Janet Yellen’s Long History as a Regulator

Among the issues likely to arise during Janet Yellen’s Senate confirmation hearing is her role as a Federal Reserve policy maker and bank regulator before and during the 2008 financial crisis.

As the president of the Federal Reserve Bank of San Francisco from 2004 until 2010, Ms. Yellen had a front-row seat to the crisis and the buildup of risks that caused it, and along the way she identified some of the growing dangers that many other officials missed or dismissed. Like most, Ms. Yellen, who is now Fed vice chairwoman, vastly underestimated the severity of those repercussions.

At least some members of the Senate Banking Committee, particularly Republicans, are likely to press her on why numerous financial institutions failed in her banking district. They’ll likely ask whether she could have done more to prevent the problematic lending practices that contributed to the crisis and whether the Fed should have raised interest rates to pop the housing bubble.

In 2005, Ms. Yellen started growing concerned that there was a bubble in the housing market, she said in a 2010 interview with the Financial Crisis Inquiry Commission, set up by Congress to investigate the crisis. She said she used speeches in the months and years following to highlight that possibility and the broader economic fallout a decline in house prices could trigger. (See, for instance, her 2005 speech “Housing Bubbles and Monetary Policy”)

Meanwhile, her team of bank examiners was growing more concerned about the commercial real estate lending activity they were seeing, Ms. Yellen has said. She voiced some of these worries publicly, warning an audience of bankers in 2006 that a high concentration of home development and construction loans some banks were holding could be a problem with the residential market softening.

But Ms. Yellen has said she didn’t feel she had the authority to direct her examiners to crack down on the banks in her jurisdiction until the Fed board in Washington, which sets supervisory policy, issued new guidelines. She said she pushed Washington to issue tougher guidelines; they didn’t come until December 2006 and were weak, Ms. Yellen told the FCIC.

“I think what we’ve learned in hindsight is it was very hard for all of the regulators involved to take away the punch bowl in a timely way. And as the supervisors in the field, we didn’t really have the ability to either limit concentrations or, for example, to demand that banks hold higher capital against these concentrations,” Ms. Yellen said during her July 2010 confirmation hearing when questioned about her regulatory track record by Sen. Richard Shelby (R., Ala.).

Eighty banks failed in the western U.S. from 2008 through 2010, though due to the fragmented regulatory structure less than half of those were overseen directly by the San Francisco Fed.

She is now a whole-hearted endorser of the tougher set of rules the Fed is constructing for banks, especially the biggest, most-complex institutions. Internally, she was involved in setting up the Fed’s new Office of Financial Stability, a cross-disciplinary department whose mission is to seek out and address weaknesses in the financial system.

Transcripts of Fed policy meetings from before the crisis show Ms. Yellen making far-sighted comments about developments in the housing market, the risks being taken on by mortgage-finance giants Fannie Mae and Freddie Mac, and the threat to economic growth posed by a bursting housing bubble.

“In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector,” she said at the Fed’s June 2007 meeting. She raised the possibility of a “vicious cycle” emerging in which defaults by subprime borrowers with little incentive to keep up with their mortgage payments would push down home prices, leading to more foreclosures and more downward pressure on prices.

Still, in a speech a few weeks later, she declared “I do not consider it very likely that developments relating to subprime mortgages will have a big effect on overall U.S. economy performance.”

A few months later, with financial markets seizing up, she changed her tune. “The possibilities of a credit crunch developing and of the economy slipping into recession seem all too real,” she said at the Fed’s December 2007 meeting. She urged the Fed to cut its benchmark short-term interest rate — then at 4.5% — by half-a-percentage-point. “This may not be enough to avoid a recession… but it would at least help cushion the blow and lessen the risk of a prolonged downturn,” she said.

The committee decided to go with a smaller quarter-point cut. Ms. Yellen wasn’t a voting member at the time. A committee of economists later determined the U.S. recession began that December.

During the housing boom the Fed debated whether to raise interest rates to deflate asset bubbles, and she was firmly in the camp that believed it should not, Ms. Yellen said in the FCIC interview. She added that her views were “gradually changing on this.”

“It’s not that I thought bubbles and asset markets cannot pose risks to the economy. I certainly thought they could. But I felt, and in a way I continue to feel, that supervision and regulation are the appropriate first line of attack,” she said.

Ms. Yellen’s recent remarks on the issue show her closely in line with Fed Chairman Ben Bernanke. She still favors supervision and regulation as the “as the main line of defense” against financial instability rather than raising interest rates to tamp down on risk-taking in financial markets, she said during a panel discussion in April.

Interest-rate policy is “a blunt tool for addressing financial stability concerns,” she said, but, if the situation demanded, the Fed would adjust interest rates to preserve financial stability.

“I don’t think we have taken that off the table as something that could conceivably govern the response of monetary policy,” she said.