This morning I came across a speech given by Mr. Donald Kohn, Vice Chairman of the Board of Governors of the Federal Reserve System (US). He was speaking at a college forum, which was held to discuss “Great Decisions in the Economic Crisis” – (ed: aren’t those concepts mutually exclusive in the same context?)…

The reason I bring this to your attention is that Mr. Kohn’s speech is another clear indicator that the road to the future for the financial industry and others, is paved with the bricks of regulation and policy.

My source in this instance is the Bank for International Settlements and the article can be found here.

I have abbreviated the full text of his speech to draw attention to the relevant bits… I encourage you to consult the full text via the links above.

Donald L Kohn: Policies to bring us out of the financial crisis and recession

Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Forum on Great Decisions in the Economic Crisis, College of Wooster, Wooster, Ohio, 3 April 2009. 

The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve System’s website. 

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The policy response 

 

Mr. Donald Kohn

Because the threat to economic stability in the current episode has been so closely related to problems in the financial sector, most of the policy responses have been focused on financial institutions and markets and the flow of credit to households and businesses. Many of these policies have been aimed at countering the tightening of financial conditions that occurred as lenders became more risk averse and took steps to conserve capital and liquidity. To that end, the Federal Reserve has lowered interest rates, made backup sources of liquidity available to private lenders, and used its own lending capacity to try to revive a variety of financial markets. In addition, the Federal Reserve, the Treasury, and the Federal Deposit Insurance Corporation (FDIC) have taken a number of steps to stabilize and repair financial institutions in order to limit the tendency of those institutions to pull back from lending and thereby intensify the decline in spending.  

Other government policies operate at the intersection of the financial and real sectors. Foreclosure mitigation, for example, not only serves to keep people in their homes, but also should reduce downward pressures on house prices and hold down loan losses at lenders. Finally, fiscal stimulus works directly on demand, in effect bypassing the financial sector in its first-round effects; by strengthening aggregate demand, it too should help alleviate strains on lenders and contribute to stemming the vicious cycle. Although I’ll be discussing each of these policy initiatives separately, it is important to keep their interactions in mind. They all attempt to break into that adverse feedback loop we’ve been talking about at different points in the chain of cause and effect and then cause again. 

The expectation of recovery rests importantly on the natural recuperative powers of the economy, but it also depends on the effects of the various policy efforts reinforcing each other: A stable financial system is critical to realizing the positive effects of monetary and fiscal policies; the financial system won’t stabilize very quickly without monetary and fiscal stimulus to help support spending and ease credit problems.

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Financial repair 

In addition to the Federal Reserve’s monetary policy actions, which broadly support the financial sector and the economy, the government – including the Treasury, the Federal Reserve, and the FDIC – has been working to provide more direct support to financial firms.4 In part, this effort has involved targeted actions to prevent the failure or substantial weakening of specific systemically important institutions, including Bear Stearns, Fannie Mae, Freddie Mac, AIG (American International Group, Inc.), Citigroup, and Bank of America. These actions were not taken to protect the affected firms’ managers or shareholders from the costs of past mistakes. Indeed, managers have been replaced in some cases, and shareholders of the weakest firms have experienced massive losses. Instead, our actions have been driven by concerns that the disorderly failure of a large, complex, interconnected firm would impose significant losses on creditors, including other financial firms, dislocate a range of financial markets, and impede the flow of credit to households and businesses. 

Losses sustained by other financial firms could erode their financial strength, limiting their ability to play their intermediation role, or even cause them to fail, reinforcing financial pressures. Moreover, the disorderly failure of a large, complex interconnected firm could undermine confidence in the U.S. financial sector more broadly, potentially triggering a widespread withdrawal of funding by investors and an additional tightening of credit conditions, which would, in turn, cause a further reduction in economic activity.  

