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The Current Financial Challenges: Policy and Regulatory Implications

The Opening Plenary Session of the 2008 Corporate Conference

Speaker: Timothy F. Geithner, President and CEO, Federal Reserve Bank of New York
Presider: Charlene Barshefsky, Senior International Partner, Wilmer, Cutler, Pickering, Hale and Dorr, LLP
Introductory Speaker: Richard N. Haass, President, Council on Foreign Relations
March 6, 2008
Council on Foreign Relations

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RICHARD N. HAASS:  -- (in progress) -- from my perspective, she is a current member of the board of directors at the Council on Foreign Relations.  So, Charlene, I think you're doing the introductions of Tim.  Thank you.

CHARLENE BARSHEFSKY:  Thank you, Richard.

Just a few ministerial announcements:  First of all, this is the opening session of the Corporate Conference 2008 at the Council on Foreign Relations.  We ask that you turn off your cell phones, Blackberries, all wireless devices, and anything else that makes noise.  And please remember -- and Tim, this is also for you -- that this session is on the record.  It's the only session of this Conference that is on the record, and media are present.

It is my great pleasure to introduce our keynote speaker this afternoon, and that is Tim Geithner.  Tim has had an extraordinarily distinguished career.  He is the ninth president and CEO of the Federal Reserve Bank of New York.  In that capacity he's served as vice chairman, and a permanent member of the Federal Open Market Committee, the group responsible for formulating our nation's monetary policy.

Prior to his appointment to the Fed, Tim joined the Treasury Department.  He served three administrations and five secretarys of the Treasury, culminating in his appointment as undersecretary for International Affairs during the Treasuryships of Bob Rubin and then Larry Summers.  And before that, he was -- or after that, he was at the IMF.

Tim graduated from Dartmouth and Johns Hopkins-SAIS  He has studied Japanese and Chinese, and he has lived in East Africa, India, Thailand, China and Japan -- but I'm quite sure, not all at the same time. He serves as chairman of the G-10's Committee on Payments and Settlement Systems for the Bank -- of the Bank for International Settlements.

He is a member of the Council and, ask Richard, that certainly is the most important part of this.  And he is a member, of course, of the Group of Thirty.

So with that, Tim, it is our great pleasure to have you with us today.  (Applause.)

TIMOTHY GEITHNER:  Thanks, Charlene, that was way generous.  And thanks, Richard, for having me.  It's nice to be back at the Council.  You guys run a terrific public institution.  I'm a deep believer in the basic mission of trying to improve the basic quality of the public policy debate in the United States.  And credit to you -- compliment you on, wanting to invest some time in that -- in that important, noble effort.

Your technology is sort of an interesting test of the wisdom of crowds -- (laughter).  Let's say, markets today are not a very encouraging commentary on the wisdom of crowds, but that's -- that's the way markets are like sometimes.

So I'm going to talk today a little bit about the challenges facing the U.S. economy and the financial system.  Important to start by saying these problems took a long time to build up, and even with a forceful mix of policy actions -- public policy actions and actions by market participants, they're going to take some time to resolve.

I'm going to talk about what I think are the central questions:  What caused this crisis?; what explains its force?; what mix of policy measures will best contain the damage?; and what changes to the financial system are likely to produce greater stability and resilience in the future.

It seems indulgent, premature to talk about the long-run, and I want you to know we're focused on the short run.  There's no long-run without the short-run.  But it's, I think, very important to keep people focused on the important challenge of how we take the lessons from this experience and figure out how to build a more resilient system in the future.

The origins of this crisis lie in a very complex interaction by a number of different forces.  Some are the product of market forces; some are the result of the incentives created by policy and regulation; some were the product of market failures.  Some of these were evident at the time, others are apparent only with the benefit of hindsight.  But together they produced a substantial financial boom on a global scale.

I'm going to run through a set of these contributing factors, but I'm not going to give it the full, complete treatment.  I do have a longer text that will be on the website today at some point soon.  So, excuse the brevity.

In the five years leading up to the present stress, the world experienced a very unusual mix of financial conditions.  Real short-term interest rates -- short-term and long-run interest rates were low around the world.  Volatility in financial markets -- expected volatility, realized volatility remained remarkably low for a long period of time.

Term premiums declined, credit spreads a across a wide range of asset classes fell to levels that assumed unusually low levels of future loses.  Credit -- mortgage credit, in particular, expanded relative to GDP.  Prices rose across a range of financial assets, real assets to -- most notably, of course, houses.

And this constellation of broad economic and financial conditions was accompanied by very rapid, substantial innovation in financial instruments that made credit risk easier to trade and, in principle at least, a hedge.  And these instruments allowed investors to buy insurance, to buy protection against a broader range of individual (idiosyncratic ?) credit risks, such as the default by a homeowner, or by a company.

Even though these instruments allowed credit risk to be shared, their holders remain exposed, though, to the less probable but potentially very damaging effects of a significant increase in losses driven by macroeconomic factors.  As underwriting standards deteriorated over this period, this exposure grew.  Exposure to this broader risk grew, and yet risk premia continued to fall, suggesting that investors did not fully appreciate the dynamic at work.

And as the boom persisted, investors grew more confident in the relative stability of macroeconomic and financial conditions, and in the high levels of liquidity of the recent past, and they projected that stability into the future.  And that confidence in a more stable future lead to greater leverage and a larger exposure to the risk of a less benign world.

