Alan Greenspan: Finance - United States and global
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the Institute of International Finance, New York, (via videoconference), 22 April 2002.
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In recent weeks, economic forecasters in the United States have been debating whether an apparent
turning point in the current business cycle augurs a modest or a more robust recovery in the months
ahead. Much less attention has been paid to a far more significant event: the impressive ability of the
American economy to withstand a severe decline in equity asset values, a sharp retrenchment in
capital spending, and an unprecedented blow from terrorists to the foundations of our market systems.
As I outlined in congressional testimony last month, if the indications that the contraction phase of this
business cycle has drawn to a close are ultimately confirmed, we will have experienced a significantly
milder downturn than the long history of business cycles would have led us to expect. Remarkably, the
imbalances that triggered the downturn and that could have prolonged this difficult period did not
fester.
The obvious questions are, what has changed in our economy in recent decades to produce such
resilience, and will these changes persist into the future?
Doubtless, the substantial improvement in the access of business decisionmakers to real-time
information has played a key role. Thirty years ago, the timeliness of available information varied
across companies and industries, often resulting in differences in the speed and magnitude of their
responses to changing business conditions.
In those earlier years, imbalances were inadvertently allowed to build to such an extent that their
inevitable correction engendered pronounced economic stress. The process of correcting those
imbalances and the accompanying economic and financial disruptions too often led to deep and
prolonged recessions.
Today, businesses have large quantities of data available virtually in real time. As a consequence,
although their ability to anticipate changes in demand seems little improved, they, nonetheless,
address and resolve economic imbalances far more rapidly than in the past.
The apparent increased flexibility of the American economy arguably also reflects the extent of
deregulation over the past quarter century. Certainly, if the energy sector were still in the tight
regulatory fetters of the 1970s, our flexibility today would be markedly less. That the relatively recently
developed markets for natural gas and electric power endured the Enron collapse without significant
disruption was encouraging. Although the terrorist attacks hit air travel especially hard, deregulation of
that industry has demonstrably increased the quantity and flexibility, if not the profitability, of air travel
over the past twenty years. Trucking and rail deregulation have added flexibility to the movement of
goods across our nation.
I need hardly remind this audience that one especially potent force for enhancing overall economic
flexibility and resilience arguably has been the combination of deregulation and innovation in the
financial sector. New financial products have enabled risk to be dispersed more effectively to those
willing, and presumably able, to bear it. Shocks to the overall economic system are accordingly less
likely to create cascading credit failure.
Lenders have had the opportunity to be considerably more diversified, and borrowers have become far
less dependent on specific institutions for funds. A major contributor to the dispersion of risk has been
the wide-ranging development of markets in securitized commercial and residential mortgages, bank
loans, and credit card receivables. These markets have tailored the risks associated with holding such
assets to fit the preferences of a wider universe of investors.
Especially important has been the flexibility and size of the secondary mortgage market. Since early
2000, this market has facilitated the large debt-financed extraction of home equity that, in turn, has
been so critical a support for consumer outlays in the United States throughout the recent period of
cyclical stress. Undoubtably, this market's flexibility has been enhanced by the extensive use of
interest rate swaps and options to hedge maturity mismatches and prepayment risk.
Financial derivatives, more generally, have grown at a phenomenal pace over the past fifteen years.
Conceptual advances in pricing options and other complex financial products, along with
improvements in computer and telecommunications technologies, have significantly lowered the costs
and expanded the opportunities for hedging risks not readily deflected in earlier decades. The
performance of these increasingly complex financial instruments, especially over the past couple of
stressful years, has been noteworthy. These financial products have contributed importantly to the
development of a far more flexible and efficient financial system--both domestically and
internationally-than we had just twenty or thirty years ago.
Greater resilience has been evident in many segments of the financial markets. One prominent
example is the telecom sector. Worldwide borrowing by telecom firms amounted to more than a trillion
dollars during the years 1998 to 2001. The financing of the massive expansion of fiber-optic networks
and heavy investments in 3G mobile phone licenses by European firms strained debt markets.
