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, EMBARGOED UNTIL FRIDAY, JUNE 3, :30 P.M. EASTERN TIME OR UPON DELIVERY

Financial Stability  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:  Market volatility  Clustered failures  Asset bubbles at early stages  So it is important to clarify the definition…  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 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:  Silver prices  Failures of savings and loan institutions  “Dot-com” stocks 9

10 Figure 1 Silver: Handy & Harman Base Price Source: WSJ / Haver Analytics Weekly, January 6, May 24, 2011

11 Figure 2 Silver: Handy & Harman Base Price Source: WSJ / Haver Analytics Weekly, January 6, May 24, 2011

12 Figure 3 S&L Failures and Assisted Resolutions Source: FDIC Year-to-Date

13 Figure 4 Mortgage Rates, Treasury Yields and S&L Failures Source: FDIC, Federal Reserve Board, Federal Home Loan Mortgage Corporation / Haver Analytics April April 2011

14 Figure 5 Dow Jones Internet Composite Stock Price Index Source: Dow Jones, WSJ / Haver Analytics July April 2011

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  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

16 Figure 6 Daily Change in Money Market Mutual Fund Assets in Prime Funds Source: iMoneyNet August 1, December 1, 2008

17 Figure 7 Assets of Money Market Mutual Funds Source: 2011 Investment Company Fact Book , Year-End

18 Figure 8 Asset-Backed Commercial Paper Rate Spreads and Issuance Source: Federal Reserve Board / Haver Analytics August 1, December 1, 2008

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:  Allowing the asset values of the funds to float  Requiring capital be set aside  Requiring a source of strength  A solution needs to address:  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

21 Figure 9 Asset Growth at Commercial and Savings Banks by CAMELS Rating* Source: Commercial and savings bank call reports, supervisory reports and author’s calculations December 31, December 31, 2008 Note: CAMELS ratings are as of December 31, Banks included are merger-adjusted. De novos are excluded

22 Figure 10 Real Commercial and Industrial Loans Outstanding at Commercial Banks Source: Federal Reserve Board, BEA, NBER / Haver Analytics 1984:Q :Q1 Note: C&I Loans were adjusted for inflation using the GDP deflator

23 Figure 11 Bank Lending Standards for Commercial and Industrial Loans Source: Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices, NBER / Haver Analytics 1990:Q :Q2

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

25 Figure 12 Spread: One-Month London Interbank Offered Rate ( LIBOR ) to Overnight Index Swap ( OIS ) Rate Source: Financial Times, Bloomberg / Haver Analytics June 1, May 27, 2011

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