The provision of financial services has steadily undergone a process of change driven by innovation. Still, close observers of the marketplace agree that financial innovation accelerated greatly in the 1980s in three essential areas: (1) markets, (2) products and services, and (3) the technology to produce them. In discussing the causes of this burst of innovation, we will see that it was propelled by essentially macroeconomic forces, all having to do with the increased volatility of exchange rates, the acceleration of inflation, and the current account imbalance that appeared in the 1970s. These forces shifted in pattern and were sustained throughout the 1980s. The nature and degree of change in the last decade has transformed the functioning of the financial structure so greatly that a number of fundamental public policy issues, such as the functioning of monetary policy and construction of safety nets, now need to be rethought. Because this process is of great importance to central bankers, it is useful to consider its concrete manifestations. This paper will discuss these manifestations first in the area of capital market instruments, then in the area of derivative instruments, and finally in the effect of technology on market players. My conclusion will consider regulation and market discipline.

The provision of financial services has steadily undergone a process of change driven by innovation. Still, close observers of the marketplace agree that financial innovation accelerated greatly in the 1980s in three essential areas: (1) markets, (2) products and services, and (3) the technology to produce them. In discussing the causes of this burst of innovation, we will see that it was propelled by essentially macroeconomic forces, all having to do with the increased volatility of exchange rates, the acceleration of inflation, and the current account imbalance that appeared in the 1970s. These forces shifted in pattern and were sustained throughout the 1980s. The nature and degree of change in the last decade has transformed the functioning of the financial structure so greatly that a number of fundamental public policy issues, such as the functioning of monetary policy and construction of safety nets, now need to be rethought. Because this process is of great importance to central bankers, it is useful to consider its concrete manifestations. This paper will discuss these manifestations first in the area of capital market instruments, then in the area of derivative instruments, and finally in the effect of technology on market players. My conclusion will consider regulation and market discipline.

Capital Market Instruments

The first and most important category is new capital market instruments. These are financial instruments that perform the same function that financial instruments have historically performed—they execute a transfer of a principal amount of cash in the borrowing-lending arrangement. In this first category of capital market instruments (borrowing and lending instruments), we have seen a proliferation of innovative products that are in some ways similar to and in some significant respects different from the bank loans, corporate bonds, and equity transactions traditionally offered by the financial sector for this purpose.

Debt Product Innovation

The parade of innovation was led off by the syndicated credit, developed in the mid-1970s in connection with the aftereffects of the first oil crisis.1 The oil crisis had led to massive energy-related current account imbalances; a small group of energy-producing countries had accumulated large surpluses, while a large group of users of energy products had accumulated deficits. A borrowing-lending transaction was needed, but there was a collective judgment in the community of policymakers that they did not want to, or could not in the short term, dramatically alter entities to accommodate the necessary scale of financing.

The world presented the financial structure with a problem that could not be solved with its existing mechanisms, mainly the conventional bond markets. The borrowers were nations with particular sovereign risk characteristics, and the scale of lending that was needed far exceeded the capacities of single institutions. A mechanism was required that would allow a number of institutions with access to liquidity to combine in a single transaction. The result was a new instrument, the syndicated credit, designed to meet the specific risk characteristics required.

This was a period of accelerating inflation, in which bond holders—holders of fixed-rate assets—were suffering serious losses in the value of their portfolios and withdrawing from the market rather than placing new money. In fact, they were trying to get themselves out of fixed-rate assets. Banks in particular avoided fixed-rate lending. Everyone was concerned that inflation would continue to accelerate, making fixed-rate lending even more disastrous. For that reason, this new instrument contained an interest rate structure different from that of the conventional instrument of the time, which had a medium-term maturity (seven years or longer). The instruments were developed with floating-rate interest arrangements because the intermediaries that admitted the instruments to the banks had access only to floating-rate liabilities and could not afford to take the risk of borrowing at a floating rate and lending at a fixed rate in a period of rising rates. These factors necessitated a new instrument, and the market produced it.

