Tag: Federal Reserve

Dodd-Frank At Five

Fed Reserve Governor Lael Brainard speech “Dodd-Frank at Five: Looking Back and Looking Forward” provides an excellent summary of the state of play of US banking regulation. In short, much done, much still to do.

If there is one simple lesson from the crisis that we all can embrace, it is that no financial institution in America should be so big or complex that its failure would put the financial system at risk. Congress wrote that simple lesson into law as a core principle of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).

Consequently, a fundamental change in our framework of regulation as a result of the crisis is to impose tougher rules on banking organizations that are so big or complex that their risk taking and distress could pose risks to financial stability. Whereas previously, our regulatory framework took a homogeneous approach focused narrowly on the safety and soundness of an institution, the reforms underway take a tailored approach to also address the risks posed by an institution to the safety and soundness of the system.

Five years on, it is an opportune time to ask how far along we are in accomplishing that basic imperative. I would argue we are at a pivotal moment when many of the key requirements that apply differentially to the biggest and most complex institutions will be finalized and their impact will become clear.

In the immediate wake of the crisis, the central focus was to reduce leverage and build capital across the banking system while also addressing risks in derivatives and short-term wholesale funding markets. For instance, considerable effort went into the new Basel III capital framework, whose key elements apply across the entire banking system. With these important foundations laid, attention turned to the tougher standards for institutions whose size and complexity are such that their distress could pose risks to the system as a whole.

Tailoring Standards for Greater Systemic Risk
The Dodd-Frank Act requires the Board to adopt enhanced prudential standards for large banking organizations, as well as for nonbank financial companies that have been designated as systemically important, and to tailor the standards so that their stringency increases in proportion to the systemic footprint of the institutions to which they apply. In addition, rigorous planning and operational readiness for recovery and resolution are required to ensure that big, complex institutions are subject to the same market discipline of failure as other normal companies in America.

Within this framework, the first line of defense is to require big, complex institutions to maintain a very substantial stack of common equity in order to enhance loss absorbency and to induce the institutions to internalize the associated risks to the system. These requirements are designed to lower their probability of “material financial distress or failure” in order “to prevent or mitigate risks to the financial stability of the United States.

The proposed capital surcharge is the regulatory requirement that is most clearly calibrated to the size and complexity of an institution. Last December, the Board proposed a framework of risk-based capital surcharges for the eight U.S. banking organizations identified as global systemically important banks by the Financial Stability Board. The capital surcharges under the proposal are estimated to range from 1.0 percent to 4.5 percent of risk-weighted assets based on 2013 data. The capital surcharge would be required over and above the 7 percent minimum and capital conservation buffer required for all banking organizations under Basel III, and in addition to any countercyclical capital buffer.

The capital surcharge is designed to build additional resilience and lessen the chances of an institution’s failure in proportion to the risks posed by the institution to the financial system and broader economy. The surcharge is calibrated so that the expected costs to the system from the failure of a systemic banking institution are equal to the expected costs from the failure of a sizeable but not-systemic banking organization. In other words, if the failure of a systemic banking institution would have five times the system-wide costs as the failure of a sizeable but not-systemic banking organization, the systemic banking institution would be required to hold enough additional capital that the probability of its failure would be one-fifth as high. The capital surcharge should help ensure that the senior management and the boards of the largest, most complex institutions take into account the risks their activities pose to the system.

Importantly, the surcharge is calibrated in proportion to how an institution scores on specific metrics that capture the system-wide costs of its failure–risks associated with size, interconnectedness, complexity, cross-border activities, substitutability, and short-term wholesale funding. With respect to the last, the logic is that greater reliance on short-term wholesale funding increases the risks of creditor runs and asset fire sales that can both erode the institution’s capital and spark contagion. By calibrating the enhanced capital expectation in direct proportion to a set of measures of size, interconnectedness, and complexity, the proposal provides clear and measurable incentives for institutions to simplify and reduce their systemic footprint.

Second, the crisis also provided a stark reminder that what may seem like thick capital cushions in good times may prove dangerously thin at moments of stress, when losses soar and asset valuations plummet. Therefore, in addition to static capital requirements, large banking institutions must undergo the forward-looking Comprehensive Capital Analysis and Review (CCAR) and supervisory stress test each year to assess whether the amount of capital they hold is sufficient to continue operations through periods of economic stress and market turbulence, and whether their capital planning framework is adequate to their risk profile.

While supervisory stress tests with adverse and severely adverse macroeconomic scenarios are required by statute for all bank holding companies with assets over $50 billion, for the eight U.S. systemic banking institutions, the stress tests are tailored to include a counterparty default scenario, and, for the six systemic institutions with significant trading activities, the stress tests also include a global market shock. In significant part as a result of these additional requirements, in 2015, the eight systemic institutions needed to hold common equity worth 4.7 percent of risk-weighted assets on average above the 7 percent minimum and capital conservation buffer in order to meet the CCAR post-stress minimum requirement, given their planned capital distributions. That’s more than twice the average common equity increment above the regulatory capital minimum plus capital conservation buffer required of the next largest group of banks, those with $250 billion or more in assets that are not globally systemic.

In addition to the quantitative assessments, CCAR provides a powerful process for assessing the quality of each institution’s risk modeling and internal controls on a portfolio by portfolio basis. This is particularly important for institutions where the sheer size and complexity of their activities make it very challenging for even the highest-quality senior executives to effectively monitor and control risk.

The CCAR and stress test exercises provide valuable, forward-looking mechanisms to ensure that large banking institutions can meet their minimum capital ratios through the cycle. For the systemic banking institutions, it will be important to assess incorporating the risk-based capital surcharge in some form into the CCAR post-stress minimum in order to ensure these institutions remain sufficiently resilient to reduce the expected losses to the system through periods of financial and economic stress. Conceptually, the stress test and the capital surcharge should work to reinforce each other–not to substitute for each other.

