When an earthquake struck Tokyo in 1923, it took a week for the full impact of the tragedy to percolate through to the west. If disaster struck today, the west's reflexes would be measured in seconds rather than days, sending shock waves through the entire world financial system.
As the Japanese insurance industry dumped scores of billions of dollars of overseas investments, analysts like Mitsubishi economist Johsen Takahashi believe, panic would break out in foreign currency markets and interest rates would spiral sickeningly upwards. Big borrowers around the world would have to scramble to stay solvent and a run could well develop on Japanese banks.
For economists who worry about the stability of the world financial system, such a major natural disaster is one of their more graphic fears (for some consequences of a Japanese earthquake, see page 117.)
There is no shortage of other bogeys ranging from legal problems in swaps markets to an old-fashioned default by a major LDC.
Hyman Minsky, an academic economist in the US who maintains the world financial system is inherently unstable, believes, for example, that the gyrating price of oil could bring about a financial explosion.
In his scenario, the action opens with large parts of the American Banking system collapsing as oil reaches $8 after a new breakdown of Opec control. Bankers and institutional investors in Japan live up to their national stereotype. Moving in lock-step, they dump dollars. The exchange rate approaches 100 yen and boat-loads of cars are turned back in the Pacific as US importers cannot afford to pay.
Some of the miracle companies of Japan's export drive might quickly be in difficulties --their stocks would collapse, knocking a fatal hole in Japanese bank balance sheets. Runs would develop on the Japanese banks' counterparties abroad as regulators rushed vainly to stem a chain reaction. Haggling about the responsibility of each country's lender of last resort would impede their effort.
Minsky, a professor at Washington University in St Louis, has been a lone voice for years in questioning the stability of the world's financial system and many find it easy to write him off as a crackpot. Perhaps he is. After all, talk about a financial apocalypse has always been cheap. "The matter is not really topical. It has been under discussion for a century and a half,' Credit du Nord chairman Bruno de Maulde told Euromoney.
But this time there is something different about the debate. Some perfectly respectable, mainstream figures are wondering if the framework of the financial system has been made more fragile by, among other things, the proliferation of complex new financial instruments, the ever-growing agglomerations of debt, especially in the US, and the growing power of the Japanese. The wonderers include Gerald Corrigan, president of the New York Federal Reserve Bank, Alexandre Lamfalussy of the Bank for International Settlements, Merrill Lynch vice chairman John Heimann, Salomon Brothers' vice chairman Henry Kaufman and, it's believed, Paul Volcker, Federal Reserve Bank chairman.
There are, to be sure, all manner of cheerful bankers, brushing aside suggestions that there might be serious instability lurking somewhere among all the swaps and warrants and options of recent creation. "We believe the financial system is more stable than it was five years ago, primarily because we are better able to cope with the Third World debt situation,' said Royal Bank of Canada chairman Allan Taylor.
Similarly Michel Francois-Poncet, chairman of the Paribas group, said: "There appears to be no risk of a repetition of events on the lines of those that occurred in the 1930s. Rapidly informed [of any major financial problem] the central banks . . . are able to take prompt action.'
However, Alfred Herrhausen, co-speaker of Deutsche Bank, said: "The sweeping structural changes in financial markets and the associated competitive pressures have introduced new elements of risk and uncertainty into the system. It has become less transparent. And the net effect of the redistribution of risks among market participants on the stability of the system is difficult to assess. Overall, the system has become more vulnerable to abrupt changes in the macro-economic and monetary environment.'
Herrhausen's rival, Dresdner Bank chairman Wolfgang Roller, is in broad agreement. "It is unfortunate that the financial system is less stable than it was, due to the fact that we have an unprecedented concentration of problems,' he said. These problems could be overcome, said Roller. But he had worries about the ability of some banks to cope with rapidly evolving techniques. "I am absolutely convinced that it is not the instrument, any instrument, which is dangerous, it is the degree of experience or inexperience of the user which can cause danger and damage.'
Some contend that new opportunities to hedge and manipulate portfolios of assets and liabilities have actually infused new strength into the system. The Chemical Bank president, Thomas Johnson, argued: "My inclination is that what reduces risk for individual participants in the system, has to reduce the risk to the system as a whole.' But he added: "Nobody can be entirely sure.'
