15 April 2008

Fed Governor on post-crisis financial architecture

The business models of many large financial institutions are in the process of significant re-examination and repair, Governor Kevin Warsh said. A changing paradigm of financial intermediation may well be on the horizon, with old business models in the process of being upended.

Outlining the evolution and possible consequences of the financial turmoil, the Govenor noted that credit is now “threatening to displace liquidity as the primary antagonist” with a credit crunch posing “meaningful downside risks” to the economy. While short-term credit markets are showing “some encouraging, early signs of repair,” Mr. Warsh says, restoring confidence will take time and patience.

“Some believe the story of the current market turmoil began in August, and will end when the housing market stabilizes”, he said. “But, in my view, the narrative actually began in a seemingly more benign time with underpinnings more fundamental than the value of the housing stock. Financial institutions and other market participants grew increasingly dependent on the extraordinary liquidity around them. When liquidity faltered, the weaknesses of the existing architecture abruptly revealed itself.”

As a consequence, Warsh expects changing forms of financial intermediation. “Investment banks may reconfigure capital structures and core trading businesses to maximize benefits in a higher volatility environment”, he said. “Asset-gatherers, whether in the form of traditional money-management firms or hedge funds, that survive this time of testing may rely more on term funding and seek equity returns across beaten-down classes of structured and debt products. And dependable, recurring revenues, even at lower levels, may warrant a premium valuation in the public markets.”

A new financial architecture, born of the forces of creative destruction, is early in the process of construction, he said. But for the new paradigmatic architecture to be enduring, market-supplied liquidity must come to predominate.”

Full speech

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