Janet L Yellen: Assessing potential financial imbalances in an era of
accommodative monetary policy
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the 2011 International Conference: Real and Financial Linkage and Monetary
Policy, Bank of Japan, Tokyo, 1 June 2011.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
I am indebted to Board staff members Matthew Eichner, Andrew Levin and Fabio Natalucci for their assistance in
preparing these remarks.
Let me begin by thanking Governor Shirakawa and the Bank of Japan for inviting me to
participate in this important conference on linkages among monetary policy, financial
markets, and the real economy. The severe economic consequences of the recent financial
crisis have underscored the need for central banks to vigilantly monitor the financial system
for emerging risks to financial stability. Indeed, such vigilance may be particularly important
when monetary policy remains highly accommodative for an extended period. As many
observers have argued, an environment of low and stable interest rates may encourage
investor behavior that could potentially lead to the emergence of financial imbalances that
could threaten financial stability.
Monetary policy in the United States has been highly accommodative now for a number of
years. Since late 2008, the Federal Open Market Committee (FOMC) has kept the target
federal funds rate close to zero and has purchased a substantial amount of longer-term
Treasury and agency securities. My reading of the evidence is that those securities
purchases have proven effective in easing financial conditions, thereby promoting a stronger
pace of economic recovery and checking undesirable disinflationary pressures. Moreover, I
believe that the current accommodative stance of U.S. monetary policy continues to be
appropriate because the unemployment rate remains elevated and inflation is expected to
remain subdued over the medium run.
Today, I will describe some of the surveillance practices that the Federal Reserve has put in
place to monitor risks to financial stability, particularly risks stemming from potential
interactions between a run-up in asset prices and leverage, and I will offer our perspective on
the current financial situation. At present, we see few indications of significant imbalances,
despite some recent developments warranting close attention, including signs of valuation
pressures in some markets and a moderate increase in leverage provided by dealers. I will
also briefly touch on the role of supervision and regulation in this context and the
development of new macroprudential tools for addressing financial imbalances.
Monetary policy and financial imbalances
In the aftermath of the crisis, the primary objective of U.S. monetary policy was to promote
financial conditions likely to spur spending on goods and services through a number of
channels. To this end, the Federal Reserve first lowered the federal funds rate and other
rates at the short end of the yield curve and, once the zero lower bound was binding, sought
to push down yields at the longer end through large-scale purchases of longer-term Treasury
and agency securities. We anticipated that lowering rates on these securities would place
downward pressure on a range of private yields as well, in turn supporting home values,
equity prices, and other asset prices. After all, this is the primary mechanism through which
monetary policy in its conventional form stimulates the economy. But a sustained period of
very low and stable yields may incent a phenomenon commonly referred to as "reaching for
yield," in which investors seek higher returns by purchasing assets with greater duration or
increased credit risk.
The shift toward riskier assets is a normal channel through which monetary policy supports
economic activity. But taken too far, this dynamic has the potential to facilitate the
emergence of financial imbalances. For example, with interest rates at very low levels for a
long period of time, and in an environment of low volatility, investors, banks, and other
market participants may become complacent about interest rate risk.1 Similarly, in such an
environment, investors holding assets which entail exposure to greater credit risk may not
fully appreciate, or demand proper compensation for, potential losses. Finally, investors may
seek to boost returns by employing additional leverage, which can amplify interest rate and
credit risk as well as make exposures less transparent.
One of the lessons of the financial crisis was that the potential adverse effects of a rapid
unwinding of financial imbalances, regardless of the causes, are significantly increased if
market participants employ significant leverage. In the extreme, changes in investor
sentiment can lead to a withdrawal of liquidity, rapid declines in mark-to-market values,
forced asset sales in the face of margin calls, and, ultimately, a rapid and disorderly
selfreinforcing deleveraging. Such painful outcomes are more likely when financing mechanisms
are opaque, when intermediation occurs without an effective liquidity backstop, when assets
are less liquid, and when financial leverage is layered on top of structural leverage.2
These dynamics were evident during the financial crisis. Before the crisis, market participants
grew comfortable with borrowing collateralized by a variety of less-liquid assets, sometimes
using structured investment vehicles (SIVs), conduits, and other off-balance-sheet structures.
