Lael Brainard: The Federal Reserve's financial stability agenda
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal Reserve
System, at the Hutchins Center on Fiscal and Monetary Policy, The Brookings Institution,
Washington DC, 3 December 2014.
* * *
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.1
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 companies2 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.
Financial stability agenda
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 Financial Stability
Oversight Council (FSOC). This work is carried out by staff in that 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.
First pillar: surveillance
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.3
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.
Second pillar: macroprudential policy
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,
throughthe-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.
Tool one: structural resilience
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.4 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.5
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.
Tool three: time-varying sector-specific tools
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
to eight quarters of the scenario that increases between 3 percentage points and 5 percentage points, which is
the amount by which unemployment has increased in the most recent three severe recessions. However, if
such an increase does not raise the level of the unemployment rate to at least 10 percent - the average level
to which it has increased in the most recent three severe recessions - the path of the unemployment rate in
most cases will be specified so as to raise the unemployment rate to at least this level. Under this
methodology, the increase in the unemployment rate would be slightly greater if the initial unemployment rate
were low - as it would be after a sustained long expansion. Moreover, setting a floor for the unemployment
rate recognizes the fact that not only do cyclical systemic risks build up at financial intermediaries during
robust expansions, but that these risks are also easily obscured by the buoyant environment. Note, however,
that while the approach to specifying the severely adverse scenario is designed to avoid adding sources of
procyclicality to the financial system, it is not designed to explicitly offset any existing procyclical tendencies.
The purpose of the stress-test scenarios is to make sure that banks are properly capitalized to withstand
severe economic and financial conditions, not to serve as an explicit countercyclical offset to the financial
system.
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 1percentage 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
sectorspecific 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.6 Financial 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.7
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.8 This 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.9
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.
As an example, the Consumer Financial Protection Bureau (CFPB) has authority 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.
7
See Stijn Claessens, Swati R. Ghosh, and Roxana Mihet (2014), "Macro-Prudential Policies to Mitigate
Financial System Vulnerabilities", IMF Working Paper Series 14/155 (Washington: International Monetary
Fund, August).
8
The Federal Reserve Board and five other federal agencies approved risk-retention rules in October 2014
designed to ensure that securitization sponsors have an incentive to monitor and ensure the quality of the
securitized assets underlying a securitization transaction. Sponsors of securities collateralized solely by
"qualified residential mortgages", or QRMs, as defined by the agencies, are not required to hold credit risk in
their securitizations. The QRM definition rests, in part, on the debt service-to-income of the mortgage
borrower, but it does not include loan-to-value ratios. The agencies have committed to review the QRM
definition at five-year intervals, or earlier at the request of any agency, in order to ensure that the definition
remains appropriate as mortgage and securitization market conditions and practices change. Altering the
QRM definition more frequently would likely be cumbersome and time-consuming.
9
A parallel evolution is also under way internationally across the major financial jurisdictions and the
international standard-setting bodies under the umbrella of the Financial Stability Board (FSB).
Fourth pillar: monetary policy
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.10 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.11
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.
Conclusion
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
sectorspecific tools, and, at times, looking to monetary policy as a powerful tool that unlike any
other operates across the entire financial system.