By Steven Beckner

DENVER (MNI) – Federal Reserve Vice Chairman Janet Yellen added, “a
top priority of systemic risk surveillance must be to assess whether
asset price movements suggest the presence of a bubble and identify at
an early stage those that might be particularly dangerous.”

She acknowledged that “in practice….we will have highly uncertain
notions of when excesses evolve into bubbles. Near the end of a bubble,
it’fs pretty clear that something is amiss. But by then it?fs too late
to do much about it.”

The Fed and its fellow regulators “will also need to monitor the
cross-sectional correlations of firms’ risk exposures,” she said. “In
addition, we need information on counterparty exposures through
derivatives and other financial instruments.”

Yellen called for “further development of financial sector stress
testing, building on the tests carried out in the United States in 2009
and in Europe this year, will provide valuable information about the
ability of the financial system to weather significant economic or
financial shocks.”

“We should refine the stresstesting methodology as we develop a
more sophisticated understanding of institutionlevel systemic risk
factors,” she said. “These enhancements can be carried out by the
quantitative surveillance unit that we have already established in our
supervision of the largest financial institutions to better integrate
macroprudential considerations with regular supervisory practice.”

Talking about the Fed’s “important role” under the recently enacted
Dodd-Frank financial overhaul legislation, Yellen said, “We will
supervise all systemically important institutions and, jointly with
other regulators in the new Financial Stability Oversight Council,
establish stricter prudential standards for such firms.”

“We will help ensure the safety of financial market utilities that
are critical to our payment, clearing, and settlement systems,” she
said. “And we will actively support the council’s mission to identify
and address emerging risks to financial stability.”

“At the same time, though, we must take care to preserve incentives
for innovation and reasonable risktaking,” she continued. “We must
remain prudent, while avoiding an overly strict approach that unduly
impedes financial intermediation and stifles capital formation.”

Yellen said “vigilance to threats of systemic financial risk must
also inform the conduct of monetary policy.”

“We have seen that the eruption of a financial crisis can have
severe economic consequences, compromising the ability of a central bank
to attain its primary macroeconomic objectives,” she said. “Monetary
policymakers should also be aware that the decisions they make in
pursuit of price stability and full employment could, in some
circumstances, affect the development of systemic risk.”

“For example, if compensation incentives in the financial sector
are misaligned, low interest rates might heighten the ability and desire
of financial market participants to reach for yield and take on risk,”
she added.

“Our goal should be to deploy an enhanced arsenal of regulatory
tools to address systemic risk, making the financial system far more
robust,” she went on. “That way, monetary policy can concentrate on its
long-standing goals of price stability and maximum employment.”

She said “supervision and regulation must serve as the first and
main line of defense in addressing systemic risk.”

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** Market News International **

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