|
PureBytes Links
Trading Reference Links
|
Remarks by Chairman Alan Greenspan
The structure of the international financial system
At the Annual Meeting of the Securities Industry Association, Boca
Raton, Florida
November 5, 1998
This afternoon I intend to address a subject that ten years ago would
have been sleep inducing.
Today it is a cage rattler: the structure of the international
financial system. Functioning well, most
participants take it for granted. Functioning poorly, it becomes a
vehicle for financial contagion and
a threat to the franchises of many in this room.
Dramatic advances in computer and telecommunications technologies in
recent years have enabled
a broad unbundling of risks through innovative financial engineering.
The financial instruments of a
bygone era, common stocks and debt obligations, have been augmented by
a vast array of
complex hybrid financial products, which allow risks to be isolated,
but which, in many cases,
seemingly challenge human understanding.
The consequence doubtless has been a far more efficient financial
system. The price-setting
functions of the market economy in the United States, for example, have
become increasingly
sensitive to subtle changes in consumer choice and capital
efficiencies, and the resulting set of
product and asset market prices and interest rates have enabled
producers to direct scarce capital
to those productive facilities that most effectively cater to consumer
preferences. Thus, despite a
rate of capital investment far short of that of many other advanced
industrial countries, the
efficiency of that capital has facilitated the creation of an economy
whose vitality is unmatched
throughout the world.
These same new technologies and financial products have challenged the
ability of inward looking
and protectionist economies to maintain effective barriers, which,
along with the superior
performance of their more open trading partners, has led over the past
decade to a major
dismantling of impediments to the free flow of trade and capital. The
new international financial
system that has evolved as a consequence has been, despite recent
setbacks, a major factor in the
marked increase in living standards for those economies that have
chosen to participate in it.
It has done so by facilitating cross-border trade in goods and services
that has enhanced
competition and expanded the benefits of the international division of
labor. Indeed, the growing
importance of finance in fostering those rising living standards,
especially in the United States, is
the major reason the share of national incomes accruing to finance has
been increasing since the
mid-1970s.
Notwithstanding the demonstrable advantages of the new international
financial system, the
Mexican financial breakdown in late 1994 and, of course, the most
recent episodes in East Asia
and elsewhere have raised questions about the inherent stability of
this new system.
The Mexican crisis had many of the characteristics of earlier financial
disorders, primarily a very
large current account deficit, but the intensity of the disruption, and
certainly the size of official
financing employed to quell it, seemed larger relative to the
underlying causes than comparable
previous episodes.
Many of the more recent crises, from Thailand to Russia, have the
conventional causes--fiscal and
trade imbalances, and/or imprudent borrowing denominated in foreign
currencies. But again the
size of the breakdowns and required official finance to counter them is
of a different order of
magnitude than in the past. This is especially the case when we
consider how outsized the
distortions were in Latin America in the early 1980s, relative to the
remedies that were employed.
But why did a relatively conventional slowdown in capital investments
and capital outflows to East
Asia over the past year and a half induce such a wrenching adjustment
in individual economies and
why has the degree of contagion been so large?
The answer appears to lie in the very same technologies that have
brought so marked an increase
in the efficiency of our new international financial structure. That
financial structure, which has
induced such dramatic increases in productive capital flows, has also
exhibited significantly
improved capacities to transmit ill-advised investments. One can
scarcely imagine the size of losses
of a single trader employing modern techniques that contributed to the
demise of Barings in 1995
being accomplished in the paper-trade environment of earlier decades.
Clearly, our productivity to
create losses has improved measurably in recent years.
The system is thus both productive of increased standards of living and
more sensitive to capital
misuse. It is a system more calibrated than before to not only reward
innovation but also to
discipline the mistakes of private investment or public policy--once
they become evident. As I
have pointed out before, the huge flows of capital into debt and equity
markets, premised on
overly optimistic assessments of risk or returns, drove asset prices to
unsustainable levels that only
worsened the subsequent correction.
