Randall Kroszner

Policymakers must be very careful to avoid any impression that government oversight comes with a promise of government financial support in the event of a risk-management failure; otherwise, private-market discipline, which has served private and public interests in the stability of CCP arrangements so well for so long, may well be eviscerated. Instead, government regulation should focus on improving the effectiveness of private-market regulation.

Private-market regulation can be effective for achieving the public policy goal of safety and soundness and broader financial stability. Government regulation and oversight should seek to provide an environment in which private regulation can be most effective. Government regulation should not place unnecessary barriers--domestically or internationally--in the path of the future evolution of private-market regulation. Innovation should be fostered, and regulatory protectionism should be rejected.

Banking integration appears to have salutary effects on business cycles by insulating the local economy from the ups and downs of its local banking system, and vice versa.

Dynamic firms are the ones making the largest contributions to the nation's overall productivity growth, which is, at bottom, the fundamental source of rising standards of living. Accordingly, it is important that the economic statistical system do a good job of measuring not only output and employment growth but also intangibles, new cutting-edge products, and quality changes.

Innovations in economic statistics must keep pace with innovations in the economy. Barriers to useful sharing of information across statistical agencies should be removed to reduce costs and enhance benefits, but in no way should we compromise the high standards of privacy protection embodied in CIPSEA and other statutes. And allocating resources to better measure the most dynamic parts of the economy will help us get the most bang per buck in economic statistics by enhancing our ability to spot trends and improve forecasts of the direction of the economy.

The savings glut story helps to explain the real component of low bond yields as well as the pattern of global capital flows, which was Chairman Bernanke’s focus. Another factor behind declining real yields in some emerging markets is that their improved fiscal situation not only increases national saving but also calms fears about the ability of governments to service their debt.

Overall, the combination of lower and less volatile inflation around the world has led to a reduction in inflation expectations and lower perceived inflation risk, hence a lower inflation uncertainty premium in long rates. I believe that these factors have been important contributors to the lower long-term yields and the flattening of yield curves, particularly in emerging markets.

An often overlooked implication is that, all else equal, an increase in the growth rate of productivity will tend to put upward pressure on real interest rates.  But in fact we have not seen the predicted rise in real rates.  Of course, we do not live in the world of simple economic models so all other things are not equal.  In particular, I believe one reason is that sound economic policies have created a more stable economic environment, and with that has come low and stable inflation and an ongoing desire by foreigners to invest in the United States to reap higher returns associated with higher productivity growth than may be available in their economies.        

Since 1995, productivity in the United States has grown substantially faster than in other advanced industrial countries.  For example, a recent study by van Ark and Inklaar (2005) indicates that while productivity in the United States accelerated after 1995, average productivity in Europe actually decelerated--indeed, they estimate that the trend in the fifteen countries that made up the European Union before 2004 has been decelerating since the mid-1980s...

Increased trade liberalization, which lowers barriers to the international flow of goods, financial capital, and direct investment, also spurs innovation and creativity....

I draw two conclusions from this work.  First, trade liberalization appears to have made it possible for multinational firms to institute highly efficient cross-border supply chains within their firms that seem to have allowed them to boost significantly the efficiency of their worldwide operations.  Second, U.S. firms, on average, have more flexible and innovative business practices, sometimes called organizational capital, that a liberalized trade regime apparently allows them to transfer to their foreign operations.

That is, in the model, an increase in the level of productivity (reflecting, for example, some technological advance) causes businesses and financial markets to revise upward their views about the level of expected profits, and it causes households to revise upward their views about the level of permanent income.  The higher level of expected profits and returns to capital, in turn, lead to a rise in business investment.  Similarly, personal consumption expenditures are boosted in response to the rise in permanent income.  The initial increases in spending are then followed by multiplier effects.  A dynamic feedback also occurs on the supply side as the higher level of investment spending increases the capital stock (relative to the supply of worker hours), which gives a small fillip to productivity and potential output.  Ultimately, the increases in aggregate supply are matched by an equivalent increase in aggregate demand.  This is, of course, Say’s law.

What about the effects of a productivity shock on inflation?  Ultimately inflation is determined by the policy actions of the central bank.  In the short run, however, a change in the trend growth rate of productivity can influence inflation dynamics...  

Nominal compensation per hour initially seems to respond sluggishly to changes in the economy, including productivity shocks.  As a result, an increase in productivity growth, for example, initially slows the growth of unit labor costs, which firms--under competitive pressure--then pass on to their customers, thereby slowing price inflation. 

In the past, deviations in the labor share of income from its mean value of roughly two-thirds have eventually been reversed.  But the two-thirds share is an empirical observation about the U.S. economy; it is not an immutable number derived from the first principles of economic theory...

A challenge for forecasters is deciphering whether this latest drop in the labor share is transitory, as such drops have been in the past, or whether some structural aspect of the economy, such as the wage-bargaining process, has changed to make the drop in the labor share permanent.  More likely, the adjustment process is taking a long time to play out, as it did in the 1990s, and some recent evidence may suggest that the gap is beginning to close.  Assuming that the drop is transitory, another challenge for forecasters is predicting whether the adjustment to real compensation per hour will be driven by a pickup in the growth of nominal compensation per hour or by a reduction in inflation.

We are still seeing some continued potential for inflation pressure.  There has been some mitigation of these pressures with recent declines in energy.

In remarks to reporters after an appearance at the Forecasters Club of New York

In the world of 2000, the notion that Mexico would issue a 30-year local currency bond and pay just a few basis points over a U.S. Treasury was unthinkable.

I would like to focus on a fundamental change that has taken place globally since I first spoke {at the Cato Institute} roughly twenty years ago. In the United States and in virtually every country around the world, inflation has declined, and in most countries dramatically so. In addition, the volatility of inflation and expectations of future inflation have also fallen significantly. I will call these changes experienced around the globe the conquest of worldwide inflation.

Friedrich Hayek had long ago advocated permitting greater competition among currencies, arguing that there would be a race to the top rather than a race to the bottom.  Regardless of what one might think of Hayek's policy proposals, technological change in a globalized and competitive marketplace, I believe, has increased competition among currencies issued by central banks.

