E. GERALD CORRIGAN
Managing Director, Goldman, Sachs & Co.
 

Introduction and Overview
I would like to revisit our experience in recent years in coping with recurring financial disturbances, with particular attention to the lessons to be learned from these events. The last twenty years have witnessed a greater number of serious financial shocks than occurred in the preceding thirty-five years of the postwar period. At least several of these shocks had the potential for causing systemic damage to the world economy. While we have managed to avoid a global meltdown, many individual countries and financial institutions have paid a very high price for financial adversity. Also, in far too many instances, financial shocks and disturbances have been mitigated largely by massive governmental intervention, often involving huge fiscal costs that will be borne by successive generations of future taxpayers.

The frequency and magnitude of the recent pattern of financial shocks are such as to raise the question of whether there may be an element of inherent instability in contemporary global finance. While I hope to persuade you that this is not the case, I also must confess that it is likely that periodic bouts of financial instability will be with us for at least the broadly foreseeable future. Thus, the dual challenge we face for the future is, first, to manage our affairs such that the frequency of such events will be reduced, and, second, to manage these problems when they arise, thereby containing the damage and reducing systemic risk.

With this dual challenge in mind, allow me to begin by reviewing our experience with financial shocks with a view toward seeking to identify common denominators across various episodes.  The identification of common denominators from the past may help to avoid or minimize such problems in the future.  Before turning to the specifics, three more general points should be made as follows: First, by their nature, financial shocks are largely unanticipated as to their specific origin and timing. Indeed, if they were widely anticipated, they would not be shocks. Second, while the proximate cause of virtually all major financial shocks is typically a sudden and violent shift in market expectations, the underlying causes vary enormously from episode to episode. Finally, markets have demonstrated a high degree of resiliency in sorting out financial shocks so long as the threat, or the reality, of serious credit problems is not present. However, when major questions arise as to whether creditors and counterparties will be paid in accordance with existing contracts and/or whether collateral or other valuables will be delivered and secured in line with contractual obligations, behavior changes in the direction of self-reinforcing tendencies toward risk aversion and market illiquidity.

In considering the diagnostics that can help identify the common denominators associated with financial shocks, it is useful to first distinguish several categories of shocks. One such category relates to situations that have their origins in improper or unlawful behavior by one or a small number of individuals that results in the collapse, or near collapse, of major financial institutions. While these episodes can be very serious, they will not be discussed here because of their unique case-by-case traits. However, we should keep in mind that in many such episodes, the circumstances that permitted things to get badly out of hand often included the absence or the breakdown in some of the most basic elements of controls.

More generalized financial shocks can be placed into three main groupings as follows:
First, sovereign financial shocks, which have their origins in serious economic and/or financial conditions in one or more countries that quickly spread to other countries having, or perceived to have, similar problems; second, financial market shocks, such as the stock market crash of 1987, the near gridlock in some segments of fixed income markets in 1994, and the near global market meltdown of 1998; and third, financial institution shocks typically associated with the failure or
near failure of major institutions that, by the nature of such institutions, can cause important secondary shocks for other institutions or for markets generally.

Sovereign Financial Shocks
Turning first to the 1980's style sovereign crises, I think it is fair to say that the two key characteristics of these events were: (1) macro policy failures both in the industrial world and in individual emerging market countries, especially in Latin America and (2) huge credit exposures to these countries by a relatively small number of internationally active banks. Beyond those factors, the troubled countries were typically characterized by (1) government sector domination of the economy, (2) large budget deficits, (3) high inflation, (4) sizeable external debt -- much of it short term in duration -- on the part of the sovereign itself, and (5) economic, financial, and political institutional arrangements, which were often in conflict with those associated with open and market driven economic systems.

The initial policy response to the 1980's style sovereign crises was forged along two roughly parallel tracks.  The first focused on major reforms in macroeconomic and structural policies in the debtor nations.  The second focused on a series of standstills, rollovers, and restructurings of the sovereign external debt.  Both tracks entailed a high degree of international cooperation and coordination as well as large-scale financial support by multi-lateral financial institutions, especially the International Monetary Fund.

