Andrew Crockett: In search of anchors for financial and monetary stability
Speech by Andrew Crockett, the General Manager of the Bank for International Settlements and the Chairman of the Financial Stability Forum, at the SUERF Colloquim in Vienna, 27-29 April 2000.
It was in the seemingly distant 1996 that Alan Greenspan coined the famous phrase, "irrational exuberance". He was not just making a passing remark. He was asking a question. His words encapsulated the dilemma of whether, and if so how, monetary policy should respond to asset prices. In fact, his public utterance was a response. The question has now become a familiar, if largely unanswered, one for central bankers.
Meanwhile, asset prices have moved higher and their volatility has increased. Far from discouraging investors, this seems merely to have increased the fascination of the equity market. TV stations devoted to the market, like CNBC, have enormously increased their viewership. The "analysis" offered by their commentators resembles nothing so much as that of hyperactive sports announcers. Viewers are sports junkies with the added thrill of a bet on every twist in the action.
These large asset price swings are themselves a palpable manifestation of the increased financial instability experienced around the world since at least the 1980s. The issue of how to deal with instability has quickly forced its way to the top of the international policy agenda. Just as policy makers appeared to be emerging victorious from one exhausting battle, that against inflation, another equally challenging front was opening up. Lower inflation, it appeared, had not by itself yielded the peace dividend of a more stable financial environment.
Today, I will explore the conjecture that the link between these two developments is less coincidental than it might seem at first sight. In order to elaborate on this proposition, let me first briefly describe the anatomy of financial instability. I will then discuss the changes in the financial sphere that have led to the observed greater instability before moving on to examine the link with the monetary sphere in a historical perspective. I will finally raise some policy questions emerging from the analysis.
The movements in asset prices that raise concern are not so much those crystallised in short-term volatility. Unless extreme and a source of strains on markets or institutions, day-to-day volatility is part of the physiology of well-functioning markets. Rather, it is those medium term swings that take prices far away from sustainable values, what economists term their "fundamental" values. Such misalignments, when they finally reverse, typically do so suddenly and violently, in a "crash". In the process, they raise short-term volatility to pathological levels. This may result in some casualties. But the major casualties follow once the reversal continues, usually in a prolonged and painful phase.
Distress among financial institutions can occur without price misalignments. In this case, however, it tends to be localised and the result of firm-specific factors. Poor management is the most usual cause. The main policy concern is systemic, not individual, distress, when large portions of the financial system are affected. Systemic distress can arise from the spreading of difficulties from individual institutions or market segments. But more often than not it stems from exposures to a common factor. Asset price misalignments are probably the most typical example of such common factors.
We care about financial instability because it is wasteful. Asset price misalignments would not matter if economic agents saw through them and discounted them. But often they do not. The misalignments can profoundly affect consumption and expenditure decisions. They impinge on perceptions of wealth and investment returns as well as on external financing constraints. Higher equity and real estate prices, for instance, act as a magnet for capital, and make it easier for borrowers to access external funds. Misalignments result in misallocation of resources across sectors and over time. Across sectors, because capital is sucked away from those where prices are relatively more sluggish towards those where they are more buoyant. Just think, for example, of the equity buy-backs in the "old economy" as IPOs surge in the "new economy" or of the construction booms that accompany soaring property prices. Over time, because if sufficiently pervasive, the misalignments result in aggregate over-investment or over-consumption, well in excess of permanent income. Once they reverse, the backlash is inevitable. And it is all the more powerful if the ability of markets and institutions to intermediate funds and generate credit is severely impaired. Hence the broader financial crises that go hand in hand with the most severe economic recessions.
Recent history provides numerous examples of the processes just described. In some cases the damage has been contained, as with the stock market crash of 1987. In others it has been more pervasive, as with the banking crises in the Nordic countries and Japan in the late 1980s and early nineties, in Latin America in the eighties and nineties and in Asia in recent years.
Beyond specific characteristics, all of these episodes shared some stylised features. There is first an over-extension phase during which financial imbalances build up, accompanied by benign economic conditions. In this phase, asset prices are buoyant and their surge tends to feed, and be fed by, rapid credit expansion. Leverage, in overt or hidden forms, accumulates in balance sheets, masked in part by the favourable asset price developments. The trigger for the reversal is essentially unpredictable. It can reside either in the financial sphere (e.g., an asset price correction) or in the real economy (e.g. a spontaneous unwinding of an investment boom). The process then moves into reverse. Ex post, a financial cycle is evident.
