Donald L Kohn: Productivity and innovation in financial services
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Official Celebration of the 10th Anniversary of the Central Bank of
Luxembourg, Luxembourg, 12 November 2008.
* * *
I am pleased to participate in this panel discussion on the importance of the growth and
productivity of the financial sector for monetary policy. I am certain that when the European
Money and Finance Forum and the Central Bank of Luxembourg planned their conference,
they did not imagine how significant the topic would be.1
We are in the midst of very difficult times for world financial markets and economies. Over
the past several decades, we witnessed a rapid expansion of financial intermediation and
financial instruments around the globe. We always understood that the new financial
relationships were substantially influencing the characteristics of economic activity -
especially in recent years, U.S. mortgage markets and residential construction, in particular,
and household borrowing and spending more generally. Unfortunately, that long period of
innovation and heightened financial activity exploded into an unsustainable credit boom that
was marked by a failure to appropriately evaluate risks in lending to households and
businesses, excessive leverage by both borrowers and lenders, and increased reliance on
complex and opaque financial instruments that were poorly understood and fragile under
stress. The resulting financial strains and severity of their effects on real activity have clearly
shown the limits of our ability to anticipate how and where problems in the financial sector
would emerge and of our understanding of the channels through which the financial stresses
could lead to a broad-based pullback in lending and adverse spillovers into the real
economy. The recent experience has also underscored the difficulties associated with
measuring financial services and the productivity of financial firms.
The financial sector and economic activity
Banks and other financial institutions allocate credit. At the most fundamental level, they take
savings from the household sector and elsewhere and lend it to firms, households, and
governments that want to borrow to spend. In the best circumstances, the operation of
financial markets is transparent to the macroeconomy. The financial system allocates credit
efficiently to firms that invest in capital resources that improve the productivity of other inputs
(for example, labor) and contribute to the growth of the economy. The financial system also
offers households choices about how they allocate consumption over time. Financial
institutions can be viewed as reducing information asymmetries that impede borrowers'
access to credit, and they provide transaction services to borrowers. And by reducing the
cost of external finance to firms generally, productivity gains in the financial sector can foster
gains in a wide array of other industries as well.
Even before the proliferation of financial institutions and products, the translation of the
economic concept of financial services into a workable measure of output posed very thorny
problems. This conference is an indication that important research continues quite actively
on a variety of issues related to the measurement of the output of financial services and the
efficiency of financial institutions.
More important from a policymaker's perspective is the need to assess the contribution to
economy-wide productivity and stability of the extraordinary expansion in the size and scope
of the financial sector that occurred in the past several decades. Certainly, as financial
innovations accelerated, we had solid reasons to believe that those advances were
contributing to the pickup in overall productivity and, possibly, to the moderation in
fluctuations of economic activity. Increased technical capabilities, together with enhanced
mathematical applications, permitted the development of products such as derivatives and
loan securitizations that provided new ways to unbundle risks. We thought that risks were
being redistributed more efficiently to individuals and firms according to their risk tolerances
and their abilities to absorb risk. And evidence suggested that opening credit markets to
more households, by enabling them to smooth spending in response to shocks, was
contributing to the overall moderation in business cycles.
Information technology also appeared to be making intermediation more efficient by reducing
the cost and uncertainty of processing information that helps financial intermediaries make
superior investment choices with better risk and return characteristics. Information
technology also made possible the creation, valuation, and exchange of complex financial
instruments on a global basis. Financial transactions were occurring faster and were less
expensive to initiate and complete. The assumption was that markets were becoming deeper
and more liquid.
These innovations did produce lasting gains, but these gains were clearly accompanied by
increasing vulnerabilities. In the United States, financial innovation, especially in the
origination and distribution of subprime mortgages, ended up contributing to an excess
supply of houses at prices well above long-term sustainable levels. And innovations enabled
households to liquefy the wealth embedded in houses, thereby boosting loan amounts
relative to the value of the house. Moreover, both borrowers and lenders badly mispriced and
misunderstood risks, which often became embedded in new, complex, financial instruments.
Neither was protected against a substantial decline in the price of houses. And that
mispricing was not just confined to the housing sector. Compensation for risk was too low
across a broad array of credits. Ironically, an important contributor to these misalignments in
spending and lending was the long period of economic expansion and low inflation over the
past 25 years, interrupted only a few times by mild recession. This good economic
performance provided skewed data and bred complacency: House prices could only go up;
income interruptions and problems servicing debt were likely to be short lived; financial
markets would always be liquid. Models based on theory and estimated with data from the
1990s and early 2000s fit well - too well. Complacency, in turn, contributed to the
unwillingness of many financial market participants to enhance their risk-management
systems sufficiently to take full account of the new (perhaps unknown) risks they were taking
on.
