On Incentives

"Never penalize those who work for us for mistakes or reward them for being right about markets. It will go to their heads, is counterproductive and, in any event, material compensation will not correlate with their ability to predict the future next time."

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Mismatches, Lags and Conflicts: Some Observations

My remarks today are divided into several parts: first, a reminiscence of financial developments worldwide over the last several decades and their implications and, second,  a summary and assessment of major issues which troubled policy makers and government officials in the recently concluded World Bank/IMF annual meetings. Let’s start with the past.

The Past

  • Floating exchange rates. At first the world was fixed. Then the Yen rose from 360 to the dollar to 300 to 240 to 200, deteriorated to 300 then revalued to 80, then devalued to 150 yen to the dollar and recently improved to the 120’s – with many changes of direction in between. That volatility, which occurred in many currencies, created the incentive to speculate or hedge on potential exchange rte movements – or if possible, to cause them.
  • Volatile interest rates. In the U.S., long-term interests moved one percent in the period 1955-1965. Since then, long-term rates have moved from 7% to 15%, down to 8%, rose to 12%, and now below 5. Short-term dollar rates have fluctuated between 3% and 20% and everywhere in between. That volatility also created a potential for profit by speculating on interest rate movements.
  • There were huge shifts in savings: build-ups in Japan, Germany, elsewhere in Europe and Asia, OPEC. Just as important, governments in the last 20 years, with little previous precedent, permitted the tapping of domestic savings by non-resident borrowers and issuers of equity alike. Similarly, those seeking capital – debt and equity - had the freedom and risk to go outside their borders – indeed, outside their currency for capital.
  • Deregulation of financial intermediaries let everyone in everyone else’s traditional line of business. In industrialized countries, insurance companies, banks, pension funds, securities firms were permitted to compete for savings between end buyers and sellers, both domestically and worldwide. They offered remarkably similar products.
  • Lowest common denominator regulatory and supervisory controls. If a financial intermediary could not offer particular services because of national controls, it moved its operation to a more accommodating environment. Or, if the site became too intrusive, financial institutions shifted to a different product, say, foreign exchange trading or derivatives where leveraging was the rule and quite difficult to understand, let alone monitor or regulate.
  • Communications. That let everyone know what all markets and participants were doing and seeing at the same time. That, in turn, narrowed spreads between buyers and sellers. However, the high volumes became destabilizing when markets responded to the same information. The increased volumes, therefore, did not reduce price volatility given the immediacy of the information flow. It increased it. It is a myth that increased liquidity and volume reduces volatility. Increased liquidity merely narrowed the financial difference between buyers and sellers – a rather unimportant economic event - except for the profit pressures on the intermediaries who inexorably were pushed into alternative ways of achieving a decent return on capital in an increasingly volatile and competitive environment.
  • Disintermediation:  money market funds vs. bank deposits; commercial paper vs. loans; short-dated governments vs. C.D.’s, securitized mortgages vs. bonds, syndicated loans vs. bonds. That meant that each product and financial intermediary “cannibalized” the world -wide savings base.
  • An accommodating accounting system. That permitted failure and risk to stay undisclosed because of the practice throughout the world of not marking assets to market – despite their depreciating value.
  • An asymmetrical compensation system. That permitted risks to be taken by managers and traders with potential asymmetrical rewards for getting it right with minimal downside penalty for loss.
  • Government insurance of the funding source for banking institutions. In the U.S., indeed, all over the world governments insured the depositors while deregulating how the deposits could be used. That removed the depositor/creditor as a constraining influence over the deployment of assets as governments permitted an ever wider range of investments and activities for banks. In short, the liability side of the balance sheet was nationalized; the asset side alone was privatized. Bad news.
  • Direct and substantial government intervention into foreign exchange and credit markets. That meant a force would directly intervene in the market, instead of as a profit-driven player, it was a politically-driven player -- therefore a potential patsy for the private sector. Moreover, combined with depositary insurance, it meant that banks, for example, could now speculate on the value of a currency – in an adversarial position against their own government or Central Bank with the government locked into making political, not financial, decisions. Yet the banks’ funding for such activity was, if not financed (and they often were), guaranteed by those same governments. Governments, therefore, found that a) they were in an adversary position to their banks; b) they didn’t have the resources of the private sector in conducting FX activity; c) they were making political, not market-based decisions; d) they funded and guaranteed their market adversaries; and e) they, indeed, did not even use the same kind of leveraged products in conducting their rate stabilizing activity. Not a happy situation for Central Banks.
  • Finally, financial engineering. It gave great advantage to first-users. More important, the products were complex, leveraged, not readily understood by senior managers or regulators, and off balance sheet, which meant that they were and are often “unrecorded” by anyone, electronically transmitted with unknown or uncertain risk and not readily subject to traditional accounting or risk management systems.

