Bernanke Sharpens Focus on Interest Rate Risk

WASHINGTON — Federal Reserve Board Chairman Ben Bernanke told lawmakers Wednesday that his concerns about the financial stability risks from historically low interest rates have "increased a bit" and the central bank continues to factor such concerns into policy decisions.

The Fed has tried to maintain a delicate balance of keeping rates low for an extended period to help improve economic growth and employment trends while monitoring the implications of its monetary policy action for the health of the financial system. The low rates have allowed banks to access large amounts of cheap funding, but institutions could suddenly see their costs multiply when rates begin to rise to historical norms.

"It's a very difficult tradeoff because, as I mentioned, a weak economy means low interest rates, which creates some of the same problems, and moreover, a weak economy means worsening credit quality, for example, and that too has financial stability implications," said Bernanke. "There are tradeoffs and difficult judgments to make."

Bernanke also distanced himself from recent proposals to break up the largest banks, saying already-enacted policies — such as the Dodd-Frank Act — should be implemented as intended to try and deal with systemic concerns. He did not endorse recent ideas, for example, to move the regulatory framework closer to that which existed under the Depression-era law known as Glass-Steagall. That law, which was repealed in 1999, created firewalls between commercial and investment banking.

"Glass-Steagall is not the solution because as we saw in the crisis, investment banks [and] commercial banks, separately, got into serious trouble," he said.

Yet the hearing focused primarily on the pace of the economic recovery and Fed monetary policy decisions.

Bernanke assured lawmakers that the Fed, as it foresees eventually letting rates rise again, has greatly increased its monitoring and attention to interest rate risk while also coordinating with other regulatory agencies to be prepared for such risks. (The joint congressional committee includes members from both the House and the Senate.)

"We are quite aware of this issue and watching it very carefully and it does factor into our thinking about the appropriate amount of accommodation and the appropriate exit strategy," he said.

The Fed has not been alone in sounding alarms about interest rate risk. In its annual report, the Financial Stability Oversight Council identified risks associated with the low interest rates as one of its top six concerns. It recommended that financial institutions and other market participants reduce their reliance on interest rates.

"Yields and volatilities in fixed income markets are very low by historical standards, providing incentives for market participants to 'reach for yield' by increasing leverage, by engaging in maturity transformation, or by investing in less creditworthy assets, thus potentially increasing exposure to risks of sudden spikes in yields," said the report, which was released in April.

Bernanke has previously addressed broad concerns raised by critics of the Fed's strategy who have expressed fears about the effects of rising rates on financial stability. He has said the central bank has utilized several strategies to mitigate such concerns, including enhancing its macroprudential oversight of the largest, most complex banks to look for a buildup of leverage. He has also cited tools made available under the Dodd-Frank Act and the Basel III reforms authorizing regulators to force banks to hold more capital and liquidity.

Still, Bernanke remained cautious about just how quickly the Fed would move to raise rates, and warned of the risks of pulling back economic stimulus too early.

"A premature tightening of monetary policy could lead interest rates to rise temporarily, but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further," Bernanke said.

On eliminating "too big to fail", Bernanke suggested once again that more could be done if needed to limit the systemic risks associated with the biggest institutions. But rather than support ideas to break up the banks, he said policymakers should be focused on implementing Dodd-Frank and Basel III, which "move in the right direction of addressing too big to fail."

That position echoes one voiced by Treasury Secretary Jacob Lew before the Senate Banking Committee on Tuesday.

"We need to see where the process ends in order to be able to answer the question whether we have fully solved the problem," said Lew. "It is certainly the objective to be able to say in the end that we have ended 'too big to fail' and that we have eliminated any subsidy that might exist."