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Risk Management Challenges in the U.S. Financial System
|February 28, 2006|
Timothy F. Geithner, President and Chief Executive Officer
Remarks at the Global Association of Risk Professionals (GARP) 7th Annual Risk Management Convention & Exhibition in New York City
Thank you for giving me the opportunity to speak to you today.
We have seen dramatic changes in the U.S. and global financial system over the past 25 years, and we are now in the midst of another wave of innovation in finance. The changes now underway are most dramatic in the rapid growth in instruments for risk transfer and risk management, the increased role played by nonbank financial institutions in capital markets around the world, and the much greater integration of national financial systems.
These developments provide substantial benefits to the financial system. Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries.
These changes have contributed to a substantial improvement in the financial strength of the core financial intermediaries and in the overall flexibility and resilience of the financial system in the United States. And these improvements in the stability of the system and efficiency of the process of financial intermediation have probably contributed to the acceleration in productivity growth in the United States and in the increased stability in growth outcomes experienced over the past two decades.
These generally favorable judgments require some qualification, however. These changes appear to have made the financial system able to absorb more easily a broader array of shocks, but they have not eliminated risk. They have not ended the tendency of markets to occasional periods of mania and panic. They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial system from the effects of such a failure.
The resilience demonstrated by the financial system in the face of the major macroeconomic and financial shocks of the past two decades owes something to the nature of those shocks and the ability of the monetary authorities to mitigate the effects of those shocks. And there are aspects of the latest changes in financial innovation that could increase systemic risk in some circumstances, by amplifying rather than dampening the movement in asset prices, the reduction in market liquidity and the associated damage to financial institutions.
My remarks today focus on the challenges these developments, particularly the growth in the over-the-counter derivatives market, present for risk management professionals. And I will offer some perspectives on how these challenges should affect the hierarchy of priorities of central banks, and of those who have responsibility for supervision and oversight of the financial system.
A characteristic feature of periods of financial innovation is that growth in new instruments and changes in the structure of those markets can outpace the development of the risk management and processing and settlement infrastructure. This gap, the gap between the speed at which markets move to capture the benefits of new opportunities and the pace of development in the supporting control and execution infrastructure, is inevitable. The size and duration of the gap and the risks it presents to the financial system are a function both of will and of ability. They are determined, in part, by the scale of investments that firms make in the infrastructure—investments in people, in technology and in control processes—and they are determined in part by knowledge and experience, which are functions of the environment surrounding innovation.
Market discipline exercised by counterparties should create incentives to close these gaps relatively quickly, but competition among financial intermediaries can, at least for some period of time, create offsetting incentives and may make individual institutions less willing to move ahead of the pace of improvement of average practice among market participants. This can take the form of what economists call a collective action problem, leaving individual institutions and the systems as a whole with more risk than would be desirable.
And when innovation, such as we are now seeing in credit derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances. The past several years of exceptionally rapid growth in credit derivatives and the larger role played by nonbank financial institutions, including hedge funds, has occurred in a context of very low realized credit losses, low expectations of future default risk, a high degree of confidence in the financial strength of the major banks and investment banks, relatively strong and significantly more stable economic growth, less concern about the level and volatility in future inflation, and low expected volatility in many asset prices. Even if a substantial part of these changes prove durable, we know less about how these markets will function in conditions of stress, and the most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity.
Several aspects of the present context are worth highlighting.
What can be done to mitigate these risks? The two general areas that offer the highest potential return in reducing systemic risk are improvements (1) in the sophistication of the risk management process used to generate adequate capital and liquidity cushions against a severe economic or market disruption and (2) in the post trade processing and settlement infrastructure.
The frontier of challenges in the risk management process lies principally in the discipline of stress testing and scenario analysis to capture potential losses in adverse conditions in the "tail" of the distribution. This has been and will continue to be a principal focus of our supervisory efforts. Best practice in these areas is defined by several factors, including:
Alongside the ongoing efforts by firms to get closer to the frontier of best practice in risk management, it is very important to see a substantial and sustained investment in improving the infrastructure that underpins the over-the-counter derivatives market.
The major dealers in the credit derivatives market have begun a major effort to close the gap between the level of the business they are undertaking and their operational capacity to manage effectively the legal, operational and settlement risks in that business.
Over the past six months:
I want to conclude with a few observations about the role of supervision in encouraging progress in both these areas of risk management and the infrastructure for these markets.
These changes have many positive implications but they also mean that differences in the incentives faced by institutions with different supervisory and regulatory regimes can have larger competitive effects, and the effects of regulatory arbitrage can reduce the impact of changes applied only to regulated or supervised institutions. They suggest that adverse developments outside the banking system, such as the failure of a major nonbank financial intermediary, can potentially cause greater damage to the core of the financial system than might have been the case in the past. They mean that in thinking about ways to mitigate systemic risk it is not tenable to focus simply on bank-centered financial institutions, and it is not feasible to achieve change through national approaches applied only to the institutions of the home country.
For these reasons, where we see a need to induce a broader change in market practice, a broader range of informal mechanisms of cooperation among supervisors, among market participants and involving supervisors and market participants would be useful.
The second generation of the Counterparty Risk Management Policy Group, led by Jerry Corrigan, is one example of a market-led initiative to define a set of common challenges and recommendations for change. Supervisors in the major financial centers are following progress against those recommendations closely.
The effort to improve the post trade processing infrastructure for over-the-counter derivatives is an example of regulatory cooperation to help address a collective action problem among market participants, with some encouraging initial results. In this effort, the 14 major dealers along with almost as many supervisors and market regulators from the United States and other major countries, met at the New York Fed in September 2005. We outlined our concerns and asked the dealers to give us a plan for how to fix the problem. They came up with a credible plan, with a set of outcomes-based targets, and agreed to report progress on a common set of metrics. The clarity of the objectives and the reporting system provided a stronger collective confidence that individual firms would be held to similar standards independent of their principal supervisor.
And we have made a more systematic effort to share concerns with the SEC, the FSA and other supervisors and identify areas where we can work in parallel to highlight issues we see in the major markets and encourage change among the major institutions. We are in the process, for example, of consulting with these and other authorities on the use of stress testing and scenario analysis in the largest institutions.
These efforts of course complement a substantial amount of cooperation in other contexts in the U.S. and internationally in the Financial Stability Forum, the Joint Forum and the Basel Committees on Banking Supervision and Payment and Settlement Systems.
These initiatives help keep the supervisors closer to developments in markets, more informed of differences in approaches across the functional and geographic lines of supervision, somewhat more nimble in responding to potential problems and closer to creating a more integrated supervisory framework.
The evidence to date suggests that dramatic growth in new instruments for risk transfer and the greater role of nonbank financial institutions have contributed to a more stable and more efficient financial system. But these changes present continuing challenges for the discipline of risk management. And these challenges are likely to continue to require a substantial level of investment by financial institutions to improve the sophistication of the risk management process and the operational infrastructure that supports these markets.
I would like to thank Stefan Walter, Robard Williams and Tim Clark of the Bank Supervision Group and Beverly Hirtle of the Research and Statistics Group at the Federal Reserve Bank of New York for assistance and comments.