| William J. McDonough, President and Chief Executive
Remarks by President
William J. McDonough "International Financial
Crises: What Role for Government?"
- Good morning. It is a pleasure to have the opportunity
to join you on the occasion of this timely conference, and
to share with you my thoughts on promoting financial resilience.
- Despite the fact that periodic surges in volatility are
a fact of life in financial markets, I think there is general
acknowledgment that recent years have been extraordinary
in this regard. This has been a period of historic change
and remarkable volatility in markets, going well beyond
the emerging markets, and carrying with it important implications
for political, social, and institutional stability in significant
segments of the globe.
- The experiences of recent years have reinforced old lessons
and brought home new insights about maintaining financial
stability and sustained growth. In particular, a broad consensus
continues to develop on ways of strengthening the institutional
framework at the national and international level to create
more robust, and thus more crisis-resistant, economies.
There is general agreement that in order for countries to
enjoy sustained and stable growth, the following are crucial:
- a sound and stable macroeconomic environment, and
- well-functioning and robust financial systems in both
capital-exporting and capital-importing countries.
Moreover, both of these are most effective when supported
by a dynamic and adaptive policy regime.
- The simple reality is that countries with robust financial
systems, strong fiscal accounts, low inflation, credible
and coherent monetary and exchange rate policies, moderate
external and internal indebtedness, reasonable current accounts,
and adequate domestic savings rates are less likely to be
buffeted by financial and economic turbulence. Moreover,
when shocks do occur, such countries tend to be far more
- There is also considerable agreement on many of the elements
needed to achieve these goals. This agreement has been reflected,
in part, in the development and promulgation of globally
accepted standards and codes for best practices in areas
ranging from transparency in fiscal, monetary, and financial
policies, to public debt management, and core principles
for bank supervision. Guiding themes across these various
standards have included the importance of consistent disclosure
practices and of building stability up from the firm and
sector level. The latter is accomplished by encouraging
sound risk management and stronger balance sheets, and creating
efficient systems of market, legal, and regulatory discipline.
- But the learning process continues. For example, in this
country, recent experiences have brought to light the need
to do more to strengthen corporate accounting and disclosure
standards, particularly with regard to guarantees and complex
financial arrangements, such as those funded offshore or
through special-purpose entities.
- Our ongoing efforts to revise the Basel Capital Accord
also reflect a learning process. We embarked on this voyage
in the late 1990s because we realized that the original
1988 Basel Accord had been overtaken by advances in the
financial sector – and in the broader economy. While the
1988 Accord represented an important advance, new technology,
the globalization of financial markets, and innovative financial
products and services have changed the way that banks monitor
and manage credit, market, and operational risks in a manner
that the 1988 Accord could not anticipate and does not address.
- To ensure that the New Accord remains flexible, forward-looking,
and appropriate for the risks and capital needs of internationally
active banks of the twenty-first century, the Basel Committee
established several goals for its work, goals that the industry
- First, we intended to develop a framework that encompasses
the "three pillars" necessary to support an
effective system of regulatory capital: the appropriate
measurement and minimum requirements, supervisory review,
and market discipline.
- Second, we wanted to align the minimum requirements
more closely with the actual underlying economic risks
to which banks are exposed, which should help allocate
capital resources effectively.
- A third goal was to encourage banks to refine their
measurement and management of risk over time. By creating
incentives in the New Accord for banks to re-evaluate
and enhance their tools constantly, we expect that banks
themselves will adopt a forward-looking perspective on
- I’m pleased to say that, through the Committee’s efforts
and the cooperation and support of other supervisors and
the industry, it appears that the proposed framework will
attain each goal. We can now count them among the milestones
- However, though we have covered quite a bit of territory
over the past three years, the last miles of any marathon
are the toughest to finish. I’d like to turn now to the
status of the New Accord and of the issues we are still
- Since the Second Consultative Document’s release 21 months
ago, the members of the Basel Committee have worked collaboratively
and publicly with supervisors, banks, and others to revise
the proposals so that they best serve the needs of modern
banking. We’ve published and discussed thousands of pages
of proposals and studies with the industry and the public.
