they are not unachievable. and we all have an interest in encouraging progress toward that objective. implications for policy and risk management what are the implications of these challenges for central banks and supervisors? the changes in the financial system we ’ ve seen over the past decade don ’ t change the principal objectives of policy - to ensure that the core financial institutions maintain an adequate cushion of capital in relation to risk, and to build greater resilience into the infrastructure that supports the financial markets. we have very limited ability to predict the sources of stress to the financial system, but if the cushions at the core of the system are robust, the risk of a systemic crisis will be diminished, and central banks will have greater ability to mitigate the risk of broader damage to the economy. the pace and extent of the changes in financial markets requires supervisors to work harder to understand the consequences of changing market practice for the incentives and constraints we impose on financial institutions. let me give two examples of evolving market practices that may help alleviate one concern only to exacerbate another. collateral plays an increasingly important role in counterparty credit risk management, particularly for highly leveraged counterparties. the increased importance of variation margining plays a critical role in counterparty credit risk management. these changes help limit the exposure of the core financial institution to losses among their leveraged counterparties, but they also act to exacerbate volatility, with asset price declines forcing further margin calls, adding for further market declines. where initial margin is thin in relation to potential exposure, counterparties are more exposed to adverse movements in asset prices, and in a situation of stress the actions they take to reduce their exposure to further losses are likely to have a greater negative impact on market dynamics. in market conditions where initial margin may be low relative to potential future exposure, the selfpreserving behavior of leveraged funds and their counterparties may be more likely to exacerbate rather than mitigate an unexpected deterioration in asset prices and market liquidity. as financial firms demand more collateral, funds are forced to liquidate positions, adding to volatility and pushing down asset prices, leading to more margin calls and efforts by the major firms to reduce their exposure to future losses. in the context of the previous discussion of externalities, firms ’ incentives to minimize their own exposure can amplify the initial shock and impose on others the negative externality of a broader disruption to market liquidity. the fact that this potential adverse dynamic exists

timothy f geithner : hedge funds and derivatives and their implications for the financial system remarks by mr timothy f geithner, president and chief executive officer of the federal reserve bank of new york, at the distinguished lecture 2006, sponsored by the hong kong monetary authority and hong kong association of banks, hong kong, 14 september 2006. * * * i want to thank joseph yam for inviting me to hong kong for this occasion. we are approaching the 10 - year anniversary of the financial crises of 1997 - 99. those crises were remarkable both in the scope of countries and markets they affected, and for their speed and severity. the circumstances leading up to the crises varied across countries and regions, as did the magnitude of the resulting damage to the real economy. but each of these events had one dynamic in common the confluence of a sharp increase in risk perception, and the subsequent actions taken by financial institutions and investors to limit their exposure to future losses. as asset prices declined and volatility increased in response to increased concern about risk, firms moved to call margin, to reduce positions and to hedge against further losses. these individual actions had the aggregate effect of inducing even larger price declines and further heightening perceptions of risk, ultimately propagating and amplifying the effects of the initial shock. the dynamic i just described was not unique to the crises of the late 1990s, nor was the damage to overall economic activity they left in their wakes. systemic financial events with spillovers to the real economy have been a persistent feature of the economic environment, and both financial market participants and policymakers have grappled with the challenge of how to reduce their incidence and to minimize their severity, longevity and impact on the broader economy. there is a lot we do not understand about these challenges, but we know more today than we once did. in the case of the crises of the late 1990s, despite the broad - based nature of the financial market turmoil, in countries where capital cushions in the financial sector were strong relative to risk, where there was a greater diversity of institutions in the financial system to absorb the losses, and where monetary authorities were in a position to provide liquidity to restore confidence, the financial and macroeconomic impact of the crises was relatively modest. where those conditions did not exist, the damage was acute. the u. s. economy appears to have become more resilient to financial shocks. over the past two decades, the u. s. economy has experienced several episodes of significant financial market