The essential elements of the process are visible in that first episode. By the early to the mid-1980s, it had become clear that these types of innovations were proliferating. A whole string of borrowing and lending transactions with new attributes appeared. Assets became securitized, which means that the conventional bank loan, ordinarily not a negotiable instrument, was executed with a change in the associated legal indenture that made it a negotiable asset. Thus, it began to look more like a bond underwriting in its economic function but nevertheless remained an asset of a depository institution. Banks sought to securitize their assets because of the liquidity pressures that were a consequence of the events of the 1970s and early 1980s. The banks wanted the ability to sell their assets and redeploy their resources. Liquidity of the instrument was more important than ever before in the history of banking. In response, a means developed of taking an instrument that was not liquid and making it liquid: assets that had traditionally been held in commercial and savings bank portfolios were packaged into securities for resale in the secondary market.

On the liability side, many instruments appeared with essentially the same characteristic—for example, medium-term notes, perpetual floating rate notes, Eurocommercial paper—specifically, instruments designed to be used by borrowers looking for certain aspects of short-term risk characteristics but with a lengthened maturity.

“Non-Straight Debt”

In the latter half of the 1980s, we began to see yet more complex borrowing and lending instruments that may be called “non-straight debt.” This term plays off the market term “straight debt,” which basically refers to the straight bond, the traditional fixed-rate, medium-term corporate borrowing. “Non-straight” is everything else that has been invented: callable bonds, indexed bonds, warrant bonds, junk bonds.

Let me give you an example: the bull-bear bond, which is a type of indexed bond. Suppose that $200 million of these bonds is issued at a floating or fixed rate; it does not matter which. The principal amount at maturity is indexed to the price of something else, most commonly gold. Half of the $200 million is set up so that the amount returned on maturity is a direct function of the price of gold. A 10 percent rise in the price of gold produces a 10 percent higher return at maturity; a 10 percent fall means a 10 percent lower return. The return on the other $100 million is inversely related to the price of gold. If the price goes up, the principal is reduced by 10 percent, and vice versa. In other words, there is a bull portion and a bear portion. By selling equal amounts of both portions, there is no risk with respect to the principal, because however much one tranche goes up, the other goes down.

The rationale for this instrument is that buyers are willing to pay a slightly higher price for the non-straight issue than for a straight issue because the bull-bear feature allows them to speculate or to hedge another exposure. For example, a gold producer or an industrial enterprise that uses gold in production may want to hedge its price over a medium-term exposure and can do so with a bull-bear bond. The investor can select the tranche of such an asset and achieve a price hedge against another commodity. There are many such instruments, of different maturities and indexed against all sorts of things. All a market maker has to worry about is whether there are two sides to the market and whether someone needs the particular implied futures contract on the other commodity that is embedded in the instrument.

Equity Product Innovation

If we turn from the debt side to the equity side, we discover hardly any innovations. One temporary attempt was made to develop an international equities market. An international equities market is different from the entry of foreign investors into national equities markets. I define an international equities market as one in which the original underwriting is conducted internationally and assets are traded, either in the context of an exchange or not, in a true international sense. We have seen some equity linkages in conventional debt borrowings, in particular in the Euromarkets. For example, London underwriters of equity-linked bond transactions coming out of Japan—that is, dollar-denominated bond transactions with detachable or nondetachable equity warrants embedded in them—were quite successful. That was really a regulatory arbitrage and a product of the fact that it is expensive to raise new equity in Tokyo.

The closest thing to innovation with respect to equity is still in the category of debt borrowing. In fact, during the 1980s, in the United States, something on the order of $350 billion of outstanding net equity was retired, that is, was essentially replaced by debt, giving rise to what Paul Volcker, then chairman of the Federal Reserve System, called the “leveraging of America.” Not only was there a massive emission of new debt instruments, but there was actually a reduction in the amount of equity outstanding. From a central banker’s point of view, this is not the function of a financial market, and certainly not in a period of sustained economic growth. Rather, it is a historical anomaly, and nobody really understands its significance.

Derivative Instruments

The second category of innovation comprises what the market calls derivative instruments, or transactions that do not contain an exchange of principal amount. They are defined and priced in relationship to some other financial or real asset. Futures, forwards, swaps, and options are the four main forms. While forwards, notably foreign exchange forwards, and futures have been in the U.S. financial marketplace for some time, the 1980s saw a geographical proliferation of exchanges willing to trade such contracts. In addition, huge numbers of such contracts were invented, many of which failed. However, I will concentrate on swaps and options. The swap in particular has characteristics that differ radically from existing financial instruments.


