As Prepared for Delivery
We pursue financial stability policies because the financial sector can create or amplify shocks. Not infrequently, the amplification can lead to financial crises, which have enormous economic and social costs. Financial crises since 1870 have led to significantly deeper and longer recessions, and slower recoveries than typical. The global financial crisis (GFC) reminds us that crises are not a relic of the past.
The GFC revealed the inadequacy of the financial regulatory system for the evolving financial system. Safety-and-soundness standards for banks and dealers, investor and consumer protection rules, and enforcement authorities were not sufficient. Nonbank financial intermediaries – entities that conduct credit intermediation or maturity transformation outside of the banking system – lacked prudential oversight and took positions that generated run risk and other vulnerabilities. The GFC also revealed the challenges governments face in responding quickly to financial crises, reflecting the difficulty of assessing the gravity of a situation in real time, concerns about encouraging moral hazard, and political constraints.
In the years following the GFC, many countries tightened microprudential regulation and adopted pre-emptive macroprudential policies to ensure the financial sector would continue to function and support real economic activity during periods of stress. The new macroprudential approach involves risk measurement and regulatory tools that can be applied to banks and to nonbank financial intermediation to take account of externalities. It also involves new governing bodies for decision-making that is especially important when regulatory gaps arise and traditional regulators do not have mandates for financial stability.
In my remarks today, I would like to look back at tests and achievements of the new macroprudential approach, and look ahead at emerging threats and what should be changed. I’d like to look back at the macroprudential framework through the lens of the strains triggered by the COVID-19 crisis, and by Russia’s unprovoked invasion of Ukraine, which has added to economic and financial stress in a period when monetary policy already had begun to pivot to reduce inflation.
I’d also like to look ahead and test our macroprudential framework through the ongoing developments of digital assets. Strictly speaking, the main difference between digital assets and more traditional financial products is that ownership of digital assets is maintained using distributed ledger technology. By itself, the fact that digital assets are supported by a new type of technology should not make a fundamental difference from a policy perspective – as suggested by the idea that policy should aspire to be “tech neutral.” Yet, unlike earlier forms of nonbank intermediation that relied on the banking system, distributed ledger technology was designed to bypass banks and other intermediaries – in a sense, an extreme form of nonbank intermediation. Not surprisingly, then, digital assets may give rise to new products or activities that do not fit neatly within existing regulatory strategies.
Overall, I believe the macroprudential approach and the reforms established since the GFC have substantially strengthened the core of the financial system; as evidence of this, the financial sector was supportive of the real economy amid recent risk events. But the events also suggest that there could be benefits from adjustments to bank capital and CCP margin practices to reduce procyclicality, and that reforms to reduce vulnerabilities in nonbank financial intermediation to date have fallen short. As the system continues to evolve, including to digital assets, I believe the macroprudential framework is still highly relevant. However, developing macroprudential strategies for digital assets will be complex, reflecting the features of digital assets themselves, as well as that macroprudential policy will need to be part of a broader government approach that also accounts for other objectives, such as uniform currency, global competitiveness, as well as equity, inclusion, and privacy goals.
Before turning to recent events, I will take a moment to describe developments in the macroprudential framework over the past decade-and-a half.
Turning first to monitoring and measurement, most countries now produce financial stability reports, and they track leverage, liquidity and maturity mismatches, and interlinkages within the financial sector; debt burdens of the nonfinancial sector; as well as asset price valuations as indicators of risk-taking. Such monitoring is inherently multi-dimensional — see the complicated heat maps for vulnerabilities in banks and nonbanks — and try to capture in some way complex linkages across the system.
It is also useful for a macroprudential framework to have a quantifiable summary objective, much like price stability as an objective for U.S. monetary policy is summarized by PCE inflation at 2 percent. Following the GFC, macroprudential policymakers tended to focus on various intermediate objectives, such as mitigating systemic risk at banks arising from excess credit growth and leverage, which then were linked to specific systemic risk measures and policy tools to achieve overall financial stability. These innovations helped to put macroprudential policy into practice, but did not provide a way to understand aggregate risks to the system of economy.
