Hedge Funds and Derivatives and Their Implications for the Financial System - FEDERAL RESERVE BANK of NEW YORK
Speech
Hedge Funds and Derivatives and Their Implications for the Financial System
September 15, 2006
Timothy F. Geithner
, President and Chief Executive Officer
Remarks at the Distinguished Lecture 2006, sponsored by the Hong Kong Monetary Authority and Hong Kong Association of Banks, Hong Kong
I want to thank Joseph Yam for inviting me to Hong Kong for this occasion.
We are approaching the 10-year anniversary of the financial crises of 1997-99.
Those crises were remarkable both in the scope of countries and markets they affected,
and for their speed and severity. The circumstances leading up to the crises varied
across countries and regions, as did the magnitude of the resulting damage to
the real economy. But each of these events had one dynamic in common—the
confluence of a sharp increase in risk perception, and the subsequent actions
taken by financial institutions and investors to limit their exposure to future
losses. As asset prices declined and volatility increased in response to increased
concern about risk, firms moved to call margin, to reduce positions and to hedge
against further losses. These individual actions had the aggregate effect of inducing
even larger price declines and further heightening perceptions of risk, ultimately
propagating and amplifying the effects of the initial shock.
The dynamic I just described was not unique to the crises of the late 1990s,
nor was the damage to overall economic activity they left in their wakes. Systemic
financial events with spillovers to the real economy have been a persistent
feature of the economic environment, and both financial market participants
and policymakers have grappled with the challenge of how to reduce their incidence
and to minimize their severity, longevity and impact on the broader economy.
There is a lot we do not understand about these challenges, but we know more
today than we once did. In the case of the crises of the late 1990s, despite
the broad-based nature of the financial market turmoil, in countries where capital
cushions in the financial sector were strong relative to risk, where there was
a greater diversity of institutions in the financial system to absorb the losses,
and where monetary authorities were in a position to provide liquidity to restore
confidence, the financial and macroeconomic impact of the crises was relatively
modest. Where those conditions did not exist, the damage was acute.
The U.S. economy appears to have become more resilient to financial shocks.
Over the past two decades, the U.S. economy has experienced several episodes
of significant financial market strain. These episodes were associated with
spikes in risk perception and significant market volatility within financial
markets, but none proved exceptionally damaging in terms of the overall macroeconomic
impact. The mild impact of these episodes on the real economy contrasts with
financial events such as the “credit crunch” that exacerbated the
1990-91 recession. That episode was characterized by a widespread reduction
in the provision of credit by banks in response to loan losses and the need
to raise capital.
The resiliency we have observed over the past decade or so is not just good
luck. It is the consequence of efforts by regulatory, supervisory and private
financial institutions to address previous sources of systemic instability.
Risk management has improved significantly, and the major firms have made substantial
progress toward more sophisticated measurement and control of concentration
to specific risk factors. What seems to have been most critical in preventing
financial market turmoil from translating into a significant reduction in credit
provision by banks and other financial institutions were the steps taken by
regulatory authorities and financial institutions alike to strengthen capital
in the core of the financial system, and to measure and manage risk.
These efforts have most notably manifested themselves in increased levels of
risk-adjusted capital in the core of the system relative to what prevailed in
the early 1990s. In the United States, for example, tier-one risk-based capital
ratios have stabilized near 8.5 percent, considerably higher than the estimated
levels around 6.5 percent for the early 1990s. This is based on a relatively
crude measure of risk, but the direction of the improvement is right and the
magnitude of the change is significant.
Relative to the conditions that prevailed in the early 1990s, the higher levels
of capital in the core now provide a larger buffer against shocks and enhance
the ability of the banking industry to act as a critical stabilizer in times
of stress by providing liquidity to the corporate sector. When financial markets
dry up, firms turn to banks and their unused loan commitments and lines of credit.
Banks are in a position to fund this liquidity because transaction deposits
tend to flow into the banking sector. In times of crisis, it appears that U.S.
investors now run to banks, not away from them.
