Monetary Policy and Financial Stability in the U.S.

These remarks are based on remarks that I made at the Sveriges Riksbank Conference on Rethinking the Central Bank’s Mandate in Stockholm, Sweden, on June 4, 2016.

I thank the University of Sydney for inviting me to participate in today’s conference on banking and financial stability. Since the 2008 global financial crisis, economists and policymakers all over the world have been evaluating the factors that led to the crisis, assessing what could have been done to prevent, or at least limit, the damage, and considering what can and should be done to reduce the probability and impact of future disruptions to financial stability. To its credit and understanding the importance of the financial system to a vital economy, Australia began undertaking thoughtful, periodic reviews of its financial system and regulatory structure well before the crisis. Based on the recommendations coming out of these inquiries, Australian policymakers implemented changes to address the evolving nature of the financial services landscape.

I appreciate the opportunity to learn more about the financial stability efforts underway here and to provide a perspective from the other side of the Pacific. Today, I will focus my remarks on the connections between monetary policy and financial stability. To help put the discussion into context, I will start with a brief overview of the U.S. financial system regulatory structure as it pertains to financial stability. I should note that the views I’ll present today are my own and not necessarily those of the Federal Reserve System or my colleagues on the Federal Open Market Committee.

The U.S. Financial System Regulatory Structure and Financial Stability

It is probably an understatement to say that the financial system regulatory structure in the U.S. is complex. In part, its complexity reflects the wide array of institutions that provide financial services, helping to support an $18 trillion economy. Banks, a category that includes commercial banks, savings and loans, and credit unions, provide only about a third of the credit in the U.S. Other providers include insurance companies; mutual funds; pension funds; government-sponsored enterprises, including Fannie Mae and Freddie Mac, which issue mortgage-backed securities; and other non banks including broker-dealers, finance companies, and mortgage real estate investment trusts.¹

These diverse financial institutions are able to provide valuable credit, risk-management, and liquidity services to businesses and households because they are designed to take risks and are highly leveraged compared with nonfinancial businesses. But this risk-taking and leverage raise the possibility of systemic problems that could threaten the functioning of the financial system, hurt real economic activity, and impose significant economic costs.

The 2008 financial crisis exposed gaps in the regulatory and supervisory architecture in the U.S., which contributed to a buildup in financial imbalances and systemic risk. In response to the crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010. Provisions in the act aim to foster financial stability in two ways: first, by lowering the probability of a financial crisis, and second, by reducing the costs imposed on the rest of the economy when a shock hits the financial system. Under Dodd-Frank, the Federal Reserve and other financial regulatory agencies in the U.S. were directed to augment their traditional microprudential approach, which promotes the safety and soundness of individual institutions, with a macroprudential approach in which examiners and supervisors take a horizontal view of risk across institutions rather than looking at only one institution at a time. Although there is still more to be done, U.S. regulators continue to make progress in developing tools to implement the macroprudential approach and to monitor the risks over the business and financial cycles.

In the U.S., the application of these tools is complicated by the complexity of the regulatory structure itself. At the federal level, there are multiple financial regulators, including the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency, the National Credit Union Association, the U.S. Treasury, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Consumer Financial Protection Bureau, and the Federal Housing Finance Agency. There are financial system regulators at the state level as well. In many cases, the regulatory authority of these agencies is defined by type of institution rather than by instrument.

The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC) to promote coordination and information sharing across these financial system regulators. The 10 voting members of the FSOC include the heads of the nine federal regulatory entities I just mentioned, and an independent member with insurance expertise, who is appointed by the president of the U.S. An important power of the FSOC is its ability to designate nonbanks as systemically important, bringing them under more banking-type supervision and regulation. The Board of Governors of the Federal Reserve System has the responsibility for supervising systemically important financial institutions, including these FSOC-designated nonbank financial companies, large bank holding companies, and the U.S. operations of certain foreign banking organizations.

The complexity of the financial system makes monitoring risks more complicated. The Office of Financial Research, established under Dodd-Frank, is collecting data to aid in this task. The Federal Reserve has also developed a framework for systematically tracking risks, which is helping us to better identify changes in conditions over time. Financial stability surveillance is receiving regular attention at meetings of the Federal Open Market Committee (FOMC), the body within the Federal Reserve that is responsible for setting monetary policy.² One might ask why that’s the case given that financial stability is not an explicit part of the FOMC’s monetary policy mandate. It is because the goals of monetary policy and financial stability are interconnected.

