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Writings & Speeches

Capital Markets

Permit me to open this session by making comments about innovation in capital markets.  As you know, we have seen in recent decades, and indeed in recent years, remarkable innovations in financial capital markets.  [We will see more in the future.]  Innovation generally increases risk because innovation typically precedes liquidity—a dangerous circumstance when things go wrong.  Arbitrage and hedging possibilities are—at the inception of any innovation—quite limited.  Generally, accounting rules lag innovation.  Innovation usually is off-balance sheet, leverage is rarely constrained, and the more sophisticated the innovation, the less senior management is likely to know what is going on unless they were the innovators.

And recently we have been seduced by the assumption that mathematical models can predict the probability of a default particularly say, on credit derivatives.  We read the sentence, “assuming the probability of default is known,” as if the sentence reads “we know the probability of default” even though we know, subliminally, that there are few defaults—not enough “points” to test our models.  We also assume that there is a correlation between, say, the rating of a bond issuer and the probability of a default and that ratings predict when spreads will narrow or widen before it occurs.  We assume, with much more justification, that a pool of securities will give us more certainty and better pricing than an individual ad hoc pricing for a single issuer.  There is also good news in that in recent years risks have been spread because of massive securitization which reduces the risk to an individual bank or insurance company.  That means only that systemic trauma is reduced.   Any loss will be shared by many. 

But my role as the moderator of this meeting is not to lay out the risks or advantages of derivatives particularly those arising from the recent explosion of credit derivatives.  Let me, therefore, summarize my sense of what will happen over the next five to ten years in a more general fashion without either the time or the necessity (fortunately) to prove my case for each of the following propositions:

1. There will be significant losses in financial institutions – particularly arising from the credit derivative market.  Rising rates will increase risks.  Innovation will outspeed liquidity.  Regulatory authorities will fall behind in their understanding of what is happening in the market.  But, unlike the past, the damage will be widely spread because of securitization and not concentrated in a few banks or insurance companies.  Unless, of course, they decide to become greedy and hold all the risk themselves.  Not likely.
2. There will be increasing pressure for inflation linked securities as a floor as energy costs begin to be systemically imbedded in the world economy.
3. We will see in response to the demand for housing – mortgage-backed securities – pools, particularly in Europe in an attempt to spread risks.
4. Banks will exercise and securitize both their commercial loans and credit cards throughout the world in an effort to liquefy their balance sheets and spread the risk to persons other than Bank shareholders.
5. Emerging Market debt will be in their own currencies particularly when combined with inflation linked instruments and the increasing use of credit derivatives.  Packages and pools will be created which include synthetic debt of many countries which will be hedged by real debt of those same countries.
6. Bond issuers will be pressed to provide a fixed total return and currency protection and an equity kicker based on published indices all in an effort to attract buyers and raise capital.  And, this, in turn, will provide risks and opportunities for issuers, intermediaries, and buyers to either hedge or leverage the component parts of the contract.
7. The insurance industry and banks will continue to innovate as pooling and new products will require sophisticated actuarial assumptions which previously was only the province of securities firms’ expertise and experience.
8. All securities firms will need substantial capital either through affiliation with banks or insurance companies in order to meet the demands of customers—whether speculators or hedgers—to take risk positions.  But they will try quickly to sell off their positions to end buyers – pension funds, insurance companies, and other institutional investors.  The intermediaries will hope to profit from arbitrage or superior modeling.

Permit me to conclude by quoting from an article I wrote twenty years ago:

“Communications now permit buyers and sellers to respond to each other virtually instantly, while simultaneously aware of competing financial opportunities throughout the world.  National savings and markets are increasingly freed from legal, regulatory, and practical constraints that were designed to inhibit the transfer of capital across domestic borders.  Financial engineering permits mistakes once made from getting worse; wise decisions to be captured; the hedging of risks attributed to currency, interest rates, and spreads; and the leveraging of financial decisions through options and warrants.” 

* * *

            “We are in the midst of a fundamental restructuring of how savings move worldwide as well as an opening up of a whole range of possibilities—extending from disaster scenarios to explosive and exciting implications for growth in both the industrialized and developing world.  Indeed, issues involving national sovereignty and the political economy are likely to confront us with as much drama as the industrial and managerial revolutions.

            “Everyone seems to be writing and talking about pieces of the picture.  The political and social implications, however, are illusive.  I suspect that one of the reasons for the lack of focused public-policy attention is that, when one is in the midst of a structural change, it is hard to notice and harder yet to understand or predict the political implications.  These may be outside the expertise—or interest—of the participants who have only technical familiarity with what is going on.  A logical conclusion:  Learn Chinese!

“Even the Chinese will become interdependent—through finance, not politics.  And private capital from outside their own country will increasingly become available to meet their requirements.  More generally, wealth will concentrate in relatively few pockets in the world where immediate returns are deemed highest and safest—and savings essentially will be outside the control of national authorities.”

I would now like the opportunity to introduce….. 

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