My Translation of Yellen's Speech on Bank Regulation
Gary North - July 07, 2014
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Janet Yellen gave a speech on July 2. It of course received considerable attention in the financial media.

Over the years, I have dutifully provided translations of speeches by the chairmen of the Board of Governors of the Federal Reserve System -- that tiny part of the FED that is technically part of the U.S. government. As far as I know, I am the only financial columnist who provides a translation service out of FEDspeak into English.

Greenspan was a master of FEDspeak. Bernanke preferred to give long, boring summaries, with lots of footnotes, of the recent history of financial events that everyone already knew about. When he did say anything of substance, it usually turned out to be wrong, such as his repeated insistence that there was no housing bubble.

Yellen takes a different approach. She prefers to talk about what the Federal Reserve might do, and really ought to do, but has not yet done. She scrupulously avoids mentioning deadlines. The following observation is clearly the essence of her job as chairman: "Janet Yellen would not be caught dead with a deadline." This leaves the door open to wiggle room in the future.

All of this confuses the issues. All of this fills up allotted speech time without providing any specifics. This is the FED's version of "transparency." Transparency in bureaucratic affairs means this: "provide an illusion to the public that something significant is being revealed, when nothing significant is being revealed." On the contrary, anything significant is being concealed.

The key to understanding Dr. Yellen's Chairmanship from this point on is to understand that she is something of a mystic. Imagine an Indian swami in a loincloth, his eyes closed, and his face revealing oneness with the universe. He keeps repeating a mantra. He says: "Om."

Her mantra is "macroprudential."

FED Chairmen all correctly assume that no one in the mainstream media will actually spend the time to go through her speeches, point by point, to see if anything of significance is being presented. The message these days is always the same.

1. Before 2008, we didn't know what we were doing.
2. We have learned from our mistakes.
3. The economic issues are highly complex.
4. The exact nature of economic causation remains a mystery.
5. We are working on emergency plans.
6. We have great confidence in these plans.
7. These plans have not yet been fully implemented.
8. We are not sure when they will be fully implemented.
9. We are monitoring the situation.
10. There are still important questions to be answered.
11. We as yet have no specific answers to any of these questions.
12. We are leaving our options open.

Let me show you how this works. She began with the admission of questions.

The recent crises have appropriately increased the focus on financial stability at central banks around the world. At the Federal Reserve, we have devoted substantially increased resources to monitoring financial stability and have refocused our regulatory and supervisory efforts to limit the buildup of systemic risk. There have also been calls, from some quarters, for a fundamental reconsideration of the goals and strategy of monetary policy. Today I will focus on a key question spurred by this debate: How should monetary and other policymakers balance macroprudential approaches and monetary policy in the pursuit of financial stability?

Translation: "The recent crises, beginning in 2008 in New York banking and investment circles, and rapidly spreading all over the world, caught central bankers flat-footed. Nobody saw it coming. Therefore, we are now devoting resources to monitoring all this. This means we require lots more paperwork from bankers."

In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: 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; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role.

Translation. "We still have no theory of cause and effect with respect to monetary policy. These issues are 'not well understood,' if you get my drift. For a century, the Federal Reserve System has been justified to the public as crucial because it is in charge of monetary policy. Unfortunately, monetary policy is not well understood, so we have pretty much given up on monetary policy as a tool of central planning. We have therefore returned to the tried and true promise of the Progressive movement in 1913: we will regulate the overall economy by regulating the banks, meaning about a dozen large banks. I call this regulatory system, to the extent that it is a system, 'macroprudential.' This sounds very scientific. It sounds comprehensive. It sounds prudent. That ought to keep you rubes happy."

Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities.

Translation. "That's what the approach should do. There is no evidence yet that this is what it will in fact do. We will not know that until the next crisis hits. Wish us luck. Your financial future is dependent on us."

I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability.

