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For release on delivery
3 00 p m Tokyo time (2 00 a m
October 14, 1992

EDT)

INTERNATIONAL FINANCIAL INTEGRATION

Remarks by

Alan Greenspan
Chairman, Board of Governors of the Federal Reserve System

before the

Federation of Bankers Associations of Japan

October 14, 1992

It Is a pleasure to address the Federation of Bankers
Associations of Japan

The linkages among the banking and financial

sectors in the United States, In Japan, and in the world at large have
Increased substantially over the past decade and now can only be
described as Intense

The links between Japanese and U S

markets are particularly strong
significant operations in U S

financial

Japanese financial institutions conduct
markets, and Japan-based risk, largely

through interbank transactions, is by far the largest country exposure
for U S

banks
Developments in financial sectors around the world have been

dramatic over the past decade, and especially in the past few years

It

is a challenge for market participants and the financial authorities
alike to understand the factors underlying these changes, so that we can
each carry out our responsibilities in an efficient, sound, and
constructive manner
Market participants, on the one hand, and financial authorities,
on the other, have a shared interest in sound financial institutions and
well functioning financial markets through which monetary policy can help
to achieve price stability and maximum sustainable growth of economic
activity and income

Changes in market prices for financial assets,

along with appropriate and comprehensive data on changes in the assets
and liabilities of banks and other financial institutions, are an
important part of the information base upon which macroeconomic policy is
formulated
Public policy, and central bank policy in particular, perform
two crucial functions for private participants in financial markets
First, monetary and fiscal policies condition the macroeconomic

- 2 -

environment in which financial markets evolve and participants operate
Second, the financial authorities enforce and often establish the
specific rules that govern the activities of participants in financial
markets

I will discuss these two areas this afternoon, against the

background of the evolution of financial markets

Forces Behind Evolution of Financial Markets
The most important force underlying the evolution of banking and
finance in the world today is the rapid explosion of technology in the
areas of information processing and communication

Banking and finance

are information-intensive service industries, and are especially well
situated to exploit these technological advances
reduced dramatically

Unit costs have been

At the same time, banks and other financial

service companies offer a broader array of financial products, often
highly customized to the needs of specific clients

Unfortunately,

changes that are essential for the continued profitability that is needed
to attract and retain capital often require difficult and painful choices
for bank managers, particularly when they necessitate a cutback of
experienced personnel
For years, technological changes have been accelerating the
rapidity with which payments are made and securities transferred in the
United States and around the world

More and more countries are

installing, or increasing the effectiveness of, electronic large-value
transfer systems

Proposals are increasingly heard for cross-border

multicurrency payment and settlement systems

All of these developments

bind world financial markets ever more tightly and thereby increase the
need for central bank cooperation in these areas

- 3 -

In the United States we recognize the risk implications of these
developments and have considered how markets will think about the units
of time over which payments are due and made and what the effect will be
on the conduct of monetary policy

Let me first address the risk issue

In retrospect it appears that the transition from manual, paperbased systems to electronics may not have been managed by those
sufficiently sensitive to credit and risk exposures

In both the private

and the public sectors, low-cost, high-speed, highly efficient systems
were built that delivered what was requested

speed at low cost

Only

after the fact did we all become aware that the financial systems were at
risk with serious implications for world markets

In the United States,

we began to insist that private systems adopt finality rules, losssharing, collateralization, and other techniques designed to assure
settlement each day and--more importantly--to focus participants'
attention on counterparty risk

In the public sector, we began to

control our own risk exposures by real-time monitoring, by credit limits,
and--just this month--by adopting a pricing scheme to induce changes in
the behavior of participants in their use of Federal Reserve intraday
credit

_
In part through joint efforts at the Bank for International

Settlements, the other G-10 countries are also devoting substantial
efforts to controlling risk in both the private and public sectors

All

of us need continuously to be sensitive to this issue and to think
carefully about the implications of certain difficulties and the
development of contingency plans needed to address them
The spread of systems made possible by technology has already
affected how participants think of units of time

