Janet L Yellen: Macroprudential supervision and monetary policy in the
post-crisis world
Speech by Mrs Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the Annual Meeting of the National Association for Business Economics, Denver,
11 October 2010.
* * *
I would like to thank John Williams and Sam Zuckerman, both of the Federal Reserve Bank of San Francisco, for
assistance in preparing these remarks.
Thank you for that very kind introduction. When I look at the roster of previous recipients of
the Adam Smith Award, it is very august company indeed. It's a tremendous honor to appear
before you this year, and I am very grateful.
I should stress that my remarks represent my own views and not necessarily those of my
Federal Reserve colleagues. Today I would like to cover a subject that is of surpassing
importance for economic policy: the implications of financial market excesses for the
supervision of the financial system, and beyond that, for the formulation of monetary policy.
Just two years ago, we lived through an almost unimaginable catastrophe - the near
collapse of a global financial system that many economists had come to believe was
impervious to the sort of panic that could bring on a worldwide recession. The prevailing view
was that modern economic policymaking, and central banking in particular, had mastered the
management of the business cycle, and that the application of modern risk-management
tools had greatly increased the stability of the financial system. Financial markets were not
held to be perfect, of course. But they were viewed as self-correcting systems that tended to
return to a stable equilibrium before they could inflict widespread damage on the real
economy.
That view lies in tatters today as we look at tens of millions of unemployed and the trillions of
dollars of lost output and lost wealth around the world. These events should have convinced
any doubters that our financial system is vulnerable to the kinds of catastrophic breakdowns
that can wreck the overall economy. An inescapable conclusion is that a first-order priority
must be to engineer a stronger, more robust system of financial regulation and supervision -
one capable of identifying and managing excesses before they lead to crises. We must find a
way to contain these threats without putting a straitjacket on financial innovation and
risktaking. I don't claim this is an easy task, but it is an essential one.
Lessons from the crisis
It is now clear that our system of regulation and supervision was fatally flawed. Despite
volumes of research on financial market metrics and weighty position papers on financial
stability, the fact is that we simply didn't understand some of the most dangerous systemic
threats. Looking back, I believe the regulatory community was lulled into complacency by a
combination of a Panglossian worldview and benign experience. The notion that financial
markets should be as free as possible from regulatory fetters had evolved into the conviction
that those markets could, to a very considerable extent, police themselves. Meanwhile,
things went along so well for so long that the common belief came to be that nothing could
go disastrously wrong. Over a period of decades, the financial system was tested repeatedly
- the Latin American debt crisis, the savings and loan crisis, the Asian crisis, the failure of
Long-Term Capital Management, and the stock market crashes of the late 1980s and early
2000s. With each crisis, policymakers rolled up their sleeves and beat back the systemic
threat. The levees held. Despite these financial market ups and downs, economies in the
United States and other parts of the world performed very well. We appeared to have
entered a new era of stability. We even gave it a name: the Great Moderation. We were left
with the mirage of a system that we thought was invulnerable to shock, a financial Maginot
Line that we believed couldn't be breached. We now know that this sense of invincibility was
mere hubris.
To understand what went wrong, I refer you to Hyman Minsky's path-breaking work on
speculative financial booms and busts.1 As Minsky showed, success can lead to excess, and
excess to ruin. The Great Moderation saw a progressive growth of credit and extension of
risk, which came to a head in the mortgage market. Credit flowed freely and cheaply, and
households and financial institutions alike took on greater risk, borrowing to the hilt. House
prices soared off the charts. Financial innovators found increasingly exotic ways of
packaging loans for investors. Securities became so opaque that few understood their risks.
Originators sold mortgages to investors whose due diligence consisted of glancing at ratings.
The financial system became increasingly complex, interconnected, and hyperleveraged.
When housing prices plunged, the value of real-estate-related assets on the balance sheets
of financial institutions, both in the traditional and shadow banking sectors, collapsed. Not
only were many of those institutions highly leveraged, they had also relied heavily on
short-term borrowing to acquire those assets. The combination of leverage and short
maturity funding left them perilously vulnerable to runs. The result was panic and market
breakdowns on an unimaginable scale, bringing us frighteningly close to a meltdown of the
global financial system and a second Great Depression.
