Alan Greenspan: Corporate governance
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the 2003 Conference on Bank Structure and Competition, Chicago, Illinois (via satellite),
8 May 2003.
* * *
Corporate governance, the subject of our conference, has evolved over the past century to more
effectively promote the allocation of the nation's savings to its most productive uses. And, generally
speaking, the resulting structure of business incentives, reporting, and accountability has served us
well. We could not have achieved our current level of national productivity if corporate governance had
been deeply flawed.
Yet, our most recent experiences with corporate malfeasance suggest that governance has strayed
from the way we think it is supposed to work. By law, shareholders own our corporations, and
corporate managers ideally should be working on behalf of shareholders to allocate business
resources to their optimum use.
But as our economy has grown and our business units have become ever larger, de facto shareholder
control has diminished: Ownership has become more dispersed, and few shareholders have sufficient
stakes to individually influence the choice of boards of directors or chief executive officers. The vast
majority of corporate share ownership is for investment, not for operating control of a company.
Thus, corporate officers, especially chief executive officers, have increasingly shouldered the
responsibility for guiding businesses in what one hopes they perceive to be the best interests of
shareholders. Not all CEOs have appropriately discharged their responsibilities and lived up to the
trust placed in them, as the events that led to the passage of the Sarbanes-Oxley Act demonstrated. In
too many instances, some CEOs, under pressure to meet elevated short-term expectations for
earnings, employed accounting devices for the sole purpose of obscuring adverse results.
A change in behavior, however, may already be in train. The sharp decline in stock and bond prices
after the collapse of Enron and WorldCom has chastened many of those responsible for questionable
business practices. Corporate reputation is emerging out of the ashes of the debacle as a significant
economic value. I hope that we will return to the earlier practices of firms competing for the reputation
of having the most conservative and transparent set of books.
* * *
It is hard to overstate the importance of reputation in a market economy. To be sure, a market
economy requires a structure of formal rules--a law of contracts, bankruptcy statutes, a code of
shareholder rights--to name but a few. But rules cannot substitute for character. In virtually all
transactions, whether with customers or with colleagues, we rely on the word of those with whom we
do business. If we could not do so, goods and services could not be exchanged efficiently. Even when
followed to the letter, rules guide only a small number of the day-to-day decisions required of
corporate management. The rest are governed by whatever personal code of values corporate
managers bring to the table.
Market transactions are inhibited if counterparties cannot rely on the accuracy of information. The
ability to trust the word of a stranger still is an integral part of any sophisticated economy. A reputation
for honest dealings within a corporation is critical for effective corporate governance. Even more
important is the reputation of the corporation itself as seen through the eyes of outsiders. It is an
exceptionally important market value that in principle is capitalized on a balance sheet as goodwill.
Reputation and trust were particularly valued assets in freewheeling nineteenth-century America.
Throughout much of that century, laissez-faire reigned and caveat emptor was the prevailing
prescription for guarding against the wide-open trading practices of those years. A reputation for
honest dealings was thus a particularly valued asset. Even those inclined to be less than scrupulous in
their private dealings were forced to adhere to a more ethical standard in their market transactions, or
they risked being driven out of business.
To be sure, the history of business is strewn with Fisks, Goulds, and numerous others treading on, or
over, the edge of legality. But they were a distinct minority. If the situation had been otherwise, the
United States at the end of the nineteenth century would never have been poised to displace Great
Britain as the world's leading economy.
Reputation was especially important to early U.S. bankers. It is not by chance that in the nineteenth
century many bankers could effectively issue uncollateralized currency. They worked hard to develop
and maintain a reputation that their word was their bond. For these institutions to succeed and
prosper, people had to trust their promise of redemption in specie. The notion that "wildcat banking"
was rampant before the Civil War is an exaggeration. Certainly, crooks existed in banking as in every
business. Some banks that issued currency made redemption inconvenient, if not impossible. But they
were fly-by-night operators and rarely endured beyond the first swindle.
In fact, most bankers competed vigorously for reputation. Those who had a history of redeeming their
bank notes in specie, at par, were able to issue substantial quantities, effectively financing their
balance sheets with zero-interest debt. J.P. Morgan marshaled immense power on Wall Street in large
part because his reputation for fulfilling his promises was legendary.
Today, most banks rely partly on deposit insurance in lieu of reputation to hold below-market-rate
deposits. And a broad range of protections provided by the Securities and Exchange Commission, the
Commodity Futures Trading Commission, and myriad other federal and state agencies has similarly
partially crowded out the value of trust as a competitive asset.