Hence, the recent crises, while sharing many, if not most, of the
characteristics of past episodes,
nonetheless, appear different. Market discipline today is clearly far
more draconian and less
forgiving than twenty or thirty years ago. Owing to greater information
and more opportunities,
capital now shifts more readily and increasingly to those ventures or
economies that appear to
excel.
A measure of the broader sensitivity of current technologies relative
to those of a bygone era is
reflected, for example, in the impact of "collars" on program trading
on the New York Stock
Exchange. In the aftermath of the October 1987 crash, electronic
submission of index arbitrage
trades was suspended when the Dow Jones Industrial Average moved
inordinately in a day.
Analyses of trading when that collar was in effect indicated that S&P
futures and cash indices
converged far more slowly than when electronic order submission was
permitted. In effect, we
had an experiment in the comparative market responsiveness of a modern
technology and an older
paper-based system that was used prior to 1976, when electronic order
routing was first
introduced. The collar was revised in 1988 to allow electronic order
submission, but another
anachronism, the requirement that these orders be executed only on
stabilizing upticks or
downticks, now has the same effect.
The faster reaction time has not only accelerated the pace of domestic
capital flows to ferret out
the increasingly more subtle differences among investments, it has also
markedly accelerated
international capital flows. Cross-border bank lending, for example,
has doubled in the past
decade. Daily foreign exchange transactions have more than doubled and
now stand at $1.5
trillion.
The crises seem to reflect, arguably, an inability of people to come to
grips with the vastly
accelerated pace of financial activity--its complexity and its volume.
In the throes of the 1990s'
virtuous cycle that propelled asset prices higher and risk premiums
lower, the accelerated pace of
competitive pressures, until the crises struck, was hardly likely to
appear threatening. But the
inevitable reversal engendered fear and retrenchment. While this was
evident in Asia a year ago, it
became particularly pronounced in the remarkable increase in risk
aversion and an increased
propensity for liquidity protection in both the United States and
Europe in recent months without
significant signs of underlying erosion in our real economies,
tightened monetary policy, or higher
inflation. This is virtually unprecedented in our post World War II
experience.
In the wake of the Russian debt moratorium on August 17, demand for
risky assets, which had
already declined somewhat, suddenly dried up. This, in the United
States, induced dramatic
increases in yield spreads across the risk matrix. In Europe spreads
have moved less, apparently
owing to widespread reliance on relationship finance. Volumes in risk
markets, however, have
declined sharply. Even more startling is the surge for liquidity
protection that has manifested itself
through significant differentiation in yields among riskless assets
according to their degree of
liquidity. We are all familiar with the dramatic rise in late September
in the illiquidity premium for
off-the-run Treasury securities, or the spreads on government sponsored
agency issues.
The surge toward less risky assets reflected dramatic increases in
uncertainty, but still a risk
differentiation judgment among various assets. The surge toward
liquidity protection, however, is a
step beyond, since it implies that any commitment is perceived as so
tentative that the ability to
easily reverse the decision is accorded a high premium. Risk
differentiation, despite its recent
abruptness, is, of course, a straight-forward feature of
well-functioning capital markets. The
enhanced demand for liquidity protection, however, reflected a markedly
decreased willingness to
deal with uncertainty--that is a tendency to disengage from risk-taking
to a highly unusual degree.
It is, of course, plausible that the current episode of investor fright
will dissipate, and yield spreads
and liquidity premiums will soon fall into more normal ranges. Indeed
we are already seeing
significant signs of some reversals. But that leaves unanswered the
question of why such episodes
erupted in the first place.
It has become evident time and again that when events become too
complex and move too rapidly
as appears to be the case today, human beings become demonstrably less
able to cope. The
failure of the ability to comprehend external events almost invariably
induces disengagement from
an activity, whether it be fear of entering a dark room, or of market
volatility. And disengagement
from markets that are net long, the most general case, means bids are
hit and prices fall.
Over the long run, perhaps, people can adjust to a state of frenetic
change with equanimity.