...

In a nutshell, I believe that the factors of globalization, deregulation, and financial innovation, arising partly in response to episodes of high inflation, have effectively eroded the central bank monopoly on the provision of monetary services and have enhanced global competition among currencies. These changes have, in turn, altered the incentives for central banks to behave badly and for finance ministries to use central banks as "piggy banks" to finance their fiscal policies.

The current low level of long-term yields in the United States and other advanced economies is widely acknowledged as somewhat of a puzzle, or, to use former Chairman Greenspan's term, a conundrum. Of course, flat and even inverted yield curves in advanced economies are nothing new. We know that the short end of the yield curve is dominated by monetary policy and cyclical factors.

...To some extent, low forward rates may reflect a persistent decline in expected future real rates of interest or in the real term premium. Chairman Bernanke has suggested that an excess of ex ante global saving relative to global investment has held down real interest rates around the world.

Relationship finance continues to be at the heart of community banking. I believe that the most significant characteristics of community banks are: 1) their importance in small-business lending; 2) their tendency to lend to individuals and businesses in their local areas; 3) their tendency to rely on retail deposits for funding; and 4) their emphasis on personal service.  Hence, successful community banking today depends importantly on the same characteristics that formed the foundations of the U.S. banking industry two centuries ago--personal interactions among bankers, their customers, and their communities.

...

Along with the benefits of relationship finance, however, come some risks, including the potential for conflicts of interest. This particular risk appears to have been mitigated significantly in the United States, although it is important for bankers to remain vigilant and to regularly review the corporate governance mechanisms they have in place.

"The outlook for the U.S. economy has not materially changed," Kroszner said during a question-and-answer session at a community banking conference in Washington. 

  "The financial markets seem to be working well and there seems to be sufficient liquidity in the system to respond to the rapid changes that have been occurring recently," Kroszner said, in a nod to recent sharp declines in Asian and U.S. equities markets.

As reported by Dow Jones Newswires

The forces behind currency competition that have bolstered incentives for central banks to maintain low inflation and so have helped anchor inflation expectations are likely to persist and perhaps strengthen.  The ease with which funds move across capital markets should continue to ensure that the responses to inflationary central bank policies will be swift and significant.  The resulting incentives provided by currency competition should continue to foster relatively low far-forward nominal interest rates in many countries.  As long as capital markets remain open and people remain aware of the costs of high inflation policies, I believe that the forces behind the low level of long-term interest rates and hence the general flatness of yield curves around the globe will tend to persist for some time.  

I’m pleased to be here today to participate in this discussion about liquidity and monetary policy. Apparently many others are having a similar discussion--a quick search of LexisNexis turned up 2,795 separate articles in the past six months alone that mentioned the word “liquidity” in the context of its abundance in financial markets. The use of the term liquidity in these articles spans a wide variety of meanings--perhaps 2,795 of them!

Rather than grapple with the definition of the rather slippery concept of liquidity in my short remarks here, I will focus on aspects of global financial markets that many analysts associate with liquidity and that are particularly relevant for monetary policy--namely, the relatively low level of long-term interest rates in both real and nominal terms and the resulting relatively flat slope of yield curves around the world.

One notable change is that movements in inflation now appear to tell us much less about future inflation than was the case, say, thirty years ago. Here I am talking about predictions of inflation using only information on past inflation, without taking into account any other information. The evidence suggests that, at the peak of U.S. inflation in the late 1970s and early 1980s, the best such “univariate” forecast of inflation--into the indefinite future--was a simple average of inflation over the past few quarters (Stock and Watson, 2007; Cecchetti and others, 2007). In that period, sharp increases in inflation were reversed only slowly. By contrast, shocks to inflation since roughly the mid-1980s have tended to be short-lived, so that the best forecast of future inflation would be a very long average of past inflation. Thus, when inflation moves above its recent long-run average, most of the upswing will likely be quickly reversed, although this result is not guaranteed.

As Milton Friedman famously said many years ago, “Inflation is always and everywhere a monetary phenomenon.” Unfortunately, given the lack of a stable relationship between money growth and inflation, the pure monetarist view has taken a beating since then. However, Friedman was right that inflation is, ultimately, something that central banks determine, at least on average, over time.

Another apparent change in the inflation process has been a reduction in the correlation between inflation and unemployment (Atkeson and Ohanian, 2001; Roberts 2006). Now, this relationship was always loose, as most of the historical variation in inflation has reflected influences aside from movements in unemployment or other measures of resource utilization. Still, in the 1960s and 1970s, a reasonably strong empirical relationship between inflation and unemployment could be found for the United States, with inflation tending to rise in periods when unemployment was low and vice-versa. Starting in the 1980s, however, this correlation began to weaken noticeably. In fact, some researchers now find no relationship at all, whereas others tend to find one that is of reduced economic importance.

[O]ne recent study even purports to show that foreign output gaps are more important in explaining domestic inflation in industrialized countries than domestic factors (Borio and Filardo, 2006). However, this result has been challenged by the Federal Reserve staffers, who find that estimates to this effect are fragile.⁷

[T]he reduced sensitivity of core inflation to oil and natural gas prices likely also reflects both the increased energy efficiency of the economy and the fact that shocks to the prices of these goods since the mid-1980s have, at least until the latest episode, been viewed as mostly temporary. In contrast, the rise in oil prices during the 1970s was probably seen at the time as largely reflecting a permanent shift in global demand/supply balances.

After adjusting for the rising share of imports in domestic price increases, we see little indication of a reduction in the effect of import prices on U.S. inflation. We have some evidence, however, of a reduced effect of exchange rates on import prices (Ihrig, Marazzi, and Rothenberg, 2006), although this result may be sensitive to specification (Thomas and Marquez, 2006).

