to-market gains and losses don't appear in net income. This treatment implicitly presumes that these gains and losses are temporary and that banks can ride them out by not having to sell the security in question before it matures. While I would not want to go so far as to claim that our model justifies this accounting practice, it at least provides a starting point for thinking about it. contrast, the practice would be incomprehensible in a world in which changes in asset prices reflected changes in expected future cash flows. Second, our approach may help shed some light on the bricks-and-mortar costs associated with bank deposit-taking. As I mentioned earlier, we estimate these costs to be quite high, averaging on the order of 1.30 percent of deposits over the period from 1984 to 2012. And of course, these costs ultimately represent an endogenous decision-- banks could always choose to offer their customers fewer and less attractive branch locations, fewer opportunities for interacting with a human teller, and so forth. One view is that these amenities are simply a separable flow of services to depositors, conceptually analogous to interest income. However, an interesting alternative is that they represent a deliberate effort to build loyalty--that is, to create a form of switching costs. To the extent that other elements of their business model are also devoted to creating and exploiting deposit stickiness, it may make more sense for banks to make complementary investments of this sort in enhancing customer loyalty. By contrast, a money market fund complex--which also takes deposits, but which invests exclusively in short-term assets-- has less reason to spend as heavily on a branch network. Let me summarize. The creation of private money--that is, safe claims that are useful for transactions purposes--is obviously central to what banks do. But safe claims can be manufactured from risky collateral in different ways, and banks are not the only type of intermediary that engages in this activity. What makes banks unique is that they use a particular combination of financial and institutional arrangements--including capital, deposit insurance, and access to a lender of last resort--as well as substantial investments in bricks and mortar, to create liabilities that are not only safe and money- like, but also relatively stable and thus unlikely to run at the first sign of trouble. This is in contrast to shadow banks, who create money-like claims more cheaply, by relying on an early exit option, and who are therefore more vulnerable to runs and the accompanying fire-sale risk. I have argued that there is a synergy between banks' stable funding model and their investing in assets that have modest fundamental risk but whose prices can fall significantly below fundamental values in a bad state of the world. This synergy helps explain both why deposit-taking banks might have a comparative advantage at making information-intensive loans and, at the same time, why they tend to hold the specific types of securities that they do. ------ (2013). , , , vol. 51 , vol. , vol. , vol. 48 , ,

r140225a_FOMC

united states

Monetary Policy and Financial Stability

tarullo

The financial crisis and its aftermath prompted an almost immediate call for change in financial regulation. Beyond the basic reaction that prudential regulation needed to be stronger and less subject to arbitrage, considerable support grew for the formerly minority view that regulation also needed to be firmly grounded in a macroprudential perspective explicitly directed at the stability of the financial system as a whole, not just at each regulated firm individually. The crisis also prompted increased attention to the relationship between monetary policy and financial stability. Here the lines of debate seem more sharply drawn than in the area of financial regulation. While few today would take the pre-crisis view common among central bankers that financial stability should not be an explicit concern of monetary policy, there is considerable disagreement over--among other things--the weight that financial stability concerns should carry compared with traditional monetary policy goals of price stability and maximum employment. This morning I will offer some comments on this ongoing debate. In part, these remarks will give my perspective on some of the familiar points of contention, such as the relative priority and role of nonmonetary, compared with monetary, policy instruments in responding to risks to financial stability. I also want to suggest that the cumulative effect over the past few decades of changes in financial technology, financial regulation, monetary policy itself, and perhaps the real economy have significantly altered the ways in which monetary instruments transmit through to the real economy. These changes may argue for refinement of monetary policy tools. They may also indicate the need for regulatory measures that are neither time varying nor limited to prudentially regulated firms, so as to provide a more stable financial foundation within which monetary policy will operate. The Federal Reserve, as we have been reminded by many accounts on the occasion of its centennial, was created largely in response to what we would now call financial stability concerns, as specifically revealed by the Panic of 1907. When confronted with an even deeper financial panic a hundred years later, the Federal Reserve deployed its full range of policy tools-- monetary policy, lender of last resort, and supervision--in an effort to stabilize the U.S. financial system. The Federal Reserve cut the federal funds rate to nearly zero by the end of 2008. It developed an innovative set of programs to provide liquidity to financial institutions and to restore confidence in the markets. These tools provided liquidity not only to commercial banks, but also to other financial institutions such as investment banks and money market funds, as well as to key financial markets such as those for commercial paper and asset-backed securities. provision of liquidity was instrumental in helping restore market confidence. Similarly, the development of the first supervisory stress test in 2009 helped to stabilize and restore confidence in the financial system as a whole by helping to ensure that the 19 largest bank holding companies were sufficiently capitalized so that they could continue serving as viable financial intermediaries. The combination of these tools was effective in restoring financial stability. The Great Recession that followed the crisis posed a new set of challenges. Given the constraint imposed by the effective lower bound on the federal funds rate, the Federal Reserve took unconventional measures to provide additional monetary accommodation during the recession and the subsequent protracted recovery. These alternative policy tools included large-scale purchases of longer-term Treasury and mortgage-backed securities for the Federal Reserve's portfolio and enhanced communication about its anticipated future policy, or "forward guidance," regarding the likely path of the federal funds rate. Large-scale asset purchases provided additional monetary accommodation by putting downward pressure on longer-term interest rates through a portfolio-balance subsequently initiated a series of purchase programs during the next several years and, in September 2012, implemented an open-ended program that would continue until there was a substantial improvement in the outlook for the labor market. With evidence accumulating that the labor market is improving materially, the Committee has begun to scale back the rate of these purchases. The Committee's forward guidance is also intended to put downward pressure on longer-term interest rates by influencing market expectations about the future path of short-term rates. Initially, the Committee relied on date-based descriptions of the likely path of interest rate policy. But in December 2012 the Committee shifted to quantitative, state-contingent guidance to provide greater clarity about the likely course of the federal funds rate under different paths for the economy. At that time, the Committee indicated that no increase in the federal funds rate target should be anticipated so long as unemployment remained above 6 1/2 percent and inflation was projected to be no more than 2 1/2 percent one-to-two years ahead. These unconventional tools appear to have been effective in helping promote the economic recovery. In particular, research largely supports the conclusion that changes in guidance influenced interest rate expectations, that asset purchases pushed down longer-term interest rates and boosted asset prices, and that these improvements in financial conditions contributed to the economic recovery in recent years. unemployment rate has fallen from 10 percent at its 2009 peak to 6.6 percent today, although debate continues over whether significantly lower labor force participation rates and other labor market indicators should be read to indicate somewhat less progress than the unemployment rate alone would suggest. But, while the recovery has been frustratingly slow and remains incomplete, there has been real progress, despite the fact that in the past couple of years a restrictive fiscal policy has been working at cross- purposes to monetary policy, and that balance sheet repair and financial strains in Europe have made it more difficult for the economy to muster much self-sustaining momentum. I hardly need remind this audience that the monetary policy pursued by the Federal Reserve in the past five years has occasioned considerable debate and controversy. Much of the debate revolves around the degree of efficacy of the unconventional instruments, particularly large-scale asset purchases, and particularly whether there might be diminishing returns to these purchases in some circumstances. I am certain that analysis of these issues will continue not only in the near term, but also in academic circles for years to come. A good bit of criticism has focused on the large expansion of the balance sheet and the sizable amount of excess reserves in the banking system. One oft-stated worry is that when it is time to normalize policy, we will be unable to withdraw reserves as quickly as needed to prevent an unwanted rise in inflation. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves could well have impeded the FOMC's ability to raise short-term interest rates. But we have a variety of tools to neutralize the effects of our balance sheet without selling assets. For example, we now pay interest on reserves; raising that rate would put upward pressure on short-term rates. In addition, we can drain reserves by employing fixed-rate overnight reverse repurchase agreements, term deposits, and term repurchase agreements. We will continue to develop and, as appropriate, test these tools to allow normalization of the balance sheet without unwanted inflationary consequences. The area of concern about recent monetary policy that I want to address at greater length relates to financial stability. The worry is that the actual extended period of low interest rates, along with expectations fostered by forward guidance of continued low rates, may be incentivizing financial market actors to take on additional risks to boost margins, thereby contributing to unsustainable increases in asset prices and a consequent buildup of systemic vulnerabilities. Indeed, in the years preceding the crisis, a few prescient observers swam against the tide of conventional wisdom to argue that a sustained period of low rates was inducing investors to "reach for yield" and thereby endangering the financial system. The incentive to reach for yield can be a real and significant concern in some circumstances. A low rate environment tends to squeeze the profitability of financial intermediaries of many types as they reinvest in assets with lower yields. Because these institutions can be driven by a variety of agency and accounting concerns to target high returns or place undue weight on the short-term performance of their portfolios, the pressure to maintain current yield can create incentives for these firms to take on excessive risk. This risk can manifest itself as excessive leverage, or greater credit or duration risk in portfolio choices, with the potential for large losses under adverse conditions. In addition, to the extent that investors crowd into similar asset classes, low rates can potentially inflate a speculative bubble, the ultimate unwinding of which could have negative consequences for economic activity. Here, then, is the potential quandary: The very accommodative monetary policy that contributed to the restoration of financial stability could, if maintained long enough in the face of slow recovery in the real economy, eventually sow the seeds of renewed financial instability. Yet removal of accommodation could choke off the recovery just as it seems poised to gain at least a bit more momentum. Such a situation requires assessment of the extent of this risk and, of particular importance to my topic today, the appropriate role of monetary policy in containing it. In presenting the mix of salient considerations in reacting to possible financial stability risks arising from extended periods of accommodative monetary policy, I should state at the outset something that will not likely come as a surprise to any of you. My observation has been that people's views on these risks tend to be at least generally correlated with their views on the effectiveness of monetary policy over the past few years and on the size of the output gap that remains today. Having said that, I have also observed that most people engaging in these discussions--whether in policy circles, commentary, or academic work--would agree on the basic policy instruments available for systemic risk containment, even as they would disagree on the extent of the threat and the relative utility of those instruments. So let me now present some of my own thoughts on both the specifics of the present situation and on some of the ongoing policy issues raised by these discussions. As a preliminary matter, it is important to note that incorporating financial stability considerations into monetary policy decisions need not imply the creation of an additional mandate for monetary policy. The potentially huge effect on price stability and employment associated with bouts of serious financial instability gives ample justification. Of course, this preliminary observation underscores the fact that the identification of systemic risks, especially those based on the putative emergence of asset bubbles, is not a straightforward exercise. The eventual impact of the bursting of the pre- crisis housing bubble on financial stability went famously underdiagnosed by policymakers and many private analysts. But there would be considerable economic downside in reacting with policy measures each time a case could be made that a bubble was developing. That is, there is ample opportunity for both Type 1 and Type 2 errors. As the metrics for assessing systemic risks continue to improve, this problem may be alleviated, but I suspect it will never be eliminated. We are paying close attention to the macroprudential risks posed by the low interest rate environment, particularly given the possibility that interest rates may remain historically low for some time even after the FOMC begins to increase its target for the federal funds rate. The Federal Reserve has, as a result of a number of organizational changes made since the crisis, a more focused structure for monitoring potential risks to financial stability and using the information we glean from this monitoring to shape our supervisory and regulatory actions. One prominent change has been the reorientation of our supervision of large bank holding companies through the creation of the Large systemic risk considerations. Another has been the creation of the Office of Financial Stability Policy and Research, which is charged with monitoring financial risks, analyzing the implications for financial stability, and identifying macroprudential policies for mitigating detected risks. At present, our monitoring does find some evidence of increased duration and credit risk, but the increases appear relatively moderate to date--particularly at the largest banks and life insurers. Moreover, valuations for broad categories of assets such as real estate and corporate equities remain within historical norms, suggesting that valuation pressures, if present, are confined to narrower segments of assets. For example, valuations do appear stretched for farmland, although recent data are suggesting some slowing, and for the equity prices of some small technology firms. Still, there are areas where investors appear to have been very sanguine regarding certain types of exposure and modest in their demands for compensation to assume such risk. High-yield corporate bond and leveraged loan funds, for instance, have seen strong inflows, reflecting greater investor appetite for risky corporate credits, while underwriting standards have deteriorated, raising the possibility of large losses going forward. In these circumstances, it has to date seemed appropriate to rely on supervisory responses. For example, in the face of substantial growth in the volume of leveraged lending and the deterioration in underwriting standards, the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued updated guidance on leverage lending in March 2013. This guidance outlined principles related to safe and sound leveraged lending activities, including the expectation that banks and thrifts originate leveraged loans using prudent underwriting standards regardless of their intent to hold or distribute them. In addition, the Federal Reserve, alongside other regulators, has been working with the firms we supervise to increase their resilience to possible interest rate shocks. For instance, in both the 2013 and 2014 stress test and capital planning exercises, we incorporated various combinations of interest rate shocks in the adverse scenarios. Supervisors have also been working to estimate the implications of a wider variety of interest rate shocks. Our analysis to this point (undertaken outside of our annual stress test program) suggests that banking firms are capitalized to withstand the losses in asset valuations that would arise from large spikes in rates, which, moreover, would see an offset from the increase in the value of bank deposit franchises. This finding is consistent with the lack of widespread stress during the period of May through June 2013 when interest rates increased considerably. The next set of stress-test results, which we will release next month, will provide further insight on this point, both to regulators and to markets. While ad hoc supervisory action aimed at specific lending or risks is surely a useful tool, it has its limitations. First, it is a bit too soon to judge precisely how effective these supervisory actions - such as last year's leveraged lending guidance - have been. Second, even if they prove effective in containing discrete excesses, it is not clear that the somewhat deliberate supervisory process would be adequate to deal with a more pervasive reach for yield affecting many areas of credit extension. Third, and perhaps most important, the extent to which supervisory practice can either lean against the wind or increase the overall resiliency of the financial system is limited by the fact that it applies only to prudentially regulated firms. This circumstance creates an incentive for intermediation activities to migrate outside of the regulated sector. Should this shift occur in significant ways, the financial system could ultimately be exposed again to the very risks against which much post-crisis regulatory reform has been directed. To be sure, it is not a trivial task for unregulated financial-sector participants to move into activities in which regulated institutions have traditionally operated. But if the potential gains were high enough, unregulated actors could have sufficient incentive to do so. Indeed, it must be recognized that regular recourse to supervisory measures in response to nascent financial stability concerns would likely be perceived as increasing the payoff from this form of regulatory arbitrage. The limitations of supervision as a tool for managing the risks to financial stability that could arise from protracted periods of low interest rates have intensified interest in time-varying macroprudential policies -- that is, measures that can be calibrated to changing economic or financial conditions. A frequently cited example is increased loan-to-value requirements for certain types of lending such as residential or commercial mortgages. The appeal of such requirements is that they could, at least in principle, be adopted reasonably quickly as risks increased, implemented in a straightforward way, and applied to all market actors engaged in the covered activities, not just prudentially regulated firms. Having just recently addressed at some length the promise and limitations of such time-varying macroprudential tools, I will not repeat those views at length today. I can summarize by saying that, in practice, such policies face a number of challenges, including questions about the reliability of measures to guide policy actions, which officials should make macroprudential decisions, the speed with which policies might realistically be implemented and take effect, and the appropriate calibration of policies that will be effective in damping excesses while not unnecessarily reducing well- underwritten credit flows. And, as with supervisory policies, there is reason to doubt how effective they would be in circumstances where credit growth had been excessive across wide parts of the economy. As I have said previously, however, given that procyclicality is an important contributor to systemic risk, there is good reason to continue work on developing time- varying policies. I would devote particular attention to policies that can act as the rough equivalent of an increase in interest rates for particular sources of funding. Such policies would be more responsive to problems that were building quickly because of certain kinds of credit, without regard to whether they were being deployed in one or many sectors of the economy. In that respect, such policies should be more effective (and perhaps less controversial) in slowing the buildup of excess credit than a measure directed squarely at one sector, which might be quickly met by the redirection of a reach for yield to other asset classes. One example is the countercyclical capital buffer in Basel III, which provides for an increase in the risk-weighted capital requirements of prudentially regulated banking organizations of up to 2-1/2 percentage points when "credit growth is excessive and is leading to the buildup of system-wide risk." Because stricter capital requirements lead to higher levels of bank equity--which is typically more expensive than debt--they would likely result in higher funding costs for the bank-intermediated credit utilized by other market participants. In this regard, time-varying macroprudential policies can be thought of as addressing cyclical systemic risks via interest rates in a manner somewhat akin to a tightening of monetary policy, which by raising benchmark interest rates affects a similar increase in funding costs. Clearly, time-varying macroprudential policies could not be viewed as a substitute for monetary policy. Like ad hoc supervisory policies, they would influence a narrower set of transactions and, as such, would not "get in all the cracks" of the financial system, to use a phrase coined by my colleague Jeremy Stein. But, to shift metaphors, they could potentially provide something of a speed bump, while not producing the much broader effect on the economy that a federal funds rate increase would. Moreover, time-varying macroprudential policies may also give monetary policymakers more of an opportunity to assess whether the asset inflation is generalized and sustained enough to warrant a change in monetary policy. Although the three federal banking agencies included a countercyclical capital provision in the capital regulation to implement Basel III adopted last summer, the provision will not take effect in the United States until 2016. However, when the countercyclical capital buffer provision of Basel III does come into effect in the United States, we will have the benefit of experience for this tool from other countries. Over the Committee at the Bank of England have all finalized general statements on how this policy lever will operate in their jurisdictions, with implementation in each case proceeding in advance of when the policy will come into effect under Basel III. Moreover, in December, the Norwegian Ministry of Finance accepted the advice of the Norges Bank to activate a countercyclical capital buffer in the face of rising financial imbalances. The level of the buffer will be set at 1 percent of risk-weighted assets, The foregoing discussion has considered the ways in which existing supervisory authority and new forms of macroprudential authority may allow monetary policymakers to avoid, or at least defer, raising interest rates to contain growing systemic risks under circumstances in which policy is falling well short of achieving one or both elements of the dual mandate. However, as has doubtless been apparent, I believe these alternative policy instruments have real limitations. As I noted earlier, I do not think that at present we are confronted with a situation that would warrant a change in the monetary policy we have been pursuing. But for that very reason, now is a good time to consider these issues more actively. One useful step would be development of a framework that would allow us to make a more analytic, less instinctual judgment on the potential tradeoffs between enhanced financial stability and reduced economic activity. This will be an intellectually challenging exercise, but in itself does not entail any changes in policy. I have to this point described the possible need to balance longer-term financial stability and shorter-term economic growth considerations in the implicit context of a specific point in time, with the decision on use of supervisory, macroprudential, or monetary policy tools dependent on the level and nature of the potential systemic risk, the likely efficacy of each tool in containing that risk, and the expected side effects of each tool on growth. But in thinking about the relationship between monetary policy and financial stability, it is also worth taking a view less focused on decisions at a specific point in time. Changes in financial technology, regulation, and perhaps the real economy over the past few decades have profoundly affected the channels by which credit is created in the economy, and thus the potential for financial instability. The progressive integration of traditional lending and capital markets activities has created a fundamentally different financial system from that which existed from the mid-1930s through the mid-1970s, during which strict activities restrictions, limitations on competition, and deposit interest rate caps had shaped a banking system that was very stable and reasonably profitable, but not particularly innovative in meetings the needs of either savers or borrowers. The extensive deregulation of banking in the 30 years preceding the crisis, while understandable as a response to the threat posed by capital markets and unregulated financial firms to the franchise of regulated firms, left the financial system without a basic framework to contain the risks posed in the new environment. The explosive growth of short-term wholesale funding in the years preceding the crisis is the exemplary case of how the regulatory system has not kept pace with the integration of traditional lending and capital market activities. The amount of credit created through those channels meant that aggregate credit growth in the economy relative to GDP was much higher than just a few decades earlier, a development that may itself be connected to a greater likelihood of financial crises. Moreover, this funding was peculiarly susceptible to runs that can prompt fire sales and the sudden withdrawal of credit from counterparties. These direct financial stability concerns have been my principal motivation in devoting so much attention to measures such as minimum margins on securities financing transactions, a version of which are currently under development internationally under the auspices of the Financial Stability Board. But these kinds of changes might also make the trade-off between systemic risk and near-term growth aims a bit easier, since a financial system with more ballast will be less prone to listing in response to accommodative monetary policies directed at the dual mandate goals of price stability and maximum employment. Were such a regime of minimum margins in place, one could also see the potential for enhancing the effectiveness of monetary policy by adding a time-varying, countercyclical component. Finally, it may also be worth considering some refinements to our monetary policy tools. Central banks must always be cognizant of important changes that may result in different responses of households, firms, and financial markets to monetary policy actions. There is little doubt that the conduct of monetary policy has become a good deal more complicated in recent years. Some of these complications may diminish as economic and financial conditions normalize, but others may be more persistent. Central banks, in turn, may want to build on some recent experience, adapted for more normal times, in addressing the desire to contain systemic risk without removing monetary policy accommodation to advance one or both dual mandate goals. One example would be altering the composition of a central bank's balance sheet so as to add a second policy instrument to changes in the targeted interest rate. The central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones. In reviewing the relationship between financial stability considerations and monetary policy, I have suggested that monetary policy action cannot be taken off the table as a response to the build-up of broad and sustained systemic risk. But I have also tried to suggest that the development of existing supervisory tools, the judicious use of macroprudential measures, the adoption of some structural measures affecting certain forms of financing, and perhaps some refinements of monetary policy tools can together reduce the number of occasions on which a difficult tradeoff between financial stability considerations and near-term growth or price stability aims will need to be made.

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united states

Comments on "Market Tantrums and Monetary Policy"

stein

I am delighted to have the opportunity to discuss the paper "Market Tantrums and Monetary Policy." It is timely, provocative, and extremely insightful. Let me start by summarizing what I take to be the paper's main messages. First, the authors argue that policymakers should pay careful attention not just to measures of leverage in the banking and shadow banking sectors, but also to the financial stability risks that might arise from the behavior of unlevered asset managers, such as those running various types of bond funds. Notably, assets under management in fixed-income funds have grown dramatically in the years since the onset of the financial crisis, even while various measures of financial-sector leverage have either continued to decline or remained subdued. Second, the authors develop a model of agency problems in delegated asset management, according to which an environment of low short-term rates can encourage asset managers concerned with their relative performance rankings to "reach for yield," which in turn acts to compress risk premiums. Moreover, the model has the feature that this reach for yield can end badly, with a sudden and sharp correction in risk premiums that arises endogenously in response to a small tightening of monetary policy. The events of the spring and summer of 2013, when there was a rapid rise in bond market term premiums, are cited as a leading example of what the model sets out to capture. Third, the authors assert that the conventional regulatory toolkit, which is largely designed to contain intermediary leverage, is not well suited to dealing with the asset- management sector. Given this limitation of regulation, and because monetary policy has a direct influence on the behavior of asset managers, the financial stability risks that these managers create should be factored into the design and conduct of monetary policy. Presumably, this consideration would imply that monetary policy should be somewhat less easy in a weak economy, all else being equal, to reduce the probability of an undesirable upward spike in rates and credit spreads down the road. The authors are careful to note that "our analysis neither invalidates nor validates the course the Federal Reserve has actually taken." Rather, they are highlighting a set of considerations that they believe should ultimately be incorporated into the design of a monetary policy framework. This is the spirit in which I will discuss the paper--not as a comment on the current stance of policy, but as an exploration of the factors that should be taken into account when thinking about the tradeoffs associated with monetary policy more generally. The model in the paper is a simple one, and it does a nice job of framing the issues. In particular, here is how I think about the value-added of the theory: On the one hand, an emerging body of empirical work documents that an easing of monetary policy-- even via conventional policy tools in normal times--tends to reduce both the term premiums on long-term Treasury bonds and the credit spreads on corporate bonds. is, monetary policy tends to work in part through its effect on capital market risk premiums, perhaps through some sort of risk-taking or reaching-for-yield mechanism. On the other hand, while this empirical observation sheds some interesting light on how monetary policy influences the real economy, it does not by itself suggest that there is any financial stability dark side to the lowered risk premiums that go with monetary accommodation. For there to be any meaningful tradeoff, there would have to be some sort of asymmetry in the unwinding of these risk premiums, whereby the eventual reversal either happens more abruptly, or causes larger economic effects, than the initial compression. Said a little differently, if an easing of Federal Reserve policy puts downward pressure on term premiums and credit spreads, and if this downward pressure is only gradually reversed as policy begins to tighten, then what is the problem? The nice feature of the model is that it speaks to this asymmetry. That is, it features a gradual compression of risk spreads during a period of monetary ease, and then, when policy begins to tighten, it delivers a sharp and abrupt correction, driven by a particular form of market dynamics. Of course, this is just a theoretical prediction. One thing that the paper does not do, but which would be very helpful in assessing the real-world relevance of the model, would be to see if this sort of asymmetry in bond returns is present in the data. In particular, if I am interpreting the model correctly, it implies a specific form of conditional volatility and skewness in bond returns. For example, when term premiums are unusually low relative to historical norms, the model suggests an elevated probability of a sharp upward spike in rates. I don't know of any evidence that bears on this hypothesis in the bond market, though an analogous pattern does appear in stock market returns. It is worth saying a little about the "musical chairs" mechanism that leads to the sharp spike in rates. The fund managers in the model care about their relative performance in that they are averse to posting lower returns than their peers, holding fixed absolute performance. These relative-performance concerns induce a form of strategic complementarity of fund manager actions. Specifically, as short-term rates begin to rise and fund manager i contemplates whether she should bail out of long-term bonds and move into short-term bills, she is more apt to do so if she thinks that some other manager, j, is also going to bail--because she is worried that otherwise, she may wind up underperforming manager j and finishing last in the relative-performance tournament. While appearing in a different guise here, this strategic-complementarity effect-- the idea that any one agent is in more of a rush to get out when he or she thinks that others may also want to get out--is essentially the same mechanism that drives bank runs in the classic work of Diamond and Dybvig, and that, in one manifestation or another, creates financial fragility in many other settings. However, one thing that is distinctive about the variant presented in the current paper is that there is a clear prediction of exactly what sets off the run for the exits on the part of money managers--namely, a small increase in short rates beyond a certain threshold level. The model focuses on one particular source of run-like fragility that might emanate from the asset-management sector, but there are others. One that the paper briefly mentions, and that is worth a fuller treatment, has to do with the potential for outflows of assets under management (AUM) from open-end funds. Note that the model is effectively one of a closed-end fund, since the manager is assumed to have a fixed amount of AUM; the fragility, in this case, comes entirely from the manager's portfolio allocation decision and from the strategic interaction among fund managers . But another source of run-like risk comes from the strategic interaction among fund investors and the incentives that each of them may have to get out before others do when asset values are at risk of declining. These AUM-driven run dynamics are more likely to arise in those open-end funds that hold relatively illiquid assets. The key question in determining whether there is a strategic complementarity in the withdrawal decisions of fund investors is, When investor i exits on day t , does the net asset value (NAV) at the end of the day that defines investor i 's exit price fully reflect the ultimate price effect of the sales created by his exit? If not, those investors who stay behind are hurt, which is what creates run incentives. And, if the run incentives are strong enough, then a credit-oriented bond fund starts looking pretty bank-like. The fact that its liabilities are not technically debt claims is not all that helpful in this case--they are still demandable, and hence investors can pull out very rapidly if the terms of exit create a penalty for being last out the door. A fund's stated NAV is less likely to keep pace with the ultimate price impact of investor withdrawals if the underlying assets are illiquid, for two distinct reasons. First, some of the assets are likely to have stale prices--that is, not to have been recently marked to market. And, second, if most of a fund's assets are illiquid securities, its manager will be inclined to accommodate early exits by drawing down on the fund's cash reserve while planning to sell securities and replenish the cash stock later. Why, at the end of the day, should one care if run-like incentives come predominantly from the strategic behavior of fund investors, as opposed to that of fund managers? Isn't there the same worrisome fragility in either case? Perhaps, but the policy response may differ depending on the exact diagnosis. In the former case, when the primary worry is AUM runs on the part of investors, there is at least in principle a natural regulatory fix: One could impose exit fees on open-end funds that are related to the illiquidity of the funds' assets, in an effort to make departing investors more fully internalize the costs that they impose on those who stay behind. In the latter case, when the problem is driven more by the portfolio choices of fund managers, it is harder for me to see an obvious regulatory response, so I am more inclined to share the authors' view that if there is, indeed, a significant financial stability problem, monetary policy would be left to take up some of the slack. To be clear, I am not advocating for exit fees of the sort I just described; I do not think we know enough about the empirical relevance of the AUM-run mechanism, to say nothing of its quantitative importance, to be making such recommendations at this point. But, given the detailed nature of the microdata that are available on individual fund holdings and returns, there is clearly room to make significant further progress on this front. Indeed, recent work by Chen, Goldstein, and Jiang is very much in this spirit, although it restricts its analysis to equity funds and doesn't consider the fixed-income categories that are the focus of the current paper. With this framing in mind, let me comment briefly on the empirical work in the paper. There is a lot of it, and I will just touch on a couple of points. A first observation is that the heavy focus on flows in and out of funds is a bit at odds with the theoretical model. As I mentioned earlier, the model, taken literally, is one of closed-end funds with fixed AUM. If one were interested in testing the specific mechanism in the model most directly, it seems to me that one would want to look not at fund flows but rather at the portfolio allocations within each fund. For example, the model suggests that, during the unfolding of an episode of bond market volatility like the one in the spring and summer of last year, we should see a coordinated shift among bond managers out of long-term bonds and into bills so that the average durations of their portfolios would co-move strongly together. There is a well-developed empirical literature on herding among fund managers in their portfolio allocations, but, as far as I know, this work has not looked at how such herding responds to changes in the monetary policy environment. So this avenue seems like a potentially promising one to pursue. The paper's focus on flows in and out of funds is, however, well suited to thinking about mechanisms related to AUM-run dynamics. In this regard, a particularly interesting set of findings has to do with the ability of flows to forecast future asset returns, even controlling for past returns. And, most notably, this forecasting effect is much stronger in the less liquid high-yield and emerging market categories than it is in U.S. Treasury securities; indeed, it is essentially nonexistent in the latter category. While not a decisive test, this pattern is consistent with one of the necessary preconditions for the existence of strategic complementarities and run-like dynamics. Again, the key idea is that, when a fund's assets are illiquid, outflows today are met in part with drawdowns from cash reserves, with the other assets being sold off more gradually over time--hence, the predictable downward pressure on prices going forward. This predictability is what creates the incentive for any given investor to pull out quickly if he or she sees a large number of co-investors pulling out. Let me summarize by noting the areas in which I agree most closely with the authors and by adding one key qualification. First, I think they are absolutely on target in emphasizing that the rapid growth of fixed-income funds--as well as other, similar vehicles--bears careful watching. As they point out, it would be a mistake to be complacent about this phenomenon simply because such funds are unlevered. Other economic mechanisms can mimic the run-like incentives associated with short-term debt financing, and one or more of these mechanisms may well be present in fixed-income funds. Second, I also agree that there is no general separation principle for monetary policy and financial stability. Monetary policy is fundamentally in the business of altering risk premiums such as term premiums and credit spreads. So monetary policymakers cannot wash their hands of what happens when these spreads revert sharply. If these abrupt reversions also turn out to have nontrivial economic consequences, then they are clearly of potential relevance to policymakers. My one qualification is as follows: In the absence of a general separation principle, when one might consider addressing financial stability issues either with regulation or with monetary policy, it becomes all the more critical to get the case-by- case analysis right--that is, to really dig into the microeconomic details of the presumed market failure and to ask when a regulatory intervention is comparatively more efficient than a monetary one, or vice versa. So while I think it is important to remain heterodox and to be open to taking either approach, I would not want to rule out the possibility that some of the risks identified by the authors could be mitigated, at least in part, via a regulatory approach. I look forward to seeing more work that helps us sort through these challenging issues. vol. 61, pp. . vol. . . of Governors of the Federal Reserve System, July, available at . Turnovsky, eds., vol. 1 .

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united states

Remarks at the Ceremonial Swearing-in

yellen

Good afternoon. Thank you Dan, and thank you to everyone gathered here and others throughout the System who are listening in. To members of Congress, Secretary Lew and others from the administration and fellow financial regulatory agencies who are with us today, welcome to the Federal Reserve. Many friends and family of mine are here, including my spouse, George, my brother, John, and my sister-in-law, Alison. I am honored also to welcome back former Chairman Greenspan. I want to particularly thank President Obama for the honor of being asked to lead the Federal Reserve and carry on its important work. When I accepted his offer, I promised the president I would do my very best, working with my Fed colleagues, to help restore the health of the economy and promote a strong and stable financial system. I am repeating this promise, in this distinguished company and to all others listening because that is what this ceremony is about. The oath I have affirmed, identical to the one taken by everyone serving the Federal Reserve, is a public promise to carry out my duties guided by no interest other than the public's interest. Today's event comes, as many of you know, a busy month after I began my duties as Chair. In that short time, the Board has taken significant steps to further strengthen financial regulation, and I have discharged one of my most important responsibilities, accounting for the Fed's actions and explaining its policies in our semi-annual report to Congress. I'll do more of that explaining in two weeks, when I respond to questions from the media after the next meeting of Such communication is vital in a democracy and especially important for the Federal Reserve, which relies on the confidence of the public to be effective in carrying out its mission. Chairman Bernanke initiated press conferences in 2011 as one of a number of steps to make the Federal Reserve more transparent and accountable, and I promise to build on his legacy. Since 2010, when Chairman Bernanke stood where I stand today, we have made considerable progress. The economy is stronger and the financial system is sounder. We have come a long way, but we have farther to go. More work lies ahead to complete implementation of Congress' plan for strengthening financial regulation, the Dodd-Frank Act. I promise to stay focused on moving that process forward as quickly and responsibly as possible and to verify that these reforms are meeting the goal of safeguarding the financial system. I will also continue the work of helping repair the damage done by the financial crisis to the economy. Too many Americans still can't find a job or are forced to work part-time. The goals set by Congress for the Federal Reserve are clear: maximum employment and stable prices. It is equally clear that the economy continues to operate considerably short of these objectives. I promise to do all that I can, working with my fellow policymakers, to achieve the very important goals Congress has assigned to the Federal Reserve. I take up these challenges aided by the immensely skilled, talented, and dedicated men and women who comprise the Federal Reserve's staff. Our staff constitute one of the Fed's greatest strengths and I am proud to serve with individuals who exhibit the highest standards of professionalism and integrity. They work tirelessly, day in and day out, to serve the public interest. Their skill, creativity and perseverance enabled the Fed to do its part to meet the grave threats our nation faced in the financial crisis and then persevere in a disappointingly slow recovery. And their knowledge, analysis and judgment will be indispensable in fulfilling the mission of the Federal Reserve in the years ahead. Congress has entrusted the Federal Reserve with great responsibilities. The tools we deploy, to guide the financial system and influence our vast economy, can seem far removed from the lives and concerns of average Americans. And yet the decisions we make affect the welfare and shape the future of every American. I promise to never forget the individual lives, experiences and challenges that lie behind the statistics we use to gauge the health of the economy. The unemployment rate represents millions of individuals who are eager to work but struggling to provide for themselves and their families. When we make progress toward our goals, each job that is created lifts this burden for someone who is better equipped to be a good parent, to build a stronger community, and to contribute to a more prosperous nation. Let me close by offering my heartfelt thanks for the many messages I have received since my nomination from individuals around the country who have written to wish me well and offer their support. I pledge to do my very best to meet the challenges that lie ahead. Thank you all for coming today.

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united states

Incorporating Financial Stability Considerations into a Monetary Policy Framework

stein

I would like to talk today about how one might explicitly incorporate financial stability considerations into a monetary policy framework. Doing so involves tackling two questions--one that is relatively easy and one that is much harder. The easier question is, should financial stability concerns, in principle , influence monetary policy decisions? To be specific, are there cases in which one might tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level than one would otherwise, because of a concern that a more accommodative policy might entail a heightened risk of some sort of adverse financial market outcome? This question is about theory, not empirical magnitudes, and, in my view, the theoretical answer is a clear "yes." I will say a bit more about why shortly, but let me stress that I am not breaking any new conceptual ground here; the basic argument has been laid out by a number of others, including Woodford and Kocherlakota. The second question is, how does one operationalize the theory? What sorts of data should one look to, and what sorts of empirical methods should one use, to calibrate by how much the stance of monetary policy should be altered relative to the case in which financial stability considerations are completely set aside? This question is very difficult. In the interests of advancing the conversation, I will venture some tentative thoughts on one possible approach, which is somewhat different than what I have seen in other recent work on this topic. While I hope to convince you that this path is worth exploring, I cannot say that I know yet exactly where it will lead--and, in particular, whether it will ultimately deliver monetary policy prescriptions that differ in a quantitatively meaningful way from those offered by our current models. So I do not intend anything that follows as a comment on the current stance of our policy. Before getting too deep into the details, let me preview my bottom line. I am going to try to make the case that, all else being equal, monetary policy should be less accommodative--by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level--when estimates of risk premiums in the bond market are abnormally low. These risk premiums include the term premium on Treasury securities, as well as the expected returns to investors from bearing the credit risk on, for example, corporate bonds and asset-backed securities. As an illustration, consider the period in the spring of 2013 when the 10-year Treasury yield was in the neighborhood of 1.60 percent and estimates of the term premium were around negative 80 basis points. Applied to this period, my approach would suggest a lesser willingness to use large-scale asset purchases to push yields down even further, as compared with a scenario in which term premiums were not so low. The informal intuition I have in mind is that there is a cost associated with pushing risk premiums too low, because doing so increases the likelihood that they may revert back in a way that hinders the Federal Reserve's ability to achieve its mandated objectives. In what follows, I will try to make this intuition more precise and to generalize its applicability. However, let me start with the conceptual question of whether financial stability considerations belong at all in a monetary policy framework. As I said earlier, I think the clear in-principle answer here is "yes." The generic argument rests on three assumptions. First, suppose that the Federal Reserve focuses only on its traditional dual mandate of maximum employment and price stability. To keep things simple, suppose further that these two goals are not in conflict with one another--say, because aggregate demand is weak, depressing both employment and inflation--so that we can boil things down to one objective: keeping unemployment close to target. With the usual quadratic loss objective function, this assumption would say that the Federal Reserve cares about minimizing the expected value of ( - . A little bit of algebra shows that this objective function can in turn be decomposed into two pieces: (1) an "expected shortfall" term, given by the squared deviation of expected unemployment from the target level of term, given by the variance of realized unemployment, Second, the argument assumes that there is some variable summarizing financial market vulnerability--I will be abstract for the moment and just call it FMV--which is influenced by monetary policy. That is, easier monetary policy leads to increased vulnerability as measured by FMV. Moreover, when FMV is elevated, there is a greater probability of an adverse event--some kind of financial market shock--that, if it were to occur, would push up the unemployment rate, all else being equal. The third and final assumption is that the risks associated with an elevated value of FMV cannot be fully offset at zero cost with other nonmonetary tools, such as financial regulation. To be clear, this assumption does not imply that regulation is not helpful in reducing financial vulnerabilities--it only says that regulation is not a perfect instrument. These imperfections could stem from regulatory arbitrage; political-economy constraints; or the fact that too much regulation can also impede economic growth, just like overly restrictive monetary policy. Thus one way to think of my construct of FMV is that it is a stand-in for the level of financial vulnerabilities that remain after regulation has done the best that it can do, given the existing real-world limitations. In this setting, even with inflation concerns entirely set aside, monetary policy faces a tradeoff. Consider a situation in which unemployment is above target. A more accommodative policy has the usual benefit of lowering expected unemployment and thus reducing the expected shortfall term in the objective function. If, however, it also raises the conditional variance of the unemployment rate via an elevated-FMV channel-- thereby increasing the risk term in the objective function--then there is a cost to be weighed alongside the benefit. And importantly, this is true even when financial stability is not a separate objective in and of itself; as I have framed it, financial stability matters only insofar as it affects the degree of risk around the employment leg of the Federal Reserve's mandate. To be sure, absent a concrete measure of FMV, as well as some sense of the responsiveness of FMV to monetary policy, this discussion is all pretty theoretical and non-operational. So I will turn to measurement in a moment. But it is worth noting one useful qualitative observation that emerges just from the logic and from the nature of a quadratic loss function. In making the tradeoff I just described, the marginal benefit of using easier policy to reduce the expected unemployment gap is greater when the gap itself is large--that is, when unemployment is far above target. In this case, even a quite high level of financial vulnerability may not imply a much different stance of monetary policy than would fall out of a more traditional analysis. However, as the unemployment gap shrinks, financial stability risks loom larger in relative terms, so an analysis that takes them on board may lead to more of an adjustment in the stance of policy. At an abstract level, the framework that I have sketched corresponds closely to that in Woodford's work, although his model is much more fully articulated. When it gets down to implementation, Woodford suggests that the most natural measure of financial market vulnerability is a variable that captures "leverage in the financial sector." In other words, faced with unemployment above target, he would have monetary policy be less accommodative, all else being equal, when financial-sector leverage is high. This recommendation rests on three key premises. First, when financial-sector leverage is high, the probability of a severe crisis in which multiple large intermediaries become insolvent is elevated--that is, we are more likely to have a replay of what happened in 2008 and 2009. Second, easy monetary policy is asserted to increase the incentives for the financial sector to lever up. And, third, focusing on leverage as opposed to asset prices avoids putting the central bank in the position of having to "spot bubbles": Even if it is impossible for the central bank to know when an asset class is overvalued, the risks to the economy associated with overvaluation are presumably greater when intermediaries are highly levered. In my view, these are generally sensible arguments, and an approach of the sort that Woodford outlines may well turn out to be fruitful. At the same time, this leverage- centric approach also has some drawbacks, which suggest that there is likely to be value in a parallel exploration of other tracks. For one thing, the effective degree of leverage in the financial system is not easy to measure in a comprehensive fashion. One can certainly look at things like banks' capital ratios, but some of the important action, from a financial stability perspective, is likely to be in subtler forms of leverage that are either outside of the traditional banking sector or more prone to shape shifting. More to the point, recall that, for the purposes of informing monetary policy, one wants to focus on those sources of financial vulnerability that are least effectively dealt with via regulation. And the more reliably a form of leverage can be measured, the better a candidate it is for being handled with a regulatory or supervisory approach. In other words, if we were to see signs that banks' capital ratios were in danger of eroding, we would certainly want to do something, but it is hard for me to imagine that the something should involve monetary policy--the obvious first line of defense in this case would be to turn to our regulatory and supervisory tools. In response to this critique, one might instead seek to focus the attention of monetary policymakers on broader measures of private-sector leverage that are outside the reach of traditional financial regulation. For example, Borio and Drehmann document that the ratio of credit to the private nonfinancial sector relative to gross domestic product (GDP), once suitably detrended, has substantial predictive power for financial crises, so perhaps it might make sense for monetary policy to condition on this kind of broad credit-to-GDP ratio. However, if one goes this route, another measurement challenge arises: How, if at all, does monetary policy influence the evolution of the ratio? Without an answer to this question, it is hard to say how much one would want to alter the stance of policy when, say, the ratio is abnormally high relative to trend. And the measurement problem is likely to be a difficult one, given that the credit-to-GDP ratio is a slow-moving variable: Unlike with asset prices, there is no scope for doing an event-study analysis of the effect of a change in policy on the item of interest. Motivated in part by these observations, I would like to spend the rest of this talk exploring an alternative, albeit potentially complementary, approach to the problem. Rather than focusing primarily on some measure of intermediary leverage as an input into the monetary policy framework, my suggestion is to also look at estimates of risk premiums in the bond market. Thus, at a broad thematic level, I am taking a capital- markets-centric view of financial stability, as opposed to a purely intermediary-centric view. This is, of course, not to suggest that shocks to large leveraged intermediaries are not as important--if not more so--as those that play out primarily in capital markets. Rather, the premise is simply that disruptions originating in the capital market can be of consequence in their own right, and that they may be less amenable to being dealt with via financial regulation. In this regard, I am echoing a point made recently by Feroli and others, who have emphasized the fragilities related to bond fund flows. Let me start by being clear on terminology: By the "risk premium" on an asset category, I mean the ex ante expected return, based on an objective statistical model, that an investor can anticipate earning on the asset in excess of that on short-term Treasury bills. So I will use the words "risk premium" and "expected return" interchangeably in what follows. And, for the sake of concreteness, I will focus on two of these bond market risk premiums in particular: the so-called term premium, which is the expected excess return on longer-term Treasury bonds relative to short-term bills, and the credit risk premium, which is the expected excess return on bonds with credit risk (for example, corporate bonds, or asset-backed securities) relative to safe Treasury securities. With all of the rhetorical heat that gets generated about whether the Federal Reserve can or should try to spot bubbles, it is worth keeping some uncontroversial facts in mind. It is widely accepted among researchers in finance that there is an economically large amount of predictable variation in the risk premiums on a wide range of assets classes. For example, Cochrane and Piazzesi document that the excess returns on longer-term Treasury securities can be predicted one year ahead with a simple model that delivers an R-squared in excess of 40 percent. show that the returns on junk bonds relative to Treasury securities over two- to three-year horizons can also be forecast with R-squared values in the ballpark of 30 to 40 percent, in this case by using two intuitively appealing forecasting variables: credit spreads and the high-yield share, which is the fraction of total bond issuance that comes from the high- yield category. Figure 1 illustrates the time-series variation in estimates of both of these risk premiums. Again, these sorts of findings are largely undisputed. Where there is more controversy is over the interpretation of these patterns, with some arguing that they reflect waves of irrational investor sentiment and others taking the view that they come from more rational factors, such as time variation in either the risks facing investors or their tolerance for bearing such risks. Here is where one can get into hard-to-resolve debates about bubble spotting and about whether one can expect the Federal Reserve to be smarter than other market participants. However, at least for some purposes, these debates are beside the point. In particular, the implications for monetary policy that I have in mind do not seem to depend critically on the difficult question of why there is so much time variation in expected bond market returns; they only require that this variation exists, as we know it does. In other words, there may be scope to make considerable practical progress while remaining largely agnostic about the whole metaphysical are- there-bubbles question. Okay. So let's stipulate that risk premiums in the bond market move around a lot. The next observation to throw into the mix is that monetary policy is one of the factors that have an important influence on these movements. An emerging body of empirical work finds that an easing of monetary policy--even via conventional policy tools in normal times--tends to reduce both the term premiums on long-term Treasury securities and the credit spreads on corporate bonds. That is, monetary policy always tends to work in part through its effect on capital market risk premiums, perhaps through a risk- taking or reaching-for-yield mechanism. However, while this empirical observation sheds some interesting light on how monetary policy influences the real economy, it does not by itself suggest that there is any financial stability dark side--that is, any meaningful increase in what I have been calling FMV--to the lowered risk premiums that go with monetary accommodation. For there to be such a dark side, there would have to be some sort of asymmetry in the unwinding of the effects of monetary policy on these risk premiums, whereby the eventual reversal either happens more abruptly, or causes larger economic effects, than the initial compression. Let's take an example. Suppose that initially, the credit risk premium on high- yield bonds is 400 basis points, and that, because the unemployment rate is well above target, the Federal Reserve wants to add monetary accommodation. Suppose further that doing so lowers the credit risk premium to 200 basis points temporarily but also increases the odds that this risk premium will, at some point in the next couple of years, revert sharply, moving back in the direction of 400 basis points. What is the downside here? Given a desire for accommodation, is it not better to have credit risk premiums pushed down to a lower on-average level, even if that potentially involves a more volatile down- then-up path? Again, the answer depends critically on whether there is some kind of asymmetry, whereby the eventual increase in spreads either is more abrupt, or has a larger effect on the real economy, than the initial compression. In table 1 and figure 2, I present some new evidence that bears on this asymmetry. To do so, I build directly on recent work by Gilchrist and Zakrajsek (hereafter, GZ). GZ show that changes in credit risk premiums have substantial predictive power for measures of economic activity like GDP and unemployment. More specifically, GZ construct a variable called the excess bond premium (EBP). The EBP at any point in time is, roughly speaking, a measure of marketwide credit spreads minus an estimate of the expected default losses on bonds. Hence, it can be thought of as a proxy for the excess return that bondholders can expect to earn, net of defaults, on a going-forward basis--very much in the spirit of the risk premium concept to which I have been referring. Not surprisingly, the EBP exhibits considerable time-series variation, reaching a peak in the wake of the Lehman Brothers bankruptcy. Moreover, in simple forecasting regressions, changes in the EBP are associated with significant movements in GDP and unemployment one year later. In other words, an increase in the EBP--that is, a widening of the non-default-related component of credit spreads--portends a decline in economic activity and employment a year later. The specifications of GZ are linear, so they impose the assumption that increases in the EBP have an effect that is symmetric to decreases. In table 1 and figure 2, I look explicitly for asymmetries, with a specification that allows an upward move in the EBP to have a different effect on the economy than a downward move. The results, which come from a sample spanning the period from January 1973 to December 2012, are striking. Upward moves in EBP--again, those corresponding to a widening of credit spreads--are very informative about the future evolution of the real economy. The coefficient estimates imply that an increase of 50 basis points in the EBP in a single quarter, which is roughly a once-every-five-years kind of move, is associated with a two percentage point slowing of GDP growth over the next four quarters and slightly more than a one percentage point increase in the unemployment rate over the same interval. effects are, by any standard, economically important. By contrast, declines in the EBP have no discernible effect at all on economic activity. Putting it all together, this reasoning suggests that the credit risk premium--as measured, say, by a forecasting model like that of Greenwood and Hanson--may be an operationally useful measure of financial market vulnerability. When this risk premium is low, there is a greater probability of a subsequent upward spike in credit spreads and the EBP. Moreover, such upward spikes, when they do occur, are associated with significant adverse economic effects. To be clear, we are not necessarily talking about once-in-a- generation financial crises here, with major financial institutions teetering on the brink of failure. Nevertheless, the evidence suggests that even more modest capital market disruptions may have consequences that are large enough to warrant consideration when formulating monetary policy. If so, the indicated directional adjustment would be to be less aggressive in providing monetary accommodation in the face of above-target unemployment, all else being equal, when risk premiums are abnormally low. Of course, there are many caveats. Foremost among them is the fact that the ability of increases in the EBP to predict future economic activity may not reflect a causal link from the former to the latter. Perhaps there are economic slowdowns that are caused entirely by nonfinancial factors, and, when investors see one on the horizon, they get skittish, causing the EBP to rise. If so, it would be wrong to conclude that easy monetary policy--even if it does, in fact, cause lower risk premiums--has any causal effect on the probability of a future slowdown. So at this point, the evidence that I have reviewed can only be thought of as suggestive. Making progress on these difficult issues of causality will likely require a clearer articulation of the underlying mechanism that leads to such pronounced asymmetries in the relationship between credit spreads and economic activity. If a causal link is, indeed, present, what is there about it that leads increases in spreads to have a much stronger effect on the economy than decreases? I suspect that the answer has to do with something that mimics the effect of leveraged losses to financial intermediaries--and the attendant effect on credit supply. For example, GZ document that their EBP measure is closely correlated with the credit default swap spreads of broker-dealer firms. The reason could be that losses on their inventories of risky bonds erode the capital positions of these firms, which might in turn compromise their ability to provide valuable intermediation services. Alternatively, a similar mechanism may play out with open-end bond funds, whereby losses cause large outflows of assets under management, again compromising the intermediation function and aggregate credit supply. To restate my main point, I believe that measures of bond market risk premiums-- for example, estimates of the expected excess returns on long-term Treasury securities relative to Treasury bills and on credit-risky bonds relative to Treasury securities--may turn out to be useful inputs into the monetary policy framework. These variables have the potential to serve as simple proxies for a particular sort of financial market vulnerability that may not be easily addressed by supervision and regulation. Again, however, let me emphasize the conjectural nature of these remarks. Even if this broad way of thinking about the problem turns out to be useful, there is a ways to go--in terms of modeling and calibration--before it can be used to make quantitative statements. Thus, at this early stage, I would not want to claim that one is likely to get policy prescriptions that differ significantly from those of our standard models. We will have to do the work and see what emerges. Finally, a more general theme that has been lurking in the background here is the sharp difference in perspective that subfields of economics sometimes bring to a given question. As I noted earlier, one of the central and most widely shared ideas in the academic finance literature is the importance of time variation in the risk premiums (or expected returns) on a wide range of assets. At the same time, canonical macro models in the New Keynesian genre of the sort that are often used to inform monetary policy tend to exhibit little or no meaningful risk premium variation. Even if most of the specifics of what I have had to say in this talk turn out to be off base, I have to believe that our macro models will ultimately be more useful as a guide to policy if they build on a more empirically realistic foundation with respect to the behavior of interest rates and credit spreads. Journal of Monetary Policy Forum, a conference sponsored by the Initiative on Global the U.S. Monetary Policy Forum, a conference sponsored by the Initiative on

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united states

Welcoming Remarks

stein

Good morning. Let me start by welcoming everyone to the Federal Reserve. Today's topic of crowdfunding for community development finance is an important and topical one, and I want to thank you all for helping us think through the challenges and opportunities presented by this new technology as it relates to raising funds for local communities. This gathering is particularly timely for two reasons. First, in many communities, traditional resources for community development are shrinking, and the field is actively seeking to identify new sources of funding. Second, the Securities and Exchange Commission recently released its proposed rule under the Jumpstart Our Business Startups--or JOBS--Act, which is likely to influence the environment for crowdfunding in general and for community development finance specifically. To the extent that most people know about crowdfunding at all, they may associate it with tech startups or independent movie production, since the press coverage has often focused on examples in these areas. These stories typically describe the use, and often success, of crowdfunding, as aspiring inventors and artists are able to tap the Internet to raise the money that can help make their visions a reality. The question for today is whether this power of the crowd can be harnessed to support community development, a field that has not widely benefited from crowdfunding thus far. Indeed, when I say "power of the crowd," it is worth noting that while individual investment amounts may be small, the total amount of funds raised from this source can be large. Although we lack reliable data on the current size of crowdfunding, some sources indicate that it's a multibillion-dollar industry, with more than 1 million separate offerings each year, and that the field is growing rapidly. While crowdfunding may not be as well known in the community development context, there are, in fact, existing models of crowdfunding for community development that we can learn from. I understand that several of these existing models will be discussed on a panel later this morning. One local example is Fundrise, an investment platform for commercial real estate that gives individuals the opportunity to invest directly in neighborhood businesses. Fundrise started on the H Street corridor here in D.C., and has completed 18 real estate deals totaling more than $10 million. For example, this platform attracted 361 people to invest a total of $350,000 toward the redevelopment of 906 H Street, N.E. Currently a vacant building, this property, which is located on the quickly revitalizing H Street corridor, now has the funding necessary to renovate the property and transform it into a restaurant or retail space. an interesting one because Calvert Foundation was essentially doing something akin to crowdfunding for community development before Internet platforms became available. As you may know, Calvert Foundation is a certified Community Development Financial found strong interest among its clients to invest directly in underserved communities. Since 1995, 13,000 people have invested in these notes, which provide a financial return while economically empowering communities. 13,000 individual investments have collectively helped to create 430,000 jobs for low- income individuals, built or rehabilitated 17,000 affordable homes, and financed close to 26,000 nonprofit facilities and social enterprises. Foundation examples hint at the potential of scaling up crowdfunding for community development. Many of you may be wondering, "Why is the Fed interested in this topic?" First, at a fundamental level, it's important for us to keep our finger on the pulse of financial innovation and the changing dynamics of the financial services industry--even in those parts of the industry where we do not have a direct regulatory role. We know that financial innovation can offer both opportunities and pitfalls; by carefully and even- handedly studying each new product or service at an early stage in its lifecycle, we can hope to better understand both the potential benefits, as well as any risks for adverse impacts on households and communities. Also, through convenings like today's event and by sharing promising practices, the Federal Reserve System has a longstanding history of supporting local and regional community and economic development efforts that contribute to economic growth and employment. To the extent that crowdfunding has the potential to bring new capital into low- and moderate-income communities, we want to be involved in helping the learning process along. As I mentioned earlier, many people associate crowdfunding with tech startups and art initiatives. However, there may be ways that this new form of fundraising can be adapted to community development investing. Given how wide open the issues are, today's event is a working meeting with discussion groups. We appreciate your willingness to share your time with us, and we look forward to benefiting from your insights. Thank you.

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united states

Remarks on Women's History Month

yellen

It's an honor and a pleasure for me to be here with you to mark Women's History Month, which itself has some history behind it. a full month. Women, of course, are also a part of history for the other 11 months of the year. And I would add that women were influencing the course of history long before 1980, or 1911. But I am glad that there is, each year, a time when we pause to think about the role of women, because history is more than simply what happened, and more than what women and men did to make it happen. History is what we remember about those deeds. It is the lessons we have taken from the past and the knowledge we draw on to live today and to shape the future. For me, one lesson from history is that it is no coincidence that America's great success in the past century came as women steadily increased their participation in every aspect of society. Starting with gaining the vote, just a few years before International Women's Day, "The American Century," as it's sometimes known, was also a century of progress for women. Fundamental to our country's values, to those ideals that have been and continue to be so influential around the world, is the principle of equality for all, including for women. One reason America's example is influential elsewhere is because progress toward these ideals has been accompanied by great success in broadly raising living standards. And I think our economic success has been due in substantial part to the fuller participation and contribution of women to the economy. Their increasing participation in the workforce, particularly after 1970, was a major factor in sustaining growing family incomes. Making fuller use of the talents and efforts of women in the workplace has made us more productive and prosperous. If I were to apply this lesson, I would hope that our nation continues to reap the benefits of greater participation by women in the economy and that we do everything that we can to foster that participation. Women have made great progress in many occupations and professions, but lag in others. In my own profession, there has been a gradual increase in the share of women in economics, but women still remain underrepresented at the highest levels in academia, in government and in business. There are doubtless numerous reasons for this, and in fact economists themselves are among those engaged in trying to understand the factors that explain why more women aren't rising to higher levels. I hope we continue to seek this understanding, in my field and others where women are in the minority, because the benefits of greater participation for women, it seems to me, are clear and substantial. As we continue to make progress in recovering from the Great Recession, our country is going to need the best efforts, ideas and talent it can muster to succeed in an increasingly competitive global economy. If women's history can shape the future, I hope that it inspires America to take those steps we can take to draw forth these contributions from all

