Timothy F Geithner: Changes in the structure of the US financial system and
implications for systemic risk
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, to the Federal Reserve Bank of Chicago Conference: Systemic Financial Crises -
Resolving Large Bank Insolvencies, Chicago, 1 October 2004.
* * *
My compliments to Michael Moskow for putting together this conference and for bringing together this
formidable group of talent on systemic banking crises.
There are those who regard this type of enterprise - that of strengthening the regime for managing
financial failures - as misdirected. Some think focusing on bank resolution is like devoting resources to
redesigning the morgue rather than improving the hospital. Some think that by preparing to deal with
crises you make them more likely. I think the wiser judgment is the contrary. In this area at least, if you
want peace or stability, it's better to prepare for war or instability.
I think this is particularly important for us in the United States. Although we have a rich history of
banking crises in our past, and have watched other countries confront such crises more recently, it's
been some time since we've experienced the prospect or the reality of a systemically significant bank
failure in this country. It is important that knowledge among practitioners of this art of bank resolution
does not fade with time and is not dulled by the comfort of the relative stability and financial resilience
we have been fortunate enough to enjoy over the past decade and more.
I want to reflect tonight on the changes in the structure of the U.S. financial system of the last 20 years
or so, and what implications these have for the nature of systemic risk. For those of us who are
responsible for thinking about the overall stability of the financial system, the questions we face are, of
course, broader than the potential insolvency of a large bank and the most appropriate resolution
methodology. They include not just how to make the system better able to withstand the failure of a
major bank or financial enterprise built around a bank, but also how to better withstand the failure of a
major non-bank financial intermediary or a systemic liquidity crisis that may or may not arise from a
solvency problem at a large supervised financial institution.
The central bank of the United States was legislated into existence in the wake of the banking crises of
the early 20th century. And the framework that evolved in the decades that followed was directed
specifically at dealing with the special risks posed to banks and by banks to the economy as a whole.
Changing market structure
Let me highlight a few of the changes in the financial structure that are germane to the mandate of the
Federal Reserve. They are:
•
The greater systemic importance of a smaller number of large bank-centered financial
institutions;
•
The greater role played by non-bank financial institutions;
•
The growth of the GSEs;
•
Greater operational demands on the core of the clearing and settlement structure;
•
An increase in the complexity of risk management and compliance challenges; and
•
The extent of global financial integration.
These are not all that new, and not all are unique to the United States, but taken together they are
significant.
Most conspicuously, we have seen the emergence of a small number of very large, complex,
bankcentered financial institutions that now account for a substantial share of the assets and liabilities of
the U.S. banking system. The top five domestic bank holding companies now hold about 45 percent of
banking assets, almost twice the share as they did 20 years ago.
The earnings capacity of these very large banking institutions, the absolute size of their capital
cushions, and the diversity of their activities, geographic and functional, should make them less
vulnerable to specific shocks and better able to absorb larger shocks than has been true in the past. In
other words, the core of the U.S. banking system should be more stable in the face of a broader range
and greater magnitude of shocks. However, the increased size and scope of these entities necessarily
exposes them to a wider array of potential shocks and risks and means that the failure of one of them
could have a broader impact than in the past and be considerably more difficult to resolve. The
implications of such a failure would almost certainly fall outside of the range of experience captured in
conventional models.
At the same time, despite their size and scale, banks now account for a smaller share of financial
intermediation in the United States than was true in the past. Depository institutions now hold about
one fifth of all assets held by financial institutions, or less than half of what they did in 1984. This crude
comparison understates the importance of banks in the credit origination process and wholesale
financial markets, but the broad picture it paints of the increased role of non-bank financial
intermediaries is still noteworthy. To put it differently, financial intermediaries that are not subject to
consolidated risk-based capital frameworks and the full complement of supervisory constraints applied
to banks and bank holding companies, now account for most of the assets of financial institutions in
the United States.
There has also been substantial convergence in the types of financial transactions bank-centered and
non-bank affiliated financial intermediaries perform. This translates into a more competitive and more
innovative financial system, one that is more flexible and resilient, with weakness in one part of the
system more likely to be offset by a capacity for expansion elsewhere. And, because their overall risk
profiles are likely to differ from banks, the greater importance of non-bank financial intermediaries, and
of the capital markets more generally, offsets some of the potential concern associated with
consolidation in the banking system.
