NEW YORK (–Banks need to do more to monitor and control risk, particularly with respect to their hedge fund lending policies, the head of New York’s Federal Reserve Bank told a gathering of international bankers on Wednesday [June 9].

Timothy F. Geithner, president and chief executive of the Federal Reserve Bank of New York, addressed the Institute of International Bankers’ annual general meeting, saying it is necessary and useful to examine leading risk management practices and to encourage their broad adoption.

“Through horizontal reviews that focus on specific dimensions of risk management, we have a reasonably good sense of where the frontier in risk management practices is across the industry and understand where the gap between this frontier and average practice is the greatest,” Mr. Geithner said. “The size of this gap in practice can increase in market conditions where competitive pressures and a search for return works to erode discipline.”

Specifically, Mr. Geithner said that with regard to counterparty risk management, the leading banks use more “careful and sophisticated” analysis tools to measure potential future exposures and how those exposures could respond in times of “significant market stress.”

“With respect to hedge fund exposure in particular, the leading firms employ comprehensive evaluation of the risk profile of the hedge fund to set credit thresholds and terms and a more disciplined approach to setting sufficiently high levels of initial margin,” Mr. Geithner said. The clear implication was that such an approach should be standard throughout the industry.

Calling the fundamentals of the U.S. economic recovery “relatively strong,” Mr. Geithner suggested now is the time to assess how the U.S. financial system might handle the transition from recession to recovery and whether it is positioned to handle future stresses.

Risk, he said, is generally being spread more broadly through the financial system, thanks to securitization and growing numbers of instruments for transferring credit risk.

In terms of highlighting areas where the industry best practices are farthest ahead of the industry standard, Mr. Geithner pointed to six areas: comprehensive aggregation of credit exposure; stress testing and scenario analysis; counterparty credit risk management; measuring and managing interest rate risk; liquidity risk; and compliance risk management.

For each, he outlined steps taken by the leading firms. “These are examples of leading practice, and they are not at this point standard operating procedure across the range of institutions where they should be,” Mr. Geithner said.

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