Federal Reserve Chair Janet Yellen says she's aware of the dangers of complacency in financial markets. Complacency at the Fed can be dangerous, too.
In a news conference today, Yellen explained that monetary policy will stay on the course previously announced. That's fine: Macroeconomic conditions haven't changed. But she also addressed the calm that's descended on the markets -- a mood reflecting investors' belief that interest rates will stay low through next year. Although she stopped short of saying that investors have become overconfident, she noted the possibility that docile markets can encourage excessive risk-taking. This risk "is very much on my radar screen," she said.
It needs to be. The VIX index, which tracks expectations of stock-market volatility, is hovering near its lowest-ever levels. At such times, investors tend to get overextended. Markets don't look bubbly on the whole, but there are notable pockets of excess. For instance, firms are issuing risky corporate debt at unusually low yields. As surely as the Earth circles the sun, the cycle will eventually turn from boom back to bust.
So what are the Fed and other regulators doing to prepare for the next surge of financial instability? Not enough.
Regulators are building a financial early-warning system, but it's far from complete. Yellen says Fed officials are watching indicators of risk-taking -- such as the amount of borrowed money, or leverage, investors are using. If they have good measures, they should share them with the public: The ones they've published to date are far from comprehensive.
On a global level, reporting of derivatives and asset holdings is so fragmented that U.S. regulators can't say which banks, hedge funds or other institutions are most at risk if, say, emerging markets crash or a European government defaults. The Fed's periodic stress tests, though better than before, offer only a snapshot of banks' constantly evolving risks.
Beyond that, regulators need to be sure that when financial turmoil does strike, big institutions are strong enough to survive without relying on government support. The crucial thing is equity capital -- the money financial institutions get from investors willing to risk losses in return for a share of profits.
Earlier this year, the Fed issued a new rule requiring large bank holding companies to have $5 in capital for each $100 in assets. That's more than the $3 international minimum, and the change was considered a great achievement. But that much capital still means that a mere 5 percent drop in the value of a bank's investments could render it insolvent. Experience and research suggest that safety requires much more.
And that's just traditional banking. In other areas of finance, the Fed and other regulators also have a lot more work to do. When markets are calm is a good time to press on. Next time they aren't calm, it will be too late.
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