Within the universe of non-bank financial intermediaries, there are other material changes worth
noting. Let me highlight three. First, the role of the major investment banks in the United States as
market makers and providers of liquidity in a broad range of foreign exchange, securities, and
derivatives markets has continued to grow over the past decade, as has the international importance
of these firms. These institutions are now key participants in the domestic and international clearance
and settlement processes associated with these activities.
Second, a sustained period of rapid growth in the major mortgage GSEs has left us with two very large
financial institutions, whose balance sheets and associated off-balance sheet positions today account
for a much larger share of the U.S. mortgage market than was the case a decade ago. This means
that the credit and market risks associated with the home mortgage business in the U.S. are now in
some respects more concentrated. It means that the actions taken by the GSEs to manage interest
rate risk can have a substantial impact on interest rate volatility. And, it means that the exposures of
major banks and investment banks to these GSEs is larger than in the past, measured relative to
capital, and large relative to other major counterparties.
Together, these changes mean there are a larger number of non-bank financial intermediaries
operating outside the supervisory safety and soundness framework established for banking
organizations, that are sufficiently large or integral to the financial system that their failure or
anticipated failure could have major implications for the functioning of the markets in which they
operate and their financial institution counterparties.
And third, hedge funds now play a more substantial role in the U.S. financial system. They are a
significant source of liquidity in some markets. They play an important role in making our financial
markets more efficient. And they are likely in some circumstances to help markets equilibrate more
quickly in conditions of stress, as was the case in the summer of 2003, when they helped meet a
substantial increase in mortgage-related hedging demand from banks and the GSEs. Assets managed
by hedge funds have grown very rapidly, more than doubling since 1998 to current estimates in the
range of one trillion dollars. Gross credit exposure and potential future credit exposure to hedge funds
as a group are probably larger today relative to the capital of banks and investment banks, although
also likely more diversified. Overall leverage seems lower relative to 1998, and may not look that high
relative to banks and investment banks, but leverage is hard to measure and the quality of the data is
not very good. While hedge funds are large enough to provide meaningful efficiency and liquidity
benefits to some key markets, they are also large enough that the failure of a major hedge fund or
number of funds could have a significant impact directly and indirectly on the major banks and
investment banks in the United States.
Within the clearance and settlement infrastructure, economies of scale have led to high levels of
concentration in some areas. Two institutions together now handle the vast majority of clearing
business for U.S. government securities and the associated triparty repo market in which over
$1 trillion turns over twice each day. The dramatic increase in the volume of transactions handled by
the core parts of the payments infrastructure places substantially greater demands on the operations
of those institutions. Moreover, many of the major payment and settlement utilities operate across
national boundaries, raising complicated questions for the appropriate allocation of oversight
responsibility.
Alongside these changes in the relative size of institutions and in market structure, financial innovation
has led to a dramatic increase in the complexity of the risk management challenge. The frontier of
financial innovation inevitably advances somewhat ahead of improvements in the risk management
and clearing infrastructure. The models used to assess risk in the more novel areas of finance are, by
definition, less grounded in experience and less valuable in anticipating how prices and correlations
change in conditions of stress. Consensus on the appropriate accounting treatment is less well
established. With the dramatic increase in the scope of operations of the major financial institutions,
the challenge of pulling together an integrated risk management framework that captures exposures
across the entirety of the firm is much greater.
The potential for conflicts of interest and opportunities for fraud are greater, placing significant burdens
on internal compliance regimes. The changes in regulation and technology that have increased the
opportunities for risk transfer mean that more risk may end up in parts of the financial system where
supervision and disclosure is weaker and in parts of the economy less well able to manage it.
And finally, we have seen substantial growth in the integration of national financial systems. Indeed, a
number of foreign and foreign-owned banking organizations are among the largest financial
institutions in the U.S., with operations here that run into the hundreds of billions of dollars, and in
some cases representing the majority of their global assets. The major U.S. banks and investment
banks are more global in the scope of their operations, and their affiliates are a major presence in
many of the countries in which they operate, in some cases with a larger share of financial activity than
they have in the U.S. market. Payments and clearing arrangements are increasingly transnational in
scope. But, the legal and supervisory frameworks for financial activity are still national, and are likely to
remain so for the foreseeable future. And despite the development of a much more intensive and
extensive network of cooperation among supervisory and regulatory and enforcement authorities, and
movement toward an ever-higher standard of convergence in key elements of the regulatory structure
across jurisdictions, the regime is inevitably uneven, with different standards across jurisdictions and
therefore continuing opportunities for regulatory arbitrage.
