By Alexandre Lamfalussy
Let me begin with a quotation. "While the Committee strongly believes that large, deep, liquid and innovative financial markets will result in substantial efficiency gains and will therefore bring individual benefits to European citizens, it also believes that greater efficiency does not necessarily go hand in hand with enhanced stability". This is taken from the Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (March 2001), which I had the pleasure to chair. The Committee did not elaborate for the simple reason that prudential considerations were not within its remit. But we are now more than six years older, and as the former chairman of the defunct Committee I may perhaps be allowed to ask myself whether this implicit concern about financial stability was justified at that time and, if so, would still be justified to-day.
Just a short historical reminder. At the time of writing this sentence we were in the first phase of the bursting of the dotcom bubble and the general decline of equity markets, which implied a sharp increase in volatility and considerable negative wealth effects (The decline of S&P 500, between its peak in 2000 and its through in 2002, implied a loss in stock market capitalisation of an amount roughly equivalent to half of the US GDP in 2000). I believe that we were indeed justified to voice our concern: financial stress in the equity markets continued well into 2002, and there were even talks about potential deflation. Yet in the end things sorted themselves out, and after a very short and shallow recession in the United States recovery set in during the spring of 2003. Most remarkably, not one of the large banks in the United States or for that matter in the developed world got itself into trouble and we know that a banking crisis is the traditional prerequisite for turning financial stress into a systemic financial crisis.
There were several reasons why banks came out unscathed from this experience. Basel I played a key role in allowing the banks to confront the equity market turbulence with a more than comfortable capital base. There had been substantial improvement in the banks' risk management capabilities, of which the most visible example was the transfer of a large part of their credit risks to willing risk takers all over the world. But this was not the whole story. It is questionable whether the banks would have been able to weather a much longer and deeper recession.
That no such recession occurred owes a lot to the Fed's decision to bring down the targeted federal funds rate from 6.5% in December 2000 to 2% by end-2001, which amounted to an exceptionally large and speedy monetary stimulus. Further cuts brought this rate down to 1% by early 2003, that is, to an inflation adjusted rate of close to minus 1%. The most significant effect of this was that the sharp decline of stock prices was not accompanied by any meltdown in real estate prices: rather the opposite happened. Add to this the radical swing towards a large and growing federal fiscal deficit, and the conditions were set for a lasting pick-up in the rate of growth of US GDP. In other words the resilience of our global financial system to a very large shock was not tested. This may have been regarded by some as an intellectually frustrating outcome: we shall never know whether, short of this powerful joint monetary and fiscal stimulus, we would have had to face up to a genuine systemic crisis. But I think that most of us were, and probably still are happy to live with this frustration.
The dotcom meltdown was followed over the past six years by a rich variety of shocks which even in isolation, but surely in combination with each other, might well have led to severe financial turbulence, perhaps with systemic ramifications. Yet nothing of this kind has happened so far. Of the "external" type of shocks let me recall the horror story of September 11 2001, the war in Iraq which has been degenerating into something akin to a genuine civil war, the more or less trebling of the oil price, the skyrocketing and subsequent gyrations of commodity prices, the breakdown of the very tentative peace process between Israel and the Palestine, Israel's invasion of Lebanon to which you have to add all the "Enrons" on both sides of the Atlantic, as well as such "minor" events as the downgrading, to sub-investment status, of the corporate debts of GM and Ford, the flow of bad news about sub-prime mortgage lending or the winding up of some not-so-small hedge funds. Finally, note that global payments imbalances, the adjustment of which may well entail disruptive exchange and interest rate developments, are still very much with us.
But what can we see today in the financial world? Stock market indices have risen above, or at least are flirting with the historical peaks reached in 2000; leveraged lending is growing at astronomical rates; by the end of 2006 credit derivatives contracts reached $34,500 billion, which is more than the double of where this figure stood a year before; mergers and acquisitions are booming; bank profits are soaring; credit spreads remain exceedingly thin; and market volatility is remarkably low. Not only have we managed to avoid major financial turbulences these past years, we now apparently enjoy a financial prosperity exceeding all expectations.
One major reassuring fact is that this financial prosperity does not appear to be disconnected from the "real" economy of the world, which is in better shape than it has been for a great number of years. As has been shown by the latest World Economic Outlook of the IMF, the world economy grew last year by 5.4%. Moreover, while some very poor countries barely participated in this growth, developing regions expanded faster than this average. This applies in particular to the whole of developing Asia (9.4 %), within which pride of place was taken by China and India. I don't recall anyone daring to expect this happening, say, 8-10 years ago. But this is not all. For the first time since the mid-1990s the rate of growth of the euro area has outstripped that of the United States, and this is expected to continue without the US tumbling into recession. This is good news for all those who hope that the adjustment process of the US current account will proceed in an orderly manner. Finally, inflation has been kept under reasonably firm control in the advanced economies, and has been the lowest since years for the majority of developing countries.
Yet we are all wondering how long this can last, and how it will end. No one can pretend to know the answer to this double question; but if historical experience can be of any guide and if we are ready to accept what ancient business cycle theories tell us, we can be sure that this "golden era" an expression so aptly coined and its implications analysed by Martin Wolf will come to an end, and the later this happens, the riskier will be the landing process. So both market participants and policy makers should make good use of current opportunities and prepare themselves for leaner years.
