Mario Draghi: Monetary policy and new financial instruments
Speech by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability
Forum, at Session I on Challenges in the World's Financial Markets of the 2007 Money and Banking
Conference "Monetary Policy Under Uncertainty", hosted by the Central Bank of Argentina, Buenos
Aires, 4 June 2007.
* * *
1. Introduction
In my talk on "Monetary Policy and New Financial Instruments" I will first review some of the most
important financial innovations we have seen in recent years, and the consequences they have had
for financial markets and institutions. Then I'll discuss some of the implications for financial stability
policies, before closing with some thoughts on the implications for monetary policy.
2. The recent wave of financial innovation
While there have been many changes in how financial markets function in recent years, perhaps the
most striking changes have come in the area of credit risk. Large banks in the developed markets are
rapidly moving away from the traditional business of making loans and holding them to maturity.
Increasingly they see their business model as originating credit claims (or packaging claims originated
by others) and selling them, often in seniority-based tranches, to investors. As a result, the process of
disintermediation - which was already well underway in many markets in the 1980s and 1990s - has
accelerated. Credit is now something that is largely bought and sold on markets, rather than held for
the long term on the balance sheets of financial intermediaries.
The increased trading of securitized credit instruments has accompanied, as both cause and effect,
the explosive growth in the market for credit derivatives. Meanwhile, derivatives and structured
products in other risk categories, such as interest rates, foreign exchange and equities, have also
continued to grow in volume and complexity.
Rapid innovation in financial instruments has accompanied - again, both as cause and effect -
increased activity by non-traditional financial players, notably hedge funds and private equity funds. As
institutions, of course, these are not themselves new. But there has been a qualitative shift in the size
and scope of their activity. They have gone from being niche players to being key participants and
drivers of innovation in a broad range of markets and transactions.
The growth of hedge funds is part of an ongoing realignment of the roles of different categories of
financial institutions. Hedge funds now account for a large share of trading in many core market
segments, and manage a steadily increasing share of the assets of the world's pension funds and
university endowments. At the same time, traditional asset managers have adopted hedge-fund-like
strategies, including taking on leverage and adopting short positions. Some hedge funds are taking a
prominent role in credit markets, either as direct providers, as investors in the riskiest tranches of
funded or synthetic CDOs, and by providing liquidity to the credit derivative market. The rise of
standalone CDO vehicles as a channel for credit intermediation in turn has altered and potentially reduced
the role of traditional banks in credit markets. Private equity funds have assumed an important role in
restructuring corporate assets, with the help of innovative loan structures and financing techniques
that rely on hedge funds as traders and investors. And the boundaries between the functions and
behaviour of private equity funds and hedge funds have blurred as well.
In some respects it's still too early to forecast the full consequences of these developments. But we
can already see some of the changes in financial systems that have resulted. Let me suggest some of
the consequences that these changes may have, for financial markets, for financial institutions, and for
how we go about fulfilling our responsibilities as central bankers.
With respect to markets, the most critical change has been the increased liquidity and transferability of
risk. Not only are there ever more instruments and markets in which all kinds of risks can be hedged or
traded; there is also a growing pool of counterparties willing to take one or the other side of a
risktransfer transaction - as long as the price is right. When analysts talk about the increased liquidity of
markets, this is what they're referring to: in more and more markets, an asset can readily find a buyer
at a price that does not command too great a liquidity premium.
One reason for this is that many of the new instruments are capital-efficient, meaning that traders do
not need to allocate a large amount of up-front capital to adopt the relevant exposure. A second factor
helping to increase market liquidity is that more and more players are structurally better at providing it.
For example, institutional investors with long investment horizons have now become the largest
investors in private equity and hedge funds. Because these investors can agree to lengthier "lock in"
periods, in normal times, hedge funds and private equity funds can provide ready liquidity to markets
because they themselves do not need to worry about meeting the liquidity needs of their investors.
The funds may, however, face liquidity demands from other counterparties, particularly in times of
stress - a point I'll come back to in a moment.
