Mr Crockett asks whether the international
financial system needs mending
Speech by Mr Andrew Crockett, General Manager of the Bank for International Settlements and
Chairman of the Financial Stability Forum, at the Friedrich-Ebert-Stiftung in Frankfurt on 8 December
1999.
* * *
The collapse of the Bretton Woods system in the early 1970s marked an important turning point in the
post-war evolution of the financial system. Until about that time, the international monetary system
was a heavily managed and administered one, based on fixed exchange rates, regulated domestic
markets and restrictions on the cross-border flow of financial capital. As these arrangements crumbled
under the weight of widening payment imbalances and the growing internationalisation of finance, a
market-led system emerged. The process of equilibrium-seeking and adjustment was progressively left
to the forces of competition. Exchange rates were allowed to float, domestic financial intermediation
was liberalised and capital accounts were gradually opened. Some labelled these new arrangements a
"non-system" - although there is nothing inherently unsystematic about an economic system based on
competitive forces and decentralised decision taking.
For the last quarter century or so, domestic as well as international financial arrangements have thus
relied on increasingly open and integrated markets as the main engines of adjustment and stability.
Spurred by the freedom to innovate, technological progress and the appeal of investment opportunities
in an increasingly global economy, financial activity has expanded enormously. The role of the
financial sector in mobilising and allocating resources, both within national economies and across
geographic boundaries, has expanded commensurately. For the most part, an open international
financial system has operated to the benefit of economic activity and wider social welfare. It has
channelled savings to countries with productive investment opportunities, it has been a vehicle for the
transfer of managerial and technological know-how, and it has served as a source of discipline on
unsustainable and harmful macroeconomic policies. An open trading and financial environment
enabled many Asian countries to lift their peoples out of poverty in the space of a single generation.
Recent years, however, have witnessed events that show the darker side of these market forces. A
particularly virulent crisis enveloped several Asian economies in 1997. Only shortly thereafter, Russia
and Brazil succumbed to financial turmoil. And even financial markets in the more mature economies
took fright as the globalisation of markets allowed contagion to spread beyond the emerging market
economies. The social costs, while not wiping out earlier gains, were severe.
Do these crises demonstrate that the post-Bretton Woods model of financial arrangements has
outlasted its useful life? Do financial markets show an inherent and damaging instability which argues
for a return to administrative control? Is now the time to consider a fundamental change in the way
financial activity is organised, in the way it is monitored and managed, and in the way losses and gains
are shared? Many indeed are calling for a "new financial architecture", though concrete proposals of
what this new construction could look like have yet to be formulated.
My own view is that the basic components of today's system of financial intermediation continue to be
the only reliable and efficient ones, but that the rough edges of the market-led system need better
monitoring and in some cases repair. In other words, the architecture or design of the financial system
- the basic rule of decentralised, market-led decision-making - remains sound, but its internal wiring
and plumbing - the preconditions which ensure that markets can indeed operate efficiently and stably
- may require upgrading.
* * *
Which are the areas of vulnerability or failure which cause markets to display excessive instability,
and lead to such severe costs? And why are financial markets particularly prone to such failures? At
the risk of over simplification, I propose to focus on three sources of market failure which have been
particularly prevalent in the recent episode of worldwide financial turbulence. They are: first, the lack
of relevant information and its asymmetric distribution across market participants; second, the
presence of externalities that can give rise to undesired and unintended market outcomes; and third,
the difficulty of establishing an adequate infrastructure in financial markets. Note that I make hardly
any distinction between the domestic and the international financial system. With the globalisation of
finance and the lifting of controls, the two have basically merged. As I will argue, however, dealing
with market failures at the international level may be much more complex than in a domestic setting.
Information and financial activity
Let me start with the first area of financial market vulnerability, that of information deficits. Financial
activity is particularly information-intensive. More than any other sector perhaps, financial markets
have to cope with a high degree of uncertainty. This is a reflection of the fact that by nature finance is
an intertemporal activity: services to which counterparties commit themselves in financial contracts
are delivered over sometimes very long periods during which circumstances can change in unforeseen
ways. Moreover, with finance having become increasingly borderless, exposures have grown to
counterparties and markets much less familiar than those at home. The global and the intertemporal
character of financial intermediation therefore puts a premium on ensuring that clear and
comprehensive information is at the disposal of market participants.
