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THE ROY BRIDGE MEMORIAL LECTURE
BY
WILLIAM J. MCDONOUGH
PRESIDENT
FEDERAL RESERVE BANK OF NEW YORK
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GUILDHALL, LONDON
WEDNESDAY, APRIL 12, 1995


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Federal Reserve Bank of St. Louis

International Economic Cooperation

I am greatly honored to be here this evening to present the
annual Roy Bridge Memorial Lecture.

I am well aware of being the

first American public official to deliver this lecture and feel
it is pa~ticularly apt that you have given that honor to an
official of the Federal Reserve Bank of New York.

Roy Bridge's

American counterpart was Charles Coombs of the New York Fed, the
man who taught me a great deal about the workings of the
international economy and especially the foreign exchange markets
when he served as an adviser to the commercial bank at which I
worked.
Both Roy Bridge and Charlie Coombs were legendary experts on
foreign exchange matters and were closely involved in
international financial policy in the 1960s and '70s.

They

believed that it was international financial cooperation that
underpinned the functioning of the Bretton Woods System, which
they fought so valiantly to preserve.

The friendship between

Messrs. Bridge and Coombs reminded many of the extraordinary
friendship and cooperation between Montagu Norman and Benjamin
Strong, the first head of the New York Fed, and Norman's cocreator of central banking cooperation.

That is a legacy which

my good friend Eddie George and I try to keep alive today.
This evening I would like to share some thoughts on
international financial cooperation -- a subject that obviously
would have met with Roy Bridge's approval.

Like Roy Bridge, I

fully subscribe to the view that proper functioning of the


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2

international financial system requires close and on-going
cooperation among central bankers and market participants.

I

hope that my remarks will honor, however inadequately, Roy
Bridge's remarkable career at the Bank of England and his
contributions to the cause of international cooperation.
Discussions of international economic cooperation are
usually concerned with efforts of major countries to coordinate
their foreign exchange market intervention, or their monetary or
fiscal policies.

But economic cooperation is much broader in

scope than just the coordination of macroeconomic policy actions
by central banks and national governments.

I believe the focus

on macroeconomic issues alone leads to a considerable underappreciation of international cooperative efforts.
International economic cooperation, in the broader context,
involves both the public and private sectors and spans a wide
range of activities beyond the macroeconomic and financial arena.
These include agreements on trade policy, shipping and
navigation, public health standards and product safety.

In fact,

international agreements in the nonfinancial area deserve much of
the credit for the smooth flow of commerce that we now take for
granted.
Though I have that broad context in mind, it is not my
intention to offer a comprehensive picture of international
cooperation .

Instead, I will highlight some financial issues

that have been at the forefront of central bank cooperation in
recent years.


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Federal Reserve Bank of St. Louis

Specifically, I would like to focus on three broad

3

areas:

banking supervision and related issues concerning

financial markets; payment and settlement issues; and financial
policies aimed at dealing with international financial crises or
major financial sector problems.
First, let me be clear that, in my view, international
cooperation is not a coded phrase for central bankers and finance
ministers telling market participants what to do.

The evolution

and expansion of financial markets over the last thirty years has
moved too far for anyone to believe that central bankers alone
have the wisdom or power to absolutely control markets or
behavior.

Nor do I think that the private sector is always right

or that the greed of the most aggressive trader produces the best
results for society.

Rather, international cooperation is public

servants and market participants working together to make markets
function as best they can.
Indeed, financial markets are a highly cooperative form of
competition, and depend upon shared assumptions and expectations
of all participants about the rules of the game, and those rules
being followed.

Thus, international cooperation must begin with

the market participants themselves and perhaps best at the level
of each marketplace.
When I got into banking in 1967, foreign exchange markets
were relatively simple and not highly profitable because of the
rules of the Bretton Woods System.

Perhaps because of that

relative simplicity and absence of the boxcar-size profits known


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4

today,

informal cooperation among dealers, chief dealers and

their bosses was quite common.

If one of us saw something that

looked strange at another institution, we would make a quiet
phone call and suggest somebody look into it.

