December 3, 2015

Federal Reserve Vice Chair Fischer Discusses Financial Stability and Shadow Banking

Steven Lofchie Commentary by Steven Lofchie

Board of Governors of the Federal Reserve System Vice Chair Stanley Fischer: (i) offered an assessment of vulnerabilities in the financial system; and (ii) identified gaps in the current understanding of conditions inside and outside of the banking sector that should be addressed by regulators and researchers.

In discussing the current financial system's cyclical developments, Mr. Fischer mentioned the following "five factors that contribute to financial fragility": (i) high debt burdens at households and firms; (ii) elevated leverage and maturity transformation within the financial sector; (iii) complexity and interconnectedness in intermediation chains; (iv) low risk premiums on assets, especially assets funded with debt; and (v) complacency on the part of investors, supervisors and decision-makers in the private sector of the financial system.

Mr. Fischer made the following assertions regarding what needs to be understood to monitor financial stability:

  • A Closer Look at Shadow Banking: The reduction in leverage and maturity transformation associated with better regulations leaves the financial system "much more resilient - even if such regulations have modestly affected market liquidity."
  • What We Know and What We Do Not: Data on a range of activities - including securities lending, bilateral repos, and derivatives trading - that create funding and leverage risks "remain inadequate and hence could prove destabilizing if sufficiently large or widespread."
  • Data Are Not Enough: We Need Theory Too: An "important area in need of development" is economic modeling on interconnectedness, particularly on the interaction of shadow banking, banks and the broader financial system. Further, research that distinguishes between banks and nonbanks, or highlights how their interactions are driven by economic incentives, could guide regulator efforts to collect data and set policies to limit possible instabilities associated with interconnectedness.

"An essential element of [the federal regulatory] infrastructure is learning the lessons of history - both the lessons of what happened, and the fact that supervisors and regulators will on occasion be surprised," he stated.

Mr. Fischer delivered his remarks at the "Financial Stability: Policy Analysis and Data Needs" 2015 Stability Conference sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial Research.


In his remarks, the Vice Chair of the Federal Reserve announced that "the Federal Reserve will be developing regulations that would establish minimum margins for securities financing transactions on a marketwide basis. The margins would apply to all market participants, thereby mitigating the risks associated with regulation along institutional lines."

It is not clear under what process, or under what authority, the Federal Reserve will propose and implement these regulations governing all market participants. Whatever the process is, the proposed rulemaking would seem to be of a type that goes materially beyond the Federal Reserve Board's historical discretionary authority to regulate the money supply. If the Federal Reserve Board believes that such broad rulemaking should not be subject to Congressional oversight, it would at least be useful for the Federal Reserve Board to indicate what it believes are the furthest reaches of its discretionary authority.

Further deference to the Federal Reserve Board might be all to the good if one were really convinced that the Federal Reserve is consistently correct in its actions. The strength of that argument is, however, uncertain. Similarly uncertain is the assertion that the economy is now more structurally resilient than it was before the crash. By what measure? How resilient would the economy (or housing prices) be if interest rates were to soon rise 2 or 3%?

Vice Chair Fischer's prescriptions are important to consider in the debate over the degree of control that Congress should exercise with respect to the Federal Reserve. Even if one questions the wisdom possessed by legislators (and is there anyone who does not at one time or another?), one should still accept that certain powers are properly exercised by the legislative branch, or at least are properly overseen by the legislative branch. The powers to be exercised by the legislative branch should include the oversight of the making of rules by the federal financial regulators.

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