The Current Financial Challenges: Policy and Regulatory Implications - FEDERAL RESERVE BANK of NEW YORK
Speech
The Current Financial Challenges: Policy and Regulatory Implications
March 6, 2008
Timothy Geithner
, President and Chief Executive Officer
Remarks at the Council on Foreign Relations Corporate Conference 2008, New York City
I am going to talk today about some of the challenges facing the U.S.
and financial system. These problems took a long time to build up, and, even
with a forceful mix of public policy and action by the private sector, they
will take time to resolve.
The central questions are: what caused the crisis and what explains
its severity? What mix of policy measures will best contain the damage? And
what changes to the financial system are likely to produce greater stability
and resilience in the future?
Origins
The origins of this crisis lie in complex interaction of number of forces. Some
were the product of market forces. Some were the product of market failures. Some
were the result of incentives created by policy and regulation. Some
of these were evident at the time, others are apparent only with the benefit
of hindsight. Together they produced a substantial financial boom on
a global scale.
In the
five years leading up to the present stress, the world experienced an unusual
mix of financial conditions.
Real short-term interest rates were reduced around the world, following a
nearly decade long secular decline in inflation rates, a slowdown in growth
at the turn of this decade and subsequent deflation. As central banks
raised their policy rates when the outlook improved and deflation risks had
dissipated, both real and nominal long-term interest rates remained anomalously
low.
Global savings appeared to rise faster than did perceived real investment
opportunities, and this development helped to push down real long-term interest
rates around the world. At the same time, many emerging market
economies built up very large levels of official reserves to reduce external
vulnerability and to hold the value of their currencies stable against the
dollar. The exchange rate policies in these economies—economies
that together accounted for a increasing share of global GDP—made overall
global financial conditions more accommodative, even as the United States and other
countries tightened their monetary policies.
Expected and realized volatility in both debt and equity markets were remarkably
low for most of the last half a decade. Term premiums declined and remained
low over much of this period. Credit spreads across a wide range of asset
classes fell to levels that assumed unusually low levels of future losses. In
the United States, credit, and mortgage credit in particular, expanded relative
to GDP. Many households—including those previously lacking access
to credit or with access only to expensive credit—found they could borrow
on a significant scale to finance the purchase of a home and other expenses. Prices
rose across a range of real and financial assets, most notably the prices of
homes.
This constellation of broad economic and financial conditions was accompanied
by rapid innovation in financial instruments that made credit risk easier to
trade and, in principle at least, to hedge. These instruments allowed
investors to buy insurance or protection against a broader range of individual
credit risks, such as the default by a home owner or a company. Issuance
of asset-backed securities (ABS), collateralized debt obligations (CDOs) and
collateralized loan obligations (CLOs), as well as credit default swaps (CDS),
expanded on a dramatic scale, particularly from 2005 through to mid-2007. And
over this same period, the composition of the assets in ABS, as well as in
CDOs and CLOs, shifted to higher credit risk mortgages and loans issued by
noninvestment grade companies.
Even though these instruments allow credit risk to be shared, their holders
remain exposed to the less probable, but potentially very damaging effects
of a significant increase in losses driven by macroeconomic factors. As
underwriting standards deteriorated over this period, this exposure grew. And
yet risk premia continued to fall, suggesting that investors did not fully
appreciate the dynamic that was at work. As the boom persisted, investors
grew more confident in the relative stability of macro and financial conditions
and in the high levels of liquidity of the recent past, and projected that
stability into the future. That confidence in a more stable future led
to greater leverage and a larger exposure to the risk of a less benign world.
The interaction of these forces made the financial system as a whole more
vulnerable to a range of different weaknesses. The models used by issuers
to structure these products and by credit rating agencies to assess risk and
assign ratings turned out to be much more sensitive to macroeconomic assumptions
than was apparent to investors at the time. Assumptions about home price
appreciation and the correlation of defaults within the underlying collateral
pool were particularly critical in this context.
The proliferation of credit risk transfer instruments was driven in part by
an assumption of frictionless, uninterrupted liquidity. This left credit
and funding markets more vulnerable when liquidity receded. Banks and
other financial institutions lent substantial amounts of money on the assumption
that they would be able to distribute that risk easily into liquid markets. A
sizable fraction of long-term assets—assets with exposure to different
forms of credit risk—ended up in vehicles financed with very short-term
liabilities and was placed with investors and funds that were also exposed
to liquidity risk.
As is often the case during periods of rapid change, more significant concentrations
of risk were present than was apparent at the time. Banks and investment
banks sold insurance against what seemed like low probability events, but did
so at what even at the time seemed like low prices. And on the assets
they retained, these same institutions purchased insurance from financial guarantors
and other firms that were exposed to the same risks.