Yet such information is often not readily available. It may be expensive, or it may be distributed
unevenly across market players. Not all participants are willing to bear the cost of collecting the
necessary information, in particular when it is easy for others to free-ride on their efforts. Decisions
may then be taken on the basis of a less-than-complete information set and risks may be run which in a
more informed environment would have been avoided.
Another frequent occurrence in financial markets is that participants have unequal access to
information. Borrowers typically are several steps ahead of lenders in knowing the probabilities of
success of their projects and how gains and losses might be shared. Lenders may be unaware that the
funds they provide flow to the most risky investments, or are wasted on less productive activities. To
protect themselves against this information deficit, lenders may ration their finance or even withdraw
from participation altogether. In the economic literature, these problems, known as adverse selection
and moral hazard, have been shown to have a negative impact on financial market efficiency,
especially in a cross-border setting.
The recent Asian crisis is a good example of how lending and borrowing decisions can be biased by
lack or uneven distribution of information. Few investors realised to what extent the massive flow of
foreign-currency funds into several Asian economies was diverted into activities with little or no
prospects of generating foreign-currency resources, or, should the economy turn down, of yielding any
returns at all. Confidence in official reserve data was greatly shaken as it became clear to what extent
foreign exchange assets were mortgaged by massive short forward positions in Thailand or by
placements in overseas branches of Korean banks facing problems themselves in meeting foreign
currency obligations.
Moral hazard was also a problem. Given that they believed that their liabilities were implicitly
guaranteed, Korean chaebol embarked on a largely unfettered investment spree. At the same time,
domestic banks and foreign investors in South East Asian countries took unwarranted comfort from
governments' commitments to maintain fixed exchange rates, or from expectations that the
international community would help safeguard private investment. These expectations prolonged the
period of excessive capital inflow; and thus rendered more costly its eventual reversal.
Market outcomes: the sum of its parts or somewhat less?
A second problem in financial markets is that the sum of individual decisions which on their own are
perfectly rational may not always lead to a stable equilibrium or a socially desirable outcome. A
sudden loss of confidence in one particular bank can sometimes lead to an indiscriminate run on the
entire banking system. Similarly, evidence of an isolated foreign debt servicing problem can be
magnified into a generalised "rush for the exits". The crisis which follows almost always seems to
push the domestic currency beyond an equilibrium level with damaging social consequences. In both
of these examples, attempts by individual agents to protect their financial positions generate
externalities which precipitate the very consequence against which these actions are designed to guard.
Many other examples of similar problems of aggregation in financial markets can be given. Herd
instinct is often identified as one of the main factors behind the surges in capital flows and their
sudden shifts in recent years. Such herd behaviour may be rational in the context in which it occurs.
Fear of under performance runs deep in the highly competitive financial industry and induces portfolio
managers to mirror each other's investment strategies or to stick close to benchmarks. Often, too,
attitudes are more lenient towards those who are wrong in good company, than to those making a
wrong bet on their own. Whether understandable or not, herd behaviour nevertheless adds to an
unacceptable degree of volatility in financial markets.
In the East Asian case, herd instinct undoubtedly played a part in the over-lending that preceded the
crisis. Western banks and fund managers were fearful of being left behind in the rush to participate in
the Asian "miracle". Then, when sentiment turned, investors wanted to reduce their exposure as
rapidly as possible, fearing a currency and banking collapse that would threaten their investments.
With limited reserves and borrowing possibilities, the countries in the region all saw their currencies
overshoot. The succeeding interaction of banking and currency problems imposed costs out of all
proportion to the original policy mistakes.
At times, these aggregation problems are in part self-inflicted. If short-term lending enjoys more
favourable risk weights than longer-term credit exposures, as is the case in the 1988 Basel Capital
Accord, creditors may want to shorten the maturity of their cross-border claims even further, in
particular when the economic climate becomes more gloomy. However, if all lending becomes short
term, the vulnerability of borrowers will rise substantially and the intrinsic liquidity of their liabilities
may be much lower than if the maturity of their exposures had been kept more medium term.
In sum, instead of helping to build a stable equilibrium for a diversified set of profit-maximising
agents, the market mechanism may at times fall prey to one-dimensional views and become one-sided,
producing highly volatile outcomes and price overshooting. It would be too much to say this was the
cause of the Asian crisis, but it may have contributed to its unexpected virulence.
Inadequate infrastructure
A final major area of fragility in financial markets is that of an insufficiently developed infrastructure.
