For example, some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk.  But those unregulated or less regulated entities should in principle be subject to more-effective market discipline than banks because, without a safety net supporting them, their creditors have stronger incentives to monitor and limit their risk-taking.  In fact, while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred to institutional investors that are far less leveraged than banks. 

"The outlook for the U.S. economy has not materially changed," Kroszner said during a question-and-answer session at a community banking conference in Washington. 

  "The financial markets seem to be working well and there seems to be sufficient liquidity in the system to respond to the rapid changes that have been occurring recently," Kroszner said, in a nod to recent sharp declines in Asian and U.S. equities markets.

As reported by Dow Jones Newswires

The U.S. economy continues to demonstrate extraordinary resilience, no doubt supported by the ability of financial markets to absorb substantial shocks. Financial markets have been buffeted by a number of significant events, including a spate of corporate accounting scandals, the bond rating downgrades of Ford Motor Company and General Motors Corporation to speculative-grade status, the failure of Refco, (at the time the largest broker on the Chicago Mercantile Exchange), and the imposition (and pullback) of capital controls in Thailand. But the effects on broader markets appear to have been remarkably contained. Even the episode last year involving the hedge fund, Amaranth, which accumulated losses of $6 billion in a few short weeks, seemingly had little impact beyond its direct stakeholders.

Our principal focus should ... be not in the search for the capacity to preemptively diffuse conditions of excess leverage or liquidity, but in improving the capacity of the core of the financial system to withstand shocks and on mitigating the impact of those shocks.  And, as always, central banks need to stand prepared to make appropriate monetary policy adjustments if changes in financial conditions would otherwise threaten the achievement of the goals of price stability and sustainable economic growth.  

Finally, in today's global economy, very settled financial market conditions--narrow risk spreads and low expected market volatility--coexist with unprecedented current account imbalances among nations and interest rates that are low by historical standards.  In such a world, it would be imprudent to rule out sharp movements in asset prices and a deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions.  

But other forces have also led central banks and other financial supervisors around the world to increase their emphasis on financial stability. Perhaps most important, the financial system, once essentially bank-centered, has become more market-centered. Of course, banks continue to be core participants in the financial system and to provide an indispensable window on market activities. But the development of a relatively market-oriented system has been accompanied by a large number of new participants, many with global reach, and a much larger array of financial instruments. This vastly expanded web of participants and instruments has increased the number of potential channels for the creation and transmission of financial shocks.

In every step we take to deter or manage financial crises, it is important that we recognize that we impose costs, and that our efforts can be most effective if we both enhance and are supported by market discipline. Institutions and investors must be allowed to take risks and must be prepared to accept the consequences of their actions. For its part, the government should limit its intervention to those circumstances that could lead to placing the system in serious danger and could spill over to the economy. Otherwise, even the most well-intentioned government intervention can actually weaken the system by undermining the incentives for market participants to limit the risks they undertake.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

The Fed undertook similar discussions with other supervisors and with financial firms in response to the failure of Drexel Burnham Lambert in 1990 and the collapse of Long Term Capital Management (LTCM) in 1998.  As the condition of Drexel deteriorated, other firms became less willing to trade with it, making it difficult to wind down its positions in an orderly manner (Breeden, 1990).  Because of the Federal Reserve’s ongoing supervisory relationships with the main clearing banks and its detailed knowledge of the payments system, the Fed was able to address the banks’ concerns and facilitate the liquidation of Drexel’s positions (Greenspan, 1994).  In the case of LTCM, the Federal Reserve had the credibility with large financial firms to facilitate a discussion, from which emerged a private-sector solution that helped to avoid potential market disruptions (Greenspan, 1998).

We think markets are better...at absorbing stress," Geithner said, although he added that the rise in concentration in the banking sector, coupled with increased leverage and the growth of financial derivatives not yet tested in times of true market trouble mean that problems, should they arise, could be more severe. He said future crises are likely to have "longer, fatter tails."

As reported by DJ Newswires

Some observers have viewed the large expansion of hedge funds as a rising danger to financial stability, requiring additional regulation and Fed readiness to intervene. I myself believe the dangers of systemic problems from hedge fund failures are vastly overrated. The hedge fund industry is indeed large but it is also highly diverse and competitive. Many and perhaps most of the large positions taken by individual firms have other hedge funds on the opposite side of the transactions. I trust normal market mechanisms to handle any problems that might arise.

These changes in policies, and the reduction in external vulnerability that they have brought about, make it less likely that financial market shocks will trigger the types of acute, broad-based crises we saw in the late 1990s. The combination of less balance sheet exposure to exchange rate changes, less refinancing risk in debt structures, stronger fiscal and financial cushions, a large stock of reserves available to absorb shocks, and more flexibility for policy means that future sudden changes in financial flows should not precipitate the damaging runs on the financial assets of the country that they have in the past.

The collaborative process that produced this progress {on credit derivatives clearing} has much to recommend it. What principles led to this outcome?

First, regulators and supervisors -recognised that they were more likely to achieve their goals if they worked with the private sector in the development of solutions to complex problems. In this case, supervisors laid out broad objectives but let the market design the solution. Working with the market may be necessary to keep pace with changes at the frontier of innovation.

Second, to fix the credit derivatives problem it was necessary to involve a large and diverse pool of financial institutions. No firm or national authority had the capacity to make progress on its own. To correct this collective action problem, firms needed confidence that competitors would be held to similar standards. Having firms set common metrics and insisting on sharing aggregate reporting data with the entire group ensured that each firm could measure its progress against the group, discouraging individual firms from free-riding or circumventing the group's effort.

Finally, in a more integrated global market, we will increasingly find ourselves compelled to pursue borderless solutions. In the case of derivatives, a local or national solution would have been insufficient to protect domestic financial markets from the risks posed by market practices.

FT article co-authored with Callum McCarthy and Annette Nazareth.

In the case of the crises of the late 1990s, despite the broad-based nature of the financial market turmoil, in countries where capital cushions in the financial sector were strong relative to risk, where there was a greater diversity of institutions in the financial system to absorb the losses, and where monetary authorities were in a position to provide liquidity to restore confidence, the financial and macroeconomic impact of the crises was relatively modest.