Timothy F Geithner: Restoring market liquidity in a financial crisis
Welcoming remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the
Federal Reserve Bank of New York, at the Second New York Fed-Princeton University
Liquidity Conference, New York, 13 December 2007.
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Welcome to the New York Fed and to this conference on liquidity. You are addressing some
of the most important issues affecting financial markets today. Your timing is good, perhaps
too good. We are all going to need some time and perspective before we will know enough to
draw conclusions and recommendations from the events of the past six months. The
conditions that led to this crisis took a long time to develop and they will take some time to
resolve. I think it is appropriate, though, that as central banks act to address the challenges
in markets today, we also begin to define the agenda for future research and policy.
On December 12, the Federal Reserve and several other major central banks, announced a
series of actions in response to the elevated pressures in funding markets. Together, these
actions provide a more flexible and potentially more effective set of instruments, alongside
our conventional monetary policy instruments, to help mitigate the risks that liquidity
pressures in markets going forward could pose to the broader economy. With this framework
of tools, we have the capacity to calibrate our response as market conditions change.
Although the specifics vary across central banks, the approaches outlined have several
important common elements. We each have taken actions to provide more financing at terms
longer than overnight. We each have chosen to auction funding against a broader range of
collateral, collateral other than government securities, and in our case with a broader set of
counterparties. And we have activated swap lines to help the relevant central banks provide
liquidity in dollars in their markets.
The initial spark to the pressures we observe in markets today was the sharp deterioration in
the value of nonprime mortgage securities and the resulting increase in uncertainty about the
value of a much larger amount of financial assets exposed to that risk. This was magnified by
a substantial increase in uncertainty about the economic outlook and the consequences of
that uncertainty for asset values and credit losses. Financial institutions faced a sharp drop in
demand for a range of assets, impairing the securitization market as a source of funding. And
a substantial amount of these illiquid assets were held in vehicles with implicit or explicit
liquidity guarantees provided by banks. This produced a large unexpected increase in
demand for funding from banks at the same time banks confronted a reduced capacity to
raise financing.
As market participants have adjusted to what has been a very acute change in expectations
about economic and credit risk, they have become more cautious in how they use their
liquidity and capital. The symptoms of this are apparent in the high risk premia across a
range of assets, as well as in the dramatic contraction in the volume of transactions for
certain assets and the securities that reference those assets. Elevated term premia in the
interbank market has the effect of tightening overall financial conditions, offsetting some of
the impact of reductions in the target federal funds rate.
The danger this poses is the risk of an adverse, self-reinforcing dynamic in which concerns
about overall liquidity magnify concerns about credit problems. As financial institutions
prepare for a more challenging funding environment, in part by conserving capital, and as
they anticipate the higher potential losses that would normally accompany an economic
slowdown, their response, in aggregate, makes markets and the economy potentially more
vulnerable to that adverse outcome. The risk is a greater contraction in the availability of
credit beyond what might have otherwise occurred, with attendant risks to growth.
Monetary policy has an important role to play in addressing these dynamics in markets. By
adjusting policy proactively as the risk to the outlook changes, central banks can help reduce
the probability of the extreme adverse outcome. And this can positively affect the incentives
that might otherwise lead market participants to protect themselves against the extreme
outcome.
Central banks have been employing a range of different tools to help reduce the incentive for
an excessive level of liquidity hoarding by banks that might impede an efficient flow of
liquidity among banks. Although the mix of tools and approaches has varied across the major
economies, each has tried to provide a more effective form of liquidity insurance to its
financial institutions by expanding the capacity of banks to borrow at longer maturities from
the central banks against a broader range of collateral.
The actions to address liquidity issues - those we announced this week and those that we
have taken over the past five months - can help reinforce our monetary policy actions by
providing greater assurance for market participants of access to funding. By allowing strong
banks to borrow against collateral that they can no longer easily finance in the market, the
central bank is providing an additional source of liquidity to banks as a complement to our
open market operations.
The Term Auction Facility gives us a tool that lies somewhere between our open market
operations and our primary credit program. It provides a mechanism for expanding the range
of collateral against which we provide funds to the market - in effect to change the
composition of our balance sheet - in ways we cannot do through traditional open market
operations. And it does this in a way that may be more effective in mitigating a broader
marketwide liquidity shortage than does the existing discount window facility, in part because
of the perceived stigma in recourse to a facility that has come to be regarded as a source of
funds for individual institutions facing a temporary, exceptional need for liquidity. Because the
quantity of funds to be injected is known in advance, this mechanism poses fewer
complications for our ability to reduce volatility in the fed funds rate around the target.
The auction facility and other measures we have taken to address market liquidity problems
do not directly address the balance sheet or capital constraints facing financial institutions.
Nor can they be expected directly to reduce the perceived risk in exposure to other financial
counterparties. But by providing a more effective form of access to liquidity, these new
measures can help reduce the uncertainty that gives institutions the incentive to secure
liquidity in ways that might lead to a further deterioration on market conditions.
Major financial institutions in the United States and elsewhere entered this period of
adjustment with capital substantially above the various regulatory thresholds. These capital
cushions have enabled banks to expand their balance sheets as they have met contingent
commitments and as the economics of other non-bank financing vehicles have deteriorated.
This has been an important part of the adjustment process in markets.
We have also seen some early steps by a range of different institutions to bring new capital
into the banking and financial system. This is a healthy development. It reduces the need for
further asset sales to preserve capital ratios. And it gives those institutions that acted earlier
and on a more substantial scale the flexibility to play a greater role in markets and in the
economy going forward.
Finally, let me say something about future challenges in this area that are of special
relevance to today's conference and to the research agenda in which you are all engaged.
We are already involved in a coordinated review with other central banks and supervisors of
how we should adapt policy and supervision in the wake of this financial crisis. Two issues
are of particular interest in the context of this conference.
The first relates to the incentives we create, through regulation and supervision and other
policies, for influencing how financial market participants manage liquidity risk. Several
aspects of the existing capital framework and other parts of the policy and regulatory
framework affect these incentives. In addition, the evolution of the financial system has
altered the role and importance of liquidity provision by banks and how that provision of
liquidity responds to different types of stress to the financial system.
The second issue relates to the tools that central banks have at their disposal for providing
liquidity in ways that do support our monetary policy objectives. Do we need additional
instruments that would better enable us to mitigate marketwide liquidity problems? And how
can we mitigate the moral hazard risk inherent in such instruments?
Efforts are underway to address these issues both within the Fed and among our central
banking colleagues around the world. We will be looking both to financial market participants
and to the academic community for advice.
For now, though, our principal task is to address the challenges of the present. The Federal
Reserve Act gives us broad authority to act in response to these types of conditions. We will
continue to examine ways to adapt our instruments as market conditions evolve. We will do
so in close cooperation with other central banks, as indeed we have since August. And we
will do so in the tradition of pragmatism and flexibility that has been one of the defining
features of the central bank of the United States.
Thank you.