International Financial Arrangements: Architecture and Plumbing
The Third David Finch Lecture by Andrew Crockett, the General Manager of the Bank for International Settlements and the Chairman of the Financial Stability Forum, in Melbourne, 15 November 1999.
It is an honour and a pleasure to be invited to give the third David Finch lecture. I first met David over thirty years ago when he was part of an IMF team that came to London in the wake of sterling's 1967 devaluation to explain IMF financial programming to the British authorities. I was then a junior official at the Bank of England. My task, I seem to remember, was that of rationalising my superiors' instinctive mistrust of anything that smacked of monetarism. Later, David and I were colleagues for many years at the IMF, where in the course of a distinguished career he gained a justified reputation as an intellectual conscience of the organisation. He was closely involved in every major issue confronting the Fund for over twenty years. His principled resignation on a matter of policy, rare for a staff member, is only one illustration of his concern that the organisation should not become hostage to political pressures and partisan interests.
David has always been, in the best sense of the word, a "worrier". His chosen career, as an official of the institution at the centre of the international monetary system, gave him plenty of cause to indulge this particular personality trait. And since leaving the Fund, he has continued to think about, and make practical proposals for improving, the functioning of the system. If there remains much work to do, it is certainly not due to a lack of contributions on David's part. The fact is that the environment of international finance changes very rapidly, and our techniques for its effective management do not always keep up.
The East Asian crisis was only one in a series of crises, of greater or lesser magnitude, to afflict domestic and international financial systems. But it is noteworthy in at least four respects. A first is that it affected countries whose economic performance had been, by almost any measure, outstandingly successful, and whose macroeconomic policies had been largely consistent with accepted norms. A second is the contagion by which the crisis spread across national boundaries to countries that were not initially considered vulnerable. A third is the severity of the economic consequences. In the five most seriously affected economies, the fall in GDP below trend was around 15%. And a fourth is the way in which the volatility of international capital flows interacted with weaknesses in domestic financial structures to trigger and intensify the crisis. These features underline the vulnerability of the current system and reinforce the urgency of efforts to strengthen its stability.
In this lecture, I want to try to place the current international financial arrangements (or the "architecture", to use the now popular jargon) in a historical and institutional context. My purpose will be to show how it has evolved from the Bretton Woods system of the post-war period, and what are its principal characteristics. Against that background, I will try to assess its sources of weakness and what might be done to mitigate them.
I am of course aware that the two previous Finch lecturers, Jeffrey Sachs and Stanley Fischer, dealt in their lectures with aspects of this same issue. Sachs1 pointed out that global capitalism, for all of its many benefits, has failed to address certain key aspects of human welfare. These include income inequality, and the need to preserve the environment, to mention only two. His message was that the international economic system needed to be consciously managed to deal more satisfactorily with these problems.
Stanley Fischer2 focused on some of the weaknesses in the functioning of the monetary system. Against this background he reviewed proposals to improve the working of the system. His particular focus was the role of the IMF in promoting better policies and dealing with financial crises more effectively than in the past.
How do I intend to differentiate my lecture from theirs? Not, I must emphasise straight away, by disagreeing with the points they made. Sachs is clearly right that the international economic system must look beyond financial efficiency and deal better with deeper issues of human welfare. And Fischer's analysis of how to more effectively prevent and deal with financial crises is, as one would expect, cogent and to the point.
In this lecture, I will limit my focus to the financial system, but I will try to put its evolution in a broad historical context. My basic thesis will be that monetary arrangements have gradually evolved from an administered, or government-led system, to a decentralised or market-led system. This has been an inevitable and in many ways desirable evolution. For all their flaws, markets are a more efficient mechanism for resource allocation than any conceivable alternative.
We should not forget that the system that produced the Asian crisis of 1997-98 also produced the impressive economic performance of the previous two decades. Rapid growth lifted major portions of the population of Asian countries out of poverty in the space of a single generation. This growth was certainly facilitated by a system that provided a liberal trade regime and access to international capital markets. A liberal trade regime underpinned the strategy of export-led growth, while access to foreign capital hastened technological and managerial innovation; provided additional real resources to countries where investment opportunities outstripped domestic saving; and sometimes acted as a useful source of discipline on macroeconomic policies.
