Markets Wired

As Prepared for Delivery

Thank you for the opportunity to speak at this conference today.  I will talk about some recent developments in macroprudential policy in the U.S. 

Macroprudential policymaking is still relatively new in advanced economies, having become more mainstream only after the global financial crisis (GFC).  The core idea underpinning macroprudential policies is that regulators need to take a holistic approach to safeguard the broader financial system.  That means regulators need to consider not only what is appropriate for individual financial institutions or markets.  They also need to consider how these constituent parts are exposed to one another and how they interact to provide credit and other vital services to support economic activity.  Most countries have established new financial stability committees to help to ensure that financial authorities consistently consider financial stability risks.  This work requires that regulators more formally communicate and coordinate on a regular basis using existing tools and adopting new ones.¹ So macroprudential policymaking can be complicated.  

Today I’d like to walk through three examples of how macroprudential policies in the US are developing, to illustrate that they need to be flexible and adaptive.  The first example concerns how to identify and address vulnerabilities in the nonbank financial sector.  The second example concerns countercyclical features of bank capital regulation.  The third concerns bank liquidity risk management in light of accelerated runs on uninsured deposits. 

Nonbank financial intermediation tools — designation and activities-based analysis

Nonbank financial intermediaries, such as money market and open-end funds, hedge funds, and insurance companies, play a large and growing role in directing savings to credit.  By one estimate, relative to U.S. GDP, credit provided to households and businesses by nonbank intermediaries has more than doubled since 1985, while credit provided by banks has remained relatively flat.  In the U.S., these entities have traditionally been regulated to protect investors and consumers and, in some cases, for safety and soundness. 

The Financial Stability Oversight Council (FSOC) was established in 2010 and is charged with identifying and responding to potential risks to financial stability, including those that arise from nonbank intermediaries and activities.  Since its inception, the FSOC has worked with financial regulators to evaluate where systemic risks could be significant and how to reduce vulnerabilities associated with financial activities and products.  In addition, the Dodd-Frank Act empowers the FSOC to designate a nonbank financial company for Federal Reserve supervision and prudential standards if the FSOC determines that material financial distress at the company, or the nature, scope, size, scale, concentration, interconnectedness or mix of the activities of the company, could pose a threat to U.S. financial stability.  Once designated, a nonbank is subject to supervision and regulation by the Federal Reserve including, potentially, capital and liquidity requirements, resolution planning, and other enhanced prudential standards.  The FSOC designated an insurance company and a finance company that required federal support during the GFC, and two other insurance companies in 2013 and 2014.  One of the insurance companies contested and a federal court struck down its designation in 2016.  The FSOC voted to rescind the three remaining designations by 2018.  

In 2019, during the previous administration, the FSOC adopted new guidance that made it significantly harder to designate institutions.  Among other changes, the new guidance prioritized an “activities-based approach” over the designation of individual firms.  Under this approach, the FSOC would examine financial products, activities, or practices and would work with financial regulators to address any risks they might pose to financial stability; the FSOC would consider designating individual institutions only as a last resort, after having exhausted other options.

Earlier this year, FSOC proposed for public comment revised interpretative guidance on nonbank financial company determinations, which would no longer require the Council to use an activities-based approach prior to considering entity designation. The proposal is consistent with the intent of the Dodd-Frank statute, which does not require the Council to first use an activities-based approach before considering other options.  The proposed approach does not prioritize firm designation over an activities-based approach, but instead reflects that the FSOC should be able to use any of its tools if needed so that it can respond appropriately to potential threats to financial stability.  As Treasury Secretary Yellen explained when introducing the proposal:

[T]he Council does not broadly prioritize one type of tool over another. Rather, we plainly examine a risk – and design our response to address the risk we are seeking to mitigate.²

To provide greater transparency about how it identifies and considers policies to reduce risks to financial stability, FSOC also issued for public comment a proposed analytic framework. Under the framework, the Council would monitor a broad range of markets, asset classes, and types of entities, working closely with regulators to evaluate vulnerabilities, such as excessive leverage or liquidity mismatch, in activities or in firms.   Having identified a significant vulnerability, the Council could then work with the appropriate regulators to reduce vulnerabilities, issue recommendations informally or formally to the primary regulators, or make use of one of its designation authorities.

