Timothy F Geithner: Change and challenges facing the US financial system
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, before the New York Bankers Association's Annual Financial Services Forum,
New York, 25 March 2004.
* * *
It is a pleasure to join you at the New York Bankers Association Financial Services Forum. The
institutions represented in this room, together with the rest of the New York financial community,
remain at the center of the U.S. and global financial systems.
Your meeting today takes place against the backdrop of a relatively favorable national and global
economic outlook. The U.S. financial system is in reasonably strong shape. Financial innovation has
enabled substantial improvements in the quality of risk management and in the capacity of the system
to handle shocks. But the benefits of innovation have come with significant challenges to the people
who run financial institutions and to those responsible for supervision and oversight. How effective we
are in responding to these challenges will determine whether the U.S. financial system is as
successful in the future as it has been in the past.
The consensus forecast for the U.S. economy expects solid growth this year and next, somewhat
above the upper bound of the range of most estimates of U.S. potential growth. Confidence in the
sustainability of the U.S. expansion, as measured by changes in these forecasts, for example, seems
to be increasing. The rate of economic growth outside the United States is also looking better.
Although there are pockets of weakness and potential sources of vulnerability, the overall rate of
global growth has accelerated significantly and looks as if it's now running at the strongest levels in
four years.
The broad measures of U.S. consumer price inflation are very low. Inflation expectations as reflected
in surveys and in the Treasury inflation-protected securities, although higher than current rates, still
suggest an outlook of very modest future price increases. Deflation risks worldwide appear to have
diminished, and there are some signs of accelerating price increases in some economies. Overall,
however, despite the sharp increases in energy and commodity prices, the inflation outlook globally
appears quite benign.
At the core of the U.S. economic experience of the past decade is a significant and sustained
acceleration in productivity growth. This offers the prospect of more rapid growth in income over time,
both for the United States and for the rest of the world.
In the economics profession, there is a debate about whether we are in the midst of a secular trend
characterized by lower GDP volatility and general price stability, which some have called the "great
moderation." As important as the question of the extent of this moderation in macroeconomic volatility
is the debate over its source. It's undoubtedly the result of a combination of factors, including better
economic policy, innovation and globalization, plus simple good fortune in the form of smaller shocks.
But, the relative contribution of these factors is uncertain.
Despite the uncertainty that exists about the sources and durability of this apparent moderation in
some types of risks, financial market prices now reflect a very benign view of economic and credit
fundamentals. Credit spreads generally and risk premia in many asset classes are at levels that are
very low even in relation to previous periods of relative optimism.
The U.S. financial system, when judged by many conventional measures, looks reasonably healthy as
well. Bank profitability is at the highest levels we have seen, depending on which measure you
choose, in two to three decades. Capital positions for U.S. banks, which have been around 13 percent
of assets over the past two years, are very strong, significantly above the regulatory standards
required to be considered well capitalized. Asset quality also remains robust. Nonperforming loan
ratios are now only 1.2 percent across the commercial banking industry. The financial markets are
pricing financial institution risk at very favorable levels, with bank equity prices, subordinated debt
spreads, and credit default swap spreads suggesting a high degree of investor and counterparty
confidence in the financial health of the major banks and other financial institutions.
As these numbers suggest, the U.S. financial system came through the recent recession, the spate of
corporate bankruptcies, the sharp adjustment in some asset prices, and the difficulties in some
emerging market economies in reasonably strong financial shape. This apparent resilience, relative to
past downturns and relative to the experience of other countries, is the result of a number of factors.
Some of these factors stem from developments outside the financial system, like better
macroeconomic policy and better microeconomic or supply-side fundamentals. And some stem from
changes in the nature of financial intermediation, the structure of the financial system, and the capacity
of financial institutions to manage risk.
To start with the broader economic context, the strength and length of the expansion of the 1990s
helped ensure that U.S. financial institutions entered the latest recession with strong capital positions.
The fact that the recession was shallower and shorter than the average of the past helped limit the
scale and scope of losses to financial institutions. The forcefulness of the monetary policy response
and the large fiscal stimulus provided by the tax cuts and expenditure increases played a significant
role in limiting the depth of the downturn and in helping to bring about the recovery. It is significant that
the yield curve has been steeper and stayed steep longer in this latest recession than in the previous
one. And, finally, the stronger microeconomic fundamentals of the U.S. economy - the shift to
just-in-time inventory management, the speed of innovation in the U.S. economy, and other factors
that seem to have reduced the amplitude of the business cycle and improved the flexibility and
resilience of the U.S. economy in response to shocks - have also contributed to financial stability.
Changes in the nature of financial intermediation have also played a role in improving the overall
resilience and performance of the U.S. financial system that was evident in this latest period of
economic recession and financial stress. Four different types of changes are particularly important.