I’d like to share with you the latest news on how we are
resolving the key challenges and concerns that have surfaced
in this process.
- One general issue raised is that the New Accord’s increased
sensitivity to risk will reinforce procyclical behavior
by banks, leading to increased cost of credit during cyclical
downturns. While we are working to address this concern,
I would note that banks already are expected to operate
above minimum capital requirements, manage to their economic
capital needs, and evaluate how their risk profiles may
change over time. Along those lines, the Committee recently
agreed that banks adopting the "internal ratings based"
approach to credit risk will be required to conduct appropriate
credit risk stress testing, which should help to contain
- Another concern raised about Basel II is its complexity.
If the New Accord is to be more risk-sensitive, however,
it must involve an irreducible degree of complexity, which
parallels the changes in bank practices and market instruments.
Indeed, some of this complexity stems from the various options
the New Accord provides to address the wide range of risk
profiles, strategies, and systems that banks maintain.
- The treatment of operational risk has been a more specific
area of concern. While operational risk cannot be quantified
with the same degree of precision as credit or market risk,
the Committee believes that introducing a separate charge
for operational risk will bolster efforts to find better
ways to address it. In this vein, we have seen encouraging
progress in operational risk measurement, although we recognize
that the industry has not settled on particular methodologies
or principles. Accordingly, the New Accord will permit an
unprecedented amount of flexibility to accommodate a spectrum
of approaches to operational risk. Toward that end, under
the "advanced measurement approach," the most
sophisticated institutions will be free to experiment with
a great variety of methodologies.
- The Basel Committee expects that we will achieve our goal
of not raising in aggregate the capitalization required
of the banking industry, though clearly and appropriately
those banks that engage in higher risk businesses may see
their requirements rise, and vice versa.
- To help ensure this, the Committee launched its third
Quantitative Impact Study on October 1, 2002, involving,
to date, 265 banks from nearly 50 countries. The banks
will assess how the proposals will affect them and submit
their findings by December 20, 2002. These results will
allow us to ascertain the need for adjustments prior to
the release of an updated proposal for public comment
in the second quarter of 2003, followed by finalization
of the New Accord in the fourth quarter of 2003, and implementation
at year-end 2006.
- While much work clearly remains to be done over the next
three years - including evaluating banks' readiness, training
supervisory staff, and working towards consistent implementation
across supervisors - in my view, both the journey and the
ultimate destination of a New Accord will contribute substantially
to a more resilient international financial system.
- Unfortunately, while there is a deepening consensus on
key elements about how to promote resilience ex ante, there
is no comparable degree of consensus on how best to handle
international financial crises once they do erupt, or the
proper roles of public institutions and the private sector
in containing and resolving such crises. Notwithstanding
considerable efforts at the public and private level to
search for a better way, no magic bullet or formula has
been found, although at times some have been asserted.
- Nor is one likely to be available. Experience and a reading
of the historical record suggest that the seductive allure
of grand solutions must be resisted. Cases differ greatly
with respect to what is possible and desirable in terms
of their implications for the interests of the public and
private sectors. Moreover, history tells us that new developments
in markets and practices quickly will render obsolete those
measures that might seem well attuned to today’s circumstances.
- Allow me to explain how I think progress can be made by
first focusing a bit on the problem that confronts us. I
would like to highlight some of the important changes that
have taken place over the past two decades in the patterns
and instrumentation of capital flows to the emerging world,
and in the nature of crises that can arise associated with
- First, it is important to keep in mind that the constellation
of investors and the range of instrumentation have broadened
considerably over the past two decades. Equity
investors (both direct and portfolio) are now the principal
source of net inflows for emerging market countries, and
most medium-term debt is held in tradable form by a broad
array of diversified, well-capitalized, fixed-income investors.