These risk-management challenges have not gone unnoticed by market participants themselves.  In 2005, a private-sector group, the Counterparty Risk Management Policy Group II, or CRMPG II, chaired by E. Gerald Corrigan, produced a report highlighting many of these issues.⁹  

...CRMPG II called attention to the growing backlogs and the risks that they posed to market participants and called for the convening of an industry roundtable to address them.¹⁰  Prudential supervisors then took the lead.  In September 2005 they called fourteen leading dealers to the Federal Reserve Bank of New York, where the supervisors collectively made clear their concerns about the risks posed by the growing backlogs.

The supervisors wisely avoided any temptation to design their own improvements to the market infrastructure.  Instead, they simply insisted that the backlogs be reduced and left it to the dealers who had been at the meeting (and who became known as the Fed 14) to figure out with other market participants how best to achieve that objective.  The market participants recognized that automation was the key; manual processes simply are not scalable.  Both dealers and asset managers embraced use of the Depository Trust & Clearing Corporation’s Deriv/Serv electronic confirmation service.

[S]yndicated loans are not a new instrument.  They have been around since the 1970s.  But recently, the secondary-market liquidity of syndicated loans has improved dramatically, in part because of the demand for loans by CLOs.  This improved liquidity has transformed loans from buy-and-hold investments into traded assets.

For example, some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk.  But those unregulated or less regulated entities should in principle be subject to more-effective market discipline than banks because, without a safety net supporting them, their creditors have stronger incentives to monitor and limit their risk-taking.  In fact, while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred to institutional investors that are far less leveraged than banks. 

Although improving convenience has been an important force behind successful innovation, consumers and businesses have increasingly demanded greater security in their electronic payments, particularly as more information is linked to these payments. In general, there is often a basic tradeoff between security and convenience: the easier a system is to use and access, the less secure it tends to be.

These considerations suggest that the current pattern of international capital flows represents a win-win scenario: Developing economies gain access to better financial services, and industrial economies enjoy the larger quantities of imports they can purchase with this financing. These explanations also suggest that the uphill flow of capital will be reversed to the extent that financial systems of emerging-market economies develop and improve. Because such a process is likely to take time, this set of explanations suggests that the uphill flow of capital is likely to persist for a while.

I believe that the current net flow of capital toward the industrial world is not in the long-term interest of the developing economies. To raise incomes and reduce poverty, the developing economies must boost their productivity, and that, in turn, will require complementing their large and growing labor forces with increasing quantities of capital.

Let's begin by getting some sense of the size, source, and composition of the net capital flows that are moving from developing to industrial countries.  One reasonable measure of the size of these flows is the combined current account balance of the developing economies.  According to estimates by the International Monetary Fund (IMF), the developing economies as a group had a current account surplus of $640 billion last year (IMF, 2007a).³  Because the financial counterpart to this surplus is a deficit on the financial accounts, it represents the net capital outflow to the industrial economies.  $640 billion is a big number and stands in sharp contrast to the situation preceding the Asia crisis.  For example, in 1996 the combined current account balance of the developing economies was a deficit of $80 billion, representing a capital inflow of that amount from the industrial world.

The sources of the $640 billion in net capital flow out of the developing economies are remarkably concentrated.  Of those developing economies running current account surpluses, a mere seventeen of them--China, four other Asian economies, Russia, and eleven members of the Organization of Petroleum Exporting Countries--accounted for a combined surplus of $710 billion.  And about half of that was generated by the major oil-exporting countries in the Middle East and by Russia, whose surpluses ballooned in the past several years as oil prices soared.  Thus, the other 131 developing economies in our data had a combined current account deficit, or net capital inflow, of $70 billion.  This is not to say that things have not changed for these 131 countries in the past decade:  In 1996, their combined current account deficit was twice as large as it was last year.

I have argued that globalization, deregulation, and financial innovation, in part spurred by recent experiences of high inflation, have fostered currency competition that has led to improved central bank performance and, hence, the reduction of inflation worldwide. The resulting enhancement of central bank governance and credibility has allowed the development of long-term bond markets in many countries and the flattening of yield curves around the globe.

I believe that the factors of globalization, deregulation, and financial innovation, arising partly in response to episodes of high inflation, have effectively eroded the central bank monopoly on the provision of monetary services and have enhanced global competition among currencies. These changes have, in turn, altered the incentives for central banks to behave badly and for finance ministries to use central banks as "piggy banks" to finance their fiscal policies. The resulting constraint on monetary policy, combined with increased public understanding of the costs of inflation, have led to institutional changes in central bank governance that bolster their credibility for maintaining price stability in the future. Thus, improved central bank performance and credibility are the consequences of this combination of factors.

In fulfilling its responsibility to protect consumers, the Federal Reserve will do all that it can to prevent fraudulent and abusive mortgage lending practices. Because information is critical to more competitive, and thus more efficient, markets, effective disclosure also has the capacity to weed out abuses. Consumers who do not have accurate information and an understanding of what that information means will have difficulty choosing among competing products and making decisions that are in their best interest. This is true in both credit card and mortgage markets.

Turning to inflation risks, the high level of resource utilization continues to have the potential to put additional upward pressure on inflation.  And, of course, higher oil prices and the possibility of further increases also pose an upside risk to inflation.  With these concerns in mind, the latest statement issued by the Federal Open Market Committee again highlighted the risk that inflation could fail to moderate as expected, and I believe that the risks to the inflation outlook are primarily to the upside.

Long-run inflation compensation derived from spreads between yields on nominal and inflation-indexed Treasury securities stood at 2.4 percent on May 30 (ten-year, adjusted for carry effect), in the middle of the range observed since the turn of the year.

The Federal Reserve will do all that it can to prevent fraud and abusive mortgage lending practices.  However, any new rules should be drawn clearly to avoid creating legal or regulatory uncertainty that could have the unintended consequence of restricting consumers' access to responsible subprime credit.  

Another area of possible financial risk that we are watching is leveraged lending.  Business borrowing for mergers and acquisitions and for corporate refinancing has been quite robust over the past few years as firms have taken advantage of relatively low interest rates to reduce their cost of capital.  As underwriters have brought these deals to the market, the good earnings of corporate borrowers and several years of very low defaults have encouraged lenders and investors to fund hundreds of billions of dollars in leveraged loans.  However, with this growth we are seeing some trends in the leveraged loan market that warrant closer monitoring:  Deals continue to be structured with thin pricing, more leverage, and looser covenants than is typical for non-investment-grade borrowers.  Further, originating banks are capitalizing on the strong investor demand for these loans by underwriting to distribute them, including through securitization, while holding only nominal exposures themselves. 

