Banking

Vigilance is essential in monitoring potential sources of financial instability, even areas beyond the most obvious possible problem spots, Atlanta Fed President Dennis Lockhart said during a November 27 speech at a conference in Berlin.

Lockhart discussed two particular arenas from which financial instability could emanate: payments systems and underfunded public pension plans. The Federal Reserve System, as a member of the Financial Stability Oversight Council, is monitoring and seeking to better understand an array of possible sources of systemic trouble. In that role, the Federal Reserve, including the Atlanta Fed, is researching the systemic risks surrounding the payments industry and public pensions, Lockhart told the Hyman P. Minsky Conference at the Levy Economics Institute.

Cyberattacks on payments system a concern
The payments industry is highly fragmented. That fragmentation and the industry's rapid technological evolution are creating many vulnerabilities, Lockhart pointed out. Perhaps the most serious financial stability concern is the potential that cyberattacks could cause malicious disruptions to the payments system.

In recent months, Lockhart noted, the United States has experienced increasing numbers of so-called distributed denial of service attacks. These attacks often disable essential systems of financial institutions and damage the institutions' reputations and finances. Serious though this problem is, it must be kept in perspective, Lockhart said.

"In my judgment, cyberattacks on payments systems are not likely to have as deep or long lasting an impact on financial system stability as fiscal crises or bank runs, for example," Lockhart said. "Nonetheless, there is real justification for a call to action."

Underfunded pensions a gathering threat
Turning to public pensions, Lockhart explained that this area of concern is more likely to be a gradually gathering threat, rather than a sudden shock. The core issue is that the funding ratio of many state and municipal employee pension funds has declined precipitously since the financial crisis. The funding ratio is the current market value of the invested portfolio as a percentage of the present value of promised future benefits.

Losses on investment portfolios lowered the aggregate funding ratio from 88 percent in 2007 to 75 percent in 2011. Several large state plans, including those in Illinois and Connecticut, have funding ratios below 60 percent, Lockhart said. 

These pension funds, therefore, face a huge gap in what they have and why they eventually will need to pay out. That gap varies in size from about $800 billion to $4 trillion, based on different assumptions of returns on investments. "The public pension funding problem, as it grows, has the potential to sap the resilience we wish for to withstand a future spell of financial instability," Lockhart said.

December 14, 2012