Russian Crisis Notes

As we shall see, the effects of the Russian crisis on the US economy are virtually opposite as compared to the Asian crisis. The following three articles explain what exactly happened and will get us started. We begin in the summer of 1998, roughly a month before things got real bad. Enjoy the articles, we have lots to talk about!

July 13, 1998

IMF Tentatively Agrees on PlanFor Emergency Aid to Russia

By MATTHEW BRZEZINSKI and ANDREW HIGGINS Staff Reporters of THE WALL STREET JOURNAL

U.S. officials said the International Monetary Fund has agreed to provide Russia with an emergency-assistance package of $10 billion to $14 billion, and that the agreement may be announced as early as Monday or Tuesday.

The funds, the bulk of which will come from the IMF with a small amount from the World Bank, will be disbursed within six months to two years, provided Russia adopts a series of reforms outlined by Prime Minister Sergei Kiriyenko. His “anticrisis” package aims to raise tax revenue, cut the country’s budget deficit and increase competition in Russia’s economy. It will be put to a vote Wednesday in Russia’s lower house, the Communist-dominated Duma.

U.S. officials said IMF and World Bank money wouldn’t start flowing to Russia until there is a legal framework for the reforms, but they also said rejection of the reform package by the Duma wouldn’t necessarily block the deal because President Boris Yeltsin could enact most of the measures by decree. President Yeltsin has sometimes resorted to decree to sidestep Russia’s often recalcitrant legislature.

The tentative agreement was reached after weeks of wrangling and was finalized in talks Sunday between Mr. Kiriyenko and John Odling-Smee, an IMF official dealing with Russia’s crisis. The agreement also followed appeals for help to President Clinton and other world leaders by President Yeltsin. Russian officials said Sunday that they had reached a deal with the IMF on “all key issues,” but didn’t provide any details of the agreement.

Anatoly Chubais, Russia’s chief negotiator with the IMF, said in an interview last week that Russia was also talking to Western commercial banks and hoped they would grant loans equal to the final sum provided by the IMF. This could take the total IMF-led package to between $20 billion and $28 billion.

A Western banker said Russia was in talks with syndicates for two loans totaling $10 billion. Half of this would go directly to the Finance Ministry; the Central Bank is looking to establish a $5 billion credit line to be used only as a backup to fortify its

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dwindling reserves. Russia’s foreign-currency reserves stood at $15.1 billion on July 3 but have fallen since then because the central bank has been buying rubles in an effort to prop up the currency.

Nearly the entire IMF package will comprise new money for Russia, not an acceleration of previously committed funds, U.S. officials said. The only exception, they said, would be two payments by the IMF of $670 million each.

The new package doesn’t contain any funds from the U.S., officials said, but Japan is negotiating to provide bilateral aid of about $600 million to Russia in co-financing with the World Bank. Mr. Kiriyenko left Sunday for talks in Tokyo with Japanese leaders.

Talks in Moscow with the IMF got a boost after President Yeltsin telephoned President Clinton and the leaders of France, Britain, Japan and Germany to appeal for assistance and promise that Russia would carry out its reform proposals. Treasury Secretary Robert Rubin, on a visit to Africa, said Saturday that a strong and speedy IMF program for Russia “is of critical importance.”

In an interview, Russia’s Finance Minister Mikhail Zadornov said Russia aimed to increase tax collection by more than 25% by year-end. He said Russia urgently needed IMF funds to win a “breathing space” and avoid a devaluation that could cause havoc in the country’s ailing banking system.

Russia is the latest country to be hammered by the financial turmoil that began in Thailand last July. It follows Thailand, South Korea and Indonesia in seeking help from international organizations. Adding to Russia’s woes is the drop in world oil prices. Oil and gas are Russia’s principal exports.

Investors have been fleeing Russia since October when financial turmoil in Asia triggered an exodus from emerging markets. Since then, Russia’s stock market has lost two-thirds of its value.

“The prospect of a big IMF package is good news,” said Charles Blitzer, a former World Bank economist in Moscow and an analyst at Donaldson, Lufkin and Jenrette in London. “There seems to be a decision that the government is going to get space to implement its reforms ... and not be driven to bankruptcy by market sentiment of the moment.”

The capital flight has left Russia particularly exposed because the Kremlin has relied greatly on foreign investors to finance the country’s budget deficits through high-interest-rate government-debt issues. Recently, Russia’s rickety domestic banks have dumped ruble-denominated treasurys and borrowed rubles to buy dollars in anticipation of a currency crash. Friday, the Standard & Poors rating agency downgraded six leading Russian banks, warning the banking sector could be headed for a liquidity crisis.

The Finance Minister, Mr. Zadornov, said Russia urgently needed IMF funds until new tax revenue begins flowing in. He said Moscow currently spends $1 billion a month servicing its foreign debt and $1 billion to $1.5 billion a week covering redemptions of domestic treasurys.

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Carla Anne Robbins in Washington contributed to this article.Return to top of page | Format for printing Copyright © 1998 Dow Jones & Company, Inc. All Rights Reserved.

September 22, 1998

Why a World-Wide Chain ReactionSet Financial Markets Into a Spin

Once again, Russia is the Evil Empire.By Michael Siconolfi, Anita Raghavan, Mitchell Pacelle and Michael R. Sesit of The Wall Street Journal.

This time, it isn’t some ill-starred military adventure. Instead, the world is blaming Russia for the chaos sweeping through financial markets over the past month. Russia’s abrupt decision in mid-August to let the ruble’s value fall and default on part of its debt is widely viewed as the reason for widespread selling in everything from Brazilian bonds to U.S. stocks.

But has Russia—which has an economy that accounts for less than 1% of the world’s gross domestic product—even one spinning out of control— really wreaked billions of dollars of market losses? Not by itself, it hasn’t.

What the virtual collapse of Russia’s markets did was touch off a global flight from financial risk of all kinds. Russia’s actions were the trigger for that panicked flight, but once started, it behaved like a chain reaction.

Big bets by sophisticated investors, many made with borrowed dollars and many having nothing to do with Russia, suddenly went bad.

In a scramble to shore up their crumblingfinances and meet lenders’ demands for more collateral, those investors were forced to sell out of other, safer investments. And as these investments in turn tumbled under the selling pressure, the urge to flee became contagious, spreading quickly until it hammered just about every financial instrument except super-safe U.S. Treasury securities and German government bonds—which soared.

The result is that in the past five weeks, international investors have lost an estimated $95 billion on the stocks and bonds of so-called emerging markets, according to J.P. Morgan & Co. Throughout, huge amounts of debt, built up over years to finance securities purchases, have been unwound. Some victims have disclosed staggering losses.

Long-Term Capital Management, a fund for wealthy investors run by bond legend John Meriwether, has lost $1.8 billion. Credit Suisse First Boston Corp. is out at least $400 million after tax, according to someone familiar with its situation. And Bankers Trust Corp., a firm that had been trying for two years to lower its risk profile, has had its entire third-quarter profit wiped out by losses totaling $350 million before taxes.

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Even Merrill Lynch & Co., the most broadly diversified firm on Wall Street, has taken a $135

million hit. And in many cases, securities firms’ losses are worse than disclosed because they are using financial reserves to mask their full extent.

To be sure, the trading losses follow year upon year of lush profits by many of the same firms now being punished for aggressively playing international markets. “What we’re seeing is the dark side of a truly global marketplace,” says Merrill Lynch’s chairman, David Komansky. “Going forward, this is what a global, wired economy will look like during a market correction.”