The initial policy response to the sovereign crises of the 1980's had the character of a holding action, in part because the problems in many of the countries were so deeply entrenched but also because the magnitude of the exposures on the part of many individual banks represented a clear and present threat to the workings of the international financial system.  Over time, as reforms took hold in the countries and as relative exposures of the banks fell, the policy response changed.  The culmination of this evolution was the large-scale program of debt and/or debt service reduction for individual countries through the modality of the so-called Brady Bonds.

While the economic and human costs of the crisis to individual countries were of colossal proportions, and while the creditor banks experienced huge losses, containing the 1980's style sovereign crisis was relatively manageable because (1) the underlying problems were largely macroeconomic in nature; (2) the debtor was largely the sovereign itself; (3) there was a
relatively small number of creditors; and (4) the credit instruments themselves were almost exclusively syndicated bank loans.

The second wave of sovereign shocks, including Mexico in 1994-95, Asia 1997-98, and Russia 1998-99, were very different from the experience of the 1980's. For example, in the 1990's, the underlying problems in many of the countries were much more structural than macroeconomic; the primary debtors were private sector entities; there were hundreds, if not thousands, of creditors; and the credit and investment instruments were very diverse.  As was the case in the 1980's, the specific circumstances associated with the crisis countries of the 1990's differed from one country to the next. Yet, looking across countries, the serious problem countries tended to be the ones in which some combination of the following traits were present:
       First, the presence of a fixed exchange rate system;
       Second, the presence of large to very large current account deficits;
       Third, the presence of large amounts of unsecured, very short-term foreign currency borrowing, especially via the inter-bank market; and
       Fourth, the presence of weak and unstable domestic banking systems.

In considering the four factors listed above, experience across a wide range of emerging market countries suggests that individual countries adhering to highly disciplined macro-policies can withstand the presence of one -- or perhaps two -- of these traits.  But, when three or four are present, it is almost always a recipe for trouble.

For the reasons mentioned earlier, designing the policy response to the sovereign crises of the 1990's was more difficult than in the 1980's.  Indeed, while the "case-by-case" philosophy of the 1980's was still relevant, the importance of this approach took on even greater urgency in the 1990's.  As in the 1980's, large-scale IMF-led official support packages were used to provide bridge and interim financing for the affected countries.  However, reflecting in large part the diversity of investors, creditors, debtors, and financial instruments, timely standstills and restructurings, which had been so important in the 1980's, proved -- with a couple of noteworthy exceptions -- to be largely unworkable in the 1990's.  Similarly, because of the nature of the underlying problems -- especially banking sector problems -- much of the once conventional wisdom about macropolicy conditionality as a prerequisite for official financing had to be re-framed.

The experience with the sovereign financial crisis of the 1990's has also brought into even sharper focus a number of issues surrounding the so-called moral hazard problem and the closely related question of the roles of the public and private sectors in both crisis prevention and crisis management. Specifically, within the official sector there is now a view that the financial burden of crisis management and bridge financing must be more evenly shared by the private sector.

While I do not have the time to go into this complex and controversial subject in any detail, I would offer several general observations: First, as someone who has spent most of my professional career on the official side, I have some instinctive sympathy with the issue as seen from the perspective of public policy. Second, as someone who prides himself in being pragmatic, I find it difficult to see how approaches such as collective action clauses in bond contracts or modified covenants in loan documents would materially influence the speed and scope of debt restructurings, or to produce commitments for new money in the short run.  Similarly, rule-based formulas that cut against the grain of the voluntary and case-by-case philosophy will probably make things worse.  Third, in the future even more than in the past, emerging market countries will be heavily dependent on private capital flows. Thus, any solution to the burden-sharing problem must be one that works toward greater stability and predictability of such private capital flows.

