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Fed Chair Bernanke Discusses Fed's Evolving Approach to Monitoring Financial System

Fed Chair BernankeSince the financial crisis, the Federal Reserve System has shifted its supervisory and regulatory philosophy toward a more systemic approach that includes closely tracking vulnerabilities in the broad financial system, Federal Reserve Chairman Ben Bernanke said during a May 10 speech in Chicago.

The Fed, Bernanke pointed out, has always closely followed financial markets for regulatory and monetary policy purposes. "However, in recent years, we have both greatly increased the resources we devote to monitoring and taken a more systematic and intensive approach," the chairman said, "led by our Office of Financial Stability Policy and Research and drawing on substantial resources from across the Federal Reserve System."

Attempting to better foresee problems
Bernanke explored the question of whether systemic risks can be accurately identified before they cause problems. He noted that, after all, economists within and outside the Fed failed to predict the most recent financial crisis. In response to his own question, Bernanke distinguished between triggers and vulnerabilities. Triggers are the specific events that initiated the crisis. For example, one major trigger of the 2007–09 crisis was losses incurred by holders of subprime mortgages.

On the other hand, vulnerabilities associated with a crisis are preexisting features of the financial system that can worsen and spread the initial shocks. High levels of debt, maturity transformation, interconnectedness, and complexity are examples of vulnerabilities that all could magnify shocks to the financial system, Bernanke said.

Triggers need vulnerabilities to cause all-out crises
"Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises," the Chairman remarked. "The collapse of the relatively small market for subprime mortgages, for example, would not have been nearly as consequential without preexisting fragilities in securitization practices and short-term funding markets, which greatly increased its impact."

Monitoring seeks to identify potential triggers, such as indications of an asset bubble. Yet shocks are inevitable, so identifying and addressing vulnerabilities are critical to strengthening the financial system overall, Bernanke pointed out. Monitoring can be especially important during good economic times, because market participants apparently tend to take more risks when general economic conditions are relatively stable.

"Indeed, it may be that prolonged economic stability is a double-edged sword," Bernanke said. "To be sure, a favorable overall environment reduces credit risk and strengthens balance sheets, all else being equal, but it could also reduce the incentives for market participants to take reasonable precautions, which may lead in turn to a buildup of financial vulnerabilities."

May 28, 2013


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