A generation or so

- 4 -

ago, one-day money meant just that--close-of-business to close-ofbusiness, or 24 hours

Now, most one-day credits are really overnight,

with the borrower receiving funds late one day and repaying it early the
next day

lenders want the funds to begin other payments during the day

that in a paper-based world simply could not occur that fast

The true

value of money is beginning to become evident in less than one day units
Market participants thus already think of overnight and during-the-day as
distinct components of a 24-hour period

Central bank and private sector

efforts to control risk, the wider and wider reach of electronic systems,
and the lack of synchronization of operating schedules in major world
centers all lead inevitably to viewing a "day" in much finer time
intervals
The U S

decision to price explicitly intraday credit simply

accelerates the inevitable development of an intraday market for funds
Around the world of the future, even 30-year contracts will specify the
time of the maturing day in which payment is to be made

The 24-hour

day, the intraday price of money, ever faster and better technology, and
accelerating efforts to control risk will, I believe, inevitably lead not
only to 24-hour trading and time-of-day maturities, but also to
simultaneous settlement of both legs of foreign exchange transactions
Movement in this direction may well be incremental as the gradual
expansion of central bank operating hours shrinks the time interval
between final settlement of the two legs, but simultaneous settlement
seems inevitable once 24-hour trading produces round-the-clock liquidity
in money markets

In the United States, we have just proposed opening

our funds transfer service 2 hours earlier, a first step toward what I
suspect eventually will be 24-hour, or nearly 24-hour, operations

- 5 -

These changes will affect the way we conduct monetary policy
With intraday credit costless and its supply subject to very little
constraint, the overnight interest rate has been virtually the same as
the 24-hour rate because the intraday rate was zero

But as intraday

money becomes explicitly of value, the 24-hour rate will have at least
two components

the overnight and the daylight rates

We central bankers

thus must be cautious, as intraday interest rates develop, that we do not
inadvertently disrupt financial markets by thinking that the same
overnight rate will provide the same indication of market conditions that
we had grown used to when intraday money was free

And, inevitably, we

will discover that this change, too, has other implications that we had
not perceived, but to which policy must nevertheless adjust
Increased integration of banking and financial markets, both
within countries and across international boundaries, has been an
important result of the explosion of information-based technology
Within countries, direct borrowing in capital markets has become an
increasingly close substitute for bank credit

Information has become

available to a wider array of potential investors at low cost

As a

consequence, the information advantage once enjoyed by banks has been
reduced

This development is an important factor in the increasing

proportion of credit demands met outside the banking sector

But, in

addition, it has facilitated the ability of banks to originate and sell
the high quality loans they make--that is, to securitize a portion of
their credit portfolio
Internationally, financial market Integration has proceeded
apace with domestic integration for many of the same reasons

Over the

decade 1982-1991, world trade, measured in current dollars, increased by

- 6-

about 80 percent

The stock of cross-border assets held by banks at the

end of 1991, measured in current dollars and adjusted for changes in
reporting coverage, was about 3-1/2 times as large as at the end of 1981
Data showing the rapid growth of cross-border banking alone
understate the true extent of international financial integration because
they refer only to the growth of assets reported on banks' balance
sheets

They do not include cross-border financial services provided by

nonbank intermediaries

Annual issuance of international securities was

9 times as great in 1991 as a decade earlier

Moreover, these data

covering the decade 1982-1991 do not include the more recent growth in
various cross-border off-balance-sheet instruments, such interest-rate
and currency swaps and options or standby letters of credit

A recent

survey by the Federal Reserve Bank of New York indicated that foreign
exchange turnover in the New York market tripled between 1986 and 1992
In the area of off-balance-sheet business, data published by the BIS
indicate that in the three-year period from December 1988 to December
1991 the notional principal of currency and interest-rate swaps
approximately quadrupled