In view of the critical role that efficient credit provision plays in economic
growth and development, the benefits to the global economy of getting the underpinnings
of a stable, efficient financial system in place are substantial. At the same
time, we also know that these important markets are susceptible to certain “market
failures,” such as information asymmetries, incentive conflicts, moral
hazard and agency problems. By at times distorting incentives to manage risk,
these market imperfections can alter credit decisions and lead to a higher overall
level of risk-taking than may be optimal for the economy as a whole. This provides
the classic rationale for supervision and regulation. Supervision and regulation
have the potential to help mitigate these sources of market failure. The recognition
of a market failure does not mean, of course, that policymakers have the capacity
to design solutions that can effectively mitigate those failures without raising
others problems.
The fundamental challenge for policy is how to achieve the appropriate balance
between efficiency and financial resilience. With too much government intervention,
innovation is constrained and the system is stifled. With too little, the probability
of systemic crisis may rise to levels that are unacceptably high. We judge the
appropriate balance not against the standard of whether it reduces to zero the
probability of a major financial crisis, the failure of a large individual financial
institution or a major reduction in asset prices. That is not an appropriate
objective of policy. Some vulnerability to crisis is a necessary and unavoidable
feature of a dynamic and efficient financial system where asset prices need
to be able to adjust to changes in fundamentals. The consequences of trying
to induce regulated financial institutions to self-insure against all conceivable
potential risks would do substantial damage to the level and efficiency of economic
activity and cause the same risks to migrate to other institutions.
This leaves policymakers with a set of normative questions, the answers to
which must be based on knowledge about how markets work, as well as a substantial
degree of judgment about what policy actions are likely to be both appropriate
and effective. What level of exposure to very low probability, extreme adverse
events should we be comfortable living with? What fraction of that residual
exposure to the potential range of adverse events can and should the official
sector try to protect the system against?
The apparent success that market participants and supervisors have had so far
in confronting these issues does not imply that the potential for systemic risk
in financial markets no longer deserves the attention of central banks and supervisors.
Although improvements in capital adequacy and risk-management tools seem to
have been a key part of the increased resiliency we’ve seen in recent
years, we can’t assume that the standards and risk-management practices
consistent with stability in the recent past are the ones that will perform
well in the future. This is partly because it is impossible to know for sure
how the favorable macroeconomic conditions and the financial sector stability
interacted and reinforced each other. That is, would financial sector outcomes
be as favorable in a weaker macro environment?
But probably more important is the fact that even as we have pushed forward
on regulatory, supervisory and risk-management efforts, financial markets, instruments
and institutions have continued to evolve as well. Among the most notable of
these changes has been the rapid growth and innovation in derivatives and the
greater relative importance of private leveraged financial institutions, such
as hedge funds.
The changes in credit markets that have accompanied the latest wave of innovation
in derivatives and the large role played by leveraged financial institutions
in those markets may exacerbate some of the traditional sources of challenges
in financial markets. And they present new challenges for the framework of incentives
and constraints that central banks and supervisors set for financial institutions.
On balance, we believe these changes in the financial environment are likely
to come with substantial benefits in terms of overall market efficiency. In
the remainder of my remarks today, I will highlight some of these benefits,
but will also consider some of the challenges they present for central banks
and governments in determining where on the spectrum of efficiency and vulnerability
to crisis the financial system should operate, and in crafting the policies
consistent with achieving that objective.
Changes in Financial Markets Since the Late 1990s
In the United States and the other major markets, the policies designed to
mitigate the risk of financial crises rely primarily on a capital-based system
of supervision of the major financial institutions, reinforced by measures to
improve market discipline. These policies have evolved to reflect both the fundamentally
important role credit markets play in the economy, as well as the reality that
these complex markets are susceptible to a range of potential market failures.
In thinking about the potential supervisory and regulatory challenges presented
by the broad evolution of the financial system over the past decade, it makes
sense to first consider how some of these changes may have enhanced market functioning
by mitigating at least some of the imperfections that characterize these markets.
