Roger W Ferguson, Jr: Realism during times of opportunity
Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, at Widener University, Chester, Pennsylvania on 6 April 2000.
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It is a pleasure to be here at Widener University and to join the list of Federal Reserve officials who
have addressed this distinguished audience. As you know, the current economic expansion is now the
longest in our nation's history. This is due, in part, to a combination of good fiscal and monetary
policies. However, more than anything that we do in Washington, D.C., the economy's strength is the
direct result of the myriad private decisions made on a daily basis by you and all Americans. In a very
real sense, you are the heroes of this story, and you deserve to be commended.
Having said that, it is important to be mindful that now is the most important time for realism,
prudence, and vigilance by both policymakers and the public at large. We should be mindful that
generally good economic times can soften the impact of - and often mask totally - poor judgments.
Eventually, however, those judgments will have detrimental consequences. Let me focus on three
areas of realism that are required in this time of historic opportunity: the financial sector, individual
decisions, and the international sphere.
Realism in the financial sector
As you know, at the end of last year, the Congress passed and the President signed into law a bill to
modernize the financial industry of the United States. This law, the Gramm-Leach-Bliley Act, presents
opportunities and challenges for the financial sector, which must be approached realistically and
prudently. The most obvious opportunity for the financial sector now is one of ongoing consolidation
and broadening - consolidation largely in continuing response to the end of legal constraints on
geographical operations and broadening as financial institutions take advantage of the opportunities to
expand lines of business offered by the act. The consolidation movement among banking
organizations, of course, predates the passage of the most recent financial modernization law. In fact,
it is reasonable to believe that the forces for consolidation and broadening were so strong that they
provided an impetus for the repeal of Glass-Steagall, following a generation of effort not only by the
Congress but also by financial institutions and regulators. Nevertheless, by enhancing certainty about
what can be done and how it can be done, I believe that the financial modernization law will likely
bring an increase in mergers among firms that had been specializing in different financial services.
These mergers will be undertaken to take advantage of the perceived synergies and cost advantages
imagined from such combinations. If synergies in back office operations or in delivery of service can
be captured, such linkages might well provide a more efficient, and hence less costly, delivery of
complementary services.
The extent of consolidation and broadening remains in question, however, which gives rise to the
second opportunity: the opportunity to deepen specialization. In a world of large, full-service
providers, I think there will be demand for specialty providers. These niche players presumably will be
smaller and potentially more competitively agile than the larger competitors. The ability to foresee the
creation of important specialty competitors requires no more than an ability to generalize from other
industries, such as retailing, in which consolidation has existed side by side with the emergence of
successful specialty businesses.
Another opportunity open to the financial sector is the continuation of the impressive trend toward
globalization and international consolidation. Major overseas markets are becoming more open,
although the degree of openness varies from market to market. "Big bangs" have occurred in major
markets, and privatization is the norm in a number of others. Of course, wisely or not, some still
demand "national champions", and others worry about privatizing the "crown jewels". Importantly,
the sophistication, scale, and scope that firms are building domestically, both here and in Europe,
translates easily into a global platform. Examples abound: not only the success of US securities firms
in European and Asian markets but also European banks in the United States.
Also, the emergence of the euro as a successful global currency, with the payments infrastructure,
unified monetary policy, and converging fiscal policies that are associated with it, creates an attractive,
large market. This is a market that US firms have found, and will continue to find, hospitable and in
which European cross-border mergers will, no doubt, continue. And, of course, the deepening of
technology capabilities in most financial institutions means that management on a global scale,
particularly risk management, is now feasible as well as necessary.
This dynamic presents many challenges. The most obvious is in achieving the benefits and promise of
consolidation and broadening. As we have seen, mergers between banks do not all achieve the full
promise originally envisioned. In some cases, post-merger integration skills are found wanting, as the
challenge of providing seamless service while integrating disparate back offices and branch networks
proves to be beyond the skills of management. In other cases, the dynamics of newly acquired
businesses prove unpredictable and leave even experienced managers explaining revenue shortfalls
and earnings disappointments. As we know, markets can be unforgiving of such surprises, and boards
of directors often follow the market signal and punish the top management thought to be responsible
for failure. An obvious difficulty is the inability to predict which merger will be successful, with the
winners not just cost-cutters but those who know how to develop new sources of revenue. While in
general the early experience in large, cross-industry consolidation appears to be successful, we have
not yet had the test of a slowing economy. Until we have gone through a full business cycle, it is hard
to know how strong the business case for integration truly is.
