The Fed sees no financial crisis ahead – so, can we all relax?

The Fed sees no financial crisis ahead – so, can we all relax?

Last week, leading media outlets led with a sensational headline that instantly grabbed my attention – “Fed’s Yellen expects no new financial crisis in ‘our lifetimes”. She was saying that the US now has a safer financial system, thanks largely to the efforts of the Fed. But will a safer system embolden market participants to take greater risks, thereby making the system riskier?

The headline grabbed me in two ways:

• If the headline was taken at face value, it would suggest that policymakers are comfortable with the state of the financial system. But does this promote a moral hazard that increases the risk of a greater shock to the system?
• This statement seems rather definite for an institution famed for nuanced language. (Having started my career at the Reserve Bank of Australia, I know how carefully each word is considered by central bankers).

With such a strong first impression, a review of the source was required for much needed context. The headline itself is actually ambiguous when considered carefully at face value – we don’t know what is meant by a “financial crisis” or how long “our lifetimes” is, and when definitions aren’t provided we tend to assume our own.

This headline was part of a conversation held at the British Academy that went longer than an hour, yet the press successfully grabbed the 5 seconds that would grab the most attention. Let’s look at this statement in the context of the full response:

“In the aftermath you asked are we safer now? We have been very focused on making sure that the corner of our financial system has enough capital that we can provide assurance that our major banks would be able to go on lending and providing credit to the economy if and after a very severe shock.

We do what are called ‘stress tests’, and the Fed just completed the first half of these stress tests last week. We hit the major banks that we subjected to these stress tests with enormous shocks: unemployment increasing to 10%, huge declines in house prices, commercial real estate prices. Enormous shocks. And publicised exactly how each of these firms would fare and what losses they would take in every portfolio and what their capital position would be at the end of that. And I think the public can see that the capital positions of the major banks are very much stronger at this point of this year, all the firms passed the quantitative part of the stress test.

So we have strong capital requirements, also liquidity. Suppose there were a scare and depositors decided we want our money, we’re worried there’s something wrong in your bank, well having enough liquidity that you would be able to meet deposit outflows that could occur let’s say over a 30 day period even if they were severe, would put in place for systemic banks, internationally active banks, liquidity requirements to hold in order of magnitude more liquid assets.

We’ve also changed the system in terms of how derivatives work. Now most standardised derivates are centrally cleared rather than being involved in complex webs that are very difficult to untangle when a major institution gets in trouble …

… So I think the system is much safer and much sounder, and as I mentioned we are doing a lot more to try to look for financial stability risks that may not be immediately apparent, but to look in corners of the financial system that are not subject to regulation outside those areas in order to try to detect threats to financial stability that may be emerging.

So would I say there will never, ever be another financial crisis? Probably that would be going too far, but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.”

It’s a well-rounded answer to a complex question. In this context, it would seem the Fed is maintaining its characteristic conservatism, while holding the view that the current financial system is safer than the previous crisis.

However, while added context is certainly helpful, it was not enough to resolve my first impressions of the main headline. It may well be the case that the US does not experience a bank run for many years – but will a perceivably safer financial system embolden market participants to take greater risks, thereby making the system riskier? It’s interesting to note that soon after passing these stress tests the major US banks unveiled plans to return capital to shareholders (with the approval of the Federal Reserve).

So the headline is sensationalised, but the underlying message certainly warrants attention.