The greater diversity of players and instruments, and the increase in liquidity, have had a profound
impact on how financial markets function. Volatility and risk premia have fallen steadily over this period
of rapid innovation. To a degree, this has reflected reduced real volatility. But, more fundamentally,
markets have become structurally more efficient at pricing risks and arbitraging valuation differences
across assets. Financial prices are now driven more actively towards fundamentals than before.
One consequence of this is that we are moving to a world where financial shocks are more easily
absorbed than they used to be, because there is a larger pool of players available who are willing and
able to switch quickly from one market to another. As a result, liquidity shortages in one market or
financial sector can rapidly be made up by transfers of liquidity from another. This helps ensure that
prices for related assets are broadly in line with one another.
But at the same time the risk of a broader shock, affecting several markets at once, may have
increased. Such a shock could result from a fall in risk appetites of a broad range of participants,
perhaps in conjunction with a fall in the liquidity available to hedge funds and other active traders.
Hedge funds may be shielded from liquidity demands from their investors, by lock-up periods and
withdrawal gates, but they still need liquid funds to meet margin calls on their positions. Those
demands are likely to rise most steeply at times when markets are turbulent and the supply of liquidity,
whether from other traders or from dealers and prime brokers, is likely to be reduced. If initial price
movements trigger counterparty concerns, this could well generate deeper and more broad-based
liquidity erosions that can pose risks of a systemic nature.
What are the implications of this new environment for financial institutions, particularly the ones that
are subject to regulation? One important development is that improved trading and pricing of risks
enable financial institutions of all kinds to manage their risks better. For the official sector, this is
clearly good news. At the same time, however, competitive pressures from new players and new ways
of doing "old business" pose challenges. Greater risk management capacity also means it is easier for
participants to take on risks, which can reinforce moral hazard problems. The operating environment
has also become riskier, with complex instruments posing risk management and valuation challenges
even for the most sophisticated firms. A shock to profitability that reduces the credit standing of one or
more large institutions, or leads banks to take on riskier strategies in order to reach a desired level of
profits, could have systemic implications that authorities need to be aware of.
A critical question for the stability of global financial markets is whether the core intermediaries - the
fifteen or twenty large global firms that make markets in the most widely traded derivatives and act as
prime brokers to hedge funds - are adequately managing their counterparty and principal-based
trading activities. The large dealers firms manage counterparty exposures through a combination of
initial margin, variation margin, and allocations of their own capital. So far, these firms seem to be
direct
keeping their credit exposures to hedge funds and principal trading under control. However,
there is evidence that competition for hedge fund business may be putting margining arrangements
indirect
under pressure. It is also unclear whether firms have adequately protected themselves against
exposures to the consequences of greater leveraged activity, such as the risk of a sudden global
shock to liquidity as I mentioned a moment ago. Firms are still devising methodologies to model such
events and incorporate them in stress tests. But ultimately the best safeguard will be adequate capital
and liquidity cushions.
3. Implications for financial stability policy
What do these developments mean for financial stability policy? In the new environment, risks seem to
be dispersed more widely, but transparency about where risks are located has declined. This reduces
the sectoral impact of real and financial shocks, but may also make it harder to anticipate which
sectors are vulnerable to a shock. Even more than before, policy needs to move from a reactive
orientation, where we intervene in response to problems and threats, to a preventative stance in which
systems are made more robust to potential shocks.
Certainly it's not the task of the official sector to stand in the way of innovation or improved efficiency.
However, we do need to minimize the moral hazard risks that might come from the increased risk
capacity of regulated firms. One way to do this is to redouble our efforts to use regulatory tools -
riskbased capital requirements, prudential rules, disclosure that is aimed towards strong market discipline
- to align the decisions of regulated firms more closely to market signals.
New instruments and trading patterns also call for the expansion or adaptation of the market
infrastructure that underpin financial activity. Here, collective action problems among market
participants can arise that prevent the market from finding appropriate solutions on its own. Giving the
impetus that the markets need to resolve collective action problems is a key task of central banks and
financial regulators. We've seen some creative examples of this in the last few years, for example the
efforts of the Federal Reserve Bank of New York and the Financial Services Authority in London to
press large dealers to reduce their backlogs of unconfirmed credit derivatives contracts and to create
more resilient settlement arrangements for these transactions.
