For release on delivery
12:00 p.m. EST
November 28, 2018
The Federal Reserve's Framework for Monitoring Financial Stability
Remarks by
Jerome H. Powell
Chairman
Board of Governors of the Federal Reserve System
at
The Economic Club of New York
New York, New York
November 28, 2018
It is a pleasure to be back at the Economic Club of New York. I will begin by
briefly reviewing the outlook for the economy, and then turn to a discussion of financial
stability. My main subject today will be the profound transformation since the Global
Financial Crisis in the Federal Reserve's approach to monitoring and addressing financial
stability. Today marks the publication of the Board of Governors' first Financial
Stability Report. Earlier this month, we published our first Supervision and Regulation
Report. Together, these reports contain a wealth of information on our approach to
financial stability and to financial regulation more broadly. By clearly and transparently
explaining our policies, we aim to strengthen the foundation of democratic legitimacy
that enables the Fed to serve the needs of the American public.
Outlook and Monetary Policy
Congress assigned the Federal Reserve the job of promoting maximum
employment and price stability. I am pleased to say that our economy is now close to
both of those objectives. The unemployment rate is 3.7 percent, a 49-year low, and many
other measures of labor market strength are at or near historic bests. Inflation is near our
2 percent target. The economy is growing at an annual rate of about 3 percent, well
above most estimates of its longer-run trend.
For seven years during the crisis and its painful aftermath, the Federal Open
Market Committee (FOMC) kept our policy interest rate unprecedentedly low--in fact,
near zero--to support the economy as it struggled to recover. The health of the economy
gradually but steadily improved, and about three years ago the FOMC judged that the
interests of households and businesses, of savers and borrowers, were no longer best
served by such extraordinarily low rates. We therefore began to raise our policy rate
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gradually toward levels that are more normal in a healthy economy. Interest rates are still
low by historical standards, and they remain just below the broad range of estimates of
the level that would be neutral for the economy--that is, neither speeding up nor slowing
down growth. My FOMC colleagues and I, as well as many private-sector economists,
are forecasting continued solid growth, low unemployment, and inflation near 2 percent.
There is a great deal to like about this outlook. But we know that things often
turn out to be quite different from even the most careful forecasts. For this reason, sound
policymaking is as much about managing risks as it is about responding to the baseline
forecast. Our gradual pace of raising interest rates has been an exercise in balancing
risks. We know that moving too fast would risk shortening the expansion. We also know
that moving too slowly--keeping interest rates too low for too long--could risk other
distortions in the form of higher inflation or destabilizing financial imbalances. Our path
of gradual increases has been designed to balance these two risks, both of which we must
take seriously.
We also know that the economic effects of our gradual rate increases are
uncertain, and may take a year or more to be fully realized. While FOMC participants'
projections are based on our best assessments of the outlook, there is no preset policy
path. We will be paying very close attention to what incoming economic and financial
data are telling us. As always, our decisions on monetary policy will be designed to keep
the economy on track in light of the changing outlook for jobs and inflation.
Under the dual mandate, jobs and inflation are the Fed's meat and potatoes. In
the rest of my comments, I will focus on financial stability--a topic that has always been
on the menu, but that, since the crisis, has become a more integral part of the meal.
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Historical Perspective on Financial Stability
The term "financial stability" has a particular meaning in this context. A stable
financial system is one that continues to function effectively even in severely adverse
conditions. A stable system meets the borrowing and investment needs of households
and businesses despite economic turbulence. An unstable system, in contrast, may
amplify turbulence and prolong economic hardship in the face of stress by failing to
provide these essential services when they are needed most.
For Economic Club of New York trivia buffs, I will note that the second ever
presentation to this club by a Federal Reserve official was about this very topic. The date
was March 18, 1929. Weeks before, the Fed had issued a public statement of concern
over stock market speculation, and had provided guidance frowning on bank funding of
such speculation. William Harding, a former Fed Chair and then president of the Federal
Reserve Bank of Boston, defended the Fed's actions in his talk. He argued that, while the
Fed should not act as the arbiter of correct asset prices, it did have a primary
responsibility to protect the banking system's capacity to meet the credit needs of
households and businesses. At the meeting, critics argued that public statements about
inflated asset prices were "fraught with danger;" that the nation's banks were so well
managed that they should not "face public admonition"; and, more generally, that the Fed
was "out of its sphere."1 Of course, Harding spoke just a few months before the 1929
stock market crash, which signaled the onset of the Great Depression.2
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Fast forwarding, a host of Depression-era reforms helped avoid, for the next
three-quarters of a century, a systemic financial crisis and the associated severe economic
dislocation--the longest such period in American history. Those decades saw many
advances in monetary policy and in bank regulatory policy, but the appropriate role for
government in managing threats to the broader financial system remained unresolved.
