Timothy F Geithner: Principles to guide the future evolution of financial
supervision and regulation
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Bond Market Association's Annual Meeting 2006, New York, 19 May 2006.
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Thanks for inviting me to speak to you today.
You are meeting at a time of significant confidence in the strength of the global economy and in the
overall health of the financial system. On the available evidence, the core of the U.S. financial system
is stronger than it has been in some time. Capital levels are higher and earnings stronger and more
diversified.
This strength is the result of many factors. It is the result of the length and strength of the economic
expansion in the United States and the associated improvements in credit fundamentals. It reflects
increases in the scale and scope of the operations of the largest institutions. It is the result of the
dramatic innovations in the technology of finance and in the opportunities that has created for
managing risk more effectively. And it reflects the increased integration of national financial institutions
and the resulting competitive pressure and opportunities for diversification.
We have seen substantial improvements in risk management practice and in internal controls over the
past decade. These improvements are the product of large investments in people and technology, as
well as changes to the internal architecture around control and compliance. These investments were,
of course, driven by a series of important changes in law and regulation, but they also reflect a rational
response by the institutions themselves to the financial and reputational damage associated with some
of the earlier weaknesses.
The progress achieved in internal control regimes has of course come with some costs. Many of these
costs can be measured in dollars, but others, such as management attention and the uncertainty
induced by greater vulnerability to enforcement action and litigation, are more difficult to measure.
Despite the difficulty of adding up all these costs, it is hard to challenge the widespread view that they
have been quite substantial. But the relevant metric is not merely their magnitude, but how they
compare to the magnitude of the resulting gains.
There is no straightforward way to make this assessment, but today I want to offer some perspectives
on our continued efforts to balance critical financial stability objectives with the need to foster and
encourage the innovation and dynamism that is such a central part of the U.S. financial system.
I'll begin with the observation that profitability measures suggest that the business of financial
intermediation is reasonably healthy, despite the costs induced by changes in the regulatory
environment. Part of this reflects the reduction in credit costs and increased macroeconomic stability
of the past several years. The financial performance of the well-run U.S. financial institutions seems to
compare favorably to that of their peers in other markets.
The pace of innovation in U.S. financial markets has continued to be robust. The explosive growth in
the volume and type of credit derivatives is only one example of the overall creativity and dynamism of
U.S. financial markets in recent years. This suggests that the incentives and opportunities for
innovation in our markets remain powerful despite concerns about the impact of changes in the overall
regulatory environment.
And confidence in the integrity of U.S. financial markets seems to be strong today - integrity in the
sense of reduced vulnerability to illicit activity and improvements in the reliability of public disclosure.
We can see evidence of this confidence in the apparent willingness of the world's savers to invest in
the United States and in the scale of capital formation in our markets.
The apparent robustness of market activity and innovation in the face of fairly substantial changes in
the legal, supervisory and enforcement environment is encouraging. But the cumulate effects may
take years to manifest themselves fully. Therefore, the official community has to be very attentive to
the risk that we have the balance wrong.
I thought I might outline some broad principles that should guide the official community as we apply
the existing body of regulation and supervisory guidance, as we refine current proposals, and as we
design future changes.
It is imperative that we get it right. The efficiency, dynamism and resilience of the financial system are
strategic assets for U.S. economy. The relatively favorable performance of the U.S. financial system is
the result both of the wisdom of past choices made to foster a very open and competitive financial
system, but also is the result of good fortune and some of the special advantages that have come from
the unique role of the United States and the dollar in the world economy and financial system.
Some of these relative advantages are likely to decline over time with the maturation and deregulation
of other financial markets around the world. And this healthy evolution prompts us to be even more
attentive to the potential risk that the costs we impose on financial institutions in our markets and on
companies that want to raise capital in our markets become prohibitively high.
Here are a few considerations or principles that I believe should guide us in the official community as
we strive to improve the regulatory framework going forward. I want to emphasize that these
principles, as in the case of many principles, are easier to state than to achieve.
Let me start by acknowledging there are aspects of the exacting standards we have sought to impose
on our financial system that have turned out to be expensive in relation to the return against our public
policy objective. And provisions that seem optimally designed at any given time are likely to need to
evolve as conditions change. That this should occur is a natural aspect of a dynamic financial
environment. There are areas where we are likely to have erred in being too prescriptive and others
where we left too much room for discretion and judgment. It would be good if we could find a way to
build into the initial design of guidance and regulation the capacity for quicker and continuous
evolution as we learn more.
Second, we need to continue to adapt our approach to the imperatives of a much more integrated
global financial system. Global integration, of course, gives us all a greater stake in the quality of
supervision outside our borders. This pragmatic interest will lead us to spend progressively more
resources and attention on the international dimension of our work. This recognition informed the
efforts that led to the Basel Capital Accord, the Lamfalussy Standards for payment and settlement
systems and many other international cooperative efforts. But the imperative is much stronger today
because of the much greater extent of financial integration, and it is only likely to grow.
It is also important that the design of regulatory initiatives in the United States be informed by a careful
assessment of their relative impact on U.S. institutions and markets. Effective solutions to many of the
concerns we face in our national financial systems will require multilateral approaches. Rather than
starting with a presumption that we will act in the United States and then hope to induce the world to
follow, there are some areas where the more effective approach will be to start with the borderless
solution by which I mean one designed to apply to a class of institutions and financial instruments,
independent of geography and currency. Where this does not prove possible on terms or in a time
frame we like, we of course preserve the option to move alone.
