Timothy Geithner

Policy makers in Asia are well aware of the complications and costs involved in sustaining their current regimes. Many are moving toward permitting more flexibility against the dollar, and even in their effective exchange rates. Few however are comfortable with the prospect of accepting large short-term volatility and large movements over time in their effective exchange rates.

It is important that the world’s major private financial institutions run themselves with a sufficiently strong financial cushion, a cushion calibrated not just against the risks they confront in this uncertain world, but to the much more central role they play in many markets. Particularly for those institutions whose size and scope make them systemically important, capital, liquidity, and the overall risk management and control architecture need to be exceptionally strong.

Fiscal policy in most of the major economies is on a path that will lead to increasing, rather than stable or falling debt-to-GDP ratios.

We need to preserve confidence that policy will move toward a positive real fed funds rate at a pace sufficient to keep inflation expectations stable at a low level. How far policy moves and the pace at which it moves will depend on how the outlook evolves. Preserving the credibility of our commitment to price stability is vitally important, not least because of the flexibility it affords us to confront future shocks that have the potential to cause damage to the financial system and the economy.

We are significantly more dependent today on the confidence of the rest of the world in U.S. economic policy and the safety and stability of our financial markets. This gives us, along with the rest of the world, a compelling interest in sustaining credibility and confidence in U.S. financial management and the strength of our financial system.

The present fiscal trajectory entails an uncomfortable scale of borrowing and little insurance against possible adverse outcomes in an uncertain world.

The expected trajectory for this imbalance [in the current account] produces a dramatic deterioration in our net international position and cannot be sustained indefinitely.

Our underlying fiscal position is stronger, our debt to GDP burden lower, our demographic cliff more moderate, and our trend growth rate substantially higher than that of the other major economies.

[The current global exchange rate regime] is not an ideal mix, either for the monetary system as a whole, or for those countries which permit very little variability in their real effective exchange rates, and it’s probably not sustainable over time...It creates the risk of larger moves in the major currencies than might otherwise be the case. In the national economies of those not yet prepared to allow more flexibility in their effective exchange rates, it creates the risk of growing distortions in the allocation of resources, conflict with domestic monetary policy objectives, and the risk of larger and more abrupt future movements in the exchange rate.

The global economy has weathered the oil price shock quite well. If the long term futures prices are right, we need to be prepared to live with the possibility of a sustained period of higher oil prices, and perhaps more volatility in oil prices, and the world seems to be getting itself more prepared for that prospect.

By many measures, the economic landscape looks reasonably good.

We are seeing a significant erosion in the traditional premium accorded higher education in the United States and in some dimensions of the relative level of educational achievement in America. This cannot be good for the cause of improving the odds of sustaining this productivity surge.

Fiscal deficits of the magnitude projected are large enough to damage future growth prospects of the U.S. economy, which in turn magnifies our vulnerability to a decline in the willingness of other countries to lend us their savings, which could lead to higher risk premia on U.S. financial assets, also damaging long-term growth prospects...Building a stronger fiscal cushion and strengthening confidence in our fiscal sustainability is critical to reducing the risk in the size of our external imbalance

This combination of fiscal sustainability problems, large external imbalances, and the tension in the existing exchange rate system creates the risk of unanticipated shocks to financial prices, even in a context where monetary policy credibility is strong. The probability of these shocks may be low, but it is higher than it has been, and higher than we should be comfortable with. These shocks could be large enough to lower future growth outcomes.

The U.S. expansion has proven quite resilient. We enter the new year with what appears to be a pretty solid underlying pace of growth. Core inflation is moderate, and various measures of inflation expectations suggest confidence in the outlook for price stability. Estimates of structural productivity growth remains high, although there has been some moderation recently.

If the economy follows the present forecast of slightly above-trend growth, then it would be appropriate for monetary policy to continue to move the real fed funds rate higher. The pace at which we move and the distance we move will depend, of course, on how the economy performs and how the forecast evolves. But we need to be careful to give the world confidence that we will conduct policy in a manner that will keep inflation expectations stable, at low levels.

The present [global exchange rate] system, where the major currencies adjust against each other, but many large emerging market economies tie their currencies to the dollar or shadow it closely, creates an awkward asymmetry. This system carries with it the seeds of future stress for the global economy.

We face a delicate balance between genuinely positive near-term economic conditions, and some fundamental challenges...Even with good policy choices, and with considerable luck, these imbalances [in our economy] will take time to unwind. During this time we face some risk of a more volatile and less benign overall financial environment. This makes it important that we continue to invest in making our financial system stronger and more resilient.

We now face a substantial and unsustainable gap between our fiscal commitments and our resources, not just over the longer term with respect to Social Security and Medicare, but also with respect to budget projections for the coming ten years. Reducing this gap to a more sustainable level is vital.

These favorable fundamentals are reflected in low risk premia of many forms -- low credit spreads, low and quite stable inflation expectations, and low actual and implied volatility. Market participants appear to believe that future macroeconomic shocks will be more moderate, less frequent, and less damaging than past shocks have been. To say this another way, the price of insurance against a less benign world is now quite low.

Achieving a substantial and sustainable reduction in our fiscal imbalance is important to decrease the risk of lower future growth in private investment which could dampen future productivity gains. Reducing our fiscal imbalances is also important for reducing the risk of adverse shocks to financial markets, and for maintaining the willingness of investors to invest in our economic future. Improving the credibility of our commitment to this fiscal challenge is the most important contribution we can make towards improving the chance of a more benign adjustment in our external imbalance.

Many [policy makers in Asia] are moving toward more flexibility in their exchange rate regimes. The challenge ahead is to help manage the transition to a monetary system that provides flexibility in the exchange rates of all the major economic areas, and this has to be handled with care...Bringing these imbalances down to a more sustainable level will take time. During this period of adjustment, despite our fundamental economic strengths, we will be vulnerable to an elevated risk of volatility in financial markets.

External imbalances have reached unprecedented levels, most dramatically in the case of the U.S. current account deficit, which is on a path to exceed six percent of GDP. These imbalances – fiscal and external – cannot be sustained indefinitely.

The process of integrating China and India into the world economy offers tremendous gains in global living standards. But the greater adjustment pressures that come with integrating the two most populous economies in the world will put a greater burden on the political sustainability of open trade policies.

Preserving the credibility of our commitment to price stability is vital. It is important because price stability is critical to giving enterprises confidence to invest in the future. It is more important at a time when we are running very large external deficits, because countries investing their savings here must remain confident that their investments will not be eroded by future inflation. And it is important because confidence in our commitment to price stability affords us more flexibility to act aggressively in the event of future shocks.

Markets now reflect a fairly positive view about overall economic prospects. Global growth is reasonably strong and broad-based. Underlying inflation is low. Estimates of structural productivity growth in the United States remain high. The global economy has weathered the oil price shock and other recent shocks quite well. Most of the major emerging market economies look stronger than they have in some time. Overall volatility in output and inflation has moderated significantly in the United States and, to a lesser extent, in other economies as well.

The actions of the Fed over the last 25 years have helped to produce a sustained period of low inflation, less variability in inflation, more stable inflation expectations, and a substantial reduction in output volatility. These are the best measures of credibility, and they look very good against the record of other central banks that now occupy the spectrum between the soft and flexible and pure and harder inflation targeters.

Independence is the freedom to pursue a defined monetary policy objective without consideration of political or private interests, and without fear of subordination to other economic policy objectives...Independent central banks do, in fact, do a better job of achieving price stability. The greater the independence of the central bank, the lower the average level of inflation and the less volatile the inflation rate

The U.S. monetary policy framework that exists today has proven reasonably good at laying the foundation for price stability that is a necessary condition for sustaining growth at full employment over time.

The constituency for price stability in the United States today seems broad and strong and reasonably bipartisan, but it's been a generation since we've had high inflation and had to face the costs of bringing it down.

The imbalances in our fiscal and external positions could be diffused gradually and smoothly. But the transitions to a more sustainable equilibrium could also bring greater volatility in asset prices, less stability in macroeconomic outcomes, slower growth and more uncertainty.

[The disequilibria in the economy] put a very important premium on keeping U.S. monetary policy as close to the frontier of credibility as possible.

We need to continue to examine the case for a measured further evolution in the U.S. monetary policy framework—evolution in the direction of finding ways to provide more clarity about our long term inflation objective.