We assumed,

correctly, that the favor would be returned if the need arose.
To the degree that is not happening in the much fiercer
competitive environment in which you must live, I recommend it to
you.

It has merit if for no other reason than that a quiet phone

call from a friendly competitor is likely to have a less
unpleasant aftermath than one of those quiet phone calls from the
Bank of England or the considerably less subtle boot in the
backside from the New York Fed.
The same kind of courtesy can extend internationally.

Note

that I do not recommend this informal "community foreign exchange
market protection association" as a substitute for the internal
controls so necessary in each bank or for the appropriate
supervision by regulators, but as an additional protection for
all market participants from the rogue trader or the rogue group
within a market participant.

It is rare, indeed, that a number

of people do not say after one of these unfortunate incidents
that they saw something strange going on or were aware that such
and such a dealer was swinging much too big and too wide.
More formal cooperation in the private sector is
demonstrated by such efforts as the Group of Thirty study on
derivatives and the many fine works produced by the Foreign


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5

Exchange Committee in New York, a private sector group encouraged
and supported by the New York Fed.
Now let me turn to the central banks and our role.
It is clear that international cooperation on financial
issues of mutual concern to central banks has improved
significantly in recent years.

But, I believe that increasingly

greater internationalization of the financial marketplace
requires even stronger on-going cooperative efforts to reduce
potential systemic risk, and to deal with other major challenges
to the stability of the international financial system .

Indeed,

international cooperation on many financial matters is no longer
just a good thing, but an absolute necessity, not only to deal
with ad hoc financial problems or crises but also to ensure the
day-to-day functioning of the international financial and payment
systems.

The on-going financial innovations and internationa-

lization of financial activities have greatly increased the
degree of interdependence among national financial policies and
have exposed serious gaps in the supervisory apparatus.

They

also have put new pressures on payment and settlement systems.
Any systemic risk stemming from a major disruption in one market
is now essentially international in character and requires
cooperative remedies .
Given the extens i ve public discussions of banking
supervision and capital standards in recent years, you probably
will not be surprised to hear me say that international


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6

cooperation in bank oversight, at least among the G-10 countries,
has advanced significantly over the last decade.

Much of this

progress has occurred in the context of the Basle Committee on
Banking Supervision, which has acted as the key point of contact
to safeguard the stability of the financial system and to ensure
fair competition among banks across countries.
One of the most important, and perhaps the best known,
achievements in international cooperation on banking supervision
is the Capital Accord of 1988.

The Accord established minimum

capital standards and helped level the playing field for
internationally active banks.

While there were many forces at

work, the Accord stressed the importance of capital as the
bedrock of financial strength, and had the effect of generally
raising bank capital positions and making the banking system
safer.
Another major recent achievement in coordinating banking
supervision was the 1992 revision of the Basle Concordat to
incorporate "minimum standards" for the supervision of
international banking groups and their cross-border
establishments.

You will recall that the original 1975 Concordat

had delineated the roles of host and home country supervisors in
the aftermath of the failure of Herstatt Bank, and its subsequent
1983 revision established the principle of consolidated
supervision for all internationally active banks.


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7

Over the last few years, the Basle Committee on Banking
Supervision has been working to develop capital requirements for
market risks in banks' trading activities to complement the
original Capital Accord, which dealt exclusively with credit
risk.

The Committee's April 1993 draft proposals generated

extensive comments from market participants, with many of them
suggesting alternatives to the proposed approach based on banks'
own internal models for measuring risk in their trading
activities.

In response, the Committee has been exploring the

feasibility of an approach under which banks could be given the
choice between using the standard approach as the basis for
calculating the capital charge, or using their own model, which I
strongly prefer.

These proposals are being made public today and

I look forward to the comments of banks and other interested
parties to the changes the Basle Committee is putting forward.
The discussions on these issues reflect a basic tension that
has emerged in the efforts to promulgate capital standards:

the

desire to have easily understood rules that are not
mathematically complex competing with the desire for more
precise, if complex, standards.

