Regional President Speech

Oce of the President Money Museum Last Updated: 120109 The International Financial Crisis: Asset Price Exuberance and Macroprudential Regulation 2009 International Banking Conference Chicago, IL Thank you, Justin I'm Charlie Evans, President and CEO of the Federal Reserve Bank of Chicago On behalf of the World Bank and everyone here at the Chicago Fed, it's my pleasure to welcome you to the 12th annual International Banking Conference Over the years, this conference has served as a valuable forum for the discussion of current issues aecting global nancial markets, such as international regulatory structures, the globalization of nancial markets, systemic risk, and the problems involved with the resolution of large, globally active banks Also, we have been fortunate to have leading academics, regulators, and industry executives participate in the various venues—providing valuable perspectives and enriching the discussions on the issues This year's theme is the international nancial crisis If you look back at the past conferences, you will see that the most common theme over the years deals with various aspects of nancial crises After looking over this year's program, I want to compliment the organizers from both the World Bank and the Chicago Fed for putting together a very impressive group of experts in the current debate on how best to reduce the probability of another nancial crisis, and, if one should occur, how to respond I look forward to the next two days and believe you will nd the discussion cutting edge and useful for deciding how we as a global nancial community should move forward Again, on behalf of the World Bank and the Federal Reserve Bank of Chicago, enjoy the 12th annual International Banking Conference Before I turn the podium over to Doug, I'd like to oer a few remarks on the theme of this year's conference—nancial crisis— with an emphasis on the oversight of nancial markets I should note that my remarks reect my own views and are not those of the Federal Open Market Committee or the Federal Reserve System When thinking about the events of the past couple of years, what comes to mind most often, or the big "take away" from all of this, is that we don't ever want to nd ourselves in this situation again If we are committed to that outcome, we should ask ourselves, rst, how can policies be changed so that in the future, it will be much less likely that systemically important nancial institutions will nd themselves in crisis situations? And, second, if such crises do occur, how can we best contain them, preventing them from having a major impact on the rest of the economy as in the recent crisis? Surely, prevention should form our rst and strongest line of defense and remedial, or containment, policies should form the second I recently gave a speech to the European Economic and Financial Center on the issues associated with too-big-to-fail I argued that in the current regulatory environment it is unrealistic to expect that regulators would allow the uncontrolled failure of a large, complicated, and interconnected nancial institution—certainly not if they had the ability to avoid it and if there were systemic ramications to the failure If you accept this premise, and I believe the failure of Lehman Brothers is the counterexample that proves it, then it becomes imperative to construct an environment that prevents our economic and nancial system from again reaching the crisis state we have seen over this past year In my earlier speech I stressed the need for policy reforms, such as the introduction of an orderly and ecient failure resolution process that would create a credible regulatory environment in which rms and their creditors would not expect rescues or bailouts This would reduce the moral hazard issues associated with the too-big-to-fail perception It also would better align the incentives of the stakeholders of nancial rms with those of society at large In addition it would allow a larger role for nancial markets to oversee and regulate rm behavior However, even though I think we can signicantly strengthen the role of market discipline, regulation will continue to play a very important role in ensuring nancial stability The kinds of events that lead to our recent interventions inevitably occur during periods of nancial exuberance One way or another, asset prices rise beyond conservative fundamental valuations and risk premiums fall well below appropriate compensation levels We typically use the loose term "asset price bubble" to describe such situations Although I will continue that tradition, we should keep in mind that not all increases in asset prices represent departures from fundamentals, and not all 1 asset bubbles need be disruptive Denitions aside, it seems clear that we need to nd a way to deal with potential exuberance in nancial markets if we want to ensure nancial stability Some seven years ago, at an earlier International Banking Conference, which was also cosponsored by the World Bank, we 2 discussed the implications of asset bubbles The typical view expressed at the conference, which aligned well with much of the research literature at the time, was that central banks should not use monetary policy tools to "manage" or lean against the inated prices associated with asset bubbles In the event of a sudden collapse in asset prices, central banks were expected to respond with their standard policy tools to address any adverse impact on real economic activity In other words, monetary 3 policy should be prepared to "clean up" ex post rather than try to prevent ex ante a run-up in asset prices However, given the enormous costs of the recent nancial crisis, as well as new research suggesting an increase in the 4 frequency and amplitude of asset price cycles, many commentators are reassessing the proper role of the central bank in monitoring and trying to deate rising asset prices In reevaluating the eectiveness of monetary policy for this purpose, two approaches are typically considered One is for the central bank to take an activist role and directly incorporate asset price uctuations into its monetary policy deliberations—that