Bernanke: ‘Shadow banking,’ other financial sectors still pose risks

By Ylan Q. Mui, The Washington Post

Federal Reserve Chairman Ben S. Bernanke on Friday defended the central bank’s ability to shield the economy from another financial crisis but warned that risks remained in the lightly regulated “shadow banking” system.

The Fed is responsible for overseeing individual banks to ensure their safety and soundness, but in recent years it has ramped up its monitoring of an increasingly complex web of financial services. Bernanke said it is now conducting regular stress tests on banks, tracking credit availability among nonbank financial institutions, evaluating asset prices for overheating and monitoring the health of households and businesses.

“Systemic risks can only be defused if they are first identified,” Bernanke said during a a speech at the Chicago Fed’s annual conference.

The central bank has been widely criticized for failing to foresee the 2008 financial crisis. Bernanke had told Congress a year earlier that the ripple effects of high numbers of defaults in subprime mortgages seemed “likely to be contained.” At the time, he predicted moderate economic growth. Instead, the country fell into recession.

In his speech Friday, Bernanke acknowledged the limits of the Fed’s abilities. He noted that the central bank may not be able to pinpoint the triggers of a crisis, such as losses in subprime mortgages. But he said the Fed is focused on reducing the overall vulnerability of the financial system. In the most recent crisis, for example, the turmoil in subprime mortgages was magnified by the heavy debt and complex instruments that financial institutions used to package, buy and sell those loans — causing the entire system to implode.

“Shocks of one kind or another are inevitable, so identifying and addressing vulnerabilities is key to ensuring that the financial system overall is robust,” Bernanke said.

Beefing up oversight of the shadow banking sector is critical to that effort. Bernanke said that the network of financial institutions outside of the traditional banking structure is smaller than it was before the crisis but that more reforms are needed. He cited the potential for a run on money market funds that could cause losses for investors. The Securities and Exchange Commission is considering rules for reforming the market.

Bernanke also highlighted risks in the securities markets that many financial institutions use to pay for short-term operations. A failure by one of the buyers and sellers of those securities could still shake the system, he said.

But even though Bernanke has made financial stability a bigger Fed priority, many of the proposals have been bogged down in regulatory weeds. The central bank took three years to finalize the definition of nonbank institutions that may be “systemically important” to the economy, which would subject them to tougher standards. The regulation must be approved by the inter-agency Financial Stability Oversight Council before individual firms are named.

Bernanke also discussed concerns that some financial institutions are still considered to be too big to fail. Though the Dodd-Frank financial reform legislation and new international banking standards are important steps, he said, more action may be needed to maintain the stability of those large institutions. Bernanke said he would support increasing banks’ capital requirements rather than capping their size.

“So there’s no confusion, I think that too-big-to-fail is a very big issue, and we will not have completed the goals of financial regulatory reform unless we have adequately addressed this issue,” he said.