The overall environment for investment and innovation could be materially affected by the disposition of our fiscal and external imbalances and our exceptionally low net national savings rate.

To mitigate the risks [resulting from large fiscal and current account deficits]...we can work to keep monetary policy credible, to preserve confidence we will act to keep inflation and inflation expectations stable at moderate levels.

This mix of challenges in our fiscal and external positions deserve concern and attention. They may end up being diffused gradually and benignly, but they necessarily bring with them a greater risk of higher risk premia, a more adverse investment environment and poorer growth outcomes. Under some circumstances, this could undermine an important foundation of the environment for innovation that has delivered our productivity acceleration.

[A] substantial part of the world economy...has an interest in shadowing the dollar closely, as they absorb excess capacity, and...these governments are likely to continue to want to acquire dollars to make that exchange rate objective possible.

We don’t know how likely it is that those outside the United States are going to be willing to continue to acquire claims on the United States at the recent pace.

Our current account deficit reflects in part the relative attractiveness of the United States as a place for the world to invest its apparently ample present supply of savings. It is true that much of the cause of our imbalance seems to lie in optimism about future U.S. economic performance reflected in the willingness of non-Americans to put their savings to work here rather than in their own countries or in Europe or Japan. In this sense, our external deficit may reflect relative strength, rather than weakness. This argument would be more reassuring if we were facing a lower and more sustainable current account deficit. And it would be more powerful if the capital inflows that are the counterpart of our current account imbalance were going to finance private rather than public investment, and if a larger share of those flows were private rather than official.

The U.S. fiscal deficit, although a problem, is a problem of manageable dimensions for the medium term, provided we deliver modest changes to the paths of expenditures and revenues. The more daunting problems we face of bringing our healthcare and social security commitments and resources into balance come later and are less acute than those facing most other large mature economies.

Together, however, these imbalances [in the federal budget and current account] raise the potential for higher risk premia on U.S. financial assets and more uncertainty about future returns on claims on the United States. This in turn could reduce expected future investment, productivity growth and U.S. growth potential. This could reduce the willingness of the world’s savers to put their capital to work in the United States. And this could mean lower growth outcomes and slower growth in future incomes.

Our fiscal deficit...is in the zone of unsustainability. Our external imbalance—the current account deficit—is...[at] a level without precedent in U.S. economic experience. Each of these imbalances magnifies the risk in the other.

Negative shocks, whether they come from poor macroeconomic policy outcomes or from bad luck, will most likely be less acute for the system as a whole in a world of more integrated financial markets.

A...challenge worth noting relates to how we handle systemic financial crises and the liquidity needs they can produce. Firms that operate across borders normally manage their liquidity market by market, and liquidity in any one market and in any one currency normally is not readily transferable to where it may be needed. This can limit access to liquidity where it’s needed most, and can also complicate the capacity of central banks to respond quickly and effectively to a liquidity problem of financial institutions it supervises.

Further progress in financial integration by itself will not bring a smooth transition to a world with fewer national financial crises with less contagion. The degree of financial stability we face in the future will depend, as always, on a number of other factors, most importantly the wisdom of the choices governments make in economic policy.

Integration gives us each a greater stake in the quality of financial supervision outside our borders. This is true not just to ensure a more level competitive playing field for institutions that operate across borders. It’s necessary to provide a stronger framework of protection for depositors and investors with claims on foreign financial institutions and to reduce our respective vulnerabilities to a failure of such an institution.

Although hedge funds help improve the efficiency of our system and may also contribute to greater stability over time by absorbing risks that other institutions would not absorb, they may also introduce some uncertainty into market dynamics in conditions of stress.

The U.S. financial system seems less vulnerable to specific shocks and better able to absorb larger shocks than was true in the relatively recent past. At the same time, however, changes in the structure of the financial system and an increase in product complexity could make a crisis more difficult to manage and perhaps more damaging...While the probability of a major crisis induced by the financial failure of a major institution may be lower, the damage associated with such an event could be higher.

The current regulatory treatment of market risk does a good job of capturing directional risk from movements in interest rates, exchange rates and equity and commodity prices. It is less effective, however, in capturing the full range of risks associated with some newer products and trading strategies, where values can react sharply and discontinuously.

More rigorous and comprehensive stress testing of large shocks across multiple markets, geographic regions and business lines is vital, particularly for systemically important institutions...Stress regimes need to take into account the effects of a firm’s own actions and trading strategies on market prices during times of stress, and the constraints on their room for maneuver imposed by size.

As we move to refine and implement the Basel II framework for credit and operational risk, we need to strengthen the framework for market risk and encourage further improvements in how firms capture the possibility of extreme events.

Among the major non-bank financial institutions, the most important part of the financial system today where we need a stronger capital regime relates to the CSEs [Consolidated Supervised Entities]. Even with the improvements in risk management at these institutions over the last few years, we are some distance from the point where their regulatory capital requirements appropriately reflect their risk.

In the end, we cannot eliminate the risk inherent in mortgages with refinancing options. But we can markedly contain the accompanying risks to systemic stability by diversifying the concentration of risk away from large, highly leveraged portfolios for which misjudgments can have quick and devastating consequences. A system of diversified and less-leveraged interest-rate-risk management would be far more resilient to the inevitable mistakes and shocks of individual risk-mitigating strategies.

This change in market perception of future risk has occurred in the context, however, of a substantial increase in leverage in the balance sheets of the United States, the federal government and the U.S. household sector. These developments are a potential source of greater macroeconomic uncertainty.

We need to produce a substantial reduction in our structural deficit over the medium term and begin to reduce the more dramatic longer term gap between our resources and commitments. And we need to restore a reasonable cushion in our structural budget balance to help us deal with future shocks.  If we are unable to begin to generate more confidence in the capacity of the U.S. political system to produce these improvements, we would face a greater risk of future increases in risk premia.

The impact of a reduction in the scale of official accumulation of dollar assets could be fully offset by increases in purchases by private investors. But even in the context of a continued high degree of confidence in the relative return on claims on the United States, it is hard to know with confidence how the preferences of private savers might respond to the process of gradual evolution in their nation’s exchange rate regimes now underway.

Successfully integrating asset prices into monetary policy formulation is also hard to do because of the difficulty of assessing how potential alternative paths for monetary policy will feed through to overall financial conditions and thereby for output and inflation—in other words it is difficult to forecast how changes in current or expected policy will affect asset values.

Monetary policy does not today and is unlikely in the future to offer us an effective tool for directly reducing the incidence of large or sustained deviations of asset values from what might turn out to be their fundamental values, what some call bubbles.

This uncertainty surrounding the current behavior of asset values complicates the task of assessing the future trajectory of asset prices, and the impact of alternative monetary policy paths on asset values. And by widening the already substantial degree of uncertainty that surrounds estimates of the equilibrium real rate of interest, these developments complicate the task of assessing the appropriateness of a given stance of monetary policy against the objectives of the Federal Reserve.

In circumstances where the central bank observes a large realized movement in asset prices and is confident in its knowledge of the impact of those moves on the path of aggregate demand, monetary policy may need to follow a different path than might have seemed appropriate in the absence of those developments.

I think we've been carefully to reduce enthusiasm for the proposition that we can look at the world today and make tightly calibrated judgments with confidence about where equilibrium is, and therefore where we are against it. You know, as you know, you must know that those estimates, a lot of candle power is thrown at those estimates. And I think the state of the art shows wide bands of uncertainty around that measure. And that the center of the range moves around a lot over time, quite a lot over time.

From the audience Q&A session

This leaves us with no simple or clear doctrine for the role of asset prices in monetary policy regimes. Asset prices probably matter more than they once did, but what that means for monetary policy necessarily depends on the circumstances.

[I]n any area of central bank communication, in some ways the critical thing for us to do is not to leave you with less uncertainty than we have about what we know about what's happening.  And we try to be very careful not to convey more confidence than we could reasonably have about what's happening to the forecast, and what that means for - for monetary policy.

From audience Q&A session

For global growth to be sustained at a reasonably strong pace during this period of adjustment, the desirable increase in U.S. savings, and the necessary slowing in U.S. domestic demand growth relative to growth of U.S. output, would have to be complemented by stronger domestic demand growth outside the United States, absorbing a larger share of national savings. Exchange rate regimes, where they are currently closely tied to the dollar, will have to become more flexible, allowing exchange rates to adjust in response to changing fundamentals. Reforms to financial systems and to social safety nets over time would help reduce the need for exceptionally high levels of domestic saving we see in many countries. The global nature of these requirements does not imply that the United States can put the principal burden for adjustment on others

The continuing buildup in liabilities should soon push U.S. net investment income balances into deficit, with progressively larger net transfers of income to the rest of the world. In that event, net income flows will begin to boost the nation's current account deficit instead of reducing it, reinforcing the deterioration in net liability position of the United States.

