by Calculated Risk on 5/10/2013 09:47:00 AM

From Fed Chairman Ben Bernanke: Monitoring the Financial System

Ongoing monitoring of the financial system is vital to the macroprudential approach to regulation. Systemic risks can only be defused if they are first identified. That said, it is reasonable to ask whether systemic risks can in fact be reliably identified in advance; after all, neither the Federal Reserve nor economists in general predicted the past crisis. To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities. The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. 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 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. Of course, monitoring can and does attempt to identify potential triggers--indications of an asset bubble, for example--but shocks of one kind or another are inevitable, so identifying and addressing vulnerabilities is key to ensuring that the financial system overall is robust. Moreover, attempts to address specific vulnerabilities can be supplemented by broader measures--such as requiring banks to hold more capital and liquidity--that make the system more resilient to a range of shocks.

Two other related points motivate our increased monitoring. The first is that the financial system is dynamic and evolving not only because of innovation and the changing needs of the economy, but also because financial activities tend to migrate from more-regulated to less-regulated sectors. ...

The second motivation for more intensive monitoring is the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword. 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. Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential and other policy tools that can be used to address them.
emphasis added

And on current activities:

So, what specifically does the Federal Reserve monitor? In the remainder of my remarks, I'll highlight and discuss four components of the financial system that are among those we follow most closely: systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector.

For details on each of the four components, see Bernanke's speech.

As Bernanke notes - and economist Hyman Minsky pointed out years ago - long periods of stability lead to increased speculation and eventually a financial crisis. Currently regulators are vigilant, but unfortunately over time policymakers and regulators will become less cautious.