It is likely that the credit and

market risk parts of the extended Capital Accord will end up with
different approaches.
Two other cooperative initiatives in the financial
supervision area are worth mentioning.

First, since January

1993, an informal tripartite working party of G-10 banking,


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8

securities and insurance supervisors has been working toward
achieving consistency in supervisory approaches to similar type
risks in banking and the so-called financial conglomerates
companies engaged in banking, insurance and securities, with
exclusive or predominant activities in at least two of those
financial sectors.

The tripartite group is developing a deeper

understanding of supervisory approaches in different sectors, and
has made progress in identifying the main issues about which all
supervisors are concerned.

But further work is needed to achieve

agreements on capital standards and other matters.
Second, supervisors of both banks and securities firms have
made good progress in developing a cooperative approach to
dealing with risks in derivatives.

Last July, the Basle

Committee on Banking Supervision and the Technical Committee of
the International Organization of Securities Commissions (IOSCO),
acted jointly, for the first time, in issuing risk management
guidelines for derivatives.

The two sets of guidelines are

consistent and are based on three basic principles:

appropriate

oversight by boards of directors and senior management, adequate
risk management, and comprehensive internal controls and audit
procedures.

I hope that such cooperation will strengthen and

expand over time to a broader range of issues.

For example, the

Basle Committee and IOSCO have been working constructively on a
framework for regulatory reporting and, I also expect the Basle


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Committee's market risk proposal to further stimulate the
Basle/IOSCO dialogue.
On other more general aspects of derivatives activities,
G-10 central banks, the Group of Thirty and the Institute for
International Finance, among others, have issued reports aimed at
achieving greater public disclosure of risks in derivatives and
enhanced market transparency.

I regard these areas as critical

for both risk management and banking supervision.

A striking

aspect of the markets in the last year has been the recurrent
dramatic problem situations at individual institutions,
accompanied by tremendous uncertainty as to the exact nature of
market forces at work and the size of overhang positions.

This

uncertainty created considerable potential for volatile and
disorderly markets.
In this environment, I see a strong and urgent need for bold
and ambitious disclosure standards.

While all of us recognize

that greater disclosure and market transparency will not
eliminate abuse or fraud, they will reduce the potential for such
problems.

Weak and inadequate information systems clearly add to

the difficulties of senior management and supervisors in
detecting fraud related to complex trading activities.
The observations and recommendations presented in the Fisher
Report, a discussion paper released last September by the G-10
central banks, provide a good foundation for enhancing public
disclosure of risks in trading of derivatives and other financial


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10

instruments.

With similar efforts underway in the private

sector, I think it is reasonable to expect significant progress
in this area over the near term.

The 1994 annual reports of

major U.S. banks -- many just out -- show that substantial
strides are being made.
Personally, I am convinced that our collective efforts over
the past years have prevented some incipient financial problems
from developing and have ameliorated others.

But I am also

concerned that as we have intensified our efforts on the official
side, perhaps particularly in banking regulation and supervision,
market participants run the risk of making the mistake of
accepting official minimum standards in place of their own best
judgments.

As financial markets have grown more complex,

regulators and supervisors are drawn into greater levels of
detail, and necessarily so.

But the increasingly-detailed

minimum standards we suggest, whether for capital, trading
practices, audit controls or disclosure, should not -- and really
cannot -- be a substitute for the optimum levels of capital, the
optimum trading practices, and the optimum financial disclosures
that market participants should expect of themselves.
In recent years, the rapid growth of cross-border financial
activity and the worldwide inter-relationship of payment and
settlement systems have heightened the importance of payment
issues for the safety and soundness of the international


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11

financial system.

In inter-connected markets, payment problems

in any market spread quickly around the world.
The G-10 central banks, largely working through the Basle
Committee on Payment and Settlement Systems, which I chair, have
focused on cooperative efforts to define and set out the benefits
and limits of netting and to promote safer payments arrangements.
In my view, the Lamfalussy report, released in November 1990, was
a particularly important step in central bank cooperation on
coping with the payment system risks.

