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
Premise
Macro volatility
has fallen
Markets deeper
Leverage higher
Implication for financial crises
Odds
Severity
Lower
Worsened
Lower
Milder
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 (preliminary, do not cite).
#
obs
Change in yield (percentage
points)
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
Bond rating
t statistic
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