The cause of such doubts is what one prominent source called "an awkward feeling that you don't quite know where the risk has gone' as a result of all the hedging and swapping. Perhaps some bank down the line, overloaded with risk, will collapse and bring the house of cards down--not even the best minds can be more specific, so complex and interwoven has the financial system become. NatWest Investment Bank chairman Charles Villiers put it this way: "Many banks have rushed into off-balance-sheet risks to enhance their returns, but I wonder how many have systematically assessed the additional exposure. Interest rate swaps, when they have been traded on several times, may end up in the hands of someone who does not fully understand his obligations.'
Added to all this are concerns about the economy. A fragile financial structure might be fine during a recovery, but what happens during a downturn? Will a weak system and a weak world economy drag each other down? (For a discussion of that gloomy idea, see Group of Thirty member Geoffrey Bell's article on page 127).
Worrier-in-chief is Henry Kaufman, Salomon Brothers economist. "If you had asked me in 1960, what was the risk of a major crisis I would have said 1,000 to 1 against. In 1970, I would have said 100 to 1, in 1980 10 to 1 and that is where the risk remains now . . . The world's financial system is now flying at a low altitude and a modest speed. The problem with that is you can stall out.' Kaufman's reservations are shared by Gerald Corrigan, president of the Federal Reserve Bank of New York, who has been an outspoken critic of the pace of financial innovation. "Most measures of the quality of financial assets in bank portfolios and elsewhere are at disturbingly low levels given where we are in the business cycle,' he said recently.
Corrigan's views are believed to reflect the concerns of Paul Volcker, chairman of the Federal Reserve, who, because of his pivotal position in the monetary system, is usually more cautious in his public remarks. But even Volcker has taken to voicing serious concerns about new instruments and techniques. In a major speech in June, for instance, Volcker commented: "We should not be beguiled by claims of what has been termed by some as a "brave new world' for banking without examining just what we would be getting into.'
As a study group co-ordinated by the Bank for International Settlements pointed out earlier this year, there are several major reasons for concern. The group, whose report has been dubbed the Cross report after chairman Sam Cross, enumerated them:
Many of the new instruments are underpriced and there seems to be a persistent tendency for excessive competition to break out in providing new financial instruments. This is partly because new instruments are generally not patentable and are quickly copied by competitors, some of whom may not understand fully all the costs in determining pricing.
Many of the new instruments foster greater interdependence among participants in financial markets--so the health of one depends, to a greater degree than before, on the health of the others. The report raised the question of whether there are significant "aggregation effects'.
Many financial markets have become significantly more volatile in recent years. That not only increases systemic risk but also lends support to the theories of pessimists like Minsky, who believe that the eventual collapse will be preceded and partly triggered off by violent volatility.
Instantaneous distribution of information may actually be destabilizing markets-- precisely the opposite of the effect predicted by traditional Adam Smith economics.
Exploding volume in financial transactions of all sorts leaves the system unprecedently vulnerable to disruption if, say, a major computer fails.
The liquidity of many of the new instruments could disappear in the first down cycle they encounter--partly because they trade largely in over-the-counter markets whose liquidity is notoriously unreliable.
Underlying all these concerns is the basic question of systemic risk. The international banking industry's risk capital remains dangerously depleted four years after the default of Mexico, many argue. Shozo Nurishi, a senior manager in the Industrial Bank of Japan's international department, pointed out that the size of transactions in, for instance, foreign exchange markets has ballooned in recent years. "The transaction volume is now very big--10 years ago we were afraid of a $10 million trade in foreign exchange but now we don't worry about $100 million. Even after discounting for inflation there has been a big increase in the real size of our exposure in these markets.'
Typically, American money-centre banks' equity-to-assets ratio has improved from about 4 to 5% in the last five years. Citicorp's ratio rose from 4.47 to 4.66 in the six months ended June 30, for example. There have been similar improvements in the reported numbers at banks in other major economies. The British clearers reported earnings up between 30 and 70% for the first half of 1986. NatWest, to take one, improved its gearing from 6% to 6.9% in that period. Deutsche has taken to trumpeting a capital ratio "at its highest level since 1957.' But if questionable assets are marked to market in an attempt to get a first approximation of the real capital resources in the system, it is easy to argue the system is still in trouble.
