Mr Meyer reports on lessons from recent global financial crises
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, before the International Finance Conference, Federal Reserve Bank of Chicago, held on
1 October 1999.
* * *
On the principle that mistakes teach us as much as, if not more than, successes, I will take this
opportunity to consider what can be learned to improve bank supervision and regulation from the
financial crises that afflicted so many economies over the past 21⁄2 years. I will consider two episodes -
the Asian financial crisis and the financial market turmoil surrounding the near-bankruptcy of the
hedge fund Long-Term Capital Management (LTCM). Because these episodes are too recent and too
complicated to draw many firm conclusions that lead to concrete policy recommendations, part of my
objective today is to identify some areas where I believe that further study would be particularly
productive.
The two crises
The details of these two episodes are familiar to everyone here. The floating of the Thai baht in July
1997 marked the onset of a period of market turbulence associated with the halting of new funds to
and, in most cases, the flight of existing money from, many economies in Southeast Asia. Because
many entities in those nations relied on short-term funding in foreign currency for their ongoing
operations, the drying up of funding from global financial markets quickly placed serious strains on
them. And because the lines between the private and official sectors were often drawn imprecisely,
these funding problems for firms soon became the burdens of national governments. Such pressures,
unfortunately, exposed numerous and substantial flaws in some of these financial systems, including
lax lending policies, substantial mismatches in the maturities and foreign exchange denominations of
assets and liabilities, seriously deficient standards for disclosure of basic private financial information,
hedges based on erroneous presumptions about the correlations among returns, the failure to monitor
ongoing loan performance, and the inadequacy of reserves against potential losses.
In autumn 1998, we in the major industrial countries were reminded that emerging market economies
did not have a monopoly on financial institutions that were inadequate in the task of assessing risks.
The effective default of the government of Russia on some of its obligations and the travails of LTCM
in rebuilding its capital in the face of enormous trading losses - occurring as they did so soon after the
crisis in Asia - triggered a generalized reassessment of risk-taking by investors and market makers.
Interest rate risk spreads widened into ranges normally associated with the troughs of recessions, and
reductions in the liquidity of even government securities markets suggested a marked contraction of
trading activity. In retrospect, the counterparties of LTCM had underestimated the risks associated
with that firm's strategy, both in terms of the leverage undertaken and the size and scope of open
positions, some of which were in illiquid markets or ones that would become illiquid if attempts were
made in scale to close out positions. Many firms dealing with LTCM quickly found themselves with a
considerably greater potential exposure to loss than they had bargained for, both directly on their
credits to LTCM and - should the hedge fund have failed and prices moved as its positions were
liquidated - indirectly in their own trading books and on some of their other outstanding credits.
Some tentative lessons and responses
I take three lessons away from this experience and suggest a like number of supervisory and regulatory
responses.
As for the lessons, first, measures of direct risk-taking can provide misleading assessments of overall
exposure in an environment with so many interconnections. The direct lending exposure of most
global financial institutions to Thailand, Malaysia, and Korea was limited at the time. However, proxy
hedging of country risks in international financial markets propagated shocks across national borders
beyond that called for by direct trade and financial linkages alone, spreading the initial problems in
Asia to many other markets. Simply, those entities with direct exposure to troubled credits sometimes
took offsetting hedging positions in obligations of other economies that traded in deeper and more
liquid markets on the theory that the usual correlation among returns in that asset class would trim at
least some of their potential losses. In the process, those deeper markets used for hedging purposes,
including ones in Hong Kong, Australia, Brazil, and Mexico, suffered their own downdrafts at the
peak of the Asian crisis. Similarly, concerns about the potential fire sale of LTCM's assets, as well as
the efforts of counterparties to rebalance their positions in advance of possible failure of the hedge
fund, produced wide swings in many financial prices and contributed to a drying up of market
liquidity. As a result, institutions with no direct exposure to Asian economies, Russia, or LTCM found
themselves caught flat-footed.
