Ben S Bernanke: Fostering financial stability
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the 2012 Federal Reserve Bank of Atlanta Financial Markets Conference, Stone
Mountain, Georgia, 9 April 2012.
* * *
I commend the organizers of this conference for the event's apt subtitle: "The Devil's in the
Details." For the Federal Reserve and other financial regulators, getting the details right is
crucial as we implement the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank Act) and strive to meet our broader financial stability responsibilities. About
three and a half years have passed since the darkest days of the financial crisis, but our
economy is still far from having fully recovered from its effects. The heavy human and
economic costs of the crisis underscore the importance of taking all necessary steps to avoid
a repeat of the events of the past few years.
Tonight I will discuss some ways in which the Federal Reserve, since the crisis, has
reoriented itself from being (in its financial regulatory capacity) primarily a supervisor of a
specific set of financial institutions toward being an agency with a broader focus on systemic
stability as well. I will highlight some of the ways we and other agencies are working to
increase the resiliency of systemically important financial firms and identify and mitigate
systemic risks, including those associated with the so-called shadow banking system. I will
also discuss the broad outlines of our evolving approach to monitoring financial stability. Our
efforts are a work in progress, and we are learning as we go. But I hope to convey a sense of
the strong commitment of the Federal Reserve to fostering a more stable and resilient
financial system.
Systemically important financial firms
Banking institutions
Since the crisis, the Federal Reserve has made important strides in the traditional,
microprudential regulation and supervision of individual banking organizations. Promoting the
safety and soundness of individual financial firms is a critical responsibility. To an increasing
extent, however, we have also been working to embed our supervisory practices within a
broader macroprudential framework that focuses not only on the conditions of individual firms
but also on the health of the financial system as a whole.
Even before the enactment of the Dodd-Frank Act, we had begun to overhaul our approach
to supervision to better achieve both microprudential and macroprudential goals. In 2009, we
created the Large Institution Supervision Coordinating Committee - a high-level,
multidisciplinary working group, drawing on skills and experience from throughout the
Federal Reserve System - and charged it with overseeing the supervision of the most
systemically important financial firms. Through the coordinating committee, we have
supplemented the traditional, firm-by-firm approach to supervision with a routine use of
horizontal, or cross-firm, reviews to monitor industry practices, common trading and funding
strategies, balance sheet developments, interconnectedness, and other factors with
implications for systemic risk. Drawing on the work of economists and financial market
experts, the coordinating committee has also made increasing use of improved quantitative
methods for evaluating the conditions of supervised firms as well as the risks they may pose
to the broader financial system.
An important example of our strengthened, cross-firm supervisory approach is the recently
completed second annual Comprehensive Capital Analysis and Review (CCAR).1 In the
CCAR, the Federal Reserve assessed the internal capital planning processes of the
19 largest bank holding companies and evaluated their capital adequacy under a very severe
hypothetical stress scenario that included a peak unemployment rate of 13 percent, a
50 percent drop in equity prices, and a further 21 percent decline in housing prices. From a
traditional safety-and-soundness perspective, we looked at whether each firm would have
sufficient capital to remain financially stable, taking into account its capital distribution
proposal, under the stress scenario. The simultaneous review, by common methods, of the
nation's largest banking firms also helped us better evaluate the resilience of the system as a
whole, including the capacity of the banking system to continue to make credit available to
households and businesses if the economy were to perform very poorly. Because stress
tests will be an enduring part of the supervisory toolkit, we are evaluating the recent exercise
particularly closely to identify both the elements that worked well and the areas in which
execution and communication can be improved.
We also now routinely use macroprudential methods in analyzing the potential
consequences of significant economic events for the individual firms we supervise and for
the financial system as a whole. A good example is our response to the European sovereign
debt concerns that emerged in the spring of 2010. Since those concerns arose, we have
been actively monitoring U.S. banks' direct and indirect exposures to Europe and tracking
the banks' management of their exposures. We have also been analyzing scenarios under
which European sovereign debt developments might lead to broader dislocations, for
example, through a sharp increase in investor risk aversion that adversely affects asset
values. This work not only has improved our understanding of banks' individual risk profiles,
it also has helped us better evaluate the potential effects of financial disruptions in Europe on
credit flows and economic activity in the United States.
