For release on delivery
12:30 p.m. EDT
June 27, 2017
An Assessment of Financial Stability in the United States
Remarks by
Stanley Fischer
Vice Chairman
Board of Governors of the Federal Reserve System
at the
IMF Workshop on Financial Surveillance and Communication:
Best Practices from Latin America, the Caribbean, and Advanced Economies
Washington, D.C.
June 27, 2017
In the years since the start of the global financial crisis, an enormous amount of
effort has gone into ensuring that we have a robust financial system that promotes
responsible risk taking and an efficient allocation of resources. But despite these efforts,
financial stability cannot be taken for granted, for financial decisions that benefit the
people who make them can create systemic risk and harm society as a whole. Further,
the phenomenon familiar from macroeconomics--and for that matter from life--of
decisions that result in short-run happiness and long-run grief is visible also in the area of
financial stability. For example, excessive leverage and reliance on short-term funding,
which may reward risk takers whose bets pay off, may also increase the risk of fire sales
and contagion, creating a fragile financial situation. The disruption in credit
intermediation that typically accompanies such episodes can have lasting negative
consequences for the real economy and welfare--some of which we are still seeing today.
The Federal Reserve's financial stability
responsibilities therefore strongly complement
its dual-mandate objectives of achieving price stability and full employment.
Today I will review the monitoring framework we have implemented at the
Federal Reserve, before providing an assessment of current U.S. financial stability
conditions. I will conclude by arguing that while significant progress has been made in
recent years toward making the financial system more stable and resilient, we should not
ever be complacent.1 We still lack sufficient information to understand some parts of the
shadow banking system, and risks sometimes evolve outside the scope of prudential
regulation, with potentially negative implications for financial stability. And sometimes
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we fail to understand the situation in which we find the financial system and the
economy.
Framework for Monitoring Financial Stability
Participants in today's workshops have grappled with the question of what is the
best framework to monitor financial stability. One approach is to focus on trends in, and
interactions among, financial vulnerabilities across financial institutions, markets, and
instruments. Another approach is to track the resilience of institutions, either broad
categories or individual systemically important institutions. Good monitoring
frameworks combine elements of both.
Let me start with the vulnerabilities-focused approach, as developed by Tobias
Adrian, Daniel Covitz, and Nellie Liang.2 That approach defines financial vulnerabilities
as a collection of factors that may amplify financial shocks and, when elevated, have the
potential to generate systemic risk. The focus is on vulnerabilities rather than shocks,
because the timing of shocks, such as sudden drops in asset prices, are inherently hard to
predict. Vulnerabilities, in contrast, tend to build up over time, and policies can be
designed to help contain these vulnerabilities, reducing the likelihood of systemic events.
Some financial vulnerabilities are cyclical in nature, rising and falling over time,
while others are structural, stemming from longer-term forces shaping the nature of credit
intermediation. Informed by academic research, some of it in-house, we at the Federal
Reserve focus on four broad cyclical vulnerabilities: (1) financial-sector leverage, (2)
nonfinancial-sector borrowing, (3) liquidity and maturity transformation, and (4) asset
2
See Adrian, Covitz, and Liang (2015).
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valuation pressures.3 Briefly, leverage, across a range of institutions, is a key amplifier of
solvency shocks, leading to a greater chance of a credit crunch or fire sale. Liquidity and
maturity mismatches can generate run risk, leading to fire sales and contagion. Finally,
elevated valuation pressures, especially when combined with high leverage, can lead to
excessive credit growth. When asset prices are appreciating rapidly and expected to
continue to do so, borrowers and lenders are more willing to accept higher degrees of risk
and leverage.
Using a range of indicators, we assess these cyclical vulnerabilities relative to past
experience. That is, we evaluate where the current levels of these indicators stand
compared with their historical values, to identify whether they point to a low, average, or
high level of vulnerabilities. While we try to rely on quantitative indicators, in the end,
this evaluation requires some degree of judgment. We also closely monitor potential
structural vulnerabilities, such as funding models and institutions that provide critical
plumbing services to the system. Because these structural vulnerabilities are less
amenable to traditional quantitative monitoring, their identification and assessment
follow a less formal process. I will leave that discussion to another time.
As mentioned, complementary to the vulnerabilities-oriented approach is an
approach that focuses on institutions. If the financial system is overleveraged, that
vulnerability has to be evident at particular institutions. An institutions-oriented
framework can help us keep track of sector- or institution-specific structural
vulnerabilities that may be masked by our overall assessment and provides additional
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ways to understand how distress at a particular institution or class of institutions may spill
over to the wider financial system.
