Mr Greenspan offers some suggestions to improve the international financial architecture  (Central Bank Articles and Speeches, 20 May 1999)
Central bank: fed | Type: speech | Date: 1999-05-20

## Mr Greenspan offers some suggestions to improve the international architecturefinanciaTestimony by the Chairman of the Board of Governors of the US Federal Reserve Sys Alan Greenspan, before the Committee on Banking and Financial Services of the US Hous Representatives on 20 May 1999.Mr Chairman, Mr. LaFalce, and Members of the Committee, we at the Federal Reserve ar broad agreement with the approach outlined by Secretary Rubin, and expect to conti work closely with the Treasury in this area.As

I have indicated previously before this committee, dramatic advances in comput telecommunications technologies in recent years have enabled a broad unbundling of through innovative financial engineering.

The financial instruments of a bygone era, stocks and debt obligations, have been augmented by a vast array of complex hybrid f products that has led to a far more efficient financial system.

These same new tec and financial products, however, have challenged the ability of inward-looki protectionist economies to maintain effective barriers, which, along with the performance of their more open trading partners, has led, over the past decade, t dismantling of impediments to the free flow of trade and capital.

The new inter financial system that has evolved as a consequence has been, despite recent setbacks factor in the marked increase in living standards for those economies that have participate in it.Notwithstanding the demonstrable advantages of the new international financial syst Mexican financial breakdown in late 1994 and, of course, the most recent episodes Asia and elsewhere have raised questions about the inherent stability of this new sysThese newly open markets were exposed to a huge expansion in capital inflows that economic and financial systems were not ready to absorb.

These flows in turn engendered by the increasing diversification out of industrial country investment augmented by huge capital gains through 1997.

Net private capital inflows into e markets roughly quadrupled between 1990 and the onset of the Asian crisis. diversification was particularly directed at those economies in Asia that had been vigorously through the 1970s, 1980s, and into the 1990s - the so-called 'Asian tiger event, these economies were ill prepared to absorb such volumes of funds.

There were not enough productive investment opportunities to yield the returns that investors i were seeking.

It was perhaps inevitable then that the excess cash found its way in instances into ill conceived and unwisely financed real estate ventures.What appeared to be a successful locking of currencies onto the dollar over a perio in East Asia, led, perhaps inevitably, to large borrowings of cheaper dollars to lend at elevated domestic interest rates that reflected unheeded devaluation risk premiu the amount of such unhedged dollar borrowings finally became excessive, as was a inevitable, the exchange rate broke.While it might seem that the consequences were easily discernible, they were not. with imprudently financed real estate investments emerge with chronic frequency aro globe without triggering the size of the collapse experienced in East Asia in 1997.the crisis became evident only when the normal buffers that any economy builds up to abs shocks were, in the case of the East Asian economies, so readily breached under pressure.It has taken the longstanding participants in the international financial community decades to build sophisticated financial and legal infrastructures that buffer shocks. infrastructures discourage speculative attacks against a well entrenched currency bec financial systems are robust and are able to withstand the consequences of vigorous po responses to such attacks.

For the newer participants in global finance, their instituti recently, had not been tested against the rigors of major league pitching, to use a b analogy.The heightened sensitivity of exchange rates of emerging economies under stress would be less concern if banks and other financial institutions in those economies were strong an capitalized.

Developed countries' banks are highly leveraged, but subject to suffici effective supervision both by counterparties and regulatory authorities, so that, in countries, banking problems do not escalate into international financial crises.

Most ba emerging market economies are also highly leveraged, but their supervision often has proved adequate to forestall failures and a general financial crisis.

The failure of som is highly contagious to other banks and businesses that deal with them, as the Asian cri so effectively demonstrated.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 international financial system over the past decade or so.

Exposure of an economy to sh term capital inflows, before its financial system is sufficiently sturdy to handle unanticipated withdrawal, is a highly risky venture.It thus seems clear that some set of suggested standards that countries should strive t would help the new highly sensitive international financial system function effectively. are many ways to promote such standards without developing an inappropriately exclusiv and restrictive club of participants.For example, in any set of standards there should surely be an enhanced level of transpa in the way domestic finance operates and is supervised.

This is essential if investors make more knowledgeable commitments and supervisors are to judge the soundness of such commitments by their financial institutions.

A better understanding of financial regimes unseasoned in the vicissitudes of our international financial system also will e counterparties to more appropriately evaluate the credit standing of institutions inves such financial systems.