Second, regulators and industry participants in industrial countries have reason to be proud that
improvements in capital, regulatory structure, and risk management over the years allowed depository
institutions to weather the storms without substantial adverse effects. Exposures to emerging market
economies were much more limited in this episode when compared with the debt crisis of the early
1980s. For instance, on the eve of the debt crisis in 1982, US banks' direct exposure to Latin America
ran about 125% of their capital, and for the largest banks, it was more than 180% of capital. In
contrast, in mid-1997, US banks' direct credit exposure to all emerging markets was around one-third
of their capital. These lower exposures reflect, to an important degree, a better management of risk that
recognizes the importance of diversification across asset classes.
Third, regulators and industry participants also have reason to be humble. Few would have predicted
that the floating of the Thai baht would topple dominoes all over the region with such force. And the
almost universally accepted opinion of the risk-taking prowess of LTCM proved mistaken in
retrospect. These examples should serve as a reminder that we will not be able to know where, when,
or with how much force the next crisis will hit. However, one of the surest lessons of history is that
there will be a next crisis, a crisis that will share some attributes of the ones that came before while
offering new challenges in its own right.
And that brings us to the appropriate responses: first, in preparation for the next round of problems,
supervisors and regulators should reinforce efforts to get the basics right. For all the talk of financial
wizardry that allows the unbundling and transferring of risks and the lightening speeds of transmission
that occupy so much attention, I would like to remind everyone that, by and large, the mistakes of the
past few years were rather humdrum. In Asia, there were widespread failures of supervision and
regulation, including the failure to enforce limits on lending to individual entities, to appreciate the
implications of over-reliance on potentially changeable short-term sources of funding, to evaluate
repayment risk on a timely basis, and to react quickly as problems emerged. In industrial countries, it
was a widespread misassessment of counterparty risk. Whether lulled by the collateral provided for
credit exposure by each daily marking to market or the lofty reputation of the principals of the firm,
counterparties failed to provide an effective check on the leverage of LTCM.
That said, we should appreciate that in the United States and Europe, bank supervision and regulatory
capital standards worked well in protecting the banking system. Thus, a second item on my list of
responses to the recent financial crisis is that work must continue to determine the incremental
improvements that can be put in place within the existing structure, especially including
supplementing those efforts with an increased reliance on market discipline.
And a third important response is to recognize that these incremental improvements will be more
drastic for some institutions and less drastic for others. The general principle, I think, is that the
complexity and focus of both the supervisory examination and the capital requirements should be
determined by the complexity, diversity, and perhaps the scale of the organization being examined.
This suggests not only different approaches across nations but also different approaches within
nations. A one-size-fits-all supervisory and regulatory framework is simply inconsistent with the
existing and evolving banking structure. Banks are just too different, with different risk profiles, risk
controls, strategies, and approaches to managing risks to be supervised and regulated by one yardstick.
Similar institutions should be supervised and regulated similarly, and different institutions differently.
The consultative document released by the Basel supervisors in June recognizes this multitrack
approach
Agendas for action
By the United States
In the United States, this suggests that the current structure of supervision and regulation - including
minimum capital rules - probably does not have to be changed very much for most banks and perhaps
can even be simplified for some. But there is a small subset of megabanks, who through growth and
consolidation have reached a scale and diversity that would threaten the stability of financial markets
around the world in the event of their failure - or even if they faced severe stress under certain
circumstances. For these larger, complex banking organizations, the Federal Reserve has already
begun a different supervisory focus, and we believe that further modifications are required in both that
approach and capital regulations.
We have chosen about thirty US banking organizations - about one-third subsidiaries of foreign
banks, by the way - whose scale, complexity, and diversity distinguish them from other organizations,
especially the role that they play in US and world financial markets. For each of these large, complex
banking organizations - creatively known as LCBOs in supervisory circles - we have established
dedicated teams of examiners, assisted by roving teams of specialists in payments systems, risk
management, information technology, financial engineering, and modeling. Each examiner team is
headed by a Central Point of Contact, and that team is dedicated full-time to understanding and
supervising everything about that organization - especially its risk profile, risk controls, and strategy.
Just as each institution is different, the team is supplemented by different experts as needed. As these
institutions grow more sophisticated and complex, our challenge is to attempt to develop the skills to
evaluate their activities.
