I popped uptown this afternoon, to the Council on Foreign Relations, to hear NY Fed president Tim Geithner give a big speech on the current financial crisis. Geithner is the central banker closest to the markets, but he’s been pretty quiet through this crisis until now, so a lot of people were very interested in what he had to say.
In the end, he gave a shorter version of the speech on the NY Fed’s website; he also had a brief Q&A session at the end. I’ll try and pull out some of the more interesting bits of what he said in Mark Thoma’s mock-interview style. Anything in italics was spoken, and not part of the prepared speech.
Q: In the current financial crisis, things got very bad very quickly. Given how fast the markets move these days, does that mean there’s hope for a relatively swift resolution to the crisis, too?
Tim Geithner: I am going to talk today about some of the challenges facing the U.S. and financial system. These problems took a long time to build up, and, even with a forceful mix of public policy and action by the private sector, they will take time to resolve.
Q: What have you learned from the crisis about the state of risk management on Wall Street?
TG: The crisis exposed a range of weaknesses in risk management practices within financial institutions in the United States and throughout the world. Today, a group of the primary supervisors of the largest banks and investment banks in the world released a comprehensive assessment of risk management practices in these institutions. This assessment will help lay the foundation for consensus on changes to supervision going forward in the major financial centers. The report examines a range of practices that helped determine relative performance during this crisis. It’s a pretty powerful indication of the returns on good risk management.
In effect, some major banks and investments banks made the choice to follow the market down as underwriting practices eroded. They took on more exposure to low probability but extremely adverse events, despite the potential consequences of getting caught when the music stopped.
Q: How pro-cyclical is risk management on Wall Street? To what extent does protecting against a downturn exacerbate that downturn?
TG: As market participants have moved to reduce exposure to further losses, to step on the brake, the brake became the accelerator, amplifying the shock. Measured risk has increased more quickly than many institutions have been able reduce it, and attempts to reduce it have added to volatility and downward pressure on prices, further increasing measured exposure to risk. Uncertainty about the market value of securities and about counterparty credit risk has increased, and many hedges have not performed as intended. The rational actions taken by even the strongest financial institutions to reduce exposure to future losses have caused significant collateral damage to market functioning. This, in turn, has intensified the liquidity problems for a wide range of bank and nonbank financial institutions.
Q: Do people even have faith in markets any more? And could a loss of faith in markets damage the economy more broadly?
TG: The intensity of the crisis is in part a function of the size of the preceding financial boom, but also of the speed of the deterioration in confidence about the prospects for growth and in some of the basic features of our financial markets. The damage to confidence–confidence in ratings, in valuation tools, in the capacity of investors to evaluate risk–will prolong the process of adjustment in markets. This process carries with it risks to the broader economy. Macroeconomic and supervisory policies have an important role to play in containing those risks.
Q: Well, you’re on the FOMC, you can help contain those risks by cutting interest rates and by pumping liquidity into the banking system. How big do you think the risks are?
TG: The critical risk to the economic outlook remains the potential for the strains in financial markets to have an outsized adverse effect on real economic activity, particularly by exacerbating the already significant weakness in the housing sector. It is important for monetary policy and liquidity instruments to be used proactively in addressing this risk.
Q: But might cutting rates like that not feed through into higher inflation?
TG: Headline and core inflation have come in higher than anticipated, and inflation expectations have also moved up. If the risk of significant damage to growth from these financial market pressures is attenuated and if global growth remains strong and drives a continuing rise in energy and commodity prices, then inflation may not moderate as much as we anticipate. If the medium term outlook for inflation deteriorates significantly, the FOMC will move with appropriate speed and force to address this risk.
Q: So you’re not really worried about stagflation, then: for you, the inflation risks only really go up if the financial risks are "attenuated". What happens if the financial risks stick around for a while, as you said at the beginning of your speech that they would?
TG: We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time.
Q: How do you feel about the recent capital injections into banks from sovereign wealth funds?
TG: The Federal Reserve is working closely with other financial supervisors and regulators to facilitate the adjustment underway in markets. This approach has two important elements. … The second element is to encourage new equity capital raising, so that the burden for preserving capital ratios does not fall principally on actions, such as asset sales or reduced lending, that might exacerbate the credit crunch. We have seen a very, very substantial flow of new capital into the financial system much more quickly than has been the case in past crises. More will come. Those institutions that move more quickly will obviously be in a stronger position to deal with the challenges, and take advantage of the opportunities, ahead.
Q: And how about President Bush’s fiscal stimulus package? Is that going to help?
TG: Overall policy will be more effective, particularly given the strains to the financial sector, if the full burden does not fall on the tools available to the Federal Reserve. Fiscal policy can play an important role. The stimulus program signed into law by the President will provide a meaningful level of support to growth, somewhere in the range of three quarters to one and half of a percentage point of GDP growth over the next few quarters.
Q: "Next few quarters"? Can you be more specific?
TG: The next two quarters.
Q: Thanks, I guess that’s when the tax rebates will come through and be spent. And how about all those bills and announcements relating to the housing market specifically? Will they help?
TG: Carefully designed, targeted programs in cooperation with the private sector can play an important role in resolving the various constraints that are now impeding economically viable mortgage restructurings. Given the breakdowns in the securitization process and its potential impact on the supply of new mortgage credit, it also makes sense to explore ways to expand the scope for existing government programs to support financing of new homes.
