Timothy F Geithner: Reducing systemic risk in a dynamic financial
system
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at The Economic Club of New York, New York, 9 June 2008.
* * *
Since the summer of 2007, the major financial centers have experienced a very severe and
complex financial crisis. The fabric of confidence that is essential to the viability of individual
institutions and to market functioning in the United States and in Europe proved exceptionally
fragile. Money and funding markets became severely impaired, impeding the effective
transmission of U.S. monetary policy to the economy. Central banks and governments, here
and in other countries, have taken dramatic action to contain the risks to the broader
economy.
Why was the system so fragile?
Part of the explanation was the size of the global financial boom that preceded the crisis. The
larger the boom, the greater the potential risk of damage when it deflates.
The underpinnings of this particular boom include a large increase in savings relative to real
investment opportunities, a long period of low real interest rates around the world, the greater
ease with which capital was able to flow across countries, and the perception of lower real
and inflation risk produced by the greater apparent moderation in output growth and inflation
over the preceding two decades.
This combination of factors put upward pressure on asset prices and narrowed credit
spreads and risk premia, and this in turn encouraged an increase in leverage across the
financial system.
This dynamic both fed and was fed by a wave of financial innovation. As the magnitude of
financial resources seeking higher returns increased around the world, products were
created to meet this demand. Financial innovation made it easier for this money to flow
around the constraints of regulation and to take advantage of more favorable tax and
accounting treatment.
The U.S. financial system created a lot of lower quality mortgage securities, many of which
were packaged together with other securities into complex structured products and sold to
institutions around the world. Many of these securities and products were held in leveraged
money or capital market vehicles, and financed with substantial liquidity risk. And yet, by
historical standards, the overall level of risk premia in financial markets remained
extraordinarily low over this period.
The structure of the financial system changed fundamentally during the boom, with dramatic
growth in the share of assets outside the traditional banking system. This non-bank financial
system grew to be very large, particularly in money and funding markets. In early 2007,
asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate
preferred securities, tender option bonds and variable rate demand notes, had a combined
asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5
trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance
sheets of the then five major investment banks totaled $4 trillion.
In comparison, the total assets of the top five bank holding companies in the United States at
that point were just over $6 trillion, and total assets of the entire banking system were about
$10 trillion.
This parallel system financed some of these very assets on a very short-term basis in the
bilateral or triparty repo markets. As the volume of activity in repo markets grew, the variety
of assets financed in this manner expanded beyond the most highly liquid securities to
include less liquid securities, as well. Nonetheless, these assets were assumed to be readily
sellable at fair values, in part because assets with similar credit ratings had generally been
tradable during past periods of financial stress. And the liquidity supporting them was
assumed to be continuous and essentially frictionless, because it had been so for a long
time.
The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities
made many of the vehicles and institutions in this parallel financial system vulnerable to a
classic type of run, but without the protections such as deposit insurance that the banking
system has in place to reduce such risks. Once the investors in these financing
arrangements - many conservatively managed money funds - withdrew or threatened to
withdraw their funds from these markets, the system became vulnerable to a self-reinforcing
cycle of forced liquidation of assets, which further increased volatility and lowered prices
across a variety of asset classes. In response, margin requirements were increased, or
financing was withdrawn altogether from some customers, forcing more de-leveraging.
Capital cushions eroded as assets were sold into distressed markets. The force of this
dynamic was exacerbated by the poor quality of assets - particularly mortgage-related
assets - that had been spread across the system. This helps explain how a relatively small
quantity of risky assets was able to undermine the confidence of investors and other market
participants across a much broader range of assets and markets.
Banks could not fully absorb and offset the effects of the pullback in investor participation -
or the "run" - on this non-bank system, in part because they themselves had sponsored
many of these off-balance-sheet vehicles. They had written very large contingent
commitments to provide liquidity support to many of the funding vehicles that were under
pressure. They had retained substantial economic exposure to the risk of a deterioration in
house prices and to a broader economic downturn, and as a result, many suffered a sharp
increase in their cost of borrowing.
The funding and balance sheet pressures on banks were intensified by the rapid breakdown
of securitization and structured finance markets. Banks lost the capacity to move riskier
assets off their balance sheets, at the same time they had to fund, or to prepare to fund, a
range of contingent commitments over an uncertain time horizon.
The combined effect of these factors was a financial system vulnerable to self-reinforcing
asset price and credit cycles. The system appeared to be more stable across a broader
range of circumstances and better able to withstand the effects of moderate stress, but it had
become more vulnerable to more extreme events. And the change in the structure of the
system made the crisis more difficult to manage with the traditional mix of instruments
available to central banks and governments.