Now let me make four specific points relating to the current financial scene, which highlight the extreme difficulty of trying to reply to the question in the title of my presentation.
My first remark concerns the accelerating pace of financial innovation. Most innovations can be (and are) used by risk averse and prudent market participants as hedging devices, but also by willing risk takers and the first group needs the cooperation of the second. As we have been seeing in the case of credit derivatives, this leads to redistributing and spreading risks more widely, and therefore may well enhance the resilience of our global financial system. I use the word "may" deliberately, because this desirable objective will be achieved only if the willing risk takers know what they are doing, if they are ready and capable of assessing their risk resistance capability in times of stress and, most important, if they hold reasonably diversified views about the future in other words if they do not succumb to the temptation of herd behaviour.
These are weighty "ifs". Take just the second. I do not doubt that risk takers are willing to undergo stress-testing exercises, but what is questionable is whether they really possess the right information on which stress resistance can be tested. They have to rely on co-variances, which go back only for a few years; moreover what is the robustness of co-variances in our rapidly changing world ? Remember how the Russian crisis in 1998 played havoc with seemingly robust co-variances. We are light years away from the sturdiness, and therefore the reliability of mortality tables on which life insurance contracts are based. As for the third "if", I noted the observation made in the June 2006 Financial Stability Review of the ECB that since mid-2003 hedge fund returns, both within and across different investment strategies became increasingly correlated.
My second concern is about what I take the risk of calling excess liquidity. I am aware that there is no consensus about the definition, and even less about the measurement of excess liquidity (or for that matter of liquidity itself), but I am unaware of any possible indicator pointing towards tight liquidity conditions even now, well after the change in the stance of monetary policies. My main concern here is that abundant liquidity creates a favourable breeding ground for excessive risk taking. Anyone who has the opportunity of watching the generalised, often frantic search for assets that yield a return only a shade higher than treasury bills (yet carry a substantially higher risk) knows what I am talking about.
To this remark you might be tempted to object that it is precisely the existence of highly liquid markets that allowed the speedy return to "normality" after the initial disturbance created by events like the downgrading of the corporate debt of GM and Ford. This of course is true. But in this specific case it was true because this shock was considered by the majority of market participants as sufficiently benign, and not entirely unexpected, which explains why it did not trigger herd behaviour. On the other hand, market liquidity can disappear overnight in the case of a totally unexpected shock which is large enough to trigger such behaviour, and then we would really be in trouble. The only qualification I am ready to make is that with the rapidly growing financial industry the threshold for "large enough" is also growing. Is this a sufficiently strong argument for forgetting that high liquidity breeds risk taking excesses?
I do not think so, because my third remark is about moral hazard. The persistent appetite for risk taking has been encouraged by the perception that while central banks (or governments) have displayed a remarkable ability to prevent that specific crisis manifestations turn into a full blown systemic crisis, they did not do much to discourage bubbles from arising in the first place. Whether the perception of this asymmetry is warranted or not is debatable, but in my experience it is widespread among market participants. This is perhaps the price to pay for successful crisis prevention, but we have to realise that ample liquidity plus moral hazard provides a lethal combination for encouraging reckless risk taking.
My fourth and last remark has to do with the growing opaqueness of our global financial system, which of course is the result of the spectacular growth of derivatives of all shapes and sizes. There is no way of establishing a chart showing the interconnections between financial market participants. In the case of a debt crisis, there is little chance of finding an answer to the question: who are the "final" lenders? Perhaps the question itself has become meaningless. But this is not helpful, to say the least, for those whose duty is to assess the risk of experiencing a systemic crisis, nor indeed for those who are in charge of preventing or indeed managing such a crisis.
Contrast this with the good old days, when in the early 1980s the international banking statistics of the BIS enabled the G-10 central banks to identify within a matter of hours the 40-50 banks which held (as final lenders) a very large proportion of the international claims on Mexico which in turn helped to assess the size and the nature of the Mexican problem and at the same time enabled the IMF to involve these banks in the crisis management process. The opaqueness of our system is a major reason why we must have at our disposal a well organized prudential regulatory and supervisory system which would make it less likely that we would be driven to undertake the arduous task of handling a systemic crisis.
It is time to conclude. The main point I wanted to make is that we are sailing in uncharted waters. I have no doubt that our innovative financial system has led, and will continue to lead to greater efficiency, which is a prerequisite for economic growth. In my more optimistic moments I also believe that this system has increased its resilience in the case of isolated, not too large and not entirely unanticipated shocks. But we should not exclude the possibility of very large and totally unanticipated shocks, nor should we believe that this "golden era" will go on for ever. It will not, but it is just impossible to know when and how it will come to an end. This requires on the part of the market participants strongly risk aware management, and on the part of governments responsible fiscal and supply side policies. As for the central banks, they will have to continue to closely monitor financial market developments from a macroprudential angle, to consider how to contribute to the orderly absorption of excess liquidity and to carefully avoid actions or words that would enhance moral hazard. I am happy to say that from what I have seen and heard over the past few months, I don't think that in either of these areas they would need my advice.
Alexandre Lamfalussy is former general manager of the Bank of International Settlements and former president of the European Monetary Institute