Regulation – How to reduce risk in the financial system, by the NY Fed

Timothy Geithner

In FT.com, Geithner describes a scenario of financial boom feeding a demand for risk products. These products used highly leveraged, long-term illiquid assets financed with short-term liabilities. Banks were overstretched, concerns about risk increased, investors pulled back, triggering a run of forced liquidation of assets, higher margin requirements, and increased volatility.

Geithner identified five issues where improvements have to be made:

• Stronger controls are needed in the form of better capital, liquidity and risk management levels – these should be set high enough to discourage usage of central bank liquidity, but not too high in that they push capital to unregulated areas.
• The ability to withstand default by a big institution must be improved - this needs improvements to the centralised clearing houses.
• Higher levels of margin and collateral are needed for derivatives and secured borrowing to cover against market illiquidity.
• The US regulatory framework needs to be streamlined according to the Hank Paulson Blueprint (see "Regulation – Can Paulson restructure the regulators?", Chase Cooper News, 7th April).
• The ability and capacity of central authorities to respond to crises needs to be strengthened.

In referring to the current crisis, Geithner said “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.”

[Source: www.ft.com]