NY Fed’s Geithner emphasises systemic risk in derivatives markets

Geithner, president of the Federal Reserve Bank of New York, also called on dealers to strengthen best practices in risk management in terms of stress testing, margining practices and operational infrastructure.

His latest remarks, at a lecture organised by the Hong Kong Monetary Authority (HKMA) and the Hong Kong Association of Banks, echo similar comments made in recent months in the US.

“The fundamental challenge for policy is how to achieve the appropriate balance between efficiency and financial resilience. With too much government intervention, innovation is constrained and the system is stifled. With too little, the probability of systemic crisis may rise to levels that are unacceptably high,” he said.

While financial institutions have made substantial progress in incorporating stress testing and scenario analysis into their risk management processes, he said the results should be used not only to monitor risks, but also to influence decisions on how much exposure a firm actually takes.

“Supervisors should focus on concentrations of exposure to a range of different risk factors, not just on the concern of the particular moment or the most recent sources of shocks. Just as generals are often accused of preparing to fight the last war, practice tends to chase measures of direct exposure implicated in past crises, or what seem like the plausible candidates for future crises, whether to real estate, to hedge funds, to structured financial products, to emerging markets, or to a particular industry.”

Geithner also reiterated the dangers posed by the credit derivatives market, over and above the back-office issue. He noted that the desire of funds to maintain the confidentiality of their trading strategies has traditionally led firms to be “quite opaque” to outsiders and reluctant to provide banks with detailed information on a real-time basis about the risk profiles of the overall fund. “Without that information, individual dealers or banks have a difficult time evaluating the probability of default of a leveraged counterparty and the potential covariance with other positions of the firm.”

Last September, a group of 14 major financial institutions and their principal supervisors met at the Federal Reserve Bank of New York to discuss a program of improvements to the infrastructure to support the over-the-counter derivatives market. “When the group reconvenes next week, we will review the extent of progress in reducing the backlog on unconfirmed trades and increasing the number of trades confirmed through automatic systems. We will also assess the progress towards agreement on a protocol for settlement events. And we will review new commitments to expand this effort to other OTC derivatives, including equity derivatives.”