mr meyer reports on lessons from recent global financial crises remarks by mr laurence h meyer, member of the board of governors of the us federal reserve system, before the international finance conference, federal reserve bank of chicago, held on 1 october 1999. * * * on the principle that mistakes teach us as much as, if not more than, successes, i will take this opportunity to consider what can be learned to improve bank supervision and regulation from the financial crises that afflicted so many economies over the past 2½ years. i will consider two episodes – the asian financial crisis and the financial market turmoil surrounding the near - bankruptcy of the hedge fund long - term capital management ( ltcm ). because these episodes are too recent and too complicated to draw many firm conclusions that lead to concrete policy recommendations, part of my objective today is to identify some areas where i believe that further study would be particularly productive. the two crises the details of these two episodes are familiar to everyone here. the floating of the thai baht in july 1997 marked the onset of a period of market turbulence associated with the halting of new funds to and, in most cases, the flight of existing money from, many economies in southeast asia. because many entities in those nations relied on short - term funding in foreign currency for their ongoing operations, the drying up of funding from global financial markets quickly placed serious strains on them. and because the lines between the private and official sectors were often drawn imprecisely, these funding problems for firms soon became the burdens of national governments. such pressures, unfortunately, exposed numerous and substantial flaws in some of these financial systems, including lax lending policies, substantial mismatches in the maturities and foreign exchange denominations of assets and liabilities, seriously deficient standards for disclosure of basic private financial information, hedges based on erroneous presumptions about the correlations among returns, the failure to monitor ongoing loan performance, and the inadequacy of reserves against potential losses. in autumn 1998, we in the major industrial countries were reminded that emerging market economies did not have a monopoly on financial institutions that were inadequate in the task of assessing risks. the effective default of the government of russia on some of its obligations and the travails of ltcm in rebuilding its capital in the face of enormous trading losses – occurring as they did so soon after the crisis in asia – triggered a generalized reassessment of risk - taking by investors and market makers. interest rate risk spreads widened

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