Kevin M Warsh: Financial stability and the Federal Reserve
Speech by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal
Reserve System, at the New York State Economics Association 60th Annual Conference,
Loudonville, New York, 5 October 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Thank you to the New York State Economics Association and our hosts here at Siena
College for inviting me to participate in the conference. They say you can never go home
again. Well, I am testing that theory and am pleased to be back in upstate New York for the
second time in as many weeks. In my remarks at the School of Business at the University at
Albany, I argued that the conditions causing the turmoil in the financial markets were long in
the making and that these causes should not be conflated with the particular troubles in the
mortgage markets. I also posited that the financial market conditions may have proven to be
overly ebullient, masking troubles that may have sown the seeds of financial distress.1 This
evening, I will underscore the responsibility of the Federal Reserve during periods of financial
market turmoil and offer some perspective on the current state of financial markets.
The gathering storm
Several months ago, many large, global commercial and investment banks appeared on
pace to post another record year of corporate profits. Underwriting and M&A activities were
robust. Sales and trading revenues were bolstered by the acceleration of financial innovation.
Principal investing appeared to be an increasingly accepted industry practice alongside
traditional advisory business. Private pools of capital were growing strikingly. Public and
private pension funds were reportedly increasing capital allocations to alternative
investments. And, thanks in part to accommodative credit markets, the golden age of private
equity appeared upon us. Finance companies and other nondepository financial institutions
were increasingly able to thrive, proving to be formidable competitors for traditional banks
and thrifts. In sum, market functioning appeared robust, and risks underlying various assets
were seemingly dispersed among a range of sovereignties, financial intermediaries, and
investors.
During this period of seemingly benign economic conditions, most market participants
appeared more focused on the dynamics of the new financial architecture than on the policy
judgments of central bankers. Surely, market participants did not presume that the Federal
Reserve was a mere spectator to market developments. Nonetheless, discussions of the Fed
and financial stability may have seemed somehow anachronistic with the new paradigm
sweeping financial markets.
How quickly times change. As you well know, by mid-August, volatility spiked in many
markets. Risk premiums widened significantly. Term premiums reappeared with force. Signs
of illiquidity were evident in a number of important markets. And clarion calls for the Fed to
bring stability to financial markets were loud. Almost overnight, the role of the Federal
Reserve and other central banks in fostering financial stability found its way to the front
pages of major media. So, let me discuss the responsibilities of the Federal Reserve in
promoting stable financial conditions. Although our policy tools are powerful, and our
judgments are informed, our pronouncements are not made in isolation. The roles and
responsibilities of other public agents, domestic and abroad, and private market participants
are particularly critical during times of financial turmoil. We are, after all, central bankers, not
central planners.
Responsibilities of the Federal Reserve
So what is the role of a central bank like the Federal Reserve in fostering financial stability?2
Historically, episodes of financial instability and the sharp economic downturns that
sometimes ensued were a driving force in the creation of the Federal Reserve itself. After
earlier, sporadic, and ultimately less-than-successful attempts to create a central bank of the
United States, the U.S. financial system found itself lacking an effective means to address
the periodic financial crises that occurred in the second half of the nineteenth and in the early
twentieth century.3 Against this backdrop, the Congress authored the Federal Reserve Act in
1913, creating the Federal Reserve System. It is worth emphasizing that the Federal
Reserve's concern with financial stability stems largely from the adverse implications of
financial instability for overall economic performance.4 The Fed's interest in promoting
financial stability is thus intimately connected with its macroeconomic objectives: maximum
sustainable employment and price stability.
From the founding of the Federal Reserve to the present, a key question confronts
policymakers and market participants alike: What is financial stability? Perhaps it is better to
address what it is not. In my view, financial stability does not demand a state of lessened
financial market movements, a state of muted volatility. More often than not, financial
markets process new information efficiently: If some unexpected news arrives, markets
adjust, sometimes even sharply, and they should. These types of movements are healthy,
even necessary. They serve to quickly bring prices in line with underlying fundamentals. And
markets that move quickly and adroitly do not necessarily produce unstable financial
conditions. Nor should those who take up the cause of ensuring financial stability protect
individual investors or financial institutions from substantial losses or insolvency. To the
contrary, a healthy and well-functioning financial system will tend to reward well-managed
risk-taking and punish imprudence.