My remarks here are a mix of what we see happening in practice and how we might
expect things to work in principle.
To begin with, financial institutions within the regulated core of the financial
sector have become larger, and the industry considerably more concentrated.
The 10 largest bank holding companies now hold roughly half of banking assets,
compared to less than a third in 1990. These institutions now operate with greater
geographic scope and offer a broader range of financial products, but overall
volatility of earnings has not changed much relative to capital.
Hedge funds, private equity funds and other leveraged financial institutions
control increasingly large shares of aggregate financial capital and play very
active roles in many asset markets and in credit markets. Although assets under
management in hedge funds still represent a relatively small share of total
financial assets, their relative share has increased significantly and their
ability to take on substantial leverage magnifies their potential impact on
financial market conditions. These private leveraged funds have become an important
source of protection to regulated institutions by being large sellers of credit
insurance in the rapidly growing market for credit default swaps.
In terms of enhancing overall market efficiency, the growth of these private
leveraged institutions can be expected to provide benefits in terms of improved
liquidity, price discovery via arbitrage, diversity of opinion and diversification
opportunities for investors. The increase in the share of assets managed by
private pools of capital devoted to arbitrage activity should improve the overall
functioning of markets. In most circumstances, increased trading and participation
contributes to market liquidity and makes markets less volatile. The ultimate
benefit should be lower risks for all market participants. This in turn should
reduce the risk premia associated with holding financial assets, and ultimately
reduce the cost of capital.
The rapid growth in the relative importance of these leveraged financial institutions
has been accompanied by a number of structural changes as well. The total number
of funds has grown dramatically. There are more very large hedge funds and private
equity firms. Greater institutionalization, and the maturity of risk management
and operational infrastructure in the largest of these private funds, has likely
reduced operational risk. To the extent these changes have increased the diversity
of firms and strategies in this part of the financial system, and this is hard
to measure with any confidence, this heterogeneity should provide diversification
opportunities, foster more efficient price discovery and could help improve
stability.
These changes in market participants have occurred in conjunction with a dramatic
acceleration in number and type of derivative instruments. These developments
have likely had the important impact of allowing for a more efficient distribution
and more effective management of risk.
All of these changes should move the market in the direction of fostering the
efficient allocation of credit and capital formation, and thus enhancing the
economy’s real growth potential.
The available evidence is consistent with the view that the changes in the
core of supervised institutions, growth of the leveraged sector and rapid financial
innovation have strengthened the efficiency and resiliency of the overall financial
system. As I mentioned at the start, a broad range of recent financial shocks
do not seem to have adversely impacted the real economy. The international financial
crisis that began in 1997 did not spillover to the nonfinancial sector in the
United States. The equity price collapse and deterioration in credit in 2000
did not cause significant damage to the core institutions in the U.S. market.
The relatively limited damage caused by operations failures of the 9/11 attacks
reflected the strength of the capital position of major intermediaries, as well
as the policy actions by the Federal Reserve to provide liquidity to the markets.
More recently, the series of smaller financial shocks experienced since 2001,
including the corporate bond defaults after 2001, the corporate accounting scandals
in 2002, credit downgrades in the U.S. automobile industry in 2005, the failure
of Refco, the sharp declines in mid-2006 in equity, commodity and emerging
markets debt prices caused little contagion to other markets and limited strain
on financial institutions.
Challenges
The favorable balance between efficiency and resilience in the financial system
we have observed recently does not of course guarantee we will achieve as favorable
a balance in the future. The prospects for future stability will depend in part
on how effective supervisors are in adapting policies in response to the ongoing
evolution in markets.
Financial institutions face strong incentives to monitor and limit their risk
profile and the risk-taking of their leveraged counterparties to some efficient
level where benefits balance costs at the margin. This is good for the firm
and also good from society’s perspective.
Private pools of capital have the capacity to use extensive leverage to amplify
returns. This leverage can be acquired in a variety of ways: through repurchase
agreements and reverse repos, through secured financing and securities lending
and through derivatives and structured financial products.