First repair, then reform
What should be done to reduce these vulnerabilities?
Our first and most immediate priority remains to help the economy and the financial system
get through this crisis.
A range of different measures of liquidity premia and credit risk premia have eased
somewhat relative to the adverse peaks of mid-March.
Part of this improvement - this modest and tentative improvement - is the result of the range
of policy actions by the Federal Reserve System, the U.S. Treasury and other central banks.
Part is the consequence of the substantial adjustments already undertaken by financial
institutions to reduce risk, raise capital and build liquidity.
These actions by institutions and by the official sector have helped to reduce the risk of a
deeper downturn in economic activity and of a systemic financial crisis.
But the U.S. economy and economies worldwide are still in the process of adjusting to the
aftermath of rapid asset price growth and unsustainably low risk premiums. This process will
take time.
As we continue to work with other central banks to ease the adjustment now under way in
the U.S. economy and globally, we are working to make the financial system more resilient
and to improve its capacity to deal with future crises.
We are working closely with the Securities and Exchange Commission (SEC), with banking
supervisors in the United States and the other major economies, and with the U.S. Treasury
to strengthen the financial foundation of the major investment and commercial banks. We
have encouraged a significant increase in the quality of public disclosure. We have
supported efforts that have brought a very substantial amount of new equity capital into many
financial institutions. These efforts will help mitigate the risk of a deeper credit crunch. And
even as the Federal Reserve has worked to mitigate the liquidity pressures in markets by
implementing a new set of lending facilities, we have worked with the SEC and others to
ensure that the major institutions are strengthening their liquidity positions and funding
strategies.
We are also initiating important steps to strengthen the financial infrastructure. We are in the
process of encouraging a substantial increase in the resources held against the risk of
default by a major market participant across the set of private sector and cooperative
arrangements for funding, trading, clearing and settlement of financial transactions that form
the "centralized infrastructure" of the financial system. We have begun to review how to
reduce the vulnerability of secured lending markets, including triparty repo by reducing, in
part, the scale of potentially illiquid assets financed at very short maturities.
This afternoon, 17 firms that represent more than 90 percent of credit derivatives trading,
meet at the Federal Reserve Bank of New York with their primary U.S. and international
supervisors to outline a comprehensive set of changes to the derivatives infrastructure. This
agenda includes:
•
the establishment of a central clearing house for credit default swaps,
•
a program to reduce the level of outstanding contracts through bilateral and
multilateral netting,
•
the incorporation of a protocol for managing defaults into existing and future credit
derivatives contracts, and
•
concrete targets for achieving substantially greater automation of trading and
settlement.
These changes to the infrastructure will help improve the system's ability to manage the
consequences of failure by a major institution. Making these changes will take time, but we
expect to make meaningful progress over the next six months.
The set of ongoing and near-term initiatives I just outlined are only the beginning and should
be considered a bridge to a broader set of necessary changes to the regulatory framework in
the United States and globally.
I believe the severity and complexity of this crisis makes a compelling case for a
comprehensive reassessment of how to use regulation to strike an appropriate balance
between efficiency and stability. This is exceptionally complicated, both in terms of the
tradeoffs involved and in building the necessary consensus in the United States and the world. It
is going to require significant changes to the way we regulate and supervise financial
institutions, changes that go well beyond adjustments to some of the specific capital charges
in the existing capital requirement regime for banks.
We have to recognize, however, that poorly designed regulation has the potential to make
things worse. We have to distinguish carefully between problems the markets will solve on
their own and those markets cannot solve. We have to acknowledge not just that regulation
comes with costs, but that if not carefully crafted it can distort incentives in ways that may
make the system less safe. And we have to focus on ways regulation can mitigate the moral
hazard risk created by the actions central banks and governments have taken and may take
in the future to avert systemic financial crises.
I am going outline some broad proposals for reform, focusing on the aspects of our system
that are most important to reducing systemic risk. These proposals do not address a myriad
of other important aspects of regulatory policy, including consumer protection issues in the
mortgage origination business, the future role of government and government-sponsored
enterprises in our housing markets, and many others.
Any agenda for reform has to deal with three important dimensions of the regulatory system.
•
Regulatory policy. These are the incentives and constraints designed to affect the
level and concentration of risk-taking across the financial system. You can think of
these as a financial analog to imposing speed limits and requiring air bags and
antilock brakes in cars, or establishing building codes in earthquake zones.
• Regulatory
structure. This is about who is responsible for setting and enforcing
those rules.
• Crisis
management. This is about when and how we intervene and about the
expectations we create for official intervention in crises.
Here are a few broad points on each of these.
