Defining Financial Stability, and Some Policy Implications

of Applying the Definition

Eric S. RosengrenPresident & CEO

Federal Reserve Bank of Boston

Stanford Financial ForumStanford, CA

June 3, 2011

www.bostonfed.orgEMBARGOED UNTIL FRIDAY, JUNE 3, 2011 3:30 P.M. EASTERN TIME OR UPON DELIVERY

Financial Stability

Financial stability is receiving increased attention But there is no one clear definition It’s defined quite differently by different people Interestingly, it is never actually defined in the

Dodd-Frank Act Dodd-Frank Act seems focused on the failure of

large institutions and payments systems – certainly a gap that warrants attention

But a large interconnected failure is only one of the ways a systemic problem can emerge

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The Definition Matters

Some argue that the pursuit of financial stability should address a variety of things: Market volatility Clustered failures Asset bubbles at early stages

So it is important to clarify the definition… To help frame the policy response To identify what problems we will seek to solve and

what problems we will not To identify the needed supervisory tools

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My Definition Financial stability reflects the ability of the financial

system to consistently supply the credit intermediation and payment services that are needed in the real economy if it is to continue on its growth path

Financial instability occurs when problems (or concerns about potential problems) within institutions, markets, payments systems, or the financial system in general significantly impair the supply of credit intermediation services – so as to substantially impact the expected path of real economic activity

Three key elements:Problems in the financial system, impairment of intermediation (or its supply), and a substantial impact on the real economy 4

Financial Intermediation

The central theme is financial / credit intermediation services (supporting the real economy)

Intermediation allows funds from many depositors to be pooled and channeled to investment projects that support real economic activity

Financial institutions’ role in intermediation: “match” borrowers and lenders “maturity transformation” (from short for depositors to

longer for borrowers) “risk transformation” (safer for depositors to potentially

higher for investors)

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Financial Intermediation Cont…

Disruption of intermediation can have significant macroeconomic consequences

Reinhart and Rogoff: recoveries from crises in which financial intermediation has been badly disrupted can take much longer, and be more uneven

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Failures May Not Impair Intermediation

Per my definition, if individual institutions or even groups fail – but intermediation services are not significantly impaired – then financial stability is not compromised

For example, if intermediation services were highly substitutable

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Not In My Definition: Asset Bubbles

Not all asset bubbles result in a disruption of financial intermediation

Only if key intermediaries use significant leverage to purchase the asset, and are compromised when it bursts

Then their balance sheet constraints could impair the availability of intermediation services (and thus the future path of the economy)

So not all asset bubbles reflect financial instability, but some do

This illustrates how the definition of financial instability is important

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Examples Not Meeting the Definition

First, a few examples that would not meet my definition for affecting financial stability or creating financial instability:

Silver prices Failures of savings and loan institutions “Dot-com” stocks

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Figure 1Silver: Handy & Harman Base Price

Source: WSJ / Haver Analytics

Weekly, January 6, 1976 - May 24, 2011

0

10

20

30

40

50

06-Jan-76 24-Nov-81 13-Oct-87 31-Aug-93 20-Jul-99 07-Jun-05 26-Apr-11

$44.72 on January 22, 1980

$11.76 on May 27, 1980

Dollars per Troy Ounce

$44.90 on April 26, 2011

$33.42 on May 17, 2011

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Figure 2Silver: Handy & Harman Base Price

Source: WSJ / Haver Analytics

Weekly, January 6, 2009 - May 24, 2011

0

10

20

30

40

50

06-Jan-09 23-Jun-09 08-Dec-09 25-May-10 09-Nov-10 26-Apr-11

Dollars per Troy Ounce

$44.90 on April 26, 2011

$17.65 on July 27, 2010

$33.42 on May 17, 2011

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Figure 3S&L Failures and Assisted Resolutions

Source: FDIC

1970 - 2011 Year-to-Date

0

50

100

150

200

250

300

350

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

Number of S&Ls

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Figure 4Mortgage Rates, Treasury Yields and S&L Failures

Source: FDIC, Federal Reserve Board, Federal Home Loan Mortgage Corporation / Haver Analytics

April 1971 - April 2011

0

75

150

225

300

375

0

4

8

12

16

20

Apr-71 Apr-75 Apr-79 Apr-83 Apr-87 Apr-91 Apr-95 Apr-99 Apr-03 Apr-07 Apr-11

Percent

30-Year Fixed-Rate Mortgage Rate (Left Scale)

10-Year Treasury Yield (Left Scale)

S&L Failures (Right Scale)

Number of S&Ls

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Figure 5Dow Jones Internet Composite Stock Price Index

Source: Dow Jones, WSJ / Haver Analytics

July 1997 - April 2011

0

100

200

300

400

500

Jul-1997 Jul-1999 Jul-2001 Jul-2003 Jul-2005 Jul-2007 Jul-2009

Index, June 30, 1998=100

Examples of Financial Instability

A large interconnected failure is only one way a systemic problem can emerge

The weakest link in the financial stability chain might be small, rather than large, financial intermediaries Experience of money market mutual funds (MMMFs)

during the crisis Risk that widely-held exposures could cause

intermediation services to be cut simultaneously, even without a failure of a large intermediary

Failure of Lehman Brothers highlights the issue of interconnection

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Figure 6Daily Change in Money Market Mutual Fund

Assets in Prime Funds

Source: iMoneyNet

August 1, 2008 - December 1, 2008

-150

-120

-90

-60

-30

0

30

1-Aug-08 29-Aug-08 29-Sep-08 28-Oct-08 26-Nov-08

Billions of Dollars

Lehman fails(Sep 15)

The Reserve Primary Fund breaks the buck (Sep 16)

Fed announces AMLF program (Sep 19)

