Prevention instead of intervention: conditions for a more efficient, global economic and financial architecture

Speech at the 6th European Forum Berlin by Andrew Crockett, the General Manager of the Bank for International Settlements and the Chairman of the Financial Stability Forum, Berlin, 24-25 November 2000.

I have been asked by the organisers to focus my comments on the role of the BIS in helping prevent international financial crises. In doing so, I will also say a few words about the role of the Financial Stability Forum, and touch on the relationships between the Basel-based community and other groups involved in this set of problems.

Before commenting on how various groups try to contribute to solutions, however, we need to establish a shared understanding of the nature of the problem. What are we trying to fix? A commonly held view seems to be that improving the "International Financial Architecture" has primarily to do with strengthening financial systems in emerging market countries. This is a considerably simplification. In a highly integrated international financial system, problems at the periphery have a complex two-way relationship with developments at this core.

The problems we share today can be better understood with a little historical context. Difficulties in the 1930s led to strict regulation of the financial sector in most countries. However, as the memories of this period faded, deregulation and financial liberalisation became the order of the day. The emphasis shifted to promoting efficiency, and the role of the free financial markets in improving resource allocation and lowering the costs of financial intermediation.

However, the number and severity of recent financial crises remind us that efficiency may come at a price. Competition in the financial sector has sharply increased the emphasis on profits and the pursuit of shareholder value. Faced with this challenge, institutional and other investors moved out the risk/return frontier. With easier access to credit, consumers and business have been tempted to take on more debt.

Technological change has added further fuel to the fire. Financial markets which were previously closed are attracting non-traditional competitors. Protected franchises have disappeared. New and untested methods of generating profits have been identified, both in the financial sector and elsewhere. In a "winner take all" world the risks of failure have risen. New ways of doing things using modern technology have increasingly exposed those active in financial markets to operational and other risks.

The conclusion is that policymakers must also search for new ways to maintain the balance they have sought for generations, that between efficiency and stability in the financial system.

The urgency of this work is made all the greater by the macroeconomic imbalances that currently characterise the global economy. The record low rates of personal savings in the United States stand in sharp contrast to record high rates in Japan.

Current account imbalances are a manifestation of the same set of circumstances. The high value of the yen and the weakness of the euro are not easy to reconcile with the relative cyclical strength of their respective economies. And the further recent strengthening of the dollar sits uncomfortably with the new-found status of the United States as the world's largest debtor country.

Finally, the recent volatility in equity markets, particularly in the previously fashionable new economy sectors (information technology, media and telecommunications) sectors, reminds us that the recent high levels of financial and physical investment in those areas must eventually raise profits sharply if high equity price valuation are to be justified. Given the potential for macroeconomic disturbances, it is all the more important that the global financial system be both sound and resilient.

Problems, platforms and prescriptions

Before making some practical suggestions for making the global financial system healthier, it is useful to sketch an analytical framework. For convenience, the three key words all begin with the letter "p". The starting point is that observed problems in the financial system are commonly manifestations of deficiencies in the platforms (institutions, markets and infrastructure) which support that system. Prescriptions to remedy identified deficiencies are essentially based on introducing incentive systems to promote stabilising behaviour. Let me say a bit more about each of the "three p's"!

While clearly interrelated in practice, three different kinds of market problems have been observed in recent years. The first has been very high short-term volatility in financial markets. This problem became acute in the wake of the Russian debt default and the associated problems this posed for Long Term Capital Management. Liquidity dried up, counterparties withdrew, and risk spreads widened enormously.

The second phenomenon may be harder to identify, but history teaches us that it has an even greater capacity to inflict harm on the economic system. I refer here to medium-term price misalignments in financial markets which are eventually reversed. When fundamentals do re-establish themselves, the value of loan collateral maybe sharply reduced, threatening the viability of lending institutions. This was a problem in Scandinavia and Japan in the late 1980s, and in Mexico in the middle of the 1990s. Moreover, given the still high value of share and property prices in many countries, it may be a potential problem even today.