But scale and complexity imply that the supervisor cannot alone accomplish the job, or at least cannot
do so without a degree of intrusion and network of rules and regulations that would be simply
inconsistent with the need for flexibility and rapid response by financial businesses operating in an
increasingly complex market environment. We have no choice, therefore, but to rely increasingly on
market discipline as both a supplement to supervision and regulation and as a source of information to
the supervisors. Such market discipline - which in practice can best be applied only to those large
institutions that rely significantly on uninsured on- and off-balance-sheet liabilities to finance their
activities - requires a larger scale and scope of public disclosure than so far has characterized banking,
even with the substantial disclosures already made by large US banks. Information on the risk
categories of credit exposure, credit concentration, and exposure retained in securitizations is an
example of the kind of disclosure that may be required if the cost and availability of funding is to truly
reflect the riskiness of individual institutions.
Capital regulation for LCBOs also must change. Best-practice banks in the United States have already
begun the process of risk-categorizing their portfolios and using historical data to establish internal
capital allocations, loan loss reserving, and pricing. Our examiners have been instructed to begin
evaluating these systems and urging their improvement. We have also begun work on how best to tie
the required minimum capital regulation for an individual large bank directly into its own internal
risk-profiling system, rather than to one or even multiple externally defined "risk buckets". This isn't
going to be easy. The US regulators and our colleagues abroad are hard at work on how to do it. At the
outset, I am sure, the approach will be relatively simple, but as both banks and supervisors learn, it
will become more sophisticated.
The framework for LCBOs in the United States, then, will be based on the three pillars discussed in
the Basel Supervisors consultative paper: market discipline, supervision, and capital regulation. My
personal view is that in the near term we will have to rely more on supervision, supplemented
increasingly by market discipline, as we develop and deploy the revised capital regulations.
By emerging market economies
In emerging market economies, national authorities have to develop the expertise in supervision and
regulation to monitor activities of complex financial organizations and foster enhanced risk
management practices in their local industry. But we must appreciate that such experience
accumulates only over time. In the interim, national authorities may well want to consider
supplementing their supervisory and regulatory framework with quantitative restrictions that limit
risk-taking. When the skills to interpret regulations flexibly are in short supply, national authorities
might prefer to bind themselves to simple rules. Such rules presumably would be structured to prevent
the outsized behaviors that in the past have preceded financial crises, such as extremely rapid growth
in lending for property development or a large share of real estate loans on depositories' balance
sheets.
I would also like to point out that the institutional depth to both manage and examine complex banking
organizations need not always be home grown. While I appreciate the natural sensitivities of countries
trying to build their own economic capabilities, emerging market economies seeking to strengthen
their own financial systems should not restrict - and, indeed, may want to encourage - entry by
foreign banks. Foreign banks will bring with them the human and financial capital that can raise the
level of financial expertise for the entire industry, to the benefit of local banking services. The
presence of such global banks will also foster the development of complementary institutions, such as
credit-rating agencies and accounting firms, that will be valuable for both local institutions and
national supervisors. Those foreign banks also will likely have access to strong parents, implying that
the resources that can be applied to quelling financial turmoil will extend beyond the limits of the
national central bank.
By international organizations
We must also recognize that the agendas for strengthening banking systems in industrial and emerging
market economies are intertwined. There are important cooperative advances to be made, starting with
progress on monitoring compliance with international standards. But all the effort in establishing
standards and guidelines will go for naught if there are not clear, comprehensive procedures for
monitoring the performance of banks in meeting them and incentives for adopting them. Part of this,
no doubt, will require strengthening cooperation among national supervisors. Many financial
institutions have increased their global reach, and those who have not are still affected by development
abroad. Supervisors must therefore also strengthen their connections outside their national markets.
While the events of the last few years that have buffeted world markets caught us by surprise, they
were not a total surprise. With the benefit of hindsight, we can pick out warning signals in some
countries that were missed in advance of the Asian crisis, including an overreliance on leverage, a
troubling buildup of short-term financing, and an overvalued exchange rate. With LTCM, there was
similar excessive leverage and reliance on short-term financing arrangements. Going forward,
international organizations and national authorities will have to invest more resources in monitoring
markets for signs of stress. While there is not a single indicator of banking or balance-of-payment
crises, the tracking of financial market prices in many markets and financial flows across borders
should help to identify trouble spots. Where appropriate, national authorities should consider
broadening the information they collect.
