Chicago Federal Reserve Bank President Charles Evans Tuesday said that the United States is “slowly emerging” from a severe financial crisis and pointed to serious problems in commercial real estate.
Evans expressed “skepticism” about using monetary policy to counter asset price bubbles, but said that if the Fed loses its regulatory authority it may have no other choice but to use monetary policy.
Evans, in remarks prepared for the Institute of Regulation & Risk North Asia, in Hong Kong, did not have that much to say about the economy or current monetary policy issues, as he focused on how to avoid future financial crises.
But he did touch on economic and financial conditions.
“We are slowly emerging from the worst financial crisis since the 1930s,” he said. “The hardships created by these exceptional circumstances for households and businesses are well known….Now, as we slowly emerge from the crisis, we are engaged in a vigorous debate on how best to address the major weaknesses in our financial regulatory framework that were revealed by the crisis.”
In the process of illustrating how regulators failed to prevent the boom and bust in commercial real estate, Evans sketched the scope of problems in that sector.
“Currently, the U.S. financial system faces problems with commercial real estate (CRE) loans,” he said. “At the end of 2009, depository institutions in the U.S. held over $1.5 trillion in commercial real estate and construction loans on their books.”
“In addition, there are currently nearly $800 billion in commercial mortgage-backed securities (CMBS) outstanding,” he continued. “Over the past two years, delinquencies on these loans and securities have been rising at an uncomfortably rapid rate….”
“Of the over $1 trillion in commercial real estate loans held by depository institutions today, nearly 4% are noncurrent,” Evans noted. “This ratio was about 0.5% before the crisis (June 2007).”
Evans said “the picture is even worse for the riskier construction and land development loans. While these loans total less than $0.5 trillion, the noncurrent portion had risen from 1.5% at the end of June 2007 to nearly 16% by the end of last quarter.”
“For CRE loans packaged into securities, serious delinquencies represent 4% of all CMBS currently outstanding, up from nearly zero before the crisis,” he added.
Evans said preventing such problems “requires very early and courageous action by policymakers.” But he said “microprudential regulations alone are not likely to resolve these issues.”
Evans said Chicago Fed staffers have told him that the Fed “needed to act very, very early – probably in 2004 or 2005″ to head off CRE problems, but said “at that time, it would have been difficult to argue convincingly in favor of reigning in this lending….”
“The economy was coming out of the jobless recovery and just beginning to gain traction,” he recalled. “And the banking industry had proven it could maintain profits through a recession, it had reduced problem loans back to historically low levels, and it appeared to have more than sufficient capital to cushion against potential losses.”
Evans said the Fed needs “macroprudential,” not just “microprudential” supervision because “a collection of negligible micro risks can add up to a far greater macro risk. Focusing on individual institutions and controlling risks on a firm-by-firm basis are not enough for detecting and controlling systemwide stress points….”
“Suppose for a particular class of assets, values decline on an economy-wide basis,” he said. “This means losses are going to be taken at the macro level. Perhaps managers at a few individual banks can be smart, foresee the price declines, and liquidate their positions in time to avoid large losses at their institution.”
“But the macro economy has to take these losses, and that’s where we get stuck,” he continued. “Not everyone can get through the exit door at once; someone has to end up bearing the macro losses.”
So Evans called for empowering the Fed and its fellow regulators with “macroprudential” authority to do such things as impose “dynamic capital requirements” and loan loss provisions that vary over the credit cycle.
The aim of macroprudential regulation would be “to assess and control systemwide risks,” said Evans.
But even if such an approach, Evans said “we are going to face challenges.”
Evans again observed that “CMBS and CRE loans have large delinquencies.” But he asked, “Could anyone have made this call confidently in time to arrest the problems we face today?”
He recalled that in 2007 the Fed and its fellow regulators issued a supervisory guidance on concentrations in commercial real estate and “gave a number of speeches prior to the crisis about risk pricing and about market exuberance – to little avail.”
“These warnings were largely ignored and we got a lot of push-back from banks,” Evans said. “During boom periods when risks are silently building up, there are a lot of people with a lot of money at stake who will come out against such pronouncements.”
“So, if policymakers do not follow words with actions, then we are not likely to make much progress,” he said.
Evans called for a “comprehensive, multi-pronged approach” to regulation. Needed is “a robust regulatory structure: a structure that takes full advantage of the existing tools supervisors have; a structure that supplements the existing one with dynamic capital requirements and a comprehensive approach to risk management; a structure that includes a macroprudential supervisor than can monitor and assess incipient risks across institutions and markets and, when necessary, impose higher regulatory requirements on firms that pose systemic risks.
Even with such a regulatory structure, he said crises will occur, and authorities will need to be able to “contain the disruptive spillovers that result from the failure of systemically important institutions without resorting to bailouts or ad hoc rescues.”
That will require a mechanism for resolving the failure of a systemically important institution, he said.
Echoing many of his colleagues, Evans stressed the need for the Fed to exercise a major supervisory role to head off future asset bubbles and resulting crises. Monetary policy alone is inadeqaute to the task, he said.
“I am skeptical about our ability to easily and definitively sort out in real time whether a rapid increase in asset prices is associated with overvaluation,” he said. “That is, how confidently can we state that we are in the midst of a bubble?”
“I also think that monetary policy is too blunt a tool for pricking bubbles: It can’t be targeted precisely and it will affect other financial and macroeconomic variables in addition to the suspected bubble asset,” Evans went on. “In addition, the typical changes in interest rates that a central bank might contemplate are likely to be too small to produce big changes in asset prices.”
However, Evans warned, “But without supervisory powers, there may be no choice.”
“We know that time consistency issues can lead a central bank to choose inflationary outcomes in the short run, even though there is no long-run tradeoff between output growth and price stability…,” he said, adding that to avoid that pitfall, a conservative central banker might need to be “tougher than the public” to “ensure that appropriate decisions would be made and appropriate actions would be taken.”
“Now, consider the reaction function of a central banker that has the additional responsibility for financial stability – but not the additional tools provided by a supervision and regulation role,” he said. “Such a central banker might have to act against exuberance in financial markets more actively than it would otherwise.”
“That would be entirely necessary and appropriate to preserve financial stability,” he continued. “However, that policy may not be the most appropriate one at that time for addressing the traditional goals of monetary policy of maximum sustainable employment and price stability.”
“A central bank with three goals and only one lever is a recipe for producing some difficult policy dilemmas,” he added.
By Steven K. Beckner – imarketnews.com
Add A Comment