A more comprehensive quantitative measure is offered by Tobias Adrian, Nina Boyarchenko, and Domenico Giannone, who propose a summary measure of financial stability risk as the conditional forecast of GDP growth at a low percentile (such as the 5th or 10th), labeled Growth at risk (GaR). GaR links current financial sector conditions to future risks to economic growth. It builds on the empirical observation that the distribution of forecasted U.S. GDP growth conditional on financial conditions varies over forecast horizons and is not symmetric. Instead, the forecast conditional distribution shows that while loose financial conditions – due perhaps to less binding regulatory constraints – can reduce downside risks to GDP in the near-term, those loose conditions are more prone to a sharp tightening when a negative shock occurs, and GaR becomes very negative in later quarters.
In additional work with Tobias Adrian and others, we expand the term structure of GaR and show for 11 advanced economies that loose financial conditions combined with rapid nonfinancial credit growth reduce downside risks to GDP growth in the near-term but increase downside risks at about two-years ahead. Moreover, we show that the effects of financial conditions and credit are causal. A significant implication of this research is that there is an intertemporal tradeoff, where good times characterized by loose financial conditions and high credit growth can sow the seeds for a future financial crisis. Related work is underway in a range of jurisdictions to evaluate whether bank capital or foreign exposures can forecast GaR. And there is work beginning to link to regulatory remedies.
Turning to tools for banks, macroprudential tools added as part of post-GFC reforms include capital surcharges for systemically important banks, liquidity buffers, and new resolution standards. Basel III also introduced a countercyclical capital buffer (CcyB) that could be built up in boom times when the cost of equity is relatively cheap, and released in downturns to support credit provision.
For nonbanks, the macroprudential toolkit is less structured than for banks perhaps because they may evolve in response to prudential regulation for banks. Banks remain, in many ways, the core of the financial system, at least because their liabilities serve as money and payments. Yet nonbank financial intermediation has grown in importance due to regulatory, technological, and other factors. In the U.S., even as credit to households and businesses has risen sharply in recent decades, credit-to-GDP provided by banks has been flat, while credit-to-GDP from nonbanks has more than doubled (from about 30 percent of GDP in 1985 to about 70 percent currently). Bernanke cites the growth of nonbank financial intermediation as one of three main reasons for the substantive change in monetary policy in the 21st century.
An important tool for macroprudential authorities is the ability to bring new firms or activities into the regulatory perimeter. A couple of examples lie in the powers of the FSOC and FPC. The FSOC has the authority to designate nonbank financial companies, as well as payment, clearing, and settlement activities, for additional regulation and supervision; that authority could have led to prudential regulation for large investment banks before the GFC. The FPC regularly reviews regulatory boundaries in the UK.
Other macroprudential tools for nonbanks will depend on their activities and the ways the resulting vulnerabilities could affect the rest of the system. Metrick and Tarullo have proposed a “congruence principle” for financial regulation, according to which financial activities posing similar risks to financial stability should be subject to similarly stringent macroprudential regulation regardless of legal form, charter, or business model. As they emphasize, however, the congruence principle does not imply that nonbanks should be subject to the same regulations as banks, in part because bank regulation needs to also incorporate microprudential considerations.
To create focus and accountability for financial stability outcomes, many countries created financial stability committees after the GFC and, in some cases, gave them powers to meet the new mandates. In work with Rochelle Edge, we document a more than four-fold increase in committees worldwide: there were 11 in 2008, and 47 ten years later. The majority of the committees focus mainly on improving communications and coordinating actions among the regulators. About one-quarter have some authority to take or recommend actions. The committee structure matters: countries with these stronger committees were more likely to activate the CcyB during 2016 to 2019 after accounting for credit growth and other factors.
An interesting feature of these new committees is the presence of the ministry of finance, in addition to the regulators and central bank. By their nature, ministries of finance reflect the views of elected officials more than independent regulators or central bankers. The ministry of finance is a member in 40 of the 47 financial stability committees, and is the chair in 25. In the US, the Financial Stability Oversight Council is chaired by Treasury. In the UK, the Financial Policy Committee is chaired by the Bank of England, while HMT is an observer.
Finance ministries may be included simply because taxpayer resources may be needed for crisis management. But as suggested by Paul Tucker, finance ministries can also help strengthen the political legitimacy of macroprudential policies, which can have distributional consequences, as such as credit for housing and small businesses. Finance ministries may also play a coordinating role across independent regulatory agencies and the central bank and, as a non-regulator, may have a more independent perspective on gaps in existing regulatory authorities and how those gaps should be addressed. Still, some have expressed concerns that leadership by the finance ministries will lead to an easing bias in policy making because their leaders are less insulated from political processes.
