## Mr McDonough discusses the role of central banks in the global financial markets
Remarks by the President of the Federal Reserve Bank of New York, Mr William McDonough, before the Economic Club of New York, New York City, on 14/12/98.
Good evening, ladies and gentlemen. I am delighted to be here tonight and to share the with my good friend Dick Grasso. Dick and I have worked together for many years now, have come to value greatly both his warm friendship and his thoughtful counsel.
Dick has spoken eloquently about how equity markets have developed globally over the several years and some of the concerns he has going forward. For my part, I will foc global debt markets and the interests of central banks in the stability of these markets
The role of central banks in the fixed-income and related capital markets may not be im obvious because, one can argue, debt markets are a zero-sum game. One side of a trad what the other loses. If only it were as easy as that! In fact, trading in the globa serves an important purpose and it does not follow that central banks have no inter stability of these markets. Quite the contrary. Central banks are and should be deeply about the functioning of these markets, their dependability, their liquidity, and their Before explaining why I hold such a view, and therefore why we at the Federal Reserve concerned when these markets faltered this past summer, I would like to stand back f moments and highlight how the global capital markets have changed over the past s decades.
No one doubts that there has been a sea change in the global capital markets in recent the ways business is transacted in these markets. These changes are, of course, root remarkable technological advances we have been witnessing. Today, the technology processing information and making this information widely available has fundamentally the way the world channels saving into investment. No longer does the global econom primarily on loans from commercial banks to meet its financing and investment needs. more than ever before, the global economy of today looks to funds from the fixed-inco related capital markets to intermediate its credit needs.
Because the global capital markets have become so important in the credit interme process, the economic well-being of us all depends on the orderly flow of funds in thes The flow of these funds, in turn, increasingly relies on price signals generated by tra that takes place daily in these markets. The reliance on secondary market trading discovery constitutes the fundamental difference between funds from securities marke loans from banks.
Let me be a bit more specific. In securities markets, investment decisions are driven that arise from a trading process that reconciles differential information from a dive investors. In bank loans, investment decisions are based on the bank's private informat specific borrowers. While a bank makes its own investment decisions, securities markets the consensus of a multitude of investors.
When securities markets work well, they provide efficient ways of aggregating informat allocating risks among a wide range of investors. In order to function well, howev markets require a trading infrastructure. This infrastructure may consist of an ex network of brokers and dealers, and a clearing system. These markets also rely on a relatively well-informed investors, who confidently judge asset prices and take positi
strength of their judgments. If the trading infrastructure fails or investors lose conf will grind to a halt.
The global fixed-income markets are unlike equity markets. In equity markets, everyone something about the trading infrastructure, which is centralized in exchanges. Thus, t question as to the focal point of trading information. But the importance of fix markets, which are multiple-dealer, over-the-counter markets, is sometimes hard to ap because they are so decentralized.
In the United States, the bond market is where companies have been raising most of the in recent years. During the last ten years, for example, U.S. nonfinancial corporations net amount of $785 billion in the form of bonds, three times the net amount they borro banks. Over this same period, these companies as a group spent $600 billion more to ret - through buybacks and mergers - than they raised in new offerings.
Accompanying these increased levels of debt market activity has been a continuous pro financial innovation. This innovation has served to unbundle different kinds of risk an to enlarge the menu of risks that investors may choose to bear. For example, interestfutures and options help reconfigure various interest-rate risks. Total return swaps spread options are tools for reallocating the payment risks primarily of emerging mar Credit-default swaps and credit-linked notes are ways to redistribute default risks.
In practice, this unbundling of risk means that a broad range of financial institu performs the credit intermediation process, eroding the historical comparative adva banks in bearing credit risk. At various times, some institutions will be underwrit while others will be making bridge loans, providing credit enhancements, writing de contracts and taking up riskier components of securities.
Within the United States, the fixed-income market is today a market of some $13 t roughly the same size as the total equity market. Trading activity in fixed-income ins concentrated in Treasury securities. On an average day, over $150 billion in Treasury changes hands, about seven times the value of stocks traded daily on the New York Exchange.
All of this trading activity serves the very important function of price discovery. Mo other securities market in the United States, the Treasury market responds forcefull information about macroeconomic fundamentals. The days when the most intense trad activity takes place are also the days when major reports are released on such indicat economic performance as the employment report, the consumer price index or the producer index. These releases allow market participants to digest important new information review their expectations about where the economy is going. The interest rates on securities of varying maturities are the market's most important signals about economy's prospects for growth and risks of inflation.
In the rest of the fixed-income market, trading in corporate bonds, mortgage-backed s and sovereign debt also serves the price discovery process. This trading activit differentiate, for example, a triple-A risk against a triple-B risk, the prepaym mortgages against the prepayment risk of credit card receivables, and OECD country risk emerging market risk.
What then is the role of central banks in this new financial landscape, where in investors and other nonbank financial institutions hold a larger share of assets and a
of credit risk than they ever have before - and where an increasing share of conventio risk is intermediated through the capital markets? I would argue that the role of a cen this new environment is very much in keeping with its traditional responsibilities. Ce in all countries fundamentally care about the flow of credit in their economies, wh credit flows from banks, nonbank financial institutions, or institutional investors.