Third, as we learned from the crisis, risk modeling and risk weighting are subject to considerable uncertainty, and stressed financial markets can make even the most rigorous risk assessments look optimistic in hindsight. Thus, the Basel III capital framework includes a simple, non-risk-adjusted ceiling on leverage that is designed not to bind under most circumstances while providing a robust cushion as a backstop. Although all internationally active U.S. banking organizations are subject to a 3 percent leverage standard that takes into account on- and off-balance sheet exposures under Basel III,6 our systemic banking institutions are required to meet a higher 5 percent leverage standard. The higher leverage standard for the systemic banking institutions is designed as a backstop to the surcharge-enhanced risk-based capital standard, reflecting the higher potential losses to the system from the failure of systemic institutions.

Fourth, in addition to the surcharge, regulatory minimum, and capital conservation buffer, starting in 2016 and phasing in through 2019, the U.S. banking agencies could require the largest, most complex U.S. banking firms to hold a countercyclical capital buffer of up to 2.5 percent of risk-weighted assets when it is warranted by rising macroprudential risks.

In sum, if the tailored capital framework that is under construction had been in place in 2007, the largest, most complex banking institutions could have been required to hold common equity of up to 14 percent of risk-weighted assets on average, which is roughly double the amount of common equity they held at the time.

Fifth, the crisis shined a harsh light on the severe inadequacies in the banking system not only in capital, but also with respect to liquidity risk management. At key moments of financial stress, run-like behavior in the short-term funding markets threatened the solvency of some large, complex banking organizations and compelled them to engage in asset fire sales. As part of the enhanced prudential standards mandated under the Dodd-Frank Act and Basel III liquidity reforms, large banking organizations are now required to maintain substantial buffers of high-quality liquid assets calibrated to their funding needs in stressed financial conditions. They are also required to maintain certain amounts of stable funding based on the liquidity characteristics of their assets.

As with assessments of capital, supervisors also evaluate liquidity at the largest firms in annual horizontal exercises called the Comprehensive Liquidity Analysis and Review (CLAR). In part because of these measures, the total amount of high-quality liquid assets held by the eight U.S. systemic banking institutions has increased by over 60 percent, or $1 trillion, since 2011 to $2.4 trillion currently. And whereas these institutions were materially more reliant on short-term wholesale funding than deposits before the crisis, now the reverse is the case.

Finally, the structure of incentive compensation also came under scrutiny post-crisis with the recognition that the heavy emphasis on stock options and bonuses created skewed incentives that provided substantial rewards for short-term risk taking going into the crisis. The logic of imposing tougher standards on large and complex institutions whose activities could pose risks to the broader financial system extends to requiring better alignment of the incentives of senior executives and senior risk managers with the longer-term fortunes of their banking institutions. Most simply, this calls for a greater share of compensation to be deferred for several years. Under the proposal issued by the Board and other federal financial regulatory agencies in 2011 to implement section 956 of the Dodd-Frank Act, at least 50 percent of incentive compensation of certain executive officers at financial institutions with total consolidated assets of $50 billion or more would have to be deferred over a period of at least three years, and the deferred amounts would need to be adjusted for actual losses that are realized during the deferral period.

Beyond this, for systemic banking institutions, I would like to see consideration given to changing the structure of deferred compensation so that it better balances the interests of the full set of the firm’s stakeholders over the longer term. In particular, when evaluating risky activities, senior executives should internalize not only the upside risk faced by stockholders, but also the downside risk borne by bondholders, especially as that better aligns with the public interest in reducing the likelihood of material financial distress or failure at the systemic banking institutions.9 This set of considerations should help to inform ongoing deliberations regarding implementation the Dodd-Frank Act incentive compensation provisions.

Making Failure Safe
You can see now why I argue we are reaching a key moment in our efforts to build a more resilient financial system. In combination, these more stringent standards, several of which are still in train, should prove powerful in inducing systemic banking institutions to reduce the risks they pose to the system. Beyond this, Congress sought to address too big to fail by requiring systemic institutions to plan and prepare for failure, and by creating a new “orderly liquidation authority.” Under section 165(d) of the Dodd-Frank Act, large bank holding companies are required to submit credible plans for their rapid and orderly resolution under the U.S. Bankruptcy Code. In addition, the orderly liquidation authority created under title II of the Dodd-Frank Act empowers the U.S. government to put a failing systemic banking institution into a governmental resolution procedure as an alternative to resolution under the Bankruptcy Code.

The resolution planning process provides regulators with an important tool to address too big to fail. And we have set the bar realistically high, reflecting lessons from the crisis in the requirements that large banking institutions must meet to ensure their plans and preparations are not deemed to be deficient by the regulators.11

Earlier this month, the eight U.S. systemic banking institutions submitted their most recent resolution plans, which are currently under review. Each of the submissions must provide detailed work plans in several specific areas that have been found to be critical for orderly resolution.

First, an orderly resolution requires that the large, complex firms simplify and rationalize their structures to align their legal entities with business lines and reduce the web of interdependencies among them to ensure separability along business lines. As the crisis made clear, the tangled web of thousands of interconnected legal entities that were allowed to proliferate in the run up to the crisis stymied orderly wind down and contributed to uncertainty and contagion.

Second, the largest, most complex banking organizations must demonstrate operational capabilities for resolution preparedness.  These capabilities include maintaining an ongoing, comprehensive understanding of the obligations and exposures associated with payment, clearing, and settlement activities across all the material legal entities and developing strong processes for managing, identifying, and valuing collateral across all the material legal entities. Capabilities for resolution preparedness also include establishing mechanisms to ensure that there would be adequate capital, liquidity, and funding available to each material legal entity under stressed market conditions to facilitate orderly resolution.