Regulatory policy
The objectives of regulatory policy should be to improve the capacity of the financial system
to withstand the effects of failure and to reduce the overall vulnerability of the system to the
type of funding runs and margin spirals we have seen in this crisis.
First, this means looking beyond prudential supervision of the critical institutions to broader
oversight of market practices and the market infrastructure that are important to market
functioning. Two obvious examples: we need to make it much more difficult for institutions
with little capital and little supervision to underwrite mortgages, and we need to look more
comprehensively how to improve the incentives for institutions that structure and sell
assetbacked securities and CDOs of ABS. And supervision will have to focus more attention on
the extent of maturity transformation taking place outside the banking system.
Second, risk-management practices and supervisory oversight has to focus much more
attention on strengthening shock absorbers within institutions and across the infrastructure
against very bad macroeconomic and financial outcomes, however implausible they may
seem in good times. After we get through this crisis and the process of stabilization and
financial repair is complete, we will put in place more exacting expectations on capital,
liquidity and risk management for the largest institutions that play a central role in
intermediation and market functioning.
This is important for reasons that go beyond the implications of excess leverage for the fate
of any particular financial institution. As we have seen, the process of de-leveraging by large
but relatively strong institutions can cause significant collateral damage for market
functioning and for other financial institutions.
Inducing institutions to hold stronger cushions of capital and liquidity in periods of calm may
be the best way to reduce the amplitude of financial shocks on the way up, and to contain the
damage on the way down. Stronger initial cushions against stress reduces the need to hedge
risk dynamically in a crisis, reducing the broader risk of a self-reinforcing, pro-cyclical margin
spiral, such as we have seen in this crisis.
How should we decide where to set these constraints on risk-taking? This is hard, but the
objective should be to offset the benefits and the moral hazard risk that come from access to
central bank liquidity in crises, without setting the constraint at a level that will only result in
pushing more capital to the unregulated part of the financial system.
Risk management and oversight now focuses too much on the idiosyncratic risk that affects
an individual firm and too little on the systematic issues that could affect market liquidity as a
whole. To put it somewhat differently, the conventional risk-management framework today
focuses too much on the threat to a firm from its own mistakes and too little on the potential
for mistakes to be correlated across firms. It is too confident that a firm can adjust to protect
itself from its own mistakes without adding to downward pressure on markets and takes too
little account of the risk of a flight to safety - a broad-based, marketwide rush for the exits as
the financial system as a whole de-leverages and tries collectively to move into more liquid
and lower risk assets of government obligations.
Third, although supervision has to focus first on the stability of the core of financial
institutions, it cannot be indifferent to the scale of leverage and risk outside the regulated
institutions.
I do not believe it would be desirable or feasible to extend capital requirements to institutions
such as hedge funds or private equity firms. But supervision has to ensure that
counterpartycredit risk management in the regulated institutions contains the level of overall exposure of
the regulated to the unregulated. Prudent counterparty risk management, in turn, will work to
limit the risk of a rise in overall leverage outside the regulated institutions that could threaten
the stability of the financial system.
Supervision has to explicitly focus on inducing higher levels of margin and collateral in
normal times against derivatives and secured borrowing to better cover the risk of market
illiquidity. Greater product standardization and improved disclosure can also help, as will
changes to the accounting rules that govern what risks reside on and off balance sheets.
Finally, central banks, governments and supervisors have to look much more carefully at the
interaction between accounting, tax, disclosure and capital requirements, and their effects on
overall leverage and risk across the financial system. Capital requirements alone are rarely
the most important constraint.
The President's Working Group on Financial Markets and the Financial Stability Forum has
laid out a very detailed list of reforms to begin this process. And we are fortunate to have
Jerry Corrigan engaged in working to shape a set of recommendations to help us get the
balance right.
Regulatory structure
Apart from the mix of incentives and constraints set by regulatory policy, the structure of the
regulatory system in the United States needs substantial reform. Our current system has
evolved into a confusing mix of diffused accountability, regulatory competition, an
enormously complex web of rules that create perverse incentives and leave huge
opportunities for arbitrage and evasion, and creates the risk of large gaps in our knowledge
and authority.
This crisis gives us the opportunity to bring about fundamental change in the direction of a
more streamlined and consolidated system with more clarity around responsibility for the
prudential safeguards in the system. In this regard, Secretary Paulson's blueprint outlines a
sweeping consolidation and realignment of responsibilities, with a clear set of objectives for
achieving a better balance between efficiency and stability, between market discipline and
regulation. This proposal has stimulated a very constructive set of discussions, and will help
lay the foundation for action when the dust settles.