Besides this targeted support, the government has undertaken programs to inject capital more broadly into the banking system. Since last fall, nearly $200 billion has been distributed under a Treasury program that provides government capital investments to banks in good condition. More recently, the Treasury, in conjunction with the bank supervisory agencies, announced a new program to ensure that U.S. banking institutions are appropriately capitalized. Under this program, the capital needs of the major U.S. banking institutions are being evaluated relative to the losses that would be anticipated under a significantly more challenging economic environment than anticipated in the consensus of private forecasters. Should that assessment indicate that an additional temporary capital buffer is warranted, institutions will have an opportunity to raise the capital from private sources. If these efforts are unsuccessful, the temporary capital buffer will be made available from the government. By providing additional capital, the government can reduce concerns about the adequacy of bank capital, build investor confidence in U.S. banking institutions and the U.S. financial sector more generally, and so ease financial pressures and encourage new lending. 

 

In addition to providing capital, the government, through the FDIC, has temporarily guaranteed selected liabilities of insured depository institutions and their holding companies. This program provides a stable source of funds for these institutions and so eases the pressures on funding that some of them faced.  

4  To clarify the appropriate roles of the Federal Reserve and the Treasury during the current financial crisis and in the future, the Federal Reserve and the Treasury issued a joint statement on March 23, 2009. See Board of Governors of the Federal Reserve System and U.S. Department of the Treasury (2009), “The Role of the Federal Reserve in Preserving Financial and Monetary Stability,” joint press release, March 23. 

 

Finally, the Treasury recently announced a program to assist banks and other lenders in reducing their “legacy assets” – that is, real estate loans held directly on their books (“legacy loans”) and securities backed by loan portfolios (“legacy securities”) that were accumulated during the housing boom and which have since declined in value and become relatively illiquid. Uncertainty about the value of legacy assets is weighing on confidence in banks, reflecting concerns that the assets will turn out to be worth much less than currently thought and so undermine the financial strength of the banks holding them. Moreover, the lack of liquid markets for legacy assets means that banks cannot readily manage the associated risks and cannot easily make room on their balance sheets for new loans if they have attractive lending opportunities. In part, buyers for these assets are scarce because credit is expensive and difficult to obtain and because investors are highly averse to risk.  

Under the new program, the Treasury, with the participation of the FDIC and the Federal Reserve, is establishing public-private investment funds to purchase legacy assets. Capital for the funds will be provided jointly by private investors and the Treasury. In addition, the government will provide the funds with leverage (through Federal Reserve lending or FDIC guarantees) that currently cannot be raised from market sources, allowing the funds to increase their purchases of legacy assets. These facilities are structured to give the government a share of any gains in the value of assets purchased while protecting the private-sector investors from some of the downside risks inherent in real estate credit at present. By providing such protection along with leverage that is unavailable in markets today, the government hopes to bolster demand for these assets and restart markets in them.  

Taken together, these financial repair programs are a comprehensive and substantial effort to help financial institutions resume lending and so support economic activity. Banks worried about the adequacy of their capital have been reassured by the capital provided by the Treasury, and they may also be more optimistic about their ability to raise private capital once they have shed legacy assets. At the same time, concerns about the availability of funding should be eased by access to government-guaranteed funding options. Moreover, as I noted at the outset, these programs need to be viewed as complementing the monetary, fiscal, and other policies put in place to alleviate financial strains and support aggregate demand. Indeed, when I think back to the exceedingly perilous financial situation last September and October, I judge the efforts at financial repair as at least a qualified success. 

Risk spreads in bank funding markets have narrowed, and the liquidity positions of many institutions have improved. Despite significant pressures on many financial firms, we have generally avoided fire sales of assets by institutions that were troubled or were anticipating trouble. 

 

 

 

 

 

Despite this progress, financial markets remain very fragile, lenders are still very protective of their capital and liquidity, risk spreads remain elevated, and many segments – especially securitization markets – continue to be impaired. However, some of the government programs I have discussed – those to restart markets, provide additional capital buffers, and open outlets for legacy assets – are just now being implemented. While these programs are quite promising, we will not be able to judge their success at restarting lending for a time.