* * *
Trust still plays a crucial role in one of the most rapidly growing segments of our financial system--the
over-the-counter (OTC) derivatives market. This market has played an important and successful role
in the management of risk at financial institutions, a major element of their corporate governance. I do
not say that the success of the OTC derivatives market in creating greater financial flexibility is due
solely to the prevalence of private reputation rather than public regulation. Still, the success to date
clearly could not have been achieved were it not for counterparties' substantial freedom from
regulatory constraints on the terms of OTC contracts. This freedom allows derivatives counterparties
to craft contracts that transfer risks in the most effective way to those most willing and financially
capable of absorbing them.
Benefits of derivatives
Although the benefits and costs of derivatives remain the subject of spirited debate, the performance
of the economy and the financial system in recent years suggests that those benefits have materially
exceeded the costs. Over the past several years, the U.S. economy has proven remarkably resilient in
the face of a series of severe shocks--the collapse of equity values, terrorist attacks, and geopolitical
turmoil. To be sure, economic growth has been subpar for some time, but we seem to have
experienced a significantly milder downturn than the long history of business cycles and the severity of
the shocks to the economy would have led us to expect.
Although no single factor can account for this resilience, one striking feature that differentiates this
cycle from earlier ones is the continued vitality of most U.S. banks and nonbank financial institutions.
In past cycles, economic downturns often produced credit losses that were so severe that the capacity
of those institutions to intermediate financial flows was impaired. As a consequence, recessions were
prolonged and deepened. This time, the economic downturn has not significantly eroded the capital of
most financial intermediaries, and the terms and availability of credit have not tightened to such an
extent as to be significant factors in deepening the contraction or impeding the recovery.
The use of a growing array of derivatives and the related application of more-sophisticated methods
for measuring and managing risk are key factors underpinning the enhanced resilience of our largest
financial intermediaries. Derivatives have permitted financial risks to be unbundled in ways that have
facilitated both their measurement and their management. Because risks can be unbundled, individual
financial instruments now can be analyzed in terms of their common underlying risk factors, and risks
can be managed on a portfolio basis. Concentrations of risk are more readily identified, and when
such concentrations exceed the risk appetites of intermediaries, derivatives can be employed to
transfer the underlying risks to other entities.
As a result, not only have individual financial institutions become less vulnerable to shocks from
underlying risk factors, but also the financial system as a whole has become more resilient. Individual
institutions' portfolios have become better diversified. Furthermore, risk is more widely dispersed, both
within the banking system and among other types of intermediaries and institutional investors. Even
the largest corporate defaults in history (WorldCom and Enron) and the largest sovereign default in
history (Argentina) have not significantly impaired the capital of any major financial intermediary.
Likewise, record amounts of home mortgage refinancing and accompanying declines in mortgage
asset durations have not imperiled the principal intermediaries in the mortgage markets, in substantial
part because these institutions were able to use derivatives to transfer a significant portion of the
convexity risk associated with prepayments of fixed-rate mortgages to investors in callable debt and
issuers of putable debt.
Risks associated with the use of derivatives
If derivatives and the techniques for risk measurement and management that they have facilitated
have produced all these benefits, why do they remain so controversial? The answer is that the use of
these instruments and the associated techniques pose a variety of challenges to risk managers.
Inevitably, risk-management failures occur, and in two instances--the highly publicized cases of
Barings and Long Term Capital Management--they proved destabilizing. Those that question the net
benefits of derivatives see daunting risk-management problems and thus foresee catastrophic
outcomes. In particular, they fear that common deficiencies in risk management will result in
widespread failures or that the failure of a very large derivatives participant will impose heavy credit
losses on its counterparties and yield a chain of failures.
Others, like myself, who see the benefits of derivatives exceeding the costs, do not deny that their use
poses significant risk-management challenges. But we see ample evidence that the risks are
manageable in principle and generally have been managed quite effectively in practice, at least to
date. Indeed, credit losses on derivatives have occurred at a rate that is a small fraction, for example,
of the loss rate on commercial and industrial loans. Market discipline in the largely unregulated
derivatives markets has provided strong incentives for effective risk management and has the potential
to be even more effective in the future.
To be sure, there undoubtedly will be further risk-management failures. But the largest market
participants have such diversified businesses that a risk-management failure involving a single product
line is unlikely to be a threat to solvency. Furthermore, risk-management failures are more likely to be
idiosyncratic than to reflect common deficiencies in procedure or technique among market
participants. In the case of the management of market risk, our bank examiners observe significant
differences in approach across the largest U.S. banks, even in the measurement of such a basic
concept as value-at-risk.