However, any system based on markets is vulnerable to market failures. These will not be corrected without intervention to tackle their underlying causes, which at times needs to be detailed and painstaking. Hence my title: architecture and plumbing. The broad architecture of the system, I will argue, is with some exceptions, appropriate to the needs of the world economy. The problems are with the plumbing. Markets have at times shown alarming disequilibrium tendencies. Private institutions have got into difficulties with potential spillover or systemic consequences. The causes lie in specific aspects of market functioning that must be corrected if we are to preserve support for open markets and the benefits they can bring.
Let me begin by sketching the main characteristics of the monetary arrangements established after the Second World War, and the factors that led to their downfall. At Bretton Woods, the founders of the post-war international monetary system sought to impose an order on international financial arrangements that had been conspicuously lacking in the 1930s. Exchange rates, which in the pre-war period had been used to secure competitive advantage in a mercantilist world, were to be fixed within narrow margins and adjusted only in cases of "fundamental disequilibrium". Current account payments, which had been subject to severe restrictions, were to be progressively liberalised (as a complement to measures to liberalise trade flows). Capital account controls were permitted, and even encouraged where they were necessary to preserve current account convertibility and avoid recourse to competitive devaluations. The balance of payments adjustment process was to be monitored internationally, with a view to maintaining exchange rate stability. Liquidity, needed to facilitate adjustment while avoiding payment restrictions, was to be provided through access to the conditional resources of the International Monetary Fund.
Financial markets, though not an explicit focus of the Bretton Woods arrangements, were largely domestic in scope and heavily regulated. Interest ceilings, credit controls and entry restrictions were among the measures that protected domestic financial institutions from competition, reducing the incentive for risk taking. Capital controls segregated national financial markets, reducing the scope for contagion.
This "administered" international monetary system was logically coherent and, indeed, successful in facilitating the rehabilitation of war-damaged economies and the post-war growth of trade. The industrial economies recorded high rates of economic growth and liberalised their trade and payment systems. By the end of the 1950s, most countries had reintroduced de facto convertibility for current account payments. World trade grew rapidly, and exchange rates were stable.
Note that in this "administered" architecture, the capacity of faulty plumbing to do damage was limited. There were no integrated capital markets, so that spillover effects from financial problems in one country were minor. The competitive climate for financial institutions was benign, so they had no incentive to run risks with their solvency. And sophisticated financial instruments with complex payoff characteristics hardly existed.
There were, of course, a number of problems, but for the most part they were dealt with within the framework of the managed system. For example, it was apparent that there was no mechanism to ensure that gold reserves could increase in line with the growth of the world economy. As a result, holdings of dollars had to play a growing role, which provoked criticism that the United States benefited from an "exorbitant privilege" that enabled it to absorb resources from the rest of the world.3 In a different vein, economists inside and outside the IMF feared that the accumulation of dollar balances would eventually become unsustainable (the "Triffin dilemma").4 The solution that was eventually found to this problem was to create an internationally-controlled supply of liquidity in the form of issues of Special Drawing Rights. (Few noticed at the time that market developments were beginning to make the concept of international liquidity itself obsolete.)
Another perceived problem was the working of the international adjustment process. With the growth of world trade and the liberalisation of trade and payments regimes, the size of current account disequilibria was tending to increase. Given the multilateral nature of the balance of payments adjustment process, it was felt that its working should be managed internationally. Various mechanisms to this end were put in place, of which perhaps the most noteworthy was the establishment of a high-level committee of the Group of Ten industrial countries (Working Party 3 of the OECD). WP 3's objective was to promote the harmonisation of domestic macroeconomic policies so as to make them consistent with continued stability in the pattern of international exchange rates.
In the end, however, it was the growth of international financial markets that undermined the administered international monetary system, and spelt the end of the Bretton Woods arrangements. Fixed exchange rates would anyway have been hard to sustain with divergent policies and cyclical positions among the key countries in the system. These divergences were beginning to grow as inflationary tendencies picked up in the late 1960s. But the freedom of capital movements had the effect of bringing forward the consequences of underlying economic divergences. Market participants could see the potential for unsustainable trends developing and used the financial markets to protect themselves against their consequences. With exchange rates fixed in a narrow band they had almost a one-way bet. The incentive structure virtually guaranteed the build-up of pressure on suspect currencies.
