Timothy F Geithner: Implications of growth in credit derivatives for financial
stability
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the New York University Stern School of Business Third Credit Risk Conference,
New York City, 16 May 2006.
* * *
Thank you for giving me the opportunity to speak to you today.
We're in the midst of a period of rapid growth and innovation in the market for credit derivatives, and
the developments in this market have important implications for broader financial market functioning
and stability. A vital and efficient financial system such as ours is defined by its ability to identify new
ways to allocate capital and share risk, but often the pace of innovation in the instruments themselves
outstrips the pace of improvement in the risk management and control infrastructure. The credit
derivatives market is no exception to this general observation. In my remarks today, I'll focus on some
of the implications of these changes in the credit derivatives market for the stability of the overall
financial system. As with any attempt to explore the broader implications of rapid growth in a new
market, I'll say more about what we do not know than about what we do know. I'll also highlight the
need for continued progress in addressing the challenges posed by the rapid growth in this market.
Credit derivatives have contributed to dramatic changes in the process of credit intermediation, and
the benefits of these changes seem compelling. They have made possible substantial improvements
in the way credit risk is managed and facilitated a broad distribution of risk outside the banking system.
By spreading risk more widely, by making it easier to purchase and sell protection against credit risk
and to actively trade credit risk, and by facilitating the participation of a large and very diverse pool of
non-bank financial institutions in the business of credit, these changes probably improve the overall
efficiency and resiliency of financial markets.
With the advent of credit derivatives, concentrations of credit risk are made easier to mitigate, and
diversification made easier to achieve. Credit losses, whether from specific, individual defaults or the
more widespread distress that accompanies economic recessions, will be diffused more broadly
across institutions with different risk appetite and tolerance, and across geographic borders. Our
experience since the introduction of these new instruments - a period that includes a major asset price
shock and a global recession - seems to justify the essentially positive judgment we have about the
likely benefits of ongoing growth in these markets.
Despite the benefits to financial resilience, the changes in the credit markets that are the subject of
your conference have also provoked some concerns and unease, even among those on the frontier of
innovation and the most active participants in these markets.
These concerns are based in part on uncertainty - a candid acknowledgment that there is a lot we do
not yet know about how these instruments and the increased role of nonbank institutions in these
markets will affect how the financial markets are likely to function in conditions of stress. Or to put it a
bit differently: this concern comes from an awareness of the formidable complexity of measuring the
scale of potential exposure in many of these instruments, and it comes from an awareness of the
difficulty in anticipating how changes in credit market structure are likely to affect the behavior of
financial market participants and market liquidity across a wide spectrum of financial and
macroeconomic conditions.
The velocity of change itself would not be particularly interesting if the scale of exposures involved
were still small, but this is not the case today. Credit derivatives, although still only 7 percent of
estimated total notional over-the-counter (OTC) derivatives contracts, generate a significant fraction of
total counterparty credit exposure. The direct counterparty credit exposure in OTC derivatives is quite
large relative to the capital cushions of the major banks and investment banks, and relative to more
traditional forms of credit exposure.
Further, these exposures merit more attention because they may be harder to measure than those in
the more mature interest rate and exchange rate derivatives. The underlying economic exposures
involved are harder to assess in part because of the complexity of the instruments, the embedded
leverage in many products and the difficulty of estimating correlations across different exposures.
For these reasons, the risk individual dealers attribute to exposures involving some types of credit
derivatives exhibit a very large variance, substantially larger than one would typically find in
measurements of traditional credit exposures. That variance illustrates the magnitude of the
uncertainty involved in capturing the direct exposure in these markets.
But perhaps the more difficult challenge is to capture the broader risks the institution might confront in
conditions of a general deterioration in confidence in credit and an erosion in liquidity in these markets.
This task, which is the province of stress testing and analysis of very low probability but extreme
scenarios, is, of course, fundamentally difficult. The analytical challenge is magnified by the inherent
difficulty in predicting how behavior changes in crisis, that is, how investors and counterparties would
react to actual losses and the fear of future losses. This challenge is substantially more difficult in
markets where there have been dramatic changes in the instruments involved, in the nature of the
participants and in the structure of the markets. We tend to look more closely at things we can
measure than those we cannot. We are drawn to approaches that offer the comfort of precision and
tend to look past the wide band of uncertainty that surrounds those estimates.