It’s easier to state that than it is to navigate one’s way through. You need a mix of pragmatism and creativity to navigate this, but it’s a really important focus of attention.
Q: It all seems like a lot of mopping-up. Wouldn’t it have been easier to be more on the ball earlier on, and to have prevented the credit bubble from forming in the first place? Have you learned anything which might help you stop this thing happening again in the future?
TG: Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks. And yet policy plays an important role in determining the dimensions of financial booms, and policy helps determine the ability of the financial system and the economy to adjust to its aftermath. We need to undertake a broad set of changes to address the vulnerabilities in our financial system revealed by this crisis. Just as a long list of factors contributed to the trauma, there is no single reform that offers the promise of sufficient change.
The Presidents Working Group on Financial Markets and the Financial Stability Forum, which bring together policymakers and regulators from the major financial centers around the world, are in the process of outlining a comprehensive framework of reforms. Many of these recommendations will focus on changes to the mortgage finance market, the ratings process for ABS and structured credit products more broadly, regulatory and accounting treatment of these instruments and special purpose financing vehicles, the disclosure requirements on instruments and institutions, and other dimensions of the securitization process.
Q: Was the complexity of the US regulatory structure at all to blame?
TG: The regulations that affect incentives in the U.S. financial system have evolved into a very complex and uneven framework, with substantial opportunities for regulatory arbitrage, large gaps in coverage, significant inefficiencies, and large differences in the degree of oversight applied to institutions that engage in very similar economic activities. Some illustrations of this include the large shift in subprime mortgage originations to less regulated institutions; the incentives to shift risk to where accounting and capital treatment is more favorable; and the amount of risk built up in entities that operate in the grey areas of implied support from much larger affiliated institutions.
We need to move to a simpler framework, with a more uniform set of rules applied evenly across entities involved in similar functions, and a more effective balance of regulation and market discipline. And institutions that are banks, or are built around banks, with special access to the safety net, need to be subject to a stronger form of consolidated supervision than our current framework provides.
Charlene Barshefsky: Hank Paulson said this week that most of the losses were in regulated institutions, not unregulated institutions. What does that say about regulation in this country?
TG: Economists wouldn’t be surprised by that. They say that regulation brings moral hazard, and moral hazard brings risk-taking.
Problems occur in the middle: institutions attached to banks, or institutions which were a source of credit protection, or asset-backed financing vehicles, where there’s a mix of explicit and implicit credit support. Banks were well capitalized going into the crisis and absorbed their losses reasonably well. The more awkward stuff was in the awkward middle.
This is all a product of the incentives created by regulation. We want to look at simplification and consolidation.
Q: Did regulators’ rules about marking assets to market, and their focus on the health of individual banks rather than the system as a whole, end up exacerbating rather than helping the situation?
TG: The U.S. banking system entered this financial shock with capital cushions significantly above the regulatory thresholds, and in a stronger position to withstand a downturn than was the case in the past. This has made it possible for bank balance sheets to expand rapidly, which in turn has helped offset the effects of the withdrawal of many nonbank financial institutions from credit markets.
Yet the shock absorbers in the financial system as a whole–the financial cushions that are critical to financial stability–have proved to be thinner, and behavior has been more pro-cyclical than desirable.
This is in part the consequence of changes in the structure of the financial system. Because banks are now a smaller share of the system, a given level of stress on nonbanks creates greater strain on the system as a whole. It is in part the consequence of the fact that the present system focuses on mitigating the risks of firm specific shocks, rather than a systematic market shock. And it is in part the consequence of the fact that the present system is not designed to induce institutions, particularly the largest ones, to internalize the negative consequences, the negative externalities, of their actions on markets as a whole in conditions of stress.
Q: How about the markets? Did recent innovations there help or hurt?
TG: The resilience of the broader financial infrastructure has been a source of strength for the financial system during this crisis. However, the systems and practices that support the over-the-counter (OTC) derivatives market significantly lags that of securities markets and other mature markets. We need to move quickly to put in place a more integrated operational infrastructure that supports all major OTC derivatives products, is highly automated, has robust operational resilience and risk management, and is capable of handling very substantial growth in volumes.
Q: And how are those markets behaving now? Are they more risk-averse than might reasonably be warranted?
TG: Prices and risk premia in many markets already reflect a much more sober and cautious view of the world than they did a year ago. You could say, well beyond caution, in many markets. And the degree of stress on markets that we have seen over the past six months is due in part to the sheer magnitude and speed of that adjustment to a more cautious view of the future.
Q: But are you ultimately hopeful?
TG: The United States, the world economy, and the financial system as a whole, are more resilient, than they were on the eve of previous downturns. The improvements in productivity growth in the United States of the past decade have been followed by significant improvements in potential growth and wealth accumulation in many other countries. The scale of investable assets around the globe is very substantial, and this will be an important source of demand for risk assets. The improvements in monetary policy credibility and in financial strength developed over the past few decades mean that policy around the world has more room to adjust to deal with the challenge in the present environment.
Nevertheless, the challenges that remain are substantial. The speed and agility with which public policy makers and private financial institutions respond to the continuing pressures in a rapidly evolving environment will determine how quickly and how smoothly market conditions return to normal–and how rapidly the risks to the economic outlook are mitigated.
Q: Thank you.
TG: Thank you.
