‘Financial Stability Monitoring’

In order to stabilize the financial system, there are two recommendations that I would definitely make. One is to reduce the chance of runs in the shadow banking system — a key factor behind the financial crisis. As noted below, the Dodd-Frank Act “does not address structural problems in wholesale short-term funding markets, such as the susceptibility of money market funds to investor runs or the inherent fragility of repo markets.” Regulators have been working on fixes for this problem, but it’s not fixed yet and that should be a bit more alarming than it seems to be.

The other change is to develop a better early warning system for financial crises. Dean Baker would say just call me, but I’d like to go beyond that and develop new tools, statistics, etc. that can help us do a better job of identifying risks before they become destructively large. I won’t be satisfied with the excuse that we can’t predict bubbles reliably until we have done the work of trying to find better leading indicators for problems.

Those two changes are far from exhaustive, reducing leverage, for example, should be on the list as well. But they are key issues that need to be addressed and it’s nice to see that the Fed recognizes this and is trying to develop a “broad and forward-looking monitoring program” (the problem of bank runs in the shadow banking system isn’t directly addressed, the idea is to prevent problems through early detection coupled with a policy response to relieve the pressure in the market).

Before moving on to the paper, given recent developments surrounding the work of Reinhart and Rogoff, I should probably remind people of this:

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors.

Here’s the abstract and introduction (on the continuation page) to the preliminarypaper:

Financial Stability Monitoring, by Tobias Adrian, Daniel Covitz, and Nellie Liang, FRB Working PaperAbstract While the Dodd Frank Act (DFA) broadens the regulatory reach to reduce systemic risks to the U.S. financial system, it does not address some important risks that could migrate to or emanate from entities outside the federal safety net. At the same time, it limits the types of interventions by financial authorities to address systemic events when they occur. As a result, a broad and forward-looking monitoring program, which seeks to identify financial vulnerabilities and guide the development of pre-emptive policies to help mitigate them, is essential. Systemic vulnerabilities arise from market failures that can lead to excessive leverage, maturity transformation, interconnectedness, and complexity. These vulnerabilities, when hit by adverse shocks, can lead to fire sale dynamics, negative feedback loops, and inefficient contractions in the supply of credit. We present a framework that centers on the vulnerabilities that propagate adverse shocks, rather than shocks themselves, which are difficult to predict. Vulnerabilities can emerge in four areas: (1) systemically important financial institutions (SIFIs), (2) shadow banking, (3) asset markets, and (4) the nonfinancial sector. This framework also highlights how policies that reduce the likelihood of systemic crises may do so only by raising the cost of financial intermediation in non-crisis periods.

1. Introduction Systemic risk stems from market failures such as moral hazard, coordination failures, adverse selection, other information and agency problems, as well as behavioral biases. These market failures can lead to excessive risk taking, which makes the financial system susceptible to fire sales and an adverse feedback loop, and can result in a financial crisis when adverse shocks hit. Systemic financial crises occur when the financial sector’s ability to intermediate funding is impaired, leading to inefficient disruptions in real economic activity.

The Dodd Frank Act (DFA), passed in 2010, attempts to address market failures and the systemic risks they pose by strengthening the supervision and regulation of banking institutions and bringing some nonbank institutions under the regulatory umbrella. In addition, DFA addresses the moral hazard in the financial sector that might arise from expected government support in times of crisis by establishing a new resolution regime and putting new limits the government’s ability to support distressed financial institutions during a crisis.

However, DFA also has significant limitations. In particular, the new limits on the ability of the regulatory agencies to address systemic events ex post could increase the severity of financial crises that cannot be averted. In addition, DFA does not address structural problems in wholesale short-term funding markets, such as the susceptibility of money market funds to investor runs or the inherent fragility of repo markets. Moreover, DFA augments incentives for financial intermediation to move to what has been termed the shadow banking system, where maturity transformation takes place without public sector liquidity and credit backstops, and for the development of new innovative risk transformation products and strategies outside of regulatory oversight.

The higher standards for governmental interventions in crisis, the failure to eliminate known structural vulnerabilities, and incentives for risk-taking to move outside the regulated sector all point to a need for a regulatory and supervisory regime that implements policies preemptively to foster greater financial stability. A systemic risk monitoring program that is broad, flexible, and forward-looking is an essential element of that regime. Monitoring helps to measure the degree of vulnerability in the financial system and the extent to which shocks might trigger systemic events. A monitoring program that extends beyond institutions also is an important complement and input to effective supervision of regulated firms, as these firms are deeply interconnected to other parts of the financial system. Macroprudential policies are designed to reduce vulnerabilities to mitigate the amplification of negative shocks, and also to pre-position institutions so that they can absorb shocks.

To organize a broad and flexible monitoring program, we appeal to a stylized systemic risk framework. … This systemic risk framework is motivated by the research on leverage, maturity mismatch, and other amplification mechanisms through which an entity’s distress imposes externalities on others through fire sales and adverse feedback loops from interconnections, leverage, runs, contagion, and other coordination failures (see e.g., Geanakoplos (2003), Allen and Gale (2000), Adrian and Shin (2010a), Brunnermeier and Pedersen (2009), He and Krishnamurthy (2012a,b,c), and Adrian and Boyarchenko (2012)).

In our monitoring program, we look for vulnerabilities in four areas: (1) systemically important financial institutions, (2) shadow banking, (3) asset markets, and (4) the nonfinancial sector. The focus on vulnerabilities emphasizes that policymakers might be most effective by focusing their efforts on increasing the resilience of the financial sector to a set of possible shocks, rather than trying to predict the likelihood of particular shocks. This monitoring program is part of a broader effort to promote financial stability, which also involves better data collections, enhanced disclosures, and the meaningful implementation of macroprudential regulatory and supervisory policies designed to target building vulnerabilities and to pre-position the financial system to be better able to absorb shocks.

Financial stability monitoring is distinct from supervision because of its focus on the risks for the whole financial system, in both regulated and non-regulated institutions and markets. In contrast, supervisory monitoring primarily focuses on the financial conditions and risks of regulated firms. Macroeconomic monitoring, on the other hand, traditionally does not focus on the dynamics of the financial sector at all, but rather uses market prices and its effects on household and business spending to model macroeconomic activity. In contrast, financial stability monitoring explicitly links the behavior of financial institutions to financial market prices and risks, and explicitly analyzes the connections between the real and financial sectors. …

This piece is cross-posted from Economist’s View with permission.