Defining Financial Stability,
and Some Policy Implications
of Applying the Definition
Eric S. Rosengren
President & CEO
Federal Reserve Bank of Boston
Stanford Financial Forum
Stanford, CA
June 3, 2011
EMBARGOED UNTIL FRIDAY, JUNE 3, 2011 3:30 P.M. EASTERN TIME OR UPON DELIVERY
www.bostonfed.org
Financial Stability
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Financial stability is receiving increased attention
But there is no one clear definition
It’s defined quite differently by different people
Interestingly, it is never actually defined in the
Dodd-Frank Act
 Dodd-Frank Act seems focused on the failure of
large institutions and payments systems –
certainly a gap that warrants attention
 But a large interconnected failure is only one of
the ways a systemic problem can emerge
2
The Definition Matters
 Some argue that the pursuit of financial stability
should address a variety of things:


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Market volatility
Clustered failures
Asset bubbles at early stages
 So it is important to clarify the definition…

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To help frame the policy response
To identify what problems we will seek to solve and
what problems we will not
To identify the needed supervisory tools
3
My Definition
 Financial stability reflects the ability of the financial
system to consistently supply the credit intermediation and
payment services that are needed in the real economy if it
is to continue on its growth path
 Financial instability occurs when problems (or concerns
about potential problems) within institutions, markets,
payments systems, or the financial system in general
significantly impair the supply of credit intermediation
services – so as to substantially impact the expected path
of real economic activity
Three key elements:
Problems in the financial system, impairment of intermediation
(or its supply), and a substantial impact on the real economy
4
Financial Intermediation
 The central theme is financial / credit intermediation
services (supporting the real economy)
 Intermediation allows funds from many depositors to
be pooled and channeled to investment projects that
support real economic activity
 Financial institutions’ role in intermediation:



“match” borrowers and lenders
“maturity transformation” (from short for depositors to
longer for borrowers)
“risk transformation” (safer for depositors to potentially
higher for investors)
5
Financial Intermediation
Cont…
 Disruption of intermediation can have
significant macroeconomic consequences
 Reinhart and Rogoff: recoveries from crises in
which financial intermediation has been badly
disrupted can take much longer, and be more
uneven
6
Failures May Not Impair
Intermediation
 Per my definition, if individual institutions or
even groups fail – but intermediation services
are not significantly impaired – then financial
stability is not compromised
 For example, if intermediation services were
highly substitutable
7
Not In My Definition: Asset Bubbles
 Not all asset bubbles result in a disruption of financial

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
intermediation
Only if key intermediaries use significant leverage to
purchase the asset, and are compromised when it bursts
Then their balance sheet constraints could impair the
availability of intermediation services (and thus the
future path of the economy)
So not all asset bubbles reflect financial instability, but
some do
This illustrates how the definition of financial instability is
important
8
Examples Not Meeting the Definition
 First, a few examples that would not meet my
definition for affecting financial stability or
creating financial instability:


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Silver prices
Failures of savings and loan institutions
“Dot-com” stocks
9
Figure 1
Silver: Handy & Harman Base Price
Weekly, January 6, 1976 - May 24, 2011
Dollars per Troy Ounce
50
$44.72 on January 22, 1980
$44.90 on April 26, 2011
40
30
$33.42 on May 17, 2011
20
$11.76 on May 27, 1980
10
0
06-Jan-76
24-Nov-81
Source: WSJ / Haver Analytics
13-Oct-87
31-Aug-93
20-Jul-99
07-Jun-05
26-Apr-11
10
Figure 2
Silver: Handy & Harman Base Price
Weekly, January 6, 2009 - May 24, 2011
Dollars per Troy Ounce
50
$44.90 on April 26, 2011
40
$33.42 on May 17, 2011
30
20
$17.65 on July 27, 2010
10
0
06-Jan-09
23-Jun-09
Source: WSJ / Haver Analytics
08-Dec-09
25-May-10
09-Nov-10
26-Apr-11
11
Figure 3
S&L Failures and Assisted Resolutions
1970 - 2011 Year-to-Date
Number of S&Ls
350
300
250
200
150
100
50
0
1970
1974
Source: FDIC
1978
1982
1986
1990
1994
1998
2002
2006
2010
12
Figure 4
Mortgage Rates, Treasury Yields and S&L Failures
April 1971 - April 2011
Percent
20
16
Number of S&Ls
375
30-Year FixedRate Mortgage
Rate (Left Scale)
S&L Failures (Right Scale)
300
12
225
8
150
4
10-Year Treasury
Yield (Left Scale)
75
0
Apr-71
0
Apr-75
Apr-79
Apr-83
Apr-87
Apr-91
Apr-95
Apr-99
Apr-03
Apr-07
Apr-11
Source: FDIC, Federal Reserve Board, Federal Home Loan Mortgage Corporation / Haver Analytics
13
Figure 5
Dow Jones Internet Composite Stock Price Index
July 1997 - April 2011
Index, June 30, 1998=100
500
400
300
200
100
0
Jul-1997
Jul-1999
Jul-2001
Source: Dow Jones, WSJ / Haver Analytics
Jul-2003
Jul-2005
Jul-2007
Jul-2009
14
Examples of Financial Instability
 A large interconnected failure is only one way a
systemic problem can emerge
 The weakest link in the financial stability chain
might be small, rather than large, financial
intermediaries
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Experience of money market mutual funds (MMMFs)
during the crisis
Risk that widely-held exposures could cause
intermediation services to be cut simultaneously, even
without a failure of a large intermediary
Failure of Lehman Brothers highlights the issue of
interconnection
15
Figure 6
Daily Change in Money Market Mutual Fund
Assets in Prime Funds
August 1, 2008 - December 1, 2008
Billions of Dollars
30
AMLF program begins (Sep 22)
0
-30
Lehman f ails
(Sep 15)
-60
-90
The Reserve Primary
Fund breaks the buck
(Sep 16)
Fed announces AMLF
program (Sep 19)
Treasury announces insurance
f or MMMFs (Sep 19)
-120
-150
1-Aug-08
Source: iMoneyNet
29-Aug-08
29-Sep-08
28-Oct-08
26-Nov-08
16
Figure 7
Assets of Money Market Mutual Funds
1990 - 2010, Year-End
Trillions of Dollars
4.5
Tax-Exempt
4.0
Taxable - Government
3.5
Taxable - Non-Government (Prime)
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1990
1994
1998
Source: 2011 Investment Company Fact Book
2002
2006
2010
17
Figure 8
Asset-Backed Commercial Paper
Rate Spreads and Issuance
August 1, 2008 - December 1, 2008
Asset-Backed Commercial Paper Rate Spreads over Federal Funds Effective Rate
500
Basis Points
400
1-Day AA-Rated ABCP
1-Month AA-Rated ABCP
300
200
100
0
-100
01-Aug-08
29-Aug-08
29-Sep-08
28-Oct-08
26-Nov-08
Percent Maturing in 1-4 Days
Asset-Backed Commercial Paper Issuance: Share Maturing in 1-4 Days
100
90
AA-Rated ABCP
80
70
60
50
40
01-Aug-08
29-Aug-08
Source: Federal Reserve Board / Haver Analytics
29-Sep-08
28-Oct-08
26-Nov-08
18
A Digression: MMMFs
 Such funds still remain vulnerable to an unexpected credit
shock that causes investors to doubt the ability to redeem
at a stable net asset value
 I am certainly not predicting this outcome, but we all do
well to recognize and address this vulnerability
 It would be prudent to address this issue now, as MMMFs
have the potential to be impacted should there be
unexpected international financial problems emanating
from Europe
 Many, but not all, MMMFs have exposures to European
banks by virtue of holding the banks’ short-term debt
 Conversely, European banks are reliant on MMMFs, which
are a major source of their dollar-funding needs
19
Possible Solutions
 There have been various discrete proposals to
address the issue:
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Allowing the asset values of the funds to float
Requiring capital be set aside
Requiring a source of strength
 A solution needs to address:
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The impact of unexpected credit losses
The incentive for investors to withdraw funds rapidly
The operational convenience that MMMFs provide as a
transactions account vehicle
 Despite the challenges, this is a vulnerability that
needs to be addressed with focused and constructive
attention
20
Figure 9
Asset Growth at Commercial and Savings Banks
by CAMELS Rating*
December 31, 2007 - December 31, 2008
Percent Change, December 31, 2007 - December 31, 2008
15
10
5
0
-5
-10
Camels Rating of 1 or 2
Camels Rating of 3, 4, or 5
-15
Total Assets
Total Loans
Commercial and
Industrial Loans
Commercial Real Estate
Loans
*The CAMELS rating is a highly conf idential supervisory rating which assesses six components of a bank's condition: capital
adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L), and sensitivity to market risk (S). Ratings ar e assigned
f or each of the six components in addition to an overall rating. The ratings are assigned on a scale of 1 (strongest) to 5 ( weakest).
Note: CAMELS ratings are as of December 31, 2008. Banks included are merger-adjusted. De novos are excluded
Source: Commercial and savings bank call reports, supervisory reports and author’s calculations
21
Figure 10
Real Commercial and Industrial Loans Outstanding
at Commercial Banks
1984:Q1 - 2011:Q1
Index Level 1984:Q1=100
225
1
200
1
Real C&I Loans
175
1
150
0
125
0
100
75
0
1984:Q1
1989:Q1
1994:Q1
1999:Q1
2004:Q1
2009:Q1
Recession
Note: C&I Loans were adjusted for inflation using the GDP deflator
Source: Federal Reserve Board, BEA, NBER / Haver Analytics
22
Figure 11
Bank Lending Standards for
Commercial and Industrial Loans
1990:Q2 - 2011:Q2
Net Percent Tightening Standards
100
1
Standards for C&I Loans
to Large and Medium-Sized
Borrowers
80
60
1
Standards for
C&I Loans to
Small Borrowers
40
1
20
0
0
0
-20
-40
1990:Q2
0
1994:Q2
1998:Q2
2002:Q2
2006:Q2
2010:Q2
Recession
Source: Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices, NBER / Haver Analytics 23
Interconnectedness
 Interconnectedness manifests itself in a variety
of forms:
1 Immediate credit exposure to the firm (e.g., the
failure of a large financial firm creating a credit
loss that could generate runs on money market
funds broadly)
2 Opaqueness makes it difficult to determine
counterparty exposure or whether similar
exposures exist at other financial firms
24
Figure 12
Spread: One-Month London Interbank Offered Rate
(LIBOR) to Overnight Index Swap (OIS) Rate
June 1, 2007 - May 27, 2011
Basis Points
350
Peak Spread (Oct 10): 338 basis points
300
250
200
150
Lehman Fails (Sep 15):
Spread at 68 basis points
100
50
0
1-Jun-07 16-Nov-07 2-May-08 17-Oct-08
3-Apr-09 18-Sep-09 5-Mar-10 20-Aug-10 4-Feb-11
Source: Financial Times, Bloomberg / Haver Analytics
25
Interconnectedness
Cont…
3 The criticality of firms that are significant market
makers (…as when they’re troubled, broader
intermediation services can be impacted)
4 The increasing global nature of large financial
intermediaries, which greatly complicates
resolutions of such firms should they fail
26
Questions to Explore
 If interconnectedness can be measured, how will
that information be used?
 Should highly interconnected firms have higher
capital requirements, to reduce the probability
that they become insolvent?
 Should banks be required to disclose measures
of interconnectedness to bank supervisors – or
in public statements?
 What role can stress tests play in understanding
how a failure of a large firm impacts other firms?
27
Concluding Observations
 Some ambiguity on how broadly or narrowly
financial stability should be defined
 Mine is a relatively simple definition
 The examples highlight that much work remains
to be done if we want to significantly reduce the
likelihood of impairment of critical financial
intermediation services – the sort of impairment
that could substantially impact economic activity
28