In the view of people like Kaufman, the banks' continuing wafer-thin capital ratios combined with financial innovation has created an explosive cocktail. It is now harder than ever to discover who in the system is carrying the real risk. Worse, the world's lenders of last resort are in a daze about who bails out what if a crisis blows up --not only because swaps have introduced untested new cross-border entanglements into the system but because many of the players in the new markets are not even banks, so are not necessarily any central bank's responsibility.
Several bankers pointed out an unnerving aspect of the fast development of swaps. The legal background has not been fully tested. Lord Chandos, director of the international capital markets division of Kleinwort Benson, reported that it was not clear how the courts would deal with a situation where a bank had many offsetting positions with the same defaulting counterparty.
"The question is whether the receiver of a defaulting party is entitled to cherry pick --renege only the unprofitable contracts,' he said. "Counsel gives different opinions every day of the week about whether offset is enforceable. So far no one has been able to rely on offset--so gross exposure is what we look at.'
Chief among the optimists is former Citicorp chairman Walter Wriston. "Somehow the word fragile has entered the vocabulary of finance. Fragile connotes to me something that will shatter. The financial system is exactly the opposite. It bends and stretches. And it survives.'
He explained: "Look at the history of the last 15 years. We have seen the advent of 100 new countries--the shattering of the British and French empires. We have seen one of the bloodiest wars in history in the Iran-Iraq war. The Soviet Union invaded Afghanistan, Vietnam invaded Cambodia, then there's Nicaragua and Angola. We have watched oil go from $2 to $30 and back to $10--silver is down to 6 or 7 cents. We have watched the financial deregulation of the US and now the UK. It would be hard to invent a scenario that would be more scary, yet in all that time there have been only two casualties-- Herstatt and Franklin National. In the case of Herstatt, the Eurodollar system went down on Friday night and Monday noon the whole system had cleared itself.' Poncet of Paribas agreed: "Whatever the Cassandras say, the international financial system has over the past 15 years shown proof of extraordinary efficacity.'
Many of the voices on the opposite side of the debate are in the regulatory field. Takehiko Sekine, adviser on international relations at the Bank of Japan, for instance, fears an economic downturn and accompanying turmoil in the financial community. "The world is more dangerous now than a few years ago--certainly from a Japanese point of view. If we look back five years, the price of oil then was high and people thought it would continue to go up. Now people have different worries--people do not believe as strongly in the growth in the worldwide economy any more. The methods for improving the LDC position heavily limit their growth prospects.'
One of the most terrifying aspects of the situation for some observers is how fast non-traditional forms of banking have been growing. US domestic paper volume now totals about $300 billion a year--compared with $161 billion five years ago. The total of outstanding interest rate swaps is $150 billion, and the daily trading volume in US note and bond futures amounted to $22 billion earlier this year--up from $8 billion in 1983. The turnover rate in US bonds with a maturity of 10 years or more has quadrupled in 10 years.
The pace of trading and innovation has induced fears among regulators that top executives in the banking industry are having trouble keeping up with their trading desks. "The first thing to be done is to understand what is happening and what are the contents of these transactions,' said Keiji Matsuda, chief of the international finance division of the Bank of Japan. "But when you meet the top management of banks in Japan or even in the US you sometimes find they really don't understand the implications of, for instance, the swaps they have on their books. Even among my colleagues here it is only recently that they have become aware of the implications.'
Some bankers are candid enough to admit the justice of this. Societe Generale's general manager, Marc Vienot, said: "These new instruments are complex and hard to assess and manage. Those who use them, and even more so those responsible for supervising their use, are clearly not so far ahead in their thinking as the technicians who invented them are in their techniques.'
Matsuda's point was echoed by Lionel Price, a Bank of England official who was a contributor to the Cross report. "There are some banks where the information top management is getting is not good enough,' he said. "The extent to which top management knows what is happening varies considerably. Problems might come where a bank has got in late into a business and is trying to copy the market leaders. Commercial banks reacting to securitization, for instance.'
An additional problem worrying some regulators is that increasingly banks entering a new area have taken to poaching whole teams of people from competitors. The practice, which can leave the competitors completely bare of top talent in crucial new products, has been particularly noticeable in London, where the Bank of England has publicly made clear its displeasure.