Translation. "Yes, I know all about the carry trade: borrow short at rates just above zero, and lend long at rates way above zero. That is what blew up Lehman Brothers in 2008. It could happen again. We will have to change our policy at some point in the future. Since we are buying half of the U.S. government's annual deficit, putting it all in T-bonds as part of Operation Twist, plus $180 billion in Fannie/Freddie IOU's, in this, the recovery phase, you can imagine how much we will have to buy when the next recession hits, and the deficit goes back over a trillion a year. Hold onto your seats then, boys and girls."

Despite these complementarities, monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments.

Translation. "We have provided the incentives, but households have ignored them. Households have contracted their debt. The ratio of debt service repayment to household disposable personal income has fallen like a stone. Businesses have been cautious for five years. But the top five banks have cashed in on these incentives like there is no tomorrow -- exactly as they did, 2004-2007."

But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant.

Translation. "Sure, things can go too far. So what? The federal government is running a deficit of half a trillion dollars a year, and we are going to buy over half of it in T-bonds, plus $180 billion of Fannie and Freddie bonds. We are all Keynesians here."

Although it was not recognized at the time, risks to financial stability within the United States escalated to a dangerous level in the mid-2000s. During that period, policymakers--myself included--were aware that homes seemed overvalued by a number of sensible metrics and that home prices might decline, although there was disagreement about how likely such a decline was and how large it might be.

Translation "We didn't have a clue that the housing market was a bubble. That's why Bernanke went public and categorically denied it in 2005. He said it again in 2007. Nobody at the FED said a word in public about the possibility of a decline in housing prices. The word 'overvalued' was never mentioned. But I know none of you will look it up, so I'll get a free pass."

What was not appreciated was how serious the fallout from such a decline would be for the financial sector and the macroeconomy. Policymakers failed to anticipate that the reversal of the house price bubble would trigger the most significant financial crisis in the United States since the Great Depression because that reversal interacted with critical vulnerabilities in the financial system and in government regulation.

Translation. "We didn't understand cause and effect in the run-up to 2008. We of course gave lots of indications that we were on top of things. We told the world 'no problem.' The world -- except for those crackpot Austrians -- believed us. We even believed us. But that was then. This is now. Now we're on top of things."

In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.
In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important financial institutions (SIFIs) and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.

Translation. "We didn't see it coming."

It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.

Translation. "Under Greenspan in 2001 through 2004, we inflated. We pulled out the stops. We were right to do so. Things would have been worse if we hadn't. Don't blame us for the bubble. Don't blame us for the nutty leverage schemes. Monetary policy had nothing to do with any of that. The cause was the lack of regulation. We needed more regulation. Now we have the authority we did not have then. We screwed up. We therefore asked Congress for more power. Congress gave it to us. Any power Congress did not give us, we have asserted anyway. We believe Rahm Emanuel: 'You never let a serious crisis go to waste. And what I mean by that is it's an opportunity to do things you think you could not do before.' Also, if the crisis really isn't serious, you need to pretend it is."

A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble. Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households' ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly.

Translation. "We used the 'blunt tool' of monetary expansion to reverse the 2001 recession. We used the same blunt tool after 9-11. But once we start using this blunt tool to goose the economy, it becomes a sharp tool. I mean, it's like a scalpel. At that point, calling a halt to monetary base expansion constitutes a blunt tool."

Similar mixed results would have been likely with regard to the effects of tighter monetary policy on leverage and reliance on short-term financing within the financial sector. In particular, the evidence that low interest rates contribute to increased leverage and reliance on short-term funding points toward some ability of higher interest rates to lessen these vulnerabilities, but that evidence is typically consistent with a sizable range of quantitative effects or alternative views regarding the causal channels at work.

Translation. "When I say 'mixed results would have been likely,' I mean nobody here knows what would have happened. We still don't know. We were flying blind. The rest of the paragraph is my attempt to imitate Greenspan's FEDspeak. How am I doing?"

In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities.

Translation. "Since nobody at the Federal Reserve understands cause and effect with respect to monetary policy, we are turning to regulation. We will continue to buy Treasury IOU's and Fannie/Freddie IOU's. We will keep rates low. But if anyone tries to make a profitable use of this opportunity, we will regulate it. We will not let the ten largest banks take advantage of this. No, sireee, Bob. You can count on us."

