Fed playing Whac-A-Mole faces limits in hammering asset bubbles

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What’s more, the potentially dangerous speculative activity has a tendency to shift outside the regulated banking industry to places where the Fed has less oversight and control, San Francisco Federal Reserve Bank President John Williams told the American Economic Association’s annual conference.

His colorful reference to the arcade game where players try to hammer critters that randomly pop out of holes highlights one of the themes that have emerged at the San Francisco meeting: The central bank is going to have a tough time countering speculative excesses that might threaten the health of the financial system in the future.

Fed Vice Chairman Stanley Fischer voiced concern to the conference on Jan. 3 that the central bank may lack some key tools needed both to prevent another financial crisis and to contain the fallout should one occur.

Williams, who has spent more than 20 years at the U.S. central bank and was Chair Janet Yellen’s research director when she ran the San Francisco Fed, echoed some of those worries at an AEA panel session the following day.


Hard to Find

“In the U.S., macro-prudential tools or instruments are hard to find,” he said. Such measures run the gamut from tax changes to discourage borrowing to limits on how much credit lenders can extend.

He told reporters after his AEA presentation that he is not particularly worried about asset bubbles and other financial risks at the moment. “My level of concern is still relatively low,” he said.

In his talk to the conference, Williams said that a big difficulty facing the Fed is that so much of the credit extended in the U.S. occurs in the less-regulated shadow banking sector that comprises everything from money market and hedge funds to insurance companies.
While financial legislation passed in 2010 expands the ability of the central bank to oversee institutions such as insurers by deeming them systemically important, Williams described that as "a small step in the right direction."
 

Shadow Banking

Stanford University professor Arvind Krishnamurthy told the conference that some lending activity already has migrated to less-regulated sectors as the Fed and other authorities have made it more expensive for banks to do business by requiring them to hold more capital.

Williams did highlight one area where he said the Fed and other regulators had recently had some success in discouraging too much risk-taking -- leveraged lending.

Banks have backed away from some of the more speculative leveraged deals after the regulators introduced guidelines in 2013 to curb excessive risk-taking in the market and then followed that up with additional steps.

"We’ve seen the area slow down somewhat," Williams said.

Krishnamurthy agreed. "It worked well," he said at a panel discussion with the San Francisco Fed president.

Williams told reporters that he’s now focused on the commercial real estate market, where prices have grown rapidly, for signs of stress in the financial system. It’s "definitely an area to keep an eye," though not a concern right now, he said.


Veiled Warning

On Dec. 18 the Fed and other agencies issued a thinly veiled warning to banks in which it “reminded” them about “existing regulatory guidance on prudent risk management practices for commercial real estate lending.”

"When you think of financial stability, it’s a bit like a game of Whac-a-Mole," Williams said. "You can stem some of the risk in parts of the financial system. That doesn’t mean it won’t appear somewhere else relatively soon.


Rich Miller and Jeanna Smialek
Bloomberg News

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