The approach to regulation of hedge funds has been much discussed over the years. After extensive
debate following the 1998 LTCM crisis, political and financial authorities agreed an "indirect approach".
This approach relies on the counterparties who provide hedge funds with leverage - largely regulated
banks or investment banks - to exercise appropriate discipline in their lending and dealing with hedge
funds. Counterparties are expected to impose limits on their exposure to a hedge fund that takes on
excessive leverage, is engaged in excessively risky strategies, or is not sufficiently forthcoming with
information about their risk exposures.
This indirect approach has generally worked well in containing the financial stability risks posed by
hedge funds. It is a joint effort, involving first and foremost the exercise of discipline by the private
sectors, with supervisors buttressing that discipline when competitive pressures erode it. As markets
grow and evolve we need to work constantly to ensure that all of the relevant parties are doing what
they need to do.
This is the message that came out of the Financial Stability Forum's recent update of its 2000 report
on highly leveraged institutions. In the update we set out five recommendations - addressed to
supervisors, hedge fund counterparties, investors, and the hedge fund industry - that FSF members
agree are likely to be most effective in financial stability risks related to hedge-funds Three of the
recommendations are addressed to supervisors. They are urged to press dealer firms to strengthen
counterparty risk measurement and management, especially where instruments are new and
complexity is high. They will also work with firms to strengthen their capacity to assess and mitigate
their exposures to the market liquidity erosions I mentioned earlier. Lastly, supervisors will evaluate
the case for developing more systematic data on core institutions' global credit exposures to hedge
funds. A fourth recommendation calls on counterparties and investors in hedge funds to demand and
act upon appropriate information from hedge fund managers, while a fifth urges the hedge fund
industry to review and enhance existing sound practice benchmarks for hedge fund managers.
I would like to dispel the notion that this indirect approach is a light approach. In particular, for
supervisors to be able to judge the adequacy of firms' risk management processes and to induce more
conservatism where this is needed, they must establish - continuously - where the frontier in terms of
risk management practices is. And they must then set out expectations about changes that firms
individually and collectively must make, and oversee firms' implementation of necessary changes. An
extensive review by the main supervisory authorities of how the largest banks and prime brokers in the
world manage their hedge fund related risks is now underway. Separately, the hedge fund industry
has begun to take steps to strengthen existing sound practice guidance, notably in the areas of risk
management, valuation practices and disclosures to investors and counterparties. We will be following
progress in these areas very closely in period ahead.
4. Implications for monetary policy
The widespread innovations in the financial markets that I just mentioned - the expansion in the use of
marketable instruments, the rise of new players, the development of derivatives and structured
products markets - have brought important changes in the way monetary policy is conducted,
communicated and transmitted to the economy.
First of all, the transmission mechanism is changing. While the effect of monetary policy on the
availability and cost of bank credit is decreasing, monetary policy actions have prompter effects on a
whole range of financial market yields and asset prices. The latter development may be positive, if our
intentions are communicated well and correctly interpreted by investors. It could be detrimental, if it
causes more volatility.
Our decision-making process is also changing. We have at our disposal a wide range of new
information from asset prices, which enables us to gauge market expectations more carefully and take
them into account. However, the interpretation of other crucial variables, such as monetary and credit
aggregates, is more difficult than in the past, although by no means less important, and calls for
renewed research efforts.
Let me address some of these issues in turn.
4.1 Monetary policy, asset securitization and the changing role of banks
The role of the banking system in the transmission of monetary policy decisions to the economy - the
so called "bank lending channel" - was once central. It is now rapidly diminishing. Compared with the
traditional way of thinking, this is a sea change.
Banks were previously at the centre of the monetary transmission process. The existence of
asymmetric information on the quality of borrowers assigned a special role to banks in assessing firms'
creditworthiness and providing external finance; the sensitivity of banks' checking deposits to interest
rate changes gave monetary policy a powerful tool with which to affect banks' funding and
intermediation activity.
