Tuesday, March 10, 2009

Financial market design: the view from the Fed

Fed chairman Ben Bernanke, in a speech today (March 10) to the Council on Foreign Relations, after speaking of immediate steps to bail out financial institutions, talks about ways in which the financial markets might be redesigned in the longer term.

"At the same time that we are addressing such immediate challenges, it is not too soon for policymakers to begin thinking about the reforms to the financial architecture, broadly conceived, that could help prevent a similar crisis from developing in the future. We must have a strategy that regulates the financial system as a whole, in a holistic way, not just its individual components. In particular, strong and effective regulation and supervision of banking institutions, although necessary for reducing systemic risk, are not sufficient by themselves to achieve this aim.
Today, I would like to talk about four key elements of such a strategy. First, we must address the problem of financial institutions that are deemed too big--or perhaps too interconnected--to fail. Second, we must strengthen what I will call the financial infrastructure--the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets--to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality--that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing."

Regarding the financial infrastructure, he mentions among other things that
"To help alleviate counterparty credit concerns, regulators are also encouraging the development of well-regulated and prudently managed central clearing counterparties for OTC trades. Just last week, we approved the application for membership in the Federal Reserve System of ICE Trust, a trust company that proposes to operate as a central counterparty and clearinghouse for CDS transactions. "

On the subject of clearinghouses, he goes on to say
"The Federal Reserve and other authorities also are focusing on enhancing the resilience of the triparty repurchase agreement (repo) market, in which the primary dealers and other major banks and broker-dealers obtain very large amounts of secured financing from money market mutual funds and other short-term, risk-averse sources of funding.
it may be worthwhile considering the costs and benefits of a central clearing system for this market, given the magnitude of exposures generated and the vital importance of the market to both dealers and investors. "

His comments on "procyclicality" e.g. on making sure that regulation of capital reserves don't cause banks to cut back lending just when credit needs to be loosened, are also worth reading. His concluding paragraph is a sober look at market design contemplated (as it often must be) in advance of reliable scientific knowledge, but in light of recent experience:

"Financial crises will continue to occur, as they have around the world for literally hundreds of years. Even with the sorts of actions I have outlined here today, it is unrealistic to hope that financial crises can be entirely eliminated, especially while maintaining a dynamic and innovative financial system. Nonetheless, these steps should help make crises less frequent and less virulent, and so contribute to a better functioning national and global economy."

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