NEW YORK – The two-year fiscal crisis indicates that the economy’s health is tied to the financial system, San Francisco Federal Reserve Bank President Janet Yellen said today.
“It is no longer obvious that setting policies to stabilize the economy on the one hand and to safeguard the financial system on the other can be cleanly separated-either in conception or implementation,” Yellen said in a speech in Hong Kong, according to prepared text released by the Fed. “This experience has important implications for both monetary and regulatory policy.”
The crisis revealed “we need to develop stronger and more effective capital and liquidity standards, strengthen our oversight of risk management practices, and insure that compensation arrangements do not create incentives that could compromise safety and soundness,” she added.
“Overall, the crisis has exposed serious deficiencies in our micro-prudential regulatory structure,” she said. “We clearly need to address gaps, such as inadequate authority or tools to properly supervise the so-called shadow banking system, including major investment banks, nonbank lenders, and vital financial insurance providers such as AIG.”
However, she noted, such changes come with “tradeoffs between stability and efficiency-that is, between managing systemic risk and cultivating a fertile environment for economic growth.” Policymakers must “be aware that stronger capital standards that reduce leverage might hamper the flow of funds to businesses and households in ways that could impede investment and consumption. Of course, finding the right balance is an immense challenge.”
Yellen said regulators need to identify and correct “behaviors and structures … that create excessive risk before they mushroom into something that threatens the entire financial system.” Additionally, the entire financial system needs to be watched to make sure large institutions don’t all invest in the same class of assets, where “a downturn in that asset class can cause a rush to the exits as everyone tries to sell at the same time,” which she said is what happened with mortgage-related securities that led to this recession.