I do not wish to suggest, however, that I am entirely sanguine with respect to the risks associated with
derivatives. One development that gives me and others some pause is the decline in the number of
major derivatives dealers and its potential implications for market liquidity and for concentration of
counterparty credit risks. I also fear that the potential contribution of market discipline to stability in the
derivatives markets is not being fully realized because, in our laudable efforts to improve public
disclosure, we too often appear to be mistaking more extensive disclosure for greater transparency.
This is an issue to which I shall shortly return.
Concentration and market liquidity
In recent years, consolidation has reduced the number of firms that provide liquidity to the OTC
derivatives markets by acting as dealers in the more standardized or "plain vanilla" contracts. To be
sure, the resulting concentration sometimes is overstated because of the failure to recognize that the
OTC derivatives markets are global markets in which major banks and securities firms from more than
half a dozen countries compete. For example, measures of concentration based on data reported by
U.S. banks overstate concentration significantly because they ignore the competitive activities of U.S.
securities firms and foreign banks.
Nonetheless, not all major dealers make markets in all products, and concentration is substantial for
certain important types of OTC contracts. Examples include U.S. dollar interest rate options and credit
default swaps. In each case, a single dealer seems to account for about one-third of the global market,
and a handful of dealers together seem to account for more than two-thirds.
When concentration reaches these kinds of levels, market participants need to consider the
implications of exit by one or more leading dealers. Such an event could adversely affect the liquidity
of types of derivatives that market participants rely upon for managing the risks of their core business
functions.
Exit could be voluntary. In particular, losses incurred in making markets could lead a dealer to
conclude that the returns from market-making are not commensurate with the risks. Alternatively,
downgrades of a dealer's credit rating could force the dealer to exit. Counterparties in the OTC
derivatives market are quite concerned about the potential credit risks inherent in such contracts and
generally are unwilling to transact with dealers unless their credit rating is A or higher.
If a major dealer exited and other dealers were unwilling to fill the void, the liquidity of the market likely
would be impaired. Market participants need to consider what their alternatives would be in such
circumstances. Are there other liquid markets in which they could manage their risks? In some cases
market participants may be able to manage risks reasonably effectively in cash markets or
exchangetraded derivatives markets. But in other cases managing risks may become more difficult with the exit
of some dealers. If market participants perceive that they are vulnerable to such exit by a liquidity
provider, they will tend to redirect some of their risk-management activity to other, more liquid markets
or seek out new dealers in the market in which exit is a concern. If enough participants perceive the
concentration of dealers as entailing market-liquidity risk, their actions to mitigate the risk should over
time reduce that degree of concentration.
Concentration and counterparty risk
Perhaps the more obvious way in which concentration in OTC derivatives markets creates risks for
market participants is through its implications for counterparty credit risks. Concentration of
marketmaking has the potential to create concentrations of credit risks between the dealers and the
end-users of derivatives as well as between the dealers themselves. This latter concentration of risk
results from dealers frequently managing their market risks through derivatives transactions with a
limited number of other dealers. As mentioned earlier, critics of derivatives often raise the specter of
the failure of one dealer imposing debilitating losses on its counterparties, including other dealers,
yielding a chain of defaults.
However, derivatives market participants seem keenly aware of the counterparty credit risks
associated with derivatives and take various measures to mitigate those risks. The vast majority
carefully evaluate the creditworthiness of counterparties before entering into transactions and monitor
their credit quality over the life of the transactions. As I indicated earlier, users of derivatives have
been reluctant to transact with dealers that are not perceived as solid investment-grade credits. Market
participants also establish credit limits for their counterparties and actively monitor their exposures to
ensure that they remain within the limits established. Such monitoring, parenthetically, relies heavily
on trust in the accuracy of the information forthcoming from the counterparties.
Counterparty risk management has been materially assisted by the widespread use of master
agreements for derivatives transactions. In the event of a counterparty's default, such agreements
permit the termination of all transactions with the counterparty and the netting of the resulting gains
and losses. For many years, market participants have been putting such master agreements in place
and working with legislatures to ensure that national laws support the enforceability of netting. Data
reported by U.S. banks indicate that, on average, netting now reduces counterparty exposures by
almost three-fourths.