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united states

Regulating Large Foreign Banking Organizations

tarullo

The financial crisis exposed, in painful and dramatic fashion, the shortcomings of existing regulatory and supervisory regimes. In both the United States and the European Union (EU), the crisis also revealed some particular vulnerabilities created by foreign banking operations. This evening I would like to focus on these vulnerabilities and on how best we should address them. Let me note at the outset the now commonplace observation that we have a quite integrated international financial system, with many large, globally active firms operating within a system of national government and regulation or, in the case of the EU, a hybrid of regional and national regulation. I add the equally commonplace observation that there is no realistic prospect for having a global banking regulator and, consequently, the responsibility and authority for financial stability will continue to rest with national or regional authorities. The question, then, is how responsibility for oversight of these large firms can be most effectively shared among regulators. This, of course, is the important issue underlying the perennial challenge of home-host supervisory relations. Another introductory observation is that--at least in a world of nations with substantially different economic circumstances, different currencies, and banking and capital markets of quite different levels of depth and development--there will be good reason to vary at least some forms of regulation across countries. Presumptively, at least, nations should be able to adjust their regulatory systems based on local circumstances and their relative level of risk aversion as it pertains to the potential for financial instability. Although the financial systems and economies of the United States and the EU are more similar to one another than they are to those of many other jurisdictions, they are hardly identical. Even between these two, for example, there may be legitimate differences within the broader convergence around minimum regulatory and supervisory standards developed at the Basel Committee, the International Organization of These opening observations are important in responding to the curious charge of "Balkanization" that has been levelled at the United States and, to a lesser extent, some other jurisdictions, as a result of actions taken or proposed in response to problems presented by foreign banks during the crisis. I say "curious" for several reasons. One is that the charge reflects a misunderstanding of the allocation of responsibility between home and host supervisors that has evolved in the Basel Committee during the past several decades. Another is that the charge seems implicitly, and oddly, premised on the notion that what we had in 2007 was a well- functioning, integrated global financial system with effective consolidated supervision of global banks. A third is that the charge overlooks the fact that much of what the United States is now doing is matching what the EU has quite sensibly been doing for years. In the rest of my remarks I will elaborate on these points, though not in the spirit of a debater's arguments, but in an effort to answer the question I posed a moment ago: How, that is, can we successfully reduce the risks to financial stability posed by large, internationally active banks? As I hope will become apparent, a theme I wish to emphasize is that we need to redouble efforts at genuine supervisory cooperation if we are to manage effectively the vulnerabilities and challenges posed by the perennial home-host issue. While the circumstances and risks may have changed, the issue of the appropriate roles of home and host countries is not a new one. Indeed, it was a key motivation for creation of the Basel Committee in 1975 following the failures of the Herstatt and Franklin National banks. Many of the Basel Committee's early activities were focused on the challenges created by gaps in the supervision of internationally active banks, as evidenced by the fact that Basel subjects. This task has, of necessity, been ongoing, as experience revealed gaps in supervisory coverage and as the scale and scope of internationally active banks grew. The principle of consolidated supervision emerged in the early 1980s to ensure that some specific banking authority--generally the home-country regulator--had a complete view of the assets and liabilities of the bank. This principle was reinforced and elaborated following the Bank of Credit and Commerce International episode in the early 1990s. It is important to note that each Basel Committee declaration on the importance of home- country consolidated oversight has also included a statement of the obligations and prerogatives of host states in which significant foreign bank operations are located. This feature of the Basel Committee's approach makes sense as a reflection both of the host authority's responsibility for stability of its financial system and of the practical point that a host authority will be more familiar with the characteristics and risks in its market. In accordance with this history, the current version of the "Core Principles for Effective Banking Supervision" sets out as one of its "essential criteria" for home-host relationships that "[t]he host supervisor's national laws or regulations require that the cross-border operations of foreign banks are subject to prudential, inspection and regulatory reporting requirements similar to those for domestic banks." It is clear, then, that consolidated supervision is not intended to displace host-country supervision. Instead, as the Basel Committee has regularly noted, the two are intended to be complementary, so as to assure effective oversight of large, internationally active banks. Similarly, the stated purpose of the Basel Committee in requiring consolidated capital requirements is not to remove from host countries any responsibility or discretion to apply regulatory capital requirements, but to "preserve the integrity of capital in banks with subsidiaries by eliminating double gearing." Likewise, and contrary to suggestions that are sometimes made, the capital accords and frameworks developed by the Basel Committee have always been explicitly minimum requirements. They are floors, not ceilings. Finally, it is worth noting that, in establishing a post-crisis framework for domestic systemically important banks (D-SIBs), the Basel Committee made clear that a host country may in appropriate circumstances designate domestic operations of a foreign bank as systemically important for that country, even if the parent foreign bank has already been designated a global The idea informing the newly created concept of a D-SIB is that an entity whose stress or failure could destabilize a domestic financial system might thereby indirectly destabilize the international financial system. Thus, the D-SIB category carries along with it higher loss-absorbency requirements than are generally applicable to domestic banks, although perhaps not as high as requirements for G-SIBs. Of course, our regulation for foreign banking organizations (FBOs) does not entail D-SIB designation or require higher than generally applicable loss absorbency. But I cite this feature of the D-SIB framework that permits designation of the domestic operations of foreign G-SIBs because it reflects rather clearly the principle that the specific characteristics of domestic markets may call for regulation of foreign banks in the host country, not just at a consolidated level. In short, the work of the Basel Committee over the years has not been directed at restraining host-country authorities from supervising and regulating foreign banking operations in their country. On the contrary, the committee has repeatedly asserted the complementary responsibilities of both home and host countries to oversee large, internationally active banking groups, in the interests of both national and international financial stability. And the committee has frequently returned to this set of issues in responding to developments that pose a threat to the safety and soundness of the international financial system. Unfortunately, neither the Basel Committee nor national regulators responded in a timely fashion to the magnitude of the expansion in scale and scope of the world's largest banking organizations in the roughly 15 years before the financial crisis. As illustrated in figure 1, at the end of 1974, just before the Basel Committee was created, the assets of the world's 10 largest banking organizations together equaled about 8 percent of global GDP. The three largest were combined assets were equal to less than 3 1/2 percent of world GDP and, as illustrated in figure 2, about 10 percent of the GDP of their home country, the United States. By 1988 the combined assets of the world's 10 largest banking organizations as a proportion of world GDP had nearly doubled to about 15 percent, a ratio that held constant during the succeeding decade, at the beginning of the emerging market financial crisis in 1997. Then the explosive growth began. In the next decade--that is, up to the onset of the financial crisis in 2007--the combined assets of the world's 10 largest banks as a share of global GDP nearly tripled, to about 43 percent. The largest bank in the world at that time, Royal Bank of Scotland (RBS), had assets equivalent to about 6.8 percent of global GDP, nearly twice the comparable figure for the three largest banks combined in 1974. Adding the assets of Deutsche Bank and BNP Paribas--the second and third largest banks in 2007--to those of RBS, the three had combined assets equal to about 17 percent of global GDP. And each of the three had assets nearly equal to, or in one instance substantially more than, the GDP of its home country. Even the eighth-ranked bank, UBS, had assets well over four times the GDP of its home country, Not only did the size of the largest banks change dramatically, so, too, did their scope, reflecting the overall integration of capital market and traditional lending activities that accelerated in the decade and a half preceding the crisis. This trend was particularly apparent in the United States and the United Kingdom, homes to the world's two largest financial centers. In the United States, the proportion of foreign banking assets to total U.S. banking assets has remained constant at approximately one-fifth since the late 1990s. But the concentration and character of those assets have changed noticeably. Today there are as many foreign as U.S.- owned banks with at least $50 billion in U.S. assets, the threshold established by the Dodd-Frank Wall Street Reform and Consumer Protection Act for banks for which more stringent prudential measures must be established. Perhaps even more important was the shift in composition of foreign bank assets in the 15 years before the crisis, with the proportion of assets held in the U.S. broker-dealers of the 10 largest FBOs rising from approximately 15 percent to roughly 50 percent. Today, 4 of the top 10 broker-dealers in the United States, and 12 of the top 20, are owned by foreign banks. Meanwhile, even the traditional branching model of large foreign commercial banks in the United States had changed. Reliance on less stable, short-term wholesale funding increased significantly. Many foreign banks shifted from the "lending branch" model to a "funding branch" model, in which U.S. branches of foreign banks were borrowing large amounts of U.S. dollars to upstream to their parents. These "funding branches" went from holding 40 percent of foreign bank branch assets in the mid-1990s to holding 75 percent of foreign bank branch assets by 2009. Foreign banks as a group moved from a position of receiving funding from their parents on a net basis in 1999 to providing significant funding to non-U.S. affiliates by the mid- 2000s--more than $600 billion on a net basis by 2008. A good bit of this short-term funding was used to finance long-term, U.S. dollar- denominated project and trade finance around the world. There is also evidence that a significant portion of the dollars raised by European banks in the pre-crisis period ultimately returned to the United States in the form of investments in U.S. securities. Indeed, the amount of U.S. dollar- denominated asset-backed securities and other securities held by Europeans increased significantly between 2003 and 2007, much of it financed by the short-term, dollar-denominated liabilities of European banks. Just as regulatory systems did not, in the years preceding the crisis, address vulnerabilities such as reliance on short-term wholesale funding that were created by the integration of capital markets and traditional lending, so they did not respond to the transformation of foreign banking operations. Accordingly, just as home countries of systemically important banks have been playing catch-up on capital, liquidity, and other requirements, so host countries of very large foreign banking operations are playing catch-up in dealing with the very different character of many internationally active banks from that of 20 or 30 years ago. In a sense, the major strengthening during the past few years of capital and liquidity requirements for internationally active banks--including the capital surcharge for banks of global systemic importance--has to date been the most important international regulatory response to the revealed vulnerabilities associated with large foreign banking operations. Building capital and improving the liquidity positions of banks on a consolidated basis is surely a key step toward assuring the stability of major FBOs in host countries. Of course, these agreed changes have not yet been fully implemented. It is critical not just that all jurisdictions adopt appropriate regulations that fully incorporate the new Basel standards, but also that we ensure our banks will be substantively, and not just formally, compliant as the various transition target dates are reached. It is also the case that there is more to be done in addressing the risks posed by large global banking organizations, including additional measures to deal with the run risks associated with short-term wholesale funding and ensuring that even the largest firms can be successfully resolved without either creating major systemic problems or requiring an infusion of public capital. I will return to these subjects a bit later, in discussing the cooperative agenda that lies ahead for the United States, Europe, and our partners throughout the world. First, though, I want to describe how Europe, the United Kingdom, and the United States are dealing with the vulnerabilities associated with large foreign banking operations, and thus are fulfilling their responsibilities as host-country supervisors. I discuss the United Kingdom separately from the EU both because it is outside the euro zone and because, as a host jurisdiction, it is more similar to the United States than to other EU member states or, indeed, to any other country in the world. The EU has not, since the crisis, specifically adjusted the structure of regulation of foreign banks by its member states in their role as host supervisors. For more than a decade before the crisis, EU member states had prudently required that not only commercial banking, but also investment banking subsidiaries of foreign (non-EU-based) banking organizations, be subject to Basel capital requirements in the same way as EU-based firms. With the adoption of the directive implementing the new EU capital requirements, Basel III will now be applied to all EU firms, including EU bank and investment bank subsidiaries of non-EU banking organizations. Branches of non-EU banks are generally not subject to local requirements. Before the crisis and the subsequent development of Basel III, there was no leverage ratio requirement in EU capital directives. Insofar as a new leverage ratio is part of the Basel III package agreed upon internationally, one would anticipate that it will be applied to commercial banking and investment banking firms in the EU, again including local subsidiaries of non-EU firms. Likewise, one would anticipate that the Basel III liquidity requirements will be implemented in the EU in accordance with the internationally agreed timeline and, again, that it will apply to EU subsidiaries of FBOs. A greater challenge for the EU has been dealing with banks headquartered in one EU country but doing business in other EU countries under the "single passport," which basically allows for full access in the rest of the EU, with supervision provided only by the home country. During the crisis, there were some notable instances of banking stresses and failures involving such institutions, with consequent negative effects on depositors, counterparties, and economies in other parts of the EU. Much of the ongoing post-crisis reform agenda in Europe seems directed at ensuring the safety and soundness of EU-based institutions. The most important of these changes may be the assumption by the European Central Bank of supervisory responsibility for larger euro area banks. And, as we saw just last week, work continues on the long process of creating a credible resolution mechanism for those banks. As a member state of the EU, the United Kingdom of course implements the EU policies I have just described. But that country has applied an additional set of requirements on the local operations of foreign banks, particularly with respect to liquidity. The Prudential Regulation Authority of the Bank of England applies local liquidity requirements to commercial and investment banking subsidiaries of non-U.K. banks, requiring them to hold local buffers as determined by internal stress tests with both 14- and 90-day components. The assumptions on which the stress tests are premised are quite strict. For example, the U.K. subsidiary generally must assume zero inflows from non-U.K. affiliates--even for claims on non-U.K. affiliates with short terms that mature within the stress test period--and 100 percent outflows to non-U.K. affiliates. The requirements generated by the test are subject to a supervisory review and add-on that for some firms has resulted in a significant increase in the buffer requirement. Branches of foreign commercial banks may in some circumstances be subject to local liquidity requirements as well. The U.K. initiative in applying local liquidity requirements is wholly understandable in light of the difficulties encountered because of stress on foreign institutions, including the Lehman bankruptcy, during the crisis. Because London is one of the world's two largest financial center hosts, the United Kingdom is the only country other than the United States hosting numerous, very large broker-dealers that are owned by foreign banks and also a broad array of commercial bank subsidiaries and branches that are owned by foreign banks. In fact, the six institutions headquartered outside the United States and the United Kingdom that are in the top three tiers of G-SIBs hold roughly 40 percent of their worldwide assets in those two jurisdictions. Thus the U.K. initiative on liquidity and its internal debates on matters such as structural supervision, the Vickers proposals, and stress testing have all been very instructive for the Federal Reserve Board. Even where we have eventually adopted somewhat different approaches, we respect the motivation and scrupulousness of the U.K. banking authorities in addressing the systemic vulnerabilities posed by FBOs and in fulfilling their responsibility to the rest of the world to assure the stability of one of the world's two most important financial centers. Unlike the EU, the United States did not--prior to the financial crisis--require that all broker-dealers and investment banks meet Basel capital standards. The legacy of the Glass- Steagall Act, which had separated investment banking from commercial banking, meant that only commercial banks were subject to the prudential regulation of the federal banking agencies. In Europe, the dominance of universal banking, or variants thereon, led more naturally to application of capital and other prudential standards to all forms of banking activity. Even after the Gramm-Leach-Bliley Act removed the remaining barriers to affiliation between investment banks and commercial banks in the United States, Basel capital requirements applied at a consolidated level to the activities of an investment bank or broker-dealer only if it did affiliate with a commercial bank. Thus, the five large "free-standing" U.S. investment banks were generally not subject to full application of Basel capital standards. During the crisis, the ill-advised nature of this regulatory state of affairs became apparent. The decline in value of many mortgage-backed securities and the consequent market uncertainty as to the true value of that entire class of securities raised questions about the solvency of major broker-dealers. Because the dealers were so highly leveraged and dependent on short-term financing, the uncertainty also led to serious liquidity strains, first at Bear Stearns and Lehman Brothers and eventually at most dealers--domestic and foreign owned. Bear Stearns and Merrill Lynch were acquired by existing bank holding companies after coming close to failure. Lehman Brothers went bankrupt. Goldman Sachs and Morgan Stanley became bank holding companies. liquidity to the broker-dealer affiliates of the bank holding companies, as well as to the primary dealer subsidiaries of foreign banks. At the same time, the shift in strategy of many foreign banks toward using their U.S. branches to raise dollars in short-term markets for lending around the world created another set of vulnerabilities that resulted in substantial and, relative to total assets, disproportionate use of the Federal Reserve's discount window by foreign bank branches. The experience of the crisis made clear, first, that the perimeter of prudential regulation around U.S. financial institutions needed to be expanded. As noted a moment ago, this had occurred de facto during the crisis. The Dodd-Frank Act has given a legal foundation for this change, first by mandating that Goldman Sachs and Morgan Stanley will remain subject to consolidated prudential regulation even were they to divest their insured depository institutions and, second, by giving the Financial Stability Oversight Council the authority to designate other financial firms as systemically important, a step that would place them under Federal Reserve regulation and supervision. Dodd-Frank further required the Federal Reserve to apply progressively more stringent prudential regulation to bank holding companies with more than $50 billion in assets. Congress also required the Federal Reserve to apply special prudential standards to large FBOs. As I have already implied, much of what we have done is simply to catch up to EU and U.K. practice. Under our recently finalized Section 165 enhanced prudential standards regulation, an FBO with U.S. non-branch assets of $50 billion or more must hold its U.S. subsidiaries under an intermediate holding company (IHC), which must meet the risk-based and leverage capital standards generally applicable to bank holding companies under U.S. law. Such an FBO must also certify that it meets consolidated capital adequacy standards established by its home-country supervisor that are consistent with the Basel Capital Framework. FBOs with combined U.S. assets of $50 billion or more must also meet liquidity risk- management standards and conduct internal liquidity stress tests. The IHC must maintain a liquidity buffer in the United States for a 30-day liquidity stress test. The U.S. branches and agencies of an FBO must maintain a liquidity buffer in the United States equal to the liquidity needs for 14 days, as determined by a 30-day liquidity stress test. The IHCs of FBOs must also conform to certain risk-management and supervisory requirements at the IHC level. Structurally, the U.S. capital requirements for FBOs are similar to those that apply to foreign banks in the EU. That is, generally applicable Basel capital requirements are applied to the U.S. operations of FBOs that own local banking subsidiaries, investment banks, and broker- dealers. In fact, the new U.S. rules are somewhat more favorable to foreign institutions, in that they only apply once the non-branch U.S. assets of an FBO exceed $50 billion. That dollar amount, incidentally, is the same as the Dodd-Frank threshold for more stringent prudential measures, though note that this statutory threshold applies if the total assets of any U.S. banking organization--foreign, as well as domestic--exceed that level. As in the EU, the capital requirements do not apply to U.S. branches of foreign banks, even though the crisis experience provides some credible arguments for doing so. The leverage ratio requirement has received particular attention. One complaint is that the foreign operations of U.S. banks are not subject to leverage ratios for their local operations. It is true that many foreign countries--including the EU member states--do not currently have leverage ratio standards for their banks. As noted earlier, however, one may reasonably expect that those countries will be implementing the Basel III leverage ratio in a timely fashion. Also, I would note in passing that the U.S. leverage ratio requirement for foreign firms will be phased in more slowly than originally proposed, so as to align it more closely with the effective date of the Basel III leverage ratio requirement. A second complaint is that there is something unfair about the United States requiring an FBO to meet the international leverage ratio in its U.S. operations, because its operations may be heavily weighted toward broker-dealer activities, which generally have higher leverage, whereas the leverage ratio for U.S. firms is based on their global operations. Again, one suspects that the foreign operations of U.S. firms could be subject to a similar ratio requirement abroad as countries implement their Basel III commitments. However, quite apart from what may happen in the future, there are two U.S.-based firms--Goldman Sachs and Morgan Stanley--whose global business mix resembles that of the U.S. subsidiaries of FBOs that are predominantly engaged in broker-dealer activities in the United States. In fact, under the enhanced supplementary leverage ratio the Board proposed during the summer, these and other U.S. G-SIBs would be subject to a higher Basel III leverage ratio requirement (5 percent) than would apply to FBO IHCs (3 The applicable liquidity requirements, while somewhat differently defined, are roughly comparable to those already applicable to FBOs in the United Kingdom. The similar positions of our two nations as host countries for foreign bank operations heavily involved in trading and significantly reliant on potentially runnable short-term wholesale funding explain this rough parallelism. The most notable departure of the new U.S. FBO standards from existing EU and U.K. practice lies in the IHC requirement for foreign banks with large domestic operations. Given the structure of U.S. financial regulation that is a legacy of Glass-Steagall, as well as the efforts by a small number of very large foreign banks to evade the intent of Congress that capital standards apply to their U.S. operations, we needed to create this structural requirement. It is unclear how much difference this makes for the capital requirements of FBOs in the United States as opposed, say, to those of U.S. operations in the EU. That would depend on the existence and size of financial affiliates owned by the U.S. firm that are not subject to Basel standards directly. In any case, it seems sound prudential practice--and consistent with the various Basel Committee principles to which I earlier referred--that large domestic operations of foreign banks meet capital standards on the basis of all exposures in the host jurisdiction and, indeed, that they manage their risks in that country across all their affiliates. To return to the issue of Balkanization, three things should now be apparent. First, in its new capital regulations applicable to FBOs, the United States is more a follower of the pattern set by the EU than it is an initiator of new kinds of requirements. Of course, a few foreign banks would prefer the old system under which they held relatively little capital in their very extensive U.S. operations. But that was neither safe for the financial system nor particularly fair to their competitors--U.S. and foreign--that hold significant amounts of capital here. Indeed, a firm that is genuinely well capitalized, including holding the G-SIB surcharge at its global consolidated level, should require only moderate adjustment efforts during the transition period established in the FBO rule. Second, there is considerable scope for a foreign bank to integrate its U.S. operations with its global activities within the rule the Federal Reserve adopted last month. For example, while foreign firms with more than $10 billion in non-branch assets have some additional reporting requirements, only when U.S. non-branch assets rise above $50 billion do the quantitative Basel capital requirements become applicable to the U.S. subsidiaries. Moreover, no capital requirements apply to branches so long as their parent is subject to home-country consolidated capital rules consistent with Basel standards. The U.S. operations of FBO branches and subsidiaries will not be subject to "due from" restrictions. They remain free to lend money to their worldwide affiliates; they must simply do so with a more stable funding base. Finally, I note that many FBOs, like many U.S.-based banks, have made considerable progress in reducing dependence on short-term wholesale funding and in building capital. To some extent, the new requirements are intended to preserve this progress. Third, the capital and liquidity requirements that do apply are wholly consistent with the responsibility of host-country supervisors to assure financial stability in their own markets. Collectively, foreign banks with a large presence in the United States conduct activities of a scope, and at a scale, that could lead to problems for the U.S. financial system should they come under stress. Realistically, exposures and vulnerabilities in a large host-country market are much more difficult for home-country supervisors to assess. Indeed, U.S. regulators count on the expertise and proximity of U.K. regulators in overseeing the London operations of large U.S. financial institutions to enhance the effective consolidated supervision and regulation for which we are responsible. On the issue of home-host-country coordination in regulating large, globally active banking organizations, I would make three additional points. First, our FBO capital requirements, like those of the EU for foreign commercial and investment banks, are based on the capital rules agreed to in the Basel Committee. Thus, there is an overall compatibility between national and international rules with respect to applicable definitions, standards, and required ratios. Second, home countries must implement and enforce faithfully at a consolidated level these same capital rules. More broadly, home-country supervisory expectations for strong consolidated capital levels, liquidity positions, and risk-management practices are likely to facilitate compliance with domestic requirements for large FBOs of the sort applicable in the United States and the EU. It is also important that home countries assure the credibility of resolution mechanisms for their large banking organizations. This task entails the implementation of the Financial Stability Board's principles for effective resolution regimes, including establishing a resolution authority with adequate legal powers to manage the process in an orderly fashion without injection of public capital. It also includes requiring each such institution to have total loss absorption capacity sufficient to recapitalize the firm even if its substantial equity buffer is lost in an extreme tail event. Home and host countries should work together toward international standards that will ensure that an appropriate amount of this capacity would be available to host authorities faced with the potential insolvency of large FBOs in their jurisdiction or with the consequences for their market of the failure of parent banks. In this regard, I think that capital requirements for FBOs of the sort now required by the EU and the United States are very likely to reduce the considerable strains that have traditionally accompanied financial distress at global banking firms. In most cases, including both internationally and within the EU itself in recent years, stress has resulted in the demand by host authorities for ex post ring fencing of capital, liquidity, or both, often in the absence of any ex ante requirements. The existence of FBO capital and liquidity standards, particularly if supplemented with the total loss absorbency measures to which I just referred, should mitigate the need for such demands, which of course come at the worst possible time for the firm trying to meet them. Third, we--by which I mean both home and major host banking regulators--need to find better ways of fostering genuine regulatory and supervisory cooperation. Particularly at the most senior levels of the agencies that actually supervise globally active banks, our interactions with our counterparts from other countries have become almost exclusively focused on developing international standards or reviewing compliance with existing ones. These discussions are usually conducted with numerous colleagues who are not themselves responsible for banking regulation in their own jurisdictions. As important as these efforts have been, and continue to be, following the crisis, there is a risk that by not having opportunities for senior officials of the various national agencies that have direct supervisory responsibility for banking organizations to meet and discuss shared challenges, we give short shrift to the collective interest of bank regulators in effective supervision of all globally active firms. Proposals to include prudential requirements or, more precisely, to include limitations on prudential requirements in trade agreements would lead us farther away from the aforementioned goal of emphasizing shared financial stability interests, in favor of an approach to prudential matters informed principally by considerations of commercial advantage. The job of regulating and supervising large, globally active banking organizations is a tough one. Issues of moral hazard, negative externalities, and asymmetric information are, if not pervasive, then at least significant and recurring. The job is made only harder by the fact that these firms cross borders in ways their regulators do not. But we cannot ignore this fact and pretend that we have global oversight. International standards for prudential regulation are not the same as global regulations, and consolidated supervision is not the same as comprehensive supervision. The jurisdictions represented on the Basel Committee not only have the right to regulate their financial markets--including large FBOs participating in those markets--they have a responsibility to their home jurisdictions, and to the rest of the world, to do so. The most important contribution the United States can make to global financial stability is to ensure the stability of our own financial system. There must be some assurance beyond mere words from parent banks or home-country supervisors that a large FBO will remain strong or supported in periods of stress. After all, as we saw in the crisis, while a parent bank or home-country authorities may have offered those words with total good faith in calm times, they may be unable to carry through on them in more financially turbulent periods. None of this means that we need be at odds with one another. On the contrary, these very circumstances call not only for more tangible safeguards in host countries, but also for more genuine cooperation among supervisory authorities. Indeed, as I hope will continue to be the case with the international agenda on resolution, total loss absorbency, and related matters, we should aspire to converge around the kinds of protections that we can expect at both consolidated and local levels.

r140331a_FOMC

united states

What the Federal Reserve Is Doing to Promote a Stronger Job Market

yellen

I am here today to talk about what the Federal Reserve is doing to help our nation recover from the financial crisis and the Great Recession, the effects of which were particularly severe for the people and the communities you serve. Part of that effort has involved strengthening the financial system. New rules are in place to better protect consumers and ensure that credit is available to help communities grow. The Federal Reserve also plays a role in communities by fostering dialogue that promotes community development. I will highlight some initiatives around the Federal Reserve System that I believe are making a real difference. Later today, I will visit the Manufacturing Technology Program at Daley College, on Chicago's south side, where adult students are acquiring the skills they need to connect to good-paying jobs in that sector. The Fed supports the work you do in communities because you make a difference. You help ensure that credit is available for families to buy homes and for small businesses to expand. Your organizations sponsor programs that help make communities safer and families healthier and more financially secure. One of the most important things you do is to help people meet the demands of finding a job in what remains a challenging economy. And that help is crucial, but I also believe it can't succeed without two other things. The first of these is the courage and determination of the people you serve. The past six years have been difficult for many Americans, but the hardships faced by some have shattered lives and families. Too many people know firsthand how devastating it is to lose a job at which you had succeeded and be unable to find another; to run through your savings and even lose your home, as months and sometimes years pass trying to find work; to feel your marriage and other relationships strained and broken by financial difficulties. And yet many of those who have suffered the most find the will to keep trying. I will introduce you to three of these brave men and women, your neighbors here in the great city of Chicago. These individuals have benefited from just the kind of help from community groups that I highlighted a moment ago, and they recently shared their personal stories with me. It might seem obvious, but the second thing that is needed to help people find jobs...is jobs. No amount of training will be enough if there are not enough jobs to fill. I have mentioned some of the things the Fed does to help communities, but the most important thing we do is to use monetary policy to promote a stronger economy. The Federal Reserve has taken extraordinary steps since the onset of the financial crisis to spur economic activity and create jobs, and I will explain why I believe those efforts are still needed. The Fed provides this help by influencing interest rates. Although we work through financial markets, our goal is to help Main Street, not Wall Street. By keeping interest rates low, we are trying to make homes more affordable and revive the housing market. We are trying to make it cheaper for businesses to build, expand, and hire. We are trying to lower the costs of buying a car that can carry a worker to a new job and kids to school, and our policies are also spurring the revival of the auto industry. We are trying to help families afford things they need so that greater spending can drive job creation and even more spending, thereby strengthening the recovery. When the Federal Reserve's policies are effective, they improve the welfare of everyone who benefits from a stronger economy, most of all those who have been hit hardest by the recession and the slow recovery. Now let me offer my view of the state of the recovery, with particular attention to the labor market and conditions faced by workers. Nationwide, and in Chicago, the economy and the labor market have strengthened considerably from the depths of the Great Recession. Since the unemployment rate peaked at 10 percent in October 2009, the economy has added more than 7-1/2 million jobs and the unemployment rate has fallen more than 3 percentage points to 6.7 percent. That progress has been gradual but remarkably steady--February was the 41st consecutive month of payroll growth, one of the longest stretches ever. Chicago, as you all know, was hit harder than many areas during the recession and remains a tougher market for workers. But there has been considerable improvement here also. Unemployment in the city of Chicago is down from a peak of nearly 13 percent to about 9-1/2 percent at last count. That is about the same improvement as in the larger Chicago metro area, where unemployment has fallen to 8-1/2 percent. Metro Chicago has added 183,000 jobs since 2009, just below the rate for job gains nationwide. But while there has been steady progress, there is also no doubt that the economy and the job market are not back to normal health. That will not be news to many of you, or to the 348,000 people in and around Chicago who were counted as looking for work in It will not be news to consumers or to owners of small and medium-sized businesses, who surveys say remain cautious about the strength and durability of the recovery. The recovery still feels like a recession to many Americans, and it also looks that way in some economic statistics. At 6.7 percent, the national unemployment rate is still higher than it ever got during the 2001 recession. That is also the case in Chicago and in many other cities. It certainly feels like a recession to many younger workers, to older workers who lost long-term jobs, and to African Americans, who are facing a job market today that is nearly as tough as it was during the two downturns that preceded the Great In some ways, the job market is tougher now than in any recession. The numbers of people who have been trying to find work for more than six months or more than a year are much higher today than they ever were since records began decades ago. We know that the long-term unemployed face big challenges. Research shows employers are less willing to hire the long-term unemployed and often prefer other job candidates with less or even no relevant experience. That is what Dorine Poole learned, after she lost her job processing medical insurance claims, just as the recession was getting started. Like many others, she could not find any job, despite clerical skills and experience acquired over 15 years of steady employment. When employers started hiring again, two years of unemployment became a disqualification. Even those needing her skills and experience preferred less qualified workers without a long spell of unemployment. That career, that part of Dorine's life, had ended. For Dorine and others, we know that workers displaced by layoffs and plant closures who manage to find work suffer long-lasting and often permanent wage reductions. Jermaine Brownlee was an apprentice plumber and skilled construction worker when the recession hit, and he saw his wages drop sharply as he scrambled for odd jobs and temporary work. He is doing better now, but still working for a lower wage than he earned before the recession. Vicki Lira lost her full-time job of 20 years when the printing plant she worked in shut down in 2006. Then she lost a job processing mortgage applications when the housing market crashed. Vicki faced some very difficult years. At times she was homeless. Today she enjoys her part-time job serving food samples to customers at a grocery store but wishes she could get more hours. Vicki Lira is one of many Americans who lost a full-time job in the recession and seem stuck working part time. The unemployment rate is down, but not included in that rate are more than seven million people who are working part time but want a full-time job. As a share of the workforce, that number is very high historically. I have described the experiences of Dorine, Jermaine, and Vicki because they tell us important things that the unemployment rate alone cannot. First, they are a reminder that there are real people behind the statistics, struggling to get by and eager for the opportunity to build better lives. Second, their experiences show some of the uniquely challenging and lasting effects of the Great Recession. Recognizing and trying to understand these effects helps provide a clearer picture of the progress we have made in the recovery, as well as a view of just how far we still have to go. And based on the evidence available, it is clear to me that the U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress. The first of those goals is maximum sustainable employment, the highest level of employment that can be sustained while maintaining a stable inflation rate. Most of my colleagues on the Federal Open Market Committee and I estimate that the unemployment rate consistent with maximum sustainable employment is now between 5.2 percent and 5.6 percent, well below the 6.7 percent rate in February. The other goal assigned by the Congress is stable prices, which means keeping inflation under control. In the past, there have been times when these two goals conflicted--fighting inflation often requires actions that slow the economy and raise the unemployment rate. But that is not a dilemma now, because inflation is well below 2 percent, the Fed's longer-term goal. The Federal Reserve takes its inflation goal very seriously. One reason why I believe it is appropriate for the Federal Reserve to continue to provide substantial help to the labor market, without adding to the risks of inflation, is because of the evidence I see that there remains considerable slack in the economy and the labor market. Let me explain what I mean by that word "slack" and why it is so important. Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill. During a period of little or no slack, there still may be vacant jobs and people who want to work, but a large share of those willing to work lack the skills or are otherwise not well suited for the jobs that are available. With 6.7 percent unemployment, it might seem that there must be a lot of slack in the U.S. economy, but there are reasons why that may not be true. One important reason relates to the skills and education of people in the workforce. It is no secret that America faces some daunting challenges in educating people and preparing them to work in a 21st century, globalized economy. Many of you in this audience are helping workers address this challenge, but you also know that the economy continues to change very rapidly. To the extent that people who desire to work lack the skills that employers are demanding, there is less slack in the labor market. This is an example of what economists call "structural" unemployment, and it can be difficult to solve. Even understanding what workers need to appeal to employers is difficult in a fast-changing economy. For government, effective solutions for structural unemployment, beginning with improved education, tend to be expensive and take a long time to work. The problem goes deeper than simply a lack of jobs. But a lack of jobs is the heart of the problem when unemployment is caused by slack, which we also call "cyclical unemployment." The government has the tools to address cyclical unemployment. Monetary policy is one such tool, and the Federal Reserve has been actively using it to strengthen the recovery and create jobs, which brings me to why the amount of slack is so important. If unemployment were mostly structural, if workers were unable to perform the jobs available, then the Federal Reserve's efforts to create jobs would not be very effective. Worse than that, without slack in the labor market, the economic stimulus from the Fed could put attaining our inflation goal at risk. In fact, judging how much slack there is in the labor market is one of the most important questions that my Federal Reserve colleagues and I consider when making monetary policy decisions, because our inflation goal is no less important than the goal of maximum employment. This is not just an academic debate. For Dorine Poole, Jermaine Brownlee, and Vicki Lira, and for millions of others dislocated by the Great Recession who continue to struggle, the cause of the slow recovery is enormously important. As I said earlier, the powerful force that sustains them and others who keep trying to succeed in this recovery is the faith that their job prospects will improve and that their efforts will be rewarded. Now let me explain why I believe there is still considerable slack in the labor market, why I think there is room for continued help from the Fed for workers, and why I believe Dorine Poole, Jermaine Brownlee, and Vicki Lira are right to hope for better days ahead. One form of evidence for slack is found in other labor market data, beyond the unemployment rate or payrolls, some of which I have touched on already. For example, the seven million people who are working part time but would like a full-time job. This number is much larger than we would expect at 6.7 percent unemployment, based on past experience, and the existence of such a large pool of "partly unemployed" workers is a sign that labor conditions are worse than indicated by the unemployment rate. Statistics on job turnover also point to considerable slack in the labor market. Although firms are now laying off fewer workers, they have been reluctant to increase the pace of hiring. Likewise, the number of people who voluntarily quit their jobs is noticeably below levels before the recession; that is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another. It is also a sign that firms may not be recruiting very aggressively to hire workers away from their competitors. A second form of evidence for slack is that the decline in unemployment has not helped raise wages for workers as in past recoveries. Workers in a slack market have little leverage to demand raises. Labor compensation has increased an average of only a little more than 2 percent per year since the recession, which is very low by historical standards. Wage growth for most workers was modest for a couple of decades before the recession due to globalization and other factors beyond the level of economic activity, and those forces are undoubtedly still relevant. But labor market slack has also surely been a factor in holding down compensation. The low rate of wage growth is, to me, another sign that the Fed's job is not yet done. A third form of evidence related to slack concerns the characteristics of the extraordinarily large share of the unemployed who have been out of work for six months or more. These workers find it exceptionally hard to find steady, regular work, and they appear to be at a severe competitive disadvantage when trying to find a job. The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce. But the data suggest that the long-term unemployed look basically the same as other unemployed people in terms of their occupations, educational attainment, and other characteristics. And, although they find jobs with lower frequency than the short-term jobless do, the rate at which job seekers are finding jobs has only marginally improved for both groups. That is, we have not yet seen clear indications that the short- term unemployed are finding it increasingly easier to find work relative to the long-term unemployed. This fact gives me hope that a significant share of the long-term unemployed will ultimately benefit from a stronger labor market. A final piece of evidence of slack in the labor market has been the behavior of the participation rate--the proportion of working-age adults that hold or are seeking jobs. Participation falls in a slack job market when people who want a job give up trying to find one. When the recession began, 66 percent of the working-age population was part of the labor force. Participation dropped, as it normally does in a recession, but then kept dropping in the recovery. It now stands at 63 percent, the same level as in 1978, when a much smaller share of women were in the workforce. Lower participation could mean that the 6.7 percent unemployment rate is overstating the progress in the labor market. One factor lowering participation is the aging of the population, which means that an increasing share of the population is retired. If demographics were the only or overwhelming reason for falling participation, then declining participation would not be a sign of labor market slack. But some "retirements" are not voluntary, and some of these workers may rejoin the labor force in a stronger economy. Participation rates have been falling broadly for workers of different ages, including many in the prime of their working lives. Based on the evidence, my own view is that a significant amount of the decline in participation during the recovery is due to slack, another sign that help from the Fed can still be effective. Since late 2008, the Fed has taken extraordinary steps to revive the economy. At the height of the crisis, we provided liquidity to help avert a collapse of the financial system, which enabled banks and other institutions to continue to provide credit to people and businesses depending on it. We cut short-term interest rates as low as they can go and indicated that we would keep them low for as long as necessary to support a stronger economic recovery. And we have been purchasing large quantities of longer-term securities in order to put additional downward pressure on longer-term interest rates--the rates that matter to people shopping for a new car, looking to buy or renovate a home, or expand a business. There is little doubt that without these actions, the recession and slow recovery would have been far worse. These different measures have the same goal--to encourage consumers to spend and businesses to invest, to promote a recovery in the housing market, and to put more people to work. Together they represent an unprecedentedly large and sustained commitment by the Fed to do what is necessary to help our nation recover from the Great Recession. For the many reasons I have noted today, I think this extraordinary commitment is still needed and will be for some time, and I believe that view is widely shared by my fellow policymakers at the Fed. In this context, recent steps by the Fed to reduce the rate of new securities purchases are not a lessening of this commitment, only a judgment that recent progress in the labor market means our aid for the recovery need not grow as quickly. Earlier this month, the Fed reiterated its overall commitment to maintain extraordinary support for the recovery for some time to come. This commitment is strong, and I believe the Fed's policies will continue to help sustain progress in the job market. But the scars from the Great Recession remain, and reaching our goals will take time. In the meanwhile, the Federal Reserve will continue to expand its efforts to promote community development. The Board and each of the Reserve Banks have community development staff members who focus on improving the availability of financial services in low- and moderate-income communities. They help bankers comply with the Community Reinvestment Act, but they are also a source of research and a facilitator of communication among financial institutions and practitioners to identify and share best practices. This conference is one example of how the Fed pursues those goals, and I would like to mention a few of the Fed's other community development initiatives that I find institution that bridges the gap between low-income neighborhoods and private capital sources, to publish the book . This book cited innovative and effective community development initiatives across the country and advocated for a "Community Quarterback" model to coordinate initiatives and better leverage funding among groups with similar goals. In a similar way, the Federal Reserve Bank of Boston has been the catalyst for the Working Cities Challenge, inspired by its own research on cities that managed to diversify away from a declining, manufacturing-based economy. The research found that one key to success is "collaborative leadership," when governments, businesses, and nonprofits unite behind one focused approach. The Working Cities Challenge promotes that principle by inviting smaller Massachusetts cities to consider how they would use collaborative leadership to unite their communities to address a major challenge for lower-income residents. Twenty cities competed for $1.8 million in funding from the state and other sources. Six cities were awarded funds this past January, but many more will benefit from the spread of a new approach to capacity building that Fed research shows helps communities thrive. Leadership recruitment is also at the heart of a grassroots-oriented program called Kansas, residents and neighborhood leaders are forming a leadership council that will have responsibility for managing the program, which aims to create and grow local businesses, create jobs, and promote homeownership. The bank's community development staff is providing education and training to get the council off the ground, will measure and evaluate its progress, and assist in connecting leaders to resources and other programs. These examples are just a few among many throughout the Federal Reserve System. By testing ideas, developing better measurement tools, convening interested parties, and sharing the Federal Reserve's skills and knowledge with our partners at the national and local levels, we aim to serve as a catalyst to improve lives. Through these initiatives, together with the use of monetary policy and steps to safeguard the financial system, the Federal Reserve is committed to strengthening communities and restoring a healthy economy that benefits all Americans. It is my hope that the courageous and determined working people I have told you about today, and millions more, will get the chance they deserve to build better lives.

r140409a_FOMC

united states

Longer-Term Challenges for the American Economy

tarullo

In the more than five years that I have been a member of the Board of Governors of the Federal Reserve System, it has been hard not to concentrate on near-term economic prospects. The severe decline in the economy precipitated by the financial crisis and the magnitude of job and production loss in the Great Recession that followed have made a focus on recovery both understandable and imperative. But as I have prepared for examining incoming data and the analyses of our own staff and of outside economists, I have been struck by the evidence of longer-term challenges to the American economy that poke through shorter-term discussions. There is considerable ongoing debate about whether the financial crisis and recession amplified changes already afoot in the economy, accelerated them, or simply revealed them more clearly. Whatever one's view on that question, the confluence of some apparently secular trends raises important questions about our nation's future growth potential and our ability to provide opportunity for all of our people. Indeed, these changes reflect serious challenges not only to the functioning of the American economy over the coming decades, but also to some of the ideals that undergird the nation's democratic heritage. This evening I will address in some detail four particularly important developments: Productivity growth has slowed. As a result, the overall economic pie is expanding more slowly than before. Some indicators further suggest that workers have been claiming a smaller share of the overall economic pie during the past decade. Inequality has continued to increase, meaning that a larger portion of overall economic resources is commanded by a smaller segment of the population. Economic mobility across generations is not particularly high in the United States, and it has not been increasing over time. After detailing these trends, I will turn briefly to both the role and the limits of monetary policy in countering them. Lagging productivity growth Over the long term, the pace at which our standards of living increase depends on the growth of labor productivity--that is, the increase in the amount of economic value that a worker can generate during each hour on the job. Unfortunately, the data on productivity growth in recent years have been disappointing. Although output per hour in the nonfarm business sector rose about 2-3/4 percent per year from the end of World War II through 1971, productivity has risen just 1-1/2 percent per year since then, excluding a brief burst of rapid growth that occurred roughly between 1996 and 2004. Just as it took economists a long time to identify the sources of the surge in productivity that began nearly two decades ago, they are only now beginning to grapple with the more recent slowdown. Some have argued that the burst of productivity growth that began in the mid-1990s was the anomaly, and that the more pedestrian pace of growth over the past decade represents a return to the norm. In this view, the long period of rapid productivity growth that ended in the 1970s grew out of the technological innovations of the first and second Industrial Revolutions. But now, despite continued technological advances, a return to that pace of performance is thought unlikely. In particular, these authors argue that the information technology revolution of the past several decades--including the diffusion of computers, the development of the Internet, and improvements in telecommunications--is unlikely to generate the productivity gains prompted by earlier innovations such as electrification and mass production. This somewhat pessimistic perspective is far from being conventional wisdom. While productivity has increased less rapidly in recent years than during the first three- fourths of the 20th century, per capita income (a statistic available over a longer time span) is still rising more quickly than it was even during the second Industrial Revolution. Indeed, some have argued that the problem with new technology is not with productivity growth but with our ability to capture the productivity in our statistics. Moreover, many economists and technophiles remain optimistic that we have yet to fully realize the potential of the information revolution, and that technological change will continue to bring inventions and productivity enhancements that we cannot imagine today. This view holds that there is no reason productivity could not continue to rise in line with its long-term historical average. It must be noted that, even among the productivity optimists, there are differences over how the expected progress will affect job creation and income distribution. In particular, some in this camp believe that we are likely to see a continuation of the pattern by which recent productivity growth seems to have mostly benefited relatively skilled workers. It may also have favored returns to capital investment, as opposed to labor, in greater proportion than past productivity gains. While there is some reason for optimism about the prospects for technological progress, there are grounds for concern over the decline in the dynamism of the U.S. labor market, an attribute that has contributed to productivity growth in the past and has traditionally distinguished the United States from many other advanced economies. Historically, the U.S. labor market has been characterized by substantial geographic mobility. Our high rates of geographic mobility are one facet of the overall dynamism of our labor market, which is also manifest in the continual churning of jobs through hirings and separations, as well as firm expansions and contractions--a process that the To give a sense of the magnitude of this process, while net job gains and losses are typically measured in the hundreds of thousands each calendar quarter, gross job creation and destruction commonly run at a pace of roughly 7 million jobs each quarter. Creative destruction has been shown to improve productivity as jobs that have low productivity are replaced with jobs that yield greater productivity. However, a variety of data indicate that this feature of labor market dynamism has diminished. Since the 1980s, internal migration in the United States over both long and short distances has declined. To give an example, the rate of cross-state migration was less than half as large in 2011 as its average over the period from 1948 to 1971. while we still see the level of employment rising and falling over the business cycle, the gross flows of people between jobs and of jobs across firms that underlie the observed aggregate changes have fallen over the past 15 years. At this point, we do not have a full understanding of the factors contributing to the decline in labor market dynamism. As a number of economists who have studied the issue have pointed out, some of the explanations may be benign or even positive. instance, the aging of the population accounts for some of the decline in migration and job churning, as older individuals are less likely to move and change jobs; such demographic factors probably do not represent an adverse reduction in dynamism. Moreover, some of the decline in turnover could be the result of individuals and firms finding productive job matches more quickly than before. For many employers and workers, the Internet has reduced the cost of posting job openings and the cost of searching for jobs. This more efficient process could result in better matches between firms and workers and thus fewer separations. Similarly, a reduction in firm uncertainty about the costs and benefits of investing could reduce firm-level churning in jobs. In both cases, workers and firms are able to achieve a good outcome with less turnover and presumably no loss of productivity. While it seems possible that improved information could be a force behind the reduction in geographic mobility and labor turnover, there are less benign possibilities as well. For instance, an increase in the costs to firms of hiring and firing individuals or an increase in the costs to individuals of changing jobs could lead to fewer productivity- enhancing job changes. Alternatively, the reduction in churning could itself be a function of slower productivity growth, as slower productivity growth implies lower benefits to forming new matches. One recent trend that is particularly disturbing is stagnation in the formation of new firms. Statistics from the Bureau of Labor Statistics (BLS) show that the number of establishments in operation for less than one year rose between the mid-1990s, when the data start, and the early 2000s. But, smoothing through the ups and downs of the business cycle, new firm formation has been roughly flat since then. Moreover, the number of individuals working at such firms stands almost 2 million below its peak in 1999. Given the role of innovation by entrepreneurs and the well-documented importance of successful young firms in creating jobs, these trends are disheartening. The lagging share of national income accruing to workers A second adverse development in recent years has been the apparent reduction in the share of overall national income that accrues to workers. Here I will be brief and suggestive because the scholarship is far from settled. But the basic trends in the data are troubling. Labor's share of total income generated in the nonfarm business sector has been on a downtrend since the 1980s and has fallen sharply since the turn of the millennium. It stood at 56 percent at the end of 2013, the lowest level since the BLS began collecting data on the measure in 1948. To be sure, various conceptual and measurement challenges make it difficult to compute labor's share of income with any degree of precision. However, taken at face value, these data have significant implications for the distribution of income in our society, given how skewed the holdings of capital are. Economists have focused less attention on the factors underlying the apparent decline in labor's share of income than they have on the rise in income inequality in general, but among the candidates are technological change, which has allowed for the substitution of capital for labor in the handling of routine tasks, an increase in firm bargaining power, and perhaps a decline in competition in product markets. The increase in inequality Of the trends I have identified, the one that has received the largest amount of press attention recently is the rise in income inequality. While income inequality has been increasing since the 1970s, over the past two decades the process has been characterized by what some have called polarization, with those at the top of the distribution accumulating a significantly larger share of income, those at the bottom of the distribution experiencing modest relative gains, and those in the middle of the income distribution falling further behind in relative terms. Gauging by one fairly comprehensive measure of income used by the Congressional Budget Office, the share of income garnered by those in the top 1 percent of the distribution more than doubled between 1979 and 2007 to about 17 percent, while the share accruing to those in the 1st through 80th percentiles fell 9 percentage points. And while it is true that those at the upper end of the income distribution were disproportionately affected during the financial crisis, with the result that inequality actually fell a bit in the wake of the recession, high earners also appear to be benefiting disproportionately from the recovery. Thus, the crisis does not seem really to have changed the trajectory of inequality. As interesting as these statistics on inequality are, they obscure a key part of the story--one that has been an important part of our identity as Americans: whether a family has the ability, through hard work, to attain a better standard of living. And on that point, we find that households in the middle and lower parts of the earnings distribution have experienced, at best, only modest improvements in inflation-adjusted income. 1979 and 2007, households in the middle quintile of the income distribution--a functional definition of the middle class--saw their real labor income (adjusted for household size) rise only about 3 percent. Meanwhile, households in the bottom one-fifth of the distribution did a bit better, experiencing about a 24 percent rise, although this figure reflects an improvement of just 1 percent per year, and that from a very low base. In contrast, income rose more than 70 percent among households in the top one-fifth of the earnings distribution. The polarization of the labor income distribution has been mirrored in the types of jobs we are creating. Since the 1990s, job gains have been concentrated at the upper and lower ends of the earnings distribution. There have been healthy gains in employment in highly paid occupations, such as computer and information systems managers, and a rise in low-paid jobs, such as home health-care workers, but growth has been much slower in occupations with earnings in the middle of the distribution, such as machinists. This trend accelerated during the Great Recession and the ensuing recovery. For example, food services, retail, and employment services, all low-wage industries, accounted for nearly 45 percent of net employment growth from the start of the recovery through early 2012, while employment in a number of industries that offer good jobs for mid-wage workers--including construction, manufacturing, and finance, insurance, and real estate-- did not grow in those years or grew too slowly to make up for their job losses during the recession. There is no single explanation for the rise in inequality and the decline in the share of jobs that provide a middle-class standard of living. Economists generally agree that technological change and globalization have played a role. Both of these forces have reduced the demand for workers whose jobs had involved routine work that can easily be mechanized or offshored while, at the same time, increasing the productivity of higher-skilled workers. However, it is less clear whether technology and globalization are sufficient explanations for the increased share of income going to those at the very top of the income distribution. It may be that by increasing the effective size of the markets for their skills, technological change and globalization can also explain some of the large increase in earnings of top athletes, musicians, and even chief executive officers. In the popular press, the phenomenon of the very few reaping enormous windfalls has become known as the winner-take-all economy. However, other researchers have noted that a large share of the top earners is found in industries such as finance and law, suggesting that deregulation, corporate governance, and tax policy may have also played a role in the trend toward rising inequality. Economic mobility has not increased to mitigate higher inequality Despite the fact that rising inequality has compounded the stakes associated with one's position in the income distribution, mobility up and down the economic ladder from one generation to the next in the United States has been stagnant. Work by Raj Chetty and his coauthors using income tax data has shown that a child who was born in the early 1990s had about the same chance of moving up in the income distribution as a child born in the 1970s. Combining these results with previous research suggests that mobility has not increased in the postwar era. And, despite the long-held view of the United States as the land of opportunity, we actually fall short of other advanced economies in terms of intergenerational mobility. In the United Kingdom, for example, about 30 percent of sons with low-income parents end up being low-income themselves, while in the United States the comparable figure is over 40 percent. As must be apparent, the challenges I have discussed are not susceptible to easy or rapid solution. It is equally apparent that monetary policy cannot be the only, or even the principal, tool in addressing these challenges. But that is not to say it is irrelevant. There is not as sharp a demarcation between cyclical and structural problems as is sometimes suggested. Monetary policies directed toward achieving the statutory dual mandate of maximum employment and price stability can help reduce underemployment associated with low aggregate demand. And, to the degree that monetary policy can prevent cyclical phenomena such as high unemployment and low investment from becoming entrenched, it might be able to improve somewhat the potential growth rate of the economy over the medium term. More generally, reducing labor market slack can help lay the foundation for a more sustained, self-reinforcing cycle of stronger aggregate demand, increased production, renewed investment, and productivity gains. Similarly, a stronger labor market can provide a modest countervailing factor to income inequality trends by leading to higher wages at the bottom rungs of the wage scale. The very accommodative monetary policy of the past five years has contributed significantly to the extended, moderate recoveries of gross domestic product (GDP) and employment. To this point, however, there has not been a corresponding upturn in wages. To be sure, there have been notable wage increases in specific areas of the country enjoying economic growth much higher than the national average. And, as is nearly always the case, labor shortages in discrete skilled job categories may be placing some upward pressures on wages for those jobs (though, judging by such aggregate data as we have, not by as much as one might have thought based on the widespread anecdotal reports of skilled labor shortages). But one sees only the earliest signs of a much-needed, broader wage recovery. Compensation increases have been running at the historically low level of just over 2 percent annual rates since the onset of the Great Recession, with concomitantly lower real wage gains. The reasons for the lag in wage gains in the context of continuing moderate growth are not totally clear. Nominal wage rigidity on the downside may have played a role to the extent that employers were reluctant to cut nominal wages even in the period from late 2008 to early 2009, when they were eliminating jobs in staggering numbers. The secular labor market factors mentioned earlier are also likely relevant. There is, of course, also a debate around the question of how much of current unemployment--particularly long-term unemployment--is structural and thus how much slack still exists in labor markets. Last week Chair Yellen explained why substantial slack very likely remains. I would add to her explanation only the observation that, in the face of some uncertainty as to how best to measure slack, we are well advised to proceed pragmatically. We should remain attentive to evidence that labor markets have actually tightened to the point that there is demonstrable inflationary pressure that would place at risk maintenance of the FOMC's stated inflation target (which, of course, we are currently not meeting on the downside). But we should not rush to act preemptively in anticipation of such pressures based on arguments about the potential increase in structural unemployment in recent years. In this regard, the issue of how much structural damage has been suffered by the labor market is of less immediate concern today in shaping monetary policy than it might have been had we experienced a period of rapid growth during the recovery. Remember that, just a few years ago, many forecasters--in and out of the Federal Reserve--were projecting growth rates at an annualized rate of 4 percent or greater for at least a year. That expectation raised the question of whether a reasonably rapid tightening in monetary policy might at some point be needed. But now, in part because we did not have such a spike in the early stages of recovery and instead have had modest growth in place for several years, it seems less likely that we will experience a growth spurt in the next couple of years that would engender concerns about rapid wage pressures and changes in inflation expectations. In short, by promoting maximum employment in a stable inflation environment around the FOMC target rate, monetary policy can help set the stage for a vibrant and dynamic economy. But there are limits to what monetary policy can do in counteracting the longer-term trends I have discussed. In economic research and in policy debates, we need more focus on these issues and more attention to concrete proposals to address them. I would suggest that one element, though by no means the only one, in such a program is a well-formulated government investment agenda. A pro-investment policy agenda by the government could help address some of our nation's long-term challenges by promoting investment in human capital, particularly for those who have seen their share of the economic pie shrink, and by encouraging research and development and other capital investments that increase the productive capacity of the nation. There is already a well-known list of investments that have been shown to be successful. For instance, early childhood education can increase the educational attainment of children from low-income families as well as improve other outcomes. addition, recent innovations in job training programs, which more tightly link the training to the needs of employers in sectors of the economy with a demand for workers, have been shown to increase both the employment and wages of participants. Investment in basic research by the federal government is another area in which greater investments could yield significant returns and in which a public policy role is warranted because of externalities. Econometric studies suggest that the rates of return to this type of investment can be very high. And a range of policy commentators agree that there is a continuing role for government investment in infrastructure, including various forms of transportation, as a way to enhance productivity. Not too long ago, the American Society of Civil Engineers gave the United States a rating of D+ on its roads and bridges. Improving that system, both by doing necessary maintenance to maintain safety and functionality and by reducing congestion could yield substantial benefits. This agenda might sound ambitious. In fact, spending in these areas is currently not a very large proportion of federal outlays. For example, the entire federal budget for nondefense research programs--including expenditures on health research, the National percent of federal spending (or less than 0.4 percent of GDP), well below the share in the 1960s, when we last made a significant effort to advance our capacities in math and science during the era of space exploration. Moreover, spending in these areas has been the target of much of the budget restraint in recent years. Even in the area of physical infrastructure, we have fallen behind past efforts. After a surge associated with fiscal stimulus during the recent recession, public spending on infrastructure has tumbled, resulting in the slowest growth (1 percent) in the state and local capital stock since I certainly am not intending here to join the broader debate on fiscal policy, either short or longer term. But I do note that fiscal policymakers could promote the longer- term prospects of the nation by increased spending in areas that are likely to yield increases in living standards. The amount of increased investment spending that could reasonably be absorbed would be quite modest in comparison with the very large amounts associated with major fiscal issues such as health-care expenses. And even a strong investment agenda would not be a complete response to the economic challenges I have discussed. But, like monetary policy, it could play a useful role. The longer-term challenges to the American economy that I have identified this evening are real. But I certainly do not regard a continuation of these trends as inevitable. On the contrary, the American economy is still possessed of great advantages and potential that, while always and necessarily evolving, have served us well over the years. My principal aims this evening have been, first, to echo those who have been drawing attention to these challenges in recent years and, second, to encourage more discussion and debate of the specific policies that can best help us meet these challenges. As should be apparent in my remarks on monetary policy and an investment agenda, I believe that there are policies already developed and available to us that can contribute to this effort. My hope is that such policies will be pursued and that others, perhaps yet to be developed, will follow.

r140415a_FOMC

united states

Opening Remarks

yellen

Good morning. I'm delighted to have this opportunity to speak to you today, even though I am unable to be with you in person. I'd like to share a few thoughts about the important issues that the Financial Markets Conference (FMC) is addressing this year. Many of these issues, of course, are ones the FMC has grappled with every year since the crisis, an event which elevated the importance of this gathering and of the vital contributions made by the research and the policy discussion the FMC fosters. One of those issues is liquidity. Maturity transformation is a central part of the economic function of banks and many other types of financial intermediaries. But as we saw in the crisis, maturity transformation also exposes intermediaries to liquidity risk, particularly when intermediaries are heavily reliant on short-term wholesale funding. In 2007 and 2008, short-term creditors ran from firms such as Northern Rock, Bear Stearns, and Lehman Brothers, and from money market mutual funds and asset-backed commercial paper programs. Together, these runs were the primary engine of a financial crisis from which the United States and the global economy have yet to fully recover. In response to the crisis, the Basel Committee on Banking Supervision's first task was to strengthen bank capital requirements through the adoption of the Basel III capital accord and, last summer, our domestic rule implementing the Basel III capital requirements in the United States. Strong bank capital rules remain the foundation of bank regulation. But capital requirements as currently constructed are generally based on credit and market risks from the asset side of the balance sheet and from off-balance- sheet transactions. They do not directly address liquidity risk. Thus, the Basel Committee's second task was to develop new liquidity standards Funding Ratio (NSFR). The LCR is designed to improve a bank's ability to withstand severe short-term liquidity stress events by requiring banking firms to hold a buffer of highly liquid assets to cover net cash outflows in a 30-day stress scenario. The NSFR is meant to promote resilience over a one-year horizon by requiring banks that hold less liquid assets to fund their activities with more stable sources of funding. As others have observed, the new Basel liquidity standards address financial stability risks associated with excessive maturity transformation through at least two channels. First, the new standards insulate banks from liquidity shocks. In the case of the LCR, requiring firms to hold a buffer of highly liquid assets will help to ensure that they have a means of generating liquidity in the event of creditor runs. In the case of the NSFR, requiring firms to use higher levels of stable funding for less liquid assets reduces the vulnerabilities of a firm to structural maturity mismatches. Banking firms that self- insure against liquidity risk in these ways are less likely to need government liquidity support in times of stress. Second, the new standards provide an incentive for firms to move to more stable funding structures. Under the LCR and NSFR, firms that engage in unstable forms of maturity transformation will be required to maintain buffers of highly liquid assets and use stable funding, both of which will impose costs for the firms. Reducing the amount of maturity transformation they engage in will help firms minimize these costs. While the LCR and NSFR are important steps forward, they do not fully address the financial stability concerns associated with short-term wholesale funding. These standards tend to focus on the liquidity positions of firms taken in isolation, rather than on the financial system as a whole. They only apply to internationally active banks, and not directly to shadow banks, despite the fact that liquidity shocks within the shadow banking system played a major role in the crisis. Furthermore, the current versions of the LCR and NSFR do not address financial stability risks associated with so-called matched books of securities financing transactions. Federal Reserve staff are actively considering additional measures that could address these and other residual risks in the short-term wholesale funding markets. Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding--would likely apply only to the largest, most complex banking organizations. Other measures-- such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis. In designing such measures, we are carefully thinking through questions about the tradeoffs associated with tighter liquidity regulation that will be discussed at this conference. While these cost-benefit questions are difficult to answer with either certainty or precision, let me highlight one data point that suggests that there may be net social gains from introducing further reforms to address short-term wholesale funding risks. In 2010, the Basel Committee assessed the long-term economic impact of stronger capital and liquidity requirements for global banks. Factoring in the Basel III capital requirements and the NSFR, the Basel study suggested that tightening risk-based capital and liquidity requirements would, on net, provide economic benefits, and that benefits would continue to accrue at even higher levels of risk-based capital than are part of Basel III. While it would be a mistake to give undue weight to any one study, this study provides some support for the view that there might be room for stronger capital and liquidity standards for large banks than have been adopted so far. As the Board continues to weigh such steps to further strengthen the financial system, I expect that conferences like the FMC will continue to be a vital part of the process, providing the ideas, analysis, and debate that will help us make the best possible judgments. Thank you for listening and for this opportunity to be a part of this important conference. .

r140416a_FOMC

united states

Monetary Policy and the Economic Recovery

yellen

Nearly five years into the expansion that began after the financial crisis and the Great Recession, the recovery has come a long way. More than 8 million jobs have been added to nonfarm payrolls since 2009, almost the same number lost as a result of the recession. Led by a resurgent auto industry, manufacturing output has also nearly returned to its pre-recession peak. While the housing market still has far to go, it seems to have turned a corner. It is a sign of how far the economy has come that a return to full employment is, for the first time since the crisis, in the medium-term outlooks of many forecasters. It is a reminder of how far we have to go, however, that this long-awaited outcome is projected to be more than two years away. Today I will discuss how my colleagues on the Federal Open Market Committee (FOMC) and I view the state of the economy and how this view is likely to shape our efforts to promote a return to maximum employment in a context of price stability. I will start with the FOMC's outlook, which foresees a gradual return over the next two to three years of economic conditions consistent with its mandate. While monetary policy discussions naturally begin with a baseline outlook, the path of the economy is uncertain, and effective policy must respond to significant unexpected twists and turns the economy may take. My primary focus today will be on how the FOMC's monetary policy framework has evolved to best support the recovery through those twists and turns, and what this framework is likely to imply as the recovery progresses. The FOMC's current outlook for continued, moderate growth is little changed from last fall. In recent months, some indicators have been notably weak, requiring us to judge whether the data are signaling a material change in the outlook. The unusually harsh winter weather in much of the nation has complicated this judgment, but my FOMC colleagues and I generally believe that a significant part of the recent softness was weather related. The continued improvement in labor market conditions has been important in this judgment. The unemployment rate, at 6.7 percent, has fallen three-tenths of 1 percentage point since late last year. Broader measures of unemployment that include workers marginally attached to the labor force and those working part time for economic reasons have fallen a bit more than the headline unemployment rate, and labor force participation, which had been falling, has ticked up this year. Inflation, as measured by the price index for personal consumption expenditures, has slowed from an annual rate of about 2-1/2 percent in early 2012 to less than 1 percent in February of this year. This rate is well below the Committee's 2 percent longer-run objective. Many advanced economies are observing a similar softness in inflation. To some extent, the low rate of inflation seems due to influences that are likely to be temporary, including a deceleration in consumer energy prices and outright declines in core import prices in recent quarters. Longer-run inflation expectations have remained remarkably steady, however. We anticipate that, as the effects of transitory factors subside and as labor market gains continue, inflation will gradually move back toward 2 percent. In sum, the central tendency of FOMC participant projections for the unemployment rate at the end of 2016 is 5.2 to 5.6 percent, and for inflation the central tendency is 1.7 to 2 percent. If this forecast was to become reality, the economy would be approaching what my colleagues and I view as maximum employment and price stability for the first time in nearly a decade. I find this baseline outlook quite plausible. Of course, if the economy obediently followed our forecasts, the job of central bankers would be a lot easier and their speeches would be a lot shorter. Alas, the economy is often not so compliant, so I will ask your indulgence for a few more minutes. Because the course of the economy is uncertain, monetary policymakers need to carefully watch for signs that it is diverging from the baseline outlook and then respond in a systematic way. Let me turn first to monitoring and discuss three questions I believe are likely to loom large in the FOMC's ongoing assessment of where we are on the path back to maximum employment and price stability. Is there still significant slack in the labor market? The first question concerns the extent of slack in the labor market. One of the FOMC's objectives is to promote a return to maximum employment, but exactly what conditions are consistent with maximum employment can be difficult to assess. Thus far in the recovery and to this day, there is little question that the economy has remained far from maximum employment, so measurement difficulties were not our focus. But as the attainment of our maximum employment goal draws nearer, it will be necessary for the FOMC to form a more nuanced judgment about when the recovery of the labor market will be materially complete. As the FOMC's statement on longer-term goals and policy strategy emphasizes, these judgments are inherently uncertain and must be based on a wide range of indicators. I will refer to the shortfall in employment relative to its mandate-consistent level as labor market slack, and there are a number of different indicators of this slack. Probably the best single indicator is the unemployment rate. At 6.7 percent, it is now slightly more than 1 percentage point above the 5.2 to 5.6 percent central tendency of the Committee's projections for the longer-run normal unemployment rate. This shortfall remains significant, and in our baseline outlook, it will take more than two years to close. Other data suggest that there may be more slack in labor markets than indicated by the unemployment rate. For example, the share of the workforce that is working part time but would prefer to work full time remains quite high by historical standards. Similarly, while the share of workers in the labor force who are unemployed and have been looking for work for more than six months has fallen from its peak in 2010, it remains as high as any time prior to the Great Recession. There is ongoing debate about why long-term unemployment remains so high and the degree to which it might decline in a more robust economy. As I argued more fully in a recent speech, I believe that long- term unemployment might fall appreciably if economic conditions were stronger. The low level of labor force participation may also signal additional slack that is not reflected in the headline unemployment rate. Participation would be expected to fall because of the aging of the population, but the decline steepened in the recovery. Although economists differ over what share of those currently outside the labor market might join or rejoin the labor force in a stronger economy, my own view is that some portion of the decline in participation likely represents labor market slack. Lastly, economists also look to wage pressures to signal a tightening labor market. At present, wage gains continue to proceed at a historically slow pace in this recovery, with few signs of a broad-based acceleration. As the extent of slack we see today diminishes, however, the FOMC will need to monitor these and other labor market indicators closely to judge how much slack remains and, therefore, how accommodative monetary policy should be. Is inflation moving back toward 2 percent? A second question that is likely to figure heavily in our assessment of the recovery is whether inflation is moving back toward the FOMC's 2 percent longer-run objective, as envisioned in our baseline outlook. As the most recent FOMC statement emphasizes, inflation persistently below 2 percent could pose risks to economic performance. The FOMC strives to avoid inflation slipping too far below its 2 percent objective because, at very low inflation rates, adverse economic developments could more easily push the economy into deflation. The limited historical experience with deflation shows that, once it starts, deflation can become entrenched and associated with prolonged periods of very weak economic performance. A persistent bout of very low inflation carries other risks as well. With the federal funds rate currently near its lower limit, lower inflation translates into a higher real value for the federal funds rate, limiting the capacity of monetary policy to support the economy. Further, with longer-term inflation expectations anchored near 2 percent in recent years, persistent inflation well below this expected value increases the real burden of debt for households and firms, which may put a drag on economic activity. I will mention two considerations that will be important in assessing whether inflation is likely to move back to 2 percent as the economy recovers. First, we anticipate that, as labor market slack diminishes, it will exert less of a drag on inflation. However, during the recovery, very high levels of slack have seemingly not generated strong downward pressure on inflation. We must therefore watch carefully to see whether diminishing slack is helping return inflation to our objective. Second, our baseline projection rests on the view that inflation expectations will remain well anchored near 2 percent and provide a natural pull back to that level. But the strength of that pull in the unprecedented conditions we continue to face is something we must continue to assess. Finally, the FOMC is well aware that inflation could also threaten to rise substantially above 2 percent. At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2 percent, but we must always be prepared to respond to such unexpected outcomes, which leads us to my third question. What factors may push the recovery off track? Myriad factors continuously buffet the economy, so the Committee must always be asking, "What factors may be pushing the recovery off track?" For example, over the nearly 5 years of the recovery, the economy has been affected by greater-than-expected fiscal drag in the United States and by spillovers from the sovereign debt and banking problems of some euro-area countries. Further, our baseline outlook has changed as we have learned about the degree of structural damage to the economy wrought by the crisis and the subsequent pace of healing. Let me offer an example of how these issues shape policy. Four years ago, in April 2010, the outlook appeared fairly bright. The emergency lending programs that the Federal Reserve implemented at the height of the crisis had been largely wound down, and the Fed was soon to complete its first large-scale asset purchase program. Private- sector forecasters polled in the April 2010 Blue Chip survey were predicting that the unemployment rate would fall steadily to 8.6 percent in the final quarter of 2011. This forecast proved quite accurate--the unemployment rate averaged 8.6 percent in the fourth quarter of 2011. But this was not the whole story. In April 2010, Blue Chip forecasters not only expected falling unemployment, they also expected the FOMC to soon begin raising the federal funds rate. Indeed, they expected the federal funds rate to reach 1.3 percent by the second quarter of 2011. By July 2010, however, with growth disappointing and the FOMC expressing concerns about softening in both growth and inflation, the Blue Chip forecast of the federal funds rate in mid-2011 had fallen to 0.8 percent, and by October the forecasters expected that the rate would remain in the range of 0 to 25 basis points throughout 2011, as turned out to be the case. Not only did expectations of policy tightening recede, the FOMC also initiated a new $600 billion asset purchase program in November 2010. Thus, while the reductions in the unemployment rate through 2011 were roughly as forecast in early 2010, this improvement only came about with the FOMC providing a considerably higher level of accommodation than originally anticipated. This experience was essentially repeated the following year. In April 2011, Blue Chip forecasters expected the unemployment rate to fall to 7.9 percent by the fourth quarter of 2012, with the FOMC expected to have already raised the federal funds rate to near 1 percent by mid-2012. As it turned out, the unemployment rate forecast was once more remarkably accurate, but again this was associated with considerably more accommodation than anticipated. In response to signs of slowing economic activity, in August 2011 the FOMC for the first time expressed its forward guidance in terms of the calendar, stating that conditions would likely warrant exceptionally low levels for the federal funds rate at least through mid-2013. The following month, the Committee added to accommodation by adopting a new balance sheet policy known as the maturity extension program. Thus, in both 2011 and 2012, the unemployment rate actually declined by about as much as had been forecast the previous year, but only after unexpected weakness prompted additional accommodative steps by the Federal Reserve. In both cases, I believe that the FOMC's decision to respond to signs of weakness with significant additional accommodation played an important role in helping to keep the projected labor market recovery on track. These episodes illustrate what I described earlier as a vital aspect of effective monetary policymaking: monitor the economy for signs that events are unfolding in a materially different manner than expected and adjust policy in response in a systematic manner. Now I will turn from the task of monitoring to the policy response. Fundamental to modern thinking on central banking is the idea that monetary policy is more effective when the public better understands and anticipates how the central bank will respond to evolving economic conditions. Specifically, it is important for the central bank to make clear how it will adjust its policy stance in response to unforeseen economic developments in a manner that reduces or blunts potentially harmful consequences. If the public understands and expects policymakers to behave in this systematically stabilizing manner, it will tend to respond less to such developments. Monetary policy will thus have an "automatic stabilizer" effect that operates through private-sector expectations. It is important to note that tying the response of policy to the economy necessarily makes the future course of the federal funds rate uncertain. But by responding to changing circumstances, policy can be most effective at reducing uncertainty about the course of inflation and employment. Recall how this worked during the couple of decades before the crisis--a period sometimes known as the Great Moderation. The FOMC's main policy tool, the federal funds rate, was well above zero, leaving ample scope to respond to the modest shocks that buffeted the economy during that period. Many studies confirmed that the appropriate response of policy to those shocks could be described with a fair degree of accuracy by a simple rule linking the federal funds rate to the shortfall or excess of employment and inflation relative to their desired values. The famous Taylor rule provides one such formula. The idea that monetary policy should react in a systematic manner in order to blunt the effects of shocks has remained central in the FOMC's policymaking during this recovery. However, the application of this idea has been more challenging. With the federal funds rate pinned near zero, the FOMC has been forced to rely on two less familiar policy tools--the first one being forward guidance regarding the future setting of the federal funds rate and the second being large-scale asset purchases. There are no time-tested guidelines for how these tools should be adjusted in response to changes in the outlook. As the episodes recounted earlier illustrate, the FOMC has continued to try to adjust its policy tools in a systematic manner in response to new information about the economy. But because both the tools and the economic conditions have been unfamiliar, it has also been critical that the FOMC communicate how it expects to deploy its tools in response to material changes in the outlook. Let me review some important elements in the evolution of the FOMC's communication framework. When the FOMC initially began using its unconventional tools, policy communication was relatively simple. In December 2008, for example, the FOMC said it expected that conditions would warrant keeping the federal funds rate near zero for "some time." This period before the "liftoff" in the federal funds rate was described in increasingly specific, and (as it turned out) longer, periods over time--"some This fixed, calendar-based guidance had the virtue of simplicity, but it lacked the automatic stabilizer property of communication that would signal how and why the stance of policy and forward guidance might change as developments unfolded, and as we learned about the extent of the need for accommodation. More recently, the Federal Reserve, and I might add, other central banks around the world, have sought to incorporate this automatic stabilizer feature in their communications. In December 2012, the Committee reformulated its forward guidance, stating that it anticipated that the federal funds rate would remain near zero at least as long as the unemployment rate remained above 6-1/2 percent, inflation over the period between one and two years ahead was projected to be no more than half a percentage point above the Committee's objective, and longer-term inflation expectations continued to be well anchored. This guidance emphasized to the public that it could count on a near-zero federal funds rate at least until substantial progress in the recovery had been achieved, however long that might take. When these thresholds were announced, the unemployment rate was reported to be 7.7 percent, and the Committee projected that the 6-1/2 percent threshold would not be reached for another 2-1/2 years-- in mid-2015. The Committee emphasized that these numerical criteria were not triggers for raising the federal funds rate, and Chairman Bernanke stated that, ultimately, any decision to begin removing accommodation would be based on a wide range of indicators. Our communications about asset purchases have undergone a similar transformation. The initial asset purchase programs had fixed time and quantity limits, although those limits came with a proviso that they might be adjusted. In the fall of 2012, the FOMC launched its current purchase program, this time explicitly tying the course of the program to evolving economic conditions. When the program began, the rate of purchases was $85 billion per month, and the Committee indicated that purchases would continue, providing that inflation remained well behaved, until there was a substantial improvement in the outlook for the labor market. Based on the cumulative progress toward maximum employment since the initiation of the program and the improvement in the outlook for the labor market, the FOMC began reducing the pace of asset purchases last December, stating that "[i]f incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer- term objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings." Purchases are currently proceeding at a pace of $55 billion per month. Consistent with my theme today, however, the FOMC statement underscores that purchases are not on a preset course--the FOMC stands ready to adjust the pace of purchases as warranted should the outlook change materially. At our most recent meeting in March, the FOMC reformulated its forward guidance for the federal funds rate. While one of the main motivations for this change was that the unemployment rate might soon cross the 6-1/2 percent threshold, the new formulation is also well suited to help the FOMC explain policy adjustments that may arise in response to changes in the outlook. I should note that the change in the forward guidance did not indicate a change in the Committee's policy intentions, but instead was made to clarify the Committee's thinking about policy as the economy continues to recover. The new guidance provides a general description of the framework that the FOMC will apply in making decisions about the timing of liftoff. Specifically, in determining how long to maintain the current target range of 0 to 25 basis points for the federal funds rate, "the Committee will assess progress, both realized and expected, toward its objectives of maximum employment and 2 percent inflation." In other words, the larger the shortfall of employment or inflation from their respective objectives, and the slower the projected progress toward those objectives, the longer the current target range for the federal funds rate is likely to be maintained. This approach underscores the continuing commitment of the FOMC to maintain the appropriate degree of accommodation to support the recovery. The new guidance also reaffirms the FOMC's view that decisions about liftoff should not be based on any one indicator, but that it will take into account a wide range of information on the labor market, inflation, and financial developments. Along with this general framework, the FOMC provided an assessment of what that framework implies for the likely path of policy under the baseline outlook. At present, the Committee anticipates that economic and financial conditions will likely warrant maintaining the current range "for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored." Finally, the Committee began explaining more fully how policy may operate in the period after liftoff, indicating its expectation that economic conditions may, for some time, warrant keeping short-term interest rates below levels the Committee views as likely to prove normal in the longer run. FOMC participants have cited different reasons for this view, but many of the reasons involve persistent effects of the financial crisis and the possibility that the productive capacity of the economy will grow more slowly, at least for a time, than it did, on average, before the crisis. The expectation that the achievement of our economic objectives will likely require low real interest rates for some time is again not confined to the United States but is shared broadly across many advanced economies. Of course, this guidance is a forecast and will evolve as we gain further evidence about how the economy is operating in the wake of the crisis and ensuing recession. In summary, the policy framework I have described reflects the FOMC's commitment to systematically respond to unforeseen economic developments in order to promote a return to maximum employment in a context of price stability. It is very welcome news that a return to these conditions has finally appeared in the medium-term outlook of many forecasters. But it will be much better news when this objective is reached. My colleagues on the FOMC and I will stay focused on doing the Federal Reserve's part to promote this goal.

