Remarks by OFR Director Richard Berner at the Brookings Institution: Can the Financial Sector Promote Growth and Stability?
Published: June 8, 2015
Good morning. It’s a pleasure for me to be here. I want to thank Martin Bailey and Doug Elliott for organizing this event and for inviting me to join you.
I’m delighted that Martin and Doug persevered after this event was snowed out back in March, because the topic is clearly central to discussions about financial stability. I will start by noting that the views I express here are solely my own and do not reflect those of the Department of the Treasury.
You framed the topic in the question, “Can the financial system promote growth and stability?” My answer is a strong yes — but that answer depends on the resilience and proper governance of the financial system.
As the financial crisis of 2007-2009 clearly demonstrated, when those critical ingredients are lacking, shocks can be highly disruptive to growth and stability. Thanks to strong intervention, the financial system and the economy have recovered, but challenges to build and assure resilience remain.
To this audience, the proposition that growth depends on a strong and stable financial system may now seem obvious. Yet a decade ago, many of you would not have asked whether the financial system could promote growth and stability. The consensus was that monetary policy had achieved price stability — low and stable inflation — and by reducing the inflation risk premium, had unlocked the door to strong, sustainable economic growth. To be sure, nagging questions lingered about financial booms and bond-market conundrums. But 20 years of the “Great Moderation” fed a lack of caution.
In my remarks this morning, I will try to look at these issues in greater detail and answer three related questions:
- Has the legacy of the crisis held back economic recovery?
- Are there tradeoffs between stability and growth?
- What have we done to assure financial stability, what is left to do, and what are the current threats?
The short answers to those questions are yes; yes and no; a lot, a lot, and three that I will highlight. In answering the last question, I will of course describe what we at the Office of Financial Research are doing to promote financial stability.
Regarding the first question, the slow healing of the financial system and of its capacity to provide credit continues to be a headwind to growth.
This is not news. The crisis impaired the availability of credit by forcing financial firms, other businesses, and households to deleverage; that is, to reduce their debt. However, deleveraging also helped advance U.S. financial healing. As evidence, household debt and debt-service ratios have declined to, or below, sustainable levels and some forms of credit are now growing along with the economy.
But healing is incomplete. For example, U.S. mortgage credit availability is still constrained and that’s a factor behind our subpar economic performance. Slow financial healing is a key reason why central banks globally continue to deploy both conventional and unconventional monetary policies, and why real, long-term interest rates are at such low levels.
Are there tradeoffs between stability and growth? In the short run, some of the efforts to increase resilience may require adjustments that could raise intermediation costs and hence be temporary headwinds to growth. But in the spring and summer of 2009, the incentives of the stress tests and future TARP repayment requirements enabled banks massively to raise capital. That stabilized the system and enabled banks to resume lending to support the recovery.
That there may be some short-run trade-offs should hardly be surprising. Analogously, between 1979 and 1982, achieving price stability incurred significant short-run economic costs. But the long-run gains were considerable, and I think the long-run gains in this case will also be significant.
Yet concerns are arising that regulation may perversely be contributing to more permanent adjustments that could impair market functioning. For example, several developments since the financial crisis have altered trading liquidity in securities markets and the ways investors redeem holdings to get cash. Some of these developments are by design: Regulations imposing tighter restrictions on bank leverage have increased the cost of securities financing activities — even against low-risk securities, such as Treasuries — and have reduced incentives to maintain these activities and the portfolios behind them. Bank trading books require more capital, and the Volcker rule requires banks and their affiliates to refrain from proprietary trading.
However, regulations are far from the only factors at play. Some causes are cyclical, such as changes in the supply of — and demand for — collateral, and changes in risk preferences. Other causes appear to be structural, such as changes in the investor base, in securities markets, and in the development of new financial products. In addition, changes in market structure, such as the spread of high-frequency trading and algorithmic trading to fixed-income markets, may be at work in the sharp movements in prices we observe from time to time.
Some traditional indicators, such as bid-ask spreads, suggest that reasonable market liquidity persists. But others do raise concerns. Since the crisis, market liquidity has become more fragmented in a few markets, such those for sovereign bonds in emerging markets and U.S. corporate bonds. Signs of bifurcation or fragmentation include the concentration of dealer inventories in high-quality liquid assets, declines in trading turnover relative to market size, declines in the size of average trades, and increased settlement failures.
