Mr. Greenspan examines the crises in Asia, considers the existence and provision of safety nets and ponders possible policy responses to problems in the international financial system  (Central Bank Articles and Speeches, 7 May 98)
Central bank: fed | Type: speech | Date: 1998-05-07

Mr. Greenspan examines the crises in Asia, considers the existence and provisio of safety nets and ponders possible policy responses to problems in the international fin system Remarks by Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before 34th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chi on 7/5/98.Events in Asia over the past year reinforce once more the fact that, whi burgeoning global system is efficient and makes a substantial contribution to standards worldwide, that same efficiency exposes and punishes underlying economic imprudence swiftl decisively.

These global financial markets, engendered by the rapid proliferation of cr financial flows and products, have developed a capability of transmitting mistakes at a far throughout the financial system in ways that were unknown a generation ago.

Today's intern financial system is sufficiently different, in so many respects, from its predecessors reasonably be characterized as new, as distinct from being merely a continuing evolution past.As a consequence, it is urgent that we accelerate our efforts to develop a soph understanding of how this high-tech financial system works.

Specifically, we need s understanding if we are to minimize the chances that we will experience a systemic di beyond our degree of comprehension or our ability to respond effectively.

We need it if continue to make progress in reducing settlement risk in foreign exchange markets and to sound infrastructure for payments and settlement systems generally.

And we need it if we ar confidence in our processes of supervision and regulation.In this regard, I intend to focus my remarks this morning on three related topi start by examining the crises in Asia, which, along with the one in Mexico just a few provide the first evidence of how crises arise in the new system, especially the central ro play.

I will note that, while the support provided to banks by public safety nets appea element of stability in the new system, it has also been part of the process that engen crises.

Next, I will consider why, if the existence of safety nets can encourage crises, w provide them.

Finally, I will consider possible policy responses to some of the system' problems and tensions.

Put differently, can we learn to stabilize our burgeoning, sometime new international financial system so that we can realize its full potential?***Let me start with Asia.

In hindsight, it is evident that those leveraged e could not provide adequate profitable opportunities at reasonable risk in the 1990s to surge in capital inflows.

That surge reflected in part the diversification of the western e huge capital gains to a sector of the world which was perceived as offering above averag Together with distortions caused by a long-entrenched government planning ethos, the f investment resulted -- some would say inevitably -- in massive deadweight losses.

As slowed, burdened by fixed-cost obligations that were undertaken on the presumption of con growth, business losses and nonperforming bank loans surged.

The capital of banks in economies -- especially when properly accounted for -- eroded rapidly.

As a consequence, sources dried up as fears of defaults rose dramatically.In an environment of weak financial systems, lax supervisory regimes, and v assurances about depositor or creditor protections, the state of confidence so necess functioning of any banking system was torn asunder.

Bank runs occurred in several countr reached crisis proportions in Indonesia.

Uncertainty and retrenchment escalated.In short, the slowing in activity in Asia exposed the high fixed costs of a economy, especially one with fixed obligations in foreign currencies.

Failures to make induced vicious cycles of contagious, ever rising, and reinforcing fears.It is quite difficult to anticipate such crises.

Every borrower, whether a nonbank company, presumably structures its balance sheet to provide a sufficient buffer ag emergence of illiquidity or insolvency.

The scramble by borrowers to protect their balan when this buffer is unexpectedly breached can lead to a surge in the demand for liquidity produces a run on the financial system.

At one moment, an economy appears stable, the ne subject to an implosion of fear-induced contraction.In this context a preventive effort to lessen the probabilities of such crise for example, by bolstering the financial system's buffer through more capital or improv supervision -- may not in itself further insulate a country from crisis if financial ins faced with a lower cost of capital or lower spread on their debt, leverage away the incre Indeed, one form of moral hazard is that an initially sound financial system that attra premia could merely induce a ratcheting up of the risks that a nation's borrowers choose t This is not to disparage endeavors to bolster financial systems.

But we should keep in some of the advantages of such initiatives could be drained away by moral hazard.What is becoming increasingly clear, and what is particularly relevant t conference, is that, in virtually all cases, what turns otherwise seemingly minor imbala crisis is an actual or anticipated disruption to the liquidity or solvency of the banking least of its major participants.

That fact is of critical importance for understanding both the previous Latin American crises.

