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

In light of the considerable efforts under way to implement a macroprudential approach to enhance financial stability and the increased focus of policymakers on monitoring emerging financial stability risks, I see three key principles that should guide the interaction of monetary policy and macroprudential policy in the United States.

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

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.14 Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability.

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.

Born of necessity during the depths of the financial crisis as part of an effort to restore confidence in the U.S. financial system, supervisory stress testing has in the intervening five years become a cornerstone of a new approach to regulation and supervision of the nation's largest financial institutions. First, of course, it is a means for assuring that large, complex financial institutions have sufficient capital to allow them to remain viable intermediaries even under highly stressful conditions. More broadly, supervisory stress testing and the associated review of capital planning processes have provided a platform for building out a regulatory framework that is more dynamic, more macroprudential, and more data-driven than pre-crisis practice...

While some important features of capital planning are observable only during the formal CCAR process, most of the risk-management and capital planning standards incorporated in CCAR are operative and observable by supervisors throughout the year. These should be an important focus of ongoing supervisory oversight and of discussions between firms and supervisors. Only in unusual circumstances should supervisors learn for the first time during CCAR of significant problems in the quality of the capital planning processes, and only in unusual circumstances should firms be surprised at the outcome of the qualitative assessment.

We have already taken steps to further this integration of CCAR and regular supervision. At the end of each CCAR process our supervisors send to each firm a letter detailing their conclusions concerning the qualitative assessment. To the extent weaknesses or areas for improvement are identified, those letters provide a basis for regular stocktaking by both firms and supervisors. More generally, last year we released a paper on our expectations for all aspects of capital planning, providing greater detail than what is included in the annual CCAR instructions.

I anticipate that we will take additional steps to integrate ongoing supervisory assessments of risk-management and other internal control processes with the annual CCAR exercise, and to assure that communications in both directions are heard. One such step has just recently begun: The committee chaired by senior Board staff that is responsible for the oversight of CCAR, supported by the relevant horizontal assessment teams, will directly engage with firms during the course of the year to evaluate progress in remediating weaknesses or other issues identified in the post-CCAR letters. Increasingly, our regular supervisory work on topics such as risk-identification and internal audit will focus on processes that are critical to risk management and capital planning at the firms, areas of focus for CCAR. The aim of these and additional measures is to make CCAR more the culmination of year-round supervision of risk-management and capital planning processes than a discrete exercise that takes place at the same time as the supervisory stress tests...

Although strong capital regulation is critical to ensuring the safety and soundness of our largest financial institutions, it is not a panacea, as indeed no single regulatory device can ever be. Similarly, supervisory stress testing and CCAR, while central to ensuring strong capital positions for large firms, are not the only important elements of our supervisory program. Having said that, however, I hope you will take at least these three points away from my remarks today.

First, supervisory stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions--and to apply these specifications on a dynamic basis--has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system. The opportunities it provides to incorporate macroprudential elements make it, in my judgment, the single most important advance in prudential regulation since the crisis.

Second, supervisory stress testing and CCAR have provided the first significant form of supervision conducted in a horizontal, coordinated fashion, affording a single view of an entire portfolio of institutions, as well as more data-rich insight into each institution individually. As such, these programs have opened the way for similar supervisory activities and continue to teach us how to organize our supervisory efforts in order most effectively to safeguard firm soundness and financial stability.

Finally, supervisory stress testing and CCAR are the exemplary cases of how supervision that aspires to keep up with the dynamism of financial firms and financial markets must itself be composed of adaptive tools. If regulators are to make the necessary adaptations, they must be open to the comments, critiques, and suggestions of those outside the regulatory community. For this reason, transparency around the aims, assumptions, and methodologies of stress testing and our review of capital plans must be preserved and extended.

Let me be quick to add that one negative, collateral impact of engaging in reverse repos is that during a period of heightened financial risk, investors might flee to the reverse repo market. This would provide a safe asset for investors, but might also encourage runs from higher-risk, short-term private debt instruments. This would have the potential to create significant private sector financing disruptions during times of stress. Presumably, capping the size of the reverse repo facility could help limit the impact.

There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place. But it has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. One example, drawn from Federal Reserve practice, is the recent supervisory guidance requiring that every notice of a "Matter Requiring Attention" (MRA) issued by supervisors must be reviewed, and compliance signed off, by the board of directors. There are some MRAs that clearly should come to the board's attention, but the failure to discriminate among them is almost surely distracting from strategic and risk-related analyses and oversight by boards.

My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity, posing risks to achieving sustainable growth over the longer run.

