Alan Greenspan: Structural changes in the economy and
financial markets in the United States
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the America's Community Bankers Conference, Business Strategies for Bottom Line
Results, held in New York, 5 December 2000.
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Good morning. It is a great pleasure for me to join America's Community Bankers for your winter
conference. I would like to take the opportunity today to talk with you about some of the structural
changes in the economy and financial markets that are challenging both bankers and policymakers.
Technological innovation, and in particular the spread of information technology, has revolutionized
the conduct of business over the past decade and resulted in rising rates of productivity growth.
Accelerated productivity has been elevating standards of living, and it has been containing cost and
price pressures, even as the economy operates at unusually high levels of labor resource utilization.
Higher prospective rates of return from the application of the newer technologies has led to a surge in
business capital spending. And, in recent years, the capitalization of those higher expected profits has
boosted equity prices and contributed to a significant pickup in household spending on houses, durable
goods, and consumption more generally. Also contributing has been the measurable rise in the
turnover of existing homes, engendering a marked increase in realized capital gains. For a long time,
those who were advancing funds shared the sanguine expectations of those using the funds for rapid
increases in profits and incomes, and credit and equity were available with unusually low risk spreads.
During the past couple of years, however, the widespread optimism that was apparent in financial
markets has given way to some reassessment of risks and opportunities. This process has been
underway ever since the global financial crisis in the fall of 1998. That episode forced many market
participants to recognize the potential for international risks to feed back on US markets. Events
brought into sharper focus the possibility that liquidity in many markets can dry up simultaneously
when fear spurs risk aversion, and an intense, near-term focus on protecting capital values markedly
elevates the demand for liquidity. Markets largely recovered from that episode, but an imprint was left
in the form of wider credit spreads and more cautious behavior on the part of banks and other lenders.
Recently, wariness about risk again has increased as default rates on less than investment-grade bonds
have moved higher, debt downgrades have become more commonplace, and many high-flying
dot-com ventures have collapsed. More broadly, equity market analysts have been revising down their
near-term profit forecasts - with revisions occurring across a range of industries.
As a consequence, stock prices this year have given back some of the extraordinary gains posted in
recent years, risk spreads have widened appreciably in markets for lower-rated long-term and
short-term credits, and - as I'll be discussing in more detail later - banks report that they have
tightened terms and standards on business loans.
To be sure, our current circumstances are in no way comparable to those of 1998. Financial markets
have continued to function reasonably well, and credit continues to flow, although admittedly with
reduced availability to less-than-investment-grade borrowers and at interest spreads sufficiently
elevated to press on profit margins of those lower-rated borrowers. Both lenders and borrowers are
reassessing their positions in light of an apparent uptick in domestic risks, but the palpable fear that
dominated financial markets at the height of the crisis two years ago is not now in evidence. Net funds
raised by non-farm, non-financial business are estimated to have risen in November from October
levels, though remaining below the rates of earlier this year.
Why then, one might ask, is this process of reassessment taking place now? In large part, it appears to
be the expected byproduct of the economy's transition to a more sustainable balance in the growth of
demand and supply. The orders and output surge this past year in a number of high-technology
industries, amounting in some cases to 50% and more, was not sustainable even in the more optimistic
new economy scenarios. Technological innovation combined with intense competition has resulted in
some overreaching. Many firms rushed to gain first-mover advantages of the newer technologies. The
successful creation of industrywide networking standards was expected to allow these firms to
dominate a particular market niche and, thus, to reap a considerable reward in earnings.
Demand for high-tech equipment and fiber optics expanded rapidly, but in some segments of the
market available supply appears to have increased even faster. To the extent that some aspiring
entrepreneurs entered the tail end of a short-term boomlet, there was bound to be some
disappointment. In many respects, the situation may be analogous to a phenomenon of which I am sure
many of you are all too painfully familiar - the tendency to overbuild in commercial real estate when
low vacancy rates prompt commercial building starts well beyond the point that, on completion, could
be supported by the ongoing growth in demand. Problems have even arisen among a number of
well-established companies whose forays into uncertain newer technologies have come up short.
To a considerable degree, then, the current shakeup in some segments of the telecom and other
high-tech sectors seems to reflect an inevitable winnowing process as the market begins to draw firmer
conclusions about which firms will be able to establish a long-lived market niche and which will not.
Of course, these events are not inconsistent with investment in high technology continuing to serve as
an engine of strong productivity growth in the years ahead. As one might expect, the cyclical
component of the growth of output per hour has slowed, but during the summer months output per
hour advanced at a pace sufficiently impressive to affirm a definitely elevated underlying rate of
structural productivity growth from the levels of a decade ago.
Moreover, despite recent short-term earnings disappointments, many corporate managers appear not to
have measurably altered their long-standing optimism on the future state of technology. At least this is
the impression one gets from the persistent upward revision through most of this year of security
analysts' long-term earnings projections. Analysts, one must presume, obtain most of their insights
from corporate managers, who are most intimately aware of the potential gains from technological
synergies and networking economies. According to IBES, a Wall Street firm, the three- to five-year
average earnings projections of more than a thousand analysts, though exhibiting some signs of
flattening in recent months, have generally held firm. Such expectations, should they persist, bode well
for continued capital deepening and sustained growth of structural productivity over the longer term.