Depending on circumstances, the original impulse for t may begin in the banking system or it may begin elsewhere and cause a problem in the b system that converts a troubling event into an implosive crisis.The aspects of the banking system that produce such outcomes are not particu opaque.First, exceptionally high leverage has often been a symptom of excessive risk that left financial systems and economies vulnerable to loss of confidence.

It is not eas the cumulative cascading of debt instruments seeking safety in a crisis when assets ar funded with equity.

Moreover, financial (as well as nonfinancial) businesses have employ leverage to mask inadequate underlying profitability and did not have adequate capital cu match their volatile environments.Second, banks, when confronted with a generally rising yield curve, which is often the case than not, have had a tendency to incur interest rate or liquidity risk by le funding short.

This has exposed banks, especially those that had inadequate capital to begi collapse of confidence when interest rates spiked and capital was eroded.

In addition, whe intermediaries, in an environment of fixed exchange rates, but still high inflation pre domestic currency interest rates, sought low-cost, unhedged, foreign currency funding, the depositor runs, following a fall in the domestic currency, escalated.Third, banks play a crucial role in the financial market infrastructure. institution can fend off unexpected shocks.

But when they are undercapitalized, have la standards, and are subjected to weak supervision and regulation, they have become a so systemic risk to both domestic and international financial systems.Fourth, recent adverse banking experiences have emphasized the problems that arise if banks, especially vulnerable banks, are almost the sole source of intermedia breakdown induces a marked weakening in economic growth.

A wider range of nonbank instituti including viable debt and equity markets, can provide important safeguards of economic when the banking system fails.Fifth, despite its importance for distributing savings to their most valued i use, excessive short-term interbank funding, especially cross border, may turn out to be th heel of an international financial system that is subject to wide variations in financia This phenomenon, which is all too common in our domestic experience, may be particul dangerous in an international setting.

I shall return to this issue later.Finally, an important contributor to past crises has been moral hazard, th distortion of incentives that occurs when the party that determines the level of risk recei from, but does not bear the full costs of, the risks taken.

Interest rate and currency risk leverage, weak financial systems, and interbank funding have all been encouraged by the e of a safety net.

The expectation that national monetary authorities or internationa institutions will come to the rescue of failing financial systems and unsound investments engendered a significant element of excessive risk-taking.

The dividing line between pu private liabilities, too often, has become blurred.***Given that the existence of safety nets generates moral hazard, and moral distorts incentives, why do we continue to provide safety nets to support our financial sysIt is important to remember that, notwithstanding the possibility of ex leverage, many of the benefits banks provide modern societies derive from their willingnes risks and from their use of a relatively high degree of financial leverage.

Through leve form principally of taking deposits, banks perform a critical role in the financial in process; they provide savers with additional investment choices and borrowers with a grea of sources of credit, thereby facilitating a more sophisticated allocation of resources t contribute importantly to greater economic growth.

Indeed, it has been the evident intermediation and leverage that has shaped the development of our financial systems f earliest times -- certainly since Renaissance goldsmiths discovered that lending out depo was both feasible and profitable.In addition, central bank provision of a mechanism for converting highly i portfolios into liquid ones, in extraordinary circumstances, has led to a greater degree o banking than market forces alone would support.

Traditionally this has been accomplis making discount or Lombard facilities available, so that individual depositories could t assets into liquid resources and not exacerbate unsettled market conditions by the forced such assets or the calling of loans.

More broadly, open market operations, in situation which followed the crash of stock markets around the world in 1987, satisfy marked increas for liquidity for the system as a whole that otherwise could feed cumulative, self-r contractions across many financial markets.To be sure, we should recognize that if we choose to have the advantages leveraged system of financial intermediaries, the burden of managing risk in the financial not lie with the private sector alone.

As I noted, with leveraging there will always exist however remote, of a chain reaction, a cascading sequence of defaults that will culminate iimplosion if it proceeds unchecked.

Only a central bank, with its unlimited power to crea can with a high probability thwart such a process before it becomes destructive.

Hence, cen will of necessity be drawn into becoming lenders of last resort.

But implicit in the existe role is that there will be some form of allocation between the public and private sectors o of risk, with central banks responsible for managing the most extreme, that is the most s sensitive, outcomes.

Thus, central banks have been led to provide what essentially am catastrophic financial insurance coverage.