Swaps are a huge market—the total outstanding amount of the swaps market, what is called notional principal amount, is in the range of half a trillion dollars globally.2 Yet surprisingly few people are familiar with it. Each swap individually is a simple and subtle transaction, one in which two counterparties agree to exchange streams of payments over time. This is because each party has lower-cost access to funds in a particular market than does his counterparty. Accordingly, each party can issue the original debt more cheaply than his counterparty can and then they swap their obligations.

The first major swap transaction took place between the World Bank and IBM in 1983, in connection with the simultaneous borrowings of those two institutions in dollars and Swiss francs.3 At the time the World Bank was lending in Swiss francs and wanted to borrow in Swiss francs, but it had basically exhausted its borrowing ability in that market and so faced rising costs. IBM was a dollar borrower that had never borrowed in Swiss francs, and did not anticipate a need for them because it had only very limited operations in Switzerland. Nevertheless, Salomon Brothers, the investment bank, called IBM and said, “We have a way to make your cost of funds cheaper. Do your next $100 million borrowing in Swiss francs.” Basically, IBM could borrow Swiss francs more cheaply than the World Bank could. In fact both institutions borrowed in currencies they did not want—the World Bank in dollars, IBM in Swiss francs. Each then converted the proceeds into currencies they did want. The World Bank converted dollars into Swiss francs, and IBM its Swiss francs into dollars. They did this simultaneously, underwritten by Salomon Brothers with no other legal or business connection. The two institutions then swapped their debt liabilities: IBM agreed to service the World Bank’s dollar debt, that is, to make the interest payments and supply an amount at maturity, in exchange for a commitment by the World Bank to pay IBM’s Swiss franc debt. Thus, each ended up with the currency it needed and with a debt obligation, but the debt obligation was at a lower interest rate than each could have obtained directly in the currency it actually needed.

Streams exchanged in this way can be anything against anything. All that must be agreed is the notional principal amount (the common amount against which the streams will be calculated) and the maturity. All other rates are market-determined, for example, the market rates on Swiss franc and dollar denominated bonds. The swap opens up the possibility that any institution may borrow in any geographic arena, in any instrument, and for any maturity, provided that there is a counterparty. Anything can be swapped against anything as long as there is a market for the underlying assets, because if there is a market, someone can hedge it. If someone can hedge it, someone can deal in it. Gold can be swapped against oil because there are futures markets in these commodities. Fixed rates can be swapped against floating rates in the same or different currencies.

The swap has immense implications for the financial world. It is probably the most powerful instrument yet invented, because of its ability to increase the speed and volume of transactions. It can bridge all kinds of market segmentations—legal, regulatory, and geographic. That kind of price arbitrage mechanism is a far more powerful tool in globalizing markets than, say, the portfolio manager’s technique of diversifying currencies.


Options are troublesome for central bankers, for lawyers, and for certain other financial players. They are most troublesome for people who do not know anything about them, including many of those who trade them. An option is a contract conveying the right, but not the obligation, to buy or sell a specified financial instrument at a fixed price before or at a specified future date. The distinguishing characteristic of an option relative to all other financial instruments is that it is asymmetrical with respect to benefits and risks. The buyer of an option gains the right, but is not obligated, to purchase an asset at a fixed price. For example, Ms. Smith has a three-month option on a stock priced at $30 a share today. If the market price rises to $35, she can choose to exercise the option, buy shares at $30, sell them for $35, and pocket $5 a share less the cost of the option itself. If, on the other hand, the market price falls to $25, she can choose not to exercise her $30 per share option. She has lost only the cost of the option. Thus the asymmetry: the buyer has the option to benefit from a movement in the asset price favorable to her and to avoid the consequence of a loss if it moves against her.

That asymmetry of benefit is matched by an asymmetry of risk. The seller, or “writer,” of the option faces the mirror image of that risk, which cannot be hedged by anything other than an exactly matching option. The way to hedge these things is by constantly adjusting a cash hedge in the actual market, and therein lies the rub. If the volatility of the market price for the underlying asset increases, the seller is whipped back and forth. The seller prices the option on some assumed volatility of the underlying price; if the volatility increases, loss is inevitable. If prices are more stable, however, the seller makes a lot of money. The buyer of this instrument is betting on the price of the underlying asset, while the seller is betting not on price but on volatility of price. In that sense the option is a different kind of financial asset: a volatility asset.