Second, we must be cautious in assuming that more diversified and larger firms are inherently less
risky. One of the ongoing challenges in the emerging world of high tech finance is risk management.
The experiences of the last 2.5 years indicate that the speed of market movements, combined with the
scale of financial endeavor, can lead to a rapid reversal of fortune for even the most sophisticated
market participants. Models are inherently backward-looking, and even the best of them have not
proven to be foolproof in sounding the alarm for newer risks. There is evidence that banking
organizations, and probably financial institutions more generally, will use the benefits gained from
diversification to increase the risk in the individual components of their portfolios. Indeed, some
activities now permissible in financial organizations, such as merchant banking, have high average
returns, but those returns mask a wide variance in result, with some outcomes quite detrimental to
profits and potentially to organizational vitality. In practice, the results will differ from firm to firm,
but appropriate disclosure and risk-management practices will become even more important. I am
heartened, I might add, by what seems to be the fact that US bank risk-management skills paid large
dividends - although clearly not avoiding all losses - in the Asian financial crisis a couple of years
back.
A major reality of financial institutions is that their businesses are ultimately built on understanding
and trust by both retail consumers and wholesale counterparties. The third, and most ephemeral,
challenge is to build scale and complexity and still maintain understanding and trust while protecting
proprietary information. The debate about privacy that accompanied the modernization discussion in
the Congress reflects the challenges and constraints that lie ahead. On the wholesale side the challenge
is to reveal to the market enough about risk and performance to allow for full and accurate evaluation
by counterparties without disclosing proprietary information. Future LTCMs will be expected by
counterparties to be much less opaque. Similarly, the ongoing review of the role of publicly issued
subordinated debt for large and complex organizations is another example of the expectation that such
organizations will be held to a higher test of transparency in order to build counterparty understanding
and trust.
In addition to realism in considering the opportunities that the new law allows, bank managers must be
prudent in managing and monitoring the performance of banks. There has been a recent decline in
profit-growth expectations among equity analysts. The consensus view among analysts appears to be
that the industry will experience earnings-per-share growth in a range of 10 to 12% over the next five
years. This is a respectable growth but is somewhat lower than the growth experienced in the last five
years.
I hope that bank managers are keenly aware of the risk profiles of their companies and are not inclined
to take additional risks to hit earnings targets. Banks are clearly trying to diversify their earnings
streams. They will need to monitor carefully the performance of newer products developed and
marketed during the 1990s in response to broad consumer needs. While we have enjoyed record
expansion, the prospects for a business and an economic downturn must be factored into pricing
decisions. Credit and underwriting decisions should take into account realistic downside sensitivity
analysis.
Prudence in individual investment and borrowing decisions
However, financial institutions are not the only economic actors who need to maintain realistic
expectations and to exercise prudence and caution during this period. Individuals must exercise
ongoing vigilance in their personal financial behavior. In particular, individuals should recognize that
in this era of technology-induced growth, high growth goes hand in hand with high uncertainty and,
for newer companies, volatility in their financial performance. This means that accurately valuing a
company in the high-growth industries is dauntingly complex. Therefore, individual investors are best
advised to consider a range of scenarios, including not just the rosy outcome of possible success but
also the very real one of potential failure. History clearly demonstrates that for every successful
start-up the vast majority find success elusive.
Individuals would also be well advised to consider a range of personal financial scenarios. Perhaps
based on expectations of solid income growth, which we all hope will be borne out, households have
increased their debt faster than their disposable personal income in every quarter over the past five
years. Despite increased borrowing, however, the household debt service burden, as conventionally
measured to include consumer and mortgage debt, remains below the levels reached in the 1980s. This
burden has been held down in recent years by falling interest rates and a shift toward longer maturity
mortgage debt. Nonetheless, even in good economic times it is prudent for households to be prepared
for a range of outcomes, not just the most optimistic ones.
Caution in the global economy
While being cautious, let me not convey a pessimistic tone, because I believe that the four major
forces currently driving the domestic economy could well provide the underpinning for a new era of
prosperity in the global economy. The first of these forces is the creation of, and massive investment
in, technology - particularly information and communication technologies. Technology is thought to
have played an important role in the increase in productivity - the output of goods and services per
hour of labor - that is currently providing momentum for the economy of the United States. The
second major force is business deregulation. The removal of unnecessary government regulation
started more than twenty years ago during the administration of President Gerald Ford but gathered
momentum during the Carter years. Deregulation allowed businesses, indeed forced businesses, to
focus more clearly on the competitive market place, with lessened constraints and increased flexibility.