Financial market infrastructure covers a very broad range of elements. It includes modern contract law
and efficient law enforcement procedures. It deals with accounting rules and valuation standards, with
prudential regulations, effective supervision and appropriate disclosure requirements. It also covers the
creation of well-functioning payments and settlement systems and the design of safety net provisions.
In many respects, this infrastructure is a public good. It is of benefit to all, but market participants will
not be able or willing to supply or fund it fully. It will therefore be left to the relevant authorities to
ensure that the necessary infrastructure is put in place and ways are found to share its cost among
participants.
Financial history if replete with cases of crisis which were caused by poor supervision, inadequate
legal frameworks or deficient payment and settlement arrangements. This shows how complex and
expensive a well-performing infrastructure is, in particular in an international context. It also explains
why so often these public goods are being undersupplied and markets often remain immature.
Moreover, the financial infrastructure may propagate biased incentives and excessively risky
behaviour as long as its design is faulty and pricing inappropriate.
In the case of countries affected by the recent crises, financial supervisory arrangements were almost
always deficient in some respects. Accounting conventions were applied insufficiently rigorously, and
financial institutions were allowed to become excessively exposed. In some countries, bankruptcy
arrangements were virtually non-existent, and in those where they existed, they were often subject to
delays. Hence the process of recovering value from impaired financial claims (an essential part of a
well-functioning financial system) was burdened by major uncertainties. In Russia, the costs of the
absence of reliable contract law and law enforcement are at their most evident.
* * *
It is now time for me to move from problems to solutions. But first, let me briefly recapitulate the
argument so far. Open markets continue to be the most appropriate and efficient arrangement for
allocating resources and bringing about adjustment. From this perspective, there is no real alternative
to the present basis for financial intermediation, both domestic and cross-border. However, this firm
belief should not blind us to the inherent vulnerabilities which characterise financial markets. I
therefore now propose to explore for a few minutes the approaches we may take to find solutions to
these market failures.
Information
First, how to ensure that market participants have adequate access to the information they need? An
impressive list of recent initiatives in this area can be put together. The efforts have moved in three
distinct directions. Some have been aimed at improving participants' appreciation of the risks in the
macroeconomic environment. The IMF's Special Data Dissemination Standard is an example of this
kind of initiative, as are efforts to improve the consistency of international reserve data. Others have
sought to increase our understanding of the potential implications of the build-up of market positions
and price trends in particular markets; examples of this effort are the more timely international
banking statistics provided by the BIS. Still others aim at sharpening awareness of the
creditworthiness of counterparties; the work of private sector groupings in laying down more rigorous
counterparty credit guidelines should improve disclosure practices in this area.
But rather than elaborate on specific initiatives, I would prefer to make two more general observations.
First, unlike what financial news services would like us to believe, the main issue that confronts us is
not so much to generate more information, but better information. Relevant, clear and comprehensive
information, and its efficient disclosure and dissemination, are what is called for. From the point of
view of the authorities, the challenging task here will be to transmit the correct guidance to financial
markets and participants. Blanket guarantees and time-inconsistent commitments to exchange rate
targets have all too often been part of the messages which the authorities have conveyed to financial
markets. The recent crises in much of the emerging world have shown how counterproductive, if not
disastrous, this market guidance can be.
My second point is that not only do we need to consider carefully what the right information is, we
also have to put in place the appropriate incentives for participants to use and disclose it. Awareness of
this incentive issue can be found in the proposed revision of the Basel Capital Accord. For instance,
sovereign risk weights are expected to be lower for those countries which have reached internationally
accepted standards with respect to data dissemination. More importantly perhaps, the new accord's
call for more comprehensive qualitative supervision, rather than the mechanical checking of
quantitative ratios, is likely to induce banks to focus on their risk management and monitoring
capabilities, and thus on their ability to incorporate all information that is relevant to risk control.
There is little doubt in my mind that the encouragement of a credit culture which requires lending
officers to realistically appraise the credit and market risks of their portfolio or investment decisions
will generate many incentives to use and disclose market-relevant information.
Externalities
I come now to the second area of market vulnerability, that of undesired externalities and aggregation
problems. This may be even more complex. In theory it is course possible to consider the radical
solution of forcing financial institutions to reduce their leverage and increase the degree of their
liquidity so much that a run on them becomes highly unlikely. Similarly, one could consider pushing
countries into holding a sufficiently large stock of international reserves which would reduce the
likelihood of currency runs to a minimum. However, the costs of such measures in terms of efficiency
and economic growth would be large. The financial sector makes its contribution to the wider
economy by adding to the liquidity of intersectoral claims. This depends on leverage. To reduce its
capacity to this would involve economic costs. We therefore need to strike a balance between
efficiency and stability objectives.