Directly or indirectly, market participants used short-term funding that needed to be renewed
almost continually but lacked a formal liquidity backstop (although, in some cases, such
support was seen by market participants as implicit). Further, much of the financing -
through repurchase agreements (repos), over-the-counter (OTC) derivatives, and other
mechanisms - was collateralized by securities that already embedded significant structural
leverage.
This layering of leverage had profound consequences when sentiment changed. Lenders
who had financed securities, either directly in the repo market or through structured vehicles,
were suddenly no longer comfortable with the collateral and were unsure of their potential
exposure to losses. Given the uncertainties, the rational response went beyond raising
haircuts or other means of tightening credit terms: Banks simply stopped lending, typically by
not "rolling over," or renewing, short-term financing when trades matured. In addition,
collateralized borrowing had taken on many transactional forms, including OTC derivatives or
securities financings, which were not always recognized as economically equivalent. Given
the extent of layering, and sometimes opacity of leverage, the result was a rapid and
disorderly unwinding, over just weeks or months, of a very complicated system that had
taken years to evolve.
Assessing current financial imbalances
In light of this experience, the Federal Reserve is carefully monitoring financial indicators for
signs of potential imbalances and is assessing the extent to which leverage is currently
employed by investors, particularly where some of the potentially amplifying factors I just
discussed may be present.
Asset valuations
Misaligned asset prices are notoriously difficult to detect in a timely fashion, and no single
metric or set of metrics can consistently and reliably identify stretched valuations.
Nonetheless, it is clearly worthwhile to track a wide range of metrics and to view them in the
context of their historical norms. Current conditions can be evaluated against a baseline of
past experience, and then assessed in light of the various institutional and market factors
that could conceivably account for deviations from historical ranges. The Federal Reserve
tracks a large number of indicators, and I will highlight a few examples.
Overall, these indicators do not obviously point to significant excesses or imbalances in the
United States. For example, as shown in figure 1, forward price-to-earnings ratios in the
stock market fall within the ranges prevailing in recent decades, and are well below the
early2000 peak, although corresponding measures for small-cap equities (not shown) appear
somewhat elevated. In the residential real estate market, price-to-rent ratios are now
somewhat below their long-run averages, in sharp contrast with the situation immediately
before the financial crisis.
Notwithstanding this general view, some areas warrant our ongoing attention. As shown in
figure 2, credit spreads on nonfinancial corporate bonds have dropped sharply since the
financial crisis. This decline partly reflects improvements in earnings and corporate balance
sheets, but also lower risk premiums. One measure of risk premiums, the forward spreads
far in the future, are extremely low compared with historical norms for high-yield bonds,
suggesting that investors have become more willing to assume credit risk. In the syndicated
leveraged loan market, strong inflows appear to have contributed to an increase in prices. I
will return to developments in this market and discuss their potential ramifications shortly.
Rapid debt growth may also signal emerging imbalances. In recent quarters, issuance of
high-yield bonds by nonfinancial corporations has been robust. As shown in figure 3, credit
flows have also been solid in the syndicated leveraged loan market, with a substantial
amount of this credit being ultimately provided by nonbank institutional investors such as
loan mutual funds, pension funds and insurance companies. Nonetheless, a portion of the
recent corporate issuance has been used to refinance existing debt, and small business
lending remains quite weak. Overall, despite a recent pickup in commercial and industrial
lending, we see little evidence that financial institutions are significantly expanding the level
of private credit, on net.
Of course, these aggregate measures provide only a limited picture of overall credit
conditions. Another type of evidence comes from surveys of market participants' practices.
For example, the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending
Practices provides information about changes in the supply of and demand for bank loans to
businesses and households.3 As shown in figure 4, recent surveys indicate that banks have
reversed only a portion of the substantial tightening in credit standards and terms put in place
after the crisis.
Dealer-intermediated leverage
In the wake of the crisis, the Federal Reserve has intensified its efforts to monitor leverage,
particularly outside of the traditional banking system. Information on the use of leverage is
incomplete at best, and in our attempts to better measure leverage, we must grapple with
several complexities. For instance, in recent years a significant volume of credit
intermediation has migrated outside the traditional banking system, where it is not only
unprotected by a formal government backstop but also difficult to capture by traditional
accounting measures. A further complication stems from the fact that dealers in securities
and OTC derivatives - the key providers of leverage outside of the traditional banking system
- can facilitate a particular economic exposure using a variety of transactional structures
including, for example, combinations of securities financing, OTC derivatives, and prime
brokerage activities.