The crisis exposed a range of weaknesses in risk management practices within
financial institutions in the United States and throughout the world. Today,
a group of the primary supervisors of the largest banks and investment banks
in the world released a comprehensive assessment of risk management practices
in these institutions. This assessment will help lay the foundation for
consensus on changes to supervision going forward in the major financial centers. The
report examines a range of practices that helped determine relative performance
during this crisis. Banks and investment banks with stronger risk management
practices and cultures did substantially better. The most common failures
were in how firms dealt with uncertainty about the scale of losses they would
face in a less benign economic and financial environment; the scale of the
cushion they built up against that uncertainty; how well they managed the internal
tension between risk and reward; and how quickly they moved to mitigate risk
as conditions deteriorated.
The typical arsenal of risk management tools relies, by necessity, on history
and experience, and as a result has only limited value in assessing the scale
of potential future losses. These limitations were particularly damaging
in a period in which significant innovation in financial instruments and market
structure was coupled with relatively stable macroeconomic and financial conditions. Uncertainty
about the future, and the greater complexity of leveraged structured products,
created a dense fog around estimates of potential loss, making institutions
and markets more vulnerable to an adverse surprise when conditions changed,
and making it harder to manage the many principal agent problems inherent in
the financial business.
In effect, some major banks and investments banks made the choice to follow
the market down as underwriting practices eroded. They took on more exposure
to low probability but extremely adverse events, despite the potential consequences
of getting caught when the music stopped. And even though the largest
firms were able to move quickly to protect themselves as conditions worsened,
those actions had significant negative effects on market functioning and liquidity.
The current episode has a basic dynamic in common with all past crises. As
market participants have moved to reduce exposure to further losses, to step
on the brake, the brake became the accelerator, amplifying the shock. Measured
risk has increased more quickly than many institutions have been able reduce
it, and attempts to reduce it have added to volatility and downward pressure
on prices, further increasing measured exposure to risk. Uncertainty
about the market value of securities and about counterparty credit risk has
increased, and many hedges have not performed as intended. The rational
actions taken by even the strongest financial institutions to reduce exposure
to future losses have caused significant collateral damage to market functioning. This,
in turn, has intensified the liquidity problems for a wide range of bank and
nonbank financial institutions.
In this environment, banks have faced several different types of liquidity
and funding challenges. They have been called on to fund a range of
different contingent liquidity and credit commitments, as is typically the
case in crises. The substantial impairment of securitization and syndication
markets has been an additional challenge because it has reduced banks’ access
to liquidity and their capacity to move assets off balance sheets. As
the market value of many securities has declined, and investors have reduced
their willingness to finance more risky assets, liquidity conditions have eroded
further. In response, even the strongest institutions have become much
more cautious, building up large cushions of liquidity, bringing down leverage
and reducing financing for their leveraged counterparties.
Policy Measures
The self-reinforcing dynamic within financial markets has intensified the
downside risks to growth for an economy that is already confronting a very
substantial adjustment in housing and the possibility of a significant rise
in household savings.
The intensity of the crisis is in part a function of the size of the preceding
financial boom, but also of the speed of the deterioration in confidence about
the prospects for growth and in some of the basic features of our financial
markets. The damage to confidence—confidence in ratings, in valuation
tools, in the capacity of investors to evaluate risk—will prolong the
process of adjustment in markets. This process carries with it risks
to the broader economy. Macroeconomic and supervisory policies have an
important role to play in containing those risks.
Let me mention several critical areas of policy.
Monetary policy.
The Federal Open Market Committee (FOMC) has
reduced the nominal federal funds rate target substantially in a relatively
short period of time, with much of this reduction occurring ahead of the deterioration
in confidence and the broader slowdown in spending that is now apparent. But
even with those reductions in short-term interest rates in place, financial
conditions have tightened as risk spreads on a wide range of asset classes
and institutions have increased considerably. The critical risk to the
economic outlook remains the potential for the strains in financial markets
to have an outsized adverse effect on real economic activity, particularly
by exacerbating the already significant weakness in the housing sector. It
is important for monetary policy and liquidity instruments to be used proactively
in addressing this risk.
But this is not the only challenge we face. Headline and core inflation
have come in higher than anticipated, and inflation expectations have also
moved up. If the risk of significant damage to growth from these financial
market pressures is attenuated and if global growth remains strong and drives
a continuing rise in energy and commodity prices, then inflation may not moderate
as much as we anticipate. If the medium term outlook for inflation deteriorates
significantly, the FOMC will move with appropriate speed and force to address
this risk.