Certainly our teenagers seem far more adaptive to the newer
technologies than their parents and
grandparents. But I have my doubts that newer generations' human
response to change will differ
in any material way from earlier ones. That leaves us with the
challenge: how can we harness
burgeoning international financial flows in a manner that does not
strain human evaluation
capacities?
First let me stipulate that capital controls, which worked in part to
contain international flows
earlier in this post war period, are unlikely to be effective over the
longer run given the vast
increase in technical capabilities to evade them. But more importantly,
should controls nonetheless
succeed, they would cut off capital investment inflow to an economy,
and the higher level of
technology and standards of living that normally accompany access to
such flows. Restricting
controls to short-term capital inflows, as is often recommended, is not
a solution. They will
invariably also restrict direct investment that requires short-term
capital to facilitate it.
Clearly, to live with enhanced global finance, it has become necessary
to find ways to buttress our
financial institutions to be able to weather the dramatic increase in
capital flows, both domestic and
cross-border, before they strain human capacities.
It has taken the longstanding participants in the international
financial community many decades to
build sophisticated financial and legal infrastructures that can buffer
the shocks of such flows. But
even they, on rare occasions, run into trouble (for example, Sweden in
1992). Those advanced
infrastructures generally have been able to discourage speculative
attacks against a
well-entrenched currency because their financial systems are robust and
are able to withstand
large and rapid capital outflows of foreign currency instruments, and
the often vigorous policy
responses required to stem such attacks. For the more recent
participants in global finance, their
institutions, had not yet been tested against the rigors of major
league pitching, to use a baseball
analogy.
Many emerging market economies have tried to fix their exchange rates
against the dollar and, in
recent years, many borrowed dollars excessively, unhedged, to finance
unproductive capital
projects. Eventually their currencies became overvalued and their
financial systems, under the
increasing strain of the unhedged debt, broke down.
But such behavior need not undermine financial systems that are
otherwise sound. Last month's
unprecedented three-day weakening in the dollar, relative to the yen,
reportedly as a consequence
of a large scale unwinding of the so-called yen carry trade, has not
induced spasms in the U.S.
financial markets, nor for that matter in Japan, despite its severe
banking problems.
The heightened sensitivity of exchange rates of emerging market
economies under stress would be
of less concern if banks and other financial institutions in those
economies were strong and well
capitalized. Developed countries' banks are, to be sure, highly
leveraged, but subject to sufficiently
effective supervision that local banking problems do not generally
escalate into international
financial crises. Most banks in emerging market economies are also
highly leveraged, but their
supervision often has not proved adequate to forestall failures and
general financial crisis. The
failure of some banks is highly contagious to other banks and
businesses, both domestic and
international, that deal with them.
This weakness in banking supervision in emerging market economies was
not a major problem for
the rest of the world prior to those economies' growing participation
in the international finance
system over the past decade or so. Exposure of an economy to short-term
foreign currency
capital inflows, before its financial system is sufficiently sturdy to
handle a large unanticipated
withdrawal, is a highly risky venture.
A key conclusion stemming from our most recent crises is that economies
cannot enjoy the
advantages of a sophisticated international financial system without
the internal discipline that
enables such economies to adjust without crisis to changing
circumstances.
Between our Civil War and World War I when international capital flows
were, as they are today,
largely uninhibited, that discipline was more or less automatic. Where
gold standard rules were
tight and liquidity constrained, adverse flows were quickly reflected
in rapid increases in interest
rates and the cost of capital generally. This tended to delimit the
misuse of capital and its
consequences. Imbalances were generally aborted before they got out of
hand. But following
World War I, such tight restraints on economies were seen as too
inflexible to meet the economic
policy goals of the twentieth century.
From the 1930s through the 1960s and beyond, capital controls in many
countries, including most
industrial countries, inhibited international capital flows and to some
extent the associated financial
instability--presumably, however, at the cost of significant shortfalls
in economic growth and
misallocated resources. There were innumerable episodes, of course,
where individual economies
experienced severe exchange rate crises. Contagion, however, was
generally limited by the
existence of restrictions on capital movements that were at least
marginally effective, in that period
of paper-based transactions.