First, fundamental value is extremely hard to assess. We can disaggregate it formally into expected returns, a discount rate and a risk premium. In fact, however, like beauty, fundamental value is largely in the eye of the beholder. A function of financial claims is to telescope into the present intrinsically uncertain cash flow streams. Past experience can be a flimsy anchor for these expectations. Consequently, they are subject to powerful waves of optimism and pessimism, greed and fear. We see what we want to see. Paradigms about how the world works colour our observations. We eagerly discount what is inconsistent with our theories or beat it into shape until it fits them.
Such partial vision is true of individual agents taken in isolation. It is even stronger in the social behavioural patterns reflected in market prices. Price reactions to "news" can go through phases in which, whatever the intrinsic information content, the news is interpreted as reinforcing the prevailing paradigm. We do not need to go as far as Keynes in explaining the inherent indeterminacy of asset prices in terms of beauty contests. I suspect that it is not so much a matter of consciously guessing the majority's view - most people are too risk averse for that - as of inadvertently falling victim of a shared vision.
Second, in contrast to other industries, in the financial sector excess supply does not necessarily put immediate downward pressure on prices and profits. To the contrary, lending booms initially tend to sustain economic activity and boost asset prices, thereby improving for a while the financial condition of both borrowers and lenders. The mutually reinforcing process between perceived wealth and access to external funding masks the extent of the underlying imbalance, until the process necessarily turns into reverse. Excess capacity and risk build up partly unnoticed.
Third, generating liquidity, a key function of the financial sector, can result in fragile balance sheet structures, especially given its link with leverage. Fragile balance sheet structures can intensify instability. The sudden and sometimes indiscriminate retrenchment of suppliers of funds can cause institutions and markets to be starved of liquidity, exacerbating price declines and impairing the functioning of markets. If bank runs are the text book example, the market turbulence in 1998 has shown that markets are not immune to similar problems. Liquidity has a binary side to it, it is either on or off.
Finally, ill-designed safety nets can exacerbate instability. The very forms of official protection historically put in place in response to financial instability can be counterproductive if they weaken market discipline without providing offsetting prudential incentives. This is the familiar moral hazard issue. The financial sector generally, and banking in particular, are characterised by an "exit problem". Institutions are allowed to remain in being when, in a more competitive environment without a safety net, they would have gone under much earlier. From this perspective, financial crises can be viewed as a kind of "safety valve of last resort", a catalyst for needed structural adjustments.
While the above characteristics are inherent in financial activity and in the institutional safeguards put in place in the first half of this century, a number of changes in the financial regime over the last twenty years have arguably increased the potential for financial instability. All of them can ultimately be traced back to the financial liberalisation and technological innovation that has gathered pace during this historical phase. The process has resulted in a broader range of services, at lower prices, and more accessible terms than ever before. But these great benefits have not come for free. Let me focus on four implications of the profound forces just mentioned.
First, competitive pressures have vastly increased and a wave of "creative destruction" has affected both the real and financial spheres of the economy. This has heightened uncertainty in the economic environment. Previously sheltered financial institutions have had to learn to measure and price risks. In some cases, they have had to compete with nimbler opponents, not saddled with burdensome cost structures inherited from the past. Net operating cushions have come under pressure, making it harder to earn a given return for the same amount of risk. Consequently, the incentives to take on added risk have increased. And for much the same reasons so has "herd instinct", or the tendency to conform behaviour to the norm, for fear of being left behind and in the hope of limiting blame in case of failure.
Second, the new environment has structurally increased liquidity and the potential for leverage. Think of liquidity as the ability to realise value, whether through the sale of an asset or external finance. Such external finance will only be supplied against some form of perceived value. Perceived value can be as transparently intangible as the future earning stream from a unit of capital or labour, or as deceptively tangible as a piece of property or financial asset. Think of leverage as the additional sensitivity of net worth to risk factors resulting from a liability vis-à-vis a third party. Leverage can be easily apparent, as in the case of a firm choosing to take out a loan rather than issue shares, or less obvious, as in the case of an uncovered option position or the extension of a contingent guarantee. It is then clear that the same kind of forces that have heightened competition have also provided the means and the incentives to increase the availability of liquidity and the potential for leverage. In other words, they have provided more fuel for the fire.