The Nexus Between Monetary Policy and Financial Stability

In my view, a central bank should care about financial stability to the extent that it affects the health of the real economy. Volatility or minor disruptions in financial markets that represent the ebb and flow of a dynamic economy but do not threaten the health of the economy are not something the monetary policy authority should respond to. Indeed, to the extent that the word “stability” gives the impression that the financial system is static, we may want to adopt the language used in the United Kingdom and speak about financial system resiliency, that is, the financial system’s ability to continue to provide the core financial services of intermediation, risk management, and payments in the face of the inevitable shocks that will hit a dynamic economy.³

Monetary policy mainly works through its ability to affect current and expected future interest rates; however, in certain circumstances, it also has the ability to affect risk-taking by investors and financial institutions, and thereby is linked to financial stability.⁴ I believe that, in general, the goals of monetary policy and financial stability are complementary. For example, price stability helps businesses, households, and financial institutions make better decisions, thereby fostering the stability of the financial system. And a stable financial system allows for more effective transmission of monetary policy throughout the economy. I view this complementarity as similar to the complementarity between the two monetary policy goals that the U.S. Congress has given to the FOMC, namely, price stability and maximum employment.

But during the financial crisis we learned that financial imbalances can build up even in a low-inflation environment, so that while price stability may promote financial stability, it is not a sufficient condition. We also learned that financial instability can arise from nonbanks and from institutions that are solvent and not necessarily highly leveraged.⁵

A large body of research has aided our understanding about how systemic risk can build up and propagate through the economy. Well before the financial crisis, Kiyotaki and Moore (1997) did seminal work on the important role collateral plays in lending markets. In their model, because borrowers cannot be forced to repay, all lending is collateralized. When the economy is performing well, the value of the collateral increases, which supports further borrowing and higher output. But when a negative shock hits the economy and output declines, collateral values also fall, which means borrowing falls, which depresses output even further. Thus, the collateral constraint is a mechanism that amplifies and propagates the effects of temporary shocks on the economy.

Brunnermeier and Sannikov (2014) build on the Kiyotaki and Moore model. In their model, an economic boom increases bank capital levels high enough so that credit is amply available to borrowers. This lowers the volatility of both output and asset prices. The lower volatility induces banks to increase their leverage and lend even more, so much so that the system is now vulnerable to a negative shock. Gorton and Ordoñez (2014) examine how private market activities generate endogenous accumulations of and subsequent collapses in leverage. These models illustrate that systemic risk is endogenous, determined by the choices of the model’s decision makers, and varies across the cycle.

During the financial crisis, we saw that when financial markets are not functioning well, the transmission of monetary policy to the economy can be disrupted. In those circumstances, the actions taken to implement monetary policy can also affect financial stability. The FOMC has acknowledged that nonconventional monetary policy, including large-scale asset purchases and the extended period of very low interest rates, could pose potential risks to financial stability by affecting market functioning and by spurring risk-taking in a search for yield.⁶ Empirical work is beginning to document this effect. For example, Jiménez, Ongena, Peydró, and Saurina (2014) use data on 23 million bank loans from the Spanish credit registry and find that a lower overnight policy rate induces low-capitalized banks to lend more to ex ante riskier firms and to require less collateral compared to high-capitalized banks, direct evidence of monetary policy’s effect on risk-taking.⁷

Thus, while I believe that, in most circumstances, the goals of monetary policy and financial stability are complementary, we need to recognize that, at times, actions taken to foster financial stability and those taken to promote our monetary policy goals might be in conflict, at least in the short run. In the U.K., the Financial Services Act recognizes this potential tradeoff and explicitly says that the Financial Policy Committee (FPC) is not authorized to act in a way that it feels is “likely to have a significant adverse effect on the capacity of the financial sector to contribute to the growth of the U.K. economy in the medium or long term.”⁸

In deciding whether to take action against a growing imbalance, policymakers need to balance the expected improvement in future economic conditions against the potential cost of unduly limiting credit extension. Too high a resiliency standard will thwart risk-taking and innovation, which will undermine longer-run economic growth. In setting the standard, we need to come to some common understanding about the amount of growth and prosperity we are willing to give up in order to lower the risk to financial stability. In the U.S., people who are 80 years old have lived through two major financial crises (the Great Depression and the 2008 crisis). Is that too many? Would we rather lower the probability of such an event to one every 1,000 years? What would we be willing to give up to do that?