Such was the environment. Such is the environment.

The Results

a) All of this was in the context of little expertise by policy makers in the workings of a rapidly changing and complex market; b) tremendous unrecorded access to capital by virtually any government or the private sector borrower in the world; c) disparate legal and property rights world-wide; d) little corporate governance and social safety nets in emerging markets; e) huge disparities in the liquidity of certain instruments as compared to others; f) very uncertain risk management controls.

The results should not have been unexpected:

  • An S&L Crisis in the U.S.
  • Excessive or Imprudent Lending by Banks
  • Currency Crises in Mexico, Western Europe, Russia
  • Orange County, Barrings, Long-Term Capital
  • Korea, Malaysia, Indonesia

The 1998 Annual Meeting

It is the context of these troublesome events that we recently concluded the World Bank/IMF meetings in September 1998.

The recent World Bank/IMF Annual Meeting provided, yet again, an opportunity to hear what the assembled Heads of State, Finance Ministers, Planning Ministers and Central Bank Governors were worried about. It also provided insights into what problems were under their control, which were contentious and which were simply too painful even to be discussed. The fact is that the world’s financial system is now subject to events and conditions which cannot be coped with at this time by either national governments or multilateral organizations. There are simply too many mismatches, lags and conflicts between the problems and the “solution.” The comments below reflect the speakers’ consensus in the meetings and my own observations.

Short Term Capital Flows

Consensus: They were dangerous and should be monitored and controlled.

  1. First, and perhaps fundamental, is the mismatch between the expertise of the private financial market participants as compared to the policy makers in the public sector. There is no regulatory or supervisory agency in any country, including the United States, which fully and comfortably understands, for example, how leverage is accomplished, in what volumes, with what participants and products, the nature of the collateral and the minute-to-minute shifts of positions by the players. It was not meaningful, therefore, to talk about monitoring, let alone controlling or regulating the activities of, say, hedge funds (which at least a dozen Finance Ministers suggested) without an underlying detailed knowledge as to how leveraging and complex derivatives actually work in the private sector. The public sector does not have that knowledge base.
  2. Governments also are mismatched in their use of derivatives in their attempts to stabilize currencies as compared to private sector players. As a result,their lack of sophistication not only inhibits their regulatory posture, but also inhibits effective market response by a central bank when it attempts open market currency support using inefficient and awkward instruments against the leveraged instruments used in the private sector.
  3. There is also a mismatch between the sheer volume of transaction flow, much of it electronically transmitted, and the monitoring or recording of such transactions within a given country let alone globally across borders. The reason is because the private sector players either have no recording obligation, or the data is not centralized and certainly not coordinated across national borders. While Central Bank Governors and Financial Ministers fell all over each other supporting the need for constraints (they called it sequencing) over volatile (speculative) flows, it was clear they didn’t have the vaguest idea of how to do so without shutting down their access to resources.
  4. Virtually, every official commented on the volatility of the short-term financial credit flows in their country, and the severe impact on interest rates and currencies when capital was quickly withdrawn. Few, however, noted the mismatch between those flows and the lethargic, bureaucratic and often hostile attitude toward direct foreign equity investment. As a result, governments have created incentives to investing short, liquid and as a creditor rather than as a long-term, less liquid equity investor. That comes from dealing with financial institutions rather than the corporate sector. That tilt, in turn, reflected an underlying hostility in a number of countries to a concern over the potential for losing independence and patrimony to foreign ownership of commodities and natural resources. The result was bound to create substantial pressure in the alternative investment vehicles – the debt and currency markets where, as noted above, the official sector was at a decided disadvantage, their monitoring tools least advanced and where adverse impact was swift and without recourse. Moreover, the availability of liquid and leveraged instruments on the debt and currency side encouraged market players to engage in transactions whose very volumes would prove destabilizing when withdrawn.

Social Safety Nets and Trauma

Consensus: Safety Nets are required. They are not in place.

