[A-List] Greenspan on Corporate Governance, Derivatives and Risk Management

[Sabri Oncu <soncu@xxxxxxxxxxx>]

If I am not wrong, we have already covered this, but let us have
a copy of Greenspan's May 8th talk in the archives.

Best,

Sabri

+++++++

The following remarks are by Mr Alan Greenspan, Chairman of the
Board of Governors of the US Federal Reserve System, at the 2003
Conference on Bank Structure and Competition, Chicago, Illinois
(via satellite), 8 May 2003.

Corporate governance, the subject of our conference, has evolved
over the past century to more effectively promote the allocation
of the nation?s savings to its most productive uses.

And, generally speaking, the resulting structure of business
incentives, reporting, and accountability has served us well. We
could not have achieved our current level of national
productivity if corporate governance had been deeply flawed.

Yet, our most recent experiences with corporate malfeasance
suggest that governance has strayed from the way we think it is
supposed to work. By law, shareholders own our corporations, and
corporate managers ideally should be working on behalf of
shareholders to allocate business resources to their optimum use.

But as our economy has grown and our business units have become
ever larger, de facto shareholder control has diminished:
Ownership has become more dispersed, and few shareholders have
sufficient stakes to individually influence the choice of boards
of directors or chief executive officers. The vast majority of
corporate share ownership is for investment, not for operating
control of a company.

Thus, corporate officers, especially chief executive officers,
have increasingly shouldered the responsibility for guiding
businesses in what one hopes they perceive to be the best
interests of shareholders. Not all CEOs have appropriately
discharged their responsibilities and lived up to the trust
placed in them, as the events that led to the passage of the
Sarbanes-Oxley Act demonstrated. In too many instances, some
CEOs, under pressure to meet elevated short-term expectations for
earnings, employed accounting devices for the sole purpose of
obscuring adverse results.

A change in behavior, however, may already be in train. The sharp
decline in stock and bond prices after the collapse of Enron and
WorldCom has chastened many of those responsible for questionable
business practices. Corporate reputation is emerging out of the
ashes of the debacle as a significant economic value. I hope that
we will return to the earlier practices of firms competing for
the reputation of having the most conservative and transparent
set of books.

It is hard to overstate the importance of reputation in a market
economy. To be sure, a market economy requires a structure of
formal rules--a law of contracts, bankruptcy statutes, a code of
shareholder rights--to name but a few. But rules cannot
substitute for character. In virtually all transactions, whether
with customers or with colleagues, we rely on the word of those
with whom we do business. If we could not do so, goods and
services could not be exchanged efficiently. Even when followed
to the letter, rules guide only a small number of the day-to-day
decisions required of corporate management. The rest are governed
by whatever personal code of values corporate managers bring to
the table.

Market transactions are inhibited if counterparties cannot rely
on the accuracy of information. The ability to trust the word of
a stranger still is an integral part of any sophisticated
economy. A reputation for honest dealings within a corporation is
critical for effective corporate governance. Even more important
is the reputation of the corporation itself as seen through the
eyes of outsiders. It is an exceptionally important market value
that in principle is capitalized on a balance sheet as goodwill.

Reputation and trust were particularly valued assets in
freewheeling nineteenth-century America . Throughout much of that
century, laissez-faire reigned and caveat emptor was the
prevailing prescription for guarding against the wide-open
trading practices of those years. A reputation for honest
dealings was thus a particularly valued asset. Even those
inclined to be less than scrupulous in their private dealings
were forced to adhere to a more ethical standard in their market
transactions, or they risked being driven out of business.

To be sure, the history of business is strewn with Fisks, Goulds,
and numerous others treading on, or over, the edge of legality.
But they were a distinct minority. If the situation had been
otherwise, the United States at the end of the nineteenth century
would never have been poised to displace Great Britain as the
world?s leading economy.

Reputation was especially important to early U.S. bankers. It is
not by chance that in the nineteenth century many bankers could
effectively issue uncollateralized currency. They worked hard to
develop and maintain a reputation that their word was their bond.
For these institutions to succeed and prosper, people had to
trust their promise of redemption in specie. The notion that
?wildcat banking? was rampant before the Civil War is an
exaggeration. Certainly, crooks existed in banking as in every
business. Some banks that issued currency made redemption
inconvenient, if not impossible. But they were fly-by-night
operators and rarely endured beyond the first swindle.

In fact, most bankers competed vigorously for reputation. Those
who had a history of redeeming their bank notes in specie, at
par, were able to issue substantial quantities, effectively
financing their balance sheets with zero-interest debt. J.P.
Morgan marshaled immense power on Wall Street in large part
because his reputation for fulfilling his promises was legendary.