Treasury announces insurance for MMMFs (Sep 19)

AMLF program begins (Sep 22)

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Figure 7Assets of Money Market Mutual Funds

Source: 2011 Investment Company Fact Book

1990 - 2010, Year-End

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

1990 1994 1998 2002 2006 2010

Tax-Exempt

Taxable - Government

Taxable - Non-Government (Prime)

Trillions of Dollars

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Figure 8Asset-Backed Commercial Paper

Rate Spreads and Issuance

Source: Federal Reserve Board / Haver Analytics

August 1, 2008 - December 1, 2008

-100

0

100

200

300

400

500

01-Aug-08 29-Aug-08 29-Sep-08 28-Oct-08 26-Nov-08

Bas

is P

oin

ts

Asset-Backed Commercial Paper Rate Spreads over Federal Funds Effective Rate

1-Day AA-Rated ABCP 1-Month AA-Rated ABCP

40

50

60

70

80

90

100

01-Aug-08 29-Aug-08 29-Sep-08 28-Oct-08 26-Nov-08

Per

cent

Mat

urin

g in

1-4

Day

s

Asset-Backed Commercial Paper Issuance: Share Maturing in 1-4 Days

AA-Rated ABCP

A Digression: MMMFs Such funds still remain vulnerable to an unexpected credit

shock that causes investors to doubt the ability to redeem at a stable net asset value

I am certainly not predicting this outcome, but we all do well to recognize and address this vulnerability

It would be prudent to address this issue now, as MMMFs have the potential to be impacted should there be unexpected international financial problems emanating from Europe

Many, but not all, MMMFs have exposures to European banks by virtue of holding the banks’ short-term debt

Conversely, European banks are reliant on MMMFs, which are a major source of their dollar-funding needs

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Possible Solutions

There have been various discrete proposals to address the issue:

Allowing the asset values of the funds to float Requiring capital be set aside Requiring a source of strength

A solution needs to address: The impact of unexpected credit losses The incentive for investors to withdraw funds rapidly The operational convenience that MMMFs provide as a

transactions account vehicle

Despite the challenges, this is a vulnerability that needs to be addressed with focused and constructive attention

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Figure 9Asset Growth at Commercial and Savings Banks

by CAMELS Rating*

Source: Commercial and savings bank call reports, supervisory reports and author’s calculations

December 31, 2007 - December 31, 2008

-15

-10

-5

0

5

10

15

Total Assets Total Loans Commercial and Industrial Loans

Commercial Real Estate Loans

Camels Rating of 1 or 2

Camels Rating of 3, 4, or 5

Percent Change, December 31, 2007 - December 31, 2008

*The CAMELS rating is a highly conf idential supervisory rating which assesses six components of a bank's condition: capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L), and sensitivity to market risk (S). Ratings are assignedfor each of the six components in addition to an overall rating. The ratings are assigned on a scale of 1 (strongest) to 5 (weakest).

Note: CAMELS ratings are as of December 31, 2008. Banks included are merger-adjusted. De novos are excluded

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Figure 10Real Commercial and Industrial Loans

Outstanding at Commercial Banks

Source: Federal Reserve Board, BEA, NBER / Haver Analytics

1984:Q1 - 2011:Q1

Note: C&I Loans were adjusted for inflation using the GDP deflator

0

0

0

1

1

1

75

100

125

150

175

200

225

1984:Q1 1989:Q1 1994:Q1 1999:Q1 2004:Q1 2009:Q1

Recession

Index Level 1984:Q1=100

Real C&I Loans

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Figure 11Bank Lending Standards for

Commercial and Industrial Loans

Source: Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices, NBER / Haver Analytics

1990:Q2 - 2011:Q2

0

0

0

1

1

1

-40

-20

0

20

40

60

80

100

1990:Q2 1994:Q2 1998:Q2 2002:Q2 2006:Q2 2010:Q2

Recession

Net Percent Tightening Standards

Standards for C&I Loans to Large and Medium-Sized Borrowers

Standards forC&I Loans to Small Borrowers

Interconnectedness

Interconnectedness manifests itself in a variety of forms:

1 Immediate credit exposure to the firm (e.g., the failure of a large financial firm creating a credit loss that could generate runs on money market funds broadly)

2 Opaqueness makes it difficult to determine counterparty exposure or whether similar exposures exist at other financial firms

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Figure 12Spread: One-Month London Interbank Offered Rate

(LIBOR) to Overnight Index Swap (OIS) Rate

Source: Financial Times, Bloomberg / Haver Analytics

June 1, 2007 - May 27, 2011

0

50

100

150

200

250

300

350

1-Jun-07 16-Nov-07 2-May-08 17-Oct-08 3-Apr-09 18-Sep-09 5-Mar-10 20-Aug-10 4-Feb-11

Basis Points

Lehman Fails (Sep 15): Spread at 68 basis points

Peak Spread (Oct 10): 338 basis points

Interconnectedness Cont…

3 The criticality of firms that are significant market makers (…as when they’re troubled, broader intermediation services can be impacted)

4 The increasing global nature of large financial intermediaries, which greatly complicates resolutions of such firms should they fail

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Questions to Explore

If interconnectedness can be measured, how will that information be used?

Should highly interconnected firms have higher capital requirements, to reduce the probability that they become insolvent?

Should banks be required to disclose measures of interconnectedness to bank supervisors – or in public statements?

What role can stress tests play in understanding how a failure of a large firm impacts other firms?

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Concluding Observations

Some ambiguity on how broadly or narrowly financial stability should be defined

Mine is a relatively simple definition

The examples highlight that much work remains to be done if we want to significantly reduce the likelihood of impairment of critical financial intermediation services – the sort of impairment that could substantially impact economic activity

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