Given the rescue expectations that have built up over the last several decades, I believe it will take more than a sincere pledge to limit central bank lending to solve the time consistency problem. The resolution planning provisions of the Dodd-Frank Act — often called “living wills” — require the creation of credible plans for resolving large institutions in bankruptcy without government funding. Work is underway implementing these provisions, but much more is needed. It’s worth emphasizing, however, that such plans should not take the current complexity and scale of large institutions as immutably given. The strategy should be to work backward from resolvability, without government funding backstops, to deduce how their current operations and funding need to be structured. Significant changes may be required, but resolution planning appears to be the only plausible way to dismantle “too big to fail.”

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.

Why was it that the banking system in this part of the country was, apparently, especially vulnerable, and what lessons can be drawn from this experience?

At the risk of some oversimplification, I'll propose four takeaways.

First, concentrations can be deadly. Many of the banks that failed, especially around Atlanta, were relatively young banks that became highly concentrated in residential real estate loans, particularly acquisition, development, and construction, or ADC loans.

Second, many of the banks that failed were excessively reliant on wholesale funding. The median wholesale funding-to-asset ratio of the Georgia banks that failed was 30 percent. Hot money can burn you.

Another factor that contributed to failures was inexperience with severe conditions along with overdependence on collateral values without an understanding of cash flows under various scenarios. I'm a former commercial banker. I was taught that cash generation repays loans, and analysis of the borrower's ability to repay is basic...

Finally, many of the failed banks suffered from weak governance. Banks need board members who understand their role as directors. Directors as a group set policy, define the risk appetite of the bank, and hold management accountable for risk management.

The financial crisis is behind us, thankfully, but not far behind. The image in the rearview mirror is still largeand perhaps closerthan it appears. The Federal Reserves history is important, but it is only helpful to the extent that it positions us to consider how we might address the considerable challenges that await the central bank in the years to come. Those challenges include normalizing monetary policy, effectively supervising the largest financial institutions, and ensuring a safe, efficient and accessible payments system.

Greg Robb: Thank you. I'd like to take you back to last summer when there were hints, the Fed made hints, that they were going to taper and long-term interest rates spiked. Mortgage rates rose. What lessons, looking back at that -- at that period, what lessons have you -- have you learned from it? And are you confident that you won't repeat those mistakes again?

YELLEN: Well, I think there were quite a number of things happening at that time. I think it's probably true that monetary policy may have played a role in touching off that market reaction, but I think the market reaction was exacerbated by the fact that we had a very significant unwinding of carry trades and other leveraged positions that investors had taken, perhaps thinking that the level of volatility was exceptionally low and perhaps lower than was safe for them to have assumed.

But we certainly saw -- now, in some ways, the fact the term "premia" and interest rates have come up somewhat, although it has had a negative effect on the recovery, and that's evident in housing, in the slowdown in housing, perhaps it's diminished some financial instability risk that may have been associated with these carried (ph) traits and speculative activities that were unwinding during that time.

A lesson is that we will try, and we were trying then, but we will continue to try to communicate as clearly as we possibly can about how we will conduct monetary policy and to be as steady and determined and as transparent as we can to provide as much clarity as is reasonably certain, given that the economic developments in the economy are themselves uncertain.

But we will try as hard as we can not to be a source of instability here.

A top Federal Reserve official known for his dovish views on policy acknowledged on Friday that monetary policymakers may need to take financial stability risks into account when making policy choices.

But Minneapolis Fed President Narayana Kocherlakota, who has repeatedly called on the U.S. central bank to ease policy further, stopped short of saying that such risks should keep the Fed from doing whatever it can to return the economy more quickly to full employment.

…

Arguably, the "large increase in yields only happened because monetary policy (QE3) had lowered yields so much," Kocherlakota said. The key question, he said, is whether that sudden rise in yields hurt overall economic growth more than the earlier decline in yields had helped. The answer, he said, is far from clear.

"There is considerable need for new theory and empirics," he concluded.

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From Market News International

Minneapolis Federal Reserve Bank President Narayana Kocherlakota said Friday that supervision is the best way for the Fed to tackle threats to financial stability, but said "residual risks" may remain for monetary policy to deal with.

Kocherlakota suggested "a framework to incorporate systemic risk mitigation into monetary policymaking" using a "mean variance framework." But he did not flesh out this suggestion, saying more theoretical work is needed.

In addition to that we're looking particularly through the stress tests at financial institutions in a low interest rate environment. We have to worry about whether or not they're appropriately dealing with interest rate risk. We have been looking at that and, in fact, our current stress test
I would say at this stage broadly I don't see concerns. But there are pockets, a few things that we've identified that do concern us. For example, underwriting standards and leveraged lending clearly appear to be deteriorating. We have addressed that with supervisory guidance and special exams, and we'll continue to be very vigilant in that area. That's worrisome to us.
There are a few areas within asset price evaluations, broadly speaking. I wouldn't worry, but there are a few areas where I would be concerned. Many people have emphasized farm land as a concern, farm land prices.
So there are a few areas. We have regulatory and supervisory tools. To me, they should be the first line of defense. But I don't rule out monetary policy.