Vice Chair Yellen Explains Fed's Role in Financial Stability

Vice Chair Yellen Explains Fed's Role in Financial Stability

Vice Chair Janet YellenThe Federal Reserve and other U.S. financial regulators are adopting a macroprudential approach to supervision and regulation and have implemented processes for identifying and responding to sources of systemic risk in the financial system, Federal Reserve Vice Chair Janet Yellen said during a November 11 speech in Chicago.

"The macroprudential approach,"Yellen said, "focuses on achieving financial stability by reducing systemic risk—that is, the risk of a financial disruption that is severe enough to inflict significant damage on the broader economy. Ideally, this approach is done through preemptive policies that restrain risks to the financial system before they develop into crises."

The pursuit of financial stability
These measures are aimed at pursuing financial stability, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted just over a year ago. "The bottom line is that developing an effective macroprudential policy is critical to preserving financial stability and supporting overall U.S. economic activity,"Yellen said in a speech at the Federal Reserve Bank of Chicago's International Banking Conference. "Accomplishing this objective will be a considerable challenge, but it is one of great importance."

Unlike the traditional "microprudential" approach to regulation and supervision, which focuses on the safety and soundness of individual financial institutions, markets, and infrastructures, the macroprudential approach also calls for attention to the financial system as a whole, she explained.

New office focuses on stability
The Federal Reserve, Yellen noted, has not only reoriented its approach to the supervision of large bank holding companies but also has created the Office of Financial Stability Policy and Research. The office plays an important role in monitoring financial risks, analyzing the implications for financial stability, and devising strategies for mitigating the risks.

The Fed has established several means to measure cyclical forms of systemic risk. Those methods include monitoring measures of leverage and maturity mismatch at financial intermediaries, examining asset valuations, underwriting standards for loans, and eyeing credit growth for signs of a credit-induced buildup of systemic risk. In gauging systemic risk for the largest banking firms, the Fed's actions include ongoing stress tests and capturing financial market perceptions of the danger such a firm could cause the broader financial system were it to become stressed.

November 29, 2011