In this environment, financial institutions stretched the amount of capital they were holding,
building leverage. With better models, sophisticated contracts, and the belief that risks had
been distributed more efficiently, many market participants believed that less capital was
needed. Because the amount of capital held by financial institutions on their balance sheets
was so small, productivity in the financial sector looked as though it had increased
dramatically when the amount of securitization and other off-balance-sheet activities (for
example, derivatives) increased. But many of those off-balance-sheet instruments came
back onto the balance sheet when markets started to seize up. Finally, many market
participants also had inadequate liquidity backstops, apparently because they (wrongly)
assumed that markets would be sufficiently liquid to smoothly adjust risk profiles to new
developments in markets and the broader economy. Thus, capital and liquidity cushions fell
short of what was needed for the complexity of instruments that were created, for the funding
risks being incurred, and for the broad array of market and other risks to the firms and to the
financial system more generally. Systemic risk is an externality that results from exposures
that cannot be diversified away.
The financial turmoil that we have been experiencing for more than a year originated in the
market for subprime mortgages, in which the combination of falling house prices and poor
underwriting standards triggered a rapid rise in delinquencies. Multilayered securitizations
made it more difficult to implement loan modifications and other time-honored mechanisms to
reduce default costs and other negative consequences of foreclosures. What has occurred
since then has revealed how closely interwoven the global array of highly leveraged financial
structures and investors had become. Risk did not go away when it was sliced and diced
across market participants, and it was not as distributed and diversified as had been thought
- in short, the amount of capital to insure against such risks should not have been reduced
as much as it was. With the viability of counterparties in question, financial institutions
needed to conserve capital and liquidity. Perceptions of inadequate capital and liquidity
cushions sparked a flight to liquidity and safety by those lending to financial institutions,
beginning an unwinding of leverage that, in turn, has exacerbated economic weakness. As
the market price of risk increased, more capital was needed for risks that had already been
undertaken. The financial decelerator engaged: Households and businesses needed more
collateral and net worth to qualify for loans; lenders, in turn, needed more collateral and
capital to back their own liabilities, which had become more costly to issue. The resulting
tightening of lending terms and conditions and reduction in credit availability has restrained
spending - first in housing and then, as financial distress spread, in many other sectors.
Robust, dynamic markets are the lifeblood of market economies. They are the source of
rising productivity and, as such, of increasing standards of living. But the dynamic functioning
of markets also means that productivity advances will not necessarily occur smoothly - and,
indeed, are likely to involve some cyclical overshooting and undershooting, often
exacerbated by waves of optimism and pessimism that seem to be inherent in human nature.
Innovation by its nature is risky; some innovations work better than others, and, thus, some
new ideas and the businesses that invest in or use them must be allowed to fail.
In many instances, these cyclical swings in productivity - such as the boom and bust in
hightechnology investment in the late 1990s - occur in sectors with limited spillovers to the
functioning of the financial markets. Risks are borne by private investors who reap the
rewards or bear the losses associated with the economic outcomes of their investments. And
they are often funded by equity, not debt, so financial intermediaries are not at risk. The
gains to aggregate economic activity from successful innovation - as in the high-tech case -
are realized over time. When overinvestment occurs, market returns respond, new
investment slows, and the capital stock eventually adjusts. In the end, productivity is higher
than it would have been otherwise.
In contrast, as we have seen, when the innovations heavily involve the financial sector, the
unwinding of any resulting boom can quickly begin to entail more far-reaching and deeper
effects on the functioning of credit markets and, thus, can pose a more serious threat to
economic stability. Although we are far from having written the final chapter on the current
situation, we can identify several challenges that it has raised for central banks.
The challenges for central banks
The most immediate and important challenge is to take actions that will help restore the
financial system to productive functioning and put our economies on a path to growth and
price stability. Government authorities and central banks have responded to the current crisis
with forceful and innovative measures to rebuild confidence in the financial system, improve
the ability of financial institutions to raise capital from private sources, and free up the flow of
credit to businesses and households. For central banks, these measures have entailed
lowering policy interest rates and opening or expanding liquidity facilities to banks and others
to augment the credit that private parties are unable or unwilling to extend to each other.
Although we have seen signs of improvement, financial market functioning remains impaired
in many ways, and we will need to continue to consider whether additional steps are needed
to re-open credit flows and support the economy.
When, in the future, the financial system stabilizes and our economies start to recover,
central banks will need to decide how best to phase out these extraordinary liquidity actions
and credit-market interventions. In many cases, the rates charged for credit under these
facilities have been set to be attractive when markets are disrupted, but uneconomical for
users once more-normal functioning returns, and usage should naturally decline as
risktaking returns. But, in addition, we will need to decide the appropriate timing of the
windingdown of many of the special lending facilities. The actions taken by the Federal Reserve to
intervene directly in some financial markets, such as the commercial paper market, are
clearly emergency operations only. Except in the most extreme circumstances, when market
functioning breaks down and systemic risk reaches unacceptable levels, central banks
should distance themselves from decisions about the allocation of credit among private
parties.
The most critical challenge policymakers are facing involves deciding what steps they can
take to minimize the risk that such a severe financial crisis will be repeated. To this end,
central banks are already considering what lessons they can draw from their experiences for
the design of their policy instruments in a financial environment where borders between
countries, institutions, and instruments have all eroded, producing tight linkages among
previously disparate markets. Some of what we have done - for example, swaps with other
central banks and auctions of discount window credit - might be part of our permanent tool
kit, kept on standby to contain the effects of a future emergency.