Even if we could be confident that the world would be comfortable financing the United States on these terms for some time, that fact alone does not mean that it is prudent for the United States to continue borrowing on this scale, particularly given that doing so means that the net obligations of the United States to the rest of the world are likely to rise sharply relative to GDP.

If the deficit continues to run at a level close to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations. This fact alone suggests that something will have to give eventually, and this raises the interesting question of how these imbalances have persisted on a path that seems unsustainable with so little evidence of rising risk premia.

Monetary policy itself cannot sensibly be directed at reducing imbalances, but the past and future evolution of global capital flows will of course matter for monetary policy by virtue of their impact on the outlook for output and inflation.

The arguments I have just described highlight factors that may improve the odds of a more protracted, gradual and benign scenario, but they do not really alter the general conclusion that these [current account] imbalances are unsustainable and that they will need to unwind at some point. Time does not necessarily help. The longer these gaps continue to build, the greater the ultimate adjustment required, and the greater the risks that accompany that process.

The United States needs to restore a reasonable cushion in its structural budget balance to help deal with future shocks. If we are unable to begin to generate more confidence in the capacity of the U.S. political system to produce these improvements, we would face a greater risk of future increases in risk premia. And even though substantial fiscal consolidation would not by itself bring the external imbalance down to a more sustainable level, it would improve the prospect for a smoother adjustment to that outcome.

The size and duration of these imbalances, perhaps the most visible of which is the U.S. current account deficit, present challenges—and risks—for the world economy.

Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries. These changes have contributed to a substantial improvement in the financial strength of the core financial intermediaries and in the overall flexibility and resilience of the financial system in the United States. And these improvements in the stability of the system and efficiency of the process of financial intermediation have probably contributed to the acceleration in productivity growth in the United States and in the increased stability in growth outcomes experienced over the past two decades.

Adverse developments outside the banking system, such as the failure of a major nonbank financial intermediary, can potentially cause greater damage to the core of the financial system than might have been the case in the past.

When innovation, such as we are now seeing in credit derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances.

These changes [in the U.S. and global financial system] appear to have made the financial system able to absorb more easily a broader array of shocks, but they have not eliminated risk. They have not ended the tendency of markets to occasional periods of mania and panic. They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial system from the effects of such a failure.

The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved.

The robust productivity outlook for the United States relative to the rest of the world is consistent with an increase in the U.S. current account deficit, such as we experienced in the late 1990s. If this gap in potential growth were sustained, the United States would be able to sustain a larger external imbalance than we might have thought historically would be the case. But the present magnitude of the U.S. external imbalance seems difficult to reconcile with plausible estimates of future productivity and potential output growth.

If one were confident that observed imbalances simply reflected a more efficient allocation of the world’s stock of saving to its most productive uses, that relative prices adjust freely in response to changing fundamentals and that economies are flexible and agile in adapting to those changes, then we might also reasonably expect these imbalances to resolve themselves through smooth and gradual adjustments in relative prices and flows of goods and services. These conditions do not fully exist today. We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease despite obvious concerns about its sustainability...The anomaly is that these imbalances have persisted on a seemingly unsustainable path with relatively low interest rates and very little evidence of rising risk premia.

The demographic shifts underway in the major economies seem to have contributed to an increase in demand for longer-dated fixed income assets to fund growing pension liabilities, and these shifts have been reinforced by actual and anticipated changes in the regulations that affect pension fund managers. These changes may have operated to push up the price and lower the yield on longer maturity bonds, but the effect of these changes seems likely to be small in comparison to the changes in the behavior of forward interest rates.

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets...The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources. These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies...Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease despite obvious concerns about its sustainability.

To the extent that these forces act to put downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. And, if all else were equal, which of course is unlikely ever to be the case, monetary policy in the affected countries would have to adjust in response; policy would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation. To do otherwise would run the risk that monetary policy would be too accommodative, pulling resources from the future in a way that would alter the trajectory for the growth of the capital stock, perhaps amplifying the imbalances, and compromising the price stability.

These aspects of global monetary arrangements and financial conditions have important implications for how we communicate about monetary policy. They strengthen the case for why central banks should be clear about their objectives and credible in their commitment to price stability. They reinforce the case for preserving the flexibility to adjust policy in response to changing conditions. And they underscore the importance of being open about the greater level of uncertainty we face in understanding the forces at work on the trajectory of demand and inflation. Central banks, of course, need to be careful not to convey more certainty about what we know than we reasonably can know.

When Alan Greenspan first used the term “conundrum” to describe the surprising behavior of forward interest rates, he was reacting to the decline in forward nominal rates over a period in which the Federal Open Market Committee was raising its federal funds target rate. This behavior of forward rates, the counterpart of which is the behavior of the bond yield curve, looked anomalous both in comparison to observations from past tightening cycles and with what seemed to be strong evidence about the fundamental soundness of the outlook for the real economy. The source of the relatively low level of nominal rates is still a matter of considerable debate. Part of the explanation lies in the decline in expectations of future inflation and uncertainty about future inflation. Part of the explanation may also lie in greater confidence that the secular decline in the variability of economic growth observed over the past two decades in the United States is likely to continue. However, even with the information provided by the development of the market for inflation-indexed government securities, we have less ability than we would like to draw conclusions about what any nominal forward rate means for expectations about the level of future real rates, uncertainty about future real rates, and what those might imply about expectations about future economic activity. This uncertainty makes it harder to assess the appropriate path of monetary policy.

The other surprising feature of the current economic environment is the pattern of global imbalances, and the size and persistence of the U.S. current account deficit. As Alan Greenspan has explained, the greater dispersion in external imbalances can be seen as the inevitable result of fundamentally healthy changes in the world economy. As the world progresses toward increasingly integrated financial and goods markets, other things being equal, one might expect to see an increase in the number of countries with surpluses or deficits, and potentially larger surpluses and deficits, as flows of both financial assets and goods work to equalize desired saving and investment around the world.

The expansion in global economic activity has become more broad-based. In the United States, underlying productivity growth remains strong and some of the structural changes underway in other mature, large economies offer the prospect of greater productivity growth in those countries, as well.

The more critical role played by hedge funds and other nonbank financial institutions in credit and other markets has the potential to magnify the impact of distress in those institutions on market dynamics and liquidity if counterparty risks are not managed appropriately.

We are in a period of perceived strength in economic fundamentals in the United States and many countries around the world. This strength has helped to induce significant reductions in a range of market-based perceptions of risk. Much of this confidence may prove warranted and durable, but the extent to which it endures will depend in part on the degree to which those running the major financial institutions in the United States use the opportunity presented by this period of relatively high profitability to strengthen their capacity to withstand a less favorable overall macroeconomic and financial environment.

By spreading risk more widely, by making it easier to purchase and sell protection against credit risk and to actively trade credit risk, and by facilitating the participation of a large and very diverse pool of non-bank financial institutions in the business of credit, these changes probably improve the overall efficiency and resiliency of financial markets.

We need to find ways to accelerate the pace at which the regulatory framework evolves to meet new challenges. The increase in the pace of change in financial innovation and in market structure requires greater agility among supervisors and regulators. Without this agility we risk lagging too far behind changes in the frontier of risk. This does not mean that each innovation needs to be met with a regulatory response. That would be an unfortunate and surely counterproductive impulse to encourage in regulation.

Operational risk and infrastructure failures have played a prominent role in past financial crises, and the infrastructure weaknesses that have characterized the credit derivatives markets since their inception are another credible source of concern.

We need to continue to adapt our approach to the imperatives of a much more integrated global financial system. Global integration, of course, gives us all a greater stake in the quality of supervision outside our borders. This pragmatic interest will lead us to spend progressively more resources and attention on the international dimension of our work.

Technological progress, along with the transition to greater labor force participation in emerging and developing economies has probably served to keep inflation low in many other countries and has served to increase the rate of growth in potential output globally. But the rapid growth in the market sectors of emerging and developing economies may also contribute to more rapid growth in global demand and inflation pressures. This changing configuration of world markets complicates the task of forecasting inflation and output within national economies.