These steps, in turn, hinge on each institution demonstrating the requisite management information systems capabilities to ensure that key data related to each material legal entity’s financial condition, financial and operational interconnectedness, and third-party commitments is readily accessible on a real-time basis.

Fourth, the largest, most complex banking organizations are required to develop robust operational and legal frameworks to ensure continuity in the provision of shared or outsourced services to maintain critical operations during the resolution process.

Fifth, the largest, most complex banking organizations are in the process of amending financial contracts to provide for a stay of early termination rights of external counterparties, recognizing that the triggering of cross-default provisions proved to be a major accelerant of contagion at the height of the crisis and greatly impeded cross border cooperation.

Sixth, the largest, most complex banking organizations are required to develop a clean top-tier holding company structure, in which the parent’s obligations are not supported by guarantees provided by operating subsidiaries, to support resolvability. This will be critical for any institution pursuing the single point of entry strategy.

In addition, the publicly disclosed summary of each institution’s plan is required to include information on the strategy for resolving each material legal entity and what an institution would look like following resolution in order to bolster public and market confidence that resolution would be orderly.

We look forward to assessing the plans submitted earlier this month, which we expect to demonstrate concrete progress on the detailed feedback that was provided by the regulators over the past year. In parallel, Board supervision staff have been engaged in an extensive horizontal review of the operational readiness of the systemic banking institutions on several dimensions of the resolution planning that were detailed in earlier supervisory guidance. Together, the annual plan submissions along with the ongoing supervisory examination of operational readiness provide potent, complementary mechanisms in addressing too big to fail.

Finally, in order to make the firms resolvable, it will be necessary for the largest, most complex firms to maintain enough long-term debt at the top-tier holding company that could be converted into equity to recapitalize the institution’s critical operating subsidiaries so as to prevent contagion. The availability of sufficient capacity at the parent to both absorb losses and recapitalize the critical operating subsidiaries is designed to provide comfort to other creditors of the firm and thereby forestall destructive runs, since the long-term unsecured debt issued by the parent holding company would be structurally subordinate to the claims on the operating subsidiaries. We are in the process of developing a proposal for a long-term debt requirement that would fully address the estimated capital needs of each institution in a gone-concern scenario.

Scale and Scope
Having provided a detailed assessment of the measures Congress chose to require in order to address too big to fail, it is worth spending a minute reflecting on what Congress chose not to require in the Dodd-Frank Act. In particular, it is noteworthy that Congress did not prescribe major changes to scope or scale of systemic institutions in the too-big-to-fail toolkit.

One rationale is that the public sector on its own is unlikely to be the best judge of the optimal scope and scale of financial institutions. While the private sector may be in a better position to judge the market benefits associated with economies of scope and scale and business models associated with particular banking organizations, the public sector is likely to be a better judge of the risks that their size, interconnectedness, and complexity pose to the financial system. Accordingly, the Dodd-Frank Act assigns regulators the responsibility for calibrating requirements such that investors, senior executives, and board members internalize those risks.

Notwithstanding the fact that the law does not prescribe broad structural changes, some observers may judge whether reform has gone far enough based on the extent of changes in the scope or scale of the U.S. systemic banking institutions relative to the crisis. These eight banking institutions now hold $10.6 trillion in total assets and account for 57 percent of total assets in the U.S. banking system today–not materially different from the $9.4 trillion and 60 percent of total assets in 2009. And while some of the U.S. systemic banking institutions have reduced their capital markets activity, they remain the largest dealers in those markets.

To be fair, we are entering an important period when the more stringent standards that we are putting in place to reduce expected losses to the system should inform the cost-benefit analysis of these institutions’ size and structure. As standards for systemically important firms tighten, some institutions may determine that it is in the best interest of their stakeholders to reduce their systemic footprint. Indeed, there already have been some notable structural changes at a few of the largest institutions over the past few years that are not readily apparent from looking at the aggregate assets across the systemic institutions. But it is also possible that some may judge that the economies of scale and scope are such that it makes sense to maintain their systemic footprint, even at the expense of the greater regulatory burdens necessary to protect the system relative to those faced by their non-systemic competitors.

One thing we can all agree is that we have a more resilient and dynamic financial system as a result of having a very large number of banking organizations, in different size classes, pursuing different business models. Indeed, that diversity is one of the hallmarks of the U.S. system, which distinguishes it from many other advanced economies. Accordingly, we want to make sure that our regulatory framework supports banks in the middle of the size spectrum, as well as community banks, and the customers they serve. Thus, by the same rationale that argues for the greater stringency of the standards associated with greater systemic risk at the top end of the scale and complexity spectrum, we will carefully examine opportunities to ease burdens at the lower end of the spectrum. And we will want to continue to refine our regulatory standards, using the authorities under Dodd-Frank to make sure they are tailored to be commensurate with the risk to the system.

Supervisory Stress Testing of Large Systemic Financial Institutions – The Fed

Interesting speech by Fed Vice Chairman Fischer on supervisory stress testing of large systemic financial institutions.

Stress testing has become a cornerstone of a new approach to regulation and supervision of the largest financial institutions in the United States. The Federal Reserve’s first supervisory stress test was the Supervisory Capital Assessment Program, known as the SCAP. Conducted in 2009 during the depths of the financial crisis, the SCAP marked the first time the U.S. bank regulatory agencies had conducted a supervisory stress test simultaneously across the largest banking firms. The results clearly demonstrated the value of simultaneous, forward-looking supervisory assessments of capital adequacy under stressed conditions. The SCAP was also a key contributor to the relatively rapid restoration of the financial health of the U.S. banking system.

The Fed’s approach to stress testing of the largest and most systemic financial institutions has evolved since the SCAP, but several key elements persist to this day. These elements include, first, supervisory stress scenarios applicable to all firms; second, defined consequences for firms deemed to be insufficiently capitalized; and third, public disclosure of the results.

