William J McDonough: Toward greater financial stability
Remarks by Mr William J McDonough, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Bank of Thailand, Bangkok, 5 February 2001.
* * *
It is my pleasure to accept the invitation of the Bank of Thailand to speak to you tonight on how we
can promote greater financial stability.
In the wake of the Asian crisis, authorities in the region have done much to promote increased
financial stability, through a variety of measures to strengthen domestic banking systems and
corporate sectors, and institute broader improvement in accounting, legal, and supervisory systems.
Thailand has taken a number of such actions, including efforts, among others, to close troubled
financial institutions, attract significant private sector capital (including foreign capital) into the banking
system, and improve the legal framework. Macroeconomic policy adjustments, including the move to
flexible exchange rates, have also furthered greater stability. These actions have helped countries
recover from large-scale banking crises, and restore solid growth generally.
That said, in Thailand and elsewhere, the recovery is not yet complete, and much remains to be done.
Moreover, the restructuring and reform agenda will be challenged by slowing global and regional
growth, which may contribute to already apparent signs of increasing reform fatigue within the region.
In my view, Asia stands at an important policy crossroads, involving a choice between pushing forward
market-based reforms that are the only way toward long-term financial stability, or pursuing actions
that provide short-term relief at the risk of threatening the hard-won gains of the last three years.
The recognition that we have entered a new international financial environment has set in motion a
range of efforts dedicated to strengthening the new international financial architecture. My remarks
today will focus on what I believe can be done, from my perspective, to enhance domestic financial
resiliency, within the context of these international efforts, and particularly on two essential building
blocks: a strong financial system and a sound and stable macroeconomic environment. My comments
reference the experience of East Asia, but reflect lessons that are more broadly applicable.
Overview of recent recovery
Given the depth of the problem a little more than three years ago, the Asian recovery on the whole has
been remarkable, and has largely defied initial expectations that the crisis would cast a long shadow
over regional growth prospects. The regional recovery has exhibited a solid "V" shaped trajectory
supported by strong performance in the external accounts, and a pickup in domestic demand. Banking
sectors - faced with unprecedented crisis three years ago - have been shored up through substantial
capital injections and problem asset carve-outs. Corporate sector conditions also appear to have
improved notably with the advent of recovery and debt restructuring efforts.
At the same time, authorities in a number of Asian countries initiated a wide range of fundamental
enhancements to financial system infrastructure, including strengthening prudential regulation and
supervision, bolstering bankruptcy and collateral recovery processes, and improving disclosure
requirements. With the full implementation of these measures, standards in Asia will closely
approximate international norms.
Reform fatigue
But with the pace of growth slowing, reform fatigue represents a significant risk to sustained recovery.
Crises entail wrenching change and costly solutions that are difficult to bear over a long period. The
desire for a return to "normalcy" is strong. Under these conditions, it is human nature to
overemphasize positive information, tire of reform, declare victory and move on. These impulses might
be expected to be particularly powerful against the backdrop of years of strong and unbroken Asian
economic growth.
It is no wonder therefore that governments the world over initially tend to underestimate the size of
problems, underfund solutions, and postpone loss recognition. It also is not surprising that, given the
many obstacles involved, authorities may be tempted to prematurely mark a case closed, particularly
with the advent of economic recovery.
In the new international financial landscape, a government's perceived ability to deliver on the policy
front is crucial, preferably based on coherent, comprehensive, and achievable objectives. Confidence
in a government's ability to deliver is nurtured both by actions and by communication. Complacency
and reform backsliding, however, create the dangerous potential for a shift in expectations.
Vulnerabilities
On a microeconomic level, the still-fragile condition of regional financial and corporate sector
institutions remains a real threat to medium-term stability.
Notwithstanding significant official rescue efforts, regional financial sectors remain burdened by a high
level of problem loans, and require further substantive bolstering of capital and reserves. Authorities,
by and large, have yet to articulate a program for reprivatizing banks and liquidating purchased assets.