is, explicitly putting asset prices into the policy response function and "leaning against the wind" As an alternative, policymakers could incorporate asset prices into the price indexes used in determining the future direction of monetary policy While recent events have indeed imposed signicant costs on society, I fear that monetary policy tools may be too blunt for 5 such a ne-tuning policy Central bankers have imperfect information, and for many asset classes, sudden price declines may 6 have minimal impact on the real economy So, my concern is that using monetary policy to "lean against bubbles" could end up causing more harm to the economy than good To elaborate a bit, taking an activist role would likely have policy aim at explicitly hitting some target range for asset prices or risk premiums So, we would rst have to determine those target ranges I don't know of any economic theory or empirical evidence we currently have in hand that would give us adequate guidance here In addition, there is the "bluntness" of monetary policy Using wide-reaching monetary policy to slow the growth of certain asset prices could have signicant adverse eects on other sectors of the economy In normal times, we use our policy instrument, the short-term federal funds rate, to try to achieve our dual mandate goals of maximum sustainable employment and price stability Adding a third target—asset prices— would likely mean we couldn't do as well on the other two The desirability of incorporating asset prices into the ination measures targeted by central banks is also not obvious Some claim that standard consumer price indexes do not adequately incorporate inationary expectations; rather, they only account for past price adjustments Certain asset prices, for example, those of equities or real estate, may better incorporate such expectations Thus, some argue that to the extent these asset prices are predictors of future price changes, including them in the target price indexes provides a reasonable operating procedure that leans against rising asset prices and adds an automatic stabilizer to monetary policy One potential issue with this argument is whether real estate or equity market prices accurately forecast future ination rates A bigger question, however, is how to operationalize such an index What weights should be assigned to asset prices in the aggregate indexes? Index number theory provides the conceptual linkage between utility maximization and the expenditure weights used to construct consumer price indexes I have not yet seen the theoretical work that says how to include asset prices in an aggregate index I am open-minded to new research making the case for using monetary policy to address asset ination 7 But as of now, I am skeptical Fortunately, monetary policy is not the only tool that central banks have to deal with asset price swings and their potentially disruptive consequences In my view, redesigning regulations and improving market infrastructure oer more promising paths to increased nancial stability This is the "prevention" that forms the rst line of defense in our eorts to never be in this position again Regulation may or may not be sucient to avoid all of the market events that help to create excessive exuberance, but it should play a very large role in controlling the existence, size, and consequences of any bubble For example, research suggests that a crisis caused by sudden declines in asset prices is less disruptive to markets when nancial systems and 8 individual bank balance sheets are in sound condition before the crisis Better supervision and a sound regulatory infrastructure can increase the resiliency of markets and institutions, enabling them to better withstand adverse shocks How do we promote such increased resiliency? First, we can make more eective use of our existing regulatory structure, tools, and authority And second, a number of reforms of our current infrastructure—both market and regulatory—may help us to better address the type of problems we saw emerge during the recent crisis Within the existing structure, regulators have the ability to promote better, more resilient nancial markets, either through 9 rule-making or by serving as a coordinator of private initiatives They can also encourage more and better disclosure of information—a key element of eective risk management Regulators and supervisors are also often in positions to foresee emerging problems before they grow into crises Along these lines, supervisors can do more "horizontal supervision," similar to the Supervisory Capital Assessment Program SCAP that was designed for the largest 19 US banks Using procedures similar to those in SCAP, the likely performance of banks can be evaluated on a consistent basis under alternative stress scenarios In addition to evaluating resiliency to future conditions, this type of "stress test" also enables supervisors to identify best practices in risk management and to push banks with weak risk 10 management to improve When emerging issues or practices that could lead to disruptions are identied, regulators can more eectively use tools such 11 as memorandums of understanding or supervisory directives to dampen the adverse impact of a variety of nancial shocks Indeed, we probably should have been more aggressive in utilizing this supervisory power during the period leading up to the recent crisis It can be an eective and powerful tool Although I believe we can use existing regulatory tools more eectively, we may also need to address the shortcomings of 12 current regulations Already policymakers in the US and elsewhere are exploring a variety of reforms Introducing a systemic regulator who can identify, monitor, and collate information on industry practices across various institutions tops most of the reform agendas While plans for systemic regulation vary in the structures they propose—for example, a single regulator versus a committee of regulators—they all envision macroprudential supervision and regulation as the key mandate of the new regulator This would be a major component of what I called our rst line of defense Reform proposals also typically include ways in which