The interaction of these forces made the system as a whole more vulnerable to a range of different weaknesses.  The models used by issuers, by rating agencies to structure and rate these products turned out to be much more sensitive to macroeconomic assumptions than was apparent to investors at the time, most particularly, of course, to assumptions about house prices appreciation and the correlation of the default.

Now this proliferation of credit risk transfer instruments was driven in part by a prevailing assumption of frictionless, uninterrupted liquidity.  And this left credit and funding markets more vulnerable when liquidity receded.  A lot of long-term assets -- assets with credit risk, ended up in vehicles financed with very short-term liabilities, many of which were placed with investors and funds that were also exposed to liquidity risk.

Banks and investment banks, along with lots of other institutions, sold insurance against what seemed like low probability events, and they did so at what the time -- even at the time seemed like relatively low prices.  And on assets they retained on their balance sheet, these same institutions purchased insurance from firms like the financial guarantors that had concentrated exposure to the same risk.

So, as this suggests, the crisis revealed a range of weaknesses in risk management practices within institutions in the United States and around the world.  And this morning, a group of the primary supervisors of the major banks and investment banks in the world released a pretty comprehensive assessment of risk management practices in these institutions on the way up.

And this assessment was designed -- and I think it'll help lay the foundation for changes -- a consensus, globally, or at least in the major financial centers, on changes to supervision going forward.  The report goes through -- it's a pretty dense report, but it's worth, it's worth a read, it goes through a range of practices that helped determine relative performance -- to distinguish performance across institutions.

And, of course, banks and investment banks with stronger risk management practices, with better culture, better governance, more sophisticated approach, more conservative approach to this stuff, did substantially better.  It's a pretty powerful indication -- not as powerful as what we've been through, pretty powerful indication of the returns on investments and good risk management.

The most common failures were in firms -- in how firms dealt with uncertainty about the scale of losses it would face in a less-benign economic and financial environment.   They were in the scale of the cushion -- the cushions, the financial cushions they built up against that uncertainty.  They were in how well they managed the inherent internal tension between risk and reward that most compensation regimes create.  And they were -- they were in how quickly firms moved to mitigate risk as conditions deteriorated.

This current episode is different than many past crises -- just like all crises are different, but it has a basic dynamic in common with many past crises.  As market participants moved to reduce exposure to further losses, as they -- so, you know, to put it in a different way, as they stepped on the brake, the brake became the accelerator, amplifying the shock.

Now, this self-reinforcing dynamic in markets now has obviously intensified -- necessarily intensified the downside risk to growth for an economy that is already confronting -- was already confronting a very substantial adjustment in housing, and the possibility of a significant rise in household savings.  And the intensity of this shock, this turmoil, is, in part, a function of the size of the preceding boom, as it always is, but it's also a consequence of the speed of the deterioration in confidence, or at least the speed of the increase in uncertainty about growth prospects here and around the world.

And it's a function of the damage to confidence that's occurred in really important aspects of the global financial intermediation system -- confidence in ratings, in valuation tools, in the capacity of investors to evaluate risk.  And that damage will necessarily prolong the adjustment going through in -- that's now underway in markets.  And this process, as I said, carries risks to the broader economy, and policy -- macroeconomic policy measures, supervisory policies have a very important role to play in containing those risks.

So I'm just going to walk, briefly, through the basic framework of policy now in place.  And let me start with monetary policy.  The FOMC has reduced the nominal fed funds rate very substantially in a relatively short period of time, which much of the increase -- sorry, much of the reduction, much of the action occurring ahead of deterioration in confidence and the broader slowdown in economic indicators of spending that is now apparent.

But even with those reductions in short-term interest rates in place, financial conditions have tightened as risk threats, across a range financial assets and institutions, have increased.  The critical risk to the outlook now remains the potential for these strains in financial markets to have outsized, adverse effects on real economic activity, particularly exacerbating the already significant weakness underway in the housing sector.  And it's very important, in this context -- and this basic judgment underpins the strategy the committee has adopted -- to recognize it's important that monetary policy, and the liquidity instruments we have, are used proactively in addressing this risk.

But, of course, this is not the only challenge we face.  Headline inflation, core inflation have come in higher than anticipated, and inflation expectations have moved up somewhat.  And if the risk of a significant -- of significant damage to growth from these financial pressures, from these financial headwinds is attenuated, if global growth remains strong and still drives continuing increases in energy and commodity prices, then inflation may not moderate as much as we expect.

And if the medium-term outlook for inflation deteriorates significantly, then the FOMC will move with appropriate speed and force to address that risk.  This requires a very fine balance.  And the challenge for policy -- the principal challenge we face 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 can't know with confidence today what level of the short-term real fed funds rate will be consistent with our objectives of sustainable growth and low inflation.  But if these financial headwinds and the associated downside risks persist, then monetary policy will have to remain a accommodated for some time.

Let me move to the liquidity front:  Concerns about credit quality are at the heart of the current strains in markets, but a substantial impairment in market liquidity can exacerbate and prolong the adjustment in credit markets.  And we've taken a series of actions to mitigate these risks by allowing institutions to finance with the central bank assets they can't finance as easily in these markets.  We've reduced the need for them to take other actions, actions that might have amplified these pressures on markets.