While U.S. and European stocks have taken their lumps—the Dow Jones Industrial Average is 15% below its peak in July—the losses in these markets are nothing like the carnage in many others, including many kinds of bonds. When Mr. Komansky got home one night, his wife asked him what the U.S. stock market did. His weary reply: “I have no idea—I’ve been worried about the global bond markets.”

Much of the damage has been concentrated at securities firms and banks, and especially hedge funds—investment pools for rich investors that often use arcane trading strategies and borrowed money in a quest for outsize returns. Their holdings of Russian stocks and bonds, needless to say, took a beating. But interviews with scores of Wall Street executives, traders and bankers show that some of the biggest hedge funds, as well as many securities firms in the U.S., Europe and Japan, made three major bets unrelated to Russia that have gone disastrously awry:

In a bid to take advantage of tiny price discrepancies among types of bonds, Long-Term Capital and many other firms borrowed to finance big purchases of riskier bonds while betting that U.S. government securities’ prices would fall.

Hedge funds, among them Julian Robertson’s Tiger Management, made big wagers that while Japan struggled vainly with its worsening economic malaise, investors would continue to sell the Japanese yen and buy American dollars.

Securities firms, chief among them Travelers Group’s Salomon Smith Barney, made billion-dollar bets that as European monetary union approached, differences in the yields of various government bonds would narrow.

Indeed, no firm has been more emblematic of the global scope of the losses than Salomon Smith Barney. Even though co-chairman Jamie Dimon had ordered its traders to liquidate their positions in Russia in July, weeks before Moscow defaulted, Salomon has suffered after-tax losses totaling $360 million.

Just $10 million of that stemmed directly from investments in Russia. A further $50 million was from lending to a hedge fund that invested in Russia and went bust. The rest came from bond-market bets that had little or nothing to do with Russia but went bad anyway, as investors’ headlong rush for safety confounded expectations of the way various kinds of bonds would behave.

“Russia was the match, but the markets were ripe for dislocation,” Mr. Dimon says.

And they haven’t settled down yet. The scramble to unload almost any kind of risky investment has been so urgent that some markets, particularly for riskier bonds, are

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paralyzed, leaving firms holding far more of them than they want. The firms’ continuing efforts to cut their holdings suggest more declines ahead.

Beyond that are fears that other nations will follow Russia’s lead. Already, Malaysia has applied rigid controls that limit foreign investors’ ability to get their money out. Stock markets around the world remain volatile as investors worry about a crisis of confidence erupting in another developing nation.

“It’s not like in ‘87 when the market plunged and by 6 p.m. you knew what your losses were,” says Max Chapman Jr., chairman of Nomura Securities Co.’s three regional units outside Japan. “This one is more insidious. It is getting you from all places. If you’re a global player, you get kind of dizzy.”

Until this summer, Russia made some sense as a place to invest. The Asian turmoil that began with a mid-1997 devaluation of the Thai baht hadn’t reached Moscow. Yields on Russia’s government debt were high. Major firms such as Goldman, Sachs & Co. and Chase Manhattan Corp. were competing to underwrite government bonds and lead syndicated loans to Russian companies, while hedge-fund investors such as George Soros and Leon Cooperman were there, too. With such stars paving the way, other investors felt comfortable in the Russian market. Some Wall Street traders bought Russian bonds for their personal accounts.

“Interest rates were so high it was almost as if they were giving money away,” says Dana McGinnis, a San Antonio manager of three emerging-market hedge funds. His McGinnis Advisors invested a large chunk of its $200 million in Russia.

Then in August, Russian political and economic conditions, which had been slowly worsening, began to disintegrate. Investors increasingly anticipated a ruble devaluation. Yet some, such as Mr. McGinnis, weren’t worried. They thought they had purchased protection: the right to convert rubles into dollars at fixed rates, through contracts they had made with Western and Russian banks.

Marc Hotimsky, global-bond chief for Credit Suisse First Boston, met with officials in Moscow and was assured that Russia would meet its obligations and wanted a stable ruble. Leaving the country on Friday, Aug. 14, he says, he “had a sense the situation in Russia was critical, but I didn’t think they would default.”

On Monday, they did. Although Russia didn’t tamper with the government’s foreign-currency debt, it announced it would restructure its treasury bills and impose a moratorium on repayment of $40 billion in corporate and bank debt to foreign creditors. It said it would let the ruble’s value against the dollar fall by up to 34%. (The ruble didn’t stop where it was supposed to, as devalued currencies often don’t.)

Wake-Up CallThe news came as a jolt to Rodolfo Amoresano. As chief of emerging-markets proprietary trading for Nomura’s New York unit, he was sitting on a $200 million position in Russian treasury bills, traders other than Mr. Amoresano say, after returning from Russia with assurances that the government wanted a stable ruble. Awakened at 3 a.m. by the news, he dashed to the office to warn others of the danger, the traders say. Then he boarded a plane back to Russia to try to sort out the mess.

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The bills were supposedly protected by forward currency contracts entered into with big Russian banks. But Russia’s debt moratorium apparently allows its banks to ignore their forward-contract obligations for 90 days; terms of the freeze are so confused that parties are still haggling over what they mean.

Those holding Russian securities were stuck. There was no trading. No bids, no offers. A trading strategy that had been profitable—Nomura’s New York unit had made a total of about $100 million in Russia in the prior three years, the traders say—suddenly was destroyed. Nomura ended up with Russia-related pretax losses totaling $350 million, including $125 million in Mr. Amoresano’s “book.” (The rest came from the London operation.) A Nomura spokesman declines to comment.

Investors in Russian securities weren’t the only ones affected; so were those who had lent to such investors. Creditors of hedge funds, convinced the funds wouldn’t get back all the money they had put into Russia, issued demands for more collateral, known as margin calls.

The funds had to raise capital to meet the calls, but they couldn’t do so by selling Russian securities, with those markets paralyzed. So they began selling other assets, including U.S. stocks.

One who got a margin call was Mr. McGinnis in San Antonio. His funds had $100 million of Russian bonds, bought with leverage; he, too, found that his currency contracts didn’t protect him when Russia defaulted. He says Citicorp, First Boston and Lehman Brothers Holdings Inc. demanded more collateral. To raise it, he says, he began dumping “everything else.”

It wasn’t enough. In late August, Mr. McGinnis’s funds sought Chapter 11 bankruptcy protection in San Antonio federal court.

Talk spread that Russian treasury bills might be worth only 10 cents on the dollar. “The second you hear that, you’re feeling, ‘I don’t want to hold any other similar emerging-market debt,’ “ says Philipp Hildebrand, a strategist for the British affiliate of Moore Capital Management, a New York hedge fund. “You had an immediate and substantial collapse in risk appetite.” Holders began selling bonds from South Korea, Greece, Turkey, Mexico, Brazil.

Some Who’ve Taken Big Hits

Institution Damage Bank America$330 million pretax trading losses

Bankers Trust$350 million trading losses in July, August

Republic New York Russia-related charges of $155 million

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Salomon Smith Barney $360 million in after-tax trading and Russia-related credit losses

Nomura Securities $350 million in pretax Russia-related losses

Credit Suisse First Boston $400 million in after-tax Russia-related losses

Long-Term Capital Hedge fund down 44% in August

III Offshore Advisors One hedge fund filed for liquidation

Sources: J.P. Morgan, Telerate

But buyers for what they wanted to sell were rapidly disappearing. “If you didn’t sell by Aug. 25, you were probably stuck in the mud,” says Peter Marber, president of Wasserstein Perella Group Inc.’s asset-management unit, whose two hedge funds incurred big August losses. From the Friday before Russia devalued until 10 days afterward, the J.P. Morgan Emerging Market Bond Index fell nearly 25%.