Thankfully, that depression never occurred. Governments and central banks around the
world took extraordinary action to prevent complete collapse. But what we did get was bad
enough - the deepest and most prolonged recession in generations. And the recovery has
been agonizingly slow, held back, in part, by the ongoing efforts of overleveraged
households and financial institutions to repair their balance sheets. These events
demonstrate both the natural tendency of the financial system to cycle through booms and
busts and the potential, absent adequate supervision and regulation, for breakdowns in the
financial system to threaten the global economy.
Financial market participants can be bipolar - prone to fads, manias, myopia, panics, and
depression; driven by short-term gain; and easily caught up in the madness of crowds. One's
belief about the beliefs of others is critical, like Keynes's example of a beauty contest.2 In
addition, the structure of compensation and incentives in the financial sector created strong
motives for excessive risk-taking, especially during boom years. Methods of modern risk
management may have intensified the cycle because of their reliance on metrics such as
value at risk that are highly sensitive to recent performance, especially volatility. In good
times, volatility declined, and value at risk along with it. This pattern generated a pro-cyclical
willingness to take on risk and leverage, amplifying and propagating the boom and bust
cycle. The vicious cycle of a collapse of confidence, asset fire sales, evaporation of liquidity,
and a deleveraging free fall was the mirror image of the manic mortgage market that
preceded it.
To avoid a repeat of these events, it is essential that we change the landscape of supervision
and regulation. The landmark legislation recently passed by the Congress, the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), is designed to do just
that. It requires regulators to contain risks to the financial system before they erupt into
crises. And it creates a structure to collect data, identify emerging threats to financial stability,
and formulate policies to contain these risks.
Within this structure, the Federal Reserve will play an important role. We will supervise all
systemically important institutions and, jointly with other regulators in the new Financial
Stability Oversight Council, establish stricter prudential standards for such firms. We will help
ensure the safety of financial market utilities that are critical to our payment, clearing, and
settlement systems. And we will actively support the council's mission to identify and address
emerging risks to financial stability. At the same time, though, we must take care to preserve
incentives for innovation and reasonable risk-taking. We must remain prudent, while avoiding
an overly strict approach that unduly impedes financial intermediation and stifles capital
formation.
Vigilance to threats of systemic financial risk must also inform the conduct of monetary
policy. We have seen that the eruption of a financial crisis can have severe economic
consequences, compromising the ability of a central bank to attain its primary macroeconomic
objectives. Monetary policymakers should also be aware that the decisions they make in
pursuit of price stability and full employment could, in some circumstances, affect the
development of systemic risk. For example, if compensation incentives in the financial sector
are misaligned, low interest rates might heighten the ability and desire of financial market
participants to reach for yield and take on risk.
Our goal should be to deploy an enhanced arsenal of regulatory tools to address systemic
risk, making the financial system far more robust. That way, monetary policy can concentrate
on its long-standing goals of price stability and maximum employment. Supervision and
regulation must serve as the first and main line of defense in addressing systemic risk. We
have at our disposal a tool kit of regulatory instruments that are well adapted for this
purpose. Monetary policy cannot be a primary instrument for systemic risk management.
First, it has its own macroeconomic goals on which it must maintain a sharp focus. Second, it
is too blunt an instrument for dealing with systemic risk. All the same, I cannot unequivocally
rule out the possibility that situations could emerge in which monetary policy should play
some role in reining in risk-taking behavior. I will return to this point later.
In the remainder of my remarks, I will discuss key issues that must be resolved before an
effective policy regime for the containment of systemic risk can be established. First, we
must understand the sources of systemic risk and design surveillance practices that enable
us to detect threats to financial stability early on. Second, we must develop a tool kit of
supervisory policy instruments - so-called macroprudential policies - and guidelines on how
and when to deploy them. And third, we must strive to avoid situations in which
macroprudential and monetary policies are working at cross-purposes, given that
macroprudential policies affect macroeconomic performance and that monetary policy may
affect risk-taking incentives.
All of these issues raise complex questions of design and implementation. Interesting
parallels may be drawn, however, between the design issues we face in macroprudential
policy and those we have grappled with in conducting monetary policy. These parallels
include the appropriate roles of rules versus discretion, the need for policies that are robust
in addressing uncertainty, and the assignment problem, all of which I will discuss later. The
fertile field of monetary policy research may therefore offer lessons that can fruitfully be
applied to managing systemic risk.
