Kevin M Warsh: The promise and peril of the new financial architecture
Speech by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal
Reserve System, at the Money Marketeers of New York University, New York, 6 November
2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Overview
The financial markets did not observe the August anniversary of the onset of turmoil with
even a hint of fondness.1 Instead, market participants seemed to mark the occasion as a
kind of coming-of-age opportunity to act out. The subsequent despair among market
participants, disrepair in credit markets, and disregard for proper market functioning was
more pronounced than witnessed in generations. Significant market dislocations disrupted
credit flows to households and firms and impaired economic growth. All and all, these
conditions demanded - and received - a forceful response from monetary, fiscal, and
financial policymakers.
There are some notable signs of improvement. Short-term funding spreads are retreating
from extremely elevated levels. Funding maturities are being extended beyond the very near
term. Money market funds and commercial paper markets are showing signs of stabilization.
And credit default swap spreads of banking institutions are narrowing significantly.
Nonetheless, financial markets overall remain strained. Risk spreads remain quite high and
lending standards appear strict. Indications of economic activity in the United States have
turned decidedly negative. The economy contracted slightly in the third quarter, and the
recent data on sales and production suggest that the fourth quarter will be weak.
Still, the depth and duration of this period of weak economic activity remain highly uncertain.
The financial turmoil revealed that the old financial architecture is broken. But its successor is
not yet established.2 In my view, the prospects for robust economic growth over the
intermediate term are likely to be determined, not principally by the trajectory of housing
prices, but by the speed with which a new financial architecture emerges and the form that it
takes. This challenge of creating a new financial architecture is hardly unique to the United
States. The difficult choices made by policymakers and market participants around the globe
will have real implications for future growth prospects.
What do I mean by a new financial architecture? Recent travails contributed to a consensus
that the financial regulatory framework requires fundamental reform. But, in my view, the
financial architecture is necessarily broader than the government's regulatory and
supervisory response. The new financial architecture, properly understood, must account for
the dynamic relationship between private-market actions and public-sector strictures. The
economy's financial architecture is a function of the relationship among financial institutions
and market participants that transfer capital and risk between borrowers and savers. But the
architecture is also informed by the mix of prescriptions and postures of the Congress, the
Administration, and the financial regulators, including the Federal Reserve. This
circumstance is particularly the case during times of financial turmoil.
In my remarks today, I will first advance a plain assessment of what is afflicting global
financial markets. Many observers judge that weaknesses in housing finance, and the
associated boom and bust in the housing sector, are the principal cause of the market turmoil
and economic malaise. In my view, however, recent market developments - in the United
States and abroad - strongly indicate that the causes of the turmoil are broader and more
fundamental than the problems in the mortgage markets.
Second, I will highlight actions by financial market participants in the transition to a new
financial architecture. Financial institutions are being fundamentally transformed by the
events of the last several quarters. Massive changes in business models, corporate forms,
and funding sources are taking place faster than could be imagined even a few months ago.
There is no going back to the old arrangements, nor should there be. And a new equilibrium
will take shape only when financial institutions seize new opportunities and the changes in
the rules of engagement and the relationship with the official sector are more clearly
understood.
Third, I will discuss actions of the official sector during this period of turmoil. Most of these
policy actions have been taken in vigorous pursuit of financial stability - that is, to reduce
financial stresses, shore up credit intermediation, and thereby support economic activity. And
that makes good sense. Some material lessening of financial instability is essential so that
markets can function properly and the economy can avoid more substantial weakness. But
stability in and of itself should not be the be-all and end-all of policy. Rather, actions fostering
financial stability should be temporary, providing a bridge to a new, more effective financial
architecture. And that architecture should aspire to increase, not decrease, potential output
through an economic cycle.
The nature of the financial market turmoil
Many observers maintain that the boom and bust in the housing market are the root cause of
the current turmoil. No doubt housing-related losses are negatively affecting household
wealth and spending. Moreover, the weakness in housing markets and uncertainty about its
path have caused financial institution balance sheets to deteriorate. This situation has further
accelerated the deleveraging process and tightened credit conditions for businesses and
households.
When liquidity pulled back dramatically in August 2007, housing suffered mightily.3 For
reasons well documented, including expectations that home prices would invariably increase,
housing proved to be a highly vulnerable asset class. Many homeowners, particularly those
that purchased properties during 2005 through 2007, are suffering. And many banks and
other financial firms that extended mortgage credit or purchased mortgage-related assets
have written down sharply the value of those assets. Public and private policy actions have
been taken to help cushion the blow to many homeowners and financial firms.4
While housing may well have been the trigger for the onset of the broader financial turmoil, I
have long believed it is not the fundamental cause.5 Indeed, recent financial market
developments strongly indicate that housing, as an asset class, does not stand alone.
Indeed, the problems associated with housing finance reveal broader failings, including
inadequate market discipline, excessive reliance on credit ratings, and poor credit and
liquidity risk-management practices by many financial firms.