Much more constructive, I feel, would be to improve our understanding of how financial regulation
can give rise to aggregation issues and generate externalities. Greater awareness of the link between
individual behaviour and market outcomes can contribute to better rules and more appropriate market
guidance. As a result, the incidence of capital flow volatility would be less. More discriminating and
critical behaviour on the part of market participants may be promoted, and a bunching of particular
types of lending and investment might be more easily avoided.
No doubt, many controversial issues will have to be dealt with in this area, and solutions which seem
adequate from one point of view may be questionable when looked at from a different angle. For
instance, the pressure to maintain prescribed capital ratios is sometimes argued to have undesirable
macroeconomic consequences. The need to satisfy capital requirements can aggravate economic
recessions, if banks feel forced to curtail their lending beyond what the underlying economic situation
would warrant. Similarly, a comfortable capital cushion in economic booms may induce banks to
engage in lending sprees. To the extent they have pro-cyclical effects, capital requirements may
generate externalities and aggregation effects.
Some have accordingly argued that institutions should be allowed to run down capital in recessions
and rebuild it in periods of greater economic buoyancy. Whatever the appeal of this argument,
however, it ignores the fact that a capital cushion is needed precisely when economic conditions are
adverse and confidence is shaky. A policy which appears beneficial to the macroeconomy could then
be harmful to the soundness of the financial system and, through this channel, put economic stability
in even greater danger. If, therefore, banks' capital is to serve its purpose as a cushion in bad times, it
follows that banks should hold additional capital reserves when times are good.
Infrastructure and public goods
Finally, what could be done to ensure that sufficient public goods are supplied for an efficient
functioning of financial markets? Governments have generally accepted the responsibility at the
domestic level to provide the main elements of the infrastructure which financial markets need.
Unfortunately, most of these domestic initiatives cannot be simply transposed to the international
level. Insolvency arrangements may be effective within national boundaries, but remain complicated,
even non-existent, when the insolvency involves sovereign states or relates to cross-border claims.
Supervision remains in the hands of national regulatory authorities, creating difficulties of
communication and coordination once financial activity becomes more global. The problem is further
compounded by the fact that different types of financial institution are often supervised separately and
according to differentiated rules. To a certain extent, the "Core Principles" for effective supervision
developed by the various regulatory bodies, address these problems; however, their implementation
still has to proceed much further.
Safety net provisions promote the stability of the domestic financial system, but are discussed at best
in a conceptual or abstract manner at the international level. Even in areas which seem more
manageable, such as the definition of appropriate accounting standards and valuation principles,
international acceptance and uniformity are still a long way from being realised. Most of these issues
are being addressed in various expert groupings, but the complexities of the issues at hand limit the
speed at which progress can be made.
* * *
If we are to make significant progress in proposing solutions to and correcting the main financial
market failures, strategy will be an important consideration. By this I mean, how does the international
community go about reaching agreement on how market failures are tackled, then ensuring that the
necessary measures are implemented.
The first thing to say is this is not an area that lends itself to international treaties. Prudent financial
behaviour is not something that can easily be reduced to legislative provisions. For a variety of
reasons, the most promising approach appears to be the development of standards of best practice,
whose implementation is encouraged by market forces, and effectively monitored by impartial
assessment. For this approach to gain broad acceptance, it should, first of all, be the outcome of a
legitimate process of standard setting. By this, I mean that the task should be carried forward by
national experts who from their own direct experience are familiar with the practical issues of best
practice and how to promote it. Legitimacy also implies that a representative sample of countries
should be involved or consulted.
Second, discussions need to focus on the many ways in which measures in one area impact on other
areas. Supervisors of banks, for example, need to be aware of how their activities impact on the choice
between bank finance and other forms of intermediation. More generally, there needs to be a better
appreciation of how "environmental" factors such as corporate governance practices, accountancy
conventions and bankruptcy arrangements affect the balance of risks and incentives in the financial
sector. And third, the general purpose of the exercise should be to promote a better understanding and
pricing of risks, not so much by administrative directives and regulation, as through the reinforcement
of appropriate incentives and behaviour.
