(Archived Content)
FROM THE OFFICE OF PUBLIC AFFAIRS
JS-73
Over the last twenty-five years, traded capital markets have provided the principal means for deepening international capital flows. These flows have contributed to rising standards of living around the world. For some countries, however, these flows have become volatile and disruptive. What can be done to promote the continued growth of international capital flows while reducing the propensity for disruption?
One prerequisite is for individual countries to pursue macro-economic policies that promote sustainable economic growth. Here in the United States, we are doing our part. The Presidents Growth and Jobs Plan promotes balanced growth of consumption and investment. Eliminating the distorting influence of the double taxation of corporate dividends will increase the efficiency of investment, thereby promoting formation of capital, businesses, and jobs.
To sustain capital flows and reduce their volatility we also need to improve the rules of the road for sovereign lending. My colleague, Treasury Under Secretary John Taylor, has been pressing the agenda on sovereign debt work-outs for two years. Now, with the real leadership of the Mexican Ministry of Finance we are seeing tangible progress.
But to sustain the continued growth of global capital flows we cannot rely upon government action alone. International bankers, in particular, must work to improve the rules of the road for sovereign and private capital-raising so that our traded markets can continue to prosper.
Capital markets are extremely efficient at pricing and allocating resources on the basis of available information. Unfortunately, the important information is too often not available.
When important information is absent, or where great disparities exist in the quality of information available to different market participants, the power of markets is misdirected, the allocation of resources is skewed, and the stage set for future volatility.
Without fundamental improvements in disclosure practices by you intermediaries and all issuers of debt and equity instruments I am not optimistic that we will sustain the growth of international capital flows.
As I look back over the last decade, I see a series of capital market disturbances that were at root credit events. Each involved inadequate disclosure of off-balance sheet leverage and insufficient attention to the cash flows needed to sustain that elevated leverage.
In 1994, in the wake of the bond market sell off and Orange County, the hue and cry was about derivatives. Looking back, perhaps it is now easier to recognize the combination of inadequate disclosure and off-balance sheet leverage.
In the Asian crisis of 1997, whole countries were criticized for the purported failure of their economic model. Was it really that? Or were we observing the consequence of heavy off-balance sheet leverage, combined with opaque disclosures, across entire banking systems?
Early in the summer of 1998, the worlds financial markets were abuzz with the question: who was the better credit, Russia or Argentina? The conventional wisdom was that possessing missiles made for the better credit risk. Within weeks it turned out that credit risk wasnt about missiles, it was about cash flow.
Anxieties then focused, in 1998, on hedge funds. But it wasnt really about hedge funds themselves. The real issue was inadequate disclosure and excessive off-balance sheet leverage.
Over the last two years, we have all been engrossed by the accounting and corporate leadership scandals. But these episodes were not just about misguided or greedy individuals. In most of these scandals, I also see inadequate disclosure of high degrees of leverage achieved through the use of off-balance sheet devices. Even where off-balance sheet leverage was not involved, murky disclosures appear to have provided the mask for old-fashioned diversion and embezzlement.
Let me be clear: there are lots of legitimate purposes for the use of derivative instruments, structured finance and special purpose vehicles to transfer and pool risk. But hiding an issuers real, economic leverage from its shareholders, creditors and counterparties is not one of them.
Disclosure failures and the obscuring use of off-balance sheet leverage punctuate each of the major disturbances in our capital markets over the last nine years. Let me suggest that efforts to improve private sector disclosure practices are now over due and that this is a responsibility that you should shoulder at least, you should if you want international capital flows to continue to grow.
We need to explode the idea that the balance sheet remains a useful concept for measuring a firms true assets and liabilities. We need to move beyond the false dichotomy between the balance sheet and the off-balance sheet. Why do we continue, collectively, to pretend that we can make reasoned investment decisions about other firms without knowledge of their real, economic leverage?
For our capital markets to prosper, we need disclosures that will depict a measure of all the contractually-obligated liabilities, whether contingent or fixed, future or current. We also need a parallel measure of all the firms contractually obligated revenues. Tying them together will give the firms contractually-obligated net present value a real indicator of economic leverage.
Exposing the real, economic leverage is the only way that shareholders and creditors can judge true performance and distinguish sustainable revenues from financial engineering. We all know that leverage is easy; but that sustained cash flow is not.
For international capital flows to continue to grow, governments need to put in place sensible economic and financial policies that will promote economic growth and financial stability. But bankers need to do their job, too.
If our capital markets are to contribute to the next quarter century of prosperity, market participants like you need to be role models for the disclosures that are necessary for the efficient allocation of capital and credit.