Mr Greenspan draws lessons from the global crises of 1997 and 1998
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the World Bank Group and the International Monetary Fund, Program of Seminars,
Washington, D.C., on 27 September 1999.
* * *
With the benefit of hindsight, we have been endeavoring for nearly two years to distill the critical
lessons from the global crises of 1997 and 1998. From what seemed at the time to be isolated and
contained disruptions in Thailand and Indonesia, economic turmoil deepened and spread, ultimately
engulfing the emerging-market economies of East Asia and other parts of the globe and then the
financial markets of industrial countries.
The failure of normal adjustment processes to contain the financial turmoil made this crisis longer and
deeper than any of us had expected in its early days. One possible clue to this breach may reside not in
the events leading up to the East Asian crisis in the spring of 1997, but rather in the extraordinary
episode of financial market seizure that afflicted some emerging-market and industrial-country
markets, particularly in the United States, a year ago.
Following the Russian default of August 1998, public capital markets in the United States virtually
seized up. For a time not even investment-grade bond issuers could find reasonable takers. While
Federal Reserve easing shortly thereafter doubtless was a factor, it is not credible that this move was
the whole explanation of the dramatic restoration of most, though not all, markets in a matter of
weeks. The seizure appeared too deep seated to be readily unwound solely by a cumulative 75 basis
point ease in overnight rates. Arguably, at least as relevant was the existence of backup financial
institutions, especially commercial banks, that replaced the intermediation function of the public
capital markets.
As public debt issuance fell, commercial bank lending accelerated, effectively filling in some of the
funding gap. Even though bankers also moved significantly to risk aversion, previously committed
lines of credit, in conjunction with Federal Reserve ease, were an adequate backstop to business
financing.
With the process of credit creation able to continue, the impact on the real economy of the capital
market turmoil was blunted. Firms were able to sustain production, business and consumer confidence
were not threatened, and a vicious circle - an initial disruption in financial markets leading to losses
and bankruptcies among their borrowers and thus further erosion in the financial sector - never got
established.
What we perceived in the United States in 1998 may be an important general principle: multiple
alternatives to transform an economy's savings into capital investment offer a set of backup facilities
should the primary form of intermediation fail. In 1998 in the United States, banking replaced the
capital markets. Far more often it has been the other way around, as it was most recently in the United
States a decade ago.
Highly leveraged institutions, such as banks, are, by their nature, periodically subject to seizing up as
difficulties in funding leverage inevitably arise. The classic problem of bank risk management is to
achieve an always elusive degree of leverage that creates an adequate return on equity without
threatening default.
The success rate has never approached 100%, except where banks are credibly guaranteed, usually by
their governments, in the currency of their liabilities. But even that exception is by no means ironclad,
especially when that currency is foreign.
When American banks seized up in 1990, as a consequence of a collapse in the value of real estate
collateral, the capital markets, largely unaffected by the decline in values, were able to substitute for
the loss of bank financial intermediation. Interestingly, the then recently developed mortgage-backed
securities market kept residential mortgage credit flowing, which in prior years would have contracted
sharply. Arguably, without the capital market backing, the mild recession of 1991 could have been far
more severe.
Similarly Sweden, like the United States, has a corporate sector with a variety of non-banking funding
sources. Bank loans in Sweden in the early 1990s were concentrated in the real estate sector, and when
real estate prices also collapsed there, a massive government bailout of the banking sector was
initiated. The Swedish corporate sector, however, rebounded relatively quickly. Its diversity in funding
sources may have played an important role in this speedy recovery, although the rapidity and vigor
with which Swedish authorities addressed the banking sector's problems undoubtedly was a
contributing factor.
The speed with which the Swedish financial system overcame the crisis offers a stark contrast with the
long-lasting problems of Japan, whose financial system is the archetype of virtually bank-only
financial intermediation. The keiretsu conglomerate system, as you know, centers on a "main bank,"
leaving corporations especially dependent on banks for credit. Thus, one consequence of Japan's
banking crisis has been a protracted credit crunch. Some Japanese corporations did go to the markets
to pick up the slack. Domestic corporate bonds outstanding have more than doubled over the decade
while total bank loans have been almost flat. Nonetheless, banks are such a dominant source of
funding in Japan that this non-bank lending increase has not been sufficient to avert a credit crunch.
The Japanese government has intervened in the economy and is injecting funds in order to recapitalize
the banking system. While it has made some important efforts, it has yet to make significant progress
in diversifying the financial system - which arguably could be a key element, although not the only
one, in promoting long-term recovery. Japan's banking crisis is also ultimately likely to be much more
expensive to resolve than the American and Swedish crises, again providing prima facie evidence that
financial diversity helps limit the effect of economic shocks.
