timothy f geithner : us monetary policy in the global financial environment remarks by mr timothy f geithner, president and chief executive officer of the federal reserve bank of new york, at the japan society corporate luncheon, new york city, 9 march 2006. i would like to thank margaret mcconnell of the bank ’ s research and statistics group for valuable contributions to this speech. * * * we are in the midst of another wave of global economic and financial integration. this movement toward greater openness and the associated rise in capital mobility offers the prospect of substantial economic gains for the u. s. and the global economy. stronger real and financial linkages across nations have the potential to significantly raise the prospects for long - run world growth. the ensuing development of the market sector in emerging market and developing economies offers probably the most powerful means available for raising income growth and living standards in a very large share of the world ’ s population. these changes, and the complementary advances in technology, offer the prospect of more productive and stable real economies. the increase in the ties between national financial systems, the greater sophistication of financial markets and financial market instruments and the increase in capital flows across borders, allow risks to be shared more broadly and capital to flow to where the returns are highest, also contributing to stronger and more stable future economic growth. this process of integration has, of course, a range of implications for policymakers. many of these implications are positive, for the benefits of integration over time are powerful and compelling for all economies. in important ways, economic integration may have made the principal job of central banks easier, by contributing to productivity growth and reducing some sources of inflation pressure, at least during the transition when a large share of the working age population of the world is being brought into the market. but the process of change in how economies and financial markets interact also complicates the task of central banks. our understanding of the how these changes affect our capacity to forecast economic activity and inflation and our ability to assess how monetary policy affects the economy almost certainly lags the changes underway. in my remarks today, i will talk about some of the implications of these challenges for the conduct of monetary policy. i will focus on two features of what is happening in the world economy and financial markets today that are among the most interesting and consequential of the many questions we face today in thinking about the changes in the world economy and the task of central banking. these are, first,

it demands much greater understanding of the business and risk profile of the institution and the exercise of judgement as to where dangers may possibly arise. we are already doing more regular on - site inspections of financial institutions, and we are building up expertise in risk management. but to shift fully to risk - focussed supervision will take longer. at the same time, as regulators, we must learn to accept that there are risks in allowing financial institutions to innovate. it is a supervisory challenge that we simply have to manage. we used to be able to add on many layers of bullet proofing, in the hope of reducing risks to the bare minimum substantial capital requirements, plus hidden reserves, plus unrealised valuation surpluses, etc. the cost was a sluggish industry and low returns. this is no longer viable. we must be more explicit in assessing the risks, and in setting the safety margin that we require. we expect institutions to comply with our requirements with some to spare, and not to try to game the rules that have been set. they must make prudent commercial decisions, which rules alone cannot compel them to do. banks and life insurance companies in particular have a special responsibility to safeguard the interest of depositors and policy holders. but within these limits institutions will also want to mobilise their balance sheets and maximise shareholder returns, and we must allow them to do so. risks are a matter of judgement as much as calculation. different mas officers will not necessarily all take the same view of what risks are acceptable. the officers responsible for supervision will naturally be more conservative than those promoting the financial sector. managed well, this tension is constructive. officers must continue to speak up and express their views, even though they may sometimes be overruled. with this approach to regulation, it is imperative for mas to foster closer cooperation with the industry. we have made a serious effort to build a constructive exchange and dialogue with the private sector. we must continue to strengthen this culture of openness. central bankers must treat some matters with the utmost discretion, to be discussed only in hushed tones among a select priesthood. but we cannot do all our business this way. in our day - to - day dealings with the financial institutions, we have to be constantly willing to explain the rationale for decisions and policies. at the same time, we must listen to proposals and ideas from the industry and feedback. as we continue to liberalise, we will need inputs from industry participants on many issues