Timothy F Geithner: Hedge funds and derivatives and their implications for the
financial system
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Distinguished Lecture 2006, sponsored by the Hong Kong Monetary
Authority and Hong Kong Association of Banks, Hong Kong, 14 September 2006.
* * *
I want to thank Joseph Yam for inviting me to Hong Kong for this occasion.
We are approaching the 10-year anniversary of the financial crises of 1997-99. Those crises were
remarkable both in the scope of countries and markets they affected, and for their speed and severity.
The circumstances leading up to the crises varied across countries and regions, as did the magnitude
of the resulting damage to the real economy. But each of these events had one dynamic in common -
the confluence of a sharp increase in risk perception, and the subsequent actions taken by financial
institutions and investors to limit their exposure to future losses. As asset prices declined and volatility
increased in response to increased concern about risk, firms moved to call margin, to reduce positions
and to hedge against further losses. These individual actions had the aggregate effect of inducing
even larger price declines and further heightening perceptions of risk, ultimately propagating and
amplifying the effects of the initial shock.
The dynamic I just described was not unique to the crises of the late 1990s, nor was the damage to
overall economic activity they left in their wakes. Systemic financial events with spillovers to the real
economy have been a persistent feature of the economic environment, and both financial market
participants and policymakers have grappled with the challenge of how to reduce their incidence and
to minimize their severity, longevity and impact on the broader economy.
There is a lot we do not understand about these challenges, but we know more today than we once
did. In the case of the crises of the late 1990s, despite the broad-based nature of the financial market
turmoil, in countries where capital cushions in the financial sector were strong relative to risk, where
there was a greater diversity of institutions in the financial system to absorb the losses, and where
monetary authorities were in a position to provide liquidity to restore confidence, the financial and
macroeconomic impact of the crises was relatively modest. Where those conditions did not exist, the
damage was acute.
The U.S. economy appears to have become more resilient to financial shocks. Over the past two
decades, the U.S. economy has experienced several episodes of significant financial market strain.
These episodes were associated with spikes in risk perception and significant market volatility within
financial markets, but none proved exceptionally damaging in terms of the overall macroeconomic
impact. The mild impact of these episodes on the real economy contrasts with financial events such as
the "credit crunch" that exacerbated the 1990-91 recession. That episode was characterized by a
widespread reduction in the provision of credit by banks in response to loan losses and the need to
raise capital.
The resiliency we have observed over the past decade or so is not just good luck. It is the
consequence of efforts by regulatory, supervisory and private financial institutions to address previous
sources of systemic instability. Risk management has improved significantly, and the major firms have
made substantial progress toward more sophisticated measurement and control of concentration to
specific risk factors. What seems to have been most critical in preventing financial market turmoil from
translating into a significant reduction in credit provision by banks and other financial institutions were
the steps taken by regulatory authorities and financial institutions alike to strengthen capital in the core
of the financial system, and to measure and manage risk.
These efforts have most notably manifested themselves in increased levels of risk-adjusted capital in
the core of the system relative to what prevailed in the early 1990s. In the United States, for example,
tier-one risk-based capital ratios have stabilized near 8.5 percent, considerably higher than the
estimated levels around 6.5 percent for the early 1990s. This is based on a relatively crude measure of
risk, but the direction of the improvement is right and the magnitude of the change is significant.
Relative to the conditions that prevailed in the early 1990s, the higher levels of capital in the core now
provide a larger buffer against shocks and enhance the ability of the banking industry to act as a
critical stabilizer in times of stress by providing liquidity to the corporate sector. When financial markets
dry up, firms turn to banks and their unused loan commitments and lines of credit. Banks are in a
position to fund this liquidity because transaction deposits tend to flow into the banking sector. In times
of crisis, it appears that U.S. investors now run to banks, not away from them.
