OFR Director Berner Discusses Financial Sector Growth and Stability (with Lofchie Comment)

In his remarks at the Brookings Institution, Office of Financial Research ("OFR") Director Richard Berner discussed growth and stability in the financial sector.

According to Mr. Berner, the slow healing of the financial system since the crisis "is a key reason why central banks globally continue to deploy both conventional and unconventional monetary policies, and why real, long-term interest rates are at such low levels." In his words, Mr. Berner "touched on" three risks to financial stability: (i) "vulnerabilities associated with market liquidity," (ii) "the migration of financial activities toward opaque and less resilient corners of the financial system," and (iii) "excessive risk-taking in some markets during the extended period of low interest rates and low volatility."

Mr. Berner stated that regulation might be contributing perversely "to more permanent adjustments that could impair market functioning," such as developments that have altered trading liquidity in the securities markets and the ways in which investors redeem holdings for cash. Mr. Berner noted that some of these developments occurred by intent and "by design," such as the imposition of tighter restrictions by regulations on bank leverage, which led to the increased cost of financing activities. However, he stated, other factors are at play, some of which are "cyclical, such as the changes in the supply of – and demand for – collateral, and changes in risk preferences." Others are "structural, such as changes in the investor base, in securities markets, and in the development of new financial products." Mr. Berner observed that the spread of high-frequency trading might have led to "sharp movements in prices."

In an effort to promote and assure financial stability, Mr. Berner advocated for the continued development of "the macroprudential toolkit," which must assess the fundamental sources of vulnerability, be more forward looking, and test the resilience of the financial system during a wide range of events and incentives. Progress has been made in assessing a number of risks, he argued, such as the shadow banking system and regulations to strengthen the derivatives market, but, "more needs to be done".

Lofchie Comment: All three principal risks to financial stability identified by Mr. Berner increased under current government regulation. First, liquidity decreased, a result of an increase in capital requirements, liquidity requirements and leverage requirements. (As to liquidity, the question should be whether the trade-off of higher capital levels will benefit society if markets are more likely to crash because no one is willing to provide liquidity in a downturn.) Second, credit activities have moved to more opaque venues (which presumably means non-banks) because the increased costs of bank regulation make it possible for non-banks that do not accept deposits to compete with banks. Third, investors are chasing after returns largely because the federal regulators are holding down interest rates.Thatthe government itself may be a significant source of risk is something that Mr. Berner "touches on" so lightly that he effectively dismisses it. To Mr. Berner, the fundamental problem is that "vulnerabilities are still present outside the banking perimeter," which means that more regulation is needed. This argument can be likened to the old story of the man with only a hammer who sees every problem as a nail; in this case, a banking regulator thinks that all financial activities should be carried out by firms that are regulated as if they were banks.

See: Mr. Berner's Speech.