Such a public subsidy should be reserved for rarest of disasters.

If the owners or managers of private financial institutions were to a propped up frequently by government support, it would only encourage reckless and irresp practices.In theory, the allocation of responsibility for risk-bearing between the priv and the central bank depends upon the private cost of capital.

In order to attract, or a capital, a private financial institution must earn at minimum the overall economy's margin riskless capital, adjusted for firm-specific risk.

In competitive financial markets, th leverage, the higher the rate of return, before adjustment for risk.

If private financial i to absorb all financial risk, then the degree to which they can leverage will be res financial sector smaller, and its contribution to the economy more limited.

On the othe central banks effectively insulate private institutions from potential losses, howeve increased laxity could threaten a major drain on taxpayers or produce inflationary insta consequence of excess money creation.Once a private financial institution infers the amount of capital it must ensure against, first, illiquidity and, finally, insolvency, the size of its balance she rate of return on equity, adjusted for risk, is determined.

That inference depends on the judgment of how much of the tail of its risk distribution requires a capital provision.

The is presumed to respond to the remainder of the risk tail by lending freely and reducing th illiquidity.

Protecting private financial institutions' solvency through guarantees of li significant moral hazard.In practice, the policy choice of how much, if any, of the extreme market ri government authorities should absorb is fraught with many complexities.

Yet we central make this decision every day, either explicitly or by default.

Moreover, we can never know whether the decisions we made were appropriate.

The question is not whether our actions ar have been necessary in retrospect; the absence of a fire does not mean that we should not for fire insurance.

Rather, the question is whether, ex ante , the probability of a systemic collapse was sufficient to warrant intervention.

Often, we cannot wait to see whether, in hindsight, will be judged to have been an isolated event and largely benign.Thus, governments, including central banks, have been given certain responsib related to their banking and financial systems that must be balanced.

We have the respons prevent major financial market disruptions through development and enforcement of pr regulatory standards and, if necessary in rare circumstances, through direct intervention events.

But we also have the responsibility to ensure that private sector institutions hav to take prudent and appropriate risks, even though such risks will sometimes result in un bank losses or even bank failures.Our goal as supervisors, therefore, should not be to prevent all bank failures, suggested to this conference many times, but to maintain sufficient prudential standard banking problems that do occur do not become widespread.

We try to achieve the proper bthrough official regulations, as well as through formal and informal supervisory pol procedures.To some extent, we do this over time by signalling to the market, through our a the kinds of circumstances in which we might be willing to intervene to quell financial tu conversely, what levels of difficulties we expect private institutions to resolve by the market, then, responds by adjusting the risk premium addition to the riskless cost of capi to banks.***To return to the question I raised at the beginning:

Can we learn to stabi burgeoning, sometimes frenetic, new international financial system so that we can realiz potential?

What types of regulatory initiatives appear fruitful in achieving the be minimizing the costs of the new system?In addressing those questions, I will confine myself again to issues relat narrowly to banks: in particular, to bank supervision and to possible ways in which the b individual banks could be improved.

I will not discuss the important issues concerning th efficient bankruptcy procedures or for alternative means for coordinating debtors and cred in the domestic context in many countries and in the cross-border context, that may be r our new system.While failures will inevitably occur in a dynamic market, the safety net -mention concerns over systemic risk -- requires, to repeat, that regulators not be indiff banks manage their risks.

To avoid having to resort to numbing micromanagement, regulator increasingly insisted that banks put in place systems that allow management to have b information and procedures to be aware of their own true risk exposures on a global basis able to manage such exposures.

The better these risk information and control systems, the a bank can prudently assume.

In that context, an enhanced regime of market incentives, i greater sensitivity to market signals and more information to make those signals more r essential.In this rapidly expanding international financial system, the primary protect adverse financial disturbances is effective counterparty surveillance and, hence, go regulation and supervision should seek to produce an environment in which counterparties c effectively oversee the credit risks of potential transactions.Here a major improvement in transparency is essential.

To be sure, counterp often exchange otherwise confidential information as a condition of a transaction.

But dissemination of detailed disclosures of governments, financial institutions, and firms i the risks inherent in our global financial structure are to be contained.

A market system c an appropriate equilibrium only if the signals to which individual market participants r accurate and adequate to the needs of the adjustment process.