Financial Market Shocks
We all recognize the specific origins of major financial market shocks can come from an almost endless list of events, starting with substantial and unanticipated changes in economic policy or performance.  We also recognize that in today's world of high-speed, high-tech banking and finance, shocks are transmitted from place to place, market-to-market, and institution- to-institution with incredible speed. Finally, we all recognize that every major market financial shock has its own dynamics and distinctive characteristics.

Yet when we look across the major financial market shocks of recent years, I believe that there are three crucial common denominators that have been at the center of all such events.   They are:
       First, the distinction between market risk and credit risk blurs or disappears;
       Second, market liquidity across a wide range of financial instruments dries up, or as in 1998, virtually disappears; and
       Third, once seemingly comfortable amounts of collateral and/or margin quickly become inadequate, then calling into question  basic issues such as to the workability of netting and close-out arrangements.

As we have seen, once a major financial market disturbance occurs, these three phenomena begin to feed on themselves, thereby adding to market pressures and making it difficult for market participants to design and execute risk mitigation strategies and tactics.  In the midst of a crisis, some statistical measures of risk may tend to increase even as institutions are following risk reduction tactics such as liquidating positions.

Based on my long experience, the 1987 stock market crash and the 1998 market meltdown presented special challenges in part because of the speed and linkage factors and in part because of market movements of the magnitudes experienced in these episodes inevitably called into question real time issues about credit worthiness of market participants.

Financial Institution Shocks
Financial institution shocks with potential systemic consequences have occurred with troubling frequency in recent years.  Moreover, these problems have occurred in many countries at all stages of economic and financial development.  And, while most such problems have been associated with "banks," non-bank financial institutions have not been exempt from such
difficulties.

Obviously, it is impossible to generalize about causes and common denominators regarding financial institutions shocks.  However, experience does tend to suggest that such problems often have their roots in several areas that can be summarized by reference to six short phrases having the common denominator that each phrase contains a key word beginning with the letter "c."  Those phrases are:
       First, inadequate capital relative to risk;
       Second, large credit losses;
       Third, excessive concentrations of credit and/or market risk;
       Fourth, serious weakness in the control environment;
       Fifth, insufficient discipline of operating costs; and
       Sixth, the absence or breakdown of corporate culture and values.

In citing these six phrases, I am under no illusion that they have universal application nor that they can remotely capture all of the forces that give rise to serious financial institution shocks.  As an example, these six factors are silent on the role that external shocks -- including macroeconomic conditions -- can play in helping to create the preconditions that heighten the likelihood of financial institutions shocks.  However, based on my experience, when most -- and certainly when all -- of the conditions summarized in these six phrases are present, serious problems will follow.

 Looking to the Future
To this point, I have endeavored to distinguish the major categories of financial disturbances we have experienced in recent years and to identify the important common denominators that have been associated with each such group of disturbances. I want to discuss where we stand in terms of the dual challenge I mentioned earlier: reducing the frequency of such disturbances and improving management of them when they occur.  Starting with sovereign financial crises, I believe it is fair to say that the overwhelming majority of emerging market countries are making solid progress in both their macroeconomic and structural policy agendas. Further, in areas such as greater transparency, improved debt management, deregulation, and trade and labor market reforms, real progress is also being made.  However, on the structural side, in particular, a great deal remains to be done, perhaps especially with regard to domestic banking systems and the institutional foundations in accounting, banking supervision, and legal and judicial systems that are so essential to the functioning of banking systems.

These policy efforts in emerging market countries do not ensure that individual countries will be free from future problems anymore than policy efforts in industrial countries ensure that they will never incur problems. But, the broad thrust of policy in most emerging market countries is working in a direction that provides some assurance that the frequency and severity of problems in individual countries will be reduced. Further, these efforts also provide some real hope that investors and creditors will become more discriminating, thus reducing the spillover problems associated with contagion risk phenomenon.

However, we must remember that all countries -- but perhaps especially emerging market countries -- must be able to sustain the political will that is necessary to make the hard choices in economic policy. This is never easy, but it is particularly difficult in a setting often characterized by widespread poverty and social stress, amid relatively young democratic political institutions.

