By Steven K. Beckner
(MNI) – 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.
** Market News International **
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