we can make capital requirements more dynamic and tailor them to the type of risks an institution poses for the nancial system Varying capital requirements and loan loss provisions over the cycle are examples of these proposals History shows that during boom times, when nancial institutions are perhaps in an exuberant state, they may not price risks fully in their underwriting and risk-management decisions During downturns, faced with eroding capital cushions, increased uncertainty, and binding capital constraints, some institutions may become overcautious and excessively tighten lending standards Both behaviors tend to amplify the business cycle Allowing the required capital ratio to vary over the cycle could serve to oset some of this volatility and to partially oset the boom–bust trends we have seen in the past Varying loan loss provisions over the cycle is an alternative or complementary way to better cushion rms against sudden declines in asset prices Capital requirements also could be adjusted by extending risk-based weighting schemes to account for institutions' contributions to systemic risk This could involve higher risk weights based on factors such as institution size and the extent of o-balance-sheet activities It might also include some assessment of the degree to which the institution was interconnected with others Such adjustments to capital requirements would make the decisions of nancial institutions more closely reect their impact on society The information needed to account for the new risk factors—for example, the degree of interconnectedness—ts well within the framework of information that would be required by a new systemic regulator, and is now being considered in regulatory reform proposals in the US So, in order to fortify our rst line of defense, we must make more eective use of the existing regulatory structure and tools, introduce a systemic risk regulator, and reform capital requirements to make them more dynamic and tailored to systemic risks But adjustments to the current regulations and infrastructure alone are probably not enough We also need to fortify our second line of defense—containing the disruptive spillovers that result from the failure of systemically important institutions without resorting to bailouts or ad hoc rescues A necessary element of this is having a mechanism for resolving the failure of a systemically important institution This is something we currently lack in many cases, though there are proposals now under 13 discussion that would provide this resolution power Another reform proposal that I think can play an important role in the resolution process of systemically important institutions is what is typically referred to as a "shelf bankruptcy" plan Under this proposal, systemically important institutions would be required to provide the information necessary to determine how their failures could be handled in a relatively short period of 14 time, as well as to design a plan to eciently implement such a resolution I see a number of ways these plans can fortify both our rst and second lines of defense Requiring systemically important institutions to identify and think through their organizational structure and interactions with various parties can improve the risk-management practices of their institutions By developing plans to address systemic problem areas ex ante, the need for an ex post "too-big-to-fail" action could be reduced In addition, should the rst line of defense fail, these plans could provide an initial blueprint for the resolution of large interconnected institutions and, in so doing, improve our second line of defense Currently, individual institutions may not 15 have an incentive to make such plans—after all, they would bear the costs of the planning and see little of the benets But, society as a whole would benet from such contingency planning Another way to cushion nancial rms against sudden asset 16 price declines would be to require them to hold contingent capital Under these proposals, systemically important banks would be required to issue "contingent capital certicates" These would be issued as debt securities that would be converted 17 into equity shares if some predetermined threshold was breached It would provide rms with an additional equity injection at the very time that equity would be dicult to issue, thus enabling rms to better withstand sudden shocks and potential spillover eects These new policy options, while not easy to implement, would enhance the ability of banks and other nancial intermediaries to survive shocks—whether from a sudden fall in asset prices or from some other source I am fully aware that the challenges in reforming regulatory structures and practices are not insignicant But, given the magnitude of the cost incurred in the wake of the recent crisis and the possible benets that would arise from making our economy more resilient to such events, it is imperative that we take on these challenges Thus, I think we need to strengthen our existing regulatory infrastructure and give strong consideration to making the adjustments that could reduce the likelihood of a crisis similar in magnitude to the one we have seen over the past two years We also need to devise mechanisms to dampen the adverse eects of any disruption that might occur This year, as in others, this conference invites us to examine and discuss nancial crises and asks whether the rules of nance have changed I've argued that in order to avoid a situation like the one we have faced in the past two years; we need to fortify our regulatory lines of defense We need to have the rules of regulation change Not necessarily through more regulation, but through better regulation that is more ecient and eective in its design and implementation I hope this conference serves as a platform to inform your thinking and stimulate good debate about the issues I've laid out Thank you Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily reect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System 1 Evidence of the disagreement concerning what constitutes an asset bubble can be found in Peter M Garber, 2000, Famous First Bubbles: The