For release on delivery
9:00 a.m. EDT (8:00 a.m. CDT)
May 10, 2024
Financial Stability Risks: Resiliency and the Role of Regulators
Remarks by
Michelle W. Bowman
Member
Board of Governors of the Federal Reserve System
at
Texas Bankers Association 2024 Annual Meeting
Arlington, Texas
May 10, 2024
I would like to thank the Texas Bankers Association for the invitation to share my
thoughts with you at this year's Annual Meeting.1 My remarks today focus on financial stability
and the role of banking regulators in promoting financial stability and resiliency in the financial
system.2 I will also describe principles that are complementary to promoting safety and
soundness-to help inform the regulatory and supervisory agenda.
Of course, it would be difficult to provide an exhaustive list of the financial stability risks
facing the financial system in the time we are together today. So, while I will highlight a few
key risks, one must approach this topic with humility, acknowledging that there are limits to a
regulator's ability to anticipate every possible financial stability risk in a dynamic and
increasingly interconnected world.
Financial stability is an important function of the Federal Reserve. Our financial stability
function is supported through appropriate monetary policy, bank supervision and regulation, and
by monitoring risks in the U.S. and abroad. A stable financial system provides a solid
foundation for a healthy banking system and a growing economy that facilitates maximum
employment and stable prices. The Fed's recently published Financial Stability Report discusses
financial stability risks in terms of interactions between shocks and vulnerabilities. A financial
stability shock is an adverse event or series of events that often occur without warning and
severely affect the financial system. A financial stability vulnerability includes a specific
characteristic of, or activity conducted in, the financial system that can increase the severity of a
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stress event when a shock occurs.3 Since shocks are difficult to predict, the Federal Reserve's
monitoring efforts primarily focus on vulnerabilities and the buildup of risks that can accrue over
time potentially affecting the resiliency of the financial system.
The Financial Stability Report is worth a read. And while I will not recite the many
findings of that report today, I will highlight a few of the risks discussed in the report. It is
important to keep in mind that the report provides only a snapshot of the current financial
stability vulnerabilities and risks. Because the report treats cyberattacks and geopolitical events
as shocks, it touches on them only in a cursory way, even though these are important financial
stability risks. Instead, the report focuses on key vulnerabilities that are more easily monitored
and provides insights into the financial stability outlook as it relates to these factors.
While the framing of the Financial Stability Report-in terms of shocks and
vulnerabilities-can be a useful, structured approach to consider this topic, there are many ways
to think about financial stability. Often the boundary between shocks and vulnerabilities is a
permeable one, and the buildup of risk can become so severe that it becomes a shock. The
Federal Reserve plays an important-but limited and non-exclusive-role in proactively
addressing financial stability risks and responding to them once they manifest as stress across the
system.
As I think about the tools we use to address financial stability concerns-and the
tradeoffs we are often forced to make when exercising these powers-it is helpful to consider the
lessons regulators have learned over time. While the end goal is the same-ensuring resiliency
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in the financial system to promote financial stability-there are a number of tools that can be
used to address the unique characteristics of vulnerabilities and shocks.
The Federal Reserve's financial stability monitoring does not operate in a vacuum. To
the contrary, our other statutory authorities-including monetary policy or promoting safety and
soundness in the banking system-can complement or conflict with the goal of promoting
financial stability. Many of these authorities interact with banking activities and institutions that
are subject to our supervisory or regulatory authority.
In light of this, I will begin by discussing how the use of traditional tools to support
safety and soundness-both regulation and supervision-can help promote financial stability. I
will then describe the limits of these tools, and then conclude with a brief discussion of some
other key financial stability risks.
Financial Stability and the Role of Regulators
The Federal Reserve plays an important but limited role in promoting the stability of the
financial system through resiliency to shocks, and by proactively addressing vulnerabilities. This
responsibility can be complemented and supported, or in some cases weakened through the
execution of the Federal Reserve's other responsibilities, including monetary policy or the
exercise of our emergency authorities. At times, these objectives may appear to present tension
or be in conflict.
For example, the banking stress last year resulted from a number of underlying causes.