Systemic risk: sources and surveillance
At its most basic level, systemic risk stems from the possibility that some event or sequence
of events could result in severe impairment of the financial sector's ability to provide credit in
the economy. At their most extreme, such events can trigger panicky attempts to withdraw
credit, creating runs that lead to failures of important financial institutions and, ultimately,
systemic collapse.
If policymakers are to detect emerging threats to the financial system, we must understand
the determinants of systemic risk and develop appropriate metrics for measuring it.
Economists have long studied these issues, and the recent crisis has intensified research on
the subject. This work points to several key elements in the buildup of risks in the financial
system. Let me mention three factors that current research suggests are critical.
One factor is the accumulation in the financial sector of very high levels of risk and leverage,
along with excessive reliance on unstable short-term funding. The emergence of such
behavior among the largest and most interconnected financial institutions is particularly
dangerous, since these institutions are linchpins in our financial system and their failure
could cause significant damage to large numbers of counterparties and the system as a
whole, as the examples of Lehman Brothers and American International Group demonstrate.
However, a buildup of leverage and growing maturity mismatches are also worrisome when
they occur more broadly in the financial system.
A second element is a high positive correlation of risk exposures across institutions. A wide
array of commercial banks, investment banks, and other financial institutions held
mortgages, mortgage-backed securities, or positions in mortgage-related derivatives. The
result was the massive vulnerability of the financial system to a collapse of housing prices.
What seemed like moderate risks taken by individual institutions ultimately led to an
enormous risk to the system as a whole.
A third element is the extraordinary interconnectedness and complexity within the financial
system. The intricate and opaque web of connections among financial players multiplies the
dangers of contagion in the form of lost confidence, frozen liquidity, fire sales, and domino
effects.3 A key factor in this channel of systemic risk is the institutional arrangements in
payment, clearing, and settlement systems. For example, weaknesses in the market
infrastructure for repurchase agreements, or repos, and over-the-counter derivatives
intensified the crisis.4
Systemic risk reflects the confluence of factors that may grow slowly over years. Therefore,
surveillance must look at a variety of indicators and be forward looking, considering the paths
of factors that influence such risk for years to come. To facilitate timely recognition of the
emergence of systemic risk, we should design quantifiable indicators related to the three
elements I just outlined: risk buildup at systemically important institutions and within the
financial sector more broadly, positive correlations of risk among financial market
participants, and interconnectedness among those participants.
Systemic risk surveillance will demand Herculean efforts by the regulatory agencies and the
Office of Financial Research created by the new legislation. I see parallels between the way
we take the pulse of the economy when considering monetary policy decisions and the way
we should monitor and evaluate systemic risk when formulating macroprudential policies. In
assessing the economy, we collect and analyze a myriad of data. In practice, though, we
regard certain metrics as most critical, such as gross domestic product, employment and
unemployment, and inflation. Similarly, in risk surveillance, we will gather an array of data on
risk spreads, credit flows and volumes, asset prices, debt and leverage, markets, and
institutions, including detailed, often proprietary, microdata on balance sheets and data from
such markets as those for over-the-counter derivatives and repos. Nonetheless, surveillance
is likely to concentrate on key factors in the buildup of systemic risk such as the ones I
identified: the accumulation of credit and funding risk on the balance sheets of systemically
important institutions and throughout the financial system, the correlation of risk among
financial market participants, and the extent of counterparty exposures.
Of course, we must also keep a close eye on broad credit and asset market conditions. One
strand of surveillance will involve watching variations of risk and term spreads of bonds and
other securities relative to historical norms. Narrow risk spreads and risk premiums may be a
harbinger of excessive risk-taking by investors. Another strand will focus more directly on
measuring credit flows and exposures to credit risk. If overall credit growth is extraordinarily
rapid, it may be a sign that financial institutions are taking greater risks onto their balance
sheets. Because of financial system complexity, leverage is impossible to measure perfectly.