Macroprudential considerations are being incorporated into the development of new
regulations as well as into supervision. For example, in December, the Federal Reserve
issued a package of proposed rules to implement sections 165 and 166 of the Dodd-Frank
Act. The rules would establish prudential standards for the largest bank holding companies
and systemically important nonbank financial firms, standards that become more stringent as
the systemic footprint of the firm increases. We are also collaborating with the Federal
Deposit Insurance Corporation (FDIC) and foreign authorities to help implement the FDIC's
new resolution authority for systemically critical firms. In particular, last fall we issued a joint
rule with the FDIC that requires each of these firms to produce a credible plan - known as a
living will - for an orderly resolution in the event of its failure.
In the international arena, we strongly supported the Basel Committee's adoption in the
summer of 2009 of tougher regulatory capital standards for trading activities and
securitization exposures. We have also worked closely with international partners to help
develop the Basel III framework, which requires globally active banks to hold more and
higher-quality capital and larger liquidity buffers, and which now incorporates a provision to
impose capital surcharges based on firms' global systemic importance. These surcharges
are intended to reduce the risk of failure of systemic firms and also to force these firms, in
their decisions regarding their size and complexity, to internalize the possible costs that
those decisions might impose on the broader economic and financial system. The purpose of
each of these steps is to improve the traditional prudential regulation of systemically
important firms while fostering greater stability and resilience in the banking system as a
whole.
Nonbank Financial Firms
Gaps in the regulatory structure, which allowed some systemically important nonbank
financial firms to avoid strong, comprehensive oversight, were a significant contributor to the
crisis. The Federal Reserve has been working with the other member agencies of the
Financial Stability Oversight Council (FSOC), established by the Dodd-Frank Act, to close
these regulatory gaps. On April 3 the FSOC issued a final rule and interpretive guidance
implementing the criteria and process it will use to designate nonbank financial firms as
systemically important.2 Once designated, these firms would be subject to consolidated
supervision by the Federal Reserve and would be required to satisfy enhanced prudential
standards established by the Federal Reserve under title I of Dodd-Frank. The FSOC's rule
provides detail on the framework the FSOC intends to use to assess the potential for a
particular firm to threaten U.S. financial stability. The analysis would take into account the
firm's size, interconnectedness, leverage, provision of critical products or services, and
reliance on short-term funding, as well as its existing regulatory arrangements.
The FSOC's issuance of this rule is an important step forward in ensuring that systemically
critical nonbank financial firms will be subject to strong consolidated supervision and
regulation. More work remains to be done, however. In particular, although the basic process
for designation has now been laid out, further refinement of the criteria for designation will be
needed; and, for those firms that are ultimately designated, it will fall to the Federal Reserve
to develop supervisory frameworks appropriate to each firm's business model and risk
profile. As the FSOC gains experience with this process, it will make adjustments to its rule
and its procedures as appropriate.
Regulation of shadow banking
I have been discussing the oversight of systemically important financial institutions in a
macroprudential context. However, an important lesson learned from the financial crisis is
that the growth of what has been termed "shadow banking" creates additional potential
channels for the propagation of shocks through the financial system and the economy.
Shadow banking refers to the intermediation of credit through a collection of institutions,
instruments, and markets that lie at least partly outside of the traditional banking system.
As an illustration of shadow banking at work, consider how an automobile loan can be made
and funded outside of the banking system. The loan could be originated by a finance
company that pools it with other loans in a securitization vehicle. An investment bank might
sell tranches of the securitization to investors. The lower-risk tranches could be purchased by
an asset-backed commercial paper (ABCP) conduit that, in turn, funds itself by issuing
commercial paper that is purchased by money market funds. Alternatively, the lower-risk
tranches of loan securitizations might be purchased by securities dealers that fund the
positions through collateralized borrowing using repurchase (repo) agreements, with money
market funds and institutional investors serving as lenders.
Although the shadow banking system taken as a whole performs traditional banking
functions, including credit intermediation and maturity transformation, unlike banks, it cannot
rely on the protections afforded by deposit insurance and access to the Federal Reserve's
discount window to help ensure its stability. Shadow banking depends instead upon an
alternative set of contractual and regulatory protections - for example, the posting of
collateral in short-term borrowing transactions. It also relies on certain regulatory restrictions
on key entities, such as the significant portfolio restrictions on money market funds required
by rule 2a-7 of the Securities and Exchange Commission (SEC), which are designed to
ensure adequate liquidity and avoid credit losses. During the financial crisis, however, these
types of measures failed to stave off a classic and self-reinforcing panic that took hold in
parts of the shadow banking system and ultimately spread across the financial system more
broadly.