Improvements in the financial system infrastructure depend critically on follow-through on these
issues, a long-term process.
Corporate sectors similarly remain fragile: recent debt restructurings have involved a high degree of
debt rescheduling, and firms across the region remain burdened with significant amounts of debt. The
relatively limited restructuring of corporate operations to date across the region raises questions about
the medium-term sustainability of recent improvements in bank asset quality.
The relative lack of breadth in the region's recovery also creates vulnerabilities. Asia's export
orientation has long been a key focal point of strength, to which the recent recovery attests. However,
too great a dependence on export-driven growth brings increased vulnerability to external shocks.
Asia, in particular, will feel the negative effects of a worldwide slowing from last year's strong rate of
growth. Moreover, domestic demand has not recovered sufficiently from the crisis to sustain the
region's economies. With fiscal policy constrained to varying degrees by heavy public sector debt
burdens, regional central banks, in some cases with new-found independence, will need to maintain
their stimulative policies to support the recovery.
Unfinished business
While important progress has been made in rehabilitating Asia's financial systems, a great deal
remains to be done to continue the strengthening of weakened financial and corporate sectors, and
improve the region's resistance to future problems.
I am well aware that universal policy prescriptions are difficult to draw, given the wide range of
experience and initial conditions. Indeed, individual countries in Asia have followed differing reform
strategies, and the results of these efforts will help to inform the ongoing debate. Nonetheless, I am
fond of citing a few of the cautionary lessons from recent international experience with financial sector
reform:
• Restructuring and reform must adequately address both the current "stock" of problem assets, as
well as the potential "flow" of new problems attributable to deficiencies in the broader
financial system infrastructure. Lack of adequate action on either front can lead to a
continuation of the substantial costs of weak banking sectors, sometimes well beyond the
immediate crisis itself.
• Clean-up efforts must be sufficient to the task. Half-done measures that leave financial institutions
with significant levels of impaired assets at best postpone the reckoning and potentially
create incentives for excessive risk-taking.
Fundamental improvements in bank corporate governance are critical.
• Just as risk management
and internal control processes usually need to be thoroughly overhauled in weak institutions,
more often than not, so too does management.
• Protracted forbearance to preserve the appearance of solvency is not a solution. While some
degree of forbearance may be unavoidable and even appropriate under the right conditions,
it is at best a temporary measure. It is critical that forbearance not become institutionalized,
but be tied directly to actions by both bankers and supervisors to address underlying
problems.
• Governments are not good long-term asset managers. Prolonged government holding of impaired
assets is not likely to enhance their value, nor aid in the restoration of market liquidity.
• Governments are not good commercial bankers. Delayed privatization of nationalized banks
always means higher future costs, and usually inhibits fundamental reform.
• Government-directed lending means future fiscal losses. Similarly, efforts to stimulate credit
growth by nonmarket forces in the context of a banking crisis at best buy additional time, and
usually dig a deeper hole.
• Foreign investment in domestic financial sectors can yield important benefits. Foreign direct
investment in the banking sector can provide much-needed capital resources, technology and
knowledge transfer, and a more diversified capital and funding base in the event of future
economic instability.
• Financial sectors are only as healthy as their borrowers. Without corresponding corporate sector
restructuring, financial sector rescue efforts are likely to be necessary in the future.
• Strong financial systems depend on a reliable and credible legal system. In the absence of a
strong legal system, borrowers lack appropriate incentives to repay.
• There are no "quick fixes" to financial sector problems. Remedial actions need to be evaluated in
terms of their short-term efficacy as well as their longer-term implications.
• Unbalanced financial systems create vulnerabilities. Financial systems that are unduly reliant on
banks for financial intermediation are likely to be more vulnerable and slower to recover from the
onset of weakness. Shallow capital markets limit lending alternatives and delay the recovery of
financing to the real sector.
The challenges can be daunting, but recent experience both within and beyond Asia confirms that a
dedicated commitment to financial reform contributes to sustainable recoveries and greater
crisisresilience. Just as strong financial systems act as stabilizers when a domestic economy is battered,
weak financial systems amplify the scope and reach of the problems, making bad situations worse.
