Timothy F. Geithner, President and
Chief Executive Officer
at The Economic Club of New York, New York City
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
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
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, asset-backed commercial paper
conduits, in structured investment vehicles, in auction-rate preferred
securities, tender option bonds and variable rate demand notes, had a
combined asset size of roughly $2.2 trillion. Assets financed overnight
in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew
to roughly $1.8 trillion. The combined balance sheets of the then five
major investment banks totaled $4 trillion.
In comparison, the total
assets of the top five bank holding companies in the United States at
that point were just over $6 trillion, and total assets of the entire
banking system were about $10 trillion.
This parallel system
financed some of these very assets on a very short-term basis in the
bilateral or triparty repo markets. As the volume of activity in repo
markets grew, the variety of assets financed in this manner expanded
beyond the most highly liquid securities to include less liquid
securities, as well. Nonetheless, these assets were assumed to be
readily sellable at fair values, in part because assets with similar
credit ratings had generally been tradable during past periods of
financial stress. And the liquidity supporting them was assumed to be
continuous and essentially frictionless, because it had been so for a
The scale of long-term
risky and relatively illiquid assets financed by very short-term
liabilities made many of the vehicles and institutions in this parallel
financial system vulnerable to a classic type of run, but without the
protections such as deposit insurance that the banking system has in
place to reduce such risks. Once the investors in these financing
arrangements—many conservatively managed money funds—withdrew or
threatened to withdraw their funds from these markets, the system became
vulnerable to a self-reinforcing cycle of forced liquidation of assets,
which further increased volatility and lowered prices across a variety
of asset classes. In response, margin requirements were increased, or
financing was withdrawn altogether from some customers, forcing more
de-leveraging. Capital cushions eroded as assets were sold into
distressed markets. The force of this dynamic was exacerbated by the
poor quality of assets—particularly mortgage-related assets—that had
been spread across the system. This helps explain how a relatively small
quantity of risky assets was able to undermine the confidence of
investors and other market participants across a much broader range of
assets and markets.
Banks could not fully
absorb and offset the effects of the pullback in investor
participation—or the "run"—on this non-bank system, in part because they
themselves had sponsored many of these off-balance-sheet vehicles. They
had written very large contingent commitments to provide liquidity
support to many of the funding vehicles that were under pressure. They
had retained substantial economic exposure to the risk of a
deterioration in house prices and to a broader economic downturn, and as
a result, many suffered a sharp increase in their cost of borrowing.
The funding and balance
sheet pressures on banks were intensified by the rapid breakdown of
securitization and structured finance markets. Banks lost the capacity
to move riskier assets off their balance sheets, at the same time they
had to fund, or to prepare to fund, a range of contingent commitments
over an uncertain time horizon.
The combined effect of
these factors was a financial system vulnerable to self-reinforcing
asset price and credit cycles. The system appeared to be more stable
across a broader range of circumstances and better able to withstand the
effects of moderate stress, but it had become more vulnerable to more
extreme events. And the change in the structure of the system made the
crisis more difficult to manage with the traditional mix of instruments
available to central banks and governments.
What should be done to reduce these vulnerabilities?
Our first and most
immediate priority remains to help the economy and the financial system
get through this crisis.
A range of different
measures of liquidity premia and credit risk premia have eased somewhat
relative to the adverse peaks of mid-March.
Part of this
improvement—this modest and tentative improvement—is the result of the
range of policy actions by the Federal Reserve System, the U.S. Treasury
and other central banks. Part is the consequence of the substantial
adjustments already undertaken by financial institutions to reduce risk,
raise capital and build liquidity.
These actions by
institutions and by the official sector have helped to reduce the risk
of a deeper downturn in economic activity and of a systemic financial
But the U.S. economy and
economies worldwide are still in the process of adjusting to the
aftermath of rapid asset price growth and unsustainably low risk
premiums. This process will take time.
As we continue to work
with other central banks to ease the adjustment now under way in the
U.S. economy and globally, we are working to make the financial system
more resilient and to improve its capacity to deal with future crises.
