FROM THE OFFICE OF PUBLIC AFFAIRS

DEPUTY SECRETARY OF THE TREASURY LAWRENCE H. SUMMERS
INSTITUTE FOR INTERNATIONAL ECONOMICS
WASHINGTON, DC

In just over a week, the G-7 Heads of State and Government, together with Russia’s President Yeltsin, will meet in Denver for the Summit of the Eight. There, the leaders will discuss an important array of challenges facing the global community in shaping arrangements to promote lasting peace, broaden prosperity and address global concerns.

The Denver economic agenda is part of a multi-year effort to work with other nations to build a global economic system ready for the 21st century --a system in which trade, investment, capital, information and know-how can flow freely to where they can be used most effectively in creating wealth. And a system in which all countries can participate. Growing integration of the global economy will also create the basis for sustained prosperity at home, by providing vast new opportunities for cutting-edge U.S. firms in the global marketplace.

A crucial aspect of building the global economic system is ensuring that international financial markets remain strong, stable and resilient. In Denver the Heads of State will endorse a set of important initiatives to strengthen financial stability. I would like to focus my remarks today on this part of the Summit agenda, but I would be happy to answer any questions you have following my remarks on the broader economic issues we face in Denver.

The Summit financial agenda is important because strong financial systems are critical to economic prosperity. One need only look back at history --to the Great Depression --to understand the havoc that widespread failures of financial institutions and collapse of markets can cause. More recently, people have literally died in the streets of Albania due to the failure of financial regulation. Over the course of this century, the United States has developed step-by-step the institutions and laws needed to effectively supervise the domestic monetary and banking system and to regulate securities markets, establishing the Federal Reserve System, deposit insurance, and the entire framework of securities and banking law now in place.

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We are now in the process of trying to replicate at a global level the types of safeguards against risk that have been so important to growth in the United States. The United States has taken a leadership role in the last several years through the G-7 and international fora of financial regulators on a range of initiatives to promote further international cooperation to reduce risks in global financial markets. The Denver Summit will mark an important step along this path.

Before describing these initiatives in some detail, let me try to place recent developments in the evolution of financial markets into perspective.

Growth of International Financial Markets

In the last 15 years we have seen truly breathtaking developments in the growth of international financial markets. Financial liberalization and integration, innovation in information and communication technologies, and the development of new financial products have combined to create a global financial market where cross-border capital flows exceed a trillion dollars a day. The speed of capital flows and transmission of price movements have increased dramatically as markets have become more integrated and complex. Products such as financial futures and options, and interest rate and currency swaps, have mushroomed in importance, creating tighter links across markets. Large financial firms from major financial markets operate on a global basis, and the distinctions between banks and securities firms have become blurred. It is clear now that we now have one global financial market, where investors, borrowers and financial firms from a growing range of countries are participating.

Some of the most dramatic developments have been in emerging economies. Consider the following:

· Last year over $250 billion in private capital, in the form of direct investment, portfolio flows and bank loans flowed to emerging markets, compared to $25 billion in 1986. It was not too long ago when official flows exceeded private flows to these economies.

· There has been a dramatic increase in the number of countries with access to international capital markets. Just in the last two years, 31 countries have tapped global financial markets for the first time, bringing the total number with access to 56. Across the emerging markets public enterprises, private companies, and even sub-national governments have been able to access global capital markets.

The dramatic growth and innovations in the international financial system growth have brought tremendous benefits to the global economy by increasing access to capital for businesses, speeding development in emerging economies, enabling investors to seek higher returns and greater diversification of risk, and allowing business and financial firms to better manage their balance sheets.

At the national level, financial sector development and integration promotes a virtuous circle of economic progress by creating the conditions for further economic reforms, increasing access to capital and improving the efficiency by which savings are mobilized and invested, which can lead to further capital market development.

The United States has been at the forefront of efforts to build a truly global capital market by supporting efforts aimed at liberalizing capital flows, developing domestic financial markets and promoting greater access by foreign financial firms to domestic markets. This is an integral part of our strategy to build a global economy and to spread prosperity.