In view of the critical role that efficient credit provision plays in economic growth and development, the
benefits to the global economy of getting the underpinnings of a stable, efficient financial system in
place are substantial. At the same time, we also know that these important markets are susceptible to
certain "market failures," such as information asymmetries, incentive conflicts, moral hazard and
agency problems. By at times distorting incentives to manage risk, these market imperfections can
alter credit decisions and lead to a higher overall level of risk-taking than may be optimal for the
economy as a whole. This provides the classic rationale for supervision and regulation. Supervision
and regulation have the potential to help mitigate these sources of market failure. The recognition of a
market failure does not mean, of course, that policymakers have the capacity to design solutions that
can effectively mitigate those failures without raising others problems.
The fundamental challenge for policy is how to achieve the appropriate balance between efficiency
and financial resilience. With too much government intervention, innovation is constrained and the
system is stifled. With too little, the probability of systemic crisis may rise to levels that are
unacceptably high. We judge the appropriate balance not against the standard of whether it reduces to
zero the probability of a major financial crisis, the failure of a large individual financial institution or a
major reduction in asset prices. That is not an appropriate objective of policy. Some vulnerability to
crisis is a necessary and unavoidable feature of a dynamic and efficient financial system where asset
prices need to be able to adjust to changes in fundamentals. The consequences of trying to induce
regulated financial institutions to self-insure against all conceivable potential risks would do substantial
damage to the level and efficiency of economic activity and cause the same risks to migrate to other
institutions.
This leaves policymakers with a set of normative questions, the answers to which must be based on
knowledge about how markets work, as well as a substantial degree of judgment about what policy
actions are likely to be both appropriate and effective. What level of exposure to very low probability,
extreme adverse events should we be comfortable living with? What fraction of that residual exposure
to the potential range of adverse events can and should the official sector try to protect the system
against?
The apparent success that market participants and supervisors have had so far in confronting these
issues does not imply that the potential for systemic risk in financial markets no longer deserves the
attention of central banks and supervisors. Although improvements in capital adequacy and
riskmanagement tools seem to have been a key part of the increased resiliency we've seen in recent
years, we can't assume that the standards and risk-management practices consistent with stability in
the recent past are the ones that will perform well in the future. This is partly because it is impossible
to know for sure how the favorable macroeconomic conditions and the financial sector stability
interacted and reinforced each other. That is, would financial sector outcomes be as favorable in a
weaker macro environment?
But probably more important is the fact that even as we have pushed forward on regulatory,
supervisory and risk-management efforts, financial markets, instruments and institutions have
continued to evolve as well. Among the most notable of these changes has been the rapid growth and
innovation in derivatives and the greater relative importance of private leveraged financial institutions,
such as hedge funds.
The changes in credit markets that have accompanied the latest wave of innovation in derivatives and
the large role played by leveraged financial institutions in those markets may exacerbate some of the
traditional sources of challenges in financial markets. And they present new challenges for the
framework of incentives and constraints that central banks and supervisors set for financial institutions.
On balance, we believe these changes in the financial environment are likely to come with substantial
benefits in terms of overall market efficiency. In the remainder of my remarks today, I will highlight
some of these benefits, but will also consider some of the challenges they present for central banks
and governments in determining where on the spectrum of efficiency and vulnerability to crisis the
financial system should operate, and in crafting the policies consistent with achieving that objective.
Changes in financial markets since the late 1990s
In the United States and the other major markets, the policies designed to mitigate the risk of financial
crises rely primarily on a capital-based system of supervision of the major financial institutions,
reinforced by measures to improve market discipline. These policies have evolved to reflect both the
fundamentally important role credit markets play in the economy, as well as the reality that these
complex markets are susceptible to a range of potential market failures.
In thinking about the potential supervisory and regulatory challenges presented by the broad evolution
of the financial system over the past decade, it makes sense to first consider how some of these
changes may have enhanced market functioning by mitigating at least some of the imperfections that
characterize these markets. My remarks here are a mix of what we see happening in practice and how
we might expect things to work in principle.