- Second, there have been equally important changes in
the destination of flows. Reflecting the predominance
of private-to-private flows since 1990, today sovereign
foreign debt often represents only a relatively small
part of maturing debt in crisis cases. Most maturing debt
is owed by private borrowers and/or is locally issued.
- Third, the context has been fundamentally altered by
broad institutional change. Accounting, regulatory, technological,
communications, and structural market changes have fostered
an environment characterized by mark-to-market accounting
and much more liquid and actively managed balance sheets.
Investors are focused on financial performance, and on
their fiduciary responsibilities to their largely private
clients and shareholders, rather than on long-term strategic
relationships with sovereigns. Today this is as true for
banks, which remain important providers of credit, as
it is for other providers of capital.
- Last, the new environment entails new and complex linkages
- - between domestic and international markets, and within
and across countries - - reflecting the internationalization
of local banking, equity, debt, and currency markets,
and the greater complexity of funding structures.
- This new environment has important implications for
policymakers and market participants alike. Let me comment
on just a few:
- On the negative side, crises are more complex and unfold
much more quickly and with surprising dimensions. Variable
and often highly interdependent cross-market developments
are often critical in the evolution of a given case and
its implications for others. Indeed, many of the more
recent crises were triggered by problems in domestic banking,
currency, and debt markets that then spread to the capital
account. Also, in today’s environment, the fear of an
event often is the event itself, because of the inherent
tendency of markets to anticipate developments and overreact.
- But on the positive side, financial recoveries can proceed
more rapidly in today’s environment, particularly with
the right policy responses from borrowers. In part, this
reflects the fact that today’s market participants generally
capacity - - and many have little choice, under mark-to-market
accounting - - to digest losses and move on. The broader sourcing
of capital today also gives more scope to the possibility
that, while some investors may withdraw, others may take their
place. The caveat here is that the well not be poisoned through
unnecessarily broad or heavy-handed approaches, a point I
will return to later.
- What is the right way to deal with this changed and changing
environment? In my view, the solution is neither a single
piece of financial engineering nor a compact between the
official lenders and private creditors. Rather, it is a
process incorporating a number of elements. Essentially,
I would suggest that our current case-by-case approach to
crisis management needs to evolve in ways that are market-based
and adaptive, yet strategic, creative, and principled.
- Being successful in today’s environment requires adapting
to the particularities of the case at hand, as well as the
global financial and economic context, and requires seeking,
as far as possible, to work with the grain of a given situation.
The approach needs to be market-based, in part because
that is what the game is all about. Today, the relevant
considerations for crisis management relate more to markets
and the problem of restoring market confidence, than to
individual borrowers and creditors.
- To the extent that systemic concerns pertain, they more
often relate to the risks of market disruption and over-adjustment
than to potential domino effects caused by the failure
or impairment of key institutions. Also, in today’s environment,
a market-based approach is much more feasible, because
financial recoveries can proceed more rapidly than in
- To be more specific, in my view, although much has been
made of the difficulties in achieving debtor workouts,
the truly thorny issues associated with emerging market
financial crises usually relate to the following:
- containing the fallout to domestic financial systems
and to local consumer and investor confidence,
- minimizing contagion and spillovers to other cases
- maintaining or restoring market access, particularly
for private sector borrowers, and
- most importantly, encouraging policy reform so that
a given crisis falls as closely as possible to the liquidity,
rather than the solvency, end of the spectrum.
- Working with the grain means recognizing the realities
and limitations inherent in the current market structure
and its functioning, and tailoring approaches to the specifics
of individual cases. This involves acknowledging that
attempts to impose solutions from outside are unrealistic
and potentially counterproductive. Instead it involves
identifying ways to induce and encourage desired behaviors.
I would also suggest that it means avoiding departures
from normal market functioning whenever possible. Interventions
should seek not to override or suspend market functioning,
but rather to guide market processes.
