sarah bloom raskin : beyond capital – the case for a harmonized response to asset bubbles speech by ms sarah bloom raskin, member of the board of governors of the federal reserve system, at the the exchequer club luncheon, washington dc, 17 july 2013. * * * i want to thank daniel covitz, andreas lehnert, rochelle edge, mark van der weide, william treacy, karen pence, andrew cohen, sean chu, sean campbell, seth carpenter, ben mcdonough, april snyder and winthrop hambley for their assistance in the preparation of these remarks. thank you for inviting me to speak to you this afternoon. 1 i ’ m honored to have the chance to be with so many former colleagues and friends. as i look around this room, i ’ m reminded of your efforts and the variety of perspectives that you have brought, over the years, to the endeavor of financial regulation. i ’ m reminded of the contributions you have made to the richness of these debates and tasks. there has been a flurry of pronouncements lately regarding regulations, rules, and guidance, and today ’ s meeting of the exchequer club seems like an opportune moment to pause and offer a perspective that lifts us above the many details. newly adopted capital rules, and those newly proposed, in particular, have received the most attention, and i believe that these rules and proposed rules are a big step forward. there is no question but that a higher quantity and quality of bank capital will strengthen the banking system. today, i want to discuss regulatory policies in the context of the growth and inevitable collapse of asset bubbles, with a focus on the role of credit. regulatory policies, when well crafted, can lean against credit excesses that result in asset bubbles. in so doing, they can lean against vulnerabilities in the financial system that encourage the growth of excess credit. well - crafted regulatory policies can also build resilience for banks after asset bubbles have burst. many such regulatory policies are already in use, but there are others at the frontiers of regulation that haven ’ t been widely employed. significantly, both sets of regulatory policies – those that lean against excesses and those that build resilience – need to be understood in the context of a comprehensive system of prudential supervision for all financial institutions. in my remarks, first, i will briefly review how asset bubbles form, and i ’ ll highlight certain features of asset bubbles so we can disc

##ern how regulatory policy might respond to them. second, i ’ ll assert that regulatory tools, including those related to capital, only work if part of a system of prudential supervision for all financial institutions. third, i ’ ll ask whether capital and other regulatory requirements have meaning without a prescriptive and individualized analysis of risk for individual financial institutions. in this regard, i ’ ll suggest several other considerations that financial institutions and regulators should consider in the regulatory context. asset bubbles in order to think about regulatory policy from the perspective of leaning against excesses and vulnerabilities created by asset bubbles, or from the perspective of strengthening resilience to asset bubbles, we need to understand how financial institutions participate in the creation of bubbles. the story of asset bubbles, for me, is one in which there is usually explicit and purposeful financial institution involvement. it used to be believed that asset bubbles the views expressed here are my own and are not necessarily those of the other members of the federal reserve board or its staff. bis central bankers ’ speeches emerged spontaneously, or perhaps came from sunspots or other mysterious causes. now we know more and we know better, and, while we may not be able to predict bubbles, we understand them to be a product of particular actions and choices by financial institutions and their regulators. here is one way a bubble might start. and, to approximate current economic conditions, we ’ ll assume an environment of interest rates that have been low, and continue to be low, for a long time. to start, retail investors may become dissatisfied with their low yields and begin to seek higher yields by purchasing some specific higher - yielding asset. if investors have access to credit, they might try to raise the return on their money by funding a greater portion of their purchases with debt. the asset purchased could serve to collateralize their loan. if many investors employ this strategy and they borrow to invest in the same asset, the price of that asset, and perhaps the prices of closely related assets as well, will increase noticeably faster than the historical trend. at the same time, increased demand for credit to finance these asset purchases could lead lenders to increase their reliance on less expensive, unstable short - term funding, such as uninsured deposits, commercial paper, or repo transactions, in order to fund the loans. besides meeting customers ’ growing demands for credit, financial intermediaries may themselves decide to “ reach for yield ” and take on additional risk in a low