But it is clear that trends in the interest rate environment when the Federal Open Market
Committee's (FOMC) was rapidly tightening policy to combat inflation were an important factor
that contributed to Silicon Valley Bank's (SVB's) failure. The Federal Reserve's documented
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supervisory shortcomings and the lack of SVB management attention to these risks were also key
contributors to the firm's failure.
To be sure, the role of monetary policy in the demise of SVB does not excuse SVB's
management from its inability to manage the firm's interest rate risk exposures or excuse the
ineffective supervisory response that enabled the buildup of the firm's excessive risk. And I am
not calling into question the FOMC's monetary policy decisions from that time, which were
appropriately focused on our congressionally established mandates of maximum employment
and stable prices. Instead, these issues highlight the challenging interrelationships of the various
roles and functions of the Federal Reserve.
This becomes more complicated when we consider the Federal Reserve's financial
stability objectives in the context of its prudential mandates to promote the safe and sound
operation of regulated financial institutions. The tools of bank regulation and supervision can
promote the safety and soundness of individual financial institutions, but they can also be a
positive force when it comes to financial stability. When regulators are successful in their task
of ensuring the safe and sound operation of the banking system-one of the core mandates for
banking regulators-often there is a corresponding benefit to financial stability. Put another
way, if the individual parts of the banking system are healthy, this often promotes the health and
stability of the broader financial system.
But the goal of promoting bank safety and soundness is narrowly focused within the
regulatory perimeter-and the institutions and activities within our regulatory and supervisory
authority. By contrast, financial stability must be concerned with the broader financial system,
including the multitude of nonbank institutions that play an important role not only in delivering
financial products and services, but also in the broader U.S. economy.
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So today, I'd like to share three principles that can help frame a discussion of the role of
banking regulators in promoting financial stability:
1. Bank supervision can be an effective and efficient tool to promote financial
stability. It is important that supervisors focus on core banking risks.
2. Where bank regulation may create or exacerbate financial stability risks, we need
to take a hard look at whether those risks are justified by the safety-and-soundness
benefits of the regulation.
3. As we evaluate the merits of bank regulation and supervision, we must consider
how the Federal Reserve's regulatory proposals affect markets and institutions
beyond the bank regulatory perimeter. This will enable us to better understand
the potential unintended consequences.
There is value in our current approach to addressing financial stability risks. We monitor
risks and how they build up or manifest as stress in the financial system. And we react in a way
that is informed by that monitoring, either to proactively address the buildup of risk, or to
address the consequences of events that could threaten financial stability. A review of past
events that presented stability concerns can help us evaluate our existing work and inform the
direction of future investments.
Effective Bank Supervision to Promote Financial Stability
First, bank supervision can be an effective and efficient tool to promote financial
4
stability. I think it is helpful to consider commercial real estate (CRE) as an example.
Commercial real estate continues to be an area of focus for both banks and regulators. Some
banks have experienced an increase in CRE loan delinquencies, although delinquency rates
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generally remain low. As we know, one of the factors that has led to CRE stress in certain
property types, like office, is the post-pandemic changes in the demand for, and use of, these
CRE properties. Should this trend continue, we could see declines in property values, reduced
rental income cash flows, or other conditions that could lead to impairment of some banks' CRE
loans or portfolios, especially if those loans mature and are refinanced at higher interest rates. I
expect we will continue to see material differences in the performance of CRE across the various
types of commercial property and in specific geographic regions. This will be due, in part, to
variations in regional return-to-office patterns, and the shifting demand for different types of
CRE properties.
So, what can we learn from this CRE experience? First, supervision can be an effective
tool to mitigate vulnerabilities, like the increasing credit risk associated with certain kinds of
lending. Underwriting standards and loan-to-value ratios have improved significantly since the
2008-09 financial crisis, and more recently we have seen credit conditions for CRE lending
tighten, even as loan demand weakened. I see this as reflecting both better management of these
loans and portfolios, and more proactive supervision of material risk.5 Banks are also well-
equipped to work with their CRE borrowers to mitigate stress, including through loan
accommodations and workouts.6 Supervision can be particularly effective at addressing well-
known, core banking risks, especially when this supervisory work is conducted effectively and
without being distracted by non-core risks.