The ability of funds to take on risk and leverage is constrained by two external
sources of discipline—the returns required by their investors, and the
terms on which their dealers/financers are willing to extend credit. In other
words, the fund is constrained by the willingness of outsiders, collectively,
to take exposure to the fund. The willingness of banks and investment banks
to take on exposure to hedge funds is in turn influenced by the capital and
supervisory framework that applies to those institutions and the discipline
imposed on them by the market.
The effectiveness of market discipline in constraining the risk-taking behavior
of financial firms, however, may be compromised by the presence of market failures
of the type mentioned above. While this issue is at the heart of risk management
challenges for the provision of credit more broadly, the rise in the relative
size of the private leveraged fund sector and the rise in the importance of
new derivative financial instruments may complicate the design of policies and
risk-management practices to counteract these traditional frictions.
Virtually all types of credit markets suffer from informational problems—consider the challenge faced by a bank in assessing the risk associated with
lending to a small unrated company. But the complexity of new financial products,
the rapidity with which positions can change, and the lack of a long time series
of historical relationships seems likely to enhance these problems for leveraged
institutions operating in new markets such as credit derivatives.
Funds typically deal with several different banks and investments banks. The
desire to maintain the confidentiality of their trading strategies has traditionally
led firms to be quite opaque to outsiders and reluctant to give their banks
sufficiently detailed information on a real time basis about the risk profile
of the overall fund. Without that information, individual dealers or banks have
a difficult time evaluating the probability of default of a leveraged counterparty
and the potential covariance with other positions of the firm.
Individual firms may also see only a piece of the hedge fund’s positions,
and if their direct exposure to the individual fund is small, may perceive less
need to worry about the overall risk profile of the fund. Public disclosure
requirements designed to compensate for this information problem do not exist.
Even if information on the overall size of the fund’s positions were available
periodically, it would be difficult to accurately ascertain its risk profile.
This gives individual firms an incentive to free-ride on the due diligence or
monitoring by others, which may render resultant collective discipline inadequate.
The foundations of modern risk measurement rest on a framework that uses past
returns to measure or estimate the distribution of future returns. The stability
of the recent past, even if much of it proves durable, probably understates
potential risk. The parameters used to estimate value at risk can produce very
large differences in predicted exposure, especially at extreme confidence intervals.
Estimating the potential interactions among these exposures in conditions of
stress is even harder, due to the uncertainty about the behavior of investors
and other market participants and because of the potential effects of financial
distress on overall economic activity.
The relatively short history of returns for new products, the complexity of
measuring exposure in many new instruments and limitations on transparency
also create the potential for classic “agency” problems—internal
conflicts of interest that can lead to problematic outcomes. In exposures where
the measurement of potential loss is more uncertain, more subjective, and less
amenable to independent evaluation, for example, reasonable people can come
to very different judgments about the potential risk in a particular position.
Normal competitive pressures can push valuation methods away from the conservative
extreme and generate larger exposures to risk. As a result, individual firms
and the overall market are more exposed to risk in a stress scenario than would
be desirable.
Another set of challenges comes with the broader damage to markets that can
accompany the failure of a major financial institution. Firms have strong incentives
to avoid large financial losses and to reduce the risk of failure, of course,
but they do not have the incentive to internalize the potential external consequences
of their distress on the financial system, and it is unrealistic for market
participants to incorporate these risks into market prices. This “public
good” dimension of financial stability means that while the whole economy
benefits from a more stable financial system, each individual institution would
prefer that others incur the costs associated with its provision. As a result,
firms may collectively underinsure against the risk of failure and underinvest
in the infrastructure and policies that promote financial stability.
And finally, policies designed to reduce the risk of failure in financial markets
create moral hazard, dulling the incentive individual firms face to self-insure
against potential loss. We apply a set of capital requirements and supervisory
constraints to offset the distortion created by the safety net, but these may
not fully compensate for the impact on behavior of the broader range of financial
intermediaries of the perception that the authorities will act to protect the
financial system from systemic risk.
