timothy f geithner : reducing systemic risk in a dynamic financial system remarks by mr timothy f geithner, president and chief executive officer of the federal reserve bank of new york, at the economic club of new york, new york, 9 june 2008. * * * since the summer of 2007, the major financial centers have experienced a very severe and complex financial crisis. the fabric of confidence that is essential to the viability of individual institutions and to market functioning in the united states and in europe proved exceptionally fragile. money and funding markets became severely impaired, impeding the effective transmission of u. s. monetary policy to the economy. central banks and governments, here and in other countries, have taken dramatic action to contain the risks to the broader economy. why was the system so fragile? part of the explanation was the size of the global financial boom that preceded the crisis. the larger the boom, the greater the potential risk of damage when it deflates. the underpinnings of this particular boom include a large increase in savings relative to real investment opportunities, a long period of low real interest rates around the world, the greater ease with which capital was able to flow across countries, and the perception of lower real and inflation risk produced by the greater apparent moderation in output growth and inflation over the preceding two decades. this combination of factors put upward pressure on asset prices and narrowed credit spreads and risk premia, and this in turn encouraged an increase in leverage across the financial system. this dynamic both fed and was fed by a wave of financial innovation. as the magnitude of financial resources seeking higher returns increased around the world, products were created to meet this demand. financial innovation made it easier for this money to flow around the constraints of regulation and to take advantage of more favorable tax and accounting treatment. the u. s. financial system created a lot of lower quality mortgage securities, many of which were packaged together with other securities into complex structured products and sold to institutions around the world. many of these securities and products were held in leveraged money or capital market vehicles, and financed with substantial liquidity risk. and yet, by historical standards, the overall level of risk premia in financial markets remained extraordinarily low over this period. the structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. this non - bank financial system grew to be very large, particularly in money and funding markets. in early 2007,

reduce the incentive to become systemically important in the first place. however, i expect that it will take considerable time for the surcharge to have a meaningful impact on size and complexity. we also need to create new mechanisms and incentives for bank management to act early, well before resolution becomes necessary. early intervention is likely to be much more successful in preventing failure as compared to last - ditch efforts. these actions can take many forms – cutting capital distributions earlier, raising new capital faster, restructuring businesses sooner, and reorganizing senior management and boards of directors more radically when the firm is not performing well. in this regard, the comprehensive capital analysis and review ( ccar ) should bolster the incentives for early action. the ccar is a significant supervisory innovation intended to ensure that large, complex bank holding companies have robust internal capital planning processes and sufficient capital to withstand stressed economic conditions and to continue to be viable financial intermediaries. importantly, the ccar takes a forward - looking perspective in assessing a bank ’ s capital adequacy, including ensuring that its internal stress testing processes address its unique vulnerabilities and exposures. the ccar should push banks to proactively manage their capital so as to be well prepared for the type of market stresses that could cause significant declines in income and capital. other steps could be taken to complement the ccar. one approach would be to implement a long - term debt requirement in a way that further enhances market discipline and provides incentives for regulators to promptly intervene if necessary. another might be to structure compensation practices to strengthen senior bank managers ’ incentives to proactively manage risk. for example, imagine how incentives would change if a significant portion of senior bank management ’ s compensation each year were deferred to be available to cover future capital losses. i suspect that over time this would meaningfully alter management ’ s risk tolerance. also, in addition to the quantity of the deferred compensation, the form it takes could also affect incentives. if most of the deferred compensation were in the form of debt rather than equity, i suspect this would also affect management ’ s risk tolerance and the appetite to cut dividend payments, reduce share repurchases or raise more capital more promptly when the firm began to become stressed. the terms and the form of deferred compensation are an important tool that could be further developed to generate a better set of incentives consistent with our financial stability objectives. we must also ensure that firms can