Instability Shouldn't Prompt Rate Change

Yellen explains stance in global debate over central banks using interest rates to improve financial stability.

Federal Reserve Chair Janet Yellen said that concerns about financial stability shouldn’t prompt a change in current monetary policy while flagging “pockets of increased risk-taking” in the financial system.

Yellen delivered a comprehensive salvo in the global debate among central bankers over whether interest rates should be a first-order tool to curb financial excess, saying supervision should be “the main line of defense” against turmoil.

“Monetary policy faces significant limitations as a tool to promote financial stability,” Yellen said yesterday at the International Monetary Fund (IMF) in Washington. “Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach.”

Yellen said the “primary role” should fall to a macroprudential approach, a combination of multiagency oversight, attention to bank capital and liquidity, and regulatory pressure to create buffers against failure.

“She’s reflecting and also moving toward the leading edge of what’s going on in central bank management of bubbles and the view of bubbles,” said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago.

Economists said Yellen’s comments seemed to lean against the view of former Fed Governor Jeremy Stein, who left the central bank in May to return to Harvard University.

Stein in a 2013 speech favored keeping “an open mind” on using monetary policy to control asset-price bubbles. Shifting interest rates “gets in all of the cracks” of the financial system while the Fed’s regulatory reach only extends to banks, he said.

Yellen is “pushing back on what he said,” said Dana Saporta, a U.S. economist at Credit Suisse Group AG in New York. “She clearly believes macroprudential policy should be the primary tool.”

U.S. stocks were little changed, with the Standard & Poor’s 500 Index closing at 1,974.62 in New York. The yield on the benchmark 10-year Treasury note rose 0.06 percentage point to 2.62 percent.

Yellen and her Fed colleagues are debating when to raise the benchmark lending rate for the first policy tightening since 2006. The long period of low interest rates may have increased risk in the financial system as investors seek higher returns.

“A powerful and pervasive search for yield has gathered pace,” the Basel, Switzerland-based Bank for International Settlements said in its annual report dated June 29.


Near Zero

The Fed has kept the benchmark lending rate near zero since December 2008 and is buying longer-term Treasury debt and mortgage-backed securities, holding down yields on the safest debt. Policy rates in Japan, the euro area, and the U.K. are all below 1 percent.

In the U.S., bank regulators have tried to limit risk, issuing guidance on high-yield, high-risk leveraged loans in March 2013.

The directive, which is less stringent than a rule, was unusually prescriptive, saying that debt levels exceeding six times a measure of earnings “raise concerns for most industries.”

Still, U.S. leveraged loans sold to institutional investors have topped $329 billion so far this year, the third biggest first half on record, following last year’s record $414 billion in the first six months.

About half were covenant-light, meaning they lack standard protections for lenders such as limits on debt relative to earnings, according to data compiled by Bloomberg.

Yellen said so far the Fed doesn’t see a “systemic threat” from the high-yield loan market since broad measures of credit growth don’t suggest excessive debt, and improved capital and liquidity positions at banks “should ensure resilience” against losses.

Bank regulators overlooked the risk of securitization prior to the previous crisis. One feature of the current leveraged-loan boom is that high-risk loans are bundled into structured financial instruments and distributed around the world.

“What is the contagion risk, and how do banks spread it is a critical question,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington.

When we draw regulatory boundaries and supervise inside them “there is the prospect that activities will move outside those boundaries and we won’t be able to detect them, and if we can we won’t have adequate regulatory tools,” Yellen said in a question and answer period with IMF Managing Director Christine Lagarde. “That is a huge challenge to which I don’t have a great answer.”


Riskier Loans

A spokesman for the Office of the Comptroller of the Currency said in an e-mail this week that U.S. banks own less than 5 percent of riskier leveraged loans, with foreign banks owning another 5 percent.

That leaves most of the credit risk residing with institutional investors such as mutual funds, hedge funds, and collateralized loan obligations (CLOs) that pool the loans and slice them into securities of varying risk and return.

CLOs, the biggest buyers of leveraged loans, have raised more than $60 billion in the U.S. this year and may surpass the record $101 billion pooled in 2007, according to Wells Fargo & Co.

The race to buy riskier assets is permeating almost every corner of the global debt markets, driven by low central bank policy rates worldwide.

Yellen said the financial crisis wouldn’t have been averted or mitigated by “substantially tighter monetary policy” in the mid-2000s.

Higher interest rates would have increased unemployment and wouldn’t have closed regulatory gaps that allowed large banks to “escape comprehensive supervision,” nor would they have brought transparency to derivatives markets or improved bank risk management practices, she said.

While Yellen’s comments show she’s open to Stein’s views on using monetary policy, “in practice there’s a chasm between them,” said Guy Berger, a U.S. economist at Royal Bank of Scotland Group Plc in Stamford, Connecticut.

“Stein is concerned in the here and now that monetary policy is already affecting financial stability,” Berger said. “Yellen’s view is she sees pockets of risk taking but nothing yet that’s raising serious alarm bells, and if it does then regulatory tools are the best way to tackle it.”

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