randall s kroszner : recent events in financial markets speech by mr randall s kroszner, member of the board of governors of the us federal reserve system, at the institute of international bankers annual breakfast dialogue, washington dc, 22 october 2007. * * * good morning. in my remarks this morning, i will share my views on events in u. s. financial markets over the past several months. specifically, i will describe what i believe were contributing factors in the breakdown of the price discovery mechanism in certain markets, and i will assess the future prospects for these markets. while i will draw some preliminary conclusions about recent market events, my views and those of other policymakers will likely continue to evolve as we develop a more informed perspective and benefit from further analysis. 1 price discovery when markets are functioning properly, one of the key roles that they perform is what economists refer to as " price discovery. " 2 essentially, price discovery is the process by which buyers and sellers ’ preferences, as well as any other available market information, results in the " discovery " of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. this market - determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change. in well - functioning markets, the price discovery process represents the efforts of market participants to use all available information to decide whether to buy or to sell or to abstain from buying and selling. in efficient and competitive markets, participants will tend to undertake a certain amount of due diligence before making their decisions. this means that prices do not just appear by themselves ; a substantial amount of work is required by buyers and sellers for markets to produce prices that clear markets and provide useful signals to consumers and producers. indeed, this is one of the brilliant aspects of the market mechanism in that a number of participants, each pursuing their own interests and trying to maximize their own welfare and profits, determine a market - clearing price. a core principle of economics is that markets are more competitive, and therefore more efficient, when accurate information is available to both buyers and sellers. but for markets to work best, market participants must utilize available information, including analysis of costs and benefits of obtaining such information. in the case of new and innovative products, there might be a particularly strong demand for information. then this information must be processed appropriately before decisions

the availability of funding and thus assisted the functioning of the interbank market. the vigorous provision of funds through open market operations succeeded in damping pressures in overnight funding markets. yet, markets for term interbank funding remained strained. on august 17, the federal reserve board took further action by cutting the discount rate – the rate at which it lends directly to banks – by 50 basis points, or half a percentage point. the fed also adjusted its usual practices to facilitate the provision of financing for as long as thirty days, renewable at the request of the borrower. these actions also appear to have improved market functioning, though strains, particularly in term funding markets, persist even now. moreover, judging from forward curves in interbank and overnight indexed swaps markets, market participants expect pressures in term funding markets to persist for several quarters. i should emphasize that the purpose of these actions was not to insulate financial institutions from the consequences of their business decisions, but rather to facilitate the orderly function of markets more broadly in the face of risks to the overall economy. i believe that this provision of liquidity has contributed, at least in part, to the recent improvements we have seen in the functioning of financial markets. importantly, the federal open market committee ’ s most recent action, the 50 basis point cut in the target federal funds rate in september, was an attempt to help offset the potential effects of financial market turmoil on real economic activity. the breakdown in the price discovery process can, after all, have real economic consequences that the federal reserve should, in my opinion, consider when fulfilling its statutorily mandated goals of maximum employment and price stability. conclusion in the months ahead, the federal reserve will continue to monitor developments in the financial markets and act as needed to support the effective functioning of these markets and to foster sustainable economic growth and price stability. in addition, we will be reviewing the events of the past several months to understand the likely causes and effects. thank you very much, and i look forward to a lively dialogue following my esteemed colleagues ’ remarks.