Even with wider use of netting, however, the outsized growth of derivatives markets has resulted in
ever-larger counterparty exposures. Market participants have increasingly responded by entering into
collateral agreements to further mitigate counterparty credit risks. Such agreements typically permit
counterparties to derivatives transactions to demand collateral if their net credit exposure exceeds a
negotiated threshold amount. The threshold often varies with the credit rating of the counterparty: The
lower a counterparty's credit rating, the smaller the threshold. If its credit rating falls below investment
grade, a counterparty is often required to overcollateralize its counterparties' exposures. In effect, it
becomes obligated to meet a margin requirement.
Collateral agreements are a very effective means of limiting counterparty credit risks. At the same
time, they increase market participants' exposures to other types of risk, especially funding-liquidity
risks. Once a counterparty has agreed to collateralize its derivatives contracts, day-to-day declines in
the value of those contracts expose it to immediate demands for more collateral. Furthermore, the
practice of tying the size of thresholds and margin requirements to credit ratings exposes a
counterparty to extraordinary demands for collateral if its rating is downgraded. Collateral demands
arising from rating downgrades may be especially costly to meet because a downgrade would reduce
the availability of funding and increase its costs at the same time.
Incentives for effective risk management
As this discussion of the risks associated with derivatives makes clear, effective risk management by
market participants is the key to ensuring that the benefits of derivatives continue to exceed their
costs.
Some may see government regulation of OTC derivatives dealers as essential to ensuring efficacious
risk management. This view presumes that government regulation can address the challenges these
types of markets engender and that it can do so without lessening the effectiveness of market
discipline supplied by counterparties. Market participants usually have strong incentives to monitor and
control the risks they assume in choosing to deal with particular counterparties. In essence, prudential
regulation is supplied by the market through counterparty evaluation and monitoring rather than by
authorities. Such private prudential regulation can be impaired--indeed, even displaced--if some
counterparties assume that government regulations obviate private prudence.
We regulators are often perceived as constraining excessive risk-taking more effectively than is
demonstrably possible in practice. Except where market discipline is undermined by moral hazard,
owing, for example, to federal guarantees of private debt, private regulation generally is far better at
constraining excessive risk-taking than is government regulation.
The very modest credit losses that have appeared in derivatives portfolios at U.S. banks are a
testament to the effectiveness of market discipline in this area. Indeed, credit losses on OTC
derivatives also have been quite modest at derivatives affiliates of U.S. broker-dealers, which are
subject to very limited government regulation. This is further evidence of the powerful effects on
behavior that result when market participants recognize that they bear the bottom-line consequences
of their risk-taking decisions.
A key support for market discipline is the information that market participants have for evaluating the
creditworthiness of counterparties. Over the past decade, enormous attention has been given to
disclosures market participants make with regard to their risk exposures, particularly those associated
with derivatives activities. Both public authorities and private-sector working groups have
recommended ways to enhance market discipline through improved public disclosures. The result of
these efforts, however, has been mixed.
Clearly, we have made great strides in expanding the volume of publicly disclosed information related
to risk exposures and derivatives. A more complex question is whether this greater volume of
information has led to comparable improvements in the transparency of firms.
In the minds of some, public disclosure and transparency are interchangeable. But they are not.
Transparency implies that information allows an understanding of a firm's exposures and risks without
distortion. The goal of improved transparency thus represents a higher bar than the goal of improved
disclosures. Transparency challenges market participants not only to provide information but also to
place that information in a context that makes it meaningful. Transparency challenges market
participants to present information in ways that accurately reflect risks. Much disclosure currently falls
short of these more demanding goals.
Despite the substantial room for progress with regard to transparency, we should not underestimate
the barriers to achieving it. Managers no doubt have to struggle with selecting and organizing data in a
meaningful way. The difficulties are well illustrated by the annual reports of large institutions that
routinely exceed one hundred pages; pressures are enormous to update existing tables and charts as
well as to provide even more. In addressing this challenge, however, both managers of firms and
makers of public policy would do well to be mindful of the ultimate goal--a clear understanding of a
firm's activities that fosters market discipline.
Conclusion
In conclusion, the benefits of derivatives, in my judgment, have far exceeded their costs. Derivatives
unquestionably do pose risk-management challenges to market participants. But those challenges are
manageable and thus far have generally been managed quite well. The best way to ensure that those
challenges continue to be met is to preserve and strengthen the effectiveness of market discipline.
Market incentives, in particular, reinforce the importance of reputation and trust as sources of market
value.
Just as market discipline has fostered effective risk management in the derivatives markets, so too it is
now being brought to bear on corporate governance generally. Once market discipline firmly
reestablishes reputation and trust as corporate values, the incidence of corporate malfeasance should
be greatly reduced.