But, as Lord Chandos pointed out, there is a dilemma here--for the entry of new players into a market without any experienced people on board may pose bigger risks for the stability of the system. "It is important for new players to have a strong team to start with,' he said. "It is difficult to go into these businesses gradually--you can't be half pregnant. You are not going to do well if you compete on a half-hearted basis. The major risk for many financial institutions is to go in out of their depth and be only half-committed.'
One possible source of systemic risk would be a sustained upward movement in interest rates. Alexandre Lamfalussy, general manager of the Bank for International Settlements, was one of many observers who pointed out that the explosion in new instruments has come at a time when interest rates generally were falling. "In a period of falling interest rates it is virtually impossible for either investors or intermediaries and traders to make persistent losses on securities transactions,' he said.
Lamfalussy added: "The test will come in a period of economic hardship. While there is no reason at present to anticipate any worsening of our economic climate, it would be wise to recognise that this new era of worldwide financial competition requires an adjustment of policies, both by managements and governments, commensurate with the scale and the speed of the changes affecting financial markets.'
A recession could pose a severe--perhaps impossible--test for the new instruments. Several commentators pointed to a small but disturbing manifestation of illiquidity in the Comex gold options market in 1985. On that occasion three exchange customers went bankrupt and there were dislocations for other customers. One banker commented: "This was an isolated incident and it was containable because what goes on in gold options has little bearing on anything else. But if something like this happened in a mainstream market there would be chaos.'
Some observers believe that on balance many of the new instruments have improved the stability of the system and their views got some support in the Cross report. Stephen Axilrod, vice-chairman of Nikko Securities International and a former top regulator at the US Federal Reserve, made the point that many of the new instruments made their appearance just as the US economy was in the transition period after the inflation of the 1970s. It was, he said, coincidental that there was a lot of financial turbulence around; the new inventions did not cause it.
In theory, the new instruments should be a force for better distribution of risk. As the Cross report pointed out, many instruments have the effect of unbundling different aspects of a financial transaction--often isolating the pure financial risk so that it can be assumed by a player with strength and experience.
Kleinwort Benson's Lord Chandos spoke for many bankers when he argued that, by making bank balance sheets more liquid, securitization has strengthened the system. But the point was disputed by Merrill Lynch Capital Markets vice-chairman John Heimann, and by Kaufman, who suggested that a manifestation of Gresham's law was at work--securitization might actually drive good assets out.
Kaufman also suggested that securitization might induce dangerously excessive competition in financial markets: "In a securitized world, banking spreads are market-determined rather than set through regulation. At times this results in efforts to make these spreads regardless of credit quality.'
He added: "Securitization also tends to create the illusion that credit risk can be reduced by the marketability of the credit instruments. The risk is that the disciplinary force involved in the relationship between creditor and debtor is loosened because creditors are not permanent holders of debt.'
A related worry was voiced by Bank of Japan's Sekine--that the very marketability of bank assets may in some circumstances have a dangerously depressive effect. He said: "Some monetary authorities are indirectly worsening the LDC problem because they are giving big tax breaks to banks that realize LDC loan losses. In effect banks that dump their LDC debt can afford to take a price below market because their losses are being subsidized by their home tax authorities. The problem is mainly in northern Europe.'
Globalization and the new instruments could also throw a spanner into the workings of national economic policies. Lamfalussy of the BIS commented: "A financially integrated and innovative world economy will be markedly less tolerant of major macro-economic policy blunders of the kind western governments collectively committed in the late 1960s and early 1970s by embarking on inflationary policies.'
Lamfalussy argued that to fight inflation in the new environment through monetary policies would require even sharper swings in interest rates than those that were experienced a few years ago. His point was that the effect of government economic policies was now muted because capital now moves much more freely across national boundaries. He said: "What would be the effect on the securities markets in that case? And with what consequences for the real economy? We shall have to bear in mind that the globalization of financial markets imposes a duty of additional prudence in the conduct of macro-economic policies. It does for the industrial world--it does so even more for individual countries whose margin of error in policy decisions will have been even more drastically reduced than that of the world economy as a whole. The wisdom and efficiency of policies will have to develop at the same pace as globalization-- quite a task ahead for governments.'
Meanwhile, regulators in the new environment may be exacerbating the damaging side-effects of innovative new market-oriented products. Guaranteeing deposits in America, for instance, encourage irresponsible risk-taking. There is a contradiction in the present situation--the authorities are encouraging more entrepreneurial, more deregulated acitivity yet spreading an official safety net.
