There's been a lot of turbulence and a lot of turmoil. Risk spreads that were unusually small during the last couple of years have now become unusually large. You've got some markets that don't seem to be equilibrating easily. ... Arbitrage opportunities that could bring two prices together are not necessarily occurring.

From Q&A as reported by Market News International

If I were to select a light-hearted title for my remarks, it might be “Fear and Loathing on Wall Street.” The basic premise is that as firms have become increasingly concerned about the valuation (pricing) of certain assets, their ability to accurately assess counterparty risk and the liquidity position of counterparties has become clouded. The lack of transparency in the prices of underlying assets, and the significant losses of some financial firms whose deteriorating situation had not been evident in earlier financial statements, have together made investors skittish. As a result, financial firms are increasingly willing to pass up the use of other attractive financing opportunities if they believe that action might lead to speculation about the liquidity or financial strength of their firm.

While such skittishness is not unusual during periods of illiquidity, it is unusual for a period of illiquidity to last this long.

The changing business of the largest commercial banks means that threats to financial stability do not necessarily come from traditional sources such as a deposit run or a deterioration in a bank's portfolio of business loans. The largest banks' capital markets businesses have given rise to new threats to financial stability. These threats stem from banks' securitization activity, from the complexity of banks' capital markets activity, and from the services that banks provide to the asset-management industry, including hedge funds. And risks that are more traditional to banking, such as liquidity risk and concentration risk, have appeared in new forms.

I believe it is fair to say that the creation of new, innovative financial products outstripped banks' risk-management capabilities. As I noted earlier, some banks that chose to hold super senior CDO securities did so because they trusted in an external triple-A credit rating. Because some banks did not fully understand all aspects of these exposures, once the risks crystallized last year in a weak house price environment, compounded by widespread liquidity pressures in many markets, banks had to scramble to measure and hedge these risks.

To protect their capital and liquidity, banks and other financial market participants are addressing the weaknesses revealed by market developments by becoming much more careful about the risks they are taking. This is a necessary process, but it has been a difficult one as well; it is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy. It is this tightening that is accentuating the downside risks for the economy as a whole. And in some sectors, as lenders seek protection against perceived downside risks, it is probably going further than is necessary to foster financial stability in the long run.

So we must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms. To be sure, investment banks are still different in many ways from commercial banks. Among other things, their assets are mostly marketable and their borrowing mostly secured. Ordinarily, this should protect them from liquidity concerns. But we learned that short-term securities markets can suddenly seize up because of a loss of investor confidence, such as in the unusual circumstances building over the past six months or so. And investment banks had no safety net to discourage runs or to fall back on if runs occurred. Securities firms have been traditionally managed to a standard of surviving for one year without access to unsecured funding. The recent market turmoil has taught us that this is not adequate, because short-term secured funding, which these firms heavily rely upon, also can become impaired.

With many securities markets not functioning well, with the funding of investment banks threatened, and with commercial banks unable and unwilling to fill the gap, the Federal Reserve exercised emergency powers to extend the liquidity safety net of the discount window to the primary dealers.³ Our goal was to forestall substantial damage to the financial markets and the economy. Given the changes to financial markets and banking that we've been discussing this morning, a pressing public policy issue is what kind of liquidity backstop the central bank ought to supply to these institutions. And, assuming that some backstop is considered necessary because under some circumstances a run on an investment bank can threaten financial and economic stability, an associated issue is what sorts of regulations are required to make the financial system more resilient and to avoid excessive reliance on any such facility and the erosion of private-sector discipline.

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Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks. In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired. Commercial banks should meet the same requirement. Implementation of such plans is likely to entail substitution of longer-term secured or unsecured financing for overnight secured financing. Because those longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalization of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability.

"Credit default swaps are a good example of a market that has huge potential for helping people manage risks," said Kohn, but he added that those who use the swaps "need to be aware of the risks they're taking."

Kohn said "good progress" has been made in improving the infrastructure of the credit default swaps market, so that "counterparties are not assigned arbitrarily." But he said swaps purchasers still need to "be very careful about where their exposures are in that market."

From Q&A as reported by Market News International

Although our actions appear to have helped stabilize the situation, financial markets remain under considerable stress. For example, many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements. Credit availability has also been restricted because some large financial institutions, including some large commercial and investment banks, have reported substantial losses and asset write-downs, which reduced their available capital. The capacity and willingness of some large banks and other financial institutions to extend new credit has also been limited by the reduced availability of external funding from the capital markets for originated assets. The resulting unplanned increases in their balance sheets have strained their capital, thus reducing lending capacity. The good news is that several of these firms have been able to raise new capital, and others are in the process of doing so. However, market stresses are likely to continue to weigh on lending activity in the near future.

The Fed has to be careful not to aggravate boom-bust cycles in monetary policy and the economy. We have to be somewhat cautious in our approach.

From press Q&A as reported by Market News International

Credit is threatening to displace liquidity as the primary antagonist. A credit crunch, particularly for small businesses and consumers, poses meaningful downside risks to the real economy. And market participants are struggling to assess the possibility that the narrative turns into a multi-act, macroeconomic drama.

Market participants now seem to be questioning the financial architecture itself. The fragility of short-term credit markets is a powerful manifestation of that loss of confidence. There are some encouraging, early signs of repair, but regaining the confidence that markets require will take time, and perhaps uncomfortably to some, patience. It may also require new forms of credit intermediation.

Volatility is generally a friend, not a foe, of market functioning. It should not be treated as an externality from which we suffer. Volatility, absent destabilizing moves, should be allowed to effectuate change in the financial architecture of private markets. Only then, I suspect, will a more robust recovery in market liquidity, investor confidence, and real economic activity be achieved.

More transparency about the risks and other characteristics of securitized credits on the part of their sponsors would obviously help. But more generally, investors must take responsibility for developing independent views of the risks of these instruments and not rely solely on credit ratings.

Improving the performance of the credit rating agencies is another key priority. As I mentioned, analytical weaknesses and inadequate data underlay many of the problems in the ratings of structured finance products. Beyond improving their methods, however, the credit rating agencies would serve investors better by providing greater transparency. Credit rating agencies should, for example, publish sufficient information about the assumptions underlying their rating methodologies and models so that users can understand how a particular rating was determined. It is also important for the credit rating agencies to clarify that a given rating applied to a structured credit product may have a different meaning than the same rating applied to a corporate bond or a municipal security. Indeed, some have suggested that the agencies use different rating nomenclatures for different types of products. Transparency about methods should also help to reduce concerns about conflicts of interest that might arise from the fact that issuers of securities pay the rating agencies for their work in rating those securities.

The credit rating agencies themselves clearly appreciate that concerns about the quality of ratings and potential conflicts of interest represent a fundamental challenge to their business model, and they have begun to address these issues. The SEC, which has regulatory responsibility for the credit rating agencies, is conducting a broad review of issues regarding potential conflicts of interest at the rating agencies and is likely to identify further measures that should be implemented.

Of course, like exotic foods, consumption of new risk products can lead to indigestion, and even allergic reactions. Lately, we have witnessed many allergic reactions—in the form of losses and setbacks—especially among money center banks and other financial institutions whose fiduciary eyes—as old Ruth Walgren would have said—“simply got too big for their stomachs.”