In some cases, vulnerabilities arise from activities undertaken by a range of firms of different sizes and may be most effectively addressed through broad-based regulations.  Liquidity mismatch in open-end bond or loan mutual funds are good examples.  Investors in bond and loan open-end mutual funds can redeem fund shares daily, but, unlike most equities, the underlying bonds and loans cannot be sold that quickly without significant transaction costs, which would be borne by the remaining investors.  This mismatch leads to a first-mover advantage and incentives for investors to run, which can have systemic consequences especially when different funds’ portfolios are highly correlated, such as in March 2020.   In addition, some money market funds that are generally expected to pay a fixed net asset value also can face runs if they hold “information-sensitive” assets, that is those with quality that can come into question under stress.  

The FSOC has repeatedly called attention to this issue in its annual reports and elsewhere.  In 2012, it proposed to issue a “comply or explain” directive to the SEC, a FSOC member, to address the run risks in MMFs, and the SEC then issued new regulations.  More recently, as it became evident in March 2020 that run incentives at prime and tax-exempt money market funds had not been addressed fully by the previous reforms, the SEC adopted new rules.  And the SEC is in the process of reviewing comments on a proposed rule aimed at reducing run incentives in open-end funds.

In other cases, individual institutions may be so large, complex, and interconnected that they require the kind of comprehensive supervision and regulation that designation would require.  Currently while no nonbank financial companies are designated by the FSOC, FSOC under a separate authority has designated eight financial market utilities (FMUs), mainly central clearing houses, as systemically important.  These firms are subject to heightened regulation and supervision by the SEC, CFTC, or Federal Reserve.

Together, the FSOC’s proposed analytic framework and proposed nonbank designations guidance would bolster the Council’s ability to identify, assess, and address potential risks to financial stability arising from nonbank financial intermediation.    

Systemically important banks – structural and cyclical tools

Let me turn to the second example: macroprudential tools for systemically important banks.  In the wake of the global financial crisis, new Basel III regulations recognized that the largest, most complex and interconnected banks pose unique systemic risks to financial stability.  Under new rules, global systemically important banks (G-SIBs) are required to hold additional capital resources relative to their non-G-SIB peers.  This additional capital is a structural macroprudential tool, intended to make these banks, and by extension the broader financial system, more resilient to shocks regardless of when they arise during the business cycle.  

Global regulators also recognized that a rapid contraction of credit supply during cyclical downturns could be particularly destabilizing.  To address this risk, Basel III includes a counter-cyclical capital buffer (CCyB), a cyclical macroprudential tool, intended to lean against the credit cycle.  It does this by requiring banks to increase capital in good times and then relaxing the requirement when the credit cycle turns down, thereby reducing the likelihood that banks will cut back on lending at precisely the time it is most needed.  

In the U.S., G-SIBs are subject to a capital surcharge, which varies by banks risk characteristics, as required under Basel III.  U.S. regulators have also adopted a counter-cyclical capital buffer framework but have held this buffer at zero since its inception.

Given that the US CcyB has not changed over the business cycle, one might conclude that our regulators have revealed a preference for structural, rather than cyclical, macroprudential tools.  While there is some truth to this claim, this conclusion is too strong because it neglects the cyclical aspects of our Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST) bank stress testing regime, a key part of the way capital for G-SIBs and other large banks is regulated in the US.

Bank stress tests serve both microprudential and macroprudential objectives.  In addition to assessing the adequacy of bank capital for severe stress, they can lean against the business cycle in two ways, as I documented in a 2019 paper with Don Kohn.³  First, the level of the assumed macroeconomic path included in the stress tests are generally similar from year to year, regardless of the starting state of the economy.  For example, the stress scenarios require that the unemployment rate rise to at least 10%, whether the current unemployment rate is 3.8%, as it was last month, or some other higher value.  As a result, the severity of the stress scenario relative to the starting state of the economy tends to be higher during good times than during bad times.  The second way stress tests have been counter-cyclical – and the more binding way —is that they required banks to pre-fund (that is hold the capital in place) their planned dividend payments and stock buybacks over the stress period horizon.  These can be as much as 2 percentage points of capital a year when earnings are high, so this feature would naturally raise the capital required by the stress tests when the starting state of the economy is strong.  