Thirdly, financial markets have often seemed subject to an unwarranted degree of contagion across markets and countries. This was part of the problem in East Asia in 1997 and in the LTCM crisis of 1998, even if such contagion effects were unexpectedly muted around the time of the devaluation of the Brazilian real.

It is of course not possible to predict individual financial crises in advance and to take specific measures to avoid them. Given this reality, the approach to crisis prevention must be to strengthen systematically each of the main platforms supporting the international financial system. We need healthy financial institutions, especially those that operate internationally. We need financial markets that are both efficient and stable. And we need a sound financial infrastructure that includes legal and judicial processes along with risk-proof payment and settlement systems.

How are these varied needs to be met in practice? What prescriptions can the BIS and the groupings that are based in Basel offer? The first point to make is that there is a Standing Committee of national experts, meeting regularly at the BIS, that focuses on an important part of each of these three areas.

  • The Basel Committee on Banking Supervision has been concerned for over two decades about the health of a crucially important set of financial institutions - commercial banks. And the International Association of Insurance Supervisors (whose secretariat also resides at the BIS) is now mounting a vigorous effort to catch up.
  • The Committee on the Global Financial System is concerned about market stability.
  • The Committee on Payment and Settlement Systems deals one very important aspect of the financial infrastructure.

While a proper focus on the requirements for financial stability is a necessary condition for effective measures to prevent crises, it is by no means sufficient. What is also needed is a set of incentive systems to promote prudent behaviour on the part of all those directly involved in the financial system. Here too, there are three pillars.

  • The starting point must obviously be self-interest leading to good internal governance. In this regard, having one's own money at stake is crucial.
  • A second set of incentives can come from market discipline. Given adequate knowledge of what is going on, the market should be able to reward prudent behaviour through lower risk spreads, easier access to funding and higher share prices.
  • Finally, supervisory oversight can and should provide another set of incentives to promote proper behaviour.

Some might feel that having recourse to three sets of incentives is overkill. But the reality is that no one set of incentives seems sufficient to ensure the desired outcome. Self interest is a compelling motive for prudent behaviour but, if one has nothing to lose, it is not surprising that people go for broke. In this regard, we have the example of the Savings and Loan Associations in the United States in the late 1980s.

Market discipline also has its attractions as an incentive system. Nevertheless, it is often the case that market participants collectively lose their objectivity. We have many historical examples of the prices of financial assets being bid up to spectacular levels on the grounds that a "New Era" had been established. This happened, not just in the 1920s, but also many times before.

All of this to say that the need for the third set of incentives, oversight by the official community, will remain valid as long as human nature, and its tendency to extrapolate well-founded optimism into "irrational exuberance", remains unchanged.

Promoting healthier financial institutions

Promoting the health of individual financial institutions is a fundamental requirement for a stable financial system. Most crises have their origins in financial institutions overreaching themselves in good times, only to pay the price later. Let me now consider how each of the three sets of incentive systems might be applied to reduce the financial risks arising from this sort of behaviour.

The first set of incentives, better internal governance, would work better if firms (and their shareholders) focused more on risk-adjusted rates of return, particularly when rewarding management and staff. Without such an approach, the system may force pursuit of profit rates which are simply not attainable over any sustained period. In this regard, the growing use of stress testing at the level of individual firms ("micro stress testing") is greatly to be welcomed. Managers need to be more keenly aware of the implications of key assumptions not being realised, since this so frequently happens in the real world.

Both Boards of Directors and management should assess more carefully the contribution of Mergers and Acquisitions to the bottom line. The historical reality is that M&As in the financial sector have been as likely to destroy value as to create it. Also pertinent to the internal assessment of the risks and returns is the existence of public safety nets. Public sector involvement in the financial sector risks blunting prudential incentives and lead to moral hazard. This can happen through direct government ownership, implicit or explicit government support, or poorly-designed deposit insurance schemes.

