In 2018, the Federal Reserve began issuing semi-annual financial stability reports, similar to such reports from other central banks, notably the Bank of England. Earlier this month, the Fed issued its latest report. Further, in May of this year, it issued an inaugural supervision and regulation report, in conjunction with semi-annual congressional testimony by Randal Quarles, vice-chair for supervision of the Federal Reserve Board of Governors. These reports enhance significantly Fed communications. They are first-rate and high quality. But they are also works in progress.
Fed Chair Jerome Powell holds press conferences after each Federal Open Market Committee meeting and the central bank has conducted a public ‘listening tour’ on its monetary policy strategy. While public communications are often fraught with risks, the Fed should be praised for its substantial and welcome efforts to bolster transparency.
The latest financial stability report paints a broadly positive assessment. Asset prices offer a mixed, though overall not concerning picture. In some areas they point to elevation, but taking into account low Treasury yields and other categories in line with historical norms, valuations and risk appetite on the whole do not appear particularly problematic. Household balance sheets remain healthy. But business borrowing – especially among riskier firms – is high. Banks remain in good shape, though leverage to some non-bank sectors is rising. Funding risks remain moderate, while overseas developments pose possible challenges for the US. The boxes on stablecoins and market outreach on US financial stability risks were excellent. The latter offers opportunities for follow-up by Fed staff.
Future reports could shed greater light on US financial system developments.
Despite the report’s modestly positive tenor, it could further draw out existing and tail risks. In particular, readers could benefit from a more detailed discussion of trends in and concerns about corporate borrowing. The minutes from the 29-30 FOMC meeting seemingly expressed greater apprehensions. Discussions on weakening credit lending standards and the greater recourse to leveraged lending and covenant lite loans, though covered extensively, may also warrant greater attention.
Similarly, the rise in leverage to hedge funds is concerning. In 1998, the New York Fed arranged the bail-out of Long-Term Capital Management. As a result, regulators and supervisors have often emphasised the role of indirect oversight of hedge funds receiving financial backing from regulated banks, as a means to check excesses in such leverage. Greater detail is needed on how the US financial system would be impacted if there were increased reach for yield, a surge in volatility or a sharp rise in interest rates.
In underscoring the US banking system’s general health, the financial stability report observes that non-bank activities are playing an increasing role in the country’s financial system. Yet, non-banks often use credit from banks, and run risks from non-bank activities can spill over to the broader economic and financial system.
Non-banks’ activities are not necessarily under the purview of Fed oversight. As such, the supervisory and regulatory implications are difficult to encapsulate in the financial stability or supervision and regulation reports. The latter, in any case, is focused on technical banking issues. These implications should be reflected fully in the annual report of the Financial Stability Oversight Council, a Treasury-led committee of all the relevant regulators. But the current FSOC has taken a light touch approach to issues under its remit, maintaining a deregulatory philosophy.
On balance, one might ask if risks to financial stability are being captured adequately in the panoply of US documentation. That this question arises should come as no surprise, though, given the excessively fragmented nature of the US supervisory structure and the differing regulatory philosophies of supervisors, which aside from banking agencies often lack an adequate prudential focus.
Perhaps the major critique of the financial stability report is that while its analysis is superb, it fails to offer prescriptions. It could be improved substantially if the Fed were to tell readers what it plans to do about identified challenges and weaknesses. The Bank of England’s report, for example, discusses thinking on the use of the counter-cyclical capital buffer in the UK.
If a risk poses a systemic challenge – even if oversight for that risk is not under the direct purview of the Fed – the central bank could offer thoughts on remedial actions, given its responsibility for maintaining financial stability. It could, for example, assess whether the US has adequate macroprudential tools to deal with non-bank risks. Such a discussion, in principle, could feature in either of the Fed’s reports, but might be overlooked under the current US reporting framework.
On balance, the Fed is to be praised for its new reports and quest for greater transparency. But its analyses could dig deeper into challenges and risks confronting the US financial system.
Mark Sobel is US Chairman of OMFIF.