To obtain information on the usage and pricing of such leverage, the Federal Reserve relies
on a number of different indicators, including supervisory and market surveillance data, as
well as ongoing dialog with a range of market participants to construct a composite picture of
the extent to which leverage is being deployed, on what terms, and the channels through
which leverage is being facilitated by dealers. These indicators include results from the
Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), which was
launched by the Federal Reserve last year in June.4 This survey provides qualitative
information on credit terms and availability of various forms of dealer-intermediated financing
- including for securities positions - and OTC derivatives.
The available qualitative and quantitative indicators suggest that dealer-intermediated
leverage has risen modestly since its post-crisis nadir in 2009. For example, responses to
several consecutive SCOOSs point to an easing of price and nonprice credit terms
applicable to a range of counterparties (including hedge funds, private equity firms, and other
private pools of capital, shown in figure 5) since early 2010. In addition, dealers have
consistently reported an increase in demand for funding across various collateral types.
Furthermore, special questions included in the March 2011 SCOOS suggest an increase in
the use of leverage by some traditionally unlevered investors (such as pension funds and
insurance companies) as well as hedge funds during the previous six months.
In spite of this increase, many indicators suggest that the overall use of financial leverage
remains markedly below levels prevailing before the crisis and has increased only modestly
over the past year. For example, as shown in figure 6, activity in the triparty repo market has
in fact changed little, on balance, over the past year, and haircuts on the most important
types of collateral have been steady over this period.5 Of note, increases in the utilization of
leverage have been driven by the financing of relatively liquid asset types (such as equities)
through comparatively transparent transactions. Moreover, issuance of structured products
that embed leverage, which were originated in large volumes prior to the crisis, has not
resumed on any significant scale. More broadly, the appetite of most market participants for
additional leverage appears to remain generally muted, with most investors not fully using
their existing funding capacity. Therefore, the risk of a rapid and disorderly deleveraging in
the event of a swift change in market sentiment seems to be limited at this point.
Nonetheless, two dynamics with respect to the use of leverage bear watching. First,
important classes of generally unlevered investors (for example, pension funds) are
reportedly finding it difficult in the present low interest rate environment to meet nominal
return targets and may be reaching for yield by assuming greater interest-rate and credit risk
in their portfolios. While some investors have also apparently boosted returns by increasing
leverage, we see little evidence at present that this behavior is occurring on any significant
scale. Second, additional funding is reportedly broadly available to traditionally levered
investors such as hedge funds. To the extent that investors choose to take advantage of the
readily available funding for less liquid assets, their use of leverage could rise quickly,
increasing the risks of a disorderly deleveraging.
A case study: the syndicated leveraged loan market
I mentioned earlier that strong demand has been pushing prices higher in the syndicated
loan market and figure 7 shows recent developments: Inflows into this asset class have
indeed been robust and prices have been rising quite rapidly. An important characteristic of
syndicated loans is that they are floating rate instruments, priced at a fixed spread to Libor
(the London interbank offered rate). In an environment where interest rates may be expected
to rise, this characteristic may partly explain such strong investor interest.
To assess the potential financial stability ramifications of these developments, we have
focused initially on two key questions. First, to what degree would financial intermediaries be
exposed to a rapid change in investor sentiment? Recall that prior to the financial crisis, a
number of important financial institutions, in their role as lead arrangers of syndicated loans,
amassed significant "pipelines" of very large deals, which effectively represented
commitments to provide financing. When investor interest waned, banks were left with
notable positions in "hung" deals, which resulted in substantial mark-to-market losses.
Today, in contrast, banks report that they have significant risk mitigants in place to protect
their balance sheets. In particular, deals are smaller, financings are reportedly arranged on a
"best efforts" basis, and banks are said to maintain considerable contractual flexibility
postcommitment to adjust the pricing and structure of loans, at the expense of borrowers, to
market-clearing levels.6
A second question is whether leveraged loans are being funded on any significant scale
using mechanisms, such as repo funding, total return swaps and other OTC derivatives, and
collateralized loan obligations, or CLOs, that were prevalent before the crisis. During the
market disruption in 2007-08, the significant leverage deployed through these channels, and
the operation of the associated mark-to-market triggers, clearly contributed to the disruptions
in the loan market, and to the losses experienced by banks and other market participants.
