Running The Bank Of Central Banks.

TIE contributing editor Klaus Engelen interviews Andrew Crockett, General Manager, Bank for International Settlements.

TIE: As general manager of the Bank for International Settlements, you are running what some call the "Bank of Central Banks, "an institution very much focused on monetary stability. As chairman of the Financial Stability Forum, your focus is on securing financial stability. What comes first, monetary of financial stability?

AC: There can, of course, be no debate about the importance of the twin goals of price stability, on the one hand, and the stability of the financial system on the other. What is less well understood is the relationship between them.

TIE: How do you define the relationship?

AC: It is an issue that is both important and timely. Important because we need to ensure that arrangements for the pursuit of price stability do not inadvertently endanger the stability of the financial system. And we need to ensure that financial system weaknesses do not impede the effective operation of monetary policy. Timely because the new Basel Capital Accord is focusing additional attention on the issue of systemic risk. Moreover, in a number of countries, responsibility for the supervision of financial institutions has been moved from the central bank to an independent regulatory authority, with the central bank itself retaining a more general responsibility for overall systemic stability. Australia and the United Kingdom are perhaps the clearest examples of such a shift, but similar moves have taken place in Korea, Hungary, and a number of other countries. These institutional changes have sparked a lively debate about the appropriate institutional framework for monetary and financial stability policies. I would argue that the terms of this debate are too narrow. What matters is not so much the institutional division of responsibilities. It is rather the nexus between monetary and prudential policies and how to devise a set of arrangements that can promote both. The channels of causation run in both directions and take many forms. In implementing prudential policies, supervisory authorities may require a keener recognition that some of the main roots of systemic instability have been macroeconomic. One common macroeconomic element behind overextension in the financial system has been misjudgements about the economy's potential growth rate--a major factor in Japan in the 1980's and in Southeast Asia in the mid-1990's. Another element is that financial market sentiment tends to move with the business cycle. Many of the dilemmas of policy arise because it is difficult in practice to distinguish what is cycle and what is trend.

TIE: What was your impression of the latest spring meetings in Washington?

AC: The meetings in Washington were very productive. The atmosphere was good and there was general agreement that medium term economic prospects were reasonably promising.

TIE: What do you consider to be the achievements of the Financial Stability Forum?

AC: I think the main achievement is that we have now created a permanent group in which all of those authorities and groupings responsible for financial stability meet on a regular basis. That is to say, the finance ministry, central banks, and top regulators of the G7 countries, along with the Basel Committee, the IOSCO, the IAIS, and the international organizations (IMF; World Bank and so on).

As to the nature of the Forum, former U.S. Treasury Secretary Larry Summers came up with the analogy to compare the Financial Stability Forum to the Working Party III of the OECD, a body that he chaired. The Working Party III doesn't take any decisions, but is a forum in which the representatives of the major countries can sensitize each other to concerns and developments that affect the macroeconomy, and particularly macroeconomic interactions through balance of payments and so on. I think it's a very useful forum in advance warnings of potential policy changes and financial policy issues on the macroeconomic level.

In the FSF, we have a forum where we talk and share views on potential vulnerabilities of the financial system. This is not a very glamorous activity but it is important to have regular meetings to get to know people, and to be able to anticipate potential problems. Having a body in which such discussions can take place is already a very important achievement. The Financial Stability Forum can allow those with responsibility for financial stability to raise the consciousness of the other members of the Forum at an early stage about developments affecting the financial sector, whether conjunctural or structural. This, in turn, may induce either joint action or at least individual action early on to deal with those developments.

The benefits of the Forum are not simply formal recommendations of the working groups, but the ongoing informal dialogue amongst interested parties.

TIE: What about the practical recommendations of the Forum?

AC: We set up working groups and received reports on a number of issues we considered crucial for strengthening the underpinnings of the international financial system. One of the best known groups was that on offshore financial centers.

It is not necessarily the most important, but it is important for us to make sure that all-important financial centers, offshore and onshore, have effective and transparent supervision systems. I am quite encouraged that the offshore centers themselves have recognized, for the most part, the need to strengthen supervision. We are intent on helping them if they want to do that. Overall, it has been a positive experience, although painful in some ways. Some people feel that certain aspects of it were not handled necessarily in the best way, the end result has been to give new impetus to strengthening the financial system.

We also had a group on Highly Leveraged Institutions (HLIs). After the experience of 1998, it was recognized to be very important that these institutions did not constitute a source of instability in the financial system. The report that was produced made a number of important recommendations. Some of them have already been implemented. But we still have further to go. There was also a report on how to manage the risks associated with capital flow volatility. Again, an important issue with major implications for financial stability.

TIE: How is the work on codes and standards progressing?