The Bank of Japan's Sekine voiced fears that misguided first-aid work by regulators in some countries may be destabilizing the entire system by their attempts to treat the symptoms rather than the disease. He said: "Regulatory efforts to avert failures by small banks are weakening the system. If banks were allowed to go under, they would behave more cautiously. But unfortunately some monetary authorities are more worried about day-to-day events and are not concerned enough with the bigger picture. It is very easy to save one bank--but very difficult to save a whole banking system.'
For many observers, a major destabilizing factor is the level of debt in the US economy --an oil omen not only for interest rates but for asset quality. Corrigan of the New York Fed said recently that the US foreign debt could hit $500 billion by the end of the decade.
The growth of debt in American society has been the theme of persistently gloomy comments by Kaufman. He said: "Credit market debt now exceeds annual GNP by almost two to one. The ratio was 1.6 to one in 1964. A pronounced widening of the gap has occurred in the past five years. Even so the figures understate the real position because there is sharply expanding hidden debt in, for example, futures, options, interest rate swaps, credit guarantees by banks and insurance companies and line of credit.' He added that accounting conventions that permit the netting out of many assets and liabilities also tended to understate the growth in recent years.
Corrigan recently commented: "There is at least the question whether foreigners will be eager to continue to accumulate dollar-denominated assets of the amounts suggested at current, much less lower, rates of interest. Looking at the rate at which we are building debt in the federal sector and looking at the closely related issue of the rate at which the US is accumulating external debt it is difficult to escape the conclusion that we are approaching or are in uncharted waters.'
An additional worry is the level of private sector debt. "For the private sector as a whole, the ratio of debt to GNP is at an unprecedented level and is still rising,' he said. "The increase is not as pronounced as for the federal government but there is at least the question as to whether it is reasonable to assume there is that much more good quality debt relative to GNP today than there was a decade or two ago.'
As Kaufman pointed out, the ratio of total credit market debt to the market value of equities in the US hovered around 2 to 1 in the mid-1960s--but since then it has shot up to around 3 1/2.
Much of the increase reflected ballooning debt--but a worrying factor was a real decline in equty. In 1984 alone about $100 billion was retired as a result of leveraged buy-outs and M & A activity.
Certainly numbers compiled by Kaufman look very forbidding. US credit market debt grew from $2.4 trillion to $7.1 trillion between 1974 and 1984, a faster growth rate than US GNP. Equally ominous are statistics from Edward Altman, of New York University, that defaults on junk bonds in the first half of 1986 reached 2.7%, against 1.5% annually for the last 10 years.
There are fears in other parts of the world, too. On private sector debt in the UK, Barclays chairman Sir Timothy Bevan said recently: "Both lenders and borrowers might show some restraint, otherwise over-generous terms offered by some financial institutions were bound to end in tears.'
Many participants in financial markets, however, brush aside fears about the growth of debt. Donald Marron, chairman of New York investment bank PaineWebber, commented: "The real issue is debt service. Analysts who worry about rising debt don't look at the other side--rising assets.' Wriston, an indefatigable optimist, made a similar point. Commenting on Kaufman's analysis, he said: "If I borrow $80,000 to buy a $100,000 house, all Kaufman counts is $80,000--he does not take account of assets. He sees just one side of the picture.'
Richard Huber, a group executive at Citicorp, maintained that leveraged buy-outs were one of the healthiest things to happen to the US economy in years. He explained: "They are vital to the industrial sector. Some of this activity is tax-driven but the main point is that there is a unification of ownership with management. It is always fascinating to see what happens after a deal. The first thing the management does is throw out the executive jets, the hunting lodges and the suites of executive apartments.'
But the upbeat note was not echoed by Arthur Burns, a former chairman of the Federal Reserve, whose comments on other aspects of the financial system were generally optimistic. In a telephone interview, he said: "People should be looking at LBOs--there is a real concern about the risk that banks and borrowers are taking on.' He added: "I would question the wisdom of any new regulations on this subject--it is a case for voluntary action on the part of the banks. Some plain talking by the regulators to the banks is usually effective. They should tell the bankers that they are planting the seeds of trouble for themselves.'
Worries about buy-outs and other debt-oriented corporate restructuring have been a major theme for Corrigan. He recently pointed out that more equity was retired in 1984-85 in the non-financial corporate sector than the net issuance of equity since the Korean War.