The development of new financial products and intermediaries is radically reshaping this environment.
Banks are taking on a new role in originating, pooling and distributing credit risks outside the banking
system. In most markets the securitization of bank loans is booming, and this is affecting the way
monetary policy operates. By disseminating information about firms, loan securitization is helping to
reduce the spread between the cost of internal and external finance. The possibility to securitize loans
and sell them to institutional investors, such as hedge funds, insurance companies and pension funds,
eases banks' funding constraints for new lending. It also allows banks to transfer a substantial part of
credit risk and reduce their capital requirements, making possible, other things being equal, a further
increase in loans supplied.
We are devoting a good deal of research to the implications of securitization on the role of banks in the
transmission mechanism. Ongoing research by the Bank of Italy and the ECB (using microdata on
3,000 euro-area banks over the last eight years)1 finds that banks that make greater use of
securitization are more sheltered from the effects of monetary policy changes: in response to
increases in official rates, their lending activity shrinks less than does that of other institutions.
Securitization therefore appears to reduce the overall effect of monetary policy on loan supply
significantly.
This finding has important implications on how we assess policy. We can no longer limit ourselves to
examining the state of the banking system and its credit risk in order to evaluate the effect of monetary
policy on credit conditions and the stability of the financial system. While the banking system may still
be the lever by which the entire financial system is controlled, other actors, often located far from
where the loans are originated, have an increasing influence on credit supply. The changing
distribution of credit risk in the economy may affect the way the transmission mechanism operates, in
ways we do not yet completely understand.
The resilience of the financial system in the face of larger shocks has yet to be fully tested. Although
credit risk will be less concentrated on banks, the financial risks that are being created by the system
may actually be greater. It cannot be precluded that episodes of credit risk mispricing may be followed
by abrupt adjustments, posing new challenges to the stability of the financial system as a whole. It is
too early to tell whether the changes on the financial markets have determined the end of "credit
cycles".
4.2 Monetary policy and asset markets
While the role of banks in monetary policy transmission is diminishing, other channels are gaining in
importance. To the extent that financial innovation makes markets more complete and more efficient,
actual and expected changes in official interest rates are readily transmitted to a wide range of
financial assets. Overall, the effects of policy decisions on financial markets are stronger and faster.
A more immediate impact of monetary policy on a wide range of asset prices may have favourable
implications, since it provides monetary authorities with a powerful instrument for affecting the
economy. Market expectations on future policy intentions move long-term rates and affect financing
conditions, even before official interest rates are changed. The modification of asset prices affects
consumption and investment decisions. If policy communication is effective, these changes may partly
"do the job" for central banks.
At the same time, unless we are suitably careful the consequences may be disruptive. Policy actions
that diverge from the pace expected by economic agents, which is built into long-term interest rates
and other yields as well as into positions taken on the market, may upset markets, increase volatility
and, in extreme cases, induce a simultaneous revision in positions, with potentially disorderly effects
on liquidity and asset prices.
The concern not to destabilize financial markets is one reason why many central banks have striven in
recent years to reduce the uncertainty arising from policy decisions. They are paying more attention to
proper communication of their objectives, strategies and, with different nuances and practices, future
intentions. A trend to greater gradualism in policy action has emerged in all the main industrialized
economies (policy moves in excess of 25 basis points are now quite rare for major central banks)
partly in response to the greater uncertainty over the impact of rate changes on the financial markets.
As the interplay between policy actions and market expectations gathers importance, we should also
guard against the risk of what has been described by Alan Blinder as the "dog chasing its tail". It is
fundamental that we to avoid a situation in which financial markets look at the central bank and the
central bank looks at financial markets, both losing sight of the underlying factors that determine
inflation.
In the Eurosystem, we consider it definitely desirable that our policy be predictable in order to reduce
uncertainty and volatility in financial markets. However, our actions are ultimately dictated by the
economic outlook, not the view of the financial market. In general it is better to avoid surprising the
market, but there are times when it cannot be avoided, because we have new information or, more
simply, different views from market participants. In these cases, effective communication is even more
important. To deliver price stability over the medium term, it is essential that the leadership remain with
the monetary authorities.
