(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
NY Fed President
Calls for Broad Reform of Securitization Process
NY Fed President
Timothy Geithner has called for the comprehensive reform of the entire
securitization process in light of the ongoing crisis in the financial markets.
Improper valuations of complex securitized instruments and inadequate risk
management significantly contributed to the problem, in his view. The damage to
investor confidence in credit ratings of securitized products, in the tools used
to value those securities, and in the capacity of investors to evaluate risk,
will prolong the process of adjustment in markets. His remarks
were delivered at the recent Council of Foreign Relations corporate seminar.
As part of the major
reform, the NY Fed chief said that banks, and institutions that are built around
banks, must be subject to a stronger form of consolidated supervision than the
current framework provides. At the same time, there must be a move to a simpler
framework, with a more uniform set of rules applied evenly across entities
involved in similar functions, and a more effective balance of regulation and
market discipline.
He noted that U.S.
financial regulations have evolved into a very complex and uneven framework,
with substantial opportunities for arbitrage, large gaps in coverage,
significant inefficiencies, and large differences in the degree of oversight of
institutions that engage in very similar activities. Some illustrations of this
are the current incentives to shift risk to where accounting and capital
treatment are more favorable and the amount of risk built up in entities that
operate in the grey areas of implied support from much larger affiliated
institutions. The official thus raises the specter of regulatory arbitrage, a
serious problem that must be resolved.
The Presidents
Working Group on Financial Markets and the Financial Stability Forum are
laboring to produce a comprehensive framework of reforms. The senior Fed
official said that many of these recommendations will focus on changes to the
ratings process for asset-backed securities, regulatory and accounting treatment
of these instruments and special purpose financing vehicles, enhanced
disclosure, and other dimensions of the securitization process.
The NY Fed official
said it is imperative to encourage improvements in the quality of valuation
methods and disclosure by the major regulated financial institutions and the
necessary adjustment in valuations and reserves to reflect the deterioration in
expected losses. Better disclosure can reduce some uncertainty about the
incidence and magnitude of potential losses, he posited.
Analyzing the
crisis, Mr. Geithner said that, as complex derivatives and structured securities
products proliferated, the models used by issuers to structure these products,
and by credit rating agencies to assess the risk and assign ratings to them,
turned out to be much more sensitive to macroeconomic assumptions than was
apparent to investors. In addition, the proliferation of credit risk transfer
instruments was driven in part by an assumption of frictionless, uninterrupted
liquidity, he noted, which left credit and funding markets more vulnerable when
liquidity receded. For their part, banks and other financial institutions lent
substantial amounts of money on the assumption that they would be able to easily
distribute that risk into liquid markets through securitized products.
In his view, the
crisis exposed a range of weaknesses in risk management practices within global
financial institutions. Banks and investment banks with stronger risk management
practices and cultures did substantially better. The most common failures were
in how firms dealt with uncertainty about the scale of losses they would face in
a less benign financial environment; the scale of the cushion they built up
against that uncertainty; how well they managed the internal tension between
risk and reward; and how quickly they moved to mitigate risk as conditions
deteriorated.
The typical arsenal
of risk management tools relies on history and experience, he said, and thus has
only limited value in assessing the scale of potential future losses.
Uncertainty about the future, and the greater complexity of leveraged structured
products, created a "dense fog'' around estimates of potential loss, he
noted, making institutions and markets more vulnerable to an adverse surprise
when conditions changed.
In turn, the
substantial impairment of securitization markets reduced banks' access to
liquidity and their capacity to move assets off balance sheets. As the market
value of many securities declined, and investors reduced their willingness to
finance more risky assets, liquidity conditions eroded further. In response,
even the strongest financial institutions have become much more cautious,
building up large cushions of liquidity and reducing financing for their
leveraged counterparties.
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