Options have been around for a long time. The first options that were traded were in the Japanese rice market in the 11th century. What was new in the 1980s was their proliferation, both geographically and across the range of instruments. Now there are options that are still unrecognized. In the United States, for example, a home mortgage that contains a legal provision entitling borrowers to repay the instrument at their discretion before maturity is a type of option. The problem in the U.S. thrift industry crisis was that a very large number of managers of thrift institutions did not understand that they were in the options business. And in today’s world, the options business is almost the only one they are in. It is the options risk in their portfolios that makes or breaks them, much more than the credit risk.

Consider what happened in the 1970s. U.S. thrift institutions sat with fixed-rate mortgages while their floating-rate liabilities and interest rates went through the roof. They went broke because the value of their assets fell through the floor. In the early 1980s, these institutions began issuing high-rate 15 percent mortgages. They believed that they could avoid making the same mistakes again. They borrowed funds at fixed rates that were a half point lower than the mortgage interest rates they were charging. Had they locked in profits for the next 30 years? No, because as interest rates fell, the mortgage payers exercised their options, repaying 15 percent mortgages and replacing them with 9 percent mortgages. The thrift institutions, however, still had their 14.5 percent liabilities, so they went broke again.

In fact, each time these institutions went broke, it was for a different reason. In large part, the problems of the 1980s were the result of a failure to recognize that prepayment risk had to be managed using the discipline of options portfolio management—the only way to manage such risk. If it is not managed in this way, an institution can lose money hand over fist. If it is managed properly—and many institutions did manage it correctly—the institutions survive.

This process is what economists call “unbundling.”4 Historically, the various forms of risk that appear in any financial transaction—credit risk, maturity risk, liquidity risk, price risk—have been permanently combined. The new process destroyed that bundle and replaced it with new and active transactors, including households. Now, at the corporate and portfolio manager level, each component of financial risk is treated separately. Not only did unbundling become possible in the 1980s; it became pervasive.

This change is an irreversible one that central bankers must think about. The essential force behind it is a macroeconomic story: the stresses that were imposed on everybody by accelerating inflation, inflation rate differentials between countries, and exchange rate volatility. Without the dramatically increased capacity of every kind of economic actor—corporate finance vice president and portfolio manager alike—to alter exposures far more radically and flexibly than in earlier decades, the level of bankruptcies and the risk of a downward economic spiral like that of the 1930s would have been far greater. For, while a substantial amount of risk was only transferred and still exists, without the new processes we would have been in much worse shape at the end of the 1980s than we actually were.

Effect of Technology on Market Players

Technology is an important factor. A swaps market could not exist without PCs and spread sheet software to provide cheap, flexible, generic processing power. Creating a swaps market requires the capacity to perform net present value calculations rapidly and flexibly. The options market requires slightly more expensive software, but there are now options packages for $500. Moreover, because the same few firms sell those packages to everybody, there are common reference points for pricing financial products.

The process of innovation, as mentioned above, accelerated in the 1980s for fundamental economic reasons, producing what Sam Cross called “the search for the quark,” that is, the search for the unbundled components of financial risk essential to creating markets and to pricing and trading those risks separately.5 It is going to be a permanent activity. The cost of developing the needed analytic and management tools has been paid, it is sunk; on the margin it is possible to produce more tools very cheaply. People today are not searching for the quark. They are what I call “alchemists”; they have available to them competitively priced, infinite supplies of whatever risk they want.

Everybody is a corporate finance specialist today. As recently as 15 years ago, an analyst who took in tradable assets produced for a client, either borrower or lender, a customized transaction that fit the client’s needs. The analyst earned his or her fees by figuring out the risks and hedging those exposures. Such transactions made up a relatively small, specialized part of the financial services industry. Now, because everyone has access to the same markets, anyone can do specialized transactions cheaply.

Thus, for instance, my Visa card says “National Wildlife Federation,” since my child wants to save the whales. Accordingly, a certain percentage of the earnings of my card are given to the National Wildlife Federation. Even in a retail service like credit cards, the process of innovation is taking place, with the result that the credit card business, like the swaps business and the options business, has become commodity-like. The servicing companies can process Visa cards for any organization. All that is needed is an additional tag on an account that says, “Take a piece of the profit out of that and give it to the National Wildlife Federation.” In terms of production technology, it is just another field in a relational data base. In this context what is produced in a very generic way is something that, from a marketing point of view, is highly specialized and differentiated. One can describe that process as alchemy. It is increasingly common throughout the financial structure.