Trimmed HedgesOne hedge fund, III Offshore Advisors’ High Risk Opportunities Hub Fund, faced margin calls from lenders such as Salomon Smith Barney, First Boston, Lehman and Bankers Trust, according to a person familiar with the matter. To raise the money, the fund sought to collect on forward currency contracts it had signed with Deutsche Bank AG, Credit Lyonnais, Societe Generale Group and the ING Barings unit of ING Group. Although those contracts hadn’t yet come due, III Offshore partner Warren Mosler says the hedge-fund firm was entitled to demand some payment—he puts it at $300 million—based on the contracts’ present value. But the European banks wouldn’t pay, he says, and III Offshore, which is based in West Palm Beach, Fla., had to file to liquidate the hedge fund. The banks “defaulted,” Mr. Mosler asserts. “What brought down the fund is these guys failed to meet their obligations.”

Credit Lyonnais and Societe Generale decline to comment. A spokeswoman for ING says it is unaware of any dispute. Deutsche Bank says it “complied with all contractual obligations.” Even if a firm was prescient, it wasn’t easy to move quickly enough. In July, Mr. Dimon hammered home his concerns over Russia and Indonesia to Salomon Smith Barney’s risk-management committee. “I want out,” Mr. Dimon said, according to some who were there.

The traders were resistant. Indonesia had already taken its licks, and prospects for an IMF-led credit made Russia’s situation appear calmer. But the traders went to work, whittling down Russian-bond positions of more than $100 million. Salomon’s repurchase-agreement desk, which does overnight financing for institutions such as hedge funds, also started to reduce its exposure to funds investing in Russia. But the effort wasn’t rigorous enough. Salomon got stung by a loan of nearly $50 million it made to the III Offshore Advisors fund that is being liquidated. Mr. Dimon declines to comment.

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Bonds DivergeNow, as investors rushed for the sanctuary of U.S. Treasurys, the value of those bonds began to soar. Monday the 30-year bond’s yield got as low as 5.05% before late trading pushed it back up to a still-ultralow 5.124%. But the same thirst for safety caused investors to flee from riskier bonds, including those of emerging markets, U.S. mortgage-backed securities, high-yield “junk” bonds and even investment-grade corporate bonds. “The whole world was on one side of the ship for three years, and now they wanted to go to the other side of the ship all at once,” says Greg Hopper, a portfolio manager at Bankers Trust Global Investment Management.

The shift wreaked havoc with some of the most complex and leveraged market bets made prior to the Russian turmoil. Among them were bets on the spreads between the yields on various kinds of bonds. Many hedge funds and investment banks had wagered that growing demand for riskier bonds around the world would cause these bonds’ prices to rise and their yields to fall, but that yields would rise on the safest government bonds. The flight to safety caused the reverse to happen.

At Long-Term Capital’s plush headquarters in Greenwich, Conn., traders watched in horror as one after another of the firm’s bets exploded. Traders were left to follow “the action on the screens and marvel at the violence out there in the marketplace,” a person familiar with the operation says. “When you have a global movement, all the trades go against you at the same time.”

Declines in the hedge fund’s net worth triggered internal controls requiring that risk be reduced. So it started dumping some securities and unwinding interest-rate bets. Through it all, the firm was being peppered with calls from Lehman and Salomon Smith Barney, two of its lenders, for information about trades and the extent of losses.

Rumors spread that Long-Term Capital was in trouble. They intensified after the New York Stock Exchange, as part of a broader Wall Street sweep, quizzed securities houses about whether Long-Term Capital was meeting its margin calls. It was.

Grim NewsBut on Sept. 2, Mr. Meriwether, who once was Salomon Brothers’ vice chairman, broke the news to the hedge fund’s investors: Its value had plunged 44% in August. The total loss was $1.8 billion. Yet, in a measure of how far the ripples had spread beyond Moscow, only 8.7% of the losses came in Russian markets, says a person familiar with the results.

Nor was Merrill Lynch spared. In the wholesale flight to safety, even U.S. corporate bonds got slammed, and Merrill Lynch, as a leading underwriter and market maker, owned a $5 billion portfolio of them. Making matters worse was that one way Merrill had tried to protect itself from such a decline was by selling U.S. Treasurys short, figuring that if corporate bonds fell, so would Treasurys; when they soared, this bet only worsened Merrill’s losses.

Merrill’s bond-related losses exceeded $100 million, pretax, traders say. Although the firm has said it had after-tax emerging-markets losses in July and August of $135 million, it won’t provide a breakdown.

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A broader concern in the bond market has been gridlock. In recent weeks, buyers have simply shunned a broad range of bonds, from U.S. junk bonds to any emerging-market debt. Some emerging-market bonds have vast spreads between the bid price and the offer, making it all but impossible to trade. Last week, recalls Andrew Brenner, a bond trader at Societe Generale, the bid-offer spread on a bond from a Brazilian state water utility known as Sabesp was 15 points-you could sell it at 70 and buy it at 85. “Obviously, I couldn’t get anything done,” Mr. Brenner says.

Indeed, not much of anything is going on in broad parts of the bond market—even on days when the stock market rallies. On Sept. 8, as U.S. stocks were soaring on a bout of investor optimism, Donaldson, Lufkin & Jenrette Inc. executive David DeLucia received word from his top traders that buyers were nowhere to be found in much of the high-yield market. “There’s still decent demand for high-quality names, but liquidity seems to dry up for names beneath that,” Mr. DeLucia says.

Merrill owned Brazilian corporate bonds that it had hedged by taking short positions in Brazilian government bonds—that is, it had bet on a decline in the government bonds’ price by selling them without owning them. The minute bids for the bonds appeared on traders’ screens, they were snapped up. “Any buying was quickly satisfied,” Mr. Komansky says. “You couldn’t cover your shorts. You couldn’t sell your longs.”

All the recent turmoil in the bond market has hammered home a lesson in protecting one’s assets. Quips Mr. Komansky: “The only perfect hedge is when someone else owns it.”

Masking LossesEven when firms have disclosed their global market losses, these amounts often are severely understated. This is because many major brokerage firms have been tapping into reserves they had accumulated during the big bull market to mask the full extent of their recent trading deficits. Though Lehman Brothers, for example, recently announced an after-tax loss of $60 million from emerging-markets woes, Wall Street traders say the firm actually had total pretax losses of about $200 million. Lehman declines to comment on its use of reserves.

Traders say Lehman’s losses also were tempered by separate winning trades, including selling emerging-market stocks (which have plunged) and purchasing U.S. government bonds (which have soared). “We lost some money in hedging some securities positions, but offsetting that we were long governments in a big way,” says Richard Fuld, Lehman’s chairman. “We had a view that during time of turmoil there would be a flight to quality.”

All that didn’t stop some rumors from becoming entrenched. Lehman’s already-battered stock was slammed an added 7% on Sept. 11 amid speculation the firm would file for bankruptcy protection. Senior officials scrambled to assure clients Lehman was secure. But so prevalent were the rumors that the New York Stock Exchange examined Lehman’s books. Big Board Chairman Richard Grasso personally called Mr. Fuld later in the day to tell him the firm had passed the review. Monday, Moody’s Investors Service confirmed Lehman’s debt ratings and said the firm’s ratings outlook is “stable.”