4.3 Monetary policy and financial market indicators
Let me further observe that the development of financial markets and the introduction of new
instruments affect not only monetary transmission but also our decision-making process. The
availability of a wide range of new products gives us a wealth of information that we jacked even just a
few years ago. By contrast, the traditional indicators are now harder to interpret.
We have at our disposal a large set of information from derivatives markets (futures, options, swaps)
that is key to our decision-making. Prices on these markets allow us to estimate, with a degree of
precision that a few years ago would have been unthinkable, the entire distribution of market
expectations about crucial variables. We now have indicators of market expectations about inflation,
growth and policy decisions, of the uncertainty surrounding those expectations, and even of investors'
attitude towards risk. This helps us to produce better policy decisions: investors' expectations shape
the way the economy is likely to react to our actions and are a source of information on the underlying
economic trends.
However, the diffusion of new financial instruments is also likely to affect the information content of
some of the indicators that central banks regularly monitor and that serve as a basis for policy
decisions. The behaviour of money and credit is particularly affected by the emergence of new
products and new players.
Ten years ago, most of M3 in the euro area was held by households and firms, whose behaviour as
money-holders we could understand reasonably well. Only around 6 per cent was held by so-called
non-bank intermediaries (which include mutual funds and "financial vehicle corporations" that
purchase, pool and repackage bank loans as marketable securities). This percentage is now almost
twice as large, and about one fifth of M3 growth is accounted for by these intermediaries.2 Their
demand for money is likely to respond to different motives, and is harder to interpret. Moreover,
marketable instruments (such as money market funds) now represent 14 per cent of M3, as against 10
per cent at the beginning of the nineties and only 5 per cent in the mid-eighties. They are held for
portfolio purposes and are less directly connected to transactions and spending on goods and
services.
These developments call for deeper analysis. It would be wrong to conclude, as some commentators
seem to have done, that they require a reduction in the role of money in the strategy of central banks,
and of the ECB in particular. The dynamics of monetary aggregates still conveys important information
on the future evolution of prices, but in order to extract this information it is necessary to process a
larger set of monetary data and take account of the significant impact of the recent financial
innovations. All the central banks in the Eurosystem are committed to improving their analysis in this
direction.
Ongoing research at the Bank of Italy is aimed at developing techniques to extract information from
the common trend of a large set of monetary indicators (M3, but also its components, the monetary
holdings of different sectors of the economy, and the counterparts of M3, including credit
developments), using multivariate techniques (dynamic factor analysis) to get rid of noise. Our results
indicate that the common trend derived from the various monetary components conveys useful
information on the behaviour of inflation a few years down the road.3 This confirms that the analysis of
monetary variables remains essential in the conduct of monetary policy, provided it is based on the
assessment of a large information set and sound economic interpretation.
This implies that we should not be complacent about the value of our current tools, which are clearly
affected by the ongoing change in the euro-area financial landscape. However, playing down the
importance of monetary and credit analysis would be a dangerous mistake. In this respect I believe
that the "full-information" strategy adopted by the Eurosystem, based on cross-checking the signals
derived from real and monetary variables, is probably the best to deal with the challenges posed by a
changing environment.
5. Conclusions
I have offered a few thoughts on how financial innovation may affect monetary policy. Certainly, I have
not exhausted the issues, but sought rather to highlight the key themes and the main lines of current
thinking among central banks and other official institutions. We need the experience of a full credit
cycle before drawing conclusions. As with any period of rapid innovation, there is a great deal of
uncertainty about how critical variables - including credit aggregates, consumption, fixed investment,
and inflation - will behave under different scenarios. Policymakers will need to be humble about what
they do not know, and to be creative and flexible in dealing with the changes to the traditional
relationships that are rapidly taking place. Conferences like this one are of vital importance to foster
understanding of these developments and exchange views on what they mean for the tasks we face
as central bankers.