By James Hamilton, J.D., LL.M.
At the intersection of banks, securitization, risk management and derivatives stands Timothy Geithner, NY Fed CEO. who is carrying the Fed's banner into these uncharted waters. In remarks at a symposium hosted by the Richmond Federal Reserve Bank, he said that there is no strong empirical support for the proposition that derivatives increase volatility in financial markets, but that aspects of this latest wave of innovative financial instruments are different in substance and require attention. And, said the Fed official, even the most sophisticated participants in the derivatives markets find the risk management challenges associated with these instruments to be daunting.
The recent experience in subprime mortgages and related asset-backed securities and credit derivatives illustrate different types of surprises faced by the participants in these markets. They are a reminder of the dimensions of uncertainty that exist about the shape of the distribution of potential returns.
The senior official correctly said that it is impossible to turn back the clock or reverse the increase in complexity around risk management. Even more, the Fed does not have the capacity to monitor or control concentrations of leverage or risk outside the banking system; and thus cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.
But there are ways that regulators and policymakers can mitigate these risks, assured the Fed official. The most productive policy is to improve the shock absorbers at the core of the financial system in terms of capital and liquidity relative to risk and the robustness of the infrastructure.
These issues are the principal focus of market oversight in the global financial centers. For its part, the Federal Reserve is working closely with the primary regulators of global financial institutions and the critical parts of the financial infrastructure to encourage further progress. In this context, the Fed seeks a stronger regulatory capital regime and a strengthening of the capacity of firms to absorb losses in stress conditions.
In addition, the Fed is encouraging more sophisticated and more conservative management of credit exposures in OTC derivatives and structured financial products, as well as of exposures to hedge funds. Similarly, the Fed is promoting a range of efforts to modernize the operational infrastructure underpinning the OTC derivatives market, and to improve the capacity of market participants to manage a major default.