However, this new financial environment is not without its risks. As Robert Merton has said, it’s a bit like the impact of the interstate highway system --people get places faster and new opportunities are created, but accidents can be much worse. This new financial environment poses some new challenges:

· The IMF reports that two-thirds of its member countries have had significant banking problems over the last fifteen years. The fiscal costs have claimed a significant share of domestic resources, ranging from about 3% of GDP for the S&L crisis in the U.S. to 30% of GDP for Chile in the 1980s.

· Mexico’s 1994 financial crisis reverberated throughout the international financial system.

· ARogue traders@ have brought a number of financial institutions to their knees.

The main concern of the monetary authority is systemic risk --the possibility that the failure of a major financial firm, or a disruption in one financial market or country, could have contagion effects on other firms and markets, with serious adverse economic consequences. This is important because the consequences of financial crises are not just economic, but can affect political stability and the conditions necessary for maintaining a democratic society.

Promoting Global Financial Stability: The G-7 Agenda

In response to these risks, the G-7 has undertaken a variety of initiatives to ensure that the international architecture --the IMF, the various cooperative fora of the major monetary authorities, and the international regulatory bodies --stays abreast of the frontier of developments in the major financial markets. President Clinton started this process with his proposal at the Naples Economic Summit in 1994 to undertake a broad set of reforms to help make the international financial architecture better able to meet new challenges in the world economy.

The financial part of this initiative has been directed, as Secretary Rubin has said, at making our institutional framework for dealing with systemic risks as modern as the markets. Just as war is too important to be left to the generals and economic policy is too important to be left to the economists, financial regulation is too important to be left only to the regulators. We want to ensure that the benefits of the global financial market are fully realized, while the risks are reduced.

Managing Sovereign Financial Crises

The first phase was directed at efforts to strengthen the international monetary system as a whole. The first series of proposals was intended to reduce the risk of and to better manage future sovereign financial crises. These initiatives included:

· Early warning and prevention of financial crises, through strengthened IMF surveillance procedures and adoption by the IMF of data disclosure standards for countries seeking to borrow in the global capital markets. It is hard to over-emphasize how important a factor transparency is in bringing problems to the light of day before they become serious. The development of the U.S. Generally Accepted Accounting Standards (GAAP) and the disclosure requirements in the securities laws were critically important to the development of U.S. securities markets. The IMF data disclosure standards are a significant step toward greater transparency.

· Enhancing international financing arrangements for crises, through the IMF’s emergency financing mechanism; and the agreement to establish the New Arrangements to Borrow (NAB), in which the G-10 and 13 non-G-10 countries plus Hong Kong agreed to expand the financial resources available to the IMF in financial crises.

· And new proposals for market-based responses to sovereign liquidity crises.

We managed the Mexico crisis successfully, but we did so in an ad hoc fashion. With the new proposals, we believe that the international community will be better able to help forestall a future sovereign financial crisis, and to manage the impact if one does occur.

Strengthening Financial Systems in Emerging Economies

The second phase of this effort was directed at the micro level, at strengthening prudential safeguards in the emerging markets and in the major financial centers.

In April a Working Party established following the Lyon Summit outlined a broad strategy for strengthening financial systems in emerging markets.

The major elements of the strategy include:

· A consensus on the key features of sound financial systems, reflected in sound principles and practices developed by international financial regulatory groups such as the Basle Committee and IOSCO through a consultative process.

· A concerted effort by the international financial institutions to assist countries in adopting these standards.

· Reliance on market discipline as an incentive for national supervisors and private firms to adopt sound supervisory practices and for firms to improve corporate governance and disclosure.

I think it is fair to say that observers have been surprised at the extent of progress that has been achieved over the last year --we’ve come further, faster than most would have imagined. We have embraced many of the elements of Morris Goldstein’s proposal for an International Banking Standard, and where we took a different approach we are convinced we made the right choice. In addressing complex international concerns of this type, you can’t get anywhere without first reaching a shared understanding on what should be done and who should do it. That we have accomplished. There is a danger in trying to seek agreement on standards at any cost, and we recognized that sometimes floors can become ceilings.