I will now turn to recent tests of our macroprudential framework.
Our first test was the COVID-19 pandemic. You’ll recall that prior to the pandemic, U.S. inflation was below target while the U.S. unemployment rate was near half-century lows. Financial conditions were loose, but nonfinancial credit growth was moderate and banks held capital well above minimum requirements. GaR metrics did not indicate notable downside risks to conditional GDP growth a year ahead. But the onset of the pandemic was unexpected, and the resulting change was dramatic.
The massive shock placed enormous strain on financial markets. Asset prices fell sharply. A “dash for cash” led to significant stress across a wide array of financial markets, including illiquidity in the Treasury market, especially for deep off-the-run securities. Variation and initial margin calls caused some levered investors to exit from the Treasury cash-futures basis trade, and open-end bond funds faced record outflows and sold Treasury securities as well as corporate bonds to meet redemptions. Runs on prime money market mutual funds (MMFs) were comparable in speed and intensity to those in September 2008.
While financial markets were stressed, banks and central clearing houses (CCPs) showed considerable resilience. However, actions taken by CCPs to protect themselves may have contributed to broader market stresses, and clients of clearing members had to fire sale assets.
The Fed took a set of extraordinary actions to restore market functioning. These actions and government spending of more than $3 trillion softened the blow of the pandemic on the financial sector and economy.
Our second test is still ongoing. Over the past few months, the financial sector has generally proven resilient in the wake of Russia’s invasion of the Ukraine and as many central banks are tightening monetary policy. Margin calls by CCPs for energy and other commodities contracts have been large, especially in Europe, with CCP margin requirements (on a global basis) exceeding what they were in March 2020. Commodity trading firms faced significant pressures, and some requested support from the official sector. More recently, some open-end bond funds have incurred significant losses and experienced notable outflows, a interest rates have risen. Overall, the shock of Russia’s invasion and tighter monetary policy to date has not been amplified materially by the financial vulnerabilities.
What did we learn about macroprudential policy from these tests? What are next steps?
First, bank resilience dampened the amplification of the COVID-19 shock through the core of financial system. Banks faced a real-life stress test with more capital and liquidity put in place after the GFC, and had stronger risk management capabilities, including the capacity to make near-real-time assessments of their direct exposures, such as to Russia or commodity firms. Of course, banks surely would not have been so resilient without the extraordinary central bank and fiscal authority interventions.
Second, countries actively used the CcyB. Pre-pandemic, 16 countries had raised the CcyB to above zero. As governments took aggressive actions at the onset of the pandemic, 15 of the countries (all but one) quickly relaxed it, in part or in full. The intent was to support lending, and most countries also instructed or urged banks not to distribute the freed-up capital to shareholders. Many of the countries that had not set the CcyB above zero instead took other capital actions, often multiple and idiosyncratic ones. Examples include releasing other types of capital buffers, though these could trigger automatic reductions in dividends and compensation, or offering ad hoc adjustments such as temporary relief for loan forbearance. In sum, 41 (of 55) countries took 64 capital relief actions. As economies recover, over half of the 15 countries that released the CcyB have raised it again, and three more are raising it for the first time, further suggesting the utility of this countercyclical tool. Overall, the evidence suggests that countries believed that countercyclical capital actions could help to offset the inherent procyclicality in structural regulations and behavior, which might otherwise have deepened the recession and slowed the recovery.
Based on this evidence, some changes could be considered to improve the use of the CcyB and offset an apparent reluctance by banks to use buffers to support lending. There could be better communication to banks about the goals of the CcyB and the simplicity of using it, and seek to assuage banks’ concerns about possible negative reactions from supervisors. In addition, authorities may be slow to activate the CcyB because of uncertainty about when financial stability risks are sufficiently elevated – until imminent and obvious. The UK (and some other countries) set a positive CcyB as the default in normal times, perhaps offset by other regulatory adjustments, to ensure a usable buffer when risks are realized.
