SAJEMS NS Vol 2 (1999) No 2 176 International Financial Stability - How Can It be Restored and Maintained?" Andrew Croekett General Manager, Bank/or International Settlements INVITED LECTURE JEL F 30 I am greatly honoured to be invited to give the] 999 Gerhard de Kock memorial lecture. Gerhard de Kock was a distinguished central banker, whose reputation and influence, like that of his father, another prominent Governor of the Reserve Bank, spread far beyond his native South Africa. In his long service to the Reserve Bank, de Kock never wavered in his conviction that a strong and stable financial system was the best basis for economic and social progress. In these times of turbulence in the international economy, his legacy is an inspiration to those who seek a better-functioning international monetary system. It is a privilege to pay tribute to his memory. For me it is a special pleasure to make my first visit to South Africa; to honour the contributions of Chris Stals as he prepares to take his retirement, and to welcome Tito Mboweni to the community of central bankers. The transition in governorship that is taking place at the Reserve Bank mirrors what is happening elsewhere in your country. It is the unique achievement of the current political leadership in South Africa to have charted a new course for the country's economic and social development that is not afraid to build on the strengths of the past, even as it sets new goals for the future. In the field of finance, this means harnessing the skills and experience of financial institutions and markets to meet changing social needs. To be effective, however, development goals have to work with the grain of underlying economic forces. When market disciplines are ignored, instability can too easily result. And financial instability is, as we have seen, a powerful obstacle to social progress. In my remarks today, I want to consider some of the forces that have contributed to financial instability at the global level. Why have so many countries been victims of volatile capital flows and currency instability? And what can be done to prevent it? • Gerhard de Kock Memorial Lecture, Pretoria. 23 March 1999. R ep ro du ce d by S ab in et G at ew ay u nd er li ce nc e gr an te d by th e P ub lis he r (d at ed 2 00 9) . 177 SAJEMS NS Vol2 (1999) No 2 DRIVING FORCES FOR FINANCIAL CHANGE First, however, it is necessary to understand the underlying developments that have been taking place in the financial sector. The financial system has undergone a remarkable transformation in the past two or three decades. Many of these changes have their origin in deep-seated, technological and social forces. Such forces cannot simply be resisted or repealed because some of their consequences are unwelcome. Financial systems will have to adapt to the new environment, not vice versa. One of the principal driving forces has been the revolution in communication and information processing technology. This has transformed economic processes in many sectors, but in few more fundamentally than in finance. It has greatly increased the information available to economic agents, and led to an enormous reduction in the cost of making transactions across borders. It has made many traditional structures and methods of providing financial services obsolete. And it has facilitated the development of complex new financial instruments. These have provided innovative ways of hedging against risks and taking positions across markets and geographic boundaries. In short, the ability to make tinancial judgements and act on them has been enormously enlarged. A related development has been liberalisation in financial markets. Related, because technological innovation has rendered ineffective many of the administrative restrictions and controls that used to characterise the tinancial system. But liberalisation also reflects a deep-seated change in economic and social philosophy. In the political arena, it is reflected in the growing support for democracy and open societies. The economic counterpart is a greater willingness to let market forces play their role in the allocation of economic resources: in international trade, in domestic competition and in the economic role of the state. This should not be mistaken for "market fundamentalism", the notion that unrestrained markets are always right. Far from it. But it is a recognition that, with proper safeguards, the signals free markets can give are the practical basis for better resource allocation and faster growth. Another major factor underpinning financial transformation has been rising levels of income and wealth. As societies have become richer, individuals have become better able to provide for the future, both tor themselves and their families. They have sought additional ways of insuring against risk and providing for retirement. This has led to an increasing demand for financial assets, in forms that meet a diversity of individual needs. R ep ro du ce d by S ab in et G at ew ay u nd er li ce nc e gr an te d by th e P ub lis he r (d at ed 2 00 9) . SAJEMS NS Vol 2 (1999) No 2 178 An important aspect of these driving forces of change in the financial system is that they are largely irreversible. The genie of technology cannot be put back into the bottle. Financial markets are now so open and innovative that it would be almost impossible to roll back the tide of liberalisation, even