To begin with, financial institutions within the regulated core of the financial sector have become
larger, and the industry considerably more concentrated. The 10 largest bank holding companies now
hold roughly half of banking assets, compared to less than a third in 1990. These institutions now
operate with greater geographic scope and offer a broader range of financial products, but overall
volatility of earnings has not changed much relative to capital.
Hedge funds, private equity funds and other leveraged financial institutions control increasingly large
shares of aggregate financial capital and play very active roles in many asset markets and in credit
markets. Although assets under management in hedge funds still represent a relatively small share of
total financial assets, their relative share has increased significantly and their ability to take on
substantial leverage magnifies their potential impact on financial market conditions. These private
leveraged funds have become an important source of protection to regulated institutions by being
large sellers of credit insurance in the rapidly growing market for credit default swaps.
In terms of enhancing overall market efficiency, the growth of these private leveraged institutions can
be expected to provide benefits in terms of improved liquidity, price discovery via arbitrage, diversity of
opinion and diversification opportunities for investors. The increase in the share of assets managed by
private pools of capital devoted to arbitrage activity should improve the overall functioning of markets.
In most circumstances, increased trading and participation contributes to market liquidity and makes
markets less volatile. The ultimate benefit should be lower risks for all market participants. This in turn
should reduce the risk premia associated with holding financial assets, and ultimately reduce the cost
of capital.
The rapid growth in the relative importance of these leveraged financial institutions has been
accompanied by a number of structural changes as well. The total number of funds has grown
dramatically. There are more very large hedge funds and private equity firms. Greater
institutionalization, and the maturity of risk management and operational infrastructure in the largest of
these private funds, has likely reduced operational risk. To the extent these changes have increased
the diversity of firms and strategies in this part of the financial system, and this is hard to measure with
any confidence, this heterogeneity should provide diversification opportunities, foster more efficient
price discovery and could help improve stability.
These changes in market participants have occurred in conjunction with a dramatic acceleration in
number and type of derivative instruments. These developments have likely had the important impact
of allowing for a more efficient distribution and more effective management of risk.
All of these changes should move the market in the direction of fostering the efficient allocation of
credit and capital formation, and thus enhancing the economy's real growth potential.
The available evidence is consistent with the view that the changes in the core of supervised
institutions, growth of the leveraged sector and rapid financial innovation have strengthened the
efficiency and resiliency of the overall financial system. As I mentioned at the start, a broad range of
recent financial shocks do not seem to have adversely impacted the real economy. The international
financial crisis that began in 1997 did not spillover to the nonfinancial sector in the United States. The
equity price collapse and deterioration in credit in 2000 did not cause significant damage to the core
institutions in the U.S. market. The relatively limited damage caused by operations failures of the 9/11
attacks reflected the strength of the capital position of major intermediaries, as well as the policy
actions by the Federal Reserve to provide liquidity to the markets.
More recently, the series of smaller financial shocks experienced since 2001, including the corporate
bond defaults after 2001, the corporate accounting scandals in 2002, credit downgrades in the U.S.
automobile industry in 2005, the failure of Refco, the sharp declines in mid-2006 in equity, commodity
and emerging markets debt prices caused little contagion to other markets and limited strain on
financial institutions.
Challenges
The favorable balance between efficiency and resilience in the financial system we have observed
recently does not of course guarantee we will achieve as favorable a balance in the future. The
prospects for future stability will depend in part on how effective supervisors are in adapting policies in
response to the ongoing evolution in markets.
Financial institutions face strong incentives to monitor and limit their risk profile and the risk-taking of
their leveraged counterparties to some efficient level where benefits balance costs at the margin. This
is good for the firm and also good from society's perspective.
Private pools of capital have the capacity to use extensive leverage to amplify returns. This leverage
can be acquired in a variety of ways: through repurchase agreements and reverse repos, through
secured financing and securities lending and through derivatives and structured financial products.
