1. Over the 12 quarters ending in the first quarter of this year, borrowing by the nonfinancial business sector increased at an annual rate just above 6 percent, on average, and borrowing by households and nonprofit institutions rose at an annual rate of 3-1/4 percent, on average; the corresponding average pace of increase in nominal gross domestic product was 3-3/4 percent. Over the same period, lending by private depository institutions advanced at an annual rate of nearly 6-1/2 percent. Return to text
2. A contemporaneous perspective on subprime mortgage market developments at this time is provided in Ben S. Bernanke (2007), "The Subprime Mortgage Market," speech delivered at the Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure and Competition, Chicago, May 17. Return to text
3. On August 17, 2007, the Federal Reserve Board reduced the primary credit rate at the discount window by 50 basis points and announced a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. The changes were announced to remain in place until the Federal Reserve determined that market liquidity had improved materially. See Board of Governors of the Federal Reserve System (2007), "Federal Reserve Board Discount Rate Action," press release, August 17. Return to text
4. The proceedings from the 2007 conference are instructive about the range of views regarding housing-related developments preceding the acute phase of the financial crisis. See Federal Reserve Bank of Kansas City (2007), Housing, Housing Finance, and Monetary Policy,proceedings of an economic policy symposium (Kansas City: FRBKC). Return to text
5. For a discussion of the correspondence between the steps taken by the Federal Reserve and those suggested by Walter Bagehot in the 19th century, see Brian F. Madigan (2009), "Bagehot's Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis," speech delivered at the Federal Reserve Bank of Kansas City's annual economic symposium, Jackson Hole, Wyo., August 21. Return to text
6. A timeline of developments in the United States over the financial crisis is available on the Federal Reserve Bank of St. Louis's website at https://www.stlouisfed.org/financial-crisis/full-timeline. The failure of Fannie Mae and Freddie Mac is marked by the decision of the Federal Housing Finance Agency (FHFA) to place Fannie Mae and Freddie Mac in government conservatorship on September 7, 2008. Links to documents outlining the actions taken around this time are available on the FHFA's website at https://www.fhfa.gov/Media/PublicAffairs/Pages/Conservatorship-of-Fannie-Mae-and-Freddie-Mac.aspx. Return to text
7. In the fall of 2008, the three largest investment banks were (in alphabetical order) Goldman Sachs, Merrill Lynch, and Morgan Stanley. Merrill Lynch agreed to be acquired by Bank of America, and the remaining two firms became bank holding companies. Return to text
8. The notion that popular sentiment may contribute to mispricing of assets--for example, the power of the madness of crowds--is attributed to Charles Mackay (1841), Memoirs of Extraordinary Popular Delusions and the Madness of Crowds (London: Richard Bentley). A more modern perspective, and one using a phrase as memorable as the madness of crowds, is provided by Robert J. Shiller (2016), Irrational Exuberance, 3rd ed. (Princeton, N.J.: Princeton University Press). The notion that economic stability can generate a buildup of imbalances that subsequently contributes to instability is presented in Hyman P. Minsky (1974), "The Modeling of Financial Instability: An Introduction," in Modeling and Simulation, Vol. 5, Part 1, proceedings of the Fifth Annual Pittsburgh Conference (Pittsburgh: Instrument Society of America), pp. 267-72. A related discussion of how financial excesses often precede downturns (and even panics) is provided in Charles P. Kindleberger and Robert Z. Aliber (2005), Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. (Hoboken, N.J.: John Wiley & Sons). Return to text
9. These improvements encompass a number of changes. The regulatory requirements for capital have been increased and focus on Tier 1 common equity, which proved more capable of absorbing losses than lower-quality forms of capital. The role of bank internal models in determining risk-weighted assets also has been significantly constrained in the United States. In addition, exposures previously considered off balance sheet have been incorporated into risk-weighted assets. Return to text