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Europe’s YieldsAcross the Atlantic, another problem was festering. Costas Kaplanis, head of Salomon Smith Barney’s global-arbitrage trading group in London, had made good money over two years betting that the differences in yields on various European bonds would narrow as European monetary union neared. Among its billion-dollar trading positions, say people familiar with the situation, was a bet on a convergence in the yields of German and Italian bonds.

But in the flight to quality set off by the Russian crisis, the yields started diverging, because German bonds were regarded as safer than Italian bonds. Executives in New York ordered Mr. Kaplanis to unwind some of the bets and reduce others. The paralysis gripping bond markets hampered the effort, and the global-arbitrage group wound up with $180 million in after-tax trading losses.

More losses arose in Salomon Smith Barney’s U.S. arbitrage group. Its traders had placed $1 billion bets on the London Interbank Offered Rate, or Libor, on the expectation that the spread between that rate and U.S. Treasury yields would narrow. Instead, it ballooned, leading to after-tax losses of $120 million.

At New York headquarters, Salomon Smith Barney’s senior executives roamed the trading floors telling their traders not to be heroes by taking on risky positions that clients were trying to shed. They were urged to bid for securities 10% to 15% below the last trade, rather than the usual 2%, 3% or 4%. Clients asking the firm to bid on a million shares of stock were rebuffed or got steeply discounted bids. More frequently, traders told clients they would bid for much smaller blocks and try to parcel out the rest of the order.

Yen Bet Goes BadSteven Black, a Salomon Smith Barney vice chairman, told his troops to balance their priorities: “We can’t trade just for the benefit of clients if it would be irresponsible to the firm’s position or to shareholders. Anything we do should be prudent.”

The U.S. dollar, like U.S. Treasury securities, is a haven for worried investors, but the market has been so topsy-turvy that even some bets on a stronger dollar went sour. With Japanese interest rates extremely low, hedge funds and others had borrowed huge amounts of Japanese yen and sold them in order to buy the higher-yielding securities of other countries. This meant, of course, that eventually the funds would have to buy yen to repay the loans.

In late August, a Japanese official said Tokyo was close to intervening to support the yen. Meanwhile, plunging U.S. stocks raised fear of a weaker dollar vis-a-vis the yen. Hedge funds abruptly began buying yen to cover their borrowings.

That further strengthened the yen. Mr. Robertson’s $21 billion Tiger Management Fund, one of the biggest bettors against the yen, lost 10%, or $2.1 billion, in the first two weeks of September.

What’s With Stocks?Through it all, individual investors in many markets, including the U.S. stocks, were mystified. For the first time since the 1987 crash, falling prices weren’t drawing large sums from people intent on “buying the dip.” Nor were falling interest rates. Twice in the

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month following Russia’s devaluation, the Dow Industrials slipped close to 20% below their July high, the level loosely regarded as marking a bear market. In one stretch, the Dow Industrials moved up or down at least 100 points in 10 of 12 trading sessions.

Exchange officials grew worried that two “specialist” firms, which buy and sell to meet demand and smooth out trading, would be in danger if the market continued to falter. Big Board officials met with principals of the firms, paving the way for one to get a capital injection from its partners and the other to be absorbed by rival firm.

In contrast to 1987, however, the systems underpinning the U.S. stock market haven’t cracked. Trading has been relatively orderly, nothing like the violent selling seen on Oct. 19, 1987.

On Aug. 31, as the market spiraled toward what became a 512-point, 6.37% plunge, Mr. Grasso—who has been a Big Board executive for more than a decade—sought a reading from Edward McMahon, Merrill Lynch’s chief of trading in exchange-listed stocks. Mr. McMahon had a simple but clear message: “No shouting. Bids wanted.”

Translation: Traders were filling orders without panic—a far cry from the frantic message he heard in 1987.

Matt Murray contributed to this article.Return to top of page | Format for printing Copyright © 1998 Dow Jones & Company, Inc. All Rights Reserved.

November 17, 1998

How the Fed Fumbled and ThenRecovered in Making Policy Shift

By DAVID WESSEL Staff Reporter of THE WALL STREET JOURNAL

WASHINGTON—Shortly after the Federal Reserve announced early in the afternoon on Sept. 29 that it was cutting interest rates, top Fed officials realized they had made a mistake.

They had hoped their first rate cut in nearly three years would reassure financial markets that the world’s most powerful central bank was prepared to do what was needed to avoid a global economic meltdown.

But Fed Chairman Alan Greenspan, known for often-obscure pronouncements, had sounded a clear alert that a rate cut was imminent, and the markets shrugged when the Fed trimmed just a quarter percentage point off its key short-term interest rate.

Edward Boehne, president of the Philadelphia Federal Reserve Bank, says he knew a few days later that the Fed had goofed. When he checked into a hotel in a small town in Pennsylvania, the clerk looked at his title and said, “You didn’t do enough.”

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“You don’t usually get that from a hotel clerk,” Mr. Boehne says.

Inside the Fed, the next two weeks were filled with introspection and second-guessing of Mr. Greenspan’s go-slow proclivities.

The handful of Fed policy makers who had argued for a more dramatic half-percentage-point rate cut felt vindicated. Officials at the Federal Reserve Bank of New York worried that the rate cut had done little to reverse a stampede away from risky, and even not-so-risky, bonds.

Something MoreQuietly, but forcefully, New York Fed President William McDonough, 64, who sees himself as a potential successor to the 72-year-old Mr. Greenspan, and Alice Rivlin, the former White House budget director who is vice chairman of the Fed, pushed for something more.

That “something more” turned out to be a surprise quarter-percentage-point cut in rates on Oct. 15, a moment that Mr. Greenspan chose because he sensed that financial markets were ready to respond favorably.

The Fed knew the move would grab attention: It was first time since 1994 that the central bank had changed interest rates between scheduled policy-committee meetings. But would it provide a jolt of confidence to the markets? Or would it be seen as evidence that the Fed’s take on the financial crisis was bleaker than everyone else’s?

To the Fed’s relief, it turned out to be the former. Markets rallied instantly, and have hardly looked back.

Indeed, as Fed officials prepare to sit down Tuesday around their two-ton mahogany-and-granite conference table to ponder another rate cut, prospects for the U.S. economy look rosier than they did a month ago—so much better that some Wall Street analysts who were confidently predicting the Fed would reduce rates again now aren’t so sure.

Promising SignalsThe economy seems to be growing at a better-than-expected pace of nearly 3% in the second half of 1998. The stock market is ebullient, causing a few at the Fed to begin worrying again about “irrational exuberance,” and prompting some to raise forecasts for consumer spending next year. Global markets are calmer.

Nonetheless, the Fed’s internal forecasts indicate the economy will slow substantially in the first half of 1999, putting the nearly eight-year-long U.S. expansion at risk. The bond market is still showing signs of stress and lack of liquidity. And Fed officials know that if they are to give any boost to next year’s economy, they must move soon. But whether or not a rate cut comes Tuesday, the widespread expectation is for further cuts in the months ahead.

For an institution that rarely changes direction quickly, this is a remarkably rapid about-face. After all, the Fed came very close to raising interest rates this past spring because it feared the unexpected vitality of the U.S. economy would lead to inflation.

The policy change reflects the deterioration of the global outlook following Russia’s default on its debts in August. But the Fed hasn’t always reacted rapidly to changes in the

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financial environment. Indeed, at times, it has prided itself on not being swayed by Wall Street phobias of the moment.