r140501a_FOMC

united states

Tailored Supervision of Community Banks

yellen

Thank you for inviting me to ICBA's policy summit. I am pleased to have this opportunity to share my views on some of the key issues facing community banks and how I see the community banking model fitting into the financial system in the years ahead. In particular, I will discuss steps the Federal Reserve has taken to address the "too-big-to-fail" problem and how these steps affect community banks; I will describe how the Fed strives to improve our understanding of the unique role that community banks play in the economy; and then I'll show how we are using this knowledge to better tailor our supervisory expectations and approaches to community banks. had the privilege of serving for six years as president and chief executive of the Federal Reserve Bank of San Francisco. The 12th district is the largest of the Fed's districts, covering nine western states, and it is home to a significant number of community banks, the majority of which are supervised by the San Francisco Fed directly or indirectly through bank holding companies. Community bankers helped me, when I served as president, to take the pulse of the local economy and also to understand how regulatory and policy decisions in Washington affect financial institutions of different sizes and types, sometimes in very different ways. During the financial crisis, I saw firsthand the challenges that community banks faced in a crisis they did little to cause, and I have felt strongly ever since that the Fed must do what it can to ensure that the actions taken following the crisis do not place undue burdens on your institutions. I believe a healthy financial system relies on institutions of different sizes performing a variety of functions and serving different needs. In some communities, your banks are actually situated on Main Street, but all community banks serve Main Street by providing credit to small business owners, homebuyers, households, and farmers. Because of their important role, I am pleased that the condition of many community banks has been improving. Although there is still considerable revenue pressure from low margins, earnings for most community banks have rebounded since the financial crisis. Asset quality and capital ratios continue to improve, and the number of problem banks continues to decline. Notably, after several years of reduced lending following the recession, we are starting to see slow but steady loan growth at community banks. While this expansion in lending must be prudent, on balance I consider this growth an encouraging sign of an improving economy. Let me begin by discussing an issue that I know has been on the minds of many community bankers: how policymakers are addressing the problem of banks that are perceived to be too big to fail. Community banks share the interest we all have in reducing the systemic risk posed by firms that are large, complex, and interconnected, and also in reducing any potential competitive advantages that such firms may enjoy as a result of too-big-to-fail. addresses the too-big-to-fail issue through steps intended to limit both the likelihood that systemically important firms would fail and the potential damage from any that do. The Federal Reserve and the other financial regulatory agencies have issued a number of regulations to implement the requirements set forth in the legislation and to enhance the supervision of the largest financial firms. But even before Dodd-Frank became law, the Federal Reserve began to strengthen its oversight of the largest, most complex banking firms and require these firms to materially improve their capital adequacy. For example, in 2009, we conducted the first stress tests of the largest 19 U.S. bank holding companies. That test has subsequently evolved into our annual Comprehensive Capital Analysis and Review, known as CCAR, which requires all bank holding companies with total assets of $50 billion or more to submit annual capital plans for review by the Federal Reserve. CCAR helps ensure that the largest banking organizations will have enough capital to continue operating through times of economic and financial stress. To be clear, as the federal banking agencies have stated previously, these stress testing and capital planning requirements do not, and should not, apply to community banks. In addition to strengthening requirements for stress testing and capital planning, the agencies have also strengthened capital requirements for the largest firms by approving more robust risk-based and leverage capital requirements. Because the financial crisis demonstrated the importance of having adequate levels of high-quality capital at banks of all sizes, many elements of the revised capital framework apply to all banking organizations. In designing the revised capital rules, however, the agencies considered financial stability risks and adjusted the final rules to make the requirements substantially more rigorous for the largest, most systemically important banking organizations than for community banks. While we have taken a number of steps to address too-big-to-fail concerns, our work is not finished. Because the failure of a systemic institution could impose significant costs on the financial system and the economy, the Board recently finalized a requirement for the eight large, globally systemic banks to meet a significantly higher leverage requirement than other banking organizations. And we are working to implement risk-based capital surcharges for these systemically important firms. We also need to ensure that the new rules are embedded in our supervision of the largest firms; and, we must continue to watch for emerging sources of systemic risk and take steps as appropriate to address these risks. One such risk that the Federal Reserve has been monitoring closely is the reliance of some firms on potentially volatile short-term wholesale funding. We are carefully considering the systemic vulnerabilities that may be posed by overreliance on short-term wholesale funding and are weighing potential policy responses. While it would be premature to indicate whether or how we might address these vulnerabilities, I can say that few, if any, community banks are reliant on levels of short-term wholesale funding that could raise concerns about systemic risk, and regulators would carefully consider the ramifications of any action, including the effect on community banks. In carefully considering how our actions affect community banks, the Federal Reserve is committed to understanding your institutions and the challenges you face. We continue to try to improve that understanding in two important ways--research and outreach. The Fed is uniquely positioned to employ these two methods because of our traditional strength as a research institution and because of our structure, with Reserve Banks that have deep roots in communities in every region of the country. In the past several years, research staff across the Federal Reserve System who were independently exploring issues related to community banking have developed an informal network to share findings and identify areas for further research. After some of the fruits of this effort were shared with the Board, we decided to join with the Conference of State Bank Supervisors (CSBS) to host a research and policy conference focused on community banks. This It was one of very few research conferences to focus specifically on community banks and also brought together researchers, community bankers, policymakers, and bank supervisors to discuss the practical implications of the papers presented. Among the topics that researchers addressed in their papers were the link between bank failures and local economic performance, the role of management in the performance of community banks, and the impact of Dodd-Frank on community banks. I'm pleased to say that the conference was so successful that the Federal Reserve and CSBS are planning another in In addition to research, our understanding of community banks is enhanced by the Fed's outreach to community bankers. At the most basic level, supervisory staff at each Reserve Bank gain insights from their regular contact with community bankers. Additional knowledge comes by way of community outreach initiatives, which provide the added benefit of informing the Fed about local economic conditions. Here in Washington, in addition to participating in events like this one, the Board of Governors meets twice a year with the Community Depository Institutions The council, which includes representatives from small banks, credit unions, and savings associations from each Federal Reserve district, provides information about economic conditions around the country and those issues that are of greatest concern to community institutions. In addition, we have been taking steps to improve our communication with community bankers. In that regard, we have been using various platforms to go beyond formal policy issuances and better explain our supervisory expectations for community banks. We have also developed and continue to enhance our industry training efforts. In particular, we have developed two programs--Ask the Fed and Outlook Live--that have become quite popular with community bankers who are interested in learning more about topics that are of importance to both banks and supervisors. Ask the Fed is a program for officials of state member banks, bank and thrift holding companies, and state bank commissioners. Outlook Live, which is a companion program to the Federal Reserve's quarterly publication, is a webinar series on consumer compliance issues that is led by Federal Reserve staff. We are also now using periodic newsletters and other communication tools to highlight information that community bankers may be interested in knowing and to provide information on how examiners will assess compliance with Federal Reserve policies. In addition to in 2012 the Federal Reserve System established a website and quarterly newsletter to focus on safety-and-soundness issues that are of practical interest to community bankers and bank board members. launched a series of special-purpose publications called . These publications highlight key elements of specific supervisory topics and discuss how examiners will typically address the topic. The common goal for all of these outreach efforts is building and sustaining an ongoing dialogue with community bankers. One theme that has come through loud and clear in this outreach is concern about regulatory burden. The financial crisis has prompted significant changes to regulation, so the Federal Reserve understands this concern and strives to minimize regulatory burden for all institutions, including community banks. At the same time, we are taking a fresh look at how we supervise community banks and possible ways that supervision can be smarter, more nimble, and more effective. In that regard, and consistent with my earlier points about too big to fail, we know that a one-size-fits-all approach to supervision is often not appropriate. In recent years, we have taken a number of actions to tailor supervisory expectations to the size and complexity of the banking organizations we supervise. The first step is taking a disciplined approach to judging which supervisory policies should apply to community banking organizations. This involves not only weighing the costs and benefits of proposed rules and their implementation, but in some cases also asking whether it makes sense for a specific policy to apply to community banks. In other cases, it may not make sense to exclude community banking organizations entirely from the scope of a supervisory policy, but we may be able to scale expectations to the size and complexity of the supervisory portfolio, to minimize the burden where possible and appropriate. The final capital rules for community banks that I mentioned earlier illustrate this kind of tailoring. Let me turn now to upcoming changes in the accounting standard for credit losses on loans and securities. We have heard the concern that overly complex accounting rules in this area would increase costs with little benefit for the users of community bank financial ensure that the new standard, which is an important component of financial reform efforts, can be implemented in a reasonable and practical way for community banks. We have stressed to FASB that its proposal should not require community banks to utilize complex modeling processes. We expect that a final standard will permit loss-estimation techniques that build upon current credit-risk management techniques used by community banks. We will work with community banks to help implement the new standard when it is final. In addition, our supervisory guidance will emphasize that regulatory expectations for implementation of the standard will differ based on bank size and complexity. In addition to tailoring our rules, we are also taking steps to tailor and improve our examination processes to be more efficient and effective. For example, we are currently in the process of developing and adopting common technology tools across the Federal Reserve System that should allow our examiners to more effectively focus their time and enhance the consistency of our examination processes nationwide. Furthermore, we are exploring ways that our community bank examiners may be able to complete more examination work off site. For example, for banks that have electronic loan files, examiners may be able to read these files off site rather than on the bank premises. We are also seeking ways to utilize the financial information that we collect from banks to tailor the examination procedures that are used on site, with less work being required at institutions with lower risk profiles. These efforts should reduce the disruption that an on-site examination can cause to a bank's day-to-day operations. We recently adopted a new consumer compliance examination framework for community banks. Under this new program, our consumer compliance examiners base examination intensity more explicitly on the individual community bank's risk profile, weighed against the effectiveness of the bank's compliance controls. We expect that examiners will spend less time on low-risk compliance issues at community banks, increasing the efficiency of our supervision and reducing regulatory burden on many community banks. Much of the work to tailor our supervisory requirements and programs is being overseen by the community bank subcommittee of the Board's Committee on Bank Supervision. This subcommittee oversees the supervision of community and regional banks and reviews proposed supervisory policies to help ensure that they are appropriate for, and tailored to, community banks. This subcommittee was formed several years ago under the direction of now former governors Betsy Duke and Sarah Bloom Raskin, and I want to assure you that the subcommittee will continue to play an important role in helping ensure that our supervisory policies make sense for community banks. I should also add that we are working closely with our colleagues at the state level to help ensure that our supervisory approaches and methodologies are as consistent as possible. In closing, let me repeat my strong belief that community banks will continue to play an important role in our financial system in the years ahead, serving the credit needs of the communities they are a part of and know so well. The Federal Reserve will continue to promote a stronger and more resilient financial system, while carefully considering the effects of our actions on community banks and tailoring supervision appropriately. Thank you.

r140506a_FOMC

united states

Challenges for Monetary Policy Communication

stein

The Money Marketeers have a long tradition of hosting policymakers and fostering informed public discussion, and I am delighted to join in this tradition. Last month I announced that I would be leaving the Federal Reserve Board at the end of May in order to return to my teaching position at Harvard. So I would like to take a moment to express my gratitude to my many colleagues at the Board and around the Federal Reserve System who have taught me so much--not just about economic policy, but about public service. It has been a privilege to work alongside such a talented and selfless group of people and to be a part of such a special institution. One of the many aspects of the job that I had not fully appreciated before joining the Board is how challenging the whole process of communicating about monetary policy can be. As you know, over the past several years the Federal Reserve has dramatically altered how it talks to financial markets and to the public at large. For much of its 100-year history, the Fed was remarkably opaque; indeed, around the time I started my academic career in the mid-1980s, there was an active literature on the causes and consequences of such opacity. The title of Marvin Goodfriend's 1986 paper captured the however, the Fed began to move toward greater transparency, with the Federal Open Market Committee (FOMC) providing more timely information about its policy decisions. This evolution in the direction of greater openness has continued. And, in the last 10 years, there have been numerous changes in the FOMC's communications policies: accelerated release of the minutes, an increase in the frequency and scope of participants' economic projections, and the introduction of postmeeting news conferences, to name a few. These are all welcome developments, and I expect there will be further changes down the road, as the Committee keep s trying to improve how it explains its policy decisions to the public. In this spirit, I would like to spend the rest of my time discussing a few of the things that make life interesting for those trying to communicate clearly and effectively about monetary policy. More specifically, I am going to touch on three factors that strike me as particularly relevant for our efforts in this area: the fact that the market is not a single person, the fact that the Committee is not a single person either, and the delicate interplay between the Committee and the market. This point was very nicely made by Hyun Shin in his remarks at the Federal The "market" is not a person. Market prices are outcomes of the interaction of many actors, and not the beliefs of any one actor. . . . But most discussions of central bank forward guidance treat the market as if it were an individual that you can sit down and reason with. . . . By doing so, I believe we are in danger of committing a category mistake where we anthropomorphize the "market" as a rational individual with beliefs. Let me give you a particular example that illustrates the wisdom of Shin's observation. In early May 2013, long-term Treasury yields were in the neighborhood of 1.60 percent. Two months later, shortly after our June 2013 FOMC meeting, they were around 2.70 percent. Clearly, a significant chunk of the move came in response to comments made during this interval by Chairman Bernanke about the future of our asset purchase program. For example, in his June 19 press conference, he said: If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. Perhaps it is not surprising that news about the future course of the asset purchase program would have a strong effect on markets. But here is the striking fact: According to the Survey of Primary Dealers conducted by the New York Fed, there was hardly any change over this period in the expectation of the median respondent as to the ultimate size of the program. Chairman Bernanke's comments may have clarified the FOMC's intentions, but, according to the survey, they did not have any clear directional implications for the total amount of accommodation to be provided via asset purchases. Thus, FOMC communications in this period did not appear to be meaningfully hawkish. So what gives? One hypothesis is that going into the May-June period, there was a wide divergence of opinion among market participants as to the future of the asset purchase program. In particular, however reasonable the median expectation, there were a number of "QE-infinity" optimists who expected our purchases to go on for a very long time. And, crucially, in asset markets, it is often the beliefs of the most optimistic investors--rather than those of the moderates--that drive prices, as they are the ones most willing to take large positions based on their beliefs. Moreover, this same optimism can motivate them to leverage their positions aggressively. In this setting, a piece of monetary policy communication that merely "clarifies" things--that is, one that delivers the median market expectation but truncates some of the more extreme possibilities--can have powerful effects. Highly levered optimists are forced to unwind their positions, which then must be absorbed by other investors with lower valuations. This effect is likely to be amplified if the preannouncement period was one with unusually low volatility, as was the case in early May 2013, when the implied volatility on long-tenor swaptions was near historical lows. To the extent that some of the optimists are operating subject to value-at-risk constraints, low volatility is likely to induce them to take on more leverage. If volatility rises sharply in the wake of an announcement, this increase will tend to exacerbate the unwind effect. To be clear, I am not saying that monetary policy communications should have been different during this period. Rather, the point is that in some circumstances there are very real limits to what even the most careful and deliberate communications strategy can do to temper market volatility. This is just the nature of the beast when dealing with speculative markets, and to suggest otherwise--to suggest that, say, "good communication" alone can engineer a completely smooth exit from a period of extraordinary policy accommodation--is to create an unrealistic expectation. In this spirit, I think the FOMC may face a similar communications challenge as the nature of the forward guidance for the path of short-term interest rates evolves over the next couple of years. The 6.5 percent unemployment threshold that we had until recently was not only quantitative in nature, but it also represented a relatively firm commitment on the part of the Committee. While this kind of commitment was entirely appropriate at the zero lower bound, as policy eventually normalizes, guidance will necessarily take a different form; it will be both more qualitative as well as less deterministic. So, for example, when I fill in my "dot" for 2016 in the Survey of Economic Projections, I think of myself as writing down not a commitment for where the federal funds rate will be at that time, but only my best forecast, and one that is highly uncertain at that. Chair Yellen made a similar point in her March press conference: More generally, you know, the end of 2016 is a long way out. Monetary policy will be geared to evolving conditions in the economy, and the public does need to understand that as those views evolve, the Committee's views on policy will likely evolve with them. And that's a kind of uncertainty that the Committee wouldn't want to eliminate completely from its guidance because we want the policy we put in place to be appropriate to the economic conditions that will prevail years down the road. I agree completely with this view, and I suspect that many in the market also understand the distinction that is being drawn--that as policy normalizes, forward guidance will be less commitment-like and, hence, a less precise guide to our future actions than it has been in the recent past. But I would not want to presume that everybody is thinking about it the same way; one can imagine that there might again be some optimists who are in this case underestimating the degree of uncertainty about the future path of policy and are placing levered bets accordingly. So we may have some further bumps in the road as this all plays out. It is common to hear observers talk about the Committee's reaction function, which describes how we will behave in various contingencies. However, even if all of the individual members of the Committee have well-defined and carefully thought-out individual reaction functions--that is, each member knows what his or her policy preference is for any given state of the world--it does not follow that the Committee as a whole has an equally well-defined reaction function. The reason for this divergence is that when one says that the Committee has a reaction function for how it will behave if contingency X arises, such a statement implies that we have fully litigated this contingency in advance. In other words, we have debated the pros and cons, we have hashed out our differences, and we have come to an agreement on how to proceed under contingency X. But such litigation is difficult and sometimes costly, as it may, for example, take considerable time or lead to a loss of cohesion on other, more pressing issues. So it may be easier and more efficient to leave our behavior in some important contingencies for future discussions. Think of why people often forgo prenuptial agreements when getting married--it is simply too painful to negotiate over every contingency ahead of time. This observation is helpful in understanding some of the differences between an open-ended asset purchase program, such as QE3, and its closed-end predecessors. One advantage of going with an open-ended approach is that when we rolled out QE3 in September 2012, we were able to make a forceful statement that we would continue with asset purchases until we observed, as Chairman Bernanke put it in his postmeeting press conference, a "substantial improvement in the outlook for the labor market." We were able to do so even though I suspect that, had we tried to put a number to it, there would have been considerable disagreement among Committee members as to the exact meaning of "substantial improvement." So in this case, leaving the Committee's reaction function incompletely worked out allowed us to move forward with a major policy initiative in a timely manner, which otherwise might have been very difficult. Of course, the flip side of this reaction-function incompleteness is that it becomes harder for the Committee to precisely communicate its future intentions to the market--in part because these future intentions have not yet been fully fleshed out. Rather, it makes more sense in this case to think of the Committee's reaction function as being something that is not entirely predetermined and that will naturally tend to evolve over time. The Interaction of the Committee and the Market Going further, it is important to note that this evolution of the reaction function does not happen in a vacuum, where the Committee deliberates in a cloistered fashion and then simply reports its decisions to the market. All along, the market is making conjectures about how we will behave, and these conjectures in turn can have a powerful influence on the debate itself. This feedback effect has been especially relevant in the case of QE3, because the policy has relied significantly on a signaling channel for some of its effectiveness. That is, QE3 has, in my view, mattered not just because of the direct downward pressure on longer-term interest rates associated with removing a given quantity of duration from the private market, but also because it has buttressed our forward guidance by serving as a credible signal of the Committee's intentions with respect to the future path of the federal funds rate. Of course, if the Committee is using asset purchases to signal its policy intentions, then the information content of purchase decisions depends importantly on what the public expects it to do. For example, if it is early 2013 and the market has somehow arrived at the belief that the Committee will continue buying assets at an $85 billion per month clip so long as monthly payroll growth does not exceed 200,000 jobs per month for three months in a row, then even a small cut down to $80 billion per month is likely to elicit a powerful market reaction--not because the $5 billion cut is consequential in and of itself, but because of the message it sends about the Committee's policy leanings more generally. But then you can see the feedback loop that arises: The more strongly the market becomes attached to this belief--even if it was initially somewhat arbitrary--the more wary the Committee must be of making an unexpected change, and this wariness further reinforces the market's initial belief. In this sense, the Committee's reaction function for the appropriate quantity of asset purchases under the QE3 program is not only evolving over time, it is coevolving along with the market's beliefs. In part for this reason, I believe we are currently in a very good position with respect to the market's expectations for our asset purchases going forward. Market participants now appear to almost uniformly expect that, barring a material change in the outlook for the economy, the Committee is likely to continue tapering our purchases in further measured steps over the remainder of this year. With these expectations in place, the execution of the taper itself becomes much easier, as we no longer have to worry about a step-down at each meeting sending a potentially misleading message about our intentions with respect to the future path of the federal funds rate. The case of QE3 illustrates the point that the Committee's reaction function is shaped by market expectations and vice versa. But I suspect that the point has more general applicability. Consider the well-known phenomenon of "gradualism" in monetary policy, whereby changes to the policy rate during an easing or tightening cycle tend to come in a series of small and relatively predictable steps. This phenomenon is reflected in the fact that the Committee's behavior in normal times can be approximately described by an "inertial" version of a Taylor rule--one in which, in addition to putting weight on inflation and unemployment, the Committee also behaves as if it has an aversion to making sudden large changes in the federal funds rate. However, such a reduced-form description of the Committee's behavior does not answer the question of why this kind of inertia might be optimal. Why should the Committee act as if it is averse to making sharp changes in the funds rate? At one level, the answer is clear: This behavior is in the service of our mandate, and nothing more. For if we were to make an unexpectedly abrupt adjustment at any time, it would likely have a large effect on long-term rates and credit conditions more generally, which in turn might compromise our ability to reach our goals for employment and inflation--for example, a large bond-market move of this sort might nip a nascent recovery in the bud, which is why it is to be avoided. Digging deeper, though, it is important to recognize that part of the reason that the bond market would react so strongly to a sharp change in the short-term policy rate is that we have settled into a self-sustaining equilibrium in which the Fed tends to act gradually, and the market has come to expect that gradualism. In other words, the market has learned that a given increase in the federal funds rate at the beginning of a tightening cycle is typically followed by many more moves in the same direction, so there is naturally a multiplier effect on long-term rates of a given change in short-term rates. And that multiplier depends on the expected degree of gradualism: The more inertia there is in Fed policy, the more significant is any small move, and hence the larger is the multiplier. Thus, an expectation of gradualism on the part of the market makes it all the more important for the Fed to adjust the policy rate gradually, thereby fulfilling the market's beliefs. This line of reasoning can be thought of as a piece of positive economics--that is, it may shed some light on why the world is as it is. But what, if any, are its normative implications? On the one hand, as I have emphasized, a gradualist approach to monetary policy is likely to be the best way for us to deliver on our mandate at any point in time, taking as given the market's expectations for Fed behavior. As such, it would probably not make sense, in the short run, for the Committee to deviate from this approach--with an unprepared market, the result might well be an undesirable degree of market turbulence, with attendant negative effects on the real economy. On the other hand, there is clearly a time-consistency problem lurking here; the world we are in need not be the best of all possible worlds. In particular, it is interesting to think about an alternative long-run equilibrium in which the Fed has somehow developed a reputation for worrying less about the immediate bond-market effect of its actions and is known to react more aggressively to changes in economic conditions. this alternative equilibrium, the market would expect the Fed to behave in a less gradualist fashion, so any given move in the funds rate would have a smaller multiplier effect on long rates. Thus, it is possible that in this alternative world, market volatility would be no higher than it is in our world, but the Fed would nevertheless be able to adjust policy more nimbly when it needed to. Of course, even if this alternative world is a better place, it may be difficult as an institutional matter to get from here to there. And I do not have any particularly helpful insights on how one would make the transition. Nevertheless, I do think there is a useful message to be borne in mind when thinking about communications strategy more generally. There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified. So efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating. As we evaluate our own performance in the communications department, it is probably better for us to focus on how legitimately transparent we have succeeded in being, as opposed to how much or how little our various announcements have moved markets.

r140508a_FOMC

united states

Rethinking the Aims of Prudential Regulation

tarullo

Among the questions posed by the organizers of this 50 Structure and Competition is how the "regulatory-supervisory framework has fundamentally changed." I think one answer is that the aims and scope of prudential regulation have been fundamentally redefined since the financial crisis. Most significantly, a concern with financial stability and an increased emphasis on macroprudential regulation have informed major changes in both banking law and supervision. This salutary shift in perspective has important implications for prudential regulation. One is that prudential regulation must deal with threats to financial stability whether or not those threats emanate from traditional banking organizations. Hence the need to broaden the perimeter of prudential regulation, both to certain nonbank financial institutions and to certain activities by all financial actors. A second implication--to which I will devote most of my remarks this morning--is that the aims of prudential regulation for traditional banking organizations should vary according to the size, scope, and range of activities of the organizations. By specifying these aims with more precision, we can shape both a more effective regulatory system and a more efficient one. That is, once we have specified the regulatory aims for a particular type of financial institution, we can more effectively rationalize and, as appropriate, differentiate the rules and requirements to be applied to each kind of institution. When I was teaching banking law prior to my appointment to the Board of Governors, I noticed an interesting disconnect in the best casebooks in the field. An introductory chapter on the history and purposes of bank regulation revealed a complicated set of issues concerning changes in the structure and activities of banks, which, among other things, suggested that the rationales for regulating banks might vary depending on the size, business model, and affiliations of a bank. Yet the remaining chapters of the casebooks treated bank regulation as a more or less unitary endeavor--with prudential rules applicable in about the same way to the activities and affiliations of all banking organizations, and only to banking organizations. To be sure, topics such as bank affiliations with nonbank financial institutions were, for practical reasons, more focused on larger banks. And there were a few measures directed at the more complicated balance sheets of larger banks, such as the Basel II internal ratings-based (IRB) approach to regulatory capital, although there was no evidence the underlying purpose of capital regulation differed. But in all the chapters elaborating applicable doctrine and rules, there was little hint that the purposes and principles of bank regulation might vary across the bank population. And, to the extent that nonbank financial institutions such as broker-dealers, investment companies, or insurance companies were covered, the pedagogical point seemed to be that the aims of regulating these kinds of firms were dominantly investor and customer protection--not prudential considerations such as limiting moral hazard, much less fostering financial stability. The reason for this disconnect was, to a great extent, that pre-crisis statutes and regulations reflected what I have termed a unitary approach to banking regulation. The core of banking regulation could be explained with a relatively simple narrative, by which deposit insurance and access to the discount window had been granted to depository institutions in order to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified everything from capital requirements to limitations on banks getting into nonbanking businesses. Even when traditional banks were permitted to affiliate with other kinds of financial firms, laws such as the Bank Holding Company Act and were oriented mostly toward protecting the insured depository institution and the federal deposit insurance fund (DIF) from possible depredation by those nonbank businesses. The activities of broker-dealers, for example, were relevant to prudential regulation only insofar as they affected an affiliated depository institution. Of course, banking law had not only tried to protect the DIF from the risky activities of banks and their affiliates. It had also, albeit far less explicitly, tried to protect banks from nonbank competition and, to some degree, from each other. Just as banks were supposed to stick to their knitting--the business of banking--so everyone else was supposed to stay out of that business. But as we all know, the distinction between demand for commercial bank loans and for investment bank underwriting of public debt issuance was never absolute, and in the 1970s it began to erode more rapidly with the growth of capital markets and financial innovations such as money market funds. The financial crisis has confirmed that the pre-crisis regulatory structure reflected a view of the financial system that was at once too broad and too narrow. It was too broad in that prudential rules generally applied to all banks and bank holding companies through a microprudential approach focused on the soundness of each individual bank. The rules were implemented somewhat differently, based on the size and relative complexity of banking organizations, and separate supervisory portfolios were created. But the principles informing regulation were basically the same whether the institution was a community bank or a holding company with a $1 trillion balance sheet whose failure might shake the entire financial system. The prudential regulatory structure was too narrow in that it did not extend to firms and activities outside of banking organizations, even those that could pose a threat to financial stability, because the soundness of the federal deposit insurance system was not implicated. Thus Lehman Brothers, whose failure did seriously shake the financial system, was not subject to even the microprudential standards applicable to bank holding companies. The run on the repo market involved a wide range of market actors of different sizes, operating under different regulatory constraints. It is important to recognize that the statutory and administrative changes in regulation following the financial crisis were not only about strengthening existing regulation following 30 years of largely deregulatory measures that had preceded the crisis. The turmoil that attended the collapse of several large nonbank financial institutions, and the extraordinary government measures necessary to contain that turmoil, had quickly changed into a consensus--previously the minority view--that prudential regulation should be broadened to better safeguard the financial system as a whole. This perspective was embraced by Congress in the Dodd-Frank and market regulators to add to their existing mandates the responsibility for protecting financial stability. Dodd-Frank provided numerous new authorities for executing this new mission. One regulatory innovation in Dodd-Frank that is particularly salient for present purposes was the creation of different categories of banking organizations--largely, but not exclusively, on the basis of total assets--to which different regulatory requirements are to apply. Most prominently, section 165 requires that "in order to prevent or mitigate risks to the financial stability of the United States," the Federal Reserve Board is to establish for all bank holding companies with at least $50 billion in assets prudential standards that "are more stringent" than generally applicable standards and that "increase in stringency" based on a variety of factors related to the systemic importance of these institutions. These standards must cover capital, liquidity, risk management, resolution planning, and concentration limits; the Federal Reserve may add other standards as it finds appropriate. Section 165 also establishes requirements for the establishment of a risk committee and for stress testing, but these are applicable in at least some respects to all bank holding companies with at least $10 billion in assets. In implementing the section 165 requirement of increasing stringency for enhanced prudential standards applicable to banking organizations of increasing systemic importance, the Federal Reserve has essentially created several categories within the universe of banking organizations with $50 billion or more in assets. All firms in this universe will be subject to the basic enhanced standards, including supervisory stress tests, capital plan submissions, resolution plan requirements, single counterparty credit limits, and a modified form of the Liquidity assets or $10 billion in on-balance-sheet foreign assets are also subject to the advanced approach risk-based capital requirements of Basel II, the Basel III supplementary leverage ratio, the full LCR requirement, and the countercyclical capital buffer provision of Basel III. firms designated as global systemically important banks will be additionally subject to risk-based capital surcharges, the enhanced Basel III supplementary leverage ratio, tighter single counterparty credit limits, and a long-term debt requirement designed to support the effectiveness of orderly resolution processes. In addition, the supervision of these firms is disciplinary group created by the Federal Reserve Board in 2010. Thus, there are regulatory categories for banks with $10 billion or more in assets, with $50 billion in assets, with either $250 billion in assets or $10 billion in foreign assets, and with a combination of large asset holdings and other characteristics that have resulted in their being designated of global systemic importance. In fact, Dodd-Frank creates another category of banks in making its provision on incentive compensation applicable to banking organizations with at least $1 billion in assets. Clearly, the unitary approach of the pre-crisis period has been abandoned. This is an important move in the right direction. But in terms of differentiating regulatory aims, Dodd-Frank really identifies only one additional objective--that of preventing or mitigating risks to U.S. financial stability. By developing this objective a bit more, and by introducing other salient considerations, we may be able to specify the varying aims of regulation for different kinds of banks in a manner that helps us rationalize applicable regulatory structures. Let me begin with what I regard as relatively straightforward cases in specifying regulatory aims--those of the very largest banking organizations and of small ones. The largest, of course, have commanded enormous attention, with too-big-to-fail concerns often dominating the public debate on regulatory reform in the aftermath of the financial crisis. There is now a consensus among banking authorities, both U.S. and foreign, that the failure of financial institutions of sufficient combined size, interconnectedness, and leverage could threaten the entire financial system, and, therefore, must be subject to a stricter regulatory regime. The special regulatory aims for such institutions should reflect this systemic focus. The very large negative externalities associated with such failures could be realized through a classic domino effect or through contagion effects. As the financial crisis showed, losses in a tail event are likely to be correlated for large firms deeply engaged in trading, structured products, and other capital market instruments, and relying on similar sources of short-term funding. Thus, the regulatory framework should aim to reduce the chances of distress or failure at such firms to a greater extent than traditional, microprudential regulation would. Moreover, it should explicitly take into account the correlations and inter-dependencies in asset holdings and funding. Finally, the regulatory system should aim to offset the perception of too-big-to-fail status, which carries with it the possibility of funding advantages in normal times, and protection of creditors and perhaps even shareholders in highly stressed times. The systemic perspective and consequent aim of protecting financial stability argue for the stronger and broader regulatory measures that have been undertaken in recent years. At the other end of the spectrum are community banks, conventionally defined as those with less than $10 billion in assets. The roughly 5,700 banks in this group constitute 98 percent of insured commercial banks in the United States, but hold just under 20 percent of the aggregate assets of all commercial banks. Indeed, 90 percent of community banks are what supervisors classify as "small" community banks--those with less than $1 billion in assets. While these banks will suffer the fallout from systemic problems, they are unlikely to cause such problems. The regulatory aim, therefore, is about as close as can be to the traditional microprudential bank regulatory aims of protecting the federal DIF and limiting the use of insured deposits by restricting the scope of bank activities. It is true that the relative lack of geographic and portfolio diversification in many community banks can make them vulnerable to localized economic problems. But that is just the kind of problem that traditional microprudential regulation has been concerned with addressing. What, then, of the 80 or so U.S. banks that have assets of $10 billion or more, but are not among the eight large, complex institutions that have been designated of global systemic importance? Obviously they vary enormously in size, from just over $10 billion in assets all the way up to very large regional banks with hundreds of billions in assets. They bridge the $50 billion threshold for enhanced prudential standards established by Dodd-Frank. Yet, whatever their size, most banking organizations in this group are overwhelmingly recognizable as traditional commercial banks (though a few do have significant capital market or other It is with this similarity in mind that some executives of some pretty sizable banks have described their institutions to me as essentially a community bank, but with a bigger balance sheet. But there are at least two reasons why the aims for prudential regulation of such institutions might reach beyond conventional microprudential purposes. First, some at the higher end of this range may have a large enough systemic footprint that their stress or failure could have material effects on the rest of the financial system, though less than the LISCC firms. Second, more than one-third of U.S. commercial banking assets are held by these 80 banks. If a number of these banks simultaneously came under pressure or failed, a harmful contraction of credit availability in significant regions or sectors of the economy could ensue, even if there were little chance of a financial crisis. Thus, particularly to the degree that there are correlations in the risks associated with loans held across such institutions, there should be a macroprudential objective in the regulation of at least some of these firms. Of course, I would not lump all 80 of these institutions into the same category for purposes of specifying the aims of regulation. In particular, only a small fraction of these firms have a significant enough systemic footprint that their stress or failure would impose sizable negative externalities on the rest of the financial system. And the lines delineating the possible categories are not as easy to draw as for community banks and LISCC firms. Nonetheless, I will suggest in a few moments some possible classifications for this group of banks, along with examples of the varying regulations that might apply. The preceding observations have portrayed the prudential regulatory framework as one that should be constructed with different aims in mind. With respect to all depository institutions, this framework maintains the traditional aim of protecting the DIF and limiting the use of insured deposits to engage in nonbank activities. With respect to banks of a certain size-- even those predominantly involved in conventional lending activities--a macroprudential aim should be added. Finally, with respect to banking organizations of such size and complexity that serious stress or failure could pose risks to the entire financial system, a financial stability aim should be the basis for additional forms of regulation. As suggested in section 165 of Dodd- Frank, the stringency of these additional regulations should increase in proportion to the systemic importance of the banking organizations. Let me now give a few examples of how specifying these aims can help us think through ways in which the current overlays of regulatory and supervisory requirements might be rationalized. In part, such a rationalization is motivated by the familiar goal of limiting regulatory costs that are not necessary to achieve a given set of regulatory aims, thereby lowering the cost of the underlying economic activity. But it is also motivated by the advantage to be gained if supervisory resources can be deployed where their payoff in achieving well-specified regulatory aims will be highest. Community banks. I will begin again with community banks. Community bankers often argue that they are subject to a range of rules and requirements that are not really necessary given the relevant regulatory aim which, as previously suggested, is quite straightforward. That regulatory aim needs to be implemented with an eye to the context in which community banks operate. One obvious point of context is that any regulatory requirement is likely to be disproportionately costly for community banks, since the fixed costs associated with compliance must be spread over a smaller base of assets. A second important point of context is the business model of community banks. As is well-known, over the past few decades they have substantially reduced their presence in lines of business such as consumer lending in the face of competition from larger banks benefiting from economies of scale. Today, as a group, their most important forms of lending are to small- and medium-sized businesses. Smaller community banks--those with less than $1 billion in assets-- account for nearly a quarter of commercial and industrial lending, and nearly 40 percent of commercial real estate lending, to small- and medium-sized businesses, despite their having less than 10 percent of total commercial banking assets. This state of affairs is not surprising when one considers that credit extension to smaller firms is an area in which the relationship lending model of community banks retains a comparative advantage. It means that community banks are of special significance to local economies. It also means that, particularly in rural areas, the disappearance of community banks could augur a permanent falloff in this kind of credit, at least a portion of which may not be maintained in the more standardized approach to lending characteristic of larger banks. Banking regulators have taken a number of steps to try to avoid unnecessary regulatory costs for community banks, such as fashioning simpler compliance requirements and identifying which provisions of new regulations are of relevance to smaller banks. But a number of new statutory provisions apply explicitly to some smaller banks or, by failing to exclude any banks from coverage, apply to all banks. This means that smaller banks do need to expend at least some compliance effort. And, even where regulatory frameworks try to place a lesser burden on smaller banks, there may be some risk of "supervisory trickle down," whereby supervisors informally, and perhaps not wholly intentionally, create compliance expectations for smaller banks that resemble expectations created for larger institutions. It would be worthwhile to have a policy discussion of statutes that might be amended explicitly to exclude community banks (which, again, are generally defined as those with less than $10 billion in assets) from their coverage. In my view, two candidates would be the Volcker rule and the incentive compensation requirements in section 956 of Dodd-Frank. The concerns addressed by these statutory provisions are substantially greater at larger institutions and, even where a practice at a smaller bank might raise concerns, the supervisory process remains available to address what would likely be unusual circumstances. Indeed, relieving both banks and supervisors of the need to focus on formal compliance with a range of regulations less relevant to community bank practice would free them to focus on the actual problems that may exist at smaller banks. Middle-range banks. As I have already suggested, financial stability and macroprudential aims do not apply equally to all 80 of the banks in this wide category of firms holding over $10 billion in assets, other than the LISCC banking organizations. While it is reasonable to adopt a macroprudential aim for all firms in this category, few of these banks have the kind of systemic footprint that would warrant extensive special regulation for financial stability purposes. In establishing requirements for firm (though not supervisory) stress testing and risk-management committees for all bank holding companies in this group, but mandating that only bank holding companies of $50 billion or more be subject to enhanced prudential standards, Congress has reflected a similar judgment. The key question is whether $50 billion is the right line to have drawn. Experience to date suggests to me, at least, that the line might better be drawn at a higher asset level--$100 billion, perhaps. Requirements such as resolution planning and the quite elaborate requirements of our supervisory stress testing process do not seem to me to be necessary for banks between $50 billion and $100 billion in assets. If the line were redrawn at a higher figure, we might explore simpler methods for promoting macroprudential aims with respect to banks above $10 billion in assets but below the new threshold. Were such a change to be adopted, bank holding companies with less than $100 billion in assets would not be subject to any of the enhanced prudential requirements of section 165 of Dodd-Frank; bank holding companies with assets between $100 billion and $250 billion would be subject to supervisory stress testing and a basic set of the section 165 requirements; and holding companies with $250 billion or more in assets would be subject to the supplementary leverage ratio, the full LCR, and the countercyclical capital buffer provision. Of course, this is not the only way to draw the lines, and there could be reasons for applying additional requirements to specific banks, even if they fall below the presumptive asset threshold. But I use this example to illustrate how the specification of aims and the progressive stringency of section 165 could be usefully combined. Largest institutions. Specifying prudential regulatory aims in the context of community and middle-range banks suggests a rationalization that could possibly eliminate certain requirements as they apply to some of these banks. In the case of the LISCC institutions, however, I believe there are additional requirements needed to implement prudential aims associated with financial stability. These include capital surcharges and minimum amounts of "gone concern" loss absorbing capacity, among others. Most important is continued work on the vulnerabilities posed by short-term wholesale funding and, more generally, by large trading books, including maturity matched books of securities financing transactions. The regulatory response to these vulnerabilities will likely require some combination of measures directed at capital, liquidity requirements, and resolution procedures. There is also a need for a complementary set of measures such as minimum margining requirements applicable to all securities financing transactions, whether or not they involve systemically important firms. But there are some opportunities for rationalization even with respect to regulation of the larger institutions. While necessary new rules will now be applied to these institutions, vestiges of the pre-crisis regulatory approach that did not rest on well-specified regulatory aims are still in place and might sensibly be modified or removed. Most prominent in this regard is the Basel II IRB approach for risk-weighted capital requirements. The IRB approach, which generally applies in the United States to all bank holding companies with $250 billion or more in assets, was developed a decade ago in an effort to align risk weightings more closely to the increasingly sophisticated quantitative risk-assessment techniques in the financial industry. At the time of its development, the IRB approach seemed intended to result in a modest decline in risk-weighted capital requirements, a goal that the financial crisis revealed to be badly misguided. But even with the higher capital ratios required by Basel III, the IRB approach is problematic. The combined complexity and opacity of risk weights generated by each banking organization for purposes of its regulatory capital requirement create manifold risks of gaming, mistake, and monitoring difficulty. The IRB approach contributes little to market understanding of large banks' balance sheets, and thus fails to strengthen market discipline. And the relatively short, backward-looking basis for generating risk weights makes the resulting capital standards likely to be excessively pro-cyclical and insufficiently sensitive to tail risk. That is, the IRB approach--for all its complexity and expense--does not do a very good job of advancing the financial stability and macroprudential aims of prudential regulation. Yet a capital measure that incorporates these aims is precisely what is needed to complement the traditional microprudential elements of our capital standards. The supervisory stress tests developed by the Federal Reserve over the past five years provide a much better risk-sensitive basis for setting minimum capital requirements. They do not rely on firms' own loss estimates. They are based on adverse scenarios that would affect the entire economy and take correlated asset holdings into account. As we gain experience, we have been enhancing the macroprudential features of the annual stress test exercise. And, of course, the disclosure of the results helps inform counterparties and investors, thereby increasing market discipline. They are undoubtedly a substantial amount of work for both the banks and supervisors but, unlike the IRB approach, the benefits seem worth the work. For all these reasons, I believe we should consider discarding the IRB approach to risk- weighted capital requirements. With the Collins Amendment providing a standardized, statutory floor for risk-based capital; the enhanced supplementary leverage ratio providing a stronger back-up capital measure; and the stress tests providing a better risk-sensitive measure that incorporates a macroprudential dimension, the IRB approach has little useful role to play. We would continue to expect that firms practice sound quantitative risk management using internal models and other techniques. Indeed, the qualitative assessment included in our annual firms have this capacity. But, in light of all that has happened in the last decade, I see little reason to maintain the requirements of the IRB approach for our largest banks. Of course, the IRB approach was agreed internationally as part of the Basel II framework concluded in 2004. It would be best if all the Basel Committee countries moved together to adopt standardized risk-weighted and supervisory stress testing requirements for all internationally active banks. This would be a somewhat complicated shift for a number of reasons, including the likely appropriateness of applying different adverse scenarios for different parts of the world and the challenges in conducting a peer review at the Basel Committee of supervisory stress tests by member countries. Yet, as documented by the Basel Committee's work on divergence in risk weightings by banks applying IRB methods, Basel II created its own problems of consistency and transparency. There is no reason to believe that the task of creating an oversight and review framework for supervisory stress testing would be any more difficult. In practical terms, the unitary approach to banking regulation has been supplanted by various statutory, regulatory, and supervisory responses to the financial crisis. In particular, the aim of protecting financial stability has figured prominently in those responses, though a broader macroprudential aim can be detected as well. I have tried today to suggest that an explicit effort to specify relevant aims as they pertain to different kinds of banking organizations can provide a basis for rationalizing applicable regulatory frameworks--sometimes by paring back or foregoing regulation for certain kinds of firms, and sometimes by adding a regulatory measure where the relevant aim has not been adequately promoted by existing measures. By design and necessity, I have offered only a handful of illustrations as to how this perspective might lead to certain regulatory changes. I look forward to debate on the merits of these, and other, possible implications of a more precise specification of prudential regulatory aims. I also look forward to seeing new editions of banking law casebooks that differentiate regulatory measures with an eye to these multiple aims and their differential application to various banking organizations.

r140515a_FOMC

united states

Small Businesses and the Recovery

yellen

Chamber, to have this opportunity to be part of Small Business Week, and to meet the outstanding entrepreneurs here this evening. I am also grateful to be able to share a few thoughts on the important role I believe small businesses have played and will continue to play in America's recovery from the financial crisis and the Great Recession. After the onset of the crisis, the Federal Reserve took extraordinary steps to stabilize the financial system and halt the plunge in economic activity. Since then, the Fed has continued to use its monetary policy tools to promote the recovery and make progress toward our mandated objectives of maximum employment and price stability. By putting downward pressure on interest rates, the Fed is trying to make financial conditions more accommodative--supporting asset values and lower borrowing costs for households and businesses and thus encouraging the spending that spurs job creation and a stronger recovery. Crucial to this process, as I just mentioned, is job creation. The Federal Reserve tries to promote the conditions to foster job creation, but, overwhelmingly, it is businesses that create the jobs. About 85 percent of nonfarm employment is in the private sector, which traditionally is the source of a similarly large share of new jobs during economic expansions. So far during this expansion, public-sector employment has declined and the private sector has accounted for all of the net increase in employment, so businesses have been even more crucial to job creation than usual. Small businesses, of course, are responsible for a large share of these new jobs. According to the latest data from the Labor Department, a little more than half of the net number of jobs created since employment began growing in 2010 has been generated by firms with fewer than 250 employees, and most of that amount was accounted for by firms with fewer than 50 employees. One of the reasons I wanted so much to be here this evening was to be able to acknowledge these important contributions. America has come a long way since the dark days of the financial crisis, and small businesses deserve a considerable share of the credit for the investment and hiring that have brought that progress. Although we have come far, it is also true that we have further to go to achieve a healthy economy, and I am certain that small businesses will continue to play a critical role in reaching that objective. I am honored to be addressing the owners of 53 small businesses whose excellence exemplifies the enormous contributions that millions of small businesses collectively make to our economy. You come from different places and have achieved success in a wide variety of ways, but you all share the entrepreneurial spirit that has always been central to our nation's prosperity. We at the Federal Reserve are keenly aware of your vital role, and we pledge to continue to do our part in promoting the recovery so that you can continue to help America grow and prosper. Thank you.

r140521a_FOMC

united states

Commencement Remarks

yellen

Thank you, President Sexton. On behalf of the honorees, let me express my thanks to NYU. And congratulations from all of us to you, the Class of 2014, and to your families, especially your parents. This is a special day to celebrate your achievements and to look forward to your lives ahead. Your NYU education has not only provided you with a foundation of knowledge; it has also, I hope, instilled in you a love of knowledge and an enduring curiosity. Life will continue to be a journey of discovery if you tend the fires of curiosity that burn brightly in all of us. Such curiosity led Eric Kandel, here at NYU, to his lifetime goal, to discover the chemical and cellular basis of human memory. A few years after his graduation, he was doing research on cats. But he had the idea of focusing on an animal with a simpler, more fundamental brain: the California sea slug. His colleagues all but ridiculed him for the idea. They "knew" that the study of the lowly sea slug was irrelevant for understanding human memory. Kandel's surgically-skilled collaborator deserted him. To get up to speed on sea slugs, he had to go abroad to study. But Kandel persisted and, in 2000, his curiosity won him the Nobel Prize. It was, as you must have guessed, for deciphering the chemistry of memory in humans, as revealed by his research on sea slugs. Kandel's life, I believe, demonstrates how a persistent curiosity can help us reach ambitious goals, even with great roadblocks in the way. A second tool for lifelong intellectual growth is a willingness to listen carefully to others. These days, technology allows us access to a great breadth of perspectives, but it also allows us to limit what voices we hear to the narrow range we find most agreeable. Listening to others, especially those with whom we disagree, tests our own ideas and beliefs. It forces us to recognize, with humility, that we don't have a monopoly on the truth. Yankee Stadium is a natural venue for another lesson: You won't succeed all the time. Even Ruth, Gehrig and DiMaggio failed most of the time when they stepped to the plate. Finding the right path in life, more often than not, involves some missteps. My Federal Reserve colleagues and I experienced this as we struggled to address a financial and economic crisis that threatened the global economy. We brainstormed and designed a host of programs to unclog the plumbing of the financial system and to keep credit flowing. Not everything worked but we kept at it, and we remained focused on the task at hand. I learned the lesson during this period that one's response to the inevitable setbacks matters as much as the balance of victories and defeats. There is an unfortunate myth that success is mainly determined by something called "ability." But research indicates that our best measures of these qualities are unreliable predictors of performance in academics or employment. Psychologist Angela Lee Duckworth says that what really matters is a quality she calls "grit"--an abiding commitment to work hard toward long-range goals and to persevere through the setbacks that come along the way. One aspect of grit that I think is particularly important is the willingness to take a stand when circumstances demand it. Such circumstances may not be all that frequent, but in every life, there will be crucial moments when having the courage to stand up for what you believe will be immensely important. My predecessor at the Fed, Chairman Ben Bernanke, demonstrated such courage, especially in his response to the threat of the financial crisis. To stabilize the financial system and restore economic growth, he took courageous actions that were unprecedented in ambition and scope. He faced relentless criticism, personal threats, and the certainty that history would judge him harshly if he was wrong. But he stood up for what he believed was right and necessary. Ben Bernanke's intelligence and knowledge served him well as Chairman. But his grit and willingness to take a stand were just as important. I hope you never are confronted by challenges this great, but you too will face moments in life when standing up for what you believe can make all the difference. Having dwelt for a moment on failure and grit, let me turn to the deeper meaning that underpins grit and can carry us beyond failure. The hard work of building a life that makes a difference is much easier to sustain when you are passionate about what you pursue. When I first came to the Federal Reserve 37 years ago, I was struck by the passion of my colleagues for the mission of the Fed. And these many years later, each day at work, I see the importance of that passion to carrying out the Fed's duties effectively. If there is a job that you feel passionate about, do what you can to pursue that job; if there is a purpose about which you are passionate, dedicate yourself to that purpose. Finally, I hope that you can find joy in the lives you choose. You are completing one important phase of your life today and embarking on an amazing new adventure. Serious decisions about life surely lie ahead, but take the time to savor the joys, large and small that come along the way. Share those joys with others, and share a laugh when you can. In closing, thank you again, on behalf of myself and the other honorees. Thank you for the opportunity to speak to you today. Congratulations and good luck to the

r140606a_FOMC

united states

A Conversation on Central Banking Issues

powell

Thank you for inviting me here today. I should say at the outset that the views that I offer are my own and not necessarily those of any other member of the Federal You have asked about the effectiveness of forward guidance. My view is that forward guidance has generally been effective in providing support for the economy at a time when the federal funds rate has been pinned at its effective lower bound. The FOMC has provided various forms of forward guidance since 2009, both for rate policy and for asset purchases. I will focus today mainly on rate policy. There is more than can be said in five minutes, however, so I will leave the rest to our discussion afterward. In my view, forward rate guidance has helped reduce medium and longer-term interest rates, and by doing so has provided meaningful support for the economy. First, by increasing public understanding and market confidence in the path of rates, guidance has helped reduce term premiums. Second, by communicating that rates would remain lower for longer than market participants might otherwise have expected, guidance has lowered medium- and longer-term rates through the expectations channel. Finally, even when guidance has initially been well aligned with market expectations, it has reduced the likelihood that rate expectations will subsequently shift upward in ways that the Committee does not intend. Event studies as well as market-implied quotes and surveys corroborate the view that guidance has reduced medium- and longer-term interest rates and has held down volatility as well. To be sure, there have also been times when forward guidance and market expectations have diverged, with resulting spikes in volatility. Such situations may be difficult to avoid, given the use of new, unconventional policy tools, although we always try to communicate policy as clearly as possible. Our forward guidance has evolved over time--from qualitative, to date-based, to quantitative guidance, and from largely unconditional to state-contingent guidance explaining how the Committee will react to future economic outcomes. In March 2009, the Committee offered the qualitative guidance that it expected to hold the federal funds rate near zero "for an extended period." In August 2011, the Committee moved to date- based guidance, saying that it expected to hold the rate near zero at least until mid-2013. In December 2012, the Committee adopted quantitative thresholds that were explicitly tied to future economic conditions. In particular, it stated its intention to hold the policy rate near zero "at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." unemployment threshold approached, the Committee offered new guidance that contained qualitative and time-based elements but retained the state-contingent nature of the threshold guidance. First, the Committee said that, in determining how long to hold the federal funds rate near zero, it "will assess progress--both realized and expected-- toward its objectives of maximum employment and 2 percent inflation"; it also indicated that, in making this assessment, it would take into account a wide range of information, "including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments." Second, the Committee indicated, "based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends"--a time-based reference, since the Committee has indicated that it expects to wind down its asset purchases by the end of this year if the economy continues to evolve as expected. Of course, the actual timing of liftoff will depend on the performance of the economy. Third, the Committee stated that it "anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run." Committee members have differing thoughts on why that may be the case. In my view, the reasons would include the lingering effects of the financial crisis, including lower potential growth for a time. Turning briefly to asset purchases, since last December's FOMC meeting, the Committee has reduced asset purchases in a series of measured steps from a pace of $85 billion a month to its current pace of $45 billion per month. If incoming information continues to broadly support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, these measured steps would continue and asset purchases would come to an end in the fourth quarter of this year. Market expectations seem to be well aligned with this guidance. Thank you. I look forward to our discussion.

r140609a_FOMC

united states

Corporate Governance and Prudential Regulation

tarullo

It is a pleasure to be back among law professors here at the Association of American Law collaboration between corporate and financial law scholars. Indeed, it is striking how much of the insightful legal scholarship that followed the financial crisis has come from corporate law scholars. On reflection, this outcome is not really surprising. After all, much corporate law scholarship revolves around incentive structures, agency costs, and asymmetric information flows--all matters of great relevance to financial regulation. Furthermore, legislatures and courts have a long history of debating, and sometimes adopting, special corporate law and governance rules for financial institutions. In my remarks this afternoon I will try to further the collaboration between corporate and financial law scholarship by suggesting how the nature of finance and financial regulation affects corporate governance and why, in turn, special corporate governance measures are needed as part of an effective prudential regulatory system. In making the latter argument, I will review some of the measures, both longstanding and more recent, that illustrate the point and then suggest some additional steps that might complement existing prudential regulations. Finally, I will offer some more tentative thoughts on the possible implication of this analysis for corporate law fiduciary duties. A theme running through these remarks will be the centrality of risk--its assessment, assumption, and allocation--in understanding the relationship between corporate governance and financial regulation. There are at least three significant ways in which the nature of financial activities and regulation affect the operation of key mechanisms of corporate governance. First, it has long been recognized that the unique features of deposit-taking financial institutions raise the question whether generally applicable corporate law and governance principles are adequate. Because banks are financial intermediaries that use deposits to provide much, if not most, of the funding for their lending, an insolvent bank may well be unable to satisfy all its deposit liabilities. The fear of this possibility lies at the heart of banking runs and panics. In the days before federal deposit insurance, the impracticality of contractual solutions to reduce the vulnerability of depositors led to a variant of normally applicable limited liability rules. Many states enacted so-called double liability rules, whereby shareholders could be liable for the losses of a failed bank in an amount equal, and in addition, to their investment in the bank. Presumably, these rules were intended to change the calculus of shareholders as to the risks they wished their banks to assume and, perhaps, the degree to which they monitored management. Following the creation of federal deposit insurance, a series of constraints on normal corporate prerogatives has been applied to insured institutions, justified in large part by the need to counteract the resulting moral hazard and to protect the federal deposit insurance fund (DIF). Bank charters have always differed from general corporate charters insofar as they grant special privileges and forbid certain activities by the chartered institutions. In addition, special prudential requirements have always applied to chartered banks. Perhaps the most important of these today is the imposition of minimum capital requirements on all insured depository institutions and bank holding companies. Second, there is a variety of ways in which the attributes of financial markets and financial regulation affect the capital market discipline assumed in much corporate governance theory and corporate law. The prior point about the moral hazard associated with insured deposits implies that--at least in traditional, deposit-reliant banks--the kind of market discipline associated with the price of funding and creditor monitoring will be attenuated. More generally, to the degree uninsured depositors or other bank creditors expect that they will be protected by the government in the event the bank encounters serious difficulties, those same features of market discipline will again be weakened. This, of course, is the problem of moral hazard associated with too-big-to-fail perceptions, whereby investors or counterparties are willing to extend credit at prices that do not fully reflect the risk associated with the bank. The market discipline traditionally associated with the market for corporate control is also affected by banking regulation and supervision. Mergers and acquisitions involving banking organizations are subject to review, and possible disapproval, on a broad range of grounds beyond the antitrust considerations relevant in all industries. These include an assessment of the adequacy of the financial resources of the firms, the "competence, experience, and integrity" of the officers and directors, and the impact of the acquisition on systemic risk. Moreover, of course, any firm that acquires a commercial bank must be a bank holding company, thereby subject to a range of activity restrictions and other regulatory requirements. There are very good prudential reasons for these constraints upon acquisitions of, and by, banking organizations. But, by screening out transactions that would result in unacceptable increases in risk, either to an institution or to the financial system as a whole, these provisions may in some cases unintentionally limit the salutary disciplining effect on boards and management of the market for corporate control. The third way in which the nature of financial activities and regulation affect the operation of key mechanisms of corporate governance is that the risks associated with financial intermediaries--especially those that are significantly leveraged and that engage in substantial maturity transformation--pose a particular challenge for corporate governance. All firms bear the risk that problems may unexpectedly arise because of, say, product flaws that were unknown to boards of directors and perhaps even senior management. But in the case of financial intermediaries, these problems can be incredibly fast-moving, including runs on funding that can quickly place the very survival of the firm in doubt. These risks have increased during the past 25 years, as many institutions have combined traditional lending activities with capital markets businesses that rely on other funding models. Accordingly, judgments about risk appetite and control systems to manage risk must be effectively executed by senior management and overseen by the board. This imperative, in turn, means that the information and monitoring processes and systems established for, or available to, boards of financial institutions may need to be more extensive than those in large, nonfinancial firms. In the wake of the financial crisis, the public interest in regulation of banks and other financial firms is, I think it fair to say, both self-evident and substantial. A full discussion of the rationales for various forms of regulation is beyond the scope of my remarks today. But let me briefly note that prudential regulation has two distinct motivations--microprudential and macroprudential. Microprudential regulation is concerned largely with the safety and soundness of a financial institution considered individually. It seeks to protect the DIF by combatting what would otherwise be moral hazard and subsidized funding through capital requirements, activities restrictions, and other measures. Because microprudential regulations were designed primarily to minimize losses to the DIF, they have traditionally focused on insured depository institutions (IDIs); the regulation of owners and affiliates of IDIs is essentially about ensuring that the activities and risks of those other entities do not threaten the IDIs themselves. Up until the last several years, microprudential regulation would have come close to covering the entire field of prudential regulation. The financial crisis highlighted the need to supplement traditional microprudential regulation with a macroprudential approach oriented toward the well-being of the financial system as a whole. Here there are two related objectives, both of which seek to avoid costs that failure or severe stress would impose on the economy beyond those suffered by shareholders of a financial firm. One is protecting against systemic risk--for example, the risk that certain activities or the failure of a firm would result in very large negative externalities, either through a classic domino effect or through contagion effects producing a financial crisis. Losses in a tail event are likely to be correlated for large firms deeply engaged in trading and relying on short term wholesale funding. This objective, long neglected in financial regulation, is prominently featured in post-crisis statutory, regulatory, and supervisory reforms. The Dodd-Frank Wall stability and the containment of systemic risk as the aim of dozens of new regulatory provisions. Thus, for example, any firm whose failure could pose systemic risk is subject to prudential regulation, quite apart from its relationship with IDIs. A second objective of macroprudential regulation is to avoid a harmful contraction of credit availability in significant regions or sectors of the economy, even if there were little chance of a financial crisis. This outcome could ensue were banks accounting for a material portion of credit extension simultaneously to come under solvency or funding pressures that caused them to pull back from lending. The importance of both macroprudential objectives is that the regulatory framework should aim to reduce the chances of transmission of systemic risk by such firms to a greater extent than traditional, microprudential regulation would. But even stipulating these crucial objectives, why should prudential regulation need to involve itself with corporate governance? After all, there are many important forms of regulation applicable to corporations. A regulatory field may establish certain behavioral norms, require conformity with certain product or byproduct characteristics, or prohibit certain activities. Corporations are expected to conform to these obligations, many of which are extensive and detailed. While some regulatory systems require certain procedures within the regulated entities--particularly as remedial measures following violations--few, if any, create specific and significant ongoing requirements for corporate decisionmaking or oversight. Corporate and securities law may establish a duty of management and directors to limit regulatory violations, but the rationale for these duties is to protect shareholders from the consequences of regulatory violation, not directly to further the public regulatory objective. The answer, I think, lies at least in part with the centrality and nature of risk in the activities of financial intermediaries. Risk-taking--whether well- or ill-considered--is perhaps the central activity of all financial intermediaries. Where those intermediaries are significantly leveraged and engaged in maturity transformation, the risk-taking carries substantial potential societal consequences beyond the possible losses to investors, counterparties, and employees of the financial firm. Microprudential and macroprudential regulation each respond to this divergence between the private and social balances of costs and benefits associated with a given level of risk-taking by financial intermediaries. The focus of microprudential regulation is on the distortions to funding costs that may arise when depositors or capital markets do not require the funds they provide fully to price in the risks assumed by banks in using those funds, whether because of federal deposit insurance or expectations of a government safety net. The focus of macroprudential regulation is on the negative externalities that large financial firms can impose on the rest of the economy. In both instances, the private assessment by shareholders and their representatives of the risk-reward tradeoffs of the financial firm's activities will differ from the public's assessment of that risk- reward tradeoff. That is, while the public has an interest in healthy, profitable banks, and thus the interests of shareholders and the public overlap, they are not coincident. At root, then, prudential regulation seeks to influence risk-taking in regulated entities. But this is difficult to do directly. Conceptually, "risk" is not reducible to a single metric, such as--for example--the density of particulate matter in the emissions of a power plant. Practically speaking, a financial institution more or less continually makes risk decisions, the circumstances of which can vary substantially over time, across asset classes, and even contemporaneously in a single asset class based on the differing circumstances of borrowers or counterparties. Prudential rules can limit or prohibit certain bank activities that are thought to be particularly risky. With respect to activities that are permitted, prudential regulation can indirectly influence corporate decisions on risk-taking by requiring minimum amounts of capital to be held by the regulated firms. But, fundamental as they are to contemporary prudential regulation, capital requirements--particularly static, backward-looking standards--will necessarily be somewhat imprecisely related to the range of actual risk incident to specific assets or transactions within the various risk categories established by the capital regime. In fact, the capital regime may itself invite arbitrage, as firms look to maximize risk-taking within regulatory risk categories. Thus it is also important for prudential regulation to influence the processes of risk- taking within regulated financial firms as a complementary tool to capital requirements and other substantive measures. This view is reflected in various banking laws, most notably in the Dodd- Frank Act requirement that all bank holding companies with $10 billion or more in assets have a risk committee, composed of independent directors and "responsible for the oversight of the enterprisewide risk management practices" of the firm. This provision in itself requires only that the bank holding companies have capable and independent risk committees that, by extension, should be overseeing well-developed risk-management practices and systems of controls in the firms. It does not specify what the risk appetite of the firm should be. However, its inclusion in section 165 of the Dodd-Frank Act, which requires an array of additional prudential measures directed at firms that could pose threats to financial stability, suggests that the risk-committee mandate has a prudential motivation. Of course, good risk management is important for shareholders as well. Regulatory prods for efficient management information systems and well-developed risk-assessment procedures should generally be welcomed by shareholders. Similarly, regulatory insistence on capable and independent oversight of risk management is consonant with shareholder interests, which might be damaged by employees who exercise poor judgment or whose compensation structures may incentivize them to take risks not desirable for the firm as a whole. To a considerable extent, then, fostering sound risk-management practices serves the overlapping interests of both shareholders and regulators. The possible divergence of interests comes not in the architecture of risk management but in substantive decisions on risk appetite. How, then, might corporate governance be changed to incorporate risk considerations consistent with micro- and macroprudential regulatory objectives? One way would be to broaden the fiduciary duties of boards and management. The other, which has already been followed to some degree, is to apply regulatory and supervisory requirements to relevant corporate governance processes. Of course, realization of the first approach would require either changes in state corporate law or amendments to federal securities or financial regulatory statutes. I shall speak briefly to this possibility after describing some examples of the second approach already in place, along with some possibilities for further measures. With no claim to comprehensiveness, let me suggest three kinds of regulatory and supervisory measures that can better align corporate governance of financial firms with regulatory objectives. First, regulatory requirements can be directed at changing the incentives of those making decisions within a financial firm. One good example is incentive compensation for senior managers and other bank employees with substantial decisionmaking authority. Compensation arrangements that create high-powered incentives using stock options or other forms of reward dominantly based on equity have their origins in efforts better to align management and shareholder interests. Otherwise, managers who stand to suffer reputational or job loss as their firm declines or fails may have a more conservative risk appetite than diversified shareholders, who value the upside of risk-taking and whose limited liability makes them relatively less concerned with catastrophic downside possibilities. As has been observed by numerous commentators, however, where these kinds of incentive compensation arrangements have succeeded in better aligning the interests of shareholders and employees, they intensify the conflict between shareholder and regulatory interests. Ironically, regulatory objectives match up better with the old-style managers for whom the preservation of the firm is considerably more important than for shareholders. Various suggestions for change have been made. Some have proposed making incentive compensation packages more closely reflect the composition of the liability side of a banking organization's balance sheet by including returns on debt, as well as equity, instruments in the calculation of compensation. Others have proposed the much simpler approach of making a significant part of incentive compensation deferred and subject to clawback and forfeiture, with the employee's ultimate right to the compensation dependent on the firm not having become insolvent, received government assistance, or experienced a similar triggering event. While developing the details of an effective mechanism that also allows for motivating employees to advance shareholder interests will take some work, some measure along these lines is key to adjusting incentives so as to promote prudential objectives across the many risk decisions made within the firm. Incentive realignment can also be achieved by fostering more of the capital market discipline that has, as explained earlier, been limited. One example is a byproduct of measures to increase the total loss absorbency of systemically important financial firms by requiring minimum amounts of debt that could be converted to equity upon a firm's insolvency. As you may know, the Federal Reserve Board intends to issue a proposed rulemaking that would implement such a requirement at the largest financial firms. While the principal motivation of such a requirement is to help ensure that even a very large financial firm can be resolved in an orderly fashion without the injection of public capital, identifying debt instruments as convertible to equity in a context where resolution is a credible option should make the price of those instruments especially sensitive to the relative risk of failure of those firms. Requiring systemically important financial firms to issue a meaningful amount of long-term debt would indirectly influence corporate governance by introducing at-risk debt holders as a constituency whose concerns management must monitor and address. A second kind of measure to align corporate governance at financial firms more closely to regulatory objectives is a substantive requirement or constraint upon decisions made within the firm. As a practical matter, it would be hard to develop a rule setting a comprehensive risk appetite consonant with regulatory objectives. However, there are regulatory requirements that can serve as partial surrogates for such a rule. A good example, already in place, is a feature of the Federal Reserve's program of stress testing and capital planning. A firm may not make capital distributions (whether in the form of dividends or capital repurchases) that would, when added to losses under hypothesized adverse scenarios as projected in our annual supervisory stress test, reduce the firm's capital below certain minimum levels. When we adopted this rule several years ago, we were criticized by some for encroaching on the prerogative of boards of directors of financial firms to decide on capital distribution policies, in accordance with general corporate governance practice. This criticism has always seemed to me misplaced. After all, banking regulators are not only permitted, but obliged, to set minimum capital requirements at banking organizations and other systemically important financial firms. Limiting capital distributions is, conceptually, no different from requiring a firm to build capital in the first place. A regulation designed to maintain minimum capital levels in large banking organizations in a projected period of stress is consistent with the macroprudential objectives discussed earlier. Indeed, these requirements counteract the practices seen at some banks in the run-up to the financial crisis, whereby boards of directors continued to return capital to shareholders even as conditions deteriorated severely. Tying capital levels to corporate governance decisions about capital distributions simply recognizes that capital levels and capital distributions are two sides of the same coin. A third kind of measure seeks to affect the institutions and processes of corporate governance, rather than directly to change incentive structures or regulate decisions. Many possible actions of this sort would really be efforts to improve the risk-assessment and risk- management capacities of management and boards, rather than to focus specifically on the divergence between shareholder and regulatory interests with respect to risk appetite. An effective system of controls is important both to shareholders and to regulators. Thus, for instance, the considerable and continuing emphasis we have placed on firms developing and maintaining effective management information systems makes risk assessment work better for shareholders, even as it facilitates supervisory oversight. With respect to the institutional features of board oversight of risk management, there is also substantial overlap in the interests of shareholders and regulators. For example, both shareholders and supervisors should expect a board to include members with the expertise, experience, and time commitment that are appropriate to risk management of the kinds of activities in which the financial firm engages. Of particular interest are three board positions-- the nonexecutive chair or lead director, the head of the risk committee, and the head of the audit committee. More generally, shareholders and supervisors must have confidence that globally active institutions with hundreds of thousands of employees have audit and risk committees with the practical ability to provide effective oversight of risk decisions. I might note in passing that regular discussion between board members and supervisors can also serve the interests of shareholders, since supervisors may have an informed perspective on the firm's operations that enables boards better to fulfill their strategic and risk-oversight functions. Supervisors should also expect a well-conceived process for board review of major firm decisions, which will nearly always carry some implications for risk management and risk appetite. In practical terms, such a process would connect decisions on strategy, risk-appetite setting, and capital planning. Neither we nor shareholders should be comfortable with a process in which strategic decisions are made in one silo, risk-appetite setting in another, and capital planning in yet a third, with the convergence of these efforts coming together only when it is too late for each to affect the other, or for the board to be able to exercise effective oversight. These major decisions need to be made in an integrated manner. While regulators should have clear expectations for boards, we need to make sure that we are creating expectations that lead to boards spending more time overseeing the risk-management and control functions I have emphasized this afternoon. There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place. But it has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. One example, drawn from Federal Reserve practice, is the recent supervisory guidance requiring that every compliance signed off, by the board of directors. There are some MRAs that clearly should come to the board's attention, but the failure to discriminate among them is almost surely distracting from strategic and risk-related analyses and oversight by boards. One might ask how the strengthening of systems of controls and risk-appetite decision processes can promote achievement of regulatory interests beyond those shared with the owners of firms. One answer is that it clearly improves the supervisory line-of-sight into the safety and soundness of financial firms. The more timely and accurate the information that can be aggregated by supervisors, the more responsive our supervisory and financial stability oversight can be. A well-developed set of risk and control functions also allows an effective point of entry for pursuing certain regulatory objectives. To date, the best example of this potential is our which I have already referred. As a substantive matter, the CCAR requirements limit capital distributions of large financial institutions based upon a forward-looking assessment of the losses that would be suffered under hypothetical adverse economic scenarios, so that capital will be built and maintained at levels high enough for the firms to remain viable financial intermediaries even under such stressed conditions. In addition to the microprudential improvement that comes from substituting a dynamic for a static capital calculation, there is an important macroprudential motivation, reflected in the design of scenarios and the required levels of post-stress capital. The efficacy of the CCAR process is substantially enhanced as the information systems and internal risk-management capacities of the firm improve. Beyond this important, but discrete regulatory measure, well-developed processes for determining risk appetite give supervisors better insight into risks specific to the activities and strategic decisions of each firm. As a result, supervisors should be better able to identify points at which a firm's risk-taking may diverge from that which is consistent with microprudential and macroprudential objectives. This, in turn, should permit more timely supervisory or regulatory responses. The regulatory focus on risk in corporate governance will produce additional examples of each of the three kinds of measures I have just described. For instance, the Office of the Comptroller of the Currency has recently proposed guidance for risk governance at large national banks. Still, particularly with an audience half composed of corporate law professors, it is natural to ask whether corporate law tools might usefully supplement regulatory measures. Specifically, the question arises as to whether the fiduciary duties of the boards of regulated financial firms should be modified to reflect what I have characterized as regulatory objectives. Doing so might make the boards of financial firms responsive to the broader interests implicated by their risk-taking decisions even where regulatory and supervisory measures had not anticipated or addressed a particular issue. And, of course, the courts would thereby be available as another route for managing the divergence between private and social interests in risk-taking. As I noted at the outset, there is a long history of actual or considered measures to alter the duties or liabilities of those with decisionmaking authority in the corporate governance of banks. A more contemporary variant on these ideas was offered a little over a decade ago by Jon Macey and Maureen O'Hara, who proposed expanded fiduciary duties for directors of insured banks, including giving bank creditors the right to sue for violations of these duties. In a provocative recent paper, John Armour and Jeff Gordon suggest that the duties of directors of systemically important financial institutions should be modified precisely because diversified shareholders have a strong interest in avoiding risk decisions by these institutions that increase systemic risk. Their analysis implies that the customary tension between regulatory and diversified shareholders' interests may be considerably mitigated in the case of systemically important firms whose failure could result in financial turbulence and consequent economic loss for the entire economy. A consideration of the merits of these or other such proposals is beyond the scope of my remarks today. Obviously, any such changes in corporate law are beyond the authority of the Federal Reserve. I mention them in the hope and anticipation that corporate law scholars will continue to evaluate such ideas, since whatever one's eventual conclusions on their desirability, the analytic process is sure to yield further insights into the key question of how best to respond to the points of divergence between shareholder and regulatory interests in risk-taking by large financial firms. In the wake of the financial crisis, the changes in finance, in financial regulation, and in the relationship among government agencies that carry out prudential regulation have created any number of opportunities for financial law scholars to collaborate with their colleagues in other disciplines--from administrative law to constitutional law to bankruptcy law. This collaboration is perhaps natural, since major shocks to the economy, and thus the country, have in the past occasioned legal changes whose implications reached far beyond the original area of reform. As I hope you can tell from my remarks today, I have already found the interaction between corporate and financial law scholarship to have been helpful in thinking through the policies that will shape a safer financial system. I look forward to the fruits of the collaborations encouraged by the event sponsored today.