10. The Federal Reserve Board, the FDIC, and the Office of the Comptroller of the Currency adopted a final rule to strengthen the leverage ratio standards for the largest, most interconnected U.S. banking organizations on April 8, 2014. Under the final rule, covered bank holding companies must maintain a leverage buffer of 2 percentage points above the minimum supplementary leverage ratio requirement of 3 percent, for a total of 5 percent, to avoid restrictions on capital distributions and discretionary bonus payments (see Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2014), "Agencies Adopt Enhanced Supplementary Leverage Ratio Final Rule and Issue Supplementary Leverage Ratio Notice of Proposed Rulemaking," joint press release, April 8). The Federal Reserve approved a final rule imposing risk-based capital surcharges on the largest, most systemically important U.S. bank holding companies on July 20, 2015; in connection with the final rule, the Board issued a white paper describing the calibration of the risk-based capital surcharges (see Board of Governors of the Federal Reserve System (2015), "Federal Reserve Board Approves Final Rule Requiring the Largest, Most Systemically Important U.S. Bank Holding Companies to Further Strengthen Their Capital Positions," press release, July 20). Return to text
11. Moreover, the Federal Reserve's Comprehensive Liquidity Analysis and Review, in which supervisors analyze the liquidity risks and practices at large banks, has promoted improvements in liquidity-risk management. The U.S. banking agencies also have proposed a net stable funding ratio (NSFR) to help ensure that large banks have a stable funding profile over a one-year horizon, and we are working toward finalization of the NSFR. Return to text
12. In addition to these steps, the Board issued another proposal to make G-SIBs more resolvable in May of last year (see Board of Governors of the Federal Reserve System (2016), "Federal Reserve Board Proposes Rule to Support U.S. Financial Stability by Enhancing the Resolvability of Very Large and Complex Financial Firms," press release, May 3). This proposed rule would impose restrictions on G-SIBs' qualified financial contracts--including derivatives and repurchase agreements (or repos)--to guard against the rapid, mass unwinding of those contracts during the resolution of a G-SIB. The proposed restrictions are a key step toward G-SIB resolvability because rapidly unwinding these contracts could destabilize the financial system by causing asset fire sales and toppling other firms. Return to text
13. One area in which regulations have shifted to a lesser degree in the United States is that of time-varying macroprudential tools, in which regulatory requirements are adjusted to address changes in vulnerabilities that may affect the financial system. For example, U.S. regulatory authorities have adopted rules that allow use of the countercyclical capital buffer, but other time-varying tools are limited in the United States. This issue is discussed in, for example, Stanley Fischer (2015), "Macroprudential Policy in the U.S. Economy," speech delivered at "Macroprudential Monetary Policy," 59th Economic Conference of the Federal Reserve Bank of Boston, Boston, October 2. Return to text
14. For example, the FSOC contributed, through its identification process, to the development of the Securities and Exchange Commission reforms affecting money market funds. The FSOC has also designated four firms as systemically important--AIG, GE Capital, Prudential, and MetLife. GE Capital chose to shrink, adjust its business model, and reduce its footprint in short-term wholesale funding markets--and hence reduce a source of systemic risk. These actions caused the FSOC to subsequently remove its designation as systemically important last year--illustrating how the designation process allows both identifying systemic firms and removing such designations when appropriate. Return to text
15. The increase in Tier 1 common equity among bank holding companies has been sizable, especially for the largest banks. If the largest banks are defined as either the eight U.S. global systemically important banks or the U.S. bank holding companies that participated in the CCAR in 2017 (and for which data are available for 2009:Q1), Tier 1 common equity has more than doubled in dollar terms and relative to risk-weighted assets from the first quarter of 2009 to the most recent observations. Return to text
