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Yellen pushes back on deregulation with rousing defense of post-crisis rules

Joe Mont | August 30, 2017

President Trump has expressed openness to the idea of Janet Yellen, chairman of the Board of Governors of the Federal Reserve, continuing to serve in that capacity. He might be reconsidering after she delivered an impassioned defense of post-Financial Crisis rulemaking that flies in the face of the White House’s deregulatory agenda.

Yellen’s discussion of regulatory achievements came during an Aug. 25 speech, “Financial Stability a Decade after the Onset of the Crisis,” during a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming

“Because of the reforms that strengthened our financial system, and with support from monetary and other policies, credit is available on good terms, and lending has advanced broadly in line with economic activity in recent years, contributing to today's strong economy,” Yellen said. “At the same time, reforms have boosted the resilience of the financial system. Banks are safer. The risk of runs owing to maturity transformation is reduced. Efforts to enhance the resolvability of systemic firms have promoted market discipline and reduced the problem of too-big-to-fail. And a system is in place to more effectively monitor and address risks that arise outside the regulatory perimeter.”

The long period of economic stability beginning in the 1980s led to complacency about potential risks, and the buildup of risk was not widely recognized. “As a result, market and supervisory discipline was lacking, and financial institutions were allowed to take on high levels of leverage,” Yellen said of the run-up to the Financial Crisis on 2008. “Securitization and the development of complex derivatives products distributed risk across institutions in ways that were opaque and ultimately destabilizing.”

The result, once the crisis hit: “The United States, through coordinated regulatory action and legislation, moved very rapidly to begin reforming our financial system, and the speed with which our banking system returned to health provides evidence of the effectiveness of that strategy.”

“Moreover, U.S. leadership of global efforts through bodies such as the Basel Committee on Banking Supervision, the Financial Stability Board. and the Group of Twenty has contributed to the development of standards that promote financial stability around the world, thereby supporting global growth while protecting the U.S. financial system from adverse developments abroad.” Yellen added.

Several important reforms have increased the loss-absorbing capacity of global banks, she explained. The quantity and quality of capital required relative to risk-weighted assets have been increased substantially. A simple leverage ratio provides a backstop, reflecting the lesson imparted by past crises that risk weights are imperfect and a minimum amount of equity capital should fund a firm's total assets. Both the risk-weighted and simple leverage requirements are higher for the largest, most systemic firms, which lowers the risk of distress at such firms and encourages them to limit activities that could threaten financial stability.

Importantly, Yellen added, the largest U.S. banks participate in the annual Comprehensive Capital Analysis and Review stress tests.

“In addition to contributing to greater loss-absorbing capacity, the CCAR improves public understanding of risks at large banking firms, provides a forward-looking examination of firms' potential losses during severely adverse economic conditions, and has contributed to significant improvements in risk management,” she said. Reforms to money funds, spearheaded by the Securities and Exchange Commission, helped reduce banks' reliance on unsecured short-term wholesale funding, since prime institutional funds were significant investors in those bank liabilities.

Liquidity risk at large banks has been further mitigated by a new liquidity coverage ratio and a capital surcharge for global systemically important banks (G-SIBs). The liquidity coverage ratio requires that banks hold liquid assets to cover potential net cash outflows over a 30-day stress period. The capital surcharge for U.S. G-SIBs links the required level of capital for the largest banks to their reliance on short-term wholesale funding.

“While improvements in capital and liquidity regulation will limit the reemergence of the risks that grew substantially in the mid-2000s, the failure of Lehman Brothers demonstrated how the absence of an adequate resolution process for dealing with a failing systemic firm left policymakers with only the terrible choices of a bailout or allowing a destabilizing collapse,” Yellen said. In response, Congress adopted the orderly liquidation authority in Title II of the Dodd-Frank Act to provide an alternative resolution mechanism for systemically important firms to be used instead of bankruptcy proceedings when necessary to preserve financial stability.

Another important step, in Yellen’s opinion, was the Congress's creation of the Financial Stability Oversight Council. The council is responsible for identifying risks to financial stability and for designating those financial institutions that are systemically important and thus subject to prudential regulation by the Federal Reserve. “Both of these responsibilities are important to help guard against the risk that vulnerabilities outside the existing regulatory perimeter grow to levels that jeopardize financial stability,” she said

“The evidence shows that reforms since the crisis have made the financial system substantially safer,” Yellen said, later addressing debates over whether “this safer system” is supporting growth. Have reforms gone too far, resulting in a financial system that is too burdened to support prudent risk-taking and economic growth?

“The Federal Reserve is committed individually, and in coordination with other U.S. government agencies through forums such as the FSOC and internationally through bodies such as the Basel Committee on Banking Supervision and the FSB, to evaluating the effects of financial market regulations and considering appropriate adjustments,” she said. “Furthermore, the Federal Reserve has independently taken steps to evaluate potential adjustments to its regulatory and supervisory practices.”

Striking a cautious note, Yellen said to expect “that the evolution of the financial system in response to global economic forces, technology, and, yes, regulation will result sooner or later in the all-too-familiar risks of excessive optimism, leverage, and maturity transformation reemerging in new ways that require policy responses.”

“We relearned this lesson through the pain inflicted by the crisis. We can never be sure that new crises will not occur, but if we keep this lesson fresh in our memories—along with the painful cost that was exacted by the recent crisis—and act accordingly, we have reason to hope that the financial system and economy will experience fewer crises and recover from any future crisis more quickly, sparing households and businesses some of the pain they endured during the crisis that struck a decade ago.”