 Still, incoming data support prospects for an improvement in investment.  Orders and shipments of nondefense capital goods excluding aircraft rose in April for a second month.  In addition, business sentiment--as measured, for example, by the Institute for Supply Management survey of purchasing managers--has moved higher lately. 

We seek to promote the availability of consumer credit while ensuring that consumers receive the information they need to understand their options. Consumers who do not have accurate information and an understanding of what that information means will have difficulty choosing among competing products. Because information is critical to more competitive, and thus more efficient markets, more effective disclosure also has the capacity to weed out some abuses.

We must be careful, however, not to curtail responsible subprime lending or beneficial financing options for consumers. A robust and responsible subprime mortgage market benefits consumers by allowing borrowers with non-prime or limited credit histories to become homeowners, access the equity in their homes, or have the flexibility to refinance their loans as needed.

The simple risk-bucketing approach in the existing Basel I rule, for example, creates perverse incentives for risk-taking. This approach--in which (1) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, (2) all unsecured consumer credit card exposures are treated equivalently, and (3) almost all first-lien residential mortgage exposures are deemed equally risky--provides incentives for banking organizations to shed relatively low-risk exposures and acquire relatively high-risk exposures within each of these asset classes. The existing Basel I rule also ignores important elements of credit-risk mitigation--such as most forms of collateral, many guarantees and credit derivatives, and the maturity and seniority of an exposure--and thus blunts bank incentives to reduce or otherwise manage risk.

Most recently, supervisory guidance has emphasized the added dimension of risk when higher-risk loans are combined with other features--such as the use of simultaneous second lien loans in lieu of a down payment or the use of underwriting that involves little or no documentation of income or assets. Guidance has also underscored the safety and soundness and consumer protection concerns prompted by other underwriting practices often seen in subprime and nontraditional mortgage lending, such as excluding taxes and insurance in the underwriting process and allowing deferred repayment of principal by offering interest-only loans. Finally, this supervisory tool has been used to urge creditors to work with homeowners who are unable to make mortgage payments.

The safety and soundness of the U.S. banking and payments systems is critical to achieving economic growth, maximum employment, and general economic stability, and the Federal Reserve works closely with other regulators to achieve this goal. The Federal Reserve also has an important role to play in responding to and mitigating the impact of financial crises and shocks. If confirmed, I would continue to work vigorously to protect and promote the safety and soundness of the system.

 I would like to reinforce remarks made last week by Chairman Bernanke on the recent turbulence in financial markets.  In the United States we have seen a fairly sharp downturn in housing markets, and in recent weeks there have been growing investor concerns about mortgage credit performance, particularly with subprime mortgages.  If current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy.  And financial stress has not been limited just to mortgage markets, but has spread to other markets.  In general, a shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks. 

Clearly, banking supervision on its own can create some distortions or burden, so it is also very important to let market forces work as much as possible, with reliance on market participants--in their role as depositors, counterparties, creditors, and shareholders--to exercise discipline on banks.  Policymakers have to find the right balance between the more visible hand of government supervision and the invisible hand of market forces. 

As a final thought, I counsel policymakers and market participants alike to remember that no two crises are the same.  Recall that the Asian crisis of 1997-98 actually manifested itself differently across Asian countries, with each country having its own set of problems and needing to find its own solutions.  In other words, there is never a single remedy to each crisis and each brings its own surprises and risks.  Clearly, we can all learn a lot from past crises--which is the value in holding conferences like this one.  But we should not assume that past remedies will fully solve the next set of problems or address all future risks.  The key is to take lessons from the past and tailor them appropriately to future situations of potential distress.

In addition to providing consumers with better information, the Federal Reserve plans to exercise its rule-making authority under the Home Ownership and Equity Protection Act (HOEPA) to address unfair or deceptive mortgage lending practices. We plan to propose rules by the end of this year that would apply to subprime loans offered by all mortgage lenders. The practices that may be addressed involve prepayment penalties, stated-income lending, failure to require escrows for taxes and insurance, and making loans without regard to the borrower's ability to repay.    

As I mentioned earlier, one of the reasons that the price discovery mechanism has broken down in some U.S. markets in recent months is that a number of investors failed to exercise due diligence and relied on rating agency assessments.  That is, there was a lot of trust but not much verification.  I would suggest that the value of independent due diligence on the part of investors is especially high for newer and more-complex products compared with more traditional, familiar, and less-complex products.  

Importantly, the Federal Open Market Committee’s most recent action, the 50 basis point cut in the target federal funds rate in September, was an attempt to help offset the potential effects of financial market turmoil on real economic activity.  The breakdown in the price discovery process can, after all, have real economic consequences that the Federal Reserve should, in my opinion, consider when fulfilling its statutorily mandated goals of maximum employment and price stability.

[I]t is important that new laws carefully target lending abuses without unduly restraining responsible lending.  Getting this balance right is particularly critical now, as many borrowers facing rate adjustments may need to refinance into more affordable loans.  

To the extent possible, efforts should be made to avoid foreclosure. We encourage servicers to reach out to financially stressed homeowners, to make every effort to keep them in their homes. Lenders and servicers, for example, may be able to assist troubled borrowers by modifying the loan, deferring payments, extending the loan maturities, converting an adjustable-rate mortgage to a fixed-rate or fully-indexed loan, or capitalizing delinquent amounts. The best outcome is a loss mitigation strategy that results in a mortgage obligation that the borrower can meet in a sustained manner.

On the lender side, the originate-to-distribute model can leave lenders with weaker incentives to maintain strong underwriting standards. In particular, originators who securitize may inadequately screen potential borrowers unless investors provide oversight and insist on practices that align originator incentives with the underlying risk. The originate-to-distribute system is thus not only a potential source of risk to the financial system but also raises concerns regarding consumer protection.