The Fed has subsequently conducted five stress test exercises that built on the success of SCAP, while making some important improvements to the stress test processes. The first key innovation was the development of supervisory models and processes that allow the Fed to evaluate independently whether banks are sufficiently resilient to continue to lend to consumers and to businesses under adverse economic and financial conditions. This innovation took place over the course of several exercises and was made possible by the extensive collection of data from the banks. These data have allowed supervisors to build models that are more sensitive to stress scenarios and better define the riskiness of the firms’ different businesses and exposures.

The second innovation since the SCAP was the use of the supervisory stress test as a key input into the annual supervisory evaluation of capital adequacy at the largest bank holding companies. The crisis demonstrated the importance of forward-looking supervision that accounted for the possibility of negative outcomes. By focusing on forward-looking post-stress capital ratios, stress testing provides an assessment of a firm’s capital adequacy that is complementary to regulatory capital ratios, which reflect the firm’s performance to date. Although we view this new approach to capital assessment as a significant improvement over previous practices, we are aware that the true test of this new regime will come only if another period of significant financial or economic stress were to materialize–which is to say that we will not have a strong test of the effectiveness of stress testing until the stress tests undergo a real world stress test. The same comment, mutatis mutandis, applies to the overall changes in methods of bank regulation and supervision made since September 15, 2008.

Third, supervisory stress testing has been on the leading edge of a movement toward greater supervisory transparency. Since the SCAP, the Fed has steadily increased the transparency around its stress testing processes, methodologies, and results. Before the crisis, releasing unfavorable supervisory information about particular firms was unthinkable–for fear of setting off runs on banks. However, the release of the SCAP results helped to calm markets during the crisis by reducing uncertainty about firm solvency. Indeed, only one of the 10 firms deemed to have a capital shortfall was unable to close the identified gap on the private markets. Our experience to date has been that transparency around the stress testing exercise improves the credibility of the exercise and creates accountability both for firms and supervisors. That said, too much transparency can also have potentially negative consequences, an idea to which I will turn shortly.

With the benefit of five years of experience, the Fed is continuing to assess its stress testing program, and to make appropriate changes. Examples of such changes to date include the assumption of default by each firm’s largest counterparty and the assumption that firms would not curtail lending to consumers and businesses, even under severely adverse conditions. As part of that assessment process, we are also currently seeking feedback from the industry, market analysts, and academics about the program.

Supervisory stress testing is not a static exercise and must adapt to a changing economic and financial environment and must incorporate innovations in modeling technology. Work is currently underway on adapting the stress testing framework to accommodate firms that have not traditionally been subject to these tests. The Dodd-Frank Act requires the Fed to conduct stress tests on non-bank financial institutions that have been designated as systemically important by the FSOC–the Financial Stability Oversight Council. Three of the currently designated financial institutions are global insurance companies. While distress at these firms poses risks to financial stability, particularly during a stressful period, certain sources of risk to these firms are distinct from the risks banking organizations face. A key aspect of this ongoing work includes adapting our current stress testing framework and scenarios to ensure that the tests for non-bank SIFIs–systemically important financial institutions–are appropriate.

Another area where work continues–and will likely always continue–is the Fed’s ongoing research aimed at improving our ability to estimate losses and revenues under stress. Supervisors have both to develop new approaches that push the state of the art in stress testing and to respond as new modeling techniques are developed or as firm activities and risk concentrations evolve over time. For example, forecasting how a particular bank’s revenue may respond to a severe macroeconomic recession can be challenging, and we continue to seek ways to enhance our ability to do so.

Supervisory stress testing models and methodologies have to evolve over time in order to better capture salient emerging risks to financial firms and the system as a whole. However, the framework cannot simply be expanded to include more and more aspects of reality. For example, incorporating feedback from financial system distress to the real economy is a complex and difficult modelling challenge. Whether we recognize it or not, the standard solution to a complex modeling challenge is to simplify–typically to the minimum extent possible–aspects of the overall modelling framework. However, incorporating feedback into the stress test framework may require simplifying aspects of the framework to a point where it is less able to capture the risks to individual institutions. Even so, one can imagine substantial gains from continued research on stress testing’s role in macroprudential supervision and our understanding of risks to the financial system, such as knock-on effects, contagion, fire sales, and the interaction between capital and liquidity during a crisis.

Finally, let me close by addressing a question that often arises about the use of a supervisory stress test, such as those conducted by the Fed, with common scenarios and models. Such a test may create the possibility of, in former Chairman Bernanke’s words, a “model monoculture,” in which all models are similar and all miss the same key risks. Such a culture could possibly create vulnerabilities in the financial system. At the Fed we try to address this issue, in part, through appropriate disclosure about the supervisory stress test. We have published information about the overall framework employed in various aspects of the supervisory stress test, but not the full details that banks could use to manage to the test. This–making it easier to game the test–is the potential negative consequence of transparency that I alluded to earlier.

We also value different approaches for designing scenarios and conducting stress tests. In the United States, in addition to supervisory stress testing, large financial firms are required to conduct their own stress tests, using their own models and stress scenarios that capture their unique risks. In evaluating each bank’s capital planning process, supervisors focus on how well banks’ internal scenarios and models capture their unique risks and business models. We expect firms to determine the risks inherent to their businesses, their risk-appetite, and to make business decisions on that basis.

US Industrial Production Wobbles

According to the FED, industrial production decreased 0.2 percent in May after falling 0.5 percent in April. The decline in April was larger than previously reported, but the rates of change for previous months were generally revised higher, leaving the level of the index in April slightly above its initial estimate. Manufacturing output decreased 0.2 percent in May and was little changed, on net, from its level in January. In May, the index for mining moved down 0.3 percent after declining more than 1 percent per month, on average, in the previous four months. The slower rate of decrease for mining output last month was due in part to a reduced pace of decline in the index for oil and gas well drilling and servicing. The output of utilities increased 0.2 percent in May. At 105.1 percent of its 2007 average, total industrial production in May was 1.4 percent above its year-earlier level. Capacity utilization for the industrial sector decreased 0.2 percentage point in May to 78.1 percent, a rate that is 2.0 percentage points below its long-run (1972–2014) average.

