A recently revised staff research report from the Federal Reserve, “Financial Stability Monitoring,” by Tobias Adrian, Daniel Covitz, and Nellie Liang, looks at how risk should be tracked across financial markets. We review both the revised report and a new blog article by the authors.
The focus of the article is how to keep tabs on market vulnerabilities that “amplify shocks,” which the authors argue can be tackled by policy measures. “We identify leverage, maturity transformation, interconnectedness, complexity, and the pricing of risk as the primary vulnerabilities in the financial system.” Okay, a good start.
“The monitoring program tracks these vulnerabilities in four sectors of the economy: asset markets, the banking sector, shadow banking, and the nonfinancial sector.” Now things get tougher, given the complexity of data collection across many of these areas and the fact that truly, many of these sectors and subsectors are barely tracked today.
“The framework also highlights the policy trade-off between reducing systemic risk and raising the cost of financial intermediation by taking pre-emptive actions to reduce vulnerabilities.” This is the gold standard that regulators have been dealing with for years. Finding this balance is really concluding how much leverage will be in the global financial system, and how liquid (and frothy) economies and markets can get. This is fundamental stuff. Let’s see where the Fed is heading.
Presuming that there is enough information available on asset markets and the banking sector to know what is going on, let’s turn to shadow banking and the non-financial sector. In shadow banking, the authors suggest using securitization issuance as a proxy for the shadow banking market. There’s an argument there, but the counterargument is that regulatory trends are pushing dealers to go towards products that are balance sheet efficient. Securitization is one expression of a need for financing, so the trend in the chart below may be a function of a) shadow banking demand; b) investor preferences, and/or c) dealer balance sheet efficiency management.
Likewise, the authors look at ABCP and repo as another proxy. This isn’t bad; rather, it is using the data available to get at monitoring now rather than wait five years for better reporting across financial markets. Again though, these are proxies: repo declines, Total Return Swaps featuring junk bonds pick up, etc. The Fed may need to produce a matrix of every interrelated shadow banking product then look at ebbs and flows across the mix.
The nonfinancial market analysis is difficult too, particularly as nonfinancial actors might set up SPVs to take advantage of shadow banking opportunities. There is no easy fix here, although the authors note that “Researchers have identified excessive credit in the private nonfinancial sector as an important indicator of systemic risk.” Its another proxy, but not one that we are certain fulfills the mission.
The authors are aware of the difficulty of making policy that pushes down some form of risk only to see it resurface somewhere else (whack-a-mole). “Given these considerations, our staff report suggests that a prudent path forward is a program for monitoring systemic risks, based on improved data collection and possibly enhanced disclosure, and the implementation of targeted supervisory policies to mitigate specific emerging risks.” We agree that monitoring is the first important part of policy making. We’re not sure what that last part means, but we’re pretty sure that regulators have yet to find that best middle ground between the gold standard of risk management in financial markets and enough flexibility to let markets and the economy grow.