There should be no mechanism, however, to insulate investors fr making foolish decisions, but some of the ill-advised investing of recent years can be av in the future if investors, their supervisors, and counterparties, are more approp forewarned.To be sure, counterparties often exchange otherwise confidential information as a conditi a transaction.

But broader dissemination of detailed disclosures by governments, finan institutions, and firms is required if the greater risks inherent in our vastly expande financial structure are to be contained.

A market system can approach an appropri equilibrium only if the signals to which individual market participants respond are acc and adequate to the needs of the adjustment process.

Product and asset prices, interestdebt by maturity, and detailed accounts of central banks and private enterprises are signals so essential to the effective functioning of a global economy.

I find it believe, for example, that the crises that arose in Thailand and Korea would have b so virulent had their central banks published data prior to the crises on net reserv the not very informative gross reserve positions only.

Some inappropriate capital would almost surely have been withheld and policymakers would have been forced to difficult choices more promptly if earlier evidence of difficulty had emerged.As a consequence, the G-10 central banks and the IMF initiated an effort to e standards for disclosure of on- and off-balance-sheet foreign currency activities o sector by countries that participate, or aspire to participate, in international c The focus of this work was the authorities' foreign currency liquidity position, whi of foreign exchange resources that can be easily mobilized, adjusted for potential those resources.

This work was part of a larger effort to enhance disclosure of a br economic and financial data under the IMF Special Data Dissemination Standard.Such transparency suggests a second standard worth considering.

Countries that l seasoning of a long history of dealing in international finance should manage thei assets and liabilities in such a way that they are always able to live without borrowing for up to, for example, one year.

That is, usable foreign exchange reserv exceed scheduled amortizations of foreign currency debts (assuming no rollovers) du following year.

This rule could be readily augmented to meet the additional test average maturity of a country's external liabilities should exceed a certain thresh three years.

This could be accomplished directly, or through the myriad innovat augment maturities through rollover options.

The constraint on the average maturity degree of private sector 'burden sharing' in times of crisis, since in the event of market value of longer maturities would doubtless fall sharply.

Clearly few, if any holders of long-term investments could escape without significant loss.

Short-term creditors, on the other hand, are able to exit without significant loss as thei mature.

If the preponderance of a country' s liabilities are short term, the entir crisis would fall on the emerging market economy in the form of a run on reserves.Some emerging market countries may argue that they have difficulty selling lon maturities.

If that is indeed the case, their economies are being exposed to too generally.

For too long, too many emerging market economies have managed their ext liabilities so as to minimize their current borrowing cost.

This short-sighted appro the insurance imbedded in long-term debt, insurance that is almost always well wo price.Adherence to such a rule is no guarantee that all financial crises can be avoid confidence of domestic residents is undermined, they can generate demands for f exchange that would not be captured in this analysis.

But controlling the structure assets and liabilities nonetheless could make a significant contribution to stabilitConsiderable progress has been made in recent years in developing sophisticated f instruments.

These developments create added complexity that all financial participants, including policymakers from emerging market economies, must mana However, they also create opportunities that emerging market economies should seexploit.

In doing so there are lessons they can learn from advances in risk managem strategies developed by major financial institutions.To the extent that policymakers are unable to anticipate or evaluate the types of complex that the newer financial technologies are producing, the answer, as it always has been, leverage, i.e.

less debt, more equity, and, hence, a larger buffer against adversi contagion.A third standard could be a legal infrastructure that enables the inevitable bankruptci will occur in today' s complex world to be adjudicated in a manner that minimizes t disruption and contagion that can surface if ready resolutions to default are not availab priA fourth standard is the obvious necessity of sound monetary and fiscal policies wh absence was so often the cause of earlier international financial crises.

With inc emphasis on private international capital flows, especially interbank flows, misjudgments within flawed economic structures have been the major contributors to rece problems.

But inappropriate macropolicies also have been a factor for some emerging mark economies in the current crisis.There are, of course, numerous other elements of sound international finance that are wo of detailed consideration, but the aforementioned would constitute a good start.

Even improvements in transparency, commercial and legal structures, as well as supervision can be implemented quickly.

Such improvements and the transition to a more effective and sta international financial system will take time.

The current crisis, accordingly, has ha addressed with ad hoc remedies.

It is essential, however, that those remedies not conflic a broader vision of how our new international financial system will function as we ente next century.