While the notional value of such instruments

can be misleading for most purposes, it does convey a meaningful sense of
the growth of this activity
Such rapid growth in cross-border banking, however measured,
should not be surprising given the extent to which low-cost information
processing and communications technology have improved the ability of
customers in one part of the world to avail themselves of borrowing,
depositing, or risk management opportunities offered anywhere in the
world on a real time basis

- 7 -

These developments enhance the process whereby an excess of
saving over investment in one country will find an appropriate outlet in
another

In short, they facilitate the drive to equate the rate of

return on all investments worldwide

They thereby provide an improvement

in the worldwide allocation of scarce capital, and, in the process,
engender a huge increase in arbitrage activities

Moreover, as

technology continues to downsize the products we produce, thereby
lowering transportation costs, growth in the cross-border volume of trade
in goods will surely continue to outstrip growth in real world GDP
Trade in services will doubtless increase even more

The financing of

expanding cross-border merchandise trade and the rapid development of
accompanying arbitrage and risk dispersion suggest a far larger world
financial system than currently exists

If we can resist protectionist

pressures in our societies, we can look forward to the benefits of the
international division of labor on a much larger scale in the 21st
century

Macroeconomic Environment
But those benefits will require the maintenance of a stable
macroeconomic environment

An environment conducive to stable prices and

to maintaining sustainable economic growth is a central responsibility
of monetary authorities

How well we do our job has implications for

participants in financial markets because we provide the backdrop against
which individual market participants make their decisions

Perhaps the

most important development that has occurred in recent years has been the
shift from an environment of inflationary expectations built into both

- 8 -

business planning and financial contracts toward an environment of lower
inflation

It is important that that progress continue
Few question either the overall benefits for economic growth and

stability of the dramatic slowdown in the rate of price inflation on a
worldwide basis, or the need to maintain a credible long-run commitment
to price stability

However, the decline in inflation has been

associated with substantial declines in the prices of some real assets
with consequent implications for financial institutions

Bankers on both

sides of the Pacific, or anywhere in the world for that matter, do not
need to be reminded of problems associated with making loans for highly
leveraged commercial or residential real estate on the expectation that
continuously rising asset prices would reduce the leverage and improve
the security of these loans over time
These transitional problems underscore not only the need for
financial institutions to guard against the chance that unforeseen
developments may adversely affect their balance sheets but also the
importance of maintaining price stability

Price stability contributes

to financial stability and is the most important contribution that
central bankers can make to the general welfare

Price stability is a

condition in which households and businesses do not base their decisions
on expectations of continued price inflation

While this does not imply

literal stability in our measured price indexes, it does require low
measured inflation

Indeed, with the likelihood that most of the broader

price indexes in the industrial world fail to capture fully increases in
quality, the true underlying rate of inflation in today's world may not
be far from what I would call price stability

- 9 -

In the context of rapid changes affecting financial markets,
disruptions are inevitable

The economic consequences of these

disruptions will be minimized if they are not further compounded by
financial instability associated with fluctuations in underlying
inflation trends

Thus, as international financial markets continue to

expand, monetary authorities have twin objectives

achieving macro-

economic stability and maintaining safe and sound financial institutions
that can take advantage of stability while exploiting the inevitable new
technological advances

Regulatory and Supervisory Policies
The evolutionary changes I have broadly described have important
implications also for the regulation and supervision of banks

Consider,

for example, limits on interest rates that banks are permitted to pay on
deposits
It is interesting to note that the original purpose of deposit
rate ceilings in the United States was to improve bank profits by
protecting banks from paying high rates of interest for funds

In later

years small differentials in deposit rate ceilings for thrifts were
designed to expand loans to the housing sector

While this price

protection apparently served its intended purpose for a number of years,
over the long run the market-induced development of high yield
substitutes for bank deposits meant that bank profits overall suffered
more from the reduction In the quantity of their business

Nonmarket

interest rates for thrifts did not guarantee a continuous flow of funds
to the housing sector, but rather resulted In recurring liquidity
problems