r140625a_FOMC

united states

Stress Testing after Five Years

tarullo

Born of necessity during the depths of the financial crisis as part of an effort to restore confidence in the U.S. financial system, supervisory stress testing has in the intervening five years become a cornerstone of a new approach to regulation and supervision of the nation's largest financial institutions. First, of course, it is a means for assuring that large, complex financial institutions have sufficient capital to allow them to remain viable intermediaries even under highly stressful conditions. More broadly, supervisory stress testing and the associated review of capital planning processes have provided a platform for building out a regulatory framework that is more dynamic, more macroprudential, and more data-driven than pre-crisis practice. Each year we have refined elements of both the substance and process of the stress tests. These changes have been informed not only by our own experience, but also by critiques and suggestions offered by others. This annual symposium hosted by the Federal Reserve Bank of Boston has become an important channel for eliciting reactions and advice from outside experts Although the major elements of our approach have now been successfully established, I anticipate that we will continue to make enhancements. If supervisory stress testing is to give regulators, banks, and the public a dynamic view of the capital positions of large financial firms, it must itself respond to changes in the economy, the financial system, and risk-management capabilities. This morning I will give a retrospective on the first five years of supervisory stress testing, highlighting some of the accomplishments and identifying some areas in which we may consider changes in the future. Then I would like to turn to a topic that has gained increasing attention in the past couple of years--the qualitative assessment of firms' capital planning processes that we conduct in parallel with our quantitative assessment of firms' capital positions. The potential value of comprehensive stress testing had been much discussed among academics, analysts, and regulators in the years preceding the financial crisis, but only during the crisis was this supervisory tool first used at the same time across the largest firms. The the value of simultaneous, forward-looking projections of potential losses and revenues based on each bank's portfolio and circumstances. The forward-looking feature overcame the limitations of static capital ratios. The simultaneity, along with stress test features such as the use of common macroeconomic scenarios, introduced a critical macroprudential dimension that offered insights into the condition of the entire financial system, including whether banks were sufficiently resilient to continue to lend to households and businesses under such adverse conditions. The Federal Reserve's basic approach to stress testing has not changed materially since the SCAP. We continue to take a multidisciplinary approach, drawing on a wide range of staff expertise. We create hypothetical macroeconomic scenarios that incorporate an assumed sharp deterioration in economic and financial conditions. Supervisors estimate each bank's expected losses and revenues and use these estimates to project post-stress capital levels and ratios under the hypothetical scenarios. The estimated capital ratios are then compared with regulatory benchmarks. We use common scenarios for all firms; for the firms with the largest trading activities, we add a market-shock scenario that incorporates market turbulence of severity similar to that of the latter half of 2008. While the basic approach has remained consistent, much else has changed. In the first place, of course, the requirement for stress testing has become statutory, as Congress drew on the lessons of SCAP in crafting prudential standards for large financial firms in the Dodd-Frank Second, the annual supervisory stress test has been incorporated into CCAR, a broader program that requires large banking organizations to submit a capital plan annually. The CCAR process gives supervisors an opportunity to evaluate plans for capital distributions against the backdrop of the firm's overall capital position under both baseline and hypothesized stressed conditions. It also provides a regular, structured, and comparative way to assess the capacity of these firms to manage their capital positions and, by implication, more generally to manage their risks. I will return to this feature of CCAR a bit later. Third, there have been substantial enhancements to the supervisory stress test. Perhaps the most important change has been the development of independent supervisory models. Because the original SCAP was developed on the fly and under considerable time pressure, supervisors necessarily had to rely on firms' own estimates of losses and revenues as a starting point for analysis, although they evaluated the firms' estimates and made significant adjustments. In each stress test that has followed, and building upon the considerable progress in data collection, we have made completely independent estimates of a progressively greater proportion of potential net income or losses. These improvements in data and models have increased our ability to distinguish risks within portfolios. We have also refined the formulation of the hypothetical scenarios that form the basis of the stress tests. The severely adverse scenario is designed to reflect, at a minimum, the economic and financial conditions typical of a severe post-World War II U.S. recession. In devising recession scenarios, we draw on many of the same macroeconomic modeling tools used in making monetary policy. Because not all significant risks facing banks are tied to the business cycle, our scenarios now incorporate other adverse developments such as an exceptionally large decline in house prices, sharp drops in the value of stocks and other financial assets, or a worsening of global economic conditions more severe than might normally be expected to accompany a deep recession in the United States. We have implemented the Dodd-Frank requirement for an "adverse," as well as a "severely adverse," scenario not by simply hypothesizing a milder recession, but by testing for somewhat different risks. The past two years we have used the adverse scenario to test the impact of a sudden, significant increase in interest rates. More discrete changes of note include the assumption of default by each firm's largest counterparty and the incorporation of salient risks beyond those in the overall scenarios. former obviously serves a microprudential purpose, but it also could promote systemic stability objectives if it were to identify a single exceptionally large exposure for the entire financial system. The incorporation of salient risks helps to use stress tests to "lean against the wind," not just build a buffer for future losses. For example, the 2011 and 2012 scenarios incorporated possible severe stress in Europe. Inclusion of this factor may have led to greater awareness and better risk management of U.S. firms' European exposures. Finally, I might mention a change made this year that actually reverted to a feature of the SCAP. We did not allow banks to assume their balance sheets would shrink in the stress scenarios as a way of meeting the minimum capital charge, something that many banks had done in the stress tests of the past few years. Foreclosing this assumption serves the macroprudential goal of helping to ensure that the major financial firms remain sufficiently capitalized to support lending in a severe downturn. As I have already suggested, we are likely to continue to hone the supervisory stress test. In particular, I expect that we will devote more attention to developing the macroprudential elements of the stress tests. For example, we might sharpen our focus on the risks to the financial system of significant common exposures among firms. We have already adjusted the market shock applied to the trading books of the six largest firms to ensure that firms are not incentivized to hold significant amounts of certain assets simply because they performed well in the second half of 2008. But there is more that could be done. One idea would be to test whether individual firms that are revealed by the tests to be vulnerable to serious stress might engage in asset fire sales that could produce knock-on damage to other firms. Another would be to incorporate more assumptions pertaining to the increased cost of, or reduced access to, funding in stressed environments, when lots of credit lines may be drawn simultaneously. In short, we do not regard the supervisory stress test and CCAR as finished products. In fact, we should never regard them as finished products, since to do so would be to overlook changes in the real economy, financial innovations, and shifts in asset correlations across firms. But I think it fair to say that supervisory stress testing and the CCAR have already made important contributions to financial stability and, in the process, have led the way in transforming supervision of the nation's largest financial firms. First, they have played a key role in strengthening dramatically the capital position of the industry. The firms participating in CCAR have more than doubled their tier 1 common capital since 2009, an increase of $500 billion of additional, high-quality capital in the U.S. financial system. It is noteworthy that supervisors in other countries have themselves been moving toward greater use of stress tests as a centerpiece of efforts to build strong capital positions for their banks. Most members of the Basel Committee on Banking Supervision now use some form of stress testing. The European Union and the United Kingdom are currently conducting supervisory stress tests whose results will be publicly released. Second, they have been the leading edge of a movement toward greater supervisory transparency. The Federal Reserve's decision in spring 2009 to disclose the results of the SCAP on a firm-specific basis proved to be an important step in re-establishing market and public confidence in the U.S. financial system. In the Dodd-Frank Act, Congress endorsed the practice of disclosing both supervisory and firm stress test results in normal times, as well as in crisis periods. During the past five years we have progressively increased disclosures of firm-specific information, the methodologies we use, and the details of the stress test scenarios. From the outset, we have published the broad framework and methodology used in the supervisory stress test, including information about the types of models we use. We solicited comments on our design framework for scenarios in 2012, and incorporated into the final document some of the ideas we received--such as providing more information about the economic and financial conditions represented by paths of the variables in the scenarios. And this past spring, we published the additional set of stress test results that described how the firms would perform under the adverse scenario, in addition to the results of the severely adverse scenario, which we had previously released. Because bank portfolios are often quite opaque and thus difficult for outsiders to value, this information should allow investors, counterparties, analysts, and markets more generally to make more informed judgments on the condition of U.S. banking institutions. Coupled with other regulatory measures, this transparency should in turn increase market discipline. This level of transparency also subjects us to greater outside scrutiny and analysis, a process that increases our accountability as regulators and helps us improve our assumptions and methodology over time. These choices for greater transparency in the supervisory stress tests and CCAR have prompted healthy discussion on the merits of disclosure in other supervisory areas. As I think everyone in this audience knows, we have not disclosed the supervisory models themselves. We do not want firms simply to copy our modeling in their own assessment of risks and capital needs. And we certainly do not want them to construct their portfolios in an effort to game the model--a kind of analogue to teaching to a test. But even though we do not publicly release the models, we have put systems in place to ensure oversight and accountability. The models are evaluated by a special model validation group made up of experts within the Federal Reserve who do not work on the stress tests. We have also created a Model Validation Council made up of outside experts to provide independent views and advice. The third important effect of the supervisory stress tests and CCAR has been to pave the way for other horizontal, simultaneous supervisory exercises. We created the Large Institution of systemically important firms that was better coordinated, more data-driven, and more focused on the largest institutions as a group. While CCAR includes a number of firms that are not in the LISCC portfolio, the stress tests and CCAR have been the proving ground for LISCC, and as the committee has evolved to administer these programs more efficiently, these exercises have shown the way to other horizontal supervisory exercises or assessments. Some, like the newer Comprehensive Liquidity Analysis and Review, which focuses on assessing liquidity sufficiency and banks' internal liquidity risk-management practices, are intended to be recurring. Others are ad hoc efforts responsive to more episodic or transitory concerns. Fourth, and in some sense an extension of the prior point, CCAR in particular has defined an approach toward developing and maintaining better risk management within the banking organizations subject to these exercises. Let me turn now address this topic in somewhat greater detail. Here again, the origins of our current program lie in our experience with the SCAP in 2009, during which we learned a great deal beyond just post-stress loss and capital numbers. The horizontal, cross-firm nature of the exercise also allowed us to evaluate and compare the effectiveness of the firms' processes for determining and addressing their own capital needs. We discovered that, at the time, many of the firms had critical deficiencies in the fundamental risk- measurement and risk-management practices necessary to assess their capital needs. Many firms did not have a systematic program for assessing their capital needs and even lacked the basic data on firm-wide risks and exposures needed to begin such a program. Not surprisingly, there appeared to be a correlation between firms found to be insufficiently capitalized to withstand further financial and economic stress and firms lacking effective processes for assessing their risks and vulnerabilities. In response to these deficiencies, the Federal Reserve initiated the annual CCAR process for assessing the capital adequacy and internal capital planning processes of large, complex bank holding companies (BHCs). CCAR is premised on the belief that thorough, rigorous risk management must underpin all the activities of all such firms. Risks that are identified and understood can be evaluated and, where appropriate, assumed with proper safeguards and capital planning. Risks that are overlooked, misunderstood, or taken outside of a well-considered and comprehensive risk-management framework plant the seeds for serious trouble for individual firms and potentially for the financial system. Through CCAR, we have sought to ensure not only that all large BHCs have strong capital positions as determined through our supervisory stress test, but also that they have strong capital planning practices that are appropriately focused on the capital needed to withstand possible losses from the specific risks in each firm's business model. These processes, grounded in strong quantitative and qualitative risk management, also give supervisors a clearer window into each firm's activities and thus increase the effectiveness of regular supervision. Since the first CCAR there has been notable improvement in the firms' capital planning processes. Many firms have made meaningful investments in their risk-measurement processes, including significant enhancements to their internal data and management information systems. Many firms have adopted a formal framework to inform their capital planning through an analysis of their vulnerabilities and capital adequacy under a range of potential adverse scenarios. They have also taken steps to enhance the integrity of their risk measures, analysis, and the decision-making around their capital levels and distributions. Despite these advances, there is continuing need for improvement in the firms' capital planning processes. Some firms still lack reliable information about their businesses and exposures. Firms also are sometimes unable to measure or understand how stressful conditions can change the performance of their material business lines. In particular, the capacity to assess the impact of tail risks remains in need of further development at many firms. These deficiencies are, in some instances, compounded by weak oversight by senior management and boards of directors, and lack of effective checks and accountability in the process. The importance we attach to these risk-management and capital planning processes is reflected in the component of CCAR known as the qualitative assessment. This assessment covers a range of topics, including the extent to which the design of a firm's internal scenario captures the specific risks from the firm's activities, the firm's methods for projecting losses under stress scenarios, and how the firm identifies appropriate capital levels and plans for distributions. As detailed in our CCAR regulation, where these processes are found to be inadequate, or to raise safety and soundness concerns, they may form the basis for an objection by the Board of Governors to the capital distribution plans of a firm. If a firm's internal processes are unreliable, supervisors will necessarily be concerned that a firm may not properly have assessed risks clearly and, where needed, assured adequate capital for the many risks that cannot be fully captured by standardized stress tests. As the process and expectations for the quantitative test have become better understood, attention has shifted a bit to the qualitative assessment. To place that part of the CCAR in context, let me make several additional points. First, as I have already noted, many firms had a long way to go to meet high standards of capital planning backed by strong risk management when we began CCAR. Given that initial gap, we have allowed time for firms to work toward full achievement of those standards. Thus, what may be perceived as a raising of the bar every year is better understood as our effort to provide a demanding, but still realistic, glide path for firms to reach that goal. We do, however, expect firms to continue to make steady progress each year. Second, the horizontal nature of the qualitative assessment does not mean that every year one or more firms must receive an objection on qualitative grounds. The comparative approach helps ensure that firms are evaluated consistently and fairly. And it does allow us to see where specific firms may be outliers from good practices followed in the rest of the industry. But this is not a PGA tournament--there is no foreordained cut that some participants will miss. Third, while there are minimum standards for all CCAR firms, the standards are more stringent for firms of greater systemic importance. It is not enough for the largest and most complex banking organizations to meet only the minimum standards in CCAR. We expect the more systemically important firms to establish and maintain the most sophisticated risk- management and capital planning practices. Their risk management and capital adequacy should be sufficiently strong to help ensure their resiliency to a range of unexpected stress events, since their distress could pose a threat to the financial system and to the broader economy. Fourth, precisely because of its importance to our supervisory program, the qualitative assessment will continue to be progressively more integrated into year-round supervision of the CCAR firms. While some important features of capital planning are observable only during the formal CCAR process, most of the risk-management and capital planning standards incorporated in CCAR are operative and observable by supervisors throughout the year. These should be an important focus of ongoing supervisory oversight and of discussions between firms and supervisors. Only in unusual circumstances should supervisors learn for the first time during CCAR of significant problems in the quality of the capital planning processes, and only in unusual circumstances should firms be surprised at the outcome of the qualitative assessment. We have already taken steps to further this integration of CCAR and regular supervision. At the end of each CCAR process our supervisors send to each firm a letter detailing their conclusions concerning the qualitative assessment. To the extent weaknesses or areas for improvement are identified, those letters provide a basis for regular stocktaking by both firms and supervisors. More generally, last year we released a paper on our expectations for all aspects of capital planning, providing greater detail than what is included in the annual CCAR instructions. I anticipate that we will take additional steps to integrate ongoing supervisory assessments of risk-management and other internal control processes with the annual CCAR exercise, and to assure that communications in both directions are heard. One such step has just recently begun: The committee chaired by senior Board staff that is responsible for the oversight of CCAR, supported by the relevant horizontal assessment teams, will directly engage with firms during the course of the year to evaluate progress in remediating weaknesses or other issues identified in the post-CCAR letters. Increasingly, our regular supervisory work on topics such as risk-identification and internal audit will focus on processes that are critical to risk management and capital planning at the firms, areas of focus for CCAR. The aim of these and additional measures is to make CCAR more the culmination of year-round supervision of risk-management and capital planning processes than a discrete exercise that takes place at the same time as the supervisory stress tests. Finally, I would note that, to provide investors, counterparties, analysts, and the public with better information on the meaning of an objection on qualitative grounds to a capital distribution plan, we now release our decisions on each capital plan and, for firms whose capital plans were objected to, provide a summary of the specific reasons for those objections. Although strong capital regulation is critical to ensuring the safety and soundness of our largest financial institutions, it is not a panacea, as indeed no single regulatory device can ever be. Similarly, supervisory stress testing and CCAR, while central to ensuring strong capital positions for large firms, are not the only important elements of our supervisory program. Having said that, however, I hope you will take at least these three points away from my remarks today. First, supervisory stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions--and to apply these specifications on a dynamic basis--has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system. The opportunities it provides to incorporate macroprudential elements make it, in my judgment, the single most important advance in prudential regulation since the crisis. Second, supervisory stress testing and CCAR have provided the first significant form of supervision conducted in a horizontal, coordinated fashion, affording a single view of an entire portfolio of institutions, as well as more data-rich insight into each institution individually. As such, these programs have opened the way for similar supervisory activities and continue to teach us how to organize our supervisory efforts in order most effectively to safeguard firm soundness and financial stability. Finally, supervisory stress testing and CCAR are the exemplary cases of how supervision that aspires to keep up with the dynamism of financial firms and financial markets must itself be composed of adaptive tools. If regulators are to make the necessary adaptations, they must be open to the comments, critiques, and suggestions of those outside the regulatory community. For this reason, transparency around the aims, assumptions, and methodologies of stress testing and our review of capital plans must be preserved and extended. With that point, I end where I began--by emphasizing the importance of forums such as this one, and thanking you for your participation.

r140702a_FOMC

united states

Monetary Policy and Financial Stability

yellen

It is an honor to deliver the inaugural Michel Camdessus Central Banking Lecture. Michel Camdessus served with distinction as governor of the Banque de France and was one of the longest-serving managing directors of the International Monetary Fund (IMF). In these roles, he was well aware of the challenges central banks face in their pursuit of price stability and full employment, and of the interconnections between macroeconomic stability and financial stability. Those interconnections were apparent in the Latin American debt crisis, the Mexican peso crisis, and the East Asian financial crisis, to which the IMF responded under Camdessus's leadership. These episodes took place in emerging market economies, but since then, the global financial crisis and, more recently, the euro crisis have reminded us that no economy is immune from financial instability and the adverse effects on employment, economic activity, and price stability that financial crises cause. The recent crises have appropriately increased the focus on financial stability at central banks around the world. At the Federal Reserve, we have devoted substantially increased resources to monitoring financial stability and have refocused our regulatory and supervisory efforts to limit the buildup of systemic risk. There have also been calls, from some quarters, for a fundamental reconsideration of the goals and strategy of monetary policy. Today I will focus on a key question spurred by this debate: How should monetary and other policymakers balance macroprudential approaches and monetary policy in the pursuit of financial stability? In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macroprudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively. I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability. Because of this possibility, and because transparency enhances the effectiveness of monetary policy, it is crucial that policymakers communicate their views clearly on the risks to financial stability and how such risks influence the appropriate monetary policy stance. I will conclude by briefly laying out how financial stability concerns affect my current assessment of the appropriate stance of monetary policy. When considering the connections between financial stability, price stability, and full employment, the discussion often focuses on the potential for conflicts among these objectives. Such situations are important, since it is only when conflicts arise that policymakers need to weigh the tradeoffs among multiple objectives. But it is important to note that, in many ways, the pursuit of financial stability is complementary to the goals of price stability and full employment. A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability. Despite these complementarities, monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. I will highlight these potential costs and the clear need for a macroprudential policy approach by looking back at the vulnerabilities in the U.S. economy before the crisis. I will also discuss how these vulnerabilities might have been affected had the Federal Reserve tightened monetary policy in the mid-2000s to promote financial stability. Although it was not recognized at the time, risks to financial stability within the United States escalated to a dangerous level in the mid-2000s. During that period, policymakers--myself included--were aware that homes seemed overvalued by a number of sensible metrics and that home prices might decline, although there was disagreement about how likely such a decline was and how large it might be. What was not appreciated was how serious the fallout from such a decline would be for the financial sector and the macroeconomy. Policymakers failed to anticipate that the reversal of the house price bubble would trigger the most significant financial crisis in the United States since the Great Depression because that reversal interacted with critical vulnerabilities in the financial system and in government regulation. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important financial institutions (SIFIs) and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole. It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector. Some advocates of the view that a substantially tighter monetary policy may have helped prevent the crisis might acknowledge these points, but they might also argue that a tighter monetary policy could have limited the rise in house prices, the use of leverage within the private sector, and the excessive reliance on short-term funding, and that each of these channels would have contained--or perhaps even prevented--the worst effects of the crisis. A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble. Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households' ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly. Similar mixed results would have been likely with regard to the effects of tighter monetary policy on leverage and reliance on short-term financing within the financial sector. In particular, the evidence that low interest rates contribute to increased leverage and reliance on short-term funding points toward some ability of higher interest rates to lessen these vulnerabilities, but that evidence is typically consistent with a sizable range of quantitative effects or alternative views regarding the causal channels at work. Furthermore, vulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities. Turning to recent experience outside the United States, a number of foreign economies have seen rapidly rising real estate prices, which has raised financial stability concerns despite, in some cases, high unemployment and shortfalls in inflation relative to the central bank's inflation target. These developments have prompted debate on how to best balance the use of monetary policy and macroprudential tools in promoting financial stability. For example, Canada, Switzerland, and the United Kingdom have expressed a willingness to use monetary policy to address financial stability concerns in unusual circumstances, but they have similarly concluded that macroprudential policies should serve as the primary tool to pursue financial stability. In Canada, with inflation below target and output growth quite subdued, the Bank of Canada has kept the policy rate at or below 1 percent, but limits on mortgage lending were tightened in each of the years from 2009 through 2012, including changes in loan-to-value and debt-to-income caps, among other measures. In contrast, in Norway and Sweden, monetary policy decisions have been influenced somewhat by financial stability concerns, but the steps taken have been limited. In Norway, policymakers increased the policy interest rate in mid-2010 when they were facing escalating household debt despite inflation below target and output below capacity, in part as a way of "guarding against the risk of future imbalances." Similarly, Sweden's Riksbank held its policy rate "slightly higher than we would have done otherwise" because of financial stability concerns. In both cases, macroprudential actions were also either taken or under consideration. In reviewing these experiences, it seems clear that monetary policymakers have perceived significant hurdles to using sizable adjustments in monetary policy to contain financial stability risks. Some proponents of a larger monetary policy response to financial stability concerns might argue that these perceived hurdles have been overblown and that financial stability concerns should be elevated significantly in monetary policy discussions. A more balanced assessment, in my view, would be that increased focus on financial stability risks is appropriate in monetary policy discussions, but the potential cost, in terms of diminished macroeconomic performance, is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time. If monetary policy is not to play a central role in addressing financial stability issues, this task must rely on macroprudential policies. In this regard, I would note that here, too, policymakers abroad have made important strides, and not just those in the advanced economies. Emerging market economies have in many ways been leaders in applying macroprudential policy tools, employing in recent years a variety of restrictions on real estate lending or other activities that were perceived to create vulnerabilities. Although it is probably too soon to draw clear conclusions, these experiences will help inform our understanding of these policies and their efficacy. If macroprudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macroprudential tools are likely to be most effective, what the limits of such tools may be, and when, because of such limits, it may be appropriate to adjust monetary policy to "get in the cracks" that persist in the macroprudential framework. In weighing these questions, I find it helpful to distinguish between tools that primarily build through-the-cycle resilience against adverse financial developments and those primarily intended to lean against financial excesses. Tools that build resilience aim to make the financial system better able to withstand unexpected adverse developments. For example, requirements to hold sufficient loss-absorbing capital make financial institutions more resilient in the face of unexpected losses. Such requirements take on a macroprudential dimension when they are most stringent for the largest, most systemically important firms, thereby minimizing the risk that losses at such firms will reverberate through the financial system. Resilience against runs can be enhanced both by stronger capital positions and requirements for sufficient liquidity buffers among the most interconnected firms. An effective resolution regime for SIFIs can also enhance resilience by better protecting the financial system from contagion in the event of a SIFI collapse. Further, the stability of the financial system can be enhanced through measures that address interconnectedness between financial firms, such as margin and central clearing requirements for derivatives transactions. Finally, a regulatory umbrella wide enough to cover previous gaps in the regulation and supervision of systemically important firms and markets can help prevent risks from migrating to areas where they are difficult to detect or address. In the United States, considerable progress has been made on each of these fronts. Changes in bank capital regulations, which will include a surcharge for systemically important institutions, have significantly increased requirements for loss-absorbing capital at the largest banking firms. The Federal Reserve's stress tests and Comprehensive Capital Analysis and Review process require that large financial institutions maintain sufficient capital to weather severe shocks, and that they demonstrate that their internal capital planning processes are effective, while providing perspective on the loss-absorbing capacity across a large swath of the financial system. The Basel III framework also includes liquidity requirements designed to mitigate excessive reliance by global banks on short-term wholesale funding. Oversight of the U.S. shadow banking system also has been strengthened. The new Financial Stability Oversight Council has designated some nonbank financial firms as systemically important institutions that are subject to consolidated supervision by the Federal Reserve. In addition, measures are being undertaken to address some of the potential sources of instability in short-term wholesale funding markets, including reforms to the triparty repo market and money market mutual funds--although progress in these areas has, at times, been frustratingly slow. Additional measures should be taken to address residual risks in the short-term wholesale funding markets. Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short- term wholesale funding--would likely apply only to the largest, most complex organizations. Other measures--such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis. To the extent that minimum margin requirements lead to more conservative margin levels during normal and exuberant times, they could help avoid potentially destabilizing procyclical margin increases in short-term wholesale funding markets during times of stress. At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a "bubble" and whether policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical. Nonetheless, some macroprudential tools can be adjusted in a manner that may further enhance resilience as risks emerge. In addition, macroprudential tools can, in some cases, be targeted at areas of concern. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional loss-absorbing capacity within the financial sector during periods of rapid credit creation while also leaning against emerging excesses. The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions and incorporate the possibility of highlighting salient risk scenarios, both of which may contribute to increasing resilience during periods in which risks are rising. Similarly, minimum margin requirements for securities financing transactions could potentially vary on a countercyclical basis so that they are higher in normal times than in times of stress. In light of the considerable efforts under way to implement a macroprudential approach to enhance financial stability and the increased focus of policymakers on monitoring emerging financial stability risks, I see three key principles that should guide the interaction of monetary policy and macroprudential policy in the United States. First, it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment. Key steps along this path include completion of the transition to full implementation of Basel III, including new liquidity requirements; enhanced prudential standards for systemically important firms, including risk-based capital requirements, a leverage ratio, and tighter prudential buffers for firms heavily reliant on short-term wholesale funding; expansion of the regulatory umbrella to incorporate all systemically important firms; the institution of an effective, cross-border resolution regime for systemically important financial institutions; and consideration of regulations, such as minimum margin requirements for securities financing transactions, to limit leverage in sectors beyond the banking sector and SIFIs. Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macroprudential tools to influence these developments. The limitations of macroprudential policies reflect the potential for risks to emerge outside sectors subject to regulation, the potential for supervision and regulation to miss emerging risks, the uncertain efficacy of new macroprudential tools such as a countercyclical capital buffer, and the potential for such policy steps to be delayed or to lack public support. Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability. These first two principles will be more effective in helping to address financial stability risks when the public understands how monetary policymakers are weighing such risks in the setting of monetary policy. Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy. To that end, I will briefly lay out my current assessment of financial stability risks and their relevance, at this time, to the stance of monetary policy in the United States. In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector. Moreover, the improvements in household and business balance sheets have been accompanied by the increased safety of the financial sector associated with the macroprudential efforts I have outlined. Overall, nonfinancial credit growth remains moderate, while leverage in the financial system, on balance, is much reduced. Reliance on short-term wholesale funding is also significantly lower than immediately before the crisis, although important structural vulnerabilities remain in short-term funding markets. Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a "reach for yield" in the face of persistently low interest rates. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures. But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways. In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macroprudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions. An important contributor to the progress made in the United States has been the lessons we learned from the experience gained by central banks and regulatory authorities all around the world. The IMF plays an important role in this evolving process as a forum for representatives from the world's economies and as an institution charged with promoting financial and economic stability globally. I expect to both contribute to and learn from ongoing discussions on these issues.

r140710a_FOMC

united states

Financial Sector Reform: How Far Are We?

fischer

Although the recession in the United States that started in December 2007 ended in June 2009, the impact of the Great Recession, which began when Lehman Brothers filed for bankruptcy on September 15, 2008, continues to be felt in the United States, Europe, and around the world. After the bankruptcy of Lehman Brothers, policymakers, working through the G-20, quickly reached agreement on the macroeconomic policies needed to minimize the damage done by the crisis. For their part, central bankers and supervisors of financial systems, working through the newly established Financial program for reform of the financial sector and its supervision. In this lecture I will ask how much has been achieved so far in implementing the ambitious financial sector reform program that was widely agreed at the early stages of the global financial crisis. From among the range of topics in which financial sector reforms have been instituted since 2008, I focus on three: capital and liquidity for banks and other financial institutions, macroprudential supervision, and the problem of too big The 2007-09 crisis was both the worst economic crisis and the worst financial crisis since the 1930s. Following the collapse of Lehman Brothers, many thought that we were about to witness a second Great Depression. That did not happen, in large part because policymakers had learned some of the lessons of the Great Depression. Nonetheless, the advanced economies were put through severe economic and political tests. Fortunately, policymakers succeeded in dealing with the situation better than many had feared they would; unfortunately, we are still dealing with the consequences of the collapse and the steps necessary to deal with it. Former Congressman Barney Frank has been heard to say that economists have a wonderful technique, that of the counterfactual, to analyze what has been achieved by preventing disasters, but that real people base their judgments more on the current state of the world than on disasters that have not happened. True as that may be, we should from time-to-time allow ourselves to recognize that as bad as the Great Recession has been, it would have been much worse had policymakers not undertaken the policies they did-- many of them unorthodox and previously untried--to deal with the imminent crisis that confronted the United States and global economies after the fall of Lehman Brothers. And for that, we owe them our gratitude and our thanks. Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs--national and international--covered some or all of the following nine areas: (1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and (2) to strengthen the quality and effectiveness of prudential regulation and supervision; (3) to build the capacity for undertaking effective macroprudential regulation and supervision; (4) to develop suitable resolution regimes for financial institutions; (5) to strengthen the infrastructure of financial markets, including markets for derivative transactions; (6) to improve compensation practices in financial institutions; (7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs; (8) to find appropriate ways of dealing with the shadow banking system; and (9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance. Rather than seek to give a scorecard on progress on all the aspects of the reform programs suggested from 2007 to 2009, I want to focus on three topics of particular salience mentioned earlier: capital and liquidity, macroprudential supervision, and too big to fail. At one level, the story on capital and liquidity ratios is very simple: From the viewpoint of the stability of the financial system, more of each is better. This is the principle that lies behind the vigorous campaign waged by Anat Admati and Martin Hellwig to increase bank capital ratios, set out in their book, and in subsequent publications. But at what level should capital and liquidity ratios be set? In practice, the base from which countries work is agreement among the regulators and supervisors who membership consisted of the members of the G-10 plus Switzerland. It now includes the membership of the G-20 plus a few other countries. Following the global crisis, the BCBS moved to the Basel III agreement, which strengthens capital requirements, as opposed to Basel II, which tried to build primarily on measures of risk capital set by internal models developed by each individual bank. This approach did not work, partly because the agreed regulatory minimum capital ratios were too low, but also because any set of risk weights involves judgments, and human nature would rarely result in choices that made for higher risk weights. In the United States, the new regulations require large bank holding companies (BHCs) to use risk-weighted assets (RWAs) that are the greater of those produced by firms' internal models or the standardized risk weights, some of which have been raised, thus mitigating the problem of the use of internal risk ratings. The minimum tier 1 capital ratio has been raised from 4 percent to 6 percent of There is a minimum common equity tier 1 capital ratio of 4.5 percent of RWA. There is a capital conservation buffer of 2.5 percent of RWA, to ensure that banking organizations build capital when they are able to. A countercyclical capital buffer has been created that enables regulators to raise risk-based capital requirements when credit growth is judged to be excessive. A minimum international leverage ratio of 3 percent has been set for tier 1 capital relative to total (i.e., not risk-weighted) on-balance-sheet assets and off-balance- sheet exposures. There is a risk-based capital surcharge for global systemically important banks In addition, in the United States The Federal Reserve is planning to propose risk-based capital surcharges for U.S. achieve this ratio will face limits on their ability to distribute dividends and to pay discretionary employee bonuses. Foreign banking organizations with U.S. nonbranch assets of $50 billion or more will have to form U.S. intermediate holding companies that will have to meet essentially the same capital requirements as U.S. BHCs with $50 billion or more of assets. Many of these rules do not apply to community banks, in light of their different business models. One more point on bank capital: The Swiss and Swedish regulators have already gone far in raising capital requirements, including by requiring bail-in-able secondary holdings of capital in the form of contingent convertible capital obligations (CoCos). The United States may be heading in a similar direction, but not by using CoCos, rather by requiring minimum amounts of "gone-concern" loss absorbency--in the form of long- term debt--that would be available for internal financing recapitalization through a new orderly liquidation mechanism created by the Dodd-Frank Wall Street Reform and In addition to enhanced capital ratios and tougher measures of risk-based capital, the Basel III accord includes bank liquidity rules, another key element of global financial regulatory reform. The Basel Committee has agreed on the Liquidity Coverage Ratio (LCR), which is designed to reduce the probability of a firm's liquidity insolvency over a 30-day horizon through a self-insurance regime of high-quality liquid assets (HQLA) to meet short-term stressed funding needs. The BCBS is also working to finalize the Net Stable Funding Ratio (NSFR), which helps to ensure a stable funding profile over a one- year horizon. The bottom line to date: The capital ratios of the 25 largest banks in the United States have risen by as much as 50 percent since the beginning of 2005 to the start of this year, depending on which regulatory ratio you look at. For example, the tier 1 common equity ratio has gone up from 7 percent to 11 percent for these institutions. The increase in the ratios understates the increase in capital because it does not adjust for tougher risk weights in the denominator. In addition, the buffers of HQLAs held by the largest banking firms have more than doubled since the end of 2007, and their reliance on short- term wholesale funds has fallen considerably. At the same time, the introduction of macroeconomic supervisory stress tests in the United States has added a forward-looking approach to assessing capital adequacy, as firms are required to hold a capital buffer sufficient to withstand a several-year period of severe economic and financial stress. The stress tests are a very important addition to the toolkit of supervisors, one that is likely to add significantly to the quality of financial sector supervision. In practice, there are two uses of the term "macroprudential supervision." first relates to the supervision of the financial system as a whole, with an emphasis on interactions among financial markets and institutions. The second relates to the use of regulatory or other non-interest-rate tools of policy to deal with problems arising from the behavior of asset prices. For instance, when central bank governors are asked how they propose to deal with the problem of rising housing prices at a time when the central bank for macroeconomic reasons does not want to raise the interest rate, they generally reply that if the need arises, they will use macroprudential policies for that purpose. By that they mean policies that will reduce the supply of credit to the housing sector without changing the central bank interest rate. Sector-specific regulatory and supervisory policies in the financial sector were used extensively and systematically in the United States in the period following World War II until the 1990s and are now being used in other advanced and developing countries. Elliott, Feldberg, and Lehnert review the use of such measures in the United Frequently, these policies were aimed at encouraging or discouraging activity in particular sectors, for example agriculture, exports, manufacturing, or housing; sometimes broad, non-interest-rate measures were used to try to deal with inflation or asset-price increases, for instance, the use of credit controls. The issue of how monetary policy should relate to asset-price inflation had been on the agenda of central bankers for many years before the Lehman Brothers' failure. The issue became more prominent in the United States in the 1990s and the first few years of this century, and temporarily culminated in the Fed's "mopping-up" approach, namely that monetary policy--meaning interest rate policy--should not react to rising asset prices or suspected bubbles except to the extent that they affect either employment and/or price stability. Operationally, this approach was much more likely to lead to action after the bubble had burst than as it was forming. The policy was tested in the bursting of the tech bubble in 2001 and appeared to be successful as the economy recovered from 2002 onward. However, the mopping-up doctrine did not include the second element of the macroprudential approach--the use of regulatory and supervisory measures to deal with undesired asset-price movements when the central bank interest rate was judged not to be available for that purpose. At present, the word macroprudential is used primarily in the second sense--of the use of regulatory and supervisory noncentral bank interest rate tools to affect asset prices. In this sense, the use of the word takes us back to a world that central bankers thought they had left by the 1990s. Now, from etymology to economics: I want to review my experience with macroprudential policies--in the second sense of noninterest regulatory and supervisory policies--as Governor of the Bank of Israel to draw a few key lessons about the use of these policies. To set the background: There was no financial crisis in Israel during the Great Recession. As domestic interest rates declined along with global rates, housing prices began to rise. This is a normal part of the textbook adjustment mechanism and is expected to encourage an increase in the rate of homebuilding. The rate of building increased, but not sufficiently to meet the demand for housing, and prices continued to rise. The banks are the largest financial institutions in Israel and dominate housing finance. The supervisor of banks reports to the governor of the central bank. Starting in 2010, the supervisor began to implement a series of measures to reduce the supply of housing finance by the banks. Among the measures used were increasing capital requirements and provisioning against mortgages; limiting the share of any housing financing package indexed to the short-term (central bank) interest rate to one-third of the total loan, with the remainder of the package having to be linked to either the five-year real or five-year nominal interest rate; and, on different occasions, limiting the loan-to- Additional precautionary measures were implemented in the supervision of banks. The most successful of these measures was the limit of one-third imposed in May 2011 on the share of any housing loan indexed in effect to the Bank of Israel interest rate. Competition among the banks had driven the spread on floating rate mortgages indexed to the Bank of Israel rate down to 60 basis points, which meant that mortgage financing was available at an extremely low interest rate. The term-structure was relatively steep, so that the requirement that the remaining two-thirds of any financing package had to be indexed to a five-year rate--whether real or nominal--made a substantial difference to the cost of housing finance. In addition, increases in both LTV and PTI ratios were moderately effective. However, increasing capital charges had very little impact in practice. There are three key lessons from this experience. First, the Bank of Israel did not have good empirical estimates of the effectiveness of the different macroprudential measures. This problem is likely to be relevant in many countries in large part because we have relatively little experience of the use of such measures in recent years. Policymakers may thus be especially cautious in the use of measures of this type. Second, measures aimed at reducing the demand for housing are likely to be politically sensitive. Their use requires either very cautious and well-aimed measures by the regulatory authorities, and/or the use by the government of subsidies to compensate some of those who end up facing more difficulty in buying housing as a result of the imposition of macroprudential measures. Indeed, it often appears that there is a conflict between cautious risk management by the lenders and the desire of society to house its people decently. Third, there is generally a need for coordination among several regulators and authorities in dealing with macroprudential problems of both types. There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up, Don Kohn. Kohn sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body. After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis. Kohn remarks that he does not hold up the U.K. structure of macroprudential supervision as ideal for all countries at all times and further notes that the U.K. system vests a great deal of authority in a single institution, the Bank of England. This element is not consistent with the U.S. approach of dispersing power among competing institutions. These are important, and difficult, issues. Kohn's proposals clearly warrant serious examination. It may well be that adding a financial stability mandate to the overall mandates of all financial regulatory bodies, and perhaps other changes that would give more authority to a reformed FSOC, would contribute to increasing financial and economic stability. Diagnoses of what went wrong with the financial system at the start of the Great Recession in the United States generally placed heavy emphasis on the problem of too big to fail. The TBTF problem derives from the typical response of governments confronted by the potential failure of a large bank, which is to intervene to save the bank and some of its noninsured creditors. In the words of Governor Tarullo, "... no matter what its general economic policy principles, a government faced with the possibility of a cascading financial crisis that could bring down its national economy tends to err on the side of intervention." I will start by discussing some of the main steps in the links between TBTF and the crisis, and between the financial sector reform program and TBTF. We begin with the link between TBTF and government intervention: Once investors believe that governments will intervene to prevent large banks from becoming bankrupt, they become willing to lend to these banks at lower rates than they would lend without the implicit guarantee. This could lead to such banks becoming larger than optimal and to encouraging them to take more risks than they would absent expected government intervention to reduce the likelihood of their becoming bankrupt. A great deal of empirical work has attempted to measure the premium--in terms of a lower cost of financing--that the large banks typically receive. The results vary, but a representative set of estimates--that of the International Monetary Fund in its April 2014 issue of the --reports that in 2013 their estimates of the premium were approximately 15 basis points in the United States, 25-60 basis points in Japan, 20-60 basis points in the United Kingdom, and 60-90 basis points in the euro area. The estimated premium in the United States was higher at the height of the financial crisis, and has been declining since then in response to the significant steps made in the regulatory reform agenda. Do large banks, with lower costs of financing, take bigger risks? The empirical relationship between bank size and their risk-taking has been examined by Laeven, Ratnovski, and Tong, who find that "large banks tend to have lower capital ratios, less stable funding, more market-based activities, and (to) be more organizationally complex than small banks." From this they conclude that "[l]arge banks are riskier, and create more systemic risk, when they have lower capital and less-stable funding. [They] create more systemic risk (but are not individually riskier) when they engage more in market- based activities or are more organizationally complex." The key to these results is the recognition that banks have several sources of financing, and that the more they rely on market interest rate-sensitive short-term funding, the less stable they are likely to be. Organizational complexity is certainly an issue: Maintaining managerial control, especially risk control, in a multi-activity bank, where individual rewards may be massive, is extremely difficult--think for instance of Baring's in the late 1990s, or Societe Generale, or the so-called London Whale at JPMorgan Chase. Strong risk management is essential but faces the hurdle of the structural incentives for risk-taking implied by limited liability for individuals and by what may be a human proclivity to take risks. But of course, banks that are heavily consumer deposit financed also fail from time to time, as a result of bad lending decisions. It could be that large banks can finance themselves more cheaply because they are more efficient, that is, that there are economies of scale in banking. For some time, the received wisdom was that there was no evidence of such economies beyond relatively modest-sized banks, with balance sheets of approximately $100 billion. More recently, several papers have found that economies of scale may continue beyond that level. For suggests that large institutions may be better able to manage risk more efficiently because of "technological advantages, such as diversification and the spreading of information...and other costs that do not increase proportionately with size." That said, these authors conclude that "[W]e do not know if the benefits of large size outweigh the potential costs in terms of systemic risk that large scale may impose on the financial system." They add that their results suggest that "strict size limits to control such costs will likely not be effective, since they work against market forces..." The TBTF theory of why large banks are a problem has to contend with the history of the Canadian and Australian banking systems. Both these systems have several very large banks, but both systems have been very stable--in the Canadian case, for 150 years. Beck, Demirguc-Kunt, and Levine (2003) examined the impact of bank concentration, bank regulation, and national institutions on the likelihood of a country suffering a financial crisis and concluded that countries are less likely to suffer a financial crisis if they have (1) a more concentrated banking system, (2) fewer entry barriers and activity restrictions on bank activity, and (3) better-developed institutions that encourage competition throughout the economy. The combination of the first finding with the other two appears paradoxical, but the key barrier to competition that was absent in Canada was the prohibition of nationwide branch banking, a factor emphasized by Calomiris and Haber in their discussion of the Canadian case. In addition, I put serious weight on another explanation offered in private conversation by a veteran of the international central banking community, "Those Canadian banks aren't very adventurous," which I take to be a compliment. Why is the TBTF phenomenon so central to the debate on reform of the financial system? It cannot be because financial institutions never fail. Some do, for example, were merged out of existence, often at very low prices, with the FDIC managing the resolution process. Banks in the United Kingdom and in Europe failed during the Great Recession. It cannot be because equity-holders never lose in bank crises. It could be because until now, bond holders in large banks rarely have lost significantly in crises-- rather, for fear of contagion, they ended up being protected by the government. Almost certainly, TBTF is central to the debate about financial crises because financial crises are so destructive of the real economy. It is also because the amounts of money involved when the central bank or the government intervenes in a financial crisis are extremely large, even though the final costs to the government, including the central bank, are typically much smaller. In some cases, governments and central banks even come out slightly ahead after the crisis is over and the banks have been sold back to the private sector. Another factor may be that the departing heads of some banks that failed or needed massive government assistance to survive nonetheless received very large retirement packages. One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability. And the FDIC's single-point-of-entry approach for effecting a resolution under the new regime is a sensible proposed implementation path for the Closely associated with the work on resolution mechanisms is the living will exercise for SIFIs. In addition, there are the proposed G-SIB capital surcharges and macro stress tests applied to the largest BHCs ($50 billion or more). Countercyclical capital requirements are also likely to be applied primarily to large banks. Similarly the Volcker rule, or the Vickers rules in the United Kingdom or the Liikanen rules in the euro zone, which seek to limit the scope of a bank's activities, are directed at TBTF, and I believe appropriately so. What about simply breaking up the largest financial institutions? Well, there is no "simply" in this area. At the analytical level, there is the question of what the optimal structure of the financial sector should be. Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? That depends on whether there are economies of scale in the financial sector and up to what size of firm they apply--that is to say it depends in part on why there is a financing premium for large firms. If it is economies of scale, the market premium for large firms may be sending the right signals with respect to size. If it is the existence of TBTF, that is not an optimal market incentive, but rather a distortion. What would happen if it was possible precisely to calculate the extent of the subsidy or distortion and require the bank to pay the social cost of the expansion of its activity? This could be done either by varying the deposit insurance rate for the bank or by varying the required capital ratios for SIFIs to fit each bank's risk profile and structure. This, along with measures to strengthen large banks, would reduce the likelihood of SIFI failure--but could not be relied upon to prevent all failures. Would breaking up the largest banks end the need for future bailouts? That is not clear, for Lehman Brothers, although a large financial institution, was not one of the giants--except that it was connected with a very large number of other banks and financial institutions. Similarly, the savings and loan crisis of the 1980s and 1990s was not a TBTF crisis but rather a failure involving many small firms that were behaving unwisely, and in some cases illegally. This case is consistent with the phrase, "too many to fail." Financial panics can be caused by herding and by contagion, as well as by big banks getting into trouble. In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff. The United States is making significant progress in strengthening the financial system and reducing the probability of future financial crises. In particular By raising capital and liquidity ratios for SIFIs, and through the active use of stress tests, regulators and supervisors have strengthened bank holding companies and thus reduced the probability of future bank failures. Work on the use of the resolution mechanisms set out in the Dodd-Frank Act, based on the principle of a single point of entry, holds out the promise of making it possible to resolve banks in difficulty at no direct cost to the taxpayer--and in any event at a lower cost than was hitherto possible. However, work in this area is less advanced than the work on raising capital and liquidity ratios. Although the BCBS and the FSB reached impressively rapid agreement on needed changes in regulation and supervision, progress in agreeing on the resolution of G-SIFIs and some other aspects of international coordination has been slow. Regulators almost everywhere need to do more research on the effectiveness of microprudential and other tools that could be used to deal with macroprudential problems. It will be important to ensure that coordination among different regulators of the financial system is effective and, in particular, will be effective in the event of a crisis. A great deal of progress has been made in dealing with the TBTF problem. While we must continue to work toward ending TBTF or the need for government financial intervention in crises, we should never allow ourselves the complacency to believe that we have put an end to TBTF. We should recognize that despite some imperfections, the Dodd-Frank Act is a major achievement. At the same time, we need always be aware that the next crisis--and there will be one--will not be identical to the last one, and that we need to be vigilant in both trying to foresee it and seeking to prevent it. And if, despite all our efforts, a crisis happens, we need to be willing and prepared to deal with it.

r140811a_FOMC

united states

The Great Recession: Moving Ahead

fischer

The recession that began in the United States in December 2007 ended in June 2009. But the Great Recession is a near-worldwide phenomenon, with the consequences of which many advanced economies--among them Sweden--continue to struggle. Its depth and breadth appear to have changed the economic environment in many ways and to have left the road ahead unclear. Today I will discuss three key aspects of the challenges policymakers face as they seek to move ahead. These are: (1) The impact of the Great Recession and the associated Global Financial Crisis on the growth of output, both in the short term and over the longer term. (2) The reform of the financial sector--in other words, how much progress have we made in creating a safer and more stable post-crisis financial environment? (3) The impact of the crisis on the conduct of monetary policy--in particular, how to balance the goals of achieving stable inflation and full employment while also taking into account the need to maintain financial stability. I will leave it to others to address the important challenges facing fiscal policymakers as they determine the appropriate roles and paths for fiscal policy at both the macro- and micro-levels. To keep the focus sharp, I will deal primarily with the economy of the United States. But policymakers around the world confront related challenges and I will draw also on the post-crisis experiences of other economies. And I should make it clear that my comments today are mine alone and do not necessarily represent the views of other members of the Board of Governors of the Federal Reserve System or the Federal Open I begin by reviewing recent global economic developments and the questions they raise about where we are likely to go from here. There has been a steady, if unspectacular, climb in global growth since the financial crisis. For example, based on recent IMF data from the which uses purchasing power parity weights, world growth averaged 3 percent during the first four years of the recovery and as of July was expected to be 3.4 percent this year. The IMF expects global growth to reach 4 percent next year--a rate about equal to its estimate for long-run growth. This global average reflects a forecast of steady improvement in the performance of output in the advanced economies where growth averaged less than 1 percent during the initial phase of the recovery to an expected 2-1/2 percent by 2015. In contrast, the recovery in the emerging market economies started strong but has since fallen off, in part, as fiscal policy stimulus has been pared back. But--and this is no small "but"--the global recovery has been disappointing. With few exceptions, growth in the advanced economies has underperformed expectations of growth as economies exited from recession. Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average. In the emerging market economies, the initial recovery was more in line with historical experience, but recently the pace of growth has been disappointing in those economies as well. This slowing is broad based--with performance in Emerging Asia, importantly China, stepping down sharply from the post-crisis surge, to rates significantly below the average pace in the decade before the crisis. A similar stepdown has been seen recently for other regions These disappointments in output performance have not only led to repeated downward revisions of forecasts for short-term growth, but also to a general reassessment of longer-run growth. From the perspective of the FOMC, even in the heart of the crisis, in January 2009, the central tendency of the Committee members' projections for longer- run U.S. growth was between 2-1/2 and 3 percent. At our June meeting this year, these projections had fallen to between roughly 2 and 2-1/4 percent. This downward revision is not unique to our institution or to the United States. Indeed, the IMF's expectation for long-run global growth is now a full percentage point below what it was immediately This reconsideration reflects lower projected growth for both the advanced and the emerging market economies. This pattern of disappointment and downward revision sets up the first, and the basic, challenge on the list of issues policymakers face in moving ahead: restoring growth, if that is possible. In some respects, we should not have been surprised at the prolonged hit to output growth following the global financial crisis. As Cerra and Saxena and Reinhart and Rogoff, among others, have documented, it takes a long time for output in the wake of banking and financial crises to return to pre-crisis levels. Possibly we are simply seeing a prolonged Reinhart-Rogoff cyclical episode, typical of the aftermath of deep financial crises, and compounded by other temporary headwinds. But it is also possible that the underperformance reflects a more structural, longer-term, shift in the global economy, with less growth in underlying supply factors. Separating out the cyclical from the structural, the temporary from the permanent, impacts of the Great Recession and its aftermath on the macroeconomy is necessary to assessing and calibrating appropriate policies going forward. The difficulty in disentangling demand and supply factors makes the job of the monetary policymaker especially hard since it complicates the assessment of the amount of slack, or underutilized productive capacity, in the economy. Over the longer term it will be possible to disentangle the amount of slack on the basis of the behavior of prices and wages as the levels of resource utilization in economies rise, but it would be better to understand why growth has been so slow without experiencing either a runup in inflation or a descent into deflation. In the United States, three major aggregate demand headwinds appear to have kept a more vigorous recovery from taking hold. The unusual weakness of the housing sector during the recovery period, the significant drag--now waning--from fiscal policy, and the negative impact from the growth slowdown abroad--particularly in Europe--are all prominent factors that have constrained the pace of economic activity. The housing sector was at the epicenter of the U.S. financial crisis and recession and it continues to weigh on the recovery. After previous recessions, vigorous rebounds in housing activity have typically helped spur recoveries. In this episode, however, residential construction was held back by a large inventory of foreclosed and distressed properties and by tight credit conditions for construction loans and mortgages. Moreover, the wealth effect from the decline in housing prices, as well as the inability of many underwater households to take advantage of low interest rates to refinance their mortgages, may have reduced household demand for non-housing goods and services. Indeed, some researchers have argued that the failure to deal decisively with the housing problem seriously prolonged and deepened the crisis. Growth in other countries that experienced financial crises, including the United Kingdom, Ireland, and Spain, has been weighted down by struggling residential sectors. More recently, many of these factors have abated in the United States and yet, after encouraging signs of improvement in 2012 and in early 2013, over the past year the growth of residential construction has faltered and home sales have fallen off. The sharp rise in mortgage interest rates in mid-2013 likely contributed to this setback. The stance of U.S. fiscal policy in recent years constituted a significant drag on growth as the large budget deficit was reduced. Historically, fiscal policy has been a support during both recessions and recoveries. In part, this reflects the operation of automatic stabilizers, such as declines in tax revenues and increases in unemployment benefits, that tend to accompany a downturn in activity. In addition, discretionary fiscal policy actions typically boost growth in the years just after a recession. In the U.S., as well as in other countries--especially in Europe--fiscal policy was typically expansionary during the recent recession and early in the recovery, but discretionary fiscal policy shifted relatively fast from expansionary to contractionary as the recovery progressed. In the United States, at the federal level, the end of the payroll tax cut, the sequestration, the squeeze on discretionary spending from budget caps, and the declines in defense spending have all curtailed economic growth. Last year, for example, the Congressional Budget Office estimated that fiscal headwinds slowed the pace of real GDP growth in 2013 by about 1-1/2 percentage points relative to what it would have been otherwise. Moreover, state and local governments, facing balanced budget requirements, have responded to the large and sustained decline in their revenues owing to the deep recession and slow recovery by reducing their purchases of real goods and services. Job cuts at federal, state, and local governments have reduced payrolls by almost 3/4 of a million workers, resulting in a decline in total government civilian employment of 3-1/4 percent since its peak in early 2009. The fiscal adjustments of the last few years have reduced the federal government deficit to an expected level of 3 percent of GDP in 2014 and fiscal drag over the next few years is likely to be relatively low. A third headwind slowing the U.S. recovery has been unexpectedly slow global growth, which reduced export demand. Over the past several years, a number of our key trading partners have suffered negative shocks. Some have been relatively short lived, including the collapse in Japanese growth following the tragic earthquake in 2011. Others look to be more structural, such as the stepdown in Chinese growth compared to its double digit pre-crisis pace. Most salient, not least for Sweden, has been the impact of the fiscal and financial situation in the euro area over the past few years. Weaker economic conditions in Europe and other parts of the world have weighed on U.S. exports and corporate earnings; added to the risks that U.S. financial institutions, businesses, and households considered when making lending and investment decisions; and at times depressed U.S. equity prices. The housing market, fiscal consolidation, and unexpectedly anemic foreign demand all play a significant role in explaining the weakness of aggregate demand in the U.S. economy, weakness that could not have been accurately predicted based on past recession experiences or by the fact that this recession started with a massive financial crisis. But, turning to the aggregate supply side, we are also seeing important signs of a slowdown of growth in the productive capacity of the economy--in the growth in labor supply, capital investment, and productivity. This may well reflect factors related to or predating the recession that are also holding down growth. How much of this weakness on the supply side will turn out to be structural-- perhaps contributing to a secular slowdown--and how much is temporary but longer-than- usual-lasting remains a crucial and open question. Looking at the aggregate production function, we begin with labor supply. The considerable slowdown in the growth rate of labor supply observed over the past decade is a source of concern for the prospects of U.S. output growth. There has been a steady decrease in the labor force participation rate since 2000. Although this reduction in labor supply largely reflects demographic factors--such as the aging of the population-- participation has fallen more than many observers expected and the interpretation of these movements remains subject to considerable uncertainty. For instance, there are good reasons to believe that some of the surprising weakness in labor force participation reflects still poor cyclical conditions. Many of those who dropped out of the labor force may be discouraged workers. Further strengthening of the economy will likely pull some of these workers back into the labor market, although skills and networks may have depreciated some over the past years. Another factor that may be contributing to a slowdown in longer-run output growth is a decline in the rate of investment. As is typical in a downturn, movements in investment were important to the cyclical swings in the economy during the Great Recession. And, as would be expected given the depth of the downturn, investment declines were especially large in this episode. However, in the United States, and in many other countries as well, the growth rate of the capital stock has yet to bounce back appreciably--despite historically low interest rates, access to borrowing for most firms, and ample profits and cash--causing concerns over the long-run prospects for the recovery of investment. Turning next to productivity growth, Solow's famous result over fifty years ago was that over eighty percent of growth in output per hour in the period 1909-1949 came from technical change. Between 1964 and 2003 total factor productivity growth in the United States averaged around 1-1/2 percent, contributing to a 2 percent expansion per year in U.S. GDP per capita. At this rate, American standards of living would double every 35 years. However, productivity growth in recent years has been disappointing. Over the past decade, U.S. total factor productivity growth declined to 1 percent, which some argue may represent the real norm for the U.S. economy. In this view, the long period of rapid productivity growth spurred by the technological innovations of the first and second Industrial Revolutions ended in the 1970s and the economy has continued at a lower productivity growth rate since then, except for a brief burst in the mid-1990s. In particular, these authors argue that the information technology (IT) revolution of the past several decades--including the diffusion of computers, the development of the internet, and improvements in telecommunications--was an anomaly and is unlikely to generate the productivity gains prompted by earlier innovations such as electrification and mass production. Obviously, future productivity growth in the United States and in the world is yet to be determined. Possibly we are moving into a period of slower productivity growth-- but I for one continue to be amazed at the potential for improving the quality of the lives of most people in the world that the IT explosion has already revealed. Possibly, productivity could continue to rise in line with its long-term historical average. all, as the experience of the 1990s shows, productivity cycles are extremely difficult to predict and, even considering the slowdown of the past decade, U.S. total factor productivity growth fluctuated around 1-1/2 percent in the postwar period. In addition, the recent weakness could reflect Reinhart-Rogoff cyclical factors associated with the financial crisis, and pent up improvements could be revealed once confidence returns. Finally, fears about the end of productivity gains are based on evidence from the United States and other advanced economies. Globally, however, there is tremendous scope for productivity gains reflecting technological catch up, infrastructure investment, and the potential for human capital increases due to improvements in education and nutrition, and the incorporation and inclusion of women into the labor force. These gains should benefit not just the emerging market economies but also the rest of world more generally, including the United States. At the end of the day, it remains difficult to disentangle the cyclical from the structural slowdowns in labor force, investment, and productivity. Adding to this uncertainty, as research done at the Fed and elsewhere highlights, the distinction between cyclical and structural is not always clear cut and there are real risks that cyclical slumps can become structural; it may also be possible to reverse or prevent declines from becoming permanent through expansive macroeconomic policies. But three things are for sure: first, the rate of growth of productivity is critical to the growth of output per capita; second, the rate of growth of productivity at the frontiers of knowledge is especially difficult to predict; and third, it is unwise to underestimate human ingenuity. The severity of the Great Recession and its ongoing fallout, importantly including its influence on public opinion, has heightened the focus on the challenge of avoiding another such crisis. Indeed, financial sector reform proposals by groups such as the Basel Thirty were circulating within a few months of the Lehman Brothers' failure. Since then, policymakers, acting in their own countries and in coordination with others, have enacted financial sector regulatory reforms on a scale and scope not seen since the Great Designing, implementing, and understanding the consequences of these important reforms are major challenges for policymakers in a post-Global Financial Crisis world. Most of the initial proposals incorporated some or most of the following To strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"; To strengthen the quality and effectiveness of prudential regulation and supervision, with higher standards for systemically important firms; To build the capacity for undertaking effective macroprudential regulation and supervision; To develop suitable resolution regimes for financial institutions; To strengthen the infrastructure of financial markets, including markets for derivative transactions; To improve compensation practices in financial institutions; To strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs; To better monitor risks within the shadow banking system, and find ways of dealing with them; and To improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance. More than six years later, policymakers around the globe have made substantial progress in strengthening the financial system and reducing the probability of future financial crises. Globally, the minimum tier 1 capital ratio has been increased, and a capital conservation buffer has been put in place. In addition, a countercyclical capital buffer has been created that enables regulators to raise risk-based capital requirements when necessary, and a minimum international leverage ratio has been set. Finally, global systemically important banks will face a risk-based capital surcharge based on their systemic risk. Global bank regulators have also developed, for the first time, liquidity regulations designed to improve the funding durability and overall liquidity resiliency of internationally active banks. Additional steps have been taken in some countries. For example, in the United States, capital ratios and liquidity buffers at the largest banks are up considerably, and their reliance on short-term wholesale funding has declined considerably. Work on the use of the resolution mechanisms set out in the Dodd-Frank Act, based on the principle of a single point of entry--though less advanced than the work on capital and liquidity ratios--holds the promise of making it possible to resolve banks in difficulty at no direct cost to the taxpayer. As part of this approach, the United States is preparing a proposal to require systemically important banks to issue bail-inable long-term debt that will enable insolvent banks to recapitalize themselves in resolution without calling on government funding--this cushion is known as a "gone concern" buffer. At the same time, the introduction of macroeconomic supervisory stress tests in the United States has added a forward-looking approach to assessing capital adequacy, as firms are required to hold a capital buffer sufficient to withstand a several-year period of severe economic and financial stress. The stress tests are a very important addition to the toolkit of supervisors, one that is likely to add significantly to the quality and effectiveness of financial sector supervision, and one that should spread internationally as a best practice. Still, more remains to be done. Although the Basel Committee on Banking Supervision and the FSB reached impressively rapid agreement on needed changes in regulation and supervision, progress in agreeing on the resolution of G-SIFIs and some other aspects of international coordination has been slow. It will also be important to ensure that coordination among different regulators of the financial system is effective and, in particular, will be effective in the event of a crisis. In addition, policymakers still have a good deal to learn about how these various reforms will change financial market structure and functioning, how effective they will be in enhancing stability, and whether there will be unintended consequences. Among the most important of the possible unintended consequences is that toughened regulation of banks will move some financial activity out of the banking system and into the shadow banking system. In summary, considerable progress has been made in strengthening bank capital and liquidity; in improving the quality and effectiveness of prudential regulation and supervision; in developing suitable resolution regimes for financial institutions; and in strengthening the infrastructure for the clearing and trading of derivative contracts. It is clear that further progress is needed with respect to goals 6-9, relating respectively to: improving compensation practices; strengthening international coordination, especially with regard to the resolution and regulation of G-SIFIs; finding ways of dealing with the shadow banking system; and improving the quality of credit rating agencies. That leaves aside the question of the capacity for effective macroprudential supervision, an issue we will take up as we begin to discuss the optimal conduct of monetary policy in the wake of the crisis, given the heightened attention of monetary policymakers to the importance of maintaining financial stability. Prior to the global financial crisis, a rough consensus had emerged among academics and monetary policymakers that best-practice for monetary policy was flexible inflation targeting. In the U.S., flexible inflation targeting is implied by the dual mandate given to the Fed, under which monetary policy is required to take into account deviations of both output and inflation from their target levels. But even in countries where the central bank officially targets only inflation, monetary policymakers in practice also aim to stabilize the real economy around some normal level or path. Much has changed in the world of central banking since the onset of the Great Recession. With short-term interest rates near zero, many central banks considerably expanded their balance sheets, for instance through large-scale purchases of assets or significant liquidity injections. They also engaged in forward guidance to put downward pressure on interest rates and support aggregate demand. I consider quantitative easing to have been largely successful, and that data dependent forward guidance consistent with the central bank's expectations of its future intentions can also be successful. But the use of these tools--particularly as reflected in the size of central bank balance sheets--will make the conduct of monetary policy more complicated during the recovery. In the United States, we have a number of tools to control short-term rates, despite the large level of reserves in the system. Raising the rate of interest paid on excess reserves should play a central role in the eventual normalization of short-term interest rates. An overnight reverse repo facility could also play a useful part in setting a floor under money market rates. With these and other possible tools, we will be able to raise rates and maintain them near their targeted level at the appropriate time. Another important question is whether monetary policymakers should alter their basic framework of flexible inflation targeting to take financial stability into account. My answer to that question is that the "flexible" part of flexible inflation targeting should include contributing to financial stability, provided that it aids in the attainment of the main goals of monetary policy. The main goals in the United States are those of the dual mandate, maximum employment and stable prices; in other countries the main goal is stable prices or low inflation. What can the central bank do when financial stability is threatened? If it has effective macroprudential tools at its disposal, it can deploy those. If it does not itself have the authority to use such tools, it can try to persuade those who do have the tools to use them. If no such tools are available in the economy, the central bank may have to consider whether to use monetary policy--that is, the interest rate--to deal with the threat of financial instability. At the moment in the U.S., though there may be some areas of concern, I do not think that financial stability concerns warrant deviating from our traditional focus on inflation and employment. A decision on whether to use the interest rate to deal with the threat of financial instability is always likely to be difficult--particularly in a small open economy, where raising the interest rate is likely to produce an unwanted exchange rate appreciation. So a critical question must be whether effective macroprudential policies are to be found in the country in question. I had some experience with these issues while at the Bank of Israel. In Israel, three separate regulators deal with different aspects of macroprudential policy, but there is no formal financial stability committee. The Bank of Israel is also the supervisor of banks, so has considerable power over housing finance, which essentially is available only from the banks. Starting in 2010, the Bank of Israel adopted several macroprudential measures to address rapidly rising house prices, including higher capital requirements and provisioning against mortgages; limits to the share of any housing financing package indexed to the short-term (central bank) interest rate to one-third of the total loan, with the remainder of the package having to be linked to either the five-year real or five-year nominal interest rate; and, on different occasions, limits to the loan-to- were also implemented in the supervision of banks. The success of these policies was mixed. The limit of one-third on the share of any housing loan indexed to the short rate substantially raised the cost of housing finance and was the most successful of the measures. Increases in both the LTV and PTI ratios were moderately successful. Increasing capital charges and risk weights appeared to have little impact in practice. This experience led me to three conclusions on the effectiveness of macroprudential policies. First, we were very cautious in using these new tools because we did not have good estimates of their strength and effectiveness. Quite possibly, we should have acted more boldly on several occasions. Second, use of these tools is likely to be unpopular, for housing is a sensitive topic in almost every country. And third, coordination among different regulators and authorities can be complicated. The difficulty of coordinating among different independent regulators makes it likely that the degree to which macroprudential policies can be successful depends critically on the institutional setup of financial supervision in each country. Different countries have structured their macroprudential policymaking institutions in different ways. In the U.K., the Financial Policy Committee has been set up within the Bank of England, with the power to make financial policy--including macroprudential policy-- committee of the major regulators. And in Sweden, responsibility for macroprudential oversight and financial stability lies with the Financial Supervisory Authority, which is separate from the Riksbank. Overall, it is clear that we have much to learn about both the effectiveness of different macroprudential measures, and about the best structure of the regulatory system from the viewpoint of implementing strong and effective macroprudential supervision and regulation. And, while there may arise situations where monetary policy needs to be used to deal with potential financial instability, I believe that macroprudential policies will become an important complement to our traditional tools. Learning how best to employ all of our potential policy tools, and arrive at a new set of best practices for monetary policy, is one of the key challenges facing economic policymakers. As we continue to move forward in the aftermath of the global financial crisis and the Great Recession, policymakers around the world are dealing with new challenges that these historically important events have raised. In addition to the difficulties of assessing the relative importance of cyclical (short-term) versus structural (long-term) factors affecting the global economy, and in thinking about how to return to higher output and productivity growth, policymakers are focusing on the uses of monetary policy in attaining the dual goals of maximum employment and stable prices and in maintaining financial stability. They need also to strengthen financial sector regulation and supervision to reduce the probability of another crisis. At the same time, and although I earlier foreswore discussion of fiscal policy, it is clear that fiscal policies can be used both to increase growth and to deal with potential problems of financial stability. I look forward to hearing your views on the best way to move ahead on these and the other important issues we have gathered to discuss. Thank you.

