Federal Reserve Chairman Ben Bernanke said Friday that the U.S. economy and financial system are still struggling to recover from the financial crisis and said the Fed is working hard to prevent future crises by identifying and curbing various "vulnerabilities."
In particular, he said the Fed is watching for "excessive risk- taking" in a "reach for yield" in asset markets, although he gave no indication that he sees any new asset bubbles or other serious imbalances developing at this time.
Bernanke did express current concern about "vulnerabilities" in the shadow banking system, particularly with regard to money market funds, where he said the possibility of "runs" exists. And he said more work needs to be done to address risks in the tri-party repo market, on which so many securities firms rely for short-term funding.
The Fed is also keeping an eye out for "excessive credit growth" and "leverage" among households and businesses, although again he gave no indication he thinks this is a problem right now in remarks prepared for delivery to the Chicago Federal Reserve Bank's annual banking conference.
Bernanke did not talk broadly about the economy or monetary policy little more than a week after the Fed's policymaking Federal Open Market Committee met and left its easy money policies in place. But he did observe, "We are now more than four years beyond the most intense phase of the financial crisis, but its legacy remains."
"Our economy has not yet fully regained the jobs lost in the recession that accompanied the financial near collapse," he said. "And our financial system — despite significant healing over the past four years — continues to struggle with the economic, legal, and reputational consequences of the events of 2007 to 2009."
One result of the crisis was the Dodd-Frank legislation, which gave the Fed the lead role in conducting "macro-prudential supervision" of the financial system, and Bernanke said the Fed is actively pursuing its role with "a more systemic approach."
The Fed is monitoring four broad areas: systemically important financial institutions, shadow banking, asset markets, and the nonfinancial sector.
The aim is to look not just for "triggers" of financial instability, such as the subprime mortgage losses that began 2007, but underlying "vulnerabilities." He said those could include such things as "high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system."
"Of course, monitoring can and does attempt to identify potential triggers — indications of an asset bubble, for example — but shocks of one kind or another are inevitable, so identifying and addressing vulnerabilities is key to ensuring that the financial system overall is robust," Bernanke elaborated.
He added that, "Attempts to address specific vulnerabilities can be supplemented by broader measures — such as requiring banks to hold more capital and liquidity — that make the system more resilient to a range of shocks."
Bernanke said the Fed's financial monitoring is providing "important information" for the Federal Reserve Board and the FOMC, some members of which have expressed mounting concern that the persistence of very low interest rates could lead to "financial imbalances."
Looking at SIFIs, the Fed chief emphasized the important role of Fed "stress testing" of the biggest banks to try to determine how they would fare in the event of adverse economic and financial developments.
The Fed is looking not just at individual institutions but at their interconnectedness, he said, the goal being to "identify key nodes or clusters that could destabilize the system and to simulate how a shock, such as the sudden distress of a firm, could be transmitted and amplified through the network."
By inference, Bernanke seemed to have no particular worries about the largest banks at this time.
However, he expressed greater concern as he spoke of "shadow banking" — the complex of nonbank sources of credit and liquidity.
Before the crisis erupted, "the shadow banking sector involved a high degree of maturity transformation and leverage," he recalled. "Illiquid loans to households and businesses were securitized, and the tranches of the securitizations with the highest credit ratings were funded by very short-term debt, such as asset-backed commercial paper and repurchase agreements (repos). The short-term funding was in turn provided by institutions, such as money market funds, whose investors expected payment in full on demand and had little tolerance for risk to principal."
Bernanke focused on the central role of securities broker-dealers, which rely on short-term collateralized funding using repurchase agreements with other credit-providing firms to finance their own and their clients' securities holdings.
"The crisis revealed that this funding is potentially quite fragile if lenders have limited capacity to analyze the collateral or counterparty risks associated with short-term secured lending, but rather look at these transactions as nearly risk free," he said.
Assessing the present situation, Bernanke said that "while the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities."
Money market funds are one of the biggest areas of concern, he made clear. Although "strengthened by reforms undertaken by the Securities and Exchange Commission (SEC) in 2010," he said, "the possibility of a run on these funds remains — for instance, if a fund should 'break the buck,' or report a net asset value below 99.5 cents, as the Reserve Primary Fund did in 2008."
Echoing concerns expressed recently by the New York Fed, Bernanke also expressed concern about the tri-party repo market. While "progress has been made," he said "important risks remain in the short-term wholesale funding markets."
"One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower," he added.
Turning to asset markets, Bernanke did not single out any current concerns, but made clear he is aware of the possibility of "excessive risk-taking" in a low-rate environment.
He said the Fed is trying to "identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets."
Bernanke said the Fed's new Office of Financial Stability Policy and Research is using "empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets." And he said the Fed is looking at "measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts."
"In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals," he went on, adding that the Fed is "less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move."
"Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves," he said.
Beyond asset valuations, Bernanke said the Fed considers "the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset's value to changes in broad financial conditions."
In the nonfinancial sector, including households and businesses, Bernanke said "research has identified excessive growth in credit and leverage in the private nonfinancial sector as potential indicators of systemic risk."
"Highly leveraged or financially fragile households and businesses are less able to withstand adverse changes in income or wealth, including those brought about by deteriorating conditions in financial and credit markets," he observed. "A highly leveraged economy is also more prone to so-called financial accelerator effects, as when financially stressed firms are forced to lay off workers who, in turn, lacking financial reserves, sharply cut their own spending."
Bernanke did not appear to be saying, however, that firms or households are currently too highly leveraged.
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