To avoid these outcomes altogether, some believe that the Federal Reserve should treat financial stability itself as a goal. Often that is seen to imply a preference by policymakers for the perpetuation of existing financial institutions and products. That is not a view I share. The level of economic activity would invariably be lower if financial stability alone were our guiding light; protecting incumbents at the expense of innovators would prove detrimental to the long-term vibrancy of the economy. We should be extremely wary of protecting financial institutions and their various stakeholders from incurring losses. Such actions distort asset prices and critically impair the efficiency of capital allocation. The desire for well-functioning markets does not require us to insulate asset prices or individual financial institutions from the buffeting of the marketplace.
Liquidity and well-functioning financial markets
Now, let me briefly highlight a key attribute of well-functioning financial markets: they function best when they attract sufficient liquidity. In previous remarks, I advanced the notion that liquidity can be thought of as roughly comparable to investor confidence.5 Liquidity exists when investors are confident and willing to assume risks. And liquidity persists when risks are quantifiable and investors are creditworthy.
To trace the origins of recent financial markets turmoil, let's recall a time when the environment was more benign and financial markets were flush with liquidity. This does not require a long memory, as it aptly characterized our capital markets just four months ago. In early June, I remarked that:
There is little doubt, then, that liquidity in most financial markets is high today and that investors seem willing to take risks, even at today's market- prevailing prices. In the United States, term premiums on long-term Treasury yields are very low, corporate bonds appear to be nearly “priced for perfection,” and stock prices are setting new records. Credit markets are highly accommodative for issuers, and the volume of loans to finance highly leveraged transactions is escalating rapidly. 6
These financial market conditions were, in part, I argued, the consequence of a long period of remarkably supportive macroeconomic conditions, the acceleration in financial innovation, particularly the growth of structured finance products, and the continued export of the culture of capitalism to emerging-market countries. Taken together, confidence fostered the continued propagation of new securities, new products, and new markets. Not surprisingly, liquidity was ample.
Did success sow the seeds of distress?
So, what could go wrong? In times of abundant liquidity, investors that were no longer comfortable with their financial positions could readily sell their holdings. Similarly, financial institutions could distribute the securities they originated with few constraints. Like others who had grown increasingly watchful about the ebullience in the financial markets, I wondered whether the risks were being given their due:
These prices, terms and credit conditions may reflect solid economic fundamentals – low output and inflation uncertainty, healthy corporate balance sheets, and corporate profits that exceed market expectations –
Kevin Warsh (2007), "Financial Intermediation and Complete Markets," speech delivered at the European Economics and Financial Centre, London, June 5, www.federalreserve.gov/newsevents.
Warsh, "Financial Intermediation and Complete Markets."
BIS Review 104/2007