Stanley Fischer: Financial stability and shadow banks - what we don't
know could hurt us
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the "Financial Stability: Policy Analysis and Data Needs" 2015 Financial Stability
Conference, sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial
Research, Washington DC, 3 December 2015.
* * *
I would like to thank the Federal Reserve Bank of Cleveland and the Office of Financial Research (OFR) for inviting
me to address this conference.1
I have two goals this afternoon. First, I will briefly share my overall assessment of the current
state of the vulnerabilities of the financial system. Second, I will outline areas where regulators
and researchers can work to fill in gaps in our understanding or in the data available to monitor
conditions, especially conditions outside the banking sector.
With regard to current conditions, like most who follow financial sector developments, I see
financial vulnerabilities in the United States as greatly reduced from a decade ago, on the eve
of the beginning of the global financial crisis. But despite this relatively positive overall
assessment, the financial system is dynamic and will evolve over time, and the tightening in
regulation of the banking sector may push activity to other areas - and things happen. In
particular, while current shadow banking activities are much reduced relative to their level in
2007-08, some developments remain hard to track, and interconnections across the financial
system are hard to measure.
Several steps have been taken to reduce shadow banking risks, including restrictions on the
support banks can provide to shadow banking activities and reforms designed to lower the
incentives of investors to run on money market mutual funds. But more needs to be done. For
example, efforts to limit leverage used to finance securities positions, such as the Financial
Stability Board's (FSB) recently finalized standard on minimum and potentially countercyclical
haircuts on securities financing transactions, represent a further step in the right direction. As
the financial system evolves, we will want, as my colleague Daniel Tarullo emphasized a few
weeks ago, "to pursue a policy of case-by-case assessment that permits healthy forms of
nonbank intermediation while protecting the financial system."2 Doing so will require further
development of the economic models that we use to understand interconnections across our
complex financial system, along with better data.
The current state of the financial system
Factors promoting greater structural resilience
Returning to the current state of vulnerabilities, it is well known that a range of structural
improvements mandated by the Congress and undertaken by the Federal Reserve and other
regulatory agencies have strengthened financial stability over the past five years. Important
changes in regulation and supervision include (1) requirements for more and higher-quality
capital and other loss-absorbing capacity at banks; (2) new requirements for liquidity buffers
at banks; (3) more stringent capital and liquidity requirements at the largest, most systemically
important firms; (4) stress-testing of the largest banks; (5) the shift of the clearing of some
derivatives to central counterparties (CCPs); (6) new margin requirements for uncleared
derivatives transactions; (7) the designation of systemically important nonbank financial
institutions by the Financial Stability Oversight Council; and (8) enhanced sharing of
information among regulators and monitoring of risks to financial stability, in which the OFR
has played a leading role.3 This is an impressive list.4
Cyclical developments
Turning to developments in the cyclical behavior of the financial system, at least five factors
contribute to financial fragility: (1) high debt burdens at households and firms; (2) elevated
leverage and maturity transformation within the financial sector; (3) complexity and
interconnectedness in intermediation chains; (4) low risk premiums on assets, especially
assets funded with debt; and (5) complacency on the part of investors, supervisors and
decisionmakers in the private sector of the financial system.
At the Federal Reserve, staff members present their assessment of vulnerabilities to the
financial sector in terms of these risk factors and further organize these risk factors along
institutional lines - distinguishing among developments within the banking sector and the
nonbank sector, with a special focus on nonbank institutions that engage in maturity
transformation or deploy notable degrees of leverage.5
Using this framework, I see overall financial vulnerabilities as moderate - that is, considerably
lower than a decade ago. Asset valuations and debt burdens in key markets do not appear
outsized. Perhaps most important, house prices, while substantially above their recent lows,
do not appear broadly elevated relative to rents or disposable income, in contrast to conditions
a decade ago. Moreover, household-sector debt growth has been modest and driven mainly
by prime borrowers, although rapid growth in auto and student lending across the credit
spectrum may create repayment challenges for some households. However, signs of valuation
pressures are emerging in commercial real estate markets, where prices have been rising at
a solid clip and lending standards have deteriorated, although debt growth has not yet
accelerated notably.
In the corporate debt markets, valuation pressures had been high for a while, before risk
spreads widened and issuance slowed over the past year. The high issuance of corporate debt
in recent years is evident in the near-record-high debt-to-asset ratios at speculative-grade and
unrated corporations, making this sector vulnerable to adverse shocks. In addition, increased
defaults could lead to sharper-than-expected price declines if concerns that liquidity in
corporate bond markets is not as robust as in the past - a topic to which I will return in a few
minutes - turn out to be justified.
In the financial sector, regulatory capital ratios remain at historically high levels, and liquidity
buffers appear sizable in the banking sector. Capital ratios continue to trend upward for both
life and property and casualty insurers.
