New York Fed president Tim Geithner, who hasn't been shy about warning about financial risks from financial market innovation, doesn't seem too concerned that problems in the subprime mortgage market will spread and cause wider disruptions. Here's part of a longer speech:
Credit Markets Innovations and Their Implications, by Timothy Geithner, NY Fed President: ...The latest wave of credit market innovations has elicited some concerns about their implications for the stability of the financial system, concerns similar to those associated with earlier periods of rapid change in financial markets. Will the most recent credit market innovations amplify credit cycles, contributing to "excessive" lending in times of relative stability, and then magnify the contraction in credit that follows? Will they introduce greater volatility in financial markets? Will they create greater risk of systemic financial crisis?
These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector. It will take some time before the full implications are understood and the full impact can be assessed. As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole.
Indeed, economic theory and recent practical experience offer some reassurance against both these specific concerns and more general worries about the implications of credit market innovations for the performance of the financial system. ...
There are ... compelling arguments in favor of a generally positive assessment of the consequences of innovation. Does experience provide support for these arguments, or are these changes too new for us to know? ...
We are now well into the third decade of experience with the consequences of these earlier innovations, and this history offers some useful lessons for evaluating the probable impact of the latest changes in credit markets.
The ease with which the U.S. financial system absorbed the substantial scale of corporate defaults that peaked in recent years in 2002 provides some support for the argument that broader and deeper capital markets make the system more resilient. In general, there does not seem to be strong empirical support for the proposition that derivatives increase volatility in financial markets. ...
Credit market innovation does not appear to have resulted in a large increase in leverage in the corporate sector, as some had feared. ...
Default rates do not appear to have risen, nor recovery rates fallen as these credit innovations have spread, despite concerns they might lead to excess lending, the mis-pricing of credit risk and more messy and more complicated workouts, resulting from the greater diffusion of the investor base.
And although the sources of the broad moderation in GDP volatility observed in the United States over the past two decades are still the subject of debate, the fact that this moderation occurred during a period of extensive innovation in credit and other financial markets should provide some comfort for those who expected the opposite.
Innovations in credit markets are inevitably accompanied by challenges. Indeed, the history of innovation in financial markets provides many examples of periods of rapid change accompanied by fraud and abuse, by challenges in assessing value and risk, by concerns about the adequacy of investor and consumer protection, and by unexpected behavior of prices, defaults and correlations. To some degree, these types of problems are the inevitable consequence of change and innovation.
Although recent experience as well as theory provide some reassurance..., these judgments require qualification. Some aspects of this latest wave of innovation are different in substance ... from their predecessors. ... [B]road changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.
What should policymakers to do mitigate these risks?
We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.
The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure. ...
The Federal Reserve is actively involved in a range of efforts... The stronger these shock absorbers, the more resilient markets will be in the face of future shocks, and the more confident we can be that banks will be a source of strength and of liquidity to markets in periods of stress and that the financial system will contribute to improved economic performance over time.
Here's more from the Fed from the last few days:
Update: See also "Toothless Fed, Part 2 (Risk Management Shortcomings)" from Yves Smith at naked capitalism.