An important feature of shadow banking is the historical and continuing involvement of
commercial and clearing banks - that is, more "traditional" banking institutions. For example,
commercial banks sponsored securitizations and ABCP conduits, arrangements which, until
recently, permitted those banks to increase their leverage by keeping the underlying assets
off their balance sheets. Clearing banks stand in the middle of triparty repo agreements,
managing the exchange of cash and securities while providing protection and liquidity to both
transacting parties. Moreover, to ease operational frictions, clearing banks extend very large
amounts of temporary intraday credit to borrowers and lenders each day. This temporary
intraday credit - averaging about $1.4 trillion - allows securities dealers access to their
securities (for example, the tranches of loan securitizations mentioned earlier) during trading
hours.
Because of these and other connections, panics and other stresses in shadow banking can
spill over into traditional banking. Indeed, the markets and institutions I mentioned - the repo
market, the ABCP market, and money market funds - all suffered panics to some degree
during the financial crisis. As a result, many traditional financial institutions lost important
funding channels for their assets; in addition, for reputational and contractual reasons, many
banks supported their affiliated funds and conduits, compounding their own mounting liquidity
pressures.
Status of Shadow Banking Reform Efforts
Given the substantial stakes, I am encouraged that both regulators and the private sector
have begun to take actions to prevent future panics and other disruptions in shadow banking.
However, in many key areas these efforts are still at early stages.
A first set of reforms relate to the accounting and regulatory capital treatment of shadow
banking entities sponsored by traditional banks. The Financial Accounting Standards Board
finalized a rule in 2009 that requires securitizations and other structured finance vehicles, in
certain situations, to be consolidated onto the sponsoring bank's balance sheet. In the
context of regulatory capital, Basel 2.5 and Basel III addressed interconnectedness and other
sources of systemic risk frequently associated with shadow banking by raising capital
requirements for exposures to unregulated financial institutions, such as asset managers,
hedge funds, and credit insurers, and by strengthening the capital treatment of liquidity lines
to off-balance-sheet structures. Basel III also includes quantitative liquidity rules that reflect
contractual and other risks that arise from bank sponsorship of off-balance-sheet vehicles.
A second area of ongoing reform is money market funds. In an important step toward greater
stability, the SEC in 2010 amended its regulations to, among other things, require that money
market funds maintain larger buffers of liquid assets, which may help reassure investors and
reduce the likelihood of runs. Notwithstanding the new regulations, the risk of runs created by
a combination of fixed net asset values, extremely risk-averse investors, and the absence of
explicit loss absorption capacity remains a concern, particularly since some of the tools that
policymakers employed to stem the runs during the crisis are no longer available.
SEC Chairman Mary Schapiro has advocated additional measures to reduce the vulnerability
of money market funds to runs, including possibly requiring funds to maintain loss-absorbing
capital buffers or to redeem shares at the market value of the underlying assets rather than a
fixed price of $1. Alternative approaches to ensuring the stability of these funds have been
proposed as well. Additional steps to increase the resiliency of money market funds are
important for the overall stability of our financial system and warrant serious consideration.
A third set of emerging reforms is aimed at repo markets, an area in which the Federal
Reserve has taken an active role. The initial efforts have focused on the vulnerabilities
created by the large amounts of intraday credit provided by clearing banks in the triparty repo
market. Intraday credit, while a great convenience in normal times, may foster systemic risk
by creating large mutual exposures between securities dealers and clearing banks. In times
of market stress, a dealer default on intraday credit extended could be large enough to pose
a threat to the stability of the clearing bank - institutions tightly connected to the rest of the
financial system. But were a clearing bank to decline to provide intraday credit to a dealer,
that dealer's ability to operate normally would be substantially compromised, likely causing
difficulties for its clients and counterparties, including many other financial institutions. As a
result, during a period of market stress, the actions of clearing banks can jeopardize the
stability of securities dealers, and vice versa.
An industry task force recognized this mutual vulnerability in 2010 and recommended the
"practical elimination" of intraday credit in the triparty repo market. Although some progress
has been made, securities dealers and clearing banks have yet to fully implement that
recommendation. Nevertheless, through supervision and other means, we continue to push
the industry toward this critical goal. In doing so, we are collaborating with other agencies,
notably the SEC, which has regulatory responsibility for money market funds and securities
dealers, institutions that are active in the triparty repo market. At the same time, we continue
to urge market participants to improve their risk-management practices, and, in particular, to
ensure that tools are in place to address the risks that would be posed to the repo market by
the default of a major firm.