The report developed

minimum standards for the operation of netting schemes, together
with a cooperative oversight arrangement for central banks as
they deal with netting arrangements.
Central banks and the private sector have devoted much
recent effort to defining and understanding Herstatt risk -- the
risk of settlement failure in foreign exchange caused by temporal
and finding ways of mitigating its severity, if not

gaps

eliminating it.

Herstatt risk, named after the German bank which

failed in 1974, is especially troublesome because it necessarily
goes beyond national borders and affects the financial system
globally.
While many important changes put in place since Herstatt
have helped reduce the settlement risk in foreign exchange
transactions, we are still far from eliminating Herstatt risk.
am encouraged, however, that efforts to deal with Herstatt risk
have moved ahead at a faster pace over the last two years or so.


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I

12

In particular, the Noel report, released in September 1993 by the
Committee on Payment and Settlement Systems, the work of the New
York Foreign Exchange Committee, summarized in a study issued
last October, and a recent report by the New York Clearing House
Association, have made very significant contributions to
understanding the issues involved in reducing or eliminating
Herstatt risk.
A steering committee of central bank payments experts,
working under the auspices of the Committee on Payment and
Settlement Systems, is taking a coordinated look at the
dimensions and sources of Herstatt risk, including a series of
interviews with financial market participants in many countries.
That work is not yet complete, but it should help identify
potential vulnerabilities in current arrangements and suggest
methods of dealing with them.

It is my hope that the recent

substantial private and public sector efforts dedicated to this
issue would lead to the elimination, or at least the nearelimination, of Herstatt risk.

After more than 20 years, that

goal is long overdue.
The reason to recount the number of recent reports is to
show the depth of the dialogue on the goals and means of dealing
with Herstatt risk.

While we have not yet solved Herstatt risk ,

the tacit agreement of the public and private sectors to debate
the issues at a high level with all interested parties and
publicly airing potential solutions, augurs well for the process.


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13

This encourages maximum participation and fullest disclosure of
new ideas and the delineation of risks.

It might not be the most

efficient way, but I believe it is the best way of turning the
dialogue into a lasting solution.
Most everyone would agree that the most important objective
of international cooperation in the context of financial problems
or crises is to avoid or contain systemic risk.

Since central

banks are the ultimate sources of liquidity, their involvement in
the cooperative process is critical to solving financial problems
and containing systemic threats.

In finding solutions to

financial problems, however, central banks are not, and should
not be, interested in providing protection against "normal" risks
in the financial system.

After all, risk taking is an inherent

part of banking and finance in market economies.
I also want to stress another general point:

international

financial crises or problems and their solutions usually involve
important macroeconomic policy dimensions.

This certainly has

been true for most of the major international financial problems
of the 1980s and the 1990s -- the LDC debt crisis of the early
1980s, the dollar misalignment that prompted the September 1985
Plaza agreement, the October 1987 stock market crash, the fall
1992 exchange rate crisis of the European Monetary System, and
the recent financial difficulties of Mexico.
The importance of macroeconomic forces in causing and
resolving financial crises has increased significantly in recent


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14

years.

The main reason is that greatly enhanced international

integration and increased competition have tightened linkages
between macroeconomic factors and financial markets.

Actual or

expected changes in monetary policy, for example, can cause
sudden shifts in market confidence and huge changes in financial
flows across borders, leading to dislocations in the countries
involved, and increasing potential risks to the entire financial ·
system and the world economy.

Effective solutions to financial

crises, therefore, require that we also address their
macroeconomic causes and consequences.
Central banks' role in resolving international financial
problems is crucial because they exercise joint responsibilities
for both macroeconomic stability and oversight of the financial
system, while, at the same time, they are the ultimate sources of
liquidity.

Thus, central banks are in a unique position to

balance conflicting short-run interests stemming from the
resolution of a crisis and the broader long-run consequences of
that resolution.

The position of the Federal Reserve in

cooperative efforts is all the more important because of the role
of the dollar in international finance.
Central bank cooperation has played a critical role in
containing systemic consequences of major international financial
crises over the years.