Probably not enough negative news to hold off on interest rates rises in the US later in the year, but was enough to drive the markets lower overnight.

US Economic Outlook and Monetary Policy

A speech by Governor Lael Brainard at the Center for Strategic and International Studies, Washington, D.C. on “The U.S. Economic Outlook and Implications for Monetary Policy” suggests that whilst the US economic outlook is patchy, interest rates will rise.

This spring marks the end of the Federal Reserve’s calendar-based forward guidance and the return to full data dependency in the setting of the federal funds rate. So it is notable that just as policymaking is becoming more anchored in meeting-by-meeting assessments of the data, the data are presenting a mixed picture that lends itself to materially different readings.

No doubt, bad weather, port disruptions, and statistical issues are responsible for some of the softness in first-quarter indicators of aggregate spending. Indeed, it may be that the dismal estimate by the Bureau of Economic Analysis of the annualized change in first-quarter gross domestic product (GDP), negative 0.7 percent, is principally an extension of the pattern, seen for several years, of significantly slower measured GDP growth in the first quarter followed by considerably stronger readings during the remainder of the year. In that case, it would be appropriate to minimize the importance of the first-quarter estimate in judging the likely path of the economy over the remainder of the year.

But there may be reasons not to ignore the recent readings entirely. First, the limited data in hand pertaining to the second quarter do not suggest a significant bounceback in aggregate spending, which we would expect if all of the weakness in the first quarter were due to transitory factors. Private-sector forecasts of second-quarter growth are centered around 2-1/2 percent, while the Federal Reserve Bank of Atlanta’s GDPNow forecast, which was quite accurate in its prediction of the first estimate of first-quarter GDP growth, is projecting second-quarter GDP growth of only 0.8 percent.

Second, it would not be the first time this recovery has proceeded in fits and starts. The underlying momentum of the recovery has proven relatively susceptible to successive headwinds, which have kept overall economic growth well below the average pace of previous upturns.

My own reading is that earlier, more optimistic growth projections may have placed too much weight on the boost to spending from lower energy prices and too little weight on the negative implications for aggregate demand of the significant increase in the foreign exchange value of the dollar and large decline in the price of crude oil.

Based on today’s picture of moderate underlying momentum in the domestic economy and the likelihood of continued crosscurrents from abroad, the process of normalizing monetary policy is likely to be gradual. It is also important to remember that the stance of monetary policy will remain highly accommodative even after the federal funds rate moves off the effective lower bound, because the real federal funds rate will initially still be low and because of the elevated size of the Federal Reserve’s balance sheet and the associated downward pressure on long-term rates. Moreover, the FOMC has stated clearly that it will reduce the size of the balance sheet in a gradual and predictable manner starting at an appropriate time after liftoff, which will depend on how economic and financial conditions evolve.

In summary, the string of soft data in the first quarter raises some questions about the contours of the outlook. While it is possible that residual seasonality and temporary factors were responsible, it would be difficult, based on the data available today, to dismiss the possibility of a more significant drag on the economy than anticipated from foreign crosscurrents and the negative effects of the oil price decline, along with a more cautious U.S. consumer. This possibility argues for giving the data some more time to confirm further improvement in the labor market and firming of inflation toward our 2 percent target. But while the case for liftoff may not be immediate, it is coming into clearer view. When that time comes, the policy path will be highly attuned to incoming data and not on a preset course, and it is important to be mindful of the possibility of volatility as markets adjust to a change in the stance of policy. Thus, the FOMC will continue communicating as clearly as possible regarding the outlook and the factors underlying its policy determinations.

Five Lessons From Financial Crises

Fed Vice Chairman Stanley Fischer spoke at the International Monetary Conference, Toronto, Canada “What have we learned from the crises of the last 20 years?”

Lesson T1: Monetary policy at the Zero Lower Bound. Before the Great Recession, textbooks used to say that once the central bank interest rate had reached zero, monetary policy could not be made more expansionary–otherwise known as the liquidity trap. The argument was that the central bank could not reduce the interest rate below zero, since at a zero interest rate people could hold currency, on which the nominal interest rate is zero–which implies that the nominal interest rate could not decline below zero.

Almost immediately after the collapse of Lehman Brothers, the Fed began to undertake policies of Quantitative Easing (QE), in two forms: first, by buying assets of longer duration on a large scale, thus lowering longer term rates and making monetary policy effectively more expansionary; and second, by operating as market maker of last resort in markets that in the panic had seemed to stop working–for example, the commercial paper market.

Did these policies work? The econometric evidence says yes. So does the evidence of one’s eyes. For instance, the recent inauguration of the ECB’s QE policy seemed to have an immediate effect not only on European interest rates, but also on longer-term rates in the United States.

More recently, policymakers in several jurisdictions have discovered that zero is not the lower bound on interest rates. The reason is that it is not costless to hold currency: there are costs of storage, and insurance costs to cover the potential for theft of or damage to the currency. We do not know how low the interest rate can go–but do know that it can go below zero. Whether it can be reduced much below minus one percent remains to be seen–and many would prefer that we don’t go there.

Lesson T2: Monetary policy in normal times. In normal times, monetary policy should continue to be targeted at inflation and at output or employment. Typically, central bank laws also include some mention of financial stability as a responsibility of the central bank. At this stage the institutional arrangements under which different central banks exercise their financial stability mandate vary across countries, and depend to a considerable extent on the tools that the central bank has at its command. It will take time for the advantages and disadvantages of different arrangements to be evaluated and recommendations on what works best to be developed. On paper, the British approach of setting up nearly parallel committees for monetary policy and for macroprudential financial supervision and regulation appears to be a leading model.