Why are so many in corporate America gung-ho about taking on debt? Corrigan's analysis has a chillingly plausible ring to it: "At least some borrowers and their lenders are still hopefully anxious--that inflation will bail them out. To the extent that is true, it strikes me as a very bad bet. For one thing, it's bad in a fundamental way because renewed inflation would inevitably bring more instability, not less. I don't think it unreasonable to assume that even a sniff of a new outburst of inflation would produce a financial market response in interest rates that could be quite harmful to those with high debt service burdens.'
Perhaps competition in banking and financial innovation may be making debt too attractive. Corrigan said: "Financial innovation may be aiding and abetting the debt-accumulation process in part by transferring the incidence of credit and interest rate risk in ways that may give rise to the illusion that such risks have been reduced or eliminated.'
Optimists and pessimists disagree even about technology. For Wriston, technology has enabled the world to go to a new market-driven system that will ultimately prove more reliable.
On the other side, Merrill Lynch's Heimann, pointed to the speed with which information toppled Continental Illinois. "Unfounded rumour can travel just as quickly as truth,' he said. "Traders watching their flickering screens know that their competitors around the world see exactly what they see when they see it. Hence reaction times, always short, began for the Continental Illinois bank in the Far East and then turned into a CD run in London, all while American bankers and regulators were still asleep.'
He added: "Another example of this process was in the Ohio banking and S&L crisis. The instantaneous overreaction in the international markets to a localized, clearly manageable problem highlighted not only the participants' instant access to information and their ability to act but also their lack of knowledge about the true problem. The result can be dangerously self-fulfilling expectations, as the reaction to a rumour creates its own momentum.'
One of the most tantalizing unknowns about the present environment is to what extent new financial products may be underpriced. Charles Lucas, who represented the New York Fed on the Cross report working party, summed up the problem. "There isn't the data to be rigorous. All you can look at is bank profits. Start probing into them a little and you discover that much of what they are making is coming from traditional activities such as trading foreign exchange and bonds in volatile markets. The new instruments are contributing little or nothing in some cases--especially when a number of competitors start coming in. The argument that they should underprice to service customers who provide profitable business in other areas should be examined very critically. When you talk to the swaps guy he says he can do skinny pricing because the bank is making it up on the underwriting. Then you talk to the underwriting guy and he says he can do a skinny deal because the bank will make profits on the swap.'
He added: "We don't want to go too far with our hypothesis that new products are underpriced. Our point was that we don't want users to be too delighted when they get a very good quote--the financial institution concerned may not be around when you come to collect.'
Many bankers fear the entry of new players into financial markets could lead to chaos. Nurishi of IBJ commented: "Liberalization has brought so many new entrants into the business and many different types of institution. Our engagement with other financial institutions is necessarily getting bigger. Investment banks are very active. You cannot operate without doing business with them.'
Commenting on how bankers assess the uncertainties of the new environment, Dennis Weatherstone, president of the executive committee at Morgan Guaranty, observed: "We start by focusing on non-bank counterparties --in most cases the bank counterparties would be helped by their central banks. The position would be further complicated if a troubled foreign institution's position was in dollars rather than its own currency. If it is a non-bank the question is who would be looked after and who would not?'
The point is not merely academic. The losses by Wall Street firms in May 1986 demonstrated the vulnerability of non-banks. Corrigan has spoken privately to friends about his fear that the New York Fed might one day be obliged to bail out an investment bank or let the dominoes tumble.
The question of protocol among national lenders of last resort in a cross-border crisis has recently been the subject of a concordat promulgated by the BIS. In theory the rules are clear.
Matsuda of the Bank of Japan explained that if a Japanese bank subsidiary got into trouble with, say, a dollar transaction in London, the primary responsibility would be with the Bank of England and the Bank of Japan. But the question is--what happens if, say, the Japanese bank subsidiary's trouble stems from a problem with a Texas bank's London branch? "It would be a mess,' said one banker. "It is easy to see how the lines of responsbility can get blurred. The question in a crisis is: will there be time to sort out each regulator's role?'
Matsuda maintained that links between the regulators in the major countries are now strong. "We are reinforcing our ability to share information worldwide,' he said. But he admitted that there are blind spots. One is that monetary authorities in other parts of Asia are regarded by the Japanese as inadequate.