For example, when the LDC debt crisis

broke publicly in 1982, with a potential default by Mexico on
more than $50 billion debt to international commercial banks,


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15

central banks acted quickly to organize the provision of
immediate liquidity support, while a broader, permanent solution
was worked out.

The effort was led by the Federal Reserve, but

it would not have succeeded without the active cooperation of the
Bank of England and other central banks.

As Paul Volcker wrote

some years later, central bankers, under the leadership of Lord
Richardson and Fritz Leutwiler, then president of the BIS,
"instinctively understood what was at stake".
The inter-governmental and commercial bank cooperation to
deal with broader aspects of the LDC debt problem was much harder
to achieve and less effective.

As you know, it took more than a

decade and many debt rescheduling exercises and debt service
reduction operations to resolve the problems that followed the
debt crisis of the early 1980s.

Even here, however, central

bankers persevered with the necessary patience to encourage
continued engagement among negotiators and helped balance
long-term considerations of financial prudence and macroeconomic
goals.
Cooperation among central banks also worked effectively to
contain the consequences of the October 1987 abrupt drop in stock
prices in the U.S. and other countries.

Central banks acted

promptly to make liquidity available to financial markets,
without losing sight of prudential concerns.

During the crisis

period, the Federal Reserve and other major central banks were
engaged in nearly continuous consultations with one another,


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16

drawing upon knowledge obtained from contacts with commercial
banks and securities houses.
But October 1987 also spotlighted an element that has
greatly complicated international coordination in market crises
since then -- and that is the large flow of highly mobile
international capital.

The factors that motivate international

investors are often different from those of domestic financial
market participants, which changes the relationship between
financial and macroeconomic variables.

Large and persistent

inflows of international capital may make domestic financial
conditions appear more benign than warranted and may even lull
policymakers into believing there is more time than they really
have for macroeconomic adjustment.

But as we have seen more than

once, the speed at which international investors redirect their
capital has greatly shortened the timeframe in which global
solutions have to be identified and agreed upon.
The breakdown of the Exchange Rate Mechanism of the European
Monetary System in 1992 represented a particularly striking
example of a crisis that reflected a collision between
macroeconomic forces and the new highly integrated international
financial environment.

Given the requirement of a high degree of

macroeconomic convergence, financial markets could not endure for
long the inconsistency between the interlocked pegged exchange
rates and the wide disparities in performance across European
economies.


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Federal Reserve Bank of St. Louis

In reviewing this episode, I cannot help but notice

17

that the inflow of international capital contributed importantly
to the ability of EC members to sustain divergent policies,
thereby adding to the severity of the adjustment when it came.
The incongruence between macroeconomic forces and the new
international financial environment also is fundamental to
understanding the broader context of the recent Mexican financial
problems.

In 1992 and 1993, reflecting declining inflation and

on-going fundamental improvements in its economic and financial
structure, Mexico attracted huge amounts of portfolio capital
inflows and foreign direct investment.

But, at the same time,

Mexico was losing external competitiveness and its current
account deficit widened significantly.

In 1994, foreign

investors became increasingly less confident about the Mexican
economy as uncertainties caused by some noneconomic events -- the
Chiapas uprising, political assassinations and the August
election -- unfolded.

And, the Mexican authorities supported the

peso exchange rate and financed the large and increasing current
account deficit by short-term borrowing and drawing down their
reserves.
One interpretation of the Mexican crisis comes from looking
closely at the international reserve position of the Banco de
Mexico during 1994.

After each of the political shocks, the

market stabilized and international reserves held their new lower
levels and then began to increase slowly.

The authorities,

understandably in my view, thought that they should interpret


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18

these results as renewed external confidence in the country and
its policies.

Another interpretation, with the gift of

hindsight, is that we were looking at the last gasp of a long
bull market in Mexican financial assets.

As is almost always the

case with a long-in-the-tooth bull market, it turned with a
vengeance.

Money not only stopped flowing into Mexico, but moved

out rapidly and made it impossible to hold the exchange rate.
The result was a disorderly retreat and the severe readjustment
we have been seeing over the last few months.
From my perspective, the large financial support package for
Mexico arranged by the international community, under the
leadership of the U.S. reflected the seriousness of the
situation.