Still, real-time indicators of the leverage of financial intermediaries would help identify where
we are in a credit cycle. For example, we can look at the marginal leverage of new borrowing
by examining data on collateral haircuts. We may also monitor data on repo market activity
and haircuts to spot vulnerabilities relating to maturity mismatches. This information can be
crosschecked against firm- and sector-level data on credit risk exposure.
One aspect of systemic risk surveillance that has garnered a great deal of attention is the
identification of asset price bubbles. Bubbles present systemic danger when major financial
institutions use leverage to finance investment in risky assets that they hold on their balance
sheets. The systemic risk is multiplied when the asset bubble is accompanied by a credit
bubble that fuels highly leveraged investment.5 So a top priority of systemic risk surveillance
must be to assess whether asset price movements suggest the presence of a bubble and
identify at an early stage those that might be particularly dangerous. In practice, of course,
we will have highly uncertain notions of when excesses evolve into bubbles. Near the end of
a bubble, it's pretty clear that something is amiss. But by then it's too late to do much about
it.
We will also need to monitor the cross-sectional correlations of firms' risk exposures.6 In
addition, we need information on counterparty exposures through derivatives and other
financial instruments. Finally, further development of financial sector stress testing, building
on the tests carried out in the United States in 2009 and in Europe this year, will provide
valuable information about the ability of the financial system to weather significant economic
or financial shocks. We should refine the stress-testing methodology as we develop a more
sophisticated understanding of institution-level systemic risk factors. These enhancements
can be carried out by the quantitative surveillance unit that we have already established in
our supervision of the largest financial institutions to better integrate macroprudential
considerations with regular supervisory practice.
Qualitative information on credit will complement the quantitative evidence. The Fed recently
introduced the Senior Credit Officer Opinion Survey on Dealer Financing Terms, adding to
the information collected from the existing commercial bank Senior Loan Officer Opinion
Survey on Bank Lending Practices, a survey on credit supply and demand.7
5
Intermediaries, Financial Stability, and Monetary
See Tobias Adrian and Hyun Song Shin (2008), "Financial
Policy (1.4 MB PDF)", paper presented at "Maintaining Stability in a Changing Financial System",
a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo.,
August 21-23.
6
A number of promising measures of measuring systemic risk that take into account the correlations of
firms' strategies have recently been developed. For example, the CoVaR approach aims to measure the
marginal contribution of a financial institution to systemic risk, where systemic risk is measured by the
value at risk of all firms together; see Tobias Adrian and Markus K. Brunnermeier (2009), "CoVaR
(766 KB PDF)", Staff Report 348 (New York: Federal Reserve Bank of New York, August). See also the
risk topography approach discussed in Markus K. Brunnermeier, Gary Gorton, and Arvind
Krishnamurthy (2010), "Risk Topography (155 KB PDF)", unpublished paper, July.
7
These surveys are available on the Federal Reserve Board's website.
Systemic risk surveillance is both a science and an art: science in that we will analyze closely
a wide range of data that research shows to be diagnostic, and art in that we will have to
exercise judgment about when excesses become so dangerous that action is required. The
Fed and other regulators in the United States and abroad have made important progress in
developing systemic risk indicators. Still, we must recognize the inherent difficulty in
forecasting crises and acknowledge the failure of past risk-monitoring efforts. Moreover, we
must be mindful of the inadequacy of indicators that focus too specifically on the markets and
channels that transmitted the crisis of 2007 and 2008. Like Tolstoy's unhappy families, every
financial crisis is a crisis in its own way. For that reason, we need a flexible approach that
combines science and art, and judgmentally weighs information from all indicators.
Macroprudential policy implementation
Refining our ability to identify systemic threats is well and good. But when we detect a threat,
what will we do about it? This question brings me to the tools and implementation of
macroprudential policies. The first tool is information to help focus attention in policy circles,
and among investors and the public, on looming systemic risks. The detailed financial
stability reports published by the International Monetary Fund and a number of central banks
are intended to serve this purpose.8 And the Financial Stability Oversight Council created
under the Dodd-Frank Act is charged with preparing such a report once a year.