Another issue that remains to be settled is that of the possible use of monetary policy, i.e. the interest rate, to deal with financial stability. For instance, for some time several economists–including those working at the BIS–have been urging an increase in the interest rate to restore risk premia to more normal levels. Most central bankers say they would prefer to use macroprudential tools rather than the interest rate for this purpose. While such tools would have the advantage of being directly targeted at the problem that is to be solved, it is not clear that there are sufficiently strong macroprudential tools to deal with all financial instability problems, and it would make sense not to rule out the possible use of the interest rate for this purpose, particularly when other tools appear to be lacking.

Lesson T3: Active fiscal policy. There is a great deal of evidence that fiscal policy works well, almost everywhere, perhaps especially well when the interest rate is at its effective lower bound. Because the lags with which fiscal policy affects the economy may be relatively long (particularly the “decision lag”, the lag between a situation developing in which fiscal policy should become more expansionary and the decision to undertake such a policy), automatic stabilizers can play an important stabilizing role.

Another important fiscal policy discussion is currently taking place in the United States. Infrastructure in the United States has been deteriorating, and government borrowing costs are exceptionally low. Many economists argue that this is a time at which fiscal policy can be made more expansionary at low real cost, by borrowing to finance a program to strengthen the physical infrastructure of the American economy. This would mean a temporary increase in the budget deficit while the spending takes place. That spending would have positive benefits–both an increase in aggregate demand as the infrastructure is built, and later an increase in aggregate supply as the positive impact of the increase in the capital stock due to the investment in infrastructure comes into effect–that under current circumstances would outweigh the costs of its financing.

More generally, the case for more expansionary fiscal policy has always to take into account the consequences of greater debt on future interest rates and on the flexibility of future fiscal policy. In this regard, government intervention to save banks has in some countries resulted in massive increases in the size of the government debt as a share of GDP, as in Ireland at the start of the Great Financial Crisis, when the Irish government stepped in to guarantee bank liabilities. This process is aptly known as a “doom loop”.

Lesson T4: The lender of last resort, TBTF, and moral hazard. The role of the central bank as lender of last resort is a central theme in Walter Bagehot’s 1873 classic on central banking, Lombard Street. The case for the central bank to be the lender of last resort is clear in the case of a liquidity crisis–one that arises from a temporary shortage of liquidity, typically in a financial panic–but less so in the case of solvency crises.

In principle the distinction between liquidity and solvency problems should guide the actions of the central bank and the government in a financial crisis. But in a crisis, the distinction between illiquidity and insolvency is rarely clear-cut–and whether a company goes bankrupt will depend on how the authorities respond to the crisis.

Further, one has to be clear about which aspects of government actions are critical in this regard. If a firm is bankrupt, it may well be optimal for the firm to continue to operate while being reorganized, as typically happens in bankruptcies. In such a case, in which the firm’s capital is negative, the ownership of the bankrupt firm should be changed–unless the owners succeed in mobilizing more capital, in which case the company was probably not bankrupt.

If the government is dealing with a bank, or other financial institution, with an extremely large balance sheet and multiple interactions with the rest of the financial system, putting the firm into bankruptcy without a plan to continue its most important activities from the viewpoint of the financial system and the economy, may induce a financial and economic crisis of the order of magnitude that followed the Lehman bankruptcy.

This is where the moral hazard issue arises. If the owners of a company are saved by official actions in circumstances where the company would otherwise have gone bankrupt, it will appear that the government is saving Wall Street at the expense of Main Street. One may argue that saving financial institutions would be good for Main Street. The lender of last resort may well be producing a result that is better for everyone in the economy when it intervenes in a financial crisis. But since the counterfactuals are difficult to establish, and the moral hazard argument is easy to deploy, the public sector may shy away from acting as lender of last resort except in extremis.

Hence the phenomenon of too big to fail. If policymakers reach a point at which they confront a choice between allowing a large and/or systemically interconnected bank to fail without their having reasonable assurance that its essential activities will continue, they may well step in to “save” the financial institution. By “save”, I mean, allow the bank to continue to exist and to carry out the functions that are needed to prevent a financial crisis. It is essential to emphasize that this requires a resolution process that does not, and should not, preclude actions to ensure that equity and bond holders lose all or most of the value of their assets, to an extent that depends on circumstances. And the ability to do this depends on the resolution processes for insolvent financial institutions. In this context, the progress that has been made since 2008 in developing effective resolution mechanisms will play a key role in dealing with the too big to fail problem by significantly reducing the probability of a bank being too big to fail.

This is a good point at which to turn to the regulation and supervision of the financial system.

Lesson T5: Regulation and supervision of the financial system. The natural and sensible reaction to the problem that the central bank and the government face when the dark clouds of a massive financial crisis appear on the horizon, is to make two sets of decisions. The first relates to its immediate actions and the short run, where the goal should be to intervene in a way that prevents the massive crisis, at minimum future cost to the economy and the society. The second is for the longer run, to rebuild the financial system in such a way that the probability of having to confront such a situation again is reduced to a very low level. Hence regulations should be strengthened, essentially as they have been recently, through the activities of governments, legislators, and regulators in most countries. In the case of the United States, most of the important changes have been introduced though the Dodd-Frank Act, and they have been supplemented by decisions of the regulators and the supervisors.

We are now at a difficult point. Regulations have been strengthened and the bankers’ backlash is both evident and making headway. Of course, there should be feedback from the regulated to the regulators, and the regulated have the right to appeal to their legislators. But often when bankers complain about regulations, they give the impression that financial crises are now a thing of the past, and furthermore in many cases, that they played no role in the previous crisis.

