Philip N Jefferson: Financial stability and the US economy
Remarks by Mr Philip N Jefferson, Member of the Board of Governors of the Federal
Reserve System, at the 22nd Annual International Conference on Policy Challenges for
the Financial Sector, Washington DC, 31 May 2023.
* * *
Good afternoon, everyone. It is a pleasure to be here and share my perspective on
some key challenges policymakers currently face. Before I begin, let me remind you
that the views I will express today are my own and are not necessarily those of my
colleagues in the Federal Reserve System.
This conference is timely and relevant. Among the topics covered are current financial
stability risks and vulnerabilities, potential developments in banking supervision and
regulation, and operational risk and resilience under evolving technologies. During the
next three days, you will have an opportunity to engage in stimulating discussions with
expert panelists on these and other critical issues.
Today, I would like to share with you, at a high level, some of the Federal Reserve's
recent and ongoing initiatives on a few of these issues. I also want to share with you an
overview of the Federal Reserve's approach toward financial stability and my thoughts
on interactions between the economic outlook and financial stability. My remarks will be
U.S. focused, fully understanding that other countries monitor financial stability similarly
and that the health of the U.S. economy and financial system has an impact on other
countries, and vice versa.
The Federal Reserve's Approach Toward Financial Stability
A stable financial system is resilient even in the face of sharp downturns or stress
events. It provides households and businesses with the financing they need to
participate and thrive in a well-functioning economy. It is difficult to anticipate or prevent
shocks, but sound policies can mitigate their impact. At the Federal Reserve, we work
hard to make sure that an initial shock in one area of the financial system does not spill
over to other markets or institutions and cause severe or widespread strains. Such
spillovers could disrupt the flow of credit and cause outsized declines in employment
and economic activity. It is not our role, nor should it be our objective, to influence the
allocation of credit within or across sectors of the U.S. economy.
Financial and nonfinancial institutions and households are linked through a web of
relationships. The economic activities of households and businesses depend on the
strength of financial institutions' balance sheets, as households and businesses obtain
funding through the financial sector. Similarly, the health of the financial sector hinges
on the strength of the balance sheets of households, businesses, and financial
institutions, as financial institutions' assets are the liabilities of these sectors.
The Federal Reserve monitors and assesses potential vulnerabilities that may develop
because of interactions among key participants. We do that by focusing on the safety
and soundness of individual supervised institutions and by looking across the entire
financial and nonfinancial system for potential risks and vulnerabilities. These risks and
vulnerabilities can include elevated valuation pressures, excessive borrowing by
households and businesses, excessive leverage in the financial system, and elevated
funding risks. In other words, at the Federal Reserve, we use both microprudential and
macroprudential approaches to monitor the health of financial institutions and the
financial sector.
The recent banking stress events remind us that risks and vulnerabilities in financial
markets are continuously changing. That is why the staff at the Federal Reserve is
constantly monitoring domestic and foreign financial markets and institutions, as well as
the financial condition of households and businesses, with the goal of identifying current
and future vulnerabilities. Such forward-looking financial stability monitoring helps
inform policymakers about ongoing vulnerabilities in the financial system that may
amplify a range of potential adverse events or shocks.
The U.S. Financial System and Economic Outlook
U.S. financial markets and institutions remain resilient even though financial stability
risks and vulnerabilities in the U.S. financial system have increased since the recent
stress events. Conditions in the banking sector have stabilized thanks, in part, to
decisive emergency actions taken in March by the Federal Reserve, the Federal
Deposit Insurance Corporation, and the Treasury. The Federal Reserve, using existing
regulatory and supervisory tools, is working to ensure that banks improve and update
their liquidity, commercial real estate, and interest rate risk-management practices.
I expect spending and economic growth to remain quite slow over the rest of 2023, due
to tight financial conditions, low consumer sentiment, heightened uncertainty, and a
decline in household savings that had built up after the onset of the pandemic. Inflation
has come down substantially since last summer, but it is still too high, and by some
measures progress has been decelerating recently, particularly in the core services
sector. While it is reasonable to expect that the recent banking stress events will lead
banks to tighten credit standards further, the amount of tightening and the magnitude of
the effect such tightening might have on the U.S. economy is not yet clear, and this
uncertainty complicates economic forecasts.
