Financial Stability News

Flashing news about financial stability and central banking

Greenspan and IMF on the robust financial system before the crisis

I am back at Levy after a week or so in DC. Interesting meetings with Fed, Treasury and FDIC. They sure did not have high regards for the Volcker rule – which is sort of old news. The news are currently filled with news about Europe, but reading some of Paul Krugman’s older posts today on what Very Serious Persons said before the crisis, I found this hilarious quote from a 2005 speech by Greenspan:

Historically, banks have been at the forefront of financial intermediation, in part because their ability to leverage offers an efficient source of funding. But in periods of severe financial stress, such leverage too often brought down banking institutions and, in some cases, precipitated financial crises that led to recession or worse. But recent regulatory reform, coupled with innovative technologies, has stimulated the development of financial products, such as asset-backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk.

Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection.

These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.

This may look amazing today, as we have been through AIG, Lehman, Citi, and the rest. But the truth of the matter is that many, if not most policymakers (at least central bankers) at the time believed in this free market, flexible economy paradigm.

Krugman’s story reminded me of an IMF report back in 2005 that discussed financial stability issues and the need to educated the household sector so that they could take a more direct responsibility for their own financial future (read: manage their debt). Quote:

During the last 20 years or so, policymakers and standard setters in many industrialized countries have successfully implemented policies designed to improve the resiliency and stability of systemically important institutions, such as banks. To differing degrees, similar policies have been or are being designed to do the same with regard to insurers and, more importantly, to public and private pension systems. In numerous countries, in response to many of the public and private actions to de-risk banks, insurers, and pensions discussed in this and previous issues
of the GFSR, the financial risk profile of households is likely to be changing at this time. Overall, there has been a transfer of financial risk over a number of years, away from the banking sector to nonbanking sectors, be they financial or the household sector. This dispersion of risk has made the financial system more resilient, not the least because the household sector is acting more as a “shock absorber of last resort.” But at the same time, these new recipients of financial risks must learn how to manage the newly acquired risks.

OK, “made the system more resilient by transferring risk to non-bank sector”! Well, it turned out that risk transfer did not really make the system much more stable. And if you happen to be left in the household sector, your net worth (consolidated with your pension and insurance funds) have taken a real beating so far.

If anything, this should make some VSP (Very Serious Persons) a bit more humble about risk transfers and financial stability?


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