And these measures, the Term Auction Facility in the United States, some similar programs adopted by other central banks in the U.K. and Europe, and these swap lines, swap agreements -- they had some success in mitigating market pressures.  The important thing is that we now in place -- have in place a cooperative framework across the major financial centers for providing liquidity by the world's major central banks.  And we in the United States have considerable flexibility to adjust the dimensions of these liquids tools.  We will keep them in place as long as it is necessary, and will continue to adapt them where we see a compelling case to do so.

Third policy area is about encouraging financial repair.  We're working very closely with supervisors in the United States and in the other major financial centers to help facilitate this adjustment process in markets.  And this strategy, this approach has two important dimensions:  The first is to encourage improvements in the quality of valuation methods; and of disclosure by the major regulated institutions; and, of course, the necessary adjustment in valuations and reserves that has to -- that has to reflect the deterioration in the outlook.

Better disclosure can reduce some uncertainty about the incidence and magnitude of potential losses across the financial system, but it's important to note that these estimates of future losses are fundamentally a function of the outlook for the economy, and they will change as expectations about the future change.

The second piece of this broad supervisory approach involves new equity into the financial system.  Very important, so that the burden for preserving capital ratios does not fall principally on actions such as asset sales, or cutting back on credit growth that might exacerbate the credit crunch.  We've seen a very, very substantial inflow of new capital into the financial system that's come much more quickly that's been the case in previous crises.  More will come, and the institutions that move quickly would obviously -- will obviously be in a stronger position to deal with the challenges they face, and to take advantage of the opportunities ahead.

Quick thing on fiscal policy:  Monetary policy, of course, can play a very powerful role in reducing the downside risk to growth, but overall policy is likely to be more effective, particularly given these strains on the system if the full burden doesn't fall on the tools -- only on the tools available to the Federal Reserve.  And fiscal policy can play a very important role, and the stimulus program signed into law by the president is going to provide a meaningful level of support to growth over the next two quarters.

Finally, on housing:  I think it's important to recognize that government policy can play a very important role in helping cushion the effects of the falling housing prices and the rise in foreclosures now underway in the United States.  The decline in house prices and the surge in foreclosures has -- necessarily, inevitably -- significant spillovers to other homes in the same neighborhood, and a range of other effects -- negative effects that aren't -- that cannot be fully incorporated into the decisions made by private creditors and investors.

And the degree to which mortgages are held in securitized, complex, leveraged financial structures complicates the normal incentive problems, coordination problems that always exist in trying to organize economically sensible, beneficial refinancing restructurings.  And because of this, carefully-designed, targeted programs, in cooperation with the private sector, can play an important role, as I said, in resolving some of the constraints that are now impeding economically-viable mortgage restructurings.

In addition, just give the scale of the breakdown in the securitization process and its potential impact on the supply of new credit, it also makes a lot of sense to try to explore ways to expand the scope for existing government programs to support financing of new homes.  Now, it's easy to state that -- much easier to state that, acknowledge that, than it is to navigate one's way through the very complicated incentive problems and public policy situation involved in this area.  But there's a lot of attention and effort in thinking through this in Washington now, and, you know, I think you're, you're seeing -- you need a mix of pragmatism and creativity to navigate this, but it's a really important focus of attention.

So this broad policy framework -- monetary policy, fiscal stimulus, liquidity support, new equity for the financial system, targeted support for housing -- these policies will help reduce the risk to the outlook, and they will help bring about an earlier return to growth rates that are more in line with the economy's long-term potential.

And let me just talk a little bit about the longer term implications of this stuff.  The unwinding of this financial boom has obviously caused a lot of stress.  Was it preventable?  I don't believe that asset price and credit booms are preventable.  I don't believe they can be effectively diffused preemptively.  I don't believe there is, there are reliable earning warning -- early warning systems within the capacity of humans to design, that provide an early warning for financial shocks.

And yet, very important to acknowledge, even with those limitations -- acknowledging those limitations, that policy plays a very important role in determining the dimensions of financial booms, and policy play a very important role in determining the ability of the financial system and the economy to adjust to their aftermaths.  And I think, as I said at the beginning, we need to -- it's very important that we undertake a broad set of changes to address the vulnerabilities of the system as revealed by this crisis.

And, just as a long list of factors contributed to this stress, there's no single reform that offers the promise of a -- of sufficient change on its own.  The President's Working Group on Financial Markets, which brings together the sector -- the sector that shares -- brings together the chairman of The Fed, other principals, supervisors, regulators in the United States; and the Financial Stability Forum, which is a  similar group of a similar mix of officials from the other major financial centers -- they're, they're in the process that's been underway for about six months to try to build consensus on a pretty comprehensive framework for reform.

And these recommendations are going to refocus on everything you would think they should focus on.  They're going to look at changes to the mortgage finance market -- as the Fed proposed regulations to, current legislation does.  They're going to look at ratings process, disclosure, on asset-backed securities and structured credit products.  They're going to focus on the regulatory and accounting treatment of all sorts of different instruments and exposures, like these.  They're going to look at disclosure requirement and instruments of investors, and a whole range of other dimensions of the securitization process and the basic -- what you might call the soft infrastructure of the financial system.

