Yellen points to hedge funds, unregulated cryptocurrency as sources of instability

Treasury Secretary Janet Yellen took heat from both Republican and Democratic lawmakers Tuesday as she told them that “the inflation outlook still remains quite uncertain.”

Yellen delivered a report to the Senate Banking Committee from the Financial Stability Oversight Council (FSOC), which was set up in the wake of the subprime mortgage crisis to make sure market crashes and government bailouts on that scale would never be needed again. 

She argued for greater financial regulation at one of the most precarious economic moments since 2008, pointing specifically to risks posed by over-leveraged investment funds and unregulated cryptocurrency. The hearing came as stocks hit 52-week lows and markets brace for the latest inflation numbers.

“There is the potential for continued volatility and unevenness of global growth as countries continue to grapple with the pandemic,” she testified, calling attention to the use of borrowed money by hedge funds and other sophisticated investors that “can make them vulnerable to acute financial stresses.”

“These stresses can be transmitted and amplified to the broader financial system,” Yellen said. “The [FSOC] has taken steps to examine these risks, including reestablishing its Hedge Fund Working Group to develop an interagency risk-monitoring system and to propose options to mitigate identified risks.”

While the FSOC report identified vulnerabilities stemming from several different kinds of investment funds, Yellen agreed with a recent assessment by the Federal Reserve that “the banking system remains strong overall with robust capital and liquidity.”

Some Democratic lawmakers, including regulatory firebrand Sen. Elizabeth Warren (D-Mass.), argued during the hearing for increased oversight they said would shore up the financial system.

Warren specifically went after 2019 rule changes enacted during the Trump administration that walked back designation requirements on firms that are “too big to fail” or, in the language of the Treasury Department, “systemically important.”

The requirements were part of the market-disciplining Dodd-Frank Act that followed the 2008 crisis, which saw the government bail out Wall Street firms like Wells Fargo and Goldman Sachs and take over mortgage financiers Fannie Mae and Freddie Mac.

“Secretary Yellen, you, along with then-Fed Chair Ben Bernanke and former Treasury Secretaries Tim Geithner and Jack Lew, wrote a letter in 2019 opposing the revised guidance. You stated that the changes would ‘neuter the designation authority’ and ‘amount to substantial weakening of the post-crisis reforms,’” Warren said to Yellen.

“You also say that the 2019 guidance would ‘make it impossible to prevent the build-up of risk in financial institutions whose failure would threaten the stability of the system as a whole,’” she added. 

Yellen responded that she agreed with what she wrote in 2019.

Sen. Pat Toomey (R-Pa.), the Banking Committee’s ranking member, endorsed the Trump administration’s rule change, saying the previous policy “needlessly imposed bank-like regulations on nonbank financial institutions, such as insurance companies and asset managers.”

“More fundamentally, the act of designating a firm as a non-bank SIFI [Systemically Important Financial Institution] signals to the market that the firm is too big to fail and would be bailed out if it became insolvent, thereby introducing moral hazard,” he added.

But Republicans, for the most part, were more concerned with the macroeconomic picture than with changes to individual regulations.

“People aren’t coming back to work, though we have millions of jobs that are open,” Sen. Tim Scott (R-S.C.) said, referring to the near 50-year low unemployment rate of 3.6 percent. “The atrophying of the muscle for work seems to be endemic.”

He also took issue with the Biden administration’s stimulus packages designed to spark demand as the economy shut down in 2020 and 2021, saying they’re at least partly to blame for “persistent inflation.”

Sen. Mike Rounds (R-S.D.) wanted to know whether interest rate hikes by the Fed, which began this month at 50 basis points and are expected to continue throughout the year, would affect the ability of the U.S. to pay down its debt.

“What level of interest rates would alarm you?” he asked Yellen.

Regulatory consensus seemed to build for both Democrats and Republicans around stablecoins, a unit of cryptocurrency that is backed by a real-world asset, similarly to how the U.S. dollar used to be backed by gold.

“We do need a regulatory framework for stablecoins,” Sen. Catherine Cortez Masto (D-Nev.) said. “Last week, Fabio Panetta, one of the European Central Bank’s six executive board members, noted that the cryptocurrency market is now larger than the subprime mortgage market, which triggered the global financial crisis.”

Her sentiments echoed those of Toomey, who introduced legislation regulating cryptocurrency last month. Toomey was “glad to see [the FSOC report] acknowledged that it is the responsibility of Congress to create new rules for stablecoins.”

Yellen said she thinks “there are many risks associated with cryptocurrencies, and the president has asked the Treasury and FSOC to look at those risks. We will issue a comprehensive report shortly.”