The final decades of the
twentieth century witnessed remarkable advances in financial
engineering, financial innovation, and deregulation. As recently
as thirty-five years ago, the universe of financial instruments
was composed almost exclusively of deposits; short- and long-term,
plain vanilla debt; and equities. Financial institutions, by and
large, specialized in relatively narrow portions of these markets.
In the intervening years, significant developments in technology
and in the pricing of assets have enabled innovations in financial
instruments that allow risks to be separated and reallocated to
the parties most willing and able to bear them and the degree of
specialization by financial intermediaries changed dramatically.
In the case of debt instruments, investors may now choose among
structured notes, syndicated loans, coupon STRIPs, and bonds
secured by pools of other debt instruments. But of all the changes
we have observed in the past three decades, two of the most
dramatic have been the growing use of financial derivatives and
the increasing presence of banks in private equity markets. Today
I should like to evaluate the scope of these latter progressions,
the risks they entail, and some of the challenges in managing
those risks.
It seems undeniable that in
recent years the rate of financial innovation has quickened. Many
in fact argue that the pace of innovation will increase yet
further in the next few years as financial markets increasingly
intertwine and facilitate the integration of the new technologies
into the world economy. As we stand at the dawn of the
twenty-first century, the possible configurations of products and
services offered by financial institutions appear limitless. There
can be little doubt that these evolving changes in the financial
landscape are providing net benefits for the large majority of the
American people. The rising share of financial services in the
nation's national income in recent years is a measure of the
contribution of the newer financial innovations to America's
accelerated economic growth. Derivatives and private equities have
been in the forefront of the recent financial expansion, fostering
the financing of a wider range of activities more efficiently and
with improved management and control of the associated risks.
Fear of Change
Nonetheless, some find these developments worrisome or even deeply
troubling. The rapid growth and increasing importance of
derivative instruments in the risk profile of many large banks has
been a particular concern. Yet large losses on over-the-counter
derivatives have been few. Derivatives possibly intensified the
losses in underlying markets in the liquidity crisis during the
third quarter of 1998, but they were scarcely the major players.
Credit losses on derivatives spiked but remained well below those
experienced on banks' loan portfolios in that episode.
Derivatives credit exposures, as
you all know, are quite small relative to credit exposures in
traditional assets, such as banks' loans. In the fourth quarter of
last year, for example, banks charged off $141 million of credit
losses from derivatives-including options, swaps, futures, and
forwards-or only 0.04 percent of their total credit exposure from
derivatives. This in part reflects the fact that in some
derivative contracts, most notably in interest rate swaps, there
is no principal to be exchanged and thus no principal at risk. In
comparison, net charge-offs relative to loans were 0.58 percent in
that quarter-also small but, nonetheless, almost fifteen times as
much. In the third quarter of 1998, at the height of the recent
financial turmoil, the loan charge-off rate at U.S. banks was 4�
times that of derivatives.
In a similar vein, concerns of
highly leveraged positions caused by derivatives have led to fears
of "excessive leverage." But leverage, at least as
traditionally measured, is not a particularly useful concept for
gauging risk from derivatives. A firm might acquire an interest
rate cap, for example, to hedge future interest rate uncertainty
and hence to reduce its risk profile. Yet if the cap is financed
through debt, measured leverage increases. Thus, although one may
harbor concerns about the overall capital adequacy of banks and
other participants in derivatives markets and their degree of
leverage, the advent of derivatives appears to make measures of
leverage more difficult to interpret but not necessarily more
risky. To be sure, the unfamiliar complexity of some new financial
instruments and new activities, or the extent to which they
facilitate other kinds of risk-taking, cannot be readily dismissed
even by those of us who view the remarkable expansion of finance
in recent years as a significant net benefit.
What I suspect gives particular
comfort to those of us most involved with the heightened
complexity of modern finance is the impressive role private market
discipline plays in these markets. Importantly, derivatives
dealers have found that they must maintain strong credit ratings
to participate in the market. Participants are simply unwilling to
accept counterparty credit exposures to those with low ratings.