As I indicated in my opening remarks, we must improve our understanding of the financial
structure and, as it evolves, of where it may be vulnerable when stressed. In broad terms,
policymakers must look for ways to identify those waves of innovation and expansion in
financial services - or in any other sector, for that matter - that may be accompanied by a
buildup of destabilizing forces, such as rapidly rising asset prices or excessive leverage. We
should not underestimate the difficulty of this problem. As the recent financial boom
continued, many policymakers did indeed worry about the overpricing of houses and the
underpricing of risk, but we were only partly successful in identifying the circumstances and
channels that have seemed to trigger the most distress. Almost by definition, it is the
unanticipated event that causes the most problems.
And the way financial turmoil resonated through the global financial system indicates that the
linkages among lenders and borrowers through leverage, complex interdependent
counterparty relationships, and backup liquidity agreements propagated and intensified
financial distress in ways neither the private nor the public sector understood very well.
Clearly, to improve the likelihood that we can contain systemic risk, we need to continue to
learn more about financial products and market functioning.
A related challenge is to improve our understanding of the linkages between the financial
sector and real activity. The recent experience indicates that we did not fully appreciate how
financial innovation interacted with the channels of credit to affect real economic activity -
both as credit and activity expanded and as they have contracted. In this regard, the
macroeconomic models that have been used by central banks to inform their monetary policy
decisions are clearly inadequate. These models incorporate few, if any, complex
relationships among financial institutions or the financial-accelerator effects and other credit
interactions that are now causing stresses in financial markets to spill over to the real
economy. Rather, these models abstract from institutional arrangements and focus on a few
simple asset-arbitrage relationships, leaving them incapable of explaining recent
developments in both credit volumes and risk premiums. Economists at central banks and in
academia will need to devote much effort to overcoming these deficiencies in coming years.
However these models are adapted, recent events suggest that central banks should be
wary of placing too much faith in model-based analyses, which are necessarily predicated on
past empirical correlations and relationships. As we have seen, financial innovation can
induce structural changes that can importantly alter the way financial institutions, markets,
and the broader economy respond to shocks. For this reason, policymakers should take a
critical approach to evaluating analyses of this sort, and should always probe to find the
sensitivity of results to unstated assumptions that may no longer be valid.
Given our limited understanding, the first line of defense against systemic risk must be
building more robust and resilient financial systems. Private parties are doing a great deal to
increase capital and liquidity and enhance risk-management practices. But policymakers
must also adapt their supervisory and regulatory structures to promote a robust financial
system that can withstand occasional shocks, even severe ones, without systemic problems
that become destabilizing. We must ensure that financial firms - especially those central to
the functioning of our highly interlinked markets - have sufficient capital, liquidity, and
management resources to back financial intermediation activities both on and off their
balance sheets. Another important consideration should be to make sure that our regulatory
policies do not exacerbate credit and business cycles. And we should be considering ways to
promote transparency that would enhance market functioning and the ability of investors to
bring their own discipline to bear on decisions to buy and sell. A central challenge will be to
structure financial oversight to both deter unwanted and excessive risk-taking and permit the
innovation that can ultimately boost economic growth. Because central banks are ultimately
responsible for financial stability, they must work closely with legislators and with other
supervisory authorities at home and abroad to ensure that these goals are met.
Can the conduct of monetary policy also be adapted to reduce the odds of systemic financial
events, and should the manipulation of short-term interest rates take account of the potential
for imbalances and price bubbles as well as the traditional objectives of price stability and
economic growth? Here I think the lessons of the current episode need to be studied further.
Before the recent experience, I believed that the appropriate strategy for conventional
monetary policy was to focus exclusively on the stability of economic activity and overall
prices for goods and services over the next several years. Under such a policy, a central
bank would respond to signs of a potentially destabilizing rise in asset prices or leverage by
incorporating the implications of those developments for future output and inflation into its
deliberations. However, it would not go further and try to lean against the speculative
component of asset prices per se, on the assumption that such an attempt would likely not
work. Instead, a central bank would do better to wait for an asset bubble to run its course,
and then deal with the consequences when values inevitably returned to normal. This is how
the Federal Reserve thought about asset markets as it made monetary policy.
Whether a different approach would have produced a better outcome is still in my view an
open question. Would somewhat higher interest rates a few years ago have damped the
speculation in housing and the deterioration of lending standards? Have we learned enough
about the formation and propagation of credit-market problems to identify them in a timely
manner? Are we able to look sufficiently far enough ahead to be reasonably certain that
responding to a perceived speculative boom with tighter monetary policy will yield longer-run
benefits without undue shorter-run costs? I believe the answers to these critical questions
are still unclear.
Certainly, policymakers at central banks and elsewhere have a full agenda before them. I
have been encouraged by the way in which governments around the globe have collaborated
to craft new approaches to problems. A continued spirit of cooperation can help as we face
the challenges that this panel is discussing. Our economies have proved resilient in the face
of other economic shocks, and I am certain that we will ultimately succeed in restoring a
stronger and more robust financial system that can support solid and sustainable economic
expansion.