Finally, financial globalisation has transformed geography, with significant implications for the character of instability. Globalisation has heightened the significance of "common factors" in the genesis and unfolding of financial distress. It has done so by extending and tightening financial linkages across institutions, markets and countries; by increasing the uniformity of the set of information available to economic agents; and by encouraging greater similarity in the assessment of that information.
In addition, globalisation has heightened the significance of size asymmetries in the world, between the main industrial countries, on the one hand, and emerging market countries, on the other, i.e. between core and periphery, to use a terminology commonly applied to the Gold Standard period. Freedom of capital movements has exposed the emerging market countries to the potential volatility of access to external funding. Portfolio adjustments that are comparatively minor for institutions in the countries originating capital flows are of first order significance for the recipients. This greatly increases the recipients' vulnerability to changes in sentiment, whether these are due to revised perceptions of economic condition in the periphery or to developments in the core.
Some of the environmental changes just described are particularly acute during the transition from a sheltered to a liberalised environment. Others, I suspect, have a more permanent character. The bottom line is that market discipline alone may be insufficient to ensure the necessary degree of stability. Hence the issue of whether additional policy action is needed. But before I discuss this question, let me say something about the link between financial instability and the monetary regime.
We have grown accustomed to believe that a monetary policy aimed at delivering price stability is the best protection against financial instability. There is undoubtedly a very large portion of truth in this statement. Realised inflation is a notoriously reliable leading indicator of financial instability. Just like asset price misalignments, inflation results in a misallocation of resources and masks the build-up of over-extension in balance sheets. Inflation can also provide fertile ground for price misalignments by encouraging excessive investment in inflation hedges or clouding the distinction between real and nominal magnitudes. Much of the financial instability observed in the seventies and early 1980s reflects these distortions.
Yet this conventional wisdom does not capture the whole story. There are numerous examples of countries following successful anti-inflation policies and yet unable to avoid financial crises. The Japanese and East-Asian cases are the most obvious recent instances. And, paradoxically, success in taming inflation can provide an environment more vulnerable to those waves of excessive optimism that breed unsustainable asset price dynamics.
More fundamentally, I would conjecture that the combination of a liberalised financial system and a fiat standard with monetary rules defined exclusively in terms of inflation is not a sufficient condition for financial stability. I have already discussed the issues that pertain to the financial regime. The gist of the role of the monetary regime is straightforward. In a fiat money standard there is no exogenous constraint on the supply of credit except through the reaction function of the monetary authorities. If that reaction function is geared exclusively to controlling inflation and low inflation is insufficient to deliver stability, then the monetary anchor cannot prevent the build up of credit that accompanies the accumulation of financial imbalances. I will return to this later.
The search for a solution to this basic problem can be seen as a search for adequate anchors in the monetary and financial spheres. From this perspective, it may be instructive briefly to review the link between monetary and financial stability across regimes in the twentieth century.
In the Gold Standard, convertibility into gold acted as the single, common anchor for the monetary and financial regimes. The commitment to convertibility actually defined monetary stability, and gave way in cases of generalised financial crises. Few, if any, other constraints existed on balance sheets; the financial system was liberalised. The promise of convertibility was a rather brittle constraint on credit expansion and could not prevent waves of excessive expansion and instability. For this reason, among others, it was an unsatisfactory feature of monetary arrangements. Nevertheless, it represented a visible, exogenous constraint.
The progressive emergence of fiat standards in the interwar years obscured the link between the monetary and financial regimes. Monetary stability became progressively identified with price stability. The State's solvency, founded on the power to tax, became the sole basis for the acceptability of the currency. At the same time, the new regime loosened the constraint on credit expansion. This contributed further to the widespread financial instability during the period. The instability was the main motivation for the establishment of strict regulation of the commercial banking industry, including through a variety of liquidity, maturity matching and solvency requirements. A separate anchor in the financial sphere had been put in place.
During the Bretton Woods regime, the relationship between the monetary and financial anchors was somewhat ambiguous. A de jure gold convertibility clause for official transactions quickly developed into a de facto dollar (and hence fiat) standard. This coexisted with a complex web of regulations in the financial sphere, constraining both the balance sheets of institutions and international capital flows. Some of the controls were of a prudential nature (e.g., ceilings on deposit rates), others were rather targeted towards monetary control (e.g., ceilings on loans). But their end result was the same: they restrained the scope of financial cycles and their transmission across borders. For a while, the system delivered price and financial stability. But it did so at the expense of financial repression and increasing costs in terms of resource misallocation.