Transparency in monetary policy cannot mean that the central bank conveys more confidence in the outlook for growth and inflation than it can reasonably have, and it cannot provide more assurance about the likely future course of policy than it actually has.

It is also hard to assess the degree to which the current constellation of global monetary conditions has influenced the behavior of long-term interest rates. This makes it harder to assess the appropriateness of the current stance of monetary policy. And it may also mask some of the pressures on risk premiums we might expect to see given the deterioration of the U.S. long-term fiscal situation and the magnitude of the U.S. current account imbalance.

The process of adjustment that appears to be underway in the U.S. housing market, occurring as it is after a sustained and very substantial decline in the household savings rate, provides more than the usual challenge in predicting the future strength of consumer spending.

Energy prices have surprised us over the past few years, in terms of the extent of the rise in prices, the increase in volatility, and the limited negative effects to date on global economic growth. Our capacity to project future energy prices has proven to be very limited, as has our ability to convincingly ascertain the extent to which temporary supply factors, rather than an unrecognized strength in global demand, accounts for the energy price trajectory we've witnessed recently.

And finally, policies designed to reduce the risk of failure in financial markets create moral hazard, dulling the incentive individual firms face to self-insure against potential loss. We apply a set of capital requirements and supervisory constraints to offset the distortion created by the safety net, but these may not fully compensate for the impact on behavior of the broader range of financial intermediaries of the perception that the authorities will act to protect the financial system from systemic risk.

The foundations of modern risk measurement rest on a framework that uses past returns to measure or estimate the distribution of future returns. The stability of the recent past, even if much of it proves durable, probably understates potential risk. The parameters used to estimate value at risk can produce very large differences in predicted exposure, especially at extreme confidence intervals.

Estimating the potential interactions among these exposures in conditions of stress is even harder, due to the uncertainty about the behavior of investors and other market participants and because of the potential effects of financial distress on overall economic activity.

The relatively short history of returns for new products, the complexity of measuring exposure in many new instruments and limitations on transparency also create the potential for classic “agency” problems—internal conflicts of interest that can lead to problematic outcomes.

Collateral plays an increasingly important role in counterparty credit risk management, particularly for highly leveraged counterparties. The increased importance of variation margining plays a critical role in counterparty credit risk management. These changes help limit the exposure of the core financial institution to losses among their leveraged counterparties, but they also act to exacerbate volatility, with asset price declines forcing further margin calls, adding for further market declines.

Supervisors need to continue to focus attention on reducing the vulnerability of the market to these low probability, but extreme events, while preserving the benefits that have come with these changes in financial markets. The limitations of the conventional risk-management tools in assessing potential losses in the adverse tail of possible outcomes in today’s financial system magnify the risk that individual institutions will operate with less of a cushion than might be desirable for the market as a whole.

The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by and complicate the management of very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the large ones.

We judge the appropriate balance not against the standard of whether it reduces to zero the probability of a major financial crisis, the failure of a large individual financial institution or a major reduction in asset prices. That is not an appropriate objective of policy. Some vulnerability to crisis is a necessary and unavoidable feature of a dynamic and efficient financial system where asset prices need to be able to adjust to changes in fundamentals.

The U.S. economy appears to have become more resilient to financial shocks. Over the past two decades, the U.S. economy has experienced several episodes of significant financial market strain. These episodes were associated with spikes in risk perception and significant market volatility within financial markets, but none proved exceptionally damaging in terms of the overall macroeconomic impact. The mild impact of these episodes on the real economy contrasts with financial events such as the “credit crunch” that exacerbated the 1990-91 recession. That episode was characterized by a widespread reduction in the provision of credit by banks in response to loan losses and the need to raise capital.

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.

We are approaching the 10-year anniversary of the financial crises of 1997-99. Those crises were remarkable both in the scope of countries and markets they affected, and for their speed and severity. The circumstances leading up to the crises varied across countries and regions, as did the magnitude of the resulting damage to the real economy. But each of these events had one dynamic in common—the confluence of a sharp increase in risk perception, and the subsequent actions taken by financial institutions and investors to limit their exposure to future losses.

[A] broad range of recent financial shocks do not seem to have adversely impacted the real economy. The international financial crisis that began in 1997 did not spillover to the nonfinancial sector in the United States. The equity price collapse and deterioration in credit in 2000 did not cause significant damage to the core institutions in the U.S. market. The relatively limited damage caused by operations failures of the 9/11 attacks reflected the strength of the capital position of major intermediaries, as well as the policy actions by the Federal Reserve to provide liquidity to the markets.

More recently, the series of smaller financial shocks experienced since 2001, including the corporate bond defaults after 2001, the corporate accounting scandals in 2002, credit downgrades in the U.S. automobile industry in 2005, the failure of Refco, the sharp declines in mid-2006 in equity, commodity and emerging markets debt prices caused little contagion to other markets and limited strain on financial institutions.

These efforts have most notably manifested themselves in increased levels of risk-adjusted capital in the core of the system relative to what prevailed in the early 1990s. In the United States, for example, tier-one risk-based capital ratios have stabilized near 8.5 percent, considerably higher than the estimated levels around 6.5 percent for the early 1990s. This is based on a relatively crude measure of risk, but the direction of the improvement is right and the magnitude of the change is significant.

Relative to the conditions that prevailed in the early 1990s, the higher levels of capital in the core now provide a larger buffer against shocks and enhance the ability of the banking industry to act as a critical stabilizer in times of stress by providing liquidity to the corporate sector. When financial markets dry up, firms turn to banks and their unused loan commitments and lines of credit. Banks are in a position to fund this liquidity because transaction deposits tend to flow into the banking sector. In times of crisis, it appears that U.S. investors now run to banks, not away from them.

In terms of enhancing overall market efficiency, the growth of these private leveraged institutions {hedge funds, private equity funds and other leveraged financial institutions} can be expected to provide benefits in terms of improved liquidity, price discovery via arbitrage, diversity of opinion and diversification opportunities for investors. The increase in the share of assets managed by private pools of capital devoted to arbitrage activity should improve the overall functioning of markets. In most circumstances, increased trading and participation contributes to market liquidity and makes markets less volatile. The ultimate benefit should be lower risks for all market participants. This in turn should reduce the risk premia associated with holding financial assets, and ultimately reduce the cost of capital.

Hedge funds, private equity funds and other leveraged financial institutions control increasingly large shares of aggregate financial capital and play very active roles in many asset markets and in credit markets. Although assets under management in hedge funds still represent a relatively small share of total financial assets, their relative share has increased significantly and their ability to take on substantial leverage magnifies their potential impact on financial market conditions. These private leveraged funds have become an important source of protection to regulated institutions by being large sellers of credit insurance in the rapidly growing market for credit default swaps.

[C]entral bank credibility is vital, it's hard to earn, costly to lose. Credibility depends critically on the confidence we engender that we will keep inflation low. But credibility is more complicated than that. It depends on the confidence we engender in our capacity to understand the forces operating on our economy. It depends on how, not just whether, we achieve price stability.

Alan Greenspan commented on the eve of his departure from the Fed that confidence in central banking had risen to exceptionally high levels, and he asked whether this was entirely healthy.

I do think, though, that there's been enough change in the financial system over the last two decades or so, that we have to be prepared occasionally - reassess whether we got the broad balance right. Whether this overall framework we have of supervision regulation where we have capital base supervision over a diminished and smaller share the system as a whole works in delivering the balance between efficiency and stability it's so important. That's a judgment that we've got to be prepared to look at over time. I don't think you can look at the balance today and say it's clearly wrong, it's clearly inadequate, but we may come to the point in the future that we're going to have to revisit that - both the scope and the design of that basic framework.

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.

It is hard to look at this record and find support for the argument that the financial resources deployed by the IMF and the major economies in the crises [in the 1990s] produced a damaging degree of moral hazard—moral hazard in the form either of governments more prone to profligacy or investors prone to excess risk-taking in lending to banks and sovereign in emerging markets because of the expectation of financial resources from the IMF. Of course, those interventions must have produced some increase in moral hazard, but the effect on incentives does not seem to have been powerful relative to the countervailing effect of the economic and financial losses incurred in the crises.

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.