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Despite the promise of supervision as a tool to promote financial stability, supervision
can sometimes fail to address the significant buildup of traditional risk. And supervision can be
susceptible to being diverted from core risks to issues of less material concern. For example,
take the dynamics that led to the failure of SVB. The buildup of interest rate risk in the banking
system was a known vulnerability and material risk, not just for SVB, but for all financial
institutions. The responsibility for managing this risk fell on the management team at SVB, just
as it falls on every bank that has material exposure to interest rate risk. And yet, the failure of
SVB created something of a "shock" event within the banking system, one that led to a vigorous
response with the creation of the Bank Term Funding Program and invoking the systemic risk
exemption to guarantee all depositors of SVB and Signature Bank.
I think it is an oversimplification to point to any one factor as the root cause of the failure
of SVB. There were a number of issues that contributed to the firm's ultimate failure. These
events included rapid growth, poor risk management, poor public communication, a lack of
supervisory attention to core risks, and an insufficiently robust supervisory response to the
buildup of interest rate and funding risk. These issues were exacerbated by operational and
technological problems with FedWire and discount window lending. The cumulative effect of
these issues likely accelerated the firm's failure and increased the scope of the resulting financial
harm. But certainly, this is a clear example of where the Federal Reserve's proactive tools-
supervision of risk management, and the operation of liquidity support and payment tools-
could have been much more effective.
Therefore, the virtue of supervision as a proactive measure to support financial stability
comes with a cautionary note. Ineffective supervision itself can compound financial stability
risks by allowing the buildup of risk without commensurate risk-management measures or
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supervisory attention. One protective measure that we can take to support effective supervision
is to ensure that focus on traditional risks is not lost or diluted. One example of a supervisory
and regulatory distraction is from the Fed's recent focus on climate risk. Recently, the Federal
Reserve conducted a pilot climate scenario exercise with a subset of the largest U.S. global
systemically important banks (G-SIBs) and issued guidance to large institutions on managing
climate-related financial risk. This regulatory attention and focus on one specific, non-core risk
could reasonably call into question whether regulatory priorities are focused sufficiently on key
risks. Firms are already required to manage all material risks, and prioritizing climate risk in this
way could lead to the misallocation of risk-management resources.
Regulatory Approaches to Promote Financial Stability
Second, where regulation may create or exacerbate financial stability risks, we need to
take a close look at whether those risks are justified by the safety and soundness benefits of the
regulation.
For example, consider the threat to financial stability resulting from market illiquidity.
Liquidity is essential to effective market functioning, and liquidity in the U.S. Treasury market is
particularly important due to its critical role in the U.S. and global financial systems.7 This is an
area that, in relative terms, has recently experienced stress events as in the September 2019 repo
market stress, and the so-called "dash for cash" in March of 2020. These events raised concerns
about the resiliency of U.S. Treasury markets. Even today, some indicators signal low market
liquidity through market depth in U.S. Treasury cash markets, which have been at levels below
historical norms.8
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Banks play an important role in providing liquidity, and there are clear signs that liquidity
in Treasury markets is low.9 While there may be a number of reasons for reduced Treasury
market liquidity, I would note two specific factors and ongoing risks: (1) concerns by banks
about balance sheet capacity to engage in low-margin market activities, and (2) the cumulative
regulatory burden on banks when they engage in market-making activities, which includes most
recently the proposed increase in capital costs for market making activity proposed by the Basel
III endgame rulemaking, and an apparent lack of interest in addressing the constraints on bank
activities caused by bank leverage ratios. Ultimately, liquidity in the U.S. Treasury market has
the potential to amplify or dampen shocks to the financial system.
Where we can take proactive regulatory measures to ensure that primary dealers have
adequate balance sheet capacity to intermediate Treasury markets in times of stress, we should
do so. This could include amending the leverage ratio and G-SIB surcharge for the largest U.S.
banks. And where we can take into consideration the impact of regulatory reforms on financial
stability, we must at least acknowledge the tradeoffs and the potential downside risks that
regulatory changes could create. This is particularly important when considering significant
increases to capital requirements, especially those of the scale contemplated by the Basel III
proposal, including the market risk capital increases.
