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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Systemic Risks in World Financial Markets: Informal Remarks

My remarks this morning are divided into three parts — first, a reminiscence of the financial developments in industrialized countries over the last several decades; second, the cumulative effect of the environment on securities firms and financial institutions; and, third, the concerns of official institutions in making wise and fair policy in the context of the pressures on and activities of financial intermediaries. My remarks are quite informal. I do not have a text and ask you to bear with me if my comments are overstated, repetitious, or elliptical. That's what comes from the absence of carefully worded and polished text. My thesis here is a straightforward one: competition amongst financial intermediaries, given information and accounting systems, have created a highly risk-oriented and potentially destabilizing financial environment. But I am already getting ahead of myself. Let me start with a review of some of the significant developments over the last 20 years. 

The Environment

  • Floating exchange rates. At first the world was fixed. Then the Yen, for example, went from 360 to the dollar to 300 to 240 to 200 to 300 to 120 — with many changes of direction in between. That volatility, which occurred in many currencies, created the incentive to speculate on potential exchange rate movements — or if possible, to cause them. That, in turn, led to market risk and a proliferation of products for protection and speculation.
  • 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%, down to 7%. Short-term dollar rates have similarly fluctuated between 3% and 20% and everywhere in between. That kind of volatility also led to the potential for profit by speculating on interest rate movements. That, too, put financial intermediaries at risk — particularly if they were mismatched, as many were, between the asset and liability side of their balance sheets. It also created an environment for proprietary risk taking and trading where gains might be garnered intraday.
  • Shifts in savings flows: build-ups in Japan, Germany, elsewhere in Europe and Asia, OPEC. Governments soon permitted the tapping of domestic savings by borrowers and investors outside their domestic borders, both in dollars and local currency — and by "foreign" intermediaries. That, in turn, added to the competitive pressures on domestic financial institutions.
  • Deregulation of financial intermediaries. That let everyone in everyone else's traditional line of business. In industrialized countries, insurance companies, banks, pension funds, securities firms all competed for savings worldwide and offered remarkably similar products. Financial monopolies were dismantled.
  • 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, where controls and regulation were less sophisticated or invasive.
  • Products incorporating floating or short term interest rates provided a natural hedge against inflation. It also provided a vehicle for playing the yield curve, basis trades and taking on large longer-term positions if the cost to carry in the short term markets were favorable.
  • 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 efficiency of the information increased volatility because high levels of volume become destabilizing when markets are aware of and responding to the same information. The narrowing spreads between buyers and sellers, a natural consequence of the number and capital of the players, inexorably damaged middle man profitability — the agency business. The increased liquidity, however, did not reduce volatility given the immediacy of the information flow. It increased it.
  • Disintermediation: money market funds vs. bank deposits; commercial paper vs. loans; short-dated governments vs. C.D.'s; securitized mortgages vs. bonds. That permitted each product to "cannibalize" the savings base.
  • Clients developed market expertise and capacity to deal with each other. That removed the necessity for the use of any financial intermediary between the ultimate buyer and seller.
  • 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.
  • Very high compensation — and an assymetrical one, at that. That permitted risks to be taken by managers and traders with the potential for high rewards for getting it right with little downside penalty for loss.
  • Government insurance of the funding source for banking institutions. In the U.S., FDIC and FSLIC insured the banks and S&L's, while at the same time deregulating how the deposits could be used. That removed the creditor as a constraining influence over the deployment of assets as governments permitted a wide range of investments for banks and thrift institutions. In a sense, the liability side of the balance sheet was nationalized; the asset side privatized.
  • Direct and substantial government intervention into foreign exchange and credit markets. That meant a non-market force would directly intervene in the market, but as a non-profit-driven player. That provided a potential source of profit for the private financial intermediary. Moreover, combined with depositary insurance, it meant that banks 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 financed and guaranteed by the official sector. Governments, therefore, find that (a) they are in an adversary position to their banks; (b) they don't have the resources of the private sector in conducting FX activity; (c) they are making political, not market-based decisions; and (d) they fund and guarantee their market adversaries. Not a happy situation for Central Banks.
  • Securitization. As a practical matter, that meant if you could sell an asset after putting it on your books, you need not worry about credit quality. Someone else would pick up the pieces. Securitization and the prospects for immediate liquidity, I believe, over time, damaged the normal attention to prudential credit assessment.
  • Highly disparate regulatory controls across countries.
  • Finally, financial engineering. It gave great advantage to first users. But it was easily imitated by others. Even the most sophisticated products were replicable because of broad skills, communications and information technology. Arbitrage opportunities were quickly identified and disappeared. But more important, the products were complex, leveraged, not readily understood by managers or regulators, and off balance sheet, which meant that they were and are "unrecorded" with unknown or uncertain risk and not readily subject to capital requirements.

Such was the environment.