At the time, the financing of these investments, to a large extent, was seen as prudent because the
telecom borrowers had very high market valuation that could facilitate, if needed, a stock issuance
take-out of bank and other debt. In the event, of course, prices of telecom stocks collapsed, and many
firms went bankrupt. In decades past, this situation would have been a recipe for severe financial
distress. However, a significant amount of exposure to telecom debt had been laid off through credit
risk mitigation instruments, such as credit default swaps, collateralized debt obligations, and
credit-linked notes. This appears to have reduced telecom loan concentrations and the stress on
banks and other financial institutions.
In addition, such instruments, more generally, appear to have effectively spread losses from recent
defaults by Enron, Global Crossing, Railtrack, and Swissair in recent months. In particular, the still
relatively small, but rapidly growing, credit derivatives market has to date functioned well, with payouts
proceeding smoothly for the most part. Obviously, this market is still too new to have been tested in a
widespread credit down-cycle. But so far, so good.
The markets for more traditional derivatives, such as interest rate swaps and foreign exchange
forwards and swaps, grew rapidly over the past several years. According to the latest tabulation of the
Bank for International Settlements, the aggregate worldwide notional value of the over-the-counter
derivatives market grew to an awesome $100 trillion by the end of June 2001, though it has apparently
slowed somewhat since then. Gross credit exposure was at that time estimated at $1 trillion, after
taking account of legally enforceable netting agreements. Potential credit losses on these instruments
were further mitigated through the growing use of collateral agreements. Such agreements provided
substantial protection to Enron's counterparties, for example.
Beyond the major advances in asset securitization and the expanded development of derivative
instruments, we have witnessed a large number of unheralded advances in finance facilitated by our
enhanced computer and telecommunications capabilities. In recent years, for example, the switch to
electronic trading for interbank spot foreign exchange transactions has markedly reduced the trading
volumes required to maintain an effective market. Various types of electronic communication and
trading systems have been developed for OTC derivatives. To be sure, OTC derivatives dealers have
been slow to take advantage of these systems, but sooner or later market forces are likely to compel
them to do so.
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In summary, because of increased access to real-time information and, more arguably, extensive
deregulation and innovation in financial and product markets, economic imbalances are more likely to
be readily contained. As a consequence, cyclical episodes overall should be less severe than they
otherwise would be.
If this is indeed the situation--and it must be considered speculative until more evidence is
gathered-the implied reduction in economic volatility, other things being equal, would lower risk and equity
premiums. Other things, however, may not be wholly equal. The very technologies that appear to be
the main cause of our apparent increased flexibility and resilience may also be imparting different
forms of vulnerability that could intensify or be intensified by a business cycle.
From one perspective, the ever-increasing proportion of our GDP that represents conceptual, as
distinct from physical, value added may actually have lessened cyclical volatility. In particular, the fact
that concepts cannot be held as inventories means a greater share of GDP is not subject to a type of
dynamic that amplifies cyclical swings.
But an economy in which concepts form an important share of valuation has its own vulnerabilities. As
the recent events surrounding Enron have highlighted, a firm is inherently fragile if its value added
emanates more from conceptual than from physical assets. A physical asset, whether an office
building or an automotive assembly plant, has the capability of producing goods even if the reputation
of its managers falls under a cloud. The rapidity of Enron's decline is an effective illustration of the
vulnerability of a firm whose market value rests largely on capitalized reputation. The physical assets
of such a firm compose a small proportion of its asset base. Trust and reputation can vanish overnight.
A factory in such a context cannot.
The implications of such a loss of confidence for the macroeconomy depend importantly on how freely
the conceptual capital of the fading firm can be replaced by a competitor or a new entrant into the
industry. Even if entry is relatively free, macroeconomic risks can emerge if problems at one firm tend
to make investors and counterparties uncertain about other firms that they see as potentially similarly
situated. The difficulty of valuing firms that deal primarily with concepts and the growing size and
importance of these firms may make our economy more susceptible to this type of contagion.
