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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”, according to Timothy Geithner, president of the Federal
Reserve Bank of New York.
Writing in Monday’s Financial Times, Mr Geithner, a key US
policymaker throughout the credit crisis and one of the main architects
of the rescue of
Bear Stearns, says that the US Federal Reserve should play a
“central role” in the new regulatory framework, working closely with
supervisors in the US and round the world.
“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,” Mr Geithner says, in an excerpt
of a speech to be delivered today at the Economic Club of New York.
The credit crisis has heightened pressure
on US policymakers to consider sweeping changes to a regulatory system
for financial institutions which has commercial banks such as
JPMorgan Chase and
Citigroup regulated by the Fed and investment banks such as
Goldman Sachs and
Lehman Brothers more loosely regulated by the Securities and
Exchange Commission.
Mr Geithner called the system “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”.
However, legislation to overhaul US
financial regulation is unlikely to start advancing through Congress
until next year when the new administration takes office.
In his speech, Mr Geithner will also say
the Fed is examining whether to make “permanent” some of the new
liquidity facilities put in place during the credit crisis, and called
for central banks to establish a “standing network of currency swaps,
collateral policies and account arrangements” to bolster liquidity
during a future crisis.
Meanwhile, Malcolm Knight, the general
manager of the Bank of International Settlements, the Basel-based
central banking group, told the FT that the financial system now faces a
growing risk of exchange-rate volatility as investors and central banks
grapple with the impact of rising commodity prices and other
inflationary pressures.
“It is not clear if the rest of the world
is going to continue to fund the US current account deficit at current
levels of exchange rates,” he said. “The pattern of the exchange rates
is subject to considerable uncertainty now.”
The comments are likely to be closely
watched by investors and policymakers, since they come at a time of
renewed market focus on the outlook for the dollar relative to the euro
and other currencies. Last week, Ben Bernanke, Fed chairman, broke with
the US central bank’s traditional silence on currency matters to make
clear that it does not want any further dollar weakness.
While the dollar rallied on Mr Bernanke’s
remarks, it retreated later in the week after European Central bank
comments suggested an interest rate rise and as the price of crude oil
soared, heightening inflation fears.
“There is a perception that after a long
period of quiescent inflation, things are changing,” Mr Knight said.
“This is quite visible in terms of commodity prices in energy markets
but also in terms of what is happening with other commodities too.”
COMMENT & ANALYSIS
Comment |
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.
The writer is
president and chief executive, Federal Reserve Bank of New York
Copyright The
Financial Times Limited 2008
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