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.

In weighing these questions, I find it helpful to distinguish between tools that primarily build through-the-cycle resilience against adverse financial developments and those primarily intended to lean against financial excesses.

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.

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

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.

We are paying close attention to the macroprudential risks posed by the low interest rate environment, particularly given the possibility that interest rates may remain historically low for some time even after the FOMC begins to increase its target for the federal funds rate.

While ad hoc supervisory action aimed at specific lending or risks is surely a useful tool, it has its limitations. First, it is a bit too soon to judge precisely how effective these supervisory actions--such as last year's leveraged lending guidance--have been. Second, even if they prove effective in containing discrete excesses, it is not clear that the somewhat deliberate supervisory process would be adequate to deal with a more pervasive reach for yield affecting many areas of credit extension. Third, and perhaps most important, the extent to which supervisory practice can either lean against the wind or increase the overall resiliency of the financial system is limited by the fact that it applies only to prudentially regulated firms. This circumstance creates an incentive for intermediation activities to migrate outside of the regulated sector.
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As I have said previously, however, given that procyclicality is an important contributor to systemic risk, there is good reason to continue work on developing time-varying policies. I would devote particular attention to policies that can act as the rough equivalent of an increase in interest rates for particular sources of funding…
One example is the countercyclical capital buffer in Basel III, which provides for an increase in the risk-weighted capital requirements of prudentially regulated banking organizations of up to 2-1/2 percentage points when "credit growth is excessive and is leading to the buildup of system-wide risk."10 Because stricter capital requirements lead to higher levels of bank equity--which is typically more expensive than debt--they would likely result in higher funding costs for the bank-intermediated credit utilized by other market participants. In this regard, time-varying macroprudential policies can be thought of as addressing cyclical systemic risks via interest rates in a manner somewhat akin to a tightening of monetary policy, which by raising benchmark interest rates affects a similar increase in funding costs.
Clearly, time-varying macroprudential policies could not be viewed as a substitute for monetary policy. Like ad hoc supervisory policies, they would influence a narrower set of transactions and, as such, would not "get in all the cracks" of the financial system, to use a phrase coined by my colleague Jeremy Stein. But, to shift metaphors, they could potentially provide something of a speed bump, while not producing the much broader effect on the economy that a federal funds rate increase would. Moreover, time-varying macroprudential policies may also give monetary policymakers more of an opportunity to assess whether the asset inflation is generalized and sustained enough to warrant a change in monetary policy.

I think a major failure there was in regulation and in supervision, and not -- not just in monetary policy. So, I would say going forward, while I certainly recognize and my colleagues do that an environment of low interest rates can incent the development of bubbles, and we can't take monetary policy off table as a tool to use to address it, it's a blunt tool.
And macro-prudential policies -- many countries do things like impose limits on loan-to-value ratios, not because of safety and soundness of individual institutions, but because they see a housing bubble form and they want to protect the economy from it. We can consider tools like that, and certainly supervision and regulation should play a role and their more targeted policies.
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Nothing is more important than avoiding another financial crisis like the one that we just lived through. So, it's immensely high priority for the Federal Reserve to do what we can to identify threats to financial stability.
One approach that we're, you know, putting in place in part through our Dodd-Frank rulemakings is simply to build a financial system that is much more resilient to shocks. The amount of capital in the largest banking organizations is doubled. We do have a safer and sounder system, and that's important.
But detecting threats to financial stability, we are looking for those threats. I'd say my general assessment at this point is that I -- I can't see threats to financial stability that have built to the point of flashing orange or red. We don't see a broad-based buildup, for example, in leverage or very rapid credit growth. Asset prices generally do not appear to be out of line with traditional metrics. But this is something we're looking at very, very carefully.

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.

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.

[W]e should probably be skeptical as to how effective a macroprudential relaxation of regulatory requirements can be on the downside of economic cycles. Market discipline, which may have been lax in boom years, tends to become very strict when conditions deteriorate rapidly. Even if supervisors were to announce a relaxation in regulatory requirements, in stressed economic conditions, investors and counterparties may well look unfavorably on reductions in capital levels (even from higher levels) or relaxation of underwriting standards at any one firm, notwithstanding the potential benefits for the economy as a whole were all large firms to follow suit. Anticipating such a reaction, senior management of banks may thus have strong non-regulatory incentives to act as if microprudential regulation continued to dominate.