  1. Financial and political traumas in recent years, and particularly in the last six months, have occurred in response to rapid and severe currency attacks and flight of short-term capital from the credit markets. The immediate effects were currency devaluation, extremely high interest rates and collapse of financial intermediaries whose investments or loans depreciated in value. It occurred with such speed that there was little coping mechanism in the form of social safety nets to cushion the adverse economic outcomes from unpredictable financial events.
  2. The absence of social safety nets reflected the mismatch between the rapid privatization of productive enterprises as compared to the lagging attention paid to pensioners, those on fixed incomes, unskilled workers, the unemployed or unemployable.
  3. The fundamental debate between that part of a society, in emerging markets, which takes pride in “market efficiency” (downsizing, reduction of subsidies, low minimum wage) to obtain a comparative trade advantage versus the concern over safety nets (minimum wages, standards of employment, food and housing subsidies, unemployment compensation) has not been joined. That, in turn, reflected the absence of a political consensus as to the role of government in providing health and educational programs or other support systems versus supporting, through tax policy or otherwise private investments which have positive cash flow. There is little wonder that the social safety nets were not in place, let alone those which are automatic and quick acting. The reason they are not in place is simply because in most emerging markets there has not yet developed the basic social contract as to the roles of labor, owner, manager and government. And without that consensus the perceived easier path is to control the perceived “causes” of the trauma- the speculative or short-term capital flows - though they have neither the understanding of those markets, nor the infrastructure to monitor, let alone to regulate them.
  4. Related to the foregoing is the mismatch between the private sector (and the availability of capital to support that sector) versus the quality of corporate governance, the rule of law, and the existence of a predictable tax system. Here, too, the highest officials in scores of countries referred to the need to address these matters. But the reason they have not been addressed, again, is because the countries have not developed into a mature, political economy in which the major competing constituencies have fought and resolved highly contentious battles. The compromises have not been reached. Those compromises are precursors to establish a division of power and resources.  Instead, privatization and stock markets came first----the icing on the cake before the cake was baked.


Information Flow

Consensus: There should be more transparency of data and policies. These should be quickly disseminated.

  1. There was a lot of schizophrenia about “information” flow. The mantra was clear. Policies and data must be transparent and current. But the consensus was hedged. The IMF and World Bank should facilitate timely publication of public sector data but without breaching the confidentiality of the information provided to those institutions! Moreover, few officials recognized that the better the quality and immediacy of information given the speed of its dissemination, the greater the probability for sharp and volatile price movements as each market participant, in response to adverse information, would seek to leave through the same door. Fundamentally, free, open, transparent and immediate information was mismatched with the absence of safety nets in the event of adverse economic or financial outcomes from the quick dissemination of such information.

Prudential Lending

Conclusion: Banks should be required to be more careful in their lending.

  1. It was clear that the need and availability of capital far outstripped the rules for prudential lending. Again, here too the social/political structure did not have the time to create a system of checks and balances, a sharing of power and responsibilities so necessary as a condition precedent to the establishment of formalized rules and guidelines. The simple truth was that emerging markets in many cases were opened quickly to receive capital, before the political economy had a consensus for the establishment of the rules of wise, ethical and correct financial and corporate behavior. That takes time and rarely can be accelerated by either fiat, market forces or outside consultants. The mismatch between the ease of allocating capital and the absence of a social consensus, in certain countries, has dangerously pushed certain countries to the brink of a centalized, closed environment.


Consensus: Something should be done about it. More lending and support for the poor.

  1. While there was considerable reference to the need to address issues dealing with basic poverty at the human level, there was little recognition that the resources available from a) private investment, b) multilateral institutions, c) bi-lateral aid and d) internal taxation were finite and fundamentally in competition with the infrastructure demands in the financial and productive sectors. To the extent that, one way or another, shareholders or even depositors are protected from unwise or imprudent lending practices of financial institutions, those resources are simply unavailable to address the hardcore issues of poverty. There was scarcely a peep about “moral hazard.” Its absence told volumes about the tilt.

To conclude: the talk about safety nets, poverty alleviation, the rule of law, cultural controls, corporate governance, had a vaguely unreal quality about it. One sensed the reluctance of each speaker to admit that the fundamental coping mechanisms were not yet there because of an absence of political will/maturity which simply could not keep up with or respond to the huge cross border financial flows which so drastically affected them. And also, even if the political will were there, one sensed that nation states simply did not have the capacity to understand, predict or respond to this new variable – crossborder financial flows in the debt and currency markets – which dwarfed their domestic economy.

Almost without exception, the highest ranking officials had wisdom, concern, humility, though few were willing to admit matters were out of their control. Fewer still were prepared to make their countries’ patrimony available for direct foreign investment. None admitted to their lack of technical knowledge as to how the products which affected their markets really worked in practice. None certainly admitted that they were not yet ready for prime time, that is, their ability to handle the consequences throughout their economy of hostile, adverse and “foreign” players in their economy.