Regulation and Market Discipline

From the point of view of financial structure and regulation, the bottom line of this process of innovation is that the world we created in the 1930s is obsolete in far more profound ways than most of us recognize. That world, built for safety and soundness but not for efficiency, was one in which financial markets were intentionally segmented, competition intentionally limited, profit margins more or less guaranteed, and a safety net created in almost all countries to protect depositors and also the buyers of assets from financial intermediaries.

The new process has destroyed that segmentation. It is difficult to know in today’s world what a bank is or does. Banks trade swaps as market makers in order to manage their maturity profile. The chairman of Bankers Trust may not care what his balance sheet looks like because the balance sheet is matched, or hedged. If his loan is fixed, his borrowing is fixed; if his loan is floating, his borrowing is floating; if he has loaned for seven years, he has borrowed for seven years; if he loans in dollars, he will borrow in dollars. There is no risk in his balance sheet. Even if he accurately predicts that interest rates are going to go down, by the time he shifts his portfolio to become a long lender and short borrower, the market movement has long since happened. So he does not even try. He simply goes into the swaps market and becomes a fixed receiver and a floating payer.

Today, bankers rarely hold a nonnegotiable asset. Everything on their balance sheets is negotiable. Are their organizations still banks? They look like “traditional” banks, but should they be supported by the safety net? What are the real risk profiles that they run? If they are subject to bank regulation, what kind of regulation should that be? Should their enter-prises have access to lender of last resort support? If bankers have these advantages, what about the mutual fund managers across the street, who have similar balance sheet profiles and risk exposure?

The other counterparty in a swap transaction is just as likely to be an insurance company as another bank. Insurance companies today are big traders in the swaps market because they have massive portfolios to manage. So the maturity gap risk that traditionally was a banking intermediation function is now done by both regulated and unregulated entities. For bank regulation, this means, at the least, that the scope for regulation is far narrower than it was in the more segmented world, in which regulatory costs could be imposed without destroying the industry. In today’s world, imposing regulatory costs can drive business to competing institutions that perform the same economic function but within a different institutional, regulatory, and legal structure. At the same time, competitive pressures are so intense that underregulation is likely to destroy the banking industry as financial institutions become increasingly competitive. Remember what Adam Smith predicted: if there are enough competitors in a market, they can drive profits down to zero.

Everyone agrees that market discipline is desirable, but the question is, how much discipline can be absorbed before the system of insuring that risk starts to break down. The potential exists for thrift industry disasters to occur in other countries, in other industries, or in other segments of the financial service industry. How we will deal with that potential remains to be seen.

With few exceptions, the industrial countries decided to alter their financial structures dramatically and move to something close to a universal banking system model. They plan to stop trying to segment these markets and to allow a blurring of the distinctions between institutions to a much greater degree. A wave of legislation mandating changes in the financial structures of the developed world has been implemented in the last several years—changes which the United States and Japan alone resisted with the result that they developed the most segmented financial structures of the industrial countries. It is easy for me as a market economist to conclude that this is an unsustainable phenomenon. Financial structure and regulatory convergence are driven by market forces, and resisting that trend will cost a great deal. Here we see the dilemma. The thrift industry in the United States went bankrupt in part because it failed to understand the technologies that the world imposed on it. Ironically, the regulatory safety net may destroy part of the financial sector by making its institutions uncompetitive with other institutions that can perform similar economic functions without the cost burden that the safety net adds.



The perspective that I wish to focus on today is not only the critical significance of financial innovation and financial growth, but also the potential risk for financial institutions in the marketplace if both are not well managed.1 We can no longer chant the old pioneer refrain, “We do not know where we’re going but we know we’re on the way.” One does not have to be a Schumpeter to know that a nation cannot improve its standard of living without innovation.2 The current U.S. focus on greater international competitiveness encourages innovation and supports institutionalizing it for the greater good. Our role at the U.S. Treasury is to facilitate financial innovation while fostering stability in our capital markets through the safe and sound operation of U.S. financial institutions. We also wish to reduce potential risk to the U.S. government, a risk which is borne by the taxpayers. This discussion comes after legislative efforts to address the thrift crisis and before our imminent consideration of the broader framework for the financial services industry.3

Let us first review specific examples of financial innovation (securitization, stock index futures, zero coupon bonds, high-yield bonds, off-balance-sheet activities) from a benefit-risk approach, then set out guiding principles for harnessing innovation.