The ability of funds to take on risk and leverage is constrained by two external sources of discipline -
the returns required by their investors, and the terms on which their dealers/financers are willing to
extend credit. In other words, the fund is constrained by the willingness of outsiders, collectively, to
take exposure to the fund. The willingness of banks and investment banks to take on exposure to
hedge funds is in turn influenced by the capital and supervisory framework that applies to those
institutions and the discipline imposed on them by the market.
The effectiveness of market discipline in constraining the risk-taking behavior of financial firms,
however, may be compromised by the presence of market failures of the type mentioned above. While
this issue is at the heart of risk management challenges for the provision of credit more broadly, the
rise in the relative size of the private leveraged fund sector and the rise in the importance of new
derivative financial instruments may complicate the design of policies and risk-management practices
to counteract these traditional frictions.
Virtually all types of credit markets suffer from informational problems - consider the challenge faced
by a bank in assessing the risk associated with lending to a small unrated company. But the
complexity of new financial products, the rapidity with which positions can change, and the lack of a
long time series of historical relationships seems likely to enhance these problems for leveraged
institutions operating in new markets such as credit derivatives.
Funds typically deal with several different banks and investments banks. The desire to maintain the
confidentiality of their trading strategies has traditionally led firms to be quite opaque to outsiders and
reluctant to give their banks sufficiently detailed information on a real time basis about the risk profile
of the overall fund. Without that information, individual dealers or banks have a difficult time evaluating
the probability of default of a leveraged counterparty and the potential covariance with other positions
of the firm.
Individual firms may also see only a piece of the hedge fund's positions, and if their direct exposure to
the individual fund is small, may perceive less need to worry about the overall risk profile of the fund.
Public disclosure requirements designed to compensate for this information problem do not exist.
Even if information on the overall size of the fund's positions were available periodically, it would be
difficult to accurately ascertain its risk profile. This gives individual firms an incentive to free-ride on the
due diligence or monitoring by others, which may render resultant collective discipline inadequate.
The foundations of modern risk measurement rest on a framework that uses past returns to measure
or estimate the distribution of future returns. The stability of the recent past, even if much of it proves
durable, probably understates potential risk. The parameters used to estimate value at risk can
produce very large differences in predicted exposure, especially at extreme confidence intervals.
Estimating the potential interactions among these exposures in conditions of stress is even harder,
due to the uncertainty about the behavior of investors and other market participants and because of
the potential effects of financial distress on overall economic activity.
The relatively short history of returns for new products, the complexity of measuring exposure in many
new instruments and limitations on transparency also create the potential for classic "agency"
problems - internal conflicts of interest that can lead to problematic outcomes. In exposures where the
measurement of potential loss is more uncertain, more subjective, and less amenable to independent
evaluation, for example, reasonable people can come to very different judgments about the potential
risk in a particular position. Normal competitive pressures can push valuation methods away from the
conservative extreme and generate larger exposures to risk. As a result, individual firms and the
overall market are more exposed to risk in a stress scenario than would be desirable.
Another set of challenges comes with the broader damage to markets that can accompany the failure
of a major financial institution. Firms have strong incentives to avoid large financial losses and to
reduce the risk of failure, of course, but they do not have the incentive to internalize the potential
external consequences of their distress on the financial system, and it is unrealistic for market
participants to incorporate these risks into market prices. This "public good" dimension of financial
stability means that while the whole economy benefits from a more stable financial system, each
individual institution would prefer that others incur the costs associated with its provision. As a result,
firms may collectively underinsure against the risk of failure and underinvest in the infrastructure and
policies that promote financial stability.
And finally, policies designed to reduce the risk of failure in financial markets create moral hazard,
dulling the incentive individual firms face to self-insure against potential loss. We apply a set of capital
requirements and supervisory constraints to offset the distortion created by the safety net, but these
may not fully compensate for the impact on behavior of the broader range of financial intermediaries of
the perception that the authorities will act to protect the financial system from systemic risk.