I want to just talk, though, about some of the broader questions that will be part of, or help shape consensus in this area.  And then I'm just going to speak very briefly about broader regulatory reform -- about capital, capital and liquidity, and about the financial infrastructure itself.  Bear with me, I'm coming to the end.

So, just on regulatory reform and simplification first:  The regulations that shape the incentives of market participants in the United States have evolved into a very complex and uneven framework, with substantial opportunities and incentives for regulatory arbitrage, with large gaps in coverage, she substantial inefficiencies, and very large differences in the degree of oversight applied to institutions that engage in fundamentally equivalent economic activities.

I think it's very important that we move to a simpler framework -- with a more uniform set of rules, applied more evenly, across entities involved in similar functions, and a more effective balance of regulation and market discipline.  I think it's also important that institutions or banks -- or banks built -- or built around banks, with special access to the safety net, need to be subjected to a stronger form of consolidated supervision than our current regulatory framework provides.

On capital:  The U.S. banking system entered this financial shock with capital cushions that were significantly above regulatory thresholds, and, therefore, in a stronger position to withstand a downturn than was the case in the past.  And this has made it possible for bank balance sheets to expand very rapidly which, in turn, has helped offset some of the effects of the withdrawal of many non-bank financial institutions from credit markets.  But the shock absorbers in the financial system as a whole -- the financial cushions that are really critical to financial stability, have proved to be thinner, and behavior has been more pro-cyclical than would be desirable.

And this, in part, is a consequence of changes in the structure of the financial system.  Because banks are now a smaller share of the overall system, a given level of the stress on the rest of the system creates greater strain on the system as a whole.  Banks are less able to compensate fully for the de-leveraging that happens on institutions necessarily subject to more liquidity risks but can still take on leverage.

But this problem is also the consequence of the fact that the financial system -- the present system focuses on mitigating the risks of firm-specific shocks, principally, rather than, what you might call, a more systematic market shock.  And, in part, it's the consequence of the fact that the system is not designed to induce these institutions, particularly the largest institutions in the world, to internalize the negative consequences, the negative externalities of their actions on markets as a whole in conditions of stress.

This is very complicated.  No simple solution.  Pretty smart people have been laboring for decades to figure this stuff out.  And it's going to require a really broad look at the design of the present capital regime and its successor, the incentives that it creates for holding different types of risks.  And it's going to require us to rethink a little bit what's the appropriate scope of the application of those requirements.

And as we move to a more risk sensitive capital framework that tries to reduce some of the perverse incentives in the current regime, we need to do a better job of making sure that reserves, and capital, and liquidity cushions are more forward looking, and that they adjust appropriately through the peaks and troughs of the cycle.  This is important because it'll increase the scope for banks, and other institutions that are subject to risk-based capital requirements, to act more as a stabilizing force in response to future financial shocks.

Finally, on market infrastructure:  We've been in the midst of -- and it's still underway, of a very dramatic period of innovation and growth in derivative instruments.  But the pace of change, as you would expect, has brought a lot of challenges.  There's been a lot of -- lot of progress in strengthening the infrastructure of the OTC derivatives markets, in particular, over the past two-and-a-half years.  And I think it's important to note that the broader financial market infrastructure across the system has been a source of considerable strength over this period of time -- performed reasonably well so far.

But the systems and practices that support this very important, very big, very rapidly growing market significantly lags that of other securities markets that are mature markets.  And I think it's very important we move -- the market moves with our -- and will be supportive and encouraging -- move to put in place a more integrated operational infrastructure that supports all the major OTC derivatives markets, that's substantially automated, has much more robust operational resilience and risk management, and is capable of handling very substantial future growth in volumes.

Let me just conclude.  Obviously, the financial system is going through a very challenging period of adjustment, and I think it's important to recognize that we're likely to face a considerable -- a period of considerable uncertainty for awhile about the ultimate magnitude, and the ultimate duration of the slowdown underway.  But it's important to recognize a couple things about this.

We've already seen a lot of adjustment.  Prices and risk premia in many markets already reflect a much more sober, much more cautious view of the world than they did a year against -- you could say, beyond caution, in many markets, well beyond caution.  And the degree of stress in markets we've seen over the past six months is, in part, due to the sheer magnitude and speed of that adjustment to a more cautious view of the future.

The United States, the world economy as a whole, the financial system, is more resilient than it was -- significantly more resilient than it was on the eve of previous downturns.  The improvements in productivity growth we saw in the United States in the past decade, decade and a half, has been followed by very significant improvements in potential growth in many other countries.

The improvements in monetary policy credibility and in financial strength, that were put in place over the past few decades means that policy around the world has much more room to adjust, much more scope to adapt, to deal with the challenge in the environment.  And there are very substantial sums of investable assets around the world now which will ultimately provide a source of balance.

But these challenges are substantial, and the speed and agility -- I'm just going to end here -- the speed and agility with which public policymakers respond to the continuing pressures in this rapidly-evolving environment will determine how quickly and how smoothly market conditions return to normal, and how rapidly the risks to the outlook are mitigated.

Thanks.   (Applause.)

Can we sit?

BARSHEFSKY:  Yeah.

Tim, thank you very, very much.

This will begin a question session, and Tim and I will talk for a minute first.  A couple of ministerial tasks again.  First of all, even if you're BlackBerry is on vibrate, it still interferes with the sound system, so please do turn your Blackberries off.  Second, when we come to the question period -- for the audience, if you will just raise your hands, a microphone will be brought to you.

