Discussion of “Financial Innovation, Macroeconomic Stability and by georgehill

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									  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.
       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.
    Premises and conclusions

                   Implication for financial crises
Premise            Odds             Severity
Macro volatility   Lower            Worsened
has fallen
Markets deeper     Lower        Milder
Leverage higher    Lower, maybe Worsened

 • Meta premise: We are in a period of particularly
   rapid financial modernization.
    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.
 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.
   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.
    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 (preliminary, do not cite).
                   #    Change in yield (percentage
    Bond rating   obs             points)             t statistic
        AA         20                         -0.09           -2.5
        A         129                          0.03            1.2
       BBB        204                         -0.04           -0.9
        BB         67                          0.17            1.7
        B          35                          0.39            1.7
 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.
 Premise: Leverage has increased
• Leverage of U.S. nonfinancial corporations has
  trended down for a decade.
 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.
 Premise: Leverage has increased
• Leverage of the household sector has
  increased, but that’s beside the point.
 Premise: Leverage has increased
• Hedge fund leverage has fallen since 1998
  (based on estimates from McGuire, Remolona,
  and Tsatsaronis, 2005).
 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.
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.
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.
 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.
 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.
       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?
 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.
 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).
     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.
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?
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.
  Discussion of “Financial
Innovation, Macroeconomic
Stability and Systemic Risk”

           Bill Nelson
      Federal Reserve Board
       November 17, 2006

								
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