When prices came under pressure, calls for additional collateral followed, leading in many
cases to the sale of positions that put further pressure on valuations and started the cycle
anew. But, at present, a number of indicators, including SCOOS special questions focused
on funding of syndicated leveraged loans, provide little evidence of heavy reliance on such
mechanisms, suggesting that the potential for such a rapid and disorderly delevering is very
limited.
These comforts aside, demand from unlevered investors, presumably "reaching for yield,"
has persisted in recent months. Strong inflows into the asset class have reportedly allowed
borrowers to bargain for more attractive loan terms, especially given that many funds
catering to retail and other unlevered investors have little choice but to immediately deploy
invested funds. Manifestations of this dynamic include the reemergence of deals that do not
provide investors with the traditional protection of maintenance covenants - so-called
covenant lite structures - and of deals financing the distribution of dividends to
equityholders, as well as a gradual increase in the levering of the underlying corporate assets by
borrowers. None of these developments may, per se, be indicative of unwise or imprudent
lending, and in fact each of these may respond to a perceived need on the part of some
market participants. However, the dynamics of competition are very much on display,
including the resultant pressures on fund managers to accept and deploy incremental
investments, and the pressures on arranging banks to maintain their market share. Indeed,
these circumstances were recently highlighted to me by market participants. We will
therefore continue to watch conditions in the leveraged loan market closely in the coming
months, and we will speak out forcefully if we perceive pressures continuing to build.
Tools for addressing financial imbalances
If substantial evidence of financial imbalances on a broader scale were to develop,
particularly if accompanied by significant use of leverage, I believe that supervision and
regulation should constitute our first line of defense. Indeed, in the wake of the crisis, our
supervisory process has been significantly modified to take more explicitly into account
possible financial stability implications and effects on the broader economy, a perspective
that is frequently described as "macroprudential." Our concerns now extend beyond the
capacity of individual institutions to protect their capital and balance sheets.
In taking this broader perspective, we continue to rely on many traditional supervisory tools.
For example, should they feel the need to more directly address a continued building of
pressures in the leveraged loan market, supervisors might require institutions to strengthen
their underwriting standards while clarifying the degree to which anticipated distribution of
loans through syndication constitutes risk mitigation. In addition, supervisory expectations
concerning risk-management standards applicable to the syndication activity - in particular,
the management of "pipeline risk" related to the warehousing of loans awaiting distribution -
could be made more stringent.
The need to deploy an enhanced set of tools and standards to promote financial stability has
been widely recognized in the aftermath of the financial crisis. In the United States, for
example, more rigorous prudential standards will be applied to systemically important
financial institutions to ensure that these firms internalize the costs of the risks they pose to
the financial system and the economy. Likewise, systemically important institutions will be
required to develop living wills, or plans to facilitate their resolution in the event of insolvency.
Novel tools may be needed, however, to limit - or lean against - the buildup of financial
sector imbalances that span multiple institutions and markets. Approaches that have been
used in other countries when policymakers determine that credit growth and risk-taking have
become excessive include, for example, restrictions on underwriting practices, such as limits
on loan-to-value ratios, loan-to-income ratios, and debt-to-income ratios. Of course, the use
of such tools must be carefully evaluated in the context of the particular imbalance that
policymakers are seeking to address, and judged both on their potential benefits and
potential costs.
Should monetary policy itself be adjusted to address emerging financial imbalances? Given
the damage that financial imbalances can cause if not addressed in a timely fashion, I would
not categorically rule out the use of monetary policy when dangerous imbalances are
building and prudential steps seem ineffective. However, calibrating the magnitude of a
monetary policy response to address financial imbalances - even assuming that these can
be identified at an early stage - is difficult at best given the bluntness of the monetary policy
tool and the uncertain lags with which it operates. For these reasons, the use of monetary
policy to address financial imbalances should generally remain a last resort.
Conclusion
The Federal Reserve is fully engaged in monitoring financial markets for potential
imbalances and developing the tools necessary to carry out that task. These ongoing efforts
include attempting to recognize early signs of misaligned valuations in asset markets and
increases in leverage. At present, we see few indications of significant imbalances, and the
use of leverage appears to remain well below pre-crisis levels. That said, I've noted some
recent developments that warrant close attention, including indications of potentially
stretched valuations in certain U.S. financial markets and emerging signs that investors are
reaching for yield. Should broader concerns emerge, I believe that supervisory and
regulatory tools, including new macroprudential approaches, rather than monetary policy,
should serve as the first line of defense.
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