For our part in the industrial world, the most important thing we can do to assist these countries in this difficult transition is to promote growth and stability in our economies while keeping our markets open and receptive to the cross-border flow of goods, services, and capital.  In this latter regard, a special burden falls on the United States by virtue of the urgent need for the U.S. Congress to act swiftly and affirmatively to help bring China into the World Trade Organization.

With regard to financial market and financial sector shocks, the dual challenge of less frequent and better-contained disturbances involves initiatives on the part of both the official and the private sector. Turning first to the official sector, the aftermath of the 1998 market meltdown -- coming as it did on the heels of the other developments I have been discussing -- has produced an understandable burst of studies and recommendations.  Indeed, focusing only on efforts with an international orientation, the post 1998 market shock interval has produced a dozen or so official reports, most of which contain recommendations aimed at private institutions.  And, there are additional reports still in the pipeline.  The official sector initiatives that are still in progress include five especially important undertakings that are likely to have considerable relevance for virtually all internationally active financial institutions.

These initiatives include: First, the efforts mentioned earlier aimed at achieving a better balance of private and official financial participation in sovereign crisis management. Second, the promulgation by the Basle Committee on Banking Supervision of the new capital accord for internationally active banks. Third, the pilot project of the "Multidisciplinary Working Group on Enhanced Public Disclosure" (the Fisher Committee). Fourth, the forthcoming report or reports of the Financial Stability Forum. Fifth, the new rules and regulations to be promulgated by various U.S. regulatory bodies to implement the newly enacted financial sector legislation in the U.S.

To a very considerable degree, all of these official initiatives are aimed primarily at enhancing both the effectiveness and stability of the financial system.  For the most part, these initiatives are proceeding in a manner that provides for a high degree of communication and interaction with the private sector.  Such communication is crucial, especially in a setting in
which the subject matter is both complex and controversial and in a setting in which there are few, if any, neat and easy solutions to the issues at hand.

Obviously, I cannot anticipate the final details of this work in progress, but it does seem clear that one result will be important changes in the ground rules governing most major financial institutions.  I have every expectation that the changes will be evolutionary, not revolutionary, but in order to help insure that result, private institutions must be at the point of efforts to build a more effective and more stable financial system.

In all of this, the private sector is hardly standing pat.  Indeed, individual institutions and associations are hard at work, individually and collectively, in efforts to strengthen the workings of the global financial system.  One such collective exercise has been the work of the Counterparty Risk Management Policy Group, of which I have been an active participant.  At the risk of overstatement, I believe that the Policy Group's report of last summer falls in the category of required reading, not just for the firms represented on the Policy Group, but for all major and internationally active financial institutions.

There is one section of the Policy Group Report that is especially relevant: namely, the discussion and recommendations relating to what we called "Industry Practices," including matters relating to netting and close-out procedures.  In summary, these recommendations are designed to strengthen what I, for years, have called the "plumbing" of the financial system.

Since the report was published last year, a great deal of work and effort have been devoted to implementing changes in practices that would be compatible with the Policy Group's recommendation.  Those efforts have gained further momentum with the creation of the "Global Documentation Steering Committee" chaired by Tom Russo and Jane Carlin.  Among the Steering Committee's members are Bob Pickel, the General Counsel of the International Swaps and Derivatives Association, and Dan Cunningham of Cravath, Swaine & Moore.

As I see it, this Steering Committee is ideally positioned in time and composition to make a major and urgently needed contribution to strengthen the critically important plumbing of the financial system.  This effort alone is capable of substantially reducing risk, including systemic risk, in the global financial system.  With effort and statesmanship on the part of all, I believe that goal is within reach and I urge broad commitment to work collectively and cooperatively toward that end.

I said at the outset that the dual challenge for the future is to create an environment in which the frequency of financial shocks will be reduced and to strengthen our capacity to manage and contain such shocks when they occur.  Great progress is being made in this effort, but hard work lies ahead as the speed and complexity factors in global finance continue to increase.  Since financial instability yields few, if any, safe harbors, we will all have a responsibility to do our part in fostering the goal of greater stability.