Given the substantial number of resets from now through the end of 2008, however, I believe it would behoove the industry to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically.

Second, I believe that modernization of programs administered by the Federal Housing Administration, which has considerable experience helping low- and moderate-income households obtain home financing, could also help avoid foreclosures. FHA modernization could give the agency the flexibility to work with private-sector lenders to expedite the refinancing of creditworthy subprime borrowers and to design products that improve affordability through such features as variable maturities or shared appreciation.

Third, we must pursue initiatives to prevent these problems from recurring, and the Federal Reserve is making strides in this direction. ... For example, as I mentioned earlier, failure to escrow for taxes and insurance can lead to a situation akin to payment shock for borrowers. It is a common practice for these payments to be escrowed in the prime markets, and I see no reason that escrows should not be standard practice in the subprime markets too.

The supply of funds for subprime loans is likely to remain low for some time as investors gather information and reevaluate the risks.

Lenders and servicers generally would want to work with borrowers to avoid foreclosure, which, according to industry estimates, can lead to a loss of as much as 40 percent to 50 percent of the unpaid mortgage balance. Loss mitigation techniques that preserve homeownership are typically less costly than foreclosure, particularly when applied before default. Borrowers who have been current in their payments but could default after reset may be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable. Comprehensive data about how many loan workouts and modifications have actually occurred are not available, but some reports suggest that the numbers may be limited thus far.

Looking ahead, two considerations suggest that conditions for subprime borrowers have the potential to get worse before they get better. First, all indications are that housing activity is continuing to weaken. Incoming data in recent weeks show that sales and new residential construction have declined further. In such an environment, house prices in the aggregate are likely to remain sluggish for some time. Second, the bulk of resets is yet to come: On average, in each quarter from now until the end of next year, monthly payments for more than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset. That number is up from roughly 200,000 per quarter during the first half of 2007. Delinquencies and foreclosures are therefore likely to continue to rise for a number of quarters.

Recent market events highlight why a robust and independent assessment of risk on the part of banks is so important. The enhanced risk-sensitivity of the Basel II advanced approaches creates positive incentives for banks to lend to more-creditworthy counterparties and to lend against good collateral, by requiring banks to hold more capital against higher-risk exposures.  

Just as an analytical risk-management framework is fundamental to the safe and sound operation of large banking and financial institutions, it is also, I believe, essential for sound monetary policy-making. 

The Federal Open Market Committee recently announced that it will increase the frequency and expand the content of its economic projections.  A clear understanding of the risk-management framework should help improve the public's comprehension of these expanded announcements and thereby, I believe, improve the efficacy of monetary policy actions and the overall functioning of the economy. 

After all, as the Nobel laureate Niels Bohr once said (in a comment later attributed to Yogi Berra), "prediction is very difficult, especially when it's about the future."

Turning from the abstract to the concrete, the FOMC's decisions to ease policy at its September and October meetings were, in my view, governed in part by an attempt to manage the macroeconomic "tail risks" facing the U.S. economy.  To no small extent, stresses in financial markets contributed significantly to those macroeconomic risks.

A sequence of data releases consistent with the rough patch for economic activity that I expect in coming months would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate. 

Note:  Some hours after Gov. Kroszner suggested that further rate cuts might not be necessary, the chairman of the Senate Banking Committee, Chris Dodd,  told the press that he might not act on Kroszner's confirmation for a full term as governor until after the 2008 elections.

The recent market disruptions have dramatically underscored the importance of gathering and analyzing information about innovative products. When the price-discovery process for a product is disrupted, both investors and sellers need to engage in a period of information gathering, processing, and analysis in order to re-establish a market price. This can be a gradual process and one that results in fundamental changes to the market for the product.   

In the early days of the Chicago Board of Trade, in the mid-1850s, standardization took the form of creating “grades” or quality categories for commodities such as wheat, allowing for the fungibility of grains stored in elevators and warehouses, and breaking the link between ownership rights and specific lots of a physical commodity. Traders no longer needed to verify that a certain quantity of grain was of a sufficiently high grade because the exchange established a system of internal controls in the form of grain inspectors and a self-regulatory system to arbitrate disputes. The grain inspectors charged a set fee to certify the quality of the grain for any receipt traded at the board, a system with parallels to the mechanisms employed today by the rating agencies.¹

A second issue is the possible imposition of civil money penalties when the enforcement agencies find that there is a pattern or practice of violations. ... We would recommend that the amount of such civil money penalties, if imposed, be given a ceiling as well as a floor because of the market uncertainty that can be introduced by open-ended liability. We would also suggest that some discretion in the actual amount of the penalty, within such a range, be given to the enforcing agencies. This sort of flexibility in enforcement would help the agencies adjust the punishment to fit the infraction.

As the mortgage industry has diversified, increasing coordination among regulators has been helpful. In particular, our need to cooperate with state bank regulators has increased in importance, and we have responded to that need.

In trying to help homeowners, we must also be careful to recognize the existing legal rights of investors, avoid actions that may have the unintended consequence of disrupting the orderly functioning of the market, or unnecessarily reducing future access to credit. Provisions intended to immunize servicers from liability should be crafted to avoid creating moral hazard of parties disregarding their contractual obligations, which would ultimately have negative impacts for markets and consumers.

Because systematic approaches to dealing with troubled loans are often likely to lead to better aggregate investor returns than foreclosures, we are encouraged by industry efforts to pursue these approaches. When servicers modify loans, however, they may face potential litigation risk from investors because of their contractual obligations under the servicing agreements. One particular source of litigation risk, we understand, may be that different asset classes have conflicting interests. Therefore, we encourage ongoing industry efforts to agree to standards for addressing these issues. We are hopeful that the industry can resolve these conflicts on a consensual basis so that they do not preclude servicers from taking actions that are in the overall best interests of consumers and the industry.

...[E]ffective consumer protection can reduce uncertainty about the underwriting standards of, and hence, the value of, loans in mortgage-backed securities, thereby helping to revive and strengthen mortgage securities markets. 