This leads one to wonder how severe East Asia's problems would have been during the past eighteen
months had those economies not relied so heavily on banks as their means of financial intermediation.
One can readily understand that the purchase of unhedged short-term dollar liabilities to be invested in
Thai baht domestic loans (counting on the dollar exchange rate to hold) would at some point trigger a
halt in lending by Thailand's banks. But why did the economy need to collapse with it? Had a
functioning capital market existed, the outcome might well have been far more benign.
Before the crisis broke, there was little reason to question the three decades of phenomenally solid
East Asian economic growth, largely financed through the banking system, so long as the rapidly
expanding economies and bank credit kept the ratio of non-performing loans to total bank assets low.
The failure to have backup forms of intermediation was of little consequence. The lack of a spare tyre
is of no concern if you do not get a flat.
East Asia had no spare tyres. The United States did in 1990 and again in 1998. Banks, being highly
leveraged institutions, have, throughout their history, periodically fallen into crisis. Where there was
no backup, they pulled their economies down with them. One can wonder whether in nineteenth
century United States, when banks were also virtually the sole intermediary, the numerous banking
crises would have periodically disabled our economy as they did, had alternate means of
intermediation been available.
In dire circumstances, modern central banks have provided liquidity, but fear is not always assuaged
by cash. Even with increased liquidity, banks do not lend in unstable periods. The Japanese banking
system today is an example: the Bank of Japan has created massive liquidity, yet bank lending has
responded little.
With very large non-performing loans of indeterminate value, the size of capital in Japanese banks is
difficult to judge. The periodic eruption of the so-called Japanese funding premium in recent years
attests to the broad degree of uncertainty of the viability of individual banks. This understandably
creates considerable caution on the part of Japanese bank loan officers in committing scarce bank
capital. But unlike the United States and Sweden a decade ago, alternate sources of finance are not yet
readily available.
The Swedish case, in contrast to America's savings and loan crisis of the 1980s and Japan's current
banking crisis, also illustrates another factor that often comes into play with banking sector problems:
speedy resolution is good, whereas delay can significantly increase the fiscal and economic costs of a
crisis. Resolving a banking-sector crisis often involves government outlays because of implicit or
explicit government safety net guarantees for banks. Accordingly, the political difficulty in raising
taxpayer funds has often encouraged governments to procrastinate and delay resolution, as we saw
during our savings and loan crisis. Delay, of course, can add to the fiscal costs and prolong a credit
crunch.
The annals of the United States and others over the past several decades tell us that alternatives within
an economy for the process of financial intermediation can protect that economy when one of those
financial sectors experiences a shock. But the mere existence of a diversified financial system may
well insulate all aspects of a financial system from breakdown. Australia serves as an interesting test
case in the most recent Asian financial turmoil. Despite its close trade and financial ties to Asia, the
Australian economy exhibited few signs of contagion from contiguous economies, arguably because
Australia already had well-developed capital markets as well as a sturdy banking system. But going
further, it is plausible that the dividends of financial diversity extend to more normal times as well.
It is not surprising that banking systems emerge as the first financial intermediary in market
economies as economic integration intensifies. Banks can marshal scarce information about the
creditworthiness of the borrower to guide decisions about the allocation of capital. The addition of
distinct capital markets outside of banking systems is possible only if scarce real resources are devoted
to building a financial infrastructure. It is a laborious process whose payoff is often experienced only
decades later. It is thus difficult to initiate, especially in emerging economies that are struggling to
edge above the poverty level. They perceive the need to concentrate on high short-term rates of return
to capital rather than accept more moderate returns stretched over a longer horizon. We must
continuously remind ourselves that financial infrastructure comprises a broad set of institutions whose
functioning, like all else in a society, must be consistent with the underlying value system and hence
its time preference.
On the surface, financial infrastructure appears to be a strictly technical concern. It includes
accounting standards that accurately portray the condition of the firm, legal systems that reliably
provide for the protection of property and the enforcement of contracts, and bankruptcy provisions that
lend assurance in advance as to how claims will be resolved in the inevitable result that some business
decisions prove to be mistakes. Such an infrastructure in turn promotes transparency within enterprises
and corporate governance procedures that will facilitate the trading of claims on businesses in open
markets using standardized instruments rather than idiosyncratic bank loans. But the development of
such institutions is almost invariably molded by the culture of a society. The antipathy to the "loss of
face" in Asia makes it difficult to institute, for example, the bankruptcy procedures of western nations.
And even the latter differ from one another owing to deep-seated differences in views of
creditor-debtor relationships. Arguably the notion of property rights in today's Russia is subliminally
biased by a Soviet education that inculcated a highly negative view of individual property ownership.
