Yellen Says Regulators Ready to Act as Panel Cites Risks

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Federal Reserve Chair Janet Yellen said regulators will take steps to address risks to financial stability as officials cited high-speed trading and clearinghouses as potential threats.

Yellen, speaking Tuesday at a meeting of the Financial Stability Oversight Council, focused on clearinghouses, platforms where swaps transactions are cleared and settled. The Fed will work with other regulators to evaluate whether rules and risk-management practices are strong enough, she said.

“We also are evaluating how banks are managing their exposures” to central clearing parties, Yellen said. “We’re prepared to take steps to strengthen standards to promote financial stability if needed.”

Financial firms including JPMorgan Chase & Co. and BlackRock Inc. are arguing that reliance on clearinghouses shifts risks to a handful of entities, and the collapse of one could lead to big losses for banks.

Yellen also said “the stronger financial sector is boosting credit to households and businesses, facilitating the transfer of risks to those most able to bear them, and is supporting economic growth and financial stability.”

Cyber Threats

The FSOC, which monitors potential threats to financial stability, reiterated in its annual report regulators’ concerns about cybersecurity and companies taking too much risk to compensate for near-zero interest rates.

The council said regulators are continuing to review events that shook financial markets in October and will release in the coming weeks a paper analyzing the volatility.

While changes in market structure, “such as the ability to trade at higher speeds,” have increased competition and reduced transaction costs, the growth of electronic trading “should be assessed for potential vulnerabilities,” according to the FSOC report. The council said officials need to better understand firms that aren’t regulated and links between different financial markets, and should make recommendations to Congress to close any “regulatory gaps.”

The report, the FSOC’s fifth since it was created by the 2010 Dodd-Frank law, details the potential threats regulators are monitoring, including global economic shocks, financial innovation, short-term wholesale funding and risk-taking incentives at large firms. The panel’s chairman is Treasury Secretary Jacob J. Lew and its 10 voting members include Yellen and Securities and Exchange Commission Chair Mary Jo White.

Weathering Shocks

Overall, vulnerabilities in the U.S. financial system “remained moderate” over the past year, the council said. The economy weathered a “variety of shocks from abroad,” including tension in Ukraine and the Middle East, and slower growth in Europe, Japan and China. The panel warned that instability abroad could trigger a selloff in emerging-market bonds and destabilize markets.

U.S. regulators’ concerns about abrupt market swings have focused on the events of Oct. 15, 2014, when yields on 10-year Treasuries plunged the most since 2009, without an obvious catalyst. Last month JPMorgan Chief Executive Officer Jamie Dimon said the October volatility was a “warning shot” to investors and the next financial crisis could be exacerbated by a shortage of Treasury securities.

Yellen noted that market participants “have raised concerns that market liquidity may deteriorate during stressed conditions, citing factors such as advances in electronic trading, increased competition, and new regulations.”

Capital Planning

The council recommended Tuesday that regulators push for “forward-looking capital and liquidity planning” at large banks.

In a separate meeting Tuesday that was closed to the public, the council received an update from the Fed and the Federal Deposit Insurance Corp. on resolution planning for bank-holding companies, the Treasury Department said in a statement. The FSOC also got an update from Treasury officials on “international market developments,” the department said, without elaborating.

On clearinghouses, the FSOC report said regulators need to “evaluate whether existing rules and standards are sufficiently robust to mitigate the risk” that the clearing parties could spread “credit and liquidity problems among financial institutions and markets during periods of market stress,” the FSOC said.

Testing Clearinghouses

Council member Timothy Massad, chairman of the Commodity Futures Trading Commission, said the CFTC will look at stress-testing of clearinghouses.

The council repeated its previous warnings about threats to cybersecurity. Large-scale hacks at industry giants including Sony Corp., JPMorgan and Target Corp. have further heightened fears among U.S. corporations.

“Strong collaboration and data sharing among financial-service companies, and government agencies; improvements in technology infrastructure; and adequate plans for responding to and recovery from cyber incidents will remain areas of focus,” the FSOC said.

The regulators reiterated their concern over the so-called reach for yield as the Fed continues to keep interest rates near zero.

“The historically low-yield environment continues to encourage greater risk-taking across the financial system,” the FSOC said. “A sharp increase in interest rates or credit spreads could generate losses on longer-term assets, including less-liquid assets such as high-yield and emerging market bonds. If such losses are borne by leveraged investors, they could lead to fire sales and further declines in asset prices.”

Lew’s Criticism

The FSOC said “significant progress” had been made in addressing weaknesses in the tri-party repo market that were highlighted in previous council reports. The market’s dependence on intraday credit from clearing banks had been reduced, according to the report.

Lew criticized legislation proposed by Senate Banking Committee Chairman Richard Shelby, an Alabama Republican, that seeks to strengthen oversight of the Fed. Shelby’s bill “contains changes to our financial regulatory framework that would roll back the clock and leave us with weakened oversight, fewer consumer protections and less effective tools to address risks in the system,” Lew said.

The legislation would “needlessly tie” the FSOC “in knots with delays and hurdles that would significantly impair our ability to identify and mitigate threats to financial stability, while leaving potential risks unchecked,” Lew said.

(Updates with comments from Yellen, Massad, Lew starting in 12th paragraph.)
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