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 systema€™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 warsh, kevin ( 2007 ), " financial market developments, " speech delivered at the university at albany, state university of new york, school of business, albany, ny, september 21, www. federalreserve. gov / newsevents. 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