Admittedly, most such reports failed to identify the mechanisms behind the recent crisis. And
even when vulnerabilities were identified and warning bells sounded, they were often greeted
with yawns, as anyone who remembers the phrase "irrational exuberance" can testify. Those
who sounded the alarms were seen as killjoys who refused to join the party. Words are
important, but clearly they are not enough. We need strong policies to back them up. We
need macroprudential policymakers ready to take away the punch bowl when the party is
getting out of hand. We know that market participants won't take kindly when limits are set
precisely in those markets that are most exuberant, the ones in which they are making big
money. During the late stages of the housing boom, more than a few financial institution chief
executive officers dismissed the warnings of their own risk managers with a wave of the
hand.
So what should be the main tools of macroprudential supervision? Many of them are similar
to those of microprudential policy. They take the form of restrictions or incentives related to
financial firms' balance sheets. Still, macroprudential policies differ from purely
microprudential approaches in that they are intended to protect the financial system as a
whole and, by extension, the broader economy. Macroprudential policies will be aimed at
countering the pro-cyclical nature of credit and leverage, leaning against the wind when
systemic risk is accumulating. In addition, they will seek to stem risks related to
interconnections and spillovers in the financial system.
The Basel Committee on Banking Supervision is playing a key role in designing this new
regulatory regime as part of the Basel III initiative. And, under Federal Reserve leadership,
initiatives to implement macroprudential supervision are well under way in the United States.
Policymakers here and abroad agree that macroprudential policy must include requirements
to hold more and higher-quality capital. And capital requirements must be reformulated to
reduce the pro-cyclicality of credit and leverage. Financial institutions may be required to
build capital buffers in good times, which they can run down in bad times, thereby limiting
credit growth during booms and mitigating credit contraction in downturns. Banks may also
be required to have, in addition to their standard equity buffers, contingent capital in the form
of debt that is convertible to equity if they experience significant losses. This additional
capital would protect them from insolvency during busts while allowing them to benefit from
debt finance in boom times. U.S. regulators have also been charged with developing
heightened prudential standards for systemically important institutions to constrain risk-taking
by those firms whose failures would pose the greatest systemic risk. One approach could
involve imposing penalties or restrictions on financial firms based on factors such as the
correlation of their strategies with those of other firms or by limiting risk exposure to individual
counterparties.
Policies are on the drawing board to ensure that institutions avoid undue reliance on
shortterm debt and have adequate liquidity in market downturns. Such requirements would
diminish the risk of the shortfalls and hoarding that could fuel a credit market meltdown.
Policymakers might additionally put in place policies to discourage overreliance on short-term
debt among investors more broadly through, for example, regulations on repo haircuts. To
address unsustainable real estate price run-ups, some countries have chosen to cap
maximum loan-to-value ratios on home loans. Such an approach deserves serious
consideration. My expectation is that policies such as these will restrict dangerous
pro-cyclical movements in debt and leverage, diminish the extent of maturity mismatches and
the potential for runs, and discourage unsustainable asset price appreciation. Importantly,
the Federal Reserve and other U.S. regulators have also taken steps to ensure that the
financial institutions we supervise enforce compensation policies that control incentives for
excessive pro-cyclical risk-taking.
Macroprudential supervision must be particularly attentive to risks that could impair the
plumbing of the financial system - that is, the payments, clearing, and settlements systems -
where breakdowns would relay and amplify systemic risk. Importantly, the Dodd-Frank Act
significantly increases the trading of derivatives on exchanges and their clearing through
central counterparties.9 Because clearinghouses are themselves subject to risk from
counterparties and are important linchpins in the financial system, they must be regulated to
ensure that they operate safely.
Since the implementation of macroprudential supervision is a work in progress, I want to
highlight several important design considerations. The first relates to the appropriate balance
between fixed rules and discretion - a question familiar from monetary and fiscal policy. In
both cases, we have learned that fixed rules offer distinct advantages. In fiscal policy,
automatic stabilizers have proven helpful in mitigating the amplitude of cyclical fluctuations.
They trigger fiscal support when needed in a timely and predictable way. In the realm of
monetary policy, the Fed and other central banks commonly vary policy in a manner that
researchers and market participants find predictable and systematic. Indeed, guidance from
policy rules is increasingly used in actual decisionmaking since rule-based recommendations
create a sensible starting point for deliberations. Rule-like behavior also aligns the
expectations of markets and policymakers so that policy is transmitted quickly and effectively
to the economy.