For several reasons, this time was different:

The current crop of Fed policy makers is more pragmatic than in the past. Those who adhere to a particular school of thought—tracking the money supply or comparing today’s jobless rate to the rate at which inflation has taken off in the past—have been trumped by the fact that inflation hasn’t taken off as they anticipated. Inflation has been falling even though unemployment is at a quarter-century low. To predictions from Fed colleagues that inflation is around the corner, Mr. Greenspan has replied simply: Show me evidence. There hasn’t been much.

Influential Fed officials, including Mr. Greenspan, saw this as a time when prudent policy meant looking beyond conventional gauges. It meant asking questions like: With Japan in political paralysis and Europe preoccupied with monetary union, what can the U.S. central bank do to avert a global financial catastrophe? The Fed rarely faces such questions, but when it does, the consequences of error are huge: witness the Great Depression.

Mr. Greenspan, who dominates the institution he has run since 1987, saw a threat to what he calls the best economy in 50 years. Credibility is hard to measure, but Mr. Greenspan has lots of it. When he resisted pressure to raise rates, the markets didn’t assault him as soft on inflation, and his uneasy colleagues didn’t revolt. When he decided it was time to cut rates, the rest of the Fed followed.

Although the Fed chief cultivates consensus, there is no doubt who calls the shots. At meetings of the Fed’s policy-setting Federal Open Market Committee, Mr. Greenspan listens as each official gives his or her views on the economy. But when it is time to decide what to do about interest rates, Mr. Greenspan speaks first. Anyone advocating a different policy has to make a deliberate decision to differ with him.

A majority on the FOMC had been eager to raise rates early in the fall of 1997, before the virulence of the Asian flu was evident. That September, Mr. Greenspan held them off, arguing that he hadn’t prepared the markets. When the committee reconvened in October and November, intensifying economic woes in Asia made raising rates nearly impossible.

When the FOMC met at the end of March, the Asian financial crisis appeared to be in remission. The long-predicted slowdown in the U.S. economy had failed to arrive. The ghost of inflation was lurking, even if there were few signs that wages or prices were going up more rapidly.

“There was a sense that maybe the Asian drag wasn’t going to be as great as anticipated,” Alfred Broaddus, president of the Richmond, Va., Federal Reserve Bank, recalled in an interview during the summer.

Signing OnAgain, Mr. Greenspan, who doubted that the wage increases feared by some Fed officials would actually materialize, talked his colleagues out of raising rates. But he joined the consensus that a rate increase was “a likely prospect in the not too distant future,” according to a published summary of the session. The question wasn’t if, but when. With

13

unemployment at a low 4.6% and the pace of money-supply growth quickening, there was no thought given to cutting rates.

By July, a rate increase no longer seemed a certainty-at least to Mr. Greenspan. Although the FOMC was still formally leaning in favor of higher rates in the written statement it crafts at the end of each meeting, the chairman signaled in congressional testimony in late July that he wasn’t. By the Fed’s August meeting, which came just a day after Russia’s default, it was clear that weakening exports and mounting inventories were squeezing American manufacturers. Few Fed officials still were thinking about higher rates, but most weren’t ready to lower them.

Each year at the end of August, Mr. Greenspan and other top Fed officials attend the Federal Reserve Bank of Kansas City’s conference at Jackson Hole, Wyo., in the majestic Tetons. This year’s topic was inequality, but the only subject of coffee-break, hiking-trail and golf-course conversation was what to do about the spreading global financial crisis. Private economists, eager to be quoted, sought out reporters to argue for cutting rates. Fed officials, just as eager not to be quoted, pooh-poohed those arguments.

But the important conversations were taking place in the quiet huddles in and around the Jackson Lake Lodge among the five Fed governors, seven Fed bank presidents and top Fed and foreign central-bank staffers who were there. The market reaction to Russia’s default was severe and unexpected. The daily reports that the New York Fed prepared for officials showed a worrisome, widening gap between the yield on corporate bonds and government bonds, a rare occurrence except when the economy is in recession. In the market for supersafe U.S. Treasury bonds, there was an unusually strong preference for the most easily traded issues, which the Fed read as a sign of unhealthy anxiety.

Speaking UpIt was, the Fed officials agreed, time for them to say something to the world.

Mr. Greenspan stuck to his plan to spend a week at a tennis camp, though he got so many phone calls about the plunging stock market that he jokes that he kept a tennis racket in one hand and a cellular phone in the other. But a speech planned for the University of California at Berkeley’s business school on Friday, Sept. 4, offered a convenient opportunity.

Clearing key passages in advance with each member of the FOMC, Mr. Greenspan declared that the U.S. couldn’t hope to remain an “oasis of prosperity.” As flatly as he ever says anything, he said the Fed no longer was leaning toward raising rates.

A week later, a statement from the world’s leading central bankers and finance ministers led to speculation that the central banks would cut rates in concert. But Mr. Greenspan and his peers don’t like anyone thinking they subordinate national priorities to global ones—even if they sometimes do. Mr. Greenspan’s German counterpart, Hans Tietmeyer, quickly quashed the notion that he was coordinating anything with anyone. Mr. Greenspan did the same, telling Congress on Sept. 16, “At the moment, there is no endeavor to coordinate interest-rate cuts.” He said other things, too, but that was all the markets heard.

In the days that followed, bond-market investors grew even more skittish, making it difficult for many firms to borrow. Caught off-guard, Long-Term Capital Management

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LP, the huge hedge fund, came crawling to the New York Fed, saying it needed capital and was having trouble raising it. If LTCM’s holdings were dumped on the bond market all at once, New York Fed President McDonough told Mr. Greenspan, the odds of calamity were uncomfortably high. On Sept. 20, New York Fed officials got a look at Long-Term Capital’s books. They were shocked.

While Mr. McDonough and his staff tried to organize a Wall Street rescue of Long-Term Capital, Mr. Greenspan focused on how perplexed the markets were about the Fed’s inclinations.

To keep other Fed officials happy, Mr. Greenspan makes major policy changes only at FOMC meetings—partly so the Fed doesn’t look like the one-man show it often is. But the FOMC wasn’t set to meet until Sept. 29. He didn’t want to wait. He accepted a standing invitation to testify before the Senate Budget Committee. On Sept. 21, even though some Fed officials were unavailable because it was the Jewish New Year, he convened a conference call to be sure his colleagues were also ready to cut rates.

They were. On Capitol Hill, Mr. Greenspan essentially announced the Fed was about to act. “We know where we have to go,” he said. The stock market cheered, even though it would be six days until the Fed actually lowered to 5 ¼ % its target for the federal-funds rate, the interest rate at which banks lend to one another.

‘Irrelevant’ AmountThe argument for initially cutting rates by only a quarter point prevailed because most Fed officials figured that simply changing direction would make a big enough splash. “I thought the amount was irrelevant,” says Mr. Boehne, the Philadelphia Fed president. “The problem with 50 basis points”-jargon for a half percentage point-“was that people could have inferred that we knew more bad things than we did.” Mr. Greenspan made the same argument internally.

But after the Fed’s Sept. 29 announcement, the stock market sagged, and the worrisome spreads in the bond market widened.