Admittedly, however, shifts in the growth of structural productivity are clearly visible only in
retrospect.
The adjustment to a more sustainable supply-demand alignment is occurring in the economy more
broadly, as well as within some high-tech sectors. For some time, growth in aggregate demand
exceeded even the productivity-enhanced expansion of potential supply. More recently, though, the
pace of expansion of economic activity has moderated appreciably, in part as tighter financial
conditions have had some impact on interest-sensitive areas of the economy.
Homebuilding has declined over much of this year, though more recently demand appears to have
largely stabilized in response to the decline in mortgage rates that has occurred since the spring. Motor
vehicle sales continue to slip, however, reflecting, in part, the unwillingness of households and
businesses, faced with today's financial market conditions, to add to the stock of cars and trucks on the
road at the pace observed over the past year. Growth in the demand for consumer durables generally
appears to be shifting down after the rapid gains of the past few years. This softening, in turn, has fed
back into reduced demand from a large segment of the so-called old economy that supplies consumer
durable markets.
Given the difficulty employers have had with building up their workforces in recent years, it is not
surprising that the easing in demand growth since the spring has been reflected more in hours worked
than jobs. As a consequence, labor markets have remained tight. But the recent increase in initial
unemployment insurance claims and the level of insured unemployment may be an early harbinger of
an easing of these conditions.
In periods of transition from unsustainable to more modest rates of growth, an economy is obviously
at increased risk of untoward events that would be readily absorbed in a period of boom. The sharp
rise in energy prices, if sustained, is worrisome in this regard. As we learned from previous episodes,
rising energy prices could engender risks to both inflation and economic activity. If accommodated by
monetary policy, the jump in energy prices could spill over into general inflation and inflationary
expectations, as was so evident in the 1970s. At the same time, the hike in the price of imported
energy has acted, in effect, as a tax equivalent of roughly 1% of national income. Although there is as
yet little evidence of the type of destabilizing inflationary pressures observed in the aftermath of
previous oil price spikes or of exceptionally large restraint on consumer spending, Middle East
tensions have heightened such risks.
The most significant effect to date from higher energy prices appears to be on profit margins, where
corporate businesses, constrained by competitive market forces, have not been able to raise prices to
fully offset energy cost increases. We estimate that owing to the rise in oil, natural gas, and electric
power prices, energy costs of nonfinancial, nonenergy, corporations have increased at a 40% annual
rate since the spring of 1999. Apparently, most of the increase has eaten into the margins of domestic
corporations outside the energy sector.
With equity prices weakening in response to reduced earnings from higher costs and a more moderate
pace of sales, the "wealth effect" that spurred consumer spending is being significantly attenuated.
Moreover, high and rising equity prices had facilitated a good deal of financing for newer companies,
both in the equity and bond markets. Widened spreads in the high-yield markets reflect, in part, a
reduced potential for new equity issuance to support debt servicing. Higher costs of capital for these
companies likely is exerting some restraint on overall business capital spending.
Nonetheless, in the face of the energy price spike and the erosion of optimism in financial markets,
consumer confidence, or sentiment, appears to be holding up reasonably well to date, though there
have been some mixed signals of late. And although new orders for high-tech equipment have slowed
from their torrid pace of earlier this year, order backlogs for such equipment continued to rise through
October, and capital deepening and structural productivity growth continued apace.
Still, in an economy that already has lost some momentum, one must remain alert to the possibility
that greater caution and weakening asset values in financial markets could signal or precipitate an
excessive softening in household and business spending.
As might readily be expected, these changing economic dynamics, of necessity, are being reflected in
our banking markets. Technological innovations played a key role in rendering decades-old banking
laws and regulations obsolete. The relaxation of these regulations has, in turn, further reduced barriers
to competition and accelerated the modernization of our financial system. That evolution, however,
must continue to occur in a manner that preserves the fundamental soundness of the financial system
and, in particular, the nation's banks. History teaches us that a sound banking system, willing and able
to take deposits and extend credit, is a prerequisite for the long-term health of the national economy.
Securities markets alone will never be able to substitute for the extensive and detailed knowledge that
bankers - especially community bankers - bring to the intermediation process.
In addition, changes in regulation and supervision induced by technological innovations in information
processing are just a small part of the sea change in banking. Far more important is that these
technologies have made it possible for banks and other financial firms to adopt business models and to
offer customers a range of products and services that literally would have been impossible only a few
years ago.
What has transpired in the banking industry has been just a microcosm of the sweeping changes in the
economy at large in recent years - changes that also present both risks and opportunities to banks.