r140822a_FOMC

united states

Labor Market Dynamics and Monetary Policy

yellen

In the five years since the end of the Great Recession, the economy has made considerable progress in recovering from the largest and most sustained loss of employment in the United States since the Great Depression. More jobs have now been created in the recovery than were lost in the downturn, with payroll employment in May of this year finally exceeding the previous peak in January 2008. Job gains in 2014 have averaged 230,000 a month, up from the 190,000 a month pace during the preceding two years. The unemployment rate, at 6.2 percent in July, has declined nearly 4 percentage points from its late 2009 peak. Over the past year, the unemployment rate has fallen considerably, and at a surprisingly rapid pace. These developments are encouraging, but it speaks to the depth of the damage that, five years after the end of the recession, the labor market has yet to fully recover. The Federal Reserve's monetary policy objective is to foster maximum employment and price stability. In this regard, a key challenge is to assess just how far the economy now stands from the attainment of its maximum employment goal. Judgments concerning the size of that gap are complicated by ongoing shifts in the structure of the labor market and the possibility that the severe recession caused persistent changes in the labor market's functioning. These and other questions about the labor market are central to the conduct of monetary policy, so I am pleased that the organizers of this year's symposium chose labor market dynamics as its theme. My colleagues on the Federal Open Market Committee (FOMC) and I look to the presentations and discussions over the next two days for insights into possible changes that are affecting the labor market. I expect, however, that our understanding of labor market developments and their potential implications for inflation will remain far from perfect. As a consequence, monetary policy ultimately must be conducted in a pragmatic manner that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy. In my remarks this morning, I will review a number of developments related to the functioning of the labor market that have made it more difficult to judge the remaining degree of slack. Differing interpretations of these developments affect judgments concerning the appropriate path of monetary policy. Before turning to the specifics, however, I would like to provide some context concerning the role of the labor market in shaping monetary policy over the past several years. During that time, the FOMC has maintained a highly accommodative monetary policy in pursuit of its congressionally mandated goals of maximum employment and stable prices. The Committee judged such a stance appropriate because inflation has fallen short of our 2 percent objective while the labor market, until recently, operated very far from any reasonable definition of maximum employment. The FOMC's current program of asset purchases began when the unemployment rate stood at 8.1 percent and progress in lowering it was expected to be much slower than desired. The Committee's objective was to achieve a substantial improvement in the outlook for the labor market, and as progress toward this goal has materialized, we have reduced our pace of asset purchases and expect to complete this program in October. In addition, in December 2012, the Committee modified its forward guidance for the federal funds rate, stating that "as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored," the Committee would not even consider raising the federal funds rate above the 0 to 1/4 percent range. based" forward guidance was deemed appropriate under conditions in which inflation was subdued and the economy remained unambiguously far from maximum employment. Earlier this year, however, with the unemployment rate declining faster than had been anticipated and nearing the 6-1/2 percent threshold, the FOMC recast its forward guidance, stating that "in determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee would assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent As the recovery progresses, assessments of the degree of remaining slack in the labor market need to become more nuanced because of considerable uncertainty about the level of employment consistent with the Federal Reserve's dual mandate. Indeed, in its 2012 statement on longer-run goals and monetary policy strategy, the FOMC explicitly recognized that factors determining maximum employment "may change over time and may not be directly measurable," and that assessments of the level of maximum employment "are necessarily uncertain and subject to revision." Accordingly, the reformulated forward guidance reaffirms the FOMC's view that policy decisions will not be based on any single indicator, but will instead take into account a wide range of information on the labor market, as well as inflation and financial developments. The assessment of labor market slack is rarely simple and has been especially challenging recently. Estimates of slack necessitate difficult judgments about the magnitudes of the cyclical and structural influences affecting labor market variables, including labor force participation, the extent of part-time employment for economic reasons, and labor market flows, such as the pace of hires and quits. A considerable body of research suggests that the behavior of these and other labor market variables has changed since the Great Recession. Along with cyclical influences, significant structural factors have affected the labor market, including the aging of the workforce and other demographic trends, possible changes in the underlying degree of dynamism in the labor market, and the phenomenon of "polarization"--that is, the reduction in the relative number of middle-skill jobs. Consider first the behavior of the labor force participation rate, which has declined substantially since the end of the recession even as the unemployment rate has fallen. As a consequence, the employment-to-population ratio has increased far less over the past several years than the unemployment rate alone would indicate, based on past experience. For policymakers, the key question is: What portion of the decline in labor force participation reflects structural shifts and what portion reflects cyclical weakness in the labor market? If the cyclical component is abnormally large, relative to the unemployment rate, then it might be seen as an additional contributor to labor market slack. Labor force participation peaked in early 2000, so its decline began well before the Great Recession. A portion of that decline clearly relates to the aging of the baby boom generation. But the pace of decline accelerated with the recession. As an accounting matter, the drop in the participation rate since 2008 can be attributed to increases in four factors: retirement, disability, school enrollment, and other reasons, including worker discouragement. Of these, greater worker discouragement is most directly the result of a weak labor market, so we could reasonably expect further increases in labor demand to pull a sizable share of discouraged workers back into the workforce. Indeed, the flattening out of the labor force participation rate since late last year could partly reflect discouraged workers rejoining the labor force in response to the significant improvements that we have seen in labor market conditions. If so, the cyclical shortfall in labor force participation may have diminished. What is more difficult to determine is whether some portion of the increase in disability rates, retirements, and school enrollments since the Great Recession reflects cyclical forces. While structural factors have clearly and importantly affected each of these three trends, some portion of the decline in labor force participation resulting from these trends could be related to the recession and slow recovery and therefore might reverse in a stronger labor market. Disability applications and educational enrollments typically are affected by cyclical factors, and existing evidence suggests that the elevated levels of both may partly reflect perceptions of poor job prospects. Moreover, the rapid pace of retirements over the past few years might reflect some degree of pull-forward of future retirements in the face of a weak labor market. If so, retirements might contribute less to declining participation in the period ahead than would otherwise be expected based on the aging workforce. A second factor bearing on estimates of labor market slack is the elevated number of workers who are employed part time but desire full-time work (those classified as "part time for economic reasons"). At nearly 5 percent of the labor force, the number of such workers is notably larger, relative to the unemployment rate, than has been typical historically, providing another reason why the current level of the unemployment rate may understate the amount of remaining slack in the labor market. Again, however, some portion of the rise in involuntary part-time work may reflect structural rather than cyclical factors. For example, the ongoing shift in employment away from goods production and toward services, a sector which historically has used a greater portion of part-time workers, may be boosting the share of part-time jobs. Likewise, the continuing decline of middle-skill jobs, some of which could be replaced by part-time jobs, may raise the share of part-time jobs in overall employment. Despite these challenges in assessing where the share of those employed part time for economic reasons may settle in the long run, the sharp run-up in involuntary part-time employment during the recession and its slow decline thereafter suggest that cyclical factors are significant. Private sector labor market flows provide additional indications of the strength of the labor market. For example, the quits rate has tended to be pro-cyclical, since more workers voluntarily quit their jobs when they are more confident about their ability to find new ones and when firms are competing more actively for new hires. Indeed, the quits rate has picked up with improvements in the labor market over the past year, but it still remains somewhat depressed relative to its level before the recession. A significant increase in job openings over the past year suggests notable improvement in labor market conditions, but the hiring rate has only partially recovered from its decline during the recession. Given the rise in job vacancies, hiring may be poised to pick up, but the failure of hiring to rise with vacancies could also indicate that firms perceive the prospects for economic growth as still insufficient to justify adding to payrolls. Alternatively, subdued hiring could indicate that firms are encountering difficulties in finding qualified job applicants. As is true of the other indicators I have discussed, labor market flows tend to reflect not only cyclical but also structural changes in the economy. Indeed, these flows may provide evidence of reduced labor market dynamism, which could prove quite persistent. That said, the balance of evidence leads me to conclude that weak aggregate demand has contributed significantly to the depressed levels of quits and hires during the recession and in the recovery. One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions. Finally, changes in labor compensation may also help shed light on the degree of labor market slack, although here, too, there are significant challenges in distinguishing between cyclical and structural influences. Over the past several years, wage inflation, as measured by several different indexes, has averaged about 2 percent, and there has been little evidence of any broad-based acceleration in either wages or compensation. Indeed, in real terms, wages have been about flat, growing less than labor productivity. This pattern of subdued real wage gains suggests that nominal compensation could rise more quickly without exerting any meaningful upward pressure on inflation. And, since wage movements have historically been sensitive to tightness in the labor market, the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate. There are three reasons, however, why we should be cautious in drawing such a conclusion. First, the sluggish pace of nominal and real wage growth in recent years may reflect the phenomenon of "pent-up wage deflation." The evidence suggests that many firms faced significant constraints in lowering compensation during the recession and the earlier part of the recovery because of "downward nominal wage rigidity"--namely, an inability or unwillingness on the part of firms to cut nominal wages. To the extent that firms faced limits in reducing real and nominal wages when the labor market was exceptionally weak, they may find that now they do not need to raise wages to attract qualified workers. As a result, wages might rise relatively slowly as the labor market strengthens. If pent-up wage deflation is holding down wage growth, the current very moderate wage growth could be a misleading signal of the degree of remaining slack. Further, wages could begin to rise at a noticeably more rapid pace once pent-up wage deflation has been absorbed. Second, wage developments reflect not only cyclical but also secular trends that have likely affected the evolution of labor's share of income in recent years. As I noted, real wages have been rising less rapidly than productivity, implying that real unit labor costs have been declining, a pattern suggesting that there is scope for nominal wages to accelerate from their recent pace without creating meaningful inflationary pressure. However, research suggests that the decline in real unit labor costs may partly reflect secular factors that predate the recession, including changing patterns of production and international trade, as well as measurement issues. If so, productivity growth could continue to outpace real wage gains even when the economy is again operating at its potential. A third issue that complicates the interpretation of wage trends is the possibility that, because of the dislocations of the Great Recession, transitory wage and price pressures could emerge well before maximum sustainable employment has been reached, although they would abate over time as the economy moves back toward maximum employment. The argument is that workers who have suffered long-term unemployment--along with, perhaps, those who have dropped out of the labor force but would return to work in a stronger economy--face significant impediments to reemployment. In this case, further improvement in the labor market could entail stronger wage pressures for a time before maximum employment has been attained. The focus of my remarks to this point has been on the functioning of the labor market and how cyclical and structural influences have complicated the task of determining the state of the economy relative to the FOMC's objective of maximum employment. In my remaining time, I will turn to the special challenges that these difficulties in assessing the labor market pose for evaluating the appropriate stance of monetary policy. Any discussion of appropriate monetary policy must be framed by the Federal Reserve's dual mandate to promote maximum employment and price stability. For much of the past five years, the FOMC has been confronted with an obvious and substantial degree of slack in the labor market and significant risks of slipping into persistent below- target inflation. In such circumstances, the need for extraordinary accommodation is unambiguous, in my view. However, with the economy getting closer to our objectives, the FOMC's emphasis is naturally shifting to questions about the degree of remaining slack, how quickly that slack is likely to be taken up, and thereby to the question of under what conditions we should begin dialing back our extraordinary accommodation. As should be evident from my remarks so far, I believe that our assessments of the degree of slack must be based on a wide range of variables and will require difficult judgments about the cyclical and structural influences in the labor market. While these assessments have always been imprecise and subject to revision, the task has become especially challenging in the aftermath of the Great Recession, which brought nearly unprecedented cyclical dislocations and may have been associated with similarly unprecedented structural changes in the labor market--changes that have yet to be fully understood. So, what is a monetary policymaker to do? Some have argued that, in light of the uncertainties associated with estimating labor market slack, policymakers should focus mainly on inflation developments in determining appropriate policy. To take an extreme case, if labor market slack was the dominant and predictable driver of inflation, we could largely ignore labor market indicators and look instead at the behavior of inflation to determine the extent of slack in the labor market. In present circumstances, with inflation still running below the FOMC's 2 percent objective, such an approach would suggest that we could maintain policy accommodation until inflation is clearly moving back toward 2 percent, at which point we could also be confident that slack had diminished. Of course, our task is not nearly so straightforward. Historically, slack has accounted for only a small portion of the fluctuations in inflation. Indeed, unusual aspects of the current recovery may have shifted the lead-lag relationship between a tightening labor market and rising inflation pressures in either direction. For example, as I discussed earlier, if downward nominal wage rigidities created a stock of pent-up wage deflation during the economic downturn, observed wage and price pressures associated with a given amount of slack or pace of reduction in slack might be unusually low for a time. If so, the first clear signs of inflation pressure could come later than usual in the progression toward maximum employment. As a result, maintaining a high degree of monetary policy accommodation until inflation pressures emerge could, in this case, unduly delay the removal of accommodation, necessitating an abrupt and potentially disruptive tightening of policy later on. Conversely, profound dislocations in the labor market in recent years--such as depressed participation associated with worker discouragement and a still-substantial level of long-term unemployment--may cause inflation pressures to arise earlier than usual as the degree of slack in the labor market declines. However, some of the resulting wage and price pressures could subsequently ease as higher real wages draw workers back into the labor force and lower long-term unemployment. As a consequence, tightening monetary policy as soon as inflation moves back toward 2 percent might, in this case, prevent labor markets from recovering fully and so would not be consistent with the dual mandate. Inferring the degree of resource utilization from real-time readings on inflation is further complicated by the familiar challenge of distinguishing transitory price changes from persistent price pressures. Indeed, the recent firming of inflation toward our 2 percent goal appears to reflect a combination of both factors. These complexities in evaluating the relationship between slack and inflation pressures in the current recovery are illustrative of a host of issues that the FOMC will be grappling with as the recovery continues. There is no simple recipe for appropriate policy in this context, and the FOMC is particularly attentive to the need to clearly describe the policy framework we are using to meet these challenges. As the FOMC has noted in its recent policy statements, the stance of policy will be guided by our assessments of how far we are from our objectives of maximum employment and 2 percent inflation as well as our assessment of the likely pace of progress toward those objectives. At the FOMC's most recent meeting, the Committee judged, based on a range of labor market indicators, that "labor market conditions improved." Indeed, as I noted earlier, they have improved more rapidly than the Committee had anticipated. Nevertheless, the Committee judged that underutilization of labor resources still remains significant. Given this assessment and the Committee's expectation that inflation will gradually move up toward its longer-run objective, the Committee reaffirmed its view "that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored." But if progress in the labor market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter. Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate. As I have noted many times, monetary policy is not on a preset path. The Committee will be closely monitoring incoming information on the labor market and inflation in determining the appropriate stance of monetary policy. Overall, I suspect that many of the labor market issues you will be discussing at this conference will be at the center of FOMC discussions for some time to come. I thank you in advance for the insights you will offer and encourage you to continue the important research that advances our understanding of cyclical and structural labor market issues.

r140904a_FOMC

united states

Reforming U.S. Dollar LIBOR: The Path Forward

powell

Thank you for giving me this opportunity to speak this evening. I would like to discuss ongoing efforts to reform the current structure and uses of the London Interbank Offered Rate, commonly referred to as LIBOR. These reforms affect not only the financial industry, but also a large number of U.S. households and corporations. LIBOR is a reference rate. When two parties enter a financial contract in which interest payments are to be exchanged, they frequently choose to base those payments on LIBOR. LIBOR is currently referenced in roughly $300 trillion worth of contracts globally, which means that it is part of the global financial system's critical infrastructure. But LIBOR's credibility was badly undermined by the scandal that erupted when some of the banks that help produce the rate attempted to manipulate it by contributing inaccurate estimates of their borrowing costs. These illegal actions helped damage the public's trust not just in LIBOR, but also in financial markets and institutions more broadly. In response, a number of global efforts to reform reference rates have been undertaken. LIBOR is produced and administered in London. As a result of the steps taken by the government of the United Kingdom, LIBOR is now regulated and that reference rates and other financial benchmarks are now expected to meet. on this work, in July, the Financial Stability Board (FSB) released a report outlining a number of further reform proposals. Continuing the work of my former Fed colleague Jeremy Stein, I recently took over as co-chair--along with Martin Wheatley, chief executive officer of the FCA--of the international group that drafted the report and is now charged with implementing its recommendations. Today I will discuss the reasons why further reforms are necessary and how those reforms should proceed, and I will focus on As is made clear in the FSB report, while the goals and principles of the official sector participants are uniform, specific plans for reference rate reform will vary by currency, depending on differences in markets and institutions. I will share my conclusion at the outset. While there have been significant reforms, much remains to be done. First, U.S. dollar LIBOR needs to be updated to reflect current practices in unsecured funding markets and to be better anchored in actual transactions. Second, and equally important, regulators need to work with market participants to encourage them to develop and adopt alternative reference rates that better reflect the current structure of U.S. financial markets, in which borrowing and derivatives transactions are much more likely to be secured with collateral. Going forward, these alternative rates could replace LIBOR as the reference rate for new interest rate derivatives and some other contracts denominated in U.S. dollars. These dual transitions will need to be managed very carefully to avoid disrupting the financing markets on which borrowers and lenders depend. But I believe that they are crucial to strengthening the stability of our financial system and to helping restore the public's faith in its integrity. This problem is not just Wall Street's concern; every household with a LIBOR- linked mortgage and every corporation with a LIBOR-linked loan has an interest in more robust U.S. dollar reference rates. I will take a few moments to explain the basic mechanics of LIBOR for those who have not spent time on an interest rate swap desk. For almost three decades, LIBOR was run by the British Bankers' Association. Just a few months ago, a private corporation administration of the rate subject to the regulation and supervision of the FCA. Today, 18 banks participate in the panel that contributes to the production of U.S. dollar LIBOR. Each morning at 11 a.m. London time, those banks estimate the rate at which they could borrow at several different maturities ranging from overnight up to a year, and they send those estimates to IBA. It is often the case that banks have recent transactions at some but not all of these maturities. Where there are no transactions, they submit estimates of their borrowing costs based on their judgment. In addition to U.S. dollar LIBOR, the rate is produced in four other currencies--the euro, the yen, the British pound, and the Swiss franc--although not all banks contribute rates in all currencies. The administrator provides specific instructions to the panel banks regarding their submissions; currently, these instructions direct banks to reflect the perceived rate at which they could borrow from another bank. The administrator collects these submissions and, after dropping the highest and lowest quartiles at each maturity, publishes an average of the remaining submissions as the U.S. dollar LIBOR rate for that day. When the British Bankers' Association standardized LIBOR in the 1980s for use in interest rate products, I doubt that anyone could have imagined how pervasive it would eventually become. As I mentioned, there are an estimated $300 trillion in LIBOR contracts, roughly half which reference dollar LIBOR. In the United States, dollar LIBOR is the reference rate used in most interest rate swaps and futures contracts, in most floating-rate mortgages, in many commercial loans, and in structured products such as mortgage- and asset-backed securities. The list could go on and on, but the key point is that LIBOR touches a large number of U.S. households and businesses. Although LIBOR is currently used for all of these purposes, it is actually not ideally suited for some of them. LIBOR is designed to measure the costs of bank borrowing for a panel of large banks. The rate can be decomposed into a component that reflects the general level of risk-free rates and a component that reflects a risk premium related to the credit risk of the borrowing bank. During the global financial crisis, the credit risk component of LIBOR fluctuated dramatically, which meant that LIBOR behaved quite differently from rates with no credit risk embedded in them, such as risk- free rates. LIBOR is a less-than-ideal rate for most derivatives contracts and secured borrowing because movements in the credit risk component do not reflect well the underlying risks of those contracts. However, LIBOR's pervasiveness has become self- reinforcing. Firms use LIBOR in contracts, even when it is less than ideal, because they know they can hedge the resulting risk using highly liquid, LIBOR-based interest rate swaps or other derivatives contracts. And those derivatives markets are so liquid because most market participants use LIBOR as the reference rate in their financial contracts. Because of the progression of this dynamic over time, and not because of some careful design, LIBOR has spread well beyond its intended uses and become an important pillar of the global financial system--perhaps too important. In recent years, two separate developments have called into question the wisdom of that arrangement. I have already mentioned the first one--the emergence of a pervasive pattern of attempted manipulation of LIBOR dating back many years. This misconduct was designed either to increase the potential profit of the submitting firms or to convey a misleading picture of the relative health of such firms. Since 2012, seven financial institutions have settled related charges with the U.S. Commodity Futures Trading Commission and the U.S. Department of Justice, and the cumulative penalties and fines paid in the United States now stand at more than $3 billion. Global penalties paid related to benchmark misconduct exceed $6 billion as investigations into reference rate manipulation continue. Although these penalties and fines are themselves substantial, to my mind the longer-term damage to the public's trust represents the greater cost of this misconduct. A second problem is that unsecured interbank borrowing has been in a secular decline that predates the global financial crisis. Changes in bank behavior following the crisis exacerbated the decline and further weakened the foundation of LIBOR. The result is a scarcity, or outright absence in longer tenors, of actual transactions that banks can use to estimate their daily submission to LIBOR. Ongoing regulatory reforms and the shift away from unsecured funding raise the possibility that unsecured interbank borrowing transactions may become even more infrequent in the future. While it is also possible that activity in these markets could rebound, the threat that this form of borrowing may decline further, particularly in periods of stress, seems likely to remain. So let me pose a question: Is it wise to rely on a critical benchmark that is built on a market in decline? Clearly not. The risks to market functioning are simply too great. For example, market activity could decline to the point where publication of a rate becomes untenable. And many of the panel banks have expressed concerns about the ongoing legal risks of remaining on the panel. If the publication of LIBOR were to become untenable or if we were to simply "end LIBOR," as some have urged, untangling the $150 trillion in outstanding U.S. dollar LIBOR contracts would entail a protracted, expensive, and uncertain process of negotiating amendments to an enormous number of complex documents--a horrible mess and a feast for the legal profession, to be sure. It does not help matters that the hundreds of trillions of dollars' worth of derivatives contracts referencing LIBOR do not, in general, have robust backups in the event that publication of a rate ceases. The FSB report identifies ways to improve U.S. dollar LIBOR, and to create alternatives to it, while minimizing transition costs, particularly for end users who bear no blame for the misconduct. The proposed reforms come down to two simple ideas. First, U.S. dollar LIBOR needs to be redefined to include a broader range of transaction types. Doing so will make it more robust and will allow it to reflect actual bank funding costs, which is what the rate was intended to do in the first place. Second, we need to promote robust alternatives to U.S. dollar LIBOR that better reflect the secured nature of many of today's financial market transactions. Let me first address the efforts the Federal Reserve is considering, in cooperation with the LIBOR administrator and U.K. authorities, to update the mechanics of U.S. dollar LIBOR. Our aim is to make LIBOR more robust and more representative of current bank funding costs. In this regard, we have considered two important attributes of LIBOR--its definition and the data used to produce it. While the current definition of LIBOR is limited to unsecured borrowing between banks, LIBOR is actually intended to represent the overall cost of banks' unsecured borrowing. At the time LIBOR was created, a substantial amount of that unsecured borrowing was in the interbank market, but that is no longer the case. Broadening the definition to include the unsecured borrowing from nonbanks would make the rate more representative of current funding practices. Changing the definition of LIBOR, as has been done in the past, would acknowledge the fact that a reference rate must adapt to continue to represent what it is meant to measure. Updating the definition of U.S. dollar LIBOR could also allow other sources of transactions data to be incorporated into it. Potentially, we could even move away from the current panel-based method of calculating U.S. dollar LIBOR to a rate that is fully transactions based. In April, the Federal Reserve began collecting data from banks on a variety of unsecured transactions. These data, along with other available data, will help us understand whether there is enough borrowing activity to support a fully transactions- based rate. It will take some time to assess these data and, in particular, to analyze the depth of the markets under different conditions and during different times of the year. But preliminary analysis, which is reinforced by research done by the Market Participants Group (MPG) that was assembled by the FSB, suggests that there may be enough borrowing activity to create a transactions-based U.S. dollar LIBOR rate. Basing U.S. dollar LIBOR more on transactions could modestly increase the volatility of the rate. However, I see nothing wrong with a reference rate that more accurately reflects the volatility of the market it represents. We are working closely with the LIBOR administrator, IBA, and with its regulator, FCA, to explore these issues. In this regard, cooperation with IBA is crucial if LIBOR is to be strengthened--U.S. dollar LIBOR is produced in the United Kingdom and is not regulated here in the United States. The IOSCO review found that IBA has made progress in implementing most of the IOSCO principles; the changes I have discussed are designed to continue this progress, and I believe that IBA is well motivated to continue its efforts. Improving U.S. dollar LIBOR alone cannot eliminate all of the weaknesses in the current system. In the FSB's opinion and that of the MPG, a large portion of the derivatives that currently reference U.S. dollar LIBOR would be better served by referencing a risk-free (or nearly risk-free) rate based on a robust and liquid underlying market. These transactions are more appropriately linked to a narrower measure of interest rates that does not include a bank credit risk component. Encouraging alternatives that better reflect today's funding markets would also allow for greater choice, increase the resilience of the system, and would potentially make hedging of some risks less costly. In addition, the incentive to manipulate LIBOR would be substantially reduced if a smaller share of the multi-hundred-trillion-dollar derivatives market was referencing it. Some possible alternatives include rates based on the U.S. Treasury market or rates based on the secured funding markets that have replaced much of the borrowing banks used to do in the unsecured interbank market. The Federal Reserve is not seeking to dictate the particular rate that financial markets adopt. Instead, we will encourage key market participants to further the work done by the FSB's MPG by narrowing down the list of alternatives and developing them into robust reference rates that meet agreed-upon international standards and best practices. There are enough suggestions on the MPG's list to inspire confidence that we should be able to find common ground. Any alternative would, of course, need to be in accord with the IOSCO principles mentioned earlier, and some potential alternatives would take time to fully develop. But the establishment of alternative reference rates for certain products is in our shared interests and would substantially strengthen the financial system. We are strongly committed that at least one such rate be developed and actively used as soon as practicable. And we look forward to working with financial institutions and other market participants to achieve this end. In the near term, the Federal Reserve, along with other government agencies, intends to meet with a wide range of market participants, including end users, to hear their views as to how change can be effected and to begin the work of developing alternatives to LIBOR. Later this year, we will convene a group of the largest global dealers to discuss these issues, following a model that was successfully used to promote derivatives reform. Searching for potential alternative rates and encouraging their use will be a key point of that discussion. Of course, end users will be affected by these changes as well, and we will also consult closely with key participants outside of the dealer community to make sure that reform meets their needs and is not disruptive to them. In particular, end users who want to continue to use LIBOR will certainly be able to do so, and we will work toward the goal of ensuring that any changes to LIBOR will not require borrowers or lenders to amend their existing contracts. And the markets that reference dollar LIBOR are so enormous that there will surely be more than enough liquidity to support both a new risk free rate as well as LIBOR itself. One of the lessons that I take from our study of LIBOR is that these existing legacy contracts are quite important. As I mentioned earlier, many financial contracts, including derivatives contracts, do not have robust backups in the event that the reference rates they use cease to exist. Some derivatives, such as interest rate swaps, can be quite long lasting, and, over a long enough period of time, there is always a risk that any given reference rate will cease being published. It is important that financial contracts address the need for a backup plan if a reference rate does cease to function. This issue is something that we intend to bring up with market participants and end users as we meet with them. My hope is that governments, market participants, and end users can work together to build a stronger foundation for the reference interest rates that are so critical to our financial system. Implementation of these measures is clearly in the interest of U.S. financial stability. I also hope and expect that individual financial institutions will understand that it is also in their private interests. Reference rates are one of the foundations of the financial system, and it is in the interest of everyone, from the residential mortgage holder to the financial institutions that heavily use these rates, that those foundations have integrity and be well constructed and resistant to manipulation. As I said at the beginning, the problems with LIBOR have undermined the public's trust in the financial system. In light of the need to regain that trust, I am certain that our reform efforts will meet with the active cooperation of financial institutions in carrying forward these reforms.

r140918a_FOMC

united states

The Importance of Asset Building for Low and Middle Income Households

yellen

Thank you for this opportunity to show my support for the work all of you do on asset-building, and to say a few words on this vitally important topic. The financial crisis and the Great Recession demonstrated, in a dramatic and unmistakable manner, how extraordinarily vulnerable are the large share of American families with very few assets to fall back on. We have come far from the worst moments of the crisis, and the economy continues to improve. But the effects of the recession are still being felt by many families, particularly those that had very little in savings and other assets beforehand. To help make this point, I'd like to cite a few numbers from the Federal Reserve's Survey of Consumer Finances, published earlier this month. The Survey is conducted every three years and this new edition provides one of the first good looks at how families in different economic circumstances have fared in the recovery. For lower-income families, what we find is sobering. The median net worth reported by the bottom fifth of households by income was only $6,400 in 2013. Among this group, representing about 25 million American households, many families had no wealth or had negative net worth. The next fifth of households by income had median net worth of just $27,900. These numbers represent declines from 2010. One reason is that income has continued to fall for these families. Another likely reason for this decline in net worth is the lingering effects of the housing crisis. Home equity accounts for the lion's share of wealth for most families and many of these families have not yet recovered the wealth they lost in the housing crisis. The housing market is improving and housing will remain an important channel for asset building for lower and middle income families. But one of the lessons of the crisis, which will not be news to many of you, is the importance of diversification and especially of possessing savings and other liquid financial assets to fall back in times of economic distress. Yet for lower and middle income families, financial assets, including 401 (k) plans and pensions, are still a very small share of their assets. According to the 2013 survey, the bottom half of families by income held only 8 percent of all financial assets held by households. A larger lesson from the financial crisis, of course, is how important it is to promote asset-building, including saving for a rainy day, as protection from the ups and downs of the economy. I surely hope that our nation will not face another crisis anytime soon as severe as the one we recently experienced. But for many lower-income families without assets, the definition of a financial crisis is a month or two without a paycheck, or the advent of a sudden illness or some other unexpected expense. Families with assets to draw on are able to deal with these developments as bumps in the road. Families without these assets can end up, very suddenly, off the road. According to the Board's recent Survey of Household Economics and Decisionmaking, an unexpected expense of just $400 would prompt the majority of households to borrow money, sell something, or simply not pay at all. The Federal Reserve's mission is to promote a healthy economy and strong financial system, and that is why we have promoted and will continue to promote asset- building. One way we do this is through the Community Development programs at each and Community Affairs in Washington. As a research institution, and a convener of stakeholders involved in community development, I believe the Fed can help you in carrying out your mission, to encourage families to take the small steps that over time can lead to the accumulation of considerable assets. Thank you for the chance to be a small part of this conference, and for your commitment to a cause that I strongly support.

r140923a_FOMC

united states

Introductory Remarks

powell

It is a pleasure for me to join Jim Bullard and John Ryan in welcoming all of you to the second annual Community Banking Research and Policy Conference, co-sponsored by the addressing the inaugural community banking conference held here last year, and as chairman of delighted to return to this venue to participate in this year's event. As all of you surely know, community banks play a vital role in America's financial system, providing essential services to households, small businesses, and small farms in communities throughout the country. Community banks differ from their larger cousins, not just in size, but in the fundamental focus of their business. Community bankers' primary objective is to serve the members of their local communities, who are not only their customers but also their neighbors and friends. They have strong links to the people and businesses that reside in their communities, as well as direct knowledge of local economic conditions. These close ties give community bankers a clear advantage in understanding local needs and tailoring their products and services to meet those needs. I will confess that I have never worked at a community bank; however, I have been a community bank customer, and in that role I have had personal experience interacting with bankers whose mission is to provide high quality of service to every customer who walks in the door. Despite the advantages that I just mentioned, life is not always easy for community bankers. The number of community banks in the United States has declined sharply over the past three decades, due to a combination of failures and acquisitions. And many remaining community banks have struggled to survive, especially during the last five or six years. Although improving overall economic conditions have begun to provide some relief to these struggling banks, they continue to face significant challenges. The burden of regulatory compliance can be particularly daunting for small banks. And competition, from large banks and credit unions as well as other nonbank financial service providers, is always a concern. My colleagues on the Federal Reserve Board and I are committed to making sure that we understand the challenges faced by community banks. One way that we further our understanding is by talking to the bankers themselves. The entire Board of Governors meets twice a year with the Community Depository Institutions Advisory Council, which includes representatives of community banks, thrifts, and credit unions in each of the 12 Federal Reserve Individual governors also take advantage of opportunities to meet with community bankers from time to time. During last year's conference I met with a group of St. Louis area community bankers to hear what was on their minds. I will conduct a nationwide webinar with community bankers next month. In fact, I speak regularly to a number of bank executives, including those who run smaller institutions. I find these types of conversations--with people who live and work in the world outside the Capital Beltway and far from Wall Street--to be particularly enlightening. And, of course, this conference, which was conceived as the result of a successful collaboration between the Federal Reserve System and the Conference of State Bank Supervisors, provides an annual opportunity for community bankers, bank regulators, and academic researchers to come together to share ideas and insights surrounding the issues that matter most to community bankers. This year's program includes presentations by the authors of a number of excellent academic research papers, the unveiling of the results of a new survey of community banks conducted on behalf of the conference organizers, reactions by community bankers to the research and survey findings, and several compelling speeches. The primary focus of today's agenda is research. The response to the conference's call for papers was quite impressive, and the conference research committee faced the challenging task of selecting the most relevant, interesting, and high-quality papers to be included in the program. The authors of these papers include academics and policymakers, with backgrounds in law, economics, and finance. The topics covered clearly demonstrate a desire, on the part of the researchers, to promote a deeper understanding of what makes community banks tick and of how a wide range of government policies affects the activities, profitability, and viability of community banks. The first session considers factors underlying community bank formation, behavior, and performance. The first paper looks at characteristics of newly chartered banks--where they form, and how they fare over time. The second paper also focuses on newly chartered banks, considering possible explanations for the near absence of new bank charters over the past few years. Those of us at the Fed pay a great deal of attention to this type of bank formation, because it is the primary source of new competition in the markets in which community banks compete. The third paper in this session looks at how rivalry among banks affects their decisions to adopt new technology, and the fourth seeks to explain the persistence of low net-interest income among community banks in recent years. The second session addresses the effects, both intended and unintended, of specific government policies on community bank behavior. One paper looks at how the 2006 commercial real estate guidance for banks affected loan growth. Another paper examines the effect of the creation of the Small Business Lending Fund on community bank lending to small businesses. The third paper in this session focuses on what happens when banks perceive that examiners have given them inappropriately negative evaluations. The underlying theme of the third research session is how broad government policies affect community bank profitability and viability. The first paper provides an overview of the banks. The second paper considers whether a provision of the JOBS Act that modified the threshold for Exchange Act reporting for unlisted banks and bank holding companies helped or hurt small banks. The third paper contrasts the thousands of small community banks operating in the United States with the handful of very large financial institutions and proposes a new approach to regulation that recognizes the very different business models of these two types of institutions. The fourth and final paper takes a high-level look at the effects of regulatory policy on the structure of the U.S. banking system and the viability of community banks. On day two of the conference, you will learn about the results of a recently conducted survey that was completed by more than 1,000 community bankers from across the country, as well as the feedback obtained from more than 1,300 bankers participating in town hall meetings hosted by state bank commissioners in 30 states. The presentation of these findings will be followed by a panel discussion by a select group of community banking experts. I hope I have succeeded in whetting your appetite for the sessions that lie ahead, and I encourage you to make the most of this unique opportunity to interact with bankers, regulators, and researchers who share a common interest in the future of community banking.

r140930a_FOMC

united states

Remarks on "Government Debt Management at the Zero Lower Bound"

powell

Thank you for the opportunity to be here today. Given my role at the Federal Reserve, I am not in a position to comment on debt management policy. I would like to begin by complimenting the authors of this highly interesting paper for their systematic approach to thinking about a wide-ranging and difficult set of issues. After a period during which the Treasury's debt management needs dominated Federal Reserve policies, the Fed began to regain its independence with the Treasury-Fed Accord of 1951. Since the 1970s, there has been little or no coordination between the two institutions over debt management. This paper argues that the extraordinary response to the global financial crisis brought about a conflict between debt management and monetary policy that should have been avoided through collaboration. The paper proposes a regime in which the Treasury and the Fed would cooperate around debt management at all times and would fully collaborate in the case in which the monetary policy rate is pinned at the zero lower bound. As a policymaker, I bring a degree of skepticism to a proposal to make major changes to institutional arrangements that seem to me to have served the public well. I will mention three areas where I have significant concerns. First, the literature on financial stability and monetary policy is still in its infancy. There is no consensus that monetary policy (or debt management policy) should assume the kinds of roles assigned by the authors. In particular, policymakers are addressing the problem of private money creation through an array of regulatory initiatives. Second, in describing the costs of the existing arrangements, the paper estimates that the Treasury's post-2008 extension of the weighted average maturity (or duration) of the Federal debt offset--in a purely mechanical sense--about 35 percent of the effect of the Federal Reserve's large-scale asset purchase (LSAP) programs on the level of 10-year Treasury yields. I would challenge this ex post framing of the issue. Maturity extension merely continued a policy begun by the Treasury well before the crisis and was also broadly consistent with the Treasury's past behavior at times of substantial increases in borrowing. My starting point would be that the Federal Open Market Committee did what it thought was appropriate ex ante to return the economy to full employment and stable prices, taking Treasury decisions concerning debt management as exogenous. As the authors acknowledge, there are good reasons to think that any term premium effect of the maturity extension must have been much smaller than the "35 percent" figure implies. The paper's estimate is based solely on what is sometimes referred to as the "duration removal" channel. There are other channels that would not be offset by maturity extension--in particular, a channel by which the Federal Reserve signals the strength of its commitment to achieving the dual mandate. My view is that it is quite difficult to explain the observed effects of LSAPs on asset prices without reference to these other channels. In addition, according to the authors' estimates, the "announcement effects" of the Treasury's maturity extension policy seem to be only half the size of the effects of comparable Fed announcements. The LSAPs tripled the Federal Reserve's share of outstanding 10-year duration, from 12 percent to 36 percent, and had quite significant effects on the prices of financial assets. By most estimates, the 10-year Treasury term premium was deeply negative from mid-2011 through mid-2013; it remains near zero today, far below normal pre-crisis levels. Given the very low level of rates over this period, it is not clear to me that a slightly more negative term premium would have produced materially different real economy results. Third, the authors' proposals seem to me to be fraught with risk for the Federal Reserve. I believe that the existing institutional arrangements have served the public well. The independence of the Federal Reserve's monetary policy is highly valuable to society. There is considerable evidence that monetary policy independence leads to better macroeconomic outcomes. Any active collaboration between debt management and monetary policy, even in a crisis, would risk calling into question that independence. That is a risk I would be very reluctant to take. The period after the Second World War during which debt management imposed requirements upon monetary policy was marked by strains between the Treasury and the Fed and less than full independence for monetary policy. While current institutional arrangements may be imperfect, history suggests a need for caution before allowing these two policies to become entangled once again. Thanks again, and I look forward to our conversation.

r141011a_FOMC

united states

The Federal Reserve and the Global Economy

fischer

It is a great honor to deliver the Per Jacobsson Foundation Lecture, and I thank the organizers for inviting me. Per Jacobsson, a Swede, was the third Managing his tenure, the fund supported the return to convertibility of the major European currencies, increased its resources by securing the General Arrangements to Borrow, and established the Compensatory Financing Facility to help member countries cope with temporary fluctuations in international payments. It is a particular pleasure to be delivering this lecture at the IMF. My service in the IMF was a highlight of my professional career. But I speak now as a central banker, one who faces a new set of responsibilities. My lecture today is on the special challenges that face the Federal Reserve and the global economy in an increasingly interconnected world. Over the past 50 years, global trade has more than tripled relative to world gross domestic product (GDP), and the ratio of total exports to global GDP now stands at about 30 percent. International trade has not loomed as large in the U.S. national accounts as it has for many other countries, but it is an increasingly important driver of the U.S. economy, with the share of trade in U.S. GDP currently at about 15 percent. Although the U.S. share of world GDP has gradually declined since the mid-20th century, the broader importance of the United States to the global economy has diminished less, or possibly not at all, as a result of increasing financial linkages over the same period. In particular, U.S. residents' ownership of foreign assets has risen to nearly $25 trillion (more than 140 percent of annual U.S. GDP), reflecting the leading role of U.S. capital markets in cross-border finance. Total foreign investment in the United States is even larger, at more than $30 trillion. U.S. Treasury securities are a key component of these external liabilities: As the world's favorite safe asset, they are the preferred form of collateral for a range of financial contracts, and they also account for more than half of other countries' foreign reserves. In a progressively integrating world economy and financial system, a central bank cannot ignore developments beyond its country's borders, and the Fed is no exception. This is true even though the Fed's statutory objectives are defined as specific goals for the U.S. economy. In particular, the Federal Reserve's objectives are given by its dual mandate to pursue maximum sustainable employment and price stability, and our policy decisions are targeted to achieve these dual objectives. Hence, at first blush, it may seem that there is little need for Fed policymakers to pay attention to developments outside the United States. But such an inference would be incorrect. The state of the U.S. economy is significantly affected by the state of the world economy. A wide range of foreign shocks affect U.S. domestic spending, production, prices, and financial conditions. To anticipate how these shocks affect the U.S. economy, the Federal Reserve devotes significant resources to monitoring developments in foreign economies, including emerging market economies (EMEs), which account for an increasingly important share of global growth. The most recent available data show 47 percent of total U.S. exports going to EME destinations. And of course, actions taken by the Federal Reserve influence economic conditions abroad. Because these international effects in turn spill back on the evolution of the U.S. economy, we cannot make sensible monetary policy choices without taking them into account. In this lecture, I would like to emphasize both aspects of our global connectedness--spillovers from the United States to foreign economies and the effect of foreign economies on the United States. I will first review the effect of the Fed's monetary policies on the rest of the global economy, particularly the EMEs, which has received considerable attention in recent years. Prior to the spring of 2013, this attention was focused on the international spillover of the Fed's accommodative policies, especially our asset purchases. But beginning last year, the focus has shifted to the normalization of our policies, as exemplified by last summer's "taper tantrum." Although the effect of the U.S. economy on other countries is of vital importance to this audience, I will briefly digress to remind you that developments in other economies also can have significant spillovers to the United States, which in turn prompt reactions from U.S. policymakers. For example, in the past few years, the deflationary environment in Japan, together with the fallout from the euro-area fiscal crisis, has entailed persistent weakness in those economies, which historically have been among our most important trading partners, are major recipients of our foreign investments, and loom large in the international credit exposures of U.S. banks. These effects have weighed on global growth, which needs to be taken into account in the setting of U.S. monetary policy. Returning to spillovers from the United States, in the second part of the lecture, I will address prospective outcomes and possible risks associated with the normalization of our policies. In determining the pace at which our monetary accommodation is removed, we will, as always, be paying close attention to the path of the rest of the global economy and its significant consequences for U.S. economic prospects. In the third part, toward the end of the lecture, I will discuss the responsibilities of the Fed in the world economy. Like other national central banks, we must answer first to our own citizens and taxpayers. But, because of our size, developments in the U.S. economy will always affect foreign economies. And, since the U.S. dollar is the most widely used currency in the world, our interests in ensuring a well-functioning financial system inevitably have an international dimension. The recognition that a change in interest rates in one nation can spill over to other countries dates back at least to the 18 -century writings of David Hume on the international effect of changes in the money supply. The standard models incorporating the international transmission of monetary policy were developed in Per Jacobsson's tenure at the IMF--the pioneering research in the early 1960s by IMF staffer Marcus Fleming and Robert Mundell, which extended standard macroeconomic models to the analysis of an open international economy--work that we know now as the Mundell- Fleming model. In the Mundell-Fleming framework, as well as in modern developments of the same theme, a shift toward a more accommodative monetary policy in the United States spills over to foreign economies by causing their interest rates to fall--though typically by less than in the United States--and their currencies to appreciate against the dollar. At the same time, international capital flows tend to shift toward foreign economies in response to their relatively more attractive interest rates. The pass-through of changes in U.S. policy rates abroad depends importantly on how foreign monetary authorities respond. A decline in U.S. policy rates has a relatively large effect on foreign policy rates in economies that opt to limit exchange rate fluctuations, at least for economies with reasonably open capital accounts. Thus, for example, a fall in U.S. policy rates has a commensurate effect on interest rates in Hong Kong. By contrast, the central bank in an economy with a freely floating exchange rate might choose to lower its interest rate by a much smaller amount than in the United States if it believes that domestic conditions so warrant. In this case, the country's exchange rate would appreciate as investors rebalance their portfolios in favor of assets denominated in its currency in response to the higher interest rate differential. Moving beyond the Mundell-Fleming framework, there is also evidence that monetary policy actions can influence investors' willingness to hold risky assets, the so- called risk-taking channel. Such effects seem to be most potent when financial conditions are stressed. And countries that offer high prospective returns but have weak policy frameworks or other structural vulnerabilities may be particularly sensitive to fluctuations in international investment associated with global risk factors. International spillovers from monetary policy have been a contentious issue going back at least to the 1920s. To facilitate the United Kingdom's return to the gold standard at its pre-war parity in 1925, which valued the pound above purchasing power parity, the Fed cut interest rates substantially. Britain's subsequent departure from gold created further challenges for the Federal Reserve; tight U.S. money policy in the wake of the exit of the sterling bloc from gold in the fall of 1931 helped keep the United States on gold until 1933 but exacted high economic costs on the United States and other countries remaining on gold. monetary policy starting in the second half of the 1960s was exported to trading partners through the system of fixed exchange rates. More than a decade later, the Fed's aggressive tightening under newly appointed Chairman Paul Volcker had unwelcome contractionary effects on other economies. However, the Fed's success in achieving a permanent reduction in inflation through tight monetary policy bolstered the credibility of policies focused on achieving low and stable inflation, and many other countries followed. Turning to more recent events, I'll next assess the effects of the Fed's quantitative easing and other unconventional monetary policies pursued by central banks in advanced economies since 2008. During the period of extensive monetary accommodation after the 2007-08 global financial crisis, there has been heightened concern about the international spillovers of monetary policies--and of ours, in particular. Some EME critics argued that U.S. policy accommodation contributed to a surge of capital inflows and excessive credit growth in their economies, creating risks of financial instability. But, as time wore on, most EMEs seemed glad to receive those flows. There is little doubt that the aggressive actions the Federal Reserve took to mitigate the effects of the global financial crisis significantly affected asset prices at home and abroad as well as international capital flows. While the Fed's asset purchases were composed wholly of Treasury, agency, and agency-backed securities (for legal and practical reasons), the program also aimed to boost the prices of riskier assets and ease financial conditions for the private sector. (And this is what the textbooks say the program should have done.) The preponderance of evidence suggests that the Fed's asset purchases raised the prices of the assets purchased and close substitutes as well as those of riskier assets. Importantly, evidence--including the evidence of our eyes--shows that foreign asset markets have been significantly affected by the Fed's purchase programs. example, event studies of announcements associated with the Fed's purchase programs have found that they prompted inflows into investment funds holding both foreign debt and foreign equity securities. For asset prices, the strongest evidence came in the form of reduced foreign bond yields, but valuations of foreign currencies and stock prices also increased appreciably in some cases. The largest market reactions occurred after announcements in late 2008 and early 2009 associated with the initial program of quantitative easing, commonly referred to as QE1, likely at least in part because global financial conditions were extremely stressed at that time, but also perhaps because QE1 demonstrated that it was still possible to ease policy, even when the federal funds rate was constrained by its effective lower bound. Although much of the recent commentary on spillovers has focused on the United States, it bears mentioning that other countries' monetary policy announcements can leave an imprint on international asset prices, with market reactions to new initiatives announced by the European Central Bank (ECB) in the past few weeks the most recent example. However, event studies tend to find larger international interest rate spillovers for U.S. policy announcements than for those of other central banks. It is also worth emphasizing that asset purchases are merely one form of monetary accommodation, made necessary when policy interest rates hit their zero lower bound. Earlier studies of the international effects of conventional U.S. monetary policy--namely, changes in the policy rate--have also found significant spillovers to asset prices in other countries. Studies that have compared the spillovers of monetary policy across conventional and unconventional measures generally conclude that the effects on global financial markets are roughly similar. Given the relatively fast recovery of many EMEs from the crisis, post-crisis monetary accommodation in the United States and other advanced economies created policy challenges for many EMEs. If they resisted currency appreciation pressures by lowering their policy rates, they risked over stimulating domestic demand, exacerbating financial excesses, and overheating their economies. If, instead, they reduced their policy rates less than the US had done while intervening to resist currency appreciation, capital inflows could have increased further, thus partially offsetting their attempts to stabilize their economies. And, if they allowed currency appreciation pressures to pass through to their full extent, this could threaten their recoveries by hurting exports. In the event, EMEs tried to make the best of a difficult set of tradeoffs by allowing some exchange rate appreciation, partially reducing their interest rates, and in some countries also using capital controls. Along with the boost from U.S. monetary policy during this period, many other factors contributed to the easing of global financial conditions between 2009 and 2012, including macroeconomic policy in a number of other countries and other measures that supported stabilization of the global financial system. EME sovereign yields declined by more during that period than can be explained by movements in U.S. Treasury yields alone, and there was a worldwide recovery in markets for riskier assets. I would also argue strongly that U.S. monetary policies were not beggar thy neighbor policies in that, on balance, they generally did not drain demand from other economies. Federal Reserve staff analysis finds that an easing of monetary policy in the United States benefits foreign economies from both stronger U.S. activity and improved global financial conditions. It also has an offsetting contractionary effect on foreign economies because their currencies appreciate against the dollar. But, on average, model-based estimates imply that the net effect on foreign economies appears to be both modest in magnitude and most likely positive, on net, for most countries. because these models do not fully capture benefits from the role of Federal Reserve policies in alleviating the financial market stress and boosting confidence, positive spillovers abroad are likely to be somewhat larger than implied by the models, especially under conditions of extreme financial market stress. The taper tantrum of 2013 We should also expect spillovers when monetary policy is tightened. Central bank communications can be a tricky business, but it has long been understood that shifting perceptions of policy can have an immediate effect on market prices and investors' portfolio decisions. Indeed, financial markets reacted strongly to the first statements by Chairman Bernanke in the spring of 2013 that the Fed's asset purchases were likely to decelerate in the near future and come to an end not long after that. Some market participants clearly understood these statements to be broadly in line with previous guidance about the eventual normalization of policy as recovery of the U.S. economy took hold. But others may have grown accustomed to continuing asset purchases; the most recent purchase program, QE3, had been first announced less than a year before and was proceeding at a steady pace of $85 billion per month. The onset of the taper tantrum went well beyond a roiling of U.S. financial markets. Spillovers to other advanced-economy financial markets included stock price declines, significant increases in sovereign yields, higher overnight interest swap rates in the United Kingdom and euro area, and rising credit spreads in some countries. The ECB and Bank of England responded by using so-called forward guidance to push short-term yields back down in an effort to foster recovery. Spillovers to EME asset markets were significantly stronger. Inflows to EME investment funds reversed sharply, EME currencies depreciated, and other asset prices declined. The cumulative effects over half of a decade of the extraordinary actions by the Federal Reserve and other central banks will need to be unwound in the coming years, as progress toward economic recovery makes it necessary to withdraw our substantial monetary accommodation. In the normalizing of its policy, just as when loosening policy, the Federal Reserve will take account of how its actions affect the global economy. The taper tantrum episode notwithstanding, most EMEs have generally weathered the wind-down of our asset purchases reasonably well so far. The actual raising of policy rates could trigger further bouts of volatility, but my best estimate is that the normalization of our policy should prove manageable for the EMEs. We have done everything we can, within the limits of forecast uncertainty, to prepare market participants for what lies ahead. Some critics of our policies have argued that, by continuing for so long with quantitative easing, the United States fueled a global boom in asset prices and credit growth that could provide the seeds of the next financial crisis, with the removal of monetary accommodation serving as an eventual trigger. But I am much more hopeful. First, the Federal Reserve and other central banks are going to great lengths to communicate policy intentions and strategies clearly. Given this, markets should not be greatly surprised by either the timing or the pace of normalization. In fact, it bears mentioning that, following the taper tantrum, when the Fed started to taper its purchases, there was little reaction from markets. Second, the tightening of U.S. policy will begin only when the U.S. expansion has advanced far enough, in terms both of reducing the output gap and of moving the inflation rate closer to our 2 percent goal. Thus, tightening should occur only against the backdrop of a strengthening U.S. economy and in an environment of improved household and business confidence. The stronger U.S. economy should directly benefit our foreign trading partners by raising the demand for their exports, and perhaps also indirectly, by boosting confidence globally. And if foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise. Third, the EMEs themselves have generally done a good job of reducing their financial and economic vulnerabilities over the past couple of decades, which should bolster their resilience should normalization lead to financial market stresses. Since the 1990s, many EMEs have made remarkable progress on reducing inflation, improving government debt ratios, building foreign reserves, and better regulating and capitalizing their banking systems. In addition, the development of local-currency debt markets has made EMEs less vulnerable to exchange rate fluctuations. To be sure, some EMEs continue to face a wide array of structural and policy challenges, including, prominently, rapid credit growth. But it does not seem that the overall risks to global financial stability are unusually elevated at this time, and they are very likely substantially less than they were going into the financial crisis. Nevertheless, it could be that some more vulnerable economies, including those that pursue overly rigid exchange rate policies, may find the road to normalization somewhat bumpier. This gives all the more reason for the Fed and other major central banks to communicate policy intentions clearly and for EMEs to continue to strengthen their policy frameworks and to consider their own policy responses to the forthcoming normalization in the United States and some other advanced economies. So far, I have focused on the immediate spillovers of U.S. monetary policy abroad and the feedback of those effects to the U.S. economy. More tacitly than explicitly stated has been my view that the United States is not just any economy and, thus, the Federal Reserve not just any central bank. The U.S. economy represents nearly one-fourth of the global economy measured at market rates and a similar share of gross capital flows. The significant size and international linkages of the U.S. economy mean that economic and financial developments in the United States have global spillovers--something that the IMF is well aware of and has reflected in its increased focus on multilateral surveillance. In this context and in this venue, it is, therefore, important to ask, what is the Federal Reserve's responsibility to the global economy? First and foremost, it is to keep our own house in order. Economic and financial volatility in any country can have negative consequences for the world--no audience knows that more than this one--but sizable and significant spillovers are almost assured from an economy that is large. There is no question that sharp declines in U.S. output or large deviations of U.S. inflation from its target level would have adverse effects on the global economy. Conversely, strong and stable U.S. growth in the context of inflation close to our policy objective has substantial benefits for the world. Thus, as part of our efforts to achieve our congressionally mandated objective of maximum sustainable employment and price stability, the Federal Reserve will also seek to minimize adverse spillovers and maximize the beneficial effect of the U.S. economy on the global economy. As the recent financial crisis showed all too clearly, to achieve this objective, we must take financial stability into account. For half a decade, we have been working to understand and better guard against the financial disruptions that were the genesis of the Great Recession. These efforts have spawned many speeches, including some of my own, which testify to our efforts. In these speeches, we often emphasize that, given the integration of global capital markets, what happens in one market affects others. Thus, our efforts to stabilize the U.S. financial system also have positive spillovers abroad. These financial stability responsibilities do not stop at our borders, given the size and openness of our capital markets and the unique position of the U.S. dollar as the world's leading currency for financial transactions. For example, the global financial crisis highlighted the extent of borrowing and lending in U.S. dollars by foreign financial institutions. When these institutions came under pressure, their actions contributed to the strains in both foreign and domestic dollar funding markets. To achieve financial stability domestically and maintain the flow of credit to American households and businesses, we took action. Importantly, we developed swap facilities with central banks in countries that represented major financial markets or trading centers in order to facilitate the provision of dollar liquidity to these markets. We did so in recognition of the scope of dollar markets and dollar-denominated transactions outside of our country, the benefits they provide to U.S. households and firms, and the adverse consequences to our financial markets if these centers lose access to dollar liquidity. We have continued to maintain swap facilities with a number of central banks. Although usage is currently very low, these facilities represent an important backstop in the event of a resurgence in global financial tensions. But I should caution that the responsibility of the Fed is not unbounded. My teacher Charles Kindleberger argued that stability of the international financial system could best be supported by the leadership of a financial hegemon or a global central bank. But I should be clear that the U.S. Federal Reserve System is not that bank. Our mandate, like that of virtually all central banks, focuses on domestic objectives. As I have described, to meet those domestic objectives, we must recognize the effect of our actions abroad, and, by meeting those domestic objectives, we best minimize the negative spillovers we have to the global economy. And because the dollar features so prominently in international transactions, we must be mindful that our markets extend beyond our borders and take precautions, as we have done before, to provide liquidity when necessary. That said, as will be discussed in many venues this weekend and beyond, the world is not without resources to guard against adverse economic and financial spillovers. Most obviously, the IMF has played and will continue to play a critical role in providing liquidity and financial support to member countries. To that end, I hope that the 2010 agreement to increase IMF quotas will be fulfilled. In this regard, we also should be realistic about what a backstop is. Any global backstop or liquidity facility should have certain features--accountability and monitoring, some degree of stigma in good times, and a high hurdle for usage. In other words, backstops are not built to be liked. In the United States, we are working to ensure that our financial institutions and other market participants are prepared for the normalization of monetary policy and the return to a world of higher interest rates. It is equally important that individuals, businesses, and institutions around the world do the same. For our part, the Federal Reserve will promote a smooth transition by communicating our assessment of the economy and our policy intentions as clearly as possible. To summarize and conclude, the Fed's statutory objectives are defined by its dual mandate to pursue maximum sustainable employment and price stability in the U.S. economy. But the U.S. economy and the economies of the rest of the world have important feedback effects on each other. To make coherent policy choices, we have to take these feedback effects into account. The most important contribution that U.S. policymakers can make to the health of the world economy is to keep our own house in order--and the same goes for all countries. Because the dollar is the primary international currency, we have, in the past, had to take action--particularly in times of global economic crisis--to maintain order in international capital markets, such as the central bank liquidity swap lines extended during the global financial crisis. In that case, we were acting in accordance with our dual mandate, in the interest of the U.S. economy, by taking actions that also benefit the world economy. Going forward, we will continue to be guided by those same principles. . pdf. statement Evolving Globalization," a seminar sponsored by the Bank of Japan and the delivered at the Annual Meeting of the American Economic Association, . vol. . ed., , .

