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It's a pleasure to be here this morning, and I want to thank you for giving me the opportunity to address some of the issues we at the Treasury see as we consider the management of risk in the financial system and the role of the official sector in helping ease or improve the system's response to risk.
I should note at the outset that you are meeting to consider these questions in a remarkably benign environment. Macroeconomic conditions in the United States have been quite favorable GDP growth at 3.5% last year and projected to run at roughly that level for the current year; strong and increasing job creation, which should inevitably have attendant income effects; strong and durable productivity growth; household wealth at an all-time high. While these factors do not make financial sector stability inevitable, they are certainly a favorable context.
Moreover, it is clear that financial markets have a great deal of confidence about the future. Last week, the Dow was above 11,000 for the entire week for the first time in years. Merrill Lynch's MOVE Index of Treasury bond implied volatilities hit all time lows. A long period of low realized credit losses, lower volatility in GDP growth, and low and stable inflation have led to expectations of more of the same, and thus contributed to a general reduction in risk premia across a wide range of asset classes.
But, like you, we at the Treasury are among those paid to consider the alternatives, and some risks can be found even in what are prima facie signs of strength. Low volatility can create incentives for riskier trading strategies, to maintain return. And currently there is little cost to highly leveraged trading strategies. Swap spreads are at pre-LTCM levels. Financial institutions are facing a flat or inverted yield curve and credit spreads across a number of asset classes are historically tight. This, too, forces market participants to dig deeper to find returns. Investors are also willing to extend duration in a rising rate environment because of the low levels of realized or implied volatility.
Complicating the situation is the fact that traders have become accustomed to the superior liquidity we have experienced recently. Traders expect to get out of their positions at the next tic, and the possibility of constrained liquidity does not act as a discipline on trading strategies. Traders employing riskier strategies to chase return but expecting liquid markets to protect their downside can lead to steep reversals in asset prices upon a triggering event.
And as we consider the potential for these phenomena to be sources of stress in the financial system, we must further consider the substantial structural changes that the system has undergone over the last 20 to 25 years.
- First, the banking sector is a materially smaller portion of the overall financial system than is the past. Non-banks both securities firms and insurance companies play a larger role in the extension of credit and the distribution of risk.
- Second, concentration in the system is substantially greater. A smaller number of larger firms, both banks and nonbanks, have assumed systemic importance.
- Third, and analogously, the rapid growth of the housing GSEs in the United States and the increased demand for their securities over the last decade have greatly exacerbated the potential for events at these institutions to have systemic consequences.
- Fourth, capital accumulation is increasingly accomplished through less-regulated entities such as private equity funds and hedge funds.
- Fifth, the growth in variety and sophistication of financial instruments increasingly means that analogous or identical economic relationships can be created through instruments with different legal character, creating possibilities for regulatory arbitrage.
- Finally, the financial sector as a whole is increasingly integrated across the principal financial markets of the developed world.
In the face of these facts, what are the appropriate responses for policy makers? I would like to focus on three. These three are not comprehensive or novel, but they are illustrative of the areas where the Treasury is working to address questions of risk in the financial system and make it easier for private firms to manage those risks.
GSEs
First, is the question of the housing GSEs, which I mentioned above as among the substantial changes in the institutional structure of the financial sector that have contributed to increased systemic risk. While the mortgage securitization activity conducted by Fannie Mae and Freddie Mac does in fact provide a public benefit by increasing the amount of capital available to support mortgage credit thus decreasing its cost and increasing its supply their retention of large investment portfolios does not further this purpose. These retained portfolios do, however, concentrate rather than distribute the prepayment and interest rate risks associated with mortgages and mortgage-backed instruments held by them, and concentrate them in entities that as a result of the lower levels of capital they are required to hold are substantially more leveraged than other financial institutions. Because of the funding advantage enjoyed by the GSEs, they are able to grow these portfolios to a much greater degree than a purely private sector entity could, and as they continue to grow in size it becomes increasingly risky for counterparties to hedge them, particularly given the complicated hedging strategies run by the GSEs.