Implications
These broad developments alter the hierarchy of systemic concerns for the U.S. authorities. The
greater systemic importance of a smaller number of large bank-centered financial institutions, the
greater role played by non-bank financial institutions, the growth in the GSEs, the greater operational
demands on the more concentrated core of the clearance and settlement infrastructure, the dramatic
increase in the complexity of the risk management and compliance challenge, and the extent of global
financial integration - these developments change the nature of the potential sources of stress to the
financial system. They change how stress is transmitted. And they change the impact of tools we use
to mitigate risk ex ante and to contain the broader financial and macroeconomic fall-out of financial
distress.
These developments can have both positive and negative impacts. In many respects, they help to
reduce risk. In some ways, they increase risk. On balance the positive aspects dominate the less
positive. Shocks may act more quickly, but they can be more easily diffused and absorbed. Institutions
and markets seem better positioned to handle a substantial degree of stress. Shocks may be less
likely to result in the type of trend amplifying, self-reinforcing dynamic for sustained periods of time that
can threaten the stability of the financial system.
But it is important to recognize that that we do not know a lot about the underlying dynamics of
financial crises in the context of the evolving financial system I have described. It is also worth
reflecting on the fact that the favorable judgment of U.S. financial resilience at present is rooted in a
period of lower overall volatility in macroeconomic outcomes, with lower inflation and less variability in
inflation, and shorter and shallower recessions. Financial innovation has brought about a dramatic
increase in the opportunities for diversification and risk transfer and in the sophistication of risk
management, but it is unlikely to have brought an end to the periodic tendency of markets to
experience waves of mania and panic. The systemically significant financial institutions are larger and
stronger than in the past, but they are not invulnerable, and the impact of a failure would be greater.
And it would be imprudent to expect that the lower overall magnitude of recent macroeconomic shocks
that has contributed to lower volatility in growth and inflation outcomes will be with us indefinitely.
What are the implications of these changes for how we think about managing systemic risk in the
United States? Let me touch on five broad areas, though these cover only part of the landscape of the
financial stability agenda.
First, it is important that the standards applied to the largest financial institutions at the core of our
financial system are calibrated to reflect their systemic relevance. Relative to the standards
appropriate for a smaller financial institution with a similar risk profile, capital should be targeted to
achieve a greater proportional ability to absorb shocks and thereby attain a lower ex ante probability of
failure. This makes it important that management of these large firms maintain an ample capital
cushion over and above the high regulatory thresholds. Similarly, the funding and liquidity
management framework needs to provide a larger buffer against potential shocks. The internal risk
management regime - for credit and market risk, operational risk, compliance risk - needs to meet a
more exacting standard. The requirements for operational resilience for technology systems are
necessarily more demanding. Because of the broader implications of a failure for the financial system
and for the economy as a whole, the supervisory framework for the largest systemically significant
banking organizations, as well as the firms themselves, needs to produce a higher level of financial
soundness than might be indicated by measures of economic capital or expected by shareholders and
creditors of the institution.
This is important for banks and financial institutions built around banks because of their access to the
safety net and their special role in the payments system. Our approach at the Fed seeks to achieve
this outcome for the major institutions for which we are the consolidated supervisor. But the basic
argument for applying exacting standards for risk based capital, for liquidity management, and for
operational resilience applies to a broader range of supervised and regulated financial institutions
whose operations pose significant systemic implications for the financial system.
This is particularly compelling in the case of the major GSEs, where the regulatory framework, capital
regime and sophistication of the internal risk management framework need to be upgraded to a
standard more commensurate with their risk profile and the risks they present to the system.
It is as compelling in the case of the institutions - a number of them specialized financial utilities - that
make up the core of the payments infrastructure. Here, because of their overall importance to the
functioning of our financial system, we are working to encourage improvement in operational
resilience, to ensure they meet the recently updated international standards for risk management and
internal financial resources, and to strengthen the oversight framework.