In the 1970s and 1980s, recognition of the inefficiencies associated
with controls, along with
newer technologies and the deregulation they fostered, gradually
restored the free flow of
international capital prevalent a century earlier. In the late
twentieth century, however, fiat currency
regimes have replaced the rigid automaticity of the gold standard in
its heyday. More elastic
currencies and markets, arguably, have augmented the scale of potential
capital misallocation. It
takes discretionary countervailing--and often unpopular--policy actions
by fiscal and monetary
authorities to make needed adjustments. Where those are delayed,
imbalances build and market
contagion across national borders has consequently been more prevalent
and faster in today's
international financial markets than appears to have been the case a
century ago under comparable
circumstances.
The international financial system was not as technologically
responsive then as now. Contagion
cannot fester where financial interconnectiveness is weak or lacking.
Moreover, contagion is clearly enhanced by leverage, and while leverage
is not demonstrably
greater today than in earlier post World War II decades, the degree of
leverage that was viable
then apparently no longer appears appropriate in today's more volatile
financial environment. If
financial asset prices are more variable, firms need to protect
themselves against unexpected
adverse market conditions by having more robust financial structures.
New instruments, like
derivatives, afford the opportunity to reduce risk, but they also
afford opportunities to become
more vulnerable. Borrowers, lenders, and regulators need to improve
their understanding of the
risk characteristics of the new instruments under a variety of
circumstances--some extreme.
As the financial system becomes ever more sensitive to change,
consideration needs to be given to
discourage excess leverage by financial intermediaries worldwide. The
events of the past year
have doubtless already induced a readjustment in optimum debt-equity
balance on the part of all
investors and borrowers. Nonfinancial corporate leverage in Asia
especially urgently needs to be
addressed. Higher nonfinancial debt levels have significantly increased
inflexible debt service
requirements, especially those denominated in foreign currencies. Such
trends have been
particularly instrumental in inducing financial system breakdowns in
East Asia. Presumably, Asian
borrowers will be less inclined to high leverage in the future. Perhaps
the most effective tool to
reduce leverage in emerging market economies is to remove the debt
guarantees, both explicit and
implicit, by central banks and governments.
Another challenge confronting the international financial system is
establishing and retaining more
robust currency regimes.
The defining characteristic of the latest set of crises is the
extraordinary collapse of exchange rates
among emerging market economies. Those adjustments brought such havoc
to balance sheets of
both financial and nonfinancial entities in those economies that deep
recessions inevitably ensued.
The increasingly global character of investment--largely
technologically induced--spread
contagion.
Of course, at the end of the day the issue is not the stability of
currencies, but the underlying
policies that engender stable currencies. Open economies, governed by a
rule of law with sound
monetary, trade, and fiscal policies, rarely experience exchange rate
problems that destabilize
those economies to the degree we have seen in Asia. Problems have
arisen in recent years when
an economy without a history of sound finance endeavored to "rent it,"
so to speak, by locking its
domestic currency into one of the stable currencies of long-time
participants in the international
financial system, such as the dollar and the DM. There is nothing wrong
with these linkages
provided the tied currency is set at a competitive level and is
supported by sound policies and
flexible economies. Too often they are not, with widespread
consequences, as recent history
amply illustrates.
In hoping to gain the benefits of sound economic systems without
incurring the policy costs, many
emerging market economies have tried a number of technical devices: the
fixed rate peg, varieties
of crawling peg, currency boards, and even dollarization. The success
has been mixed. Where
successful, they have been backed by sound policies.
