Summary:
Timothy Geithner, president and chief executive, Federal Reserve Bank of New York, proposing measures to make the financial more resilient. Measures are: higher expectations on capital, liquidity and risk management, commensurate with the benefits that come from access to central bank liquidity; improving the capacity of the financial infrastructure to withstand default by a big institution; changes in the regulatory framework (more authority for the Fed); and a stronger capacity to respond to crises. Argues the Fed's responsibility for financial stability is not matched by direct authority. This gap needs to be closed. (Published: 08/06/08)
Notes:
- Why was the financial system so fragile? What can be done to make the system more resilient in the future?
- world experienced a financial boom
- boom fed demand for risk
- products were created to meet that demand, including risky, complicated mortgages
- many assets were financed with significant leverage and liquidity risk
- many of the world's largest financial institutions got themselves too exposed to the risk of a global downturn
- amount of long-term illiquid assets financed with short-term liabilities made the system vulnerable to a classic type of run
- as concern about risk increased, investors pulled back
- triggering a self-reinforcing cycle of forced liquidation of assets
- higher margin requirements
- increased volatility
- to strengthen the system in the future
- have to increase the shock absorbers held in normal times against bad macroeconomic and financial outcomes
- will require more exacting expectations on
- capital,
- liquidity and
- risk management
- for the largest institutions that play a central role in intermediation and market functioning
- should be set high enough to offset the benefits that come from access to central bank liquidity
- but not so high that they succeed only in pushing more capital to the unregulated part of the financial system
- have to improve the capacity of the financial infrastructure to withstand default by a big institution
- will require:
- taking some of the risk out of secured funding markets
- increasing resources held against default in the centralised clearing house
- encouraging more standardisation, automation and central clearing in the derivatives markets.
- regulatory framework cannot be indifferent to the scale of leverage and risk outside the supervised institutions
- does not believe it would be desirable or feasible to extend capital requirements to leveraged institutions such as hedge funds
- But: supervision has to ensure that counter-party credit risk management in the supervised institutions limits the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.
- regulatory policy has to induce higher levels of margin and collateral in normal times against derivatives and secured borrowing to cover better the risk of market illiquidity
- need to streamline and simplify the US regulatory framework
- system has evolved into a confusing mix of diffused accountability, regulatory competition and a complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion
- institutions that play a central role in money and funding markets need to operate under a unified framework that provides:
- a stronger form of consolidated supervision
- with appropriate requirements for capital and liquidity
- to complement this, we need to put in place a stronger framework of oversight authority over the critical parts of the payments system
- not just the established payments, clearing and settlements systems, but the infrastructure that underpins the decentralised over-the-counter markets.
- Federal Reserve should play a central role in such a framework
- because of its primary responsibility for the stability of the overall financial system
- needs to work closely with supervisors in the US and in other countries
- At present the Fed has broad responsibility for financial stability not matched by direct authority and the consequences of the actions we have taken in this crisis make it more important that we close that gap.
- need a stronger capacity to respond to crises
- Fed examining what framework of facilities will be appropriate in the future
- conditions for access and oversight requirements required to mitigate moral hazard risk
- some of these could become a permanent part of our instruments
- some might be best reserved for the type of acute market illiquidity experienced in this crisis
- Authority to pay interest on reserves
- would give the Fed the ability to respond to acute liquidity pressure in markets without undermining its capacity to manage the federal funds rates in line with the federal open market committee's target
- big central banks should put in place a standing network of currency swaps, collateral policies and account arrangements
- in order to make it easier to mobilise liquidity across borders quickly in a crisis
- have to recognise that regulation has the potential to make things worse
- Regulation can distort incentives in ways that may make the system less safe
- but: It is important that we move quickly to adapt the regulatory system to address the vulnerabilities exposed by this financial crisis