Among the important sign product and asset prices, interest rates, debt by maturity, and detailed accounts of centr private enterprises.

I find it difficult to believe, for example, that the crises that aros Korea would have been nearly so virulent had their central banks published data prior to th net reserves instead of the not very informative gross reserve positions only.

Some ina capital inflows would almost surely have been withheld and policymakers would have been for make difficult choices more promptly if earlier evidences of difficulty had emerged.Increased transparency can expose the prevalence of pending problems, but it c be expected to discourage all aberrant behavior.

It has not prevented reliance on real collateral from becoming problematic from time to time.

East Asia has been no exception.

Wh estate values fall sharply, as they do from time to time, such collateral tends to be illiquid.

Removal of legal impediments to more widespread forms of collateral and to promp to collateral would be helpful in dealing with these problems.It is increasingly evident that nonperforming loans should be dealt with exped and not allowed to fester.

The expected values of the losses on these loans are, of subtraction from capital.

But since these estimates are uncertain, they embody an addit premium that further reduces the market's best estimate of the size of effective equi Funding becomes more difficult.

Partly reflecting uncertainties with respect to their non loans, Japanese banks in London, for example, are currently required to pay about a 15 ba add-on over what markets require for major western banks for short-term deposits denomina yen.

It is, hence, far better to remove these dubious assets and their associated risk p bank balance sheets, and dispose of them separately, preferably promptly.A predicate to addressing nonperforming loans expeditiously is better and forceful supervision, which requires more knowledgeable bank examiners than, unfortunately economies enjoy.

In all countries, we need independent bank examiners who understand bankin business risk, who could in effect, make sound loans themselves because they understa process.

Similarly, we need loan officers at banks that understand their customers' busin officers that could, in effect, step into the shoes of their customers.

Lack of a cadre o who have experience in judging lending risk can produce debilitating losses even when lendi directed by government inducement or the need to support members of an associated gro companies.

Experienced bank supervision cannot fully substitute for poor lending procedu presumably it could encourage better practice.

Apparently even that has been lacking economies.

And training personnel and developing adequate supervisory systems will take timI pointed earlier to cross-border interbank funding as potentially the Achille the international financial system.

Creditor banks expect claims on banks, especially emerging economies, to be protected by a safety net and, consequently, consider them essentially sovereign claims.

Unless those expectations are substantially altered -- as actually incur significant losses -- governments can be faced with the choice either of those expectations or of risking serious disruption to payments systems and to financial general.Arguably expectations of safety net support have increased the level of cross interbank lending from that which would be supported by unsubsidized markets themselves. would suggest resource misallocation.

Accordingly, it might be useful to consider ways i some added discipline could be imposed on the interbank market.

Such discipline, in princip be imposed on either debtor or creditor banks.

For example, capital requirements could be borrowing banks by making the required level of capital dependent not just on the natur banks' assets but also on the nature of their funding.

An increase in required capital can as providing a larger cushion for the sovereign guarantor in the event of a bank's failur would shift more of the burden of the failure onto the private sector.

Alternatively, the i hazard in interbank markets could be addressed by charging banks for the existence of the guarantee, particularly in more vulnerable countries where that guarantee is more likely t upon and whose cost might deter some aberrant borrowing.

For example, sovereigns could char explicit premium, or could impose reserve requirements, earning low or even zero interest interbank liabilities.Increasing the capital charge on lending banks, instead of on borrowing banks, also be effective.

Under the Basle capital accord, short-term claims on banks from any cou only a twenty percent risk weight.

The higher cost to the lending banks associated with a weight would presumably be passed on to the borrowing banks.

Borrowing banks, at the ma might reduce their total borrowing or shift their borrowing to nonbank sources of funds, pe the shift facilitated by the lending banks, who might advert to securitization of short-te lending if regulatory capital charges exceeded internal requirements.

In either case, ther to be a reduction in interbank exposures, a significant source of systemic risk.

To be eval such initiative is whether such regulation would disrupt liquidity in the interbank marke where such costs exceed the benefits of reduced interbank exposure.***We are interacting every day with an emerging new international financial str one with great potential for facilitating the creation of wealth and rising standards o understanding of the new system continues to improve, as does our ability to gauge and risks.

Still, the new system will doubtless at times appear threatening and unstable.

Bu price of progress.

In my judgment, at the end of the day, it will be a price well worth pay