Capital controls were unable to provide a sufficient defence. For one thing, comprehensive capital controls did not enjoy widespread support in an environment in which businessmen, policymakers and the public at large were looking for increased freedoms to undertake cross-border transactions. For another, the growing sophistication of financial technology was offering alternative opportunities to take market positions.
It was recognised, moreover, that the function of capital flows was not simply to provide finance to "accommodate" (in the then popular jargon) autonomously generated imbalances in the current account. Capital flows made an important contribution to welfare in their own right; they were a reflection of divergences in savings/investment preferences among countries, and they were a vehicle for the transfer of technological and managerial know-how.
The fixed exchange system eventually collapsed in 1971-73, and the attempt to recreate it was abandoned following the first oil shock. With this, the international monetary system passed a critical stage in its evolution from an administered or "government-led" system (to use the term of Padoa-Schioppa and Saccomanni5) to a decentralised or "market-led" system. Subsequently, the central features of international financial arrangements -- the exchange rate mechanism, the adjustment process, convertibility, and liquidity provision -- have progressively become more subject to market forces. Let us consider each of these key features in turn, starting with the exchange rate regime.
Major currencies now float against one another, with relatively little intervention. As for the currencies of smaller countries, a variety of recent experiences have exposed the difficulty of maintaining fixed but adjustable exchange rates. As a result, there is a growing consensus that countries should either allow continuous flexibility in their exchange rate, or else credibly renounce an independent monetary policy, either through the creation of a currency board or by joining a monetary union.
The adjustment process has likewise been increasingly left to market forces. Governments have largely abandoned the attempt to formulate balance of payments objectives and to use domestic macroeconomic policies to pursue them. Rather, the balance of payments and the associated exchange rate are seen as being jointly determined by underlying saving and investment propensities. Market forces are accepted as the best available way of allowing these propensities to be reflected in relative prices and resource flows, even if they do sometimes exhibit undesirable instability.
Liquidity provision also takes place through the operation of market forces. Creditworthy economic agents (governments, companies and financial institutions) can, at a price, obtain the liquidity they believe they need through financial operations in international capital markets. It is therefore hard to conceive of international liquidity being too great or too scarce, independently of a judgement about the appropriateness of domestic monetary policies in the principal national centres.
Lastly, and in some ways most important for my present purpose, domestic financial systems have become more open, competitive and internationally integrated. Externally, geographical barriers in the provision of financial services have come down. Internally, countries have abandoned restrictions on competition and portfolio allocation constraints. Evolving financial technology and the ascendancy of the philosophy of deregulation have interacted to create what is in effect a single global capital market.
Some have labelled this a non-system. But in fact there is nothing unsystematic about international monetary arrangements based on decentralised market forces. Indeed, most theory teaches us that such a framework will, in general, be superior to the alternative, provided (and it is an important proviso) that the necessary preconditions for markets to operate efficiently are in place. In other words, the key questions are less to do with the architecture of the system than with the associated mechanisms (the "plumbing") needed to make this market-based architecture work effectively. It is to these questions that I now turn.
I will begin by reviewing some of the underlying reasons why markets may fail to work efficiently or to exhibit a stable equilibrium. Then I will consider some of the institutional responses that, at the national level, have been developed to deal with market failure. Finally, I will set this issue in an international context, asking what supplementary arrangements may be needed to ensure that the international financial system displays more resilience than it has done in the face of recent shocks.
It is sometimes supposed that reliance on unregulated market forces results in an optimal allocation of resources. This of course is only the case if markets are complete and efficient. A major gap is that markets for all future states-of-the-world do not exist. Financial markets try to fill this gap and indeed have done so increasingly in recent years with the development of new derivative instruments. Yet, financial markets are particularly prone to market failure since the assets traded in them yield services over a prolonged period. These returns depend on future states of the world and are therefore subject to uncertainties and information asymmetries. Herd behaviour and externalities are endemic, since individual asset values depend on collective expectations of future outcomes. Moreover, the public good of financial stability is likely to be undersupplied in the absence of conscious intervention by the authorities.