While these constraints and challenges may weaken the effectiveness of counterparty discipline, they
are not fatal constraints. If individual dealers to a very large hedge fund each operate with adequate
knowledge of the risk profile of the fund, if they each make conservative judgments about their
potential direct exposure to the fund in a stress scenario, if they limit the overall exposure of the firm
as a whole to the broader market distress that might accompany that failure of a major hedge fund, if
they compensate for the uncertainty in making these judgments by charging appropriate risk premia or
building in a greater cushion against adversity, and if the supervisory constraints on the core
institutions adequately offset the moral hazard that comes with that relationship, then the financial
system as a whole will be less vulnerable to distress in the hedge fund sector. These are exacting
conditions, but they are not unachievable. And we all have an interest in encouraging progress toward
that objective.
Implications for policy and risk management
What are the implications of these challenges for central banks and supervisors? The changes in the
financial system we've seen over the past decade don't change the principal objectives of policy - to
ensure that the core financial institutions maintain an adequate cushion of capital in relation to risk,
and to build greater resilience into the infrastructure that supports the financial markets. We have very
limited ability to predict the sources of stress to the financial system, but if the cushions at the core of
the system are robust, the risk of a systemic crisis will be diminished, and central banks will have
greater ability to mitigate the risk of broader damage to the economy.
The pace and extent of the changes in financial markets requires supervisors to work harder to
understand the consequences of changing market practice for the incentives and constraints we
impose on financial institutions. Let me give two examples of evolving market practices that may help
alleviate one concern only to exacerbate another.
Collateral plays an increasingly important role in counterparty credit risk management, particularly for
highly leveraged counterparties. The increased importance of variation margining plays a critical role
in counterparty credit risk management. These changes help limit the exposure of the core financial
institution to losses among their leveraged counterparties, but they also act to exacerbate volatility,
with asset price declines forcing further margin calls, adding for further market declines. Where initial
margin is thin in relation to potential exposure, counterparties are more exposed to adverse
movements in asset prices, and in a situation of stress the actions they take to reduce their exposure
to further losses are likely to have a greater negative impact on market dynamics.
In market conditions where initial margin may be low relative to potential future exposure, the
selfpreserving behavior of leveraged funds and their counterparties may be more likely to exacerbate
rather than mitigate an unexpected deterioration in asset prices and market liquidity. As financial firms
demand more collateral, funds are forced to liquidate positions, adding to volatility and pushing down
asset prices, leading to more margin calls and efforts by the major firms to reduce their exposure to
future losses. In the context of the previous discussion of externalities, firms' incentives to minimize
their own exposure can amplify the initial shock and impose on others the negative externality of a
broader disruption to market liquidity.
The fact that this potential adverse dynamic exists does not mean it will occur. The deviation of prices
from their fundamental values in times of stress is likely to create incentives for firms and investors
with resources to step in and provide liquidity. In other words, the market may itself have the capacity
to self-correct and prevent a disruptive loss of liquidity.
A second example is the recent trend to lengthen lock-ups, implement redemption gates that limit
withdrawals, and create special side-pocket accounts for particularly illiquid investments by hedge
funds. Each of these changes may serve to reduce the liquidity risk of the fund, which should be
beneficial and potentially reduce the disruption from the forced liquidation of positions. They may also,
however, reduce market discipline and increase the overall scale of leverage assumed by those funds.
We don't have the capacity to assess with confidence the balance of these effects on the probability of
crisis and the severity of market dynamics in conditions of stress.
What should be the focus of supervisory efforts in this new context? Clearly, capital supervision and
market discipline remain the key tools for limiting systemic risk. The emergence of new market
participants such as leverage institutions does not change that. I am going focus on three broad policy
priorities - risk management, capital and margining practices, and the financial infrastructure.
Risk management
We should focus more attention on parts of the risk-management process where uncertainty is
greatest and materiality of the risks that we can't readily quantify is highest. This means more attention
on the risk factors where the measurement challenges are most complex. It means more attention on
assessing potential exposure in extreme events that lie outside past experience, not just those outside
of the recent past.