The environment that unfolded in the 1970s saw a relaxation of self-imposed and exogenous constraints. Greater willingness to use fiat money to finance deteriorating fiscal positions loosened further the constraints on the monetary regime. In the meantime, pressures had been building up to liberalise the financial environment. International financial markets came to play an increasingly important role in the generation and allocation of credit. Financial instability began to emerge again, coexisting with rapid inflation.
Financial liberalisation got into its stride in the 1980s and has continued to accelerate into the present day. The transformation from a government-led to a market-led system, to use Padoa-Schioppa and Saccomanni's famous term, was largely completed. In the monetary sphere, the adoption of a stricter stance against inflation finally began to bear fruit in the 1980s. In the nineties, monetary regimes with clear inflation objectives, buttressed by central bank independence, strengthened the credibility of the anti-inflation commitment. But still financial instability intensified, despite renewed efforts to improve prudential safeguards and to adjust them to the new environment.
This short review suggests that the economic history of the twentieth century can be seen as a quest to simultaneously secure the elusive twin goals of monetary and financial stability. Attaining this objective requires that the link between the monetary and financial regimes be understood, and that mutually reinforcing anchors be put in place in the two spheres. Let me start by considering the financial sphere.
There is little doubt that all of the work already done and put in train in order to strengthen prudential safeguards is in the right direction. Attention has been devoted to the three basic components of the financial system, namely infrastructures, markets and institutions. Much has been done to buttress payment and settlement systems and the weakest parts of the legal infrastructure. Several initiatives have addressed shortcomings in trading arrangements, particularly following the 1987 stock market crash. Above all, the prudential regulation and supervision of individual institutions has made enormous strides. Upgraded minimum capital requirements have been the cornerstone of this strategy; the Core Principles for Effective Banking Supervision provide a consistent, broader corpus of guidelines that has served as the model for regulatory and supervisory arrangements world-wide.
The Basel-based process has played a significant role in these endeavours. In fact, its three Standing Committees mirror the financial system's tripartite categorisation, with the Committee on Payment and Settlement Systems addressing one key element of the infrastructure, the Committee on the Global Financial System examining markets and the Basel Committee on Banking Supervision looking after banking institutions. More recently, the establishment of the Financial Stability Forum, which I have the honour of chairing, has been playing a broader co-ordinating role, by bringing together representatives of the finance ministries, central banks, international regulatory bodies and the leading international financial institutions.
Whether the current efforts can, by themselves, be sufficient to guarantee financial stability is less clear. My previous analysis points to two potential weaknesses that still need to be adequately addressed.
The first relates to the limitations of market discipline. Undoubtedly, much can still be done to enlist market forces so as to strengthen financial discipline. In particular, there is ample room to improve disclosure standards, at the level of markets, institutions and countries. There cannot be discipline without information. Indeed, official efforts have wisely been stepped up in recent years to address possible gaps in this area. Likewise, more can be done about incentives. This implies limiting the explicit and implicit guarantees associated with safety nets, nationally and internationally. Even if information is there, perceptions of the existence of official protection may undermine the incentive to use it in the right way. Current efforts to involve the private sector more effectively in the resolution of international financial crises are an important step in the right direction.
Even so, I suspect that the problem runs deeper. It would be a mistake to believe that moral hazard is the only source of incentives for imprudent behaviour. As argued earlier, in a highly competitive environment there is no dearth of pressure to take on risks or to conform behaviour to the prevailing norms, regardless of their inherent validity. More prudent behaviour requires a heightened recognition that, in finance, an ultimate source of competitive advantage is the credit standing of an institution. This takes us to the issue of "risk culture".
Risk assessment technology has improved dramatically in recent years and has helped strengthen risk culture. But while economic agents and markets appear reasonably good at assessing the relative risk of instruments, debtors and counterparties, they seem to find it harder to evaluate the absolute, undiversifiable risk associated with the overall economic and financial environment. Indicators of risk tend to be at their lowest at or close to the peak of the financial cycle, i.e. just at the point where, with hindsight, we can see that risk was greatest. Asset prices are buoyant, credit spreads are narrow and loan loss provisions are low. There is a sense in which risk accumulates during upswings, as financial imbalances build up, and materialises in recessions. The length of the horizon here is crucial. Yet, so far, the ability to anticipate, and hence prepare for, the rainy day has proved inadequate.