Recent advances in game theory have helped us understand better some of the reasons why financial markets are so prone to disequilibrium tendencies. And actual experience, not least in the East Asian crisis, has provided forceful empirical confirmation of the potential strength of such tendencies. It is worth spending a few moments to consider in more depth some of these sources of market failure.
I will discuss three such sources: information asymmetries; aggregation effects and externalities; and the deficient supply of public goods. The three sources of market failure are of course interrelated; for purposes of analysis, however, it is convenient to treat them separately.
Market efficiency depends on all market participants having access to available information on the characteristics of the goods, services or assets being traded. In practice, however, certain markets are characterised by asymmetric information. This is a particular problem in financial markets, which are by their nature information-based. Information asymmetries give rise to two specific types of problem.
One is adverse selection. This occurs when the seller of a product or service, say, an agent trying to obtain external funding (the insider) has private information about some exogenous key characteristic of what he is selling. The issue here is how the insider can credibly transmit that information to the "outsider" (i.e. the purchaser of the good or the provider of finance). Where this is not possible (or is costly), suboptimal outcomes will result. The classic article on this subject is Akerlof's "The Market for Lemons".6 Sellers of good used cars cannot easily and credibly convey quality information to buyers. Buyers therefore offer a lower price, which induces only sellers of low-quality cars to enter the market. A similar phenomenon can affect the market for loans, unless some quality assessment mechanism can be put in place.
A second consequence of information asymmetries is moral hazard. In this case, the information insider (the "agent") can affect economic outcomes, but the outsider (the "principal") is unable to observe or infer correctly the actions taken by the insider. The inability of the insider costlessly and credibly to commit to particular courses of action creates "time inconsistency", which typically results in suboptimal outcomes, relative to the full information equilibrium.
(ii) Aggregation effects and externalities
In financial markets, more so than in most other markets, decisions by individual agents are conditioned by expectations of what others will do. (Hence the natural application of "game" theory). Uncertainties about how others will act introduce costs that in principle might be alleviated by contracting, but in practice often cannot be. The classical example is the prisoners' dilemma. Two suspects can reduce their expected penalty by cooperating to deny responsibility for a crime. If acting separately, their incentive is to confess and lighten their punishment by implicating their partner.
In the financial system, the inability to enter binding conditional contracts on future states-of-the-world means that individual agents have to protect themselves against the consequences of potential actions by others. But individually rational behaviour, if followed by a large number of agents simultaneously, can produce sub-optimal social results. A familiar example of this phenomenon is provided by the literature on bank runs. Once confidence in a bank is called in question, it becomes rational for each depositor to withdraw her funds, whatever her subjective view of the bank's soundness. But of course, this rational reaction precipitates the very consequences against which it is designed to guard. A similar sequence of events can occur in currency markets or indeed as any market where price is fixed and the ability of the supplier to meet demand at the fixed price is not infinite.
Other examples of aggregation effects are to be found in credit-granting behaviour and rules. When an economic downturn is in prospect, it is natural that lenders seek to cut back lending or exercise greater caution in credit extension. Supervisory rules often work in the same direction. But reduced credit availability can itself create or intensify a recession. Yet another example is the tendency of lenders (and supervisors) to treat short-term credits as less risky than longer-term lending. For a single lender in isolation, this may be true. But for borrowers, short-term finance is more vulnerable than long-term. If all lending is short-term, the liquidity of the loans is an illusion, and lenders have less security, not more.
Aggregation effects lie behind the now familiar phenomena of overshooting and multiple equilibria. Once a market movement away from an initial equilibrium is initiated it may gather pace. A new equilibrium may not be quickly or easily established, nor is there any guarantee that it will be socially superior to the previous equilibrium.
(iii) Inadequate supply of public goods
A final potential source of market failure lies in arrangements for the provision of public goods. Because public goods benefit everyone but cannot easily be charged for, there is a danger that they will be undersupplied. Information has itself elements of a public good, since it is costly to produce and its use cannot always be restricted to its producer. But in addition, the infrastructure of financial markets is dependent on public goods such as the structure of contact law and law enforcement, sound accounting and valuation conventions, appropriate information disclosure requirements, effective regulatory and supervisory systems, safety net arrangements and so on. In the absence of this infrastructure, uncertainties will be greater and financial contracting will be more costly. Markets will be smaller in size and more prone to disruptions.