- This is not to say that payment suspensions always
can and should be avoided, or that ever-larger bailouts
are desirable or feasible. I would note that we at the
New York Fed in numerous instances, spanning several
decades, have worked to help borrowers and creditors
find mutually beneficial solutions that involved some
degree of concerted or coordinated financing.
- But in such instances, when payment interruptions
or resort to concerted financing truly are unavoidable,
experience has shown that minimalist approaches - -
where only certain payments are suspended or delayed,
and only when absolutely necessary - - generally offer
the best prospects for minimizing spillover effects
and for restoring market access rapidly.
- The linchpin of a market-based, minimalist approach
has to be a strong policy response on the part of the
country in crisis. Markets may not always be reasonable,
but they usually have reasons for reacting adversely.
Those reasons most often relate to policy or institutional
shortcomings. Across all of the episodes of market distress
in the emerging world over the past two decades, an essential
element of heading off or minimizing damage from a crisis
has been policymakers showing that they "get the
message" about the need for reform, and are prepared
to take appropriate measures.
- In this regard, the comparative advantage of the international
public sector is in guiding economic and financial policy,
and fostering the conditions that will facilitate the
restoration or maintenance of voluntary credit and investment
flows. IMF support should provide an unambiguous signal
of the international community’s confidence in the capacity
of crisis-affected countries to take the measures necessary
to restore economic health.
- This role is particularly important in unfolding crisis
situations, because borrowing country authorities too
often are slow to recognize the full dimensions of the
policy challenges confronting them, and the private
sector is ill-equipped to deal with this.
- A case-by-case approach by definition is supremely tactical,
but it also needs to be strategic in orientation
if it is to be successful in the longer run. I would like
to highlight several ways in which the case-by-case approach
needs to be strategic.
- First off, strategy needs to be informed by a long-run
view about the case at hand. The emphasis should not be
merely on "working out" the problems at hand,
but on "working through" them. The latter orientation
focuses attention beyond the current circumstances to
the restoration of growth, access to capital, and normal
market functioning, recognizing that workouts are but
one of several means to that end, not an end in themselves.
- We should not forget that a crisis is not over when
capital outflows have been halted and prices stop falling.
Emerging market economies depend on sustained and predictable
access to international capital market and bank credit,
and economic recovery and restoration of growth depend
on confidence being reestablished, so that the necessary
financing, beyond emergency lending, can be obtained.
- Secondly, we in the public sector would be well served
to maximize the complementarity between efforts to prevent
crises and efforts to contain and resolve crises when
they do arise.
- The consensus on sound preventative policies includes
precepts that public sectors should limit the scale
of their involvement in the domestic economy, and that
borrowers, public and private, should be encouraged
to follow best practices in the management of their
liquidity, foreign exchange, and credit risk. Indeed,
as I discussed earlier, this is the essence of what
we are trying to do under the revised Capital Accord.
Moreover, countries are being encouraged to strengthen
their legal and regulatory regimes for insolvency resolution
to deal more effectively with cases when private sector
borrowers and lenders get it wrong.
- Progress in these areas, even if only incremental,
will have important implications for what is possible
and necessary in the future. For example, having stronger
bank and corporate balance sheets, with lower leverage,
expands the scope for using interest rates and asset
price adjustments as stabilizing devices. Better liquidity
management at both the micro and macro levels - - longer
maturities, and greater reserve coverage and back-up
financing - - will create margins to ride out financial
shocks. And more effective insolvency regimes would
make decentralized workouts more feasible, particularly
in cases where systemic stress is better contained.
- The approach to crisis management and resolution also
needs to be creative. In part, this can be accomplished
by relying as much as possible on the efforts of debtors
and private creditors to work things out on their own. The
perception in some circles that private creditors are not
interested in resolving payment problems expeditiously is
mistaken, and stands at odds with recent experience. If
nothing else, investors are interested in restoring liquidity
to debt instruments in order to move on to new opportunities.
There is also scope for exploring creative market-based
ways to lever in private participation and stretch the impact
of public sector funds.