I am inclined to interpret the Federal Reserve's interest in promoting financial stability as a
desire to foster conditions that favor sustainable growth and stable prices. In this sense,
financial stability concerns may rightly shape policymakers' views about the modal outlook for
2
The Federal Reserve is by no means the only institution in the United States that is concerned with the
stability and functioning of the financial system. Indeed, the Federal Reserve works closely with a number of
other U.S. government agencies on both a bilateral basis and jointly through the President's Working Group
on Financial Markets to enhance the integrity, efficiency, orderliness, and competitiveness of financial markets
and to maintain investor confidence. In addition, the Federal Reserve participates in a number of important
international groups, such as the Financial Stability Forum, the Basel Committee on Banking Supervision, the
Committee on the Global Financial System, and the Committee on Payments and Settlement Systems, to
name just a few. Indeed, in today's tightly integrated international financial markets, fostering financial stability
requires a global perspective.
3
The First Bank of the United States was created in 1791 and lasted until 1811. The Second Bank of the United
States operated from 1816 to 1836.
4
Originally, the preamble to the Federal Reserve Act of 1913 stated that the Federal Reserve System was
created "[T]o furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a
more effective supervision of banking in the United States, and for other purposes." Macroeconomic
objectives were explicitly introduced later, with the 1977 amendment of the Federal Reserve Act, which stated,
"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall
maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long run
potential to increase production, so as to promote effectively the goals of maximum employment, stable
prices, and moderate long-term interest rates."
BIS Review 112/2007
the economy as well as the risks surrounding this outlook. Financial instability may thus be
characterized as a situation in which the financial system becomes incapable of efficiently
allocating resources at market-clearing prices across the economy.5 If financial markets
become dysfunctional, financial intermediaries' flexibility may be impaired, and investors may
become uncertain about their prospects. And if this situation were to persist, overall
macroeconomic performance could be threatened. In an earlier period of financial turmoil,
this phenomenon was termed "fear-induced disengagement."6
Assessing financial stability
The Federal Reserve is well positioned to monitor developments in financial markets and
assess the quality of market functioning. We have access to a wide range of financial and
economic data and extensive contacts with market participants. Particularly in times of
financial distress, we must draw on a full range of market indicators. We also glean important
information by virtue of our responsibilities as a banking regulator and payment system
operator. And although such a dashboard of key information is exceedingly useful, it should
not be confused with a crystal ball. For even if our understanding of the financial markets
was somehow perfect, the transmission mechanism between financial markets and the real
economy is only partially understood. Like private market participants, the Federal Reserve is
in the business of making policy judgments amid uncertainty and must assess the prospects
for the real economy with considerable humility.
What indicators might help us assess the economic and financial situation? We look to prices
at which investors are willing to provide capital by reviewing risk premiums across a range of
asset markets. As an example, we monitor corporate credit spreads from bond, loan, and
credit derivative markets, and we follow closely the evolution of pricing in mortgage markets.
We also look to the terms by which market participants are willing to lock up funds over
various time horizons by reviewing term premiums embedded in financial market prices. And
we constantly revisit investors' willingness to conduct business with financial intermediaries
to assess counterparty credit risk. In this respect, market-based indicators are certainly
informative, as are measures of current exposures of financial institutions obtained through
the supervisory process. No central bank financial market dashboard is complete, however, if
it does not give considerable weight to measures of price stability. As a result, we constantly
review inflation expectations, as measured by spot and forward TIPS spreads, surveys,
commodity prices, and foreign exchange values.
Volume indicators are often particularly useful in assessing market functioning in times of
market turmoil. Volume indicators impart knowledge about the depth and extent of trading
and the willingness of financial intermediaries to serve as market makers. By reviewing the
sizes of issuance of various financial instruments as well as trade volumes in a number of
markets, we try to assess the relative strength and resilience of markets. And we try to
assess the reliability of prices by reviewing information on bid-ask spreads and quote sizes
where available. Of course, these various price and volume indicators are not easy to
disentangle, necessitating that our judgments on the state of market functioning customarily
be provisional.