A more balanced assessment, in my view, would be that increased focus on financial stability risks is appropriate in monetary policy discussions, but the potential cost, in terms of diminished macroeconomic performance, is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time.

Translation. "Once the Federal Reserve starts quantitative easing, meaning good old-fashioned monetary base inflation, it is way too risky to stop. Anyone who says so is recommending a blunt tool. There would be too many financial stability risks to go cold turkey and stop buying federal debt. Once the financial system gets addicted to monetary base expansion, the withdrawal symptoms are to horrendous to risk. We learned that in 2008. Never again."

If monetary policy is not to play a central role in addressing financial stability issues, this task must rely on macroprudential policies.

Translation. "In this, the 100th anniversary of the beginning of the Federal Reserve's operations, we now know that monetary policy isn't enough to create stability. The banks need regulation. It took a while, but we finally figured it out."

If macroprudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macroprudential tools are likely to be most effective, what the limits of such tools may be, and when, because of such limits, it may be appropriate to adjust monetary policy to "get in the cracks" that persist in the macroprudential framework.

Translation. "At this point, I return to the standard approach of every bureaucrat. I will talk about questions. I will not explain in detail what the specific answers are, or why we have any reason to believe that these proposed answers will ever be implemented, let alone why we should believe that they will work. If I keep talking about questions, the Congress will naturally assume that we have specific answers. Congress is really dumb."

Changes in bank capital regulations, which will include a surcharge for systemically important institutions, have significantly increased requirements for loss-absorbing capital at the largest banking firms. The Federal Reserve's stress tests and Comprehensive Capital Analysis and Review process require that large financial institutions maintain sufficient capital to weather severe shocks, and that they demonstrate that their internal capital planning processes are effective, while providing perspective on the loss-absorbing capacity across a large swath of the financial system. The Basel III framework also includes liquidity requirements designed to mitigate excessive reliance by global banks on short-term wholesale funding.

Translation. "We have no idea how much capital is needed. So, we will therefore require whatever the ten largest American banks are willing to tolerate. That's what we have been here to do for a century: keep the management of the ten largest banks happy. That is our unofficial mission statement. As for Basel III, the whole thing is a PR stunt. It will not go into effect until 2019, and this deadline has been extended twice. It can be extended again. There are no sanctions attached. There is no way to enforce any of this. Since big banks around the world shamelessly ignored Basel II, there is no reason why we should expect them to adhere to Basel III."

Oversight of the U.S. shadow banking system also has been strengthened. The new Financial Stability Oversight Council has designated some nonbank financial firms as systemically important institutions that are subject to consolidated supervision by the Federal Reserve. In addition, measures are being undertaken to address some of the potential sources of instability in short-term wholesale funding markets, including reforms to the triparty repo market and money market mutual funds--although progress in these areas has, at times, been frustratingly slow.

Translation. "Whenever I say 'measures are being undertaken,' this means that nothing final has been implemented. We're playing this by ear. When you are dealing with shadows, it's tricky to understand cause and effect. But we are going through the motions. That's what counts, right?"

Additional measures should be taken to address residual risks in the short-term wholesale funding markets.

Translation "When I say 'should be taken,' I am using the passive voice. I use the passive voice in order to avoid any discussion of what precisely the Federal Reserve has been doing, what precisely we are planning to do, and when we expect to be finished. When it comes to Federal Reserve policy, we reject categorically Larry the Cable Guy's motto: 'Get 'er done!' "

Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding--would likely apply only to the largest, most complex organizations.

Translation. "Or maybe not. We haven't decided."

Other measures--such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis.

Translation "Or maybe not. We haven't decided."

To the extent that minimum margin requirements lead to more conservative margin levels during normal and exuberant times, they could help avoid potentially destabilizing procyclical margin increases in short-term wholesale funding markets during times of stress.