These challenges require using a mix of different analytical tools to help illustrate the range of possible
outcomes and the dimensions of uncertainty that apply to the measurement of exposure. The focus
should be not on the specific estimates produced for various types of asset price movements or stress
events, but the uncertainty that surrounds those estimates and the magnitude of the potential
underestimation of losses. Another way to say this is that we probably need to spend as much time
discussing the limits of the quantitative outputs of the risk-management process as we do on the
estimates produced by the models.
Understanding and evaluating "tail events" - low probability, high severity instances of stress - is a
principal, and extraordinarily difficult, aspect of risk management. These challenges have likely
increased with the complexity of financial instruments, the opacity of some counterparties, the rapidity
with which large positions can change, and the potential feedback effects associated with leveraged
positions.
Stress testing and scenario analysis have become central to the process of risk management, and we
have seen substantial progress since 1998. The efficacy of these tools should be judged in part by the
extent to which they capture, on a high frequency basis, the full exposure of the firm to a sufficiently
broad range of adverse conditions, the aggregate exposure to specific types of different risk factors
and types of counterparties, the potential interactions among those factors, the effects of a general
loss of liquidity and confidence in markets, and the constraints on the ability of the firm to move to
reduce its exposure to further losses.
And, of course, the credibility of the risk-management process should be judged not just by the quality
of attempts to estimate stress exposure, but also by the impact of these results on the decisions about
how much exposure the firm actually takes. In other words, effective stress testing must be viewed not
only as a tool for monitoring the risks a firm has taken, but for actually influencing and changing
behavior.
Supervisors should focus on concentrations of exposure to a range of different risk factors, not just on
the concern of the particular moment or the most recent sources of shocks. Just as generals are often
accused of preparing to fight the last war, practice tends to chase measures of direct exposure
implicated in past crises, or what seem like the plausible candidates for future crises, whether to real
estate, to hedge funds, to structured financial products, to emerging markets or to a particular industry.
This may be necessary and desirable, but it is not the most challenging task in risk management, and
we generally don't put ourselves in the position of trying to substitute our judgment for the markets on
what level of direct exposure to a particular company or industry is prudent relative to capital.
The better approach is to look at what might happen to the firm's losses in various alternative, more
adverse states of the world, and then assess the direct and indirect effects of distress in different parts
of the portfolio and the interactions among them. The major financial institutions, for example, typically
take on very little direct current exposure to hedge funds as group. But, as you might expect, the scale
of potential future exposure is more substantial. An even greater challenge is measuring the exposure
of the firm not simply to the direct effects of the failure of a particular hedge fund counterparty, but to
the broader distress that it might cause to other market participants or its impact on the other
exposures of the firm. The management of these direct and indirect exposures needs to be an
important focus of attention.
Capital and margin
Supervisors have put a considerable amount of effort over the past decade into designing a successor
to the Basel capital accord. The present regime does not do a good enough job of capturing the risks
a major institution typically assumes today. Because it understates the amount of capital required
against some risks, overstates others, and ignores still others, we should work to put in place a
replacement regime as quickly as we can be confident we have a viable alternative. The prudent,
conservative approach should be to move forward to a more risk sensitive framework that creates
better incentives for prudent risk management, not to try to extend the life of the present accord.
It is critical that these broader efforts to fix the capital regime be reinforced with more attention by
supervisors to margin practice and limits around the counterparty risk-management process within the
major financial institutions. The regulatory capital regime is designed to offset the effects on individual
firms of lower margin. Where margin levels are low relative to potential exposure, the capital
requirement is higher. Where margin is higher, the capital charge is lower. Both capital and margins
have costs, and firms seek to limit these costs and choose their preferred combination.
The question for policymakers is whether the mix of capital and margins produced by the market is
appropriate from the perspective of the financial system as a whole. As forms of financing that enable
leverage and as leveraged funds grow in importance, the overall level of margin held against positions
can provide an important cushion against the type of adverse market dynamics and general run on
liquidity we saw in 1998. For these reasons, in the 2005 report of