We are working closely
with the Securities and Exchange Commission (SEC), with banking
supervisors in the United States and the other major economies, and with
the U.S. Treasury to strengthen the financial foundation of the major
investment and commercial banks. We have encouraged a significant
increase in the quality of public disclosure. We have supported efforts
that have brought a very substantial amount of new equity capital into
many financial institutions. These efforts will help mitigate the risk
of a deeper credit crunch. And even as the Federal Reserve has worked to
mitigate the liquidity pressures in markets by implementing a new set of
lending facilities, we have worked with the SEC and others to ensure
that the major institutions are strengthening their liquidity positions
and funding strategies.
We are also initiating
important steps to strengthen the financial infrastructure. We are in
the process of encouraging a substantial increase in the resources held
against the risk of default by a major market participant across the set
of private sector and cooperative arrangements for funding, trading,
clearing and settlement of financial transactions that form the
"centralized infrastructure" of the financial system. We have begun to
review how to reduce the vulnerability of secured lending markets,
including triparty repo by reducing, in part, the scale of potentially
illiquid assets financed at very short maturities.
This afternoon, 17 firms
that represent more than 90 percent of credit derivatives trading, meet
at the Federal Reserve Bank of New York with their primary U.S. and
international supervisors to outline a comprehensive set of changes to
the derivatives infrastructure. This agenda includes:
- the establishment of
a central clearing house for credit default swaps,
- a program to reduce
the level of outstanding contracts through bilateral and multilateral
- the incorporation of
a protocol for managing defaults into existing and future credit
derivatives contracts, and
- concrete targets for
achieving substantially greater automation of trading and settlement.
These changes to the
infrastructure will help improve the system's ability to manage the
consequences of failure by a major institution. Making these changes
will take time, but we expect to make meaningful progress over the next
The set of ongoing and
near-term initiatives I just outlined are only the beginning and should
be considered a bridge to a broader set of necessary changes to the
regulatory framework in the United States and globally.
I believe the severity
and complexity of this crisis makes a compelling case for a
comprehensive reassessment of how to use regulation to strike an
appropriate balance between efficiency and stability. This is
exceptionally complicated, both in terms of the trade-offs involved and
in building the necessary consensus in the United States and the world.
It is going to require significant changes to the way we regulate and
supervise financial institutions, changes that go well beyond
adjustments to some of the specific capital charges in the existing
capital requirement regime for banks.
We have to recognize,
however, that poorly designed regulation has the potential to make
things worse. We have to distinguish carefully between problems the
markets will solve on their own and those markets cannot solve. We have
to acknowledge not just that regulation comes with costs, but that if
not carefully crafted it can distort incentives in ways that may make
the system less safe. And we have to focus on ways regulation can
mitigate the moral hazard risk created by the actions central banks and
governments have taken and may take in the future to avert systemic
I am going outline some
broad proposals for reform, focusing on the aspects of our system that
are most important to reducing systemic risk. These proposals do not
address a myriad of other important aspects of regulatory policy,
including consumer protection issues in the mortgage origination
business, the future role of government and government-sponsored
enterprises in our housing markets, and many others.
Any agenda for reform
has to deal with three important dimensions of the regulatory system.
policy. These are the incentives and constraints designed to
affect the level and concentration of risk-taking across the financial
system. You can think of these as a financial analog to imposing speed
limits and requiring air bags and antilock brakes in cars, or
establishing building codes in earthquake zones.
structure. This is about who is responsible for setting and
enforcing those rules.
management. This is about when and how we intervene and about the
expectations we create for official intervention in crises.
Here are a few broad points on each of these.
The objectives of regulatory policy should be to improve the capacity of
the financial system to withstand the effects of failure and to reduce
the overall vulnerability of the system to the type of funding runs and
margin spirals we have seen in this crisis.
First, this means
looking beyond prudential supervision of the critical institutions to
broader oversight of market practices and the market infrastructure that
are important to market functioning. Two obvious examples: we need to
make it much more difficult for institutions with little capital and
little supervision to underwrite mortgages, and we need to look more
comprehensively how to improve the incentives for institutions that
structure and sell asset-backed securities and CDOs of ABS. And
supervision will have to focus more attention on the extent of maturity
transformation taking place outside the banking system.
practices and supervisory oversight has to focus much more attention on
strengthening shock absorbers within institutions and across the
infrastructure against very bad macroeconomic and financial outcomes,
however implausible they may seem in good times. After we get through
this crisis and the process of stabilization and financial repair is
complete, we will put in place more exacting expectations on capital,
liquidity and risk management for the largest institutions that play a
central role in intermediation and market functioning.
