Thursday, January 06, 2005

The Fed's role in responding to (and preventing) a financial crisis

FRB:Speech, Kohn--The known, the unknown, and the unknowable--January 6, 2005

Fed Governor Donald Kohn gave an interesting speech today on how the Fed reacts to crises. Some of the high points:

In crises, good information is a valuable (and rare) asset

"As I am sure we will hear time and again today, knowledge--reliable information--is essential to managing risks. In a financial crisis, however, information inevitably will be highly imperfect. The very nature of a crisis means that the ratio of the unknown and unknowable will be especially large relative to the known, and this, in turn, can influence how policymakers judge risks, costs, and benefits."

It is better to prevent a crisis than to respond to it.

"I want to emphasize at the outset that the far-preferable approach to financial stability is to reduce the odds on such crises developing at all. To this end, central banks seek to foster macroeconomic stability, encourage sound risk-taking practices by financial market participants, enhance market discipline, and promote sound and efficient payment and settlement systems. In this arena, an ounce of prevention is worth many pounds of cure"
However, Fed Policy can cut both ways.

"...some policy responses to a crisis can themselves have important costs that need to be balanced against their possible benefits....intervening in the market process can create moral hazard and weaken market discipline....Weaker market discipline distorts resource allocation and can sow the seeds of a future crisis."

"Approaches that work through the entire market rather than through individual firms run a lower probability of distorting risk-taking. Thus, a first resort to staving off adverse economic effects is to use open market operations to make sure aggregate liquidity is adequate."

"Second, we must determine whether the stance of monetary policy has to be adjusted to counteract the effects on the economy of tighter credit supplies and other consequences of financial instability."

Why the Fed?
"Whatever the origin of the crisis, the Federal Reserve has usually found itself near the center of the efforts to assess and manage the risks. To be sure, we have some authorities and powers that other agencies do not. But in addition, we bring a unique perspective combining macro- and microeconomic elements that should help us assess the likelihood of disruptions and weigh the consequences of various forms of intervention. Because of our responsibility for price and economic stability, we have expertise on the entire financial system and its interaction with the economy. Central banks need to understand--to the limited extent anyone can--how markets work and how they are likely to respond to a particular stimulus. Our role in operating and overseeing payment systems gives us a window into a key possible avenue for contagion in a crisis."

on the recent past:

"In the past few years, the financial markets have come through an extraordinarily stressful period, but one that was not marked by the sort of financial-sector distress that accompanied and intensified the economic problems in many previous such episodes. I attribute that relatively good record, in no small part, to greater diversification of risk, to the growing sophistication of risk management techniques being applied at more and more institutions, and to stronger capital positions going into the period of stress."
Remember this is his own opinion and not Fed policy!

"No institution can be "too big to fail. Handling the failure of a large, complex organization--imposing the costs of failure on management, shareholders, and uninsured creditors while minimizing the effects on the wider economy--will certainly be complicated. But we cannot allow the public interest in containing moral hazard to be held hostage to complexity."

As with all speeches by Fed officials, the text of this speech is available on line.

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