The various sources of market failure which I have discussed have provoked a variety of institutional and regulatory responses. In this part of my lecture, I want to consider what these responses have been at the national level. Later, I will discuss how they may need to be modified to deal with analogous problems at the international level.
(i) Responses at the National Level
The asymmetric information problem is one of the principal reasons explaining the establishment and subsequent evolution of financial intermediaries. Specialised credit institutions such as banks can alleviate both the adverse selection and moral hazard problems. They perform the function of assessing the ex ante creditworthiness of borrowers and monitoring their ex post performance better than could any individual lender. Similarly, investment banks help the issuers of securities provide standardised information to potential purchasers that improves the marketability of the securities concerned.
These institutional responses to the asymmetric information problem have been largely spontaneous. Banks evolved without official intervention, and market places evolved their own rules to make themselves a more attractive location for trading financial claims. But there has also been official encouragement. Rules protecting investors and providing for information disclosure have been enshrined in legislation and contracts.
Because banks can control and monitor the quality of their portfolios, and because they can pool credit and repayment risk, they are able to add liquidity to the financial system. Since market liquidity has public good aspects, this contributes to alleviating another potential source of market failure. The same can be said for the broking and dealing activities of investment banks.
But if financial intermediation helps deal with certain types of market failure, it can create others. Because they are highly leveraged, financial institutions, and particularly banks, can be subject to a loss of confidence that can threaten the effective functioning of financial intermediation. Bank runs can develop through a combination of herd instinct, the collective action problem, and the presence of multiple equilibria. The real economic consequences of a collapse of financial confidence were exhibited in their strongest form in the Great Depression. From that experience, most economists and policymakers accept that there is a need for some form of safety net for the financial system. Two aspects of such a safety net are the Lender of last resort functions of the central bank, and deposit insurance schemes.
Once again, however, the institutional response to one kind of market failure creates the soil for another to grow. The existence of an effective safety net tends to exacerbate the problem of moral hazard. The obvious danger is that banks, or their depositors, will become less careful in managing risks and monitoring counterparties. The direct loser is the deposit insurance authority, which has to underwrite the losses that arise from imprudent lending. More generally, of course, society at large loses from the resource misallocation that flows from the mispricing of risk.
The institutional response to the moral hazard problem and other forms of perverse incentive has been through the refinement of regulation and supervision. Initially, regulation focused rather crudely on limiting risk taking, or adding to capital cushions. Gradually, more sophisticated approaches have gained ground. Supervisors now aim to see that risk is not simply reduced, but that it is appropriately monitored and priced, and covered by a commensurate cushion of capital. Conceptually, the goal is to replicate the incentives to prudent behaviour that would exist in a perfectly competitive environment without the distortions of a safety net.
Lastly, the supply of public goods. I have already mentioned the supply of market liquidity and the provision of information, both of which emerge from the need of markets to improve their own internal functioning. The same can be said for such elements of the financial infrastructure as payment and settlement systems and accounting conventions. It is in the nature of public goods, however, that private incentives are insufficient for their optimal provision. So governments have typically accepted a responsibility to intervene: to mandate information disclosure; to collect and disseminate needed economic and financial data; to provide rules for payment and settlement systems; to provide a secure and predictable legal environment for contracts, including insolvency arrangement in the event of the failure of commercial institutions; and to underwrite, through the financial safety net, the overall stability of the system.
Market Failures in the International Financial Systems
At the level of the international financial system, the institutional mechanisms developed to deal with financial market failure do not always work in quite the same way as at the national level. Moreover, contagion can be more difficult to deal with. I will develop this theme with reference to the sources of market failure mentioned earlier, relating them to recent experience in the Asian crisis and elsewhere. This will serve as a background to the final section of my lecture: how to improve the "plumbing" of the system, so that the "architecture" can better perform its function.