Why is this so? The answer is simple. It is because the credit intermediation process i what determines how well our economies function and therefore how well our economies able to grow and allow their citizens to prosper. When the credit intermediation proces work well, when there are disruptions to the supply of credit to the economy, as hi amply shown, the costs for our businesses and our people can be enormous in terms of output and fewer jobs. A well-functioning credit intermediation process is, in short, c sustainability of any economy's success.
It is for these reasons that central bankers are interested in the flows of credit f securities markets, just as we have needed to know about the flows of credit from t whose operations we are charged with overseeing. At the end of the day, the flow of cr securities markets has the same impact on our respective societies as that from banks. central bankers have an obligation to understand the nature of these flows and the risk raise. Crucial to our obligations to our citizens is the need to be certain that these work smoothly and that credit flows efficiently from those most willing and able to bea to those most able to put the funds to good use. This is as true for the United State any other country, developed or developing.
Does this mean that central banks believe that capital markets should be supervised in ways banks are overseen? Clearly the answer to this question is no. This is not our role
In my view, central banks broadly have two main responsibilities with respect to the g markets. The first is to enhance the price discovery process by promoting transparenc own actions. The second is to ensure that the banks, as providers of liquidity, per proper role in supporting the trading process by making sound credit decisions.
In the United States, the Federal Open Market Committee or FOMC has a pronounced effec the fixed-income market, both through its policy decisions and in the way the Federal conducts monetary policy. Indeed, an important part of the price discovery process anticipation of the Federal Reserve's future actions. Because the Federal Reserve i critical player in the market, it is important that it not create unnecessary uncertain Federal Reserve has a responsibility to be as transparent as possible in the cond monetary policy. Since February 1994, there have been direct and immediate announcem following FOMC meetings of the Committee's policy decisions, which, in my view, have he remove uncertainty.
In addition, in implementing monetary policy through its trading role, the Open Market made numerous changes in recent years to add clarity and transparency to its day-to-da interventions. The thrust of these changes has been to reduce uncertainty and enhance discovery process in the Treasury market.
As to the Federal Reserve's responsibility for ensuring that banks support the trading making sound credit decisions, let's not forget that, despite the increase in market pl in the United States, as elsewhere, continue to play an extremely important role in th markets. Not only do banks often underwrite bond issues and structure hedging instrume
these bonds, but they also provide much of the financing that allows market makers positions. Dealers in the U.S. bond markets finance themselves through repurchase agr with bank counterparties. In many cases, banks are also the source of backup liquidit these ways that bank credit supports the price discovery process.
In its role as a bank supervisor, the Federal Reserve has the responsibility to see t credit support does not dry up at critical times. One of our primary tasks is to be nothing interferes with the credit intermediation process of banks. This is why bank so so important to us.
The events of last August illustrate what can go wrong with financial markets and why so concerned when the global credit markets seemed to seize up following the announceme the Russian government of an effective devaluation of the ruble and a debt moratorium actions were so unexpected that they shocked investors all over the world.
In the United States, the correction of stock prices in the wake of Russia's announce not of exceptional size or concern, and had even been anticipated by some astute obser the abrupt and simultaneous widening of credit spreads globally for both corporate and market sovereign debt was an extraordinary event beyond the expectations of investo financial intermediaries. The abrupt shift in investor behavior, in fact, served to i movements and to undermine confidence in market dynamics. It was not just the rebalanc portfolios that was of concern in the days and weeks following the Russian govern announcements, but also the rush away from risk altogether. In short, it was this seizi credit intermediation process that was of most fundamental concern to us as central ban
What we learned as a result of this experience was, among other things, that years of h on fixed-income market yields and spreads could not have anticipated the size of the mo in credit spreads that in fact occurred in August and September. We also learned tha that did not previously move together can suddenly do so, that trends that were under several years can abruptly come to an end, and that spreads that have been consistent for years can suddenly widen. In the wake of these events, we have become all too aw liquidity can be illusory - that individual traders may be able to exit a position wh but that not all traders can exit their positions at the same time. For many, these been humbling.
Going forward, it is important to bear in mind that there most certainly will be furth when the credit intermediation process is disrupted, when we will face other threats t being of our market positions, our institutions and the global economy. These risks nature of the intermediation process itself.
As the global capital markets continue to grow and become ever more sophisticated - as they will - what is most important for us as central bankers is to operate with a disci of priorities. It is clear that we as central banks cannot be responsible for any singl any single bank or any single financial institution. Nor can we control the function global debt markets or become the regulators of all financial market intermediaries.
What we as central bankers can do, however, is to understand the dynamics of the glob markets - how they are evolving and whether they are sufficiently liquid and transparen also ensure that banks perform their proper role in supporting the trading process thro sound credit decisions. Furthermore, we can enhance the price discovery process by pr transparency in our own actions. Finally, and most importantly, we can help create cond
our own economies that will support sustainable, non-inflationary growth. In these way central banks can encourage the efficient functioning of the credit intermediation pro countries, and in so doing, promote the welfare of the world economy, of which we are al