This is important for
reasons that go beyond the implications of excess leverage for the fate
of any particular financial institution. As we have seen, the process of
de-leveraging by large but relatively strong institutions can cause
significant collateral damage for market functioning and for other
Inducing institutions to
hold stronger cushions of capital and liquidity in periods of calm may
be the best way to reduce the amplitude of financial shocks on the way
up, and to contain the damage on the way down. Stronger initial cushions
against stress reduces the need to hedge risk dynamically in a crisis,
reducing the broader risk of a self-reinforcing, pro-cyclical margin
spiral, such as we have seen in this crisis.
How should we decide
where to set these constraints on risk-taking? This is hard, but the
objective should be to offset the benefits and the moral hazard risk
that come from access to central bank liquidity in crises, without
setting the constraint at a level that will only result in pushing more
capital to the unregulated part of the financial system.
Risk management and
oversight now focuses too much on the idiosyncratic risk that affects an
individual firm and too little on the systematic issues that could
affect market liquidity as a whole. To put it somewhat differently, the
conventional risk-management framework today focuses too much on the
threat to a firm from its own mistakes and too little on the potential
for mistakes to be correlated across firms. It is too confident that a
firm can adjust to protect itself from its own mistakes without adding
to downward pressure on markets and takes too little account of the risk
of a flight to safety—a broad-based, marketwide rush for the exits as
the financial system as a whole de-leverages and tries collectively to
move into more liquid and lower risk assets of government obligations.
supervision has to focus first on the stability of the core of financial
institutions, it cannot be indifferent to the scale of leverage and risk
outside the regulated institutions.
I do not believe it
would be desirable or feasible to extend capital requirements to
institutions such as hedge funds or private equity firms. But
supervision has to ensure that counterparty-credit risk management in
the regulated institutions contains the level of overall exposure of the
regulated to the unregulated. Prudent counterparty risk management, in
turn, will work to limit the risk of a rise in overall leverage outside
the regulated institutions that could threaten the stability of the
Supervision has to
explicitly focus on inducing higher levels of margin and collateral in
normal times against derivatives and secured borrowing to better cover
the risk of market illiquidity. Greater product standardization and
improved disclosure can also help, as will changes to the accounting
rules that govern what risks reside on and off balance sheets.
Finally, central banks,
governments and supervisors have to look much more carefully at the
interaction between accounting, tax, disclosure and capital
requirements, and their effects on overall leverage and risk across the
financial system. Capital requirements alone are rarely the most
The President's Working
Group on Financial Markets and the Financial Stability Forum has laid
out a very detailed list of reforms to begin this process. And we are
fortunate to have Jerry Corrigan engaged in working to shape a set of
recommendations to help us get the balance right.
Apart from the mix of incentives and constraints set by regulatory
policy, the structure of the regulatory system in the United States
needs substantial reform. Our current system has evolved into a
confusing mix of diffused accountability, regulatory competition, an
enormously complex web of rules that create perverse incentives and
leave huge opportunities for arbitrage and evasion, and creates the risk
of large gaps in our knowledge and authority.
This crisis gives us the
opportunity to bring about fundamental change in the direction of a more
streamlined and consolidated system with more clarity around
responsibility for the prudential safeguards in the system. In this
regard, Secretary Paulson's blueprint outlines a sweeping consolidation
and realignment of responsibilities, with a clear set of objectives for
achieving a better balance between efficiency and stability, between
market discipline and regulation. This proposal has stimulated a very
constructive set of discussions, and will help lay the foundation for
action when the dust settles.
The most fundamental
reform that is necessary is for all institutions that play a central
role in money and funding markets—including the major globally active
banks and investment banks—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 centralized
payments, clearing and settlements systems but the infrastructure that
underpins the decentralized over-the-counter markets.