That may be a premature question at this point. There are likely things that can be done and that are being done to lower the risk to financial stability without much cost in terms of longer-run growth. If we think of there being a risk-return frontier relating financial stability risk to the economic return that a well-functioning financial system can provide, then it isn’t hard to imagine that we were operating at a point well interior to that frontier in the run-up to the crisis, and that the improvements being made in our financial regulatory and supervisory regime are moving us toward the frontier without sacrificing growth.

Macroprudential Tools

To foster the resiliency of the financial system, regulators in the U.S. and throughout the world are developing macroprudential tools aimed at lowering the probability that instability will arise and to limit the damage when financial shocks do arise. Some tools focus on building up the structural resiliency of the financial system throughout the business cycle. In my view, these structural resiliency tools are the most promising. They include the Basel III risk-based capital requirements, minimum liquidity requirements, central clearing for derivatives, and bank stress tests. Living-will resolution plans and the Orderly Liquidation Authority, which is housed at the FDIC, are intended to make it easier for regulators and policymakers to allow large complex financial institutions to fail.

In addition to structural tools, there are countercyclical tools that aim to mitigate the systemic risk that can build up over the business cycle. These include the countercyclical capital buffer and the capital conservation buffer.⁹ Other possible cyclical tools, not yet established in the U.S. but used in other countries, include loan-to-value ratio limits and debt-to-income ratio limits that vary over the cycle and which have been targeted to particular sectors like housing credit or household credit.¹⁰

The performance of the set of macroprudential tools is largely untested. Cross-country studies find mixed results, with the effectiveness of the tools varying with economic circumstances and the types of shocks hitting the financial sector.¹¹ In the U.S., the need to coordinate countercyclical macroprudential policy actions across multiple regulators adds a complication to effectively using such tools in a timely way.

Currently, policymakers in the U.K. are putting one of the countercyclical tools to the test. The uncertainty arising from U.K. voters’ decision to exit the European Union has the potential to dampen economic performance in the U.K. In response, policymakers there have taken steps to ease credit conditions. One such step, taken by the Bank of England’s Financial Policy Committee (FPC), is a reduction in the countercyclical capital buffer rate for banks to zero percent from half of a percent of banks’ U.K. exposures, with the expectation that the zero percent rate will be maintained until at least June 2017.¹² This is a reduction in regulatory capital buffers by 5.7 billion pounds, which the FPC estimates will raise banks’ capacity to lend by as much as 150 billion pounds, or the equivalent of about $260 billion AUD, or about $190 billion USD. Usually, when one thinks about the use of the countercyclical tools it is to mitigate building financial stability risk by tightening credit conditions, but here is an example of the use of a macroprudential tool to ease credit conditions in support of monetary policy goals — an illustration of the nexus between monetary policy and financial stability policy.

Lessons from Monetary Policy for Financial Stability Policy

Another connection between the two stems from hard-won lessons learned from years of monetary policy-setting, lessons that can now be productively applied to financial stability policy-setting. Let me discuss two of these lessons. First, to the extent possible, policymakers should take a systematic approach in applying financial stability policy rather than relying on discretion. The financial crisis underscored the important role of incentives in financial markets — not only the incentives of financial institutions but also those of regulators and policymakers. Time-inconsistency problems and moral hazard issues are important factors that need to be considered when designing a framework for implementing financial stability policy. These types of problems argue for taking a systematic approach to such policymaking.

The benefits of systematic monetary policy are well established. When monetary policymakers respond in a systematic fashion to incoming information, the public will have a better sense of how policymakers are likely to react to economic developments — whether those developments are anticipated or unanticipated — so their policy expectations will better align with those of policymakers. This alignment helps the public make better financial and economic decisions, thereby making monetary policy more effective.

An additional benefit of a systematic approach is that it provides a mechanism through which policymakers can commit to policies aimed at promoting policy goals over the longer run. Being systematic can help alleviate time-inconsistency problems in monetary policy, whereby policymakers may favor the short run over the long run. Note that by systematic policy I do not mean that monetary policy will be set mechanically by a policy rule or that policymakers need to be prescient about the types of shocks that will hit the economy. Rather, I mean that policy will react in a systematic fashion to economic developments that change the economic outlook.