While these constraints and challenges may weaken the effectiveness of counterparty
discipline, they are not fatal constraints. If individual dealers to a very
large hedge fund each operate with adequate knowledge of the risk profile of
the fund, if they each make conservative judgments about their potential direct
exposure to the fund in a stress scenario, if they limit the overall exposure
of the firm as a whole to the broader market distress that might accompany that
failure of a major hedge fund, if they compensate for the uncertainty in making
these judgments by charging appropriate risk premia or building in a greater
cushion against adversity, and if the supervisory constraints on the core institutions
adequately offset the moral hazard that comes with that relationship, then the
financial system as a whole will be less vulnerable to distress in the hedge
fund sector. These are exacting conditions, but they are not unachievable. And
we all have an interest in encouraging progress toward that objective.
Implications for Policy and Risk Management
What are the implications of these challenges for central banks and supervisors?
The changes in the financial system we’ve seen over the past decade don’t
change the principal objectives of policy—to ensure that the core financial
institutions maintain an adequate cushion of capital in relation to risk, and
to build greater resilience into the infrastructure that supports the financial
markets. We have very limited ability to predict the sources of stress to the
financial system, but if the cushions at the core of the system are robust,
the risk of a systemic crisis will be diminished, and central banks will have
greater ability to mitigate the risk of broader damage to the economy.
The pace and extent of the changes in financial markets requires supervisors
to work harder to understand the consequences of changing market practice for
the incentives and constraints we impose on financial institutions. Let me give
two examples of evolving market practices that may help alleviate one concern
only to exacerbate another.
Collateral plays an increasingly important role in counterparty credit risk
management, particularly for highly leveraged counterparties. The increased
importance of variation margining plays a critical role in counterparty credit
risk management. These changes help limit the exposure of the core financial
institution to losses among their leveraged counterparties, but they also act
to exacerbate volatility, with asset price declines forcing further margin calls,
adding for further market declines. Where initial margin is thin in relation
to potential exposure, counterparties are more exposed to adverse movements
in asset prices, and in a situation of stress the actions they take to reduce
their exposure to further losses are likely to have a greater negative impact
on market dynamics.
In market conditions where initial margin may be low relative to potential
future exposure, the self-preserving behavior of leveraged funds and their counterparties
may be more likely to exacerbate rather than mitigate an unexpected deterioration
in asset prices and market liquidity. As financial firms demand more collateral,
funds are forced to liquidate positions, adding to volatility and pushing down
asset prices, leading to more margin calls and efforts by the major firms to
reduce their exposure to future losses. In the context of the previous discussion
of externalities, firms’ incentives to minimize their own exposure can
amplify the initial shock and impose on others the negative externality of a
broader disruption to market liquidity.
The fact that this potential adverse dynamic exists does not mean it will occur.
The deviation of prices from their fundamental values in times of stress is
likely to create incentives for firms and investors with resources to step in
and provide liquidity. In other words, the market may itself have the capacity
to self-correct and prevent a disruptive loss of liquidity.
A second example is the recent trend to lengthen lock-ups, implement redemption
gates that limit withdrawals, and create special side-pocket accounts for particularly
illiquid investments by hedge funds. Each of these changes may serve to reduce
the liquidity risk of the fund, which should be beneficial and potentially reduce
the disruption from the forced liquidation of positions. They may also, however,
reduce market discipline and increase the overall scale of leverage assumed
by those funds. We don’t have the capacity to assess with confidence the
balance of these effects on the probability of crisis and the severity of market
dynamics in conditions of stress.
What should be the focus of supervisory efforts in this new context? Clearly,
capital supervision and market discipline remain the key tools for limiting
systemic risk. The emergence of new market participants such as leverage institutions
does not change that. I am going focus on three broad policy priorities—risk
management, capital and margining practices, and the financial infrastructure.
Risk Management
We should focus more attention on parts of the risk-management process where
uncertainty is greatest and materiality of the risks that we can’t readily
quantify is highest. This means more attention on the risk factors where the
measurement challenges are most complex. It means more attention on assessing
potential exposure in extreme events that lie outside past experience, not just
those outside of the recent past.
