Discussion of “Financial Innovation, Macroeconomic Stability and Systemic Risk”

1. Discussion of “Financial Innovation, Macroeconomic Stability and Systemic Risk” Bill Nelson Federal Reserve Board November 17, 2006 Disclaimer: The views I express are not necessarily those of the Federal Reserve Board or its staff.

2. Outline of discussion • Review the premises and conclusions of the paper. • Evaluate the premises in terms of some empirical evidence. • Discuss the issues raised from the perspective of a practitioner.

3. Premises and conclusions • Meta premise: We are in a period of particularly rapid financial modernization.

4. Premise: We are in a period of particularly rapid financial modernization • Growth of derivatives and hedge funds has been spectacular. • Other periods of rapid change: • Shift from bank to market financing (discussed at 1993 Jackson Hole conference). • Stanley Fischer, at that conference: When telegraphs connected financial markets. • Growth of managed liabilities in 1960s; junk bonds in 1980s.

5. Premise: Macroeconomic volatility has fallen • Output growth volatility has fallen by half. • Implication for a financial crisis from the model: • Probability falls exponentially; it has fallen a lot. • Severity worsens linearly; it has worsened just a little. • Lower volatility is a really good thing for financial stability, on net.

6. Premise: Asset markets have become deeper. • Not clear if the assertion in the paper is that the resale market for physical or financial assets has become deeper. • Growth of CDS and syndicated loan market have made it easer to resell corporate liabilities. • Measures of liquidity in these markets are scarce and don’t go back in time very far.

7. Premise: Asset markets have become deeper. • Do credit default swaps improve corporate bond liquidity? • Corporate bond yields do not appear to consistently fall when CDS begin trading on the issuing entity, relative to similar bonds. (preliminary, do not cite).

8. Premise: Leverage has increased • Not clear in the paper whose leverage has supposedly increased, nonfinancial corporations or financial intermediaries. • In the model, financial intermediaries own the means of production. • Regardless, leverage appears to have fallen, not risen, in all the relevant sectors, at least in the U.S.

9. Premise: Leverage has increased • Leverage of U.S. nonfinancial corporations has trended down for a decade.

10. Premise: Leverage has increased • Hard to get good data on the financial sector, but leverage of U.S. commercial banks has been trending down for two decades.

11. Premise: Leverage has increased • Leverage of the household sector has increased, but that’s beside the point.

12. Premise: Leverage has increased • Hedge fund leverage has fallen since 1998 (based on estimates from McGuire, Remolona, and Tsatsaronis, 2005).

13. Premise: Leverage has increased • Perhaps the point is that hedge funds’ share of financial intermediation has risen. • But hedge funds appear to be less, not more, levered than banks. • In risk adjusted terms, maybe hedge funds are more levered. • They do seem to fail more frequently.

14. Premise: Leverage has increased • A quibble with the analysis. • Risk of crisis highest for middle-income financial systems. • But model isn’t estimated, or even really calibrated. • Hard to know what part of the curve we are on.

15. Premise: Leverage has increased • Perhaps all the economies are to the left of the maximum. • Probability of a crisis always rising in leverage. • Or to the right. • Probability falling in leverage. • Implication of leverage for probability unclear.

16. Has financial modernization made crises less likely? • While Russia/LTCM resulted in a financial crisis (maybe), subsequent shocks, (stock market crash, 9/11, Enron, Ford and GM, Amaranth) have not. • Financial sector seems resilient, importantly because of low leverage. • At odds with the paper. • But also increased market depth and role of market participants that will buy when positions are liquidated. • In accord with the paper.

17. Has financial modernization made crises less likely? • LTCM lost $2 billion. • FRBNY coordinated a private-sector bailout. • Market liquidity fell and there was a broad pullback from risk taking. • The FOMC eased policy three times to cushion the blow on the economy. • Amaranth lost $6 billion. • Citadel and JPMC acquired the portfolio. • There was barely a ripple in financial markets. • But financial institutions healthier.

18. Would crises be worse? • Maybe, it’s hard to say. • Lot’s of clever people think so. • Counterpart Risk Management Policy Group (Corrigan report); President Geithner (as quoted); Bill White at the BIS. • A couple of key questions: • How would hedge funds and their counterparties act in a crisis? • How would financial markets respond to a major economic downturn?

19. How would hedge funds and their counterparties act in a crisis? • Hedge funds are important providers of liquidity. • In a crisis, increased volatility could lead to higher VaRs, leading counterparties to raise collateral requirements, potentially resulting in a sharp reduction in market liquidity. • Hedge funds are new so their behavior is less certain. • Banks have more stable funding sources, maybe.

20. How would hedge funds and their counterparties act in a crisis? • Supervisory effort are underway to understand better how hedge funds and their counterparties manage risk. • My colleagues and I are examining if hedge funds are likely to be heading for the exits simultaneously (preliminary, do not cite).

21. How would financial markets respond to a major economic downturn? • Market for credit risk has become more complex. • However: • The CDS market has worked through some large failures and downgrades. • FRBNY has led a successful effort to strengthen CDS infrastructure. • Still, it is unclear how the CDS market would cope with a widespread deterioration in credit quality. • In addition, financial institutions could be weakened and so less resilient.

22. What additional research would be most valuable? • Financial crises require • A shock. • Propagation. • Can we predict shocks? • Probably not promising. • How will market participants respond to a shock? • When could simultaneous risk management actions result in a reduction in market liquidity? • How do asset prices behave in crises?

23. What additional research would be most valuable? • Can we get better measures of financial system resilience? • Does increased financial fragility, investor skittishness, leave a measurable imprint? • What policies are most effective for preventing or responding to a financial crisis? • Including ex ante policies designed to increase resilience. • And ex post policies such as providing liquidity.

24. Discussion of “Financial Innovation, Macroeconomic Stability and Systemic Risk” Bill Nelson Federal Reserve Board November 17, 2006