I am skeptical of a clean separation principle that places financial stability squarely in the purview of the supervisors. Instead, I think monetary policymakers also need to maintain a careful eye on the financial system and how interest rate policy affects incentives for financial markets and institutions.

As a result of near-zero interest rates for five years, the profitability of traditional banking activities is strained and incentives to reach for yield are tempting. Net interest margins continue to trend lower and are at their lowest level in 30 years. Banks are responding as we should expect, which is to say they are engaging in riskier activities. For example, an all-time high of $600 billion of leveraged loans were issued in 2013. This lending is often characterized by weaker underwriting standards, including higher debt ratios and fewer covenant provisions.

The incentives to reach for yield extend to smaller financial institutions as well. Commercial banks with assets of less than $50 billion have increased exposure to interest rate risk, due in part to the guidance the FOMC has provided regarding future interest rates. Today, 53 percent of the securities and loans held by these banks have maturities of more than three years, compared to about 37 percent back in 2005. If longer-term interest rates were to suddenly move higher, these institutions could face heavy losses.

I would also note that a number of central banks did engage in a form of macroprudential supervision before the crisis through their Financial Stability Reports. Overall, these reports show that potential risks were identified before the crisis, but it was far more difficult for central banks to judge whether these risks would be fully realized and to then pursue corrective supervisory action in an effective and timely manner. Until we better understand how to utilize such tools, macroprudential supervision and the identification of systemic risk can be most effective when it serves as a complement to a rigorous microprudential regime. Assessing risk-management policies and governance offers a window into the incentives that drive decision-making and risk appetite at the level of an individual firm, providing important context for macro views of the system.

In addition to our monetary policy responsibilities, the Federal Reserve works to promote financial stability, focusing on identifying and monitoring vulnerabilities in the financial system and taking actions to reduce them. In this regard, the committee recognizes that an extended period of low interest rates has the potential induce investors to reach for yield by taking on increased leverage, duration risk, or credit risk. Some reach for yield behavior may be evident, for example, in the lower-rated corporate debt markets where issuance of syndicated leverage loans and high-yield bonds has continued to expand briskly, spreads have continued to narrow, and underwriting standards have loosened further. While some financial intermediaries have increased their exposure to duration and credit risk recently, these increases appear modest to date, particularly at the largest banks and life insurers. More generally, valuations for the equity market as a whole and other broad categories of assets, such as residential real estate, remain within historical norms. In addition, bank holding companies have improved their liquidity positions and raised capital ratios to levels significantly higher than prior to the financial crisis. For the financial sector more broadly, leverage remains subdued and measures of short-term funding continue to be far below levels seen before the financial crisis. ... So, we can't detect within any certainty whether or not there's an asset bubble. But we can look at a variety of different valuation metrics akin to price-earnings ratios and the stock market; a variety of ways of measuring those. And we can look to see how valuations in that sense moved out of historically normal ranges. And I would say for the equity market as a whole, the answer is that valuations are in historically normal ranges. Now, interest rates, long-term interest rates are low and that is one of the factors that feeds into equity market valuations. So, there is that linkage. So, there are pockets where we could potentially see misvaluations in smaller-cap stocks, but overall those broad metrics don't suggest that we are in obviously bubble territory. But, you know, we don't have targets for equity prices and can't -- can't detect if we're in a bubble with -- with certainty.

“We’re exactly on the right track” with current policy, Williams said in an interview yesterday in San Francisco, predicting unemployment will fall to 5.5 percent by the end of next year and inflation will accelerate to about 1.7 percent.
Trying to achieve the Fed’s goals sooner “would take policy actions that might have more negative effects,” he said.
Williams, who has consistently supported record stimulus, said the Fed will probably continue paring its asset purchases and end them late this year. Central bankers should take care not to change their forward guidance on the path of interest rates in a way that eases policy too much, he said.
“Adding more and more stimulus either through asset purchases or even trying to put even stronger forward guidance does create more risks about getting policy right on the exit,” said Williams… It also raises questions about whether the Fed is “contributing to potential risks with financial stability, excessive risk-taking.”

…
The San Francisco Fed chief said he doesn’t see the currently “very narrow spreads” in some corners of the credit market such as junk bonds and leveraged loans as “a big risk” to the economy or the financial system. Even so, “that is an issue, and that’s an issue that we need to keep watching.”

officials will need to rely more on their public speeches to get their messages across rather than cram all their ideas into a single FOMC statement, said Williams, 51. He said that he “liked what we did” with the new guidance announced last month, which he described as “very good.”
“As you get closer to your goals, there are so many factors” behind “when to raise rates and how fast to raise rates,” he said. “It’s impossible to describe it in a page without losing that ability to do policy in the best possible way.”