Periodic bouts of financial stress during this period--such as the Latin American debt
crisis, the savings and loan crisis, and the Russian debt default--were met with
improvised responses. Policymakers conjured fixes from a mixture of private-sector
rescues, emergency liquidity, occasional implicit or explicit bailouts, and monetary
accommodation. Outside of these crisis responses, however, systemic issues were not a
central focus of policy.
The Global Financial Crisis demonstrated, in the clearest way, the limits of this
approach. Highly inventive and courageous improvisation amid scenes of great drama
helped avoid another Great Depression, but failed to prevent the most severe recession in
75 years. The crisis made clear that there can be no macroeconomic stability without
financial stability, and that systemic stability risks often take root and blossom in good
times.3 Thus, as the emergency phase of the crisis subsided, Congress, the Fed, and the
other financial regulators began developing a fundamentally different approach to
financial stability. Instead of relying on improvised responses after crises strike,
policymakers now constantly monitor vulnerabilities and require firms to plan in advance
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for financial distress, in a framework that lays out solutions in advance during good
times.
The New Approach to Financial Stability
This new approach can be divided into three parts. First, build up the strength and
resilience of the financial system. Second, develop and apply a broad framework for
monitoring financial stability on an ongoing basis. And third, explain the new approach
as transparently as possible, so that the public and its representatives in Congress can
provide oversight and hold us accountable for this work. Although I'll focus mainly on
the stability efforts of the Federal Reserve, a number of federal regulatory agencies have
responsibilities in this area. All of these agencies are represented on the Financial
Stability Oversight Council, or FSOC, which is chaired by the Treasury Secretary and
which provides a forum for interagency cooperation in responding to emerging risks.
Building Resilience of the Financial System
After 10 years of concentrated effort in the public and private sectors, the system
is now much stronger, with greater capacity to function effectively in stressful times. In
the banking system, we have implemented a post-crisis regulatory framework based on
robust capital and liquidity requirements, a strong stress-testing regime, and mandatory
living wills for the largest firms. As a result, banks now have much more high quality
capital than before (figure 1). The most recent stress tests indicate that, even after a
severe global recession, capital levels at the largest banks would remain above regulatory
minimums, and above the levels those banks held in good times before the crisis.4 The
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most systemically important financial institutions also now hold roughly 20 percent of
their assets in the form of high quality liquid assets--that is, safe assets that could be
readily sold at short notice (figure 2). The share of these assets is about four times its
pre-crisis level.
Compared with other economies, lending and borrowing in the United States
depend less on bank loans and more on funds flowing through a wide array of capital
market channels. The crisis revealed that this capital market centric system, despite its
many benefits, also provides more places where systemic risks can emerge. In response,
Congress and the regulatory agencies have made many stability-enhancing changes
outside of the banking system. For example, many derivatives transactions are now
required to be centrally cleared, which, through netting, has reduced exposures and
enabled better management of counterparty risk. Tri-party repurchase agreement (repo)
reforms have substantially improved the resilience of that marketplace, in particular by
limiting intraday loans. Before the crisis, prime institutional money market funds were
permitted to report a constant, $1 share price so long as the value of the underlying assets
remained near $1. This reporting convention, combined with the implicit support of the
plans' sponsors, led investors to treat those funds like bank deposits, even though they
were not likewise insured. These funds are now required to report floating net-asset
values, and after this reform investors chose to migrate to government-only funds, which
are safer and less susceptible to runs (figure 3).5 These and other measures have reduced
the risk that key non-bank parts of the system would freeze up in the face of market
stress.
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A New Framework for Monitoring Systemic Risks
Innovation and risk-taking contribute to the dynamism of our financial system and
our economy. As Hyman Minsky emphasized, along with the many benefits of
dynamism comes the reality that the financial system will sometimes evolve toward
excess and dangerous imbalances.6 This reality underscores the vital importance of the
second part of post-crisis reform: monitoring for emerging vulnerabilities.