During the past several months, this domestic housing-centric diagnosis has also been
subjected to a natural experiment. Among U.S. financial institutions, asset quality concerns
are no longer confined to the mortgage sector. At the same time, non-U.S. financial
institutions - including some with relatively modest exposures to the United States or their
own domestic housing markets - appear to be suffering substantial losses. Equity prices of
European banks declined more on average during 2008 year-to-date than their U.S.
counterparts. Moreover, economic weakness among our advanced foreign trading partners is
increasingly evident, even among economies with more modest exposures to the housing
sector.
If the challenges to the economy were predominantly about the value of the housing stock,
my focus today would be far narrower than the establishment of a new financial architecture.
So, what diagnosis, beyond housing weakness, is consistent with the unprecedented levels
of volatility and dramatic financial market and economic distress? I would advance the
following: We are witnessing a fundamental reassessment of the value of virtually every
asset everywhere in the world.
Short-term funding markets have become suspect. Roll-overs of existing maturities reveal
systematic underpricing of once seemingly benign risks - credit, liquidity, counterparty, and
even sovereign risks - which demand reassessment and recalibration. Indeed, wide-ranging
assessments of these risks are being crudely incorporated into the pricing of virtually all
assets. In some cases, at present, the risks do not appear to be reliably quantifiable, and
trading has become impaired. Until these assessments are more cleanly refined and more
broadly understood, we are likely to observe elevated levels of volatility and unwillingness by
many investors to participate in certain asset markets virtually at any price.
This phenomenon is proving quite detrimental to global economic growth. In my view, the
speed and success of a new financial architecture is likely to be more consequential to
economic growth than the design and implementation of well-intended housing policies
alone. The establishment of a new financial architecture, thus, is the essential policy
response to the greatest economic challenge of our time.
Financial institution response in pursuit of survival and success
In a speech about seven months ago, I noted that the transformation of financial institutions
would be among the key variables that would affect the path of the real economy, but "the
changing paradigm of financial intermediation" is happening even more abruptly.6 The
largest investment banks chose a different fate, or had one chosen for them. Many of the
largest nonbank financial companies are no doubt reviewing their regulatory status. Large
numbers of hedge funds, recently perceived as central to a well-diversified asset allocation
program, are struggling for survival. Their investors are being rudely reminded that
alphareturns cannot, by definition, be universally achieved. Large money center banks are casting
a keen eye on their sources and uses of funding. And traditional community-based banks are
adapting to a dramatically different competitive dynamic with respect to deposits and lending
opportunities alike.
The business of banking - and credit intermediation, more broadly - is fundamentally
changing. Wholesale funding models are severely stressed. Heavy reliance on interbank
funding and short-term indebtedness is proving highly detrimental to a financial institutions'
health and society's welfare. Some of the highest-rated financial products, ironically, are
suffering the greatest diminutions in value. Selling volatility and insuring tail risks are far
riskier propositions than many imagined. These products and practices are proving to be a
significant source of large, uncapped losses threatening to impair once-hearty franchises.
We are witnessing perhaps the fastest, most significant structural shift in the history of the
financial services sector. The direct share of value added in the finance and insurance sector
approximated 8 percent of U.S. gross domestic produce (GDP) in recent years. This is about
3 percentage points higher than the contribution of financial services to GDP only a
generation ago. Similarly, profits of the Standard & Poor's 500 attributable to the finance
sector peaked at more than 21 percent during this cycle, 5-1/2 percentage points greater
than a decade ago. As the financial sector continues to delever and many financial products
disappear altogether, the sector's shares of GDP and profits will shrink further. This reduction
could involve many firms shrinking largely in tandem or, more likely, the orderly unwinding or
sale of inefficient or unwise firms.7 The markets are fearful, in part I suspect, because of the
swiftness of the reallocation of resources in the financial sector.
The official sector response in pursuit of financial stability
The turmoil of the past several quarters coincides with further erosion of confidence in what
financial institutions and other market participants knew - or thought they knew - about the
environment in which they were operating. It is no surprise, then, that those bearing the brunt
of the turmoil are pining for calmer times, a period of less volatility, when market prices again
comport with historical regressions and newfangled financial models. To wit, a return to
financial stability.
Government officials, in the U.S. and abroad, are not unsympathetic to this aspiration for
calmer times.8 But policymakers are prudent to balance the near-term imperative to take
actions to achieve financial stability with the objective - just over the horizon - of facilitating
the development of a new financial architecture in which market participants re-engage,
provide credit to the real economy, and yes, succeed or fail.
The Fed has a long and proud tradition, not solely as the monetary authority, but also as a
regulator, supervisor, and lender of last resort to help foster financial stability.9 The Fed is in
the financial stability business. But it's not our only business. The Federal Reserve's financial
stability responsibilities are not, in my view, an independent goal of policy. They are best
understood through the lens of our broader objectives for the economy. The conduct of
monetary policy, banking supervision and regulation, and the provision of liquidity are regular
7
See, for example, Kenneth Rogoff (2008), "The World Cannot Grow Its Way Out of This Slowdown," Financial
Times, July 29.
8
Central bankers, finance ministers, and others have convened the world over to ponder the causes and
consequences of the recent period of financial instability, its impact on the global economy, and the actions
that might be taken to avoid future outbreaks. The President's Working Group on Financial Markets, the
Financial Stability Forum, the Basel Committee on Banking Supervision, the Committee on the Global
Financial System, the Institute for International Finance, the Counterparty Risk Management Group, and many
other public and private groups are making significant contributions to the discussion.
