Roger W Ferguson, Jr: Thoughts on financial stability and central banking
Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Conference on Modern Financial Institutions, Financial Markets, and Systemic
Risk, Federal Reserve Bank of Atlanta, Georgia, 17 April 2006.
* * *
I am very pleased to open this conference on Modern Financial Institutions, Financial Markets and
Systemic Risk. Let me begin by thanking the Federal Reserve Bank of Atlanta for hosting this
conference and for organizing, along with the International Association of Financial Engineers, an
impressive program that is filled with high-quality papers on topics of keen interest to central bankers.
Before proceeding, I must indicate that the views I am about to express are my own and do not
necessarily reflect the views of other members of the Board of Governors or the Federal Reserve
more generally.
Few subjects are more important for central bankers than the efficiency and stability of our financial
system. The term "financial instability" is often poorly defined. Some argue that financial instability
occurs when imperfections or externalities in the financial system are substantial enough to create
significant risks for real aggregate economic performance. Others argue that financial stability is
potentially absent, or that financial instability is on the horizon, when they perceive that some
important set of financial asset prices seem to have diverged sharply from fundamentals. Finally, many
observers have used the term "financial instability" to describe their perception that market functioning
seems to have been significantly distorted or impaired. Regardless of the definitions used for financial
instability, they lead us to a strong interest in ensuring that our financial infrastructure is robust and
that our supervisory operations are sound and up-to-date.
Ironically, our interest in financial stability seem to have increased in recent years even as real (that is,
inflation-adjusted) variability in economic aggregates seems to have decreased. Since 1985, the
volatility of real growth in gross domestic product (GDP) has been only about half of what it was during
the preceding twenty-five years. In addition, as shown in a number of papers, the volatility of many
components of GDP and of other measures of aggregate economic activity also declined sharply
between these periods.
The source of the moderation in the real economy is unclear. Changes in data construction do not
seem to be responsible. Fiscal policy has not become appreciably more countercyclical, and the shift
of the economy toward producing more services appears to have played only a small role. The leading
explanations of the moderation are that (1) economic shocks have been milder; (2) inventory
management has improved; (3) financial innovations such as improved risk assessment and
riskbased pricing have made credit more widely available, even during economic downturns; and (4)
monetary policy has been better.
The first explanation--milder economic shocks--has seemed less persuasive following the events of
the late 1990s and early 2000s. From the Asian financial crisis to the September 11 attacks to the
corporate governance scandals to the surge in oil prices, powerful economic shocks have marked the
past few years. Yet, the economy has performed rather well, on balance, over this period.
As for the second explanation--better inventory management--changes in inventory dynamics have
indeed contributed significantly to the reduced volatility of GDP growth. Those changes are consistent
with anecdotal evidence and case studies about the use of information technology and better
inventory management practices to catch incipient inventory overhangs before they become a
problem.
Regarding the third explanation--better availability of credit--Karen Dynan, Doug Elmendorf and Dan
Sichel, of the Board's staff, present evidence in a recent paper that financial innovation has been
partly responsible for the reduced variability of real activity of the past two decades or so.1 According
to their work, the greater availability and use of credit over time may have reduced economic volatility
by reducing the sensitivity of household spending to downturns in income and cash flows and to
fluctuations in interest rates, with the result that consumer spending and home purchases have
become less sensitive to contemporaneous income.
Let me focus for a moment on the fourth explanation, that monetary policy has been better. I think it
has indeed been better. We are better at understanding how the economy operates (and therefore, at
evaluating the appropriate stance of monetary policy) and we are more determined to pursue the goal
of price stability. But secondarily, I think the greater dominance of market-based finance, combined
with a greater transparency by the Federal Reserve, has made both the mechanism of monetary
policy and the intentions of the central bank more understandable to market participants.
The mechanism of monetary policy is clearer with greater market-based finance relative to
bankdominated finance because the direct effects of policy on corporate and household balance sheets are
more easily observed by both policymakers and market participants. In contrast, bank-dominated
finance involves more complicated interactions between depositor behavior, loan underwriting
standards, and interest rates.
The greater transparency of central banks also seems to have led to improved economic performance.
Market expectations are more likely to remain anchored in the face of various shocks when investors
can see more clearly that central bankers are committed to long-run objectives such as price stability
and sustainable economic growth. This commitment feeds into the planning and execution of
investments by firms and households, which are more likely to undertake such investments given
greater certainty about the commitment of the central bank. Moreover, with this greater certainty,
prices and pricing decisions more clearly communicate the desires of households and firms.