Cross-border flows of real and financial capital have also increased dramatically—a reflection of the recent notable reduction in the degree of home bias in capital markets.

Along with the evolving pattern of cross-border flows, we’ve also seen profound increases in the absolute size of current account balances in both industrial economies and emerging market economies. The average absolute value of current account balances as a share of GDP is higher today than it was three decades ago, with much of the run-up occurring in the past decade, and there is less dispersion around the average. Net external positions as a share of GDP have increased over time for both industrial and emerging market economies.

Harvard economist Ken Rogoff and others have pointed out that to the extent that globalization increases the degree of competition, it can reduce the “inflationary bias” or, to put it differently, it can strengthen the anti-inflation credibility of a central bank. By inducing greater price flexibility, competition lowers the short-run gains to output from an unanticipated inflation, and thus permanently reduces the incentives for a central bank to try to exploit those gains. The improved credibility of the central bank’s commitment to keep inflation low and stable should, in turn, allow it to deliver better inflation outcomes with fewer short-run costs to economic growth and employment.

So we have to be careful not to focus too narrowly on one particular measure. Instead we need to look at many. And indeed here in the United States we look at a range of different measures of core inflation, for example, that take energy and food prices out of the overall index. We look at these over different time horizons. We look at a variety of other measures that use different statistical techniques to strip out the more volatile parts of the index. These all have limitations, and their relative merits may change over time. Central banks approach this challenge of capturing underlying inflation differently, but ultimately we are all judged by what happens to overall inflation over time.

... [T]he dramatic rise in the level of official reserves in much of the emerging world is not simply the consequence of a desire for a greater financial cushion against external vulnerability. It also results from the lingering aversion to letting exchange rates adjust upwards in response to market forces.

As capital markets become more open, this middle ground is harder to sustain. The broadening recognition of this is leading to a gradual increase in exchange rate flexibility, and this process is likely to continue. The pace of progress, progress in the direction of more openness to capital flows and greater exchange rate flexibility, will depend in part on the pace at which these governments are able to strengthen the resilience of the domestic financial system and set in place the broader institutional framework and supervisory regime that are vital for an open economy.

The fact that official purchases of financial assets are determined by different factors than those influencing private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention...

If the prevailing patterns of capital flows were to exert downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. Among other things, this outcome complicates our ability to assess the present stance of monetary policy. It can change how monetary policy affects overall financial conditions and the economy as a whole.

Such complications can mask the effect of other forces that might otherwise find expression in risk premiums or interest rates: forces, for example, associated with the concern about fiscal sustainability in the United States or the sustainability of our external imbalances...

In today’s rapidly evolving global economy, monetary policy makers cannot ignore the international dimension. As economies become more open, external developments inevitably affect price and output dynamics. The world may thus be more complex and, in some respects the conduct of monetary policy may be more challenging.

The external factors that have in recent years had a dampening impact on domestic inflation could, at some point, fade or reverse. And the forces that have produced this constellation of capital flows and market conditions will evolve in ways we cannot anticipate.

This obliges policymakers to devote more care to the process of understanding how change in the world affects the balance of opportunity, risk and uncertainty confronting policymakers.

We live in a world where the prices of some goods and services move in different directions and at different rates. The challenge for monetary policy makers is to look at this complex and changing picture of price changes and try to gauge the forces that are operating on underlying inflation and so judge the likely future path of overall inflation.

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

MR. WILCOX. The spending side of the national income and product accounts is really the unspoken implication.
VICE CHAIRMAN GEITHNER. The other difference between exhibits 4 and 5 is “weaker” versus “subdued.” Does “subdued” sound weaker than “weak”? [Laughter] Or is “weak” weaker than “subdued”?

Part of this recent dynamic in financial markets is a consequence of the present state of the international monetary system, in which a substantial part of the world economy runs exchange rate regimes tied in some way to the dollar. This has entailed a sustained period of very substantial official accumulation of dollar reserves, putting downward pressure on U.S. interest rates and upward pressure on U.S. asset prices.

These forces are surely transitory, but their impact on capital flows, interest rates and asset prices are important, not just in terms of their short-term impact on growth. If they are large enough, they have the potential to alter or distort current decisions about investment and consumption in a way that could be detrimental to our longer-run growth prospects. And they are important because they work to mask or dampen the effects on risk premiums in financial markets that we might otherwise expect to be associated with the expected trajectory of the fiscal and external imbalances in the United States.

In this context, we are working to put in place a stronger regulatory capital regime and to strengthen the capacity of firms to absorb losses in stress conditions. We are encouraging more sophisticated and more conservative management of credit exposures in over-the-counter (OTC) derivatives and structured financial products, as well as of exposures to hedge funds. And we are encouraging a range of efforts to modernize the operational infrastructure that underpins the OTC derivatives markets, and to improve the capacity of market participants to manage adversity.

When market liquidity and funding seem abundant, this is likely to be observable in things we can measure, like interest rates and credit spreads. And when liquidity ebbs, the effect is conspicuous in a range of observable market prices and volumes. But we do not have, and probably never will have, a set of indicators that offers the promise of predicting when liquidity conditions will reverse, or when markets are particularly vulnerable to a more acute decline in liquidity.

In this sense, liquidity is like confidence. And, like confidence, liquidity plays a critical role both in establishing the conditions than can lead to a financial shock, and in determining whether that shock becomes acute, threatening broader damage to the functioning of financial and credit markets.

Liquidity can mean many different things. One dimension of liquidity is the availability of credit or the ease with which institutions can borrow or take on leverage. This is generally referred to as funding liquidity.

Another dimension of liquidity is the ease with which market participants can transact, or the ability of markets to absorb large purchases or sales without much effect on prices. This is what is generally called market liquidity.

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.  

These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector.  It will take some time before the full implications are understood and the full impact can be assessed.  As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

What should policymakers to do mitigate these risks?

We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure.

A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as "unscrambling the eggs," could exacerbate and prolong uncertainty, and complicate the process of resolution.

As is typical during periods of rapid innovation, these markets grew much more quickly than did the supporting infrastructure. Take credit derivatives, for example. For most of the early years of this market, much of the post-trade processing system was not automated and required substantial manual intervention. Positions were assigned without the knowledge of counterparties. Confirmations backlogs rose to very high levels. As Alan Greenspan put it, the market was using 19th century methods of dealing with 21st century financial instruments.

The right macroeconomic policy framework is crucial. But we have come to recognize that other issues, traditionally the province of microeconomics, have a vital role in contributing to effective macroeconomic policy. A critical factor distinguishing long-term economic performance among countries with relatively good monetary and fiscal policies is the degree of overall flexibility they exhibit in labor, product and financial markets. This is not simply about the presence or absence of regulation. It is a function of the incentives regulation creates and the extent to which it gets in the way of competition, impedes the allocation of labor and capital to industries with a higher return, favors established firms, and creates barriers to new entrants.

The development of deeper and more resilient financial markets is important for economies to be able to cope better with exchange rate flexibility and capital mobility. And financial strength is an important part of the arsenal of macro policy tools, for monetary policy is less effective in cushioning the effects of asset price and demand shocks in circumstances where the banking sector is impaired.

The most appealing political response—usually some form of selective restriction on trade or investment—is generally the option with the worst economic return.  The typical political impulse is to try to address directly the source of the competitive pressure and to relieve it, but these measures cannot offer lasting relief.  The economic price of protection, in terms of distorted incentives, reduced flexibility and broader costs on the economy as a whole, seem both more substantial and more enduring than any temporary political benefit.   

Fundamentally, the only realistic choice for policymakers is to equip their economies with the flexibility to cope more successfully in this increasingly integrated global economy. And this means preparing for a world of more rather than less flexibility in exchange rate regimes.

Japan's experience provides another example, though the context was different. There is a perception in parts of Asia that the Japanese government's decision to let the yen appreciate in the late 1980s was principally responsible for Japan's so-called “lost decade” of low growth. And, Japan, viewed through this prism, is cited as an example of the perils of letting an exchange rate move up in response to changing fundamentals. The reality is more complex. The problems of the Japanese economy in the 1990s were largely due to the aftereffects of the collapse of the real estate and asset price boom of the preceding decade, a boom fueled in part by efforts by the monetary authorities to limit the appreciation of the yen.

