Jeremy C Stein: Lean, clean, and in-between
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the National Bureau of Economic Research Conference "Lessons from the
financial crisis for monetary policy", Boston, Massachusetts, 18 October 2013.
* * *
The thoughts that follow are my own, and are not necessarily shared by my colleagues on the Federal Open
Market Committee. I am grateful to Tim Clark, Andreas Lehnert, Nellie Liang, Ben McDonough, and Lisa Ryu for
their input.
Thank you. The theme of this conference is, "Lessons from the Financial Crisis for Monetary
Policy." Given the opportunity to speak about this topic, my first thought was that I should
organize my remarks around the familiar "lean versus clean" debate. The traditional,
precrisis framing of the question went something like this: Should policymakers rely on ex ante
measures to lean against potential financial imbalances as they build up, and thereby lower
the probability of a bad event ever happening, or should they do most of their work ex post,
focusing on the clean-up?
Post-crisis, the emphasis in the debate has shifted. I think it's safe to assume that nobody in
this room would now argue that we should be putting all our eggs in the "clean" basket.
Discussion these days tends to focus instead on which ex ante measures are best suited to
safeguard financial stability. Among these, there seems to be widespread support for
unconditional, (i.e., time-invariant) tools that increase the overall resiliency of the financial
system to shocks. These tools include more robust capital and liquidity requirements, as well
as an enhanced capability to resolve a large financial institution that finds itself on the brink
of failure. They might also include universal margin requirements on securities financing
transactions, as a way of mitigating fire-sales risks. We might argue about various aspects of
calibration and implementation, but I don't think there is too much controversy about the
basic proposition that strong, comprehensive regulation aimed at enhancing resiliency is
essential.
There is considerably less agreement about the desirability and effectiveness of ex ante
measures that seek to lean against the wind in an explicitly time-varying fashion - that is,
measures that can be adapted in response to changing economic or financial conditions. At
the risk of caricature, one can distinguish three schools of thought. The first school is
generally suspicious of any kind of time-varying lean, be it with macroprudential tools such as
time-varying, countercyclical capital buffers or margin requirements, or with monetary policy.
This school emphasizes the difficulty of identifying emerging financial imbalances in real
time. It also points to the political-economy and regulatory-arbitrage impediments that can
frustrate the implementation of discretionary time-varying regulation.1
The second school is more comfortable with the idea of time-varying leans, but invokes what
amounts to a separation principle: It takes the view that any financial-stability-motivated
leans should come largely, if not entirely, from time-variation in the application of regulatory
and supervisory tools, while monetary policy should stick to its traditional dual-mandate
objectives of fostering full employment and maintaining price stability.
The third school is more heterodox. Like the first, it acknowledges that there are a variety of
practical limitations associated with discretionary time-varying regulation, though the severity
of these limitations may vary considerably across different countries, markets, and
institutional arrangements.2 In cases where regulation can be effectively adjusted over time,
doing so remains the preferred approach. But in other situations, and especially when the
imbalances in question are relatively pronounced or widespread across a range of markets,
this school of thought is more open to working on multiple fronts and to formulating monetary
policy with one eye on its potential implications for these imbalances.3
The debate between these three schools gets a lot of attention at venues like this one - and
with good reason. It touches on issues that are not only of policy interest, but also connect to
deeper and strongly held views about how the world works. In other words, this is
paradigmversus-paradigm stuff, which always helps to liven up an academic exchange.
But precisely for these reasons, the whole lean-versus-clean debate runs the risk of drawing
attention away from other crisis-derived lessons that do not make as good fodder for
academic discussion, but that are no less relevant from a practical policy perspective. Let me
focus the remainder of my remarks on one of these: the importance of the in-between. The
lean-versus-clean framing suggests a simple model in which there are just two dates: (1) an
initial ex ante date that is prior to when a shock is realized - and when we may not even
have much of a clue as to the form the shock will take - and (2) an ex post date when the
shock has hit, its full effects have been felt, and policymakers are dealing with the aftermath.
But this before-and-after dichotomy is misleading. Many financial crises unfold over months
or even years, and the choices made during this in-between period can be among the most
crucial to the eventual outcome.
Recall that problems with subprime mortgages were already surfacing in late 2006. The first
serious tremors associated with the crisis were felt in August 2007, with BNP Paribas
suspending redemptions on its money funds and investor runs on multiple asset-backed
commercial paper programs. At this point, there was no longer any real doubt about the
nature of the shock confronting us - even if its precise magnitude was yet to be determined.
And yet it was more than a full year until the failure of Lehman Brothers in September of
2008, which ignited the most intense part of the crisis. Moreover, during the interval from the
start of 2007 through the third quarter of 2008, the largest U.S. financial firms - which,
collectively, would go on to charge off $375 billion of loans over the next 12 quarters - paid
out almost $125 billion in cash to their shareholders via common dividends and share
repurchases, while raising only $41 billion in new common equity. This all happened while
there was a clear and growing market awareness of the solvency challenges they were
facing. Indeed, the collective market cap of these firms fell by approximately 50 percent from
the start of 2007 through the end of June 2008.
There are two points here worth emphasizing. First, it seems indisputable that the severity of
the crisis would have been mitigated if policymakers had clamped down on these payouts
earlier, and had compelled substantial new equity raises. Second, the conflict between the
interests of the firms, acting on behalf of their shareholders, and those of the broader public
became particularly acute once the crisis got underway, because of the debt overhang
2
For a fuller discussion of both the potential and limits of time-varying regulation, see Daniel K. Tarullo (2013),
"Macroprudential Regulation," speech delivered at the Yale Law School Conference on Challenges in Global
Financial Services, New Haven, Conn., September 20.
