January 30, 2008
As Prepared for Delivery
I'd like to begin by congratulating the organizers for arranging a conference on this crucial and timely topic. The interplay between financial innovation and monetary policy has been at the core of the work of the Fund from its inception. Ongoing events in the financial markets make this topic particularly important. It is, thus, especially gratifying for me to have the opportunity to share and discuss with you our views.
The objective of my talk is to help set the stage for the conference by discussing the preliminary views and work of the Fund on the ongoing market turmoil and raising what we see as key policy questions. The emphasis will be on the implications for the effectiveness of monetary policy.
My theme today is that monetary policy effectiveness would be enhanced by greater integration of financial stability and price stability policies. Deeper and more connected financial markets necessitate a higher degree of coordination among central banks and supervisors. Joint oversight of market players should be used to collect more information from the markets to help form an assessment of systemic stability. Greater transparency of financial and monetary policies could be used to convey these assessments to the public and the markets, to the benefit of monetary policy.
I'll first say a few words on the impact of financial innovation on monetary policy in recent years. Next, I will discuss in a general way the challenges that monetary policy is posing today. The rest of the talk will be about the implications of the current episode of financial turmoil for the effectiveness of monetary policy.
Over the past two decades, financial innovation has probably strengthened monetary policy. By financial innovation, I mean the new financial products and more liquid financial markets that have brought more households and businesses into the financial system and helped expand private sector balance sheets. The acceleration of financial innovation has taken place at the same time as most advanced countries moved to monetary policy frameworks aimed at attaining low and stable inflation using an interest rate operating targets and with high degrees of transparency and accountability.
Overall, financial innovation has in all likelihood reinforced the impact of policy interest rate changes on output and inflation. Higher levels of credit, increased leverage and liquidity and the spreading of floating interest rate loans have increased the sensitivity of borrowers to interest rate changes. Interest rates may have a larger impact on borrower net worth and thus their creditworthiness. Also, deeper and more active financial markets raise the profile of monetary policy for businesses and households, and foster central bank transparency and accountability. However, the bank lending channel could be weaker, as banks can more easily hedge against interest rate changes that affect their financing and willingness to extend credit.
Financial innovation can also create more uncertainty for monetary policymakers. The "originate and distribute" approach of banks, under which banks sell much of the credit risk they originate, has complicated monetary transmission. Many have taken the view that large changes in asset prices should be factored into monetary policy for both price stability and financial stability. However, asset price bubbles are difficult to anticipate and influence with monetary policy.
I turn now to the events beginning last July that have thrust financial stability into the policy forefront and are casting financial innovation in a less favorable light. The views are increasingly shared that the root of the current turmoil is in a slippage of credit discipline in recent years—most notably in the U.S. subprime mortgage and leveraged loan markets. Warning signs of a deterioration in loan quality prompted withdrawal from some risky assets, notably structured credit products backed by subprime mortgages, causing a widening of risk spreads and more volatile bond and equity markets. The absence of secondary markets for some structured credit products, and concerns about the location and size of potential losses, disrupted several major money markets. Funding difficulties for some financial institutions followed, as counterparties were reluctant to extend credit in the face of concerns about the quality and liquidity of assets.
Meanwhile, macroeconomic conditions have deteriorated and have placed additional stress on financial institutions. Thus, credit extension is likely to be more constrained in the period ahead.
In our view, the current situation poses three main challenges for central banks. All will be addressed in our next Global Financial Stability Report.
The first challenge is to fully restore the functioning of money markets to foster private sector liquidity management and facilitate monetary transmission. The unprecedented and coordinated interventions into money markets in December by central banks has led to a sharp drop in key interest rate spreads.
Policymakers have now turned their full attention to a second broader challenge: avoiding a credit crunch that would contribute to an economic downturn. Banks, as the originators of credit, remain the linchpin of monetary transmission. I will have little to say on this still unfolding issue, except that the Fund is following these developments closely.
The third challenge, learning the lessons of this episode and instilling them into policy thinking and implementation is the subject of the rest of my talk.
I would now like to turn to the views of Fund staff on the areas of financial and monetary frameworks that are today the focus of policy. Of course, it is still early to draw firm assessments, but many of the key issues are beginning to crystallize and some policy implications can be drawn. One of the lessons of recent events is that coordination is key. Therefore, my policy discussion here is organized not by institution—supervisory agencies on the one hand and central banks on the other—but rather by the policy areas of oversight, systemic liquidity, and monetary policy.
Oversight encompasses the monitoring and regulation of the financial sector by supervisors and central banks. Traditionally, the objective of oversight has been to ensure the solvency of individual institutions and the system as a whole. Today, we are beginning to fully appreciate that oversight can shape the effectiveness of monetary policy as well.
Recent events suggest, in the broadest terms, that supervisors and central banks will need to be more aware, assertive, and fast moving to keep up with the impact of financial innovation on stability and monetary transmission. While in most respects this may be more easily said than done, it is in the power of supervisors and central banks to gain access to the information needed to gauge systemic risks.
