Speech

For release on delivery 9 00pm G MT (4 00pm E S T) February 1, 1994 Remarks by Alan Greenspan Chairman, Board of Governors of the Federal Reserve System at the Bankers Club Banquet London, United Kingdom February 1, 1994 Mr President, my Lord Mayor, my Lords, Sheriffs, ladies and gentlemen, on behalf of the guests, I would like to thank you, Mr President, for your welcoming remarks It is indeed a pleasure to be here in historic Guildhall, in the center of the city in which so many of our financial markets and institutions have their roots Governor George has described the evolution of central banking, especially in the United Kingdom I would like to elaborate on this theme, emphasizing some of the international dimensions of central banking and the role of central banks in bank supervision This year, the Bank of England enters its fourth century as a financial institution The nature of the challenges to the Bank of England and other central banks has changed over time In the early years of the Bank, information moved slowly, constrained by the state of communications technology Financial crises in the early nineteenth century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places A London investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss As the nineteenth century unfolded, communications speeded up The spectacular failure of the prominent discount house, Overend, Gurney and Company, in 1866 and the publication of Walter Bagehot's Lombard Street in 1873 are often cited as two principal events that crystallized thinking about the Bank of England's responsibility for the stability of the financial system, particularly as a so-called "lender of last resort" during financial crises As Bagehot put it, "in time of panic [the Bank of England] must advance freely and vigorously to the public ," at a - 2 - "very high rate of interest" and on "good banking securities," he hastened to add Certainly by the time of the crisis at Baring Brothers, in 1890, just at the end of the Bank's second century, the Bank had taken this responsibility on board The Bank of England's role during the Baring crisis is a classic example of central bank activism in containing the potential damage inflicted by a financial crisis in order to protect the integrity of the financial system as a whole The Bank organized and contributed to a guarantee fund for Barings' liabilities, obtained financial support and cooperation from foreign authorities, and was actively involved in the search for a resolution of the fundamental problem of the Barings' firm and the London market The Bank's discharge of its public responsibility was all the more remarkable when one remembers that at the time it was still a private institution, although my understanding is that the Bank made a considerable effort to distinguish between its public and private responsibilities In 1890, events moved more rapidly than they did in the early part of the nineteenth century, but their speed certainly cannot match that of events in today's financial markets The environment now facing the world's central banks--and, of course, private participants in financial markets as well--is characterized by instant communication Complex financial instruments--derivative instruments, in one form or another--are being developed to take advantage of the gains in communications and information technology Derivatives activities would not have flourished as they have without these technological advances They could not be priced properly, the markets they involve could not be arbitraged properly, and the risks they give rise to could not be managed properly without high powered data processing and communications capabilities Of course, the links between technology and financial - 3 - innovation do not operate in only one direction The demands of financial engineers and managers have prompted further technological gains, with enormously valuable spillovers to the management of financial portfolios in general It is evident to those of us here that the development of derivative instruments and the attendant risk management procedures have yielded great benefits to financial intermediaries and their customers, allowing both to hedge their exposures more effectively and more efficiently than was the case just a decade or so ago--let alone in the last century In the process they have generated an elaborate web of financial interrelationships that recognize no national borders These instruments heighten the interdependences of markets and market participants Disturbances in one country or sector are rapidly transmitted throughout the world economy They pose challenges to central banks' now clearly recognized responsibility for the stability of the world's interdependent financial systems Central banks must meet these challenges We are responsible for ensuring the stability and integrity of national financial systems and, to the extent possible, the international financial system That is the essence of our mandate, whether written in law or not Its achievement extends beyond monetary policy and the establishment of noninflationary growth, and beyond payment systems, to the health of the international financial system in general Central banks in virtually every major country, in most cases de jure but always de facto, play a crucial role in the supervision of their banking systems Of course, the specifics of each central bank's role vary from country to country, depending importantly on cultural and historical features and the institutional structure of the financial - 4 - system Nevertheless, the successful resolution of financial crises often depends upon links between the insights and