The Federal Reserve
should play a central role in this framework, working closely with
supervisors here and in other countries. At present the Federal Reserve
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.
No financial system will be free from crises, whatever the design of the
regulatory framework or the rules of the game. The framework of
lender-of-last-resort policies and the regime for facilitating an
orderly resolution of a major non-bank financial institution are
critical to our ability to contain financial crises.
In response to this
crisis, the Federal Reserve has designed and implemented a number of
innovative new facilities for injecting liquidity into the markets.
These facilities have played a significant role in easing liquidity
strains in markets and we plan to leave them in place until conditions
in money and credit markets have improved substantially.
We are also examining
what suite of liquidity facilities will be appropriate in the future,
with what conditions for access and what oversight requirements to
mitigate moral hazard risk. Some of the mechanisms we have employed
during this crisis may become permanent parts of our toolkit. Some might
be best reserved for the type of acute market illiquidity experienced in
It would be helpful for
the Federal Reserve System to have greater flexibility to respond to
acute liquidity pressure in markets without undermining its capacity to
manage the federal funds rates at the FOMC's (Federal Open Market
Committee) target. The authority Congress has granted the Fed to pay
interest on reserves beginning in 2011 will be very helpful in this
regard. We welcome the fact that Congress is now considering
accelerating that authority.
The major central banks
should put in place a standing network of currency swaps, collateral
policies and account arrangements that would make it easier to mobilize
liquidity across borders quickly in crisis. We have some of the elements
of this framework in place today, and these arrangements have worked
relatively well in the present crises. We should leave them in place,
refine them further and test them frequently.
The Federal Reserve Act
gives us very broad authority to lend in crises. We used that authority
in new and consequential ways, but in the classic tradition of central
banks and lenders of last resort. As we broadened the range of
collateral we were willing to finance, extended the terms of our lending
and provided liquidity insurance to primary dealers, our actions were
carefully calibrated to improve overall market functioning by providing
an effective liquidity backstop and to avoid supplanting either the
interbank market or the secured funding market.
In addition to these new
facilities, the Fed made the judgment, after very careful consideration,
that it was necessary to use its emergency powers to protect the
financial system and the economy from a systemic crisis by committing to
facilitate the merger between JPMorgan Chase and Bear Stearns. We did
this with great reluctance, and only because it was the only feasible
option available to avert default, and because we did not believe we had
the ability to contain the damage that would have been caused by
Our actions were guided
by the same general principles that have governed Fed action in crises
over the years. There was an acute risk to the stability of the system;
we were not confident that the damage could be contained through other
means; we acted only to help facilitate an orderly resolution, not to
preserve the institution itself; and the management of the firm and the
equity holders of the institution involved suffered very substantial
Although we assumed some
risk in this transaction, that risk is modest in comparison to the risk
of very substantial damage to the financial system and the economy as a
whole that would have accompanied default.
One of the central objectives in reforming our regulatory framework
should be to mitigate the fragility of the system and to reduce the need
for official intervention in the future. I know that many hope and
believe that we could design our system so that supervisors would have
the ability to act preemptively to diffuse pockets of risk and leverage.
I do not believe that is a desirable or realistic ambition for policy.
It would fail, and the attempt would entail a level of regulation and
uncertainty about the rules of the game that would offset any possible
benefit. I do believe, however, that we can make the system better able
to handle failure by making the shock absorbers stronger.
This crisis exposed very
significant problems in the financial systems of the United States and
some other major economies. Innovation got too far out in front of the
knowledge of risk.
It is very important
that we move quickly to adapt the regulatory system to address the
vulnerabilities exposed by this financial crisis. With the leadership of
the Secretary of the Treasury, Hank Paulson, we are beginning the
process of building the necessary consensus here and with the other
major financial centers.
Let me just finish by
saying that confidence in any financial system depends in part on
confidence in the individuals running the largest private institutions.
Regulation cannot produce integrity, foresight or judgment in those
responsible for managing these institutions. That's up to the boards and
shareholders of those institutions.
One of the great
strengths of our system is the speed with which we adapt to challenge.
We can do better, and I am reasonably confident we will.