Timothy F Geithner: Systemic risk and financial markets
Testimony of Mr Timothy F Geithner, President and Chief Executive Officer of the Federal
Reserve Bank of New York, before the Committee on Financial Services, US House of
Representatives, Washington DC, 24 July 2008.
* * *
Good morning, Chairman Frank, Ranking Member Bachus and other members of the
Committee. Thank you for giving me the opportunity to testify today.
I very much welcome the opportunity to appear before you with Chairman Cox of the
Securities and Exchange Committee (SEC). The Federal Reserve and the SEC are working
very closely together in navigating through the present challenges, and my colleagues at the
Fed and I very much appreciate his, and his colleagues', support and cooperation.
The U.S. and global financial systems are going through a very challenging period of
adjustment. The critical imperative today is to help facilitate that adjustment and to cushion
its impact on the broader economy. The forces that made the system vulnerable to this crisis
took a long time to build up, and the system will need some time to work through their
aftermath.
Looking forward, the United States will have to undertake substantial reforms to the
framework of policy, regulation and oversight of the financial system. There was a case for
reform before this crisis. The regulatory framework in the United States was designed in a
different time for a very different type of financial system than the one we have today.
Nonetheless, many observers believed that this framework, although messy and complex,
worked reasonably well. It is harder to make that case today.
The financial system plays a vital role in long-term economic growth by helping to efficiently
allocate the resources of savers to those individuals and firms with ideas and the capacity to
put those ideas into action. And the financial system plays a critical role in economic stability
by affecting the capacity of the real economy to withstand shocks and the ability of
macroeconomic policy to mitigate the impact of those shocks.
The challenge is in achieving the right balance between efficiency and resilience, between
innovation and stability. Our financial system has many strengths, and we need to examine
ways to build on those while making the system more resilient to future shocks. Achieving
this balance will involve a very complicated set of policy choices. Until we get through this
crisis, it will be hard to make definitive judgments about the appropriate scope and nature of
the changes that will be necessary.
Any reform must offer the prospect of a substantial improvement in outcomes relative to
potential costs. And those trade-offs will have to be evaluated against, among other things,
the potential distortions created by differential treatment across regulated and unregulated
entities, the magnitude of the tax imposed on the overall level of financial intermediation, and
the extent of the safety net and the potential for moral hazard.
I would like to offer some observations, from my perspective at the Federal Reserve Bank of
New York, on some of the broad considerations that should guide this process.
Changes to the structure of the U.S. financial system
It is useful to start with a brief review of the changes in the structure of the financial system
that should motivate reform.
Our system was once organized around banks-defined narrowly as institutions that take
deposits and make loans. Over time there has been a gradual but pronounced decline in the
share of financial assets originated and held by banks, and a corresponding increase in the
share of financial assets held across a variety of non-bank financial institutions, funds and
complex financial structures.
The lines between banks, investment banks and other institutions have eroded over time, as
have the lines between institutions and markets. Loans made by both banks and non-banks
were increasingly sold by the originating institution and packaged into securities. And these
securities were repackaged into even more complex instruments and products, many of
which resided off the balance sheets of the major financial institutions.
Innovations in credit derivatives over this period made it easier to trade and hedge credit risk.
Access to credit was extended on a dramatic scale to less creditworthy borrowers, without a
commensurate increase in the risk premiums on the securities that embedded this more risky
credit. Risk accumulated in institutions that operated at the margin of the explicit safety net,
such as mortgage affiliates of thrifts, structured investment vehicles and the GSEs.
These changes within U.S. financial markets were complemented by a rise in global financial
integration as technology and deregulation made it easier for savings to flow across
international borders.
As a consequence of this basic evolution of our financial system, a large share of financial
assets ended up in institutions and vehicles with substantial leverage, and in many cases
these assets were being funded with short-term obligations. And just as banks are vulnerable
to a sudden withdrawal of deposits, these non-banks and funding vehicles are vulnerable to
an erosion in market liquidity when confidence deteriorates and concerns about default risk
increase.
These changes in the structure of the financial system were probably not the only causes of
the financial boom that preceded this crisis, but they may have amplified the dimension of the
boom and they were important to how the crisis unfolded and to how policy has responded.