Regardless of whether we are looking at vulnerabilities or institutions, a key
feature of this monitoring framework is its forward-looking nature. For example,
evidence suggests that periods of elevated risk appetite are frequently accompanied by a
rise in leverage at financial intermediaries.4 This evidence implies that elevated asset
valuation pressures today may be indicative of rising vulnerabilities tomorrow.5
Of course, while a framework provides a disciplined way to evaluate financial
stability, we constantly evaluate the framework so that we can identify new risks and
vulnerabilities, which may arise as the financial system evolves--for example, in response
to market-driven innovation or regulatory reform. Federal Reserve staff research helps us
understand and evaluate the evolving, dynamic financial system.
Before turning to the assessment of the current state of U.S. financial stability, let
me discuss how we communicate our views on this matter. The Federal Reserve, unlike
many other central banks, does not publish a financial stability report. The United States
already has two congressionally mandated financial stability reports, one authored by the
independent Office of Financial Research and a separate report published by the
Financial Stability Oversight Council that represents the views of the range of financial
regulators, including the Federal Reserve. Additional views of Federal Reserve officials
Board's
can be reflected in a range of other venues, including, notably, the semiannual
Monetary Policy Report, the Board's annual report, and speeches, such as this one.
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Current Assessment
That was the framework, now for the current assessment: In the interest of time,
my main focus will be on the four cyclical vulnerabilities--leverage, borrowing by
households and non-financial firms, liquidity and maturity transformation, and asset
valuations--but I will also briefly touch on the most salient structural vulnerabilities. To
summarize the assessment, overall, a range of indicators point to vulnerability that is
moderate when compared with past periods: Leverage in the financial sector is at
historically low levels, and, following the reforms of money market mutual fund
regulations by the Securities and Exchange Commission (SEC) last fall, vulnerabilities
associated with liquidity and maturity transformation appear to have decreased.
However, the increase in prices of risky assets in most asset markets over the past six
months points to a notable uptick in risk appetites, although this shift has not yet led to a
pickup in the pace of borrowing or a sizable rise in leverage at financial institutions.
Leverage
To start with, leverage: Regulatory capital at large banks is now at multidecade
highs. The largest banks have already met their fully phased-in capital requirements,
including the conservation buffer and the capital surcharge for the global systemically
important banks. Also, the largest banks have been able to meet the post-stress capital
requirements in the past couple of stress-test exercises run by the Federal Reserve.
Measures of earnings strength, such as the return on assets, continue to approach pre-
crisis levels at most banks, although with interest rates being so low, the return on assets
might be expected to have declined relative to their pre-crisis levels--and that fact is also
a cause for concern.
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Borrowing by households and businesses
In the private nonfinancial sector, which includes corporations and households,
total debt remains well below its long-run trend, largely driven by subdued borrowing
among households. However, the corporate business sector appears to be notably
leveraged, with the current aggregate corporate-sector leverage standing near 20-year
highs.
in this April's
Some studies, including one by the International Monetary Fund
Global Financial Stability Report, have recently highlighted this vulnerability, so let me
briefly offer my perspective.6 Despite the elevated levels of corporate borrowing, recent
developments show signs of improvement. Leverage has declined slightly since its peak
a year ago, and firms with high debt growth appear relatively healthy. Interest expenses
relative to earnings also declined of late and are below their median value since 2001.
Furthermore, the fraction of corporate debt due within one year relative to total debt
stands at historically low levels. Thus, positive shocks to interest rates may adversely
affect the ability of some firms to service debt, but this risk may have only limited
system-wide effects. Nonetheless, elevated leverage leaves the corporate sector
vulnerable to other shocks, such as earnings shocks.
In the household sector, new borrowing is driven mostly by borrowers with higher
credit scores, and the amount of debt that borrowers have relative to their incomes is
falling, suggesting that the debt is more manageable. That said, two pockets in the
household sector deserve scrutiny. Auto loan balances and delinquency rates are high for
borrowers with lower credit scores, meaning that the riskiest borrowers are borrowing
6
See International Monetary Fund (2017).
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more and not paying it back as often. Of note, delinquencies on recently issued auto
loans have also increased, indicating that underwriting standards in the auto loan industry
may be deteriorating. Student loan balances keep rising, and delinquency rates on those
loans are near historical highs. These strains within the household sector leave such
borrowers vulnerable to adverse shocks and probably weigh on their spending. At first
glance, one is tempted to say that the potential for this distress to adversely affect the
financial system seems moderate, because both subprime auto loan and student loan
borrowers account for a small share of other debt categories. But, on second thought, one
should remember that pre-crisis subprime mortgage loans were dismissed as a stability
risk because they accounted for only about 13 percent of household mortgages, and not
take excessive confidence.7
Liquidity and maturity transformation
Similar to my assessment of leverage, I believe that the primary vulnerability
associated with liquidity and maturity transformation--that of a self-fulfilling run--is
relatively low. In recent years, banks have shifted away from more run-prone short-term
wholesale sources of funds toward more stable sources such as core deposits. Large
domestic banks have also significantly boosted their holdings of high-quality liquid
assets, making them more resilient to funding stress.