•
Innovation in financial technology continues to expand the opportunities for financial
institutions to separate and distribute, and to manage and hedge, different types of risk.
• The increasingly greater role played by the capital markets in the financial intermediation
process relative to banks - both relative to the past and compared with most other major
economies - has improved the capacity of our system to handle stress. Loans and securities
held by commercial banks today account for less than 20 percent of overall U.S. credit
market debt, roughly two--thirds of their 1975 levels.
•
The increases in the sophistication of risk management techniques and enhancements to
risk management processes have delivered substantial improvements in how banks and
other financial institutions actually manage risk in practice. Banks, for example, have aligned
their pricing of credit products much more closely with credit risk.
• The increased scale of cross-border financial intermediation, the growing role of securitized
financial instruments in those overall flows, and the growth in the size and breadth of
financial institutions with global operations may also mean that, as shocks are transmitted
more rapidly, they are diffused more broadly.
These are positive developments, and they are likely to be enduring. But they have come with new
challenges for those of you who manage financial institutions and for those of us charged with
supervision and market oversight. The overall return on these changes will depend on the skill with
which we manage the challenges that come with them. Among these challenges are those that relate
to the complexity of financial and operational risk management, concentration in critical markets,
internal governance to manage conflicts, the quality of public disclosure, opportunities for regulatory
and capital arbitrage, and trend amplifying market dynamics in times of stress.
The financial innovations that have made risk transfer and hedging possible have increased the
complexity of risk management, both financial and operational. The seemingly simple structure of a
loan or bond issue can now involve a complex series of additional transactions that seek to allocate
risks and responsibilities along specialized lines. This increased number of transactions that need to
be separately settled and tracked by themselves create new risks that must be managed.
The economies of scale inherent in certain activities have led to a significant degree of concentration
in some markets. A relatively small number of dealers account for a very large share of the
over-the-counter derivatives business, with higher degrees of concentration in specific markets such
as interest-rate options. Two institutions dominate the government securities clearing business. The
growth in the size of government-sponsored mortgage entities creates a high degree of concentration
in a market with very large systemic implications. Concentration has benefits, but it necessarily
increases the vulnerability of the system to an operational or financial disruption in a single institution,
or the decision by a single institution to exit a particular business. Moreover, to the extent that the
same set of firms play dominant roles in multiple markets, this concentration can also give rise to
linkages between markets that are not apparent in normal circumstances and that could potentially
affect how the financial system functions in conditions of acute stress.
Increased opportunities for diversification offer the prospect - though not the assurance - of lower
overall volatility in earnings, but they also bring much more complicated management challenges in
controlling conflicts, reputational risks, and operational risks. The actual gains achieved from
diversification depend on the correlation of movements in different sources of earnings and in
economic growth among different regions as well as the relative volatility of the new business lines into
which the institution is diversifying. To the extent that diversification achieves lower overall volatility in
earnings for the major financial institutions, it is clearly good for the stability of the system. But to fully
exploit these potential gains requires careful attention to the design of the control and compliance
infrastructure, to monitoring and managing credit risk and concentration across diverse types of
financial activities, and to managing conflicts of interest.
These are formidable challenges even for the strongest management teams. Trust and reputation are
valuable competitive assets for financial institutions, and the desire to preserve those assets creates a
powerful incentive for firms to manage conflicts and compliance with exceptional care. Supervision
and regulation, and the enforcement response to management failures, should help strengthen the
incentives for a stronger compliance infrastructure, but they cannot insulate firms from the
consequences of reputational damage.
Financial innovation has made it possible for the market to assign values to a broader range of
financial activities. And this, combined with improved disclosure, has increased the potential power of
market discipline. But the increased complexity that comes with innovation also creates challenges for
investor and counterparty risk assessment. Although the overall quality of disclosure has improved in
recent years, along with accounting and auditing processes that underpin the integrity of disclosure,
the complexity of public financial reporting can make it very difficult to discern the true picture of a
firm's financial condition and its exposure to risk.
Financial innovation has also made it possible for risk to migrate to - and for leverage to accumulate
in - parts of the financial system with less strong, or simply different, supervision, capital requirements,
or disclosure norms. Risk today, on balance, seems to be allocated more effectively to those
institutions better able to manage and hold it, resulting in reduced risk to banks and to the financial
system as a whole. However, limitations in the extent of public disclosure over institutions that hold
large amounts of risk make it hard to develop a comprehensive picture. It is obviously in the interest of
institutions that transfer credit risk, interest rate risk, or other risks to understand the performance
capabilities of those institutions from which they are purchasing protection. The ability to arrive at
informed independent judgments about counterparty risk, however, can be hindered by the gaps that
remain in the quality of disclosure.