AC: I think quite well. The Forum had a broadly based working group under Andrew Sheng of Hong Kong that achieved several things in a strategic sense. First of all, it prioritized standards so that, amongst the large number of standards that have been developed, the focus of international implementation efforts is now on twelve core standards. Second, it focused incentives for implementation of standards. Implementation is most effective if countries themselves "buy" into the idea, and if they have appropriate incentives, in the sense that those that do well are rewarded by the market, by the regulators, or the international community. That work is continuing in the Forum. Then the report identified technical assistance and training as important ways of enabling countries to benchmark themselves against standards. The Fund and the World Bank are obviously the vehicle for doing the monitoring and assessment. But the standard-setting bodies also have key roles to play. So, what the Forum was able to do was to help provide a rationale, a road map, and coordination among the many bodies involved, in a process which included key emerging market economies. It is important that emerging markets do not feel they are being pushed into doing something by the industrial countries that they would not want to do on their own.

TIE: The last meeting of the Forum was held in Washington in March. What were the major topics?

AC: We looked at two different aspects of vulnerabilities to the financial system. First, the short-term conjunctural vulnerabilities--what would happen in financial systems if there should be a significant further slowdown in economic activity? And then we looked at longer-term structural trends; trends that may not pose an immediate problem, but that might be longer-term problems.

Concerning the first--conjunctural issues--it is useful to look separately at the United States, Europe, and Japan. The feeling was that the U.S. financial system was well capitalized and capable of handling a cyclical downturn. Therefore the slowdown in the United States--while it would undoubtedly throw up some additional bad loans and would impact the banks profits--would not significantly compromise their ability to continue to extend finance to good credits. So it was not felt that a slowdown in the United States would lead to a credit crunch--not unless the situation became much worse than currently foreseen.

As for Japan, I think that we concluded that there was not likely to be a significant failure in the banking system, partly because the capital position had gotten somewhat better, and partly it was concluded that the Japanese government one way or another would prevent a destabilizing failure by an institution. Whether the financial sector in Japan will contribute much to recovery is another matter. Quite clearly, more needs to be done in the area of structural reform, in further strengthening banks' capital, and reactivating financial intermediation.

As far as the European financial sector was concerned, exposure in the telecom sector had been raised in the September meeting of the Forum. As a result of that, a working party had been established under Michael Foot of the British FSA. The conclusion from that study was that although there were indeed significant exposures to the telecom industries, those were bearable, and did not pose a threat for financial stability. Of course, the economic situation in Europe still appears more robust than in Japan or in the United States.

TIE: Where did the Forum sense the major threat to the system?

AC: One of the functions of the Forum is to ask the question: will financial vulnerabilities compound the economic cycle in the real economy, making the cycle worse or causing a crisis? The general answer to that question at the Washington meeting was that the financial system is strong enough not to be an additional source of weakness. But there are some exceptions to that general statement. Japan is obviously a concern, as are some emerging markets.

Looking at the longer-term structural changes, there were two or three major issues at the Washington meeting that bear watching: for example, the issue of whether the new risk-shifting instruments are adequately understood and robust enough to stand up in times of pressure. By that, I mean credit derivatives and other securitized instruments that are sold by the originator to financial institutions in different market segments. By and large, risk-shifting instruments are good because they allow risks to be passed on to institutions that are more able or willing to bear them. If properly used, they should strengthen the financial system. However, there are some nagging doubts. One is: will these instruments stand up legally and administratively if they are really put to the test in times of stress? For example, will insurance companies that have underwritten some of the risks really be willing to pay up immediately, or will they try to test the legal robustness? In the capital markets the standard rule is pay first, argue later, whereas with insurance contracts, it sometimes can seem to be the other way around. If the insurance industry is underwriting risks in the capital markets, that could cause a problem.

TIE: What were the concerns regarding the emerging market countries like Latin America?

AC: Bear in mind that there are no representatives from Latin America in the Forum. We did have a regional meeting--a sort of Latin American forum--and we got the feeling that the slowing of the U.S. economy is not impacting them tremendously. Mexico would be most affected by the U.S. economy through their exports--but Mexico has continued to have very large inflows of foreign direct investment. The Mexicans are expecting a slowing in their economy, but they will still see some respectable growth. They are obviously not pleased, but they don't feel concerned about financial stability as a result.

As far as Argentina is concerned, in principle they actually stand to benefit more from interest rates coming down than from the fact that they are going to lose exports to the U.S. market. Brazil is somewhat in the middle, but their economy is still performing quite strongly. I did not sense from Latin America a strong sense of concern, and we didn't hear it reported in the Forum. But of course, a lot depends on Argentina coming out of its present difficulties.

TIE: But the Forum has some Asian member countries?

AC: Yes, among the Forum's member countries are Japan, Singapore, Hong Kong, and Australia. As far as Asia is concerned, the direct impact of the U.S. slowdown appears greater. Emerging Asia not only exports a lot to Japan and the United States--activity is slowing in the case of the United States and remaining stagnant in the case of Japan--but their exports are concentrated heavily in the high tech electronic area where demand has fallen most sharply. The decline in exports is much greater in Malaysia, Thailand, Taiwan, and so on than the average decline in imports into the United States.

Add to that the fact that some of the economies in East Asia have not fully implemented the reforms initiated after the 1997-98 crisis, and there is a possibility that these economies might be affected by a substantial drop in exports at the same time as the profitability of local enterprises is weakening, and the banking systems have not yet been restructured.

