03 March 2008

FED Govenor Kroszner criticizes role of banks financial turmoil

Banks have not fully considered the potential funding-liquidity problems that complex structured investment vehicles could face if there were sudden market moves or if perceptions of credit risk changed, Federal Reserve Governor Kroszner said.

Kroszner outlined the key role of banks as liquidity providers in the financial system and, hence, the crucial role of sound liquidity-risk management and regulation. He criticized that banks did not consider that their assets could fall sharply in value and what impact each of those possibilities might have on the bank. 

The experience of banks with SIVs showed that the complexity of structured investment vehicles and the lack of information about where the underlying credit, legal, and operational risks resided made these products more difficult and costly to value than many originally thought, he explained.

Furthermore, during times of systemwide stress, liquidity shocks can become correlated so that the same factors that led to liquidity problems for the SIVs could also lead to high liquidity demands in other parts of the financial market, and might also put pressure on banks' own liquidity. 

“Some banks may not have been fully prepared for the possibility that SIVs would require more liquidity from banks at the same time that the banks themselves would be facing increased liquidity demands elsewhere”, Kroszner said.

 “Many investors appear not to have demanded sufficient information about complex investment vehicles, or perhaps did not carefully evaluate that information that was available”, he said. “Instead, they simply accepted investment-grade ratings as a substitute for their own risk analysis.” 

“If certain market participants had done more verification, they might not have invested in these vehicles, or might have demanded higher returns in line with the actual risks”, Kroszner said.

Full speech

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