Examples of Financial Innovation


Securitization was probably the most important new financial concept of the 1980s. It allows for greater interaction between the borrower and the investor by reducing the role of the intermediary, with interest rate and credit risk often passed on to the investor. This is especially helpful when the creditworthiness of the borrower is higher than that of the lending institution. In such a case, it becomes cheaper to raise funds directly in the securities market. Securitization also resulted in two noticeable benefits for financial institutions. First, it helped deregulate the asset side of their balance sheets to parallel the flexibility of pricing their liabilities. And second, it demonstrated the potential of assets—be they mortgages, auto loans, or even credit cards—for liquidity and marketability.

We do not eliminate risk by transferring it. An early Federal Reserve Chairman once said that the responsibility of the regulators is to take the punch bowl away when the party starts getting too merry. This is really what the U.S. Treasury Department must do: look at these instruments and decide where we have to put in some controls. The goal should be not merely to transfer risk to a party willing to accept it, but to apply managerial and financial resource capacity to deal with it properly.

Stock Index Futures

The Treasury Department is in the midst of the debate on how best to deal with excess market volatility that threatens to impair the efficient functioning of and confidence in our financial markets. Financial futures have been a positive step forward regarding price discovery and risk transfers. Nevertheless, the Treasury Department’s internal reviews of the 1987 and 1989 market breaks found that when stock index future sales are inordinately bunched into a short time frame, they can exacerbate price declines in the stock market. What in theory is designed to promote long-term stability carries with it the potential for encouraging short-term volatility, a potentially damaging side effect.

Accordingly, the Treasury Department has tried to approach stock index futures as one component of a single market of equity and equity derivative products. In this light, the existing regulatory fragmentation of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission must be replaced with a more unified structure. Similar rules need to apply across markets on certain issues, such as margins, enforcement, and clearance and settlement. This is why the U.S. Treasury Department is reviewing the legislation to shift responsibilities for stock index futures to the SEC.4

Zero Coupon Bonds

These allow investors (1) to match liability exposure better by allowing them to tailor maturities to their specific needs, and (2) to deal with reinvestment risk. These investor benefits can lead to reduced costs for borrowers.

The Treasury Department has sold zero coupon bonds privately on certain occasions to ensure repayment of the principal of 30-year and 40-year bonds used to fund the resolution of the thrift crisis ($13 billion face amount to date, with a $30 billion maximum) and to ensure payment of the principal of 20-year and 30-year bonds in two transactions with Mexico.5 The last item, a part of the Brady Plan,6 closed in 1990 with about $30 billion in face amount. Zero coupon bond issuance has been made more practical for the Treasury Department by a change in the U.S. debt limit treatment for the discount paper that the Treasury Department issues.7 Instead of being included at face amount, they will be accounted for at the original issue discount plus accrued interest. This applies to Treasury bills, saving bonds and, where the Treasury issues public zero coupon bonds, those zeroes. Of course, the Treasury would have to take into account that issuance; for example, 30-year zero coupon bonds with $10 billion of net receipts would result in a maturity amount for payoff or rollover of $100 billion, which is not an attractive prospect. Of course, zero coupon bonds are much riskier for investors than conventional bonds since they carry greater price risk (their market value fluctuates more with the change in interest) and credit risk (the cash payment is delayed until maturity). A few years ago, an example of even greater price risk involved stripped mortgage-backed securities that landed Merrill Lynch with a very substantial loss (estimated by some at $250 million for one trader alone).

High-Yield Bonds

These bonds, also called junk bonds, especially those with interest paid in a form of noncash, payment-in-kind securities, once rode high as a funding mechanism for corporate takeovers and leveraged buyouts. When the bottom fell out of the market, people began questioning their long-term viability. In observing market trends, we thought that the pendulum had swung too far and would eventually swing back—the market would be self-correcting. If the underlying credits are solid, the debt should be able to perform acceptably, albeit with greater scrutiny than before. Nevertheless, the Treasury Department agreed with Congress that investments in junk bonds were not a proper activity for thrift institutions backed by U.S. Government deposit insurance, and the thrift restructuring legislation embodied that concern.8 As the market continues to evaluate the future of high-yield finance, lenders and investors must consider whether the high-yield bonds were fairly priced at issuance for the risk involved and also whether true liquidity exists. If there is effectively no ready market, there may be no real basis for portfolio evaluation of these bonds.