That brings me to my second point — the result: substantial competition and pressures on profitability in a volatile environment — all in the context of rather uncertain managerial and government expertise. But, again, I am getting ahead of myself. Let me comment on the competitive pressures.

There developed tremendous worldwide competition amongst financial intermediaries for five things: (1) for savings, (2) for new, and hopefully not easily replicable, products, particularly if off-balance sheet, (3) for a protected or monopolistic position, or, if that were not available, the first contact point between buyer and seller, or between borrower and investor, (4) for methods to create liquidity for the sale of assets once not marketable, and (5) for a non-regulated environment.

Basically, over the last two decades, financial intermediaries sought to replicate each other's "historic" profit center, as if these profit centers were infinitely expanding ones. It was as if profitability available for a few firms from a particular line of business could be replicated by 50 firms worldwide, consistently. That was not the case. For example, firms sought to establish a trading capacity, as agent, but quickly spreads narrowed — too many players, too much information, too much volatility for reasonably certain returns. Many firms shifted to financial engineering, but that, too, was replicable, and arbitrages quickly disappeared for the sophisticated players. Positioning was dangerous given the volatility, and shifts in the slope of the yield curve made the cost of carry uncertain.  We became overbanked, over-securitized, with some players protected, others not, because of diverse regulatory requirements in a country and across countries. There were, and are, simply too many intermediaries seeking the same investors or borrowers as access opened up worldwide. At the same time, the preoccupation with liquidity — with securitization — almost by definition contributed to an underestimation of market risk and a disdain for attention to creditworthiness — all furthered by unrealistic accounting conventions.

The effect of the pressures on profitability and of disintermediation should not be underestimated. I believe it directly resulted in the relaxation of regulatory standards which permitted, in an effort to foster profitability, high risk assets to be taken on the books of S&L's and insurance companies — permitted because their traditional profitability had been eroded by the disintermediation and narrow spreads on their traditional lines of business. All in the context of government insurance of the deposits and accommodating accounting conventions.

Let me go back to the complexity of the products and management responsibility. Derivative products put considerable strain on senior management and on customers and regulators to evaluate risk and profitability. This, in large part, was due to the fact that there were, literally, scores of complex, highly-leveraged products, painstakingly constructed, for which there was little empirical experience to define and circumscribe the underlying risk. Moreover, even to the extent known (it sometimes was not), the risk profile of the new instruments was (and is) too often kept solely within the trading community and operators, and not readily shared with managers. There were also pressures simply to skirt the edge of legality, sell to the least sophisticated, seek a marginal advantage — sometimes for a few moments in a highly competitive world.

The key, inevitably, was to find a product which permitted leverage, minimal capital, few regulatory controls, low expense to operate, and proprietary risk taking where the other side is a non-market player who could not act rationally for political reasons. Foreign exchange trading — in all of its arcane forms. I believe when the other avenues of profit shut down, FX became the new game in town — an unregulated and one-sided game where the government could not act as a rational market player, did not have the staying power, and, in any event, was and is ambivalent about damaging institutions whose deposits it guarantees and whose viability it needs to finance domestic deficits.

Another major effect of the competitive pressures on financial institutions was its effect on the day-to-day operations of U.S. commercial banks. They were and are subject to an unhappy combination of incentives: (a) over-banking — worldwide; (b) the holding of illiquid assets which, once made, were difficult to divest, despite the advances in "securitization;" (c) an accounting treatment which did not mark assets to market and which, in turn, diminished, inexorably, attention to credit quality; (d) competition for funds from money market funds, as well as for clients to lend (they had other alternatives) such as the securities markets; (e) a narrowing of spreads between the total cost of funding and the return on loans. (Indeed, the extreme reversal of that condition is the only reason for current bank profitability in the U.S.); (f) diminished U.S. economic activity; and (g) rising skills, resources and requirements outside the United States. U.S. banks, inexorably, were under pressures to find ways to increase their margins to achieve a return on their equity. Given federal insurance in the U.S., it was clear they would lend in new areas with the highest potential profit margins despite the traditional tests of prudence — unproven agricultural land, energy exploration with equity kickers, illiquid LDC loans, junk bonds, etc. And the latest intervention — to put them into the high risk but low profitability securities business will simply, I predict, create further risk and pressures on both the securities firms and the banks, with an inevitable tendency to create decent returns on equity by more and more leveraged and off-balance sheet activity. There are simply too many financial intermediaries and already too many in each other's lines of business.

All of this with weak management . The world simply moved too fast, even for most senior managers. Let me read to you how a trader described in a popular publication how he uses derivative products:

On the risk management side the bank runs five separate books: a spread book, a volatility book, a basis book, a yield-curve book and a directional book. The spread book trades swap spreads using Treasuries to hedge medium-to-long-dated swaps and a combination of futures and Treasuries for the short term. The volatility book makes markets in caps, floors and swaptions as well as captions, floortions and spreadtions. The basis book deals with the spread between different floating rate indices, such as Prime and CP versus Libor. The last two books are structured to arbitrage changes in the steepness of the curve as well as overall movements in interest rates.