A systematic approach to financial stability policy is perhaps even more important than in the case of monetary policy because of the important role played by incentives. The crisis shined a bright light on significant moral hazard problems that exist in financial markets. A financial stability policymaker that is systematic in how it applies its tools to promote stability will likely help tame some of the moral hazard problems and also some of the time-inconsistency problems to which the regulators themselves are subject.

An important tool in this regard is the resolution of insolvent financial institutions. Without a credible resolution method, during the crisis in the face of serious distress at a large financial firm, governments faced a dilemma: either rescue the firm and create future moral hazard problems or let the firm fail and risk causing a cascade of other failures. The fact that policymakers had to make these decisions in the heat of the moment using their best judgment based on limited information didn’t help. Without a credible resolution method, it is reasonable to expect that even well-intentioned policymakers will be biased toward bailouts. A resolution method that can be applied systematically can help alleviate this problem. The living-will resolution plans and Orderly Liquidation Authority in the U.S. are promising, but still untested, tools in a process that will allow large firms to fail. This, in turn, provides incentives for these large, systemically important institutions to reorganize themselves in a way that reduces the risk they pose to the financial system.

As I mentioned, the Federal Reserve has become more systematic in monitoring risks across the financial system. Coupling that monitoring with the application of a resiliency standard across the entire financial services landscape, including the so-called shadow banking system that was less-heavily regulated in the past, would limit regulatory arbitrage. As the financial crisis made clear, taking an action that pushes risk from one set of institutions to another doesn’t eliminate the risk, it just moves it around, potentially to a part of the financial system where the risk is more difficult to monitor and control.¹³

I acknowledge that this broad application of the resiliency standard across the financial system may be particularly difficult in the U.S. with its complex regulatory structure. Still, we can devise ways to make the macroprudential tools more systematic and less discretionary. Regulators could agree in advance on the contingencies under which the cyclical macroprudential tools would be invoked, rather than waiting until the risks escalated before starting the process to coordinate action. For example, we can write down a formula for a countercyclical buffer, and we can define an explicit trigger for contingent convertible bonds. Knowing that such policies will be systematically applied and what will trigger them may induce financial market participants to limit the buildup of risks in the first place.

Another lesson we’ve learned from setting monetary policy — or perhaps, we are still learning it — is the importance of transparency and clear communication. In my view, to be effective, macroprudential policy actions must be communicated in a clear way to avoid creating a conflict with or causing confusion over actions taken to foster monetary policy goals. Transparency and clear communication are hallmarks of best-practice monetary policymaking. Clear communication helps align the public’s policy expectations, which makes monetary policy more effective. Transparency is necessary so that the public and elected officials have the ability to hold monetary policymakers accountable for their decisions. The Federal Reserve has been given independence in setting monetary policy, which has been well documented as yielding more effective policy and better economic outcomes. But accountability must go hand-in-hand with independence. So the Federal Reserve regularly communicates the basis for its policy decisions.

A parallel can be drawn with financial stability policy. Although, in some cases, prudential supervisory information should be kept private, as a general principle, I think financial stability policymakers should strive for greater transparency and more disclosure. Similarly, they should require more disclosure from financial firms so that creditors and other market participants can exert market discipline.

Of course, clear communication is easier said than done. Three aspects make this even harder for financial stability policy than for monetary policy. First, the framework and tools of financial stability policy are new. It will take considerable effort on the part of the financial stability policymakers to explain the tools they are using and the rationale for their policy decisions. However, such communication is necessary so that the public understands when an action is being taken because of concerns about financial stability rather than concerns about monetary policy goals. This would be particularly true when the monetary policy authority is also responsible for taking financial stability actions, and if monetary policy were the tool used to address the financial stability concerns. It is worth considering whether separating decisions about financial stability from decisions about monetary policy within the central bank, perhaps by having separate committees as in the U.K., could aid communication and decision-making.¹⁴

A second complication in effective communication of financial stability policy is timing. If effective monetary policy means taking away the punch bowl just as the party gets going, then effective financial stability policy might mean taking away the punch bowl before the guests have even arrived because the seeds of financial instability are sown much earlier and action must be taken earlier as well. If the need for monetary policy to be forward looking is a difficult concept for the public to grasp, the need for financial stability policy to act well before there are clear signs of instability may be even more difficult to explain.

