Geithner, President and Chief Executive Officer
Thanks for giving me the opportunity to join you today.
The U.S. and the world economy now confront the conjunction
of several different transitions, which will have important
implications for the U.S. financial system.
Among the most important of these transitions are:
- The approaching demographic pressures on fiscal resources,
which will hit most major economies at a time when underlying
fiscal positions are still likely to be in substantial deficit.
- The disposition of the global imbalances reflected most
conspicuously in the U.S. current account deficit.
- The inevitable evolution in the exchange rate regimes
of those countries that have been actively targeting their
nominal exchange rate against the dollar to a system where
there is more variability in their bilateral and real effective
- The transition from a long period of exceptionally low
short-term nominal and real interest rates to levels more
appropriate to the present circumstances. The slope and
shape of this path toward equilibrium is necessarily subject
to considerable uncertainty, and will depend on how the
These are all types of disequilibria. They can be sustained
for a time, but not indefinitely. The imbalances in our fiscal
and external positions could be diffused gradually and smoothly.
But the transitions to a more sustainable equilibrium could
also bring greater volatility in asset prices, less stability
in macroeconomic outcomes, slower growth and more uncertainty.
The strength of the financial system is an important factor
in assessing the probabilities associated with, and the potential
impact of, the greater volatility that might be associated
with these transitions. Where financial systems are strong
and resilient, they provide more of a cushion against shocks
and help improve the effectiveness of monetary policy in those
circumstances. Where they are weaker, they can amplify the
impact of shocks on macroeconomic activity and reduce the
effectiveness of monetary policy in mitigating shocks.
I believe the changes in the U.S. financial system over the
past two decades have produced a stronger and more stable
system. The large financial institutions at the core of the
system have substantial capital cushions and larger and more
diversified earnings capacity. These institutions maintain
capital above both the regulatory minimums and their internal
economic capital measures. The technology and practice of
risk management has improved dramatically. All types of risks
in financial intermediation are more broadly dispersed. The
financial infrastructure is stronger.
The combined effect of these changes seems likely to have
made the U.S. financial system more stable across a broader
range of circumstances. Although a substantial degree of uncertainty
surrounds any forward looking judgment about financial resilience,
the U.S. financial system seems less vulnerable to specific
shocks and better able to absorb larger shocks than was true
in the relatively recent past.
At the same time, however, changes in the structure of the
financial system and an increase in product complexity could
make a crisis more difficult to manage and perhaps more damaging.
Consolidation has produced a system in which a smaller number
of financial institutions, banks and non-banks, account for
a substantially larger share of financial intermediation.
Therefore, while the probability of a major crisis induced
by the financial failure of a major institution may be lower,
the damage associated with such an event could be higher.
An event large enough to threaten the solvency or liquidity
of one of these core institutions could have more severe impact
on the stability of the system than was the case in a less
The substantial increase in the role of hedge funds in our
financial system also complicates the challenge of risk management.
Although hedge funds help improve the efficiency of our system
and may also contribute to greater stability over time by
absorbing risks that other institutions would not absorb,
they may also introduce some uncertainty into market dynamics
in conditions of stress.
The rapid growth in instruments for risk transfer, most recently
in the credit world, has produced a large universe of exposures
in complex products, whose future value is uncertain and difficult
to model. The risk-reducing benefits of these innovations,
for individual institutions and for the system as a whole,
are substantial, but these benefits are to some extent qualified
by the limits of our knowledge of how they will perform in
conditions of stress.
The uncertainty and challenge posed by these developments
are complicated by the confidence engendered by the stability
and resilience of the U.S. economy over the past decade. Until
very recently, we have seen an unusual dynamic in financial
markets, in which low realized volatility in macroeconomic
outcomes, low realized credit losses and low uncertainty about
future inflation and interest rates have worked together to
bring risk premia down across many asset prices. There is
a self-reinforcing character to this pattern, with past stability
seemingly increasing confidence in future stability, and this
dynamic itself can magnify the risk of a more damaging reversal.
These are all good reasons to pay careful attention to the
strength of the financial system today. We have a strong interest
in ensuring that the largest institutions in our financial
system, and the system as a whole, are able to function reasonably
effectively, even in the face of a more turbulent economic
and financial environment.
Capital is critical to this objective, and our current Basel
I regulatory framework for capital is not up to the challenge.
We have a very important global effort underway to improve
the regulatory regime for capital, by tying it more closely
to the actual risk profile of financial institutions. Basel
II provides a much better way of determining the appropriate
level of capital to hold against risk. It does a better job
of capturing default risk and the true extent of risk transfer
in securitization, guarantees and credit derivatives. It provides
explicit recognition of operational risk, which can be larger
than exposure to market risk for some complex financial institutions,
not just for processing or clearing banks.
But Basel II is not the end of the process of designing a
better regulatory framework for capital in financial institutions.
As we move to refine and implement the Basel II framework
for credit and operational risk, we need to strengthen the
framework for market risk and encourage further improvements
in how firms capture the possibility of extreme events.
The current regulatory treatment of market risk does a good
job of capturing directional risk from movements in interest
rates, exchange rates and equity and commodity prices. It
is less effective, however, in capturing the full range of
risks associated with some newer products and trading strategies,
where values can react sharply and discontinuously. In particular,
the risks of trading strategies based on changes in the correlation
between asset returns are not always captured under the current
regulatory capital regime, nor are some of the risks associated
with traded credit products. And given the relatively short
history of some of these products, the current regulatory
treatment of market risk may not capture the risks of these
products going forward. While a clear consensus on the best
way to capture these risks has yet to fully emerge, these
are very active areas of risk modeling at banks, and this
is clearly a frontier area in both the regulatory and consensus
economic capital regimes.