r141017a_FOMC

united states

Perspectives on Inequality and Opportunity from the Survey of Consumer Finances

yellen

The distribution of income and wealth in the United States has been widening more or less steadily for several decades, to a greater extent than in most advanced countries. This trend paused during the Great Recession because of larger wealth losses for those at the top of the distribution and because increased safety-net spending helped offset some income losses for those below the top. But widening inequality resumed in the recovery, as the stock market rebounded, wage growth and the healing of the labor market have been slow, and the increase in home prices has not fully restored the housing wealth lost by the large majority of households for which it is their primary asset. The extent of and continuing increase in inequality in the United States greatly concern me. The past several decades have seen the most sustained rise in inequality since the 19th century after more than 40 years of narrowing inequality following the Great Depression. By some estimates, income and wealth inequality are near their highest levels in the past hundred years, much higher than the average during that time span and probably higher than for much of American history before then. It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity. Some degree of inequality in income and wealth, of course, would occur even with completely equal opportunity because variations in effort, skill, and luck will produce variations in outcomes. Indeed, some variation in outcomes arguably contributes to economic growth because it creates incentives to work hard, get an education, save, invest, and undertake risk. However, to the extent that opportunity itself is enhanced by access to economic resources, inequality of outcomes can exacerbate inequality of opportunity, thereby perpetuating a trend of increasing inequality. Such a link is suggested by the "Great Gatsby Curve," the finding that, among advanced economies, greater income inequality is associated with diminished intergenerational mobility. such circumstances, society faces difficult questions of how best to fairly and justly promote equal opportunity. My purpose today is not to provide answers to these contentious questions, but rather to provide a factual basis for further discussion. I am pleased that this conference will focus on equality of economic opportunity and on ways to better promote it. In my remarks, I will review trends in income and wealth inequality over the past several decades, then identify and discuss four sources of economic opportunity in America--think of them as "building blocks" for the gains in income and wealth that most Americans hope are within reach of those who strive for them. The first two are widely recognized as important sources of opportunity: resources available for children and . affordable higher education. The second two may come as more of a surprise: business ownership and inheritances. Like most sources of wealth, family ownership of businesses and inheritances are concentrated among households at the top of the distribution. But both of these are less concentrated and more broadly distributed than other forms of wealth, and there is some basis for thinking that they may also play a role in providing economic opportunities to a considerable number of families below the top. In focusing on these four building blocks, I do not mean to suggest that they account for all economic opportunity, but I do believe they are all significant sources of opportunity for individuals and their families to improve their economic circumstances. I will start with the basics about widening inequality, drawing heavily on a trove the latest of which was conducted in 2013 and published last month. The SCF is broadly consistent with other data that show widening wealth and income inequality over the past several decades, but I am employing the SCF because it offers the added advantage of specific detail on income, wealth, and debt for each of 6,000 households surveyed. detail from family balance sheets provides a glimpse of the relative access to the four sources of opportunity I will discuss. While the recent trend of widening income and wealth inequality is clear, the implications for a particular family partly depend on whether that family's living standards are rising or not as its relative position changes. There have been some times of relative prosperity when income has grown for most households but inequality widened because the gains were proportionally larger for those at the top; widening inequality might not be as great a concern if living standards improve for most families. That was the case for much of the 1990s, when real incomes were rising for most households. At other times, however, inequality has widened because income and wealth grew for those at the top and stagnated or fell for others. And at still other times, inequality has widened when incomes were falling for most households, but the declines toward the bottom were proportionally larger. Unfortunately, the past several decades of widening inequality has often involved stagnant or falling living standards for many families. Since the survey began in its current form in 1989, the SCF has shown a rise in the concentration of income in the top few percent of households, as shown in figure 1. By definition, of course, the share of all income held by the rest, the vast majority of households, has fallen by the same amount. This concentration was the result of income and living standards rising much more quickly for those at the top. After adjusting for . inflation, the average income of the top 5 percent of households grew by 38 percent from 1989 to 2013, as we can see in figure 2. By comparison, the average real income of the other 95 percent of households grew less than 10 percent. Income inequality narrowed slightly during the Great Recession, as income fell more for the top than for others, but resumed widening in the recovery, and by 2013 it had nearly returned to the pre-recession peak. The distribution of wealth is even more unequal than that of income, and the SCF shows that wealth inequality has increased more than income inequality since 1989. As shown in figure 3, the wealthiest 5 percent of American households held 54 percent of all wealth reported in the 1989 survey. Their share rose to 61 percent in 2010 and reached 63 percent in 2013. By contrast, the rest of those in the top half of the wealth distribution--families that in 2013 had a net worth between $81,000 and $1.9 million-- held 43 percent of wealth in 1989 and only 36 percent in 2013. The lower half of households by wealth held just 3 percent of wealth in 1989 and only 1 percent in 2013. To put that in perspective, figure 4 shows that the average net worth of the lower half of the distribution, representing 62 million households, was About one-fourth of these families reported zero wealth or negative net worth, and a significant fraction of those said they were "underwater" on their home mortgages, owing more than the value of the home. lower than the average wealth of the lower half of families in 1989, adjusted for inflation. Average real wealth rose gradually for these families for most of those years, then dropped sharply after 2007. Figure 5 shows that average wealth also grew steadily for the "next 45" percent of households before the crisis but didn't fall nearly as much afterward. Those next 45 households saw their wealth, measured in 2013 dollars, grow from an average of $323,000 in 1989 to $516,000 in 2007 and then fall to $424,000 in 2013, a net gain of about one-third over 24 years. Meanwhile, the average real wealth of families in the top 5 percent has nearly doubled, on net--from $3.6 million in 1989 to Housing wealth--the net equity held by households, consisting of the value of their homes minus their mortgage debt--is the most important source of wealth for all but those at the very top. It accounted for three-fifths of wealth in 2013 for the lower half of families and two-fifths of wealth for the next 45. But housing wealth was only one- fifth of total wealth for the top 5 percent of families. The share of housing in total net worth for all three groups has not changed much since 1989. Since housing accounts for a larger share of wealth for those in the bottom half of the wealth distribution, their overall wealth is affected more by changes in home prices. Furthermore, homeowners in the bottom half have been more highly leveraged on their homes, amplifying this difference. As a result, while the SCF shows that all three groups saw proportionally similar increases and subsequent declines in home prices from 1989 to 2013, the effects on net worth were greater for those in the bottom half of households by wealth. Foreclosures and the dramatic fall in house prices affected many of these families severely, pushing them well down the wealth distribution. Figure 6 shows that homeowners in the bottom half of households by wealth reported 61 percent less home equity in 2013 than in 2007. The next 45 reported a 29 percent loss of housing wealth, and the top 5 lost 20 percent. Fortunately, rebounding housing prices in 2013 and 2014 have restored a good deal of the loss in housing wealth, with the largest gains for those toward the bottom. Based on rising home prices alone and not counting possible changes in mortgage debt or other factors, Federal Reserve staff estimate that between 2013 and mid-2014, average home equity rose 49 percent for the lowest half of families by wealth that own homes. The estimated gains are somewhat less for those with greater wealth. Homeowners in the bottom 50, which had an average overall net worth of $25,000 in 2013, would have seen their net worth increase to an average of $33,000 due solely to home price gains since 2013, a 32 percent increase. Another major source of wealth for many families is financial assets, including stocks, bonds, mutual funds, and private pensions. Figure 7 shows that the wealthiest 5 percent of households held nearly two-thirds of all such assets in 2013, the next 45 percent of families held about one-third, and the bottom half of households, just 2 percent. This figure may look familiar, since the distribution of financial wealth has concentrated at the top since 1989 at rates similar to those for overall wealth, which we saw in figure 3. Those are the basics on wealth and income inequality from the SCF. Other research tells us that inequality tends to persist from one generation to the next. For example, one study that divides households by income found that 4 in 10 children raised in families in the lowest-income fifth of households remain in that quintile as adults. Fewer than 1 in 10 children of families at the bottom later reach the top quintile. The story is flipped for children raised in the highest-income households: When they grow up, 4 in 10 stay at the top and fewer than 1 in 10 fall to the bottom. Research also indicates that economic mobility in the United States has not changed much in the last several decades; that mobility is lower in the United States than in most other advanced countries; and, as I noted earlier, that economic mobility and income inequality among advanced countries are negatively correlated. An important factor influencing intergenerational mobility and trends in inequality over time is economic opportunity. While we can measure overall mobility and inequality, summarizing opportunity is harder, which is why I intend to focus on some important sources of opportunity--the four building blocks I mentioned earlier. Two of those are so significant that you might call them "cornerstones" of opportunity, and you will not be surprised to hear that both are largely related to education. The first of these cornerstones I would describe more fully as "resources available to children in their most formative years." The second is higher education that students and their families can afford. Two additional sources of opportunity are evident in the SCF. They affect fewer families than the two cornerstones I have just identified, but enough families and to a sufficient extent that I believe they are also important sources of economic opportunity. The third building block of opportunity, as shown by the SCF, is ownership of a private business. This usually means ownership and sometimes direct management of a family business. The fourth source of opportunity is inherited wealth. As one would expect, inheritances are concentrated among the wealthiest families, but the SCF indicates they may also play an important role in the opportunities available to others. For households with children, family resources can pay for things that research shows enhance future earnings and other economic outcomes--homes in safer neighborhoods with good schools, for example, better nutrition and health care, early childhood education, intervention for learning disabilities, travel and other potentially enriching experiences. Affluent families have significant resources for things that give children economic advantages as adults, and the SCF data I have cited indicate that many other households have very little to spare for this purpose. These disparities extend to other household characteristics associated with better economic outcomes for offspring, such as homeownership rates, educational attainment of parents, and a stable family structure. According to the SCF, the gap in wealth between families with children at the bottom and the top of the distribution has been growing steadily over the past 24 years, but that pace has accelerated recently. Figure 8 shows that the median wealth for families with children in the lower half of the wealth distribution fell from $13,000 in 2007 to $8,000 in 2013, after adjusting for inflation, a loss of 40 percent. These wealth levels look small alongside the much higher wealth of the next 45 percent of households with children. But these families also saw their median wealth fall dramatically--by one-third in real terms--from $344,000 in 2007 to $229,000 in 2013. The top 5 percent of families with children saw their median wealth fall only 9 percent, from $3.5 million in 2007 to $3.2 million in 2013, after inflation. For families below the top, public funding plays an important role in providing resources to children that influence future levels of income and wealth. Such funding has the potential to help equalize these resources and the opportunities they confer. Social safety-net spending is an important form of public funding that helps offset disparities in family resources for children. Spending for income security programs since 1989 and until recently was fairly stable, ranging between 1.2 and 1.7 percent of gross domestic product (GDP), with higher levels in this range related to recessions. However, such spending rose to 2.4 percent of GDP in 2009 and 3 percent in 2010. estimate that the increase in the poverty rate because of the recession would have been much larger without the effects of income security programs. Public funding of education is another way that governments can help offset the advantages some households have in resources available for children. One of the most consequential examples is early childhood education. Research shows that children from lower-income households who get good-quality pre-Kindergarten education are more likely to graduate from high school and attend college as well as hold a job and have higher earnings, and they are less likely to be incarcerated or receive public assistance. Figure 9 shows that access to quality early childhood education has improved since the 1990s, but it remains limited--41 percent of children were enrolled in state or federally supported programs in 2013. Gains in enrollment have stalled since 2010, as has growth in funding, in both cases because of budget cuts related to the Great Recession. These cuts have reduced per-pupil spending in state-funded programs by 12 percent after inflation, and access to such programs, most of which are limited to lower-income families, varies considerably from state to state and within states, since local funding is often important. In 2010, the United States ranked 28th out of 38 advanced countries in the share of four-year-olds enrolled in public or private early childhood education. Similarly, the quality and the funding levels of public education at the primary and secondary levels vary widely, and this unevenness limits public education's equalizing effect. The United States is one of the few advanced economies in which public education spending is often lower for students in lower-income households than for students in higher-income households. Some countries strive for more or less equal funding, and others actually require higher funding in schools serving students from lower-income families, expressly for the purpose of reducing inequality in resources for children. A major reason the United States is different is that we are one of the few advanced nations that funds primary and secondary public education mainly through subnational taxation. Half of U.S. public school funding comes from local property taxes, a much higher share than in other advanced countries, and thus the inequalities in housing wealth and income I have described enhance the ability of more-affluent school districts to spend more on public schools. Some states have acted to equalize spending to some extent in recent years, but there is still significant variation among and within states. Even after adjusting for regional differences in costs and student needs, there is wide variation in public school funding in the United States. Spending is not the only determinant of outcomes in public education. Research shows that higher-quality teachers raise the educational attainment and the future earnings of students. Better-quality teachers can help equalize some of the disadvantages in opportunity faced by students from lower-income households, but here, too, there are forces that work against raising teacher quality for these students. Research shows that, for a variety of reasons, including inequality in teacher pay, the best teachers tend to migrate to and concentrate in schools in higher-income areas. Even within districts and in individual schools, where teacher pay is often uniform based on experience, factors beyond pay tend to lead more experienced and better-performing teachers to migrate to schools and to classrooms with more-advantaged students. For many individuals and families, higher education is the other cornerstone of economic opportunity. The premium in lifetime earnings because of higher education has increased over the past few decades, reflecting greater demand for college-educated workers. By one measure, the median annual earnings of full-time workers with a four- year bachelor's degree are 79 percent higher than the median for those with only a high school diploma. The wage premium for a graduate degree is significantly higher than the premium for a college degree. Despite escalating costs for college, the net returns for a degree are high enough that college still offers a considerable economic opportunity to most people. Along with other data, the SCF shows that most students and their families are having a harder time affording college. College costs have risen much faster than income for the large majority of households since 2001 and have become especially burdensome for households in the bottom half of the earnings distribution. Rising college costs, the greater numbers of students pursuing higher education, and the recent trends in income and wealth have led to a dramatic increase in student loan debt. Outstanding student loan debt quadrupled from $260 billion in 2004 to $1.1 trillion this year. Sorting families by wealth, the SCF shows that the relative burden of education debt has long been higher for families with lower net worth, and that this disparity has grown much wider in the past couple decades. Figure 10 shows that from 1995 to 2013, outstanding education debt grew from 26 percent of average yearly income for the lower half of households to 58 percent of income. The education debt burden was lower and grew a little less sharply for the next 45 percent of families and was much lower and grew not at all for the top 5 percent. Higher education has been and remains a potent source of economic opportunity in America, but I fear the large and growing burden of paying for it may make it harder for many young people to take advantage of the opportunity higher education offers. For many people, the opportunity to build a business has long been an important part of the American dream. In addition to housing and financial assets, the SCF shows that ownership of private businesses is a significant source of wealth and can be a vital source of opportunity for many households to improve their economic circumstances and position in the wealth distribution. While business wealth is highly concentrated at the top of the distribution, it also represents a significant component of wealth for some other households. shows that slightly more than half of the top 5 percent of households have a share in a private business. The average value of these holdings is nearly $4 million. Only 14 percent of families in the next 45 have ownership in a private business, but for those that do, this type of wealth constitutes a substantial portion of their assets--the average amount of this business equity is nearly $200,000, representing more than one-third of their net worth. Only 3 percent of the bottom half of households hold equity in a private business, but it is a big share of wealth for those few. The average amount of this wealth is close to $20,000, 60 percent of the average net worth for these households. Owning a business is risky, and most new businesses close within a few years. But research shows that business ownership is associated with higher levels of economic mobility. However, it appears that it has become harder to start and build businesses. The pace of new business creation has gradually declined over the past couple of decades, and the number of new firms declined sharply from 2006 through 2009. latest SCF shows that the percentage of the next 45 that own a business has fallen to a 25- year low, and equity in those businesses, adjusted for inflation, is at its lowest point since the mid-1990s. One reason to be concerned about the apparent decline in new business formation is that it may serve to depress the pace of productivity, real wage growth, and employment. Another reason is that a slowdown in business formation may threaten what I believe likely has been a significant source of economic opportunity for many families below the very top in income and wealth. Along with other economic advantages, it is likely that large inheritances play a role in the fairly limited intergenerational mobility that I described earlier. inheritances are also common among households below the top of the wealth distribution and sizable enough that I believe they may well play a role in helping these families economically. Figure 12 shows that half of the top 5 percent of households by wealth reported receiving an inheritance at some time, but a considerable number of others did as well-- almost 30 percent of the next 45 percent and 12 percent of the bottom 50. Inheritances are concentrated at the top of the wealth distribution but less so than total wealth. Just over half of the total value of inheritances went to the top 5 percent and 40 percent went to households in the next 45. Seven percent of inheritances were shared among households in the bottom 50 percent, a group that together held only 1 percent of all wealth in 2013. The average inheritance reported by those in the top 5 percent who had received them was $1.1 million. That amount dwarfs the $183,000 average among the next 45 percent and the $68,000 reported among the bottom half of households. But compared with the typical wealth of these households, the additive effect of bequests of this size is significant for the millions of households below the top 5 that receive them. The average age for receiving an inheritance is 40, when many parents are trying to save for and secure the opportunities of higher education for their children, move up to a larger home or one in a better neighborhood, launch a business, switch careers, or perhaps relocate to seek more opportunity. Considering the overall picture of limited resources for most families that I have described today, I think the effects of inheritances for the sizable minority below the top that receive one are likely a significant source of economic opportunity. In closing, let me say that, with these examples, I have only just touched the surface of the important topic of economic opportunity, and I look forward to learning more from the work presented at this conference. As I noted at the outset, research about the causes and implications of inequality is ongoing, and I hope that this conference helps spur further study of economic opportunity and its effects on economic mobility. Using the SCF and other sources, I have tried to offer some observations about how access to four specific sources of opportunity may vary across households, but I cannot offer any conclusions about how much these factors influence income and wealth inequality. I do believe that these are important questions, and I hope that further research will help answer them.

r141020b_FOMC

united states

Opening Remarks

powell

Thank you for the opportunity to speak with you today about some of the key issues facing community banks. As the chairman of the Federal Reserve Board's community and regional bank subcommittee, I try to meet with groups of community bankers whenever I can to better understand what is on community bankers' minds. While today's webinar is no substitute for face-to-face meetings with bankers, it is a special treat to be able to leverage technology to speak to and hear from so many community bankers across the country at the same time. As all of you surely know, community banks play a vital role in the U.S. financial system. Community banks have strong links to the people and businesses in their communities, as well as direct knowledge of local economic conditions. These close ties give community bankers a clear advantage in understanding local needs and tailoring their products and services to meet those needs. My colleagues on the Federal Reserve Board and I are committed to making sure that we understand the issues that are most important to community banks as you strive to serve the financial needs of your communities. One way that we further our understanding is by talking to the bankers themselves in a variety of venues, such as this webinar and a community banking research conference that I attended last month in St. Louis, which was co-sponsored by the And there is another opportunity to communicate with the Federal Reserve and our fellow regulators that I want to make sure you are aware of. The Economic Growth and reviewing regulations issued by the agencies at least every 10 years to identify outdated, unnecessary, or unduly burdensome regulations. The agencies kicked off that process earlier this year, and in addition to collecting comments in writing, we are beginning a series of meetings with the public in December. One of the themes that we hear in our interactions with community bankers is concern that the regulatory environment could be tailored more effectively for community banks, and the EGRPRA process gives all interested parties a voice in identifying areas where regulatory requirements may be disproportionate to risk. I therefore encourage you to participate in this important process and hope you will raise any concerns and ideas you have. The Federal Reserve is committed to tailoring its supervisory practices as appropriate for community banks to reduce unnecessary burden, while still ensuring that community banks continue to operate in a safe and sound manner. I am looking forward to our conversation today and, in particular, am interested in hearing about topics that are of importance to you as you work to serve your customers, meet the credit needs of your communities, and thrive.

r141020a_FOMC

united states

Good Compliance, Not Mere Compliance

tarullo

In the aftermath of the financial crisis, ongoing increases in capital buffers, reductions in funding vulnerabilities, improvements in risk management, and attention to orderly resolution are producing a substantially more resilient financial system. Yet even as the financial position of firms has been strengthened, headlines describing misconduct in financial firms have appeared with disturbing regularity. For a time, these stories were the legacy of pre-crisis errors and misdeeds, with a focus on the mortgages and mortgage-related products that lay at the heart of the crisis. But soon they were accompanied by allegations of post-crisis actions: rigging of LIBOR (London interbank offered rate) and foreign exchange rates, facilitation of tax evasion, inadequate controls on money laundering, and front running through dark pools, among others. A pattern of antitrust, market regulatory, and consumer protection problems would of course be troubling in any firm or industry. From a prudential regulatory perspective, such a pattern in financial institutions creates additional concerns, particularly as it poses a threat to continued progress toward a safer and more stable financial system. It is noteworthy that supervisory assessments of risks to the earnings and balance sheets of major financial institutions have, like those of many private analysts, placed increasing emphasis on exposure to public fines and private litigation losses. And senior management is surely diverted from the challenges of fashioning sound business strategies when major legal problems arise. Behind much of this malfeasance lies something other than the excessive credit and market risk that led to the crisis itself, although there may be some common roots of these problems. The hypothesis that this is all the result of "a few bad apples," an explanation I heard with exasperating frequency a year or two ago, has I think given way to a realization within many large financial firms that they have not taken steps sufficient to ensure that the activities of their employees remain within the law and, more broadly, accord with the values of probity, customer service, and ethical conduct that most of them espouse on their websites and in their television commercials. Today's conference addresses the sources of the problems and some of the corrective measures that have been, or might be, taken by both firms and regulators. While the title of the conference refers to both "culture" and "behavior," I am going to focus mostly on the behavior that regulators and the public can observe, since culture is a somewhat contested academic concept and, however defined, is difficult to observe and assess from the outside. It is the behavior of the employees of banking organizations with which we, as regulators, are ultimately concerned, since it is only through its employees that a firm can act. Where there is significant incidence of behavior that violates laws or regulations, or runs afoul of supervisory guidance, then we will need to consider some combination of tougher sanctions, additional regulation, or more intrusive supervisory oversight. After stating a few general premises relating to the manifold influences upon behavior in financial firms, I will briefly address two topics: first, what regulators have learned about the shaping of behavior within the firm from our work on risk management and, second, the role of reward and punishment systems in affecting employee behavior. Without attempting a rigorous definition of "culture" or "corporate culture," I think we can usefully posit that in every organization there is a set of norms that appear to inform behavior of those within the organization, even in the absence of explicit and specific rules or instructions. These norms are of course related to the rules, guidelines, structures, incentives, and punishments that the organization creates. Indeed, one important determinant of behavior is the shared expectation as to which of the stated values and rules of an organization will be supported and reinforced by management action, and which are generally regarded as window dressing. The identifiable norms may well differ within an organization, especially a large one in which different functions are performed in pursuit of overall organizational ends. Debates over the sources and nature of these norms are the stuff of the academic literature to which I referred a moment ago. I will not attempt to synthesize this learning, much less to fashion my own theory. Again, though, I think one can pragmatically note that these norms are shaped by both internal choices and external influences and constraints. For a private, profit-making corporation the most important internal choices are obviously made by management under the oversight of the board of directors. However, the revealed preferences and choices of employees will also affect a firm's culture. For a financial institution, external influences and constraints include shareholders and market analysts, regulators, prosecutors, elected officials, the media, and the public. Market conditions and the actions of competitors can also be significant. Financial risk-taking is arguably the fundamental activity of financial intermediaries. Unlike most non-financial firms, a financial institution more or less continually makes risk decisions, whose implications can vary significantly based on the nature of the asset involved, market conditions, counterparty identity, and many other factors. The processes by which risk appetites are set and activity managed so as to conform to these risk appetite decisions are central to determining outcomes, and thus the firm's near-term profitability and longer-term stability. For these reasons, there is considerable regulatory interest in these processes, an interest that has been formalized in the Federal Reserve's annual Comprehensive Capital Analysis and Review (CCAR) and informs the emphasis of our supervision throughout the year. Each year, in conjunction with our supervisory stress tests, we provide an assessment to every participating firm of their risk-management and capital planning processes, indicating where specific improvements are needed. The interactions between supervisors and firms on these matters are extensive, focused, and consequential. For this reason, I think we have gained considerable insight into, if not precisely the "culture" of the firms, then at least the attitudes of senior and mid-level management toward these risk functions. In some firms the attitude we perceive is one of a mere compliance exercise. The firm proceeds to address the deficiencies identified by the Fed in a discrete, almost check-the-box fashion. To oversimplify a bit, I would say that our sense is that management at these firms wants the hurdle to capital distribution removed, but once the specific problems have been remedied, they want to move on. If this is the attitude we perceive, I suspect the working level employees of such firms do the same. The supervisory reaction in such cases is quite likely to be an inclination toward greater scrutiny. Other firms, by contrast, seem to have internalized the aims of the risk-management processes and systems that we expect of them. In these firms the dialogue can be quite different, with supervisors observing that, even as a specific problem is addressed, such as deficiencies in estimating losses for a particular loan portfolio in a tail event, the firm has gone back to think about how the identified shortcomings fit into their overall risk decision-making and management processes. These firms will, on their own, then consider whether changes in other areas are needed. Again, I suspect that the line employees in these firms are also hearing a different message and presumably, to at least some degree, will behave in accordance with that message when they encounter risk-management issues not covered specifically by Fed communications. Needless to say, nothing here is meant to suggest that a focus on compliance is problematic. On the contrary, particularly as applied to areas like antitrust, securities laws, and consumer protection, well-crafted compliance programs are essential. But what we want to see is good compliance, not mere compliance. As in financial risk management, the perceived importance of what appear to be similar compliance efforts can vary greatly across firms. Are compliance programs put in place by risk managers or general counsels understood as a kind of background noise that should not drown out the voices urging employees to "make their numbers," or are they seen as reflecting the views and priorities of senior management? A related question is whether compliance with applicable law or regulations is understood to be just that, and that alone. Do employees understand their job to be maximizing revenues in any way possible so long as they do not do anything illegal, or do they understand their job to be maximizing revenues in a manner consistent with a broader set of considerations? In the former case, the message is that the law is a constraint to be observed, but that the purposes or values that underlie it have no additional importance for determining corporate activity. It may not be too great a leap from this attitude to a conscious weighing of the profitability of a particular practice that violates laws or regulations against the penalty that would be assessed for the violation, discounted by the probability of enforcement. In the latter case, the message to employees is that constraints on practices or products may be self-imposed as well as external. The potential sources of such internal constraints are manifold. For example, there might be a fear that always running close to the line will inevitably result in swerving over it at some point. Or management may worry that reputational harm will result if clients and customers believe the firm is always seeking an advantage over them that, literally or metaphorically, is buried in the fine print. This second concern recalls the much-discussed issue of whether a trading mentality has migrated to other parts of large financial firms, so that the position communicated by management to both employees and others is that the firm has no "customers" or "clients," only counterparties. While such an attitude is typical for trading in anonymous markets or with equally sophisticated institutions, it hardly seems designed to engender trust on the part of those who have ongoing relationships with the firm. This tendency may pose another challenge in managing complex banking organizations--the need to foster different kinds of norms and expectations across the different parts of the firm, which may do business with individuals and institutions of widely varying financial expertise. To encourage behavior among their employees that reflects something other than a narrow mentality of compliance and constraint, firms need to take tangible steps that reinforce stated norms such as respect for customers. Some interesting possibilities along these lines are suggested in a recent book by Thomas Huertas, a former U.K. banking regulator. Huertas focuses directly on how banks can avoid suffering losses from conduct and operational risks, his proposals would also serve the purpose just noted. One idea is that firms develop a score for conduct risk. While analogous to long-established scoring systems for credit risk, this method would, in his words, "include ranking the business or product against factors that frequently give rise to conduct issues, including without limitation the sophistication of the customer, the complexity of the product, the level of training of the staff, and so on." A second, complementary idea is for the firm to have a formal system in place to, again in Huertas' words, "monitor adherence to the original product approval criteria, especially where the product is growing rapidly and/or is generating extraordinary profits." These particular ideas may or may not be best for specific firms. The point, though, is that some concrete organizational systems are needed for firms to carry into effective action the goals or values that they nominally espouse. Before leaving this topic, I want to observe that regulators can unwittingly reinforce what I have termed a mere compliance mentality. I would first note that the detail of many regulations means that attention to narrow issues of compliance is sometimes wholly understandable and, indeed, essential. Banks, like other regulated entities, need to be able to determine how a regulation actually applies to them. Beyond that kind of unavoidable focus on narrow compliance, however, management and line employees are more likely to adopt a mere compliance mentality where regulations appear to them to have been poorly drafted or implemented. Sometimes this too is unavoidable, since regulators may simply conclude that the public interest requires a form of regulation opposed by the firm and most of its employees. Sometimes regulated firms are really complaining about the type or purpose of regulation, even when they say they are only criticizing its specifics. But in cases where those inside a firm would stipulate the stated objective of the regulation and still find a regulation badly conceived or implemented, there will be less possibility of internalization or integration into a broader set of firm norms and expectations. This is an outcome that regulators can avoid, and something with which the regulated firms themselves can assist by pointing out what they would regard as more sensible methods for achieving stated regulatory purposes. An important determinant of behavior in any organization is the system of rewards and punishments applicable to its employees. Assuming that they are able to discern factors that generally explain patterns of hiring, raises, promotions, demotions, and dismissals, employees receive very strong signals as to what those running the organization actually value. This set of signals has, I suspect, considerably more influence on employee behavior than a corporate statement of values or purposes, particularly if the system of rewards and punishments appears at odds with that statement. Indeed, the significance of reward and punishment signals is probably magnified by their role in shaping the composition of the firm's workforce--by influencing which people are attracted to work at the firm in the first place, which acquire more authority over time, and which are asked to leave. To take one example: if a financial firm's recruitment of young professionals is driven almost entirely by promises of the large amounts of money they can make and the speed with which they can make it, then the firm should not be too surprised when those same young professionals give short shrift to values such as respect for customers, or skirt risk- management guidelines, or perhaps even ignore regulatory and legal compliance requirements. One topic within this broader area of reward and punishment that has received considerable attention is incentive compensation. The deleterious effects of many incentive compensation arrangements were recognized by firms well before regulators began to focus on them in earnest following the financial crisis, as reflected in a survey conducted early in 2009 on behalf of the Institute of International Finance, which reported that all but one of 37 large banking organizations believed that compensation practices were a factor underlying the crisis. Compensation arrangements that created high-powered incentives using rewards dominantly based on equity had their origins in efforts to align better management and shareholder interests. And compensation arrangements that rewarded incentives for loan officers to write more loans or traders to generate more trading revenue were grounded in efforts to increase firm profitability. But the revenues that served as the basis for calculating bonuses were generated immediately, while the risks associated with these revenues might not have been realized for months or years after the transactions were completed. When these or similarly misaligned incentive compensation arrangements were common in a firm, the very purpose of sound risk management could be undermined by the actions of employees seeking to maximize their own pay. Since the financial crisis, both firms and regulators have devoted considerable attention to incentive compensation practices for senior managers and others with substantial decision- making authority. Several years ago the bank regulatory agencies issued guidance on incentive compensation and then began a horizontal monitoring of practices at large banking organizations. Prior to the crisis, incentive compensation arrangements at many firms incorporated virtually no adjustment for risk. Today, firms routinely take into consideration adverse outcomes. A greater proportion of pay is deferred, and a greater proportion of that pay is at risk of a variety of clawback and forfeiture provisions. There is still considerable work to be done in developing and implementing incentive compensation arrangements that truly give appropriate incentives to employees. In many cases risk metrics need to be better targeted to specific activities, and risk adjustments should be more consistently applied. And it is important that compensation arrangements, including clawback and forfeiture provisions, cover risks associated with market conduct and consumer protection, as well as credit and market risks. These kinds of improvements would give more precise signals to employees as to the risk calculus expected of them in making decisions that affect the firm. I hope the long-awaited interagency final rule implementing section 956 of the Dodd- Frank Wall Street Reform and Consumer Protection Act will be forthcoming in the not-too- distant future, so as to provide a common objective baseline for incentive compensation programs. Beyond regulatory and supervisory requirements, however, there is obviously more that firms can do to use their compensation practices to encourage certain practices and conduct by employees. For example, firms might reward employees with increased compensation or promotion not just for increasing revenues, but also for forestalling losses, such as by identifying non-obvious risks in proposed transactions or products. In order to be effective signals, though, the fact of these rewards, and the standards under which they were granted, need to be transparent. Punishment systems provide the complement of negative incentives to the positive incentives created by compensation and promotion practices (even where qualified by clawback or similar provisions). Here the role of the government differs. With respect to positive incentives, regulators affect individuals only by way of requirements or expectations for firms. When it comes to disincentivizing egregious bad behavior, however, the government can play a more direct role. Because of the required standard of proof and other constitutional protections, criminal prosecutions of individuals are harder to bring successfully than criminal prosecutions of firms. But, as I think was learned decades ago when individuals were criminally prosecuted and imprisoned for antitrust law violations, it is difficult to imagine a more effective deterrent to such conduct. Banking regulators do not have criminal enforcement powers, of course. But we can, and do, require dismissal of employees as part of our enforcement actions against firms. And we do have the authorities to remove malefactors from their positions in any institution that we regulate and to prohibit them from working in the banking industry. Somewhat like criminal prosecutions, these are not easy cases to make. But it is important that we be willing to expend the resources to initiate such actions in appropriate cases. For quite some time, large banking organizations usually dismissed employees who had engaged in significant misconduct or exercised very bad judgment in a quiet, almost surreptitious way. This was particularly true of someone in a responsible position, who would be ushered out the door discreetly, with no recognition internally or externally of the fact of dismissal, or the reasons behind it. Frequently, this person would turn up at another financial firm not long thereafter. The dismissing firm's reasoning was that any public awareness of the dismissal could hurt the reputation of the firm and perhaps cause customers or counterparties to rethink their willingness to do business with it. But the effect of this private way of doing things was to signal the rest of the firm's employees that dismissal, even for very serious reasons, carried quite manageable consequences. At least some firms are rethinking this traditional approach, though different banks seem to be reaching different conclusions about what to put in its place. Some are moving toward a more public system of dismissals, so as to let employees, regulators, and other potential employers know of the consequences of malfeasance and the identity of the responsible individual. Others are inclined toward the view that, because most serious infractions in a firm involve failures by many people and systems, there should not be excessive emphasis on the culpability of just one or two individuals. They are opting instead for a more transparent internal process to dissect the failures of action, judgment, and oversight that lay behind a significant problem, and then act more broadly in applying disciplinary or remedial measures. Whatever approach a firm takes, it is important that the consequences of violations of a firm's norms and expectations, much less regulations and laws, be well-specified and clearly communicated to employees. In these very selective remarks on the factors that affect employee behavior, I have intentionally concentrated on the roles of management and regulators. I realize, of course, that there are other forces at work. There is, for example, an interesting debate among corporate law professors as to the merits of giving shareholders more direct influence over firm policies, in order to reduce agency costs within the firm. Some fear that this would focus employees of financial firms even more on short-term equity market movements, with potential bad effects on both conventional risk management and the kinds of conduct problems noted at the outset of my remarks. Those broader concerns are relevant, to be sure, but they implicate a broader set of actors than the banks themselves, or even bank regulators. My expectation is that if banks do not take more effective steps to control the behavior of those who work for them, there will be both increased pressure and propensity on the part of regulators and law enforcers to impose more requirements, constraints, and punishments.

r141030a_FOMC

united states

Welcoming Remarks

yellen

Federal Reserve Board have organized this conference on an important issue for our profession. In trying to raise awareness of diversity in the economics profession, I am aided by the fact that economists are well acquainted with the concept of diversity from their work. When conducting a survey, economists understand that the results will be more meaningful when the diversity of the sample approaches the diversity of the population being studied. In finance, we know that diversity is fundamentally important in spreading risk. History shows that economies develop and become more stable through diversification. Often, in the things economists study and the methods we use, diversity is a good thing. To cite another example, research by economists and other social scientists supports the view that considering a diversity of perspectives and ideas leads to better decisions in an organization. I believe decisions by the Federal Reserve Board and the Federal Open Market Committee are better because of the range of views and perspectives brought to the table by my fellow policymakers, and I have encouraged this approach to decisionmaking at all levels and throughout the Fed System. One way to promote diversity of ideas is to promote diversity among the people we rely on for those ideas, including more than 300 Ph.D. economists who serve at the Board and more than 400 serving at the Fed's 12 Reserve Banks. At the Board, our Office of Diversity and Inclusion coordinates this effort, but everyone involved in the recruiting, hiring, management, and promotion of economists is engaged in it as well. When I was Vice Chair, I knew that promoting diversity among Fed economists was a priority for Chairman Bernanke, and it continues to be a priority for me. In 1977, when I joined the Board staff, I was one of relatively few women economists here. Since then, there have been significant gains in diversity at the Board and throughout the System. The Federal Reserve is committed to achieving further progress, and to better understanding the challenges to improving diversity throughout the economics profession. As an employer, the Fed is very serious about meeting its obligation to provide equal opportunity, and I also believe that diversity makes the Fed more effective in carrying out its mission, for reasons such as the one I mentioned a moment ago. But this conference offers an important opportunity to investigate all of the possible factors that influence the extent of diversity among economists at the Federal Reserve and elsewhere, including those factors that are affecting the education and advancement of economists everywhere in the United States. As a longtime member of the AEA, I am proud of the work our association has done to collect data and study diversity in the economics profession. Among the questions raised by the AEA's work on this topic is why relatively few women and minorities seem to consider economics as a concentration in college. The evidence is fairly clear that majoring in economics offers relatively high returns to college graduates whether or not they pursue further education in economics. It is worth knowing, for example, what undergrads who might consider concentrating in economics think about the curriculum and the employment prospects for economics majors compared with what those prospects actually are. To what extent might the lack of diversity among economics majors reflect a more general need to make basic economics more relevant and otherwise appealing to undergrads? The AEA has also done important work documenting and investigating the "leaky pipeline," trying to determine why some groups are more likely to abandon economics education and work before, and even after, receiving Ph.D.s. In reviewing the data on the representation and advancement of certain groups in the profession, there are differences in outcomes for women and minorities. To what extent are these disparities caused by differences in the experiences of those groups or due to broader and more general challenges faced in academia? Do the leaks from the pipeline that may be more noticeable for some groups reflect a broader lack of opportunity in academia? When economists delve into why there isn't more diversity among them, they end up asking about what is being taught in college, how economists are being trained in graduate school, and other questions that bear on the health and the future of the economics profession in general. These are not idle questions. All of you know that there has been a fair amount of public debate in recent years about the health of the economics profession, prompted in part by the failure of many economists to comprehend the dire threats and foresee the damage of the financial crisis. When the public asks whether economists did all they could have to understand those threats, in part they are asking whether our profession did enough over the years to test ideas and assumptions that turned out in some cases to have been mistaken or misplaced. And part of that question is this one: Did the economics profession recruit and promote the individuals best able to bring the energy, the fresh insights, and the renewal that every field and every body of knowledge needs to remain When this question is asked again someday, when economics is tested by future challenges, I hope that our profession will be able to say that we have done all we could to attract the best people and the best ideas. That, I believe, is the very worthy goal of this conference, and I look forward to seeing it advanced by today's discussions and by the continuing commitment demonstrated by the AEA to diversity. Thank you to those who organized the conference and to the distinguished members of our profession who have come here today to take part in it.

r141106a_FOMC

united states

A Financial System Perspective on Central Clearing of Derivatives

powell

Thank you for the opportunity to address the important topic of how the financial system and its regulation have evolved in response to the global financial crisis. I will focus my remarks on the global initiative to expand central clearing of over-the-counter (OTC) derivatives. While we have made significant progress in enlisting central clearing to reduce systemic risks, I will argue that there is a good deal more to do to ensure that the reforms achieve their potential and minimize the possibility of unintended and undesirable consequences. Prior to the crisis, the then highly opaque market for OTC derivatives grew at an astonishing and unsustainable pace of nearly 25 percent per annum in a context of relatively light regulation and bilateral clearing. With the benefit of hindsight, we know that along with this torrid growth came an unmeasured and underappreciated buildup of risk. The spectacular losses suffered by American International Group, Inc., or AIG, on its derivatives positions, and the resulting concerns about the potential effect of AIG's failure on its major derivatives counterparties, serve as particularly apt reminders of the wider failures and weaknesses that were revealed by the crisis. The threats posed were global, and the response was global as well. In September should be centrally cleared--a sea change in the functioning and regulation of these markets. And in the five intervening years, substantial progress has been made in the United States and abroad to implement this reform and begin to reduce systemic risk in these markets. According to public data, roughly 20 percent of all credit derivatives and 45 percent of all interest rate derivatives are now centrally cleared--amounts that have grown substantially since 2009, when central clearing of credit derivatives began and the amount of cleared interest rate derivatives was at roughly one-half of its current level. These amounts should continue to grow over time as central clearing and, especially, client clearing requirements take effect in more jurisdictions. Given the global nature of derivatives markets, the success of the reform agenda depends critically on international coordination. Thus, to support the move to central clearing and address other lessons from the financial crisis, regulators developed the new (PFMIs) for the infrastructures that clear derivatives, securities, and payments. The PFMIs are comprehensive international standards for the governance, risk management, and operation of central counterparties (CCPs) and other financial market infrastructures. Such standards are essential given that, in the interest of transparency and improved risk management, policymakers have encouraged the concentration of activities at these key nodes. And it is particularly important that the standards be promulgated globally, given the potential for OTC derivatives to span multiple jurisdictions and to migrate to jurisdictions where standards and risk management are less robust. Regulators are now engaged in the important work of translating these principles into national regulations. Only when these strong international standards have been implemented at CCPs around the world can the risk reduction promised by the global clearing mandate be fully realized. The task is far from complete. We must consider how central clearing and CCPs fit into the rest of the financial system. From this systemwide perspective, central clearing raises a number of important issues that should be kept in mind as its use increases. I will now consider several of those issues and associated challenges in some detail. A number of commentators have argued that the move to central clearing will further concentrate risk in the financial system. There is some truth in that assertion. Moving a significant share of the $700 trillion OTC derivatives market to central clearing will concentrate risk at CCPs. But the intent is not simply to concentrate risk, but also to reduce it--through netting of positions, greater transparency, better and more uniform risk-management practices, and more comprehensive regulation. This strategy places a heavy burden on CCPs, market participants, and regulators alike to build a strong market and regulatory infrastructure and to get it right the first time. It has also been frequently observed that central clearing simplifies and makes the financial system more transparent. That, too, has an element of truth to it, but let's take a closer look. Charts similar to the ones shown in figure 1 are frequently offered to illustrate the point that, as a CCP becomes a buyer to every seller and a seller to every buyer, it causes risks to be netted and simplifies the network of counterparties. The dizzying and opaque constellation of exposures that exists in a purely bilateral market, illustrated in the chart on the left, is replaced by a neat hub-and-spoke network that is both known and more comprehensible, illustrated in the chart on the right. The CCP and its regulators are then in a position to observe the CCP's entire network, which can be important in the event that one or more clearing members become impaired. CCPs may also be able to coordinate a response to problems in their markets in ways that individual clearing members would find very difficult. Figure 2 shows that, at the same time, in the real world CCPs bring with them their own complexities. As the figure shows, we do not live in a simple world with only one CCP. We do not even live in a world with one CCP per product class, since some products are cleared by multiple, large CCPs. Also, significant clearing members are often members of multiple CCPs in different jurisdictions. The disruption of a single member can have far-reaching effects. Accordingly, while CCPs simplify some aspects of the financial system, in reality, the overall system supporting the OTC derivatives markets remains quite complex. To carry out their critical functions, CCPs rely on a wide variety of financial services from other financial firms, such as custody, clearing, and settlement. Many of these services are provided by the same global financial institutions that are also the largest clearing members of the CCPs. The failure of a large clearing member that is also a key service provider could disrupt the smooth and efficient operation of one or multiple CCPs, and vice versa. In the event of disorderly CCP failures, the netting benefits and other efficiencies that CCPs offer would be lost at a point when the financial system is already under significant stress. Ultimately, the system as a whole is only as strong as its weakest link. People often think of these relationships between CCPs and clearing members in terms of credit exposures, but there are also important interconnections in the need for and use of liquidity. Historically, some CCPs viewed liquidity in terms of daily operational needs. From a macroprudential perspective, this view of liquidity is far too narrow. If a CCP is to act as a buffer against the transmission of liquidity shocks from a clearing member's default, the CCP itself must have a buffer of liquidity it can draw on to make its payments on time even during periods of market stress. The PFMIs introduced a new liquidity standard that requires CCPs to cover, at a minimum, the liquidity needs of the CCP on the failure of the single clearing member and its affiliates with the largest aggregate position, in extreme but plausible market conditions. Liquidity needs are to be met with a predefined list of liquid resources, starting with cash. Moreover, the largest clearing members participate in many CCPs around the world. Cash management at these clearing members, particularly intraday cash management, involves interconnected cash flows to and from a clearing member's various CCPs, other market infrastructures, and other financial institutions. If a clearing member were to default, cash flows and needed financial services could be disrupted simultaneously at several CCPs. Failure of one or more CCPs to pay margin or settle obligations as promised could impair the ability of a clearing member to meet other obligations and transmit liquidity risk to others in the financial system. Accordingly, CCPs require a liquidity profile that will allow them to absorb rather than amplify the liquidity shocks that are likely to materialize during a period of financial stress following a member's default. Of course, clearinghouses have been around for quite some time and have generally stood up well even in severe crises. But let's look a little deeper at the risks. During the global financial crisis, governments around the world took extraordinary actions to shore up many of the large financial institutions that are also large clearing members. While it is not possible to say with confidence what would have happened if these measures had not been taken, it is surely the case that whatever pressures CCPs faced would have been many times greater, and the potential consequences much greater as well. Moreover, as CCPs grow into their enhanced role in the financial system, they will represent an ever larger locus for systemic risk. It is therefore important not to be lulled into a false sense of security that past performance is a guarantee of future CCP success. After the crisis, governments firmly resolved that even the largest financial institutions must be allowed to fail and be resolved without taxpayer support and without threatening the broader financial system or the economy. CCPs therefore need to adapt to a world in which their largest clearing members will be allowed to fail and to be resolved without taxpayer support. And, as I will discuss a little later, the same is true of CCPs--they, too, should have no expectation of taxpayer support if they fail. To say it as plainly as possible, the purpose of all of this new infrastructure and regulation is not to facilitate the orderly bailout of a CCP in the next crisis. Quite to the contrary, CCPs and their members must plan to stand on their own and continue to provide critical services to the financial system, without support from the taxpayer. As you can see, central clearing represents the confluence of critical market infrastructure and systemic financial institutions. As a result, the regulation and supervision of CCPs present particular challenges. What matters most is the stability of the entire system, not that of one sector or another. In the United States, CCPs are primarily regulated by either the Commodity Futures Trading Commission or the a role in supervising and regulating systemically important CCPs and other financial market utilities. In addition, the Federal Reserve is the holding company supervisor of a number of the largest clearing members. The challenge is to ensure that regulation and supervision take into account the broad implications of derivatives trading for CCPs, their members, and the broader financial system. Close collaboration between regulators--both domestically and internationally--will be necessary to ensure that central clearing can promote the kind of financial system resiliency that will be required when another severe crisis threatens. While central clearing and CCPs do present a number of complex and unique challenges, these challenges are not insurmountable. Several measures should be considered in the near term to further strengthen the market and regulatory infrastructure relating to liquidity, transparency, stress testing, "skin in the game," and recovery and resolution. The adoption of the PFMIs around the world is driving improvements in CCP liquidity. Ultimately, CCPs and their supervisors will need to maintain vigilance to ensure that liquid resources are sufficient to withstand the kinds of liquidity shocks that would likely accompany a member's default. In addition, it is crucial that liquidity scenario analysis be a regular part of a CCP's stress-testing program to help ensure that appropriate liquidity planning does not suffer from a lack of vision or imagination. Enhanced transparency is central to the reform agenda, and there has been some progress in this area. But CCPs need to provide still greater transparency to their clearing members and to the public. The G-20's central clearing mandate shifted a significant amount of activity and control away from dealers to CCPs. With this shift, CCPs took on the responsibility of managing risks in a way that is transparent to the clearing members who are subject to the decisions of the CCP. Clearing members need a full and detailed understanding of their risk exposure to CCPs, which means that clearing members must have detailed and appropriate information on stress-test results, the specification and application of margin models, and the sizing of default funds to cover losses. Without a clear picture of a CCP's risk profile, clearing members cannot make informed decisions about whether to clear with a particular CCP or how to judge their exposures to it. All major stakeholders--clearing members, clients, regulators, and the broader market-- should be aware of the risks involved so that they can take appropriate steps to mitigate them. Stress testing The disclosure of CCP stress-test results to clearing members is important so that clearing members can have a full understanding of a CCP's risk profile. This disclosure, however, would be of little help if the stress tests themselves were insufficiently comprehensive and robust. For example, consider a case in which a bank belongs to two CCPs that clear similar products but the disclosed stress tests for the CCPs are based on materially different scenarios. This state of affairs could easily result in more confusion than clarity. It is time for domestic and international regulators to consider steps to strengthen credit and liquidity stress testing conducted by CCPs. Currently, most major CCPs engage in some form of stress testing. However, both clearing members and regulators need a more systematic view of what stress tests are performed, at what frequency, with what assumptions, and with what results. Aside from these issues involving individual stress tests, there are also important questions about the comparability of stress scenarios, assumptions, and results across similar and different types of CCPs. A related issue is whether regulators should consider some sort of standardized approach to supervisory stress testing. Not all CCPs are alike. But there may be approaches that could bring some of the benefits of standardization while allowing tailoring of some scenarios to the activities of particular CCPs or groups of CCPs. Clearly, a greater degree of uniformity would be helpful to clearing members that are comparing test results across several CCPs and to regulators that are considering systemwide stability. For example, there are likely some financial market stresses, such as rapid and significant increases in market volatility, that would be expected to have broad effects across financial markets and participants. Coordinated stress tests could also help us better understand the macroprudential risks around liquidity that I discussed earlier. Understanding the effect of such correlated stresses on a wide array of CCPs will be important for ensuring overall system resiliency. Going forward, regulators will need to work collaboratively to ensure that stress tests are robust, informative, and appropriately comparable. Skin in the game A number of commentators have urged U.S. authorities to consider requiring CCPs to place significant amounts of their own loss-absorbing resources in front of the mutualized clearing fund or other financial resources provided by clearing members. These skin-in-the-game requirements are intended to create incentives for the owners of CCPs for careful consideration of new products for clearing, for conservative modeling of risks, and for robust default waterfalls and other resources to meet such risks as may materialize. The issue is a complex one, however, and a number of factors would need to be considered in formulating such a requirement. Recovery and resolution I have focused so far on what we can do to ensure that CCPs do not fail: more transparency, enhanced stress testing, more robust capital and default waterfalls, stronger liquidity, and increased incentives to appropriately manage risks. I will conclude my remarks today by discussing what happens when all of these efforts encounter a severe stress event. Try as we might to prevent the buildup of excessive risk, we need to be prepared for the possibility that a CCP may fail or approach failure in the future. When and if such a crisis materializes, CCPs will be called on to stand on their own. CCPs and regulators need to develop clear and detailed CCP recovery and resolution strategies that are well designed to minimize transmission of the CCP's distress to its clearing members and beyond. Recovery and resolution planning is a matter of intense focus among regulators and industry participants. Just last month, the Committee on Payments and Market Infrastructures and the Board of the International Organization of Securities Commissions released their final report on the recovery of financial market infrastructures. The report is part of an ongoing effort to provide guidance on implementing the PFMI requirements for recovery planning. On the same day, the Financial Stability Board released a new report on the resolution of financial market infrastructures and their participants to supplement its earlier work on the report These reports stress that CCPs must adopt plans and tools that will help them recover from financial shocks and continue to provide their critical services without government assistance. It has been a challenge for some market participants to confront the fact that risks and losses, however well managed, do not simply disappear within a CCP but are ultimately allocated in some way to the various stakeholders in the organization--even if the risk of loss is quite remote. This realization has generated a healthy debate among CCPs, members, and members' clients and regulators that has provided fertile ground for new thinking about risk design, risk-management tools, and recovery planning. To ensure that CCPs do not themselves become too-big-to-fail entities, we need transparent, actionable, and effective plans for dealing with financial shocks that do not leave either an explicit or implicit role for the government. A key question posed at this conference is whether the reforms instituted in response to the crisis have improved the strength and stability of the financial system. In my view, the answer for OTC derivatives reform--and central clearing, in particular--is a positive one. But final pronouncements are premature. Post-crisis reforms and the rise of central clearing have started us down a path toward greater financial stability. At the same time, central clearing brings with it a number of complexities that relate to the interaction between CCPs and the rest of the financial system, especially the global systemically important financial institutions that represent many of their largest clearing members. Given the increasingly prominent role that central clearing will play in the financial system going forward, it is critical that we collectively get central clearing right. To do so, I have argued that it is imperative that we consider central clearing from a systemwide perspective, and that regulators will need to continue to work collaboratively with each other, both domestically and internationally.

r141107a_FOMC

united states

A Tiered Approach to Regulation and Supervision of Community Banks

tarullo

Earlier this year--also speaking to a conference at the Federal Reserve Bank of Chicago --I explained the need for an explicitly tiered approach to banking regulation and supervision. Today I would like to elaborate on those earlier remarks to suggest in more detail what a tiered approach would mean for community banks. Let me begin, though, by recapitulating my basic premise and the reasoning behind it. For more than 75 years following passage of the Banking Act of 1933, the motivation for banking regulation was fairly simple: the government had granted deposit insurance and access to the discount window to depository institutions to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified prudential measures, including prohibitions on non-banking activities, aimed at maintaining safe and sound banks, which would in turn protect taxpayers. Prudential regulation of bank holding companies by the Federal Reserve under authority granted by the Bank Holding Company Act of 1956 was aimed primarily at protecting insured depository institutions and the federal deposit insurance fund from knock-on effects of problems at affiliated nonbank businesses. This approach is what we now characterize as microprudential--that is, the focus is on the soundness of individual banks rather than on the financial system more broadly. This is not to say that financial stability had not been important to financial regulators, but this stability was implicitly assumed to follow from having sound individual banks. Over the years, of course, banking regulation evolved. For example, regulation expanded to encompass fair and open access to financial services for consumers. And, as developments in financial markets and deregulation over the past several decades led to a more concentrated financial sector in which bank holding companies could engage in a much broader range of activities, supervision was tiered within the bank regulatory agencies based on the size and complexity of the regulated institutions. But the financial crisis provoked a fundamental rethink of the aims of prudential regulation. There is now more widespread agreement that these aims should vary according to the size, scope, and range of activities of banking organizations. Most significantly, banks of a size and complexity such that serious stress or failure could pose risks to the entire financial system need regulation that incorporates the macroprudential aim of protecting financial stability. There is also a good argument that very large banks that fall short of this level of systemic importance should nonetheless be regulated with an eye to macroprudential aims, such as the ability of the banking system as a whole to provide credit. Although individual community banks may be an important source of credit, particularly in local economies outside urban areas, neither systemic risk nor broad macroprudential considerations are significant in thinking about prudential regulation of community banks. So what should the aims of such regulation be? The basic answer is it should protect the deposit insurance fund. In other words, the traditional microprudential approach to safety and soundness regulation continues to be appropriate for these banks. To develop that basic answer, I think it useful to begin with an understanding of both the business model of community banks--that is, how their financial intermediation adds value to the economy--and the ways in which such banks are most likely to encounter problems. There are roughly 5,700 community banks in the United States, the vast majority of which have less than $1 billion in total assets. These banks represent 98 percent of insured U.S. commercial banks, but collectively hold just under 20 percent of aggregate banking assets. Moreover, the business model of most community banks, especially smaller and rural banks, is built substantially on relationship banking. While community banks have over the years found it increasingly difficult to compete with larger banks in types of lending that can be efficiently scaled through larger volumes and standardized credit models, they maintain a comparative advantage relative to larger competitors through knowledge of their local communities and their individual borrowers. This means that community banks play a unique role in their local economies, particularly with regard to lending to small- and medium-sized businesses. Numerous studies have documented this advantage and its value to economic development. One recent study found that loans extended by rural community banks to small businesses default less frequently than similar loans granted by their urban counterparts, and that the performance advantage is greater when the bank and the borrower are located in the same county. This finding suggests that the "soft" information obtained from their local relationships usefully informs rural community banks' underwriting. Federal Reserve research also suggests that many community banks that adhered to the traditional relationship banking model of funding local lending with customer deposits continued to thrive even during the worst years of the financial crisis. In contrast, many small banks that turned to a more transactional model and funded construction loans--often outside of their local market--with borrowings, rather than core deposits, failed. And, precisely because of their business model, community banks do have their vulnerabilities. They are more likely to have geographic and portfolio concentrations that can make them vulnerable to localized economic problems. Of course, the failure of a community bank in these circumstances will only exacerbate these problems. Especially in rural areas, the disappearance of community banks could result in a permanent reduction in this local kind of credit, as the slack may not all be picked up by larger banks. Additionally, of course, there will usually be issues requiring supervisory and management consideration for at least a time. At present, as I know you have been hearing from your supervisors, these issues include cybersecurity and interest rate risks. To return, then, to the aims of prudential regulation of community banks, it seems that we can fill out the basic aims of protecting the deposit insurance fund and supporting the availability of relationship lending across the country by concentrating on traditional capital regulation to ensure solvency and on traditional examination practice to monitor the basic soundness of the relationship lending practices. We may also need to increase scrutiny when community banks move beyond their traditional business model and enter lines or markets that are more complex or with which they may not be familiar. But many rules and examinations that are important for institutions that are larger, more complex, or both, do not make sense in light of the nature of the risks to community banks. We must avoid importing measures from large bank oversight that make relationship banking more costly. With that explanation of the purposes of community bank oversight, let me now turn to more specific discussion of how we are tailoring regulation and supervision of community banks to achieve those aims. There are two complementary ways to implement a tiered approach to prudential regulation. One is to apply specific regulations only to those classes of banking organizations whose activities and scale require those measures. The second is to tailor the application of generally applicable measures based on the size, complexity, and possibly other characteristics of banking organizations. We are following both approaches in putting into place an explicitly tiered method of regulating community banks. An example of tailoring generally applicable regulations is the revised capital guidelines that were issued in 2013. It was clear in the wake of the financial crisis that strong capital positions were essential for banks of all sizes, including community banks. But a number of changes that were appropriate for large banks did not make sense for community banks. As I am sure you all recall, community banks gave us quite a bit of help in identifying which portions of the originally proposed rule were, and were not, appropriate for community banks. Following publication of the final capital rule, the three federal banking agencies developed a streamlined, supplemental to assist bank management in understanding the applicability of the rules to smaller, non-complex institutions. This exercise is an example of a broader effort to be explicit as to how prudential regulations that are sometimes quite detailed apply to community banks. By including such explanations in the introductory portions of broadly applicable regulations, our hope is that community bankers will be relieved of the task of wading through extensive regulatory texts just to find out what portions apply to their banks. This is a good point at which to note that the federal banking agencies have, in accordance with the terms of the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA), recently launched a review to identify banking regulations that are outdated, unnecessary, or unduly burdensome. One theme that has already been notable is the belief of community bankers that many regulations could be tailored more appropriately for community banks. I encourage you to participate in the EGRPRA process by giving us specific examples of regulations that should be modified in this way and, even more helpfully, by suggesting specific ways in which they might be usefully be tailored. As to exempting community banks entirely from certain regulations, I should note first that many of the statutory requirements introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act do not by their own terms apply to community banks. So, for example, the extensive enhanced prudential standards required by section 165 of Dodd-Frank for bank holding companies with more than $50 billion in assets do not apply to smaller banks. Nor do the requirements for stress testing and resolution planning. Similarly, the banking agencies have used their discretion to exclude community banks from the coverage of some new regulations adopted following the crisis. For example, we recently approved a final rule implementing in the United States a Basel agreement that establishes a quantitative minimum liquidity requirement, but limited its coverage to banking organizations with more than $50 billion in assets. We excluded community and smaller regional banks, which generally have relatively simple funding profiles and do not pose a significant potential risk to the financial system. However, some statutory requirements by their terms apply to all banks. Even if we do not believe that they actually advance safety and soundness aims for community banks, or produce only a small benefit at a disproportionately large compliance cost, we must still enforce them. It would be worthwhile to consider amendments to these statutory provisions to carve out their applicability to community banks. I have previously suggested two candidates for consideration: the Volcker rule and the incentive compensation requirements in section 956 of Dodd-Frank. The risks addressed by these statutory provisions are far more significant at larger institutions than they are at community banks. Moreover, in the unlikely event that a community bank engages in practices in either of these areas that raise heightened concerns, we would be able to address these concerns as part of the normal safety-and-soundness supervisory process. While the banking agencies have used the other method of tiering and tried to tailor the Volcker rule (as we will do with section 956), I believe that both community banks and supervisors would benefit from not having to focus on formal compliance with regulation of matters that are unlikely to pose problems at smaller banks. Today I would like to add a third candidate for consideration--a statutory amendment that would permit the Federal Reserve Board to raise the size of banks covered by our Small As background, the Board originally issued the policy statement in 1980 to facilitate the transfer of ownership of small community banks. The Board generally discourages the use of debt by bank holding companies to finance acquisitions, because debt can impair the ability of the holding company to serve as a source of strength to subsidiary banks. However, the Board also recognizes that limited access to equity funding by small institutions means that the transfer of ownership of small banks often requires the use of acquisition debt. The policy statement allows small, noncomplex bank holding companies to operate with higher levels of debt than would normally be permitted, subject to restrictions to ensure that higher debt does not pose an undue risk to subsidiary banks and that leverage is reduced over time. Bank holding companies that are subject to the policy statement are exempt from the Board's risk-based and leverage capital guidelines, and are subject to reduced regulatory reporting requirements. The original policy statement set the maximum size of qualifying holding companies at $150 million in total consolidated assets. This threshold was increased to $500 million in 2006 to address the effects of inflation, industry consolidation, and asset growth. The intervening eight years have obviously brought dramatic changes in the financial, business, and regulatory environments. Accordingly, I believe it is worth considering raising the asset threshold once again, this time to $1 billion. Approximately 85 percent of all bank holding companies qualified after the threshold was raised in 2006, a figure that has dropped to about 75 percent today. Raising the threshold to $1 billion would recoup that lost coverage and go a bit further, covering 89 percent of holding companies. Such an increase would entail some policy tradeoffs, of course, which obviously become of greater concern as the threshold rises further. But I think the balance of considerations argues for taking this action to facilitate transfers of ownership of small banks. For example, while exempting more bank holding companies could result in increased leverage, subsidiary banks remain subject to normal capital requirements. Supervisory and applications approval processes are available to limit instances in which holding companies could take on excessive debt. Similarly, because most bank holding companies under $1 billion have limited activities outside of their banks, and we will still receive detailed quarterly bank data, the reduced regulatory reporting requirements for qualifying holding companies should not be problematic for supervisors. Of course, the policy statement was issued by the Board and thus one might think the Board could raise the threshold on its own. However, the Collins amendment to Dodd-Frank effectively eliminates any authority of the Board to extend the capital treatment in the policy statement to holding companies with assets greater than the threshold in effect on May 19, 2010, or to savings and loan holding companies of any size. Thus, we would need legislative action to effect these changes. Federal banking regulators have long organized supervision into portfolios of institutions based predominantly--though for larger firms, not exclusively--on asset size. Various provisions of Dodd-Frank motivated the Federal Reserve to modify the composition of the portfolios somewhat. We have four such groups: (1) community banks, (2) regional banking organizations, (3) large banking organizations, and (4) firms overseen by the Large Institution This arrangement is not simply a matter of organizational convenience. Nor is it only a means for promoting consistency of treatment among similar banks throughout the Federal Reserve System, important as that goal is. As with tiered regulation, this tiered approach to supervision is intended to take account of differences in business models, risks, relative regulatory burden, and other salient considerations. Where specific regulatory goals for the different portfolios vary, the supervisory programs should reflect those differences. And where the goals are similar across portfolios, supervisory programs should take account of the differences among banks noted a moment ago. A tiered approach to prudential regulation calls not for a single state of the art in supervision, but for distinct state-of- the-art approaches to each supervisory portfolio. Some important implications for community bank supervision follow from this principle. First, the characteristics and business model of community banks must be reflected in the supervisory program. Detailed rules, regulations, and supervisory expectations are clearly needed at times for overseeing the systems created in large, geographically dispersed organizations where the distance from head office to operating branches can be very far indeed. But in a well-run community bank where the president may oversee a relatively small staff and can communicate and enforce expectations and standards face-to-face, some kinds of supervisory expectations needed for larger banks may be unnecessary. In fact, such supervision can be burdensome, because community banks have a smaller balance sheet across which to amortize compliance costs. Such rules can also sometimes conflict with the flexibility that is important to community banks meeting their customers' needs. For instance, community banks should readily comply with expectations that they extend credit on safe and sound terms. However, to the extent that supervisors dictate the precise details of what terms are safe and sound, banks may find it more difficult to structure a loan in a way that matches a borrower's needs or credit situation. This can result in a lessening of credit availability and economic activity. Attention to a bank's practices in making its relationship lending decisions, and on the performance of the loans that have been made, may be supervisory time better spent. A similar observation can be made with respect to consumer compliance supervision of community banks, for which the Federal Reserve implemented a new examination program in While we have traditionally applied a risk-focused approach to consumer compliance examinations, the new program more explicitly links examination intensity to the individual community bank's risk profile. Here again, the scale of community banks is directly relevant to supervisory choices. Community banks do not have large, standardized systems for dealing with many customers across a far-flung geographic footprint. They do have much more direct contact between customers and bank management. The new program calls for examiners to spend less time on low-risk compliance issues at community banks. In addition, we revised our consumer compliance examination frequency policy to lengthen the time between on-site consumer compliance and Community Reinvestment Act examinations for many community banks with less than $1 billion in total consolidated assets. A second implication of supervisory tiering is that supervision must not inadvertently undo the decisions made through regulatory tiering. This point raises the oft-cited concern about "supervisory trickle down," whereby supervisory expectations--or even regulatory requirements--formulated for larger banks are de facto applied in part to community banks. The concern has been particularly acute in the context of capital stress testing, though it is by no means limited to that area. Let me repeat here what all three federal banking agencies have explained in the clearest possible terms, both publicly, in examiner training, and in one-on-one Analysis and Review requirements and expectations for enterprise-wide capital stress testing do not apply to community banking organizations, either explicitly or implicitly. For example, while it may be sensible supervisory practice to inquire of a growing $9 billion bank if it has begun thinking about how it would meet DFAST requirements should it reach the current $10 billion statutory threshold, that bank does not need to start meeting those requirements until it has actually crossed the threshold. And there is simply no reason for examiners to make a $5 billion bank begin to develop capital stress testing capabilities. Third, the relatively straightforward business model of community banks, along with their relatively small scale and number of branches, provides the opportunity to increase the use of off-site supervisory oversight, in accordance with informing principles of risk-based supervision. For example, last year we pilot-tested a voluntary program under which some aspects of the loan review process were conducted off-site, relying on the bank's electronic records to assess loan quality and underwriting practices. Overall, community bankers that were part of the pilot expressed strong support for this approach, which reduced the time examiners needed to spend on-site at bank offices. As a result, we plan to continue using this approach in future examinations at qualified banks that maintain electronic loan records and wish to participate in this approach. This initiative could tangibly reduce burden on community banking organizations. More generally, the Federal Reserve has invested substantial resources in developing technological tools for examiners to improve the efficiency of both off-site and on-site supervisory activities. These tools should lead to greater consistency and more efficient, effective, and risk-focused examinations as they assist staff in tailoring the scope of examinations to the activities and risks at individual banks. The automation of various parts of the community bank examination process can also save examiners and bank management time, as a bank can submit requested pre-examination information electronically rather than mailing paper copies to a Federal Reserve Bank. These observations relate to another issue that I might note in passing. As you know, there have been questions raised as to whether the level of required reporting is itself a regulatory burden that might be mitigated for small banks. The banking agencies are considering these issues under the auspices of the Federal Financial Institutions Examination Council. I do think there may be some opportunities to streamline the content or frequency of reporting for smaller banks. However, I would observe that many of the efficiency improvements that I have previously described were dependent on the data collected each quarter in Call Reports. For example, the availability of this data was a factor in raising the threshold for eligibility for the 18-month examination cycle from $250 million to $500 million. Similarly, the regular Call Report data for subsidiary banks buttress the case for increasing the threshold for application of the Small Bank Holding Company Policy Statement. Thus, there may be some tradeoffs among various possible simplifying supervisory measures. As I noted in my speech six months ago, the old unitary approach to prudential oversight has in practical terms been supplanted by various statutory, regulatory, and supervisory measures, particularly since the financial crisis. Tiered regulation and supervision is a reality. My hope is that by acknowledging and, indeed, applauding that reality, legislators and prudential regulators can shape an oversight regime that most effectively realizes the complementary goals of banking soundness, financial stability, and economic growth. Post-crisis attention has understandably been focused on too-big-to-fail issues and other sources of systemic risk. But now is a good time to look at the other end of the banking industry, where the contrast is substantial. Smaller banks present a very different set of business models. Their risks and vulnerabilities tend to grow from different sources. An explicit and sustained tailoring of regulation and supervision for community banks not only seems reasonable, it seems an important and logical next step in financial regulatory reform.

r141107b_FOMC

united states

Remarks at the Panel Discussion on "Shaping the Future of the Macroeconomic Policy Mix"

yellen

I would like to thank the Banque de France for inviting me to take part in what I expect will be a lively discussion. The suddenness and severity of the global financial crisis forced policymakers to respond rapidly and creatively, employing a wide range of macroeconomic tools-- including both monetary and fiscal policies--to arrest a steep economic downturn and restart the global economy. Given the slow and unsteady nature of the recovery, supportive policy remains necessary. Today I would like to briefly review the evolution of monetary and fiscal policies following the global financial crisis both in the United States and in other advanced economies, since we have faced similar experiences and employed similar policy responses. I will try to draw some lessons and provide some thoughts on the policy mix going forward. Policy before the Crisis Prior to the global financial crisis, inflation rates in the United States and other advanced economies were near their target levels and most of these economies appeared to be operating close to their potential. Policy interest rates were similarly in the vicinity of levels considered to be normal. Fiscal deficits also appeared to be under control before the crisis. According to government deficits in 2007 were less than 4 percent of GDP in the United States and the United Kingdom, about 2 percent in Japan, and less than 1 percent, on average, in the euro area. Still, given relatively buoyant economic conditions, governments probably should have been doing more to prepare for the long-term challenge of aging populations, which will boost pension obligations and health-care expenditures in coming years. Moreover, government debt levels were already high in Japan and in some European economies and not particularly low elsewhere. In addition, some euro-area countries that appeared to have strong fiscal positions going into the crisis depended partly on revenue from housing booms that soon went bust. When the crisis hit, its global scope and severity were exceptional. Central banks in the United States and other countries responded by rapidly and sharply reducing their policy interest rates, lowering them in many cases to near zero. In addition, in their role as lenders of last resort, central banks acted rapidly to provide liquidity to help stabilize the financial system and support the flow of credit to households and businesses, in some cases creating new lending facilities. These extraordinary and creative responses showed that monetary policymakers had internalized the lessons of the Great Depression. Initially, fiscal policy also provided significant stimulus. A portion of this stimulus reflected the operation of automatic stabilizers--higher unemployment benefits, for example, and a decline in tax payments due to lower incomes--and some came through cuts in tax rates and increases in discretionary spending. Expansive fiscal policy served to raise deficits in most countries, some of which faced further costs from stabilizing financial institutions, pushing deficits even higher. Sharp increases in deficits led in turn to escalating levels of government debt. Policy during the Recovery The combination of increasing debt and depressed output led to rising ratios of debt to gross domestic product (GDP) in many advanced economies and heightened concern about whether the growth in debt could be sustained without unsettling financial markets. As a result, early in the recovery governments began to withdraw fiscal stimulus, and, in most cases, fiscal policy became a net drag on economic growth. This outcome was most evident in the euro-area periphery, where skyrocketing bond yields and deepening concerns about default left governments with little choice about whether to rein in stimulus. In Spain, for example, the OECD estimates that fiscal consolidation has subtracted an average of 1-1/2 percentage points from GDP growth each year since 2009. But fiscal policy also turned contractionary in countries facing less market pressure, such as the United Kingdom and the United States. Governments in both countries embarked on fiscal consolidation programs over the past four years, sharply reducing their structural deficits, and, as a consequence, creating headwinds that slowed the recovery. With fiscal drag weighing on growth and with private-sector deleveraging also holding back consumption and investment, monetary policy bore the brunt of supporting the economy. With policy rates at or approaching zero, central banks of necessity turned to unconventional policy tools such as large-scale asset purchases and enhanced forward guidance about the future path of policy rates. These unconventional tools have, in my view, served to support a recovery in domestic demand and, as a consequence, global economic growth. Even so, the recovery in most advanced nations has proceeded more slowly than policymakers would have hoped. This sluggishness has been due in part to the severity of the financial shock associated with the crisis and the persistent headwinds to recovery in its aftermath. But the lack of fiscal support for demand in recent years also helps account for the weakness of this recovery compared with past recoveries. States, fiscal policy has been much less supportive relative to previous recoveries. For instance, at a comparable point in the recovery from the 2001 recession, employment at all levels of government had increased by about 800,000 workers; in contrast, in the current recovery, government employment has declined by about 650,000 jobs. What lessons can we draw from this experience? The first is that governments need to address long-term challenges and significantly improve their structural fiscal balances during good times so they have more fiscal space to provide stimulus when times turn bad. When poor economic conditions drive policy interest rates close to the zero lower bound, fiscal stimulus may be more effective than usual in boosting aggregate demand because it will not have the usual effect of raising real interest rates, thereby crowding out private demand. A second lesson is that, while even if it is appropriate for fiscal policy to play a larger role when policy rates are near zero, policymakers nevertheless may face constraints in implementing fiscal stimulus. This means that central banks need to be prepared to employ all available tools, including unconventional policies, to support economic growth and to reach their inflation targets. A third critical lesson pertains to the importance of having a sound and resilient financial sector with strong capitalization and prudent risk management, supported by effective regulation and supervision. The recent crisis has appropriately increased the focus on financial stability at central banks around the world. At the European Central Bank (ECB), the recent comprehensive assessment is an important step toward building confidence in euro-area banks. I wish the ECB great success as it takes on its new responsibilities at the center of the single supervisory mechanism. At the Federal Reserve, we have devoted substantially increased resources to monitoring financial stability and have refocused our regulatory and supervisory efforts to limit the buildup of systemic risk. This macroprudential approach to promoting financial stability will be an important complement to our other tools for promoting a healthy economy. In advanced economies, the current macroeconomic policy mix generally remains one of extraordinary monetary policy stimulus and somewhat contractionary fiscal policy. Considering the headwinds that continue to weigh on growth, employment, and prices, this situation is hardly ideal. Policymakers face difficult choices as they seek to balance the need for long-term fiscal sustainability with the need to support their economies in the near term. Even so, I continue to anticipate that the headwinds associated with the financial crisis will wane. As employment, economic activity, and inflation rates return to normal, monetary policy will eventually need to normalize too, although the speed and timing of this normalization will likely differ across countries based on differences in the pace of recovery in domestic conditions. This normalization could lead to some heightened financial volatility. But as I have noted on other occasions, for our part, the Federal Reserve will strive to clearly and transparently communicate its monetary policy strategy in order to minimize the likelihood of surprises that could disrupt financial markets, both at home and around the world. More importantly, the normalization of monetary policy will be an important sign that economic conditions more generally are finally emerging from the shadow of the Great Recession.

