What Is Financial Stability?
Stability and risk management are two terms that seem to be synonymous with a healthy financial system. The former term tends to be a characteristic of the healthy system itself whereas the latter term is necessary for an entity to participate in the system successfully. Financial stability is so desirable that it is one of the congressionally mandated goals of the Federal Reserve (price stability). Now, how exactly is price stability in this sense defined because it is obviously not prices that do not change as the Fed has an inflation target of 2%. With regard to the system itself,
“A financial system is considered stable when financial institutions—banks, savings and loans, and other financial product and service providers—and financial markets are able to provide households, communities, and businesses with the resources, services, and products they need to invest, grow, and participate in a well-functioning economy.”
“The Fed Explained: What the Central Bank Does”, Federal Reserve System Publication Public Education & Outreach. (August 2021), Pg. 47 [1]
So essentially, a financial system is considered stable if it functions reasonably well. Meaning there must be liquidity in money, services, and products that allow for the participation and growth of individuals, businesses, and other entities. Notice that the definition is rather subjective, allowing for flexibility in the future, which is most likely by design. However, with the term growth used, one can assume that the long-term growth of the economy is all that is necessary for financial stability. This may explain the 2% inflation target as with continuous positive inflation it is more likely that nominal growth will be seen except in more serious economic downturns. Essentially providing a baked in skew for the system.
Anyways, despite the possible discrepancies with respect to the meaning of stability, the concept of stability in the financial system, at least superficially, is rather commonsensical. Financial institutions and other financial market structures are strong enough to withstand volatility and can continuously provide their products and services to society. This is especially true for the services these structures/institutions provide that link together the various entities of the financial system. At its most fundamental level, this means the links between lenders and borrowers are healthy and liquid so that funds can flow throughout the financial system with ease to wherever they are needed most.
The above diagram shows the flow of funding between lender-savers and borrowers-spenders. Notice an entity can show up on either side of the equation (lender-savers on one side and borrowers-spenders on the other). As the diagram shows, lenders-savers can invest/fund borrowers-spenders either indirectly through some financial intermediary or directly through financial markets. The blue boxes labeled “Investing/funding” are the links between the different sections of the financial system described in the above paragraphs.
How the Fed Monitors Risk Across the Financial System
Before the financial crisis of the late 2000s, the Federal Reserve held a more traditional “microprudential” supervisory role where their focus was on the safety and soundness of individual institutions. However, due to the complex and dynamic environment that is the global financial system, this tunnel-visioned approach allowed them to be blindsided by systemic risks that hid in the financial junctions that connect financial entities and hold the system together. Since then, the Fed has changed their supervisory role to be more macroprudential, focusing on the stability of the financial system as a whole.
Essentially, the Fed went from just checking the toilet and kitchen sink to see if the plumbing in the house was working, to actually going to the basement and looking at the pipes themselves.
Types of Vulnerabilities and Risk Within the Financial System
So, what types of risks and vulnerabilities does the Fed search for within the financial system to assess its stability? At the moment, there are four stated categories in which the Fed actively researches for this purpose: asset valuations and risk appetite, leverage in the system, funding risks, and borrowing from participants in the real economy.
Asset Valuations and Risk Appetite
The monitoring of risk appetite and asset valuations by the Fed seems to be solely for the purpose of spotting asset bubbles. This distinction is made because the term “Elevated asset valuations” is explicitly stated in the Fed’s description and, the reason they monitor asset prices, in their own words, is because the “unwinding of high prices can be destabilizing in the financial system and economy, especially if the assets are widely held and the values are supported by excessive leverage, maturity transformation, or risk opacity.”[2] This gives some credence to the “Fed put” for the stock market and giving other dimensions to the Fed’s influence on capital markets from other than a purely monetary perspective.
Above is a graph of the size of the Fed’s balance sheet versus the level of the S&P 500 taken from current market valuation (link in caption). Now, this graph is just to show that there may be a correlation between the two, not to say that increases in the Fed’s balance sheet will directly cause price increases in the S&P. Simply a proposal of a possible dynamic at play that would give some credence to the Fed’s states goal with respect to asset valuations.
Leverage
Highly leveraged institutions in the financial system are also a reason for concern as they have the ability to amplify negative outcomes in the financial system. An overabundance of leverage is deemed to be a sign of a buildup of risk-taking that left unchecked, can induce the familiar story of a crash in asset prices where such assets are sold at fire sale prices, or in another way, “sold for pennies on the dollar”.
Funding Risks
Funding risk refers to the possibility of liquidity freezing up in funding markets (i.e., the repo market). Financial institutions in the traditional and shadow banking systems will fund long-maturity assets that tend to be illiquid with short-term funding. An example of this would be an entity purchasing debt that matures in 10 years by borrowing short-term with a maturity of a day. To be more specific, a money market fund could borrow in the overnight repo market to receive funds that they will use to purchase a security that matures in ten years, since the interest rate on the 10-year security is (hopefully, if the system is operating correctly) be significantly higher than the interest rate of the overnight funding, the money market funds pocket the spread of the two rates.