Banks in the United States, particularly the largest banks,

- 10 -

sought to bypass these deposit rate ceilings by developing alternative
sources of funding, often from foreign sources, and large U S

banks came

to support deposit rate deregulation
The Japanese experience, as I understand it, has shown some
similarities to the U S

experience

At first, limits on deposit

interest rates in Japan provided a subsidy that was shared between banks
and their borrowers

Over time this system of constrained interest rates

resulted in an excess demand for funds from banks in Japan and a
migration of Japanese banking business to other centers, including the
United States, where the pricing environment had become less regulated
The progress toward deregulated interest rates in Japan, including
increased use of market-based lending rates, should remove the incentive
for Japanese banks to book business offshore and is likely to reduce the
reported size of Japanese banks in offshore markets

Market-determined

interest rates in Japan will also improve the efficiency of the Japanese
financial system in responding to price signals in the allocation of
capital
Financial markets are characterized by both a high degree of
integration of institutions and ease of substitutability of products
They differ considerably in this respect from other regulated markets,
such as public utilities, transportation, and communications, where price
distortions can persist because the products offered are less easily
substituted for each other

Firms active in these markets often have an

interest in maintaining the regulated price structure, the same is not
usually true for financial markets
My reading of the evolution of financial markets going back to
the 1960s is that any country that wishes to have a major international

- 11 -

financial center simply cannot impose restraints on international
transactions through taxation or the equivalent

Sophisticated

depositors and borrowers will avoid these costs by shifting their
business to other, untaxed centers

The development of London as a major

international banking center since the 1960s was largely driven by
successful attempts of American and other banks to avoid the costs and
restraints of doing a dollar-based international banking business in the
United States
In response to this competitive situation, in 1981 the Federal
Reserve took steps to improve the competitiveness of the United States as
an international financial center by amending our banking regulations to
permit banks to establish International Banking Facilities (IBFs)

These

facilities were able to conduct business with foreign residents without
being subject to various costly restraints such as reserve requirements
Japan followed suit by adopting regulations establishing the Japan
Offshore Market in 1986
The 1980s have taken this process one step further

The

experience of the 1980s appears to be that banking has become an
Integrated and footloose industry, where the locations at which
transactions are booked are becoming increasing less relevant

Any

country imposing taxes or other restraints on competitive market pricing
for domestic banking services will find that some of its own residents
have the option of shifting their banking business to a convenient
offshore center

Perfunctory duplicate records may actually be kept at

facilities in offshore centers to maintain the fiction that offshore
transactions have really taken place, but in reality the business

- 12 -

relationship between the bank and its customer often occurs in the home
country
The use of banking facilities in offshore centers in the
Caribbean and elsewhere by U S

residents and residents of other

developed countries has proliferated in recent years

While our data on

this activity are very far from ideal, data published by the Bank for
International Settlements indicate that banking assets and liabilities in
these centers at the end of 1991 were on the order of $1 5 trillion, of
which something approaching $600 billion may represent claims on nonbank
customers and about $300 billion may be liabilities to nonbank
depositors
The growth of banking in offshore centers suggests that banking
is a very mobile industry and that banks and their customers will find
perfectly legal ways to avoid the costs of certain kinds of regulations
by shifting the booking of their transactions, where such booking shifts
need not result In any change in the particular bank with whom they are
dealing
The migration of banking to offshore centers In response to
monetary policy measures is a serious concern

An Important Issue for

the Federal Reserve is that the statistical coverage of banking assets
and liabilities of U S

residents, which is an essential input into the

policy process, is compromised as both credits and deposits that formerly
were booked in the United States are now recorded offshore

To remedy

this problem, we have announced our intention to Improve statistics in

- 13 -

this area, which should improve our information base for policymaking and
the information base available to private market participants
Regulatory policies designed to achieve prudential objectives
also have significant effects on banking and financial markets,
domestically and internationally

The safety and soundness of the

financial system has always been a paramount concern of financial
authorities in all countries