Corporate governance that defines the distribution of power, of course, invariably reflects the most
profoundly held societal views of the appropriate interaction of parties in business transactions.
It is thus not a simple matter to append financial infrastructure to an economy developed without it.
Accordingly, full convergence across countries of domestic financial infrastructure or even of the
international components of financial infrastructure is a very difficult task.
Nonetheless, the competitive pressures toward convergence will be a formidable force in the future if,
as I suspect, additional forms of financial intermediation will be increasingly seen as benefiting an
economy that develops capital markets. Moreover, a broader financial infrastructure will also likely be
seen as strengthening the environment for the banking system and enhancing its performance. The
result almost surely will be a more robust and more efficient process of capital allocation, as a recent
study by Ross Levine and Sara Zervos suggests.1
Its analysis reinforces the conclusion that financial market development improves economic
performance, over and above the benefits offered by banking sector development alone. The results
are consistent with the idea that financial markets and banks provide useful, but different, bundles of
financial services.
It is no coincidence that the lack of adequate accounting practices, bankruptcy provisions, and
corporate governance have been mentioned as elements in several of the recent crises that so disrupted
some emerging-market countries. Had these elements been present, along with the capital markets they
would have supported, the consequences of the initial shocks of early 1997 may well have been quite
different.
It is noteworthy that the financial systems of most continental European countries escaped much of the
turmoil of the past two years. And looking back over recent decades, we find fewer examples in
continental Europe of banking crises sparked by real estate booms and busts or episodes of credit
crunch of the sort I have mentioned in the United States and Japan.
Until recently, the financial sectors of continental Europe were dominated by universal banks, and
capital markets are still less well developed there than in the United States or the United Kingdom.
The experiences of these universal banking systems may suggest that it is possible for some
bank-based systems, when adequately supervised and grounded in a strong legal and regulatory
framework, to function robustly.
But these banking systems have also had substantial participation of publicly owned banks. These
institutions rarely exhibit the dynamism and innovation that many private banks have employed for
their, and their economies', prosperity. Government participation often distorts the allocation of
capital to its most productive uses and undermines the reliability of price signals. But at times when
market adjustment processes might have proved inadequate to prevent a banking crisis, such a
government presence in the banking system can provide implicit guarantees of resources to keep credit
flowing, even if its direction is suboptimal.
In Germany, for example, publicly controlled banking groups account for nearly 40% of the assets of
all banks taken together. Elsewhere in Europe, the numbers are less but still sizable. In short, there is
some evidence to suggest that insurance against destabilizing credit crises has been purchased with a
less efficient utilization of capital. It is perhaps noteworthy that this realization has helped engender a
downsizing of public ownership of commercial banks in Europe, coupled with rapid development of
heretofore modest capital markets, changes which appear to be moving continental Europe's financial
system closer to the structure evident in Britain and the United States.
Diverse capital markets, aside from acting as backup to the credit process in times of stress, compete
with a banking system to lower financing costs for all borrowers in more normal circumstances. Over
the decades, capital markets and banking systems have interacted to create, develop, and promote new
instruments that improved the efficiency of capital creation and risk bearing in our economies.
Products for the most part have arisen within the banking system, where they evolved from being
specialized instruments for one borrower to having more standardized characteristics.
At the point that standardization became sufficient, the product migrated to open capital markets,
where trading expanded to a wider class of borrowers, tapping the savings of larger groups. Money
market mutual funds, futures contracts, junk bonds, and asset-backed securities are all examples of this
process at work.
Once capital markets and traded instruments came into existence, they offered banks new options for
hedging their idiosyncratic risks and shifted their business from holding to originating loans. Bank
trading, in turn, helped these markets to grow. The technology-driven innovations of recent years have
facilitated the expansion of this process to a global scale. Positions taken by international investors
within one country are now being hedged in the capital markets of another: so-called proxy hedging.
But developments of the past two years have provided abundant evidence that where a domestic
financial system is not sufficiently robust, the consequences for a real economy of participating in this
new, complex global system can be most unwelcome.
Improving deficiencies in domestic banking systems in emerging markets will help to limit the toll of
the next financial disturbance on their real economies. But if, as I presume, diversity within the
financial sector provides insurance against a financial problem turning into economy-wide distress,
then steps to foster the development of capital markets in those economies should also have an
especial urgency. And the difficult ground work for building the necessary financial infrastructure -
improved accounting standards, bankruptcy procedures, legal frameworks and disclosure - will pay
dividends of their own.
The rapidly developing international financial system has clearly intensified competitive forces that
have enhanced standards of living throughout most of the world. It is important that we develop
domestic financial structures that facilitate and protect our international financial and trading systems
that, aside from their periodic setbacks, have brought so much good.