In many respects, financial innovation over this period outpaced the system's capacity to
measure and limit risk, to manage the incentive problems in the securitization process and to
provide for an appropriate degree of transparency through meaningful disclosure. Once the
performance of the underlying assets began to deteriorate, these weaknesses in the system
magnified the uncertainty about the scale of potential losses and added to the intensity of
pressures that accompanied the crisis.
The growth in leverage and liquidity risk outside of banks made the system vulnerable to a
sharp erosion in liquidity, but without the protections established to limit the risk of classic
bank runs. The large share of financial assets held in institutions without direct access to the
Fed's traditional lending facilities complicated the ability of our traditional policy instruments
to contain the damage to the financial system and the economy.
This crisis provides a stark illustration of how hard it is for a supervisory and regulatory
framework designed principally around banks to contain the impact of financial shocks in a
manner that mitigates the risks to the broader economy.
Elements of reform
What broad principles and objectives should guide reform?
I would like to outline some of the key elements of a stronger framework of regulation and
oversight, and identify some of the harder questions we will need to answer to implement this
framework. These questions are more fundamental than questions of the allocation of
responsibility across supervisors, market regulators and central banks and thus must be
resolved before turning to those questions. I focus here on the issues related to financial
stability, and do not try to address the equally important areas of consumer and investor
protection, market integrity or the role of the government-sponsored entities in housing.
I believe the most important imperative is to build a financial system that is more robust to
very bad outcomes and more resilient to shocks. This means (1) a system in which the major
institutions are less vulnerable to shocks; (2) a system that is less vulnerable to margin
spirals and a generalized pull-back in liquidity and funding; and (3) a system that is more
able to withstand the effects of failure of a major financial institution.
Looking past the immediate crisis, a more resilient system must be built on stronger and
better designed shock absorbers, both in the major institutions and in the infrastructure of the
financial system.
At the level of the financial institution, the key financial shock absorbers are capital and
reserves, margin and collateral, liquidity, and the risk management and control regime.
Financial stability starts with ensuring that individual institutions in periods of expansion and
relative stability hold adequate resources against the losses and liquidity pressures that can
emerge in economic contraction or instability.
For the infrastructure of the financial system, these shock absorbers include the resources
held against the risk of default by a major market participant across the set of private sector
and cooperative arrangements for the funding, trading, clearing and settlement of financial
transactions.
Simplifying and consolidating the regulatory architecture will be instrumental to these efforts
by establishing a common framework of rules, clear responsibility and authority, and by
reducing opportunities for arbitrage. Through close coordination across central banks,
supervisors and market regulators, we need to adopt an integrated approach to the design
and enforcement of capital standards and other prudential regulations critical to systemic
stability. In this context, prudential supervisors, working with those responsible for setting
accounting standards and capital market regulations, need to systematically examine the
interaction among capital, accounting, tax and disclosure requirements to assess their effects
on the overall levels of leverage and risk across the financial system.
As we change the framework of regulation and oversight, we need to find ways to strengthen
market discipline over financial institutions, and to limit the moral hazard that is present in a
range of different forms in any regulated financial system.
The liquidity tools of central banks and the emergency powers of other public authorities
were created in recognition of the fact that individual institutions, including those central to
payments and funding mechanisms, cannot protect themselves fully from an abrupt
evaporation of access to liquidity or ability to liquidate assets. The existence of these tools
and their use in crises, however appropriate, creates moral hazard by encouraging market
participants to engage in riskier behavior than they would have in the absence of the central
bank's backstop. To mitigate this effect on risk-taking, strong supervisory authority is
required over the consolidated financial entities that are critical to a well-functioning financial
system.
A more resilient financial system will also require a framework for dealing with the failure of
financial institutions. For entities that take deposits, we have a formal resolution framework in
place. As Secretary of the Treasury Henry M. Paulson, Jr., Federal Reserve Chairman Ben
S. Bernanke and others have stated, we need a companion framework for facilitating the
orderly unwinding of other types of regulated financial institutions where failure may pose
risks to the stability of the financial system.
The elements I just outlined need to be accompanied by a clearer structure of responsibility
and authority over the payments system. Payment and settlement systems and central
counterparties play a critical role in financial stability. Our current system is overseen by a
patchwork of authorities, with responsibilities diffused across several agencies in a manner
that leaves significant gaps. We need a more formal and integrated framework of oversight,
one that establishes and enforces standards and continuously monitors the conditions in
these markets.