Against the background of the global

integration of financial markets, a significant enhancement of
prudential policy is in agreement on the need for one supervisory body to
accept responsibility for the worldwide consolidated activities of a
banking institution whose head office is domiciled in its country
Supervisors in the host country of an overseas branch or subsidiary of
the foreign parent have a shared responsibility to supervise compliance
with host country regulations

This position of joint supervisory

responsibility was set forth originally in the Concordat distributed in
1974 by the Basle Supervisors Committee, a fuller appreciation of its
implications has evolved over time, and this past spring the Committee
agreed upon minimum standards for the supervision of international
banking groups and their cross-border establishments that incorporate
this concept
In addition to agreeing to the importance of assigning
international responsibility for supervision of individual institutions,
the countries represented on the Basle Supervisors Committee have
implemented an accord on capital standards for their internationally
active banks, and some other countries have voluntarily agreed to comply
with these standards

The capital accord establishes standards for

measuring capital and for weighting the credit risk associated with

- 14 -

various assets, including off-balance-sheet assets

It thereby

established minimum capital ratios for operating in international markets
that will help to level the playing field for banks domiciled in
different countries
The capital agreements reached so far go a long way toward
improving the level and international consistency of the overall capital
base of internationally active banks, although improvements can still be
made

For example, work is in progress to incorporate risks other than

credit risk in the capital standards

At the same time, we all recognize

that capital alone is not a sufficient measure of an institution's
financial strength

Supervisors must assess the total financial

resources of an institution, its risk management procedures and controls,
and both the credit and noncredit risks inherent in its assets and
liabilities

While this is primarily a task for national supervisors,

looking at their institutions on a global consolidated basis, supervisory
authorities in other countries have a responsibility to ensure that banks
operating in their countries are subject to consolidated home-country
supervision and comply with host-country regulations

In the United

States, the Foreign Bank Supervision Enhancement Act, passed last
December, requires that foreign banks, as a condition of entry, satisfy
this standard
Prudential standards, such as capital requirements, may seem
costly to some market participants that, as a consequence, need to raise
capital at an inconvenient time

However, over the long run they improve

the public's confidence and willingness to place funds with these
institutions

Indeed, research at the Federal Reserve has indicated that

well-capitalized banks can enjoy funding advantages that In some cases

- 15 -

outweigh the costs of holding additional capital

Prudential supervision

of banks on a worldwide basis should not have any impact on the location
at which banking transactions are carried out

Over the long run sound

prudential supervision, if carried out in an efficient and low-cost
manner, may actually improve the competitiveness of supervised
institutions by improving the confidence of depositors and other
counterparties
As I noted earlier, advances in computational technology have
permitted banks to offer their customers a much wider menu of
instruments, including importantly derivative and other off-balance sheet
instruments

Banks and their customers alike can manage and hedge

various market risks more completely and more efficiently than they could
in the absence of such instruments
While new technologies have the potential to unlock efficiencies
in financial contracting, they also carry with them risks that need to be
understood clearly

For example, understanding the risks, both credit

and market risks, of any single off-balance-sheet contract may appear
relatively straightforward

However, understanding the aggregate set of

risks in a wide assortment of nonstandardized contracts is an enormously
complex undertaking

Moreover, reliance on advanced technology in the

design and monitoring of these contracts cannot be counted on completely
to replace informed analytic judgments
For example, risk management strategies involve assumptions
about potential future changes in interest rates, exchange rates,
commodity prices or equity prices over the remaining life of the
contracts

These assumptions typically are formed on the basis of

historical experience

If history turns out to be a poor guide to the

- 16 -

future, that is, if events in the real world fall outside the
judgmentally forecasted range, then the risk management efforts might
prove to be unsuccessful

History cannot be reduced to a set of

statistics and probabilities, it is important that the judgment of
experience be brought to the underlying assumptions

Senior management

of financial institutions and their supervisors must have a good
understanding of the nature of these complex instruments and of the risks
they entail