The size of the negative shock to demand from the collapse of the bubble was very substantial, and the capacity of the government and the central bank to mitigate the damage was constrained by the weakness in the banking system. A more forceful macroeconomic policy response, however, might have brought about a quicker recovery. In any case, the problem with the exchange rate choice was not the decision to let the rate adjust, but the decision to resist it and the role that played in magnifying the bubble, and thereby the subsequent damage from the fall.

The large industrial economies have, by and large, decided to let their currencies adjust to changing circumstances without official intervention in exchange markets. Japan aside, it is now close to seven years since the last episode of concerted intervention among the major economies; and there has been no Japanese intervention for two years.

The policy responses to the challenges that come with economic and financial integration principally involve choices for governments at the national level.  International cooperation can in some circumstances help provide a more supportive environment, but there are no feasible changes to the architecture of the international financial system that offer the prospect of a durably stable external economic and financial environment for nations, large or small.  Fundamentally, the only realistic choice for policymakers is to equip their economies with the flexibility to cope more successfully in this increasingly integrated global economy.  And this means preparing for a world of more rather than less flexibility in exchange rate regimes. 

The conditions we see prevailing in global financial markets today reflect a range of different factors, some fundamental and others that are less likely to be enduring. The most effective thing that policymakers and market participants can do in what is a necessarily uncertain world is to work to ensure that the shock absorbers are strong relative to the range of potential economic and financial outcomes.

The dramatic changes we’ve seen in the structure of financial markets over the past decade and more seem likely to have reduced this vulnerability {to financial crashes}. The larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking system, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread more broadly across a greater diversity of institutions.

And yet this overall judgment, that both financial efficiency and stability have improved, requires some qualification. Writing a decade ago about the history of the financial shocks of the 1980s and early 1990s, Jerry Corrigan argued that these same changes in financial markets we see today, though less pronounced then than now, created the possibility that financial shocks would be less frequent, but in some contexts they could be more damaging. This judgment, that systemic financial crises are less probable, but in the event they occur could be harder to manage, should be the principal preoccupation of market participants and policymakers today.

What factors might contribute to this risk, a risk that could be described as the possibility of longer, fatter tails? One reason is a consequence of consolidation...  Another reason is the consequence of leverage...  A third reason is the consequence of long periods of low losses and low volatility.

Financial markets over the past several years have been characterized by an unusual constellation of low forward interest rates, ample liquidity, low risk premia and low expectations of future volatility. In some markets, asset prices have risen substantially, and credit growth has expanded rapidly. In credit markets more generally, spreads have declined to levels that reflect very low expectations of near term losses and credit standards have weakened.

It would not be accurate to say this is a world without volatility, for we have had a series of episodes of sharp declines in asset prices and increases in volatility. But these episodes have been contained and short lived, with markets recovering relatively quickly and with little appreciable effect on global economic activity.

Leveraged arbitrage activity, so some of the literature suggests, is likely to reduce volatility in normal times and increase it in times of stress, because of the greater financial constraints faced by leveraged funds relative to larger, more diversified banks and investment banks. Whether this matters in a systemic sense or not depends on the heterogeneity of funds and how correlated their exposures are with those of the major banks and investment banks.

It is now the consensus of most practicing central bankers that monetary policy can’t do much preemptively to correct an existing substantial asset price misalignment. But if monetary policy is calibrated appropriately to keep aggregate demand growing roughly in balance with aggregate supply and to keep inflation low and stable, this reduces the risk that such misalignments will emerge and expand.

In terms of the financial cushions, the challenge is to sustain a level of capital and liquidity that is large enough to withstand a more adverse financial and economic environment than we have experience recently. Here the job of the risk management discipline is to try to compensate for failure of imagination, to counteract the gravitational effect on measured exposure produced by recent history, and to try to anticipate the adverse effects on market liquidity that may come with a shock. This requires a healthy skepticism about models, discipline and care in the face of competitive pressures, and humility about what we can know about the future.

Fixed, or partially fixed exchange rate regimes, of course, also constrain the independence of monetary policy. As capital accounts become progressively more open, few countries can sustain over time a commitment to exchange rate stability without risking price stability. Eventually central banks will run up against limits on their capacity to sterilize the effects of exchange market intervention designed to limit the pace and extent of appreciation of the exchange rate. Although measured inflation in emerging Asian economies remains relatively low, the pace of credit growth and the behavior of asset prices provide some evidence of a growing tension among competing objectives. The longer this policy conflict persists, the greater the distortions building up in the economy, the greater the risk of future inflation and the greater the risk of a bumpy future.

"It's possible" the recent jump in fluctuations marks a return to historical levels, Geithner said in responding to questions following a speech today in Singapore. "It's hard to know what normal is in a world that's changed so much and what normal will prove to be."

As reported by Bloomberg News

Faced with the challenges of managing policy in an increasingly integrated world economy, the dominant instinct of officials is often to try to shield the economy from volatility.  But the crises of the 1990s helped demonstrate why this approach can be both futile and counterproductive...The more promising approach is to invest in the complement of institutions and policies that enable an economy to live more comfortably with openness.  Focusing on those measures that will enable an economy to be more flexible and to adapt more quickly to change ultimately will be a more effective policy strategy.  It is politically more difficult, but economically more effective than those solutions that seem to offer protection from competition and volatility.

We need to be more attentive to the risk that specific aspects of our system, regulations or other constraints, create a greater disincentive to locate a financial business here, or to invest here, or to raise capital here, than would have been the case five or ten years ago. We need to take a careful look at how we regulate financial activity in a world where capital is more mobile, and the structure of the financial system has diverged substantially from the system for which our regulatory framework was designed.

The Federal Reserve Act gives us broad authority to act in response to these types of conditions. We will continue to examine ways to adapt our instruments as market conditions evolve.  We will do so in close cooperation with other central banks, as indeed we have since August.  And we will do so in the tradition of pragmatism and flexibility that has been one of the defining features of the central bank of the United States.

Although the specifics vary across central banks, the approaches outlined have several important common elements. We each have taken actions to provide more financing at terms longer than overnight. We each have chosen to auction funding against a broader range of collateral, collateral other than government securities, and in our case with a broader set of counterparties. And we have activated swap lines to help the relevant central banks provide liquidity in dollars in their markets.

.....

The Term Auction Facility gives us a tool that lies somewhere between our open market operations and our primary credit program. It provides a mechanism for expanding the range of collateral against which we provide funds to the market—in effect to change the composition of our balance sheet—in ways we cannot do through traditional open market operations.  And it does this in a way that may be more effective in mitigating a broader marketwide liquidity shortage than does the existing discount window facility, in part because of the perceived stigma in recourse to a facility that has come to be regarded as a source of funds for individual institutions facing a temporary, exceptional need for liquidity. Because the quantity of funds to be injected is known in advance, this mechanism poses fewer complications for our ability to reduce volatility in the fed funds rate around the target.

The stimulus program signed into law by the President will provide a meaningful level of support to growth, somewhere in the range of three quarters to one and half of a percentage point of GDP growth over the next few quarters.

There are a lot of aspects of our regulatory framework that are hard to defend.

From Q&A as reported by Reuters.

The unwinding of this global financial boom has caused a substantial degree of stress to the financial system. Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks.

The principal challenge for policy is to provide an adequate degree of insurance against the downside risks that still confront the economy as a whole, without adding to concerns about inflation over the medium term. We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time.

Headline and core inflation have come in higher than anticipated, and inflation expectations have also moved up. If the risk of significant damage to growth from these financial market pressures is attenuated and if global growth remains strong and drives a continuing rise in energy and commodity prices, then inflation may not moderate as much as we anticipate. If the medium term outlook for inflation deteriorates significantly, the FOMC will move with appropriate speed and force to address this risk.

No central bank can be indifferent to the fall of the value of its currency. It's important to look at all sorts of policy changes people are going to make in this context.

From audience Q&A, as reported by Market News International, Bloomberg

By allowing institutions to finance with the central bank assets they could no longer finance as easily in the market, we have reduced the need for them to take other actions, such as selling other assets into distressed markets, or withdrawing credit lines extended to other financial institutions, that would have amplified pressures in markets. These measures—the Term Auction Facility and swap arrangements—have had some success in mitigating market pressures, in part by providing a form of insurance against future stress. We now have in place a cooperative framework for liquidity provision among the major central banks. And we have considerable flexibility to adjust the dimensions of these liquidity tools. We will keep them in place as long as necessary, and continue to adapt them where we see a compelling case to do so.

