Structural Changes in the Financial Markets: Economic and Policy Significance

Article excerpt

Over the recent weeks, we have gotten an eye-opening, though relatively brief, preview of how profound changes in the structure of world financial markets have magnified the potential for extreme market volatility that can reverberate across the global financial system. Today, I want to speak to you about those structural changes, the new financial risks they will almost certainly spawn, and how these serious financial risks should be contained. For it is undeniable that we have moved into a more hazardous environment in which new financial excesses are practically unavoidable. The reason is that certain defects are already deeply imbedded in the genes of our financial condition. These defects will contribute to progressively greater fluctuations in the prices of stocks, bonds, and currencies, to bouts of turbulence in the credit markets, and possibly to a plunge in financial asset values that will dwarf what we have experienced so far this year.

Indeed, from a longer perspective, the latest swings in bond and stock prices are likely to be merely a prologue to much greater volatility in the years ahead. This potential for financial trauma is a by-product of radical changes in the structure of financial institutions and markets that over time are leaving the system without an adequate institutional buffer and, therefore, more susceptible to sharp oscillations in the flows of investment and credit.

While new financial excesses cannot be totally prevented, proper action can mitigate their adverse consequences to some extent. To accomplish that, however, we must be willing to acknowledge the risks that lie ahead, to take them into account in the formulation of monetary policy, and to make some fundamental changes in the structure of official oversight and regulation of financial institutions and markets.

I suspect that to many it seems incongruous that market volatility has burst forth in a dramatic way at the very time when the financial positions of American households, corporations, and financial institutions themselves were on the mend. Financial rehabilitation in the United States has, in fact, proceeded at a very good pace. Debt burdens have been reduced sharply and capital positions have increased significantly for financial institutions and businesses.

But there is a dark side to financial rehabilitation. A sense of financial well-being--and the capacity of aspiring demanders of credit to tap into the resources of willing lenders and investors--is a necessary condition for incubating new financial excesses. Thus, it would be wrong to become complacent about what might follow as the economic expansion matures. Sooner or later, credit demands of businesses and households will begin to pick up momentum, and stronger financial institutions will be in a position to readily meet those demands. Monetary policy will switch, first, from accommodating to neutral as it has already started to do in the last few months and, eventually, toward overt restraint. Somewhere in this sequence of events, the structural changes in the financial markets will have a far more profound impact on securities values than the gyrations that occurred in recent months.

FUNDAMENTAL CHANGES IN FINANCIAL INSTITUTIONS AND MARKETS

I particularly want to call attention to three structural changes that keep the financial system vulnerable to excess.

First, in the United States, traditional lending and investing institutions are playing a diminishing role in determining the composition of investment and the response to market developments, whereas the household sector, mainly through the vehicle of the mutual fund, is playing an enormously expanded and still unfolding role.

Second, the global financial markets are undergoing what I would call the "Americanization of finance." This encompasses (1) increasing deregulation of markets and institutions, (2) rapidly increasing securitization, (3) much greater use of new financial instruments and trading techniques, especially incorporating financial derivatives, and (4) the growing presence in the markets of an expanding group of "high-octane" portfolio managers who are free to roam throughout the financial sphere, in and out of currencies, equities, bonds, commodities, and related derivative instruments with primarily a very near-term focus and no particular loyalty to any national marketplace. …