In much of the committee work done at the BIS, attention is given as much as possible to these
principles of strategy. By focussing on the soundness of institutions (via the Basel Committee on
Banking Supervision), the functioning of financial markets (via the Committee on the Global Financial
System) and the development of the market infrastructure (via the Committee on Payment and
Settlement Systems) committees have sought to address the multifaceted nature of financial
intermediation. By relying on consensus building among national experts and by encouraging the
active involvement of major emerging market economies, the legitimacy of the "Basel process" has
become more widely accepted. And increasingly, the propagation of appropriate incentives have come
to dominate committee recommendations.
However, financial stability is not the preserve of a few committees or institutions. It is the combined
responsibility of central banks, supervisory agencies, ministries of finance, international organisations
and standard-setting bodies that have been created within the various segments of the financial market.
The G7, in a report by Hans Tietmeyer, recognised the need to establish an institutional setting in
which all these agencies charged with financial stability could be brought together. The proposal led to
the establishment earlier this year of the Financial Stability Forum, which I have the honour to chair.
Its agenda focuses on increasing the awareness of the inter-relationships between the various aspects
of financial stability, promoting the exchange of information and the identification of gaps, and
enhancing the efficiency of standard setting. In other words, the Forum seeks to address the three areas
identified as major sources of vulnerability in financial markets.
Its composition reflects the diversity of interests in financial stability, and could so help to foster
greater understanding of the macro/microprudential interface among those charged with supervision
and standard setting and those concerned with macroeconomic stability. Finally, it may also help to
deal with what is to be considered the four-letter word in financial stability, namely the issue of "turf"
or the unproductive competition or lack of cooperation between agencies charged with overlapping
responsibilities.
The Financial Stability Forum brings together a wide cross-section of individuals and institutions
involved in the promotion of financial stability. The G7 countries are represented by their Deputy
Finance Ministers, Deputy Central Bank Governors and Heads of Supervision (in the case of
Germany, this means Caio Koch-Weser, Jürgen Stark and Wolfgang Artopoeus). In addition, four
other countries with systematically important financial markets are represented. The major
international institutions (the IMF, World Bank, OECD and BIS) also participate, as do the main
standard-setting bodies - the Banking, Insurance and Securities Regulators and the international
Committee on Payment and Settlement Systems.
As you see, therefore, the Forum is well constituted to take a comprehensive view of financial stability
issues. It has also incorporated the views of a wide range of countries not directly represented in the
Forum through their participation in Working Groups. At its inaugural meeting, the Forum decided to
set up three working groups covering, respectively, Highly Leveraged Institutions, Offshore Financial
Centres and Capital Flows. I expect these working groups to deliver their final reports in March. The
reports themselves will contain a number of concrete, implementable recommendations that, when
adopted, will have the effect of making the financial system safer.
I mentioned a moment ago the role of standards of best practice as a means of focussing efforts to
improve financial system stability. Of course the drawing up of standards has to be accompanied by a
means to encourage their implementation. The Forum is addressing this issue in a newly-established
working group chaired by Andrew Sheng of the Hong Kong Securities Commission. Effective
implementation requires incentives to put standards into effect, prioritisation to ensure that the key
weaknesses are tackled first, monitoring to assess compliance, and often technical assistance, to give
supervisory authorities access to relevant knowledge and expertise. I believe the Forum can play a key
role in bringing together the resources in its various members to help bring all this about.
Lastly, let me note briefly the role of the Financial Stability Forum as a source for information. The
Forum's website contains a compendium of the standards (43 in all) that have been developed in the
financial area. It also contains an inventory of training availability. We will be building up this facility
in the future to provide, we hope, a genuine focal point for sharing information on initiatives in the
field in financial stability.
* * *
In conclusion, the market-led system of financial intermediation has served the world very well, most
of the time. By lifting the liquidity constraints inherent in administrative controls and excessive
regulation, today's financial arrangements have contributed to output and income growth of
enterprises and households alike. The most vivid illustrations of the potential of open financial
markets to raise efficiency and improve resource allocation are the spectacular growth rates which
several emerging market economies realised over the last two decades.
But recurrent bouts of financial turmoil, not least in those high-performing economies, also
demonstrate that financial markets do not always work efficiently and produce competitive outcomes.
I have concentrated here on three types of market failure which can cause major financial shocks and
damaging instability. For some these failures are sufficient ground for advocating a return to
administrative control of financial activity. I do not share this view. But I am honest enough to
recognise that much still needs to be done to mitigate the vulnerabilities in financial markets. And
modest enough to admit that this will be a protracted process, heavily dependent on the political will to
succeed.