Federal Reserve & Interest Rates

Vice Chairman of the Federal Reserve Board Donald Kohn gave a speech today in North Carolina.  He stressed the needs for a better response to financial turmoil.  He offered his take on what banks and the Federal Reserve need to do.  Here are some highlights of his speech.

A more resilient financial system will also require banks to strengthen all aspects of the originate-to-distribute model. They need to pay more attention to origination, including when they are distributing credits they have not originated. And they need to ensure that when they distribute risks into the market with securitization, the risks really are distributed and will not come back onto their balance sheet later.

At the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will.

Vice Chairman Kohn also talked about some specific financial stability concerns.  Here are the three issues that he noted.

First, securities markets have become so large that commercial banks simply lack sufficient capital and balance sheet capacity to readily fill the gap when markets are impaired.

Third, large commercial banks and investment banks have increasingly similar risk profiles, so that all are subject to the same risk-management challenges under the same circumstances.

Kohn is basically worried about excessive leverage problems and the susceptibility to runs on banks and securities firms.  He believes that monetary policy needs to give attention to the “liquidity risk-management policies and practices of major investment banks,” and commercial banks.

The latest Global Financial Stability Report was released by the IMF (International Money Fund) today, and there is news of world wide economic problems.  The credit crisis stemming from the subprime mortgage losses in the United States is spreading from mortgages to other corporate debt markets.  There are significant macroeconomic risks involved.

The executive summary of the Global Financial Stability Report stated that:

In sum, the global financial system has undoubtedly come under increasing strains since the October 2007 GFSR, and risks to financial stability remain elevated. The systemic concerns are exacerbated by a deterioration of credit quality, a drop in valuations of structured credit products, and a lack of market liquidity accompanying a broad deleveraging in the financial system. The critical challenge now facing policymakers is to take immediate steps to mitigate the risks of an even more wrenching adjustment, including by preparing contingency and other remediation plans, while also addressing the seeds of the present turmoil.

Economic losses could total over one trillion dollars combined.

Important financial institutions have to raise capital or reduce assets in order to cope with the crisis.  There are increased downside risks in global financial stability, and global economic effects could be serious.  Employment, output growth and bank balance sheets could be affected.  The credit breakdown in the United States is greatly tightening the liquidity of financial markets on a global scale.  This lack of liquidity and increasing credit problems in the U.S. could result in a world-wide credit crunch.

The report explains that overall risk management in lending practices were not handled realistically, and that “There was a collective failure to appreciate the extent of leverage taken on by a wide range of institutions.“  These institutions that failed to properly access risk and liquidity include banks and government sponsored entities.

In other words, millions of people who received credit a few years back probably should not have been lent the amount of credit that they were given.  People we allowed to purchase homes that they could not afford, and businesses did not profit as well as the thought they would.  As a result, the economy is suffering wide losses, borrowers are unable to pay debts, and now all of the closely tied international financial markets are being affected by it.

The Federal Reserve and the United States government have the burden of finding effective ways of boosting our economy.  If things don’t get better here, they will only get worse on a global scale.

United States Treasury Secretary Henry M. Paulson made a statement on Federal Reserve regulations on Wednesday, March 26, 2008 at the US Chamber of Congress. He expressed the need to slightly reform the lending practices of the Federal Reserve, urging more transparency and more informed lending decisions.

Secretary Paulson discussed the discount window operations of the Federal Reserve. The discount window offers a cash flow supply for commercial banks and allows the Federal Reserve to increase market liquidity. The Secretary suggested a few minor tweaks in the more recent lending to non-depository institutions that have access to the discount window on a temporary basis.

Secretary Paulson stated:

I believe a few constructive steps would enable the Federal Reserve to protect its balance sheet, and ultimately protect U.S. taxpayers….The Fed should describe eligible institutions, articulate the situations in which funds will be made available, and the magnitude and pricing structure for the funds. The TAF process is a good model for a structure that would provide relevant information to the marketplace.

…The Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions…We suggest that the Federal Reserve, the SEC, and the CFTC continue their work of building a robust cooperative framework… These regulators should consider whether a more formalized working agreement should be entered into to reflect these events.

With this added information flow, the Federal Reserve will be better positioned to consider market stability issues like liquidity provisioning and the interconnectedness of financial institutions. The Federal Reserve’s participation could also allow for broader consideration of market stability issues by the SEC and the CFTC. This collaborative process will necessarily have a strong focus on liquidity and funding issues.

The combination of these steps should provide the Federal Reserve with a structure and the information that it would need to make liquidity backstop loans during periods of market instability to non-banks.

It seems what Paulson is basically trying to say is that the Federal Reserve would be able to handle liquidity and funding issues better if they were not standing alone. More open communications with the Securities and Exchange Commission and the Commodity Futures Trading Commission would protect taxpayers and avoid moral hazard. Moral hazard in this situation is basically when banks have incentive to take higher risks because they know that the Federal Reserve will insure them or bail them out.