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Fed Official Warns of Changes
Financial Tools Outpacing Controls, Geithner Cautions

By Nell Henderson
Washington Post Staff Writer
Wednesday, March 1, 2006

A top Federal Reserve official warned yesterday that the U.S. financial system is evolving faster than the ability of investors, lenders and regulators to evaluate and manage the risks involved.

The rapid growth in complex new investment instruments and recent changes in market structure have helped make the nation's financial system more flexible and resilient, Timothy F. Geithner, president of the Fed Bank of New York, said in a speech to a convention of risk-management professionals.

But, he said, "there are aspects of the latest changes in financial innovation that could increase systemic risk" -- the danger that the losses of a few investors could set off a chain reaction of events that disrupts the broader financial system, as did the near-collapse of a heavily leveraged hedge fund in 1998.

Geithner called for greater cooperation among government regulators, banks and other financial institutions in improving their methods for anticipating and managing financial risks.

"The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved," he said.

One source of concern Geithner highlighted was the recent rapid growth in credit derivatives -- financial contracts whose value is linked to corporate bonds and loans. The instruments allow investors to bet on the creditworthiness of a company, while spreading the risk of corporate defaults to the broader market. Some analysts worry that a big default or surprising downgrade of debt could trigger cascading losses to hedge funds and the banks, pension funds, insurers, university endowments and other investors that lend money to them.

Credit derivatives have proliferated in a period of generally healthy economic and financial conditions, Geithner said, leaving us "with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances."

Another source of concern is the growing role of hedge funds, private investment pools that are not subject to significant government oversight. A large hedge fund failure could "potentially cause greater damage to the core of the financial system than might have been the case in the past," Geithner warned.

The New York Fed is the central bank's primary liaison to financial markets. In 1998, it brokered an agreement among private lenders to rescue Long Term Capital Management, a Connecticut-based hedge fund whose near-collapse caused the bond market to briefly seize up.

Many analysts have worried that the Fed's success in managing that financial crisis and others that occurred during Alan Greenspan's 18-year tenure as Fed chairman have lulled many investors into underestimating financial risks.

Geithner delivered his warning just one month after Greenspan was succeeded by Ben S. Bernanke, a former university professor who is untested as a crisis manager.

Geithner said recent financial innovations have helped the economy absorb various financial shocks, "but they have not eliminated risk." He added, "They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial system from the effects of such a failure."

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