The most fundamental reform that is necessary is for all institutions that play a central role in
money and funding markets - including the major globally active banks and investment
banks - to operate under a unified framework that provides a stronger form of consolidated
supervision, with appropriate requirements for capital and liquidity.
To complement this, we need to put in place a stronger framework of oversight authority over
the critical parts of the payments system, not just the centralized payments, clearing and
settlements systems but the infrastructure that underpins the decentralized over-the-counter
markets.
The Federal Reserve should play a central role in this framework, working closely with
supervisors here and in other countries. At present the Federal Reserve has broad
responsibility for financial stability not matched by direct authority, and the consequences of
the actions we have taken in this crisis make it more important that we close that gap.
Crisis management
No financial system will be free from crises, whatever the design of the regulatory framework
or the rules of the game. The framework of lender-of-last-resort policies and the regime for
facilitating an orderly resolution of a major non-bank financial institution are critical to our
ability to contain financial crises.
In response to this crisis, the Federal Reserve has designed and implemented a number of
innovative new facilities for injecting liquidity into the markets. These facilities have played a
significant role in easing liquidity strains in markets and we plan to leave them in place until
conditions in money and credit markets have improved substantially.
We are also examining what suite of liquidity facilities will be appropriate in the future, with
what conditions for access and what oversight requirements to mitigate moral hazard risk.
Some of the mechanisms we have employed during this crisis may become permanent parts
of our toolkit. Some might be best reserved for the type of acute market illiquidity
experienced in this crisis.
It would be helpful for the Federal Reserve System to have greater flexibility to respond to
acute liquidity pressure in markets without undermining its capacity to manage the federal
funds rates at the FOMC's (Federal Open Market Committee) target. The authority Congress
has granted the Fed to pay interest on reserves beginning in 2011 will be very helpful in this
regard. We welcome the fact that Congress is now considering accelerating that authority.
The major central banks should put in place a standing network of currency swaps, collateral
policies and account arrangements that would make it easier to mobilize liquidity across
borders quickly in crisis. We have some of the elements of this framework in place today,
and these arrangements have worked relatively well in the present crises. We should leave
them in place, refine them further and test them frequently.
The Federal Reserve Act gives us very broad authority to lend in crises. We used that
authority in new and consequential ways, but in the classic tradition of central banks and
lenders of last resort. As we broadened the range of collateral we were willing to finance,
extended the terms of our lending and provided liquidity insurance to primary dealers, our
actions were carefully calibrated to improve overall market functioning by providing an
effective liquidity backstop and to avoid supplanting either the interbank market or the
secured funding market.
In addition to these new facilities, the Fed made the judgment, after very careful
consideration, that it was necessary to use its emergency powers to protect the financial
system and the economy from a systemic crisis by committing to facilitate the merger
between JPMorgan Chase and Bear Stearns. We did this with great reluctance, and only
because it was the only feasible option available to avert default, and because we did not
believe we had the ability to contain the damage that would have been caused by default.
Our actions were guided by the same general principles that have governed Fed action in
crises over the years. There was an acute risk to the stability of the system; we were not
confident that the damage could be contained through other means; we acted only to help
facilitate an orderly resolution, not to preserve the institution itself; and the management of
the firm and the equity holders of the institution involved suffered very substantial
consequences.
Although we assumed some risk in this transaction, that risk is modest in comparison to the
risk of very substantial damage to the financial system and the economy as a whole that
would have accompanied default.
Conclusion
One of the central objectives in reforming our regulatory framework should be to mitigate the
fragility of the system and to reduce the need for official intervention in the future. I know that
many hope and believe that we could design our system so that supervisors would have the
ability to act preemptively to diffuse pockets of risk and leverage. I do not believe that is a
desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of
regulation and uncertainty about the rules of the game that would offset any possible benefit.
I do believe, however, that we can make the system better able to handle failure by making
the shock absorbers stronger.
This crisis exposed very significant problems in the financial systems of the United States
and some other major economies. Innovation got too far out in front of the knowledge of risk.
It is very important that we move quickly to adapt the regulatory system to address the
vulnerabilities exposed by this financial crisis. With the leadership of the Secretary of the
Treasury, Hank Paulson, we are beginning the process of building the necessary consensus
here and with the other major financial centers.
Let me just finish by saying that confidence in any financial system depends in part on
confidence in the individuals running the largest private institutions. Regulation cannot
produce integrity, foresight or judgment in those responsible for managing these institutions.
That's up to the boards and shareholders of those institutions.
One of the great strengths of our system is the speed with which we adapt to challenge. We
can do better, and I am reasonably confident we will.
Thank you.