If you can stand up so people can see you and hear you better, just give your name and your affiliation, and ask your question.  And, we'd appreciate it if you'd limit yourself to one question.  I think there will be many for Tim, and we want as many people as possible to have an opportunity to be able to ask a question.

Tim, thanks very much for your remarks.  There's no question we're entering -- we are in, and will continue to be in, a difficult period.

GEITHNER:  I like the optimism in the (poll ?), by the way.

BARSHEFSKY:  (Laughs.)  Let me ask you this:  Secretary Paulson said this week that most of the weakness in the financial system occurred in regulated, rather than unregulated financial institutions.  So what does this say about our system?

GEITHNER:  I'd say it's kind of troubling.  Economists wouldn't be surprised, of course, because they say that, you know, regulation, supervision brings moral hazard.  And moral hazard brings risk taking leverage that -- but I guess I'd say that it's -- what's more troubling I think is the stuff in the middle.  You know, we have a regulated financial sector, and we have a financial sector like the alternative investment community that's largely outside regulation, except with the discipline their counterparties and their investors impose on them.

And I think most of the problems happen somewhere in the middle.  In institutions that are attached to banks -- part of that supervisory net, or thrifts; or in institutions that were, for example, a source of credit protection to a bunch of regulated institutions that operate under very different accounting capital frameworks; or in this diverse array of vehicles -- asset-backed financial vehicles.  There's a million other types of programs like that where there's a mix of explicit, implicit, implied support.  Hard for people to figure out, like, what the right, prudently anticipated level of support is, in some sense.

And, I guess, I would say that for the largest firms in the world, they've faced a level of shocks that were well within their capacity to absorb.  And as they adjusted to the change in the world, the actions they took to protect themselves from future losses had significant effects on market functioning.  But they were largely able to absorb those losses -- those losses today.

The more awkward stuff was in that gray middle -- as it always is, in some sense.  I think -- so you've got to be very careful about -- when you think about it, again, what's a better balance of market discipline and supervision in our system, you've got to focus a lot of attention on the, on the awkward middle.

BARSHEFSKY:  So, is there an issue here of regulatory consolidation?

GEITHNER:  You can -- you can think about -- obviously, this is all the product of the incentives created by regulation, in some sense.  So I think it's -- again, it's really important that we take a, sort of, broad look at that entire framework we've created in the United States.

I mean, the U.S. financial system has a lot of strengths and, in many ways it's done a better job at matching capital with ideas than any other financial system in the world.  And even with the occasional shocks of the past 25 years or so, our system has been reasonably resilient, and we've had, over that time, pretty steady improvements in productivity growth in the United States, which is, in some ways should be the ultimate test of the efficiency of the system.

But there are a lot of aspects of our -- of our regulatory framework that are hard to defend.  Some of them probably contribute at the margin to this stuff.  And we should have the chance now that we should have, sort of, the ability, a little bit more political will to think about how to get that framework to catch up.  So I think we want to look at simplification and consolidation.

BARSHEFSKY:  You touched on this in your remarks briefly, but why can't supervision be more proactive in limiting credit booms?  I know in other remarks that you've made along the way you've talked about the fact that the system needs to have shock absorbers in place so that, in fact, institutions can live with volatility because the volatility is simply going to be there.  But, why can't there be a greater proactive stance?

GEITHNER:  There's, you know, three things that supervision can do, and it's very important supervision do -- maybe it's only two-and-a-half.  But one is to try to make sure that risk management and controls stay abreast of the complexity in managing those risks.  Because, you know, business innovation is inexorably ahead of knowledge, and you'll never get a catch-up completely, unless you just decide to regulate against innovation.  But one thing supervision can do is make sure those controls catch up as quickly as possible.

The other key thing supervision could do is try to make sure that the, as I said, the, you know, the financial cushions, the -- both in terms of operational resilience in the infrastructure and in the -- and financial cushions are in capital liquidity.  As I said, you know, they look through the cycle, they're set in levels are going to be relatively conservative in good times, so that people have the room to eat into them in bad times.  And that helps reduce inherent growth cyclicality in markets.

Those two things are really important to do.  But they don't -- even if you do them optimally, which you never will, if you do them optimally, you still -- we still don't have the capacity to run a system where we come in and preemptively diffuse insipient concentrations of risk -- credit bubbles.

And we could, but we don't choose to run a financial system that prevents people from losing money, or tells institutional investors what type of instruments that they should buy.  And we don't run a system that saves them from choices they make about taking risks they don't understand.  We could run she system like that, but we -- you wouldn't want to live in that system.

So when I say that, you know, you should be careful about hope and expectation -- that we can design a system that's going to be terrifically preemptive, countercyclical, I don't mean that we shouldn't be ambitious about what supervision can do in these areas.  And, I mean, I've been in this job four-and-a-half years.  We initiated a lot of things in -- beginning in '04 which -- quite relevant, given the stress we've seen.

Just a couple of examples:  We initiated a broad effort with supervisors around the world to look at Counterparty Credit Risk Management practices, vis-a-vis hedge funds and complex structured products.  We initiated this large effort to improve the financial infrastructure.  A series of other things we did in the United States with other supervisors on a set of important aspects of risk management.  Some of those got a lot of traction.  Put those firms in a much better position to get through this.

