Risk management discussed at Senate Banking Committee hearing

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WASHINGTON DC – Federal Reserve vice-chairman Donald Kohn commented during a Senate Banking Committee hearing that the US’ financial system was in sounder shape now and that banks have improved their capital positions.

He said: “I think we've come a long way. The markets are in a lot better shape than they were in March, but having said that, I don't think anyone can guarantee what's going to happen next.”

Kohn and Erik Sirri, director, division of trading and markets at the US Securities and Exchange Commission, confirmed that the Fed and the SEC were nearing the completion of a formal memorandum of understanding (MOU) relating to the Primary Dealer’s Credit Facility (PDCF), where the Federal Reserve would operate as a backstop liquidity provider to all banks including securities firms. In connection with the PDCF, the Fed created a programme to monitor the financial and funding positions of primary dealers, and the MOU will enhance information-sharing on this between the Fed and the SEC.

There has been some success in this area. Kohn said that “broadly speaking primary dealers were strengthening their liquidity and capital positions to better protect themselves against extreme events”.

As no one agency is currently responsible for financial stability in the US, the MOU is intended to “provide one mechanism for two of the critical agencies with responsibilities in this area to gain a broader and continuous perspective on key financial institutions and markets that could impact the stability of the financial system,” said Sirri. He also added that the MOU will bridge the gap in the legal framework until Congress addresses, through legislation, fundamental questions about the future of investment bank supervision, “including which agency should have supervisory responsibility, what standards should apply to investment banks compared to other financial institutions, and whether investment banks should have access to an external liquidity provider under exigent conditions in the future”.

Kohn also stated that the Fed was ensuring that financial institutions were now taking a much more forward-looking approach to risk management and that banks fully understand the potential for their risks to crystallise in times of stress. Moreover, the Fed, and the SEC, recognise that liquidity risk management practices need to be enhanced, and that they are both working with banks to ensure they develop appropriate short-term and long-term liquidity risk management strategies.

Sirri stated that the SEC, learning lessons from the Bear Stearns debacle, has improved the supervision of the remaining investment banks, and enhanced existing relationships with other supervisors to address the current issues. But he states that it is imperative that new legislation should define explicitly “how and by whom large investment banks should be regulated and supervised, and specifically whether the Commission should be given an explicit mandate to perform this function at the holding company level, along with the authority to require compliance.”