Even dollarization, or its equivalent in other key currencies, is not a
source of stability if underlying
policies are unsound. It is questionable whether a sovereign nation,
otherwise inclined to economic
policies that are "off the wagon," can force itself into "sobriety" by
dollarization. Dollarization, fully
adhered to, eliminates the possibility of costless printing of money
and restricts budget deficits to
an economy's ability to borrow in dollars. While dollar currency
circulating in such a country is
credibly backed by the U.S. government, any domestic dollar deposits or
other claims are subject
to the whim of the domestic government that could with the stroke of a
pen abolish their legal
status. Hence, dollar deposits in such a political environment would
tend to sell at a discount to
dollar currency. Dollar interest rates in that economy could rise to
debilitating levels, if fear of
de-dollarization rose inordinately.
Thus, there is no shortcut to sound fundamentals. If we are going to
have a sophisticated high-tech
international financial system, the lessons of recent years make it
clear that all participants must
follow the policies that make it possible.
There is already under way a number of initiatives that, if effectively
implemented, should
significantly tighten international financial system discipline. These
initiatives include: endeavors to
promulgate standards of bank supervision on a global basis, initiatives
to markedly increase
transparency of central bank accounts, more prompt and detailed data on
global lending,
compliance with codes for fiscal transparency, plus moves toward
ensuring sound corporate
governance and accounting standards.
Areas crucial to increased discipline, where consensus has yet to be
reached, include appropriate
bankruptcy and workout procedures for defaulting private sector
entities, new arrangements for
risk sharing between debtors and creditors, and ways to limit explicit
and implicit government
guarantees of private debt.
Central banks that fall short of the "best practice" requirements to be
full participants in the
international financial system would doubtless be under exceptional
pressure to improve.
It is important to remember--when we contemplate the regulatory
interface with the new
international financial system--the system that is relevant is not
solely the one we confront today.
There is no evidence of which I am aware that suggests that the
transition to the new advanced
technology-based international financial system is now complete.
Doubtless, tomorrow's
complexities will dwarf even today's.
It is, thus, all the more important to recognize that twenty-first
century financial regulation is going
to increasingly have to rely on private counterparty surveillance to
achieve safety and soundness.
There is no credible way to envision most government financial
regulation being other than
oversight of process. As the complexity of financial intermediation on
a worldwide scale continues
to increase, the conventional regulatory examination process will
become progressively
obsolescent--at least for the more complex banking systems.
Overall, endeavors to stabilize the international financial system, and
keep it that way, will require
perseverance.
Until the current crisis is resolved, transition support by the
international financial community to
emerging market economies in difficulty will, doubtless, be required.
But in doing so we must
remember that the major advances in technologically sophisticated
financial products in recent
years have imparted a discipline on market participants, excluding a
few glaring exceptions, not
seen in nearly a century. Hence, the international financial assistance
provided must be carefully
shaped not to undermine that discipline. As a consequence, any
temporary financial assistance
must be carefully tailored to be conditional and not encourage undue
moral hazard.
Finally, there is somewhat of a silver lining, if one can call it that,
in the debilitating set of crises we
have experienced in the past eighteen months. First, while over the
longer run, it will be essential to
have significantly improved systems to oversee lending and borrowing by
financial intermediaries,
and incentives to dissuade excess leverage in general, in the short
run, there will be little need. If
anything, lenders are likely to be overcautious. I remember at the
onset of the American credit
crunch of a decade ago, my joshing with one of my colleagues in bank
supervision and regulation
about his going on a long overdue vacation. I suggested he could safely
sail around the world since
there was very little chance of bad bank loans being made over the
following year. (I was
concerned, however, whether anyone would make any good loans either.)
Secondly, some of the spectacular equity-driven American and European
capital gains of the
middle 1990s diversified as unproductive capital flows to some emerging
market economies. Such
capital flows, arguably a key factor in the crisis, are unlikely to be
repeated in the near future.
That both excesses have likely descended into hibernation is fortunate
since the type of
international financial restructuring that our new technologies require
will take several years.
Assuming we successfully resolve the current crisis, we will have time
to restructure. I fear only
that when available delay becomes evident, we will fall back into
inaction, raising the stakes of the
next crisis.
|