Timothy F Geithner: The changing face of risk management
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, before the Institute of International Bankers, New York, 9 June 2004
* * *
It is a pleasure to join you today for this meeting of the Institute of International Bankers. The financial
institutions you represent play a major role in our financial system. The IIB has played an important
part in shaping financial policy in the United States, by reminding us with force and persistence of the
impact of our actions on the standards of fairness and equality of opportunity that we strive to
maintain.
The U.S. financial system has a number of features that help to make it attractive to participants from
all around the world.
The structure of our financial system is characterized by a diversity of channels for financial
intermediation, with a relatively larger role for the capital markets and a smaller role for banks, than is
true in most other major economies. And we have preserved, despite substantial consolidation, a
system that comfortably accommodates the largest globally-active financial institutions side by side
with a competitive and diverse array of regional and community banking organizations.
We are very open to the presence of foreign financial institutions, and perhaps as important, have
traditionally been very open to attracting non-U.S. financial talent to work in our markets. While the
number of foreign banking organizations operating in the US has contracted over the last decade, the
overall importance has grown. Foreign banking organizations now account for 45 percent of total
banking assets in the United States, up from around 40 percent a decade ago, and they account for a
substantial share of total securities underwriting in this market.
Our framework for supervision and regulation is supportive of innovation. Much of the most
transforming innovations in finance started in our markets or were adopted more quickly and more
broadly here than in many other financial systems. The U.S. system, relative to the model in many
other countries, has involved a continuous, risk-focused process of supervision and a strong
enforcement mechanism working alongside the supervisory community. In addition, we have
traditionally assigned a more important role to market discipline, importantly through a strong
disclosure regime, in reinforcing the supervisory regime, than has been the case in other markets.
Our system is successful in matching capital with ideas, in allocating savings to where returns are
highest, in creating opportunities for households to better withstand the costs of change and
dislocation that are inevitable offshoot of an open and dynamic market economy, and in spreading risk
to where it can be best absorbed. The high degree of competition and flexibility that characterize our
approach helps drive the pace of innovation, both in new forms of financial instruments and in new
ways to manage risks.
No financial system, of course, is without vulnerability. And we face a number of important challenges
in making sure our system is as strong as it can to be. But the substantial competition from a diverse
set of financial institutions, including a strong presence by foreign financial institutions, is an integral
part of what makes our financial system work well. Our system would not be as efficient or as
innovative, and our financial institutions would not be as strong, if we were less open or less
committed to giving all institutions similar national treatment and equality of opportunity.
I thought I would give you a brief overview of the some of the key challenges we face as supervisors
and those that confront the risk management community.
The fundamentals of the present U.S. expansion seem relatively strong, with confidence in its
sustainability increasing. As the balance of risks to the outlook have evolved, and the financial markets
have built in expectations of a move to less accommodative financial conditions, this is a good time to
assess how well the U.S. financial system is positioned to deal with this transition, and to withstand the
effects of future stress, if that were to materialize.
From our perspective, the U.S. financial system is in reasonably strong shape. Risk adjusted capital
ratios are strong, and earnings have been robust. Non-performing loan ratios are very low - at about
one percent on average across the banking industry. The financial markets are pricing risk in exposure
to financial institutions at what are still relatively low levels.
Securitization and the rapid growth in credit risk transfer instruments have enabled risk to be spread
more broadly. Risk management practices have improved in sophistication and rigor. Firms have
made substantial investments in improving the strength and resilience of their technology and systems
infrastructure. Payments and settlements systems have stronger safeguards in place. The overall
capacity of the system to handle large hedging volume has increased substantially.
Despite the fact that we have experienced a sustained period of accommodative monetary and
financial conditions, net credit growth to the private sector has been moderate. The overall financial
position of the corporate sector is strong. New household borrowing has grown rapidly, but the broad
measures of the ratio of debt service to income remain at a level of roughly 13 percent, and estimates
suggest that only a quarter of total household debt is exposed to rising interest rates in the near term.
Net credit growth to emerging markets has been moderate relative to past periods. Growth in
commercial bank assets has picked up a bit in recent quarters, but remains significantly below the
pace of the second half of the 1990s.
As the financial markets have built in expectations of a gradual rise in the fed funds rate over the next
two years, financial institutions have had some time to position themselves for an environment of
higher interest rates and volatility. There have been adjustments in credit spreads and other risk
assets, which in some areas had fallen to historically low levels, but these reversals have been
tempered by what it still overall a favorable view of corporate credit fundamentals. And it is worth
drawing attention to the fact that the average duration of the mortgage market has increased
significantly over the last nine months to the point where the amount of hedging pressure on interest
rates related to extension risk is likely to be contained even as interest rates rise.
The fact that these adjustments have begun ahead of any change in monetary policy probably will
help diminish the strains in the financial system that might otherwise be expected to accompany this
type of transition. Even so, risk managers need to be attentive to, and react appropriately to, the
pressures that could emerge following this extended period of low interest rates and a steep yield
curve.
