Timothy F Geithner: Challenges facing the global payments system Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the SIBOS 2004 Atlanta Conference, Atlanta, 14 October 2004. *  *  *  I am pleased to have the chance to address SIBOS 2004. This is an important forum for us because a strong and efficient payments infrastructure is a vital strategic asset for the U.S. and the global financial system. I want to take this opportunity to talk about some of the forces shaping the evolution in this strategic infrastructure, the challenges they present, and the implications for participants, system operators, and the central banks who oversee them. In this context, I will try to identify some of the major priorities we see over the medium term in strengthening the safety and soundness and the operational resilience of the global payments and settlement system. Over the past 15 years, we have brought about a major global effort to reduce the potential for systemic risk emanating from the key elements of the payment infrastructure - the large value payments systems and the securities and foreign exchange settlement systems. Particularly notable are the 1989 G-30 standards on clearance and settlement systems, the Lamfalussy Report, the launch of CLS bank, and the paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System.
Typically, what we would like to have is a balance between the two so that the system will have its own stabilizing mechanism when the shocks hit. But in this crisis, apparently the positive feedbacks had been overwhelming. Let me cite a few examples of the positive feedback loops that were in play. BIS Review 130/2009  1  The first, example A, is the originate-to-distribute model, which was prominent at the formative period of the crisis. Here, we see that with the housing sector booming, investment funds were eager to seek entries into the credit business, despite the fact that they had no expertise in evaluating credit risks of mortgage loans, or the complex risk exposures when mortgage loans were packaged, first into CDO, then into commercial papers backed by CDO, and so on. So, with a ready market for securitsation or structured products, banks, who were assured that credit risks would be transferred off their balance sheets, enlarged their lending activities. This is a classic moral hazard problem that helped fuel the already booming housing market. Example B is a positive feedback loop linked to the stress on the SIV. Once subprime mortgages began to default, investors in the junior tranches of cash CDO started losing money. What happened was that not only the ex post rate of defaults increased, but the senior tranches were also hit by a rise in ex ante default correlation, causing losses in the senior cash CDO tranches.