Today, most banks rely partly on deposit insurance in lieu of
reputation to hold below-market-rate deposits. And a broad range
of protections provided by the Securities and Exchange
Commission, the Commodity Futures Trading Commission, and myriad
other federal and state agencies has similarly partially crowded
out the value of trust as a competitive asset.

Trust still plays a crucial role in one of the most rapidly
growing segments of our financial system?the over-the-counter
(OTC) derivatives market. This market has played an important and
successful role in the management of risk at financial
institutions, a major element of their corporate governance. I do
not say that the success of the OTC derivatives market in
creating greater financial flexibility is due solely to the
prevalence of private reputation rather than public regulation.
Still, the success to date clearly could not have been achieved
were it not for counterparties? substantial freedom from
regulatory constraints on the terms of OTC contracts. This
freedom allows derivatives counterparties to craft contracts that
transfer risks in the most effective way to those most willing
and financially capable of absorbing them.

Benefits of derivatives

Although the benefits and costs of derivatives remain the subject
of spirited debate, the performance of the economy and the
financial system in recent years suggests that those benefits
have materially exceeded the costs. Over the past several years,
the U.S. economy has proven remarkably resilient in the face of a
series of severe shocks--the collapse of equity values, terrorist
attacks, and geopolitical turmoil. To be sure, economic growth
has been subpar for some time, but we seem to have experienced a
significantly milder downturn than the long history of business
cycles and the severity of the shocks to the economy would have
led us to expect.

Although no single factor can account for this resilience, one
striking feature that differentiates this cycle from earlier ones
is the continued vitality of most U.S. banks and nonbank
financial institutions.

In past cycles, economic downturns often produced credit losses
that were so severe that the capacity of those institutions to
intermediate financial flows was impaired. As a consequence,
recessions were prolonged and deepened. This time, the economic
downturn has not significantly eroded the capital of most
financial intermediaries, and the terms and availability of
credit have not tightened to such an extent as to be significant
factors in deepening the contraction or impeding the recovery.

The use of a growing array of derivatives and the related
application of more-sophisticated methods for measuring and
managing risk are key factors underpinning the enhanced
resilience of our largest financial intermediaries. Derivatives
have permitted financial risks to be unbundled in ways that have
facilitated both their measurement and their management. Because
risks can be unbundled, individual financial instruments now can
be analyzed in terms of their common underlying risk factors, and
risks can be managed on a portfolio basis. Concentrations of risk
are more readily identified, and when such concentrations exceed
the risk appetites of intermediaries, derivatives can be employed
to transfer the underlying risks to other entities.

As a result, not only have individual financial institutions
become less vulnerable to shocks from underlying risk factors,
but also the financial system as a whole has become more
resilient. Individual institutions? portfolios have become better
diversified. Furthermore, risk is more widely dispersed, both
within the banking system and among other types of intermediaries
and institutional investors. Even the largest corporate defaults
in history (WorldCom and Enron) and the largest sovereign default
in history ( Argentina ) have not significantly impaired the
capital of any major financial intermediary.

Likewise, record amounts of home mortgage refinancing and
accompanying declines in mortgage asset durations have not
imperiled the principal intermediaries in the mortgage markets,
in substantial part because these institutions were able to use
derivatives to transfer a significant portion of the convexity
risk associated with prepayments of fixed-rate mortgages to
investors in callable debt and issuers of putable debt.

Risks associated with the use of derivatives

If derivatives and the techniques for risk measurement and
management that they have facilitated have produced all these
benefits, why do they remain so controversial? The answer is that
the use of these instruments and the associated techniques pose a
variety of challenges to risk managers.

Inevitably, risk-management failures occur, and in two
instances--the highly publicized cases of Barings and Long Term
Capital Management--they proved destabilizing. Those that
question the net benefits of derivatives see daunting
risk-management problems and thus foresee catastrophic outcomes.
In particular, they fear that common deficiencies in risk
management will result in widespread failures or that the failure
of a very large derivatives participant will impose heavy credit
losses on its counterparties and yield a chain of failures.

Others, like myself, who see the benefits of derivatives
exceeding the costs, do not deny that their use poses significant
risk-management challenges. But we see ample evidence that the
risks are manageable in principle and generally have been managed
quite effectively in practice, at least to date. Indeed, credit
losses on derivatives have occurred at a rate that is a small
fraction, for example, of the loss rate on commercial and
industrial loans. Market discipline in the largely unregulated
derivatives markets has provided strong incentives for effective
risk management and has the potential to be even more effective
in the future.