Third, margin calls proved effective at protecting CCPs and other financial institutions against counterparty default risk. But while margin requirements not surprisingly rise with volatility, margin calls appear to be unpredictable because of lack of transparency in margin methodologies or in how they are implemented intra-day. Some changes could be considered to make margin calls by CCPs less procyclical and less unpredictable to avoid unnecessary fire sales during stress periods. Any changes should also consider incentives for market participants to move substantially into bilateral transactions or reduce needed hedging activities.
Finally, the scale of fragilities in the nonbank financial sector was surprisingly large and led to dysfunction in multiple markets. There are efforts underway to increase the resilience of Treasury market liquidity, such as considering regulating more participants as dealers, increasing transparency of transactions, and mandating central clearing of Treasury repo and cash market trades. Another proposal to consider would be a countercyclical element to the leverage ratio for banking firms to support market-making in low-risk securities when stress erupts. A countercyclical leverage ratio would boost resilience by serving as a backstop to risk-weighted capital ratios when systemic risks are building, but would ease constraints on firms with central roles in the financial system when it is relaxed.
In addition, reforms need to be put in place to reduce the liquidity mismatch in open-end bond funds that have daily redemption rights while the underlying assets are less liquid. The spillovers from this mismatch to corporate bond and Treasury markets were significant as these funds have become large. Notably, the investment grade bond market faced relatively greater liquidity pressures than the high-yield segment as investors sold investment-grade funds for liquidity. A natural change would bet to more closely align liquidity by changing shareholder redemption rights in open-end funds, perhaps by creating a new type of fund, though reforms to implement swing pricing could help to remove the first-move advantage would be helpful.
For MMFs, prime funds still are subject to liquidity and credit mismatches. The reforms to MMFs in 2014 in the U.S. that created a link between the net asset value and the possibility of closing gates exacerbated the first-mover advantage, as some had predicted. It is critical that reforms such as swing pricing, and even more stringent liquidity standards to make MMFs more resilient to stress, be implemented, as have been proposed.
Regulators also need better visibility into the strategies and leverage of hedge funds. In the US, changes are underway to get better data on leverage and more timely information following certain stress events. In addition, a pilot program has been started to collect data on dealer-to-client repo transactions that are not centrally cleared.
To address excess leverage of nonbanks more broadly, margin and collateral haircut requirements could be applied. Margin requirements for uncleared swaps transactions were an important part of the post-GFC reforms. For bilateral repurchase agreements, higher through-the-cycle or countercyclical collateral haircuts could serve as a check on leverage.
I will turn now to digital assets.
Digital asset markets have grown dramatically and volatility has been substantial. The total market capitalization of all digital assets increased from under $200 billion in January 2020 to just over $3 trillion in November 2021, before falling to less than $1.0 trillion today.
While digital asset innovations may offer benefits to consumers and businesses, there are various types of risks as well. Presently, many digital assets are effectively “high-risk, high-return” assets, with potential risks related to investor and consumer protection as well as to illicit finance. A first-order task of regulators is to bring about compliance with existing rules to guard against these risks. Regulators need to ensure that banks that provide related services, such as custody, can ensure safety and soundness. More challenging is how to address risks posed by relatively novel aspects of decentralized finance, though I would note that most DeFI currently still relies on some degree of centralization.
In terms of financial stability risks, vulnerabilities within digital asset markets are similar to those in traditional financial markets. The recent turmoil has highlighted these vulnerabilities: Asset prices have tumbled amid significant volatility as investor risk appetite has waned, certain large stablecoins have either collapsed or temporarily lost their peg as a result of redemption pressures, and a large digital asset lending platform was forced to suspend withdrawals because of highly levered positions. In short, to paraphrase a colleague, the digital asset ecosystem is proving to have many of the same fragilities of the 19th century banking system with 21st century speeds.
So far, these losses have not spilled over to broader traditional financial markets. But as digital assets expand, the potential for spillovers grows. Stablecoins in particular pose significant spillover risks. They aspire to have some of the functions of money—store of value, unit of account, and medium of exchange. If stablecoins are backed by commercial paper or other assets that are key in short-term wholesale funding markets, runs on those stablecoins could result in fire sales that strain critical parts of the financial system, similar to the experience with runs on prime money funds. If stablecoins become widely used as a means of payment, disruptions in the mechanisms that support the storage or transfer of stablecoin could disrupt real economic activity. There is also the prospect of one or more large stablecoin issuers becoming too-big-to-fail, which could happen rapidly due to factors such as network effects or access to existing user bases.