16. For example, Natasha Sarin and Lawrence Summers have reviewed market-based measures of bank equity and related measures of bank risks and concluded that such measures have not improved since the mid-2000s. This assessment may understate the improvement in fundamental risk within the banking sector, as it takes the elevated valuations and low assessment of default risk implied by market prices during the earlier period as indicative of fundamentals. Despite these shortcomings, their analysis is a useful reminder of the importance of considering both regulatory metrics and assessments implied by market prices. See Natasha Sarin and Lawrence H. Summers (2016), "Understanding Bank Risk through Market Measures (PDF)," Brookings Papers on Economic Activity, Fall, pp. 57-109. Return to text
17. For example, see the review of evidence in Simon Firestone, Amy Lorenc, and Ben Ranish (2017), "An Empirical Economic Assessment of the Costs and Benefits of Bank Capital in the US (PDF)," Finance and Economics Discussion Series 2017-034 (Washington: Board of Governors of the Federal Reserve System, April). Some research is less supportive of the role of bank capital in limiting the risk of financial crises but suggests that higher levels of bank capital limit the economic costs of a financial crisis (for example, Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor (2017), "Bank Capital Redux: Solvency, Liquidity, and Crisis," NBER Working Paper Series 23287 (Cambridge, Mass.: National Bureau of Economic Research, March)). Some of the differences in findings across studies may be due to the degree to which the studies incorporate data from different countries and over different periods, as researchers disagree over the extent to which comparisons across countries or periods appropriately account for other factors that differ across such dimensions. Return to text
18. For example, Charles A.E. Goodhart, Anil K. Kashyap, Dimitrios P. Tsomocos, and Alexandros P. Vardoulakis (2013), "An Integrated Framework for Analyzing Multiple Financial Regulations," International Journal of Central Banking, supp. 1, vol. 9 (January), pp. 109-43; and Gazi I. Kara and S. Mehmet Ozsoy (2016), "Bank Regulation under Fire Sale Externalities (PDF)," Finance and Economics Discussion Series 2016-026 (Washington: Board of Governors of the Federal Reserve System, April). Return to text
19. For example, researchers at the Federal Reserve Bank of New York have developed a top-down stress-testing model, and simulation results from the model suggest that the resilience of the U.S. banking system has improved since the crisis; see Beverly Hirtle, Anna Kovner, James Vickery, and Meru Bhanot (2014), "Assessing Financial Stability: The Capital and Loss Assessment under Stress Scenarios (CLASS) Model (PDF)," Staff Report 663 (New York: Federal Reserve Bank of New York, February; revised July 2015). Return to text
20. For example, see Fernando Duarte and Thomas Eisenbach (2013), "Fire-Sale Spillovers and Systemic Risk (PDF)," Staff Report 645 (New York: Federal Reserve Bank of New York, October; revised February 2015). Return to text
21. In response to the Federal Reserve's review and other information, the Board finalized a rule adjusting its capital plan and stress-testing rules, effective for the 2017 cycle, on January 30, 2017. The final rule removes large and noncomplex firms from the qualitative assessment of the Federal Reserve's CCAR, reducing significant burden on these firms and focusing the qualitative review in CCAR on the largest, most complex financial institutions. More generally, changes to improve regulatory and supervisory practices related to stress testing by reducing unnecessary burden while preserving resilience are under consideration. Possible changes have been discussed in Daniel K. Tarullo (2016), "Next Steps in the Evolution of Stress Testing," speech delivered at the Yale University School of Management Leaders Forum, New Haven, Conn., September 26. Return to text
22. An overview of a set of principles that may guide such adjustments is discussed by Jerome H. Powell (2017), "Relationship between Regulation and Economic Growth," statement before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 22. In addition, the Federal Reserve Board has continued to engage in international efforts to assess the effects of reforms and possible adjustments; in this context, the FSB has developed a framework for the post-implementation evaluation of the effects of the Group of Twenty financial regulatory reforms; see Financial Stability Board (2017), Framework for Post-Implementation Evaluation of the Effects of the G20 Financial Regulatory Reforms (PDF) (Basel, Switzerland: FSB, July). Return to text