This requires a fine balance. The principal challenge for policy is
to provide an adequate degree of insurance against the downside risks that
still confront the economy as a whole, without adding to concerns about inflation
over the medium term. We cannot know with confidence today what level
of the short-term real funds rate will be consistent with our objectives of
sustainable growth and low inflation, but if turbulent financial conditions
and the associated downside risks to growth persist, monetary policy may have
to remain accommodative for some time.
Liquidity provision.
Although concerns about credit quality
are at the root of the current problems in financial markets, a substantial
impairment in market liquidity conditions can exacerbate and prolong the adjustment
in credit conditions. To mitigate this risk, we have taken a series
of actions to help reduce the risk that market liquidity conditions exacerbate
the adjustment process in credit markets.
By allowing institutions to finance with the central bank assets they could
no longer finance as easily in the market, we have reduced the need for them
to take other actions, such as selling other assets into distressed markets,
or withdrawing credit lines extended to other financial institutions, that
would have amplified pressures in markets. These measures—the Term
Auction Facility and swap arrangements—have had some success in mitigating
market pressures, in part by providing a form of insurance against future stress. We
now have in place a cooperative framework for liquidity provision among the
major central banks. And we have considerable flexibility to adjust the
dimensions of these liquidity tools. We will keep them in place as long
as necessary, and continue to adapt them where we see a compelling case to
do so.
Encouraging
financial repair
. The Federal Reserve is working closely with
other financial supervisors and regulators to facilitate the adjustment underway
in markets. This approach has two important elements. The first
is to encourage improvements in the quality of valuation methods and disclosure
by the major regulated financial institutions and the necessary adjustment
in valuations and reserves to reflect the deterioration in expected losses. Better
disclosure can reduce some uncertainty about the incidence and magnitude
of potential losses across the financial system, although it is important
to note that these estimates of losses are a function of the outlook for
the economy and will necessarily change as expectations of the future change.
The second
element is to encourage new equity capital raising, so that the burden for
preserving capital ratios does not fall principally on actions, such as asset
sales or reduced lending, that might exacerbate the credit crunch. We
have seen a very substantial flow of new capital into the financial system
much more quickly than has been the case in past crises. More will come. Those
institutions that move more quickly will obviously be in a stronger position
to deal with the challenges, and take advantage of the opportunities, ahead.
Fiscal
stimulus.
Monetary policy can, of course, play a powerful
role in reducing the downside risks to growth, but overall policy will be
more effective, particularly given the strains to the financial sector, if
the full burden does not fall on the tools available to the Federal Reserve. Fiscal
policy can play an important role. The stimulus program signed into
law by the President will provide a meaningful level of support to growth,
somewhere in the range of three quarters to one and half of a percentage
point of GDP growth over the next few quarters.
Targeted support for housing.
Policy can also play an important
role in helping cushion the effects of the fall in housing prices and the rise
in foreclosures in the United States. The decline in house prices and
the surge in foreclosures now underway will have significant spillovers to
other homes in the same neighborhoods, effects that are not fully incorporated
into decisions by private creditors and investors to workout mortgages on mutually
beneficial terms. The degree to which mortgages are now held in securitized
and complex leverage structures exacerbates the incentive and coordination
problems inherent in this situation. Carefully designed, targeted programs
in cooperation with the private sector can play an important role in resolving
the various constraints that are now impeding economically viable mortgage
restructurings. Given the breakdowns in the securitization process and
its potential impact on the supply of new mortgage credit, it also makes sense
to explore ways to expand the scope for existing government programs to support
financing of new homes.
This policy framework—macroeconomic stimulus, liquidity support, new
equity for the financial system, and targeted support for housing—will
help reduce the risks to the outlook and bring about an earlier return to growth
rates more in line with the economy’s long term potential.
Longer Term Reforms of the Financial System
The unwinding of this global financial boom has caused a substantial degree
of stress to the financial system.
Was this
preventable? I don’t believe that asset price and credit booms
are preventable. They cannot be effectively diffused preemptively. There
is no reliable early warning system for financial shocks. And yet policy
plays an important role in determining the dimensions of financial booms, and
policy helps determine the ability of the financial system and the economy
to adjust to its aftermath. We need to undertake a broad set of changes
to address the vulnerabilities in our financial system revealed by this crisis. Just
as a long list of factors contributed to the trauma, there is no single reform
that offers the promise of sufficient change.