A week later, Mr. Greenspan delivered a rambling, off-the-cuff early morning speech to the National Association for Business Economics. He had two goals. The first was to dispel the sense of doom and gloom that had descended. Officials from emerging-market economies who had come to Washington for the annual meetings of the International Monetary Fund and the World Bank had talked as if the era of capitalism were over. The press was filled with what he considered overblown talk of a wrenching credit crunch.

The second goal, somewhat at odds with the first, was to lay the foundation for another rate cut by detailing the evidence that uncertainty and fear were causing investors to, as he put it, “disengage.”

But when to cut? Fed officials couldn’t afford another tactical error or muddled message. They didn’t want anyone to think they were responding to a particular economic indicator, to a down day in the stock market or to rumors that a big bank was about to collapse.

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Time for ActionBy Thursday, Oct. 15, Mr. Greenspan figured the spreads in the bond market he had been tracking had grown so wide that they were bound to begin to narrow soon. It was time. He convened a telephone conference call of the FOMC.

Participants say the hour-long conversation was unusual. Breaking from past practice, Mr. Greenspan let each Fed governor and bank president speak before stating his druthers, an effort to bolster the sense that he was seeking a consensus. When he disclosed his plans, no one objected strenuously—and he didn’t ask for a vote.

The move was a success (except for an embarrassing typo in the 3:14 p.m. news release, in which the Fed misstated the details of the rate cut). Stocks and bonds leapt. One measure Mr. Greenspan has been tracking closely— the difference between yields on more-easily traded and less-easily traded Treasurys—improved.

On their TV sets and computer screens, Fed officials watched the instant analysis with a bit of trepidation. But the reaction was almost universally favorable, and the intended message was received: The Fed was prepared to do what was necessary. “Yes!” one Fed governor said late that afternoon after listening to a Wall Street pundit on CNBC, the business cable channel. “They got it right.”

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November 17, 1998

Fed Trims Short-Term Interest Rates,Marking Third Cut in Seven Weeks

An INTERACTIVE JOURNAL News Roundup

Citing “unusual strains” on financial markets, Federal Reserve policy makers cut interest rates Tuesday, moving for the third time in seven weeks to keep the U.S. economy from slipping into a recession.

The Fed announced that it trimmed its target for the federal-funds rate by one-quarter of a percentage point to 4.75%. It was the third one-quarter-point slice off the rate, at which banks lend to each other overnight, since Sept. 29.

“Although conditions in financial markets have settled down materially since mid-October, unusual strains remain,” central bank policy makers said. The sentence echoed earlier statements by Fed Chairman Alan Greenspan expressing concern over evidence that investors increasingly were putting their money into government bonds rather than similar corporate paper.

The typically brief statement lacked elaboration but nevertheless appeared to signal the Fed doesn’t expect to cut rates again soon. In an unusual look forward, the Federal Open Market Committee said that it expects that its combined three-quarter point cut since September “to be consistent with fostering sustained economic expansion while keeping inflationary pressures subdued.”

“Expectations for further cuts have been reduced substantially,” said Ken Fan, market strategist at Paribas Capital Markets in New York.

The FOMC—which includes the six Fed governors (there is one vacancy) and five of the Fed’s regional-bank presidents—also cut the discount rate by one-quarter point to 4.5%. That move in the rate, which the Fed charges depositary institutions, was made in response to requests from the Fed banks in New York, Philadelphia and Dallas.

Stocks climbed out of negative territory after the Fed move, which was announced about 2:20 p.m. EST. The Dow Jones Industrial Average ended the day with a small loss, but other indicators finished with gains. Bond prices had largely already factored in the cut and drifted lower after the announcement.

Although the Fed’s move has no direct effect on consumers, by reducing the cost of money to banks, it effects trickle down pretty quickly. BankAmerica Corp. and Chase Manhattan Corp., for example, immediately responded by cutting their prime lending rates a quarter point to 7.75%. The prime serves as a benchmark for a variety of consumer and business loans, from credit cards to auto loans.

Tuesday’s move was widely expected, but with economic data reflecting surprising vigor in recent weeks, there were some economists who considered the Fed’s move a toss-up.

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The Fed’s own manufacturing index, for example, rose 0.3% in October. Meanwhile, consumer spending is motoring along and the unemployment rate is humming at a low 4.6%.

Also, Mr. Greenspan earlier this month said that one concern that had spurred the earlier interest-rate cuts—increased investor anxiety—was easing.

But some of that renewed confidence, visible in the industrial average closing above 9000 on Monday for the first time in three months, was fueled by expectations that the Fed would reduce rates again. Indeed, traders said in advance of the Fed move that if the central bank didn’t cut rates, stocks could easily drop 200 points. Put another way, the Fed had to make the cut as much to avoid a negative outcome as to promote a positive one.

“If you’re going to make a mistake at this point, better to ease when it’s not necessary,” said Dana Saporta, an economist with Stone & McCarthy Research Associates.

And while the economy appears to be growing at a better-than-expected pace of nearly 3% for the second half of this year, the Fed’s internal forecasts indicate the economy will slow substantially in the first half of 1999, putting the nearly eight-year-long U.S. expansion at risk.

The Fed, meanwhile, had a fair amount of room to stimulate spending without spurring inflation. The government reported Tuesday morning, for example, that inflation at the consumer level is running at just 1.5% for the last 12 months. By comparison, last year’s inflation rate of 1.7% was the lowest it had been in 11 years.

There was also the global picture to consider. While the Fed is loathe to give the impression that international interests are taking precedence over domestic ones, action by the U.S. central bank can calm overseas investors who are jittery about emerging markets.

Some economists said another cut by the Federal Reserve would provide an impetus for other nations around the globe to do the same.

“Given the current benign inflationary outlook, there is plenty of leeway for them to lead,” Stephen Roach, Morgan Stanley Dean Witter’s chief economist, told the CNBC cable network Tuesday morning.

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The Following graphs depict the behavior of some major financial variables during the Credit Crunch of 1998. Source for all graphs; Federal Reserve Board of Governors

U.S. Three Month T-bill

J F M A M J J A S O N D J F M A M J J A S O N D J1997 1998

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

5.50

TCM3M

Figure 1

Figure 1 depicts the rally in the 3 month T-bill market that Russia set off in August of 1998.

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U.S. Three Month T-bill

Jun Jul Aug Sep Oct Nov Dec Jan1998

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

Figure 2

The first vertical bar is the announcement of the debt moratorium. The following three vertical bars are the three cuts by the FOMC. Note the rally in the T-bill market began

right after the Russian crisis.

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Corporate Bonds: AAA, BAA and T-bills

Jun Jul Aug Sep Oct Nov Dec Jan1998

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5BAA

AAA

TBill

Figure 3

Why is the interest rate on BAA higher than AAA ? Why are both corporate yields higher than the T-bill?

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Interest Rate Spreads: AAA minus T-bill ; BAA minus T-bill

Jun Jul Aug Sep Oct Nov Dec Jan1998

1.20

1.60

2.00

2.40

2.80

3.20

3.60

BAA - TBill

AAA - TBill

Figure 4

Note how effective the surprise interest rate cut by the Fed was in lowering the spreads.

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Spread: 90 day non-financial commercial paper minus T-bill

Figure 5

Note how the final 2 cuts seem to have done the job.

Diverse Credit Markets: The following articles describe the important role played by banks during the Russian crisis. In the second article, Alan Greenspan shares his thoughts on the benefits of having diverse credit markets.

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September 27, 1999

Greenspan Discusses Global CrisesIn Address to World Bankers

Following is the prepared text of remarks by Federal Reserve Chairman Alan Greenspan before the World Bank Group and the International Monetary Fund, in Washington, Sept. 27, 1999.