A closer look at shadow banking
Still, our view of developments at nonbank firms that have traditionally relied on high leverage
and short-term wholesale funding and were at the center of the financial crisis - the shadow
banking sector - remains incomplete.6
One source of information about leverage at nonbanks is the Senior Credit Officer Opinion
Survey on Dealer Financing Terms (SCOOS), which the Federal Reserve initiated after the
crisis. The SCOOS provides information about the availability and terms of credit in securities
financing and over-the-counter derivatives markets - for example, on credit granted by dealers
to counterparties such as hedge funds or insurers to finance investments in securities like
commercial mortgage-backed securities or corporate bonds. In recent years, the SCOOS has
suggested relatively stable use of leverage across hedge funds and other counterparties - but
this qualitative assessment provides only a high level, and very partial, view.7
An important risk factor during the mid-2000s was the growth in securitization and the creation
of so-called high quality collateral. Currently, the volume of securitization is far below
mid2000s levels, with much of the decline reflecting the collapse in private residential
mortgagebacked securities. Further, the low level of activity probably understates the improvement in
risk, as pre-crisis securitization was highly reliant on short-term wholesale funding through
vehicles such as asset-backed commercial paper programs to finance the highest-rated
tranches.
More generally, wholesale short-term liabilities have declined across the board. For example,
the gross volume of repos (repurchase agreements) fell from its peak of nearly $5 trillion in
early 2008 to about $3 trillion by early 2009, while total assets of money market mutual funds
contracted from approximately $3.75 trillion at the end of 2008 to about $2.5 trillion in recent
years.8 The decline in the volume of repos is part of a more general pullback from risk among
broker-dealers and their clients, and dealer balance sheets are much smaller, on balance, than
pre-crisis.
Some, perhaps even the lion's share, of the retreat in securitization, money market mutual
fund shares, and repos is probably due to investors' memory of the financial crisis. Institutions
and individuals burned by runs and losses from fire sale conditions have, at least for the time
being, adopted a more prudent stance. But structural changes have also played a role. The
largest broker-dealers are now part of bank holding companies and are therefore subject to
consolidated supervision by the Federal Reserve, which includes regular stress-testing and
tighter capital and liquidity requirements. The new liquidity rules for large banks and the capital
surcharge for systemically important banks discourage reliance on short-term wholesale
funding. And the ability of banks to provide support to structured investment vehicles has been
substantially curtailed through both restrictions on the accounting treatment of formerly
offbalance-sheet exposures and more stringent capital requirements, including the
supplementary leverage ratio applying to on-balance-sheet assets and off-balance-sheet
exposures.
Indeed, some have asked whether the reduction in broker-dealer activities has gone too far,
citing heightened concerns over a possible shortage of bond market liquidity as one example
of potentially negative consequences. Most measures of market liquidity in Treasury and
corporate bond markets have not shown signs of a deterioration in market functioning in recent
years. There are certainly concerns that bond market liquidity may not be as robust as in the
past, which could lead to sharper-than-anticipated price movements - of which the bond
market events in mid-October 2014 are often cited as an example. However, a review of the
evidence does not point clearly to a significant role for the reduction in broker-dealer balance
sheets or regulatory changes as being responsible for any shifts in liquidity.9 Other structural
factors, such as the long-term trends toward higher participation of high-frequency trading firms
in Treasury markets and greater disclosure of corporate bond trades, have been important.
In my view, the reduction in leverage and maturity transformation associated with better
regulations leaves the financial system much more resilient - even if such regulations have
modestly affected market liquidity.
What we know and what we do not
Despite my assessment of current vulnerabilities, conditions can change quickly. And
important blind spots in our view of the financial system remain, in part owing to data gaps.
When it comes to financial stability, what you do not know really can hurt you - and there
remains a good bit we do not know.10
This lack of data can impede the design of regulation. There is a long history of data collection
focused on banks, and supervisory data have contributed to our quantitative approach to
regulation and supervision. For example, when we examine the likely implications of the failure
of an institution's largest counterparty, we learn a great deal about the health of that institution
and gain greater insight into its connections, through that counterparty, to other institutions.
But data on a range of activities - including securities lending, bilateral repos, and derivatives
trading - that create funding and leverage risks remain inadequate and hence could prove
destabilizing if sufficiently large or widespread. We gain some insight into these markets
through our supervisory relationships with the largest bank holding companies, but the
activities of important nonbank market participants, such as asset managers, and the
interconnections across institutions remain more opaque.
