Yellen: Prudential Rules Should Be Focus of Systemic Risk Controls

WASHINGTON — Federal Reserve Chair Janet Yellen on Wednesday argued against using monetary policy to mitigate potential financial stability risks, saying that recent regulatory reforms were a better alternative.

The head of the U.S. central bank argued there were "significant limitations" in adjusting interest rates to head off excessive leverage and other financial vulnerabilities. In fact, she said, the potential for causing volatility of inflation and employment could be exacerbated by changes in the Fed's benchmark rate.

Instead, she said that macroprudential tools should "play the primary role" in addressing potential risks.

"Such an approach should focus on 'through the cycle' standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities," said Yellen in a speech before the International Monetary Fund.

Regulators, she argued, should focus their efforts on completing implementation of a slew of macroprudential measures, which would diminish the likelihood that "monetary policy will need to focus on financial stability issues rather than on price stability and full employment."

Yellen named several regulatory initiatives aimed at meeting that objective, such as the plethora of standards imposed under the Basel III accord, including new liquidity requirements, a leverage ratio, and a capital buffer for firms heavily reliant on short-term wholesale funding.

"The new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional loss-absorbing capacity within the financial sector during periods of rapid credit creation while also leaning against emerging excesses," she said.

Still, like other Fed officials, she noted the potential limitations of macroprudential policies to capture risks that can creep up in unregulated sectors. Therefore, she did not completely rule out use of monetary policy.

"Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability," said Yellen.

The Fed chair urged policymakers to be clear and consistent in communicating their views on the stability of the financial system and how those views may be influencing monetary policy. She said there is "no simple rule" to explain how monetary policy should adjust to shifts in the outlook of financial stability.

For now, the Fed chair ruled out making any changes in the central bank's monetary policy decision making based on financial stability concerns.

"I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns," said Yellen.

Yellen once again reiterated that there are signs of some reach-for-yield behavior already evident in the lower-rated corporate debt markets and high-yield bonds.

Regulators have become increasingly worried that an extended period of low interest rates could be incentivizing the market to take on additional risks to boost margins, causing spikes in asset prices and a buildup of systemic vulnerabilities.

Yellen, and other Fed officials, have pointed to a number of high risk areas that regulators are watching, including leverage lending, deteriorating underwriting standards and potential asset price bubbles.

But for now she said there's been little evidence to justify serious concerns.

"To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures," said Yellen.

The Fed has kept its key interest rate to a range of between zero percent and 0.25% since December 2008. While the central bank has begun taking steps in the direction of easing back its stimulus program, starting in December, it has pushed off the possibility of raising rates into the distant future.

Yellen highlighted a number of regulatory steps focused on large banks, undertaken by the Fed and other regulators, that she said have the effect of helping the broader economy. She included the creation of "an effective resolution regime" for large firms, margin requirements for derivatives transactions and steps to impose minimum loss absorbency on systemically important financial institutions.

"Such requirements take on a macroprudential dimension when they are most stringent for the largest, most systemically important firms, thereby minimizing the risk that losses at such firms will reverberate through the financial system," she said. "Resilience against runs can be enhanced both by stronger capital positions and requirements for sufficient liquidity buffers among the most interconnected firms.

"An effective resolution regime for SIFIs can also enhance resilience by better protecting the financial system from contagion in the event of a SIFI collapse."