Discussing the Financial Markets Conference

June 2009

Moderator: Welcome to Research Insights, a series of occasional podcasts by the Federal Reserve Bank of Atlanta. Our guest today is Paula Tkac, Atlanta Fed economist and associate policy adviser. She's here to talk about the Atlanta Fed's most recent financial markets conference, which took place at Jekyll Island, Ga., in May 2009. Thanks, Paula, for joining us, good to see you. Since you were involved in planning this conference, I wanted to ask you, how'd you come up with the theme for this year's program, which was "Financial Innovation and Crises"?

Paula TkacPaula Tkac: Thanks, Bill. Well, we began planning the conference in June of 2008 and at that time it was very clear to us that the financial turmoil, which had been roiling for about the last 10 months, was prime material for this year's 2009 conference. The issue was what perspective to take on this turmoil. We really didn't want to undertake a purely forensic post-mortem, and of course, looking forward a period of even more intense crisis was yet to come in September of 2008. So, in retrospect this was a good call.

Instead, our team wanted to take a step back and view the current events through the lens of the effects of financial innovation. If you recall, innovative securities, primarily subprime residential mortgage-backed securities were at the epicenter of the crisis. We were intrigued by questions about the effect of financial innovation and whether there's a link between innovation and the potential for financial crisis. So we selected policy topics, participants, and research presentations that would help to raise, if not answer, the questions.

In particular, we wanted to better understand the challenges market participants and regulators face when they're measuring and managing the risks of really innovative securities for which there is no historical experience. We wanted to know if the establishment of clearinghouses and the standardization of securities would help to eliminate the risk of a large-spread systemic crisis. That is, would making securities less idiosyncratic and more standardized, and trading them on exchanges rather than in under-the-radar agreements between pairs of institutions, make the system less fragile?

We also designed a session to shed light on the international mechanisms of contagion; how the crisis we experienced spread from the U.S. sub-prime market to Europe, and eventually to Asia. And then finally, a session to really look forward and think about the future of the U.S. banking system.

Moderator: OK, well, I noticed on the agenda that you had some very notable speakers. Can you tell me about some of the highlights of this year's conference?

Tkac: Sure, let me first tell you about our two keynote speakers. We were very privileged to have Chairman Bernanke give our keynote on the first night, and he gave a very timely speech on the Supervisory Capital Assessment Program, commonly known as the banks' stress test. The results of that stress test were released only days before the conference, and the chairman took this opportunity to both outline the methodology and the process for the program and also to give an overview of the results. If you recall, the program was begun in February, included 19 large financial institutions, and the idea was to conduct a very rigorous forward-looking assessment of the magnitude of losses that might be suffered by these institutions if the economy was weaker than expected. This prolonged period of slow growth and high unemployment was the "stress" scenario. This exercise was designed to reduce uncertainty about the losses that banks might face. As Chairman Bernanke noted, it was not only concern about potential losses in the banking system going forward, but the large degree of uncertainty surrounding how large those losses might be that was contributing to a lack of confidence in the banking system at the time.

Our second keynote speech was given by John Taylor of Stanford University, and he spoke on the role of government in reducing systemic risk. As we move forward, the regulatory reform debate has actually already begun. Specifically, there's an anticipation of a Treasury proposal for reforming bank regulation and the potential for a systemic risk regulator. Professor Taylor noted the importance of learning lessons both on the causes of the systemic crisis—the "who did it" question—and also about the role of government in terms of the policy responses once the crisis began to unfold. Professor Taylor's speech was provocative, especially in our venue, as he argued that the government induced the crisis and that monetary policy played a role. But this was exactly our idea: to bring together a variety of perspectives and opinions on this very important topic.

Finally, Professor Gary Gorton of Yale presented another provocative paper entitled "Slapped in the Face by the Invisible Hand: The Banking Panic of 2007." Professor Gorton argues that the financial crisis we experienced recently was a traditional bank panic, but one that occurred in what we call the wholesale, or shadow, banking system and not in traditional banks. Prior banking panics—say, the one in 1907 that ultimately led to the founding of the Federal Reserve System—saw investors rush to redeem their deposits. Banks couldn't meet all of this demand, and ultimately the system became insolvent. This time, we didn't see individual investors and traditional firms panic and run on banks by withdrawing deposits. Instead, we saw financial institutions pullback from what we call the shadow banking system, including the repo, or repurchase, market and securitization markets, essentially refusing to continue extending credit to other financial institutions. This operated in Gorton's eyes much like a traditional banking panic, and so the remedies might also be similar. Gorton argues, perhaps, that future panics can be reduced by

  • an increase in government insurance for securitizations that perform the role of collateral in these repurchase agreements,
  • for increased supervision of securitization in firms that securitize underlying assets.
  • moving this out of the purview of rating agencies and underneath government supervision, and
  • finally, for the direct supervision of institutions outside of what we think of as traditional banks.

Moderator: Very interesting. So you had a lot of timely discussion and given the forward-looking theme that you have, can you also talk a little bit about the policy implications, or the lessons learned, from this year's conference?

Tkac: Sure, I think we actually learned quite a bit. Both Chairman Bernanke and Professor Taylor directly referred to some lessons learned in their speeches. As I mentioned, Professor Taylor spoke about monetary and fiscal policy going forward and the role of government policy in lessening the potential for crisis. Chairman Bernanke spoke about the lessons learned in undertaking a policy response. He noted that, because the stress tests were designed to incorporate the same analysis across firms and to expressly consider risk exposures across the web of these interconnected institutions, that the exercise itself was instructive for illustrating the challenges that we will face going forward as regulators attempt to assess risk exposures across these financial institutions. So, this "learning by doing" will be especially valuable as plans for regulation of systemic risk move forward.

More broadly, the very nature of the conference, by both looking at what happened and debating policy proposals to reduce the risk of a future crisis really highlighted the feedback loop between innovation in financial instruments and innovation in policy. Innovative instruments create new challenges for policy as they change the nature of markets and the risks that people are exposed to, and as policy adapts, it also creates incentives and opportunities for more financial innovation going forward.

Now, while the topic of the conference was "Financial Innovation and Crises," it's clear that financial innovation is inherently a good thing and not a dark force that must be outlawed in order to prevent a future crisis. The securitization market is, in fact, a fine example of this. While the subprime mortgage-backed security market had a role in this crisis, there have been large economic gains for consumers and firms from the securitization of credit card receipts, auto loans, student loans, and, yes, even mortgages. The challenge, of course, is to evaluate and manage these innovative risks in real time or to formulate policies that are flexible and forward-looking to deal with innovation that has yet to arrive.

Moderator: OK, very interesting; thank you Paula. Again, we've speaking with Paula Tkac, financial economist and associate policy adviser with the Atlanta Fed. This concludes our Research Insights podcast on the bank's 2009 financial markets conference, with the theme of "Financial Innovation and Crises." You can find more information on the conference, including the agenda and the papers, by visiting the Atlanta Fed Web site, frbatlanta.org. Thanks for listening, and please return for more podcasts.