Another, more conventional determinant of stability will be the economy's degree of leverage--the
extent to which debt rather than equity is financing the level of capital. The proper degree of leverage
in a firm, or in an economy as a whole, is an inherently elusive figure that almost certainly changes
from time to time. Clearly, firms find some leverage advantageous in enhancing returns on equity, and
thus moderate leverage undoubtedly boosts the capital stock and the level of output. A sophisticated
financial system, with its substantial array of instruments to unbundle risks, will tend toward a higher
degree of leverage at any given level of perceived underlying economic risk. But the greater the
degree of leverage in an economy, the greater its vulnerability to unexpected shortfalls in demand and
to other miscalculations.
Although the fears regarding business leverage have been confined mostly to specific sectors in
recent years, concerns over potential systemic problems resulting from the vast expansion of
derivatives have reemerged with the difficulties of Enron. To be sure, firms like Enron, and Long-Term
Capital Management before it, were major players in the derivatives markets. But their problems were
readily traceable to an old-fashioned excess of debt, however acquired, as well as to opaque
accounting of that leverage and lax counterparty scrutiny. Swaps and other derivatives have been
remarkably free of default throughout their short history, including over the past eighteen months.
Of course, latent problems may exist in any market that expands as rapidly as these markets have.
Regulators and supervisors are particularly sensitive to this possibility. Derivatives have provided
greater flexibility to our financial system. But their very complexity could leave counterparties
vulnerable to significant risk that they do not currently recognize, and hence these instruments
potentially expose the overall system if mistakes are large.
In that regard, concerns have been raised about potential counterparty risks in the large interest rate
hedging efforts of government-sponsored enterprises (GSEs) in support of their secondary mortgage
market operations. Presumably, counterparties can manage this risk effectively through the use of
credit limits, netting, and collateral agreements. The broader risks for financial markets and the
economy result from the perception of government support for these corporations and the resulting
implicit subsidization of GSEs. Subsidies, by intent, distort the normal balance of markets. In this case,
the perception of government support may induce the counterparties of GSEs to apply less vigorously
some of the risk controls that they apply to manage their over-the-counter derivatives exposures. More
generally, we need to be careful not to allow subsidies to unduly disturb an efficient financial structure
that has so clearly contributed to increased economic stability.
Dramatic changes in our financial structure have required governments to ensure that their regulatory
regimes are appropriate to the current configuration of markets and institutions. In the judgment of the
Federal Reserve, the Commodity Futures Modernization Act of 2000 struck the right balance in
regulating derivatives in the United States, as did Gramm-Leach-Bliley in finance generally.
Our international banking and financial system is regulated primarily by counterparties whose due
diligence is fundamental to the containment of risk, including systemic risk. Government regulators can
exercise only broad oversight. We at the Federal Reserve, for example, can never bring to bear the
detailed market and counterparty surveillance that private-sector players exercise. We rely on you to
be, in effect, the front-line regulators.
Increased government regulation can cause unrealistic expectations regarding the extent to which risk
can be reduced by regulators. Such actions can create moral hazard and may prove
counterproductive. We trust that the Basel II Capital Accord, when final, will be sensitive to these
concerns.
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The surge in risk hedging in recent years is a symptom of a much broader issue of change in both
domestic and international finance that is a manifestation of changes in the real economy. As the pace
of technological change alters the conduct of business in ways we will never fully anticipate, we must
foster the ability of our ever-expanding international banking and financial system to meet the
challenge of that change.
The flexibility of our industry and workforce to reinvent themselves when the need arises forms the
basis for increasing standards of living. This "creative destruction," in turn, requires an effective and
flexible financial system. The world's bankers are in an excellent position to develop and nurture such
a system.