9
The Federal Reserve was created in response to the periods of panic and bank runs that affected the United
States in the late 19th and early 20th centuries. The Federal Reserve regularly responded to financial crises
by extending credit and by using its expertise and credibility with market participants to address market
strains.
BIS Review 134/2008
Federal Reserve activities that contribute to financial stability, and in so doing, help achieve
improved macroeconomic performance.
During this period of turmoil, the Fed has increasingly been called upon to be a steadying
influence. When appropriate, and after due consideration, the Fed has chosen to employ its
balance sheet, authority, and credibility to lessen the harm to the real economy. That is our
role and responsibility. But we should resist the temptation to play a larger role than
statutorily mandated or economically prudent. Good-faith pleas for relief in the name of
financial stability will continue for some time, and the Fed should carefully consider the facts
and circumstances. That period of consideration may require us, however, to be cognizant of
the perils of popularity and decline to take action, including when it may be more properly
considered or better addressed by the fiscal authorities. So it is, financial stability has
become the watchword of the global economy. But its frequency in our lexicon should not be
confused with clarity as to its meaning or the timing of its achievement. Nor should it be
construed as the sole beacon of policy.
What is financial stability? It is perhaps easier to define by its absence.10 Financial instability
is a situation in which stresses on markets and institutions are sufficiently severe that the
intermediation between borrowers and savers is threatened, with the prospect of significant
risks to the broader economy. Financial stability, moreover, should not be equated with an
absence of volatility. If some unexpected news arrives, markets adjust, often sharply.
Generally, these adjustments are not cases of financial instability. A healthy and
wellfunctioning financial system will reward well-managed risk-taking and punish imprudence,
sometimes harshly. Such outcomes are not pretty and can be marked by large and pervasive
losses, but most do not necessitate extraordinary policy interventions.
Nonetheless, circumstances of pronounced financial instability, while rare, do arise. In the
most recent episode, we policymakers deemed it necessary to take significant actions to
mitigate the risks to the real economy. Financial firms became highly protective of their
balance sheets and sought to disengage en masse from the provision of credit. The Fed
responded, introducing lending facilities designed to support liquidity in overnight and
shortterm funding markets. With the approval of the Congress, Treasury also took significant
action, making large capital injections directly into banks to help jump-start the credit
intermediation process. This action was supplemented by various forms of government
guarantees. But bold official policy responses, even when successful in combating financial
instability, may not be enough to support the resumption of trend economic growth over the
medium term.
Why is government action aimed at financial stability not sufficient to usher in a new era of
prosperity? Because the broader financial architecture remains in substantial flux, as is
sometimes unavoidable. Confidence in markets and institutions cannot be demanded or
forced by edict. Confidence in a new architecture cannot be jury-rigged, even by
welldesigned government actions. Nor can confidence be rushed.
Comprehensive policy prescriptions to address financial instability are now being delivered to
the ailing patient. But a dose of patience itself may be equally important to help the
recuperative process. Time is required for the medicines to be administered and their
efficacy to be judged. New prescriptions, however well intentioned, can prove unsettling to a
patient who is searching to find his footing. Of course, policy must respond to serious
situations as they arise; and, during the past 15 months, these developments have been
difficult to anticipate with precision. But, if the framework for policy decisions is not viewed as
clear, consistent, and predictable by market participants, the resulting actions run the risk of
contributing to, rather than reducing, market volatility - at the most inauspicious of times.
Finally, actions intended to help achieve financial stability should not be allowed to interfere
with the establishment of a sturdy, new financial architecture.
Concluding remarks
I am reminded of a certain Omaha-based investor who says that his investment style is to be
greedy when other investors are fearful, and be fearful when others are greedy.11 I would
modify the advice somewhat to make it applicable to policymakers: We should be steady
when financial market participants are fearful, and fearful when markets appear steady.
This call for steadiness is not some nostrum, implying that the government should be passive
during times of significant economic turmoil. Quite the contrary. But comprehensive policy
prescriptions are most effective when they establish new rules of engagement that are clear
in intent, consistent in application, and reasonably predictable in effect. This policy
formulation should allow financial firms to regain their footing and market participants, more
broadly, to take new, constructive actions to facilitate the availability of credit. Perhaps in this
way, policymakers and market participants alike can best contribute to the development of a
reformed and robust financial architecture.
I see more promise than peril over the horizon. The speed of these changes in the financial
architecture understandably brings fear to some market participants, but it may equally sow
the seeds of recovery. Policymakers are keenly observing the pulse of private financial
institutions and other market participants to gauge their ability to take up the cause of reform
and renewal. If financial institutions readily and steadily approach new ways of intermediating
credit, the real economy might recover sooner and with more vigor than expected. If not, if
private market participants prove unable or unwilling to establish new business models, then
the effects of the current financial market turmoil may be a significant drag on economic
growth long after stability is ostensibly achieved. Getting the architecture right is essential to
address the central challenge facing our economy.