Yet a third complication in effective communication is the complexity of the financial regulatory regime itself.¹⁵ In my view, a sometimes overlooked lesson from the crisis is that regulatory complexity can complicate supervision, risk monitoring, compliance, and enforcement. Given the scope and ever-changing nature of the financial system, regulatory complexity is, to a certain extent, unavoidable. But the tradeoffs should be recognized. For example, it is reasonable to require banks to hold higher levels of capital against higher-risk assets, but a system of risk weights that is overly granular and complex would be counterproductive. In practice, too much complexity would make it harder for regulators to assess compliance and to determine whether institutions were engaging in some practices merely as a way to hide risk and lower their capital requirements. If regulators have made the rules so complex that they cannot assess compliance, then, in practice, there are no consequences for firms that fail to meet the standards. Complexity also makes it difficult to monitor the monitors. It might be worth exploring whether we would be better off with a much simpler macro- and microprudential supervisory structure, one that is easier to implement and simpler to govern and that is approximately right across various economic models and states of the world even if it is never optimal in any particular model or state.

Of course, we aren’t in that simpler regime. So the question is, given the current financial structure in the U.S., how should policy respond to emerging financial stability risks and what role should monetary policy play?

Monetary Policy and Financial Stability Risks

I do not believe financial stability should be added to the Fed’s statutory monetary policy goals of price stability and maximum employment. But U.S. monetary policymakers need to remain cognizant of the linkages between financial stability and our monetary policy goals. In my view, the first line of defense against financial instability involves the tools that will make the structure of the financial system less prone to crisis. These structural resiliency tools include higher capital standards (including a minimum non-risk-based leverage ratio, as well as risk-based capital standards), liquidity standards, stress tests, living wills, and effective resolution methods for systemically important bank and nonbank financial institutions. Much work has been done to develop these structural resiliency tools, and I believe the system is in a better position to handle shocks now than it was before the financial crisis.

Countercyclical macroprudential tools, such as limits on loan-to-value ratios in particular markets, are worth further study, but at this point, I am not convinced that we have enough knowledge and experience with them to use them effectively in the U.S. That consideration leads me to think that we should set standards for the structural resiliency tools somewhat higher than they would be if we had more confidence in the countercyclical tools.

What about using monetary policy to combat heightened financial stability risks? As I’ve discussed, monetary policy and financial stability goals and actions are interrelated. Very loose monetary policy increases the likelihood that financial instabilities will develop, thereby increasing the likelihood that macroprudential policy tools will be needed. Tight macroprudential policy can tighten financial conditions more generally, thereby increasing the likelihood that a monetary policy response will be needed.

That said, in my view, U.S monetary policy should remain focused on promoting price stability and maximum employment, and financial stability should not be added as a third objective for monetary policy. First, it isn’t clear that monetary policy would be very effective against emerging financial stability risks. While interest rates affect the fundamental value of assets, it is not clear that they affect the speculative or bubble portion; the impact may depend on the underlying nature of the financial imbalance.¹⁶ Second, monetary policy tends to be a blunt instrument, so any benefits of using it to stem financial imbalances, mispricing of assets, or excessive leverage need to be weighed against the economic costs in terms of price stability and employment. Svensson (2016) brings some metrics to the question and concludes that the costs outweigh the benefits.¹⁷

While I don’t believe financial stability should be part of the Fed’s monetary policy mandate, monetary policymakers need to be aware of the linkages between our monetary policy actions and financial stability. In the case of the housing market, which precipitated the last crisis, policymakers underestimated the breadth and depth of the negative impact this would have on the rest of the economy and financial system. To the extent that we misjudged the impact, there is a larger potential gain to carefully monitoring financial market conditions, implementing the structural macroprudential tools, and being open to taking offsetting action should imbalances develop.¹⁸

If our macroprudential tools proved to be inadequate and financial stability risks continued to grow, I believe monetary policy should be on the table as a possible defense. However, in this case, the blurring between financial stability goals and monetary policy goals would be high: if we assessed the risks to financial stability to be sufficiently great, achieving our dual mandate monetary policy goals would also be in jeopardy. Which brings me back to my original point: in most cases, the goals of price stability, maximum employment, and financial stability are complementary.

Conclusion

Let me conclude by noting that in his 2015 presidential address to the American Finance Association, Luigi Zingales (2015) posed the question, “Does Finance Benefit Society?” While academics, and, I believe, central bankers, typically say “yes,” a recent survey indicates that the average American is much less certain.¹⁹ I am hopeful that the considerable efforts underway across the globe will change that. I believe it is our responsibility to ensure that we create and maintain a financial system that the public views as being beneficial, and one that truly is.