And finally, as we adapt the U.S. framework, we have to work to bring about a consensus
among the major economies on a complementary global framework. Given the level of
financial integration globally, we cannot achieve a reasonable balance at home between
efficiency and stability, without a complementary framework of supervision and regulation
across the other major financial centers.
To make it operational, the framework I just laid out will require a complicated set of choices.
•
What level of conservatism should be built into future prudential regulations over
capital and liquidity?
•
Which types of institutions should be subject to these requirements?
•
Can direct regulation over a limited set of institutions effectively protect the system
from distress among the unregulated?
•
How should responsibility for different dimensions of financial regulation be
allocated, and how centralized or decentralized?
•
What institutions should have access to central bank liquidity under what
conditions?
The role of the Federal Reserve
The Congress gave the Federal Reserve broad authority to address risks to financial
stability. Because the financial landscape has changed so substantially, many observers
have pointed out the need to revisit the scope and nature of Federal Reserve's authority.
Secretary Paulson has outlined a number of important proposals for reform, many of which
would broaden the responsibility and the authority of the Federal Reserve. I want to identify
some issues that are critical to our current responsibilities and will be important in defining an
appropriate role in the future, with the most effective mix of responsibility and authority.
There is more continuity than change in these suggestions, and they assume, as is the case
today, that we will have to work closely with other functional supervisors to make the system
work.
First, the Fed has a very important role today, working in cooperation with bank supervisors
and the SEC, in establishing the capital and other prudential safeguards that are applied on a
consolidated basis to the institutions that are critical to the proper functioning of financial
markets.
Second, the Fed, as the financial system's lender of last resort, should play an important role
in the consolidated supervision of those institutions that have access to central bank liquidity
and play a critical role in market functioning. Our ability to directly oversee the risk profile of
these institutions is essential to our capacity to make the judgments necessary for using our
lender of last resort tools, including critical judgments about liquidity and solvency for
individual institutions and for the system as a whole. Those judgments require the knowledge
that can only come from a direct, established role in supervision. And replacing our ongoing
role as consolidated supervisor with stand-by, contingent authority to intervene would risk
exacerbating moral hazard and adding to uncertainty about the rules of the game.
Third, the Federal Reserve should be granted explicit responsibility and clear authority over
systemically important payment and settlement systems, and the ability to continue to
encourage broader improvements in the over-the-counter derivatives markets.
Fourth, the Federal Reserve Board should have an important consultative role in judgments
about official intervention where there is potential for systemic risk, as is currently the case
for bank resolutions under FDICIA.
And, finally, the responsibilities for market and financial stability that are accorded the Fed in
current and any future legislation will require that the Fed adopt a more comprehensive
approach to financial supervision and market oversight. Given the changes in the structure of
the financial system, maintaining financial stability requires us to look beyond just the stability
of individual banks. It requires us to look at market developments more broadly, at the
infrastructure that is critical to market functioning, and at the role played by other leveraged
financial institutions.
Over the past four years, the Federal Reserve has led a number of initiatives with our
supervisory colleagues in the United States and in the other major financial centers to
improve the OTC derivatives infrastructure, to strengthen the systemically important payment
and settlement systems, to improve counterparty risk-management practices with respect to
hedge funds, and to place greater emphasis on ensuring robustness to low probability, high
severity instances of stress. This forward-looking, cross-institution approach, integrating
prudential supervision with market oversight and payment system expertise, offers the best
model of broad financial oversight focused on systemic risk.
I want to emphasize in conclusion that we are working now, in close cooperation with the
SEC, other U.S. bank supervisors, our international counterparts and market participants to
improve the capacity of the financial system to withstand stress. These initiatives include joint
efforts with the SEC to bolster consolidated oversight of the investment banks, formalized in
our recent Memorandum of Understanding. These institutions have made substantial
changes over the past several months to bring down overall leverage and risk-weighted
assets and to reduce liquidity risk. In addition, we have undertaken a broad based program
of initiatives to build a more robust over-the-counter derivatives infrastructure through,
among other measures, a central clearing house for credit default swaps; to strengthen the
financial cushions held by central counterparties against the risk of default by a participant;
and to reduce vulnerabilities in secured funding markets.
These initiatives will take time, but we expect to see substantial progress over the next two
quarters.
I look forward to your questions today and working with you as we move ahead in building a
more effective financial regulatory framework for the United States.
Thank you.