Some evidence for this view is found in the decline of inflation volatility relative to real interest rate
volatility. Both inflation volatility and bond term premiums have declined significantly in recent years.
Research at the Federal Reserve Board by Don Kim and Jonathan Wright, as well as work by others
outside the Federal Reserve, have suggested that inflation expectations that are more firmly anchored,
combined with the reduction in the volatility of real activity, seem to be a significant part of the
explanation for the decline in term premiums.2 I would argue that the greater transparency of central
banks has played a role in communicating and emphasizing to the markets our commitment to price
stability.
Thus, the moderation in aggregate economic volatility seems somewhat understandable. But why,
then, the seemingly greater concern these days about financial market instability? This anxiety
appears to be driven by three factors: First, some asset prices, such as housing prices, seem to be
high by historical standards. Given the substantial decline of stock prices beginning in 2000, many
observers worry that greater boom or bust cycles in some asset prices could be the "flip-side" of the
moderation of real economic volatility during recent decades.
Asset prices are the key channel through which monetary policy is transmitted to the real economy.
Moreover, because asset prices embody the expectations of forward-looking investors, they might
contain information of value for the policy-setting process. But from the Federal Reserve's perspective,
asset prices must ultimately be seen through the lens of long-term growth and price stability. If inflation
seems contained and the prospects for economic growth are good, then it's unclear why the
direct
policymaker should set aside these signals in preference for signals from asset prices that may
or may not be out of line with their historical relationships to fundamentals--the very fundamentals, I
should add, that we look at directly in judging the health of the economy. Indeed, even in retrospect,
our knowledge of what drove the price-earnings ratios for U.S. equities so high in the late 1990s and
our ability to estimate what a more "appropriate" level for the price-earnings ratio might have been are
very incomplete and, frankly, probably will not improve substantially.
Additionally, in the current conjuncture, some have expressed a concern that an unwinding of global
imbalances, should it occur, might be disorderly and associated with financial instability. Others
question whether the simultaneous removal of monetary accommodation by central banks in several
major economies could possibly trigger a period of financial instability emanating from the inevitable
rebalancing of portfolios. Should events such as these occur, central bank communication and
understanding market participants' reactions will certainly be important considerations for maintaining
financial stability.
A third source of anxiety concerning financial market instability arises because some of the more
recent crises have been financial in nature. Although their effects on the real economy in the United
States have been relatively limited, the economies of other nations have been significantly affected,
and there is concern that a financial crisis might, at some point, have more severe consequences for
the real economy in the United States. When we review these recent cases of financial market turmoil,
it appears that each is a unique event. But some common lessons can be learned, and I will outline
them after I briefly review two of these crises that have been important in the United States during the
past decade.
The market turmoil in the fall of 1998 was touched off by the Russian debt default in August and then
exacerbated by the well-publicized travails of Long-Term Capital Management. During this time, nearly
all financial indicators portrayed a dour picture of economic prospects--risk spreads widened sharply,
stock prices fell, and banks reported tightening the terms and lending standards on business loans. In
addition, market reports indicated that the capital markets were seizing up as dealers and other
marketmakers recoiled from risk taking. In response, the Federal Open Market Committee (FOMC)
lowered its target for the federal funds rate 75 basis points in three equal steps and maintained the
lower rate through June of the subsequent year. This response mainly reflected FOMC concerns that
these financial instabilities had either signaled or created significant downside risks to the economic
outlook, particularly for business investment. The FOMC's significant aversion to the possible negative
outcomes associated with these risks was part of a risk-management perspective--that is, that the
economic recovery from a financial shock could be more difficult to manage than the financial shock
itself.
As for events after 1998, it is more difficult to identify a "pure" financial crisis. The devastating terrorist
attacks in 2001 caused tragic loss of life and major damage to the physical infrastructure of a number
of key firms central to trading and market-making activities. Although there were many important
differences, this crisis mimicked a financial meltdown in the sense that important financial markets
could not operate because of the cessation of activities by some firms.
The Federal Reserve responded in a manner that was appropriate to the nature of the crisis. We
issued a statement that we were up and running and ready, if needed, to extend loans from the
discount window. Depository institutions took up the offer; their borrowing surged to more than $45
billion but dropped quickly after a few days. We also worked jointly with foreign central banks to
provide funds to promote the smoother operation of foreign exchange transactions and established
swap lines that channeled funds to institutions that needed dollars. In addition, the Federal Reserve
took a variety of other actions, including waiving daylight overdraft fees, extending the operating hours
for Fedwire, and easing the limits on securities lending to reduce the pressure on firms requiring
securities that were made scarce because of settlement difficulties. All these measures were taken
quickly, maintained temporarily, and wound down in an orderly manner as the need for them receded.