The Presidents
Working Group on Financial Markets and the Financial Stability Forum, which
bring together policymakers and regulators from the major financial centers
around the world, are in the process of outlining a comprehensive framework
of reforms. Many of these recommendations will focus on changes
to the mortgage finance market, the ratings process for ABS and structured
credit products more broadly, regulatory and accounting treatment of these
instruments and special purpose financing vehicles, the disclosure requirements
on instruments and institutions, and other dimensions of the securitization
process.
I
want to conclude with a few comments on some of the broader policy questions
we face in designing these reforms.
Regulatory reform and simplification
. The regulations that
affect incentives in the U.S. financial system have evolved into a very complex
and uneven framework, with substantial opportunities for arbitrage, large gaps
in coverage, significant inefficiencies, and large differences in the degree
of oversight and restraint upon institutions that engage in very similar economic
activities. Some illustrations of this include the large shift in subprime
mortgage originations to less regulated institutions; the incentives to shift
risk to where accounting and capital treatment is more favorable; and the amount
of risk built up in entities that operate in the grey areas of implied support
from much larger affiliated institutions.
We need to move to a simpler framework, with a more uniform set of rules applied
evenly across entities involved in similar functions, and a more effective
balance of regulation and market discipline. And institutions that are
banks, or are built around banks, with special access to the safety net, need
to be subject to a stronger form of consolidated supervision than our current
framework provides.
Capital
. The U.S. banking system entered this financial shock
with capital cushions significantly above the regulatory thresholds, and in
a stronger position to withstand a downturn than was the case in the past. This
has made it possible for bank balance sheets to expand rapidly, which in turn
has helped offset the effects of the withdrawal of many nonbank financial institutions
from credit markets.
Yet the shock absorbers in the financial system as a whole—the financial
cushions that are critical to financial stability—have proved to be thinner,
and behavior has been more pro-cyclical than desirable.
This is in part the
consequence of changes in the structure of the financial system. Because banks
are now a smaller share of the system, a given level of stress on nonbanks
creates greater strain on the system as a whole. It is in part the consequence
of the fact that the present system focuses on mitigating the risks of firm
specific shocks, rather than a systematic market shock. And it is in part the
consequence of the fact that the present system is not designed to induce institutions,
particularly the largest ones, to internalize the negative consequences, the
negative externalities, of their actions on markets as a whole in conditions
of stress.
There is no simple solution to this problem. It requires a broad
look at the design of the present capital regime, the incentives it creates
for holding different forms of risk, and the scope of the application of
these requirements. As we move to a more modern and risk-sensitive
capital framework and reduce the perverse incentives in the current capital
requirements, we need to make sure that reserves, capital, and liquidity
provisions are more forward looking, and adjust appropriately through the
peaks and valleys of the cycle. This will increase the scope for banks
and other institutions that are subject to risk-based capital requirements
to act more as a stabilizing force in response to future financial market
shocks.
Market
infrastructure.
We are in the midst of a dramatic period of financial
innovation and growth in derivative instruments, but the pace of change the
growth in volume has brought a lot of challenges. Substantial progress
has been made to strengthen this infrastructure over the past two and a half
years, and the resilience of the broader financial infrastructure has been
a source of strength for the financial system during this crisis. However,
the systems and practices that support the over-the-counter (OTC) derivatives
market significantly lags that of securities markets and other mature markets. We
need to move quickly to put in place a more integrated operational infrastructure
that supports all major OTC derivatives products, is highly automated, has
robust operational resilience and risk management, and is capable of handling
very substantial growth in volumes.
Conclusion
The U.S. economic and financial system is undergoing a very challenging period
of adjustment, and we are likely to be living with a high degree of uncertainty
for some period of time about the ultimate magnitude and duration of the slowdown
underway. But it is important to recognize that we have already seen
a lot of adjustment. Prices and risk premia in many markets already reflect
a much more sober and cautious view of the world than they did a year ago. And
the degree of stress on markets that we have seen over the past six months
is due in part to the sheer magnitude and speed of that adjustment to a more
cautious view of the future.
The United States, the world economy, and the financial system as a whole, are more
resilient, than they were on the eve of previous downturns. The improvements
in productivity growth in the United States of the past decade have been followed
by significant improvements in potential growth and wealth accumulation in
many other countries. The scale of investable assets around the globe
is very substantial, and this will be an important source of demand for risk
assets. The improvements in monetary policy credibility and in financial
strength developed over the past few decades mean that policy around the world
has more room to adjust to deal with the challenge in the present environment.
Nevertheless, the challenges that remain are substantial. The speed
and agility with which public policy makers and private financial institutions
respond to the continuing pressures in a rapidly evolving environment will
determine how quickly and how smoothly market conditions return to normal—and
how rapidly the risks to the economic outlook are mitigated.
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