WASHINGTON Federal Reserve Board Chair Janet Yellen said Wednesday she is seeing some riskier lending taking place because of the Fed's zero interest rate policy, but noted that the boost in leverage and credit that typically accompany a financial bubble have not yet materialized.
Speaking during a conference at the International Monetary Fund's headquarters, Yellen said that the uptick in riskier lending was likely due to the "unthinkable six-plus years" that the federal funds rate has been at or near zero.
"In the market for leveraged loans, we're certainly seeing reach for yield, and we're seeing deterioration in underwriting standards," Yellen said, noting that the Fed and other supervisors have been pushing for stronger underwriting standards for leveraged loans. "We're also seeing a compression of splits on high-yield debt, which certainly looks like a reach-for-yield type of behavior."
Yellen said that the Fed's low interest rate policy also could potentially lead to increased interest rate risk at financial institutions, where money is lent at very low rates for very long terms, which could tether institutions to unprofitable debts if rates go up. She said the Fed examines that risk as part of large financial institutions' annual stress tests and so far has not seen excessive risk.
Yellen added that the overall valuations for stocks are also very high, suggesting that they may outpace the fundamentals of individual businesses.
"I would highlight that equity market valuations at this point generally are quite high," Yellen said. "They're not so high that you can compare returns on equities to returns on safe assets like bonds, which are also very low, but there are potential dangers there."
Yellen's comments on stocks echo concerns raised in a paper published by the Office of Financial Research last month, which compared stock valuations today to valuations immediately preceding economic downturns and found a close correlation.
Those risks notwithstanding, Yellen was quick to point out that the heightened pursuit of yield has not led to increased systemic risk because there has not been a correlating jump in borrowing to finance market speculation.
"My assessment at this point would be that the risks to financial stability are moderated, not elevated" Yellen said. "I say that because we're not seeing any broad-based pickup in leverage, we're not seeing rapid credit growth, we're not seeing an increase in maturity transformation, and I would call those things the hallmark of a financial bubble or precursors of a financial bubble."
Many of the rules required by the Dodd-Frank Act have created a less risky environment, Yellen said, including stress testing, capital requirements, liquidity coverage and net stable funding ratios, and the requirement for large banks to create living wills. But the absence of similar rules for nonbanks means that there is additional work left to do to ensure that risks don't migrate to the nonbank sector.
"The financial crisis clearly revealed that even outside the regulated banking sector, in the shadow baking sector we had risks that were very similar to the risks we traditionally had in banking," Yellen said. "It is very important that we keep an eye on and appropriately regulate the shadow banking sector."
Lehman Brothers, Bear Stearns and AIG were all nonbanks, and all three collapsed, were absorbed in a fire sale or were bailed out by taxpayers because of their risky behaviors, Yellen said. Many rules have been pursued by regulators to reduce those risks, including the Securities and Exchange Commission's rules governing money market funds and securitization vehicles, the Fed's capital surcharge which penalizes short-term wholesale funding, and the Financial Stability Oversight Council's nascent examination of asset managers. Yellen particularly pointed to mutual funds as having the potential to create systemic risk if there were a run because they promise perfect and instant liquidity even though they represent investments in much more illiquid assets.
"If there were runs on those funds, you have a kind of liquidity maturity transformation there that can give rise to very substantial moves in asset prices," Yellen said. "We've highlighted that and we're focused on that as well."