Besides requiring a strong capital base and high credit ratings,
counterparties in recent years have increasingly insisted both on
netting of exposures and on daily posting of collateral against
credit exposures. U.S. dealers, in particular, have rapidly
expanded their use of collateral to mitigate counterparty credit
risks. In these programs, counterparties typically agree that, if
exposures change over time and one party comes to represent a
credit risk to the other, the party posing the credit risk will
post collateral to cover some (or all) of the exposure. These
programs offer market participants a powerful tool for helping
control credit risk, although their use does, as we all know, pose
significant legal and operational issues.
Legitimate Concerns
Despite the commendable historical loss record and effective
market discipline, there are undoubtedly legitimate concerns and
avenues for significant improvement of risk management practices.
Moreover, during the recent phenomenal growth of the derivatives
market, no significant downturn has occurred in the overall
economy to test the resilience of derivatives markets and
participants' tools for managing risk. The possibility that market
participants are developing a degree of complacency or a feeling
that technology has inoculated them against market turbulence is
admittedly somewhat disquieting.
Such complacency is not
justified. In estimating necessary levels of risk capital, the
primary concern should be to address those disturbances that
occasionally do stress institutional solvency-the negative tail of
the loss distribution that is so central to modern risk
management. As such, the incorporation of stress scenarios into
formal risk modeling would seem to be of first-order importance.
However, the incipient art of stress testing has yet to find
formalization and uniformity across banks and securities dealers.
At present most banks pick a small number of ad hoc
scenarios as their stress tests. And although the results of the
stress tests may be given to management, they are, to my
knowledge, never entered into the formal risk modeling process.
Additional concern derives from
the fact that some forms of risk that we understand to be
important, such as liquidity and operational risk, cannot at
present be precisely quantified, and some participants do not
quantify them at all, effectively assuming them to be zero.
Similarly, the present practice of modeling market risk separately
from credit risk, a simplification made for expediency, is
certainly questionable in times of extraordinary market stress.
Under extreme conditions, discontinuous jumps in market valuations
raise the specter of insolvency, and market risk becomes
indistinct from credit risk.
Of course, at root, effective
risk management lies in evaluating the risk models upon which
capital allocations and economic decisions are made. Regardless of
the resources and effort a bank puts into forecasting its risk
profile, it ought not make crucial capital allocation decisions
based on those forecasts until their accuracy has been appraised.
Yet forecast evaluation, or "backtesting," procedures to
date have received surprisingly little attention in both academic
circles and private industry.
Quite apart from complacency
over risk-modeling systems, we must be careful not to foster an
expectation that policymakers will ultimately solve all serious
potential problems and disruptions. Such a conviction could lull
financial institutions into believing that all severe episodes
will be handled by their central bank and hence that their own
risk-management systems need not be relied upon. Thus,
over-reliance on public policy could lead to destabilizing
behavior by market participants that would not otherwise be
observed-what economists call moral hazard.
There are many that hold the
misperception that some American financial institutions are too
big to fail. I can certainly envision that in times of crisis the
financial implosion of a large intermediary could exacerbate the
situation. Accordingly, the monetary and supervisory authorities
would doubtless endeavor to manage an orderly liquidation of the
failed entity, including the unwinding of its positions. But
shareholders would not be protected, and I would anticipate
appropriate discounts or "haircuts" for other than
federally guaranteed liabilities.
As we consider potential
shortcomings in risk management against the backdrop of an absence
of significant credit losses in derivatives, one is compelled to
ask: Has the financial system become more stable, or has it simply
not been tested?
Probability distributions
estimated largely, or exclusively, over cycles that do not include
periods of financial stress will underestimate the likelihood of
extreme price movements because they fail to capture a secondary
peak at the extreme negative tail that reflects the probability of
the occurrence of extreme losses. Further, because the experience
during crises indicates heightened correlations of price
movements, joint distributions estimated over periods that do not
include severe turbulence would inaccurately estimate correlations
between asset returns during such episodes. The benefits of
diversification will accordingly be overestimated.