Problems arise when the borrowed short-term debt must be continuously rolled over, and the funding is no longer there. This is what is meant by a liquidity freeze. The funding (liquidity) stops moving and the debt cannot be rolled over to the next interest period, therefore preventing the entity from receiving their funding that they may need immediately, which could induce a run of the fund/entity and cause it to become insolvent.
Borrowing By Businesses and Households
The final category of systemic vulnerability that the Fed monitors is private credit creation. Their reasoning is that excessive private nonfinancial credit can provide a means for disruptions in the financial economy to be transferred into the real economy. This can manifest itself as households and businesses having to reduce their consumption in response to negative activity in the financial economy, which could induce further negative effects on the financial economy, creating a negative feedback loop.
Proactive Monitoring
The Fed hopes that by proactively monitoring the above four categories, they would be able to respond to fluctuations in the economy and financial system in a manner that would prevent such systems from destabilizing. At least that is seemingly their intention. Whenever an entity begins to act proactively towards something in general, the response seems to turn rather political, at least to some degree, hence the comment on their intentions.
Macroprudential Monitoring Framework and Response
As alluded to above, after the GFC, the Fed has altered their approach to monitoring the stability of the financial system to focusing more on the system itself and the linkages between different entities rather than the entities themselves. This can be seen with the growing body of research about the systemic vulnerabilities discussed above.
The typical central bank response to a destabilizing of the financial system is to inject liquidity. Essentially, when the financial system is in trouble, the central bank should lend freely with the idea that the increased liquidity would improve the confidence in the economy during such a time of crisis (their reasoning, not mine). The Fed assumed this role of Lender of Last Resort (LOLR) during times of crisis through a few different avenues. Their standard tool (Click Here for more on Open Market Operations) is used to provide liquidity for depository institutions. However, non-depository institutions can only receive aid from the Fed from vehicles created under section 13(3) of the Federal Reserve Act which allows to Fed to do such actions in “unusual and exigent circumstances”. Examples of actions taken under section 13(3) would be the Special Purpose Vehicles (SPVs) and emergency lending programs created by the Fed. Such actions are taken under the approval of the treasury secretary since they are against the Federal Reserve Act and only permitted under certain circumstances.
Systematically Important Financial Institutions (SIFIs)
Since the Fed has taken a broad, macroprudential approach to monitoring financial stability, they have labeled some entities as Systematically Important Financial Institutions (SIFIs). SIFIs are institutions that are market participants that, if they go under, pose a risk to the collapse of the financial system as a whole. Some examples of SIFIs include large bank holding companies, U.S. operations of certain foreign banking organizations, and financial market utilities. As the system currently holds, these institutions provide services or liquidity in financial markets that if they stopped would be detrimental to the financial system. The Fed monitors SIFIs closely both on an individual basis as well as through the interlinkages of the network of financial institutions that allow liquidity to flow throughout the system in which they play a fundamental role. Due to their systematic importance, SIFIs are subject to additional capital and liquidity regulations in hopes of mitigating the risk their size and interconnectedness poses to the broader system (prevent contagion to other institutions/market segments).
Stress Tests
One element of this “enhanced supervision” of SIFIs is that they are subject to stress tests every year. Basically, the institutions’ financial situation (balance sheet) is run through many simulations of possible macroeconomic scenarios and events that would cause financial strain. This involves simulating possible outcomes of the institution if a severe recession were to occur and how they could hold up to financial adversity. As of 2020, 33 institutions participated in this stress testing process, and the 2022 tests revealed some rather concerning results. For more on these stress tests click HERE.
Cooperation Both Domestically and Internationally
As is common with the Federal Reserve and government related agencies as well, there is a committee for this. In the case of financial stability, the Financial Stability Oversight Council (FSOC) was created to proactively identify risks to the stability of the financial system and respond to possible threats. Created in 2010 under the Dodd-Franck Act, the FSOC consists of a concoction of federal and state regulators that meet routinely to provide a forum for cooperation among domestic entities. Similar entities on the international front include the Basel Committee on Banking Supervision and the FSB. Below is a diagram of the members of the FSOC.
Final Words
Stability in the financial system is characteristic of a healthy economy. An economy that rapidly alternates between depressed busts and euphoric booms doesn’t exactly emulate a well-functioning society, but this leads to the question of does government or Federal Reserve intervention amplify or smooth out the extremes of these cycles. Unfortunately, when asking the question of how to maintain financial stability, it is important to distinguish between what is optimal and what is realistic, as well as what is actually helping. So, is increasing the amount of bureaucracy really the answer?
To your wealth and future,
James Forsythe
[1] “The Fed Explained: What the Central Bank Does”, Federal Reserve System Publication Public Education & Outreach. (August 2021), Pg. 47
https://www.federalreserve.gov/aboutthefed/files/the-fed-explained.pdf
[2] Ibid. pg. 50