Perhaps more importantly, liquidity appears to have become increasingly brittle, even in the world’s largest bond markets. Although liquidity in these markets looks adequate during normal conditions, it seems to disappear abruptly during episodes of market stress, contributing to disorderly price changes. In some markets, these episodes are occurring with greater frequency. Examples include the mid-2013 sell-off in U.S. fixed-income markets, the October 2014 dislocation in U.S. Treasuries and futures markets, and the sharp moves in euro-area government bonds in early May of this year and in the past few days. None of these episodes disrupted U.S. financial stability, nor do we yet sufficiently understand their causes. But together they highlight a potential weakness in markets that could amplify the impact of financial shocks.
Research to identify causes is a cottage industry. For example, in a recent OFR working paper, our researchers explored patterns that connect daily liquidity conditions across a broad range of financial markets to financial conditions in the aggregate, both in normal times and under stress. This basic research represents a potential framework for monitoring market liquidity, to extract signals to warn of impending disruptions.
What about long-term trade-offs between stability and growth? I think the benefits of stability for growth will far outweigh any costs. In fact, financial stability is essential for sustainable growth. To quote former Fed Chairman Bernanke, “Even in (or perhaps, especially in) stable and prosperous times, monetary policymakers and financial regulators should regard safeguarding financial stability to be of equal importance as — indeed, a necessary prerequisite for — maintaining macroeconomic stability.”
Let me now move to my final questions and my final answers.
The questions were, “What have we done to assure financial stability, what is left to do, and what are current threats to it?” And my answers were, “a lot, a lot, and three that I will highlight.” To elaborate on those answers, I want to provide some context.
Out of the crisis came a widespread appreciation for a different approach to policymaking. Financial stability is now a widespread policy objective. Policy analysis is focused on assessing threats to financial stability and policymakers are creating more tools to combat those threats — developing what we call the macroprudential toolkit. Macroprudential is a fancy word that means we now look across the entire financial system, not just in individual institutions or markets, to assess and mitigate threats to financial stability.
The crisis also exposed the need to improve the quality and scope of financial data to monitor activity across the financial system. Before the crisis, the data available to measure financial activity and exposures were too aggregated, too limited in scope, too out of date, or otherwise incomplete. No wonder regulators and policymakers poorly understood the extent of leverage, liquidity, and maturity transformation, the growth of nonbank activity, and exposures. The data failed to show them.
As you know, the Dodd-Frank Act established the Financial Stability Oversight Council (FSOC or Council) to develop and implement the toolkit, and created the Office of Financial Research to fill the gaps in data and analysis. The Council is charged with assessing and monitoring threats to financial stability, developing remedies for those threats, and restoring market discipline by eliminating too big to fail. We at the OFR have a mission to help promote financial stability by collecting and improving the quality of financial data and developing tools to evaluate risks to the financial system. Simply put, our work supports economic growth by helping to strengthen the financial infrastructure that growth requires.
Our new macroprudential toolkit needs to assess the fundamental sources of vulnerability, to be more forward-looking, and to test the resilience of the financial system to a wide range of events and incentives. Assuring financial stability is not about predicting, much less preventing, the next financial crisis. Rather, the toolkit must be aimed at improving financial system resilience to withstand the next crisis and assure system functionality under stress.
In the past five years, federal financial regulators have taken important steps to make the financial system more resilient. Since the crisis, officials have conceived and put in place banks’ new capital requirements. Bank regulators also agreed on key components of liquidity regulation and minimum requirements for firms’ holdings of liquid assets. In addition, two tools have dramatically changed the approach to increasing resilience. The first is stress testing, which helps calibrate resilience and thus capital requirements. The second is a new regime to resolve large, complex, and troubled financial institutions in an orderly way.
These are consequential achievements that have made the banking system stronger. But vulnerabilities are still present outside the banking perimeter and across the financial system. We need tools to address them, and to develop the tools, we need to analyze and measure the vulnerabilities. That’s especially important as financial activity migrates to more opaque and potentially less resilient parts of the financial system.
Here too, there is progress. Work is ongoing to assess risks in aspects of so-called shadow banking and to develop tools to limit them. For example, there is agreement that minimum floors on haircuts can strengthen secured, short-term wholesale funding markets. New regulations are also in place to strengthen derivatives markets and make them more transparent. Because these initiatives must cut across the financial system, close collaboration among U.S. financial regulators is critical for their success. The Council and the OFR can each play important roles in such collaboration.