expertise gained through banking supervision and those gained from the pursuit of macroeconomic stability In order to carry out their responsibilities effectively, central banks must have hands-on supervisory involvement with a broad cross-section of banks, and, because of the global nature of financial markets, involvement with internationally active banking organizations is critical Internationally active banks create the potential for systemic risk Disruptions or difficulties at one of these institutions could well have a significant impact on a wide range of other financial institutions and through them on the economy This potential for systemic risk arises from the nature of internationally active banks These banks are generally large They fund themselves in international money markets, including London, where creditors are relatively quick to restrict funding to banks thought to be in trouble, and where the problems of one bank can easily affect funding to other banks from the same country They are almost universally used by their customers and by other banks for clearing and settlement purposes Problems affecting the financial system can and should be minimized, but some will arise inevitably because the taking of risks is an integral part of banking and our market economies If banks and other financial Institutions were not allowed to take risks, the dynamism of our economies would suffer significantly However, it is essential that problems that arise are contained and do not evolve into systemic crises Because the appropriate solution may well involve the provision of liquidity, and because central banks are the ultimate sources of liquidity, central banks inevitably become Involved in solving or - 5 - containing systemic threats This is the essential role of central banks that was forged early by experience here in London and elsewhere Given the nature of global financial markets, problems in major national financial markets that might have systemic consequences are increasingly likely to be international in scope Thus, coordination among central banks has become crucial to meeting these threats successfully Because of the dominance of the dollar in international finance, foreign financial institutions and central banks inevitably look to the Federal Reserve during times of international stress Similarly, because of the role of London as a financial center, financial institutions and other central banks look to the Bank of England for leadership All this goes with the territory of central banking today For example, when problems arose at the Bank of New England in 1990, and I do want to stress "New," the Federal Reserve called on its contacts at the Bank of England to facilitate the ongoing access by the bank to foreign markets so that an unwinding of the bank's foreign exchange book could be achieved in an orderly fashion When international systemic crises threaten, they demand immediate and comprehensive responses Decisions must be made quickly as to whether liquidity should be provided, and if so how much and to whom In such circumstances, central banks must have an intimate working knowledge of the condition of both the domestic banks and the international banks with local operations that they might be called upon to support The success of such support depends critically on contacts and credibility abroad to contain any spillovers from domestic to foreign markets and conversely When stock prices fell abruptly in October 1987 in the United States and elsewhere, the international dimension of the potential problems and any successful solutions to them were obvious - 6 - The difficult task of containing the crisis would have been substantially more difficult if each national central bank had not known the condition of its banks through the supervisory process, and if it had not had the close working relationships with these banks and with other central banks that enabled it quickly to assess the likely global ramifications In the event, central banks effectively contained the secondary consequences of the crash through the prompt but prudent provision of liquidity to financial markets and almost continuous consultations with each other and with commercial banks and securities firms In the case of the LDC debt crisis in the early 1980s, central bank supervisory reports provided vital intelligence regarding the fact that exposures to countries that were susceptible to payments difficulties were significant not just for the largest banks, but for many smaller ones as well When the Latin American debt crisis broke publicly in 1982, with a potential default by Mexico on more than $50 billion in claims by international commercial banks, central banks were positioned to act quickly to organize the international provision of liquidity support while a more permanent solution was worked out In this effort, the Federal Reserve took the lead, but it would not have succeeded without the cooperation of other central bankers Led by Gordon (now Lord) Richardson, as my predecessor Paul Volcker has written, central bankers "instinctively understood what was at stake " The cooperation between Volcker and Richardson in 1982-1983 echoed the cooperation between Benjamin Strong and Montagu Norman nearly six decades earlier After the initial phase of the debt crisis, a certain tension arose On the one hand, the financial strength of the banking system needed to be protected and restored in light of the potential losses by - 7 - banks on their exposures to developing countries On the other hand, if at least conditional access by developing countries to funding from hundreds of banks around the world had not been maintained, those