Even an institution that was relatively untouched by recent events should remain vigilant about the next potential source of turbulence, to ensure that it is prepared to analyze information about its risk exposures and distribute that information throughout the firm. Going forward, therefore, senior management at financial institutions should ensure that they have complete and timely information about risk and demonstrate the ability and will to act on it. They should also be aware that the next crisis could come precisely in the area where they are most exposed or have weaknesses. That is, a certain degree of humility is wise, because all firms have a limited understanding of what might happen next.

Kroszner demurred on whether the U.S. economy is in recession.

"There are some challenges in the economy right now," he said.

On signs of inflation, he said, "We have seen some numbers in recent reports that are higher than they were before," but he added that the Fed must be careful to honor its dual mandate that includes ensuring maximum employment along with price stability.

From Q&A as reported by Market News International

Market participants must ensure that they do not make valuation decisions based solely on excessive reliance on external ratings or evaluations, but that they also undertake their own assessment. And I would suggest that the value of independent due diligence on the part of market participants is especially high for newer and more-complex products.

Obviously, there are some challenges in the economy right now and of course we're looking at that very, very carefully. I think it's very valuable that some of the concerns about the monoline insurers are being addressed by market participants.

From Q&A as reported by Reuters

Stress testing and scenario analysis can provide valuable information about the potential risks of complex investment products, but in many cases application of such tools to structured investment vehicles appears to have been inadequate.  For example, some bankers did not necessarily explore scenarios in which these vehicles' credit ratings could be downgraded... Notably, most of these vehicles mirrored the liquidity mismatch that exists at most banks in that they contained longer-term assets funded by shorter-term liabilities, but it is not clear that banks fully considered the potential funding-liquidity problems that these vehicles could face if there were sudden market moves or if perceptions of credit risk changed.  And they may not have fully explored scenarios in which problems with these vehicles could have ramifications for the bank, such as the need to provide liquidity support to the vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet. 

The TAF function, which I believe has had beneficial effects on financial markets to date, is expected to continue as long as necessary to address elevated pressures in short-term funding markets, and the Federal Reserve will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.   

Encouragingly, we have examples of some firms recognizing the potential risks of broad market disruptions, for example, if there were dramatic and unexpected price movements, or if market illiquidity set in.

In other words, it is good to have a few people within the institution who--to paraphrase a former Federal Reserve Chairman--know when to take away the punch bowl. Being the party pooper, however, can be very difficult in any organization, and that is why it is crucial for the risk manager to be known as an independent voice who is influential with top management and for top executives, of large or small firms, to set the appropriate "tone at the top" with respect to the importance of independent and unbiased risk evaluation

The proposed requirement to assess repayment ability is intended to protect consumers from abusive practices while maintaining their access to responsible credit. We recognize that satisfying both objectives at the same time is a challenge. The proposed rule's potential for consumer actions, coupled with its careful avoidance of prescribing quantitative underwriting thresholds, could raise compliance and litigation risk. In turn, this could raise the cost of credit for higher-risk borrowers or limit the availability of responsible credit. That is why we have proposed prohibiting a "pattern or practice" of disregarding repayment ability rather than attaching a risk of legal liability to every individual loan that does not perform. Some commentators have argued that the pattern or practice requirement creates a higher standard of proof that can make it more difficult and costly for consumers to pursue litigation. We have specifically sought comment on this provision and look forward to perspectives offered by the industry and consumer groups.

Despite the adverse developments in recent months, large U.S. banking organizations, in the aggregate and individually, have maintained capital ratios in excess of regulatory requirements, in part because of steps taken by many to replenish equity positions. Indeed, since last fall, large U.S. bank holding companies have raised more than $50 billion in capital. Although the U.S. banking system will continue to face a challenging environment, it remains in sound overall condition, having entered the period of recent financial turmoil with solid capital and strong earnings.

While improvements in both macroeconomic and microeconomic policies have helped to make some Latin American countries less vulnerable to outside shocks, the region is not decoupled from the United States and the rest of the world. As globalization has proceeded, Latin America is increasingly connected to the world through global capital flows and capital markets. Further improvements in both macroeconomic and microeconomic policies are imperative to maintain those flows and economic health, particularly in the face of global financial turbulence. One area that merits particular attention is enhancing the management of risk in financial institutions and markets in Latin America as well as emerging markets more generally.

To date, permanent modifications in this credit cycle episode, as in the past, have typically involved a reduction in the interest rate or an extension of the loan terms, while reductions of principal balance have been quite rare. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of situations known as negative equity positions in which the amount owed on the mortgage exceeds the current market value of the property. A distressed borrower with a negative equity position may have neither the means nor the incentive to remain in the home. In this environment, servicers and investors may well find principal reductions that restore some equity for at-risk homeowners to be an effective means of avoiding delinquency and foreclosure.

Although principal write-downs may be especially germane today given the prevalence of negative equity positions, they are not necessary or appropriate for all borrowers who have negative home equity or who become delinquent on their mortgage. On the contrary, a strategy of targeting write-downs to certain groups of borrowers may provide the best path forward. For example, one possibility would be to limit the availability of write-downs to those borrowers with high debt payment-to-income ratios and loan-to-value ratios significantly in excess of 100 percent before loan modification, but with the capacity to carry a written-down mortgage. In any event, it seems clear that principal reductions should be part of the tool kit that servicers and investors bring to bear as they deal with delinquent loans.

Separately, the GSEs--Fannie Mae and Freddie Mac--could be asked to do more. Recently, the Congress has greatly expanded Fannie Mae's and Freddie Mac's role in the mortgage market by temporarily increasing the conforming loan limits for these GSEs. In addition, their federal regulator, the Office of Federal Housing Enterprise Oversight, has lifted some of the constraints that were imposed on these entities because they have resolved some of their recent accounting and operational problems. Thus, now is an especially appropriate time to ask the GSEs to move quickly to raise more capital, which they will need to take advantage of these new securitization and investment opportunities, to provide assistance to the housing markets in times of stress, and to do so in a safe and sound manner. As the GSEs expand their roles in our mortgage market, there is a strong need for the Congress to move forward on GSE reform legislation, including the creation of a world-class GSE regulator.

