ST. LOUIS — Federal Reserve Governor Jeremy Stein Thursday cautioned against mounting signs of credit market "overheating" and said the Fed may have to use monetary policy, not just regulation, to deal with it.
Stein said the Fed should keep "an open mind" and consider a combination of monetary and regulatory tools, if necessary, to prevent excessive risk-taking from causing financial instability.
With the Fed's policymaking Federal Open Market Committee holding the federal funds rate near zero for more than four years, Stein warned, "a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to 'reach for yield.'"
Stein said credit market overheating is hard to measure, but warned, "Waiting for decisive proof of market overheating may amount to an implicit policy of inaction."
He did not conclude that risk-taking has reached dangerous levels in prepared remarks at a St. Louis Fed conference, but cited several areas of concern, including the junk bond market.
"Overheating in the junk bond market might not be a major systemic concern in and of itself, but it might indicate that similar overheating forces were at play in other parts of credit markets," he said.
In that market, he said "credit spreads, though they have tightened in recent months, remain moderate by historical standards." But he added that "the high-yield share for 2012 was above its historical average, suggesting ... a somewhat more pessimistic picture of prospective credit returns."
Stein said "we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit," although he said "it need not follow that this risk-taking has ominous systemic implications."
He said "there appears to be only modest short-term leverage behind corporate credit, which would seem to imply that even if the underlying securities were aggressively priced, the potential for systemic harm resulting from deleveraging and fire sales would be relatively limited."
But he added a caveat: "If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange-traded funds (ETFs), and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt."
Stein also noted that inflows into mutual funds and ETFs that hold high-yield bonds "have increased sharply in the past couple of years." He also pointed to rapid growth of real estate investment trusts.
Noting that "a bank can boost its reported income by replacing low-yielding short-duration securities with higher-yielding long-duration securities," Stein said this "seems to be happening today: The maturity of securities in banks' available-for-sale portfolios is near the upper end of its historical range."
Stein said this is a concern because "the added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully — especially since existing capital regulation does not explicitly address interest rate risk."
What's more, "the possibility that banks may be reaching for yield in this manner suggests that the same pressure to boost income could be affecting behavior in other, less readily observable parts of their businesses," he added.
Another potential area of concern for Stein is collateral swaps, in which one firm uses a repo transaction to trade junk bonds for Treasury bonds for use as collateral. Such swaps produce "unwind risks" and "additional counterparty exposures," he said.
"We don't have evidence to suggest that the volume of such transactions is currently large," he said. "But with a variety of new regulatory and institutional initiatives on the horizon that will likely increase the demand for pristine collateral — from the Basel III Liquidity Coverage Ratio, to centralized clearing, to heightened margin requirements for noncleared swaps — there appears to be the potential for rapid growth in this area."
In addressing market imbalances, the Fed's tendency has been to rely primarily on supervision and regulation in the belief that monetary policy is too "blunt" a tool. But Stein suggested that such "decoupling" may not always be the best approach.
"I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly," he said. "I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability."
"If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior," he said.
The Fed "can do more than adjust the federal funds rate," he said. "By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve."
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