Though E. Gerald Corrigan left his post as head of the Federal Reserve Bank of New York five years ago, he says his "capacity to find things to worry about is undiminished." At the International Monetary Conference in Vienna last month, Mr. Corrigan, now a managing director for Goldman, Sachs & Co., discussed some of his current worries for the banking system. The following is excerpted from his speech.
Asset price inflation in equity prices and real estate is a potential source of instability for financial markets. Let me very carefully elaborate on this point because market corrections, even if large, should not be a source of major, much less systemic concern, but rather are a natural and healthy part of overall market dynamics.
Instability enters the picture when asset price changes produce the fear, or the reality, of credit problems which, in turn, raise the specter of nonpayment in accordance with contractual obligations.
Markets, as we have seen, can handle most eventualities, but when broad- based credit concerns enter the picture, things get very dicey.
That is why, in current circumstances, an extra margin of counterparty credit due diligence is in order and it is also why the persistence of narrow credit spreads may signal potential credit market problems down the road.
The fact that banking systems in so many emerging market countries are under so much stress presents both unusual risks and unusual opportunities. The risks-especially counterparty credit risks, amplified by high levels of nonperforming loans by local banks to local companies-are large and not always easy to monitor and manage.
On the other hand, the business opportunities for international banks- including acquiring or taking stakes in local banks in these countries-can be considerable. Moreover, the technological and managerial transfer growing out of increased foreign bank participation in these local banking markets can play an enormously valuable role in helping to speed the reform and restructuring of banking systems. In other words, this can be a win-win situation.
In some banking markets, including in Europe, the more rapid development of capital markets will be associated with an accelerated pace of credit disintermediation out of the banking system with corresponding pressures in profits and the need to accelerate internal restructuring.
This phenomenon is not likely to be so rapid as to be unmanageable, but I will be very surprised, if five years from now, we do not see a number of countries in which the share of total credit originating in the banking system is lower-and perhaps significantly lower-than it is today.
Shortcomings in credit due diligence, failures in internal controls and risk management, and periodic bouts of severe market volatility will continue to produce some unpleasant surprises for individual institutions.
Understanding and managing credit risk-especially potential credit risk- remains a large challenge in a setting in which credit-related losses have been the largest source of damage to financial institutions. New techniques based on statistical and mathematical models are being developed in order to provide more sophisticated insights into credit risk.
While this is a welcome development, we are a long way from the point where such models can be relied upon and an even longer way from the point where they can be incorporated into the regulatory framework. In the meanwhile, and beyond, the old standard of knowing your counterparty is, if anything, more compelling than ever.