With modernization and expansion, the FHA could play an important role in relieving stress in the mortgage and housing markets as well as in restarting securitization markets. Securitization markets are needed to help relieve capital stresses on banks and to provide more affordable mortgages to borrowers. To this end, more consideration needs to be given to how the FHA can scale up quickly and improve its processes and underwriting systems so that they are comparable in quality with those currently being used by Fannie Mae and Freddie Mac. In addition, providing the FHA with broad authority to offer innovative products that meet market needs and to outsource loan underwriting and other program elements to private-sector providers could allow the FHA to insure more mortgage borrowers and to do so more quickly. The FHA needs to be better able to compete in today's marketplace and it needs access to the best risk-management tools available when managing the risks to the government.

We have to be very sensitive to the needs of different communities, how different communities think about financing. Hopefully we can integrate everyone into a broader financial market and get lots of private-sector capital for this, to finance the immigrants, to finance the entrepreneurs.

From audience Q&A, as reported by Market News International. Kroszner was asked about Islamic finance; his answer was in the context of how to promote and allow it.

The migration toward sustainable mainstream capital sources is important in light of budgetary challenges facing governmental and philanthropic funding sources. For CDFIs to expand the scope and volume of their financing activities, they need to develop new products and innovations that tap more predictable sources of funding. Accessing the broad depth of the capital markets as a self-sustaining funding source for community development would yield enhanced benefits, such as more-efficient delivery of capital, greater funding and underwriting discipline, and reduced finance costs.

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

There is a striking parallel with the challenges for the re-emergence of the subprime mortgage market and the adoption of innovations in the community development investments market. To overcome the unease of the current financial markets and attract a new source of capital, new market entrants must make particular efforts to reduce the uncertainty associated with their investment opportunities. For the CDFI industry, the challenges that need to be addressed are improving information about these products, developing models of risk and pricing, and standardizing these contracts. Addressing these issues will be critical to jump-start sustainable private CDFI investments as well as to revive the subprime mortgage market.

As the Federal Reserve builds on  its consumer protection efforts in order to mitigate foreclosures for current homeowners, we are also concerned about the impact current mortgage market problems are having on individual communities.  The challenges of rising foreclosures are significant at the state and local level and the nature of the problem varies by location.  Through its structure, the Federal Reserve System is attuned to local issues, which both informs its national policymaking and allows for responses tailored to local conditions. 

Legislative initiatives that would allow the Federal Housing Administration to increase its scale to reach a wider range of borrowers and develop appropriate underwriting and pricing methodologies to deal with any increased risk and another that would strengthen the oversight of Fannie Mae and Freddie Mac are important compliments to our regulatory efforts to strengthen the housing markets.

Events of the past year have shown that institutions should never let their guard down when it comes to risk management.  Even though most of the high-profile losses during the past year have--so far--stemmed from market and credit risks, one should not, therefore, assume that less attention should be paid to operational risk management.  The Basel II capital framework is a positive step forward through its combination of more risk-sensitive capital requirements with strong incentives for improved risk management.  In this manner, we expect Basel II to make the U.S. banking industry more resilient in the face of future financial turbulence and generally more safe and sound.     

As market participants take steps to foster greater transparency and to reduce the complexity of structured credit instruments, I believe that recovery and repair in the mortgage markets will take hold over time. Moreover, as financial institutions strengthen risk-management practices and as supervisors ensure that the necessary actions are taken, I expect the financial system as a whole to become more resilient.  

We have taken some very strong steps to make sure that people have flexibilty thats necessary to deal with re-financing, to deal with the potential payment shock that can come from an interest rate reset.

From Q&A as reported by Market News International

This is an important and extremely valuable time to be thinking on what is the best role for individual (financial) regulators; how can we best go forward and have the most effective regulatory system. 

I think certainly the supervision and regulation function that we (the Fed) have has been very important in providing us with the information and the expertise to be able to understand financial market developments and respond quickly both to individual institutions and more broadly to market developments.

From Q&A as reported by Market News International

There were many different factors that led to a certain frothiness in the housing market, and these varied from region to region. There were a lot of local factors, not just national ones.

From Q&A as reported by Market News International

[Companies need risk managers who] know when to take the punch bowl away from the party.

From audience Q&A as reported by Bloomberg News.

Challenges in the financial markets will continue. We do see some improvement in many markets. We continue to be very watchful, very mindful of how the markets are evolving.

From Q&A as reported by Reuters.

My central tendency forecast is for the majority of markets to stabilize toward the end of this year and the beginning of next year, though in some regions it will take much more time.

From Q&A as reported by Market News International and Reuters

As market participants take steps to foster greater transparency and reduce the complexity of structured credit instruments, I believe that recovery and repair in the mortgage markets will take hold over time. Moreover, as financial institutions continue to attract capital and strengthen risk-management practices, and as supervisors ensure that banks take the necessary actions, institutions will become more resilient to shocks, and the overall financial system will be more robust as a result.    

When consumers are fully aware of and understand product terms and features, they are better positioned to make the right choices and achieve the outcomes most appropriate to their given circumstances, as well as give the signals and rewards to businesses that produce the products and services consumers most value. However, some product features and contract terms may be so complex that they are not readily understood. In some instances, even small misunderstandings, misjudgments, or the challenge of focusing on the most essential features of a product can lead to serious problems down the road. This is one reason why financial education and literacy efforts are essential to enabling consumers to navigate our complex consumer financial marketplace.  

I would like to underscore the Federal Reserve's commitment to preserving and supporting minority depository institutions.  I look forward to continuing our constructive dialogue on finding the best and most practical ways to address the challenges that these banks confront.  I am confident that we will be successful in ensuring that these companies remain strong and continue to provide critical financial support to their communities. 

By now I believe it has become clear that the initial assessment that the United States had decoupled from the rest of the world was incorrect, and that, in fact, the global economy remains closely connected by both trade and financial linkages.    