These potential spillovers raise a basic question about the appropriate regulatory structure for stablecoin issuers — a bank or nonbank. Either model could plausibly address concerns about stablecoin runs and payment system risk, but might otherwise have different implications for financial stability. Under a bank model, stablecoins could be backed by bank assets (e.g., loans) as well as bank capital and liquidity buffers. In the U.S., banks are also eligible to obtain accounts at the Federal Reserve, borrow from the Fed, and access Fed payment systems, which can support eventual direct settlement in central bank money. But because banks are at the center of the financial system, it would be especially important to ensure that safeguards are in place to prevent significant losses for the bank or its customers in this model.
Under a nonbank model, stablecoins would need to be backed 1:1 with safe assets to reduce run risk. This model would reduce direct ties between stablecoins and the banking system, but could interfere with intermediation if nonbank stablecoins compete with bank deposits and, in the process, reducing the amount of stable funding available to banking gorganizations. Moreover, in times of economic stress, a safe stablecoin could increase the risk of depositor flight from banks that could face growing risks, and further constrain credit availability. Conversely, if nonbank stablecoins are viewed instead as less safe than banking liabilities, stablecoins could themselves be subject to runs that result in fire sales of backing assets. Thus, in addition to a 1:1 backing requirement, nonbank stablecoin issuers would need to be subject to capital, liquidity, and other prudential standards commensurate with the risks of their activities.
There is clearly work to be done for macroprudential policy regarding digital assets. But digital assets raise a host of broader policy issues that fall outside the standard remit of financial regulators or where financial regulators would benefit from collaborating with other agencies.
In principle, digital assets could raise questions about preserving a uniform national currency and monetary sovereignty, issues more for a central bank than financial regulators or finance ministries. The advantages of a uniform currency and monetary sovereignty may be undermined if stablecoins used for payments were to trade at a discount and could not be redeemed one-for-one with other monies (or were denominated in currencies other than the national unit of account).
Digital assets could also affect the role that a currency and bank deposits play in the international financial system, with potential implications for objectives related to national security, guarding against illicit finance, as well as a country’s borrowing costs. There also may be a national interest in promoting technological development in digital assets to establish or maintain a strong position in global economic leadership and competitiveness. Digital assets also raise the prospect of improving social equity and inclusion, but could also raise issues about privacy of its citizens. Finance ministries need to work closely with central banks and other regulators to promote these goals.
President Biden’s recent Executive Order on digital assets has asked the US government to start to address many of the issues that I have outlined. Treasury is leading reports on potential benefits and risks of digital assets related to the future of money and payments; consumer and investor protection; financial stability; illicit finance; and international coordination; and will be coordinating with agencies across the government.
The macroprudential approach—risk measurement, policy tools, appropriate governance– has gone through some significant tests: a pandemic, the start of a war, and the response of monetary policy to inflation pressures not seen for more than 40 years.
The core of the financial system appears to have been resilient to these events. But they have revealed other lessons as well. Importantly, there is more to do for nonbank intermediation as is continues to grow and liquidity mismatches and leverage can lead to significant stress in core funding and bond markets. The apparent utility of the CcyB also provides lessons for the use of buffers in stress, and may be useful for considering the procyclicality and high uncertainty of CCP margin practices.
The policy framework also has held up well. While the shocks were unexpected, the vulnerabilities and transmission channels were fairly well understood by policymakers. Summary metrics of financial stability risks continue to be developed that express those risks in units that other macroeconomic policymakers consider in their own policy deliberations. This will help financial stability authorities to better communicate the framework, including the tradeoffs of loose financial conditions today raising the costs of financial stresses tomorrow.
The policy framework also applies well to digital assets. Financial regulators had correctly highlighted the vulnerabilities of digital assets before the recent sharp downturn. But we expect vulnerabilities to evolve rapidly, and establishing the appropriate policy framework for digital assets is not a task for financial regulators alone. Instead, it will require inputs from central banks because of implications for a uniform currency and monetary sovereignty, and from finance ministries and other parts of government because of implications for global economic leadership, national security, and social objectives.