Adopting regulatory changes to mitigate these concerns may not be sufficient to promote
market liquidity, but it would be an important step toward building resiliency in advance of
future stress events. In my view, it would be better to fix the roof now, while the sun is shining,
by addressing over-calibrated leverage ratio requirements and moderating capital increases for
the Basel III proposal.
Unintended Consequences of Overregulation and Disproportionate Supervision
Finally, as we evaluate the merit of regulations and supervisory approaches, we must
understand the broader implications beyond the regulatory perimeter. We have seen a migration
of activity out of the regulated banking sector to a variety of alternative service providers and
nonbank financial institutions and intermediaries. As the Financial Stability Report notes, hedge
fund leverage reached 18 to 1 in the third quarter of 2023 for "average on-balance sheet leverage
of the top 15 hedge funds by gross asset value."10 Throughout 2023, bank lending to nonbank
financial institutions-a category that includes hedge funds-also increased.11 While this
increase was accompanied by continued declines in delinquency rates for bank lending to
nonbank financial institutions, I think it is worth considering how this activity could ultimately
bleed back into the regulated banking system.12
We should also consider structural shifts that have potential implications for financial
stability. In shaping the bank regulatory framework, we must acknowledge that regulation and
supervision already influence the location of activity and will continue to do so.
We also know that the cost of bank regulation, including bank capital requirements,
influences where activities occur, either within the banking system or in nonbank entities outside
of the regulatory perimeter. Absent other factors, over time the cost difference of providing a
service between a bank and nonbank provider will lead activity to migrate to the lowest cost
provider. Just as with the residential mortgage market, these shifts have real consequences for
where activity occurs.
Therefore, the threshold question we need to ask is whether regulation and supervision
are appropriately calibrated to risk over time. Ultimately, even if regulation and supervision are
rigorous-imposing higher standards on banks than on nonbanks-this does not necessarily
mean that the standards applied to banks are not appropriate. It may be that activity conducted
by nonbanks lacks appropriate supervision and regulation.
Imposing the same level and type of regulation and oversight on activity that occurs
outside of the banking system is beyond the scope of bank regulatory authority. However, we
must be careful not to facilitate the transfer of activity and risk out of the banking system simply
by imposing standards that are disproportionate to risk for the same activities that are conducted
by banks. The same activity presenting the same risk should receive the same regulation. Same
activity, same risk, same regulation.
Striking the right balance and calibration for the regulation of specific activities is not
always a simple task, nor is the establishment of expectations that accompanies regulation and
supervision always subject to scientific precision. That being said, one does not need to look any
further than the proposed Basel III endgame capital rules to find reforms that are excessively
calibrated and disproportionate to risk. This proposal contemplated a 20 percent increase in risk-
weighted assets across bank holding companies subject to the rule. Public commenters raised
significant concerns that the limited analysis included with the Basel III proposal may have
significantly understated the scope of the capital increase. In response to this concern, the Board
launched a data collection to gather more information from banks to better understand the
impacts of the proposal, the results of which will hopefully be released soon.
As I have discussed in the past, if implemented as proposed, the effects are predictable:
higher costs of capital for banks, higher costs of services for customers, less availability and
narrower selection of services, and increased concentration in the providers of financial products
and services.13 Driving risk out of the regulated banking system could lead to marginal
improvements in bank safety and soundness, but the consequences for financial stability could be
severely adverse. As I noted above, we have already seen reduced market activity driven by the
leverage ratio and other regulatory constraints on bank balance sheets. We have also seen banks
tighten credit standards and reduce lending activity, which often leads to a credit "gap" left to be
filled by nonbank lenders. As activity and risk migrates from the banking system to nonbanks,
we should ask how these shifts will impact financial stability over the long run, even though we
have less visibility and insight once they leave the banking system.