International regulatory groups have also been focused on addressing the financial stability
risks of shadow banking. The Group of Twenty leaders have directed the Financial Stability
Board (FSB), whose membership consists of key regulators from around the world, including
the Federal Reserve, with developing policy recommendations to strengthen the regulation of
the shadow banking system. The FSB currently has five major projects under way devoted to
understanding the risks of, and developing policy recommendations for, shadow banking.
The areas under study include money market funds, securitization, securities lending and the
repo market, banks' interactions with shadow banks, and "other" shadow banking entities.
Given the substantial variation in the structure of shadow banking in different countries, the
FSB's agenda is ambitious. But it is also critical in light of the potential risks to stability from
shadow banking and the ease with which shadow banking entities can create intermediation
chains across national borders.
Monitoring financial stability
I've outlined a number of ongoing efforts, both domestic and international, to bring the
shadow banking system into the sunlight, so to speak, and to impose tougher standards on
systemically important financial firms. But even as we make progress on known
vulnerabilities, we must be mindful that our financial system is constantly evolving, and that
unanticipated risks to stability will develop over time. Indeed, an inevitable side effect of new
regulations is that the system will adapt in ways that push risk-taking from more-regulated to
less-regulated areas, increasing the need for careful monitoring and supervision of the
system as a whole.
At the Federal Reserve, we have stepped up our monitoring efforts substantially in recent
years, with much of the work taking place under the auspices of our recently created Office
of Financial Stability Policy and Research. We conduct an active program of research and
data collection, often in conjunction with other U.S. and foreign regulators and supervisors,
including our fellow members on the FSOC. In addition, by making use of resources
throughout the Federal Reserve System, we are developing a framework and infrastructure
for monitoring systemic risk. Our goal is to have the capacity to follow developments in all
segments of the financial system, including parts of the financial sector for which data are
scarce or that have developed more recently and are thus less well understood. This work
complements and is closely coordinated with our efforts, mentioned earlier, to supervise
systemically important banking organizations from a macroprudential perspective. For
example, based on public data, we develop and monitor measures of systemic importance
that reflect firms' interconnectedness and their provision of critical services.
Unfortunately, data on the shadow banking sector, by its nature, can be more difficult to
obtain. Thus, we have to be more creative to monitor risk in this important area. We look at
broad indicators of risk to the financial system, such as measures of risk premiums, asset
valuations, and market functioning. We try to gauge the risk of runs by looking at indicators of
leverage (both on and off balance sheet) and tracking short-term wholesale funding markets,
especially for evidence of maturity mismatches between assets and liabilities. We are also
developing new sources of information to improve the monitoring of leverage. For example,
in 2010, we began a quarterly survey on dealer financing (the Senior Credit Officer Opinion
Survey on Dealer Financing Terms) that collects information on the leverage that dealers
provide to financial market participants in the repo and over-the-counter derivatives markets.3
In addition, we are working with other agencies to create a comprehensive set of regulatory
data on hedge funds and private equity firms.
Broader economic developments can also create risks to financial stability. To assess such
risks, we regularly monitor a number of metrics, including, for example, the leverage of the
nonfinancial sector. In addition, we use data from the flow of funds accounts to assess how
much nonfinancial credit is ultimately being funded with short-term debt.4 This assessment is
important because an overleveraged nonfinancial sector could serve to amplify shocks, to
the detriment of the functioning of the financial sector and broader economy. Our judgment of
how the financial sector is affecting economic activity reflects both information on lenders
- most notably, underwriting standards, risk appetite, and balance sheet capacity - and
analytical indicators of macroeconomic vulnerability to financial risks. Meanwhile, efforts are
under way, both at the Federal Reserve and elsewhere, to evaluate and develop new
macroprudential tools and to develop early warning indicators that could help identify and
limit future buildups of systemic risk.
In the decades prior to the financial crisis, financial stability policy tended to be
overshadowed by monetary policy, which had come to be viewed as the principal function of
central banks. In the aftermath of the crisis, however, financial stability policy has taken on
greater prominence and is now generally considered to stand on an equal footing with
monetary policy as a critical responsibility of central banks. We have spent decades building
and refining the infrastructure for conducting monetary policy. And although we have done
much in a short time to improve our understanding of systemic risk and to incorporate a
macroprudential perspective into supervision, our framework for conducting financial stability
policy is not yet at the same level. Continuing to develop an effective set of macroprudential
policy indicators and tools, while pursuing essential reforms to the financial system, is critical
to preserving financial stability and supporting the U.S. economy.