The second potential weakness relates to the raw material on which the regulatory framework can draw. It stands to reason that the regulatory apparatus should align its risk measures to those used by private participants. Such an approach reduces incentives to arbitrage the restrictions away ("game the system") and encourages improvements in risk management. From this perspective, the current proposals for the revision of the Capital Accord are a major step forward. This positive step, however, still leaves unresolved the problem posed by existing biases in the measures of risk, particularly the shortcomings in assessing the non-diversiable risk associated with the financial cycle. This is especially significant in the current environment. As other constraints on the balance sheets of institutions have been dismantled, prudential standards and agents' perceptions of risk have probably become a more important factor driving the credit cycle.
The bottom line is simple. If my conjectures are correct, there is a material risk that the current anchors in the financial sphere may, by themselves, be insufficient to deliver financial stability. In a sense, anchors are no better than the ground in which they are planted. And that ground could, at worst, turn out to be quicksand. Inadequate risk perceptions and inflated asset values can lead to serious distortions. What, then, would anchor the credit expansion process?
We have thus returned to the starting point of my remarks, to the basic dilemma that has begun to loom large in the policy choices of central bankers. Should monetary policy ever be directed to limiting the build up of financial imbalances? In particular, should it respond to perceived asset price misalignments that, in the central bank's view, threaten financial stability?
The conventional view is that they should not. And for many good reasons. First, monetary policy should only respond to asset prices to the extent that they provide information about future inflation. Second, even if the central bank wished to prevent the imbalance from building up, by the time it could form a firm judgement about its existence, it would be too late. Pricking a bubble in its later stages risks precipitating the financial instability it is intended to avert. Third, the response of asset prices to monetary policy is highly unpredictable and dependent on market sentiment. A pre-emptive monetary tightening may even boost asset prices if it strengthens the market participants' sense that the central bank has inflation well under control. Fourth, who can say with confidence that an asset price movement is a bubble and not a reflection of fundamental values?
These arguments are powerful. But some doubts remain. Could there be circumstances in which the risks of inaction might exceed those of action? Allowing an imbalance to continue and grow is likely to exacerbate the severity of the eventual reversal. The worst of all possible worlds would be to react, or to give the impression of reacting, asymmetrically, only to price declines. This risks engendering an insidious form of moral hazard, in fact potentially more serious than others which have traditionally attracted greater attention.
Would a reaction function that implied responses to financial imbalances be inconsistent with strict inflation objectives? I do not think that this need necessarily be the case. At least at low inflation rates, financial instability is likely to raise the risk of price deflation. Avoiding imbalances that carry the potential for financial instability can thus can be reconciled with longer-term price stability objectives.
But even if this kind of reaction function were to be considered, a non-trivial political economy problem would remain. Communicating such a policy to the general public and justifying it would be harder in the absence of a clearer mandate. It would require serious educational efforts, not least since it could be interpreted as an unjustified intrusion into people's efforts to enrich themselves. Ironically, the largely abandoned reaction functions defined in terms of monetary and credit aggregates could provide a degree of in-built stabilisation and facilitate communication with the public.
To conclude, I am aware that my remarks have raised more questions than provided answers. I am convinced, however, that at this stage of our endeavours to secure financial and monetary stability it is worth standing back for a second and to ask such broader questions. It is only by doing so that we can gain the necessary sense of perspective to guide our efforts with renewed energy and conviction. To my mind, several issues require more attention than that received so far by academics, market participants and central bankers alike, the core SUERF constituency. Of these, I would stress two. We need to give more thought to ways of assessing and dealing with the systematic risks associated with the financial cycle. And we need to explore more fully, with a critical but open mind, the relationship between financial and monetary stability. If my conjectures turn out to be correct, these issues will inevitably gain further prominence in the years ahead. It is partly on finding adequate answers to them that the success of the elusive search of anchors for financial and monetary stability depends. As history demonstrates, this quest will no doubt continue; the stakes are high. The Basel process and the Financial Stability Forum will remain two focal places where it will be elaborated and pursued with vigour. But it is only through the pooling of everyone's efforts that the search can finally be successful.