Some of them didn't get enough traction -- overwhelmed by the power of the market and competition at that point.  But very important to be as ambitious as possible in trying to think about how you can do a better job of letting that risk management stuff catch up to -- catch up to the shifting frontier in relation to risk.  And, you know, one of the virtues of going through these kind of things is you learn a lot how to do those things.  Market learns -- will learn faster than we will.

BARSHEFSKY:  And the shock absorbers against volatility?

GEITHNER:  Shock absorbers are just about, you know, capital, and liquidity, and reserves and resilience of your infrastructure -- you know, what's the shock you calibrate your plumbing to withstand, in some sense?  How fat do you make the pipes?  What stress can they absorb?

And, you know, you can't -- you've got to make a choice on that, between efficiency and the stability benefits of the cushions.  And you've got to recognize that if you just raise the tax on one part of the system, it'll just move capital to the rest of the system.  So it's not easy to do in a system like ours where there's such huge unevenness in terms of the incentives these guys face -- you guys face.

But it's the right thing to worry about.  And nobody's going to be more worried about it than we are.  That's why we initiated these broad reviews with other major supervisors, because to do this right you've got to do it with the other major players in the system. You can't do it in New York alone, and hope the world catches up.  I don't think we're going wait for the world, to be hostage to the consensus available in the world, but you've got to start with a presumption that you've got to do it on a global -- something close to a global scale.

And so one of the reasons why we initiated this broad review of risk management strengths and weaknesses was to, as I said, to lay the foundation for a earlier consensus on the kind of changes we're going to have to make to capital accounting, disclosure, valuations.

BARSHEFSKY:  Tim, there's a lot of talk about decoupling and the question whether global financial markets are so tied to the United States.  Now, certainly as you indicated in your speech, developing countries are far more resilient than they were, for example, in the early 1980s during times of crisis.

Is there a decoupling?  Are we entering a phase where that is, in fact, happening?  And, secondarily, will growth in the rest of the world -- particularly in developing countries, help cushion the effects of a slowdown in the U.S.?

GEITHNER:  I think no doubt the world's much more -- more robust to a U.S. slowdown, and to this kind of financial shock, than it was.  And so far, growth in the rest of the world is looking reasonably good.  I mean, it's obviously slowing in many of the major economies as you would expect.  And I think the world will be more resilient than it's been, and that'll help pull us through this.

But I don't think, if you talked to policymakers in those countries, they feel that they're going to be insulated from this set of pressures we see concentrated in the United States.  They're not counting on decoupling.  And I think this has changed the basic policy calculus for everybody -- every central bank government, any major economy that's integrated in the world.

And I don't think you want to -- you'll know, for some time.  Can't tell yet, -- not going to know for some time, you know, how much -- how much this world is still fundamentally relying on demand growth here, and how this more integrated financial system affects the transmission of trust.

So, I'd say it's a -- it's a source of encouragement and resilience at the margin, but wouldn't -- wouldn't bet on a -- and you wouldn't -- I think if you were running one of these countries, you wouldn't want to bet on being fully insulated.

BARSHEFSKY:  So, we're not necessarily the importer of vast majority anymore?

GEITHNER:  Certainly not.  And, you know, again, I think there's -- part of the basic resilience of the world economy will be in the fact that you're just seeing a set changes in policy in economies around the world that -- you know, who's going to make those economies be able to grow faster, on a more durable basis -- stronger sustainable basis over time?  And that's been behind this huge increase in wealth, and that'll make the world -- that'll make income growth around the world stronger as a result.

BARSHEFSKY:  I have a number of other questions, but what I'd like to do is open it to the audience now, and if the questions I was hoping to hear about aren't asked, I'll ask them at the end.

So, again, raise your hands, and microphones will be brought to you.  And please stand up and identify yourself.

Yes, sir?

QUESTIONER:  Hi, my name is Jorge Merescalam (sp) with the Royalton Group.

My question is, what's your assessment of how much of the new regulation is going to create more of a problem?  How much are we going to see an effort to try to mitigate the short-term pain with things like freezing interest rates on mortgages or subsidies to people who took risk?  And -- that's it's going to only create a problem later on?  What's the balance of risk, from where you sit?

GEITHNER:  I'm not close enough to the details of this stuff to be able to give you much texture about that, except that the challenge you -- the dilemma you pose is central to the choices people in Washington now are making.  And very, very important to not do stuff now that's going to make it less likely -- you're going to get capital to come in, and credit to come in and support these markets going forward as the economics of it change.

But it's also important to recognize that, as I said, there's a bunch of negative spillovers associated with this adjustment going on in housing.  And it's a complicated task.  But I'm sure -- and I know for certain, that the people that are at the center making those judgments now are thinking very, very carefully through those tradeoffs.  Not easy to do, though.  And, you know, like many things in life, you've got to make a choice sometimes.

When I said at the beginning that, you know, we're kind of focused on the short-term, I didn't mean that, you know, we don't worry about the affect on incentives we're going to have going forward.  But it's also important to recognize when you're at a point where doing stuff that helps improve confidence in market functioning and in the fundamental underpinnings of growth going forward, when you do those things it does affect future incentives.  That's a necessary consequence, but it's why central banks exist.