Lessons from the Global Crises

With the benefit of hindsight, we have been endeavoring for nearly two years to distill the critical lessons from the global crises of 1997 and 1998. From what seemed at the time to be isolated and contained disruptions in Thailand and Indonesia, economic turmoil deepened and spread, ultimately engulfing the emerging-market economies of East Asia and other parts of the globe and then the financial markets of industrial countries.

The failure of normal adjustment processes to contain the financial turmoil made this crisis longer and deeper than any of us had expected in its early days. One possible clue to this breach may reside not in the events leading up to the East Asian crisis in the spring of 1997, but rather in the extraordinary episode of financial market seizure that afflicted some emerging-market and industrial-country markets, particularly in the United States, a year ago.

Following the Russian default of August 1998, public capital markets in the United States virtually seized up. For a time not even investment-grade bond issuers could find reasonable takers. While Federal Reserve easing shortly thereafter doubtless was a factor, it is not credible that this move was the whole explanation of the dramatic restoration of most, though not all, markets in a matter of weeks. The seizure appeared too deep seated to be readily unwound solely by a cumulative 75 basis point ease in overnight rates. Arguably, at least as relevant was the existence of backup financial institutions, especially commercial banks, that replaced the intermediation function of the public capital markets.

As public debt issuance fell, commercial bank lending accelerated, effectively filling in some of the funding gap. Even though bankers also moved significantly to risk aversion, previously committed lines of credit, in junction with Federal Reserve ease, were an adequate backstop to business financing.

With the process of credit creation able to continue, the impact on the real economy of the capital market turmoil was blunted. Firms were able to sustain production, business and consumer confidence were not threatened, and a vicious circle—an initial disruption in financial markets leading to losses and bankruptcies among their borrowers and thus further erosion in the financial sector—never got established.

What we perceived in the United States in 1998 may be an important general principle: Multiple alternatives to transform an economy’s savings into capital investment offer a set of backup facilities should the primary form of intermediation fail. In 1998 in the

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United States, banking replaced the capital markets. Far more often it has been the other way around, as it was most recently in the United States a decade ago.

Highly leveraged institutions, such as banks, are, by their nature, periodically subject to seizing up as difficulties in funding leverage inevitably arise. The classic problem of bank risk management is to achieve an always elusive degree of leverage that creates an adequate return on equity without threatening default.

The success rate has never approached 100 percent, except where banks are credibly guaranteed, usually by their governments, in the currency of their liabilities. But even that exception is by no means ironclad, especially when that currency is foreign.

When American banks seized up in 1990, as a consequence of a collapse in the value of real estate collateral, the capital markets, largely unaffected by the decline in values, were able to substitute for the loss of bank financial intermediation. Interestingly, the then recently developed mortgage-backed securities market kept residential mortgage credit flowing, which in prior years would have contracted sharply. Arguably, without the capital market backing, the mild recession of 1991 could have been far more severe.

Similarly Sweden, like the United States, has a corporate sector with a variety of non-banking funding sources. Bank loans in Sweden in the early 1990s were concentrated in the real estate sector, and when real estate prices also collapsed there, a massive government bailout of the banking sector was initiated. The Swedish corporate sector, however, rebounded relatively quickly. Its diversity in funding sources may have played an important role in this speedy recovery, although the rapidity and vigor with which Swedish authorities addressed the banking sector’s problems undoubtedly was a contributing factor.

The speed with which the Swedish financial system overcame the crisis offers a stark contrast with the long-lasting problems of Japan, whose financial system is the archetype of virtually bank-only financial intermediation. The keiretsu conglomerate system, as you know, centers on a “main bank,” leaving corporations especially dependent on banks for credit. Thus, one consequence of Japan’s banking crisis has been a protracted credit crunch. Some Japanese corporations did go to the markets to pick up the slack. Domestic corporate bonds outstanding have more than doubled over the decade while total bank loans have been almost flat. Nonetheless, banks are such a dominant source of funding in Japan that this nonbank lending increase has not been sufficient to avert a credit crunch.

The Japanese government has intervened in the economy and is injecting funds in order to recapitalize the banking system. While it has made some important efforts, it has yet to make significant progress in diversifying the financial system—which arguably could be a key element, although not the only one, in promoting long-term recovery. Japan’s banking crisis is also ultimately likely to be much more expensive to resolve than the American and Swedish crises, again providing prima facie evidence that financial diversity helps limit the effect of economic shocks.

This leads one to wonder how severe East Asia’s problems would have been during the past eighteen months had those economies not relied so heavily on banks as their means of financial intermediation. One can readily understand that the purchase of unhedged short-term dollar liabilities to be invested in Thai baht domestic loans (counting on the

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dollar exchange rate to hold) would at some point trigger a halt in lending by Thailand’s banks. But why did the economy need to collapse with it? Had a functioning capital market existed, the outcome might well have been far more benign.

Before the crisis broke, there was little reason to question the three decades of phenomenally solid East Asian economic growth, largely financed through the banking system, so long as the rapidly expanding economies and bank credit kept the ratio of nonperforming loans to total bank assets low. The failure to have backup forms of intermediation was of little consequence. The lack of a spare tire is of no concern if you do not get a flat.

East Asia had no spare tires. The United States did in 1990 and again in 1998. Banks, being highly leveraged institutions, have, throughout their history, periodically fallen into crisis. Where there was no backup, they pulled their economies down with them. One can wonder whether in nineteenth century United States, when banks were also virtually the sole intermediary, the numerous banking crises would have periodically disabled our economy as they did, had alternate means of intermediation been available.

In dire circumstances, modern central banks have provided liquidity, but fear is not always assuaged by cash. Even with increased liquidity, banks do not lend in unstable periods. The Japanese banking system today is an example: The Bank of Japan has created massive liquidity, yet bank lending has responded little.

With very large nonperforming loans of indeterminate value, the size of capital in Japanese banks is difficult to judge. The periodic eruption of the so-called Japanese funding premium in recent years attests to the broad degree of uncertainty of the viability of individual banks. This understandably creates considerable caution on the part of Japanese bank loan officers in committing scarce bank capital. But unlike the United States and Sweden a decade ago, alternate sources of finance are not yet readily available.

The Swedish case, in contrast to America’s savings and loan crisis of the 1980s and Japan’s current banking crisis, also illustrates another factor that often comes into play with banking sector problems: Speedy resolution is good, whereas delay can significantly increase the fiscal and economic costs of a crisis. Resolving a banking-sector crisis often involves government outlays because of implicit or explicit government safety net guarantees for banks. Accordingly, the political difficulty in raising taxpayer funds has often encouraged governments to procrastinate and delay resolution, as we saw during our savings and loan crisis. Delay, of course, can add to the fiscal costs and prolong a credit crunch.

The annals of the United States and others over the past several decades tell us that alternatives within an economy for the process of financial intermediation can protect that economy when one of those financial sectors experiences a shock. But the mere existence of a diversified financial system may well insulate all aspects of a financial system from breakdown. Australia serves as an interesting test case in the most recent Asian financial turmoil. Despite its close trade and financial ties to Asia, the Australian economy exhibited few signs of contagion from contiguous economies, arguably because Australia already had well-developed capital markets as well as a sturdy banking system. But going further, it is plausible that the dividends of financial diversity extend to more normal times as well.