These challenges require using a mix of different analytical tools to help
illustrate the range of possible outcomes and the dimensions of uncertainty
that apply to the measurement of exposure. The focus should be not on the specific
estimates produced for various types of asset price movements or stress events,
but the uncertainty that surrounds those estimates and the magnitude of the
potential underestimation of losses. Another way to say this is that we probably
need to spend as much time discussing the limits of the quantitative outputs
of the risk-management process as we do on the estimates produced by the models.
Understanding and evaluating “tail events”—low probability,
high severity instances of stress—is a principal, and extraordinarily difficult,
aspect of risk management. These challenges have likely increased with the complexity
of financial instruments, the opacity of some counterparties, the rapidity with
which large positions can change, and the potential feedback effects associated
with leveraged positions.
Stress testing and scenario analysis have become central to the process of
risk management, and we have seen substantial progress since 1998. The efficacy
of these tools should be judged in part by the extent to which they capture,
on a high frequency basis, the full exposure of the firm to a sufficiently broad
range of adverse conditions, the aggregate exposure to specific types of different
risk factors and types of counterparties, the potential interactions among those
factors, the effects of a general loss of liquidity and confidence in markets,
and the constraints on the ability of the firm to move to reduce its exposure
to further losses.
And, of course, the credibility of the risk-management process should be judged
not just by the quality of attempts to estimate stress exposure, but also by
the impact of these results on the decisions about how much exposure the firm
actually takes. In other words, effective stress testing must be viewed not
only as a tool for monitoring the risks a firm has taken, but for actually influencing
and changing behavior.
Supervisors should focus on concentrations of exposure to a range of different
risk factors, not just on the concern of the particular moment or the most recent
sources of shocks. Just as generals are often accused of preparing to fight
the last war, practice tends to chase measures of direct exposure implicated
in past crises, or what seem like the plausible candidates for future crises,
whether to real estate, to hedge funds, to structured financial products, to
emerging markets or to a particular industry.
This may be necessary and desirable, but it is not the most challenging task
in risk management, and we generally don’t put ourselves in the position
of trying to substitute our judgment for the markets on what level of direct
exposure to a particular company or industry is prudent relative to capital.
The better approach is to look at what might happen to the firm’s losses
in various alternative, more adverse states of the world, and then assess the
direct and indirect effects of distress in different parts of the portfolio
and the interactions among them. The major financial institutions, for example,
typically take on very little direct current exposure to hedge funds as group.
But, as you might expect, the scale of potential future exposure is more substantial.
An even greater challenge is measuring the exposure of the firm not simply to
the direct effects of the failure of a particular hedge fund counterparty, but
to the broader distress that it might cause to other market participants or
its impact on the other exposures of the firm. The management of these direct
and indirect exposures needs to be an important focus of attention.
Capital and Margin
Supervisors have put a considerable amount of effort over the past decade
into designing a successor to the Basel capital accord. The present regime does
not do a good enough job of capturing the risks a major institution typically
assumes today. Because it understates the amount of capital required against
some risks, overstates others, and ignores still others, we should work to put
in place a replacement regime as quickly as we can be confident we have a viable
alternative. The prudent, conservative approach should be to move forward to
a more risk sensitive framework that creates better incentives for prudent risk
management, not to try to extend the life of the present accord.
It is critical that these broader efforts to fix the capital regime be reinforced
with more attention by supervisors to margin practice and limits around the
counterparty risk-management process within the major financial institutions.
The regulatory capital regime is designed to offset the effects on individual
firms of lower margin. Where margin levels are low relative to potential exposure,
the capital requirement is higher. Where margin is higher, the capital charge
is lower. Both capital and margins have costs, and firms seek to limit these
costs and choose their preferred combination.