r141114a_FOMC

united states

Monetary Policy Accommodation, Risk-Taking, and Spillovers

powell

For release on delivery Remarks by at Economy"--is surely a timely one. I will offer brief introductory thoughts and then discuss some recent research by Federal Reserve Board economists that has bearing on these matters. The Federal Reserve's monetary policy is motivated by the dual mandate, which calls upon us to achieve stable prices and maximum sustainable employment. While these objectives are stated as domestic concerns, as a practical matter, economic and financial developments around the world can have significant effects on our own economy and vice versa. Thus, the pursuit of our mandate requires that we understand and incorporate into our policy decision-making the anticipated effects of these interconnections. And the dollar's role as the world's primary reserve, transaction, and funding currency requires us to consider global developments to help ensure our own financial stability. Since the financial crisis, the Federal Reserve has pursued a highly accommodative monetary policy, which has had important effects on asset prices and global investment flows. With unconventional tools, the scale and scope of these effects were difficult to predict ex ante. Nor is it possible to predict with confidence how markets will react day to day as policy returns to normal. The Federal Open Market Committee (FOMC) has gone to great lengths to provide transparency about its policy intentions. Yet, since Chairman Bernanke first discussed the end of the asset purchase program in mid-2013, volatility has surprised both on the upside (the "taper tantrum") and on the downside (the actual taper and the low volatility throughout most of 2014). In my view, while market volatility will continue to ebb and flow, these fluctuations are not likely to have important implications for policy. The path of policy will depend on the progress of the economy toward fulfilment of the dual mandate. Overall, accommodative monetary policy seems to have provided significant support for U.S. growth. And, of course, a strong U.S. economy contributes to strong growth around the globe, particularly in the emerging market economies (EMEs). But what of the so-called spillovers in the form of flows into, and out of, EMEs, whose financial sectors are small compared with global investment flows? Such spillovers could merely reflect investor responses to changing differentials between rates of return abroad and in the United States. But these spillovers could also reflect shifts in investor preferences for risk. By design, accommodative monetary policy--whether conventional or unconventional--supports economic activity in part by creating incentives for investors to take more risk. Such risk-taking can show up in domestic financial markets, in the international investments of U.S. investors, and even, ultimately, in general risk attitudes toward foreign financial markets. Distinguishing between appropriate and excessive risk- taking is difficult, however. I now turn to some recent research on whether there has been an increase in the riskiness of our investments abroad and whether such increases might be traced to the current low-interest rate environment. Many studies of the pre-crisis period document the pro-cyclical nature of bank lending and leverage, and the buildup of risk-taking and leverage by banks. It is much harder to find evidence that low interest rates have led to increased post-crisis risk-taking by U.S. banks. Growth in overall lending by U.S. banks has been modest at best. However, some pockets of increased risk-taking by banks and other investors are observable in domestic markets, such as leveraged loans. And on the international front, there has been a notable increase in syndicated loan originations. Recent research by Board staff, using a database of loans primarily to U.S. borrowers but also to some foreign borrowers, suggests that lenders have indeed originated an increased number of risky syndicated loans post-crisis, based on the assessed probability of default as reported to bank supervisors (figure 1). results confirm that the average probability of default is significantly inversely related to U.S. long-term interest rates. This increase in riskiness of syndicated loans post-crisis has been accompanied by a shift in the composition of loan holders: An increasing share is now held not by banks but by hedge, pension, and other investment funds (figure 2). These nonbank investors also tend to hold loans with higher average credit risk (figure 3). These data suggest that a tougher regulatory environment may have made U.S.-based bank originators unable or unwilling to hold risky loans on their balance sheets. Related work by the same researchers, using a database with more-extensive coverage of loans to foreign borrowers, shows a similar pattern of increased risky loan underwriting by international lenders, an increase that is also significantly inversely related to U.S. interest rates. Together, these results suggest a potential spillover from accommodative U.S. monetary policy through increased risk-taking in syndicated loans globally, although preliminary results also indicate that investors still require extra return for this extra risk. Another area in which to look for links between low interest rates and risk-taking is in cross-border securities purchases. The role of low interest rates in advanced economies in encouraging capital flows to EMEs where returns are higher has been a familiar theme. And recent studies have found that asset prices in EMEs do respond systematically to U.S. monetary policy shocks. For evidence of increased risk-taking in cross-border investment, let's look at the composition of U.S. investors' foreign bond portfolios. Although emerging market bonds remain a relatively small proportion of the aggregate U.S. cross-border bond portfolio (figure 4), within foreign government bonds, U.S. investors have modestly shifted their portfolio shares toward higher-yielding bonds of emerging market sovereigns (figure 5). Ex post, these portfolio reallocations delivered a higher return to U.S. investors on this part of their portfolio relative to what they would have received if they had left portfolio compositions unchanged at the average shares in 2008 and 2009, but at a cost to the portfolio's credit quality (figure 6). Regression results confirm that in choosing among foreign government bonds, U.S. investors have put more weight on returns since the crisis. But search for higher returns has not been the only motivation for international investors post-crisis: Demand for liquid high-grade "safe" or money-like assets has also increased from foreign official investors for investment of foreign exchange reserves, from pension funds and other institutions who face portfolio allocation constraints or regulatory requirements, and from investment strategies requiring cash-like assets for margining and other collateral purposes. Some shift to safe assets is also seen in U.S. portfolios: U.S. investors actively rebalanced their holdings of foreign financial sector bonds toward those with higher credit ratings, but at some cost in returns (figure 7; figure Taken together, developments in U.S. bond portfolios do not indicate a worrisome pickup in risk-taking in external investments. But it is important to recognize that portfolio reallocations that seem relatively small for U.S. investors can loom large from the perspective of the foreign recipients of these flows. At roughly $400 billion at the end of 2012, emerging market bonds accounted for a tiny fraction of the roughly $25 trillion in bonds held by U.S. investors. But to the recipient countries, these holdings can account for a large fraction of their bond markets. Even relatively small changes in these U.S. holdings can generate large asset price responses, as was certainly the case in the summer of 2013. Likewise, a reassessment of risk-return tradeoffs could disrupt financing for projects that are dependent on the willingness of investors to participate in global syndicated loan markets. We take the consequences of such spillovers seriously, and the Federal Reserve is intent on communicating its policy intentions as clearly as possible in order to reduce the likelihood of future disruptions to markets. We will continue to monitor investor behavior closely, both domestically and internationally.

r141120a_FOMC

united states

Liquidity Regulation

tarullo

The financial turbulence of 2008 was largely defined by the dangers of runs--realized, incipient, and feared. Facing deep uncertainty about the condition of counterparties and the value of assets serving as collateral, many funding markets ground to a halt, as investors refused to offer new short-term lending or even to roll over existing repos and similar extensions of credit. In the first instance, at least, this was a liquidity crisis. Its fast-moving dynamic was very different from that of the savings and loan crisis or the Latin American debt crisis of the 1980s. The phenomenon of runs instead recalled a more distant banking crisis--that of the 1930s. Despite this defining characteristic of the last crisis, measures to regulate liquidity have by-and-large lagged other regulatory reforms, for at least two reasons. First, prior to the crisis there was very little use of quantitative liquidity regulation and thus little experience on which to draw. While the Basel Committee got to work quickly, senior central bankers and heads of bank supervisory agencies extended the timeline for implementation of liquidity standards to guard against unanticipated, undesirable consequences from these innovative regulatory efforts. A second reason liquidity regulation has followed other reforms is that judicious liquidity regulation both complements, and is dependent upon, other important financial policies--notably capital regulation, resolution procedures, and lender-of-last-resort (LOLR) practice. Work on liquidity regulations has both built on reforms in these other areas and occasioned some consideration of the interaction among these various policies. But while perhaps a bit drawn out, the work has proceeded. A final version of a Liquidity Coverage Ratio (LCR) was agreed internationally and has been adopted by regulation in the United States. Ratio (NSFR) is another significant milestone in building out a program of liquidity regulation. Today I would like to take stock of the progress that has been made. I will first describe the role of liquidity regulation, including how it relates to those other dimensions of regulation I mentioned a moment ago. Next, I will review the specific liquidity regulatory and supervisory measures that have been put in place or are in the process of development. In concluding, I will offer an interim appraisal of our approach to liquidity regulation and identify some of the issues that remain. Liquidity vulnerabilities are, of course, inherent to most forms of financial intermediation. The canonical case is that of maturity transformation by a very conventional bank, which takes demand deposits and uses the funds to make loans that are repaid only over time. Should an unusual number of depositors want to withdraw their funds, for whatever reason, the bank may not have sufficient cash on hand to meet those demands. And, because the value of most of the bank's loans will be difficult for outsiders to determine, they can be sold to generate more cash only at a significant discount and probably not as quickly as the bank's liquidity needs might dictate. If depositors other than those initially seeking to withdraw funds hear that the bank may have difficulty meeting the demand, they may be motivated to join the withdrawal line before the bank runs out of cash entirely or, even worse, becomes insolvent. This, of course, leads to a bank run. The classic responses to this classic problem have been a combination of deposit insurance and discount window access. The former, established as part of New Deal banking reforms, assures depositors that they need not worry about insolvency, thereby presumably keeping out of the withdrawal line depositors who thought they might lose their funds entirely. The latter gives the bank access to short-term liquidity in order to meet the demands of depositors who have an immediate need for cash. Regulatory requirements were imposed to guard against the moral hazard that both programs could create. The resulting system meant that there were relatively few liquidity problems in the deposit-funded commercial banking system over the ensuing few decades. Beginning in the 1970s, deposits began to decline as a proportion of funding for credit intermediation, as the separation of traditional lending and capital markets activities established by New Deal financial regulation began to break down. During the succeeding three decades, these activities became progressively more integrated, as credit intermediation relied more heavily on capital market instruments sold to institutional investors. Over time, these markets became--like traditional commercial banks--an important locus of maturity transformation, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid. When, in 2007, questions arose about the quality of some of the assets on which this intermediation system was based--notably, those tied to poorly underwritten subprime mortgages--a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets. Liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop. In short, the financial industry in the years preceding the crisis had been transformed into one that was highly susceptible to runs on the short-term, uninsured cash equivalents that funded longer-term extensions of credit. Designing and implementing a policy response in light of the vulnerabilities of short-term wholesale funding markets that were revealed in the 2007-09 crisis is an integral part of post- crisis reform. The key question is how to balance the important role these markets have come to play in funding economic activity with the need to contain the destabilizing risks of runs in these same markets. To get a better sense of the terms of this balancing effort, let me examine the implications, first, of relying completely on liquidity requirements to manage liquidity problems, and then of relying entirely on LOLR liquidity from a central bank. The shortcomings associated with either of these one-dimensional approaches demonstrate why liquidity regulation and LOLR should be viewed as complements and not substitutes. Consider first a regime in which there is no LOLR and, thus, financial intermediaries are left to self-insure against liquidity risk. Absent regulation, in normal times firms might choose to As Tirole explains, firms may be incentivized to sacrifice some insurance in order to buy more illiquid (and presumably higher-yielding) investments. This choice raises the prospect of huge negative externalities, since each firm may hold a smaller buffer than is socially optimal. Were a liquidity stress to arise, particularly one following an asset price shock that broadly affected financial intermediaries, the result could be the kind of freezing up of financial system gears that took place a few years ago, with consequences for the broader economy that went well beyond the effects on specific markets or institutions. Assume, then, that regulation is put in place to force intermediaries to internalize all the liquidity costs of even the most severe, low-probability systemic events. Firms would have to demonstrate that they either maintained more or less matched durations of their assets and liabilities in the steady state or, what in some circumstances could amount to much the same thing, have liquidity buffers sufficient to meet all liquidity demands even during a systemic event following a major shock to asset values. Such an approach would entail two major costs. First, such a requirement would significantly constrain the level of liquidity and maturity transformation in normal times, surely resulting in significant constraints on credit extension, with consequent negative effects on economic growth. A primary economic function of banks and other financial intermediaries is facilitating liquidity management throughout the economy. Demand deposits and other short-term bank liabilities are safe, easy-to-value claims that are well suited for transaction purposes and provide money-like benefits to firms and households. Second, in a world without LOLR, shortages of liquid assets would be exacerbated during stress episodes. Banks would likely hoard their liquidity buffers. Knowing they must rely only on their own liquidity to meet demands even as market uncertainty is increasing and asset values suffer downward pressure, banks would have to reduce dramatically their core intermediation function. They would be reluctant to lend to firms and households that are themselves subject to the impact of the systemwide liquidity shocks. These real-economy actors would thus be unable to fulfill their own financial obligations in a timely fashion or would pare back their own activities out of concern about their ability to do so. Another adverse feedback loop could result. Even without liquidity regulation and with an LOLR, there is a tendency to hoard liquidity during periods of financial instability, as evidenced between 2007 and 2009 when banks actually increased their balance sheet liquidity instead of running down their liquidity buffers. It is worth noting that this very dynamic helped motivate the creation of the Federal Reserve. If solvent banks are confident that they will be able to borrow from the central bank against good collateral to meet any unforeseen funding needs, then they need not completely stop lending even amid increased uncertainty about future funding needs. Lending by the central bank is an essential tool to address liquidity stress and to mitigate--though not eliminate--the externalities imposed on the real economy through defensive hoarding by intermediaries. The importance of lending by the central bank is emphasized in much of the economics literature, where LOLR is often viewed as the optimal policy tool. Consider now the opposite approach to dealing with liquidity stress, one that relies largely on the LOLR function of the central bank. If the problem with complete reliance on self- insurance is that firms would ration liquidity too tightly in normal times and hoard it in periods of stress, the obvious problem with a readily available LOLR is that firms would maintain only the liquidity needed for operations in normal times and do essentially no self-insuring for periods of stress. Some might argue that this state of affairs is not actually problematic, so long as the intermediaries are sufficiently capitalized to remain solvent under stressed circumstances. The theory of LOLR lending rests on institutions being fundamentally solvent. Central bank provision of liquidity is not intended to prop up weak or insolvent institutions. Rather, the objective is to facilitate financial intermediation generally, and maturity transformation in particular, by relieving unusual liquidity strains associated with periods of financial stress. Indeed, to support their independence and to guard against their engaging in fiscal policy, central banks are correctly permitted to take on only a small amount of credit risk. Thus, most advocates of expansive LOLR programs would readily agree with the need for strong capital standards, so as to limit the number of occasions on which market participants run because they question the solvency of a firm, and to provide a solid basis for LOLR extensions of liquidity by insulating the central bank from credit risk. It is surely important to maintain strong capital standards. And it is true that the prudential supervisory role of a central bank may at times give it greater insight into the balance sheet of regulated institutions, such as through well-developed supervisory stress tests. In practice, however, the line between illiquidity and insolvency can be very blurry. Particularly in periods of stress, when the value of important asset classes may be quite volatile and very difficult to determine, the central bank cannot always easily disentangle illiquidity and insolvency risks. For the same reasons that an expansive LOLR can create the risk of central banks assuming more than small amounts of credit risk, it can also create moral hazard. Models in economic literature that conclude the socially optimal policy is for the central bank to backstop aggregate liquidity risk generally assume that credit risk is negligible (or can be priced perfectly) and the only source of risk is that related to liquidity. In this abstract world, there is no moral hazard, at least in the sense that the firm with access to the LOLR will hold an insufficient quantity of liquid assets. This is because all assets are effectively liquid, since the central bank can always lend against assets that may be illiquid in private markets. Outside the world of theory, however, moral hazard is a significant problem. The central bank will sometimes be asked to lend to a financial institution precisely because its creditors are pulling back out of concern that the institution may not be able to meet its obligations. Even if the central bank were appropriately reluctant to increase moral hazard by stepping in for private funding when an institution is in fact insolvent, the prospect of a rapid, disorderly default could still motivate LOLR lending. The reasoning would be that central bank lending in such a situation could provide a bridge to an acquisition, a more orderly failure, or an internally generated recovery of the institution. Any of these outcomes would forestall fire sales of assets or a default that could cascade across the financial system. But while LOLR lending might be the best of a bad set of choices when confronted with those circumstances, those frantic efforts are the very situations that pose the highest risk of the central bank taking on mispriced credit risk. The prospect--perhaps even expectation--of such action can foster significant moral hazard. While the central bank can, to some extent, control the potential moral hazard by pricing credit risk correctly or, more practically, by reducing credit risk close to zero by taking a large amount of collateral, this approach could at times actually compound liquidity stress. If the central bank requires so much collateral that the risk to other short-term creditors rises, then those creditors have an even greater incentive to run, thereby exacerbating the situation and complicating a bankruptcy or orderly liquidation proceeding. Similarly, if central bank lending facilitates exit by the uninsured depositors of a troubled bank, the costs borne by remaining creditors or the deposit insurance fund will increase. Indeed, it is for this reason that the Federal discount window lending by the Federal Reserve to undercapitalized banks. Thus, while liquidity regulation should not require self-insurance against low probability, severe systemic events, it has an important role to play alongside capital regulation and resolution mechanisms in reducing the likelihood of systemic events and making them more manageable when they do occur. It can serve both as a tax and a mitigant to offset the externalities associated with liquidity risk. There is an additional role for liquidity regulation, one suggested by much of the preceding discussion. When a firm faces a run on its funding, it is likely either insolvent or in a condition that makes an assessment of its solvency difficult for counterparties, investors, and regulators. That is, by this point the capital position of the firm is perceived as sufficiently uncertain so as to call into question its continued viability. Liquidity regulation can ensure that, even in these circumstances, officials have at least a bit of time to assess liquidity troubles and the underlying condition of the firm, as well as the degree to which the troubles are idiosyncratic or systemic. With appropriate insolvency mechanisms available, authorities can then decide whether the firm will recover or needs to be placed into a resolution or liquidation regime, while proceeding in a manner consistent with the Dodd-Frank Act injunction that LOLR measures in exigent circumstances are not to be used for the benefit of a single firm. This is not to say that everything will always proceed smoothly, of course. But such an approach can extend the proverbial runway for a troubled firm and help avoid repeats of the situation six years ago, when policymakers confronted with chaotic financial conditions had little time to react and few available tools other than government liquidity and, eventually, capital injections. After a somewhat lengthy gestation period, there has been considerable recent progress on measures that reflect the role for liquidity regulation I have just described. The U.S. banking agencies have worked with other regulators in the Basel Committee on Banking Supervision to develop two quantitative liquidity standards--the LCR and the NSFR. These standards complement the bank capital framework and resolution mechanisms that have been agreed internationally. They will also help central banks limit the use of LOLR. In addition, as I have previously noted, the Federal Reserve is working on a proposal to tie risk-based capital short-term wholesale funding. Together, these standards are designed to mitigate the risks associated with banks' reliance on unstable funding structures and to encourage them to embrace more resilient funding models. Under the LCR, banking organizations must hold a buffer of high-quality liquid assets sufficient to cover net cash outflows during a 30-day stress scenario. This requirement serves several of the purposes discussed earlier. A buffer of high-quality liquid assets is a form of self- insurance against liquidity risk that allows banks to meet short-term needs in the event of creditor runs. Because holding the buffer is likely to be somewhat costly, the LCR should also encourage banks to reduce use of very short-term wholesale funding that increases buffer requirements. The buffer will also provide central banks and other national authorities time to assess the financial condition of a firm encountering liquidity difficulties and to determine the extent to which these difficulties are a function of essentially firm-specific factors or a harbinger of market-wide funding stress. A revised version of the NSFR has recently been released by the Basel Committee. complements the LCR by looking beyond a 30-day period to achieve a stable funding profile for firms more generally. In this regard, it is important to recall that the deterioration of funding markets began well before the financial crisis reached its acute stages. In the summer of 2007, responding to signs of trouble in the subprime mortgage markets, creditors reduced the maturities of funding they were willing to provide to financial intermediaries that had been creating and holding securities backed by subprime--and eventually other--mortgages. This process left those intermediaries in increasingly fragile funding positions, and by the time Lehman Brothers collapsed in September 2008, the system was primed for a devastating run. Given the possibility of this type of sustained erosion of firm funding structures over an extended period, simply requiring firms to hold a liquidity buffer against 30-day outflows, as required by the LCR, would be insufficient. While there is thus a need for a longer-term structural standard such as the NSFR, the conceptual challenges in crafting it were greater than in designing the LCR. Simply extending the LCR to one-year--that is, requiring firms to hold enough liquidity to survive a one-year funding market freeze--seemed the kind of excessive self-insurance that would lead to undesirably reduced maturity transformation and financial intermediation. So a different set of standards needed to be developed, which themselves occasioned considerable discussion about the effects and incentives they would create. Also, one could argue that the NSFR should have aimed for a more complete term structure in order to protect against maturity mismatches within and beyond the one-year mark, and to create stronger incentives for firms to extend the maturity of their funding arrangements. Considerable attention was paid to these and other concerns during the consultative and deliberative processes in the Basel Committee. As I mentioned earlier, the seriousness with which central bankers and regulatory agencies took these concerns is evidenced by the fact that the NSFR was subject to considerable revision over the last four years. I anticipate we will hear similar, and perhaps additional concerns, from a variety of perspectives when the federal banking agencies issue a proposed rule next year to implement the NSFR in the United States. This process should result in a regulation that reduces the probability of banks coming under short- term funding pressures. Maintaining more stable funding, such as retail deposits and term funding with maturities of greater than six months, will help avoid the spiral of fire sales of illiquid assets that deplete capital and exacerbate market stress. Unlike the LCR--and the originally finalized version of the Basel NSFR--the newly finalized NSFR also begins to address the risks associated with matched books of securities financing transactions. On its face, a perfectly matched book might seem to pose little risk to the firm, since it could run off assets as it lost funding. In reality, however, a firm may be reluctant to proceed in so symmetrical a fashion. In such a context, "running off assets" may mean denying needed funding to clients with which the firm has a valuable relationship. Moreover, even if the firm does run off assets, a firm with a large matched book will almost surely be creating liquidity squeezes for these other market actors. To partially address these risks, the NSFR will require firms to hold some stable funding against short-term loans to financial firms. Under the enhancement of the international G-SIB surcharge being developed by the Federal Reserve, the formula used to set risk-based capital surcharge levels for U.S. G-SIBs would incorporate each U.S. G-SIB's reliance on short-term wholesale funding. Greater reliance on short-term wholesale funding leaves firms more vulnerable to runs that impose externalities on the entire financial system. Requiring higher capital levels at such firms will improve their chances of maintaining access to market funding in periods of stress by providing greater assurance of their solvency to counterparties. The LCR and NSFR developed in the Basel Committee are path-breaking measures that create quantitative liquidity requirements. Still, they do not fully cover all facets of liquidity risk. We are trying to address those residual risks in two ways--first, by adding certain requirements in our domestic implementation of the international standards and, second, through our supervisory program. As to augmenting the international standards, let me give two examples. First, the Basel LCR does not impose any regulatory charge on a bank's use of overnight funding to fund assets that mature in less than 30 days. This lacuna leaves open the possibility of a significant maturity mismatch within the 30-day LCR window. The U.S. LCR fills this gap by imposing a regulatory charge on maturity mismatch within the 30-day period. Second, because the Basel LCR and the NSFR each calculate the liquidity position of a firm on a fully consolidated basis, neither adequately addresses the risk that stress could occur in one part of the organization while the liquidity needed to deal with that stress is trapped in another. In the U.S. LCR, a holding company may include in its consolidated liquidity buffer only qualifying assets held by a subsidiary U.S. bank that are in excess of the amount of the projected net cash outflows of the subsidiary bank and that can be transferred to the holding company without statutory, regulatory, supervisory, or contractual restrictions. The Federal Reserve has also adopted rules requiring certain foreign banking organizations (FBOs) with large U.S. operations to hold financial resources in the United States commensurate with their U.S. liquidity risk. Supervisory programs are also being used to supplement the Basel measures, in a manner roughly comparable to our practice in the area of capital regulation. The very nature of quantitative liquidity standards means the effectiveness of the rules could wane over time because of changes in funding markets, reductions in the liquidity of assets previously deemed liquid, or regulatory arbitrage. Furthermore, it is difficult for any standardized quantitative liquidity regulation to capture all relevant risks. For instance, a bank's short-term funding can be more or less stable depending on the structural characteristics of a firm's funding providers. The LCR distinguishes between broad categories of funding counterparties, such as financial institutions and non-financial companies. But it does not differentiate in a more granular way among entities that may behave very differently under stress, such as traditional banks and money market mutual funds. To complement the LCR and NSFR, in 2012 the Federal Reserve launched the Analysis and Review (CCAR), CLAR is an annual horizontal assessment, with quantitative and qualitative elements, overseen by a multidisciplinary committee of liquidity experts from across the Federal Reserve. In CLAR, supervisors assess the adequacy of LISCC portfolio firms' liquidity positions relative to their unique risks and test the reliability of these firms' approaches to managing liquidity risk. CLAR provides a regular opportunity for supervisors to respond to evolving liquidity risks and firm practices over time. CLAR involves evaluations of firms' liquidity positions both through a range of supervisory liquidity metrics and through analysis of firms' internal stress tests. A variety of liquidity indicators, such as funding concentrations, measure vulnerabilities beyond those captured in the LCR; the measurements are made over a number of time horizons. In parallel to this quantitative assessment, supervisors also examine the stress tests that each firm uses to make funding decisions and to determine its liquidity needs. Recent CLAR work on the firms' own stress testing practices has focused, among other issues, on assumptions regarding liquidity needs for capital markets activity, such as prime brokerage services and derivatives trading. As with CCAR, this analysis helps inform supervisors of the reliability of firms' own risk measurement and management. Though similar to CCAR in some respects, CLAR does not include a specific quantitative post-stress minimum. Of course, LISCC firms will be required to meet the LCR, which is itself a forward-looking requirement for a buffer against a potential stress on liquidity. In addition, firms with weak liquidity positions under CLAR's liquidity metrics are directed to improve their practices and, as warranted, their liquidity positions, through supervisory direction, ratings downgrades, or enforcement actions. Because CLAR assesses all LISCC firms simultaneously, the Federal Reserve is also able to compare the range of practices in liquidity risk management across the portfolio. Qualitative deficiencies identified in CLAR, such as questionable internal stress testing regimes, are addressed through the same set of supervisory tools. Knowledge gained through CLAR assessments also provides a macroprudential perspective on liquidity vulnerabilities and funding concentrations in the system as a whole. The financial crisis revealed the need for prudential regulation to consider systemic vulnerabilities, as well as weaknesses in traditional regulation aimed at assuring the financial condition of individual firms. Both microprudential and macroprudential shortcomings were never as apparent as in the series of runs and general funding stress that defined much of the crisis. Today, as I hope I have adequately explained, we have a better appreciation for the role liquidity regulation should play in tandem with capital regulation and resolution mechanisms, and as a means for both complementing and limiting the LOLR function of central banks. We are well along the road of implementing regulatory and supervisory policies to play that role. Even though these measures are in some cases still under development and in others still being phased in, the liquidity positions and management practices of LISCC firms have improved considerably over the past few years. Since 2012, the LISCC firms' combined buffer of high- quality liquid assets has increased by about a third, and their reliance on short-term wholesale funding has dropped considerably. Despite this progress, and perhaps to some degree because of it, important issues remain. Liquidity regulation is still a relatively new undertaking, certainly in its present form that includes quantitative requirements. There is still need for conceptual work on such questions as how to specify the extent to which banks should be required to self-insure against liquidity risk by maintaining larger liquidity buffers and more closely matching assets with liabilities, and how to define the circumstances in which central banks should provide liquidity. It is also clear that liquidity regulation has the potential to generate unintended effects. For example, in periods of stress firms are likely to have multiple incentives to hoard accumulated liquidity, rather than to use it to relieve the funding needs of households and other firms. The upshot would be to exacerbate systemic strains and cause a reduction in economic activity. This tendency toward liquidity hoarding may be amplified by the very fact of quantitative liquidity requirements, since firms may fear that dipping below those levels even in a period of stress would project weakness to counterparties, investors, and market analysts. That is, we may be more successful in enforcing the maintenance of liquid asset buffers in normal times for use in stress periods than we will be in encouraging their use when such a stress period arrives. For this reason we are working on a supervisory approach in which the remedy for falling below regulatory thresholds is context dependent. That is, a firm that falls out of compliance with the LCR or NSFR during a period of generalized stress should not be subject to automatic sanctions, but instead given an opportunity to come back into compliance in a way that does not expose either the firm or the system to greater stress. Finally, the very progress made in regulating liquidity at large firms may raise a new set of regulatory arbitrage problems. Short-term wholesale funding markets are generally smaller today than before the crisis, the average maturity of short-term funding arrangements is moderately greater, and collateral haircuts are more conservative. Yet volumes are still large relative to the size of the financial system. Furthermore, some of the factors that account for the reduction in short-term wholesale funding volumes, such as the unusually flat yield curve environment and lingering risk aversion from the crisis, are likely to prove transitory. And, while prudentially regulated dealers will continue to play a central role as intermediaries in short- term funding markets, post-crisis reforms directed at the regulated sector could lead to the disintermediation of regulated entities over time. Financial, technological, and regulatory barriers to disintermediation of regulated financial firms could likely be overcome with time and sufficient economic incentive. During normal times, short-term wholesale funding can help to satisfy investor demand for safe and liquid investments, lower funding costs for borrowers, and support the functioning of important markets, including those in which monetary policy is executed. But during periods of stress, runs by providers of short-term wholesale funding and associated asset liquidations can result in large fire-sale externalities and otherwise undermine financial stability. To the extent that disintermediation of prudentially regulated firms occurs, there will be a need to supplement prudential bank regulation with policy options that can be applied on a market-wide basis, such as a framework of minimum margin requirements for securities financing transactions. Last month, the Financial Stability Board finalized minimum margin requirements for non-centrally- cleared securities financing transactions in which a bank or broker-dealer extends credit to an unregulated entity against non-sovereign collateral. The Financial Stability Board has also proposed to extend the framework to cover transactions among unregulated entities. Implementation of this initiative will be a first, important step to ensuring that better regulation of the liquidity positions of regulated firms does not result in the migration of run risks to the shadow banking system. We will need to monitor developments in order to assess whether further action is needed to consolidate the progress we have made in promoting financial stability.

r141202a_FOMC

united states

Opening Remarks

brainard

On behalf of the Federal Reserve System, I am pleased to be here at the first in a series of outreach meetings designed to hear your feedback and concerns about regulatory burden. I want to thank you all for taking the time to participate in this important dialogue and also extend my thanks to the Federal Reserve Bank of San Francisco for providing space for today's meeting at the Los Angeles Branch. The Federal Reserve takes its mandate under the Economic Growth and provides an opportunity for the agencies to consider whether current regulations are well- balanced and effective or whether any are outdated, unnecessary, or unduly burdensome. Public input is critical to this process and will help us identify potential solutions to alleviate undue burden. Well-conceived regulations help to ensure the safety and soundness of our banking system, as well as the fair treatment of consumers. But unnecessary regulations drain bank resources and reduce the important services that depository institutions provide to households and businesses. Creating balanced regulations that are effective and thoughtfully calibrated to avoid undue burden requires input from stakeholders. In-person meetings, like the one we are holding today, help us gather information that is critical to our understanding of how regulations affect not only the banking industry but also the consumers and communities they serve. They also enable stakeholders to learn from one another and provide us with multiple perspectives on the complex issues that our regulations address. Outside of these meetings, we also look forward to receiving written comments in which you can elaborate on how to improve our regulations in more detail than we can cover in the time we have today. We recognize that depository institutions come in many sizes, have different business models, and manage different risks. As a result, it is often necessary to tailor regulations to the institution. Applying a one-size-fits-all approach to regulations may produce a small benefit at a disproportionately large compliance cost to smaller institutions. Of particular concern in this regard is the need to ensure our regulations are appropriately calibrated for smaller institutions. For example, because the largest banks present the greatest risk to the stability of our financial system, many of the regulations passed under the Dodd-Frank Act) are specifically targeted at these firms. It would be counterproductive to apply those same expectations to small banks. Accordingly, we think it is important to tailor rules whenever possible to clearly differentiate expectations for different portfolios of banks and reduce undue burden on community banks. Tailoring regulations may be more challenging in some areas, such as rules that provide transparency and fairness in consumer transactions. Those are standards that apply throughout the financial system. I should note that the Dodd-Frank Act transferred rule-writing authority for many of the consumer laws and regulations to the Consumer Financial Protection Bureau, or CFPB. The review of those regulations must be undertaken by the CFPB under procedures incorporated in the Dodd-Frank Act rather than EGRPRA. However, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation retained rule-writing authority for the Community Reinvestment Act, and we are interested in your comments regarding ways we can improve the regulation. In addition to changes in the regulatory and supervisory landscape, the banking industry itself has also undergone major changes. Advances in technology and shifts in industry composition between depository institutions and nondepository companies have changed the types of financial services and products that are offered, as well as how those services and products are accessed. We will be very interested in your feedback regarding how these types of industry changes have impacted the effectiveness of our regulations. Let me conclude by saying that we will consider your comments carefully as the agencies coordinate to discuss and consider the appropriate action that is likely to best serve our financial system and the interests of institutions and consumers. The result will be contained in the agencies' report to the Congress summarizing the issues raised and the agencies' conclusions about the need for regulatory or legislative changes. Thank you for joining us today.

r141203a_FOMC

united states

The Federal Reserve's Financial Stability Agenda

brainard

Although its founding statute makes no explicit mention of financial stability, the Federal Reserve was created in response to a severe financial panic, and safeguarding financial stability is deeply ingrained in the mission and culture of the Federal Reserve Board. Today, financial stability is more important than ever to the work of the Federal Reserve Board. With the lessons from the crisis still fresh, we are in the process of strengthening our financial stability capabilities. In carrying out the work of financial stability, the Federal Reserve is seen as the agency with the broadest sight lines across the economy and one that has some important stability tools, as well as a critical first responder when a crisis hits. But the Federal Reserve also faces limitations as a financial stability authority: It is predominantly a supervisor of banks and bank holding companies in a system with large capital markets, several independent agencies have responsibilities for regulation of nonbank financial intermediaries and markets, and no U.S. agency yet has access to complete data regarding bank and nonbank financial activities. Recognizing these limitations, the Federal Reserve is likely to actively utilize the tools under its authority, which means placing a strong emphasis on structural resilience in the largest and most complex institutions, while strengthening less tested time-varying tools to lean against the buildup of risks and, in some circumstances, looking to the unique capacity of monetary policy to act across the financial system. It will also need to cooperate closely with other regulators to develop well-rehearsed working protocols and a joint sense of responsibility for financial stability, while respecting that each independent agency has its own specific statutory mandate and governing body. In the wake of the financial crisis, the Congress and the Federal Reserve itself became more deliberate and explicit about the responsibility for safeguarding the stability of the financial system. The Dodd-Frank Act, enacted in July 2010, charged the Federal Reserve with specific authorities for the purposes of safeguarding financial stability. At the Federal Reserve, we created the Office of Financial Stability Policy and Research to strengthen our cross-disciplinary approach to the identification and analysis of potential risks to the financial system and the broader economy and to support macroprudential supervision of large financial institutions and, following its creation, participation on the office as well as in many areas across the Board and is overseen by the Board's newly created Committee on Financial Stability. This work is proceeding in four pillars, which are in varying stages of advancement. The first pillar is surveillance of the possible risks that could threaten financial stability. Research and historical case studies suggest that increasing valuation pressures accompanied by rising leverage, widening maturity mismatches, and the erosion of underwriting standards often provide important warning signals. Drawing on this information and other analysis, each quarter Federal Reserve Board staff systematically assess a standard set of financial vulnerabilities, including asset valuations and risk appetite, leverage, maturity and risk transformation, and interconnectedness in the broad financial system, and borrowing by households and businesses. The research that informs this work, by helping to identify financial patterns likely to be associated with rising risks of financial crisis, continues to grow. But its predictive power is still limited; it remains difficult to identify ahead of time credit booms that are likely to cause severe damage, such as the subprime housing crisis, from those that do not, such as the high-tech boom, in part because risk-taking by financial market participants cannot always be well-observed. Over time, our and others' surveillance will benefit as the Office of Financial Research established by the Dodd-Frank Act, makes progress in facilitating the sharing of previously siloed data sets among the independent regulators and as international impediments are overcome, allowing more comprehensive analysis of financial transaction flows across different types of financial intermediaries and activities. This regular, systematic surveillance of financial vulnerabilities is buttressed by three other valuable types of analysis. First, we use the detailed information gathered through bank examinations and loan reviews that are the regular work of our supervisors to assess emerging risky practices; these reviews helped identify deteriorating underwriting standards in the leveraged loan market. Second, we undertake periodic analyses of potential systemwide consequences of possible, particularly salient shocks, such as a sharp rise in the level or volatility of interest rates, including possible bottlenecks that could impede orderly adjustments. Finally, when there is a close brush with specific risk events, we closely study the behavior of markets and institutions for insights into possible structural vulnerabilities that might be revealed and assess possible policy actions. The ultimate objective of our surveillance is to build resilience of firms and markets and to counter risks early enough to prevent disruptions to financial stability that could damage the real economy. While the macroprudential toolkit is larger than it was pre-crisis, there is a substantial amount of work remaining to implement some of these tools. In particular, as I will discuss in more detail, the ability of the available tools to counteract time-varying risks has yet to be tested in the U.S. First, the Federal Reserve is well along in promulgating an important system of new, through-the-cycle safeguards that together should deliver much greater structural resilience and make excessive risk-taking costly for the large, complex institutions that pose the greatest risks to the financial system. Second, the Federal Reserve is assessing the kinds of broad time-varying regulatory tools that might further buttress resilience during periods in which risks associated with rapid credit expansion are building. Third, the Federal Reserve is exploring tools that can be varied over the cycle to target specific activities, recognizing that we will have limited authorities relative to some foreign financial regulators in operating on the borrowing side and outside the regulatory perimeter of the banking system. Let's take each in turn. We are relatively far advanced, and compare favorably to other jurisdictions, in implementing a framework of rules and supervision that compels large, complex financial institutions to build substantial loss-absorbing buffers and to internalize the costs of undertaking activities that pose risks to the system. This framework represents a substantial improvement on structural resilience relative to the pre-crisis framework across a number of dimensions: It is forward looking in assessing risks under severely stressed conditions, and it is explicitly macroprudential in design so that bank management internalizes risks not only to the safety and soundness of their own institution, but also to the system as a whole. Reforms undertaken in recent years help ensure that institutions that are large, internationally active, and interconnected face significantly higher capital and liquidity charges when undertaking risky activities. The core of the framework is the requirement of a very substantial stack of common equity to absorb shocks and to provide incentives against excessive risk-taking. The new framework imposes "belts and suspenders" on the capital cushion by requiring a simple, non-risk-adjusted ceiling on leverage as well as requiring the largest banking firms to satisfy two sets of risk-based capital requirements: one derived from internal models and a second based on standardized supervisory risk weights. Beyond that, the largest, most complex firms will face an additional common equity requirement that reflects the risk they pose to the system and an additional layer of loss absorbency on top of that to provide adequate support to operating subsidiaries in resolution. Large financial institutions are also required to maintain substantial buffers of high-quality liquid assets calibrated to their funding needs and to their likely run risk in stressed conditions. Similar to the equity cushions, the liquidity buffers are calibrated to affect disproportionately those financial institutions that pose the greatest risks. Regular stress tests of both capital and liquidity at our largest banking firms provide a key bulwark in the new supervisory architecture. Minimum capital requirements must be met under severely adverse macroeconomic conditions and, for the very largest firms, in the face of severe market shocks, including the failure of a firm's largest counterparty. By providing a forward-looking assessment that takes into account correlations among risks under stressed conditions, these stress tests on capital and liquidity are powerful tools for building resilience in our largest banking firms. But they also have some limitations. For instance, while the severity of the stresses can be varied from year to year, it is difficult to introduce entirely new scenarios each year to target specific sectoral risks without introducing excessive complexity. And while the new U.S. framework requires that capital buffers are calibrated for the riskiness of their assets and exposures, the proportion of capital required does not vary systematically to counter the cyclicality that arises through elevated asset valuations and other channels. . Tool two: Time-varying broad macroprudential tools While our efforts are far advanced in building structural resilience, progress is less advanced in developing time-varying tools that counter the buildup of excesses across the system broadly or in a particular financial sector. These efforts are in earlier stages of elaboration and more of a departure from recent practice. Here we can learn from financial authorities in other countries that have recent experience deploying a broader array of macroprudential tools. The classic case for time-varying broad macroprudential tools is to lean against a dangerous acceleration of credit growth at a time when the degree of monetary tightening that would be needed to slow it down would be highly inconsistent with conditions in the real economy. The Basel Committee agreed on a common countercyclical capital buffer framework for addressing such circumstances, and the Federal Reserve and the other U.S. banking agencies issued a final rule to implement the Basel 3 countercyclical capital buffer for U.S. banking firms in 2013. Under the rule, starting in 2016 and phasing in through 2019, the U.S. banking agencies could require the largest, most complex U.S. banking firms to hold additional capital in amounts up to 2.5 percent of their risk- weighted assets if the agencies determine it is warranted by rising risks. We are currently considering how best to implement the countercyclical capital buffer. The existing research would suggest that indicators related to debt growth, leverage, and other signs of growing financial imbalances would provide guidance on when to implement the buffer and when to deactivate it. The countercyclical capital buffer may enhance financial stability by building additional resilience at systemic banking institutions near the height of the credit cycle. However, it may prove to be less effective in leaning against credit growth, since, as credit booms progress, there is greater potential for capital to be relatively cheap, asset valuations to be inflated, and risk weights to be incorrect. Moreover the countercyclical capital buffer has some practical limitations: It applies to a subset of the U.S. banking system and is designed to act with a one-year lag. It also cannot be used efficiently to target specific asset classes that appear frothy, a challenge I turn to next. The countercyclical buffer may be a relatively blunt tool for circumstances where the buildup of risk is highly concentrated in a particular sector. This was, of course, the challenge U.S. policymakers faced early in the recent housing bubble, with home prices rising and capital markets developing the complicated, opaque securities built on subprime mortgages that would ultimately cause damage throughout the financial system. Indeed, property booms are perhaps the most common macroprudential challenge that have confronted financial authorities in advanced economies over the years, although macroprudential challenges have also surfaced in other sectors, such as the corporate lending boom that confronted Korea in the mid-to-late 1990s. In addition to time-varying broad macroprudential tools, such as countercyclical capital buffers and dynamic provisioning, many financial authorities have the authority to promulgate rules that target activity in a specific sector. For instance, Swiss authorities activated, in early 2013, a countercyclical capital buffer that added 1 percentage point of capital requirement for direct and indirect mortgage-backed positions secured by Swiss residential property, and then increased this amount in 2014 to 2 percentage points. Time-varying lending-side tools In the United States, there is a more limited set of authorities the Federal Reserve could exercise either on its own or jointly with the other banking agencies to address sector-specific risks. Most commonly, as we have seen with leveraged lending, the banking regulators acting together can use the tools of supervisory guidance and intensive supervision to discourage banks from taking on additional risk on safety and soundness grounds. Moreover, the annual supervisory stress tests can be tailored to increase the severity of losses in specific portfolios of loans or the market shock. However, these authorities fall short of direct restrictions on activities in a particular sector. Such supervisory actions usually flow from microprudential concerns about the safety and soundness of individual institutions rather than macroprudential concerns about the stability of the entire system. By contrast, section 165 of the Dodd-Frank Act provides that the Federal Reserve could restrict the activities of banks with assets greater than $50 billion or nonbank systemically important financial institutions (SIFIs) designated by the FSOC "to prevent or mitigate risks to the financial stability of the United States," thus providing potential macroprudential authority. In addition, the Federal Reserve has authority under the Securities and Exchange Act of 1934 to set initial and variation margin requirements for repurchase agreements and securities financing transactions, which applies across the financial system. This authority was used to curb perceived excesses in the equity markets through the mid- 1970s with what was seen as limited success, and it has not been used in such a manner since. There is some interest in exploring whether imposing minimum margin requirements on additional forms of securities credit could prevent margins from compressing during booms and likewise help mitigate destabilizing procyclical margin increases at times of stress, reducing the associated "fire sales" in short-term wholesale funding markets. Consideration of the utility of these authorities is in preliminary phases. It is being undertaken as part of a broad review of macroprudential authorities and not with regard to developments in any particular sector. Time-varying borrower-side tools For purposes of comparison, it is instructive to focus on how central banks in several advanced economies have dealt with housing booms in recent years. authorities in the United Kingdom, Sweden, Switzerland, and New Zealand have recently confronted rapidly rising residential housing prices in macroeconomic environments where there were compelling reasons not to use the policy rate as the first line of defense. They responded by imposing strictures on borrowers, through loan-to-value or debt-to- income limits, in some cases in concert with disincentives to lenders, and in many cases in an escalating pattern. Indeed, restrictions on borrowing are among the most commonly employed macroprudential tools and, according to some research, among the most effective in stemming the buildup of borrowing. This is not a problem we face today. If anything, the most pressing problem currently facing housing authorities in the United States is to restore vitality to the single- family housing market, where construction activity remains puzzlingly weak. However, if, in the future, a mortgage-credit fueled house price bubble were to reemerge, the banking regulators could perhaps impose higher risk weights on mortgage loans with certain characteristics either directly or through expectations around stress testing. approach would be slow, perhaps requiring upwards of a year to adjust, and narrow in its scope of application, and it may prove ineffective at times when bank regulatory capital comfortably exceeds the required thresholds. Third pillar: Working across the regulatory perimeter In some cases, foreign central banks acted in concert with other financial authorities to address the buildup of risk in their housing sectors. In the American context, the Federal Reserve's work is embedded in a larger web of efforts by other financial authorities. In parallel to the Federal Reserve's own efforts to formalize its financial stability surveillance and policy making, the network of independent financial agencies is enhancing cooperation through the formal structure and responsibilities of the FSOC as well as through joint rulemakings and joint supervisory efforts. It is vitally important that the bank and market regulators actively work to share assessments of risks across the financial system and to develop joint macroprudential efforts to address risks that stretch across regulatory perimeters. Realistically, however, those efforts are in early stages and must respect differences of mission and mandate, authority, and governance structures. to adjust the definition of qualifying mortgages (QM), which affects mortgage credit at all lenders, whether inside or outside the banking regulatory perimeter. It is worth noting, however, that the CFPB operates primarily under a consumer protection mandate. While the ultimate consequences of a mortgage credit boom have, in the past, proved very costly for families, the danger to consumers in the initial stages of such a boom may be too unclear to warrant timely action. Recognition of the limits to the macroprudential framework brings us to a consideration of monetary policy--a powerful tool with broad reach, but also relatively blunt. Monetary policy is the only tool available to the Federal Reserve that has far- reaching effects on private credit creation across the entire financial system and one of the few tools that can be changed rapidly (although its effects have famously long and variable lags). While recognizing the far-reaching effects of monetary policy on financial conditions, there are good reasons to view monetary policy as the second line of defense. It is better viewed as a complement to rather than an alternative to macroprudential tools. In many circumstances, standard monetary policy and financial stability considerations will reinforce one another. Nevertheless, there may be times when standard monetary policy and financial stability considerations conflict. In several recent instances, foreign economies have faced some tension between high unemployment and shortfalls in inflation relative to the central bank's target, on the one hand, and financial stability concerns associated with rapidly rising real estate prices on the other. In the United Kingdom, policymakers put in place a range of measures to limit the buildup of risks in the housing market, and, partly as a result, the housing market appears to be cooling somewhat. Nonetheless, U.K. policymakers have acknowledged the potential for monetary policy adjustments to play a role in the pursuit of financial stability. The Bank of England's 2013 forward guidance had a specific financial stability "knockout" for monetary policy accommodation if the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the FPC." If, in the future, the United States did face a similar dilemma, where financial imbalances are growing rapidly against a backdrop of subpar economic conditions, the Federal Reserve may consider monetary policy for financial stability purposes more readily than some foreign peers because our regulatory perimeter is narrower, the capital markets are more important, and the macroprudential toolkit is not as extensive. Even in these circumstances, however, it is important to be prudent about the role of monetary policy, recognizing that the necessary adjustments in monetary policy could have broader consequences. For example, a tightening in monetary policy sufficient to limit strong credit growth could depress employment and potentially trigger a sharp correction in financial markets. These limitations should lead us to be circumspect regarding the use of monetary policy as a tool to address financial stability risks, perhaps viewing it as a second line of defense. But it is equally important to acknowledge the potential utility of monetary policy for addressing risks to financial stability and to the broader economy and to continue expanding our work on the appropriate role of financial stability in our monetary policy framework. In sum, while the Federal Reserve has an inherent responsibility for financial stability, it has an incomplete set of authorities and a limited regulatory perimeter in a financial system that has large capital markets and a fragmented regulatory structure. It is therefore important that we actively utilize the tools under our authority--which place particular emphasis on building structural resilience at the largest, most complicated institutions through tougher through-the-cycle standards, along with broad countercyclical measures to limit the buildup, and potential consequences, of risks to financial stability, while exploring the design of time-varying sector-specific tools, and, at times, looking to monetary policy as a powerful tool that unlike any other operates across the entire financial system.

r150120a_FOMC

united states

Comments on the Fair and Effective Markets Review

powell

I want to thank the Brookings Institution for inviting me to comment today on The Review is an ambitious and important initiative. Although London is perhaps the leading center for many fixed-income, currency, and commodities (FICC) markets, these markets are global, and the United States and the largest U.S. firms play key roles in them. So the Review addresses issues that affect our markets as well. The Review looks to identify further steps that should be taken to restore public confidence in FICC markets in the wake of the depressingly numerous instances of serious misconduct in these markets in recent years. That misconduct has been, and will continue to be, addressed through substantial fines and criminal prosecution of the firms and individuals involved. The Federal Reserve continues to take part in these enforcement actions in cooperation with other U.S. agencies. The design of the Review is not only to advance the enforcement process, but also to look carefully at markets and firms and ask whether there are structural vulnerabilities or incentives for bad conduct that have not been well addressed by reforms to date. I will offer comments on a few specific areas and discuss some of our parallel efforts here in First, as the Review notes, there is a perception that FICC markets and their participants are highly sophisticated and do not need protection. While that may be generally true, the perspective is too narrow, because the importance of these markets extends far beyond the largest participants in them. The market mechanism allocates credit and determines the borrowing costs of households, companies and governments. Proper market functioning is really a public good that relies on confidence and trust among market participants and the public. Bad conduct, weak internal firm governance, misaligned incentives, and flawed market structure can all place this trust at risk. One of the ways we have to influence incentives is through compensation practices at supervised institutions. Many have argued that pre-crisis compensation practices at the largest financial firms allowed or created misaligned incentives. In response, many firms have changed their compensation practices since the crisis to better align incentives between individuals and firms, particularly through enhanced deferral of incentive compensation, with delayed vesting and the possibility of more robust forfeiture in a broader set of circumstances. We have strongly encouraged these reforms in our supervision of these institutions. In my view, the reforms are both essential and generally on target. The U.S. financial regulators, including the Federal Reserve, are also preparing for public comment a proposed new rule on incentive compensation that will codify and strengthen these initiatives. As the Review notes, greater transparency can also help curb market abuses and strengthen competition. In the United States, we have had over a decade of experience provides similar data for municipal bonds. The Dodd-Frank Act also imposed rules requiring greater transparency in over-the-counter derivatives markets through the use of central clearing, trade repositories, and swap execution facilities. Given the issues around OTC derivatives during the recent crisis, these clearly are important initiatives. But despite significant progress, there are still a number of impediments to sharing trade report data across regulatory agencies and jurisdictions, leaving us with only a piecemeal picture of the overall market rather than the full transparency that we desire. The issues around foreign exchange (FX) benchmarks serve to illustrate one of the important challenges discussed in the Review--the difficulty of managing the potential conflicts of interest associated with the traditional market-maker model. In FX markets, a wide range of end users seek to guarantee trade execution at the WM Reuters fixing at 4:00 p.m. U.K. time each day. This practice results in dealers having advance information about flows, and at the same time places them at some risk, as they are agreeing to execute these orders at an unknown future price. This advance information can create a perception that dealers are trading ahead of their clients, and it certainly created incentives to attempt to influence the fixing price. The recent Financial Stability made a number of recommendations designed to address these issues in this specific market, including use of trading platforms to maximize the netting of fixing orders, encouraging dealers to charge a transparent bid-asked spread or other fee to compensate them for the risk they take, and strengthening dealers' internal systems and controls to better manage potential conflicts of interest. Of course, similar challenges exist with market-making in other FICC markets. Many firms have taken up these challenges with their own reforms, and their efforts serve to emphasize how complicated these issues can be. Dealers must communicate with other firms, within their own firms and with their clients, and must execute their clients' trades. The challenge is to identify and preserve the legitimate benefits of such communication and trading while safeguarding against improper uses of information. It may be that these challenges can be addressed through coordinated private efforts; for example, through such bodies as the Foreign Exchange Committee and the Treasury groups are actively working on industry best practices in their markets and have often played a constructive role on market practices that enhance market functioning. It may also be that further supervisory or regulatory action is needed. Turning to our work on interest rate benchmark reform, it is worth recalling that, before the scandal broke, the London interbank offered rate (LIBOR) was not regulated. U.K. authorities have now addressed this shortcoming by making both the submission and administration of LIBOR regulated activities. The process by which firms make their LIBOR submissions is now subject to careful monitoring. The new LIBOR administrator, ICE Benchmark Administration, now regulated by the Financial Conduct Authority, is evaluating changes to LIBOR so that it can be based as much as possible on actual arm's-length transactions from a broader base of funding transactions. With surveillance and penalties in place, and a new administrator, one might be excused for thinking that there is nothing more to be done. In fact, some people do think that. That is emphatically not the view of the FSB Official Sector Steering Group that I now co-chair with Martin, which concluded that it is essential to develop one or more risk free (or near risk free) alternatives to LIBOR for use in financial contracts such as interest rate derivatives. The reasons are related to the structure of both LIBOR and the market that underlies it. Unsecured interbank borrowing has been in a secular decline for some time, and there is a scarcity, or outright absence in longer tenors, of actual transactions that banks can use to estimate their daily submission to LIBOR or that can be used by others to verify those submissions. LIBOR is huge--there are roughly $300 trillion in gross notional contracts that reference it--so the incentives to manipulate it still remain in place. And the structural problems go much further than the incentives for manipulation. Markets need to be fair, effective, and also safe . If the publication of LIBOR were to become untenable because the number of transactions that underlie it declined further, then untangling the outstanding LIBOR contracts would entail a legal mess that could endanger our financial stability. For these reasons, the Federal Reserve has convened a group of the largest global dealers to form the Alternative Reference Rates Committee. We have asked them to work with us in promoting alternatives to U.S. dollar LIBOR that better reflect the current structure of funding markets. As the Review's consultation document notes, issues of this kind are really global in nature; U.S. dollar LIBOR contracts are traded throughout the world, not simply in the United States. For this reason we are working in close consultation with our foreign regulatory counterparts in this endeavor. One of the reasons that I emphasize structural issues such as the market-maker model or the secular decline in unsecured interbank borrowing is that FICC markets are undergoing rapid changes that seem likely to have far-ranging consequences. Issues that a few years ago concerned equity markets now arise in FICC markets as well. As the consultation document notes, broker-dealers are curtailing some of their market-making activities and their appetite for providing liquidity in response to regulatory changes and their own assessment of the risks and returns of these activities. At the same time, other players such as mutual funds, exchange traded funds, algorithmic and high-frequency traders, and electronic exchanges are taking more prominent roles. These changes will affect market liquidity and functioning in ways that are difficult to foresee. It is possible that some of these factors played a role in the sharp swing in Treasury yields last October 15, and we are working with other regulators to understand exactly what happened that day and to determine whether there are implications for regulatory or supervisory policy. The Review raises the right questions in considering the troubling patterns of market abuse, and also in considering the structural changes that we are now seeing. It is important that market participants, end users, and regulators collectively take a step back and consider, as the Review invites us to do, whether the changing structure of FICC markets will result in markets that are fair, effective, and safe.

r150130a_FOMC

united states

Advancing Macroprudential Policy Objectives

tarullo

Standing in front of this audience I feel secure in observing that we are all macroprudentialists now. The imperative of fashioning a regulatory regime that focuses on the financial system as a whole, and not just the well-being of individual firms, is now quite broadly accepted. Indeed, the two entities co-sponsoring this conference were themselves created by the regulation toward safeguarding financial stability by containing systemic risk--an aim that may not define all of macroprudential policy, but surely rests at its center. But beneath the high-level consensus for a macroprudential orientation lies a broad range of substantive views, as well as a host of analytic and practical questions, which form the subject of this conference and many like it. Experience with macroprudential policy measures in various countries is not extensive and may, in any case, have only limited applicability elsewhere because of differences in economic conditions, the relative importance of capital market and traditional bank intermediation, and many other factors. And there is sometimes a tendency to overlook the significance of institutional and legal considerations in fashioning and comparing macroprudential policies. If macroprudential policy is to be more than a catchphrase, policymakers must confront these considerations in specifying how a macroprudential perspective will inform financial regulation. Today I would like to suggest some specific macroprudential objectives that I regard as both realistic and important to incorporate into a near- to medium-term policy agenda: first, continuing the task of ensuring that very large, complex financial institutions do not threaten financial stability; second , developing policies to deal with leverage risks and susceptibility to runs in financial markets that are not fully contained within the universe of prudentially regulated firms; and third , dealing with the vulnerabilities associated with the growing importance of central counterparties. Before discussing these specifics, I will begin with some brief observations on macroprudential tools and, in particular, the special difficulties associated with time-varying macroprudential policies. In mapping out the range of macroprudential policies, analysts have developed various taxonomies. Common to most is the distinction between tools designed to prevent systemic risk from building by "leaning against the wind" and tools designed to increase the resiliency of the financial system should systemic risk nonetheless build and lead to broad-based stress. While some tools may straddle this distinction, it seems useful as a starting point for evaluating the utility of different measures. As I have explained elsewhere, I think a distinction of equal--if not greater--importance is between structural or "through the cycle" tools, on the one hand, and time- varying tools, on the other. Structural macroprudential tools are put in place as a part of the ongoing regulatory structure, but they are designed specifically from a systemic, as opposed to a firm- or asset-specific, perspective. Many proponents of macroprudential policy seem particularly attracted to time-varying measures for both resiliency and lean-against-wind measures. The aim is to regulate in an explicitly countercyclical fashion through measures that attempt to restrain rapid, unsustainable increases in credit extension or asset prices--either directly or through shifts in incentives--and to relax those measures as economic conditions deteriorate. One can readily understand the conceptual appeal of this approach, but it raises a fair number of significant issues--analytic, practical, institutional, and legal. These include the reliability of measures of excess or systemic risk, the appropriate officials to be making macroprudential decisions, the speed with which measures might realistically be implemented and take effect, and the right calibration of measures that will be efficacious in damping excesses while not unnecessarily reducing well- underwritten credit flows in the economy. Even if these issues could be addressed and a time-varying macroprudential measure developed and applied, there is some reason to believe that regulatory relaxation of such a requirement may not have much effect on the downside of an economic or financial cycle. Market discipline, which may have been lax in boom years, tends to become very strict when conditions deteriorate rapidly. At that point, counterparties and investors may look unfavorably at a reduction in capital levels or margins or other protective measures, despite their formal elimination by regulators and despite the potential benefits for the economy as a whole. None of this is to say that analysis of possible time-varying macroprudential tools should not continue. Indeed, some are clearly appropriate for near-term use. For example, since good prudential supervision must always be time-varying, we should continue to adapt oversight with a view to changing conditions. And we will be working with the other banking regulators to build out the Basel III countercyclical capital buffer regime, which takes effect in the United States next year. But as a realistic matter, the role of time-varying macroprudential tools is probably limited for the immediate future. At the same time, there is both considerable need and potential for completing or developing in the near- to medium-term what I have termed structural macroprudential measures. Of course, there are intellectual and practical challenges here as well, including the need to assess the impact of the measures on economic and financial activity in non-stress times. But unlike time-varying measures, which often must be adopted swiftly to be effective, structural measures can be developed through a full and careful process, including normal administrative law notice and comment procedures. Additionally, where appropriate, the development of such measures can readily involve multiple regulatory authorities. Let me turn now to what I regard as three priority areas for the application of macroprudential tools. By definition, too-big-to-fail problems implicate systemic risk considerations and must be addressed in any regulatory system that seeks to preserve financial stability. More generally, the dynamics observed during the financial crisis--including correlated asset holdings, common risks and exposures, and contagion among the largest firms--suggest that the well-being of any one of these firms cannot be isolated from the well-being of the banking system as a whole. Much of the post-crisis reform agenda has been centered on these institutions. Various regulatory measures informed to a greater or lesser extent by macroprudential considerations have been developed and are now at various stages of implementation. I will mention three of the most important. First is a set of strengthened capital standards, which fit squarely within the objective of increasing the resiliency of systemically important institutions. Basel III fortified the microprudential requirements for both the quality and quantity of capital for all internationally active institutions. But, both internationally and in the United States, the post-crisis reform agenda includes capital requirements derived in whole or in part from macroprudential aims. These include capital surcharges for systemically important firms and stress testing. Stress testing, unlike conventional capital requirements, provides a forward-looking assessment of losses that would be suffered under adverse economic scenarios. Moreover, the related capital planning process helps ensure that the banking system would continue to have adequate capital to provide viable financial intermediation even in the face of adverse conditions. The simultaneous testing of the largest firms using a supervisory model provides a perspective on a large part of the banking system and facilitates identification of correlated exposures and other common risks. The supervisory construction of adverse scenarios each year allows us to incorporate changes in financial practices, vulnerabilities, and conditions into a dynamic capital standard. For example, in recent tests, the Federal Reserve has assessed potential interest rate risk by analyzing how sensitive deposits will be to rate rises, whether banks might have to raise deposit rates more than expected to retain deposits, and whether banks that are hedging interest rate risk are all dealing with the same few counterparties. The system of risk-weighted capital surcharges adopted by the Basel Committee on Banking Supervision is a regulatory innovation designed to reduce the chances of distress or failure of "G-SIBs" (global systemically important institutions) to a greater degree than at other firms, in recognition of the fact that the resulting negative consequences for the financial system would likely be substantially more significant. These surcharges are an important example of the principle, embodied in section 165(a) of the Dodd-Frank Act, that prudential requirements should increase in stringency with the systemic importance of regulated firms. The surcharge applicable to institutions varies based on the relative systemic importance of a firm. As you are doubtless aware, the Federal Reserve has proposed for domestic implementation a range of surcharges higher, and somewhat differently calibrated, than the Basel framework. The approach to calibration we developed in cooperation with other Basel Committee members was to determine the additional capital necessary to equalize the probable systemic impact from the failure of a systemically important bank, as compared to the probable systemic impact from the failure of a large, but not systemically important, bank. However, the surcharge levels ultimately agreed to by the Basel Committee were toward the low end of the range suggested by this analysis. The levels included in the proposed rule are more in the middle of that range and thus higher than the Basel surcharges. As suggested in an economic impact analysis undertaken by Basel Committee members, this higher level of surcharges should provide substantial net economic benefits by reducing the risks of destabilizing failures of very large banking organizations. The proposed rule would also take into account a firm's relative dependence on short-term wholesale funding, a source of systemic vulnerability to which I will return a bit later in these remarks. During the transition period for implementation of the G-SIB surcharges (as modified following the notice and comment process), the affected firms will presumably be considering whether they wish to reduce or alter the range, amount, or types of their activities so as to place themselves in a lower "risk bucket," with a concomitantly lower capital surcharge. A second kind of post-crisis regulatory reform with a macroprudential influence is the new set of quantitative liquidity requirements, including the now-adopted liquidity coverage ratio (LCR) and the internationally agreed-upon net stable funding ratio (NSFR) soon to be considered for adoption by U.S. banking regulators. Having just recently given an entire speech on the subject, I will note here only that both the LCR and the NSFR--along with the Federal Reserve's annual Comprehensive Liquidity Assessment and Review--were motivated by the systemic liquidity squeeze experienced during the crisis. Even though the LCR, for example, is principally microprudential in design, it still reflects macroprudential concerns, as in its exclusion of deposits with other banks from the set of assets that qualify as highly liquid. And, as in the requirements applicable to matched books of large firms that are important providers of liquidity to financial markets, some overtly macroprudential provisions have been incorporated in the NSFR. A third set of regulatory measures of relevance to systemic risks from large financial institutions concerns the potential failure of these institutions. These include, among others, the II of the Dodd-Frank Act and proposals to assure the availability of debt that is convertible into equity should a firm fail, thereby providing for absorption of losses and possible recapitalization without need for the injection of public capital. I suspect these and similar measures do not appear on many lists of macroprudential tools. And it may be hard to decide whether to classify them as resiliency tools or as structural measures designed to retard the build-up of systemic risk. Yet, with their purposes of ensuring that even the largest firms can fail and be wound down in an orderly fashion, and of countering too-big-to-fail perceptions associated with systemically important financial institutions, they belong on those lists. One such tool that has gotten more attention in the past year is the resolution planning FDIC have identified substantial shortcomings in many of the plans submitted to date. In the next round of submissions, due this summer, these firms will need to produce plans that show they could be resolved in bankruptcy in an orderly fashion. Meeting this requirement will entail significant changes in some combination of corporate structure, inter-corporate relationships, the mix and extent of activities, and the legal locus of certain bank activities. As I have just described, measures to promote the macroprudential objectives associated with the regulation of large financial institutions have already been developed. They need variously to be finalized or implemented. And all will probably need to be adjusted as time passes and circumstances change. But the tools themselves have been identified, selected, and elaborated upon. When it comes to much financial activity taking place outside prudentially regulated institutions, however, there is still a need to develop, analyze, and consider tools that should be used for achieving macroprudential aims. Given the breadth and diversity of activities that can be encompassed, for example, in the term "shadow banking," it is also necessary for policymakers to identify some priority areas within which to focus work on developing an appropriate set of regulations informed by macroprudential considerations. I would suggest that priority should be given to activities that pose significant risks of rapid investor flight during stress periods, with the attendant risks of firesales and other negative effects on funding and asset markets more generally. Specifically, it seems sensible to prioritize two areas: short-term wholesale funding and the liquidity and redemption risks that may be present in asset management activities. These areas may, of course, overlap in some circumstances. I have on past occasions described at some length my concerns with short-term wholesale funding--especially, though not exclusively, funding associated with assets thought to be cash equivalents. We are, of course, addressing these risks within prudentially regulated firms through various types of liquidity regulation and supervision, as well as changes in practice by the firms that clear tri-party repo transactions. But, as demonstrated in the years preceding the crisis, short-term wholesale funding can support a form of shadow banking outside the regulatory perimeter. Indeed, one might expect that as regulatory and supervisory practice forces the internalization by regulated firms of the systemic costs of excessive dependence on runnable short-term funding, there will be increasing incentives for more leveraged credit intermediation to migrate outside the regulatory perimeter. One policy response that the Federal Reserve has advocated and that has now been proposed by the Financial Stability Board (FSB), is for minimum margins to be required for certain forms of securities financing transactions (SFTs) that involve extensions of credit to parties that are not prudentially regulated financial institutions. This system of margins is intended to serve the macroprudential aim of moderating the build-up of leverage in the use of these securities in less regulated parts of the financial system and to mitigate the risk of procyclical margin calls by preventing their decline to unsustainable levels during credit booms. Given the ease with which such transactions may move across borders, it is particularly important that the FSB has proposed a framework that could be applicable in all major financial markets. We will welcome comments on this proposal when, as I expect, the Federal Reserve issues a notice of proposed rulemaking to implement it domestically, probably by using the Federal Reserve's authority under the Securities Exchange Act of 1934 to supplement our prudential regulatory authorities. But it is also important to continue analysis of other macroprudential policy options that would address the risks associated with short-term wholesale funding. Indeed, even the FSB proposal does not extend to SFTs backed by government collateral, a very important source of short-term wholesale funds. Asset management activities have commanded considerable attention lately, both The asset management industry has grown rapidly since the financial crisis, both in terms of the dollar amount of assets under management and in the concentration of assets managed by the largest firms. These trends may well continue as stricter prudential regulation makes investment in certain forms of assets more costly for banks. To the extent that asset management vehicles hold relatively less liquid assets but provide investors the right to redeem their interests on short notice, there is a risk that in periods of stress, investor redemptions could exhaust available liquidity. Under some circumstances, a fund might respond by rapidly selling assets, with resulting contagion effects on other holders of similar assets and, to the degree they had not already been subject to redemption pressures, other asset management vehicles holding those assets. The use of leverage by investment funds, including through derivatives transactions, could create interconnectedness risks between funds and key market intermediaries and amplify the risk of such firesales. Considerable work is needed, first, to develop better data on assets under management, liquidity, and leverage, in order to fill the information gaps that have concerned so many academics and policy analysts. Then there is more work to be done in assessing the magnitude of liquidity and redemption risks, including the degree to which those risks vary with the type of assets and fund structure. And finally, we will need tools that will be efficient and effective responses to the risks identified. Both the short-term wholesale funding and asset management examples point to the broader objective for macroprudential policy of developing what we might term "prudential market regulation"--that is, a policy framework that builds on the traditional investor protection and market functioning aims of securities regulation by incorporating a system-wide perspective. Like the reforms to banking regulation that followed the crisis, this new form of regulation might start by strengthening some of the firm- or fund-specific measures associated with those traditional regulatory aims, but then move forward to take into account such considerations as system-wide demands on liquidity during stress periods and correlated risks among asset managers that could exacerbate liquidity, redemption, and firesale pressures. The specific policies associated with prudential market regulation might be transaction-specific, or apply to certain kinds of business models. In her important speech last month, Securities and Exchange a regulatory approach for the asset management industry. In thinking about short-term wholesale funding and some forms of asset management, we encounter a background circumstance that complicates the task of developing effective macroprudential tools. Demand for safe short-term assets is both real and substantial, emanating from multiple sources, including sovereign nations that wish to self-insure against exchange rate pressures; non-financial corporations that have increased their cash holdings in the wake of the market disruptions associated with defaults by Enron and other companies; and institutional investors protecting themselves against redemption demands or other unexpected cash needs. While it is important to adopt measures that protect against runs and that counteract the illusion that cash equivalents are actually cash, it is equally important to realize that the demand for relatively safe, short-term assets will not disappear. Indeed, there is some risk that, as regulation makes some forms of such assets more costly, this demand will simply turn elsewhere. Thus the ultimate effectiveness of what I have termed prudential market regulation will depend on policymakers taking into account in their regulatory approaches the sources of, and motivation for, demand for short-term, liquid, and relatively safe assets beyond the debt of very creditworthy sovereigns. My third policy objective with a macroprudential component relates to central counterparties (CCPs). A key regulatory aim following the crisis, both in the United States and internationally, has been to encourage more derivatives and other financial transactions to be cleared through CCPs. There are important financial stability benefits to be gained from the progress that has been made toward this aim--including multilateral netting, standardized initial and variation margin requirements, and greater transparency. However, as has been frequently observed, if the financial system is to reap these benefits, the central counterparties to which transactions are moving must themselves be sound and stable. Extreme but plausible events, such as the failure of clearing members or a rapid change in the value of instruments traded by a CCP, could expose it to financial distress. If the CCP has insufficient resources to deal with such stress, it may look to its clearing members to provide support. But if the problems arise during a period of generalized financial stress, the clearing members may themselves already have been weakened or, even if they remain sound, the diversion of their available liquidity to the CCP may prevent customers of the clearing members from accessing needed funding. If the CCP fails, the adverse effects on the financial system could be significant, including the prospect that the CCP's default on its obligations could amplify the stress on other important financial institutions. Considerable work to ensure the safety of CCPs has been done--internationally by the at the Bank for International domestically by the SEC, the Commodity Futures Trading Commission, and the Federal updated and strengthened regulatory standards for, among other financial market utilities, significant CCPs. These principles, once fully implemented by all relevant U.S. agencies, will provide a strong and consistent basis for heightened oversight of the CCPs designated as systemically important by the FSOC. These heightened standards must continue to be supported by robust supervisory efforts that should continue to evolve as supervisors gain experience assessing firms against new regulations and consider new and changing risks faced by CCPs. Notwithstanding the advances in CCP regulation, questions have been raised in international fora, in discussions among domestic financial and regulatory officials, and by some market participants over whether more needs to be done. To me, at least, some of the most important questions implicate macroprudential concerns. One discrete example is the possibility that CCP margining practices may have a significantly procyclical character that could be problematic in deteriorating financial conditions. More fundamentally, systemically important CCPs are now generally required to have funds sufficient to cover defaults by their two largest members ("cover 2"). Perhaps this is the right standard when contemplating the well-being of a CCP in isolation. But it seems worth considering whether this standard is adequate when hypothesizing stress throughout the financial system, since the default of two large counterparties would almost surely be accompanied by significant market disruption. At the least, it is important to ensure a consistent, robust implementation of the cover 2 standard that has already been agreed. While the question of what constitutes the optimal default fund standard needs more analysis and debate, I think there is little question that more attention must be paid to strengthening stress testing, recovery strategies, and resolution plans for significant CCPs. The typical CCP recovery strategy does not take a system-wide perspective and is premised on imposing losses on, or drawing liquidity from, CCP members during what may be a period of systemic stress. Many of these members are themselves systemically important firms, which will likely be suffering losses and facing liquidity demands of their own in anything but an idiosyncratic stress scenario at a CCP. Moreover, in at least some cases, uncertainty is increased by the difficulty of estimating with any precision the extent of potential liability of members to the CCP, thereby complicating both their recovery planning and efforts by the official sector to assess system-wide capital and liquidity availability in adverse scenarios. These and other questions will be discussed in the coming months at the CPMI, the FSB, and other international fora, as well as among U.S. regulators. Researchers with a macroprudential perspective can contribute to these discussions with analyses of system-wide liquidity demands and knock-on effects of defaults by CCP members, as well as policy suggestions to address vulnerabilities that emerge from these analyses. In a basic sense, the imperative of a macroprudential policy perspective means taking account of system-wide effects as financial regulation is developed and implemented. But as is the case with traditional microprudential policy, agreement at this high level does not necessarily assure agreement on the priorities for regulatory attention, much less the specific regulations that should be adopted. Nor can even the best-conceived macroprudential policies compensate totally for the risks created by key macroeconomic or financial conditions. It should, however, force us all to think about issues like arbitrage, correlated risks and responses, and externalities in a more explicit and regular fashion than was evident in pre-crisis practice. And even as policymakers try to move forward with a practical agenda to incorporate macroprudential concerns in their programs, it is important that the academics and policy researchers represented by this audience continue to advance this still fledgling sub-discipline through both theoretical and empirical work.