3
To be clear: Taking account of financial-stability considerations when formulating monetary policy can be fully
consistent with the dual-mandate objectives of fostering full employment and price stability. Consider a
traditional setting where the policymaker has a quadratic loss function over deviations of unemployment and
inflation from their target levels. Suppose further that high financial-sector leverage or very buoyant credit
conditions today increase the probability of a sharp upward spike in credit spreads at some later date, and the
latter prospect in turn raises the conditional variance of economic activity. Then the policymaker's risk
aversion over unemployment outcomes may make her willing to try to tighten credit conditions, even at the
cost of some employment today, so as to reduce the variance of future employment. In other words,
financialstability factors can weigh significantly in the decisionmaking process, without being an end objective in and of
themselves.
problem. Cutting back on dividends and issuing new shares might have been strong
positives for the banks' overall set of stakeholders, as well as for society more broadly, but
were clearly negatives for shareholders, given that such actions would have entailed large
transfers to underwater creditors.
This conflict of interest can make it hard for even the best-intentioned regulators to muster
the conviction to take full advantage of either the appropriate legal tools or the resources
available under the existing institutional framework. Under what circumstances does one tell
a firm that is still well above its regulatory capital requirement that it must do a share issue
that will be helpful for the economy as a whole, but highly dilutive to its existing equity
holders?
This discussion brings us to the role of the now ongoing stress-testing framework for large
financial institutions. As you may know, the Federal Reserve has been conducting annual
stress tests and capital-planning reviews of the 18 largest banks under the auspices of its
Comprehensive Capital Analysis and Review (CCAR) program, and is adding 12 more firms
this year, consistent with requirements of the Dodd-Frank Wall Street Reform and Consumer
Protection Act.4
During normal times, when banks are relatively healthy, the CCAR process functions as an
important complement to more conventional capital regulation and, like capital regulation, it
can be thought of as an ex ante instrument to increase the general resilience of the banking
system to as-yet-unknown shocks.5 I believe that it has been a very valuable addition to our
toolkit in this regard, and will continue to be so.
However, I also believe that much of the promise of the CCAR framework lies in its potential
to help us achieve a better outcome not just in normal times, but also in the important
inbetween times, in the early stages of a crisis. In other words, when thinking about the design
of CCAR, one of the questions I keep coming back to is this: Suppose we were granted a
doover, and it was late 2007. If we had the CCAR process in place, how would things have
turned out differently? Would we have seen significantly more equity issuance at this earlier
date by the big firms, and hence a better outcome for the real economy?
On the one hand, there is some reason for optimism on this score. After all, the original
stress tests - the Supervisory Capital Assessment Program (SCAP) in May 2009 - provided
the impetus for a significant recapitalization of the banking system. More than $100 billion of
new common equity was raised from the private sector in the six months after the SCAP, and
in many ways it was a watershed event in the course of the crisis.
Moreover, the current CCAR framework gives the Federal Reserve both the authority and the
independent analytical basis to require external equity issues in the event that, under the
stress scenario, a firm's post-stress, tier 1 common equity ratio is below 5 percent, and the
4
The Federal Reserve conducts the CCAR annually to help ensure that companies have forward-looking
capital planning processes that account for their unique risks and that result in sufficient capital to enable the
institutions to continue lending to households and businesses during times of economic and financial stress.
As part of the CCAR, the Federal Reserve evaluates institutions' capital adequacy, internal capital adequacy
assessment processes, and their plans to make capital distributions, such as dividend payments or stock
repurchases. The CCAR includes a supervisory stress test to support the Federal Reserve's analysis of the
adequacy of the firms' capital. Boards of directors of the institutions are required each year to review and
approve capital plans before submitting them to the Federal Reserve. The fourth CCAR will begin soon, with
the release of instructions and economic scenarios. For more information, see the Board's website at
www.federalreserve.gov/bankinforeg/ccar.htm.
5
For a more detailed discussion of CCAR design, and of the calibration of stress scenarios, see Nellie Liang
(2013), "Implementing Macroprudential Policies (PDF)," speech delivered at the "Conference on Financial
Stability Analysis: Using the Tools, Finding the Data," sponsored by the Federal Reserve Bank of Cleveland
and Office of Financial Research, held in Washington, DC, May 31.
ratio cannot be restored simply by suspending dividends and share repurchases.6 In my
view, these features of the program are among its most crucial.
At the same time, having the authority to do something is necessary, but not sufficient -
there also needs to be the institutional will. And this will is likely to be especially critical in a
time of crisis, again because of the increased prominence of the debt-overhang problem.7 A
firm that is told that it needs to improve its capital position will, given the interests of its
shareholders, strongly prefer to do so by reducing assets rather than by engaging in a
dilutive share issue, even though the latter is more desirable from the perspective of
aggregate credit provision. And it can be expected to make its case forcefully.
So if we are serious about taking a macroprudential approach to regulation - one which aims
to protect not just the solvency of individual firms, but the health of the financial system as a
whole and its ability to continue to perform its intermediation role in times of stress - it is
incumbent on us as regulators to do all that we can to develop both the intellectual case, and
the institutional resolve, to be able to push back with equal force when the time comes.
Thank you. I look forward to the rest of our discussion.