if it were judged to be desirable. And rising levels of income and wealth are a key objective of economic policy in all societies. FINANCIAL IMPLICATIONS OF ECONOMIC CHANGE The major consequences of the underlying forces shaping the financial environment can be grouped, for convenience, under four headings: globalisation, securitisation, competition and complexity. Let me say a few words about each. Globalisation is a term that is widely used, but defies precise definition. I take it to mean a process in which geographic and market barriers are being rapidly eroded. Economic agents are now able to make financial transactions with little hindrance in all major markets of the world. Not only this, they can switch with increasing ease between different types of intermediation, each of which is in increasingly close competition with the others. Perhaps the most obvious manifestation of globalisation is the huge upsurge in cross-border financial transactions. In 1975, cross-border purchases of bonds and equities in the G-7 major industrial countries were approximately 4% of the annual GNP of these countries. By 1985, the comparable figure was around 30%. By 1995 it was close to 200%. And by now there are several large countries where cross-border securities transactions are several times larger than national GNP. In the field of foreign exchange, the latest triennial survey of the Bank for International Settlements (BIS) reveals daily turnover in the foreign exchange market of some $1.85 trillion. This means that daily foreign exchange turnover in private markets is greater than the entire reserve holdings of the world's central banks. Annual turnover is somewhere in the region of twenty times world output. All this represents a huge change in the degree of integration in the world's capital markets. Securitisation refers to the process by which financial intermediation is shifted away from direct lending by institutions towards finance raised through the issue of marketable securities. This does not necessarily eliminate the role of intermediaries, since ultimate borrowers and lenders stilI often need financial expertise to access markets efficiently. The floating of equity or marketable R ep ro du ce d by S ab in et G at ew ay u nd er li ce nc e gr an te d by th e P ub lis he r (d at ed 2 00 9) . 179 SAJEMS NS Vol 2 (1999) No 2 debt by an industrial company requires underwriting and marketing services. And tinancial institutions are the ones that design products by which individual credits (mortgages, for example) can be bundled together and sold as a marketable security. Securitisation has been encouraged by technological developments that provide market participants with better information about the market and credit characteristics of the underlying assets. More information both allows a reduction in the information-providing contribution of intermediaries, and facilitates the attribution of different risks (credit, interest, exchange rate, and so on) to those most willing and able to bear them. Its consequence is that a greater proportion of financial intermediation than previously is responsive to changing market conditions. A third consequence of a changing financial environment is increased competition. Before innovation and financial liberalisation, many intermediaries enjoyed a protected franchise, the result of administrative controls, lack of intormation, and the market power of established institutions. Banks and other tinancial firms were generally disinclined to jeopardise their franchise value by taking unnecessary risks. With the removal of controls, however, and the breakdown of barriers between market segments, this comfortable situation changed rapidly. New entrants to the industry could offer similar services at lower cost, sometimes by "unbundling" existing financial products and eliminating hidden cross- subsidisation. An obvious example of this trend was the advent of money- market tunds, offering the money-management services of traditional banks, without the costly additional features entailed in widespread branch networks. Other changes involved the separation of account-management, money transmission, credit origination, liquidity provision, custody, and so on into specialised intermediaries where service charges could be more accurately aligned with costs. With increased competition, rates of return on capital began to fall for those institutions unable or unwilling to adapt. One response was to maintain protitability by reducing cross-subsidisation and cutting costs. In addition, many institutions sought higher yields from their portfolios, often by being willing to accept greater risk. Such a strategy could only be successful, however, where risk-management capabilities were up to the tasks of managing the new vulnerabilities. Fourth and last, mention should be made of the sophistication and increased complexity of financial intermediation. A wide variety of new instruments R ep ro du ce d by S ab in et G at ew ay u nd er li ce nc e gr an te d by th e P ub lis he r (d at ed 2 00 9) . SAlEMS NS Vol 2 (1999) No 2 180 enable market participants to hedge risks and take positions more etliciently than before. This is a reflection both of innovation in the design of tinancial products, and the need of institutions to hedge efficiently the risks they have taken on to enhance yield. Many of the new instruments are custom-