Information asymmetries are probably more acute in cross-border lending than in national lending. Lenders tend to know less about borrowers, and there are added uncertainties related to exchange and transfer risk. Sovereign borrowers, who are virtually risk free when they borrow from local sources in their own currency, are very far from risk free when they borrow in third currencies. Moreover, sovereign immunity and the absence of international insolvency procedures further complicate matters.
All these factors were evident in lending to the East Asian economies. Lenders were often only partially informed about the uses to which their funds were put. They failed to properly understand the nature of the security offered by sovereign guarantees. And they did not appreciate the underlying fragility of banking systems. Rating agencies' assessments also reflected these misapprehensions. In some cases, official misrepresentation of key reserve data encouraged them further.
Externalities and aggregation effects also loom large at the international level. Bank runs are more likely to occur and spread when the nature of deposit protection is uncertain, and when banks have net exposure in foreign currencies, which the authorities cannot underwrite. Currency attacks can develop, because market participants know the resources are lacking to defend the exchange rate.
This can lead to a vicious circle with added potential for multiple equilibria. Kaminsky and Reinhart7 have shown how a domestic banking crisis can contribute to a currency crisis, which then intensifies the banking crisis and adds to its real economic costs. In the case of Indonesia, for example, even if the pre-crisis exchange rate was somewhat overvalued, it is hard to justify the loss of five-sixths of its external value (as in fact happened initially) on grounds of fundamentals. Korea and Thailand similarly experienced exchange rate overshooting, as indeed, in somewhat different circumstances, did Australia, and the UK following sterling's exit from the exchange rate mechanism.
Domestically, the threat of overshooting, vicious circles and multiple equilibria is answered by the provision of a safety net, or the existence of a lender of last resort. Such a mechanism does not exist internationally, nor could it easily be created without a global political authority. The IMF performs some of the functions of a lender of last resort, making its resources available, on conditions, to limit adjustment costs and help prevent excessive exchange rate movements. But the IMF does not have the resources or the authority to provide a fully credible protection against financial disturbances.
Despite the absence of a fully credible lender of last resort, international lending has still been subject to moral hazard and other forms of perverse incentive. It is hard to explain the enthusiasm of lenders to Russia unless they expected some kind of official or unofficial support from the international community. And lenders to Thailand, Indonesia and Korea obviously attached value to the authorities' commitment to maintain fixed exchange rates or to underwrite claims on the domestic banking system.
Other forms of perverse incentive also appear to have played a role in international financial crises. Countries have an incentive to engage in time inconsistent policies, for example committing to exchange rate regimes in one set of circumstances that would prove impossible to adhere to in others. And there was a principal/agent problem reflected in the fact that lending officers were sometimes rewarded for the volume of loans made, without sharing equivalently in the risks incurred.
As noted earlier, regulation and supervision are the mechanisms by which perverse incentives are dealt with. This becomes harder to do when the activity to be regulated is global, but the regulatory authority is national. In the case of the financial sector, additional complications are presented by the fact that many countries supervise different categories of financial institution separately and according to differentiated rules. Moreover, the development of financial technology - new products that can unbundle and repackage complex risks - further adds to the difficulties of effective supervision.
The East Asian crisis revealed that supervisory guidelines were not only different in different countries, but were implemented with varying degrees of stringency. Countries like Indonesia, Korea and Thailand had risk management guidelines in place, but lacked the supervisory infrastructure to enforce the rules in spirit. The banking systems in these countries were prone to loan concentration, insider lending, currency and maturity mismatches and other lapses from prudent standards. Moreover, they were often inadequately capitalised, since despite meeting formal minimum capital ratios, accounting rules allowed bad loans to go unrecognised until they had deteriorated to uncollectible status.
Accounting lapses are an example of the inadequate supply of international public goods. In this case, the standards that are at the base of common valuation practices were inconsistent among countries. Moreover, several East Asian countries did not have a clear and efficient system of contract law enforcement, or well-developed insolvency procedures. Corporate governance arrangements were often opaque.
Allow me to recapitulate the argument so far. The international financial architecture has evolved from an administered, government-led system to a decentralised market-based system. The current architecture offers the opportunity for greater efficiency and resilience but can only reach its potential if the associated sources of market failure are effectively dealt with. Potential sources of market failure are particularly significant in the financial sector, and the global nature of financial activity only adds to the difficulty of addressing these problems.