As laid out in our new Financial Stability Report, we have developed a
framework to help us monitor risks to stability in our complex and rapidly evolving
financial system. The framework distinguishes between shocks, that is, trigger events
that can be hard to predict or influence, and vulnerabilities, defined as features of the
financial system that amplify shocks. The report is organized around four broad
vulnerabilities that have been prominent in financial crises through the centuries. Each of
these vulnerabilities is often found to some degree even in healthy market-based systems,
and there is not, at present, any generally accepted standard for assessing at what level
the vulnerabilities begin to pose serious stability risks. In lieu of such a standard, we flag
cases in which the vulnerabilities rise well beyond historical norms, and then form
judgments about the stability risks those cases present.
The first vulnerability is excessive leverage in the financial sector.7 If a highly
leveraged segment of the financial system is buffeted by adverse events, the affected
entities may all need to deleverage at the same time by selling assets, leading to what is
called a "fire sale." Both the resulting decline in asset prices and the impaired ability of
the segment to play its role in the economy can amplify the effects of a downturn. We
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saw this chain of events play out repeatedly in various parts of the financial sector in the
weeks following the failure of Lehman Brothers in 2008.
In our surveillance, we examine leverage across many types of financial
institutions, including banks, insurance companies, hedge funds, and various funding
vehicles. Currently, we do not detect a broad-based buildup of abnormal or excessive
leverage. As with banks, capital levels at insurance companies and broker-dealers appear
robust. In addition, securitization levels are far below their pre-crisis levels, and those
structures that do exist rely on more stable funding (see figure 4). Our view into leverage
and risk-taking outside the banking sector is admittedly incomplete, however, and we are
always working to get a better view of emerging leverage excesses.8
The second vulnerability is funding risk, which arises when banks or nonbank
financial entities rely on funding that can be rapidly withdrawn. If depositors or market
participants lose faith in the soundness of an institution or the system as a whole, unstable
funding can simply vanish in what is called a "run." During the crisis, we saw
widespread runs, including at broker-dealers, some segments of the repo market, and
money market mutual funds. These runs did severe damage, contributing to a
generalized panic at the time. Had the authorities not stepped in, the damage could have
been even more severe.
Today we view funding-risk vulnerabilities as low. Banks hold low levels of
liabilities that are able and likely to run, and they hold high levels of liquid assets to fund
any outflows that do occur. Money market mutual fund reforms have greatly reduced the
run risk in that sector. More generally, it is short-term, uninsured funding that would be
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most likely to run in a future stress event, and the volume of such funding is now
significantly below pre-crisis peaks.
Taken together, the evidence on these first two vulnerabilities strongly supports
the view that financial institutions and markets are substantially more resilient than they
were before the crisis. Indeed, the American financial system has successfully weathered
some periods of significant stress over the past several years.9
The third vulnerability is excessive debt loads at households and businesses.
Credit booms have often led to credit busts and sometimes to painful economic
downturns. When the bust comes, those who have overborrowed tend to sharply reduce
their spending. Defaults typically rise faster than had been expected, which may put
financial institutions into distress. These effects may combine to bring a serious
economic downturn.
This boom-bust pattern was clear in measures of household debt around the crisis
period, with mortgage debt rising far above its historical trend and then contracting
sharply (see figure 5). After the contraction, household debt has grown only moderately.
The net increase in mortgage debt has been among borrowers with higher credit scores.
While heavily indebted households always suffer in a downturn, all of this suggests that
household debt would not present a systemic stability threat if the economy sours.
Nonfinancial business borrowing presents a subtler story. With corporate debt,
the United States has not faced a massive credit boom like that experienced with
residential mortgages before the recent crisis. Instead, after controlling for its trend,
business borrowing relative GDP has risen during expansions, no doubt reflecting
business optimism, and then fallen when the cycle turned, as some of that optimism
proved unfounded (see figure 6). By this measure, the ratio of corporate debt to GDP is
about where one might expect after nearly a decade of economic expansion: it is well
above its trend, but not yet at the peaks hit in the late 1980s or late 1990s. Further, the
upward trend in recent years appears broadly consistent with the growth in business
assets relative to GDP.
There are reasons for concern, however. Information on individual firms reveals
that, over the past year, firms with high leverage and interest burdens have been
increasing their debt loads the most (see figure 7). In addition, other measures of
underwriting quality have deteriorated, and leverage multiples have moved up. Some of
these highly leveraged borrowers would surely face distress if the economy turned down,
leading investors to take higher-than-expected losses--developments that could
exacerbate the downturn. The question for financial stability is whether elevated
business bankruptcies and outsized losses would risk undermining the ability of the
financial system to perform its critical functions on behalf of households and businesses.
