Fed VC Speaks on Risk Management and Financial Stability
Vice Chairman of the Federal Reserve Board Donald Kohn gave a speech today in North Carolina. He stressed the
needs for a better response to financial turmoil. He offered his take on what banks and the Federal Reserve need to do. Here are some highlights of his speech.
A more resilient financial system will also require banks to strengthen all aspects of the originate-to-distribute model. They need to pay more attention to origination, including when they are distributing credits they have not originated. And they need to ensure that when they distribute risks into the market with securitization, the risks really are distributed and will not come back onto their balance sheet later.
Banks and investors must devote more effort to due diligence when investing in structured products, and they must avoid relying so heavily on credit rating agencies to do all their homework for them.
Banks must come to grips with the implications that their capital markets businesses have for liquidity risk management.
All banks–large and small–need to consider whether they need greater capital cushions.
At the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will.
Vice Chairman Kohn also talked about some specific financial stability concerns. Here are the three issues that he noted.
First, securities markets have become so large that commercial banks simply lack sufficient capital and balance sheet capacity to readily fill the gap when markets are impaired.
Second, banks themselves are more dependent on well-functioning securities markets, and as that dependence and the important role of banks as ultimate providers of funding to those markets became clearer, pressures on banks mounted.
Third, large commercial banks and investment banks have increasingly similar risk profiles, so that all are subject to the same risk-management challenges under the same circumstances.
Kohn is basically worried about excessive leverage problems and the susceptibility to runs on banks and securities firms. He believes that monetary policy needs to give attention to the “liquidity risk-management policies and practices of major investment banks,” and commercial banks.