While strengthening financial systems will take longer in some countries than in others, we believe that the momentum generated by the efforts now underway will help tremendously in speeding progress toward that goal.

Strengthening International Cooperation in Financial Market Supervision

In addition to the focus on emerging markets, the G-7 also has tried to give new impetus to international cooperative efforts to strengthen prudential safeguards in the major financial centers. These initiatives, which will be endorsed at the Denver Summit, include:

· Steps to develop a global network that will enhance the ability of the regulatory community to supervise internationally active firms. These arrangements are intended to close gaps in the system, reduce opportunities for regulatory arbitrage, remove barriers to the exchange of information and facilitate effective responses in the event of emergencies.

· Progress toward agreement on a framework of supervisory principles for globally-active financial institutions.

· Improve transparency, particularly reporting and disclosure of derivatives exposures; and development of supervisory tools to better understand and guide risk management processes at internationally-active firms.

· Efforts to reduce settlement risk in foreign exchange markets and to work with securities regulators to implement a disclosure framework for securities settlement systems.

The development and implementation of these proposals is being undertaken by the competent groups of supervisory and regulatory authorities --the Basle Committee, IOSCO, the BIS Committee on Payments and Settlements Systems, the International Association of Insurance Supervisors, and the Joint Forum (of banking, securities and insurance regulators). The role of the Heads of State and Finance Ministers has been to provide encouragement and some political momentum, rather than to impose a specific design on the regulatory community.

It is critical for the private and public sector to engage in a constructive dialogue as the supervisory framework for global firms evolves. I would like to acknowledge the recent contributions of the Institute of International Finance and the Group of Thirty in this area. There are a number of elements in their studies that are consistent with and supportive of the approach of the regulatory community, including the emphasis on the need to strengthen supervision of globally-active financial institutions, including through a comprehensive assessment of risk; and to improve information sharing between supervisors. The private sector has taken a responsible approach by embarking on these initiatives, which we hope will support the efforts of the regulators in a productive fashion.

The Summit leaders will also endorse an important report of the international implications of electronic money developments. This report by a G-10 working party, comprised of finance ministries, central banks, bank supervisors and law enforcement authorities, outlines a set of key considerations to help guide national approaches to electronic money systems. We succeeded in getting the major markets to appreciate the importance of a balanced approach to this issue that would promote innovation, avoid premature or excessively rigid regulation, and keep the field open for both bank and non-bank potential issuers. Keeping the supervisory system abreast of innovation without constraining innovation will continue to be an important priority.

Looking Forward

These initiatives have a lot of promise. They are designed to help make the system more safe, not to eliminate risk, not to insulate investors or governments or firms from risk or the consequences of bad decisions, and not to extend the supervisory net beyond where it should be extended. They cannot make up for failures of macroeconomic policy. And they cannot substitute for the political will necessary for action by governments.

The test of the success of these initiatives will be easy to measure. It will be evident in how quickly the gap closes between the quality of disclosure by financial institutions in New York and those in Japan and Continental Europe. It will be evident in how accurately the market prices different risks across sovereign issuers and financial institutions. It will be evident in whether supervisory authorities are in fact able to obtain from their counterparts in other countries the information necessary to assess risks to the firm on a comprehensive basis. And it will be evident in how resilient the system proves to be in the face of future shocks that affect markets and countries.

There is some risk that recent events in South East Asia and other countries could lead to a reassessment of the merits of capital account liberalization. The right lesson is that integration of domestic capital markets with global financial markets brings important benefits, but it must be accompanied by sound macroeconomic policies, improved financial market supervision and deeper structural reforms to the domestic economy in order to avoid imbalances that can lead to macroeconomic instability.

As the global economy and global financial markets evolve, official arrangements will have to keep pace to ensure that their benefits are realized and the system stays resilient. We need to focus on making the financial highways safe and fixing the potholes, not imposing limits on innovation or restrictions on integration.