Longer-term financial stability
While financial sector rehabilitation will remain a key priority for authorities in Asia, longer-term
measures need to be put in place to deal adequately with the increasingly complex and dynamic
international financial marketplace of the twenty-first century. The threats to financial stability are
many, and no one set of measures can be expected to ensure against the recurrence of future
problems. Financial intermediation is a constantly evolving activity, involving new risks, instruments,
and control challenges. Financial institutions and policymakers alike should continue to upgrade their
processes to remain in command of these risks.
Stability ultimately can be served only by the collective interaction of the three pillars of:
• sound leadership at the firm level;
• effective market discipline;
• and strong prudential regulation and supervision.
Sound leadership at the firm level is the first bulwark against financial system instability, and begins
with capable and experienced directors and management, a coherent strategy and business plan, and
clear lines of responsibility and accountability. The execution of overall objectives must be supported
by rigorous internal controls and effective risk management. The importance of a strong institutional
credit culture cannot be stressed enough.
The second line of defense is effective market discipline, an increasingly important ally of
policymakers in a global marketplace. Of course, market discipline must be supported by substantial
disclosure, sound accounting standards, and an efficient and credible legal framework.
While effective bank-level management and meaningful market discipline are crucial elements of an
overall strategy for promoting and preserving financial stability, neither can substitute for the critical
role played by official supervision. The Basel Committee on Banking Supervision, which I chair, has
identified the necessary ingredients of sound supervision, and these principles must be applied to all
internationally active banks within a more dynamic, risk-based, and process-oriented framework.
Strong regulation and supervision is a crucial part of achieving financial market stability and the
proposed revisions to the International Capital Accord that were released in January by the Basel
Committee will set the standard for banks around the world.
Recognizing the clear need for a more risk-sensitive and flexible Basel Accord, the new framework is
intended to more closely align regulatory capital requirements with underlying risks, and to provide
banks and their supervisors with a range of options for the assessment of capital adequacy.
There is more emphasis on banks' own internal methodologies as well as other elements that are
critical to ensuring the capital adequacy of banks, such as strong risk management and sufficient
public disclosure of information. The Committee has also discarded the one-size-fits-all framework for
the calculation of minimum capital requirements. Instead, the proposed framework provides a menu
from which banks can choose, with the authorization of their supervisor and depending on the
complexity of their business as well as the quality of their risk management.
The Basel Committee is seeking comments on the proposed framework until the end of May and plans
to finalize the new Accord well before the end of this year, during which time the Committee will
pursue an active dialogue with non-G10 supervisors. It is envisioned that the revised Accord will be
implemented in 2004.
The role of a sound and stable macroeconomic environment
A sound and stable macroeconomic environment is also crucial for financial stability, and more
generally for promoting sustainable growth. The converse--macroeconomic overheating--raises the
likelihood of an eventual crisis, first by promoting excessive, and eventually unsustainable, external
and internal borrowing. The next step inevitably is the correction to the real economy, interest rates
and/or the exchange rate, that can sharply worsen asset quality and expose the accumulated
weaknesses in the financial system.
Role of central banks in promoting stability and growth
A central bank's most important role in achieving stable, long-term growth involves promoting price
stability. Achieving long-run price stability is a difficult and continuous challenge, as it requires
constant efforts first to detect, and then to correct the building up of internal and external imbalances.
Moreover, because of time lags in policy effectiveness, authorities often have to take action based
only on partial evidence, well before adverse symptoms are fully evident. The principal reward for
forward-looking policy is that changes in policy, and the associated stresses they engender, are
generally smaller and more easily assimilated by markets. The effectiveness of monetary policy
naturally brings us to the question of monetary and exchange rate regimes.
A great deal has been said in various forums about the choice of monetary and exchange rate
regimes. I believe it is crucial that there be consistency between a country's choice of currency regime
and its other policies. There is no "right" regime that applies to all cases and all points in time.