To be sure, there undoubtedly will be further risk-management
failures. But the largest market participants have such
diversified businesses that a risk-management failure involving a
single product line is unlikely to be a threat to solvency.
Furthermore, risk-management failures are more likely to be
idiosyncratic than to reflect common deficiencies in procedure or
technique among market participants. In the case of the
management of market risk, our bank examiners observe significant
differences in approach across the largest U.S. banks, even in
the measurement of such a basic concept as value-at-risk.

I do not wish to suggest, however, that I am entirely sanguine
with respect to the risks associated with derivatives. One
development that gives me and others some pause is the decline in
the number of major derivatives dealers and its potential
implications for market liquidity and for concentration of
counterparty credit risks. I also fear that the potential
contribution of market discipline to stability in the derivatives
markets is not being fully realized because, in our laudable
efforts to improve public disclosure, we too often appear to be
mistaking more extensive disclosure for greater transparency.

This is an issue to which I shall shortly return.

Concentration and market liquidity

In recent years, consolidation has reduced the number of firms
that provide liquidity to the OTC derivatives markets by acting
as dealers in the more standardized or "plain vanilla" contracts.
To be sure, the resulting concentration sometimes is overstated
because of the failure to recognize that the OTC derivatives
markets are global markets in which major banks and securities
firms from more than half a dozen countries compete. For example,
measures of concentration based on data reported by U.S. banks
overstate concentration significantly because they ignore the
competitive activities of U.S. securities firms and foreign
banks.

Nonetheless, not all major dealers make markets in all products,
and concentration is substantial for certain important types of
OTC contracts. Examples include U.S. dollar interest rate options
and credit default swaps. In each case, a single dealer seems to
account for about one-third of the global market, and a handful
of dealers together seem to account for more than two-thirds.

When concentration reaches these kinds of levels, market
participants need to consider the implications of exit by one or
more leading dealers. Such an event could adversely affect the
liquidity of types of derivatives that market participants rely
upon for managing the risks of their core business functions.

Exit could be voluntary. In particular, losses incurred in making
markets could lead a dealer to conclude that the returns from
market-making are not commensurate with the risks. Alternatively,
downgrades of a dealer?s credit rating could force the dealer to
exit. Counterparties in the OTC derivatives market are quite
concerned about the potential credit risks inherent in such
contracts and generally are unwilling to transact with dealers
unless their credit rating is A or higher.

If a major dealer exited and other dealers were unwilling to fill
the void, the liquidity of the market likely would be impaired.
Market participants need to consider what their alternatives
would be in such circumstances. Are there other liquid markets in
which they could manage their risks? In some cases market
participants may be able to manage risks reasonably effectively
in cash markets or exchange traded derivatives markets. But in
other cases managing risks may become more difficult with the
exit of some dealers. If market participants perceive that they
are vulnerable to such exit by a liquidity provider, they will
tend to redirect some of their risk-management activity to other,
more liquid markets or seek out new dealers in the market in
which exit is a concern. If enough participants perceive the
concentration of dealers as entailing market-liquidity risk,
their actions to mitigate the risk should over time reduce that
degree of concentration.

Concentration and counterparty risk

Perhaps the more obvious way in which concentration in OTC
derivatives markets creates risks for market participants is
through its implications for counterparty credit risks.
Concentration of market making has the potential to create
concentrations of credit risks between the dealers and the
end-users of derivatives as well as between the dealers
themselves. This latter concentration of risk results from
dealers frequently managing their market risks through
derivatives transactions with a limited number of other dealers.
As mentioned earlier, critics of derivatives often raise the
specter of the failure of one dealer imposing debilitating losses
on its counterparties, including other dealers, yielding a chain
of defaults.

However, derivatives market participants seem keenly aware of the
counterparty credit risks associated with derivatives and take
various measures to mitigate those risks. The vast majority
carefully evaluate the creditworthiness of counterparties before
entering into transactions and monitor their credit quality over
the life of the transactions. As I indicated earlier, users of
derivatives have been reluctant to transact with dealers that are
not perceived as solid investment-grade credits. Market
participants also establish credit limits for their
counterparties and actively monitor their exposures to ensure
that they remain within the limits established. Such monitoring,
parenthetically, relies heavily on trust in the accuracy of the
information forthcoming from the counterparties.

Counterparty risk management has been materially assisted by the
widespread use of master agreements for derivatives transactions.
In the event of a counterparty?s default, such agreements permit
the termination of all transactions with the counterparty and the
netting of the resulting gains and losses. For many years, market
participants have been putting such master agreements in place
and working with legislatures to ensure that national laws
support the enforceability of netting. Data reported by U.S.
banks indicate that, on average, netting now reduces counterparty
exposures by almost three-fourths.