Short-term interest rates are 5 percentage points higher than they were a little over a
year ago. History shows that monetary policy works with long and variable lags, and
that a year is not a long enough period for demand to feel the full effect of higher
interest rates. While my base case forecast for the U.S. economy is not a recession,
higher interest rates and lower earnings could test the ability of businesses to service
debt. In addition, and perhaps more in focus given the recent events affecting certain
areas of the banking sector, higher interest rates could further exacerbate stress at
banking organizations, especially those that are highly exposed to longer-duration
assets and have a relatively high ratio of uninsured deposits to total deposits. Since late
last year, the Federal Open Market Committee has slowed the pace of rate hikes as we
have approached a stance of monetary policy that will be sufficiently restrictive to return
inflation to 2 percent over time. A decision to hold our policy rate constant at a coming
meeting should not be interpreted to mean that we have reached the peak rate for this
cycle. Indeed, skipping a rate hike at a coming meeting would allow the Committee to
see more data before making decisions about the extent of additional policy firming.
With that said, let me turn to the topics covered in our two sessions this afternoon.
Current Financial Stability Risks and Vulnerabilities
During the first session this afternoon, you will be discussing current financial stability
risks and vulnerabilities as well as historical parallels. As we have seen in the past
couple of months, the failure of a large banking organization, even if not deemed
individually systemically important under our regulations, can cause markets to
reassess the condition of other firms with roughly similar size and risk profiles, and the
resulting spillovers can generate significant negative consequences for the broader
economy. As I mentioned earlier, conditions in the banking sector have stabilized.
Moreover, broader U.S. financial markets and the overwhelming majority of financial
institutions have been resilient to the recent stress events.
The resilience of the financial system to current salient risks can be appreciated by
contrasting it to the 2008 Global Financial Crisis. Leading up to the Global Financial
Crisis, housing markets were substantially overvalued, mortgage underwriting
standards were weak, and home mortgages were at substantial risk of falling
underwater if house prices fell. Yet banks had limited loss-absorbing capacity and were
heavily reliant on wholesale short-term funding, and interconnections across the
financial system were opaque. When housing markets weakened, opacity contributed to
investors' fears, short-term funding pulled away, and excessive leverage led to fire
sales as financial institutions experienced losses and major firms failed or were rescued
by the government. The economy experienced a deep recession, and unemployment
ultimately reached 10 percent.
The current resilience of the financial sector points to substantially more limited
spillovers from recent events. The failures of Silicon Valley Bank, Signature Bank, and
First Republic Bank showed excessive reliance at those institutions on uninsured
deposits and excessive exposure to interest rate risk. Even so, the overwhelming
majority of banks have strong balance sheets with limited leverage, high levels of
lossabsorbing capacity, and healthy liquidity. Moreover, household and business balance
sheets are generally strong, and the credit quality of loans is generally much better than
on the eve of the Global Financial Crisis. Leverage across key parts of the financial
sector, including especially the largest banks and broker-dealers, is much lower than in
the mid-2000s.
Even so, we remain vigilant to the potential for vulnerabilities to emerge. Three areas of
potential concern have been the focus of our supervisory and regulatory work. First,
recent stresses highlighted the importance of effective liquidity and interest rate risk
management, including both reliance on uninsured deposits and exposure to duration
risk in asset holdings. While the resilience of the financial sector will limit the spillovers
from recent events, I expect those strains to lead to a further tightening in credit supply
from banks that will weigh on economic activity. Second, it is also important to assess
how changes in the financial sector, including expanded use of online banking and
shifts in behavior that may be driven by access to social media, may alter the potential
speed of deposit flows. Third, the weakness in some sectors of commercial real estate
will affect the credit quality of those types of commercial real estate loans and thereby
place strains on lenders with high concentrations of those loans. Changes in work
preferences and the increase in remote work is leading to a reassessment of the
outlook for office and associated retail properties, and it will take time for the extent of
that weakness to become clearer.
Ongoing Regulatory Capital Initiatives
Later in the afternoon, during the second session of the conference, you will be
discussing a few key ongoing regulatory capital initiatives, focusing on the completion of
the Basel III reforms. As Vice Chair for Supervision Michael Barr has noted, finalizing
the Basel III reforms is a high priority for the Federal Reserve. The revised framework
should improve the resilience of the banking system by producing more robust and
internationally consistent capital requirements for large firms, building on improvements
made to the capital framework following the Global Financial Crisis. Importantly, the
revised framework is expected to reduce unwarranted variability in capital requirements.
By increasing standardization, these reforms aim to increase transparency and public
confidence in risk-weighted assets while also reducing complexity.
As we speak, the staffs of the U.S. federal banking agencies are diligently working on a
Basel III endgame proposal that should be issued for public comment soon. At the
same time, the Federal Reserve staff is considering ways to enhance the ability of
stress tests to capture a wider range of risks and identify vulnerabilities at the largest
banking organizations.
Conclusion
Based on this brief overview of the issues, this afternoon promises to be invigorating
and informative. I look forward to hearing how the panel discussions go. I hope that you
enjoy the conference.
Thank you.