WASHINGTON – New credit instruments have made increased the liquidity and efficiency of the global financial system, but serious challenges remain for both investors and policymakers in managing credit risk, opined Federal Reserve Gov. Randall Kroszner speaking at a Fed-sponsored conference in Charlotte, N.C.

In his prepared remarks, Kroszner did not address the current state of the economy of the Fed’s interest-rate policy, including the Federal Open Market Committee’s decision announced yesterday to keep interest rates steady.

Neither did he comment on the contraction of the subprime mortgage market and whether problems in that segment have spilled over into other market segments.

Speaking from prepared remarks, Kroszner reportedly told attendees that credit derivatives have been a boon to the financial system by dispersing risks and creating more liquid markets. Non-bank institutional investors such as mutual funds, pension funds, insurance companies and hedge funds, now provide a greater share of credit. Such investors, Kroszner stated, are likely to be more demanding in their risk management than banks are because they do not have a safety net of federal deposit insurance to fall back on.

"These developments generally have enhanced the efficiency and the stability of the credit markets and the broader financial system by making credit markets more transparent and liquid, by creating new instruments for unbundling and managing credit risks, and by dispersing risks more broadly,” Kroszner said. But "significant challenges” still remain, he added.

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"The complexity of some instruments creates difficulties with respect to valuation, risk measurement and risk management,” he said.

Kroszner offered that the best way to manage the risks of default is for each party to the transaction to monitor the terms and underlying assets of the credit instrument. But complicated instruments, such as collateralized debt obligations, are tricky to value and assign risk to.

"Much more work remains to be done before this risk can be considered to be fully understood,” Kroszner stated.

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