Even with wider use of netting, however, the outsized growth of
derivatives markets has resulted in ever-larger counterparty
exposures. Market participants have increasingly responded by
entering into collateral agreements to further mitigate
counterparty credit risks. Such agreements typically permit
counterparties to derivatives transactions to demand collateral
if their net credit exposure exceeds a negotiated threshold
amount. The threshold often varies with the credit rating of the
counterparty: The lower a counterparty?s credit rating, the
smaller the threshold. If its credit rating falls below
investment grade, a counterparty is often required to
overcollateralize its counterparties? exposures. In effect, it
becomes obligated to meet a margin requirement.

Collateral agreements are a very effective means of limiting
counterparty credit risks. At the same time, they increase market
participants? exposures to other types of risk, especially
funding-liquidity risks. Once a counterparty has agreed to
collateralize its derivatives contracts, day-to-day declines in
the value of those contracts expose it to immediate demands for
more collateral. Furthermore, the practice of tying the size of
thresholds and margin requirements to credit ratings exposes a
counterparty to extraordinary demands for collateral if its
rating is downgraded. Collateral demands arising from rating
downgrades may be especially costly to meet because a downgrade
would reduce the availability of funding and increase its costs
at the same time.

Incentives for effective risk management

As this discussion of the risks associated with derivatives makes
clear, effective risk management by market participants is the
key to ensuring that the benefits of derivatives continue to
exceed their costs.

Some may see government regulation of OTC derivatives dealers as
essential to ensuring efficacious risk management. This view
presumes that government regulation can address the challenges
these types of markets engender and that it can do so without
lessening the effectiveness of market discipline supplied by
counterparties. Market participants usually have strong
incentives to monitor and control the risks they assume in
choosing to deal with particular counterparties. In essence,
prudential regulation is supplied by the market through
counterparty evaluation and monitoring rather than by
authorities. Such private prudential regulation can be
impaired--indeed, even displaced--if some counterparties assume
that government regulations obviate private prudence.

We regulators are often perceived as constraining excessive
risk-taking more effectively than is demonstrably possible in
practice. Except where market discipline is undermined by moral
hazard, owing, for example, to federal guarantees of private
debt, private regulation generally is far better at constraining
excessive risk-taking than is government regulation.

The very modest credit losses that have appeared in derivatives
portfolios at U.S. banks are a testament to the effectiveness of
market discipline in this area. Indeed, credit losses on OTC
derivatives also have been quite modest at derivatives affiliates
of U.S. broker-dealers, which are subject to very limited
government regulation. This is further evidence of the powerful
effects on behavior that result when market participants
recognize that they bear the bottom-line consequences of their
risk-taking decisions.

A key support for market discipline is the information that
market participants have for evaluating the creditworthiness of
counterparties. Over the past decade, enormous attention has been
given to disclosures market participants make with regard to
their risk exposures, particularly those associated with
derivatives activities. Both public authorities and
private-sector working groups have recommended ways to enhance
market discipline through improved public disclosures. The result
of these efforts, however, has been mixed.

Clearly, we have made great strides in expanding the volume of
publicly disclosed information related to risk exposures and
derivatives. A more complex question is whether this greater
volume of information has led to comparable improvements in the
transparency of firms.

In the minds of some, public disclosure and transparency are
interchangeable. But they are not. Transparency implies that
information allows an understanding of a firm?s exposures and
risks without distortion. The goal of improved transparency thus
represents a higher bar than the goal of improved disclosures.
Transparency challenges market participants not only to provide
information but also to place that information in a context that
makes it meaningful. Transparency challenges market participants
to present information in ways that accurately reflect risks.
Much disclosure currently falls short of these more demanding
goals.

Despite the substantial room for progress with regard to
transparency, we should not underestimate the barriers to
achieving it. Managers no doubt have to struggle with selecting
and organizing data in a meaningful way. The difficulties are
well illustrated by the annual reports of large institutions that
routinely exceed one hundred pages; pressures are enormous to
update existing tables and charts as well as to provide even
more. In addressing this challenge, however, both managers of
firms and makers of public policy would do well to be mindful of
the ultimate goal--a clear understanding of a firm?s activities
that fosters market discipline.

Conclusion

In conclusion, the benefits of derivatives, in my judgment, have
far exceeded their costs. Derivatives unquestionably do pose
risk-management challenges to market participants. But those
challenges are manageable and thus far have generally been
managed quite well. The best way to ensure that those challenges
continue to be met is to preserve and strengthen the
effectiveness of market discipline.

Market incentives, in particular, reinforce the importance of
reputation and trust as sources of market value.

Just as market discipline has fostered effective risk management
in the derivatives markets, so too it is now being brought to
bear on corporate governance generally. Once market discipline
firmly reestablishes reputation and trust as corporate values,
the incidence of corporate malfeasance should be greatly reduced.