Remarks by Chairman Alan Greenspan
At Lancaster House, London, U.K.
September 25, 2002
World Finance and Risk Management
It is a pleasure to be here with you tonight to discuss innovations in the management of risk and to address some of the implications of those innovations for our global financial and economic systems.
Fostered by a lowering of trade barriers, exchange of goods and services across borders has increased far faster than world gross domestic product. But what is even more remarkable is how large the scale of cross-border finance has become, relative to the value of the trade that it finances. To be sure, much global finance reflects growing investment portfolios, some doubtless with a speculative component. But, at bottom, such finance is a central element of the systems that support the efficient international movement of goods and services.
We strongly suspect, though we do not know for sure, that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services. It appears increasingly evident that many forms and layers of financial intermediation will be required if we are to capture the full benefit of our advances in technology and trade. Indeed, the potential for a far larger world financial system than currently exists is suggested by the seemingly outsized implicit compensation for risk associated with many investments worldwide.
But, as in all aspects of life, expansion of one’s activities beyond previously explored territory involves taking risks. And risk by its nature has carried, and always will carry with it, the possibility of adverse outcomes. Accordingly, for globalization to continue to foster expanding living standards, risk must be managed ever more effectively as the century unfolds.
The development of our paradigms for containing risk has emphasized, and will, of necessity, continue to emphasize dispersion of risk to those willing, and presumably able, to bear it. If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability.
The broad success of that paradigm seemed to be most evident in the United States over the past two and one-half years. Despite the draining impact of a loss of $8 trillion of stock market wealth, a sharp contraction in capital investment and, of course, the tragic events of September 11, 2001, our economy held firm. Importantly, despite significant losses, no major U.S. financial institution was driven to default. Similar observations pertain to much of the rest of the world but to a somewhat lesser extent than to the United States.
These episodes suggest a marked increase over the past two or three decades in the ability of modern economies to absorb shocks. To be sure, the recent tepid pace of world economic activity has raised concerns that the full cycle of the past decade has yet to be definitively concluded. But the increased resiliency now clearly evident arguably supports the view that the world economy already has become more flexible. This favorable turn of events has doubtless been materially assisted by the recent financial innovations that have afforded lenders the opportunity to become considerably more diversified and borrowers to become far less dependent on specific institutions or markets for funds.
A major contributor to the dispersion of risk in recent decades has been the wide-ranging development of markets in securitized bank loans, credit card receivables, and commercial and residential mortgages. These markets have tailored the risks associated with holding such assets to fit the preferences of a broader spectrum of investors.
Especially important in the United States has been the flexibility and size of the secondary mortgage market. Since early 2000, this market has facilitated the large debt-financed extraction of home equity that, in turn, has been so critical in supporting consumer outlays in the United States throughout the recent period of cyclical stress. This market’s flexibility has been particularly enhanced by extensive use of interest rate swaps and options to hedge maturity mismatches and prepayment risk.
Financial derivatives, more generally, have grown at a phenomenal pace over the past fifteen years. Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. Moreover, the counterparty credit risk associated with the use of derivative instruments has been mitigated by legally enforceable netting and through the growing use of collateral agreements. These increasingly complex financial instruments have been especial contributors, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago.
Greater resilience has been evident in many segments of the financial markets. One prominent example is the response of financial markets to a burgeoning and then deflating telecom sector. Worldwide borrowing by telecom firms in all currencies amounted to more than the equivalent of a trillion U.S. dollars during the years 1998 to 2001. The financing of the massive expansion of fiber-optic networks and heavy investments in third-generation mobile-phone licenses by European firms strained debt markets.
At the time, the financing of these investments was widely seen as prudent because the telecom borrowers had very high valuations in equity markets that could facilitate a stock issuance, if needed, to take down bank loans and other debt. In the event, of course, prices of telecom stocks collapsed, and many firms went bankrupt. In decades past, such a sequence would have been a recipe for creating severe distress in the wider financial system. However, a significant amount of exposure to telecom debt had been laid off through instruments that mitigate credit risk, such as credit default swaps, collateralized debt obligations, and credit-linked notes. Taken together, these instruments appear to have significantly reduced telecom loan concentrations and the associated stress on banks and other financial institutions.
More generally, such instruments appear to have effectively spread losses from defaults by Enron, Global Crossing, Railtrack, WorldCom, and Swissair in recent months from financial institutions with largely short-term leverage to insurance firms, pension funds, or others with diffuse long-term liabilities or no liabilities at all. In particular, the still relatively small but rapidly growing market in credit derivatives has to date functioned well, with payouts proceeding smoothly for the most part. Obviously, this market is still too new to have been tested in a widespread down-cycle for credit. But so far, so good.
The growing prominence of the market for credit derivatives is attributable not only to its ability to disperse risk but also to the information it contributes to enhanced risk management by banks and other financial intermediaries. Credit default swaps, for example, are priced to reflect the probability of the net loss from the default of an ever broadening array of borrowers, both financial and nonfinancial.
As the market for credit default swaps expands and deepens, the collective knowledge held by market participants is exactly reflected in the prices of these derivative instruments. They offer significant supplementary information about credit risk to a bank’s loan officer, for example, who heretofore had to rely mainly on in-house credit analysis. To be sure, loan officers have always looked to the market prices of the stocks and bonds of a potential borrower for guidance, but none directly answered the key question for any prospective loan: What is the probable net loss in a given time frame? Credit default swaps, of course, do just that and presumably in the process embody all relevant market prices of the financial instruments issued by potential borrowers.
Price trends of default swaps have been particularly sensitive to concerns about corporate governance in recent months. The perceived risk of default of both financial and nonfinancial firms has risen markedly in the wake of company-threatening scandals, though levels remain moderate.