Against this background, I want to conclude this lecture by considering the ways in which the operation of a market-based financial system (its "plumbing") can be made more secure. I will distinguish three components of a well-functioning financial system: the intermediary institutions that channel funds from ultimate savers to ultimate investors, the markets in which financial claims are traded and priced; and the infrastructure of law and market practices within which transactions take place.
The three components are intimately related. Financial markets will not be stable or function efficiently unless the institutions that are active in them are sound and prudently managed. In turn, financial institutions cannot be efficiently managed in a volatile financial environment, or where there is uncertainty about the underlying financial infrastructure. So while it is important to deal separately with these three pillars of the financial systems, it must be remembered that parallel and consistent progress needs to be made on each of the three fronts.
The natural place to start is with the soundness of the institutions that are the key players in financial markets, mainly banks, but also securities issuers, insurance companies, fund managers and other types of intermediary. This is primarily a national responsibility. But it is given an international dimension by the global reach of many key players, and by the fact that so many of the crises of recent lending have been created or aggravated by imprudent cross-border lending. What is needed is improved standards of risk management, consistently applied, together with appropriate levels of capital adequacy.
Realising the shortcomings of previous supervisory arrangements, financial supervisors have now put in place internationally agreed "core principles" for financial sector supervision. However, much work remains to be done to ensure that these principles are implemented in a consistent fashion across countries and in different industry segments. When this is achieved, it will go a long way to ensuring that financial sector weaknesses do not exacerbate economic disturbances in the way they did in the Asian crisis.
Strong institutions, while necessary are not a sufficient condition for financial stability. Large swings in market prices, or the drying up of market liquidity, can also have damaging consequences. For example, the dramatic falls in the exchange rates of East Asian currencies, and the disappearance of liquidity in the wake of the near failure of LTCM in September 1998, threatened financial stability more broadly.
To function more stably, markets need a stable economic environment and adequate information. To reinforce the incentives for information disclosure, standards of transparency need to be developed and enforced. Once again, three elements can be distinguished. First, information about the macroeconomic environment. This calls for timely release of meaningful data, including for financial variables such as reserve levels and indebtedness. Second, information is needed about the build up of market positions. Only if markets fully understand the sources of volume and price trends in financial markets will destabilising extrapolative expectations be contained. Third, market participants need information about their counterparties, to enable them to make informed judgements about credit extension.
Lastly, market infrastructures need to be strengthened. I have already mentioned the importance of sound, internationally consistent accounting and valuation conventions. Also important are principles of corporate governance; contract law provisions and enforcement procedures; insolvency arrangements, and payments and settlements infrastructures. Deficiencies in any of these areas can undermine institutions that seem otherwise sound.
If it is accepted that the "plumbing" of the financial system requires a broad-based effort to improve standards in a number of different areas and across all national jurisdictions, how is this to be done? And just as important, what kind of machinery is needed to ensure that the functioning of financial systems remains robust in the face of continued rapid innovation?
One way would be to have a global super-regulator with powers to set and enforce standards throughout the industry on a world-wide basis. Whatever one thinks of this idea, it is clearly outside the realm of the practical for the foreseeable future. So it seems inevitable that if financial practice is to be upgraded, it will be through a process in which national authorities come together to develop common standards which are then implemented internationally. Adherence to standards of best practice will be promoted by transparency-induced market pressures, as well as through monitoring by international organisations.
This is not the place to comment in detail on the substantive content of financial standards. However, it may be useful to make five general comments about their development.
First, they are inter-related and need to be developed in a consistent way. Prudential microeconomic standards can have macroeconomic consequences. Regulatory arbitrage can push financial intermediation to the least regulated jurisdictions and market segments. A mechanism for co-ordinating the development of standards is therefore needed.
Second, the aim of standards is not to eliminate risk, but to reinforce a credit culture. The financial system is the "brain" of the economy that directs resources to their end uses. Efficient resource use requires an appropriate understanding and pricing of risk. To achieve this involves qualitative improvement of risk management practice more than simply the quantitative application of balance sheet ratios.