The question for policymakers is whether the mix of capital and margins produced
by the market is appropriate from the perspective of the financial system as
a whole. As forms of financing that enable leverage and as leveraged funds grow
in importance, the overall level of margin held against positions can provide
an important cushion against the type of adverse market dynamics and general
run on liquidity we saw in 1998. For these reasons, in the 2005 report of the
Counterparty Risk Management Policy Group, chaired by Gerry Corrigan, a diverse
mix of major market participants recommended that margin levels be set at a
threshold that is “sustainable over the cycle.” This reflects a
view that, in general, the initial margin required of unregulated leverage counterparties
should be set to provide some cushion against potential exposure.
Financial Infrastructure
Supervisors should continue to encourage improvements in the infrastructure
that supports financial markets. When we think about infrastructure in today’s
market, it’s not enough to look just at the technology and risk-management
systems that support the major exchanges and the payments and settlement systems
operated by central banks and private utilities. This view is reflected in the
amount of recent supervisory attention that has been focused on the systems
within and among private institutions that support the bilateral over-the-counter
derivatives markets. Last September, 14 major financial institutions and their
principal supervisors met at the Federal Reserve Bank of New York to undertake a concerted program of improvements
to the infrastructure that supports the OTC credit derivatives market. When
that group reconvenes next week, we will review the extent of progress in reducing
the backlog on unconfirmed trades and increasing the number of trade confirmed
through automatic systems. We will also assess the progress toward agreement
on a protocol for settlement events. And we will review new commitments to expand
this effort to other OTC derivatives, including equity derivatives.
These priorities for policy and supervision have the potential to strengthen
our financial system and make it more robust to real systemic events. To be
effective, however, we must continue to explore ways for supervisors and regulators
to cooperate more closely together. The changes in market structure and financial
innovation during the past decade, along with the increased global integration
of capital markets, have increased opportunities for regulatory arbitrage. Policy
initiatives that focus only on the U.S. market or on a specific class of institutions
will push the activity to other markets or other institutions, raising costs
on the regulated intermediaries without reducing overall risk in the system.
Balancing the imperative of a cooperative approach across markets and institutions
with the need for a more agile response to the rapid pace of evolution in markets
will be a continuing challenge.
Conclusion
The changes in the financial system since 1998 confront us with a mix of benefits
and challenges. The larger size and scope of the core institutions, the greater
opportunities for risk transfer and hedging provided by innovation in derivatives,
the improvements in risk management, the larger role played by a much expanded
number and more diverse mix of private fund managers seem likely to have improved
the stability and resilience of the financial system across a broader range
of circumstances.
The same factors that may have reduced the probability of future systemic events,
however, may amplify the damage caused by and complicate the management of very
severe financial shocks. The changes that have reduced the vulnerability of
the system to smaller shocks may have increased the severity of the large ones.
Supervisors need to continue to focus attention on reducing the vulnerability
of the market to these low probability, but extreme events, while preserving
the benefits that have come with these changes in financial markets. The limitations
of the conventional risk-management tools in assessing potential losses in the
adverse tail of possible outcomes in today’s financial system magnify
the risk that individual institutions will operate with less of a cushion than
might be desirable for the market as a whole.
As the structure of markets change, we need to continue to review whether the
overall framework of supervision over the core banks and investment banks provides
the right balance of efficiency and resilience for the system as a whole. The
capital requirements and other constraints we place on the regulated institutions
have played an important role in encouraging the transfer of risk to a broader
range of institutions, including the leveraged private pools of capital. As
the aggregate size and importance of those funds increases, distress among those
institutions can have greater effects on overall market dynamics, potentially
increasing risks to the regulated core. Over time, this will force us to consider
how to adapt the design and scope of the supervisory framework to achieve the
protection against systemic risk that is so important to economic growth and
stability.
For the present, however, our hierarchy of priorities should focus on improving
supervisory incentives to make counterparty discipline more effective and to
strengthen the resilience of the core institutions to more adverse economic
and financial conditions.
Thank you.
____________________________________
I would like to thank Kevin Stiroh and Meg McConnell of the Research and Statistics Group at the Federal Reserve Bank of New York for assistance and comments.
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