Another aspect of the system
that may not have been appropriately tested is the set of credit
risk modeling systems that have evolved alongside the growth in
derivatives. Such models embody procedures for gauging potential
future exposure. Prevailing prices will doubtless change in the
future, so counterparties must assess whether those contracts with
small or even negative current values now have the potential
to result in large positive market values and, hence, a potential
credit loss on default. Do such calculations adequately account
for the possibility of prolonged disruptions or recessions? Are
assumptions relating exposures to default probabilities
sufficiently inclusive? These and other support columns underlying
estimation of potential future exposure should continue to be
examined under a critical light.
Private Equity Activity
Derivatives, no doubt reflecting their growth, their extensive use
in hedging that facilitates additional risk-taking, and their
gigantic notional values, continue to be the quintessential image
of financial engineering and innovation. But another dramatic
change in the activities of banking organizations has received
less attention: merchant banking. Indeed, the most dramatic change
in the financial landscape that the Gramm-Leach-Bliley Act may
have induced is not the combination of banking, securities
underwriting, and insurance, but rather the generalized merchant
banking powers for financial holding companies. And even this
change is really evolutionary for a handful of very large U.S.
banking organizations.
By merchant banking, I mean
financial equity investment in nonfinancial firms, most often, but
not always, in nonpublic companies, with the investor providing
both capital and financial expertise to the portfolio company.
Such investments are usually held for three to five, but often as
long as ten or more, years for subsequent resale to other
investors. The recent financial modernization legislation gives
banking organizations broad authority to make merchant banking
investments but prohibits them from routinely managing the
portfolio companies in which they have invested except in
extraordinary circumstances for limited periods. In addition,
banks' credit extensions to the firms in which their parents or
affiliates hold equity are limited by the same section 23 A and B
restrictions imposed on bank lending to their affiliates.
Prior to the recent legislation,
banking organizations could make only limited types of merchant
banking investments, and these were made principally through three
vehicles. First, since the late 1950s, banks and bank holding
companies have been authorized to operate small business
investment companies (SBICs) that can invest in up to half of the
equity of an individual small business, currently defined
by regulation as one with less than about $20 million of
pre-investment capital. The aggregate limit of such investments
cannot exceed 5 percent of the bank or BHC's capital. Second, Edge
corporations, which are primarily subsidiaries of banks but can
also be subsidiaries of holding companies, can acquire up to 20
percent of the voting equity and 40 percent of the total equity of
nonfinancial companies outside the United States. Finally, BHCs
more generally can acquire up to 5 percent of the voting shares
and up to 25 percent of the total equity of any company
without aggregate limit. I have, of course, been referring to
equity investments of banking organizations for their own account.
BHC's section 20s-and any future investment banking
affiliates-also hold equities in trading accounts as part of their
underwriting and trading activities. These daily mark-to-market
holdings are quite large at a couple of banking organizations that
have a significant equity underwriting business but are rather
modest for others.
Through the three long-term
holding vehicles, banking organizations have made direct equity
investments on their own and in partnership with others. They have
also made indirect investments through private investment groups,
sometimes acting as the manager of the group for performance-based
fees. In the early 1960s, banking organizations were probably the
dominant source of venture capital in the United States, and still
play an important role-perhaps accounting currently for 10 to 15
percent of the domestic private equity market. What has changed
with the recent legislation is the generalized grant of authority
for bank holding companies that qualify as financial holding
companies to exercise merchant banking powers. There are now about
155 domestic and more than 10 foreign financial holding companies
that could-but not necessarily will-undertake merchant banking.
Two-thirds of the financial holding companies have less than $500
million in assets; about one-third have less than $150 million.
In evaluating that general grant
of merchant banking authority, it is useful to consider the
experience of banking organizations that have been active
participants in the private equity market in recent decades. To
date, there have been no significant problems. To be sure, the
record on private equity investment by banks is one of substantial
year-to-year variation in return, just as one might expect with
any portfolio of risky assets. Some of the deals have resulted in
total write-offs, but over all the rates of return, especially in
recent years, have been quite impressive-30 percent or so per year
in the last five years. In part, perhaps in large part, this
reflects the substantial rise in equity prices.