Translation. "Whenever a bureaucrat or an economist says 'to the extent that,' it means 'nobody knows. We are making this up as we go along.' "

At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a "bubble" and whether policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical.

Translation. "Whenever a bureaucrat or an economist says 'it should be clear,' you know it isn't clear. As for 'resilient,' that's what we thought the financial system was in 2007. It wasn't."

Nonetheless, some macroprudential tools can be adjusted in a manner that may further enhance resilience as risks emerge.

Translation. "I say they 'can be adjusted.' But since they are brand new, nobody knows how to use any of them. The phrase 'can be adjusted' means 'we can make it up as we go along.'"

In addition, macroprudential tools can, in some cases, be targeted at areas of concern. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional loss-absorbing capacity within the financial sector during periods of rapid credit creation while also leaning against emerging excesses. The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions and incorporate the possibility of highlighting salient risk scenarios, both of which may contribute to increasing resilience during periods in which risks are rising. Similarly, minimum margin requirements for securities financing transactions could potentially vary on a countercyclical basis so that they are higher in normal times than in times of stress.

Translation. "The Basel III system has no sanctions. No central bank has to abide by them, any more than it had to abide by Basel II. As for Basel I, no one remembers it. Also, when I say 'could potentially vary,' I mean this: 'Maybe it could; maybe it couldn't.'"

First, it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment.

Translation. "No regulators have completed their efforts. We are talking about central bankers. They never complete any efforts. Ever. They just keep making it up as they go along."

Key steps along this path include completion of the transition to full implementation of Basel III, including new liquidity requirements; enhanced prudential standards for systemically important firms, including risk-based capital requirements, a leverage ratio, and tighter prudential buffers for firms heavily reliant on short-term wholesale funding; expansion of the regulatory umbrella to incorporate all systemically important firms; the institution of an effective, cross-border resolution regime for systemically important financial institutions; and consideration of regulations, such as minimum margin requirements for securities financing transactions, to limit leverage in sectors beyond the banking sector and SIFIs.

Translation. "This list of key steps is all for public relations. Since no central bank agrees on any such list of key steps, it's all irrelevant. There are no negative sanctions. Nobody has to do anything. Basel III is a PR operation, just as Basel II was. Whenever you hear 'cross border,' think 'nobody is in authority to enforce any of this.' That will help you understand Basel III."

Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macroprudential tools to influence these developments. The limitations of macroprudential policies reflect the potential for risks to emerge outside sectors subject to regulation, the potential for supervision and regulation to miss emerging risks, the uncertain efficacy of new macroprudential tools such as a countercyclical capital buffer, and the potential for such policy steps to be delayed or to lack public support. Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability.

Translation. "The regulatory system cannot cover everything. What I am saying is simple: if there is another crisis, the Federal Reserve will create as much fiat money as is required to bail out any major bank. We don't trust Congress to pony up the money for TARP II. Once bitten, twice shy."

These first two principles will be more effective in helping to address financial stability risks when the public understands how monetary policymakers are weighing such risks in the setting of monetary policy. Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.

Translation. "We are winging it. But you can count on me to give long speeches that assure the public of guaranteed financial stability. I call this 'transparency.' This means 'upbeat speeches.' "

Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns.

Translation. "The Federal Reserve will continue to buy most of the federal government's deficit, plus Fannie/Freddie bonds. Trust us."

That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a "reach for yield" in the face of persistently low interest rates.

Tranlation. "What goes up can come down. When long rates rise because of monetary inflation, junk bond holders could have their heads handed to them. We are here to keep T-bond rates low. Junk bond investors are on their own."

The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures.

Translation "The overall economy remains in the crapper. Nobody is borrowing. With GDP down 2.9% on an annualized basis in first quarter, who can blame them?""

But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.

Translation. "We will monitor things. This implies that we were not monitoring things before 2008."

In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macroprudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions.

Translation "You yokels believed our assurances before 2008. We think you will continue to do so. Now go write up your summaries of my talk. The Dow may go above 17,000 if you do."
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