r150204a_FOMC

united states

Welcoming Remarks

powell

On behalf of the Federal Reserve System, I am pleased to be here at the second in a series of outreach meetings designed to hear your comments and suggestions about reducing regulatory burden on insured depository institutions. Thank you all for taking the time to participate in this important process, and I'd also like to extend my thanks to the Federal Reserve Bank of Dallas for hosting today's meeting. The Federal Reserve takes seriously its obligations under the Economic Growth and with the opportunity to consider whether our regulations are necessary and current in keeping up with the financial services and regulatory environments. Well-conceived regulations help to ensure the safety and soundness of our banking system as well as the fair treatment of consumers. But unnecessary, outdated, or unduly burdensome regulations can exhaust the resources of insured depository institutions and reduce the important services that those institutions provide to households and businesses. Creating balanced regulations that are effective and thoughtfully calibrated to avoid undue burden requires input from stakeholders. In-person meetings, like the one we are holding today, help us gather information that is critical to our understanding of how regulations affect not only the banking industry but also the consumers and communities they serve. They also allow stakeholders to learn from one another and provide us with different perspectives on the complex issues that our regulations address. Outside of these meetings, we also look forward to receiving written comments in which you can elaborate on how to improve our regulations in more detail than we can cover in the time we have today. We understand that the sizes of depository institutions vary, that they operate through different business models, and that they manage different risks. This is why one focus of the EGRPRA review is considering the potential burden imposed by our regulations on community banks and other small insured depository institutions, so that we may carefully consider whether our regulations are appropriately adjusted for smaller institutions. We think it's important to tailor rules whenever possible to clearly distinguish requirements for different portfolios of depository institutions and reduce unnecessary burden on community banks. Of course, tailoring regulations may be more challenging in some areas, such as rules that provide transparency and fairness in consumer transactions because those are standards that apply throughout the financial system. We also recognize that, apart from changes in the regulatory and supervisory landscape, the banking industry itself has undergone major changes. For example, improvements in technology and changes in the financial industry's composition between depository institutions and nondepository companies have altered the types of financial products and services that are offered by depository institutions, as well as how those services and products are accessed. We welcome your views on how these types of industry changes have impacted the effectiveness of our regulations. Today I look forward to hearing your views on our agencies' regulations, especially in the Federal Reserve, these topics include regulations on the availability of funds; the collection of checks and other items by the Federal Reserve Banks and fund transfers through Fedwire; prompt corrective action procedures; and the disclosure and reporting of CRA-related agreements. I'd like to conclude by saying that we will consider your comments carefully as the agencies coordinate to discuss and consider the appropriate action that is likely to best serve our financial system and the interests of depository institutions and consumers. And when possible, the agencies will act to implement regulatory burden relief before the end of the EGRPRA review period. For example, in December of last year, Congress passed legislation--which was supported by the Federal Reserve Board--that would increase the consolidated asset limit for small bank holding companies from $500 million to $1 billion under the Small Bank Holding Company Policy Statement and that extends the same treatment to savings and loan holding companies of less than $1 billion. Last Thursday, the Federal Reserve issued for public comment both proposed and interim final rules for public comment that would implement that legislation. The rules would reduce regulatory burden on small entities by excluding many bank holding companies and savings and loan holding companies with total consolidated assets of less than $1 billion from the consolidated capital requirements. Of course, regulatory capital requirements will continue to apply to the depository institution level. The rules also would reduce the burden of regulatory reporting for these companies. The Federal Reserve currently estimates that the proposed revisions to the Small Bank Holding Company Policy Statement would impact over 4,200 organizations. The final results of our EGRPRA review will be contained in the agencies' report to Congress that summarizes the issues raised and the agencies' conclusions about the need for regulatory or legislative changes. Thank you for coming today.

r150209a_FOMC

united states

"Audit the Fed" and Other Proposals

powell

It is a pleasure and a particularly personal honor for me to speak to you today as a guest of this institution. I am proud to say that my grandfather, James J. Hayden, earned his doctorate of law from Catholic University and later served as dean of the law school. He was an early scholar of the regulation prompted by a technological innovation that would change the world--aviation. He was, in that sense, someone who looked to the future and wanted to be a part of it. In his years leading the law school, I hope my grandfather could also glimpse the great institution that it would become. It has been a little more than six years since the fall of 2008, when the peak of a severe financial crisis presented the very real threat of a second Great Depression. The damage was extensive, and for some time, the recovery was frustratingly slow. But the economy has improved considerably over the past two years, and I am optimistic that that this improvement will continue. The financial system is also stronger and more resilient after improvements in regulation and oversight by the Federal Reserve and other agencies and better management by banks and other financial firms. The Fed acted boldly during and after the financial crisis in the face of great uncertainty. The full effects of these policies will become clearer with the passage of time. Indeed, the Federal Reserve's role in the Great Depression of the 1930s is still actively debated. That said, as I will show, the evidence as of today is very strong that the Fed's actions generally succeeded and are a major reason why the U.S. economy is now outperforming those of other advanced nations. Other central banks are now embracing some of the same bold steps undertaken much earlier by the Fed. Against that background, I am concerned about several troubling proposals that would subject monetary policy to undue political pressure and place new limits on the Fed's ability to respond to future crises. My remarks will address three such proposals. The first goes by the somewhat misleading name of "Audit the Fed," and would subject the Federal Reserve's conduct of monetary policy to unlimited congressional policy audits (not to be confused with financial audits, which are already conducted regularly.) The second is a proposal to require the Fed to adopt and follow a specific equation in setting monetary policy and to face immediate congressional hearings and investigation by the Government Accountability Office (GAO) whenever it deviates from the policy dictated by that equation. And, third, there are discussions about imposing new limitations on the Fed's long-held powers to provide liquidity during a financial crisis. I think these proposals are misguided for three reasons. First, they are motivated by the belief that the Fed's response during the crisis was both ineffective and outside the bounds of its traditional role and responsibilities. In fact, the Fed's actions were effective, necessary, appropriate, and very much in keeping with the traditional role of the Fed and other central banks. Second, these proposals are based on the assertion that the Federal Reserve operates in secrecy and was not accountable for its actions during the crisis, a perspective that is in violent conflict with the facts. The Fed has been transparent, accountable, and subject to extensive oversight, especially during and since the crisis. We have also taken appropriate steps since the crisis to further enhance that transparency. Third, and most importantly, I believe these proposals fail to anticipate the significant costs and risks of subjecting monetary policy to political pressure and constraining the Fed's ability to carry out its traditional role of providing liquidity in a crisis. There is no dispute that the Fed's actions after the onset of the financial crisis were unprecedented in scale and scope. To help stabilize the financial system and keep credit flowing to households and businesses, the Federal Reserve lent to banks through the discount window and to financial institutions and markets through numerous new broad-based lending facilities it created using emergency lending authority granted by the Congress during the Great In a limited number of cases, the Fed also extended liquidity support to individual institutions whose imminent failure threatened to bring down the global financial system. At the same time, the Federal Reserve used monetary policy to help stabilize the economy. After cutting our target for the overnight interest rate on loans between banks- -our usual monetary policy tool--as low as it could go, the Fed took further action using unconventional policy tools. These policies involved communication, providing rates low for longer than had been expected, and also purchasing large amounts of longer-term Treasury debt and other securities to put downward pressure on long-term interest rates. While these actions were extraordinary and in some respects unprecedented, they were taken because the threats posed by the crisis were also without precedent, even in the events that led to the Great Depression. For the first time, cutting the Fed's policy rate to near zero proved insufficient to halt a plummeting economy; so the Fed took further action. For the first time since the Great Depression, our nation faced a financial panic so severe that the Fed's normal overnight lending to banks was not enough; so the Fed did more, using congressionally granted powers it had held but not used since the 1930s that were intended to deal with just such rare emergencies. As the Congress considers proposals that will affect the conduct of monetary policy and the Fed's ability to respond in a crisis, I believe it is also important to recognize how effective the Fed's response has been. With respect to monetary policy, the unconventional policies were designed to stimulate the economy in the same way as traditional monetary policy, by lowering interest rates. These actions helped deliver highly accommodative policy, which was essential given the depth of the recession. Without these steps, the slump in the labor market and the broader economy surely would have been even deeper and more prolonged, and the low wage and price inflation we are still experiencing might have turned into outright deflation. Critics warned that these policies would unleash uncontrollable inflation, fail to stimulate demand, and court other known and unknown risks. After I joined the Federal Reserve Board in May 2012, I too expressed doubts about the efficacy and risks of further asset purchases. But let's let the data speak: The evidence so far is clear that the benefits of these policies have been substantial, and that the risks have not materialized. Inflation has continued to run well below the Committee's 2 percent objective. Indeed, some argue today that low inflation should cause the Committee to hold off from raising interest rates. As I noted at the outset, due in part to the Fed's effective response to the crisis, the recovery in the United States has been stronger than that of other advanced economies, with more rapid job creation, lower unemployment, and faster growth. That is one reason why a number of central banks around the world have adopted forward guidance and asset purchase programs similar to the policies adopted by the Fed. The Federal Reserve's lending in the crisis was also successful. There is little dispute today that the crisis threatened a global financial collapse and depression, and that these liquidity policies were instrumental in arresting the crisis. Warnings about the Fed's lending also have not been borne out. Critics claimed the Fed had been reckless, throwing money ineffectively at problems and making loans to uncreditworthy borrowers. On the contrary, the Fed's lending was targeted to institutions, markets, and sectors that proved central to arresting the crisis. Loans were extended based on the same terms that the Federal Reserve has always applied--the borrowers must be solvent, the loans must be secured, and an appropriate interest rate must be charged. As a result, every single loan we made was repaid in full, on time, with interest. The Federal Reserve, like other parts of our democratic system of government, must be accountable to the public and its elected representatives. Given the scale of the Fed's actions during the Crisis, it has been not only appropriate but essential that these actions be transparent to the public and subject to close and careful scrutiny by the Congress. And that is exactly what happened. So it is jarring to hear it asserted that the Fed carries out its duties in secret and is unaccountable to the public and its elected representatives. The Federal Reserve is highly transparent and accountable to the public and to the Congress. First, the Fed does not set its own goals for monetary policy. Congress assigned us the goals of price stability and maximum employment--that is, the highest level of employment achievable without threatening price stability. Federal Reserve Board members are nominated by the President and must be confirmed by the Senate. The Chair of the Fed appears before both the House and Senate oversight committees twice every year to report on monetary policy, and, in practice, to respond to questions about anything and everything related to the Fed's activities. The Chair and other Board members routinely make additional appearances before the Congress and meet frequently with members. More generally, the Fed is open and transparent in its operations, including those related to monetary policy, accounting for itself in timely postmeeting FOMC statements, minutes, broadcast press conferences, and speeches. Details about the Fed's balance sheet are on the public record; in fact, every security owned by the Fed is identified individually on the website of the Federal Reserve Bank of New York. plans to normalize the balance sheet have been the subject of exhaustive discussion--in FOMC meetings, in speeches by policymakers, and among the many journalists and academics who analyze and discuss Fed policies. Last September, the FOMC published its Normalization Principles, which set forth its plans to reduce the balance sheet to a more normal level over time. The Fed's financial statements are also a matter of public record, and are audited annually by independent, outside auditors under the watchful eye of the Fed's I am well aware of this because I chair the committees that have oversight responsibility for the audits of the Board and the Reserve Banks. I worked for many years in the financial markets, and I can tell you that the Federal Reserve's financial statements, though they contain very large numbers, are relatively straightforward--much simpler than those of a typical regional bank. The Fed's operations, including its role regulating and supervising banks, are subject to extensive review by the GAO. If you visit the GAO's website, you'll find more than 70 reports since the crisis that are wholly or partly dedicated to reviewing the Fed's operations, including the emergency lending facilities I mentioned earlier. GAO works closely with the Fed's Office of Inspector General, which is involved in both financial audits and other oversight of our operations. The extensive oversight I describe intensified--appropriately so--as the Federal Reserve responded to the financial crisis. Our lending facilities were also the subject of Commission established by the Congress, and numerous congressional hearings and reviews. The Fed's actions were also fully transparent. As always, monetary policy decisions were debated and voted on by the FOMC and announced immediately, with detailed explanations provided in the minutes of these deliberations. The Fed provided public guidance on its plans to purchase assets and made those purchases in open, competitive transactions that were disclosed as soon as they occurred. The terms and conditions for every lending facility were publicly disclosed. The amounts lent under each program were published on the Fed's weekly balance sheet report. The Fed created a website and issued a monthly report to the Congress disclosing details on all loans, such as the quantity and quality of collateral posted by borrowers. As I said at the outset, I believe these proposals under consideration by the Congress fail to anticipate the significant costs and risks of subjecting the Fed's conduct of monetary policy to political pressure and of limiting the ability of the Fed to execute its traditional role of keeping credit flowing to American households and businesses in a financial crisis. Let me first address "Audit the Fed," which would repeal a narrow but critical exemption, adopted by the Congress in 1978, to limit GAO policy reviews of the Fed's conduct of monetary policy. The Congress granted this exemption because the costs of involving the GAO in monetary policy, including the substantial risk of political interference, far outweigh the potential benefits. It is important to note that GAO investigations are not the financial audits that many assume them to be. They extend beyond mere accounting to examine strategy, judgments and day-to-day decisionmaking. Indeed, by statute, the GAO is charged with making recommendations to Congress about the areas they have reviewed. This could put the GAO in the position of reviewing the FOMC's policy decisions and recommending its own course for monetary policy. With these features in mind, the potential benefits of GAO policy audits would be small, even before considering the potential costs. Unlike the programs that are typically the subject of GAO policy audits, such as procurement decisions that may be brought to light only by the GAO's attention, monetary policy decisions occur with all of the world watching. They are announced immediately, described in an FOMC statement, often elaborated on in a press conference, and the subject of endless same-day-analysis and debate. With all of this transparency and analysis, very little would be revealed by GAO policy audits that would help evaluate the effectiveness of monetary policy. The benefits of frequent GAO policy audits would also be low because the effects of monetary policy are felt with a considerable time lag and are often only clear years later. Audit the Fed also risks inserting the Congress directly into monetary policy decisionmaking, reversing decades of deliberate effort by the Congress to insulate the Fed from political pressure in carrying out its day-to-day duties. Indeed, some advocates of the bill have expressed support for complete elimination of the Federal Reserve. Long experience, in the United States and in other advanced economies, has demonstrated that monetary policy is most successful when decisions are rendered independent of influence by elected officials. As recent U.S. history has shown, elected officials have often pushed for easier policies that serve short-term political interests, at the expense of higher inflation and damage to the long-term health and stability of the economy. After World War II and as recently as the early 1970s, political pressures likely influenced Federal Reserve decisionmaking in a way which helped cause excessive inflation and related bouts of economic weakness. In 1977, as what came to be called the Great Inflation neared its peak, the Congress passed legislation that spelled out the goals for monetary policy--maximum employment and stable prices--but left it to the Fed to precisely define those goals and the means by which they would be achieved. preserve the Fed's independence in implementing policy to reach these goals, the Congress exempted monetary policy from the GAO investigations it was then authorizing for other Fed operations. This independence has served the nation well. Over the 20 years or so prior to the crisis, the Federal Reserve was able to maintain low and stable inflation, and recessions were brief and mild. That is not to say that the Fed got everything just right during this period. But it seems to me that any pre-crisis shortcomings were in regulation and supervision by the Fed and other agencies, rather than in monetary policy. And there are other costs from subjecting monetary policy to GAO investigations. Frequent GAO investigations would likely inhibit the debate and flow of information and ideas at FOMC meetings among staff and policymakers, which would lead to poorer decisions. Market participants would have to wonder whether the FOMC would react to GAO criticism, and they could lose confidence in the Fed's independence, reducing its credibility. To those who may doubt that GAO investigations would be used by the Congress to try to influence monetary policy, let me briefly describe another proposal which envisions exactly that. This bill would require the FOMC to carry out monetary policy according to a simple equation and require immediate congressional hearings and a GAO audit whenever monetary policy deviates from this equation. Simple policy rules of this nature are used by the FOMC and by central banks around the world as a guide to policy. No central bank applies them in such a mechanical fashion, and there is very little support among economists for doing so. Based on my own experience in business, in government service, and in life, I doubt that important decisions can be reduced ultimately to such an equation. The most such a rule might do is get you 80 percent of the way there; that last 20 percent makes all the difference. Finally, there has been discussion in the Congress of imposing new restrictions on the ability of the Fed to respond as it did with liquidity facilities during the financial crisis. Although I am not aware of a specific bill at this point, the idea is to limit the Fed's authority under section 13(3) of the Federal Reserve Act, under which the Fed is empowered to lend "in unusual and exigent circumstances" to firms beyond banks for the purpose of containing a financial crisis. The Fed used this emergency lending authority to provide liquidity in the face of a systemwide panic that threatened the financial system. As the crisis receded, the Congress took two related actions. First, it gave the regulators what they had badly needed during the crisis, which was a means of resolving the largest financial institutions without threatening the financial system. Second, the Congress prohibited emergency loans to individual firms but retained the Fed's ability to establish broadly available lending programs during a crisis, with the prior approval of the Secretary of the Treasury and timely notification of the Congress. This tradeoff came after extensive consultation between the Congress and the Federal Reserve. And I believe that it struck a reasonable balance. I also believe it would be a mistake to go further and impose additional restrictions. One of the lessons of the crisis is that the financial system evolves so quickly that it is difficult to predict where threats will emerge and what actions may be needed in the future to respond. Because we cannot anticipate what may be needed in the future, the Congress should preserve the ability of the Fed to respond flexibly and nimbly to future emergencies. Further restricting or eliminating the Fed's emergency lending authority will not prevent future crises, but it will hinder the Fed's ability to limit the harm from those crises for families and businesses. In our democratic system, the Federal Reserve owes the public and the Congress a high degree of transparency and accountability. The Congress has wisely given the Fed the tools it needs to implement monetary policy and respond to future crises as well as crucial independence to do its work free from short-term political influence. I would urge caution regarding current proposals that threaten just such political influence and place restrictions on the very tools that so recently proved essential in preventing a new depression. Congressional oversight of the Federal Reserve, including its conduct of monetary policy, is extensive, but no doubt could be improved in ways that do not threaten the Fed's effectiveness. I would welcome discussions with the Congress about ways to aid its important oversight of monetary policy. There may be differing views of how Congress can best carry out this responsibility, but there can be no disagreement about the purpose of such oversight, which is to help the Federal Reserve succeed in promoting a healthy economy and a strong and stable financial system. Those are the goals Congress assigned the Federal Reserve a century ago, and I am optimistic that Congress and the Fed will continue to work together to pursue them on behalf of the American people.

r150218a_FOMC

united states

Financial Institutions, Financial Markets, and Financial Stability

powell

It has now been over six years since the most acute phase of the financial crisis. Over the intervening years, market structures have evolved, and financial firms have changed their business models in important respects. Authorities around the world are implementing reforms that address the painful lessons of the crisis, while at the same time keeping the evolution of markets and firms in mind. Today, I will briefly summarize this sweeping reform program as it relates to large, global systemically important banks (G-SIBs), critical financial market infrastructure, and money markets. In my view, the basic agendas in these areas are, to different degrees, well developed, although a great deal of implementation remains. In contrast, I will argue that thinking about financial stability in the context of credit markets is less advanced and presents difficult challenges for supervisors. I will consider a range of factors that may address those challenges, illustrated with a discussion of recent developments in the syndicated leveraged loan market. And I will argue that the standard for regulatory intervention in the credit markets should be higher than for the other three areas. before the financial crisis ended, it was clear that reforms to strengthen the most systemically important firms and their regulation and supervision needed to be the first order of business. I will mention four critical elements of that program. First, these institutions are required to hold, and now do hold, much higher levels of higher-quality capital, as measured by both risk-based ratios and a much more comprehensive leverage ratio. Under the "enhanced prudential standards" of the phased-in capital requirements will be meaningfully higher for these institutions because of the greater threat their failure would pose to the financial system and to the broader economy. Second, these institutions are for the first time becoming subject to rule-based Ratio, and liquidity stress testing. These innovations are in part designed to address the firms' vulnerabilities to damaging runs on their short-term financing, runs that occurred repeatedly during the crisis and clearly increased its severity. Third, we now have rigorous, forward-looking capital stress testing that recognizes the dynamic nature of the financial system and guards against the excessive optimism that can build during a credit boom. These three reforms are well advanced and, in my view, have left the G-SIBs far stronger than they were before the crisis. Together, they significantly reduce the probability of a large bank failure. But they would leave us short of meeting the overriding objective of eliminating the too-big-to-fail conundrum without a fourth reform--a viable resolution mechanism that could handle the failure of these institutions without severe damage to the economy. Until recently, no nation has had a way of handling such failures without that degree of damage. Authorities around the world have been working to develop an approach to resolving large financial firms that credibly imposes losses on shareholders and debt holders consistent with the basic tenets of our capitalist system, but does so in a way that protects the rest of the financial system and the real economy from severe damage. The single-point-of-entry approach developed by the Federal Deposit Insurance Corporation (FDIC) in conjunction with other U.S. supervisors is a promising innovation, especially in combination with the recent proposal of the Financial Stability Board to increase the "total loss absorbency capacity" of systemically important firms in terms of their total levels of equity and long-term debt. When fully worked out, these new regulatory regimes should permit a large, consolidated entity that owns banks or broker-dealers to continue to function even if the ultimate holding company ceases to be viable and must be recapitalized or wound down. As I said at the outset, these reforms directed at the G-SIBs are well advanced. But much implementation remains, including, most notably, addressing cross-border issues associated with the failure of complex global firms. It will take time and continued international cooperation to complete this task. The crisis exposed a number of important weaknesses in the infrastructure of the financial markets--what might be more plainly called the plumbing. Reforms aimed at addressing these weaknesses receive less public attention than those focused on the G-SIBs, and are in some respects less advanced in their conception and execution. But they are, in my view, of great importance. I will mention two important sets of reforms in the U.S. context, one well advanced and the other still under development. The first concerns the triparty repurchase agreement (repo) market, which is a principal source of overnight financing for the largest securities dealers. Before the crisis, the functioning of this market was critically dependent on the extension of large volumes of discretionary intraday credit by two clearing banks. When confidence in Bear Stearns collapsed in March 2008, the vulnerability of this market and its settlement procedures in particular became very clear. Today, almost seven years later, in no small measure thanks to the leadership and persistence of the Federal Reserve Bank of New York, the triparty repo settlement process has been substantially reengineered, with reliance on discretionary intraday credit essentially eliminated. In addition, a smaller fraction of the market now involves the financing of lower-quality collateral, and far less of the overall funding is provided overnight and thus subject to daily rollover risk. Dealers in general manage their short- term funding risk far more conservatively than before the crisis, including by carrying substantially higher levels of liquidity, in part because of the introduction of prudential liquidity standards that I mentioned earlier. Second, as I have discussed at some length in other venues, in the run-up to the crisis, the highly opaque and fast-growing market for over-the-counter derivatives gave rise to an underappreciated and largely invisible buildup of risk, which proved a major source of instability when the crisis broke. In light of this experience, authorities around the world agreed in 2009 that standardized derivatives should be cleared through central counterparties (CCPs), and that noncentrally cleared derivatives should be subject to minimum margin requirements. Central clearing holds the promise of enhancing financial stability through the netting of counterparty risks, creating greater transparency, and applying stronger and more consistent risk-management practices. But this reform program will only succeed if CCPs, in which counterparty credit risks are concentrated, are strong enough to withstand severe but plausible stress scenarios, including, for example, the failure of multiple clearing members. Achieving this degree of resiliency will require robust liquidity risk- management practices, including the maintenance of substantial buffers of liquid resources that can quickly be tapped. In addition, adequate loss absorption capacity is essential, including through substantial initial margin requirements and default funds. A framework for such requirements has been agreed upon at the international level through Vigorous implementation at the national level is essential. There is also a need for greater transparency for clearing members and the public regarding the risk-management practices of CCPs, for heightened stress testing, for consideration of "skin-in-the-game" requirements, and for credible recovery and resolution plans. A great deal of work remains to be done to finalize and implement these additional reforms in all of the important CCPs around the world. Money markets involve money-like investments such as commercial paper and repo. Investors in these markets include money market funds, corporations and other large holders of excess cash seeking a safe return in the short term, frequently no longer than overnight. Borrowers in money markets include banks, securities dealers and other financial companies, nonfinancial corporations, and governments. By linking investors seeking a safe return with borrowers needing short- term credit, money markets do what commercial banks have always done, but without deposit insurance and other aspects of the safety net provided for regulated depository institutions. After Lehman failed and the Reserve Fund "broke the buck," money market fund investors realized that their investments were not as safe and liquid as "money" after all. There were widespread runs in these markets, and it took a U.S. Treasury guarantee, augmented by a number of unprecedented liquidity facilities established by the Federal Reserve, to stabilize the money market fund industry and, more importantly, stave off a sudden stoppage of the flow of credit to households and businesses. This experience tells us clearly that disruptions in the money markets can threaten the broader financial system. Regulation to increase the resilience of the money markets needs to reflect their systemic importance. Some important steps have been taken to address the most immediate risks--for example, through the liquidity standards for large institutions I mentioned earlier. But the risks associated with dislocations in the money markets go far beyond the large banks. to address the money market fund issue, notably through its 2014 rule amendments. address so-called repo runs, the Financial Stability Board is in the final phases of developing a framework of margin rules designed to be applied uniformly across nations for securities financing transactions involving nongovernmental securities. These minimum standards should increase the resiliency of those markets and mitigate the pressures on terms that inevitably emerge during benign periods. We expect to propose regulations implementing these rules in the United States in due course. That brings me to the credit markets, where households, businesses and governments engage in borrowing to fund their purchases and operations. These markets figured importantly in the crisis, most notoriously through securities collateralized by subprime mortgages. The story is by now well known. Lenders offered these loans to retail borrowers, often with negligible or simply fraudulent underwriting. Many of our largest financial institutions packaged the loans into marginally capitalized securitization structures that were rated highly by the credit rating agencies and thus generally viewed as suitable for purchase by a range of investors--including the most risk averse. As conditions in the housing market deteriorated, the threat of significant mortgage defaults emerged in 2007. The panic began in earnest when it became apparent that exposure to subprime mortgages was ubiquitous, from the balance sheets of key financial intermediaries and their supposedly "off balance sheet" vehicles to the investment portfolios of other institutional investors around the world. Although the total losses were initially thought to be not so large as to threaten the system, some of these toxic mortgage-backed securities (MBS) were financed with the types of short-term, confidence-sensitive funding mechanisms I have just described, which amplified the dislocations once the run in funding markets began and caused great harm to the broader economy. As the crisis has receded, supervisors--not to mention market participants, commentators, and the general public--have eyed financial markets with a heightened sensitivity to anything that resembles the buildup of risks that occurred in the run-up to the crisis--a natural and useful exercise in pattern recognition. In that spirit, the Fed, the Office of the Comptroller of the Currency (OCC), and the FDIC have focused significant attention on the origination activities of depository institutions in the syndicated leveraged loan market, where some of the troubling patterns that were evident in subprime MBS have been observed. These conditions prompted policymakers first to ask questions and then to act. Fed officials raised concerns publicly as early as 2011. The Fed, the OCC, and the FDIC issued supervisory guidance emphasizing these concerns in 2013. agencies clarified the guidance through published FAQs and began to exercise intensive supervision at the largest regulated banks emphasizing the need to improve underwriting standards and credit risk management on safety and soundness grounds. The case of the leveraged loan market is an interesting one, because it sits at the intersection between core financial institutions and credit markets and illustrates the challenges supervisors face in thinking about intervention in credit markets. I will turn to that market now in some detail. The term portions of leveraged loans are typically not held in the arranging banks' portfolios, but rather sold to a wide range of institutional investors--collateralized loan obligations (CLOs), retail loan funds, pension funds, insurance companies, hedge funds, a range of markets and reflects the movement over several decades of credit intermediation from portfolio lending (from the firm's perspective, the "storage business") to the capital markets (the "moving business"). This practice transfers and disperses credit and liquidity risks from the core of the financial sector to capital market investors that are willing to bear such risks for what they deem appropriate compensation. While the risks do not disappear, the system can, in principle, be safer if the ultimate institutional investors pose lower risk to the system than banks. For example, movement of credit exposure to speculative grade firms from a bank's balance sheet to a vehicle that is stably funded by sophisticated, deep-pocket institutional investors could be a net gain to financial stability. Movement of such loans to a highly leveraged, runnable vehicle beyond the regulatory perimeter could have the opposite effect. Pre-crisis conditions in leveraged finance markets were, with the benefit of hindsight, clearly in bubble territory. Deal leverage was at historically high levels (figure 3), and spreads were at historic lows (figure 4). Interest coverage ratios were quite low (figure 5). Unusually large leveraged buyouts were common. Banks entered into very large, long duration commitments to fund deals that faced significant regulatory and other requirements before they could close. Estimates vary, but when the crisis emerged and liquidity in these markets evaporated, large dealers were left holding roughly $350 billion in loans and commitments in their pipelines that they could not sell, and these positions remained on banks' balance sheets for a time. As loan values declined an unprecedented 40 percent (figure 6), there were significant mark-to-market losses on these assets, which may have contributed to doubts about the condition of institutions at the core of the system. Subsequent default rates were not outsized by historical standards, and recovery rates were in line with past averages (figure 7). Of course, the Fed's monetary policy eased financial conditions across the economy and enabled the refinancing of many of these loans at lower rates and with issuer-friendly terms. Because leveraged loans were generally not held in investment structures that used short-term, confidence-sensitive funding, these investments were not a principal focal point of runs such as those that plagued MBS funding structures. CLOs were the largest institutional investors in leveraged loans, holding over 50 percent of loans outstanding. These structures are funded with stable capital, with both equity and debt tranches committed for several years--a longer duration than that of the underlying loans. This picture of the pre-crisis leveraged lending market is one of a sharp decline in underwriting standards and a breakdown of risk management, resulting in a large risk buildup involving many of the G-SIBs--something the Fed and other regulators want to avoid. Leveraged loans may not have been a material cause of the crisis, and leveraged lending alone would likely not have threatened the overall health of the large institutions. But caution on the part of supervisors is certainly understandable here. It is worth remembering that the destructive potential of the subprime mortgage market was not obvious in advance and not fully reflected in real-time measures of balance sheet exposure. In light of that demonstrated uncertainty, since the crisis, supervisors have opted to react earlier and more aggressively to the buildup of risk. Let's now turn to post-crisis market conditions, which exhibit both similarities and differences compared with the pre-crisis period. Borrowing through leveraged loans by speculative-grade companies has been brisk since 2010, with about $800 billion of institutional loans now outstanding (figure 8). Over much of the post-crisis low interest rate period, demand for higher-yielding assets has been very strong, often outstripping supply. Price and nonprice terms in the syndicated leveraged loan market have been highly favorable to borrowers, as credit spreads declined, albeit not to particularly low agreements that lack traditional maintenance covenants increased to historic highs CLOs and other stably funded investors continue to be the primary owners of leveraged loans. But in recent years, mutual funds that invest in fixed income assets have seen large inflows and have become more significant investors in this market. Some of these funds, including those holding syndicated leveraged loans and high-yield bonds, provide investors with what is called "liquidity transformation"--providing daily liquidity even when the underlying assets are relatively illiquid. The risk is that, in the event of a shock or a panic, investors will demand all of their money back at the exact time when the liquidity of the already illiquid underlying assets deteriorates even further. Investors may not anticipate or recognize this problem until it is too late--the so-called liquidity illusion. Bank loan funds, which attract retail investors and offer daily liquidity, now total about $150 billion, or 20 percent of institutional leveraged loans outstanding (figure 11). The liquidity transformation provided by these funds has not created problems so far despite recent outflows from bank loan funds, but supervisors and market participants have raised valid concerns that stressful times could well bring large-scale redemptions regarding open-ended mutual funds a priority for the SEC. While it is possible to observe the characteristics of cash market investments, it is far more challenging to assess comparable positions in the derivatives and secured lending markets. Investors may take highly leveraged positions in leveraged loans through total return swaps and secured funding transactions, and a substantial buildup of these positions could present run and fire-sale risks if asset values started to fall. Today, the evidence suggests that such positions are fairly limited, but challenges in measurement and data make it hard to get a clear picture. While some of these conditions evoke the pre-crisis bubble period and thus raise red flags, there are important differences as well. The large institutions that arrange these loans have significantly reduced both the size and duration of their leveraged loan commitments (figure 13). Thus, they are not exposed to the large "pipeline risk" they faced as the crisis broke. In addition, banks now routinely limit their risk by including "flex" provisions that, among other things, enable them to increase the interest rate on a loan offered for sale by 150 basis points or more, at the borrower's expense. So far, we have not seen the very large transactions of the pre-crisis period. In these and other respects, the leveraged finance markets have evolved, probably because of supervision as well as lessons learned by the banks themselves. Given these changes, banks at the core of our financial system seem less likely to experience stress should conditions in leveraged lending deteriorate. Of course, the guidance now stands in the way of a return to pre-crisis conditions. Let's now step back from the leveraged loan market to ask the broader question of how supervisors should address a clear deterioration of credit market conditions. I will consider three factors that are often discussed in considering the broader question of when and how to intervene in the credit markets to promote financial stability through institution-specific supervisory policy. do conditions present a threat to the safety and soundness of financial institutions at the core of the system? It hardly needs saying that we must to be alert to the buildup of risks in the credit markets that could undermine the safety, soundness, or solvency of the G-SIBs or the broader system. If deterioration in one or more of the key credit markets would credibly raise such threats, the Fed and the other supervisors should react preemptively. An object lesson in this regard is the damage done by the accumulation of excessive exposures to high-risk MBS and other mortgage-related assets in the years leading up to the crisis. The originate-to-distribute model of mortgage lending on its face promised a social-welfare-enhancing distribution of mortgage credit risk away from banks and toward stable capital market investors. But the banks remained profoundly exposed through contractual putback rights, mortgage and MBS litigation, residual balance sheet holdings, and implicit support to sponsored investment vehicles. Since the crisis, there have been significant and eminently justified legislative and regulatory actions to assure that mortgage originators follow minimum underwriting standards and that banks are better protected from exposure to high-risk mortgages. These efforts include the Dodd-Frank risk retention rules and ability-to-pay standards, much higher capital and liquidity requirements, stricter accounting rules that limit off-balance-sheet treatment for sponsored vehicles, and a much greater supervisory focus on litigation and reputational risk. Second, is there use of run-prone financing by other investors that can lead to damaging fire sales? Supervisors should be highly alert to the reemergence in the markets--that is, not on the balance sheets of the large banks--of structures that are prone to runs and damaging fire sales triggered by sharp declines in asset values. As I mentioned earlier, two different features can create vulnerability to runs and fire-sale risk. The first involves funding of volatile assets with high leverage that includes short-term, confidence sensitive debt. These structures were widely used before the crisis in the funding of MBS. The second involves "liquidity transformation," in which the investment structure provides investors daily liquidity, but the underlying assets are far less liquid and prone to becoming quite illiquid in times of stress. Either or both of these features can be replicated in the derivatives or securities lending markets, which provide less visibility to market participants and supervisors. Financial markets evolve constantly in response to market conditions, financial engineering, and regulation. It will be important to keep up with trends in these markets that may give rise to this threat. Third, if left unaddressed, is it likely that conditions will risk meaningful damage to the real economy when the credit cycle turns? A positive answer on either of the first two questions should raise red flags for supervisors. Let's say, for the sake of argument, that the answers to these questions were negative. One might still try to make the case for supervisory intervention into the credit markets to avoid the risk of meaningful damage to the economy down the road. History shows that excesses that occur at the height of a credit boom can result in substantial losses not just to financial firms and market investors, but also to households and businesses, when that boom turns to bust. The question of whether to "lean against" the credit cycle through supervisory policy--and when, and with what tools--is a difficult one. An important threshold question is whether supervisors will be able to correctly and in a timely manner identify "dangerous" conditions in credit markets, without too many false positives and without unnecessarily limiting credit availability by interfering with market forces. Interesting recent research seeks to identify observable variables that could be used to monitor credit conditions and detect trends that could threaten the performance of the real economy in the future. This research is promising, and it could be used by supervisors to inform their thinking as it develops further. In the meantime, unless there is a plausible threat to the core of the system or potential for damaging fire sales, I would set a high bar for supervisory interventions to lean against the credit cycle. Such interventions would almost surely interfere with the traditional function of capital markets in allocating capital to productive uses and dispersing risk to the investors who willingly choose to bear it. Finally, another issue to consider when contemplating such intervention is that, particularly in the United States, activity is free to migrate outside the commercial banking system into less regulated entities. As supervisory scrutiny has increased in recent years, a growing number of nonbanks have become involved in the distribution of leveraged loans. Migration of this activity could be either a net positive or a net negative for financial stability, depending on whether it actually transfers risk irrevocably from the core of the financial system, and whether the institutions to which activity migrates rely on funding that is stable and robust to fire sale dynamics. To wrap up, I believe that sustaining financial stability requires supervisors to consider financial markets, in addition to financial institutions and infrastructure. That is most obviously so when conditions threaten the safety and soundness of the financial system through leverage, liquidity transformation, or deterioration of credit underwriting or other risk-management standards. At the same time, financial stability need not seek to eliminate all risks. We need to learn, but not overlearn, the lessons of the crisis. I believe there should be a high bar for "leaning against the credit cycle" in the absence of credible threats to the core or the reemergence of run-prone funding structures. In my view, the Fed and other prudential and market regulators should resist interfering with the role of markets in allocating capital to issuers and risk to investors unless the case for doing so is strong and the available tools can achieve the objective in a targeted manner and with a high degree of confidence.

r150227a_FOMC

united states

Conducting Monetary Policy with a Large Balance Sheet

fischer

For release on delivery Remarks by at the Thank you. It is a great pleasure to be here to discuss some of the important issues facing the Federal Reserve and other central banks in conducting monetary policy with a large balance sheet. I will focus on two main sets of issues that the Fed has faced and will continue to face for some time. The first involves our ongoing assessment of the effects of the asset purchases. The second concerns policy normalization in the presence of a very large balance sheet. To set the stage, consider the size of the Fed's balance sheet over the past several years. Assets have risen from about $900 billion in 2006 to about $4.5 trillion today, or-- as seen in figure 1--from 6 percent of nominal gross domestic product (GDP) to about 26 percent of nominal GDP. The net expansion over this period reflects primarily our large-scale asset purchase programs. Of course, many other central banks have expanded their balance sheets substantially over recent years as well. For example, assets of the Bank of Japan have increased from about 20 percent of nominal GDP to more than 60 percent of nominal GDP over this period, and assets of the Swiss National Bank have increased from 20 percent of nominal GDP to more than 80 percent of nominal GDP. The net increase in assets of the European Central Bank has so far been more modest, with assets increasing from less than 10 percent of nominal GDP to more than 20 percent of nominal GDP--but their quantitative easing (QE) program is not yet under way. For the remainder of my remarks, I will focus on the Fed, beginning with some remarks about the asset purchase programs. The nature of our purchase programs has changed over time. In the early programs--that is to say, QE1, QE2, and the program we call the MEP, or the maturity Committee (FOMC) specified the expected quantities of assets to be acquired over a defined period. Early in the crisis, this strategy seemed to help bolster confidence that the Fed was acting aggressively to offset the tightening in credit conditions and the steep downturn in economic activity. the FOMC launched an open-ended asset purchase program in which it directed the New York Fed's Open Market Desk to conduct purchases at an announced monthly pace until there was "significant improvement" in the outlook for the labor market. Later, the FOMC noted that the monthly pace of purchases was data dependent, allowing the pace to be revised up or down based on its assessment of progress toward its long-run objectives. Both of these types of asset purchase programs were aimed at putting downward pressure on long-term yields. Table 1 provides a summary of various studies' estimated effects of these programs on the term premium on 10-year Treasury securities. For example, the decline in 10-year Treasury yields associated with the first purchase program is estimated to have been as large as 100 basis points. The documented effects associated with subsequent programs are generally smaller. These results raise the question of whether the marginal effect of asset purchases has declined over time. While that question is a valid one, our conclusion is that asset purchases over more recent years have provided meaningful stimulus to the economy, and continue to do so. Figure 2 provides a current estimate, based on Fed staff calculations, of the effect on the term premium on 10-year Treasury securities from the combination of all asset programs. The results suggest that the Fed's balance sheet programs are currently depressing 10-year Treasury yields by about 110 basis points. And, with the Fed continuing to hold these securities, they should apply downward pressure on rates for some time. The declines in long-term yields have led to an associated drop in long-term borrowing costs for households and firms and higher equity valuations. Thus, the asset purchases have helped make financial conditions overall more accommodative and have provided significant stimulus for the broader economy. As shown in figure 3, a recent study estimates that the QE programs along with increasingly explicit forward guidance have reduced the unemployment rate by 1-1/4 percentage points and increased the inflation rate by 1/2 percentage point relative to what would have occurred in the absence of these policies. Moreover, the estimates imply that these macroeconomic effects are only now manifesting themselves in full, reflecting the inherent lags in the monetary transmission mechanism. Of course, such estimates have a wide band of uncertainty around them. As is well known, a number of potential costs might be associated with QE and the Fed's elevated balance sheet. Among these are the possibility that elevated securities holdings and low interest rates could pose risks to financial stability, possible effects on the Fed's income and remittances to the U.S. Treasury, and possible difficulties in conducting policy normalization. Such potential difficulties arise because the level of reserve balances will be very high when the FOMC begins to raise the federal funds rate, and, consequently, the Federal Reserve will employ new tools, which have their own benefits and costs, to implement monetary policy. Despite these potential costs, we think that asset purchases have had a meaningful effect in promoting economic recovery and helping to keep inflation closer to the FOMC's 2 percent goal than would otherwise have been the case. Turning to policy normalization, the FOMC and market participants anticipate that the federal funds rate will be raised sometime this year. We have for some years been considering ways to operate monetary policy with an elevated balance sheet. Prior to the financial crisis, because reserve balances outstanding averaged only around $25 billion, relatively minor variations in the total amount of reserves supplied by the Desk could move the equilibrium federal funds rate up or down. With the nearly $3 trillion in excess reserves today, the traditional mechanism of adjustments in the quantity of reserve balances to achieve the desired level of the effective federal funds rate may well not be feasible or sufficiently predictable. As discussed in the FOMC's statement on its Policy Normalization Principles and Plans, which was published following the September 2014 FOMC meeting, we will use the rate of interest paid on excess reserves (IOER) as our primary tool to move the federal funds rate into the target range. This action should encourage banks not to lend to any private counterparty at a rate lower than the rate they can earn on balances maintained at the Fed, which should put upward pressure on a range of short-term interest rates. Because not all institutions have access to the IOER rate, we will also use an operation, eligible counterparties may invest funds with the Fed overnight at a given rate. The ON RRP counterparties include 106 money market funds, 22 broker-dealers, 24 depository institutions, and 12 government-sponsored enterprises, including several should encourage these institutions to be unwilling to lend to private counterparties in money markets at a rate below that offered on overnight reverse repos by the Fed. Indeed, testing to date suggests that ON RRP operations have generally been successful in establishing a soft floor for money market interest rates. The Fed could also employ other tools, such as term deposits issued through the Term Deposit Facility and term RRPs, to help drain reserves and put additional upward pressure on short-term interest rates. We have been testing these tools and believe they would help support money market rates, if needed. Finally, with regard to balance sheet normalization, the FOMC has indicated that it does not anticipate sales of agency mortgage-backed securities, and that it plans to normalize the size of the balance sheet primarily by ceasing reinvestment of principal payments on its existing securities holdings when the time comes. As illustrated in figure 4, cumulative repayments of principal on our existing securities holdings from now through the end of 2025 are projected to be about $3.2 trillion. As a result, when the FOMC chooses to cease reinvestments, the size of the balance sheet will naturally decline, with a corresponding reduction in reserve balances. I will close by highlighting that the Fed's asset purchases have been a critical means by which the FOMC has provided policy accommodation at the zero lower bound on nominal interest rates. In other words, the Fed--and other central banks--can implement an expansionary monetary policy even when the policy interest rate is at the zero lower bound. The current high level of securities holdings will present some challenges for policy normalization, but we are confident that we have the tools necessary to remove accommodation at the appropriate time and at the appropriate pace.

r150303a_FOMC

united states

Improving the Oversight of Large Financial Institutions

yellen

Thank you for the opportunity to speak to you today, it is great to be back in New York. The Citizens Budget Commission has played an important role over the years as a forum to discuss issues of interest to New Yorkers that are often also of national and even global importance. Given New York's preeminence as a center of global finance, I thought it would be appropriate to discuss just such a topic, which is how the Federal Reserve oversees the largest financial institutions, many of which are headquartered or have a major presence here, and how that oversight has strengthened since the financial crisis. The crisis had many causes, including the numerous factors that drove a lengthy housing boom and the expansion of a largely unregulated "shadow banking system" rivaling the traditional banking sector in size. A self-reinforcing financial panic magnified the damage from risks that had built up over many years throughout the country and across the financial system. But to a considerable extent, large and complex financial institutions were the epicenter of the crisis. These institutions, some of which were not subject to Federal Reserve oversight at the time, were the locus for much of the excessive risk-taking that led to the crisis. Due to their primacy and interconnections with the rest of the financial system, these large institutions were also the means by which the crisis spread quickly and with devastating effect through the economy. The financial crisis and the recession caused great hardship for millions of individuals and families in this city and in communities throughout our country. I believe all Americans share a common interest in working to make sure that our financial system is strong, resilient, and able to serve a healthy and growing economy. A critical part of our work since the crisis to promote a stable financial system has therefore involved greater effort to ensure that large institutions are operating safely and soundly and are prepared to continue serving households and businesses even when faced with stressful financial conditions. In the run-up to the crisis, large firms failed to adequately anticipate and manage risks that grew and concentrated in their increasingly sprawling, diverse, and complex operations. Partly as a result, these firms had trouble retaining the trust of markets and creditors when the financial system came under stress. Doubts quickly mounted about whether these institutions could sustain losses in the value of many assets they held. Further doubts were raised about whether these firms had enough cash and other liquid assets to meet the immediate or potential demands of short-term creditors and large institutional customers. In the lead-up to the crisis, many large institutions had become heavily reliant on very short-term borrowing, at relatively low rates, to fund lending and other operations providing higher returns. While this approach may have appeared to be an easy source of profit, it had the disadvantage of leaving those banks exposed to devastating runs if short-term funding dried up, as it did in the crisis. Large financial institutions, of course, were not alone in failing to see these risks. The checks and balances that were widely expected to prevent excessive risk-taking by large financial firms--regulatory oversight and market discipline--did not do so. Government agencies, including the Fed, failed to recognize the extent of the risks or how severely they could damage the financial system and the economy. Investors failed to anticipate and understand the risks of large financial institutions' activities that materialized during the crisis. Before I turn to the Fed's actions to improve oversight of large financial institutions, let me be clear about what I mean by "large institutions." Generally, I have in mind those firms whose financial distress would pose a significant risk to financial stability--firms that are, in that sense, "systemically important." This would include U.S. banking organizations with large, complex, and often international operations; foreign banking organizations with extensive U.S. operations; and other large and complex financial firms. Today the Federal Reserve subjects 16 of those firms to significantly higher levels of oversight than are applied to other institutions. To put the scale and importance of these firms in perspective, the 8 U.S. bank holding companies among these 16 firms hold nearly 60 percent of all assets in the U.S. banking system. The Federal Reserve's oversight of large financial institutions is aimed at ensuring the safety and soundness of individual financial institutions as well as the resiliency of the financial system. The Fed expects the banks it oversees, including the largest banks, to be financially sound. Two core elements of soundness are capital and liquidity. Capital is the funds provided by a bank's shareholders that serve as a buffer to enable the firm to absorb unexpected losses, including during times of economic downturn or financial stress. A bank's liquidity is its ability to meet current and future obligations to customers and others with whom it enters into financial transactions. Liquidity is the lifeblood of a financial firm, because once liquidity dries up, the firm is no longer able to operate. Beyond focusing on capital and liquidity, the Fed also promotes safety and soundness by seeking to ensure that banks are well managed and subject to strong governance by a board of directors responsible to shareholders. It is unfortunate that I need to underscore this, but we expect the firms we oversee to follow the law and to operate in an ethical manner. Too often in recent years, bankers at large institutions have not done so, sometimes brazenly. These incidents, both individually and in their totality, raise legitimate questions of whether there may be pervasive shortcomings in the values of large financial firms that might undermine their safety and soundness. While the Federal Reserve looks closely at the individual safety and soundness of large financial firms, as I noted earlier, it is not sufficient to view each of these firms in isolation. The safety and soundness of large firms affects, and is affected by, the stability of the broader financial system. In the decades of relative financial stability leading up to the crisis, it is fair to say that the Fed focused too much on individual firms and not enough on their role in the financial system and the implications of those firms' operations for financial stability. To use an apt metaphor, we looked closely at the trees and not as intently as we should have at the forest. One of the most fundamental changes in the Fed's oversight of large institutions since the crisis, a principle that undergirds everything I will discuss today, is elevating the importance of financial stability in that oversight. The Fed oversees financial institutions through regulation and supervision. While they are often closely related, these are two distinct activities. On the one hand, regulation refers primarily to the rules that firms must follow. Regulation starts with laws passed by Congress which are the basis for specific and detailed rules written by the Fed and other agencies. Supervision, on the other hand, involves monitoring and examining the day-to-day operations of these firms, including their financial condition, how they manage risks, and their corporate governance, to make sure they are complying with laws and regulations and operating in a safe and sound manner. The Federal Reserve Board writes the regulations firms must follow, establishes supervisory policies and, in close collaboration with the 12 regional Reserve Banks, is deeply engaged in the supervision of large financial institutions. Much of the day-to-day work of supervision, particularly for smaller banks, occurs locally through the Reserve Banks. For systemically important firms, the Board several years ago established the coordinated supervision. I consider the effective supervision of large institutions, to ensure their safety and soundness and the stability of the financial system, to be one of the Federal Reserve Board's most important responsibilities, and one of my most important responsibilities as In improving the oversight of large firms, the Federal Reserve has made it a top priority to ensure that we appropriately tailor our regulation and supervision of banks to their size, complexity, and risks. We will use statutory authorities to ensure that we avoid a one-size-fits-all approach as we promulgate rules and regulations. As we continue this work, we will communicate to the Congress should we identify discrete issues that may benefit from further clarification or technical changes without undermining safety and soundness, such as those addressed by Congress last year related to capital requirements for insurance companies. Regulatory changes since the crisis have been extensive. While my emphasis today is on steps taken in the United States, I should also note that we work closely with our international colleagues to ensure that standards for systemically important financial firms are raised globally as well. We have made significant progress on our regulatory reform agenda both domestically and internationally, but we still have work to do. I will briefly describe five regulatory changes that have been among the most important in helping the Federal Reserve improve its oversight of the largest institutions. First, all banks are required to hold significantly more capital, with higher standards applied to the largest, most systemically important firms. Second, large institutions have also been required to substantially increase their liquidity. The blueprint for these higher capital and liquidity standards is an international agreement known as Basel III, which establishes minimum standards for internationally active banks around the world; the United States, however, has gone even further to raise capital requirements for the largest firms. Third, large firms are now required to show that they can continue to operate safely and serve their customers in stressful conditions similar to those that occurred during the crisis, an exercise known as stress testing. Fourth, under the Dodd- authorized a new regime, known as "resolution," to manage the failure of large firms in an orderly manner and reduce the chances that such a failure would threaten financial Corporation (FDIC) to require large firms to develop resolution plans. The fifth and final regulatory change I want to mention is that the Dodd-Frank Act also gave the Federal Reserve more explicit responsibilities for safeguarding financial stability. As applied to large institutions, more stringent capital requirements and the other regulatory changes I have just described are intended to promote the stability of the financial system. In addition, to address the fragmentation of responsibility for financial stability across different agencies, the Fed is part of a new work together more effectively to better promote the stability of the financial system. Along with the additional tools provided by these regulatory changes, the Federal Reserve has fortified its supervision of large financial institutions. We significantly enhanced the manner by which we assess whether these firms have sufficient capital and liquidity and are meeting new regulatory requirements in this area. We have substantially raised our expectations for how well the firms we supervise should be managing their risks, maintaining internal controls, and exercising governance. And we have reorganized our supervision of large financial institutions to increase the quality, consistency, and range of perspectives brought to bear on supervisory strategy and decisionmaking. One of the most important enhancements to large bank supervision since the financial crisis is our assessment of whether large institutions are holding enough capital to deal with stressful financial conditions. The program includes stress testing and a yearly review of how firms are planning their future capital needs. The latest results will be disclosed in the coming days. Capital stress testing for banks is not new but the Federal Reserve has employed it much more extensively since the crisis. Using information on a bank's finances and operations, these tests gauge how a firm's capital position would be affected by hypothetical scenarios covering a range of adverse economic and financial conditions. Such tests show the potential harm faced by individual banks in stressful conditions and thus the potential that such problems could affect the stability of the financial system. The goal is to see that large institutions have enough capital not just to survive in these conditions, but also to continue serving their customers. The Federal Reserve conducts stress tests once a year, and the firms are required to run their own tests and disclose results to the public twice a year. Stress testing is an important tool, but it is not sufficient to provide a full picture of the capital adequacy of large firms. The Fed also looks at other aspects of large banks' capital planning, such as their risk management, internal controls, and governance. If the Federal Reserve is not satisfied with the results from capital stress tests or identifies shortcomings in a firm's capital planning, we may restrict the firm's ability to pay dividends, buy back shares, or take other actions that would reduce its capital base. n addition to these steps related to capital, in 2012 the Federal Reserve began a comprehensive assessment of large banks' liquidity. We review the firms' own liquidity stress tests, and we conduct an independent assessment of their liquidity. These liquidity exercises provide a regular opportunity for Fed supervisors to respond to evolving liquidity risks and firm practices over time. Through this effort, we can require large firms to take specific actions to bolster their liquidity or enhance the way they manage their liquidity risks. Through stress testing and other improvements to supervision, the Federal Reserve is requiring more of large institutions. We are also requiring more of ourselves. Before the crisis, the Fed's supervision of large institutions did not make the fullest and most effective use of the expertise of our staff across the Federal Reserve System. To improve our supervision of the largest systemically important firms, we have created the LISCC brings together experts from around the Federal Reserve System in the areas of supervision, research, legal, financial markets, and payment systems in a centralized body led by the Federal Reserve Board. The LISCC program enhances supervision in several ways. First, by looking at firms both individually and collectively, it helps ensure supervisors are well positioned to identify issues at individual firms as well as trends across and interconnections among firms that may pose risks to financial stability. The LISCC also promotes high standards and consistency in the supervision of large firms through a centralized yet Systemwide approach. By bringing together staff members from across the Federal Reserve System, the LISCC is designed to ensure that diverse views and perspectives are brought to bear on important decisions about the supervision of systemically important firms. Lastly, the diversity of skills among the Fed experts involved in the LISCC allows it to consider financial stability risks from the broader economy, financial markets, and other sources. The LISCC also builds on the comprehensive analysis of financial stability by the Board's Office of Financial Stability Policy and Research, which was established after the financial crisis. The Federal Reserve has significant responsibilities for supervising large financial institutions, but we cannot guarantee their stability on our own. It is important that we communicate and coordinate with other U.S. financial regulatory agencies with responsibilities that affect the safety and soundness of large institutions. We also need to cooperate with supervisors in other countries where these firms operate. This cooperation helps us understand developments in a complex and global financial system that have implications for individual firms or for large institutions generally. It can also provide information and perspective about firms whose supervision we may share with other agencies or governments. In addition, it facilitates a coordinated approach to ensuring that large firms are operating in a safe and sound manner. To be effective, regulation and supervision must be independent of the entities subject to oversight. You may know or have heard the term "regulatory capture." Regulatory capture is when a regulatory agency advances the interests of the industry it is supposed to oversee rather than the broader public interest it should represent. Regulatory capture, which may occur in the oversight of any industry, can happen in both intentional and inadvertent ways. The most blatant ways involve tangible conflicts of interest--for example the expectation government officials might have of future rewards from the industry they oversee. But experience and extensive research shows that regulatory capture also occurs in less tangible ways, when close contact and familiarity between individuals leads those enforcing the rules to sympathize with those they oversee. Whatever the source, the risk of regulatory capture is something the Federal Reserve takes very seriously and works very hard to prevent. We enforce strict ethics rules and promote strong values among our employees, among them a commitment to public service. It is important that anyone serving the Fed feel safe speaking up when they have concerns about bias toward industry, and that those concerns be addressed. The broadening of expertise and participation in supervision conducted by the LISCC, as overseen by the Board, represents yet another check to the risk of regulatory capture in the oversight of large firms. I believe the changes I have described have significantly improved the strength and stability of large financial institutions and the financial system. As I mentioned earlier, strong capital and liquidity are fundamental to the resiliency of large institutions. The good news is that the amount and quality of capital and the strength of liquidity positions at large firms are greatly improved since the crisis. While some of the improvement in the capital positions of large firms is due to the regulatory changes I have described that are being phased in over the next several years, some of it has come as a direct result of the Fed's capital planning and stress- testing requirements. From early 2009 through 2014, capital held by the eight most systemically important U.S. bank holding companies more than doubled, reflecting an increase of almost $500 billion in the strongest form of capital held by these companies. Likewise, the Federal Reserve's increased focus on liquidity has contributed to significant increases in firms' liquidity. The high-quality liquid assets held by these eight firms has increased by roughly one-third since 2012, and their reliance on short-term wholesale funding has dropped considerably. Beyond these very tangible gains, we see some evidence of improved risk management, internal controls, and governance at large firms. But large firms still have room for improvement in this area, and supervisors will be watching closely. The compliance breakdowns in recent years that I mentioned earlier in my remarks undermine confidence in large firms' risk management and controls, which has implications for financial stability. The Fed has taken and will continue to take swift and meaningful action to ensure that firms focus on their risk-management practices and continue to strengthen them. Both the Federal Reserve and the large firms we oversee have become more forward looking in evaluating these firms' capacity to withstand significant financial stress, which has enhanced financial stability. Much of this new perspective has come through our capital and liquidity reviews, which require both firms and supervisors to make financial projections into the future rather than simply relying on current and past performance. Likewise, requiring firms to plan for their possible demise and orderly resolution has forced them to think more carefully about the sustainability of their business models and corporate structures. We have a more consistent and industry-wide perspective on risks and vulnerabilities than we had prior to the crisis. The focus on individual firms is still extremely important, but we now supplement this approach more systematically with reviews of issues across multiple firms simultaneously. These reviews allow us to identify common themes and unacceptable practices among large firms that will enable us to take consistent and effective action. Lastly, I believe the resolution authority enacted by the Congress and our work with the FDIC on the orderly resolution of large institutions are reducing the problem of firms considered "too big to fail" by addressing the risks a failure of a large firm would pose to the financial system. The plans developed by the largest firms to date still have a number of shortcomings, but the Federal Reserve has asked for and expects these institutions to make substantial progress in the coming months which will leave firms and the government better positioned to manage the failure of a large institution in an orderly way. The goal, through this and other actions I have described today, is to do whatever can be done to avert the dire threat and lasting damage of a severe financial crisis. We cannot eliminate the possibility of another crisis, but we can make a crisis less likely and less damaging by limiting excessive risk-taking by firms we oversee and by helping ensure that the most systemically important firms are better prepared to weather a crisis. We have focused our efforts on the largest firms because they were and continue to be crucial to the financial system and its ability to support the financial needs of households and businesses. By working to promote the safety and soundness of large firms, the Federal Reserve is trying to ensure that these and many other banks can continue to serve the people of New York and every community in America.