23. The related literature is sizable. An early contribution is Ben S. Bernanke and Cara S. Lown (1991), "The Credit Crunch," Brookings Papers on Economic Activity, no. 2, pp. 205-47. Research finding a sizable negative relationship between capital requirements and lending includes Shekhar Aiyar, Charles W. Calomiris, and Tomasz Wieladek (2014), "Does Macro-Prudential Regulation Leak? Evidence from a UK Policy Experiment," Journal of Money, Credit and Banking, vol. 46 (s1; February), pp. 181-214. Research finding little relationship between lending and capital ratios (outside financial crises) includes Mark Carlson, Hui Shan, and Missaka Warusawitharana (2013), "Capital Ratios and Bank Lending: A Matched Bank Approach," Journal of Financial Intermediation, vol. 22 (October), pp. 663-87. Research suggesting that higher capital levels may increase lending includes Leonardo Gambacorta and Hyun Song Shin (2016), "Why Bank Capital Matters for Monetary Policy (PDF)," BIS Working Papers 558 (Basel, Switzerland: Bank for International Settlements, April). Return to text
24. For example, see Basel Committee on Banking Supervision (2010), An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements (PDF) (Basel, Switzerland: BCBS, August); and Macroeconomic Assessment Group (2010), Interim Report: Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements (PDF) (Basel, Switzerland: MAG, August). Return to text
25. The ex ante studies from the Basel Committee and the Macroeconomic Assessment Group referenced in note 24 pointed to sizable net benefits from higher capital requirements. More academic research pointing to similar conclusions using macroeconomic models (and typically focused on model-specific measures of economic welfare) includes Michael T. Kiley and Jae W. Sim (2014), "Bank Capital and the Macroeconomy: Policy Considerations," Journal of Economic Dynamics and Control, vol. 43 (June), pp. 175-98; Laurent Clerc, Alexis Derviz, Caterina Mendicino, Stephane Moyen, Kalin Nikolov, Livio Stracca, Javier Suarez, and Alexandros P. Vardoulakis (2015), "Capital Regulation in a Macroeconomic Model with Three Layers of Default," International Journal of Central Banking, vol. 11 (June), pages 9-63; and Juliane Begenau (2016), "Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model," unpublished paper, Harvard Business School, September. Subsequent analyses, albeit ones that follow similar approaches, also suggest that there are net benefits to higher capital standards. One example is the analysis by Firestone, Lorenc, and Ranish, "An Empirical Economic Assessment," in note 17. Another is Ingo Fender and Ulf Lewrick (2016), "Adding It All Up: The Macroeconomic Impact of Basel III and Outstanding Reform Issues (PDF)," BIS Working Papers 591 (Basel, Switzerland: Bank for International Settlements, November). Indeed, this research points to benefits from capital requirements in excess of those adopted, a conclusion also reached in Wayne Passmore and Alexander H. von Hafften (2017), "Are Basel's Capital Surcharges for Global Systemically Important Banks Too Small? (PDF)" Finance and Economics Discussion Series 2017-021 (Washington: Board of Governors of the Federal Reserve System, February). Return to text
26. This conclusion is consistent with, for example, the findings in Federal Reserve Banks (2017), 2016 Small Business Credit Survey: Report on Employer Firms (PDF) (New York: Federal Reserve Bank of New York, April). Return to text
27. As I have discussed previously, the Federal Reserve has been considering improvements through a number of work streams. For example, the Federal Reserve and the other banking agencies have recently completed the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA) review. Under EGRPRA, the federal banking agencies are required to conduct a joint review of their regulations every 10 years to identify provisions that are outdated, unnecessary, or unduly burdensome. The Federal Reserve viewed this review as a timely opportunity to step back and identify ways to reduce regulatory burden, particularly for smaller or less complex banks that pose less risk to the U.S. financial system. I discussed preliminary emerging themes from this review in Janet L. Yellen (2016), "Supervision and Regulation," statement before the Committee on Financial Services, U.S. House of Representatives, September 28. For the final EGRPRA report to the Congress, see Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, and National Credit Union Administration (2017), Joint Report to Congress: Economic Growth and Regulatory Paperwork Reduction Act(PDF) (Washington: Federal Financial Institutions Examination Council, March). Return to text
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