Welcoming Remarks by Jack Guynn
Financial Markets Conference
Sponsored by the Federal Reserve Bank of Atlanta
Miami, Florida
February 26, 1998
Welcome, ladies and gentlemen, to the seventh annual financial markets conference sponsored by the Federal Reserve Bank of Atlanta. As the Federal Reserve System embarks on its 85th year, it might surprise you to hear me characterize the subject of this conference — risk management — as a kind of return to our roots as the nation’s central bank. Yes, it’s true that the discipline and practice of finance has advanced by quantum leaps, making today’s world a very different place. And many of you sitting in this room have personally contributed to the growth in the share of financial assets intermediated outside the banking industry, through which the Fed carries out its assigned roles.
Nonetheless, in 1998 — just as in 1913 — the effectiveness of risk management is directly connected to the health of our financial system, which in turn has a major influence on our economy. Considered in that light, interest in risk management is, as it has always been, a central concern for the Federal Reserve, and it goes to our very founding. The creation of a central bank in the United States was prompted by the belief that disturbances in the financial system were amplifying weaknesses in the real economy. Out of these concerns, the Fed was created and given the mandate to provide liquidity during banking crises.
The Fed’s responsibilities and operations have certainly evolved over time. Reducing seasonal fluctuations in currency and credit has become far less important than it was in 1913, when the U.S. economic base was largely agricultural. More recently, the relative importance of the banking sector has declined as financial markets have grown more important. In addition, legislation during the 1980s opened access to the discount window during emergencies to a wider array of financial intermediaries.
Of course, banks are increasingly providing risk management services to their customers and using financial engineering techniques to segment and restructure risks. Banks also use financial securities and derivatives both for managing their own risk and for proprietary trading. Thus, through its regulatory responsibilities for state member banks and bank holding companies, the Fed has been drawn deeply into the numerous regulatory issues that arise from the growth and expansion of securities and derivatives markets.
The Fed’s interest in the topic of risk management is much broader, though. Despite the many changes all around us, the Fed’s primary objective remains economic stabilization, and the health of financial markets remains a core element of this mission. Financial market shocks may still cause large, temporary increases in the demand for money. Moreover, such a shock to money demand would feed through the financial system.
In addition, while financial markets have always been subject to the possibility of large price changes, the development of new tools for trading risk has raced forward in recent decades. These tools themselves may be a source of risk: they may blur the lines defining who legally bears risk or who markets think is ultimately bearing risk. And from the Fed’s perspective, the unbundling of risks can mean some unpleasant surprises when loans go bad. This segmentation means that residual risk can show up in operational risk or other unexpected places or even outside the banking sector. What’s more, the recent disturbances in Asia remind us of the global nature of today’s financial markets, which means that problems in one country can quickly spill over into others.
Clearly, the Fed must keep an interest in understanding financial markets, risk, and risk management even in markets it does not regulate. That’s true ultimately because integration of financial markets, along with the Fed’s central role as ultimate provider of liquidity to the financial system, means that "the buck still stops here." (Since the Fed creates money through open market operations, I suppose the buck starts here as well.)
The stock market crash of 1987 illustrates the Fed’s continuing role. The crash resulted in a rapid increase in the demand for reserves, which would have led to sharply higher rates, credit rationing, and possibly a threat to the economy if not addressed. It’s true that such a Fed response was not necessary during the market break last year. One vital difference between 1987 and 1997 was that the infrastructure of securities markets has improved significantly, making it possible to process much larger volumes of trades.
This change does not mean, however, that markets are henceforth immune to disturbances. When they do occur, the Fed’s role in such circumstances has a strong bearing on monetary policy. During a financial crisis the Fed has an interest in understanding what is happening so that it can provide liquidity to match increases in the demand for money and prevent further damage to the economy.
The Fed must also understand the state of financial markets after the peak of a disturbance has passed. In order to foster noninflationary growth the Fed must be able to distinguish the underlying demand for money from the demand being driven by short-term shocks to financial markets. As the system reverts to normal operations, the Fed does not want to precipitate another crisis by prematurely withdrawing excess reserves. At the same time, we do not want to unleash inflationary pressures by waiting too long to withdraw reserves. An understanding of developments in financial markets may be crucial to identifying the source of demand during and after a crisis.
Nonetheless, having the Fed step in after a crisis has occurred is clearly a second-best solution, given what is at stake. We would all be far better off to lower the probability of such a crisis by having market participants and regulators understand markets and market risks and work together to develop solutions.<]> This conference looks at several issues related to the long-run stability of financial market participants. These range from operational risk, a seemingly old-fashioned subject that has nonetheless been the main culprit in some recent failures, to the accounting and regulatory framework for derivatives, much of which began as ad hoc reinterpretations of rules established long ago for very different purposes. That framework likewise seems anachronistic, but radical reform could impose significant transition costs on firms.
These and other issues we’ll be discussing are terribly important, as I’ve argued, to the effectiveness of the Fed’s macroeconomic stabilization role. These issues are also terribly complex. But in anticipating our debates, I’m reminded of something Winston Churchill once said: "Out of intense complexities, intense simplicities emerge." I’m not sure that’s what we’ll get or even what we’re looking for. Still, I’m hopeful that we’ll make some real progress toward agreeing on the right questions and perhaps on some practical suggestions for even more effective policy.
My optimism is based largely on all of us who are part of this conference, not just our speakers. The fact that such a distinguished group of market practitioners, scholars, and policy makers has gathered to tackle these tough issues is itself a hopeful sign about what we can expect from our discussions over the next couple of days. I look forward to beginning those discussions first thing tomorrow morning. Meanwhile, I hope you have a good night.