The Basel III capital rules are only a subset of regulatory proposals for change that
involve the challenging task of achieving the right calibration to risk over time. A glut of new
bank regulatory reforms and supervisory guidance raise this concern, including revisions to the
G-SIB surcharge, new long-term debt requirements, amended resolution plan guidance,
contemplated changes to the regulatory approval of merger and acquisition activity, and
revisions to the interchange fee cap. The cumulative effects of these regulatory proposals are
significant.
This cautionary note does not mean that I am opposed to appropriate reforms to bank
regulation and supervision-both tools must adapt to changing conditions and risks. Last year
we saw significant stress in the banking system due to a few bank failures and the persistence of
higher inflation and interest rates in the U.S. and in many other countries around the world. But
we should not assume that "more" is always better. More regulation and more supervision are
only effective if the changes are targeted to address an existing problem and are appropriately
focused and efficient.14 When they are targeted and efficient, they may result in a net positive
both in bank safety and soundness, and in financial stability. The function of bank regulators is
not to create a bank regulatory framework that eliminates risk. Banking is inherently about
managing, not eliminating, risk.
Closing
My remarks today are not meant to be an exhaustive list of all the financial stability
threats facing the U.S. banking system, but I would be remiss in concluding without briefly
mentioning a few other key financial stability risks, all of which I expect are familiar to you.
First, monetary policy and the fight against inflation. This is a key risk identified in the
Financial Stability Report, and in surveys of bankers. When effectively implemented, monetary
policy promotes price stability and maximum employment. In the long run, achieving both of
these objectives promotes the stability of the broader financial system. It is of utmost importance
that we maintain credibility in pursuing our fight against inflation by proceeding carefully and
deliberately to achieve our 2 percent goal.
But we cannot ignore the fact that monetary policy can present risks to the banking
system and the broader financial system. Changes in interest rates can make it more difficult for
banks to manage interest rate risk, particularly in the face of rapid rate increases like those from
2022 and 2023. We know that many banks have seen a significant increase in unrealized losses
on their balance sheets, a trend that has led to pressure on liquidity, funding, and capital for some
institutions.
While monetary policy mandates may support long-term financial stability, monetary
policy is an independent function that may heighten short-term stresses in the banking system.
Our supervisory activities should reflect an awareness of these effects on bank management
decisionmaking as we rely on regulation and supervision to promote resilience in the regulated
banking system, with the goal of helping banks as they navigate an evolving macroeconomic
environment and adjust to major shifts in the stance of monetary policy.
Today's banking system has also been heavily shaped by the effects of COVID-related
stimulus on deposit activity. Many banks saw a significant inflow of deposits as a direct result of
COVID-related stimulus with excess savings accumulating due to lockdowns. This trend created
challenges for banks, who may have lacked sufficient opportunities to invest or extend credit in a
world affected by COVID lockdowns. The rapid increase in deposits in the banking system, and
their subsequent drawdown, have pressure tested banks' abilities to manage funding and interest
rate risks, and posed significant challenges for banks faced with few opportunities to put funding
to productive use.
While there are important pockets of financial stability risk where the Federal Reserve
lacks authority, there are meaningful improvements that can be made to our regulatory and
supervisory approach that could enhance financial stability. Bank regulation and supervision can
best accomplish their goals when guided by transparency, fairness, and efficiency. We must
remember that there are always consequences to financial stability from miscalibrated regulatory
and supervisory actions and the cumulative effects of regulatory proposals.
I hope my discussion today has helped to highlight the role of financial regulators in
promoting financial stability, through (1) applying supervision to mitigate and promote resilience
to financial system vulnerabilities, (2) adopting bank regulatory approaches that further financial
stability goals, and (3) taking into account the unintended consequences and tradeoffs of
overregulation and disproportionate supervision-particularly as they may result in negative
consequences.
Of course, while these principles are helpful guides to how regulators can best promote
financial stability, they are also insufficient. We must be thoughtful about the limits of
regulatory authorities-and abide by those limits, even in the face of significant stress. The
Federal Reserve and the bank regulatory framework do not hold the solution to every financial
stability problem, and we must have confidence that other regulators, and other branches of
government, will take appropriate steps to preserve financial stability when needed.
Thank you for your time today, and I look forward to our discussion.