In response to a question about what he expects his legacy to be perceived to be:

Well, of course, that’s going to be for others to determine. I guess what I would hope to be able to say is several things. First, I came into the Federal Reserve as a governor now some 11 years ago; quite a long time — with a lot of interest in communication and transparency. And I think, you know, in the last 11 years or eight years, however you want to count, the Federal Reserve has made some significant strides in that area, including, for example, as I mentioned in the press conference, the stating of a numerical objective for medium-term inflation and other communications innovations as well.

So I think that’s something that I think is quite — has changed over the last decade. For better or worse, of course, I was at the Fed during the crisis and the aftermath. We have — you know, the future, again, will judge the response to that. But what is certainly true is that the Federal Reserve, as an institution, has changed very sharply in terms of its structure and the resources being devoted to financial stability questions.

And I would say that this relates both to the actions we took at the height of the crisis, which I viewed as bringing Bagehot’s wisdom, the lender-of-last-resort wisdom, back into the modern context, but also the work we’re doing now to try to reduce the risk that another financial crisis will hit someday. That includes our monitoring, our oversight of systemically important firms, our stress tests, which I think is an important development in financial regulation, and more generally our macroprudential approach to financial stability, which, again, means that we look not only at individual firms, as important as that is, but we also try to identify risks and vulnerabilities to the financial system more broadly.

In monetary policy, you know, we’ve confronted the zero lower bound. Again, people have to judge whether we confronted it successfully, but we’ve used new policies to do that. And I think we have in fact changed, to some extent, our approach to one that is more tied to the forecast and tries to lay out in more detail how monetary policy will react over time to changing economic conditions. So there are some changes in monetary policy.

But finally, I think the Federal Reserve is a remarkable institution. It has a superb staff, a great deal of expertise. And I hope that during the time that I’ve been there that we have succeeded in preserving those strengths and adding to those strengths, increasing the amount of expertise we have in critical areas like some of the financial stability areas, increasing interdisciplinary cooperation and work and just making the institution stronger as an institution going forward, because I think one of the lessons — I mean, we had a very fascinating day today talking about a hundred years of the Federal Reserve.

It’s a central institution in the United States. It has a very, very important role in the economy and in the lives of ordinary Americans. And it’s critical that it be a strong, well-managed, well- staffed institution. And these internal management issues, which are pretty invisible I think to outsiders, are very important because they’re the factors that determine how strong an institution this will be over the next hundred years.

In short, the recent crisis has underscored the need both to strengthen our monetary policy and financial stability frameworks and to better integrate the two. We have made progress on both counts, but more needs to be done. In particular, the complementarities among regulatory and supervisory policies (including macroprudential policy), lender-of-last-resort policy, and standard monetary policy are increasingly evident. Both research and experience are needed to help the Fed and other central banks develop comprehensive frameworks that incorporate all of these elements. The broader conclusion is what might be described as the overriding lesson of the Federal Reserve's history: that central banking doctrine and practice are never static.

[I]t is reasonable to ask whether systemic risks can in fact be reliably identified in advance... To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities. The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises

I still believe the following, which is that monetary policy is a very blunt instrument. If you are raising interest rates to pop an asset bubble, even if you were sure you can do that, you might, at the same time, be throwing the economy into recession, which kind of defeats the purpose of monetary policy.

And therefore, I think the first line of defense—I mean, I think, we have a sort of a tripartite line of defense. We start off with very extensive and sophisticated monitoring at a much higher level and much more comprehensively than we’ve had in the past. Then we have supervision and regulation, where we work with other agencies to try to cover all the empty or uncovered areas in the financial system. And then, in addition, we try to use communication and similar tools to affect the way that financial markets respond to monetary policy. So we do have some first lines of defense, which I think should be used first.