The agenda for the supervisory community remains dominated by the following broad priorities:
•
We are moving ahead with Basle II to bring a more sophisticated assessment of capital
adequacy and risk management techniques to the supervisory framework.
•
Our ongoing supervisory examinations continue to concentrate on strengthening the internal
management and control infrastructure across the various dimensions of risk management
and compliance.
•
We are supporting the important efforts underway to better align U.S. and international
accounting standards and to improve the quality and integrity of public disclosure.
•
We are working to encourage firms to proceed with their investments in greater resilience
and geographic range called for in the Interagency Paper on Sound Practices to Strengthen
the Resilience of the U.S. Financial System.
•
We continue to encourage efforts to strengthen all aspects of our national payments and
settlement systems.
•
And we are engaged across a number of fronts internationally to provide a more integrated
framework of supervision that better matches the integration of national financial systems
and the increased global reach of the largest financial institutions.
As part of our supervisory process we monitor closely the evolution in risk management practice
across a broad array of financial institutions. Through horizontal reviews that focus on specific
dimensions of risk management, we have a reasonably good sense of where the frontier in risk
management practices is across the industry, and understand where the gap between this frontier and
average practice is the greatest. The size of this gap in practice can increase in market conditions
where competitive pressures and a search for return works to erode discipline.
I thought it might be useful to highlight some of the areas where leading practice is farthest ahead of
typical practice. Leading practice does not imply that there is a definitely superior model that we
expect all firms to converge to over time. In most of these areas, there is some diversity in what
defines the frontier of excellence. We recognize this, even as we encourage firms to put in place
stronger and more sophisticated systems more commensurate with the complexity of the risks they
are taking.
•
Comprehensive aggregation of credit exposure: The most sophisticated among large
diversified financial institutions have well-developed systems for aggregating credit
exposure, with a common methodology and results available relatively quickly, across the full
range of transactions and business lines they engage in with a single entity or groups of
entities with correlated risks.
•
Stress testing and scenario analysis: Firms at the leading edge have moved well beyond
reliance on "value-at-risk" complemented by stress tests of discrete shocks. They employ
stress tests built around more exacting, forward-looking scenarios integrating large moves in
a number of variables, more tailored to the risk profile of the firm and current market
conditions, and the reactions of other market participants and counterparties.
•
Counterparty credit risk management: The most sophisticated firms use much more careful
and sophisticated approaches for measuring potential future exposure, and they analyze
how exposures may respond in conditions of significant market stress. With respect to hedge
fund exposure in particular, the leading firms employ comprehensive evaluation of the risk
profile of the hedge fund to set credit thresholds and terms and a more disciplined approach
to setting sufficiently high levels of initial margin.
•
Measuring and managing interest rate risk: Leading institutions assess their exposure to
interest rate risk in a comprehensive manner across the firm's business lines. The most
advanced approaches are able to assess the impact of rate, spread and implied volatility
movements under multiple scenarios in both normal and stressed market conditions. These
institutions also strive to achieve a balance between shorter term earnings impacts, and the
longer-term preservation of economic value.
• Liquidity risk: Similar evolution has occurred in liquidity management with leading practice
now subjecting dynamic cash flow projections to a range of adverse scenarios relevant to the
risk profile of the firm (such as a sustained loss of access to funding or a significant ratings
downgrade or a systemic disruption to market liquidity) to assess the impact on funding.
•
Compliance risk management: Many firms are working to enhance their overall corporate
compliance management processes, and the supervisors expect that firms will employ
strong risk management practices with appropriate levels of testing. In response to the more
exacting requirements of the Bank Secrecy and Patriot Acts and anti-money laundering
controls, leading firms have now moved beyond manual systems with very limited capacity to
look at patterns of transactions over time and across businesses and countries, and have put
in place automated systems for monitoring transactions with more sophisticated filters for
identifying suspicious patterns of behavior. The quality of internal compliance controls in the
leading firms has advanced in other areas as well, with higher level oversight of an
independent compliance function with more rigorous policies to address conflicts of interest
involving hedge funds and proprietary trading and the flow of confidential information across
the firm.
These are examples of leading practice, and they are not at this point standard operating procedure
across the range of institutions where they should be. Systematically assessing the evolving frontier of
leading risk management practice is a useful way to ensure that we continue to build on the significant
improvements in the overall stability and resilience of the U.S. financial system that have been
achieved over the past two decades. This is important to do on a continuing basis to strengthen the
shock absorbers in the financial system. It is important to do even when, or perhaps particularly when
the overall economic environment looks quite favorable, as it does today.
We look forward to working with the foreign banking community to continue to identify ways in which
risk management practices can be strengthened. It is in our mutual interest to insure that the practices
employed broadly by the industry continue to move towards the frontier of risk management practices.
Thank you.