Nevertheless, neither fiscal nor monetary policymakers rely on fixed rules alone.
Discretionary fiscal policy has been helpful, even essential, in some instances in responding
to economic fluctuations resulting from large shocks. Similarly, in the realm of monetary
policy, the Fed and other central banks certainly don't slavishly follow prescriptions from any
rule. They retain discretion to deviate from such prescriptions when responding to severe
shocks, unusually strong headwinds, or significant asymmetric risks.
In the implementation of macroprudential supervision, I believe it will be similarly
advantageous to put in place a system of controls in which fixed rules play an important role
while a place is preserved for the discretionary judgments of regulators. Fixed rules will
diminish the need for policymakers to make the difficult decision to take away the punch
bowl. Moreover, if discretionary macroprudential policy interventions are deferred until a
boom is well under way, the macroeconomic spillovers could prove difficult for monetary
policy to offset.
For these reasons, a stronger system of prudential controls designed to mitigate the buildup
of systemic risk must be put into place, a system that will incorporate mechanisms to
automatically counter pro-cyclical behavior. All the same, discretionary interventions will
inevitably play a part in macroprudential supervision. For one thing, it's important to keep in
mind that financial institutions have been very adept at gaming rule-based systems. And,
over time, there is always an incentive for risky financial activities to migrate outside the
perimeter of supervision and regulation, even if that perimeter is moving. That's precisely
what happened prior to the mortgage crisis, when leverage ballooned in the shadow banking
system and investment banks and some nonbanks became principal participants in credit
derivatives markets. Furthermore, the financial system will evolve in ways that preclude any
wholly rule-based system from countering all emerging systemic threats. Discretionary
macroprudential interventions are certain to be needed to address dangerous developments,
and judgment must play a role.
A second consideration in macroprudential supervision relates to the need for robust policies.
This concern derives from the observation that we still have a lot to learn about the behavior
of financial institutions and their effects on systemic risk and the real economy. Our ability to
model the channels by which disruptions in credit and finance affect the real economy and
the ways these effects feed back into the banking and financial systems is getting more
sophisticated.10 But our understanding of the key channels, their quantitative importance,
and the effects of our policies remain incomplete at best. It is therefore important that we
implement policies that are likely to succeed in mitigating systemic risk in a future crisis
regardless of the precise triggers and transmission channels. A rich monetary policy
literature demonstrates that simple rules result in good, even excellent, performance when
policymakers face uncertainty about the structure of the economy and the source of
economic shocks.11 This conclusion may apply to macroprudential supervision as well.
A third consideration in the design of the macroprudential supervision relates to the need for
extensive international cooperation. If the United States were to go it alone with tough
policies, we could see our financial institutions flee in a race to the bottom. But I'm convinced
that won't happen. We are working closely with our international counterparts to develop
coherent and comprehensive approaches, aided by the Basel Committee on Banking
Supervision, the Financial Stability Board, the International Monetary Fund, and other
institutions.12
Finally, we must not forget that macroprudential policies will entail some costs as well as
benefits. The magnitude of these costs remains a subject of debate. But, as with all forms of
regulation, we must find the right balance between overly strict supervision and laissez faire.
I don't know exactly where on the continuum that balance lies. But I do know that, before the
crisis, we had veered disastrously too far in the direction of laissez faire, with consequences
we know too well.
Interaction with monetary policy
One of the most challenging issues relating to systemic risk management is the appropriate
interactions between macroprudential and monetary policy. To what extent, if at all, should
monetary policy be used to mitigate systemic risk? And to what extent, if at all, should
monetary policy be coordinated with macroprudential supervision? These issues are the
subject of intense debate among policymakers across the globe. Of course, the question of
whether monetary policy should lean against asset price bubbles is hardly new.13 What has
changed is the sense of urgency surrounding this and related questions.
I noted previously - and it is now commonly accepted - that monetary policy can affect
systemic risk through a number of channels.14 First, monetary policy has a direct effect on
asset prices for the obvious reason that interest rates represent the opportunity costs of
holding assets. Indeed, an important element of the monetary transmission mechanism
works through the asset price channel. In theory, an increase in asset prices induced by a
decline in interest rates should no