Experience has shown that no currency arrangement can compensate indefinitely for imperfections
elsewhere in an economy, such as weaknesses in financial supervision, an excessively loose fiscal
stance, or inflexible wages and prices. Furthermore, no exchange rate regime can offer full insulation
from cross-market spillovers, particularly where the free movement of capital is allowed. Nevertheless,
certain policy combinations can make things far more dangerous. Fixed, but adjustable, regimes look
to be particularly fraught with perils when combined with shortcomings elsewhere, not the least of
which are the severe after-effects that always seem to follow their forced abandonment.
As you are aware, much of the emerging world has moved toward floating rates in recent years. For
Thailand and the other countries that have made the change in East Asia, it would appear that the
new monetary/exchange regimes, despite their very difficult starts under the most inauspicious of
circumstances, now appear to be serving countries well. Inflation is in the very low single-digit range in
most of the newly floating economies, and in many instances the successful effort to bolster monetary
credibility has been reflected in short-term interest rates that have declined to historically low levels.
Moreover, authorities have gained new degrees of freedom to manage their economies and to
respond to changing internal and external circumstances.
But if the promised benefits of monetary discretion are to be fully realized going forward, markets need
to understand the objectives and the framework by which the monetary authorities will decide future
policy actions.
In this regard, I would note that some countries, including Thailand, have looked to inflation targeting
as a framework to accomplish that end. And indeed, inflation targeting would seem to have much to
recommend it, provided that it is approached not as a panacea, but rather as a pragmatic organizing
framework for policy. In other words, policy frameworks such as inflation targeting can be useful where
they signal a disposition towards continuous and predictable communication, and a forward-looking,
informative policy approach. But as I said, inflation targeting per se is not a sure-fire solution - for
example, the costs of disinflation do not appear to be lower in inflation-targeting countries - nor is it a
prerequisite for effective communication and ultimately effective policy.
Role of fiscal policy
Clearly, crisis prevention through promoting stable and sustainable conditions in the macro-economy
is not solely the province of central banks. Sound fiscal policies are needed to complement the
effectiveness of even the soundest monetary policies. Chronically loose fiscal policy is a persistent
threat to macroeconomic stability, through the build-up of internal and/or external debts that can be
devastating.
For the countries of East Asia, the public sector's generally low initial indebtedness provided important
latitude for dealing with the recent crises. Governments had room to stimulate aggregate demand
recovery through fiscal ease; moreover, extensions of public guarantees and capital helped to contain
the banking crises.
However, while initially strong fiscal positions provided flexibility to address financial sector problems
and aid recovery, public debt has since risen to high levels in a number of countries, and contingent
liabilities often remain significant, raising some concern about potential future debt growth.
Thus, governments now face the challenge of moving to retighten fiscal policy in the face of slowing
economies, and over the longer term, gradually restoring their earlier prudent levels of net
indebtedness. These considerations further underscore the importance of quickly completing the
process of banking sector rehabilitation and of attracting new sources of capital. Such decisive action
would allow the banking sector to again be an engine of growth, capable of offsetting the eventual
withdrawal of fiscal stimulus.
Conclusion
In closing, the recovery in Asia has been impressive indeed, and owes much to the energy and hard
work of its people, enlightened political leadership, and the substantial and focused efforts of
policymakers to implement sound macroeconomic and financial policy. But the recovery is not yet
complete and much remains to be done.
While the crisis did substantial damage, it has not fundamentally affected Asia's prodigious economic
strengths. But if Asia is to realize its potential, it is critical that authorities attend to the unfinished
business that remains while continuing to put in place longer-term measures to promote financial
resilience, ensure the sustainability of public sector debt burdens, and encourage sustainable growth.
Asia is at an important crossroads and there is now a unique opportunity to consolidate recent reforms
and implement lasting change that will pay dividends for years to come.
Thank you for your kind invitation and attention. I would be happy to take any questions you may
have.