Friday, May 10, 2013

Bernanke on Identifying Systematic Risk
Fed Chairman Ben Bernanke delivered a speech in Chicago today on “Monitoring the Financial System.” He assured us that the Fed’s Financial Stability Monitoring Program is doing just that, i.e., focusing on systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector.

The structure of this program is detailed in a recent working paper by the Fed's staff titled, “Financial Stability Monitoring.” The Fed is on the lookout for “evidence of low pricing of risk” in four areas, specifically:
First, the risks of SIFIs are assessed using stress tests, market-implied assessments of the SIFIs, network measures for exposures, and regulatory filings of the institutions. Second, the risks in the shadow banking sector are assessed using a variety of data sources on short-term and secured funding markets, securitizations, and new products. Third, the level of asset valuations is gauged across asset classes, including equity, credit, Treasuries and TIPS, housing values, commodities and farmland, exchange rates, and foreign markets. The assessment of asset valuations is tightly linked to the observed risk taking of SIFI and shadow banking institutions. Fourth, the risks of the nonfinancial sector are assessed in connection with the financial sector developments.
Don’t you feel safer knowing that Big Ben is watching? He has yet to ask, “But how do we know when irrational exuberance has unduly escalated asset values…?” That was the famous question asked by Fed Chairman Alan Greenspan in a December 5, 1996 speech. Nonetheless, the Fed is on the lookout for irrational exuberance, and Fed officials will plant stories and give speeches to remind us that they are ever vigilant.

In his speech, Mr. Bernanke did say, “Systemic risks can only be defused if they are first identified.” He didn’t specify if any have been identified lately. He also didn’t say what the Fed would specifically do if it found irrational exuberance. "Shocks of one kind or another are inevitable,” he observed. However, he believes that “macroprudential” regulations can be designed to reduce the “vulnerabilities” of the financial system to a crisis from such “triggers.”
(Based on an excerpt from YRI Morning Briefing)

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