Oversight should strive to give market participants incentive to internalize the systemic consequences of their decisions. In particular, as Ragu Rajan has been saying for several years, financial market decision makers and market participants often are rewarded for short-term performance. Thus, they have little reason to appropriately cost the sort of infrequent but damaging "tail events" that we are now experiencing. They do not always have reason to act in the long-term interest of their shareholders, and their actions can impose systemic costs that, of course, are not factored into their compensation. Indeed, central banks have been put in the position of providing liquidity insurance for these tail events.
Let me give specific examples. In recent years, banks shifted a large share of loans to off-balance sheet entities (conduits and structured investment vehicles) with wide maturity mismatches. This shift of credit to entities which were not the focus of regulatory oversight helped banks avoid the cost of raising capital. The difficulty of pricing these assets in the current market environment, opaque internal balance sheet evaluation, and the de facto capital backing of the sponsoring banks, led to mutual mistrust between banks which impaired monetary policy transmission operating through the money markets.
Further, a shortage of bank capital may well impede the credit channel of monetary transmission looking forward. The increasing distance between the originating bank and the ultimate holder of credit risk seems to have lowered bank risk standards. The realization of credit losses hit bank capital directly by reducing the value of loans on their books, and indirectly after banks felt compelled by reputational and legal risk to bring loans back onto their balance sheets.
Therefore, consideration should be given to widening the perimeter of supervision to reduce such regulatory arbitrage, not just for financial stability, but also for monetary policy. At a minimum, supervisors and central banks should focus on assessing counterparty risk, and appropriately valuing collateral provided by any financial entities that could potentially pose systemic risks. Of course, the disclosure of such information should not come at the cost of diminishing the value-adding franchise of individual financial institutions.
The virtues of close cooperation between supervisors and central banks within and across countries is another lesson. This episode provides an opportunity to significantly strengthen the existing framework to better understand the interconnection between financial markets.
Recent events may also provide a rationale for closer central bank monitoring of market participants that bear on systemic liquidity. The collection of information by central banks, in cooperation with supervisors, on systemically important institutions and market participants, including brokers, insurers, and other specialists, would help guide systemic liquidity policies.
Further, there may be lessons for the oversight of systemic risk from the "opening up" and greater transparency of monetary policy over the past 20 years. For example, consideration could be given to a joint production of a financial stability report by the central bank and bank and nonbank supervisors aiming at a unified and highly visible view of stability to the benefit of the public. In a similar vein, supervisors and the central bank could make joint announcements to express their views on changes in the systemic risk outlook. These announcements would lay the groundwork for any actions that could be subsequently needed.
The drying up of money markets was one of the biggest surprises of the current episode of financial stress. This experience highlights the advantages for central banks of keeping the key parameters of systemic liquidity supporting operations—counterparties, collateral, and pricing—under ongoing review. Central banks should also have the balance sheet risk bearing capacity needed for the potential size of systemic liquidity interventions.
The coordinated provision of liquidity by major central banks in December, while narrowing risk spreads, also could pose a trade-off between freeing up the money markets in the shortrun and altering market mechanisms over time. Monetary operations have been traditionally designed to induce banks to employ the money markets for their liquidity management rather than the central bank. The recent measures necessarily put the immediate provision of liquidity ahead of fostering market mechanisms. Central banks are now faced with the challenge of reducing their involvement in the money markets in a way that does not threaten stability and that allows banks to manage their own liquidity.
The last policy issue that I will discuss is the refinement of monetary policy frameworks in the interest of financial stability. Financial stability policies do not always sit well with the monetary policy objective of maintaining low and stable inflation. In particular, the transparency that is at the heart of modern monetary policy can conflict with the oft-cited constructive ambiguity (at least on ex ante central bank intentions) that is generally viewed as essential to central bank financial stability policies. Thus, a less than fully transparent injection of liquidity to alleviate systemic financial stress could lead to a questioning of the central bank's commitment to the inflation target.
Lengthening policy horizons to provide monetary policy with more leeway to address asset price bubbles is one much discussed option. Many central banks present their adherence to an inflation target over a well-defined horizon. However, a longer or more flexible policy horizon could inhibit monitoring by the public of the performance of monetary policy.
Perhaps the closer monitoring of private sector balance sheets that I have already mentioned could help alleviate the transparency conflicts between price and financial stability objectives. Joint public reporting by central banks and supervisors of their informed assessment of financial stability could help give markets confidence that liquidity provision for financial stability purposes is consistent with price stability. Of course, transparency and communication are tricky, and these issues will require much further thought.
We at the Fund are working, in close coordination with standard setters, the Financial Stability Forum, and central banks toward dealing with the new challenges to monetary policy posed by financial innovation. Systemic liquidity risk will have an even bigger role in our Financial Stability Assessment Program. We will continue to assess and promote best crisis management practices. Our Global Financial Stability Report continues to serve as a timely and comprehensive assessment of financial developments and the policy implications. Strengthening our work on macro-financial linkages is one of the guiding principles of the profound institutional changes that the Fund is now undertaking.
Let me review my main points. Ongoing events in the financial markets call for greater integration of financial stability and price stability policies to enhance monetary policy effectiveness. In particular, a higher degree of coordination among central banks and supervisors is warranted. Greater coordination would facilitate the collection of more information from market participants for the assessment of systemic stability. Financial and monetary policy transparency and communication could be enhanced to convey these assessments to the public and the markets.
Thank you, and I very much look forward to the discussion today.
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