We should not make the mistake of believing that we have put an end to financial crises. We can strengthen the financial system, and reduce the frequency and the severity of financial crises. But we lack the capacity of imagining, anticipating and preventing all future financial sector problems and crises. That given, we need to build a financial system that is strong enough to withstand the type of financial crisis we continue to battle. We can take some comfort–but not much–from the fact that this crisis was handled much better than the financial crisis of the Great Depression. But it still imposed massive costs on the people of the United States and those of other countries that were badly hit by the crisis.

No-one should underestimate the costs of the financial crisis to the United States and the world economies. We are in the seventh year of dealing with the consequences of that crisis, and the world economy is still growing very slowly. Confidence in the financial system and the growth of the economy has been profoundly shaken. There is a lively discussion going on at present as to whether we have entered a period of secular stagnation as Larry Summers argues, or whether we are seeing a more frequent phenomenon–that recessions accompanied by financial crises are typically deep and long, as Carmen Reinhart and Ken Rogoff’s research implies. Ken Rogoff calls this a “debt supercycle”.

It may take many years until we know the answer to the question of whether we are in a situation of secular stagnation or a debt supercycle. Either way, there is now growing evidence that recessions lead not only to a lower level of future output, but also to a persistently lower growth rate. Some argue that it was the growth slowdown that caused the financial crisis. This is a hard position to accept for anyone who has looked closely at the behavior of the financial system in the middle of the last decade.

We need to remind ourselves that the principle underlying Basel II was that the private sector would manage risk efficiently and effectively, since the last thing a bank would want would be to fail. That did not work out as predicted. A possible reason is that incentives are misaligned. One sees massive fines being imposed on banks. One does not see the individuals who were responsible for some of the worst aspects of bank behavior, for example in the Libor and foreign exchange scandals, being punished severely. Individuals should be punished for any misconduct they personally engaged in.

One reason we should worry about future crises is that successful reforms can breed complacency about risks. To the extent that the new regulatory and supervisory framework succeeds in making the financial system more stable, participants in the system will begin to believe that the world is more stable, that we suffered a once in a century crisis, and that the problems that led to it have been solved. And that will cause them to take more risks, to exercise less caution, and eventually, to forget the seriousness of the problems we are confronting today and will confront in the future.

Economic Well-Being of U.S. Households – Fed Survey

The Federal Reserve Board’s latest survey of the financial and economic conditions of American households released Wednesday finds that individuals’ overall perceptions of financial well-being improved modestly between 2013 and 2014 but their optimism about future financial prospects increased significantly.

The 2014 Survey of Household Economics and Decisionmaking, provides new insight into Americans’ economic security, housing and living arrangements, banking and credit access, education and student loan debt, savings behavior, and retirement preparedness. Sixty-five percent of adult respondents consider their families to be either “doing okay” or “living comfortably” financially–an increase of 3 percentage points from the 2013 survey.

Looking forward, households are increasingly optimistic. Twenty-nine percent of survey respondents say they expect their income to be higher in the year following the survey, compared to 21 percent of 2013 respondents.

The survey results reveal a lack of economic preparedness among many adults. Only 53 percent of respondents indicate that they could cover a hypothetical emergency expense costing $400 without selling something or borrowing money. Thirty-one percent of respondents report going without some form of medical care in the past year because they could not afford it.

The outlook for the housing market among surveyed homeowners remained generally positive, as 43 percent believe that their house increased in value over the past year and 39 percent expect home values in their neighborhood to rise in the coming year. Many renters also express an interest in buying but report financial barriers to homeownership, with half of all renters listing an inability to afford a down payment as a reason why they rent rather than own and 31 percent citing an inability to qualify for a mortgage as a reason for renting.

Twenty-three percent of the adult population has some form of education debt, according to the survey. However, this debt is not exclusively student loans. Fourteen percent of those with education debt say that some of that debt is on credit cards. Individuals who did not complete an associate or bachelor’s degree, first generation students, blacks and Hispanics, and those who attended for-profit institutions, are all disproportionately likely to be behind on repaying their student loan debt.

Recognizing the importance of degree completion to many outcomes, the survey explores why some individuals leave college without a degree. Family responsibilities is the most common reason, and was cited by 38 percent of all respondents who dropped out and by just less than half of women younger than 45.

The survey results also suggest that many individuals are not adequately prepared for retirement. Thirty-one percent of non-retirees have no retirement savings or pension, including nearly a quarter of those older than 45. Even among individuals who are saving, fewer than half of adults with self-directed retirement savings are mostly or very confident in their ability to make the right investment decisions when managing their retirement savings.

Consistent with a lack of preparedness for retirement, 38 percent of non-retired respondents say that they either do not plan to retire or plan to keep working as long as possible. Among lower-income respondents, whose household income is less than $40,000 per year, 55 percent plan to keep working as long as possible or never plan to retire.

The survey was conducted on behalf of the Board in October and November 2014. More than 5,800 respondents completed the survey. The report summarizing the survey’s key findings may be found at: http://www.federalreserve.gov/communitydev/shed.htm

The Fed and the Global Economy

Stanley Fischer, Vice Chairman, Board of Governors of the Federal Reserve System gave a speech entitled “The Federal Reserve and the Global Economy“. He discusses aspects of our global connectedness,  spillovers from the United States to foreign economies and the effect of foreign economies on the United States.

In a progressively integrating world economy and financial system, a central bank cannot ignore developments beyond its country’s borders, and the Fed is no exception. This is true even though the Fed’s statutory objectives are defined as specific goals for the U.S. economy. In particular, the Federal Reserve’s objectives are given by its dual mandate to pursue maximum sustainable employment and price stability, and our policy decisions are targeted to achieve these dual objectives. Hence, at first blush, it may seem that there is little need for Fed policymakers to pay attention to developments outside the United States.