But watch carefully and -- I know a bunch of you guys are in conversations with those people all the time and you can -- make sure you want to be thoughtful and credible when you point to them -- point out to them the dark side of the stuff that's going to affect property rights or affect future incentives.  Because it's easy to say -- it's easy to paint that risk, but you'll be more effective if you can help them navigate it, minimize it, reduce it.

BARSHEFSKY:  Yes, sir?

QUESTIONER:  Lee Escarosis (sp) from (Phily ?).

To what extent is the Fed concerned about the dollar losing its reserve currency status?  Do you monitor interest rate differentials of other countries?  Are you concerned that the weak

(Cross talk.)

GEITHNER:  Do we monitor -- you just asked me if we monitor interest rate differentials?

QUESTIONER:  If you are that concerned about it?

GEITHNER:  (Laughter.)

GEITHNER:  Important question.  Something we think and care about a lot.  We obviously watch developments in these markets -- all other markets very carefully.  No central bank can be indifferent to the fall in the value of its currency.  I think a very important thing for all policymakers to do -- and to keep in mind, in the current context -- is to focus on things that are going to be very important to sustaining confidence in U.S. financial assets over time.

That's a really important reason to look at all sorts of policy choices people make in this context.  It's also important to recognize that the world's going through a significant evolution in the monetary system -- in the constellation of exchange arrangement system.  And I think that evolution -- you see that in the people who are softening their link to the dollar in order to get more independence to use monetary political to address their domestic mix of objectives.

That evolution will be fundamentally helpful for the system over time.  Important to manage it very carefully and well, but that's an important transition ahead -- necessary thing to go through.  No risk to that transition for the United States, except to the extent which we -- well, let me put in the affirmative way -- that provided we do a reasonably good job on focusing on -- of focusing on stuff that, as I said, are going to sustain confidence in long-term prospects of the U.S. economy.

BARSHEFSKY:  Tim, do you see an Asian monetary union?

GEITHNER:  Not in the -- not in the lifetime of -- well, how should I say it?  Not soon.  (Laughter.)

BARSHEFSKY:  Yes.

QUESTIONER:  Bal Das from InsCap Partners.

I'd be curious to get your thoughts on a view that seems to prevail on Main Street, that if we look at the assets and the current booms of the last couple of decades, conflicts and incentives seem to be at the heart of it.  I'd be curious to get your views on that.

GEITHNER:  Of course.  You know, the conflicts in the financial system since the Malaysian -- all sorts of incentive problems are pervasive.  The issue is, how will you manage them.  Every firm -- any financial institution in this room lives every day -- anybody running an institution lives every day how to mitigate those conflicts that come in it -- every aspect of a financial -- diversified financial business, and particularly those that come from the compensation context.

And, again, I think what distinguishes people who do well over time from those that are a little more exposed, and it's kind of this -- is it's not so much the compensation -- the design of the compensation schemes, because they don't vary tremendously across -- at least the core set of institution.  What distinguishes them is how well they manage those conflicts.

And you could say that that's what risk management, or risk management culture is all about.  And it's much more complicated, as this report released this morning shows.  Much more complicated than just having the formal attributes of independence of risk managers, with independent reporting lines, compensation determination.  It's much more complicated than that, and much harder to get right over time.

There is a lot of concern, of course, about incentives, problems in the securitization framework, generally.  They were very, very acute in parts of the mortgage market.  But it's hard to say this now because we've -- you know, so many things -- there's been such a loss of confidence in so many things.  But I don't think -- the further you go from subprime mortgages, particularly those originated in the last three years -- in the two-and-a-half years before the turn, the further you go from that market, it's harder to find pervasive examples of a failure to manage these incentive problems.

You know, we've been -- in securitization, you know, securitization's been around for decades -- lot of experience through the downturns; similar kind of potential incentive problems.  And market participants have found ways to manage those, contain them, mitigate -- they can't eliminate them.  So I take some comfort from that, but focus really hard, as these reports that are coming will do, on trying to get a better balance in the, in the -- that you get in the mortgage origination side, or the parts of it that touch the mortgage market.

And that's where the opportunities for regulatory arbitrage were so acute.  You know, you had this very -- in a very short -- for a time, a huge share of those mortgages,  not just shift down the credit spectrum, but shift to the much less regulated parts of the market.  And that'll change.

BARSHEFSKY:  Back of the room?  Questions?  That's a quiet back-of-the-room.

All the way in the back.

QUESTIONER:  Gene Solomon (sp) from (Munis ?) Capital.

Do you have a view on the role the credit rating agencies, S&P and Moody's, have played?  For example, at first maybe they awarded credit ratings to the bond insurers, Ambac, and MBIA, and others, that maybe they didn't deserve once they started guaranteeing some of these products; and now maybe -- even though the credit ratings agencies probably know, as most up on Wall Street do, that they don't deserve the credit ratings they still have -- they haven't downgraded them.  What's your opinion on all that?

GEITHNER:  Well, as I said, you know, I didn't do chapter and verse.  But, you know, there's a -- our system built up with a lot of rating dependence, rating reliance, incentive to use ratings.  And as the structured ABS stuff grew substantially, the system as a whole became much more vulnerable to the inherent uncertainty, vulnerability, difficulty in rating that set of instruments -- much harder to do than the corporate stuff.