The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity. This left credit and funding markets more vulnerable when liquidity receded. Banks and other financial institutions lent substantial amounts of money on the assumption that they would be able to distribute that risk easily into liquid markets. A sizable fraction of long-term assets—assets with exposure to different forms of credit risk—ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk.

Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the fed funds rate. Contagion spreads, transmitting waves of distress to other markets ...

The most important risk is systemic: if this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it is not something that the market can solve on its own. It carries the risk of significant damage to economic activity. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings and rising unemployment.

What we were observing in U.S. and global financial markets was similar to the classic pattern in financial crises. Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls...

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the Fed Funds rate.

There are those who have suggested that by intervening to forestall, and ultimately prevent, a bankruptcy filing by Bear Stearns, the Federal Reserve risks magnifying the chance of future financial crises, by insulating market participants from the consequences of excessive risk taking...

The negative consequences to Bear’s owners and employees from recent events have been very real—so real that no owner or executive or director of a financial firm would want to be in Bear Stearns’ position. While we clearly knew that our actions, both in the context of the JPMorgan Chase transaction and in the establishment of the Primary Dealer Credit Facility would affect incentives for financial market participants, adding to the risk of “moral hazard,” we believe that the lesson of the actual outcome for equity holders will serve to check and even diminish incentives for undue risk-taking.

In my view, there are a set of important objectives and principles that should guide this effort.

• We need to ensure there is a stronger set of shock absorbers, in terms of capital and liquidity, in those institutions, banks and a limited number of the largest investment banks, that are critical to market functioning and economic health, with a stronger form of consolidated supervision over those institutions.
• We need to substantially simplify and consolidate the regulatory framework, to reduce the opportunity for regulatory arbitrage, not just in the mortgage market, but more broadly.
• We need to make the financial infrastructure more robust, particularly in the derivatives and repo markets, so that the system can better withstand the effects of default by a major participant.
• We need to redesign the set of liquidity facilities that we maintain in normal times, and in extremis, in the United States and across other major central banks. And these changes will have to come with a stronger set of incentives and requirements for the management of liquidity risk by financial institutions with access to central bank liquidity.
• And we need to make sure that the Federal Reserve has the mix of authority and responsibility to respond with adequate speed and force to the prospects of systemic threats to financial stability.

It is important to recognize that a substantial adjustment, recognition of losses, and reduction in risk has already taken place. And a range of different prices of financial assets now reflect a very cautious view of the future. The severity of the pressures in markets evident over the last few months are in part a reflection of the speed and force with which markets and institutions in our financial system adapt to fundamental changes in the outlook. This capacity to adjust and adapt is one of the great strengths of our system. Nevertheless, we still face a number of challenges ahead. The seeds of this crisis took a long time to build up, and they will take some time to work through.

We have to find a better balance between market discipline and regulation in our financial system, a better balance between efficiency and innovation and reserves and stability.
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The best defence is to make sure you get the incentives right so that financial institutions hold larger cushions, larger shock absorbers, in good times, against conditions of stress. Hard to do, complicated to figure out how to do it well - but that's the critical objective.

As reported by Reuters

Timothy F. Geithner, president of the Federal Reserve Bank of New York, and a close Bernanke ally, defines the Fed chief’s “doctrine” as the overpowering use of monetary policies and lending to avert an economic collapse. “Ben has, in very consequential ways, altered the framework for how central banks operate in crises,” he said. “Some will criticize it and some will praise it, and it will certainly be examined for decades.”

The objectives of regulatory policy should be to improve the capacity of the financial system to withstand the effects of failure and to reduce the overall vulnerability of the system to the type of funding runs and margin spirals we have seen in this crisis.
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Inducing institutions to hold stronger cushions of capital and liquidity in periods of calm may be the best way to reduce the amplitude of financial shocks on the way up, and to contain the damage on the way down. Stronger initial cushions against stress reduces the need to hedge risk dynamically in a crisis, reducing the broader risk of a self-reinforcing, pro-cyclical margin spiral, such as we have seen in this crisis.

The major central banks should put in place a standing network of currency swaps, collateral policies and account arrangements that would make it easier to mobilize liquidity across borders quickly in crisis. We have some of the elements of this framework in place today, and these arrangements have worked relatively well in the present crises. We should leave them in place, refine them further and test them frequently.

We are also initiating important steps to strengthen the financial infrastructure.  We are in the process of encouraging a substantial increase in the resources held against the risk of default by a major market participant across the set of private sector and cooperative arrangements for funding, trading, clearing and settlement of financial transactions that form the "centralized infrastructure" of the financial system. We have begun to review how to reduce the vulnerability of secured lending markets, including triparty repo by reducing, in part, the scale of potentially illiquid assets financed at very short maturities.

I do not believe it would be desirable or feasible to extend capital requirements to institutions such as hedge funds or private equity firms. But supervision has to ensure that counterparty-credit risk management in the regulated institutions contains the level of overall exposure of the regulated to the unregulated. Prudent counterparty risk management, in turn, will work to limit the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.

One of the central objectives in reforming our regulatory framework should be to mitigate the fragility of the system and to reduce the need for official intervention in the future. I know that many hope and believe that we could design our system so that supervisors would have the ability to act preemptively to diffuse pockets of risk and leverage. I do not believe that is a desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of regulation and uncertainty about the rules of the game that would offset any possible benefit. I do believe, however, that we can make the system better able to handle failure by making the shock absorbers stronger.    

The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. This non-bank financial system grew to be very large, particularly in money and funding markets. In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.

In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.

This parallel system financed some of these very assets on a very short-term basis in the bilateral or triparty repo markets. As the volume of activity in repo markets grew, the variety of assets financed in this manner expanded beyond the most highly liquid securities to include less liquid securities, as well. Nonetheless, these assets were assumed to be readily sellable at fair values, in part because assets with similar credit ratings had generally been tradable during past periods of financial stress. And the liquidity supporting them was assumed to be continuous and essentially frictionless, because it had been so for a long time.

"No government, no central bank can be indifferent to changes in the value of its currency," Geithner said.

He said the dollar was important not just because of its effect on growth and inflation in the U.S. and elsewhere but also because of "the very important role" it plays in the international financial system.

Geithner added: "As a result, as you would expect, we pay very close attention to what happens in (foreign) exchange markets."

During audience Q&A, as reported by Reuters

I believe the severity and complexity of this crisis makes a compelling case for a comprehensive reassessment of how to use regulation to strike an appropriate balance between efficiency and stability. This is exceptionally complicated, both in terms of the trade-offs involved and in building the necessary consensus in the United States and the world. It is going to require significant changes to the way we regulate and supervise financial institutions, changes that go well beyond adjustments to some of the specific capital charges in the existing capital requirement regime for banks.

I believe the most important imperative is to build a financial system that is more robust to very bad outcomes and more resilient to shocks. This means (1) a system in which the major institutions are less vulnerable to shocks; (2) a system that is less vulnerable to margin spirals and a generalized pull-back in liquidity and funding; and (3) a system that is more able to withstand the effects of failure of a major financial institution.

The liquidity tools of central banks and the emergency powers of other public authorities were created in recognition of the fact that individual institutions, including those central to payments and funding mechanisms, cannot protect themselves fully from an abrupt evaporation of access to liquidity or ability to liquidate assets. The existence of these tools and their use in crises, however appropriate, creates moral hazard by encouraging market participants to engage in riskier behavior than they would have in the absence of the central bank’s backstop. To mitigate this effect on risk-taking, strong supervisory authority is required over the consolidated financial entities that are critical to a well-functioning financial system.

A more resilient financial system will also require a framework for dealing with the failure of financial institutions. For entities that take deposits, we have a formal resolution framework in place...we need a companion framework for facilitating the orderly unwinding of other types of regulated financial institutions where failure may pose risks to the stability of the financial system.

As we adapt the U.S. framework, we have to work to bring about a consensus among the major economies on a complementary global framework. Given the level of financial integration globally, we cannot achieve a reasonable balance at home between efficiency and stability, without a complementary framework of supervision and regulation across the other major financial centers.