Fundamentals of Early Manias, Cambridge, MA: MIT Press, and Ellen McGrattan and Edward Prescott, 2003, "Testing for stock market overvaluationundervaluation," in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, William C Hunter, George G Kaufman, and Michael Pomerleano eds, Cambridge, MA: MIT Press 2 See William C Hunter, George G Kaufman, and Michael Pomerleano eds, 2003, Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, Cambridge, MA: MIT Press hereafter HKP 3 See Ben Bernanke and Mark Gertler, 2001, "Should central banks respond to movements in asset prices?," American Economic Review, Vol 91, No 2, May, pp 253–257; Ben Bernanke, Mark Gertler, and Simon Gilchrist, 1999, "The nancial accelerator in a quantitative business cycle framework," in Handbook of Macroeconomics, Vol1C, John Taylor and Michael Woodford eds, New York: Elsevier Science-North Holland, pp 1341–1393 A quick aside, it should be emphasized that policymakers do currently take asset bubbles into account to the extent that they aect the real sector of the economy Thus, it is not a question of whether policymakers address bubbles At issue is whether they should or can address asset price increases ex ante to avoid a resulting sudden decline in prices that more adversely aects the real economy than would have occurred without the bubble 4 For example, see Randall Kroszner, 2003, "Asset price bubbles, information, and public policy," in HKP, pp 3–12; and Claudio Borio and Philip Lowe, 2003, "Imbalances or bubbles? Implications for monetary and nancial stability," in HKP, pp 247–263 5 There is broad literature on this issue See: Friedman, Goodfriend, Meltzer, Mishkin and White, Mussa, and Trichet, in HKP 2003; Kroszner 2003 previously cited in footnote 4; Bernanke, Gertler, and Gilchrist 1999; Bernanke and Gertler 2001 previously cited in footnote 3; Frederic S Mishkin 2008, "How should we respond to asset price bubbles?," speech to the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, the Wharton School of the University of Pennsylvania: and Janet L Yellen 2009, "A Minsky meltdown: Lessons for central bankers," speech at the 18th Annual Hyman P Minsky Conference on the State of the US and World Economies—"Meeting the Challenges of the Financial Crisis," Bard College, New York City, April 16 6 See Mishkin in footnote 5 Mishkin makes the argument that not all bubbles have the same impact on the real economy In particular, he argues that bubbles associated with credit booms are more dangerous because they put the nancial system at risk and may result in negative spillover eects for the real economy Thus, these bubbles may deserve a more activist approach 7 For an alternative discussion of potential problems, see Trichet 2003 in footnote 5 8 See Frederic Mishkin and Eugene White, 2003, "US stock market crashes and their aftermath: Implications for monetary policy," in HKP, pp 53–76 9 An example here would be the central bank serving a coordinative role encouraging banks to address operational risks associated with back-oce operations in credit default swap contracts 10 For a further discussion of SCAP, see Daniel K Tarullo, 2009, "Bank supervision," testimony before the US Senate, Committee on Banking, Housing, and Urban Aairs, Washington, DC, August 4 11 For example, memorandums could have addressed the rising role of commercial real estate in bank portfolios, or they could have addressed practices in mortgage lending that may have contributed to poor underwriting 12 See US Department of the Treasury, 2009, "Financial regulatory reform—A new foundation: Rebuilding nancial supervision and regulation," proposal, Washington, DC, June 17, available online I have previously discussed these policy issues in somewhat more detail: see Charles Evans, 2009, "Too-big-to-fail: A problem too big to ignore," speech to the European Economics and Financial Center, London, July 1 Also see the Squam Lake Working Group proposals, available at Squam Lake Working Group proposals 13 See US Department of the Treasury 2009 14 See Raghuram Rajan, 2009, "Too systemic to fail: Consequences and potential remedies," presented at the Proceedings of a Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago, May; and see the Squam Lake Working Group proposals, available at Squam Lake Working Group proposals 15 Not only would the banks not see the benets of disclosing this information, they could actually benet from keeping this information from the supervisors The more opaque the operations and risk of institutions, the more likely they could be considered too-big-to-fail if they encounter diculties Thus, the "shelf plan" could force these issues to be on the table for discussion 16 See Mark Flannery, 2005, "No pain, no gain? Eecting market discipline via reverse convertible debentures," in Capital Adequacy Beyond Basel: Banking, Securities, and Insurance, Hal S Scott ed, Oxford: Oxford University Press, chapter 5; see also the Squam Lake Working Group on Financial Regulation, Squam Lake Working Group proposals, available at Squam Lake Working Group on Financial Regulation 17 This would be somewhat similar to previous proposals to require banks to hold subordinated debt to better discipline bank behavior and to be able to absorb losses when diculties are encountered See Douglas Evano and Larry Wall, 2000, "Subordinated debt as bank capital: A proposal for regulatory reform," Economic Perspectives, Federal Reserve Bank of Chicago, Vol 24, No, 2, Second Quarter, pp 40–53 However, the convertibility of the new instrument would most likely occur when the bank is better capitalized, thus augmenting equity capital and providing an earlier cushion against losses The trigger to convert the debt would most likely also be supervisory instead of market induced

Charles L. Evans (2009, September 23). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090924_charles_l_evans

@misc{wtfs_regional_speeche_20090924_charles_l_evans,
  author = {Charles L. Evans},
  title = {Regional President Speech},
  year = {2009},
  month = {Sep},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20090924_charles_l_evans},
  note = {Retrieved via When the Fed Speaks corpus}
}