One Japanese banker thought that a problem in a Far Eastern centre could trigger off a world-wide crisis. "My worst fear is for somewhere in Asia, perhaps in Singapore or Hong Kong,' he said. "These local markets are not sophisticated in line with their function as offshore money markets. The danger is compounded by the fact that they are doing business with places like Korea and Thailand.'
According to Lamfalussy, the prime concern of managements should be to maintain profitability levels in new instruments and fully account for their risks. He also pointed to the need for strengthened internal controls and for greater disclosure of each institution's position--both balance sheet numbers and off-balance sheet ones. But, according to Lamfalussy, much of the burden of bolstering the system in the new era rests on regulators. In particular they should "radically strengthen' bank capital ratios. "Capital ratios have already been improved radically since the low point of 1982,' he said. "But the globalization of financial markets demands more than what has already been achieved: it requires a fundamental reappraisal of the level of capital ratios needed to ensure that our system sails relatively safely through possibly turbulent waters. This need is accepted at a purely intellectual level but I am not convinced that governments or even managements have fully realised its quantitative implications.'
He urged regulators to encourage "upward diversity' of capital strength--so that winning institutions could develop the strength to take over weaker ones. He explained: "The profit opportunities offered by the free market must be matched by a recognition that market forces should assume greater responsibility and therefore be given greater scope for dealing with the potentially increased systemic risks.'
Corrigan of the New York Fed has put forth several proposals for strengthening the system. These include getting the US fiscal deficit under control and reforming the tax code (in particular to reduce subsidies for borrowing and lessen the double taxation of profits).
Banking supervision can also play a big part, according to Corrigan, who cited the recently announced rules encouraging banks to structure their capital to take more account of risk characteristics of assets and liabilities.
Other players sense an opportunity in all this to press for wider powers on the theory --not wholly without merit--that broad-based institutions lend ballast to the system. Said Royal Bank of Canada's Taylor, anxious for investment banking freedom: "The volatile economic anf financial environment of recent times has demonstrated that a narrow specialization in activities by financial institutions is inappropriate. Wider business powers so that financial institutions have the flexibility to choose their best growth opportunities through diversification would help ensure the stability of the international financial system and contribute to its efficiency.'
For de Maulde at Credit du Nord, greater disclosure of bank activity, particularly off-balance-sheet activity, would be a significant step forward. "The problem is less one of control and surveillance mechanisms than of accounting clarity. A way must be found to make public in our balance sheets the exact degree of risk to which we are exposed. It is important to know the exact extent of the commitments of those with whom we have dealings--to know the precise size of their risk and its relationship to their assets.'
One thing is for sure. Even if the regulators succeed in developing effective new controls, there will be no room for anyone to relax.
Marron of PaineWebber said: "The stability of the system is not something anybody should take for granted. There should be continuous intense communication between all the parties--both regulators and leaders of the financial services industries. Everybody is so busy that this can get overlooked.'
The Bank of England's Price made the point that systemic risk is almost a condition of banking, because of the powerful crowd behaviour dynamic in the industry. He said: "There are reasons why banks do things together--for bankers more than most there is safety in numbers. It is better to be in the mainstream because when things go wrong there is help only for casualties of systemic problems. The banker who goes it alone and gets it wrong has no recourse.'
Even the ebullient Wriston concurred with the need for vigilance. "The trouble with all of this is that we always watch the wrong rat hole,' he said. "No one is smart enough to know where trouble is going to blow up next. That is why we run banking on actuarial principles --it is the oldest rule in banking.'
Photo: Gerald Corrigan of the New York Fed: "Asset quality at disturbingly low levels.'
Photo: Dennis Weatherstone, Morgan Guaranty: "Who would be looked after?'
Photo: Alexandre Lamfalussy of the BIS: "The wisdom of policies will have to develop at the same pace as globalization.'
Photo: Thomas Johnson, Chemical Bank: "What reduces risk for individual participants has to reduce the risk to the system.'
Photo: Donald Marron, PaineWebber: "The stability of the system is not something anybody should take for granted.'
Photo: John Heimann of Merrill Lynch: "Unfounded rumour can travel just as quickly as truth. Reaction began for Continental Illinois in the Far East and then turned into a CD run in London, while American bankers and regulators were still asleep.'