Off-Balance-Sheet Activities

These are undertaken to produce a higher return on a given amount of capital, and the obvious risk is a smaller proportional buffer in the case of failure. Perhaps the most direct response is the international risk-based standard established for commercial banks known as the Basle Accord.9 It demonstrates several points of international agreement and may be used as a forerunner of agreement in several other areas. These are (1) the need for owners to have significant capital up front at risk, so that they absorb the losses first; (2) the need to account for off-balance-sheet activities that increase the financial risk of the entity; (3) the need to risk-weight all bank activities so that bank management can know in advance the amount of capital required to support those activities; and (4) the need to allow discretion to national regulators above the minimum capital levels established. The Basle Accord does not discourage innovation; instead, it promotes its development and application by structuring a framework in which it can responsibly thrive. The Treasury Department used the Basle Accord as a model for aspects of our restructuring of the thrift industry.10

Guidelines for Harnessing Innovation

The last area seems unusual but is critical today. It is the ability to circumvent market discipline and lay the ultimate responsibility for financial innovation risk at the door of the U.S. Government. In other words, when is private sector risk truly private sector risk? We found in the thrift industry that financial innovations such as multiple brokered deposits under $100,000 often relied largely on U.S. Government support, that is, management and shareholders took the upside, and the Government was left with the downside—a “heads I win, tails you lose” arrangement.

Accordingly, the Treasury Department prepared two studies that will help better elucidate the existing federal safety net and allow us to make recommendations for changes that we think are necessary. The first looks at government-sponsored enterprises and many of the risks they face.11 The second focuses on federal deposit insurance and will closely tie in to our development of the new financial services framework.12 Should government be concerned if the risk appears to reside only in the private sector? The difficulty is that, in extremis, financial institutions inevitably look to the government as the lender of last resort. This is what happened with Drexel and Continental Illinois, not to mention Chrysler and Lockheed. Some might even mention securities firms during the 1987 and 1989 stock market breaks, when liquidity was a major concern for them. Is there ultimately any nongovernmental entity that credibly wants to bear long-term credit risk? What is to be done?

As I said at the outset, our task at the Treasury Department is to encourage and accommodate the implementation of financial innovation without endangering the safety and soundness of our markets. This responsibility is more difficult in a global business world with increasingly complex financial needs and fluctuating international inflation, interest, and exchange rates. What are the guiding principles that we should use? I would suggest the following.

First, the financial rules of the road must be clear—be they laws, regulations, or internationally agreed upon risk-based capital standards. At the very least, these would cover required capital, allowed activities, and the nature and scope of regulation and supervision. The focus must be as much on the process of financial innovation as on the new instruments that result.

Second, there must be adequate supervision to ensure that the rules of the road are followed. A speed limit for highways becomes immeasurably more effective when troopers are visibly on patrol.

Third, there must be prompt and adequate enforcement efforts for those who break the rules. Any human endeavor involves a risk-reward calculus, and unless the penalty for illegal risk taking has the credibility of a sanction behind it, a propensity for self-enrichment will often win out. It may be true that the measure of a civilization is its degree of obedience to the unenforceable. The thrift crisis, however, has unfortunately taught us that a government cannot adopt a policy of pure laissez-faire when the rewards for illegal or reckless activity are so great and the risks for imprudent operation apparently minimal.

Fourth, there must be greater appreciation of risk and efforts to measure and monitor its effects. An example is mark-to-market accounting for securities. The general approach is that securities which are traded are marked to market, while those intended for investment are often priced on a balance sheet at cost. The difficulty is finding intent, which can change quickly when loss occurs in a portfolio. Currently, U.S. financial regulators are reviewing regulations to define more sharply the difference between trading and investment and to put an affirmative obligation on the board of directors to monitor their implementation.

Fifth, there must be a better understanding that the market is the best determinant of which innovations should thrive and prosper and which should fall by the wayside. The more government intrudes in market decision making, the less efficient markets will be.

Sixth, government at all levels should try, when it does legislate, to differentiate between encouraging responsible public policy objectives and encouraging risk taking that in the wrong hands can become reckless or worse. That is why safeguards need to be in place, such as investor capital requirements and regulator supervision. The thrift crisis has shown that safeguards are necessary.

Sharp minds will always create new financial instruments. The attendant risks, however, have grown so great that Washington in general, and its financial regulators in particular, must be vigilant that the capital markets are not imperiled.