countries would not have been able to work through their problems in an orderly fashion, with adverse implications for global economic stability Central banks, by virtue of their combined responsibilities for oversight of the financial system and macroeconomic stability, were in a position to strike a proper balance between those two considerations and to understand that over an appropriate time horizon considerations of financial prudence and macroeconomic stability need not, in fact, conflict but rather might require the same patient responses International financial markets, including importantly foreign exchange markets, are the locus not just for payments for internationally traded goods and services but also for tremendous volumes of borrowing and investment by firms and individuals of all countries A 1992 survey conducted by the major central banks found that normal turnover in foreign exchange markets alone approximated $1 trillion a day Given the magnitude of these flows, it is no wonder that international financial and foreign exchange markets attract increasing attention by central banks Central banks must monitor international financial activities and act to reduce and cope with the payment system risks that may arise These risks can be substantial especially for transactions that involve more than one market--as all foreign exchange transactions do--in part because markets in various countries are not all open at the same time Central banks also must monitor international financial markets to assess their macroeconomic implications, because, with financial markets now so integrated, developments in international markets can either weaken or - 8 - enhance the effects of monetary policies Central banks can draw on staff with extensive and varied research, supervisory, and operational expertise Without any one of those integrally related sources of strength, the quality of the central bank's contribution to financial stability would be severely reduced The broad consensus among the central banks of the Group-of-Ten countries is that all central banks should be knowledgeable about, and sensitive to, changes in the behavior of banks because these changes affect the channels of transmission of monetary policy and the dynamics of financial markets, including their vulnerability to crises This consensus has been voiced on many occasions In 1989, G-10 central banks published a set of standards and principles governing the operation of payment systems (the Lamfalussy Report), in which it was recognized that oversight by central banks is essential It is not enough that central banks provide payment services, as they do everywhere Central banks must also have the scope to ensure that the credit risks and other risks that arise in payment systems, including the credit risks that central banks themselves must take on, are reasonable and are being properly managed Similarly, and more recently, G-10 central banks recognized the need to bring expertise across a broad spectrum of central banking functions to bear on the myriad of issues associated with derivatives activities, some of which I mentioned earlier in my remarks For example, we at the Federal Reserve, in cooperation with other U S agencies and foreign central banks, have made considerable use of our supervisory powers to review in detail how derivatives are used by banks, what purposes they serve, and how banks manage the associated risks Information from this source is combined with knowledge and insights from - 9 - other central bank functions to strike an informed balance between costs and benefits The combination of supervisory and other functions enables us to identify specific areas of systemic risk and to seek in advance improvements that could mitigate the potential for systemic disruption without destroying the benefits of these useful instruments As we move forward, we must foster an environment that allows--even encourages-- further innovation but at the same time is sensitive to our legitimate prudential and systemic concerns The history of central bank cooperation gives us a basis for optimism that we will succeed A substantive role for central banks in bank supervision, often acting jointly with each other, has prevented some incipient problems from developing and has ameliorated others When systemic problems do arise in the future, the ability of central banks to coordinate their responses will depend upon the maintenance of close contacts and sound working relationships grounded upon comprehensive in-house experience and expertise These can be built up only over time and only by continuing interactions across the full range of central banking functions--monetary policy, oversight of payment systems, and, equally important, bank supervision I am pleased--indeed, proud--to point in this context to the close personal and working relationship I have formed over the years with Lord Kingsdown and Governor George, and that our colleagues past and present at the Federal Reserve and the Bank of England have formed over the course of many decades through a wide variety of joint undertakings These relationships epitomize the kinds of contacts that a gathering like this one ought to find reassuring Thank you, Mr President, for your welcoming remarks here tonight, and for your leadership, past, present, and future

Alan Greenspan (1994, January 31). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19940201_greenspan

@misc{wtfs_speech_19940201_greenspan,
  author = {Alan Greenspan},
  title = {Speech},
  year = {1994},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19940201_greenspan},
  note = {Retrieved via When the Fed Speaks corpus}
}