In the past five years, we have improved our understanding of how the financial system functions, and our ability to measure financial activity and spot vulnerabilities. But we need to do more to understand how the financial system fails to function under stress, to spot vulnerabilities in the shadows, and to gather and standardize the data needed for our critical analysis and policymakers’ responses to identified threats. We know that financial innovation and the migration of financial activity create a moving target, so our goal to eliminate gaps in data and analysis will always elude us. But we will continue to fill the most important ones.
At the OFR, we are looking across the financial system to fill gaps in financial data and analysis. I’ll give you a few examples of our work.
First are the data initiatives, which distinguish us from other macroprudential authorities:
We are filling gaps in bilateral repo data in collaboration with the Federal Reserve. This project promises to improve our measurement and understanding of a key short-term funding market. A repurchase agreement, or repo, is essentially a collateralized loan — when one party sells a security to another party with an agreement to repurchase it later at an agreed price. Of the $3.8 trillion in funding the U.S. market provides daily, about half are in bilateral transactions, but data on such repos are scant. Because the repo market remains vulnerable to runs and asset fire sales, obtaining more information about these transactions will fill an important data gap.
The OFR is helping the Commodity Futures Trading Commission and other regulators improve data quality in registered swap data repositories. These repositories are designed to be high-quality, low-cost collection points for data that are critical to understand exposures and connections across the financial system. We and the CFTC are jointly working to enhance the quality, types, and formats of data collected. This work is inherently global, so we are each collaborating on it with our counterparts at the Bank of England and the European Central Bank.
The OFR is improving the quality of financial data by developing and promoting the use of data standards. We have led the initiative among governments and private industry worldwide to establish a global Legal Entity Identifier or LEI — a data standard that is like a bar code for precisely and uniquely identifying parties to financial transactions. If the LEI system had been in place in 2008, the industry, regulators, and policymakers would have been better able to trace the exposures and connections of Lehman Brothers and others across the financial system. The LEI initiative has become fully operational in just a few years. But ubiquity is needed to realize its full benefits, so I have called for mandating its use for regulatory reporting.
In our Research and Analysis Center, we are developing new tools to assess and monitor vulnerabilities. For example:
Our Financial Stability Monitor helps us assess risks in five functional areas — macroeconomic, market, credit, funding and liquidity, and contagion — instead of in institutions or markets. By so doing, the monitor helps us look across the financial system and spot threats wherever they arise.
We are developing tools to assess risks in each of these five categories. For example, we are using agent-based models to assess contagion risks in financial networks. These models have been used to study the spread of epidemics and ways to mitigate them. Likewise, they hold great promise for understanding the dynamics of fire sales, the spillovers from the default of a major counterparty in central clearing counterparties, and other chains of complex events.
We supplement our financial stability analysis at the OFR with market intelligence. In February, we launched a Financial Markets Monitor that summarizes major developments and emerging trends in global capital markets. By making it public, we aim to increase transparency, to enhance the availability of financial information, and to facilitate timely reactions by the private sector to emerging risks and thereby to defuse them.
Before I close this morning, I want to elaborate on the response to the final hard question that I posed at the beginning of my remarks: What are the current threats to financial stability? In our 2014 Annual Report that we published in December, we said the U.S. financial system has continued to recover and strengthen. Compared with the period just before the financial crisis, threats to financial stability are moderate. But we noted that the relatively benign backdrop is no cause for complacency because several financial stability risks increased during the previous year.
Six months later, that’s still true. In my remarks today, I have touched on two of those risks. The first is vulnerabilities associated with market liquidity and the second is the migration of financial activities toward opaque and less-resilient corners of the financial system. A third major risk is due to excessive risk-taking in some markets during the extended period of low interest rates and low volatility.
Someone asked me recently what risks keep me up at night. I worry most about the risks I understand the least. Where are our blind spots? Has the continuous evolution and innovation in the system caused a build-up of risks in a part of the system where we are not looking? The unknown risks are what keep me up at night.
To sum up, the legacy of the financial crisis lingers and we are just emerging from its effects on economic performance. Growth and financial stability can not only coexist, but financial stability is a predicate for sustainable prosperity. We have done a lot to build a more resilient financial system, but we have much more to do. Assuring financial stability will always be an ongoing challenge.
Thank you for your attention. I will be happy to take your questions.