While it is important to the U.S. that Mexico succeed

in regaining financial market confidence and reestablishing
noninflationary growth and financial stability, the stakes for
the entire international community also are high.

The Mexican

situation has had the potential for considerable systemic harm to
the global financial system and the world economy.
The implications of the Mexican situation also need to be
considered in the wider context of the post-Cold War period in
which almost all nations have been trying to emulate free marketoriented approaches of the industrialized democracies.

Mexico

has been widely perceived as a model of economic transition from
a rigid state-directed economic system toward a free-market
system.


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A reversal of Mexico's reforms and a spread of its

19

financial problems to other emerging economies could halt, or
even reverse, the international trend toward free market-oriented
approaches.
The international context of recent financial difficulties
highlights the critical importance of maintaining sound domestic
economic and financial policies in today's global financial
environment.

By inducing capital inflows from abroad and

providing access to international markets, sound domestic
policies deliver significant additional benefits to an economy
through international channels.

But domestic policy mistakes

elicit quick and harsh punishment on an economy from
international sources, and also may reverberate around the globe
at a prodigious pace, requiring international solutions.
The increasingly global financial environment also raises
some broader fundamental issues about the process of financial
disruptions and crises in our free market-based financial system:
what are the critical forces in the development of international
financial problems? how can such problems be prevented? and what
types of mechanisms are needed to deal with them once they do
occur?

We in central banks have been thinking about these issues

for some time and recent events have provided an impetus to
accelerate that process.

In this respect,

I might mention that

G-7 finance ministers and central bank governors have agreed to
make progress on issues concerning more effective prevention and


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20

coordination mechanisms dealing with international financial
problems by the time of the G-7 Halifax meeting in June.
One general issue raised by the Mexican problem and fears of
other problems in the future is whether we need a more formal
international institutional structure.

My own view is that we

definitely do not need to create another institution or a new
bureaucracy.

But a positive and necessary step to take would be

to better delineate responsibilities for more intensive
monitoring and warning systems within existing structures.

We

need to understand the process of financial crises in the new
international environment with much greater clarity before we
seriously consider making any substantive changes in
institutional arrangements.
Another general issue that I would like to raise is whether,
in today's free market-oriented global financial system, we need
to find a mechanism that incorporates for sovereign nations the
principles and procedures of private sector debt workout,
features such as prioritization of claims and standstill
provisions.

Developing such a mechanism is important if we wish

to facilitate early resolution of these problems -- always key in
workout situations -- and give the private sector a larger role.
I am optimistic and hopeful that our need for such mechanisms
will be rare, and that an episode such as the Mexican situation
will lead to a self-correcting mechanism by sensitizing other


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•
21

countries to avoid overdependence on large inflows of portfolio
capital.
In . closing, I want to emphasize that international
cooperation ultimately depends on mutual confidence and trust,
and good working relationships among people involved in decisionmaking.

These intangibles are particularly important in times of

stress when decisions must be made quickly with little time for
the deliberative process.

Central bankers have a long tradition

of close contacts and working well with each other.

The BIS

monthly meetings in Basle, for example, provide an opportunity
for central bankers not only to exchange views on current
developments and policies but also to get to know each other on a
personal level.

Over the years, mutual understanding based on

these contacts has proven vital in dealing with problem
situations.
And yet all the contacts among central bankers will
accomplish little if you, the people who are in the markets every
day trying to do the best you can for your customers and
maximizing profits for your institutions, do not keep ever
present your own collective interest in and responsibility for
the safety and soundness of financial markets.

As somebody who

was a commercial banker for twenty-two years, with responsibility
for foreign exchange operations for that entire period, and a
central banker for just over three years, I could not be more
convinced that you and we are in this together.


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The world in

•
•

22

which we live is not only a saner one, but over time a much more
consistently profitable one for you, if central bankers and
market practitioners work together to make these complicated,
difficult and yet intellectually fascinating markets both safe
and sound.
Thank you for giving me the honor to present this year's Roy
Bridge Memorial Lecture.


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