Some observers have concluded, first, that the United States is able to borrow on highly advantageous terms to finance its external deficits and, second, that the United States receives a much higher return on its foreign investments than other countries receive on their investments in the United States. Some novel theories have been developed to support these interpretations. Recent work by Federal Reserve staff, however, has shown that one need not resort to such exotic explanations to understand the behavior of the international accounts. Instead, a careful look at the published data reveals that differences in the three characteristics of U.S. claims and liabilities that I just discussed--returns, composition, and size--contain the key to understanding these apparently anomalous results and, hence, that the United States faces a “reality” similar to that of other countries.

(T)he ongoing fundamental transformation in financial services offers great potential opportunities for those institutions able to integrate strategy and risk management successfully, and I will argue that survival will hinge upon such an integration in what I will call a "strategic risk management framework."

...

Over the past year there have been a number of studies analyzing the causes of the current turmoil, which include shortcomings in the risk management practices of financial institutions.² It is absolutely clear that many financial institutions need to undertake a fundamental review of risk management. They now realize that ignoring risk management in any aspect of the banking business usually creates problems later on. Risk management shortcomings need to be addressed not only to improve the health and viability of individual institutions, but also to maintain stability for the financial system as a whole.

Over the past year, there have been a number of suggestions for possible statutory changes in U.S. financial services regulation, so bank directors must be prepared for whichever outcomes such changes might imply for the regulatory structure in the United States. For example, the Congress may wish to undertake legislative action to effect regulatory changes, or there may be changes to the existing authority and responsibility of certain regulatory bodies. In any event, there will likely be some type of adjustments in regulatory structure simply given the changes in the financial services landscape. Given the fluid situation in which we find ourselves today, bank directors and senior management in their strategic planning have to anticipate a range of potential outcomes in the regulatory sphere in both the short and long term.

(W)hile credit supply concerns are real, the weakened state of the economy appears to be the more serious challenge facing most small businesses in the current environment.  Importantly, there is some evidence that concern over access to credit is relatively stronger at larger businesses.

Some critics of the CRA contend that by encouraging banking institutions to help meet the credit needs of lower-income borrowers and areas, the law pushed banking institutions to undertake high-risk mortgage lending. We have not yet seen empirical evidence to support these claims, nor has it been our experience in implementing the law over the past 30 years that the CRA has contributed to the erosion of safe and sound lending practices.

...

Two key points emerge from all of our analysis of the available data. First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA- related loans appear to perform comparably to other types of subprime loans. Taken together, as I stated earlier, we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis.

(I)n principle, mortgage securitizations make good economic sense: By providing access to the broad capital market, securitization allows loan originators to access a wider source of funding than they can obtain directly. In addition, securitization can limit an originator's exposure to prepayment risks associated with interest rate movements, to geographic concentrations of loans, and to credit and funding risks associated with holding mortgages all the way to maturity. Effectively, securitization can significantly lower the cost of extending home loans, and some of those cost savings can be passed along to homeowners in the form of lower mortgage rates.

The paucity and inaccessibility of data about the underlying home loans was, in my opinion, one of the reasons that private-label MBS was able to expand so rapidly in 2005 and 2006 despite a deterioration in underwriting and prospective credit performance. That is not to say that better data would necessarily have led investors to completely sidestep the private-label MBS that have caused them so much difficulty. But I do think it was a significant hindrance that the information needed to infer, in real time, the extent to which subprime and alt-A mortgage underwriting was sliding simply did not exist in a form that allowed the widespread scrutiny or objective analyses needed to bring these risks more clearly into focus.

Thus, I believe that markets for private-label MBS are unlikely to recover unless comprehensive and standardized data for home mortgage pools are made widely available to market participants.

In the simplified world of an introductory economics class, a market brings together the potential buyers and sellers of a product to negotiate prices and quantities... While this stripped-down story is remarkably powerful in its essential predictions about the behavior of markets and economic agents, it leaves the operation of the market itself as a mystery.  Any real-world market must deal with at least two fundamental questions:  first, how do the buyers and sellers find one another?  And second, how can buyers be assured that sellers will deliver as promised, and that the goods will be of the quality and value that the buyer expects?  To understand how markets deal with the fundamental issues of transaction costs and information costs is an important and enduring challenge for economists.

In times of widespread distress, many counterparties may have to sell assets simultaneously to post margin.  This occurrence can potentially lead to a situation in the market in which assets are sold quickly and below their fundamental values.  When many counterparties are forced to liquidate similar assets, prices for those assets are pushed down.  If these assets are used as collateral on other positions, then the decline in value leads to additional margin calls.  This set of circumstances, in turn, forces further liquidation and price declines.  A widespread use of rating triggers can accelerate this downward slide, with further losses in asset values triggering additional downgrades and requirements to post collateral and liquidate positions.  Recent events have demonstrated this potentially destabilizing dynamic at work.

Financial crisis can serve as a powerful stimulant to the evolution of market mechanisms, and I expect that the aftermath of the present turmoil will see both innovation and incremental refinement to quality assurance in credit markets and in counterparty credit risk management.  I would like to highlight two themes that I believe will influence this process.

First, for quality assurance to be effective, some of the products traded in financial markets have to become simpler and more transparent.

...

A second key factor for effective quality assurance relates to the institutional and contractual framework for ensuring future performance on financial transactions, namely counterparty credit risk management.  Counterparty credit risk management should be focused on its effectiveness in different market situations and its implications for financial stability.

...

(I)t is not just the banking industry, but also those of us in the public sector who have some key lessons to learn.  Banks and supervisors alike need to undertake additional work to facilitate the building of robust methods of quality assurance in the financial markets that will help to restore and maintain confidence.  Ensuring that banks exercise good risk management, of course, is an important job for bank supervisors, which includes overseeing their ability to properly capture the risks in the markets in which they operate, as well as their ability to conduct appropriate stress testing to explore potential consequences of different types of market distress.  Doing so requires that supervisors themselves develop a strong understanding of the value, limits, and potential harms associated with banks' attempts to protect their exposures.