The second set of incentives for promoting healthier financial institutions has to do with market discipline. Institutions that take on greater risks should face the consequences in wider credit spreads, depressed values of subordinated debt and lower equity prices. Of course for this to happen, there must be adequate information to allow the market to make a judgement. Transparency is strongly to be encouraged along with well understood and globally accepted accounting principles. Nevertheless, there is one problem with market discipline. What if it the market as a whole is subject to the same swings of sentiment as individual financial institutions? I will return to the important issue of the efficient functioning of markets in a moment.

The third set of incentives to prudent behaviour, supervisory oversight, has recently been under intensive review. The Core Principles of Banking Supervision are being actively disseminated through a variety of channels, not least of which is the recently established BIS Financial Stability Institute. Another aspect of this work is the current review of the 1988 Capital Accord being undertaken by the Basel Committee on Banking Supervision. The basic idea underlying the new proposals is that capital requirements should become more sensitive to underlying risk. In addition to the standardised approach being suggested by the supervisors, it will also become possible for firms to use their internal ratings system to calculate regulatory capital requirements. National supervisors will have to make a careful determination of which approach may apply in the case of individual banks, recognising as well the need to maintain an internationally level playing field.

The proposed new approach is clearly superior to the old one. Those whose daily activity is making loans ought to have a well developed capacity to evaluate the relative riskiness of different credits, as well as the way risks may change as circumstances alter. Nevertheless, the fact that risk weight assessments can now change over time, which was not the case under the 1988 Capital Accord, does introduce a potential danger. Periods of economic expansion may lead internal credit ratings to be revised upwards and capital requirements thus to be revised downwards. Such pro-cyclical tendencies with respect to banker's evaluation of credit risk have been seen many times before, and are now reflected in the record low levels of provisions for losses currently seen in the United States. The supervisory community is well aware of this problem, and has stated clearly its intention to be vigilant in guarding against it.

Although not directly part of the new Capital Accord, thought might also be given in the future to a greater use of forward-looking provisioning for losses. The underlying logic is that any loan brings with it some threat of loss. An assessment of the probability of this loss should properly be based on the assumption that any economy is subject to fluctuations and that recent loan loss experience may not be a good guide to the future. Provisioning for the expected value of this loss would then leave capital as the effective provision for unexpected losses. The practical implication of this suggestion would be that reserves would be built up in good times, when risks are accumulating, rather than during bad times when losses are materialising. In principle, such an approach might aid materially in reducing the current tendency of the financial sector to exacerbate both economic upturns and downturns.

Another aspect of financial behaviour that is attracting increasing attention is what might be termed the "micro/macro interface". Prudential principles that are perfectly sensible for individual institutions may be destabilising if applied to a large number of institutions at the same time. Consider, for example, the use of Value at Risk Models in circumstances of increased force volatility. This could (indeed, did) cause many institutions simultaneously to withdraw from risky positions, thus aggravating swings in market prices, thus further raising Value at Risk calculations, and so on.

These insights have led to a greater interest on the part of the authorities in "macro stress testing", that is the implications for the system as a whole should some unlikely, although still plausible, event occur. In this area, there seems a natural complementarity between the work of central banks, often tasked with overall responsibility for financial stability, and that of other regulatory and supervisory agencies. Such cooperation is of course being actively encouraged through the Basel process and the activities of the Financial Stability Forum.

Promoting healthier markets

The events of autumn 1998 reminded all of us that properly functioning capital markets are crucial in maintaining financial stability. The first set of incentives, the self-interest of individual market participants, would be well served by greater transparency about market and other exposures. Given fuller knowledge about counterparties, there should not only be less willingness to lend excessively in the first place, but also less disposition to disengage when suddenly confronted with exogenous shocks.

Various groups at the BIS, especially the Basel Committee and the Committee on the Global Financial System, have encouraged initiatives in this area over the last few years. Given the explosive growth in financial derivatives, and the potential they offer for leverage, transparency with respect to off-balance sheet activity has been a particular focus. In a similar vein, the BIS has for some years now been publishing and constantly improving the data it collects on international banking activity. Again, the simple logic is that more transparency will lead to more rational financial behaviour.