After the initial rush of activity, we focused on the nonfinancial economy. Evidence of a weakening
economy had already emerged before the terrorist attacks; the decline in stock prices, the widening of
risk spreads, and the impairment of market functioning created by the attacks caused many
policymakers to worry that this weakening would accelerate. Again reflecting the risk-management
perspective I described earlier, the FOMC lowered its target for the federal funds rate 50 basis points
before the reopening of the markets on Monday, September 17, 2001. In explaining its action, the
FOMC pointed to a less sanguine economic outlook and to significant downside risks associated with
that outlook.
Besides the crisis of 1998 and the September 11 terrorist attacks, other episodes of financial turmoil
were important, but these episodes did not raise the same level of concern that the negative shock
might be transmitted to the nonfinancial economy in a rapid and disorderly fashion. For example, the
significant decline of stock prices starting in 2000 was not accompanied by a major market
malfunctioning, and the resulting loss of equity wealth did not seem likely to have negative
ramifications for the real economy that were so immediate and severe as to be considered a crisis.
Similarly, the major accounting and corporate scandals of 2002 led to a significant widening of risk
premiums and much anxiety about the veracity of many corporations' financial statements. But for the
most part, the markets again functioned smoothly and risks seemed to be priced normally. Finally, the
more pronounced interest rate volatility during the summer of 2003, which appears to have been
significantly amplified by mortgage hedging, created some short-lived market difficulties. But again,
this volatility seemed unlikely to have significant effects on the real economy.
Despite the rarity of internally generated financial crisis, some argue that ongoing trends in the United
States should be examined closely for their potential effects on financial stability. Four trends are often
mentioned.
The first is increased concentration in the financial services industry. In particular, consolidation has
resulted in a smaller number of firms doing a larger share of the bank lending throughout the world.
For example, the origination and servicing of consumer loans have become more concentrated. For
the most part, these rising levels of concentration appear to be motivated by cost savings that are
often attributed to economies of scale, or by expectations of greater revenue stability derived from
either greater diversification of products or greater geographic diversification. While the risks to
financial stability that arise from the creation of a small number of large and complex firms are
obvious, there may be benefits as well. Greater concentration in financial services has the potential to
have some positive impact on financial stability because lower costs can allow firms to build the capital
reserves that help insulate them from shocks, and greater diversification can reduce firm risk.
Moreover, the market and financial supervisors are requiring the adoption of more sophisticated and
comprehensive techniques for the management of risks associated with larger and more complex
firms. However, the benefits of lower costs, greater diversification, and better risk management at
large, complex firms depend on many particulars, including robust infrastructure and a reduction in the
opaqueness that results from increased firm complexity. In this regard, infrastructure is one area in
which the increase in concentration has received attention. The creation of NewBank, which I describe
later, is a recent private-sector response to the concentration of clearing and settlement activities in
the market for government securities.
The second trend is that the pricing and management of credit continues to become more market
oriented. This development should increase financial stability, because market pricing and the
management of credit risk via marketable securities would be expected to promote a more robust
system for risk management. In this scenario, a broad-based and diversified group of rational market
participants would determine the success or failure of financial products through an evolutionary
process, allowing the available set of financial assets to gradually become more useful and
comprehensive. However, some hold to a more pessimistic scenario that envisions smaller groups of
market participants, with short time horizons and an excessive interest in mark-to-market profitability,
who create more volatility because of their high sensitivity to the latest rumors and news. I tend to
adopt the more optimistic view, but in any case the central bank will need to maintain its focus on
markets as more credit is intermediated through them.
The third trend is similar to the second. The ongoing increase in the scope and availability of financial
instruments is probably providing many firms and households with improved methods of risk
diversification and hedging and with greater access to credit. As I noted earlier, such financial
innovations have likely been partly responsible for the lowered variability in many real economic
aggregates over the past two decades. That said, the increasing complexity of these instruments
raises a host of policy questions regarding, to name just a few items, financial education for
households, and, for financial institutions, operational procedures, valuation practices, accounting
treatments, disclosure policies, and capital provisions. Moreover, these financial innovations often rely
on the ready availability of market liquidity, an assumption that likely will not hold during a financial
crisis. Therefore, one hopes that all market participants who are involved in these complex instruments
have liquidity plans in place.