It is important to note that the SEC has itself outlined a framework that would provide a form of
consolidated supervision of the major investment banks with a risk-based capital framework based on
Basel II. It's not clear at this point how the SEC's regime will work in practice, but it seems to offer the
prospect of some evolution in the regulatory framework for investment banks in the direction of
convergence with those that apply to bank holding companies. That is, the proposed new CSE regime
will add a consolidated approach to risk based capital and an intensified focus on the risk
management regime to the traditional SEC focus on enforcement of laws directed at investor
protection and market integrity.
A second point is that it is important that those who run financial institutions calibrate the strength of
the internal risk management architecture to the more complicated nature of the risks they confront.
Even with the major improvements in capital, earnings capacity, and in the sophistication of the risk
management framework, there remain many aspects of the changing financial environment which
pose ongoing challenges for management.
The degree of concentration at the core of the financial system means that financial institutions have
to think more carefully about the implications of the failure of a major counterparty or clearing
organization. The increase in the combined weight of the highly leveraged financial institutions as a
group highlights the importance of both strong counterparty risk management disciplines in managing
direct credit exposure, and understanding the impact a disorderly exit would have on other positions
held by the firm. The uncertainty about how markets respond in conditions of acute stress - uncertainty
in terms of how correlations behave, how much liquidity will be available, the risk profile of
counterparties, etc., combined with the inherent uncertainty about the probability of a seemingly
remote event, and the scale of losses associated with such an event, all argue for a more prudent
cushion against risk than would be necessary in a less complex and more certain state of the world.
Third, our approach to financial stability relies a lot on market discipline and, as a result, depends
significantly on the quality of accounting and public disclosure. We see some progress in the extent to
which firms provide a clear picture of their underlying risk profiles, but there is room for improvement.
Accounting standards have notably struggled with the challenges of incorporating innovations in
financial instruments, especially when those instruments are used to offset the risks inherent in more
traditional activities whose fluctuations in value have not typically been recorded in earnings or in
balance sheet valuations. It is hard to see how we can be comfortable that we have achieved a
reasonable resting place on these issues. In the long run, it is critical for the cause of market discipline
that accounting and disclosure of financial instruments be consistent with the ongoing direction of
innovation in risk management.
And finally, the broad changes in market structure place a much higher premium on cooperation
among supervisors, market regulators, and central banks, both nationally and internationally.
Unlike other countries who have moved to integrate supervisory responsibility for banks, investment
banks, and insurance companies, the U.S. has preserved a model with multiple bank supervisory
agencies and separate functional regulation of entities that are banks, securities firms, and insurance
companies. And unlike those that have separated supervisory authority from the monetary policy and
lender of last resort functions, the U.S. has kept them integrated within the central bank. Across the
major economies, therefore, we face somewhat different cooperation challenges within our markets.
We believe the U.S. model has worked quite well, and these differences in the design of the overall
supervisory framework and its relationship to the central bank are likely to persist. But we share an
important interest in working together across borders to help ensure that we have a framework for
cooperation that matches the increased integration of national financial markets. This is important for
the supervision of international banks as well as for other global financial institutions. It is important for
the payment and settlement infrastructure. And it is important for how we operate together in crisis.
The efforts of the Basel banking supervisors are particularly important in this context. While their
efforts have long emphasized the value of international supervisory cooperation, the improved Basel II
framework raises the bar even further, putting the need for supervisory coordination squarely on the
table if Basel II is to be implemented effectively for a global bank.
Conclusion
Let me conclude by emphasizing the obvious importance of the quality of macroeconomic policy
management to the stability of the financial system. It probably is possible for a country with an
exceptionally virtuous fiscal and monetary policy framework to experience a systemic financial crisis.
But most financial crises involve a shock whose origins lie in the realm of macroeconomic policy error,
often magnified by the toxic combination of poorly designed financial deregulation and an overly
generous financial safety net. Probably the most important contribution policy makers can make to
financial stability is to avoid large monetary policy mistakes or sustained fiscal and external
imbalances that increase the risk of large macroeconomic shocks, and to try to ensure that policy
reacts with sufficient speed and force in the face of those shocks we are unable to avoid.