That being said, you know, I think that given the problems that we’ve had—not just in the United States, but globally in the last 15, 20 years—that we need to at least take into account these issues as we make monetary policy. And I think most of the people on the FOMC would agree with that. What that means exactly depends on the circumstances. I think if the economy is in very weak condition and interest rates are very low for that purpose, it’s very difficult to contemplate raising rates a lot because you’re concerned about some sector in the financial sphere. On the other hand, if you’re in an expansion and there’s a credit boom going on, that—the case in that situation for making policy a little bit tighter might be better.

So, as I’ve said many times, I have an open mind in this question. We’re learning; all central bankers are learning. But I think I still would agree with the point I made in my very first speech in 2002, as a Governor at the Federal Reserve, where I argued that the first line of defense ought to be the more targeted tools that we have, including regulatory tools and, to some extent, macroprudential tools like some emerging markets use.

In the wake of the crisis, we need to consider carefully the view that central banks should assess the effect of monetary policy on financial stability and, in some instances, adjust their policy decisions to take account of these effects…

It is important to note that incorporating financial stability considerations into monetary policy decisions need not imply the creation of an additional mandate for monetary policy. The potentially huge effect on price stability and employment associated with bouts of serious financial instability gives ample justification.

Here I want to mention some comments by my colleague Jeremy Stein a couple of weeks ago. After reviewing the traditional arguments against using monetary policy in response to financial stability concerns and relying instead on supervisory policies, Governor Stein offered several reasons for keeping a more open mind on the subject…[B]y altering the composition of its balance sheet, central banks may have a second policy instrument in addition to changing the targeted interest rate. So, for example, it is possible that a central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones.

To what extent, if at all, should monetary policy be used to mitigate systemic risk? And to what extent, if at all, should monetary policy be coordinated with macroprudential supervision? These issues are the subject of intense debate among policymakers across the globe...

...But the pursuit of macroprudential supervision under the new legislation involves other regulatory agencies beside the Fed, and the new Financial Stability Oversight Council will play an important role. And, of course, the Fed will keep sole responsibility for the conduct of monetary policy, retaining its independence. There are important reasons for this approach. One is that systemic risk surveillance will benefit from the perspectives of regulators with different windows on the financial system, all participating in the oversight council. Second, the principle of central bank independence in the conduct of monetary policy is widely accepted as vital to achieving maximum employment and price stability.

Fortunately, it is perfectly possible to attain good outcomes even if monetary policy and macroprudential policy are carried out separately and independently, and the goals of each are pursued using entirely separate tool kits. This conclusion is an application of the assignment problem made familiar by Robert Mundell and others who analyzed monetary and fiscal policy.¹⁹ A key insight from that literature is that satisfactory results can be attained without policy coordination, even though fully optimal policy generally calls for coordination when spillovers occur. Of course, it is necessary for monetary policy to take into account any macroeconomic effects resulting from macroprudential policy and vice versa.

This separate-assignments approach to formulating macroprudential and monetary policy has merit both in theory and practice. But I want to be careful not to push the argument for separation too far. I noted, for example, that situations may arise in which the Federal Reserve, in its conduct of monetary policy, might not be able to fully offset the macroeconomic effects of macroprudential interventions. This scenario could happen because of the zero bound on interest rates or monetary policy lags. In such circumstances, it makes sense for macroprudential policy to take macroeconomic effects into account. By the same token, I would not want to argue that it is never appropriate for monetary policy to take into account its potential effect on financial stability. Regulation is imperfect. Financial imbalances may emerge even if we strengthen macroprudential oversight and control. Some day in the future, it is possible that macroprudential regulators might let down their guard. In such situations, if emerging threats to financial stability become evident, monetary policy could be faced with difficult tradeoffs. My hope is that such situations will remain largely theoretical and, in practice, be exceedingly rare.

Critically, the financial regulatory structure needs to be modernized to bring oversight and market discipline to bear much more effectively on our rapidly evolving financial system and to give regulators more tools to deal with problems as they arise. At the Federal Reserve, we are improving our supervision and regulation to incorporate a broader view of emerging risks in the financial system and to become more effective at translating identified risks to supervisory oversight and, if required, remedial actions by the banks.