Regulation the Best Tool for Financial Stability, Says Fed Chair Yellen

Janet YellenStronger regulations—not monetary policy—should be the "main line of defense" for dealing with risks to financial stability, said Federal Reserve Chair Janet Yellen during a recent speech.

Monetary policy is a limited tool for such tasks, in part because its effect on financial vulnerabilities, such as excess leverage, is not well understood, said the Fed chief during a July 2 event at the International Monetary Fund. Also, because rates are a blunt tool, raising them to head off financial excesses could have adverse effects in other areas—such as unemployment. Indeed, the potential cost to the broader economy “is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time,” she said.

Building resilience a critical step
Macroprudential policies, such as stronger underwriting standards and limits on short-term funding, are a more direct and likely more effective approach, Yellen noted.

For example, stronger capital requirements help financial institutions weather unexpected losses, and effective resolution regimes for the most systemically important firms better insulate the financial system from contagion should a large, interconnected firm fail.

A focus on increasing the financial system’s resilience to adverse shocks is especially important, said Yellen, although much of the public discussion around financial stability is concerned with identifying and responding to asset bubbles. However, by building the financial system’s ability to withstand unexpected shocks, “identification of bubbles is less critical,” she noted. Additionally, some macroprudential tools can be targeted to emerging risks—an approach Yellen called “leaning against the wind.” Countercyclical capital buffers, for example, may help the financial sector to build up capital cushions during good times while also limiting the build-up of excesses.

Monetary policy not enough to prevent recent crisis
Yellen stopped short of ruling out entirely the use of interest rates to address financial stability concerns, noting that “there may be times when adjustment in monetary policy may be appropriate.”

The mid-2000s was not one of those times, however. Higher interest rates were likely insufficient to address the full range of vulnerabilities that contributed to the crisis, including weak underwriting standards, excess leverage, and gaps in the regulatory structure, she noted.

Further, the significantly higher rates needed to dampen the rise in house prices would have likely led to job losses and higher interest payments as well, thus weakening consumers’ ability to repay their debts, “suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly,” Yellen added.

In the years following the financial crisis, the Federal Reserve and other regulators have made significant progress in strengthening the oversight of the shadow banking system and putting in place stronger bank capital requirements. Still, progress in some markets—wholesale funding markets, for example—has been “frustratingly slow,” she said.

Currently, the Fed’s monetary policy is firmly focused on the Fed's dual objectives of price stability and maximum employment. Yellen's assessment of the current risks to financial stability does not call for a shift from those objectives to financial stability concerns. However, she pointed to "pockets of increased risk-taking" that could one day trigger a more robust macroprudential approach. “It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustment to the stance of monetary policy, as conditions change in potential unexpected ways,” she said.

July 16, 2014