TIE: Was the financial crisis in Turkey discussed?

AC: Turkey's crisis was not a focal point of the discussions in part because it seems to be rather localized. Contagion from Turkey is not particularly evident elsewhere. We have obviously looked at the extent to which foreign banks in Germany and the Netherlands have the highest exposure to Turkey. But in no case is it a threatening exposure. The crisis has the potential to take a bite out of profits, but it won't affect the stability of any of the institutions. The lesson from Turkey for other countries, particularly those in East Asia--is that it remains very important to reform and strengthen the banking system.

TIE: Flow come the Forum has no Latin American member?

AC: I think it is important for the Forum's to have means of evolving all significant regions. Expanding the membership would achieve that, but at the cost of increasing the size of the Forum, and therefore reducing the informality and making it more difficult to discuss. I am not advocating that we should increase the size of the Forum by adding a significant number of new members. But what I think we can do is reach out to those who are not members of the Forum, and provide them with a satisfactory way of feeding in views. We have already had one regional FSF meeting last week. The participation in that was similar to that in the Forum, namely the heads of regulation, the central bank deputy governors, and the finance deputy ministers. It is a different way of including regions in the work of the Forum. It makes it possible for me to report to them what happened in the Forum and makes it possible for them to feed in their opinion.

TIE: What was your impression of the latest spring meeting in Washington?

AC: The meetings in Washington were very productive. The atmosphere was good and there was general agreement that medium term economic prospects were reasonably promising. Getting from here to there is obviously a tricky issue, but nobody is expecting a deep or prolonged slowdown. There was a good dialogue on IMF conditionality, with a number of points of agreement. The strategy of strengthening financial systems through developing and implementing standards and codes of best practice received wide support.

Andrew Crockett: A Profile

"His outstanding management performance [is] shown in the process of transforming the Bank for International Settlements (BIS) into "a bank of central banks" with a truly global scope." Thus read the opening of the official recognition for choosing Andrew D. Crockett as "European Banker of The Year 2000." This was the way "Group of Twenty + 1," an association of leading European journalists based at the seat of the European Central Bank honored the General Manager of the BIS, who also chairs the new Financial Stability Forum (FSF). "Among Andrew Crockett's important merits are the integration of central banks from emerging markets into the structure of BIS, his contribution to the improvement of the global financial architecture, and the re-alignment of the tasks of BIS in the light of a homogenous European Monetary Policy guided by the ECB."

With ECB President Wire Duisenberg giving the "laudatio," the official ceremony at Frankfurt's history-laden "Romer" on April 25, 2001, this could be taken as a symbol that the new European Central Bank and the old BIS are on rather friendly terms.

In recent years, this prize has been awarded to such eminent personalities of the international financial community as Michel Pebereau, Josef Tosovsky, Dr. Willem Frederick Duisenberg, and Marcel Ospel. Last year's winner was Godfried J.A. van der Lugt, former Chairman of ING Groep N.V. (Amsterdam).

Crockett, who started his career at the Bank of England before moving to the IMF, has indeed done an impressive job managing the oldest multilateral financial institution. The BIS history goes back to the 1930's, has a current membership of fifty central banks, and a balance sheet of around $150 billion.

As the chairman and driving force behind the FSF, Crockett has shown that improving supervision and strengthening the international financial architecture is very serious business. With the release of the Offshore List, the Forum shocked not only the world of offshore centers around the world but also some cosy European tax havens like Switzerland and Luxembourg.

The G24's View Of The FSF: A Forum For Creditors And Investors

There was an outcry from the world's tax havens after the Financial Stability Forum, on April 5, 2000, endorsed the report of its Working Group on Offshore Financial Centers (OFCs). Since grouping offshore financial centers, according their adherence to internationally accepted standards for supervision, cooperation, and information sharing, the Forum has drawn heavy criticism from the effected OFCs as was to be expected. Since the Forum's working group on highly leveraged institutions (HLIs) put forward its recommendations, the hedge funds are fighting back to preserve their freedom of regulation.

And as the recent "Commentary on the Financial Stability Forum's Report on the Working Group on Capital Flows" from the United Nations Conference on Trade and Development shows, there are strong objections from the developing and emerging countries against some of the Forum's recommendations. In the discussion paper series of the "Group of 24"--the IMF-World Bank grouping speaking for the development member countries--Andrew Cornford put big question marks behind the report. He says the report's "main weakness is its inadequate treatment of features of the behavior of international investors and lenders, as opposed to that of borrowers and other recipients of capital flows, as well as of rules in the countries where the former operate." This could be explained to a significant extent by the mandate of the Financial Stability Forum's Working Group on Capital Flows, "which had the effect of diverting its attention from global macroeconomic factors driving capital flows." This weakness may also reflect "a widespread assumption in lending and investing countries that the main flaws of the otherwise largely beneficial system of international capital movements which has come into existence since the 1960's are to be found in the weakness of recipient countries." In other words: Whatever happens to capital flows, if something goes wrong, the development and emerging countries are at fault.

Klaus C. Engelen is the international correspondent for Handelsblatt in Dusseldorf, Germany.