Banking

In a Mark Twain–like observation, Federal Reserve Chairman Ben Bernanke said in a March 1 speech that commentators have voiced two broad concerns about the outlook for currently low long-term interest rates.

"To oversimplify," the Fed chairman said, "the first risk is that rates will remain low, and the second is that they will not."

In elaborating on those two risks, Bernanke noted that one reason to focus on the timing and pace of a possible rise in long-term rates is that such a rise could affect financial stability. In particular, if rates remain low, some investors might take on riskier bets in a "reach for yield," either through relying excessively on debt or through other forms of risk-taking. Alternatively, if longer-term rates were to rise sharply, it could impose capital losses on holders of fixed-income instruments, including financial institutions.

"So how can financial stability concerns—which the Federal Reserve takes very seriously—be addressed?" Bernanke said.

Multifaceted strategy to safeguard stability
The Fed's strategy is multifaceted and is carried out collaboratively with other regulators and central banks. First, Bernanke said, the Fed has greatly increased macroprudential oversight, focusing on potential systemic vulnerabilities, including accumulations of leverage and unstable funding patterns as well as interest rate risk. Second, the Fed is using regulatory and supervisory tools, such as stress tests and capital requirements, to help ensure that financial institutions can withstand losses and market turmoil.

"Indeed, reflecting expectations embodied in the new Basel III and Dodd-Frank standards, the largest and most complex financial firms have substantially increased both their capital and their liquidity in recent years," Bernanke said at the Annual Monetary/Macroeconomics Conference: The Past and Future of Monetary Policy, hosted by the Federal Reserve Bank of San Francisco.

Stress tests ongoing
Meanwhile, a current round of stress testing of the largest bank holding companies is set to conclude this month. The tests are designed to examine whether the firms have sufficient capital to endure a serious economic downturn and maintain their capacity to provide credit.

The Fed's third tool for addressing financial stability concerns is communications. "Our approach to communicating and implementing monetary policy provides the Federal Reserve with new tools that could potentially be used to mitigate the risk of sharp increases in interest rates," Bernanke said. "By providing greater clarity concerning the likely course of the federal funds rate, FOMC communication should both make policy more effective and reduce the risk that market misperceptions of the Committee's intentions would lead to unnecessary interest rate volatility."