In this regard, an important question to ask is how well the
current capital frameworks capture the possibility of extreme
events, those far in the “tail” of the distribution.
Stress testing can play an important role in addressing these
concerns. Stress tests should allow institutions to assess
likely losses under extreme market events, those that happen
too rarely to be captured under traditional value-at-risk
measures, but that could cause very significant losses to
the institution should they occur. Institutions have long
engaged in this kind of analysis for internal management purposes.
Now, however, those at the forefront of risk management are
assessing the adequacy of their value-at-risk results against
stress losses and finding ways of integrating the results
of stress testing into their capital frameworks. Indeed, an
important aspect of our supervisory process includes critically
assessing stress-testing regimes.
More rigorous and comprehensive stress testing of large shocks
across multiple markets, geographic regions and business lines
is vital, particularly for systemically important institutions.
In this context, we need to see more attention paid to risks
to market liquidity, and the effects on market liquidity that
could result from the exit of a major dealer. Stress regimes
need to capture market risk and credit risk across the firm,
incorporating exposures in priced credit products, such as
credit default swaps and structured credit products, and the
strong linkages between these priced credits and traditional
credit instruments such as bank loans. Stress regimes need
to take into account the effects of a firm’s own actions
and trading strategies on market prices during times of stress,
and the constraints on their room for maneuver imposed by
Banks hold a special place in our financial system, and most
of our focus on improving the regulatory framework for capital
will always be on banks. Getting to a greater degree of comfort
about the adequacy of the capital cushion for banks is a necessary
but not sufficient condition for achieving a higher level
of comfort about the resilience of our financial system. This
point applies equally well to non-bank financial firms that
play critical roles in our financial system. These institutions,
too, need to have internal controls and risk management systems
and capital levels commensurate with their critical role in
the financial system.
The SEC’s initiative to implement internal-models-based
regulatory capital requirements for securities firms as part
of the Consolidated Supervised Entity (CSE) framework will
help bring more consistency and more sophistication across
banks and securities firms in the capital treatment of traded
Among the major non-bank financial institutions, the most
important part of the financial system today where we need
a stronger capital regime relates to the GSEs. Even with the
improvements in risk management at these institutions over
the last few years, we are some distance from the point where
their regulatory capital requirements appropriately reflect
While critically important, capital alone does not define
an institution’s strength. It is vitally important for
firms to continue to invest in strong internal controls and
to make sure that advances in the operational infrastructure
keep pace with rapid growth, particularly in complex transactions.
Strong operational controls can help ensure smooth market
functioning in times of stress, and when they are weak they
can exacerbate adverse market dynamics. An important element
of a sound operational control environment is timely and accurate
information for senior managers, especially when it is most
critical for them to have a clear picture of the firm’s
exposure. As such, strong operational controls can help reduce
some dimensions of uncertainty and therefore help markets
function better in conditions of stress.
The challenge of ensuring that operational controls keep up
with front office advances in the complexity and volume of
transactions is particularly evident today in the area of
credit derivatives. The rapid growth in the trading of credit
default swaps and structured credit products has resulted
in considerable back-office backlogs (unsigned confirmations
and master agreements, delays in trade capture into risk management
systems, delayed notification of assignments of positions)
that create significant operational risk for market participants.
These types of operational problems have arisen more broadly
in the OTC derivatives market over time and they have gotten
worse with the rapid growth in activity by hedge funds. Efforts
underway to automate matching and confirmation of credit default
swap transactions should help address these concerns. But
we need to see a stronger collective commitment by the principal
dealers in these markets to reduce the outstanding backlog
of confirms, shorten confirm times and move larger share of
transactions in the more standardized instruments to automated
platforms. And we’ll act to reinforce that commitment.
These considerations are particularly important for the systemically
significant financial institutions that stand at the core
of the U.S. financial system. These institutions need to have
exceptionally high standards in terms of internal controls,
capital and risk management and governance. The greater complexity
of their risk profile puts more exacting demands on the risk
management architecture and requires a higher margin of capital
than would be necessary for a business profile with less volatility
and more predictability in returns. And the central role these
firms occupy in our financial system and the consequences
to other firms and to the stability of the financial system
should one of them face significant financial or operational
difficulties requires that they hold a higher margin of capital
above economic capital than would be appropriate for smaller
institutions with a similar risk profile.
These arguments are compelling on their own, and they are
made more compelling by the challenges ahead facing the U.S
and the world economy.
The increased stability in macroeconomic outcomes that has
characterized the last two decades, the relative ease with
which the U.S. financial system weathered the stress of the
equity market shock and September 11, the increased mobility
of the world’s savings and the optimism produced by
the acceleration in productivity growth, have all worked to
lower expected future volatility and risk premia. The reduction
in credit losses and in realized volatility has created room
for institutions to take greater risk without showing deteriorating
risk-based capital measures.
But the macroeconomic environment may not prove to be as benign
in the future as it has in the recent past. And it is important
that the major financial institutions in particular sustain
a strong capital cushion at levels that will enable them individually
and the U.S. financial system as a whole to manage safely
in a more uncertain and perhaps more volatile world.