And because so much of that innovation and growth -- and, you know, therefore, dependent -- rating dependence on the structure stuff happened in a very benign world, people were living with just much more uncertainty than they appreciated about what the distribution laws was going to be when things changed.

And you point out one example of how important those judgments are now, but -- and they're difficult to get right -- but, again, not to just point to these things that are coming, but I want to -- from -- you know, in these reports you're going to see -- these recommendations you're going to see from the secretary of the Treasury and others, you're going to see a set of -- a pretty substantial set of proposals for how to mitigate these risks going forward.

They are hard to fix now, on the fly.  It's going to take a little bit of time to do it, but they're important to get right.

BARSHEFSKY:  I'd like to ask you, if I could, two questions which are both substantial policy questions, but also very hot-button political issues -- and this is the political season.

The first is whether we should be concerned about sovereign wealth funds.  I think Morgan Stanley estimates -- I think you said it, Richard -- that they're about $2-and-half trillion in size now, in the aggregate, estimated to double by 2010, and increase quite rapidly after that.  And certainly that was the projection of this group, based on Richard's electronic poll.

Certainly, you have these large pools of capital, in part because of this gigantic U.S. budget deficit, in part the oil boom, and so on.  Money is now being recycled into a broad series of investments.  And on the one hand one could say, well, this reinserts government into businesses that were private businesses.  On the other hand, if you look at U.S. financial institutions, monies from these funds have been critical and important in stabilizing the situation.

How do you look at this issue of sovereign wealth funds?  How do you think policymakers should look at the issue?  And should we be concerned?

GEITHNER:  Not as concerned as some people think, I think.  I think that, you know, again, one of the great strengths of the U.S. financial system has been its openness to foreign capital -- not just to capital, but to ideas, and to people, and to goods and services -- very important to sustain confidence around the world that that will continue.

We have a variety of protections in place -- Charlene, you're more familiar with these than many, that will allow us to -- I'm saying, not just in CFIUS, but in a bunch of other aspects of the regulatory framework, that allow us to manage the risks that come from what you described.  And I think we can be pretty confident in the -- that that gives us an adequate set of tools to deal with these kind of risks.

And although these institutions are growing rapidly, they're not new.  They've been around for a long time.  And the best of them, and the experience of them, have done a pretty good job at navigating the inherent tensions in that basic dual role for that gray area.  So I would put the priority on, again, on trying to make sure that we sustain confidence in the rest of the world that we're going to keep our markets open to foreign capital and ideas; and be pretty confident we can have a set of protections in place so we manage whatever particular public policy pressures, tensions they raise in this context.

BARSHEFSKY:  Having looked at this quite significantly, I agree with you certainly in terms of the regulatory framework that we already have in place I think is more than adequate.

Second question I have for you, which is a policy question -- and as we just saw in Ohio from the who-hates-NAFTA-more debate -- (laughter) -- political question --

GEITHNER:  Architect of NAFTA.  (Laughter.)

BARSHEFSKY:  -- oh, God -- and that is, you know, Larry Summers now argues, in a quite absolutist way, that wage growth in the U.S. no longer tracks productivity growth.  Others have said, well, that's really not quite right; these two elements do track, but perhaps not in the short-run.  And, of course, we all know the phrase beginning "but in the long-run."

You've talked in the past about increase levels of income inequality.  You've talked about the slow pace of wage growth for the middle quintiles of the income distribution.  You've talked about the volatility in income.  You've talked about the greater exposure of families to risk as they finance health care and retirement.

What is the status of the American worker?  And, what are the policies that need to surround that worker?

GEITHNER:  Gee, umm -- (Laughter.)  I've thought less about that issue than almost any other thing I do.  And it's, it's outside my -- of course, I don't, I don't, I don't get to be the arbiter of most of the choices that make -- (inaudible).  So, I guess I would just say that I think we all understand the nature and source of the anxiety that's out there, produced by those broad trends.  We don't fully understand what's driving the underlying economics of them, but we know some of the things that are driving them.

The question really is about what to do I think, fundamentally.  And, again, it's not my role -- not my, not my sphere of attention, focus.  But, I guess I would say that you want to put the emphasis on things that will make people more confident than they seem to be today; that we have a balance between opportunity -- independent of the circumstances of your birth, mobility, opportunity, choice -- again, independent of how lucky you were, and the wealth of your parents, where you were born.

And you want to put emphasis on things that are going to give -- put a somewhat stronger set of protections in place, particularly on health care, that make people more comfortable, more confident living in a world that is just so much more uncertain than it was, where they face a lot of things that are well beyond their capacity to control or ensure against.

And I think, as a country, we can do a lot better job of both of those two things.  And they dominate what most people want to resort to, which are things that are designed to, you know, slow the pace of innovation, or try to contain the basic pressures that are immutable and inexorable in this world -- which I don't, I don't think you can do effectively without much, much more adverse cost to income growth, generally.

So, I would focus on, again, stuff that improves people's basic confidence in opportunity and mobility in the United States, and things that give them more confidence in a stronger set of protections on things like health care, to allow them to live more comfortably and in this more uncertain world.

But, I've got to go.  (Laughter.)

BARSHEFSKY:  Thank you, and so do we.  Thank you very, very much.  (Applause.)

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