The third major force is more prudent fiscal policy. The latter part of the 1990s has been characterized
by government surplus, which, many believe, has freed investment resources for private-sector
investment.
The final major change was the reduction of both actual inflation and the expectation of inflation as a
necessary component of personal and business decision-making. This trend began during the
early-1980s, and it has reached the point of fruition only in the past few years. Relatively stable prices
have allowed businesses and households to plan their economic affairs with a general expectation that
the value of investments will not be eroded through a pernicious increase in the general price level.
Indeed, price level stability has reinforced the impetus provided by deregulation for businesses to
manage their affairs with a priority on efficiency.
These developments are not unique to the United States. While our nation was the first to achieve the
full benefits of these forces, they have been at work globally as well. Software and capital goods
embodying newer information and communications technology are a major export of the United
States. Other nations have their own domestic equivalents of our Silicon Valley and Route 128,
whether they are called Bangalore in India or Helsinki in Finland. We are probably ahead in
experiencing the benefits of newer technologies, but other countries will certainly catch up.
The other three factors, which are preconditions to achieving the benefits of technology, are showing
signs of advancing outside the United States, although the pace differs from country to country. Most
industrialized economies have debated, and are continuing to debate, the question of how to free
businesses from unnecessary regulation and what governments can and should do to make labor
markets more flexible. This issue is clearly the focus of much attention currently in Europe. A number
of emerging-market economies have privatized state-owned enterprises and generally are reducing
regulation. The United Kingdom and Japan put into place financial deregulation in the 1980s and
earlier in the 1990s.
Additionally, much of the industrialized world has governments following a path of smaller deficits
and eventually smaller debt. The 1992 Maastricht Treaty, laying the groundwork for the unification of
much of Europe into a single market with its own currency - the euro - is the most obvious but not the
only example of this trend. Finally, the emerging consensus among politicians, policymakers, and the
general public in many nations is that any benefits of inflation are at best ephemeral and that inflation
ultimately is highly destructive. The efforts being made by countries that have experienced periods of
inflation, such as Brazil and Argentina, to avoid a recurrence of those experiences is instructive in this
regard. Inflation has been coming down in both industrialized and emerging-market economies during
the 1990s.
However, achieving sustained global growth requires certain improvements. This potential global
prosperity demands sounder banking institutions in all countries, particularly those that are still
heavily dependent on bank-based financial intermediation, and more stable financial systems, putting a
special burden on supervisory and regulatory authorities to remain vigilant. Similarly, technology
allows for a more intertwined financial system, which again requires discipline by both the private
sector and the public sector to remain successful. Finally, a global economy built around higher levels
of technology and greater competition in markets for goods, services, and labor input will nevertheless
also include persons or regions who by fortune or skill are not fully prepared to participate in a world
economy. Those on the outside of this highly productive economy, be they our fellow citizens or entire
nations and regions, will require special consideration from the national and international authorities
with responsibility for providing economic assistance.
Conclusion
In concluding, let me reiterate that the prosperity now experienced by the United States, and
potentially to be shared by the rest of the world, is certainly a welcome development. It is clearly the
goal of the Federal Reserve to follow policies that will help extend this prosperity for as long as
possible. However, it is also important for the financial sector and other members of the private sector
here in the United States, and for market participants, banks, and regulators in other countries, to
remain vigilant if this expansion is to continue here and to spread globally. We are in the midst of a
period of enormous opportunity, one that can be extended and strengthened if we are realistic,
remaining mindful of our obligations to act responsibly, both individually and collectively.
In this context, for managers in the financial sector acting responsibly includes recognizing that not all
financial institutions can successfully consolidate or profitably take advantage of every new power.
For individuals, personal financial decisions - both investment and borrowing - should take into
consideration the possibility that the most optimistic expectations of corporate or personal financial
success might not come true. Finally, nations seeking to replicate the growth experience of the recent
past in the United States should recognize that the current expansion is built, in part, on an
underpinning of a sound financial system, including both healthy institutions and well-functioning
capital markets, as well as solid supervision and regulation. I hope that we all recognize these lessons
so that our age of opportunity reaches its full potential.