The final trend is the ongoing and increasing globalization of markets. Make no mistake; I think such a
trend is to be welcomed because it brings about the usual gains from trade. But we must be mindful
that borrowers are raising funds in multiple financial centers in multiple currencies across diverse legal
and political systems; that investors are taking on greater international exposure; and that arbitrageurs
are establishing leveraged positions across currencies and international markets. These actions
increase cross-border interdependence and thus in some circumstances might propagate financial
problems more quickly and widely.
Given these trends, what roles should a central bank play with regard to financial stability? I would
suggest three. First and foremost, the central bank's role is to maintain a focus on the possible effects
of financial instability for its two core objectives, namely price stability and long-run real growth. Any
actions to promote financial stability need to be seen through this lens. We must always ask: Do our
potential actions credibly mitigate a risk of inflation or a threat to the real economy? Such a standard
helps reduce the danger that we might pursue financial stability to the point of changing the behavior
of market participants in counterproductive ways, such as increasing moral hazard, which would, in
turn, create problems for the real economy. This objective also suggests that the central bank needs to
continually monitor financial developments, including those regarding financial accounting and
reporting standards, to be able to appropriately assess the effect of these developments on the real
economy.
Secondly, I would argue that the examples of the recent past, combined with our understanding of
how markets function, suggest that much of the central bank's work lies in bank supervision, including
promoting better risk management and the avoidance of operational risks on the part of other financial
institutions, and emphasizing the importance of backup and contingency arrangements. That is, the
central bank can assist in getting market participants to consider and focus on the management of risk
in general and of the risk of low probability, but high cost, outcomes in particular.
Along these lines, we have encouraged banks to adopt the most modern risk-management
techniques, and we have encouraged all financial institutions to ensure the robustness of their
systems. We have also strived to bring our capital regulations up-to-date and make them more risk
sensitive through the Basel II process and the effort to revise Basel I; both of these efforts are
intended to modernize capital regimes as part of our ongoing effort to improve safety and soundness
and, ultimately, financial stability. And following our own advice, the Federal Reserve has implemented
additional layers of backup and contingency arrangements for our key payment system operations.
Most recently, the Federal Reserve Board endorsed the creation of a dormant bank, referred to as
NewBank, which would be available for activation to clear and settle U.S. government securities. Such
activation would occur if a credit or legal problem caused the market to lose confidence in an existing
clearing bank and no well-qualified bank stepped forward to purchase that bank's clearing business.
Similarly, the Federal Reserve System, operating through the Federal Reserve Bank of New York, has
met with major dealers to improve the practices of the credit derivatives industry in various ways,
including implementing procedures to improve the settlement process for credit default swaps,
establishing targets for the reduction of confirmation backlogs, and insisting that dealers obtain the
consent of the original counterparty before accepting an assignment of a contract.
The final role I would suggest for a central bank is to research the implications of longer-term financial
trends for the economy more generally. As I mentioned above, the consolidation of financial services,
increasing market intermediation of credit, the greater complexity of financial instruments, and
increasing globalization of financial institutions and markets all might raise concerns about our
financial system. Although my assessment, and that of many other observers, is that these forces and
developments support financial stability, they merit ongoing study.
In a more proactive vein, once the central bank identifies a longer-run concern, it can try to raise the
awareness of other policymakers regarding the potential problems. Recently, for example, the
government-sponsored enterprises, which lack the normal market discipline to check the growth of
their portfolios, have been a concern that the Federal Reserve Board has been highlighting before the
Congress. As another example of being proactive, I would suggest that the efforts to increase the
transparency of central bank actions that I discussed at the beginning of my talk have, in some part,
been motivated by a desire to enhance financial stability.3
One lesson that stands out from our experience gained during the past decade is that only looking
backward is not useful. Prudent central bankers must be forward-looking, searching for developments
that might become significant problems under some circumstances. What would be useful from a
riskmanagement perspective is more information along the lines of what we have for inflation--market
instruments that allow us to measure, to some extent, market participants' expectations. The absence
of such direct measures of financial stability, however, suggests that we should continue to present
our views of potential financial risks and their associated propagation mechanisms, both to other
public-sector colleagues and to private-sector analysts and observers. Participation in official
organizations such as the President's Working Group, the Financial Stability Forum, and the
Committee on the Global Financial System, which are little known to the general public but are well
regarded by the official community, offers the Federal Reserve such engagement. Moreover, we
should develop theoretical and empirical models to help us understand potential risks. That is why
conferences such as this one, which bring together researchers, policymakers, and practitioners to
discuss issues related to financial stability, are so important.