For now, my view is that such losses are unlikely to pose a threat to the safety and
soundness of the institutions at the core of the system and, instead, are likely to fall on
investors in vehicles like collateralized loan obligations with stable funding that present
little threat of damaging fire sales.10 Of course, we will continue to monitor
developments in this sector carefully.
The fourth and final vulnerability arises when asset values rise far above
conventional, historically observed valuation benchmarks--a phenomenon popularly
referred to as a "bubble." The contentious term "bubble" does not appear in our work,
however.11 Instead, we focus is on the extent to which an asset's price is high or low
relative to conventional benchmarks based on expected payoffs and current economic
conditions. Historically, when asset prices soar far above standard benchmarks, sharp
declines follow with some regularity, and those declines may bring economic misery
reaching far beyond investors directly involved in the speculative boom. We therefore
pay close attention when valuations get to the extreme ends of what we have seen in
history.
Looking across the landscape of major asset classes, we see some classes for
which valuations seem high relative to history. For example, even after standard
adjustments for economic conditions, valuations on riskier forms of corporate debt and
commercial properties are in the upper ends of their post-crisis distributions, although
they are short of the levels they hit in the pre-crisis credit boom. We see no major asset
class, however, where valuations appear far in excess of standard benchmarks as some
did, for example, in the late 1990s dot-com boom or the pre-crisis credit boom.
The asset class that gets the most attention day-to-day is, of course, the stock
market. Today, equity market prices are broadly consistent with historical benchmarks
such as forward price-to-earnings ratios (see figure 8). It is important to distinguish
between market volatility and events that threaten financial stability. Large, sustained
declines in equity prices can put downward pressure on spending and confidence. From
the financial stability perspective, however, today we do not see dangerous excesses in
the stock market.
Monitoring Likely Triggers for Financial Distress
I mentioned the distinction between vulnerabilities and shocks, or triggers. In
addition to monitoring vulnerabilities under our four-part framework, we also consult a
broad range of contacts regarding sources of risk that might trigger distress at any given
time. For example, discussions with contacts currently point to risks emanating from the
normalization of monetary policy in the United States and elsewhere, the unsettled state
of trade negotiations, Brexit negotiations, budget discussions between Italy and the
European Union, and cyber-related disruptions.12
Having identified possible triggers, we can assess how a particular trigger is likely
to interact with known vulnerabilities. A good current example is that of Brexit. U.S.
banks and broker-dealers participate in some of the markets most likely to be affected by
Brexit. The Fed and other regulators have been working with U.S. financial institutions
that have operations in the European Union or the United Kingdom to prepare for the full
range of possible outcomes to the negotiations. In addition, the scenarios used in the
stress tests routinely feature severe global contractions and show that U.S. banks have the
capital to weather even highly disruptive events.
Bottom Line: Financial Stability Risks Are Moderate
I have reviewed a few of the key facts that inform our thinking about financial
stability, and you will find a great deal more detail in our new report. You will also find
that the report does not come to a bottom line conclusion. As I noted earlier, we have
limited experience with this monitoring, and there is no widely accepted basis for
reaching a bottom line. Thus, the purpose of the report is to provide a common platform
and set of readings from which policymakers and other interested parties can form their
own views. Individual policymakers will sometimes differ in their assessments and on
the relative weight they put on particular vulnerabilities. My own assessment is that,
while risks are above normal in some areas and below normal in others, overall financial
stability vulnerabilities are at a moderate level.13
In my view, the most important feature of the stability landscape is the strength of
the financial system. The risks of destabilizing runs are far lower than in the past. The
institutions at the heart of the financial system are more resilient. The stress tests
routinely feature extremely severe downturns in business credit, and the largest banks
have the capital and liquidity to continue to function under such circumstances. Because
this core resilience is so important, we are committed to preserving and strengthening the
key improvements since the crisis, particularly those in capital, liquidity, stress testing,
and resolution.
Conclusion
I'd like to conclude by putting financial stability and our two new reports in a
longer-term context. To paraphrase a famous line, "eternal vigilance is the price of
financial stability." We will publish these reports regularly as part of our vigilance.
Over time, some may be tempted to dismiss the reports entirely or to
overdramatize any concerns they raise. Instead, these reports should be viewed as you
might view the results of a regular health checkup. We all hope for a report that is not
very exciting. Many baby boomers like me are, however, reaching an age where a good
report is, "Well, there are a number of things we should keep an eye on, but all things
considered you are in good health." That is how I view the Financial Stability Report out
today.
We hope that this report and the Supervision and Regulation Report will be
important tools, sharing Federal Reserve views and stimulating public dialogue regarding
the stability of the financial system.