The same developments in financial technology that have improved the sophistication of risk
management and the ability to transfer risk can create positive feedback mechanisms that, for at least
short periods of time, amplify large moves in asset prices. There have been substantial increases over
the past decade in the capacity of the market, meaning the principal dealers, to handle very large
increases in hedging-related flows. This dimension of the financial infrastructure is critical to the
capacity of our markets to absorb and respond to large shocks. Dynamic hedging of options and other
similar strategies, however, depend on the availability of sufficient liquidity to work effectively. Stressful
periods, of course, are marked precisely by a material reduction in market liquidity.
These changes in the nature of finance have several important implications for the supervisors and
those responsible for market oversight. Financial innovation will, in some ways, always move ahead of
the evolution in risk management techniques. As supervisors, our challenge is to work to ensure that
the sophistication of the supervisory process evolves to keep abreast of the pace of change in
financial innovation. This is a formidable challenge, and we need to continue to work hard at it. The
revisions to the Basel Capital Accord, which aim to align supervisory assessments of capital adequacy
more closely with the frontier of risk management techniques, are a good example of these efforts.
The changes in the structure of finance and the nature of the financial intermediation process reinforce
the importance of cooperation between supervisory authorities. The sources of potential risk to
financial stability are not confined to banks. Financial institutions increasingly operate across the legal
parameters that define the responsibilities of the individual supervisory authorities. The economic
characteristics of many of the financial credit instruments provided by banks and other financial
institutions have converged. Our supervisory system is a complex framework in terms of the number of
responsible supervisory institutions, differences in approaches, overlaps, and gaps. This complexity
makes it even more important that we collectively work to ensure a comprehensive look at sources of
systemic risk and that we raise the bar on the quality of supervision and market oversight where it is
necessary.
Bank supervisors have made significant progress in improving how we share and divide
responsibilities for supervision of banks and bank holding companies, reduce overlap, and raise the
overall contribution of the examination process. With the passage of the Gramm-Leach-Bliley Act in
1999, and the increased scope of activities it has allowed financial institutions to engage in across the
financial services industry, we have worked to strengthen cooperation with other regulatory bodies.
This will be increasingly important to the effectiveness of the overall supervisory process, as the SEC
moves toward providing a form of consolidated supervision for the largest securities firms.
At the international level, we have made considerable progress in developing a network for
cooperation and information sharing among national authorities that better matches the increased
integration of national financial systems. We have worked to clarify the division of labor among
supervisors of institutions with supra-national reach, and to cover gaps in the supervisory overlay. We
have also worked to identify and promote the adoption of best practices and standards for many
dimensions of the institutional framework that underpins well-functioning financial markets.
Strengthening home-host supervisory cooperation and avoiding duplication of supervisory efforts will
continue to be top priorities for the international supervisory community, especially as we adopt newer
supervisory approaches, such as Basel II.
Finally, we need to continue to promote investments in strengthening resilience in critical infrastructure
in payments and settlement systems and those institutions that play an important role in market
clearance systems. This is a critical part of the supervisory and market oversight process we perform,
and there is an active public-private effort underway to bring about further improvements in back-up
facilities and overall resilience.
The innovations that have transformed finance over the past decade have substantially improved the
overall stability and resilience of the U.S. financial system. But these improvements are unlikely to
have brought an end to what Charles Kindleberger called "manias and panics" in financial markets.
They cannot fully insulate the financial system from the effects of large macroeconomic shocks. And
they will not by themselves preclude the possibility of failure in a major financial institution or a critical
piece of market infrastructure. For these reasons, it is important that those of you who run financial
institutions build in a sufficient cushion against adversity.
Of course, the overall performance of the financial system and the degree of financial stability depends
on more than just the skill of risk managers and supervisors. The unique strengths of the U.S. financial
system in allocating capital to where long run returns are highest depend on the overall confidence
investors have in the fairness and integrity of our financial markets. These strengths depend on our
openness to competition and the opportunities and rewards to innovation that the regulatory
environment provides.
The stability of the financial system also depends significantly on the quality of macroeconomic policy,
not only in terms of the credibility of monetary policy, but also in the degree of confidence investors
have in U.S. fiscal management. The current deterioration in the U.S. fiscal position and the acute
decline in the net national savings rate represent risks to the financial system and the economy as a
whole. These risks are magnified by the size of the U.S. external imbalance and the unprecedented
scale of financing requirements it reflects.
Although the present economic environment looks quite favorable, these broader macroeconomic
policy challenges make it even more important that we build on the substantial progress we have
already made in strengthening risk management and the resilience of critical market infrastructure.
Our success in meeting these challenges will help ensure that our financial system proves as resilient
in the future as it has in the recent past.
Thank you.