However, this brings us immediately to the second set of incentives to prudent behaviour, market discipline, and a problem I have alluded to but not thus far addressed directly. Is market discipline always stabilising? In an ideal world, those who pushed prices away from levels determined by fundamentals would be quickly punished as prices reverted to their appropriate values. But, in practice, this is not always the way markets work. Extrapolative forces often seem to dominate regressive ones. Moreover, there is evidence that markets are becoming less atomistic and more prone to herding-type behaviour, particularly under stress. Common risk management schemes and growing concentration among market participants are contributory factors. So too is the spreading use of benchmarks and index tracking. And, as a down side to transparency, the instantaneous availability to all market participants of the same new piece of data may not necessarily lead to rational judgements in the short term.

What can the public sector do to alleviate the adverse effects of herd behaviour (the third set of incentives)? With respect to shorter-term liquidity problems, the development of more complete capital markets would help ensure that funds unavailable from one source might be tapped from another. When the U.S. commercial paper market dried up in the autumn of 1998, corporations were greatly supported by being able to fall back into the banks for loans. In light of this example, it is gratifying that a number of emerging markets are now making efforts to develop government bond markets. This may eventually act to spur the development of corporate bond markets as well, to complement the now dominant position of bank lending in many of these countries.

As for direct liquidity support from the pubic sector in the case of market failure, moral hazard considerations point to the need for caution. Nevertheless, let me add a warning. Just as credit risk often seems lowest just before it materialises, liquidity may also be perceived as highest just when it is most vulnerable. Moreover, as the process of globalisation proceeds, those short of liquidity may increasingly find that the shortfall is in a different currency than that which its "home" central bank can easily provide. More effective than reliance on a "lender of last resort" is prudent private sector behaviour which renders such reliance unnecessary.

Whether and how the public sector can contribute to preventing medium-term price misalignments is even more problematic. Monetary authorities with only one instrument cannot exercise more influence over asset prices without losing influence over more traditional objectives such as the Consumer Price Index. And even if they tried to do so, there are a host of practical questions. Which of many asset prices should the monetary authority focus on? How could they recognise a misalignment in the price of the chosen asset? How coud they know the point at which such misalignments would actually threaten the health of the financial system should the bubble burst? How much tightening would be needed to slowly deflate a bubble, if indeed it is possible at all? And how could the need for such tightening be justified to citizens whose focus most commonly tends to be on the positive effects of higher asset prices on their personal wealth?

There are no obvious answers to any of these questions. It might thus be better to look for regulatory approaches such as concentration limits in lending, margin requirements and restrictions on the use of collateral. Of course, this just brings us back to the supervisory pillar for promoting healthier financial systems, albeit with a systemic rather than an institutional perspective. And we should remember that regulation always invites avoidance. Again, there no easy answers.

Financial infrastructure

For the sake of completeness allow me finally to say a few words about the role of a sound financial infrastructure in helping prevent financial crises. This may not be high profile work, in part because it tends to be complex and interdisciplinary, but it is also absolutely basic. With $6 trillion a day now clearing through payment systems in the G10 countries alone, the work of the BIS Committee on Payment and Settlement Systems has become increasingly important. The Committee's recently published consultative document on "Core Principles for Systemically Important Payment Systems" is a big step forward, and should provide useful guidance to those in both the public and private sectors who operate such systems. The work being carried out jointly by the Committee and IOSCO on principles concerning securities settlement systems is a further welcome advance.

To strike a less positive note, work on the legal infrastructure supporting the international financial system needs much more attention than it is currently getting. National laws, particularly concerning financial institutions and bankruptcy arrangements, are often inadequate. Moreover, existing laws often differ substantially across countries and the uncertainty of cross border applicability is an invitation to international legal disputes. The legal tangles surrounding the failure of BCCI, as well as the legal shortcomings evident in the more recent financial crises in Mexico and Asia (including Japan), should have alerted us to our collective exposure in this regard.

