Remarks at the U.S. Monetary Policy Forum
The U.S. Monetary Policy Forum
March 9, 2007
In these brief remarks, I'm going to explore the implications of two significant developments in financial markets for central bank, and in particular Federal Reserve, responsibilities. The two phenomena I intend to consider are: 1) heightened competition in the domestic financial environment, as evidenced by a proliferation of institutions, instruments, and new markets; and 2) the growing global integration of financial markets. These topics are in the spirit of the conference because I have had the sense that the organizers were interested in subjects that may not be captured altogether neatly in standard macroeconomic models.
By the way, both developments seem related to the observed increase in the liquidity of a wide range of assets, a trend which in turn derives from the reduction in information and transaction costs stemming from technological change. Liquidity is a concept the conference organizers also suggested might be worthy of attention, and I am happy to oblige; although the term is notoriously difficult to define, I would hazard that at its core the concept relates to the ease with which an asset can be converted to cash. And I do think that liquidity helps to explain the importance of the developments I will discuss. Finally, let me be clear at the outset that I make no claim for the originality of much of this commentary. I am explicitly drawing on well-established strands in the literature. And, of course, the usual Federal Reserve caveat applies; I am speaking for myself and not for others in the Federal Reserve.
Let me start with the first phenomenon just noted and describe some of its implications more explicitly. The proliferation we have witnessed in institutions, instruments, and markets presumably allows, on average, both for improved diversification in finance and for greater flexibility in an institution's choice of its risk profile. There are other ramifications as well. As many have reported, investment banks, private equity firms, and hedge funds, among others, have invaded the traditional turf of commercial banks, increasing competition and thereby serving customers increasingly effectively. As financial innovation has progressed, banks—at least many of the largest, most sophisticated institutions—have responded by securitizing and selling off their most standard, commodity-like credits, leaving their balance sheets with a preponderance of relatively heterogeneous, information intensive, illiquid assets.
Some might think that in this process, and particularly in view of heightened competition, commercial banks have become less important in the financial system overall. John Boyd and Mark Gertler carefully examined this issue about 15 years ago, when there were similar assertions about the diminishing importance of banks.1 Their results, which adjusted for banks' off balance sheet activities and so forth, indicated no quantitative change in banks' role in finance, and recent work by staff at the Minneapolis Federal Reserve, updating Boyd-Gertler, appears to confirm the earlier conclusions, although I should note that the recent work is still quite preliminary.
Nevertheless, I suspect that there has been a significant, qualitative change in the position of large banks as they have adapted to challenges in the environment. In particular, and as foreshadowed a moment ago, as banks have disposed of plain-vanilla, readily securitized assets, their balance sheets may have become more risky.2 Coupled with expansion of off balance sheet activities and growing reliance on trading in a range of instruments and markets, large institutions, and their exposures to various counterparties, likely have become more difficult to manage and to assess.
The policy prescriptions stemming from this situation seem relatively straightforward. Concern about the possible vulnerability of, say, hedge funds or the credit derivatives market is well taken, but it shouldn't distract supervisors and policymakers from appropriate focus on more "familiar" commercial banks. As I have argued previously, in the context of the too-big-to-fail issue, problems at one or more large, complex commercial banks could potentially have systemic repercussions, and recent developments in banking have not assuaged this concern.3
Some have made a different argument for continued supervisory focus on commercial banks, suggesting that by assuring that banks have taken appropriate precautions in their lending to, and other transactions with, say, hedge funds and the like, adequate discipline will have been brought to bear on this latter group of institutions. But I'm not confident of this result for, as I implied a moment ago, to the extent that large banks do not face sufficient market discipline, we can't expect them to act altogether effectively as the levee against excessive risk taking outside the banking sector.
Now, let me move on to the second phenomenon identified in my introductory comments, namely, increasing global financial integration. This is a trend which has received lots of attention and deservedly so. There appears to be a general perception that in fact financial markets worldwide have become more closely intertwined and that financial capital flows more readily across borders than formerly. There is statistical evidence quantifying this development and, from the perspective of resource allocation, such a development is clearly welcome.4
At the same time, growing capital market integration has raised some concern about the potential effectiveness of domestic (Federal Reserve) monetary policy. The argument seems to be—and let me emphasize that what follows is for illustrative purposes only—that the effects on long-term interest rates of a Federal Reserve-engineered increase in short-term rates could be largely offset by financial inflows from abroad. Thus, so the story goes, a larger-than-anticipated increase in the Federal funds rate would be required to achieve a given degree of policy restraint or, put more mildly, policymakers would necessarily be more uncertain about the appropriate level of the funds rate in view of the potential for a global response of financial flows.
All this strikes me as logical enough, but I am unsure if it is of much moment. In my experience, there is always some, usually considerable, uncertainty attending the appropriate level of and potential changes in the Federal funds rate. An international channel may complicate the analysis incrementally, but there is ample uncertainty in any event. Further, and also to conclude, it seems to me that policy ultimately must be judged against the background of the achievement of the well-recognized dual mandate. Relative to this metric, results look pretty good for the past two decades or so and, relevant to the issue at hand, this record has been established, skillfully or with a lot of good fortune, in an ever-changing environment.
1John H. Boyd and Mark Gertler, "Are Banks Dead? Or Are the Reports Greatly Exaggerated?" Federal Reserve Bank of Minneapolis Quarterly Review 18 (Summer 1994): 2-24.
2For a discussion of this issue, see Raghuram G. Rajan, "Has Financial Development Made the World Riskier?" in The Greenspan Era: Lessons for the Future (Federal Reserve Bank of Kansas City, 2005): 313-369. See the comments and discussion on Rajan's article for alternative views. See also Wolf Wagner, "The Liquidity of Bank Assets and Bank Stability," Journal of Banking and Finance 31 (January 2007): 121-139.
3Gary H. Stern and Ron J. Feldman, Too Big To Fail: The Hazards of Bank Bailouts (Brookings Institution Press, 2004). For a discussion of recent developments, see Gary H. Stern and Ron J. Feldman, "Managing Too Big To Fail by Reducing Systemic Risk: Some Recent Developments," The Region (June 2006): 19-21, 46-49
4Martin Feldstein, "Monetary Policy in a Changing International Environment: The Role of Global Capital Flows," in Stability and Economic Growth: The Role of the Central Bank (Banco de M'exico, 2006): 245-255.