Fed governor cites economic uncertainty under stimulus, notes financial system vulnerabilities

Risks to the financial system remain moderate despite elevated asset valuations, but the recently enacted fiscal stimulus presents uncertainty for the current economy, which is already near full employment and “growing above trend,” Federal Reserve Board Gov. Lael Brainard said Tuesday.

Brainard, speaking before the Center for Global Economy and Business at the New York University Stern School of Business, credited post-crisis financial reforms for encouraging large banking institutions to build strong capital and liquidity buffers. But she said it’s difficult to know how the economy will respond to the stimulus measures.

“History suggests … that a booming economy can lead to a relaxation in lending standards and an attendant increase in risky debt levels,” she said. “At a time when valuations seem stretched and cyclical pressures are building, I would be reluctant to see our large banking institutions releasing the capital and liquidity buffers that they have built so effectively over the past few years.” She added that “it may become appropriate” to have large banks increase their capital buffers if cyclical pressures continue to grow and financial system vulnerabilities broaden.

The Fed’s most recent quarterly analysis of financial system vulnerabilities shows elevated valuations in a broad set of markets, relative to historical norms; “extreme volatility” in some cryptocurrencies (with, for example, Bitcoin rising 1,000% last year and falling sharply more recently); and “subdued” risks associated with leverage in the financial sector overall.

Leverage in the financial sector is down “notably,” Brainard said, since the crisis: issuance of securitized products is well below pre-crisis levels in most asset classes, and leverage at nonbank financial firms has been stable. “That said, there are indications that the use of leverage has been increasing at some institutions; for example, margin credit provided by dealers to equity investors such as hedge funds has expanded,” she said.

Cryptocurrency markets could pose important investor and consumer protection issues, Brainard said, adding that some “appear especially vulnerable to money-laundering (BSA/AML, or Bank Secrecy Act/anti-money laundering) concerns.” Less clear is the threat they may pose to financial stability. “For instance, it is hard to see evidence of substantial leverage used in the purchase of the cryptocurrencies or a material degree of use in payments, although our assessment of these markets is limited by their opacity,” she said. “Nonetheless, we will continue to study them.”

Speech by Fed Gov. Brainard (April 3, 2018)