The role of other international financial fora in crisis prevention

I have thus for focused on the work of the BIS, and in particular the Standing Committees that are supported by secretariats located at the BIS. Recommendations made by these committees have a particular moral force, in that they are the outcome of a long period of discussion and consensus building between national representatives, all of whom are experts in their respective areas. Moreover, these public sector representatives are in ongoing contact with their private sector counterparts whose practical knowledge they also reflect. This moral force is of particular importance in that there is no international "hard law" that requires compliance. It is true that the committees which develop these financial standards do not have universal character like the IMF. Nevertheless, the nations represented on the committees oversee the world's largest financial markets and are therefore particularly well placed to judge the requirements for maintaining financial stability. Moreover, the committees are increasingly involving emerging market representatives in their deliberations, so that a sense of "ownership" is being extended to them as well. The aim is to reach the right balance between global reach, with its associated legitimacy, and keeping the process manageable and efficient.

Let me now touch on the role of the Financial Stability Forum (FSF). The way in which the FSF operates has many similarities to other activities taking place in Basel. Membership of the Forum is limited to a number of financially important countries, but also includes international financial institutions (the BIS, IMF, OECD and World Bank) and representatives of the Standing Committees I have already referred to. The representatives from the G7 countries include a deputy Finance Minister, deputy Central Bank Governor, and Head of financial supervision. This is a unique and welcome form of representation in that all the national agencies likely to be included in both preventing and managing financial crises are involved.

The establishment of the Forum can be interpreted as a reaction to both the successes and the failures of the crisis prevention efforts made to date. On the success side, there are now over 60 agreed sets of international standards of best practice that are pertinent to preventing financial crises. A forum was clearly needed to help establish priorities, and to provide encouragement to implementation. The various incentive mechanisms I spoke about earlier have to be put in place and made to work effectively. The Forum has already published two documents addressing these subjects.

Turning to the failure side of efforts made to date, the FSF has two roles. It needs to assess where work still needs to be done ("gaps") and where it appears that resources are being wasted through duplicate efforts ("overlaps").

With respect to gaps, the FSF normally recommends that existing groups pursue particular issues. At our last meeting, for example, we requested that the Committee on the Global Financial System be asked to pursue its work on factors affecting market liquidity, both in normal times and under stress. However, the Forum can also establish working groups itself. Examples include the work done on offshore financial centres and highly-leveraged institutions. In these two cases, the political sensitivities seemed so great that the joint participation of Treasuries, regulators and central banks was desirable to give adequate force to the recommendations that emerged.

Finally, with respect to potential overlaps, the participants of the Forum include most groups in the public sector currently working on crisis prevention issues. In very broad terms, overlaps can be avoided if different kinds of groups tend to focus on different aspects of the problem. For example, standard setting is more commonly the realm of groups of national experts, meeting primarily at the BIS but also the OECD. Monitoring of compliance is increasingly the role of the IMF, in association with the World Bank, primarily in the context of the recently instituted Financial Sector Assessment Program. And providing external resources (training, technical advice, etc.) to support countries trying to conform to best standards is predominantly the responsibility of the World Bank.

Within these broad principles, however, there are inevitably practical problems in the assignment of responsibilities. One factor mitigating against the clear assignment of mandates is the growing complexity of the political framework within which all the cooperating groups operate. The IMF responds to its Executive Board but also to the recently established International Monetary and Financial Committee in which all countries are represented through the constituency system. The various Standing Committees of the BIS formally report to the G10 Governors, although the influence of non-G10 central banks and other regulatory agencies is growing. For the last four or five years, the G7 Summit Communiqu├ęs have given considerable attention to issues pertaining to financial stability. It was, indeed, the G7 that called for the establishment of the FSF. And finally, in the last year there have been regular meetings of the newly established G20 and their Deputies. This group comprises the G7 and a number of systemically important emerging market countries, similar in composition but not quite identical to those that have become shareholders of the BIS over the last few years.

In the midst of all this, the work directed to the prevention of financial crises carries on. It is of course highly unlikely is that such crises can ever be wholly eliminated. Nor would it necessarily be desirable to do so. We can, however, hope that the incidence and severity of crises can be diminished. We can also hope that, under the leadership of the IMF, their consequences can be contained. If we could realise these aspirations, we would have done a great deal to make the world a safer place.