But such an inference would be incorrect. The state of the U.S. economy is significantly affected by the state of the world economy. A wide range of foreign shocks affect U.S. domestic spending, production, prices, and financial conditions. To anticipate how these shocks affect the U.S. economy, the Federal Reserve devotes significant resources to monitoring developments in foreign economies, including emerging market economies (EMEs), which account for an increasingly important share of global growth. The most recent available data show 47 percent of total U.S. exports going to EME destinations. And of course, actions taken by the Federal Reserve influence economic conditions abroad. Because these international effects in turn spill back on the evolution of the U.S. economy, we cannot make sensible monetary policy choices without taking them into account.

The Fed’s statutory objectives are defined by its dual mandate to pursue maximum sustainable employment and price stability in the U.S. economy. But the U.S. economy and the economies of the rest of the world have important feedback effects on each other. To make coherent policy choices, we have to take these feedback effects into account. The most important contribution that U.S. policymakers can make to the health of the world economy is to keep our own house in order–and the same goes for all countries. Because the dollar is the primary international currency, we have, in the past, had to take action–particularly in times of global economic crisis–to maintain order in international capital markets, such as the central bank liquidity swap lines extended during the global financial crisis. In that case, we were acting in accordance with our dual mandate, in the interest of the U.S. economy, by taking actions that also benefit the world economy. Going forward, we will continue to be guided by those same principles.

Chair Yellen Says US Rates Will Rise, Slowly

 In a speech by Fed Chair Janet L. Yellen at the Providence Chamber of Commerce, Providence, Rhode Island, she outlined the state of play of the US economy. Whilst there are mixed signals, she affirmed that rates will begin to rise later this year.

Implications for Monetary Policy
Given this economic outlook and the attendant uncertainty, how is monetary policy likely to evolve over the next few years? Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner. Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.

For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.

After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain. If conditions develop as my colleagues and I expect, then the FOMC’s objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.

Having said that, I should stress that the actual course of policy will be determined by incoming data and what that reveals about the economy. We have no intention of embarking on a preset course of increases in the federal funds rate after the initial increase. Rather, we will adjust monetary policy in response to developments in economic activity and inflation as they occur. If conditions improve more rapidly than expected, it may be appropriate to raise interest rates more quickly; conversely, the pace of normalization may be slower if conditions turn out to be less favorable.

Federal Reserve Minutes From April Suggest Rates US Rates Will Be Lower For Longer

From the Fed: Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors. The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed. Growth in household spending declined; households’ real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment re-mains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined. Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommo-dation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual man-date. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 per-cent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissi-pate. The Committee continues to monitor inflation developments closely.

To support continued progress toward maxi-mum employment and price stability, the Committee today reaffirmed its view that the current 0 to ¼ percent target range for the federal funds rate remains appropriate. In de-termining how long to maintain this target range, the Committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2 percent inflation. This assessment will take into ac-count a wide range of information, including measures of labor market conditions, indica-tors of inflation pressures and inflation expec-tations, and readings on financial and interna-tional developments. The Committee antici-pates that it will be appropriate to raise the  target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that infla-tion will move back to its 2 percent objective over the medium term.

The Committee is maintaining its existing pol-icy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. When the Committee decides to begin to re-move policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run

Federal Reserve Fines Six Major Banking Organisations $1.8 billion For Rigging FX Markets

The Federal Reserve on Wednesday announced it will impose fines totaling more than $1.8 billion against six major banking organizations for their unsafe and unsound practices in the foreign exchange (FX) markets. The fines, among the largest ever assessed by the Federal Reserve, include: $342 million each for UBS AG, Barclays Bank PLC, Citigroup Inc., and JPMorgan Chase & Co.; $274 million for Royal Bank of Scotland PLC (RBS); and $205 million for Bank of America Corporation. The Federal Reserve also issued cease and desist orders requiring the firms to improve their policies and procedures for oversight and controls over activities in the wholesale FX and similar types of markets.

The Federal Reserve is requiring the firms to correct deficiencies in their oversight and internal controls over traders who buy and sell U.S. dollars and foreign currencies for the organizations’ own accounts and for customers. As a result of these deficient policies and procedures, the organizations engaged in unsafe and unsound conduct by failing to detect and address improper actions by their traders. These actions included the disclosure in electronic chatrooms of confidential customer information to traders at other organizations. Five of the banks failed to detect and address illegal agreements among traders to manipulate benchmark currency prices. Bank of America failed to detect and address conduct by traders who discussed the possibility of entering into similar agreements to manipulate prices. In addition, the Federal Reserve found UBS, Citigroup, JPMorgan Chase, and Barclays engaged in unsafe and unsound conduct in FX sales, including conduct relating to how the organizations disclosed to customers the methods for determining price quotes.

The Federal Reserve is requiring the six organizations to improve their senior management oversight, internal controls, risk management, and internal audit policies and procedures for their FX activities and for similar kinds of trading activities and is requiring four of the organizations to improve controls over their sales practices. The Federal Reserve is also requiring all six organizations to cooperate in its investigation of the individuals involved in the conduct underlying these enforcement actions and is prohibiting the organizations from re-employing or otherwise engaging individuals who were involved in unsafe and unsound conduct.

The Federal Reserve is taking action against UBS, Barclays, Citigroup, JPMorgan Chase, and RBS concurrently with the Department of Justice’s criminal charges against these five organizations related to misconduct in the FX markets. Bank of America was not part of the actions taken by the Department of Justice and has not been charged by the Department of Justice in this matter.

The Connecticut Department of Banking has joined the cease and desist provisions of the Federal Reserve’s action against UBS, which has a branch located in Stamford, Connecticut. The New York Department of Financial Services has taken a separate action against Barclays and its New York branch based on FX-related conduct.