- The various experiences since the late 80s with buybacks,
partial guarantees, and debt exchanges provide some hints
for how targeted deployment of public moneys can spur
tendencies in a direction consistent with public policy
goals. Such creativity is essential if we are to get beyond
stark and unpalatable choices entailing either massive
bailouts or sweeping defaults.
- Finally, a successful market-based, case-by-case approach
also needs to be principled. I would suggest that
the essence of an effective case-by-case approach is
the development of viable plans that link broad, generally
acceptable principles to the particulars of a given situation.
- To achieve this, a clearer and more transparent articulation
of the public sector’s objectives is necessary. Greater
emphasis and clarity are needed as to the purposes and
limits of public intervention, and the extent to which
those interests warrant different degrees, modes, and
timing of public and private sector involvement, depending
on the particular country and circumstances. In this way
all parties will be better placed to understand current
developments and how the international community might
react to future strains.
- There are, of course, other points of view. In particular,
it has been suggested that an early recourse to broad suspensions
of debt service, perhaps amplified or reinforced by capital
controls, would increase the manageability of crises and
- My reading of the record convinces me that trying to preemptively
override market processes would do the opposite. Let me
share a few thoughts with you on this point.
- The desire for certainty and control which seems to
underlie such proposals is understandable, as it appears
to offer the promise of using less public money, and seemingly
entails less risk that creditors will be bailed out for
poor credit decisions. But the control and manageability
that might result may be more seeming than real.
- For one, a perceived disposition to preemptively lock
the door seems likely to send investors heading for the
exits all that much sooner. As a result, many avoidable
crises soon may become inevitable. And the problem of
contagion, whereby difficulties in one case spread to
many, would seem likely to worsen.
- Moreover, a perceived weakening of the international
community’s commitment to voluntary, market-oriented approaches
and its support for honoring contractual commitments would
likely create deep distrust, making it harder to encourage
cooperation between debtors and creditors in ultimately
resolving the crisis.
- An overly quick recourse to payment suspensions also
risks discouraging precisely the types of flows that we
should wish to encourage, that is, longer maturities with
better risk-sharing characteristics, such as long-term
bonds and equities. In a crisis, the hottest money leaves
first - - by definition. It seems counterproductive to
seek to penalize those who stay.
- Finally, I would suggest that preemptive attempts to
"freeze markets" also undermine market discipline
of, and ownership by, the local authorities.
- Increases and decreases in financial flows - - and
the fluctuations in pricing that naturally accompany
positive or negative trends in policies and economic
and financial performance - - are a reflection of, and
act as a natural brake on, the development of imbalances.
- But an assertion of control by the international community
risks diverting attention from the policies of the local
authorities. As a result, denial and delay, aggravating
factors in almost every crisis, may well continue and
be exacerbated. And then, as a practical matter, once
market processes have been stopped, how and when do
you get things started again, particularly if needed
corrective policies still have not been convincingly
and transparently implemented?
- To sum up, I believe the one-size-fits-all disposition
inherent in a preemptive approach risks making situations
much worse than they need to be. The only thing that strikes
me as predictable under such an approach would be that
market access would be harmed across the board. Just as
bailouts risk encouraging too much risk taking, efforts
to orchestrate preemptive bail-ins may encourage too little.
- Underlying the suggestions that I have made is a firm
belief that the success of our approaches to crisis management
needs to be viewed and assessed with a wide focus. Certainly,
there is the question of efficacy in containing the crisis
at hand, and the balance between this and the costs, actual
and potential, to the public sector. But we also must keep
in mind the implications for the functioning of the global
financial system in the near and medium term. This requires
consideration of prospects for restoring normal market functioning
and access, and the creation of appropriate incentives.
- When difficulties arise, the challenge remains, as always,
to encourage and work with countries that are ready and
able to implement strong corrective actions and to find
financial solutions best suited to both the specific case
and the broader functioning of the global financial system.
A flexible, case-by-case, managed-market approach, represents
the best bet - - and the only realistic option - - for achieving
those goals as we face a challenging future.