I want to identify some issues that are critical to our current responsibilities and will be important in defining an appropriate role in the future, with the most effective mix of responsibility and authority.
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First, the Fed has a very important role today, working in cooperation with bank supervisors and the SEC, in establishing the capital and other prudential safeguards that are applied on a consolidated basis to the institutions that are critical to the proper functioning of financial markets.
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Second, the Fed, as the financial system’s lender of last resort, should play an important role in the consolidated supervision of those institutions that have access to central bank liquidity and play a critical role in market functioning.
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Third, the Federal Reserve should be granted explicit responsibility and clear authority over systemically important payment and settlement systems, and the ability to continue to encourage broader improvements in the over-the-counter derivatives markets.
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Fourth, the Federal Reserve Board should have an important consultative role in judgments about official intervention where there is potential for systemic risk, as is currently the case for bank resolutions under FDICIA.
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And, finally, the responsibilities for market and financial stability that are accorded the Fed in current and any future legislation will require that the Fed adopt a more comprehensive approach to financial supervision and market oversight.
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These initiatives will take time, but we expect to see substantial progress over the next two quarters.

Many people believe the program has allowed too much upside for financial institutions, while doing too little for small business owners, families who are struggling to keep their jobs and make ends meet, and innocent homeowners. We have to fundamentally reform this program to ensure that there is enough credit available to support recovery. We will do this with tough conditions to protect the taxpayer and the necessary transparency to allow the American people to see how and where their money is being spent and the results those investments are delivering.

In his confirmation hearing as Treasury Secretary.

This crisis began, not in September, but it began back in early '07. And I was at the center of efforts to try to promote a much more aggressive response early, not just on the housing side but through -- but in the financial sector in particular. And I was very involved in trying to make sure that the central bank, in particular, was moving aggressively to make sure that monetary policy was getting to a better place where it could support recovery and that we were encouraging banks to raise capital necessary it play a critical role in recovery.

And I did work very actively to try to encourage the administration to get the broader authorities that we thought were going to be necessary to address this. But this did not begin last September. It began well before that. And although policy did move, it did not move aggressively enough across the entire board. And we're living with the consequences of a deeper recession, in part, because of that.

In response to a question from Sen. Blanche Lincoln

Senator, the good bank, bad bank type solutions have been present at the solution to most financial crises around the world. And there it's very important that you -- we look carefully at whether they're going to be as effective in this context as they have been in some past cases.

But you're right to say they are enormously complicated to get right. And we want to be very careful that not just we're using the taxpayers' money most effectively with the most potential impact and leverage on the financial system, but also that we do these in ways where the taxpayer and the government understand the risks we are taking, that the system is going to be managed with the best possible return going forward.

And it is a enormously complicated set of questions. But those are among the questions and options that a team of people -- very smart people who are experienced -- are looking at today.

And it is possible that something, that it will be part of the solution going forward. But I don't want to today provide any more details on how best we can navigate this...

In response to a question from Sen. Schumer

The Department of the Treasury, the Federal Reserve, the FDIC, and all the financial agencies in our country will bring the full force of the United States Government to bear to strengthen our financial system so that we get the economy back on track.  We have different authorities, instruments and responsibilities, but we are one government serving the American people, and I will do everything in my power to ensure that we act as one.

Very important to us that we, again, design these programs that have the least risk to the taxpayer and the most benefit for getting our economy back on track. That's the overriding principle that guides everything we do.

I'll give you an example of how we try to navigate through this. In this lending facility that you described, this is designed in a way so that we have independent pricing with haircuts for margin that are designed to be conservative in normal times so that the overall economics of this work in a way that as conditions normalize, market's demand for this will fade away. It won't be economic to use these facilities. Demand will fade. That's the basic structure.

From the Q&A session

We put out a lot of details this morning on how the first stages of this thing we call the -- the Fed calls the term asset-backed lending facility is -- and you'll see a timeframe and details in there and a pass for expansion.

On this broader proposal we put out to provide government financing alongside private capital in an investment fund to help provide liquidity and financing for these legacy assets, we're going to lay out in their relatively quickly -- next couple of weeks – how we -- the sort of basic structure of that arrangement so that people can start to see how it's going to work and decide whether you want to put money to work in that structure.

The basic structure in that context is government financing -- in this case, it'll be through some combination of the Fed and the FDIC -- alongside government capital with private capital in there. That's the sort of common structure we use in the market, and we think that's the best way to protect the taxpayer, but still get liquidity in to help get these markets going again.

From the Q&A session

{The budget} acknowledges that, as expensive as it already has been, our effort to stabilize the financial system might cost more. It establishes a placeholder to help ensure we can cover any additional financial stability costs.

I should note here that the existence of the $250 billion placeholder for financial stability in the President's Budget does not represent a specific request. Rather, as events warrant, the President will work with Congress to determine the appropriate size and shape of such efforts, and as more information becomes available the Administration will estimate potential cost.

Immediately upon taking office, the President and the Administration worked with Congress to enact the American Recovery and Reinvestment Act, a package of targeted investments and tax cuts designed to get Americans back to work and get the economy growing again...  We estimate that the plan will save or create at least 3.5 million jobs over the next two years, and will boost GDP – over where it would have been had we not acted – by almost 1% this year and more than 3.2% next year.

What {the P-PIF} will do is to make financing from the government available alongside public and private capital so that we can get these markets open and up again. The reason why these markets are not moving now is because there’s no financing available and no confidence in people’s capacity to make judgments about ultimate losses. And so by providing financing, government leverage alongside public and private capital, we think we can make a meaningful difference in starting to open up these markets and starting to trade again. There’s capital that wants to come into the system, but it just can’t get financing.

The art of this is to set the terms at a level that when conditions normalize, people won’t want to come get this financing from the government because it won’t be economic to do it. So the art in this is to set the price for the financing at a level that is very conservative in normal times but still economic in times of crisis, and that’s the way this works. That’s the basic [unintelligible] that’s guided what the Fed’s done in these markets, very, very successfully, in the commercial paper financing facility and a range of other facilities you saw the Fed design over the last six to 12 months.

In response to a question about the interest rate that will be charged on government financing for the P-PIF

You've seen this administration work at a pace unlike you've ever seen before in history, moving very quickly to put in place this very powerful economic recovery act, to lay out a budget that makes some very powerful investments in things critical to our economic future, things that are going to make the economy grow more rapidly in the future by improving education, addressing healthcare costs, moving us to a clean energy economy, all in a framework that's fiscally responsible framework. We're moving to fix the housing crisis. The president laid out very quickly a comprehensive strategy to help bring interest rates down. Allow Americans to refinance, take advantage of lower rates. And again, help millions of Americans stay in their hopes with some meaningful reduction in monthly payments. We're also moving very quickly to get credit markets flowing again and help strengthen and save lives, the banking system

We knew from the beginning that we had a mess on our hands -- a very, very complicated mess we were going to have to work through. We were spending every minute, every molecule of oxygen, working to contain this big fire...

In during the Q&A session

In response to a question about Zhou Xiaochuan's comments about the need for an international reserve currency:

I haven't read the governor's proposal. He's a -- a remarkable -- a very thoughtful, very careful distinguished central banker. Generally find him sensible on every issue.
But as I understand this proposal, it's a proposal designed to increase the use of the IMF's special drawing rights. And we're actually quite open to that suggestion.
But you should think of it as rather evolutionary, building on the current architecture, than -- rather than -- rather than moving us to global monetary union.

...

I think the dollar remains the world's dominant reserve currency. I think that's likely to continue for a long period of time.  And as a country, we will do what's necessary to make sure we're sustaining confidence in our financial markets and in -- and in the productive capacity of this economy and our long-term fundamentals.

To address this will require comprehensive reform.  Not modest repairs at the margin, but new rules of the game.  The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market.

For the financial industry, your core challenge is to restore the trust and confidence of the American people and your customers and investors around the world.

You will have to make your own decisions about how best to do that, but, I thought, given that I'm here in New York, I'd offer a few suggestions as an interested observer...

Focus on improving your financial position so that your financial ratings, your cost of capital, the amount you have to pay to borrow, all reflect your own financial strength and earnings prospects, not the false expectation that the government will be there in the future to rescue you.

Discussing a "perception problem" with CEO's of major banks serving on the board of the New York Fed, Treasury Secretary Geithner said, "the American people should understand that.... those banks and the members of the board play no role in supervision. They have no role in the writing of the rules, and they play no role in decisions the Fed makes about how to respond to a financial crisis. Their role is a much more limited role, and the role is to help provide a perspective on what’s happening in the economy as a whole. But I agree with you that the, that perception is a problem. And it’s worth trying to figure out how to fix that."