Efforts are under way to deal with these gaps: The Legal Entity Identifier initiative is working
to allow regulators and private counterparties to trace activities by institution; the OFR, the
Securities and Exchange Commission, and the Federal Reserve are cooperating with the
industry to collect data on bilateral repos; and the FSB has finalized standards for collection of
data on securities financing transactions.11 Regulators in the United States and abroad have
begun to require the reporting of detailed derivatives transaction data to trade repositories.
Unfortunately, as a recent report shows, inadequate data standards and limitations on
authorities' access to trade repository data have prevented the benefits of derivatives trade
data reporting from being fully realized.12
An illustration of the possible interaction between better data and better policies is the potential
role of margins in securities financing transactions. The more stringent regulation of the
banking sector may push short-term financing activities to less regulated entities. To limit such
regulatory arbitrage, the Federal Reserve will be developing regulations that would establish
minimum margins for securities financing transactions on a marketwide basis. The margins
would apply to all market participants, thereby mitigating the risks associated with regulation
along institutional lines. Improved data collection, such as mentioned earlier, would allow a
better view of changes in conditions and potentially contribute to the deployment of
countercyclical margins, thereby further decreasing the chances of a dynamic that culminates
in adverse fire sales.
Data are not enough: We need theory, too
While the steps to improve data taken so far will help, gaps will remain, especially with regard
to unregulated or weakly regulated entities. These gaps impede both market participants'
ability to discipline the risks taken by institutions and supervisors' ability to take prompt action.
Nonetheless, I would also like to emphasize to this group of researchers that better data, by
themselves, are only the start of the journey to better understanding.
An important area in need of development is economic modeling on interconnectedness,
particularly on the interaction of shadow banking, banks, and the broader financial system.13 It
is instructive to consider the distress at Lehman Brothers and American International Group,
Inc. (AIG), in the late summer and fall of 2008 and of Long-Term Capital Management (LTCM)
in the late summer and fall of 1998. In each case, banking supervisors and market participants
appear not to have appreciated - at least until very late - the degree to which these institutions
were intertwined with large banks and other financial institutions; in each case, the concerns
over the direct connections of these institutions were compounded by uncertainty regarding
their positions, the positions of other institutions, and the potential fire sale dynamics that could
occur under forced liquidation of their assets. Most obviously, in each case the institution was
not a bank, and understanding the implications of their distress required understanding the
possibly different implications of their business models from those of banks, their
interconnections with banks, and their interconnections with the broader financial system. Of
course, many conditions across these episodes were very different, as were their end results
in the falls of 1998 and 2008. Because of those differences, distress at LTCM was resolved by
a private-sector solution with little discernible effect on the U.S. macroeconomy, while the fall
of 2008 culminated in the Great Recession. But the commonalities across episodes illustrate
similar data and conceptual gaps.
Focusing on the conceptual gaps, the theoretical and empirical literature on
interconnectedness sheds only partial light on the issues confronted in each of the highlighted
episodes.14 In addition to direct connections, common exposures and contagion are important
sources of interconnectedness and fragility, as emphasized by Bagehot nearly 150 years
ago.15 On the empirical side, researchers have worked to construct networks of banks or
broader sets of institutions based on direct connections or common holdings, but incomplete
data and modeling challenges have typically implied a focus on only parts of institutions'
balance sheets or on a subset of market participants.16 On the theoretical side, a strand of
literature notes that the connections among institutions in each of the previous frameworks
may be too small to explain the types of systemic distress witnessed during the crisis, and
instead emphasizes that complexity within firms and in interconnections heightens the risk of
correlated runs.17 This insight rings true: The complexity of Lehman's, AIG's, and even LTCM's
balance sheets and interactions with other institutions almost surely contributed to market
spillovers during their distress.
But it is also true that little research has been undertaken that distinguishes between banks
and nonbanks, or highlights how their interactions are driven by economic incentives. Such
research could guide regulator efforts to collect data and set policies to limit possible
instabilities associated with interconnectedness. At one level, this is not surprising: As we all
know, models are abstractions; nonetheless, improving the conceptual toolkit with which we
gauge interconnectedness along practical dimensions is clearly needed.18
Summary
My current assessment of the risks to financial stability remains tentative and subject to change
as we learn more or conditions shift. Policymakers and researchers need better models and
data to understand the interconnections between the banking system and nonbank financial
institutions. Indeed, one of the themes of this conference is data needs, and the focus on this
issue is an important aspect of this conference.
History has demonstrated that risks evolve in response to regulatory pressure and the animal
spirits that emerge as memories fade, as well as to animal spirits. As a result, the infrastructure
needed to learn the things we don't know needs to be put in place. An essential element of
that infrastructure is learning the lessons of history - both the lessons of what happened, and
the fact that supervisors and regulators will on occasion be surprised. Learning those lessons
is not as simple a task as it may sound. But it is certainly a far more important task than it
sounds.
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