Throughout the turbulence of the past few months, we have followed a number of indicators
that pointed to strains in several markets. For example, we saw spreads on subprime
residential mortgage-backed securities soar and securitization volumes slow to a trickle as
market participants became concerned about their ability to value those products amid
mounting delinquency rates and defaults in the sector. Investors' lack of confidence in
valuations was also apparent in other securitized products, as evidenced by higher spreads
and lower issuance in markets for collateralized debt obligations and collateralized loan
obligations. The asset-backed and the lower-grade unsecured commercial paper markets
also came under pressure; difficulties spread to other money markets, and term spreads in
interbank funding markets climbed much above historical levels.
It is also true, however, that some financial indicators provided some reassurance during this
period. Important parts of the financial system continued to function well, especially in
markets where less-complex financial products are traded and where investors are less
reliant on the role of the rating agencies. For example, although equity markets were quite
volatile at times, trading was generally not impaired, and investors were able to buy and sell
stocks at market-prevailing prices, even at the times of greatest turbulence. The markets for
longer-term Treasury securities and investment-grade corporate bonds generally continued
to function well, albeit at new market-clearing prices. It is notable that the level of
fails-todeliver in Treasury trades did not spike amid the market turmoil despite very intense
safehaven demands for Treasury securities at times. Of great importance, clearing and
settlement systems proved to be extremely resilient throughout the episode, even if most
post-trade infrastructure providers experienced record transaction volumes. To be sure,
mortgage lenders came under severe stress, and several large commercial and investment
banks were subjected to strains brought about by higher contingent liabilities and various
other commitments. Still, at least by number, most financial institutions remained "open for
business," willing to lend, albeit at tighter terms. And although many hedge funds posted
meaningful losses, on balance, they appear to have performed a useful function during this
period of considerable tumult.
Although these positive signs are acknowledged, financial conditions were clearly stressed in
recent months. When markets do not clear and some large financial institutions withdraw
from risk-taking, it is prudent for a central bank to take account of the impaired nature of
market functioning. The specter of financial instability is heightened, and the prospect of
harm to the overall economy is difficult to dismiss. The Federal Reserve responded to these
developments by providing reserves to the banking system; it announced a cut in the
discount rate of 50 basis points and adjustments to discount window practices to facilitate the
provision of term funding. In the current episode, the disruptions in the structured finance,
mortgage, leveraged loan, commercial paper, and interbank term funding markets made
credit considerably less available for many households and businesses and thus, ultimately,
represented a risk to the performance of our macroeconomy. As a result, the Federal
Reserve took action to help forestall this risk, including the 50 basis points cut in the target
federal funds rate on September 18.
Recent financial market developments
It is premature to judge the ultimate effects of our policy actions on financial conditions, let
alone on macroeconomic performance. Our dashboard of financial indicators, however,
points to some encouraging signs, suggesting that financial conditions might be normalizing
somewhat. In particular, I am encouraged by the price differentiation in certain markets
based upon company-specific and asset-specific assessments of fundamental value.
Although prices in several markets were no doubt affected by distortions around the
quarterend, some term spreads in the interbank market appear to have reversed a portion of their
earlier increases, as have spreads in some parts of the commercial paper market. On the
basis of our most recent data, it seems that the runoff in outstanding commercial paper may
be slowing. Similarly, there are some signs of stabilization in the leveraged loan market.
Banks have been able to sell substantial parts of large deals to investors in recent weeks,
and some collateralized loan obligations are coming to market. Issuance of speculative-
grade bonds resumed somewhat of late. Still, the functioning of several markets continues to
be strained, a condition which I would expect to continue for awhile. Consequently, my
colleagues and I on the FOMC will continue to assess the effects that these and other
developments could have on the prospects for the economy. We will rely not only upon
economic modeling, but also real-time, forward-looking indicators to help inform our policy
judgments.