Since the mid-1990s, the banking industry has enjoyed an unusually strong and steady growth of
profits, coupled with an improving asset quality and vibrant loan growth, which reflected, in turn, the
growing and innovative real economy. Bankers, however, were not immune from the same optimism
that affected equity markets, leading, in some cases, to less-than-realistic assessments regarding
borrowers' ability to repay. In more recent periods, pockets of weakness have emerged, especially in
large syndicated credits. I believe that these developments are inducing more realistic assessments of
risks by banking organizations. For some institutions, lapses in risk evaluation have come at some cost
as asset quality has deteriorated, net charge-offs have risen, and profitability has fallen. Recent reports
by certain large banking organizations point to some further deterioration of asset quality.
Fortunately, bankers have generally been well prepared to meet these developments. The industry's
base of earnings is historically strong and well diversified, and although credit costs as well as
problem and classified assets have risen, they remain historically modest relative to assets and capital.
Some bankers attribute the recent rise in problems to the relaxation of lending standards and terms of
two or three years ago. During that period, supervisors had noted the risks posed by an overly
optimistic outlook and by a lack of stress testing. However, while supervisors like to think that
banking organizations are attentive to our every warning, there is nothing like actual loan downgrades
and losses to focus management's attention. One can hope that the practical experience provided by
recent events will translate into better structured transactions and improved risk-adjusted pricing.
Indeed, that does seem to be the case.
For example, the Federal Reserve's November Senior Loan Officer Opinion Survey suggests that
lending standards and terms have continued to tighten in the wake of weakened borrower conditions.
In addition, more than half the institutions indicated that they anticipated further tightening of
standards and terms before the end of 2001.
At the same time, it is important that the response of management to these concerns not be overdone.
The rise in the problems that we are observing can in some sense be attributed to the kinds of
overreaching typically experienced during strong economic periods, when downside scenarios are
more challenging to visualize fully, when the ambitions of borrowers are at their height, and when
competition for market share is an especially driving force. Though lenders will be viewing new
transactions with greater caution than they did a couple of years ago, both bankers and their
supervisors should now guard against allowing the pendulum to swing too far the other way by
adopting policy stances that cut off credit to borrowers with credible prospects.
Despite some isolated pronounced losses at a few large institutions, their effect on earnings so far has
been modest in the aggregate. More widespread has been shrinking net interest margins arising from a
rapid rise in liability costs, with more than a third of the largest bank holding companies experiencing
declines in these margins of 25 basis points or more compared with a year ago. On the other hand,
savings institutions have had less severe margin contractions, and smaller commercial banks have
generally been able to keep their margins stable. The relatively moderate margin decline for savings
institutions may reflect the success of their hedging programs. The more favorable margin trends at
smaller commercial and savings institutions are also probably linked to their relatively higher levels of
core deposits, which have been less sensitive to rising rates.
That said, a growing dependence on wholesale funding is becoming an established trend for large and
small institutions alike. As loan growth has greatly exceeded that of deposits, liquidity benchmark
ratios such as loans-to-deposits have reached historic peaks.
Although day-to-day decisions about wholesale versus retail funding may appear immaterial at the
time, the effect of such decisions may gradually transform the overall liquidity and risk profile of an
institution. It is crucial, therefore, that bank managers take stock of how their balance sheets have
evolved - including the widening menu of choices available to customers on both sides of that balance
sheet - and understand the accompanying implications.
The freedom to manage your liability structure is still constrained by one remnant of 1930's era
banking regulation - the prohibition of interest on demand deposits. This is of particular concern to
community bankers, of course, given that larger banks are offering interest to their customers through
sweep accounts. Pending legislation modernizing the law would potentially help bolster deposit
growth and open opportunities for other profitable customer relationships without the unproductive
and costly circumventions of the existing statute.
Capital, of course, is the key to maintaining stability in the midst of the risks of the evolving financial
and economic landscapes. Recognizing that fact, regulators are working toward implementation of
capital standards that are more risk-sensitive through the international Basel Capital Accord. That
effort, however, is largely directed toward the diversity of risks facing the largest banks and will
undoubtedly require an even greater level of complexity than the current standards. For those of you
who already view the current capital framework as too complicated, let me offer some encouraging
words. The US banking agencies published last month an advance notice of proposed rulemaking for a
simplified capital framework that would apply to banks with less complex risk structures. The notice
sets forth very broad options for a less burdensome standard, including the use of a simplified
risk-based ratio, a stand-alone leverage ratio, or a leverage ratio modified to capture off-balance-sheet
exposures. There are many pros and cons to each of these alternatives, and the banking agencies are
eager to receive your views as well as your ideas for other alternatives. We are hopeful that this dialog
will lead to a less burdensome, yet prudent rule for noncomplex institutions.
In closing, the transition of the US economy to a more sustainable supply-demand relationship is
posing challenges for businesses, banks, and monetary policymakers. How well banks perform under
these conditions will depend on their ability to continuously reevaluate previously held assumptions
and adapt to change. Fortunately, US banking organizations of all sizes have the right tools to thrive in
this environment, in the form of improved risk management techniques, more diverse earnings, and
strong capital bases. I am confident that banking organizations will continue to monitor and respond to
risks while meeting customer demands in a way that strengthens our underlying financial structure in
the years to come.