In the nonbanking sector, the SEC revised the regulations governing money
market mutual funds, first adopted in 2014, with the aim of reducing the key structural
vulnerabilities exposed by the massive and destabilizing run on the funds in late 2008.
The second round of reforms went into full effect in October 2016; ahead of this date,
7
See Gerardi and others (2008).
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$1.2 trillion flowed out of prime money funds--the more fragile funds that also provide
direct funding to large banking institutions--toward government money funds, which are
constrained to hold government-guaranteed assets. Those assets include repurchase
agreements (or repos) with private banks backed by Treasury securities and the liabilities
of government-sponsored enterprises, such as, notably, the Federal Home Loan Banks
(FHLBs). While the current configuration of money markets reveals a reduced financial
stability risk compared with the situation prior to the recent reforms, this configuration
may not yet represent the final equilibrium. It will be important to keep an eye on the
growth of alternative investment vehicles that perform liquidity transformation in money
markets.
Of note, in part supported by increased demand from government-only money
funds, the FHLB system has increased its issuance of shorter-maturity liabilities, which
are more attractive to money funds. In turn, this development has led to an increase in
the FHLB system's maturity transformation because
its assets--loans to banks and
insurance companies--have remained relatively long maturity. As a result, the FHLBs
face an increased need to roll over maturing liabilities and thus greater vulnerability
should they encounter liquidity pressures. I should note that the FHLBs'
regulator, the
Federal Housing Finance Agency (also known as the FA-FA) flagged this issue more
than a year ago and is working with the FHLBs (the FLUBS) to address it.
Asset valuations
Let me conclude my assessment of current financial stability conditions with a
discussion of asset valuation pressures. Prices of risky assets have increased in most
major asset markets in recent months even as risk-free rates also rose. In equity markets,
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price-to-earnings ratios now stand in the top quintiles of their historical distributions,
while corporate bond spreads are near their post-crisis lows. Prices of commercial real
estate (CRE) have grown faster than rents for some time, and measures of the amount of
operating income relative to the sale price of commercial properties--the capitalization
rate--have reached historical lows, suggesting continued pressures in the CRE market
despite some tightening in credit conditions. Valuation pressures in single-family
residential real estate markets appear, at most, modest, with price-to-rent ratios only
slightly higher than their long-run trend.
The general rise in valuation pressures may be partly explained by a generally
brighter economic outlook, but there are signs that risk appetite increased as well. For
example, estimates of equity and bond risk premiums are at the lower end of their
historical distributions, and, relative to some non-price-based measures of uncertainty,
the implied volatility index VIX is particularly subdued. So far, the evidently high risk
appetite has not lead to increased leverage across the financial system, but close
monitoring is warranted.
Conclusion
Let me conclude by offering my view on where we stand in our effort to promote
financial stability in the United States. There is no doubt the soundness and resilience of
our financial system has improved since the 2007-09 crisis. We have a better capitalized
and more liquid banking system, less run-prone money markets, and more robust
resolution mechanisms for large financial institutions. However, it would be foolish to
think we have eliminated all risks. For example, we still have limited insight into parts of
the shadow banking system, and--as already mentioned--uncertainty remains about the
final configuration of short-term funding markets in the wake of money funds reform.
The U.S. financial system is inherently dynamic, with a range of institutions
competing to offer a changing mix of financial products. New financial technologies
promise great benefits but will no doubt carry novel risks. As a result, we monitor these
vulnerabilities, and we are vigilant with respect to economic and financial developments
across markets and institutions within the United States and around the world. And we
know that complacency must be avoided.
References
Adrian, Tobias, Daniel Covitz, and Nellie Liang (2015). "Financial Stability
Monitoring," Annual Review of Financial Economics, vol. 7 (December),
pp. 357-95.
Adrian, Tobias, and Hyun Song Shin (2010). "Liquidity and Leverage," Journal of
Financial Intermediation, vol. 19 (July), pp. 418-37.
Aikman, David, Michael Kiley, Seung Jung Lee, Michael G. Palumbo, and Missaka
Warusawitharana (forthcoming). "Mapping Heat in the U.S. Financial System,"
Journal of Banking and Finance.
Gerardi, Kristopher, Andreas Lehnert, Shane M. Sherlund, and Paul Willen (2008).
"Making Sense of the Subprime Crisis," Brookings Papers on Economic Activity,
Fall, pp. 69-145,
https://www.brookings.edu/wpcontent/uploads/2008/09/2008b_bpea_gerardi.pdf.
"Getting the Policy Mix Right,"
International Monetary Fund (2017). in Global
Financial Stability Report.
Washington: IMF, April,
https://www.imf.org/en/Publications/GFSR/Issues/2017/03/30/global-financialstability-report-april-2017.