Thus large U.S. banks have been subject to some counter-cyclical capital regulation even though the U.S. CcyB has not been activated.   In 2020, however, bank regulators changed the stress testing program in a number of ways, but reduced the required prefunding of shareholder distributions, from dividends and share repurchases for nine quarters to planned dividends for four quarters. These significant changes reduced the countercyclicality of the U.S. GSIB capital program.

Looking forward after the march banking turmoil

I’d like to close by touching briefly on the implications of the banking turmoil last March for macroprudential policy.

The failures of two banks over a single weekend revealed weaknesses in firm’s own risk management and governance practices, as well as weaknesses in supervision.   But a key vulnerability exposed was related to uninsured deposits and the speed at which depositors could run, much faster than in the past, if they lost confidence in the bank.  

Silicon Valley Bank had significant unrealized mark-to-market losses on government securities and high-quality mortgages, but was not able to raise new equity as it wrote down their values.  It lost over $40 billion in deposits – almost a quarter of its domestic deposits – on one day, and could have lost another $100 billion if it had opened the next day.  Almost 90 percent of its deposits were uninsured and they were concentrated.  Signature Bank had a similarly high share of uninsured deposits, though it was half the size of SVB.    

During this episode, the high share of uninsured deposits rather than size of the banks led to the contagion.    Authorities were concerned that runs at even small banks could spread more broadly in this situation.  To reduce the risk of deposit runs from other banks with similar business models, the Federal Reserve, the FDIC, and the Treasury invoked a “systemic risk exception” to stem system-wide runs on uninsured deposits by protecting uninsured depositors at the two failed banks.⁴  At the same time, the Fed established a program so banks could liquefy Treasury and agency securities.   These decisions were made not because the troubled banks were “too big to fail” – they did fail – but to prevent broader contagion from uninsured deposits.

The events last spring suggest that regulators need to look at the existing macroprudential toolkit and whether it is sufficient for the management of systemic liquidity.  Are there new liquidity management tools that could be put in place to prepare for rapid runs on uninsured deposits?  For example, are there operational changes to increase the timeliness of central bank liquidity?     

Conclusion

I opened these remarks by saying that macroprudential regulators need to be flexible and creative in responding to different situations.  While the CCyB for banks and long-to-value ratios are likely to be the most widely-used macroprudential tools, the examples I presented illustrate how the set of tools is much more varied and includes nonbank designation, existing tools applied to address systemic risks, stress tests, and possible new macroprudential liquidity management tools.  This diversity of tools and applications raises significant challenges for studying the effectiveness of macroprudential tools and promoting greater and more intentional use.  But I hope research will continue to pursue this important area of study.  

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<sub>1. See, Rochelle M. Edge & J. Nellie Liang, 2022. “Financial Stability Committees and the Basel III Countercyclical Capital Buffer,” International Journal of Central Banking, vol. 18(5), pages 1-53, December. These committees include not only the bank and market regulators, but the central bank (when it is not already the bank regulator), and very often the ministry of finance.  Some of these committees have new policy tools, but most rely on existing regulators to implement new tools and to adapt existing ones to also account for systemic risks. 
2. “Remarks by Secretary of the Treasury Janet L. Yellen at Financial Stability Oversight Council Meeting,” April 21, 2023.  Available at: https://home.treasury.gov/news/press-releases/jy1431
3. Donald Kohn and Nellie Liang, “Understanding the Effects of the U.S. Stress Tests,” prepared for the Federal Reserve System Conference, Stress Testing: A Discussion and Review, July 9, 2019. Available at: https://www.brookings.edu/wp-content/uploads/2019/07/effects-of-stress-test-paper.pdf
4. A provision of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), the systemic risk exception, allows the FDIC to waive requirements that failed banks be resolved in a way that minimizes costs to the deposit insurance fund.  This allowed the FDIC to protect uninsured depositors.</sub>