Complementary to these efforts, national authorities can take steps to facilitate transparency within
markets. The key to avoiding excessive leverage is the market discipline that should be provided by
market participants' creditors and counterparties. But market discipline works well only if
counterparties share sufficient information to allow reliable assessments of their risk profiles.
Supervisors need to ensure that, before establishing credit relationships, regulated entities have a clear
picture of a counterparty's risk profile and have ensured that information relevant to that relationship
will be available on a sufficiently timely and ongoing basis. Public disclosure also has an important
role to play, and authorities should make sure that appropriate requirements are in place. To be sure,
public disclosure is unlikely to be sufficiently timely or detailed to meet the needs of creditors. Still, it
is essential to protect retail depositors and investors, and it provides a standardized framework from
which customized bilateral disclosures can be drawn and elaborated.
Lastly, industrial countries have the responsibility to assist in the training of supervisors in emerging
market economies, an area in which, I am pleased to say, we in the Federal Reserve System have been
active for a while. We cannot afford not to take this responsibility, and in this regard, virtue is more
than its own reward. We benefit in such technical assistance by strengthening our contacts with
supervisors abroad, which is important when examining internationally active institutions based here
at home, and by reducing the potential for adverse shocks from abroad.
Issues for further consideration
As I noted, one of the contributing factors to Asian financial distress was the ill-considered buildup of
short-term foreign currency borrowing by banks in these nations from banks in industrial countries.
Some have attributed such behavior to the effects of an inappropriately low capital charge in the Basel
Accord for short-term interbank credit extensions. They argue that the experience requires an increase
in capital charges in order to effectively control the quantity of interbank loans.
I do believe that we, in fact, should question the treatment of interbank credit by the Accord. Credit
risk, in my view, ought to be determined by the specific circumstances of the individual borrower. If
that borrower is really the sovereign, let us be up front about it. If the borrower is really a bank, its
capital classification should not be determined simply by its home country. The Capital Accord should
not lend its support to the unfortunately traditional presumption of external creditors that countries
need to stand behind all external borrowings by their banks. So, by all means, I am firmly in the camp
for adjusting interbank capital charges. But, I doubt that an alignment of risk weights for interbank
credit itself would have had much effect on the borrowing and lending behavior we saw in the runup
to the Asian financial crisis.
This is not to say that interbank lending has not been a problem. But the problem may be us. That is,
we have created a significant moral hazard by, in effect, making lending banks whole, and even
increasing their returns, when the borrowing banks in emerging nations are unable to meet their
obligations. When confronted with the reality, no authority has been willing to face the implications of
bank defaults on the losses of the lending banks or the implications of the unavailability of new bank
credit for the nation in default. But our perfectly rational short-run decisions create the incentive for
lending banks to do the same thing again, and again, and again. Returns are reasonably high, and risk
to them is reasonably low.
The issue is clearly the short-run-long-run tradeoff and I do not have much to add to the argument
about interbank lending other than that some change in the architecture and process must be made or
the cycle will continue; and that change must involve some genuine risk-taking by the lending banks if
we are to reduce, if not eliminate, the moral hazard we have created.
Conclusion
A final word about short-run-long-run tradeoffs. Some have argued that both risk-sensitive capital
charges and market discipline will be pro-cyclical. The rationale, as I understand it, is that following a
peak, as economic conditions deteriorate, evaluations of risk will change, and risk premiums will rise.
As more potential borrowers are viewed as riskier, banks will be even less willing to lend so as to
avoid facing higher capital charges or higher borrowing costs or less availability in the market. In an
improving economy, the opposite occurs. As one of my colleagues states, the problem with market
discipline and risk-based capital is that they work. If and as they work, we may well observe what the
critics note. But, that short-run effect has to be evaluated against the long run, and a judgment reached
about the terms of the tradeoff. For in the long run, both market discipline and risk-based capital
charges affect ex ante risk-appetites because lenders can calculate the likely impact of their actions.
The resultant change in behavior should reduce the amplitude of cycles, and any resultant
pro-cyclicality has to be evaluated against that backdrop. Or, more generally, short runs have to be
evaluated against the backdrop of long runs, regardless of Mr Keynes's unfortunate observations about
the latter.