Greenspan abdicates responsibility

Henry C.K. Liu hliu at
Wed Mar 24 08:07:49 PST 1999

Most of the time, if the words 'interest rates" do not appeared in Greenspan's utterances, little attention is paid to them.

Yet in calm language and detached tone, Greenspan has been saying that he does not intend to exercise his responsibility as Fed Board Chairman to regulate OTC financial derivatives, even though he recognizes such instruments as being certain to produce unpredictable but highly damaging systemic risks. They justification for no-regulation is: if we don't smoke, someone else will off shore and that it is a price we must accept for a growth economy. It sounds like that we each individually have to take measure to protect ourselves: either miss out on the boom, or risk being wiped out by the bust. It is unpatriotic not to participate. With the rise of monetarism, the Fed, together with the Treasury Department, have evolved from traditionally quiet functions of insuring the long term value and credibility of the nations currency, to activist promotions of economy boom, replacing the Keynesian economic role of the Federal Budget. Never before has any central banker advocated and celebrated the institutionalization and socialization of risk as an economic policy. As Anthony Giddens, director of the London School of Economics, explains in his The Third Way: "nothing is more dissolving of tradition than the 'permanent revolution' of market forces."

Henry C.K. Liu

Excerpts from Remarks by Chairman Alan Greenspan on Financial derivatives Before the Futures Industry Association, Boca Raton, Florida March 19, 1999

By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. At year-end, U.S. commercial banks, the leading players in global derivatives markets, reported outstanding derivatives contracts with a notional value of $33 trillion, a measure that has been growing at a compound annual rate of around 20 percent since 1990.

Of the $33 trillion outstanding at year-end, only $4 trillion were exchange-traded derivatives; the remainder were off-exchange or over-the-counter (OTC) derivatives.

.... the fact that the OTC markets function quite effectively without the benefits of the Commodity Exchange Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives. On a loan equivalent basis, a reasonably good measure of such credit exposures, U.S. banks' counterparty exposures on such contracts are estimated to have totaled about $325 billion last December. This amounted to less than 6 percent of banks' total

assets. Still, these credit exposures have been growing rapidly, more or less in line with the growth of the notional amounts.

.... a Bank of International Settlements

survey for last June .... estimated that size of the global OTC market at an aggregate notional value of $70 trillion, a figure that doubtless is closer to $80 trillion today. Once allowance is made for the double-counting of transactions between dealers, U.S. commercial banks' share of this global market was about

25 percent, and U.S. investment banks accounted for another 15 percent. While U.S. firms' 40 percent share exceeded that of dealers from any other country, the OTC markets are truly global markets, with significant market shares held by dealers in Canada, France, Germany, Japan, Switzerland, and the United Kingdom. Despite the world financial trauma of the past eighteen months, there is as yet no evidence of an overall slowdown in the pre-crisis derivative growth rates, either on or off exchanges. Indeed, the notional value of derivatives contracts outstanding at U.S. commercial banks grew more than 30 percent last year, the most rapid annual growth since 1994.

...... during panic periods the usual assumption that potential future exposures are uncorrelated with default probabilities becomes invalid. For example, the collapse of emerging market currencies can greatly increase the probability of defaults by residents of those countries at the same time that exposures on swaps in which those residents are obligated to pay foreign currency are increasing dramatically.

Whole speech:

Greenspan testified on LTCM Before the Committee on Banking and Financial Services, U.S. House of Representatives October 1, 1998

While their financial clout may be large, hedge funds' physical presence is small. Given the amazing communication capabilities available virtually around the globe, trades can be initiated from almost any location. Indeed, most hedge funds are only a short step from cyberspace. Any direct U.S. regulations restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction. The best we can do in my judgment is what we do today: Regulate them indirectly through the regulation of the sources of their funds. We are thus able to monitor

far better hedge funds' activity, especially as they influence U.S financial markets.

If the funds move abroad, our oversight will diminish.

We have nonetheless built up significant capabilities in evaluating

the complex lending practices in OTC derivatives markets and hedge funds. If, somehow, hedge funds were barred worldwide, the American financial system would lose the benefits conveyed by their efforts, including arbitraging price differentials away. The resulting loss in efficiency and contribution to financial value added and the nation's standard of living would be a high price to pay--to my mind, too high a price.

we should note that were banks required by the market, or their

regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidely lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged

financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs.

Whole testimony:

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