A financial system, like all structures, is as strong as its weakest link. As the international financial system has become even more complex, the particular areas of weakness to be addressed have changed. At the risk of oversimplification, lets examine some of the key links of our current infrastructure.
Today the organized exchanges and over-the-counter markets of industrial countries can handle massive volumes of transactions. Even in emerging countries exchanges are developing and expanding. In contrast, during the world-wide stock market crash of October 1987, the transactions systems were under severe stress and, indeed, some broke down, incapable of handling the enlarged volumes. The New York Stock Exchange was straining badly under the near 400 million daily share volume of October 1987, with long reporting delays creating uncertainties that, doubtless, exaggerated the price declines. Those weaker links have since been strengthened by large infrastructure investments. Almost 1.2 billion shares traded on the NYSE on October 28 of this year, three times the 1987 volumes with no evident problems or delays.
Our equity, debt, and foreign exchange trading systems, and their peripheral futures and options markets have functioned well under stress recently. These systems are not weak links in the developed economies, nor, for the most part are they in other economies.
Neither is the payment system, that complex network, which transfers funds and securities in huge and growing volumes domestically and internationally, rapidly and efficiently. The private and public sectors across the globe have endeavored diligently for years to expand the capacity of the system to meet the increasing demands put upon it. And they have initiated and strengthened procedures for reducing risk in settling transactions, and diminishing uncertainties. That they have generally succeeded is evident from the smoothness with which huge volumes of funds produced under recent stressed market conditions were transferred and settled with finality, through various netting and clearing arrangements.
Banks are another matter. These are highly leveraged institutions, financed in part by interbank credits and, hence, prone to crises of confidence that can quickly spread. In most developed nations banking systems appear reasonably solid. Japan has been somewhat of an exception, but there have been some positive signs there, as well. Banks have been recognizing losses, and the government seems finally to be appropriately addressing their problems.
In a large number of emerging nations banks are in poor shape. Lax lending has created a high incidence of non performing loans, supported by inadequate capital, leaving banks vulnerable to declines in collateral values and nonperformance by borrowers.
How can such deficient institutions be elevated to a level that would allow their economies to function effectively in our increasingly sophisticated international financial system? Certainly, improved cost and risk management and elimination of poor lending practices are a good place to start.
But these cannot be accomplished overnight. Loan officers with experience judging credit and market risks are in very short supply in emerging economies. Training will require time. The same difficulties confront bank supervision and regulation. Important efforts in this area have been underway for several years through the auspices of the Bank for International Settlements, the International Monetary Fund, and the World Bank.
Moreover, robust banking and financial systems require firmly enforced laws of contract, and transparent, market oriented systems of corporate reporting and governance. The current crisis in Asia is, to a much greater extent than many previous crises, one of private not public debts, at least de jure. Arguably, the absence of efficient and transparent work-out arrangements for troubled private borrowers makes the problems more difficult to deal with. Efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when losses have to be imposed on creditors. Many developing countries do not have good work-out arrangements for troubled debtors, and, as a result, governments in these countries often feel compelled to bail them out rather than accept the consequences of defaults.
The most troublesome aspect of many banking systems of emerging countries is the widespread prevalence of loans driven by industrial policy imperatives rather than market forces. What is wrong with policy loans? Potentially nothing if they were made to firms to finance expansions that just happened to coincide with a rise in consumer or business or overseas demand for their newly produced products. In these circumstances, the loan proceeds would have been profitably employed and the loan repaid at maturity with interest. Unfortunately, this is often not the case. Policy loans, in too many instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan defaults. In many cases, of course, these loans regrettably end up being guaranteed by governments.
Restructuring of financial systems, while indispensable, cannot be implemented quickly. Yes, the potential risks to the banking systems of many Asian countries and the potential contagion effects for their neighbours, and other trading partners, should have been spotted earlier and addressed. But flaws, seen clearly in retrospect, are never so evident at the time.
Moreover, there is significant bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult preemptive policy moves. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in reserves, issuance by the government of equivalents to foreign currency obligations, or unreported new forward short positions against foreign currencies. Reality eventually replaces hope, and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more preemptive.
We should strongly stress to the newer members of the international financial system - the emerging economies - that they should accelerate the restructuring of their financial systems in their own interests. But having delayed timely restructuring, many now find themselves with major shortfalls in bank liquidity and equity capital that put their systems at severe risk of collapse before any full restructuring is feasible.
The IMF, the World Bank, and their major shareholders, the developed countries, may wish to facilitate adjustment through temporary loans to governments and the encouragement of private equity infusions to these banking systems. Since any severe breakdown can have contagion effects on a world-wide basis, it is in our interest to do so.
These loans must be judged in their entirety. They transform short-term obligations into medium-term loans, but they do so contingent on the country using the time to reform financial systems as well as adopt sound economic policies. Such conditionality accelerates the adjustments in financial systems needed to lay the foundation for resumption of robust, sustainable growth, while cushioning to some degree the economic effects of the immediate crisis.
Assistance without further reform of financial systems and economic policies would be worse than useless since it would foster expectations of being perpetually bailed out. That, in turn, could induce perverse behavior on the part of emerging nations governments and of private sector investors in emerging nations.
As the international financial system becomes ever larger and more efficient, the size of the financial response - whether to help banks or to add to foreign currency reserves - may have to be correspondingly larger per unit of crisis, if I may put it that way - unless we alter our approach.
While it is precarious to generalize from one observation, it is likely that the Mexican financial crisis of the 1980s was broader than in 1994-95, but the size of the assistance program, to set things right, was much larger in the latter than in the former case. The reason appears to be that the increased efficiency of the financial system created a larger negative spillover, which had to be contained. Among other developments, the marked shift from bank credits earlier, to a more securitized, anonymous set of liabilities made workouts far more complex.
It is, hence, all the more essential that the weaker links in our international financial system, the banking systems of the emerging nations, be strengthened. Preventive programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart or contain it.
Recent events in Asia have sharpened our understanding of the complexity of todays international capital flows and, presumably, of similar episodes that may emerge in the future. The rapid integration of national financial systems has fostered the growth of trade and standards of living worldwide. It has also forced a review of the soundness and viability of our burgeoning financial systems.
We should welcome such pressures even as they impose challenges to all of us. The end result is very worthwhile having.
(The author is the chairman of the US Federal Reserve Board. This text has been excerpted from his speech delivered at the Economic Club of New York on December 2) Concluded Alan Greenspan discusses how deficient banking systems in emerging markets can be elevated to a level that would allow their economies to function effectively in todays global financial system
As the international financial system becomes ever larger and more efficient, the size of the financial response to help banks may have to be correspondingly larger per unit of crisis, unless we alter our approach.
