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Timothy Geithner: We Can Reduce Risk in the Financial System

Toomre Capital Markets LLC ("TCM") is a fan of New York Federal Reserve Bank President Timothy Geithner (as demonstrated by the post Timothy Geithner: "Illigitimum non Carborundum"). On Sunday June 8th 2008, Mr. Geithner penned a commentary piece in The Financial Times that calls for global banks and investment banks whose health is crucial to the global financial system should operate under a unified regulatory framework with "appropriate requirements for capital and liquidity". Entitled We can reduce risk in the financial system, this article is must reading for those struggling with the question of what will be the value of investment banking franchises in the post-Bear Stearns environment. The commentary reads as follows:

Since last summer, we have lived through a severe and complex financial crisis. Why was the financial system so fragile? What can be done to make the system more resilient in the future?

The world experienced a financial boom. The boom fed demand for risk. Products were created to meet that demand, including risky, complicated mortgages. Many assets were financed with significant leverage and liquidity risk and many of the world's largest financial institutions got themselves too exposed to the risk of a global downturn. The amount of long-term illiquid assets financed with short-term liabilities made the system vulnerable to a classic type of run. As concern about risk increased, investors pulled back, triggering a self-reinforcing cycle of forced liquidation of assets, higher margin requirements, increased volatility.

What should be done to strengthen the system in the future? First, when we get through this crisis we have to increase the shock absorbers held in normal times against bad macroeconomic and financial outcomes. This will require more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning. They should be set high enough to offset the benefits that come from access to central bank liquidity, but not so high that they succeed only in pushing more capital to the unregulated part of the financial system.

Second, we have to improve the capacity of the financial infrastructure to withstand default by a big institution. This will require taking some of the risk out of secured funding markets, increasing resources held against default in the centralised clearing house, and encouraging more standardisation, automation and central clearing in the derivatives markets.

Third, the regulatory framework cannot be indifferent to the scale of leverage and risk outside the supervised institutions. I do not believe it would be desirable or feasible to extend capital requirements to leveraged institutiions such as hedge funds. But supervision has to ensure that counterparty credit risk management in the supervised institutions limits the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system. And regulatory policy has to induce higher levels of margin and collateral in normal times against derivatives and secured borrowing to cover better the risk of market illiquidity.

Fourth, we need to streamline and simplify the US regulatory framework. Our system has evolved into a confusing mix of diffused accountability, regulatory competition and a complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion. The blueprint by Hank Paulson, Treasury secretary, outlines a sweeping consolidation and realignment of responsibilities.

The institutions that play a central role in money and funding markets – including the main globally active banks and investment banks – need 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 established payments, clearing and settlements systems, but the infrastructure that underpins the decentralised over-the-counter markets.

Because of its primary responsibility for the stability of the overall financial system, the Federal Reserve should play a central role in such a framework, working closely with supervisors in the US and in other countries. At present the Fed 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.

Finally, we need a stronger capacity to respond to crises. The Fed has put in place a number of innovative new facilities that have helped ease liquidity strains. We plan to leave these in place until conditions in money and credit markets have improved substantially.

We are examining what framework of facilities will be appropriate in the future, with what conditions for access and what oversight requirements to mitigate moral hazard risk. Some of these could become a permanent part of our instruments. Some might be best reserved for the type of acute market illiquidity experienced in this crisis.

Authority to pay interest on reserves would give the Fed the ability to respond to acute liquidity pressure in markets without undermining its capacity to manage the federal funds rates in line with the federal open market committee's target.

The big central banks should put in place a standing network of currency swaps, collateral policies and account arrangements that would make it easier to mobilise liquidity across borders quickly in a crisis.

As we reshape the incentives and constraints for risk-taking in the financial system, we have to recognise that regulation has the potential to make things worse. Regulation can distort incentives in ways that may make the system less safe. One of the strengths of our system is the speed with which we adapt to challenge. It is important that we move quickly to adapt the regulatory system to address the vulnerabilities exposed by this financial crisis. We are beginning the process of building the necessary consensus here and with the other main financial centres.

On Monday, June 9th 2008, Mr. Geithner will be making a presentation to the same Economic Club of New York at which former Federal Reserve Chairman Paul Volker criticized the current Chairman Ben Bernanke. TCM wrote of Mr. Volker's comments in the post Volker Takes on Bernanke. Mr. Geithner's commentary and speech are no doubt in reaction to Mr. Volker's criticisms. TCM will write further of Mr. Geithner's speech contents once the text becomes available.