The recent report of Senator Rudman to the Board of Fannie Mae, while not focused on the systemic risk issues, does lay bare the focus of the company during this period on earnings growth rather than its core housing mission. While the specific abuses detailed in the report have largely been addressed or are being so, the principal legacy of this period of abuse and lack of focus on its mission remains the bloated retained investment portfolios at both Fannie and Freddie. A satisfactory solution to this risk requires a clear legislative instruction tying the portfolios to the mission of the enterprises, because their funding advantage eliminates many of the usual sources of market discipline on this risky growth, and regulatory discipline has in the past proven of limited effectiveness when not backed by an unambiguous legislative mandate.
Regulatory Framework
The GSEs are one specific area we have identified where changes in institutional structure have led to changes in systemic risk. But more broadly, we will be focused as we look forward on seeking to understand in the most comprehensive way possible whether and how changes in the structure of the financial services industry have affected the way markets operate put another way, whether the growth of certain types of institutions or instruments has materially affected the efficiency with which markets intermediate risk, whether risk is placed or pooled in different ways or different places than it has been in the past and if so, what appropriate policy responses might be.
For example, as I noted earlier and as Tim Geithner also discussed in his remarks yesterday the growth of non-bank participation in the financial sector and the increasing development of legal technology to allow the creation of similar economic relationships through instruments of quite different legal character creates a very real possibility of regulatory arbitrage, thus limiting the effectiveness of safety and soundness regulation promulgated for only one type of regulated entity. Furthering the already well developed cooperation between our own national regulators, such as the Fed, the SEC, and the CFTC, will be useful, but when the additional challenges posed by the growth in capital accumulation vehicles that are quite lightly regulated and the increasing global integration of financial activity are factored in, the challenges for the regulatory framework become greater. The fundamental question we must be focused on is ensuring that we strike the right balance between the costs of regulatory fragmentation and the benefits of regulatory competition.
Insurance
One area where policy makers on the Hill and elsewhere will be particularly focused in assessing the costs of regulatory fragmentation and the benefits of regulatory competition will be in the insurance industry. After the passage of Gramm-Leach-Bliley, the insurance marketplace is certainly different from what it was even a few years ago, even though the expected convergence of banks and insurers still has not materialized. There is a new financial services marketplace that is accelerating and being driven by industry consolidation, globalization, and the advent of e-commerce.
These changes have led some insurers to maintain that in this new environment, they find themselves in direct competition with brokerage firms, mutual funds, and commercial banks - all of which they perceive as having a competitive advantage due to regulatory structures that allow for more efficient operations.
In recent years the insurance industry has acknowledged these changes in the marketplace and called for the modernization of the state-based insurance regulatory system. For instance in 2000, the National Association of Insurance Commissioners (NAIC) adopted the Statement of Intent The Future of Insurance Regulation, pledging to design and implement uniform standards for a variety of regulatory functions.
Despite these efforts, some insurers feel that more has to be done to modernize state insurance regulation, and have called for some degree of federal involvement. In evaluating these various proposals, we are also mindful of the difficulties for the official sector in getting a comprehensive view of risk in an industry where there are over 50 different regulators, each feeling a portion of the elephant, but none seeing the whole. For example, take the commonly repeated suggestion that the very rapid growth in credit derivative transactions has resulted in credit risk being pooled in the insurance industry in unexpected ways. The official sector would currently find it difficult to evaluate the truth of this statement, and, if true, what degree of risk it might pose if any.
The Treasury has been meeting with a number of insurance industry officials on the various reform efforts that they and others are proposing. We have not yet taken a position on what approach, if any, should be taken to involve the federal government in the regulation of insurance, but we will continue to evaluate these proposals in light of these risk assessment and management principles we have been discussing today.
Thank you, and I'll now be happy to take any questions you might have.