Still another historical factor
has been the quite conservative treatment of equity portfolios by
banking organizations. Both banks and independent securities firms
engaging in merchant banking have tended to allocate substantial internal
capital to support their private equity investment
activity-between 50 and 100 percent-and to recognize unrealized
capital gains only on traded equities or when some triggering
event supported the revaluation of nontraded shares and then only
subject to a discount. In effect, banks have locked up significant
internal capital for their equity purchases and have been
conservative in recognizing gains in their earning flows and,
consequently, in their capital.
For a small number of large
banking organizations, equity portfolios are a significant share
of their business already. As of year-end 1999, for the five large
banking organizations with more than one billion dollars invested,
at cost, in equities, these assets accounted for between
approximately 10 percent and 25 percent and more of tier-1 capital
and between more than 10 percent and 35 percent at carrying value.
Moreover, the pre-tax gains recognized last year-either at sale or
because of revaluation-accounted for between 5 and 30 percent of
pre-tax reported earnings in 1999 at these five banking
organizations. In the first quarter of this year, such gains
accounted for 16 percent to more than one-half of pre-tax income.
It is likely that authorization
of merchant banking powers will lead both to deeper participation
by the current large players and to wider merchant banking
activity across banking organizations. To limit risks to the bank
subsidiary of the financial holding companies and to the insurance
fund, the Federal Reserve interim regulations require that before
this activity commences, the organizations establish appropriate
internal controls to manage the risks associated with this
activity. It must be kept in mind, as I pointed out in other
contexts, that most bad commercial loans are made during prolonged
periods of prosperity. I suspect that the experience of bank
equity investment has been similar. Current interim
regulations-which propose for comment a 50 percent capital charge
on all nontrade account equities held by banking
organizations-should not be viewed separately from the current
state of the economy any more than commercial banking should be.
In any event, at those entities
with significant merchant banking portfolios, the above average
variance in stock prices will doubtless add to the variability of
earnings of the overall organization-and hence, one can conclude,
to the organization's valuation in the marketplace. There is,
indeed, general agreement that the price-earnings ratio of trading
banks is lower than that of other banks of the same size, although
it has been difficult because of the dynamics of other variables
to nail down empirically the appropriate orders of magnitude. And,
I suspect, that if the data were readily available, we might be
able to demonstrate the same pattern at institutions significantly
involved in the private equity market and perhaps even in
derivatives trading. Any earnings stream that shows variability
has been appropriately discounted. That is not to say that real
economic value is not being created for banking organizations,
their shareholders, and the economy from what appears to be a
greater-and perhaps expanding-flow of venture and other equity
capital from banking organizations. But despite the very good
record to date in both the derivatives and private equity
activities of banking organizations, we all would be remiss if we
did not note that there are risks in these activities that, during
some periods in the future, will create reduced returns, if not
significant overall losses, for individual organizations. However,
the same might be said about portfolios of loans-the traditional
historical major asset of banks-and one that will continue to
dominate the business of most banks for the foreseeable future.
Conclusion
I have noted many times over the years that the purpose of banks
and banking organizations is to take risk in order to contribute
to, and facilitate the growth, and other needs, of an economy. We
must be cautious, however, that we understand the nature of the
new risks that have evolved with information innovation
technologies and be certain that they are managed in ways that do
not undermine this economic role.
Balancing these objectives is no
easy task. We need to ensure that strong risk-management systems
are in place and that the management of banking organizations use
these systems both to enhance their awareness and understanding of
the risks knowingly taken and to manage those risks accordingly.
But systems are never perfect; mistakes will be made; and tails in
loss distributions do represent a reality that sooner or later
occurs.
Individual foreign and domestic
banking organizations in the past have, from time to time,
suffered large losses in the derivatives and private equity
markets. We will not be immune from such events in the future. But
so long as we recognize the risks and insist on good
risk-management system, and so long as supervision moves-as it
has-from balance sheet analysis to a review, evaluation, and
criticism of risk management systems, economic growth is, I
suggest, enhanced by the kinds of financial innovation that
technology and deregulation are now producing.
