Board of Governors of the Federal Reserve System (“FRB”) Governor Lael Brainard reviewed the current state of prudential financial stability regulation including policies that address “tail risk.” Prudential, macroprudential and countercyclical policies, according to Ms. Brainard, are crucial to minimizing the risks that threaten financial stability.
In remarks at the Stern School of Business at New York University, Ms. Brainard stated that the FRB focuses on correcting vulnerabilities rather than attempting to predict “adverse shocks.” Vulnerable areas that were cited include “asset valuation and risk appetite, borrowing by the nonfinancial sector, liquidity risks and maturity transformation by the financial system and leverage in the financial system.” Noting that overall risk remains moderate, Ms. Brainard emphasized the importance of continuing to monitor existing and emerging vulnerabilities. She reported that the FRB is looking into the extreme volatility demonstrated by some cryptocurrencies due to their highly speculative nature. However, Ms. Brainard said it is unclear if the valuations of cryptocurrencies could be a threat to financial stability.
Ms. Brainard described the necessity of FRB regulations that require banks to hold substantial capital and liquidity buffers. She said that these regulations force banks to internalize the costs of engaging in risky financial behavior.
She also reinforced the importance of supervisory stress tests; however, she cautioned that stress testing has not demonstrated that it is effective in counteracting the financial system’s tendency toward pro-cyclicality. In response, the FRB implemented the countercyclical capital buffer (“CCyB”), which is designed to counteract “elevated risk of above normal losses” for banks. At least once per year, the FRB votes to determine the level of the CCyB, but so far has voted to leave the CCyB at its minimum value of zero.