Measuring these broader risks is harder today because the classic array of historical stress events
drawn from the past 25 years of financial crises are probably even less valuable than they were as an
illustration of how market dynamics might unfold today in response to similar changes in asset prices
and credit losses.
Those past crises would likely cause less damage today, if they were to recur, because of the many
changes in the structure of our financial system - namely, the greater dispersion of credit and market
risk, the improvements in risk management, the size of the capital cushions, and the improvements in
many parts of the payment and settlement infrastructure. But most crises come from the unanticipated.
Assessing a firm's exposure to risk in the tail of the distribution requires, among other things, an
evaluation of the impact of the failure of a major counterparty and the impact that failure might have on
other counterparties and on market prices. It requires, for the largest institutions, an understanding of
the constraints the firm may face in its ability to adjust positions or hedge against further losses without
amplifying the shock. And it requires anticipating potentially adverse effects on market liquidity, as
other market participants react to actual and anticipated losses.
In the financial system we have today, with less risk concentrated in banks, the probability of systemic
financial crises may be lower than in traditional bank-centered financial systems. And the increase in
the diversity of nonbank financial institutions that hold risk may also serve as a stabilizing force in
credit markets. But the greater relative importance of nonbank financial institutions also means that
distress among these institutions has the potential to have a substantial impact on market behavior
and liquidity. Understanding these relationships is an important part of the risk management challenge
for banks, even in a world where derivatives have helped spread risk more broadly.
The innovations that have taken place in the credit derivatives market were driven to a significant
degree by the losses experienced in past crises, but most of the growth in this market has occurred in
relatively favorable overall economic and financial conditions. This wave of innovation in credit
markets has occurred in an environment in which:
•
the price of insurance against credit risk has fallen substantially as realized losses have
declined and perceptions about corporate credit fundamentals have improved;
•
volatility has declined in many different types of asset prices, as have expectations of future
volatility
•
the number of bank failures in the United States have fallen to levels not seen in a
generation or more, and the price of protection against default by the largest financial
institutions has fallen to levels that suggest a very low probability of failure; and
•
overall liquidity in markets has been high.
Against the backdrop of an apparently healthy financial system, market participants report a
substantial rise in transactions leverage, erosion in the use of loan covenants, more favorable
financing terms for hedge fund counterparties, and especially a pressure to reduce initial margin
against OTC derivatives exposure to hedge funds. But the concern is that this sustained period of very
low credit losses and low volatility works to hold down measures of the underlying economic risk in
these exposures. This combined with the range of factors I just discussed, raises the odds that market
participants will be faced with negative surprises in the event of a more adverse macroeconomic
environment. And this could have more negative implications for market dynamics and liquidity as
market participants react to those losses and attempt to reduce their exposure to future losses.
These concerns are not particularly new, and my sense is that they are widely shared among the
people and institutions that are closest to these markets. They do not, in my view, challenge the
overall judgment that these changes in the credit markets on balance are likely to make the financial
system more resilient rather than more fragile. But they do suggest the need for greater caution by
financial institutions in several important areas.
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 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 an ongoing source of concern.
The major market participants, both the dealers and the traditional and non-traditional investors, are in
the process of improving the infrastructure that supports these markets. The changes underway to
clean up the backlog of unconfirmed trades and to automate the entire post-trade-processing
environment will help reduce operational risk in the derivatives market and reduce some sources of
uncertainty that could exacerbate a market shock. The efforts underway to reach agreement on an
approach for settlement in events of default are important for addressing the risks inherent in a market
where the value of derivatives substantially exceeded the value of the underlying instruments. 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. 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 boards of directors need to understand the limitations and uncertainty that
pervade 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.
Let me conclude by reiterating the fundamental view that the wave of innovation underway in credit
derivatives offers substantial benefits to both the efficiency and stability of our financial system. The
extent of these benefits will depend, in part, on the degree to which market participants can keep up
with the pace of change in the market through continued investment in both risk management and in
the processing infrastructure. We have been through a period of relatively favorable financial
conditions, and the prospect for future stability will depend in part on the degree of care and
conservatism market participants bring today to judgments about opportunity and risk management.
Thank you.