Third, proper attention needs to be given to the role of a capital cushion. A principal function of capital is to allow economic activity to proceed normally in the face of adverse shocks to cash flow. This need is common to all economic agents; governments, individuals and non-financial corporations as well as financial institutions. Leverage needs to be limited to prudent levels for all economic agents.
Fourth, the process of standard-setting requires legitimacy, if it is to be accepted. Representative groups of countries have to be involved, and all have to have the opportunity to be consulted. National experts need to be involved, since it is they rather than international organisations that have primary responsibility for monitoring and enforcing standards. At the same time standard-setting has to be done in bodies that are small enough for efficiency.
Fifth, and last, a process based on the decentralised development of standards, needs protection against the danger of inertia. Overlapping responsibilities generate issues of turf. And dealing with difficult questions becomes harder when the pressure of an immediate crisis recedes. We need to make sure that mechanisms are in place to ensure the impetus to reform is sustained.
The recently established Financial Stability Forum, which I have the honour to chair, represents an attempt to deal with some of these issues. It brings together representatives of central banks, finance ministries, supervisory agencies and the principal international organisations and standard-setting bodies. It therefore has the breadth to recognise the interconnectedness of financial stability issues. It is at a high political level (Deputy Finance Ministers, Deputy Governors and Heads of Supervision) so that it should have the authority to encourage needed compromises on difficult issues. Moreover, being constituted by the G-7 Finance Ministers, it can appeal to their influence to break deadlocks.
Of course, the establishment of a co-ordinating body is no more than a facilitating mechanism. Whether or not it succeeds depends on the collective will of those that participate in the broader process.
I have sketched a world in which financial instability can be mitigated by actions designed to improve the functioning of markets. I believe this can go a considerable way towards reducing the incidence and severity of crises in the international financial system. But what if this is not enough? What if, despite the creation of better financial infrastructures, more effective supervision and greater transparency, we continue to experience major financial shocks? What if, in other words, the root of the problem lies in the inherent instability of financial markets; the tendency towards excess in optimism and pessimism and an associated excess volatility of asset prices?
We cannot rule this out. Indeed, studies of the history of financial instability, such as those of Kindleberger8 and Minsky9 do not offer much encouragement. In such a case, the choice would be an unpalatable one between accepting damaging instability, and a far greater degree of administrative control over financial markets.
Accepting instability would, I suspect, be unsustainable. Public opinion would not accept such a price for a market system, whatever benefits it might have. Imposing wider ranging controls, while superficially attractive, would have just as damaging consequences. It would erode the efficiency of resource allocation, and condemn the international economy to a constant struggle between financial engineers trying to circumvent restrictions and regulators trying to plug loopholes.
Neither is a pretty prospect. That is why it is so important that the plumbers succeed in making the architecture we have inherited a comfortable place to live, as well as a pleasing concept to contemplate.
1 Sachs, Jeffrey,"Managing Global Capitalism", David Finch Lecture, Melbourne, 24 October 1997.
2 Fischer, Stanley, "The New International Architecture", David Finch Lecture, Melbourne, 9 November 1998.
3 De Gaulle, President Charles, speech given in 1965.
4 Triffin, Robert, "Gold and the Dollars Crisis", Yale 1958.
5 Padoa-Schioppa, Tommaso and Fabrizio Saccomanni.
6 Akerlof, George, "The Market for Lemons: Quality, Uncertainty and the Market Mechanism", Quarterly Journal of Economics 84 (August 1970), pp 488-500.
7 Kaminsky, G and Reinhard, C 1999 "The twin crises: the causes of banking and balance of payment problems", American Economic Review, Vol. 89, No. 3, June 1999, pp 473.500.
8 Kindleberger, Charles, "Manias, Panics and Crashes: A History of Financial Crises", New York, Basic Books, 1978.
9 Minsky, Hymen, P, "The Financial Instability Hypothesis, Capitalist Processes and the Behavior of the Economy", in Charles P. Kindleberger and Jean Pierre Laffargue, eds, Financial Crises, Theory, History and Policy, Cambridge and New York, Cambridge University Press, 1982, pp. 13-39.