I doubt that his CEO was equipped to supervise that operation. Nor, moreover, was, or is, the SEC or the regulatory agencies throughout the world. Nor can they efficiently assess the implications of these activities for the execution of public policy (say, in executing monetary policy), for the maintenance of fair and orderly markets, for the establishment of capital requirements or the risk potential of the underlying activity.

For S&L's, a banking subset in the U.S., the result was almost predetermined. Specifically, the current mess has as its antecedents (a) the lifting of the interest rates that S&L's could pay on deposits; (b) the general deregulation over how S&L's might invest those deposits beyond residential home mortgages; (c) a determined relaxation of supervision over such investments; (d) FSLIC insurance; and (e) the maintenance of an infamous accounting convention — "a rolling loan gathers no loss." It was, and is, a structure virtually guaranteed to result in an unwise deployment of insured deposits because there is no potential private creditor loser.

The unhappy reality is that an accounting system which does not mark loans or assets to their market value, until sold, inevitably encourages flawed decision-making — both for banking institutions and for securities firms. A system which provides government insurance and deregulates the deployment of assets, permits financial institutions to avoid a "market" test and to expand into a wide range of new markets and products was bound to run into trouble — particularly given the minimal equity capital commitment of the owners. It inevitably will put pressure on all financial intermediaries and inevitably will cause them to seek out highly leveraged products or activities. With each failure or shutting down of a profit center, the next has even greater potential for damage. As I noted before, the name of the game, I believe, will be Foreign Exchange trading.

Permit me to summarize and pull some of this together.

The risk is that as profitability has eroded in traditional lines of protected businesses for all of the reasons I have noted, there has been a seriatim of problems: junk bonds; capitalization of interest; huge losses on complex derivative products; an S&L crisis in the U.S. As each problem dissipates with a lot of damage in its' wake, firms seek another profit center: a controlled repo market, the use of equity derivatives to accelerate a decline in the Japanese market, foreign exchange speculation to test whether a government can match the strength of the private sector. The financial intermediaries — the banks and securities firms — have now become very powerful and destabilizing players, seeking out the least regulated and leveraged sector. It certainly will make difficult government's attempt to allocate resources and make economic policy. This, of course, some would argue, is an appropriate constraint. Let the private sector decide. But, I would repeat, those intermediaries are also acting — some of them — most — with direct government explicit backing.

That now brings me to some final points which, because of time constraints, I can only briefly note here — what do governments and Central Banks, worldwide, worry about, in the context of the financial environment. What are the choices and dilemmas they face?

  • How to encourage banks to be prudent about lending without constraining their lending. The U.S. is a good example. The banking excesses and the warnings from the authorities have "cooled" bank lending — perhaps too much given the state of the economy. Increased capital requirements designed to protect the taxpayer inexorably reduce credit extension. Once burned, twice shy.
  • How to maintain an adversarial and supportive relationship with financial institutions, particularly in the context of institutions who may be acting in ways inconsistent with national policy in, say, FX trading, given the unique relationships between banks and government.
  • How to control banks who set up subsidiary activities offshore where there are few supervisory or regulatory controls and where, as a practical matter, any losses will be borne by the parent and its insured depositors.
  • How to assess, become informed, and set capital requirements for derivative products — across countries and different kinds of financial institutions, including non-banks.
  • How to mark assets to market without destroying confidence in the banking system.
  • How to control (or whether to control) the credit extending activities and the speculative activities of non-banks — particularly in areas which directly affect national monetary policy.
  • How to create an environment for banking institutions which is conducive to profitability when there are so many financial intermediaries and products worldwide competing for the same customer base.
  • How to regulate the activities of "foreign" banks where those banks often represent savings from other countries which are needed for domestic growth.
  • Governments are concerned about the domino syndrome. Too many intermediaries, too many non-creditworthy borrowers, too much expertise outside of government, too many loopholes, too much leverage. Too much off-balance sheet.
  • How to adjust interest rates to be sector-specific; say, to apply only to FX speculation. The freedom to move currencies across countries means exchange rate stability will be difficult to establish. Moreover, transactions are done routinely which, in the U.S., would result in severe criminal penalties. It is not a market which would survive careful scrutiny, say, by the SEC, without resulting in numerous indictments.

These are not easy problems to handle. Their "resolution" would require an international consensus which does not now exist. It also would involve a resolution of competing and divergent principles of regulation and control both within and across countries. Private sector management clearly needs to be better informed, as do governments and Central Banks, about the intricacies of market products. And the basic relationship among governments, taxpayers and financial institutions needs to be continuously reviewed and rationalized. It is a challenging and forbidding agenda.