Former Fed Chair and current fellow at the Brookings Institution Janet Yellen gave an interview on the state of the financial system ten years after the financial crisis. Broadly speaking, she believes our financial system is more stable than it was on the eve of the crisis, but there’s significant work to be done, namely by curbing leverage.
On the relative growth of equity in the financial sector:
The banking system is better capitalized. The quantity and quality of capital required relative to risk-weighted assets have been increased substantially and capital requirements are higher for the largest, most systemic firms. This lowers the risk of distress at such firms and encourages them to limit activities that could threaten financial stability. Among the largest banks, Tier 1 common equity capital has more than doubled since 2009…
That said, there remains an argument—most passionately articulated by [Stanford Professor and Niskanen Center Advisory Board member] Anat Admati at Stanford—that capital requirements should be higher. The imposition of these requirements should reflect a cost-benefit judgment.
The figures differ on what the optimal capital requirement should be. One recent study found 19% is the magic number, while the Minneapolis Plan recommends different tiers for banks of different sizes (23.5% for non-systemically important banks and 38% for systemically important ones), but it’s clear there isn’t nearly enough equity in the financial sector.
Yellen also joins the ranks of many who support the idea of increasing the countercyclical capital buffer (CCyB), which would increase in good times but decrease in bad ones:
I would urge the Federal Reserve Board to carefully consider raising the CCyB at this time…I am concerned that asset valuations, including in sectors such as commercial real estate, are elevated and I see dangers relating to the large volume leveraged lending where there’s been a significant weakening of underwriting standards. The high debt burdens of riskier nonfinancial corporations could deepen the next downturn and impose losses on the banking system that would intensify a downturn by restricting the supply of credit. Raising the countercyclical capital buffer now would improve the resilience of the banking system, enabling it to better weather a future downturn.
One of Yellen’s primary concerns with the structure of financial regulation as it exists today is the ability (or lack thereof) of financial regulators to implement their orderly liquidation authority (OLA)–the method for resolving an insolvent financial institution–and other emergency measures needed to quickly respond to a crisis:
While the new Orderly Liquidation Authority process provides a valuable resolution method, it will be extremely challenging to carry out in “real time.” A firm’s reorganization would typically need to be completed over a “crisis” weekend. Success requires a very high degree of international coordination with a great deal of advance planning among financial authorities here and abroad…For this reason, I am very concerned that Dodd Frank eliminates the Fed’s legal authority under its 13(3) emergency lending powers to make loans to support an individual systemic institution that would otherwise fail. The law permits the Federal Reserve to implement “broad-based lending programs” to support liquidity in markets—programs like the commercial paper lending facility and the Term Asset-Backed Securities Loan Facility (TALF), that the Fed used successfully in 2009 and 2010 to help the markets meet credit needs of households and small businesses.
The logistical and political hurdles associated with resolving a crisis in “real time” are quite daunting. But this makes the case for a regulatory framework based on prevention rather than reaction all the more important. As John Cochrane said in a recent interview with the Chicago Booth Review:
Everything else we’ve done [in the wake of the financial crisis]–the tens of thousands of pages of regulations, the armies of regulators–the pretense wandering around all these large international institutions, that these regulators will “this time” see it coming and carefully tell the banks what to do, nobody has much faith that any of that is working or will stop us from another crisis. But capital is the answer.
The problem with our financial sector isn’t necessarily over- or under-regulation but misregulation. Instead of working around a system dependent on leverage, the system should instead be designed so financial institutions are buttressed by greater equity.
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