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It is not surprising that banking systems emerge as the first financial intermediary in market economies as economic integration intensifies. Banks can marshal scarce information about the creditworthiness of the borrower to guide decisions about the allocation of capital. The addition of distinct capital markets outside of banking systems is possible only if scarce real resources are devoted to building a financial infrastructure. It is a laborious process whose payoff is often experienced only decades later. It is thus difficult to initiate, especially in emerging economies that are struggling to edge above the poverty level. They perceive the need to concentrate on high short-term rates of return to capital rather than accept more moderate returns stretched over a longer horizon. We must continuously remind ourselves that financial infrastructure comprises a broad set of institutions whose functioning, like all else in a society, must be consistent with the underlying value system and hence its time preference.

On the surface, financial infrastructure appears to be a strictly technical concern. It includes accounting standards that accurately portray the condition of the firm, legal systems that reliably provide for the protection of property and the enforcement of contracts, and bankruptcy provisions that lend assurance in advance as to how claims will be resolved in the inevitable result that some business decisions prove to be mistakes. Such an infrastructure in turn promotes transparency within enterprises and corporate governance procedures that will facilitate the trading of claims on businesses in open markets using standardized instruments rather than idiosyncratic bank loans. But the development of such institutions is almost invariably molded by the culture of a society. The antipathy to the “loss of face” in Asia makes it difficult to institute, for example, the bankruptcy procedures of western nations. And even the latter differ from one another owing to deep-seated differences in views of creditor-debtor relationships. Arguably the notion of property rights in today’s Russia is subliminally biased by a Soviet education that inculcated a highly negative view of individual property ownership. Corporate governance that defines the distribution of power, of course, invariably reflects the most profoundly held societal views of the appropriate interaction of parties in business transactions.

It is thus not a simple matter to append financial infrastructure to an economy developed without it. Accordingly, full convergence across countries of domestic financial infrastructure or even of the international components of financial infrastructure is a very difficult task.

Nonetheless, the competitive pressures toward convergence will be a formidable force in the future if, as I suspect, additional forms of financial intermediation will be increasingly seen as benefiting an economy that develops capital markets. Moreover, a broader financial infrastructure will also likely be seen as strengthening the environment for the banking system and enhancing its performance. The result almost surely will be a more robust and more efficient process of capital allocation, as a recent study by Ross Levine and Sara Zervos suggests._1

Its analysis reinforces the conclusion that financial market development improves economic performance, over and above the benefits offered by banking sector development alone. The results are consistent with the idea that financial markets and banks provide useful, but different, bundles of financial services.

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It is no coincidence that the lack of adequate accounting practices, bankruptcy provisions, and corporate governance have been mentioned as elements in several of the recent crises that so disrupted some emerging-market countries. Had these elements been present, along with the capital markets they would have supported, the consequences of the initial shocks of early 1997 may well have been quite different.

It is noteworthy that the financial systems of most continental European countries escaped much of the turmoil of the past two years. And looking back over recent decades, we find fewer examples in continental Europe of banking crises sparked by real estate booms and busts or episodes of credit crunch of the sort I have mentioned in the United States and Japan.

Until recently, the financial sectors of continental Europe were dominated by universal banks, and capital markets are still less well developed there than in the United States or the United Kingdom. The experiences of these universal banking systems may suggest that it is possible for some bank-based systems, when adequately supervised and grounded in a strong legal and regulatory framework, to function robustly.

But these banking systems have also had substantial participation of publicly owned banks. These institutions rarely exhibit the dynamism and innovation that many private banks have employed for their, and their economies’, prosperity. Government participation often distorts the allocation of capital to its most productive uses and undermines the reliability of price signals. But at times when market adjustment processes might have proved inadequate to prevent a banking crisis, such a government presence in the banking system can provide implicit guarantees of resources to keep credit flowing, even if its direction is suboptimal.

In Germany, for example, publicly controlled banking groups account for nearly 40% of the assets of all banks taken together. Elsewhere in Europe, the numbers are less but still sizable. In short, there is some evidence to suggest that insurance against destabilizing credit crises has been purchased with a less efficient utilization of capital. It is perhaps noteworthy that this realization has helped engender a downsizing of public ownership of commercial banks in Europe, coupled with rapid development of heretofore modest capital markets, changes which appear to be moving continental Europe’s financial system closer to the structure evident in Britain and the United States.

Diverse capital markets, aside from acting as backup to the credit process in times of stress, compete with a banking system to lower financing costs for all borrowers in more normal circumstances. Over the decades, capital markets and banking systems have interacted to create, develop, and promote new instruments that improved the efficiency of capital creation and risk bearing in our economies. Products for the most part have arisen within the banking system, where they evolved from being specialized instruments for one borrower to having more standardized characteristics.

At the point that standardization became sufficient, the product migrated to open capital markets, where trading expanded to a wider class of borrowers, tapping the savings of larger groups. Money market mutual funds, futures contracts, junk bonds, and asset-backed securities are all examples of this process at work.

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Once capital markets and traded instruments came into existence, they offered banks new options for hedging their idiosyncratic risks and shifted their business from holding to originating loans. Bank trading, in turn, helped these markets to grow. The technology-driven innovations of recent years have facilitated the expansion of this process to a global scale. Positions taken by international investors within one country are now being hedged in the capital markets of another: so-called proxy hedging.

But developments of the past two years have provided abundant evidence that where a domestic financial system is not sufficiently robust, the consequences for a real economy of participating in this new, complex global system can be most unwelcome.

Improving deficiencies in domestic banking systems in emerging markets will help to limit the toll of the next financial disturbance on their real economies. But if, as I presume, diversity within the financial sector provides insurance against a financial problem turning into economy-wide distress, then steps to foster the development of capital markets in those economies should also have an especial urgency. And the difficult ground work for building the necessary financial infrastructure—improved accounting standards, bankruptcy procedures, legal frameworks and disclosure—will pay dividends of their own.

The rapidly developing international financial system has clearly intensified competitive forces that have enhanced standards of living throughout most of the world. It is important that we develop domestic financial structures that facilitate and protect our international financial and trading systems that, aside from their periodic setbacks, have brought so much good.

Footnotes1 Ross Levine and Sara Zervos, “Stock Markets, Banks, and Economic Growth,” American Economic Review, vol. 88 (June 1998), pp. 537-558. (Return to text.)

Russian Crisis Terms to be familiar with:

1. Margin calls2. Public capital markets3. Lack of liquidity4. Diverse credit markets5. Commercial paper6. The paper-bill spread7. The corporate bond market8. Collateral9. Risk aversion10. Emerging market bonds11. Risk premium12. Psychology of going from one side of the boat to the other13. The amount was irrelevant14. Spooking the markets15. Credit rating16. Back-up line of credit

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17. Bond market rally18. Safe haven of US securities19. Hedge funds20. Credit markets locking up

Practice Essay Questions

1. Explain the similarities and differences between the Russian crisis and the East Asian Crisis. Be specific and take a broad approach discussing the influences on economies around the world as well as the US economy.

2. What exactly is a spare tire as it applies to the Russian crisis? Explain and then give examples of countries that have a spare tire and countries that don’t. Explain why having a spare tire is so awesome, both in good times and bad, and comment on the difficulty of obtaining a spare tire. Finish your essay commenting on the potential for Europe and Japan acquiring a spare tire.

3. Explain the issues surrounding the Fed’s first cut in the fall of 1998. Provide arguments why it was considered a fumble as well as providing counter arguments why it was not a fumble at all. In your answer be sure to define and use the efficient market theory.

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