Despite a summer of relatively good news about how well capitalized major banks in the U.S. financial system are, Janet Yellen is concerned about the overall stability of the financial system due to looser standards on lending. From the Financial Times:
In an interview with the Financial Times, the former chair of the Federal Reserve said she was particularly alarmed by loosening standards in the $1.3tn market for leveraged loans, which are offered to companies with weaker credit ratings.
“I am worried about the systemic risks associated with these loans,” said the former central banker. “There has been a huge deterioration in standards; covenants have been loosened in leveraged lending.”…
“There are a lot of weaknesses in the system, and instead of looking to remedy those weaknesses I feel things have turned in a very deregulatory direction.”
Ms Yellen said that while regulators were insisting banks hold appropriate capital against leveraged loans on their balance sheet, much of the debt ended up getting repackaged and sold on elsewhere.
This “repackaging” of loans to get them off the balance sheet was an important contributor to the financial crisis. The rise of mortgage-backed securities and other financial instruments were good for diluting risk, but created tremendous moral hazard by incentivizing lenders to lend to risky borrowers, then sell the debt on the secondary market. The risk was still there, just off the books of the original lender and out into the broader financial system.
Of course, there are tools available to regulators to mitigate systemic risk, namely a greater cushion for institutions to absorb losses in the form of higher capital requirements.
Ms Yellen said she was worried about the lack of so-called macroprudential tools in the US that regulators could use to rein in risk. On that front, some Fed policymakers have been arguing that banks should be required to hold extra capital against the risk of a downturn — a so-called counter-cyclical capital buffer. Ms Yellen said she would want to hear a debate on the topic, and that there was an argument for the tool to be used.