Let me preview my bottom line. I am going to try to make the case that, all else being equal, monetary policy should be less accommodative--by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level--when estimates of risk premiums in the bond market are abnormally low. These risk premiums include the term premium on Treasury securities, as well as the expected returns to investors from bearing the credit risk on, for example, corporate bonds and asset-backed securities.

The evaluation of potential macroprudential tools that might be used to address emerging financial imbalances is another high priority. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional resilience within the financial sector during periods of buoyant credit creation. Staff members are investigating the potential of this and other regulatory tools, such as cyclically sensitive loan-to-value requirements for mortgages, to improve financial stability. A number of countries, including both advanced and emerging-market economies, have already deployed such measures, and their experiences should be instructive. Although, in principle, monetary policy can be used to address financial imbalances, the presumption remains that macroprudential tools, together with well-focused traditional regulation and supervision, should serve as the first line of defense against emerging threats to financial stability. However, more remains to be done to better understand how to design and implement more effective macroprudential tools and how these tools interact with monetary policy.

Obviously, we were slow to recognize the crisis; I was slow to recognize the crisis. In retrospect, it was a traditional, classic crisis, but in a very, very different guise, different types of financial instruments, different types of institutions which made it for an historian like me more difficult to -- to see. Whether or not we could have prevented it or done more about it, that's another question. You know, by the time I became chairman, it was already 2006, and house prices were already declining. Most of the mortgages had been made. But, obviously, it would have been good to have recognized that earlier and tried to take more preventive action. That being said, we've done everything we can think of, essentially, to strengthen the Fed's ability to monitor the financial markets, to take actions to stabilize the economy and the financial system. So I think, going forward, we're much better prepared for -- to deal with these kinds of events than we were when I became chairman in 2006.

The theme of this conference is, "Lessons from the Financial Crisis for Monetary Policy." Given the opportunity to speak about this topic, my first thought was that I should organize my remarks around the familiar "lean versus clean" debate. The traditional, pre-crisis framing of the question went something like this: Should policymakers rely on ex ante measures to lean against potential financial imbalances as they build up, and thereby lower the probability of a bad event ever happening, or should they do most of their work ex post, focusing on the clean-up?

Post-crisis, the emphasis in the debate has shifted. I think it's safe to assume that nobody in this room would now argue that we should be putting all our eggs in the "clean" basket.

I also believe that much of the promise of the CCAR framework lies in its potential to help us achieve a better outcome not just in normal times, but also in the important in-between times, in the early stages of a crisis. In other words, when thinking about the design of CCAR, one of the questions I keep coming back to is this: Suppose we were granted a do-over, and it was late 2007. If we had the CCAR process in place, how would things have turned out differently? Would we have seen significantly more equity issuance at this earlier date by the big firms, and hence a better outcome for the real economy?

On the one hand, there is some reason for optimism on this score. After all, the original stress tests--the Supervisory Capital Assessment Program (SCAP) in May 2009--provided the impetus for a significant recapitalization of the banking system. More than $100 billion of new common equity was raised from the private sector in the six months after the SCAP, and in many ways it was a watershed event in the course of the crisis.

Moreover, the current CCAR framework gives the Federal Reserve both the authority and the independent analytical basis to require external equity issues in the event that, under the stress scenario, a firm's post-stress, tier 1 common equity ratio is below 5 percent, and the ratio cannot be restored simply by suspending dividends and share repurchases.

So, one could reach the conclusion that historically low and stable interest rates pose a threat to financial stability…

I don’t believe that is the right approach… If more restrictive monetary policies were pursued to generate higher interest rates, they would likely result in higher unemployment and a sharp decline in asset prices, choking the moderate recovery. Such an adverse economic outcome is unlikely to set a favorable foundation for financial stability. Moreover, our short-term interest rate tools are too blunt to have a significant effect on those pockets of the financial system prone to inappropriate risk-taking without, at the same time, significantly damaging other markets, as well as the growth prospects for the economy as a whole. Therefore, stepping away from otherwise appropriate monetary policy to address potential financial stability risks would degrade progress towards maximum employment and price stability. This approach would be a poor choice if other tools are available, at lower social costs, to address financial stability risks.

…

If you believe that financial stability can only be achieved through higher interest rates — interest rates that would do immediate damage to meeting our dual mandate goals at a time when unemployment is still unacceptably high — then we ought to at least ask ourselves if the financial system has become too big and too complex. This conclusion is particularly vexing if supervisory, macroprudential and market-discipline tools are inadequate. If the only way we can achieve financial stability is to raise interest rates above where the forces of demand and supply in the real economy put them, then the cost-benefit calculus of our policy choices becomes much more complex. The possible benefit of such a restrictive rate move would be to reduce risks that might potentially be forming in the nooks and crannies of a highly complex financial system. But the cost would be higher unemployment; a risk of choking off the economic recovery; even lower inflation below our objective; and, somewhat paradoxically, the introduction of new financial risks by reducing asset values and credit quality.