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</x-html>From ???@??? Thu Nov 05 09:57:33 1998
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Date: Thu, 05 Nov 1998 11:24:57 -0600
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From: Ron Griess <rgriess@xxxxxxxxxxxxxxxxxx>
To: RealTraders Discussion Group <realtraders@xxxxxxxxxxxxxx>
Subject: Fwd: Greenspan speech
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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.
>
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