Third, we live in a financial system in which nonbank financial institutions play a much larger role than
they did in the past, a system in which the differences between the activities of the bank-centered
financial institutions and nonbanks has diminished, and in which the largest commercial banks and
investment banks compete with each other and with other nonbank institutions in both the United
States and abroad.
These changes in market structure have many positive implications for financial efficiency and
stability, but they also mean that differences in the size and nature of the incentives faced by
institutions with different supervisory and regulatory regimes can have larger competitive effects. The
resulting opportunities for regulatory arbitrage have the potential to reduce the impact of provisions
that apply only to regulated or supervised institutions. The risk that regulating the core of the system
simply pushes financial activity to the periphery can raise the risk that distress among nonbanks can
cause greater damage to the financial system. This means that we have to look for ways to cooperate
more closely with other supervisors across the functional lines of supervision in our system in such as
way as to impact the incentives of a broader range of market participants.
Fourth, we need to find ways to accelerate the pace at which the regulatory framework evolves to
meet new challenges. The increase in the pace of change in financial innovation and in market
structure requires greater agility among supervisors and regulators. Without this agility we risk lagging
too far behind changes in the frontier of risk. This does not mean that each innovation needs to be met
with a regulatory response. That would be an unfortunate and surely counterproductive impulse to
encourage in regulation. But when a problem in the existing framework has significant implications for
financial stability or efficiency, we need the flexibility and expertise required to act more quickly than
we have been able to in some areas in the past.
Fifth, we need to be creative in identifying areas where market-led initiatives, rather than new laws,
regulations or formal supervisory guidance, are likely to be successful and possibly more efficient in
achieving certain policy objectives. Where collective action problems limit the incentive or the ability of
individual institutions to make the necessary investments in infrastructure, the official sector can
facilitate or motivate cooperative effort among market participants to solve the problem. At times, we
may be more effective by helping to convene a group of market participants to reach consensus on
best practices or a common solution than we would be defining or imposing a solution ourselves. Of
course, not all problems are amenable to a solution by public support of private initiative, but we
should be open to these types of approaches when they are likely to be successful in achieving our
objectives.
And sixth, we have to be careful that the necessary and constructive attention that has been devoted
over the past several years to meeting control and compliance challenges does not detract from the
classic safety and soundness requirements of risk management. These should not be competing
priorities. The financial costs and reputational damage associated with compliance and control failure
can be very large. And the investments in the internal control infrastructure-in audit and corporate
governance changes and in controls over financial reporting-are crucial parts of the foundation for a
credible risk management framework. But we need to make sure that the demanding and ever
evolving challenges of managing credit and market risk receive a degree of attention by senior
management and boards that is commensurate with the risks. And this balance needs to be reflected
in where we focus our supervisory efforts, as well. These classic prudential issues, those that make a
critical difference in reducing the vulnerability of markets to systemic risk, need to be a principal focus
of supervisory attention.
This is a time where I believe it is important to encourage more care and conservatism in the discipline
of risk management. There are three areas at the top of our hierarchy of concerns.
First, it is very important that the major dealers make the investments necessary to improve the
operational infrastructure that underpins the credit derivatives and broader over-the-counter (OTC)
derivatives market. Operational risk and infrastructure failures have played a prominent role in past
financial crises, and the infrastructure weaknesses that have characterized the credit derivatives
markets since their inception are another credible source of concern.
The major market participants, both the dealers and the traditional and nontraditional investors, are in
the process of improving the infrastructure that supports these markets. The changes underway to
clean up the backlog of unconfirmed trades, to automate the entire post-trade-processing
environment, and to improve the settlement process in events of default will help reduce operational
risk in the derivatives market and reduce some sources of uncertainty that could exacerbate a market
shock. We are encouraged by the progress made to date and will continue to encourage further
improvements.
Second, we believe that the major dealers, as well as the large commercial and investment banks,
should take a cold, hard look at financing conditions and margin practice, particularly with respect to
hedge fund counterparties and in OTC derivatives. The reports issued by the Counterparty Risk
Management Policy Groups I and II both make the important observation that the financial system is
likely to be more resilient under conditions of stress when counterparties set initial margins at levels
that are likely to be sustainable in less benign conditions. When margin levels are set more
conservatively, firms are likely to have more flexibility in responding to stress and are less likely to take
action that might amplify the market shock and exacerbate the reduction in liquidity. When competitive
pressure drives margins down, markets may be less resilient.
Third, we believe the major financial institutions need to continue to improve their capacity to measure
their exposure to risk in a less benign market and economic environment than we have experienced in
recent years. The discipline of stress testing and scenario analysis that is designed to measure tail risk
is at the frontier of this challenge. Senior management and the boards of directors need to understand
the limitations of the tools we use to assess these risks, to try to better understand the potential scale
of losses the firm may face, and to carefully examine how well risk exposures reflect the overall risk
appetite of the firm, and the size of the capital and liquidity cushion maintained in relation to those
exposures.
I want to conclude with the observation that the requirements of effective risk management and control
regimes are likely to become more rather than less demanding over time. Those charged with
managing the major financial institutions need to continue to make the investments necessary to stay
abreast of change and to get as close to the frontier as possible. This reality makes it even more
important that we in the supervisory community continue to look for ways to address aspects of the
existing supervisory regime that impose unnecessary costs and burdens or that pull resources and
attention away from potential sources of risk to the financial system.
Thank you.