Friday, August 25, 2017

Yellen: "Financial Stability a Decade after the Onset of the Crisis"

by Bill McBride on 8/25/2017 10:08:00 AM

From Fed Chair Janet Yellen: Financial Stability a Decade after the Onset of the Crisis. A few excerpts (here Dr. Yellen argues for keeping most of existing regulations put in place after the financial crisis):

Is This Safer System Supporting Growth?

I suspect many in this audience would agree with the narrative of my remarks so far: The events of the crisis demanded action, needed reforms were implemented, and these reforms have made the system safer. Now--a decade from the onset of the crisis and nearly seven years since the passage of the Dodd-Frank Act and international agreement on the key banking reforms--a new question is being asked: Have reforms gone too far, resulting in a financial system that is too burdened to support prudent risk-taking and economic growth?

The Federal Reserve is committed individually, and in coordination with other U.S. government agencies through forums such as the FSOC and internationally through bodies such as the Basel Committee on Banking Supervision and the FSB, to evaluating the effects of financial market regulations and considering appropriate adjustments. Furthermore, the Federal Reserve has independently taken steps to evaluate potential adjustments to its regulatory and supervisory practices. For example, the Federal Reserve initiated a review of its stress tests following the 2015 cycle, and this review suggested changes to reduce the burden on participating institutions, especially smaller institutions, and to better align the supervisory stress tests with regulatory capital requirements. In addition, a broader set of changes to the new financial regulatory framework may deserve consideration. Such changes include adjustments that may simplify regulations applying to small and medium-sized banks and enhance resolution planning.

More broadly, we continue to monitor economic conditions, and to review and conduct research, to better understand the effect of regulatory reforms and possible implications for regulation. I will briefly summarize the current state of play in two areas: the effect of regulation on credit availability and on changes in market liquidity.

The effects of capital regulation on credit availability have been investigated extensively. Some studies suggest that higher capital weighs on banks' lending, while others suggest that higher capital supports lending. Such conflicting results in academic research are not altogether surprising. It is difficult to identify the effects of regulatory capital requirements on lending because material changes to capital requirements are rare and are often precipitated, as in the recent case, by financial crises that also have large effects on lending.

Given the uncertainty regarding the effect of capital regulation on lending, rulemakings of the Federal Reserve and other agencies were informed by analyses that balanced the possible stability gains from greater loss-absorbing capacity against the possible adverse effects on lending and economic growth. This ex ante assessment pointed to sizable net benefits to economic growth from higher capital standards--and subsequent research supports this assessment. The steps to improve the capital positions of banks promptly and significantly following the crisis, beginning with the 2009 Supervisory Capital Assessment Program, have resulted in a return of lending growth and profitability among U.S. banks more quickly than among their global peers.

While material adverse effects of capital regulation on broad measures of lending are not readily apparent, credit may be less available to some borrowers, especially homebuyers with less-than-perfect credit histories and, perhaps, small businesses. In retrospect, mortgage borrowing was clearly too easy for some households in the mid-2000s, resulting in debt burdens that were unsustainable and ultimately damaging to the financial system. Currently, many factors are likely affecting mortgage lending, including changes in market perceptions of the risk associated with mortgage lending; changes in practices at the government-sponsored enterprises and the Federal Housing Administration; changes in technology that may be contributing to entry by nonbank lenders; changes in consumer protection regulations; and, perhaps to a limited degree, changes in capital and liquidity regulations within the banking sector. These issues are complex and interact with a broader set of challenges related to the domestic housing finance system.

Credit appears broadly available to small businesses with solid credit histories, although indicators point to some difficulties facing firms with weak credit scores and insufficient credit histories. Small business formation is critical to economic dynamism and growth. Smaller firms rely disproportionately on lending from smaller banks, and the Federal Reserve has been taking steps and examining additional steps to reduce unnecessary complexity in regulations affecting smaller banks.

Finally, many financial market participants have expressed concerns about the ability to transact in volume at low cost--that is, about market liquidity, particularly in certain fixed-income markets such as that for corporate bonds. Market liquidity for corporate bonds remains robust overall, and the healthy condition of the market is apparent in low bid-ask spreads and the large volume of corporate bond issuance in recent years. That said, liquidity conditions are clearly evolving. Large dealers appear to devote less of their balance sheets to holding inventories of securities to facilitate trades and instead increasingly facilitate trades by directly matching buyers and sellers. In addition, algorithmic traders and institutional investors are a larger presence in various markets than previously, and the willingness of these institutions to support liquidity in stressful conditions is uncertain. While no single factor appears to be the predominant cause of the evolution of market liquidity, some regulations may be affecting market liquidity somewhat. There may be benefits to simplifying aspects of the Volcker rule, which limits proprietary trading by banking firms, and to reviewing the interaction of the enhanced supplementary leverage ratio with risk-based capital requirements. At the same time, the new regulatory framework overall has made dealers more resilient to shocks, and, in the past, distress at dealers following adverse shocks has been an important factor driving market illiquidity. As a result, any adjustments to the regulatory framework should be modest and preserve the increase in resilience at large dealers and banks associated with the reforms put in place in recent years.
emphasis added