That is not an easy task

We must all guard against a

situation in which the designers of financial strategies lack the
experience to evaluate the attendant risks and their experienced senior
managers are too embarrassed to admit they do not understand the new
strategies
A further complication is that a significant number of
participants in the market for financial derivatives are unregulated
nonbank financial institutions, and increasingly even nonfinancial
institutions

A failure by one of these institutions to perform on its

contractual obligations could impose serious losses on customers and
could result in serious systemic problems
In addition to monetary policy and supervisory policies, basic
law affects the structure of the financial services industry

In the

United States, we continue to have a debate over the geographical
location at which domestically chartered banks can operate full service
branches

The Federal Reserve believes that full interstate branching

would reduce costs and improve efficiency of banking in the United
States
Another statutory limitation imposed on the U S

banking system

is the limit on the appropriate financial activities for companies with a

- 17 -

bank subsidiary, that is, the ability of the holding company to provide a
full range of financial services, including securities underwriting and
insurance

Differences in banking powers across international borders,

with some banks having wider powers to conduct activities, both in their
home markets and abroad, have an international component as well

Banks

with wider powers in their home market enjoy some competitive advantage,
although the extent of this advantage is very difficult to quantify
On a more practical level, differences in regulatory structure
across countries provide the Federal Reserve with a continuous set of
difficult policy cases

These involve applications by U.S. banks to

conduct activities abroad that are not permitted in the United States,
and in considering applications by foreign banks to conduct U S
activities without unnecessarily interfering with the extra-territorial
activities of the foreign bank

Some of the more highly publicized cases

involve de novo securities powers in the United States for banks
headquartered in countries without a Glass-Steagall type of restraint
Many other cases involve permitting a foreign bank to do a banking
business in the United States without requiring it to divest some
relatively small non-complying U S

business that itself may be an

important part of a business activity outside the United States
The Federal Reserve strongly supports broader activities for a
financial services holding company that would be able to offer customers
a wide array of financial services

The holding company structure would

be utilized to insulate that part of the institution that is protected by
the safety net of government support from risks in the nonbanking
activities

In addition, the holding company structure could be used to

assure that nonbanking activities in bank-related companies do not

- 18 -

receive an unintended subsidy vis-a-vis their competitors who are not
affiliated with banks

That type of structure would rationalize the U S

financial system by improving competition in various service areas, and
would improve the competitiveness of U S

banks on a worldwide basis

A final and perhaps more complex set of structural issues
involves the direct ownership by banks of equity in nonfinancial
companies

Historically, the United States has not experienced such

ownership links, while in Germany and Japan these shareholding
arrangements are quite common, although subject to certain limitations
The basic argument favoring these equity interests by banks is
that they improve the information flow between banks and corporate
borrowers and bring a closer sharing of business risks

Improved

information and closer risk-sharing should lead to an improved allocation
of resources

The basic argument against these equity investments is

that they foster concentration of economic power and that lenders will
favor established clients in whom they hold a vested equity interest at
the expense of seeking out new promising startup ventures
Banking systems are the product of their underlying cultures and
the business relationships these cultures have developed

At present I

see no evidence to suggest that one type of structure is inherently
better than another

Therefore, I see no compelling need to seek a one-

size-fits-all resolution to the issue of ownership interlocks for
competitive equity

Rather, each country can experiment with its own

system based on its own unique circumstances, concerns, and historic
legacy

- 19 -

Conclusion
I would like to be able to reassure you that the financial
authorities have learned their lessons well, that they will never again
allow macroeconomic instability to disrupt financial markets, and that
international cooperation in the supervision of financial markets is well
advanced

Such statements undoubtedly would be both overly optimistic

and premature

However, I can say with confidence that we appreciate

that financial markets, and economies in general, are closely linked

We

have a shared responsibility internationally and with the private sector
to act to strengthen financial markets to provide the foundation of
stability that is essential to the efficient allocation of resources and
maximum global growth