Because banks are now a smaller share of the system, a given level of stress on nonbanks creates greater strain on the system as a whole. It is in part the consequence of the fact that the present system focuses on mitigating the risks of firm specific shocks, rather than a systematic market shock. And it is in part the consequence of the fact that the present system is not designed to induce institutions, particularly the largest ones, to internalize the negative consequences, the negative externalities, of their actions on markets as a whole in conditions of stress. There is no simple solution to this problem. It requires a broad look at the design of the present capital regime, the incentives it creates for holding different forms of risk, and the scope of the application of these requirements. As we move to a more modern and risksensitive capital framework and reduce the perverse incentives in the current capital requirements, we need to make sure that reserves, capital, and liquidity provisions are more forward looking, and adjust appropriately through the peaks and valleys of the cycle. This will 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 market shocks. Market infrastructure We are in the midst of a dramatic period of financial innovation and growth in derivative instruments, but the pace of change the growth in volume has brought a lot of challenges.
Timothy F Geithner: The current financial challenges – policy and regulatory implications Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Council on Foreign Relations Corporate Conference 2008, New York, 6 March 2008. *  *  *  I am going to talk today about some of the challenges facing the U.S. and financial system. These problems took a long time to build up, and, even with a forceful mix of public policy and action by the private sector, they will take time to resolve. The central questions are: what caused the crisis and what explains its severity? 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? Origins The origins of this crisis lie in complex interaction of number of forces. Some were the product of market forces. Some were the product of market failures. Some were the result of incentives created by policy and regulation. Some of these were evident at the time, others are apparent only with the benefit of hindsight. Together they produced a substantial financial boom on a global scale. In the five years leading up to the present stress, the world experienced an unusual mix of financial conditions.